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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
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FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
COMMISSION FILE NO. 1-12109
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DELTA FINANCIAL CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 11-3336165
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1000 WOODBURY ROAD, SUITE 200,
WOODBURY, NEW YORK 11797
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:(516) 364-8500
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE NEW YORK STOCK EXCHANGE
(TITLE OF EACH CLASS) (NAME OF EACH EXCHANGE ON WHICH REGISTERED)
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]
As of March 4, 1999, the aggregate market value of the voting stock held by
non-affiliates of the Registrant, based on the closing price of $5.50, was
approximately $27,101,322.
As of March 31, 1999, the Registrant had 15,358,749 shares of Common Stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III, Items 10, 11, 12 and 13 are incorporated by reference from Delta
Financial Corporation's definitive proxy statement to stockholders which will be
filed with the Securities and Exchange Commission no later than 120 days after
December 31, 1998.
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PART I
ITEM 1. BUSINESS
BUSINESS OVERVIEW
Delta Financial Corporation (the "Company" or "Delta") is a Delaware
corporation which was organized in August 1996. On October 31, 1996, in
connection with its initial public offering, the Company acquired all of the
outstanding common stock of Delta Funding Corporation ("Delta Funding"), a New
York corporation which had been organized on January 8, 1982 to originate, sell,
service and invest in residential first and second mortgages. On November 1,
1996, the Company completed an initial public offering of 4,600,000 shares of
common stock, par value $.01 per share.
Delta Financial Corporation, together with its subsidiaries, is a consumer
finance company that has engaged in originating, acquiring, selling and
servicing non-conforming home equity loans since 1982. Throughout its 17 years
of operating history, Delta has focused on lending to individuals who generally
have impaired or limited credit profiles or higher debt-to-income ratios.
Management believes that these borrowers have largely been unsatisfied by the
more traditional sources of mortgage credit, which underwrite loans to
conventional guidelines established by the Federal National Mortgage
Associations ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
The Company makes loans to these borrowers for such purposes as debt
consolidation, home improvement, mortgage refinancing or education, and these
loans are primarily secured by first mortgages on one- to four-family
residential properties.
Through its wholly-owned subsidiary, Delta Funding, the Company originates
home equity loans indirectly through licensed mortgage brokers and other real
estate professionals who submit loan applications on behalf of borrowers
("Brokered Loans") and also purchases loans from mortgage bankers and smaller
financial institutions that satisfy Delta's underwriting guidelines
("Correspondent Loans"). Delta Funding Corporation currently originates and
purchases the majority of its loans in 24 states, through its network of
approximately 1,400 brokers and correspondents.
In February 1997, to broaden its origination sources and to expand its
geographic presence, the Company acquired two related retail originators of home
equity loans, Fidelity Mortgage Inc., based in Cincinnati, Ohio, and Fidelity
Mortgage (Florida), Inc., based in West Palm Beach, Florida, and subsequently
merged the two companies into Fidelity Mortgage Inc. ("Fidelity Mortgage").
Fidelity Mortgage develops retail loan leads primarily through its telemarketing
system and its network of 15 retail offices located in Florida (3), Georgia,
Illinois, Indiana, Missouri, North Carolina, Ohio (4), Pennsylvania (2) and
Tennessee.
In May 1998, the Company and MCAP Mortgage Corporation and MCAP Service
Corporation entered into a strategic alliance to originate, underwrite and
service non-conforming mortgage loans in Canada. In February 1999, the Company
decided to close its Canadian business to focus exclusively on its U.S.-based
business.
For the year ended December 31, 1998, the Company originated and purchased
approximately $1.73 billion of loans, of which approximately $836 million were
originated through its network of brokers, $653 million were purchased from its
network of correspondents, $234 million were originated through its Fidelity
Mortgage retail network and $5 million were originated through its Canadian
brokered network.
Substantially all of the loans originated and purchased by the Company were
sold in securitizations in which the loans were transferred to a trust, which
had raised the cash payment to purchase the loans through the sale of
asset-backed pass-through securities. For the year ended December 31, 1998,
Delta sold a total of $1.72 billion of loans through four real estate mortgage
investment conduit ("REMIC") securitizations. Each of these four securitizations
was credit-enhanced, by an insurance policy provided through a monoline
insurance company and/or a senior-subordinated structure, to receive ratings of
Aaa from Moody's Investors Service, Inc. ("Moody's") and AAA from Standard &
Poor's Ratings Group, a division of The McGraw-Hill Companies, Inc. ("S&P"). The
Company sells loans through securitizations to improve its operating leverage
and liquidity, to minimize financing costs and to reduce its exposure to
fluctuations in interest rates.
The majority of the Company's revenues and cash flows result from its
securitizations and servicing of home-equity loans that it has originated or
purchased. In a securitization, the Company sells the loans to a trust for a
cash
1
payment while retaining (1) the right to service the loans, and receive a
contractual servicing fee and (2) interest-only and residual certificates in the
trust, entitling the Company to receive any "Excess Servicing" income,
consisting of any remaining cash flows collected by the trust from principal and
interest payments on its loans after the trust has first paid (a) all principal
and interest required to be passed through to holders of the trust's securities,
(b) all contractual servicing fees, and (c) other recurring fees and costs of
administering the trust. Upon securitizing a pool of loans, the Company
recognizes a gain on sale of loans ("net gain on sale of mortgage loans") equal
to the difference between cash received from the trust when it sells
asset-backed pass-through certificates and the investment in the loans remaining
after allocating portions of that investment to record the value of servicing
rights and interest-only and residual certificates received in the
securitization. The majority of the net gain on the sale of mortgage loans
results from, and is initially realized in the form of, the retention of the
mortgage servicing rights and interest-only and residual certificates. The
servicing rights and interest-only and residual certificates are each recorded
based on their fair values, estimated based on a discount rate which management
believes reflects the rate market participants would utilize in purchasing
similar servicing rights and interest-only and residual certificates, and the
stated terms of the transferred loans adjusted for estimates of future
prepayment rates and defaults among those loans. If actual prepayments and/or
defaults exceed the Company's estimates, the future cash flows from the
servicing rights and interest-only and residual certificates would be negatively
affected. (See "Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Accounting Considerations.")
Although the Company recognizes income from the securitization of loans at
the time of the securitization, the Company receives cash flows from the
securitization, in particular the retained servicing rights and interest-only
and residual certificates, over the life of the transferred loans.
The Company services substantially all of the loans it has originated or
purchased, including all of the loans sold through securitizations. As of
December 31, 1998, the Company has a loan servicing portfolio of $2.95 billion.
The Company begins to receive cash flows from monthly contractual servicing
fees in the month following a securitization. The Company's servicing fees range
from 0.50% to 0.65% per annum of the outstanding balance of the loans being
serviced.
The Company typically begins to receive cash flows from the interest-only and
residual certificates retained upon securitization approximately eight to
fifteen months after a securitization, with the specific timing depending on the
structure and performance of the securitization. Initially, securitization
trusts utilize the Excess Servicing cash flows to make additional payments of
principal on the pass-through certificates in order to establish a spread
between the principal amount of the trust's outstanding loans and the amount of
outstanding pass-through certificates. Once a spread of between 2% and 3% of the
initial securitization principal (the "overcollateralization limit") is
established, the Excess Servicing cash flows are distributed to Delta as the
holder of the interest-only and residual certificates. The Company utilizes the
more conservative "cash-out" method of valuing future cash flows from residual
certificates (See "Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations - Certain Accounting Considerations.").
In addition to the income and cash flows earned from the Company's
securitizations, the Company also earns income and generates cash flows from
whole loan sales, the net interest spread earned on loans while they are held
for sale, and from loan origination fees on Brokered Loans and retail loans.
The Company's business strategy is to increase the size of its servicing
portfolio and focus on its more profitable broker and retail channels of
originations (instead of correspondent purchases) by (1) continuing to provide
top quality service to its network of brokers, correspondents and retail
clients, (2) maintaining its underwriting standards, (3) further penetrating its
established and recently-entered markets and expanding into new geographic
markets, (4) expanding its retail origination capabilities, (5) leveraging and
continuing its investment in information and processing technologies, and (6)
strengthening its loan production capabilities through acquisitions.
2
HOME EQUITY LENDING OPERATIONS
OVERVIEW
Delta's consumer finance activities consist of originating, acquiring,
selling and servicing non-conforming mortgage loans. These loans are primarily
secured by first mortgages on one- to four-family residences. Once loan
applications have been received, the underwriting process completed and the
loans funded or purchased, Delta typically packages the loans in a portfolio and
sells the loan portfolio through a securitization. Delta retains the right to
service the loans that it securitizes.
The Company provides its customers with an array of loan products designed to
meet their needs. The Company uses a risk-based pricing strategy and has
developed products for various risk categories. Historically, the Company
offered fixed-rate loan products and, to date, the majority of the Company's
loan production is fixed-rate. As the Company has expanded geographically, it
has expanded its product offerings to include adjustable-rate mortgages and
fixed/adjustable-rate mortgages. However, during the fourth quarter of 1998, the
Company has virtually eliminated originations of its six-month LIBOR (London
Inter Bank Offered Rate) adjustable rate mortgages, which are less profitable
and more prepayment sensitive.
Historically, the Company conducted substantially all of its broker and
correspondent lending operations out of its Woodbury, New York headquarters.
Recently, however, the Company has been opening regional branch offices, which
include loan processing, underwriting and business development functions, to
bring it in closer contact with brokers and correspondents, enhance customer
service and underscore Delta's long-term commitment in newer regions. Typically,
these offices are staffed with a combination of experienced Delta personnel who
oversee implementation of Delta's operating methods and local employees with
established relationships in, and specific knowledge of, the local market.
Currently, the Company's Southeast regional office (Atlanta, Georgia) and West
Coast regional office (Anaheim, California) are the only "full service" regional
branches with full underwriting authority. Delta's Midwest (Chicago, Illinois),
New England (Warwick, Rhode Island) and Southeast (Deerfield Beach, Florida)
regional offices are "full processing" regional branches, for which final
underwriting approval is required from the Woodbury, New York headquarters for
all mortgage loans. As these branches mature and demonstrate their ability to
meet Delta's operating standards, the Company intends to strengthen their
operations by delegating full underwriting authority. Fidelity Mortgage retail
loans are underwritten by two operational offices (Cincinnati, Ohio and West
Palm Beach, Florida), which have full underwriting authority.
LOAN ORIGINATION AND PURCHASES
The Company increased its loan originations and purchases by 38% to $1.73
billion in 1998 from $1.25 billion in 1997, an increase of 90% over 1996
production of $659 million.
The following tables highlight several important trends for the Company,
including: (1) increased overall loan production, (2) a shift to higher credit
quality loans, (3) a de-emphasis of correspondent loan purchases and (4) the
maintenance of geographic diversity.
3
The following table shows the channels of the Company's loan originations and
purchases for the years shown:
YEAR ENDED DECEMBER 31,
1998 1997 1996
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(DOLLARS IN THOUSANDS)
Broker:
Principal balance...................... $ 841,079 $ 481,586 $ 321,733
Average principal balance per loan..... $ 92 $ 87 $ 85
Combined weighted average initial loan-
to-value ratio(1).................... 72.8% 69.9% 67.7%
Weighted average interest rate......... 10.0% 10.8% 11.1%
Correspondent:
Principal balance...................... $ 652,503 $ 632,639 $ 337,033
Average principal balance per loan..... $ 82 $ 77 $ 73
Combined weighted average initial loan-
to-value ratio(1).................... 73.9% 72.8% 69.8%
Weighted average interest rate......... 10.8% 11.3% 11.7%
Retail:
Principal balance...................... $ 234,011 $ 140,386 $ n/a
Average principal balance per loan..... $ 75 $ 69 $ n/a
Combined weighted average initial loan-
to-value ratio(1).................... 79.9% 80.1% n/a
Weighted average interest rate......... 9.4% 10.1% n/a
Total loan purchases and originations:
Principal balance...................... $1,727,593 $1,254,611 $ 658,766
Average principal balance per loan..... $ 85 $ 80 $ 78
Combined weighted average initial loan-
to-value ratio(1).................... 74.2% 72.5% 68.8%
Weighted average interest rate......... 10.2% 11.0% 11.4%
Percentage of loans secured by:
First mortgage......................... 95.5% 94.0% 93.8%
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(1)The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage property
at origination. The weighted average initial loan-to-value ratio of a loan
secured by a second mortgage is determined by taking the sum of the loan
secured by the first and second mortgages and dividing by the lesser of the
purchase price or the appraised value of the mortgage property at
origination.
4
The following table shows the channels of loan originations and purchases on
a quarterly basis for 1998:
THREE MONTHS ENDED
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DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31,
1998 1998 1998 1998
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(DOLLARS IN THOUSANDS)
Broker:
Number of Brokered Loans...................... 2,711 2,464 2,140 1,798
Principal balance............................. $243,721 $ 231,475 $ 198,327 $167,556
Average principal balance per loan............ $ 90 $ 94 $ 93 $ 93
Combined weighted average initial loan-
to-value ratio(1).......................... 73.1% 73.4% 72.3% 71.9%
Weighted average interest rate................ 10.0% 9.9% 10.0% 10.1%
Correspondent:
Number of Correspondent Loans................. 1,369 2,105 2,404 2,110
Principal balance............................. $108,266 $177,753 $199,057 $167,427
Average principal balance per loan............ $ 79 $ 84 $ 83 $ 79
Combined weighted average initial loan-
to-value ratio(1)........................... 73.5% 74.3% 74.0% 73.8%
Weighted average interest rate................ 10.8% 10.8% 10.7% 11.0%
Retail:
Number of retail loans........................ 883 870 674 714
Principal balance............................. $ 63,049 $ 66,974 $ 52,191 $ 51,797
Average principal balance per loan............ $ 71 $ 77 $ 77 $ 73
Combined weighted average initial loan-
to-value ratio(1)........................... 79.1% 80.3% 80.2% 80.2%
Weighted average interest rate................ 9.4% 9.2% 9.3% 9.6%
Total loan purchases and originations:
Total number of loans......................... 4,963 5,439 5,218 4,622
Principal balance............................. $415,036 $476,202 $449,575 $386,780
Average principal balance per loan............ $ 84 $ 88 $ 86 $ 84
Combined weighted average initial loan-
to-value ratio(1)........................... 74.1% 74.7% 74.0% 73.8%
Weighted average interest rate................ 10.1% 10.1% 10.2% 10.4%
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(1) The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage
property at origination. The weighted average initial loan-to-value ratio
of a loan secured by a second mortgage is determined by taking the sum of
the loan secured by the first and second mortgages and dividing by the
lesser of the purchase price or the appraised value of the mortgage
property at origination.
5
The following table shows lien position, weighted average interest rates and
loan-to-value ratios for the years shown:
YEAR ENDED DECEMBER 31,
-----------------------
1998 1997 1996
---- ---- ----
First mortgage:
Percentage of total purchases and originations... 95.5% 94.0% 93.8%
Weighted average interest rate................... 10.2% 11.0% 11.4%
Weighted average initial loan-to-value ratio(1).. 74.3% 72.6% 68.9%
Second mortgage:
Percentage of total purchases and originations... 4.5% 6.0% 6.2%
Weighted average interest rate................... 10.5% 11.3% 11.5%
Weighted average initial loan-to-value ratio(1).. 70.6% 71.1% 66.6%
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(1) The weighted average initial loan-to-value ratio of a loan secured by a
first mortgage is determined by dividing the amount of the loan by the
lesser of the purchase price or the appraised value of the mortgage
property at origination. The weighted average initial loan-to-value ratio
of a loan secured by a second mortgage is determined by taking the sum of
the loan secured by the first and second mortgages and dividing by the
lesser of the purchase price or the appraised value of the mortgage
property at origination.
The following table shows the geographic distribution of loan purchases and
originations for the periods indicated:
YEAR ENDED DECEMBER 31,
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1998 1997 1996
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REGION PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE PERCENTAGE DOLLAR VALUE
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(DOLLARS IN MILLIONS)
NY, NJ and PA............. 55.0% $949.3 52.9% $664.3 66.3% $436.9
Midwest................... 19.7 340.3 21.6 270.9 14.9 98.3
Southeast................. 9.3 161.0 9.7 121.4 4.2 27.6
New England............... 7.3 125.8 7.1 89.3 5.9 38.6
Mid-Atlantic*............. 6.9 119.1 6.5 81.3 6.6 43.7
West...................... 1.5 26.6 2.2 27.3 2.1 13.7
Canada.................... 0.3 5.5 n/a n/a n/a n/a
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* Excluding New York (NY), New Jersey (NJ) and Pennsylvania (PA).
BROKER AND CORRESPONDENT MARKETING. Throughout its history Delta has been
successful in establishing and maintaining relationships with brokers and
correspondents offering non-conforming mortgage products to their clientele.
Management believes that this success is primarily attributable to the quality
of service the Company provides to its network of brokers and correspondents.
Delta typically initiates contact with a broker or correspondent through
Delta's Business Development Department, comprised of 33 business development
representatives as of December 31, 1998, supervised by a senior officer with
over ten years of sales and marketing experience in the industry. The Company
usually hires business development representatives who have contacts with
brokers and correspondents that originate nonconforming mortgage loans within
their geographic territory. The business development representatives are
responsible for developing and maintaining the Company's broker and
correspondent networks within their geographic territory by frequently visiting
the broker or correspondent, communicating the Company's underwriting
guidelines, disseminating new product information and pricing changes, and by
demonstrating a continuing commitment to understanding the needs of the
customer. The business development representatives attend industry trade shows
and inform Delta about the products and pricing being offered by competitors and
new market entrants. This information assists Delta in refining its programs and
product offerings in order to remain competitive. Business development
representatives are compensated with a base salary and commissions based on the
volume of loans originated or purchased as a result of their efforts.
6
APPROVAL PROCESS. Before a broker or correspondent becomes part of Delta's
network, it must go through an approval process. Once approved, brokers and
correspondents may immediately begin submitting applications and/or loans to
Delta.
To be approved, a broker must demonstrate that it is properly licensed and
registered in the state in which it seeks to transact business, submit to a
credit check and sign a standard broker agreement with Delta. A correspondent is
eligible to submit loans to Delta for purchase only after an extensive
investigation of the prospective correspondent's lending operations including an
on-site visit, a review of the correspondent's financial statements for the
prior two years, a credit report on the correspondent, a review of sample loan
documentation and business references provided by the correspondent. Once
approved, Delta requires that each correspondent sign an Agreement of Purchase
and Sale in which the correspondent makes representations and warranties
governing both the mechanics of doing business with Delta and the quality of the
loan submissions themselves. Delta also performs an annual review of each
approved correspondent in order to ensure continued compliance with legal
requirements and that lending operations and financial information continue to
meet Delta's standards. In addition, Delta regularly reviews the performance of
loans originated or purchased through its brokers or correspondents.
BROKERED LOANS. For the year ended December 31, 1998, the Company's broker
network accounted for $841.1 million, or 49%, of Delta's loan purchases and
originations compared to $481.6 million, or 38%, of Delta's loan purchases and
originations for the year ended December 31, 1997 and $321.7 million, or 49%, of
Delta's loan purchases and originations for the year ended December 31, 1996. No
single broker contributed more than 5.2%, 5.8% or 11.4% of Delta's total
purchases or originations in the years ended December 31, 1998, 1997 and 1996,
respectively.
Once approved, a broker may submit loan applications for prospective
borrowers to Delta. To process broker submissions, Delta's broker originations
area is organized into teams, each consisting of loan officers and processors,
which are generally assigned to specific brokers. Because Delta operates in a
highly competitive environment where brokers may submit the same loan
application to several prospective lenders simultaneously, Delta strives to
provide brokers with a rapid and informed response. Loan officers analyze the
application and provide the broker with a preliminary approval, subject to final
underwriting approval, or a denial, typically within one business day. If the
application is approved by the Company's underwriters, a "conditional approval"
will be issued to the broker with a list of specific conditions to be met and
additional documents to be supplied prior to funding the loan. The loan officer
and processor team will then work directly with the submitting broker to collect
the requested information and meet all underwriting conditions. In most cases,
the Company funds loans within 14 to 21 days after preliminary approval of the
loan application. In the case of a denial, Delta will make all reasonable
attempts to ensure that there is no missing information concerning the borrower
or the application that might change the decision on the loan.
The Company compensates its loan officers, who on a loan-by-loan basis are
the primary relationship contacts with the brokers, predominantly on a
commission basis. All of the Company's loan officers must complete an extensive
9- to 12-month training program to attain the level of knowledge and experience
integral to the Company's commitment to providing the highest quality service
for brokers. Management believes that by maintaining an efficient, trained and
experienced staff, it has addressed three central factors which determine where
a broker sends its business: (i) the speed with which a lender closes loans,
(ii) the lender's knowledge concerning the broker and his business and (iii) the
support a lender provides.
CORRESPONDENT LOANS. For the year ended December 31, 1998, Delta's
correspondent network accounted for $652.5 million, or 37%, of Delta's loans
purchases and originations compared to $632.6 million, or 51%, of Delta's loan
purchases and originations for the year ended December 31, 1997 and $337.0
million, or 51%, of Delta's loan purchases and originations for the year ended
December 31, 1996. No single correspondent contributed more than 3.8%, 6.5% or
6.3% of Delta's total loan purchases and originations in 1998, 1997 or 1996,
respectively.
An approved correspondent is a licensed mortgage banker or savings and loan
who sells loans to Delta which the correspondent has originated, processed,
closed and funded in its own name in conformity with Delta's underwriting
standards. The loans are sold to Delta either on an individual flow basis or in
block sales. When selling on a flow basis, a correspondent typically will seek a
pre-approval from Delta prior to closing the loan, and Delta will approve the
loan based on a partial or full credit package, stipulating any items needed to
complete the
7
package in adherence to Delta's underwriting guidelines. On a block sale, a
correspondent will offer a group of loans, generally loans that have not been
pre-approved, to Delta for sale, and Delta will purchase those loans in the
block that meet Delta's underwriting criteria.
RETAIL LOANS. The Company acquired its Fidelity Mortgage retail origination
network in 1997. For the year ended December 31, 1998, this channel accounted
for $234.0 million, or 14%, of Delta's loan purchases and originations compared
to $140 million, or 11%, of Delta's loan purchases and originations in 1997.
Through its marketing efforts, Fidelity Mortgage is able to identify, locate and
focus on individuals who, based on historic customer profiles, are likely
customers for the Company's products. Fidelity Mortgage's telemarketing
representatives identify interested customers and refer these customers to loan
officers at the retail branch offices who then proceed to determine the
applicant's qualifications for the Company's loan products, negotiate loan terms
with the borrower and process the loan through completion.
LOAN UNDERWRITING
All of Delta's brokers, correspondents and retail offices are provided with
the Company's underwriting guidelines. Loan applications received from brokers
and correspondents or retail customers are classified according to certain
characteristics, including but not limited to: credit history of the applicant,
ability to pay, condition and location of the collateral, loan-to-value ratio
and general stability of the applicant in terms of employment history and time
in residence. Delta has established classifications with respect to the credit
profile of the applicant, and each loan is placed into one of four letter
ratings "A" through "D", with subratings within those categories. Terms of loans
made by Delta, as well as maximum loan-to-value ratios and debt-to-income
ratios, vary depending on the applicant's classification. Loan applicants with
less favorable credit ratings are generally offered loans with higher interest
rates and lower loan-to-value ratios than applicants with more favorable credit
ratings. The general criteria used by Delta's underwriting staff in classifying
loan applicants are set forth in the following table:
8
DELTA'S UNDERWRITING CRITERIA
"A" RISK "B" RISK "C" RISK "D" RISK
EXCELLENT CREDIT
HISTORY GOOD OVERALL CREDIT GOOD TO FAIR CREDIT FAIR TO POOR CREDIT
---------------- ------------------- ------------------- -------------------
Existing mortgage
history............... Current at Current at Up to 30 days 90 days delinquent
application time application time delinquent at or more
and a maximum of and a maximum of application time
two 30-day late four 30-day late and a maximum of
payments in the payments in the four 30-day late
last 12 months last 12 months payments, two
60-day late
payments and
one 90-day late
payment in the
last 12 months
Other credit............ Minor 30 day Some slow pays Slow pays, some Not a factor.
late items allowed allowed but open delinquencies Derogatory
with a letter of majority of credit allowed. Isolated credit must
explanation; no and installment charge-offs, collec- be paid with
open collection debt paid as agreed. tion accounts or proceeds. Must
accounts, charge- Small isolated judgments case- demonstrate
offs, judgments charge-offs, collec- by-case ability to pay
tion accounts or
judgments case-
by-case
Bankruptcy filings...... Discharged more Discharged more Discharged more May be open at
than three years than two years than one year closing, but must
prior to closing prior to closing prior to closing be paid off with
and excellent and excellent and good proceeds
reestablished reestablished reestablished
credit credit credit
Debt service to
Income ratio.......... Generally 45% Generally 50% Generally 55% Generally 55%
or less or less or less or less
Maximum loan-to-value
ratio:
Owner-occupied........ Generally 80% Generally 80% Generally 75% Generally 65%
(up to 90%*) for (up to 85%*) for (up to 80%*) for (up to 70%*) for
a one- to four- a one- to four- a one- to four- a one- to four-
family residence family residence family residence family residence
Non-owner
occupied............ Generally 70% Generally 70% Generally 65% Generally 55%
(up to 80%*) for (up to 80%*) for (up to 75%*) for (up to 60%*) for
a one- to four- a one- to four a one- to four- a one- to four-
family residence family residence family residence family residence
Employment.............. Minimum 2 years Minimum 2 years No minimum No minimum
employment in the employment in the required required
same field same field
------------
* On an exception basis
Delta uses the foregoing categories and characteristics as guidelines only.
On a case-by-case basis, the Company may determine that the prospective borrower
warrants an exception, if sufficient compensating factors exist. Examples of
such compensating factors are a low loan-to-value ratio, a low debt ratio,
long-term stability of employment and/or residence, excellent payment history on
past mortgages or a significant reduction in monthly housing expenses.
9
The following table sets forth certain information with respect to Delta's
originations and purchases of first and second mortgage loans by borrower
classification, along with weighted average coupons, for the periods shown and
highlights the improved credit quality of the Company's originations and
purchases.
(DOLLARS IN THOUSANDS)
PERCENT
YEAR CREDIT TOTAL OF TOTAL WAC(1) WLTV(2)
- - ---- ---- ----- -------- ------ ------
1998 A $ 990,988 57.3% 9.7% 77.0%
B 425,056 24.6 10.4 73.2
C 248,488 14.4 11.3 69.0
D 63,061 3.7 12.7 57.2
---------- ----- ---- ----
Totals $1,727,593 100.0% 10.2% 74.2%
========== ===== ==== ====
1997 A $ 617,724 49.2% 10.4% 76.2%
B 349,166 27.8 11.0 72.0
C 222,854 17.8 11.8 67.7
D 64,867 5.2 13.2 56.7
---------- ----- ---- ----
Totals $1,254,611 100.0% 11.0% 72.5%
========== ===== ==== ====
1996 A $ 219,550 33.4% 10.6% 72.1%
B 234,589 35.6 11.2 70.2
C 156,296 23.7 12.2 65.7
D 48,331 7.3 13.8 56.9
---------- ----- ---- ----
Totals $ 658,766 100.0% 11.4% 68.8%
========== ===== ==== ====
- - ------------------
(1) Weighted Average Coupon ("WAC").
(2) Weighted Average Initial Loan-to-Value Ratio ("WLTV").
Delta employs experienced nonconforming mortgage loan credit underwriters to
scrutinize the applicant's credit profile and to evaluate whether an impaired
credit history is a result of adverse circumstances or a continuing inability or
unwillingness to meet credit obligations in a timely manner. Personal
circumstances including divorce, family illnesses or deaths and temporary job
loss due to layoffs and corporate downsizing will often impair an applicant's
credit record. Assessment of an applicant's ability and willingness to pay is
one of the principal elements that distinguishes Delta's lending practices from
methods employed by traditional lenders, such as savings and loans and
commercial banks. All lenders utilize debt ratios and loan-to-value ratios in
the approval process, however, in contrast to Delta, many lenders simply use
software packages to score an applicant for loan approval and fund the loan
after auditing the data provided by the borrower.
Delta had 97 underwriters on staff as of December 31, 1998, and its senior
underwriters have an average of more than nine years of non-conforming
underwriting experience. Delta does not delegate underwriting authority to any
broker or correspondent. Delta's Underwriting Department functions independently
of its Business Development and Mortgage Origination Departments and does not
report to any individual directly involved in the origination process. No
underwriter at Delta is compensated on an incentive or commission basis.
Delta has instituted underwriting checks and balances designed to ensure that
every loan is reviewed and approved by a minimum of two underwriters, with
certain higher loan amounts requiring a third approval. Management believes that
by requiring each file be seen by a minimum of two underwriters, a high degree
of accuracy and quality control is ensured throughout the underwriting process.
10
Delta's underwriting of every loan submitted consists not only of a thorough
review of credit and ability to repay, but also (i) a separate appraisal review
conducted by Delta's Appraisal Review Department and (ii) a full compliance
review to ensure that all documents have been properly prepared, all applicable
disclosures have been given in a timely fashion, proper compliance with all
federal and state regulations, the existence of title insurance insuring Delta's
interest as mortgagee and evidence of adequate homeowner's insurance naming
Delta as an additional insured party. Appraisals are performed by third party,
fee-based appraisers or by the Company's staff appraisers and generally conform
to current FNMA/FHLMC secondary market requirements for residential property
appraisals. Each such appraisal includes, among other things, an inspection of
the exterior of the subject property and, where available, data from sales
within the preceding 12 months of similar properties within the same general
location as the subject property.
Delta performs a thorough appraisal review on each loan prior to closing or
prior to purchasing. While Delta recognizes that the general practice by
conventional mortgage lenders is to perform only drive-by appraisals after
closings, management believes this practice does not provide sufficient
protection. In addition to reviewing each appraisal for accuracy, the Company
accesses other sources to validate sales used in the appraisal to determine
market value. These sources include: interfacing with Multiple Listing Services,
Comps, Inc. and other similar databases to access current sales and listing
information; and other sources for verification, including broker price opinions
and market analyses by local real estate agents.
Post closing, in addition to its normal due diligence, the Company selects
one out of every ten appraisals and performs its own drive-by appraisal. This
additional step helps to give the Company an added degree of comfort with
respect to appraisers with which the Company has had limited experience. Delta
actively tracks all appraisers from which it accepts appraisals for quality
control purposes and does not accept work from appraisers who have not conformed
to its review standards.
The Company performs a post-funding quality control review to monitor and
evaluate the Company's loan origination policies and procedures. At least 10% of
all loan originations and purchases are subjected to a full quality control
re-underwriting and review, the results of which are reported to senior
management. Discrepancies noted by this review are analyzed and corrective
actions are instituted. However, to date, this important quality control process
has not revealed material deficiencies in the Company's loan underwriting
procedures. A typical quality control review currently includes: (a) obtaining a
new drive-by appraisal for each property; (b) obtaining a new credit report from
a different credit report agency; (c) reviewing loan applications for
completeness, signatures, and for consistency with other processing documents;
(d) obtaining new written verifications of income and employment; (e) obtaining
new written verification of mortgage to re-verify any outstanding mortgages; and
(f) analyzing the underwriting and program selection decisions. The quality
control process is updated from time to time as the Company's policies and
procedures change.
LOAN SALES
Delta sells substantially all the loans it originates or purchases through
one of two methods: (i) securitizations, which involve the private placement or
public offering by a securitization trust of asset-backed pass-through
securities, and (ii) whole loan sales, which include the sale of blocks of
individual loans to institutional or individual investors. Since 1991, the
Company has sold more than $4.2 billion of the loans it originated or purchased
through securitization and $63 million through whole loan sales.
SECURITIZATIONS. During 1998, Delta completed four securitizations totaling
$1.72 billion. The following table sets forth certain information with respect
to Delta's securitizations (all of which have been rated AAA/Aaa by S&P and
Moody's, respectively) by offering size, which includes prefunded amounts,
weighted average pass-through rate and type of credit enhancement.
11
INITIAL
OFFERING SIZE WEIGHTED AVERAGE CREDIT
SECURITIZATION COMPLETED (MILLIONS) PASS-THROUGH RATE ENHANCEMENT
- - -------------- --------- ------------- ----------------- -----------
1998-1............ 03/31/98 $400.0 7.24% Senior/Sub Structure
1998-2............ 06/29/98 $445.0 7.06% Senior/Sub Structure
1998-3............ 09/29/98 $475.0 7.50% Bond Insured
1998-4............ 12/23/98 $400.0 7.97% Hybrid *
- - ------------------
* Senior/Sub Structure and Bond Insured
When Delta securitizes loans, it sells a portfolio of loans to a trust (a
"Home Equity Loan Trust") for a cash payment and the Home Equity Loan Trust
sells various classes of pass-through certificates representing undivided
ownership interests in such Home Equity Loan Trust. As servicer for each
securitization, the Company collects and remits principal and interest payments
to the appropriate Home Equity Loan Trust which, in turn, passes through such
payments to certificateholders. For each of the 1998 securitizations, Delta
retained 100% of the interests in the residual certificates while selling the
interest-only certificates for cash. Management contemplates continuing to
retain residual certificates in the future as long as, in management's opinion,
this practice maximizes earnings while remaining within the Company's liquidity
requirements.
Each Home Equity Loan Trust has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a senior-subordinated
securitization structure, which insures the timely payment of interest and the
ultimate payment of principal of the credit-enhanced investor certificate. In
"senior-subordinated" structures, the senior certificate holders are protected
from losses by subordinated certificates, which absorb any such losses first. In
addition to such credit enhancement, the Excess Servicing amounts are initially
applied as additional payments of principal for the investor certificates,
thereby accelerating amortization of the investor certificates relative to the
amortization of the loans and creating overcollateralization. Once the
overcollateralization limit is reached, the use of Excess Servicing to create
overcollateralization stops unless it subsequently becomes necessary to obtain
or maintain required overcollateralization limits. Overcollateralization is
intended to create a source of cash (the "extra" payments on the loans) to
absorb losses prior to making a claim on the financial guaranty insurance policy
or the subordinated certificates.
Whole Loan Sales Without Recourse. From time to time, the Company has found
that it can receive better execution by selling certain mortgage loans on a
whole loan, non-recourse basis, without retaining servicing rights, generally in
private transactions to institutional or individual investors. The Company
recognizes a gain or loss when it sells loans on a whole loan basis equal to the
difference between the cash proceeds received for the loans and the Company's
investment in the loans, including any unamortized loan origination fees and
costs.
For the years ended December 31, 1998, 1997 and 1996, Delta sold $8.7
million, $0 million and $15.3 million of loans, respectively, on a whole loan,
non-recourse basis, which represents 0.5%, 0.0% and 2.3%, respectively, of its
originations and purchases.
LOAN SERVICING AND COLLECTIONS
Delta has been servicing loans since its inception in 1982, and Delta has
serviced or is servicing substantially all of the loans that it has originated
or purchased. Servicing involves, among other things, collecting payments when
due, remitting payments of principal and interest and furnishing reports to the
current owners of the loans and enforcing such owners' rights with respect to
the loans, including, recovering any delinquent payments, instituting
foreclosure proceedings and liquidating underlying collateral. The Company
receives a servicing fee for servicing residential mortgage loans of 0.50% per
annum (0.65% per annum on all securitizations completed before and including the
1996-1 securitization) on the declining principal balance of all loans sold
through securitization and on the declining principal balance of the loans sold
to investors on a recourse basis. These servicing fees are collected by the
Company out of the monthly mortgage payments. Management believes that servicing
the Company's own portfolio enhances certain operating efficiencies and provides
an additional and profitable revenue
12
stream that is less cyclical than its primary business of originating and
purchasing loans. As of December 31, 1998, Delta had a loan servicing portfolio
of $2.95 billion.
Delta services all loans out of its headquarters in Woodbury, New York,
utilizing a leading in-house loan servicing system ("LSAMS") which it
implemented in 1995. LSAMS has provided Delta with considerably more flexibility
to adapt the system to Delta's specific needs as a nonconforming home equity
lender. As such, Delta has achieved significant cost efficiencies by automating
a substantial number of previously manual servicing procedures and functions
since its conversion to LSAMS on July 1, 1995. Management believes that even
greater cost efficiencies can be realized through further automation provided by
LSAMS.
At the same time that it upgraded its primary servicing system, Delta
purchased a default management sub-servicing system with separate "modules" for
foreclosure, bankruptcy, and REO to provide it with the ability to more
efficiently monitor and service loans in default. These sub-servicing modules
provide detailed tracking of all key events in foreclosure and bankruptcy on a
loan-by-loan and portfolio-wide basis; the ability to track and account for all
pre- and post-petition payments received in bankruptcy from the borrower and/or
trustee; and the ability to monitor, market and account for all aspects
necessary to liquidate an REO property after foreclosure. Additionally, Delta's
Management Information Systems Department has created a market value analysis
program to run with LSAMS, which provides Delta with the ability to monitor its
equity position on a loan-by-loan and/or portfolio-wide basis. These features
have led to cost savings through greater automation and system upgrades and have
helped mitigate loan losses as the Servicing Department has been able to
identify problem loans earlier, thus allowing for earlier corrective action.
Delta's collections policy is designed to identify payment problems
sufficiently early to permit Delta to quickly address delinquency problems and,
when necessary, to act to preserve equity in a pre-foreclosure property. Delta
believes that these policies, combined with the experience level of independent
appraisers engaged by Delta, help to reduce the incidence of charge-offs of a
first or second mortgage loan.
Centralized controls and standards have been established by Delta for the
servicing and collection of mortgage loans in its portfolio. Delta revises such
policies and procedures from time to time in connection with changing economic
and market conditions and changing legal and regulatory requirements.
Borrowers are billed on a monthly basis in advance of the due date.
Collection procedures commence upon identification of a past due account by
Delta's automated servicing system. If timely payment is not received,
proprietary software automatically places loans in the Unison/Davox predictive
dialer auto-queue downloaded from the LSAMS servicing system and collection
procedures are generally initiated on the day immediately following the payment
due date for chronic late payers, or the day immediately following the end of
the grace period for those borrowers who usually pay within the grace period, or
shortly thereafter. The Unison/Davox predictive dialer, through LSAMS,
automatically queues up each loan in the assigned collector's "auto-queue" daily
based upon a particular borrower's payment history over the prior three months.
The account remains in the queue unless and until a payment is received, at
which point LSAMS automatically removes the loan from that collector's auto
queue until the next month's payment is due and/or becomes delinquent.
When a loan appears in a collector's auto queue, a collector will telephone
to remind the borrower that a payment is due. Follow-up telephone contacts are
attempted until the account is current or other payment arrangements have been
made. Standard form letters are utilized when attempts to reach the borrower by
telephone fail and/or, in some circumstances, to supplement the phone contacts.
During the delinquency period, the collector will continue to contact the
borrower. Company collectors have computer access to telephone numbers, payment
histories, loan information and all past collection notes. All collection
activity, including the date collection letters were sent and detailed notes on
the substance of each collection telephone call, is entered into a permanent
collection history for each account on LSAMS. Additional guidance with the
collection process is derived through frequent communication with Delta's senior
management.
For those loans in which collection and initial loss mitigation efforts have
been exhausted without success, the loss mitigation team recommends the loans be
sent to foreclosure at one of the Foreclosure Committee Meetings held each
month. At each such committee meeting, the loss mitigation administrator and
team leader meet with the Servicing Manager, the Default Management Manager and
a member of the Executive Department, to determine
13
whether foreclosure proceedings are appropriate, based upon their analysis of
all relevant factors, including a market value analysis, reason for default and
efforts by the borrower to cure the default.
Regulations and practices regarding the liquidation of properties (e.g.,
foreclosure) and the rights of a borrower in default vary greatly from state to
state. As such, all foreclosures are assigned to outside counsel, located in the
same state as the secured property. Bankruptcies filed by borrowers are
similarly assigned to appropriate local counsel. All aspects of foreclosures and
bankruptcies are closely monitored by Delta through its sub-servicing loan
system described above and through monthly status reports from attorneys.
Prior to foreclosure sale, Delta performs an in-depth market value analysis
on all defaulted loans. This analysis includes: (i) a current valuation of the
property obtained through at least two drive-by appraisals or broker price
opinions conducted by an independent appraiser and/or broker from a network of
real estate brokers, complete with a description of the property, recent list
prices of comparable properties, recent closed comparables, estimated marketing
time, estimated required or suggested repairs and an estimate of the sales
price; (ii) an evaluation of the amount owed, if any, for real estate taxes;
(iii) an evaluation of the amount owed, if any, to a senior mortgagee; and (iv)
estimated carrying costs, broker's fee, repair costs and other related costs
associated with real estate owned properties. Delta bases the amount it will bid
at foreclosure sales on this analysis.
If Delta acquires title to a property at a foreclosure sale or otherwise, the
REO Department immediately begins working the file by obtaining an estimate of
the sale price of the property by sending at least two local real estate brokers
to inspect the premises, and then hiring one to begin marketing the property. If
the property is not vacant when acquired, local eviction attorneys are hired to
commence eviction proceedings and/or negotiations are held with occupants in an
attempt to get them to vacate without incurring the additional time and cost of
eviction. Repairs are performed if it is determined that they will increase the
net liquidation proceeds, taking into consideration the cost of repairs, the
carrying costs during the repair period and the marketability of the property
both before and after the repairs.
Delta's loan servicing software also tracks and maintains homeowners'
insurance information and tax and insurance escrow information. Expiration
reports are generated bi-weekly listing all policies scheduled to expire within
the next 15 days. When policies lapse, a letter is issued advising the borrower
of such lapse and notifying the borrower that Delta will obtain force-placed
insurance at the borrower's expense. Delta also has an insurance policy in place
that provides coverage automatically for Delta in the event that Delta fails to
obtain force-placed insurance.
The following table sets forth information relating to the delinquency and
loss experience of the mortgage loans serviced by Delta (primarily for the
securitization trusts) for the periods indicated. Delta is not the holder of the
securitization loans, but generally holds residual or interest-only certificates
of the trusts, as well as the servicing rights, each of which may be adversely
affected by defaults. (See "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations Certain Accounting
Considerations"):
14
YEAR ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
` ---- ---- ----
(DOLLARS IN THOUSANDS)
Total Outstanding Principal Balance
(at period end)................................... $ 2,950,435 $ 1,840,150 $ 932,958
Average Outstanding(1)................................ $ 2,436,343 $ 1,376,109 $ 686,465
DELINQUENCY (at period end) 30-59 Days:
Principal Balance................................. $ 153,726 $ 90,053 $ 54,583
Percent of Delinquency(2)......................... 5.21% 4.89% 5.85%
60-89 Days:
Principal Balance................................. $ 50,034 $ 28,864 $ 14,273
Percent of Delinquency(2)......................... 1.70% 1.57% 1.53%
90 Days or More:
Principal Balance................................. $ 47,887 $ 17,695 $ 9,224
Percent of Delinquency(2)......................... 1.62% 0.96% 0.99%
Total Delinquencies:
Principal Balance................................. $ 251,647 $ 136,612 $ 78,080
Percent of Delinquency(2)......................... 8.53% 7.42% 8.37%
FORECLOSURES
Principal Balance................................. $ 145,679 $ 85,500 $ 34,766
Percent of Foreclosures by Dollar(2).............. 4.94% 4.65% 3.73%
REO
Principal Balance................................ $ 18,811 $ 10,292 $ 5,673
Percent of REO.................................. 0.64% 0.56% 0.61%
Net Gains/(Losses) on liquidated loans................ $ (8,704) $ (4,986) $ (2,866)
Percentage of Net Gains/(Losses) on liquidated
loans (based on Average Outstanding Balance)...... (0.36%) (0.36%) (0.42%)
- - ---------------
(1) Calculated by summing the actual outstanding principal balances at the end
of each month and dividing the total by the number of months in the
applicable period.
(2) Percentages are expressed based upon the total outstanding principal
balance at the end of the indicated period.
COMPETITION
As an originator and purchaser of mortgage loans, the Company faces intense
competition, primarily from mortgage banking companies, commercial banks, credit
unions, savings and loans, credit card issuers and finance companies. Many of
these competitors in the financial services business are substantially larger
and have more capital and other resources than the Company. Competition can take
many forms, including convenience in obtaining a loan, service, marketing and
distribution channels and interest rates. Furthermore, the level of gains
realized by the Company and its competitors on the sale of the type of loans
originated and purchased has attracted additional competitors into this market
with the effect of lowering the gains that may be realized by the Company on
future loan sales. In addition, efficiencies in the asset-backed market have
generally created a desire for even larger transactions giving companies with
greater volumes of originations a competitive advantage.
Competition may be affected by fluctuations in interest rates and general
economic conditions. During periods of rising rates, competitors which have
"locked in" low borrowing costs may have a competitive advantage. During periods
of declining rates, competitors may solicit the Company's borrowers to refinance
their loans. During economic slowdowns or recessions, the Company's borrowers
may have new financial difficulties and may be receptive to offers by the
Company's competitors. Furthermore, certain large national finance companies and
conforming mortgage originators have recently adapted their conforming
origination programs and allocated resources to the origination of
non-conforming loans and/or have otherwise begun to offer products similar to
those
15
offered by the Company, targeting customers similar to those of the
Company. The entrance of these larger and better capitalized competitors into
the Company's market may have a material adverse effect on the Company's results
of operations and financial condition.
REGULATION
Delta's business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and is subject to
various laws and judicial and administrative decisions imposing requirements and
restrictions on part or all of its operations. Delta's consumer lending
activities are subject to the Federal Truth-in-Lending Act and Regulation Z
(including the Home Ownership and Equity Protection Act of 1994), the Equal
Credit Opportunity Act of 1974, as amended (ECOA), the Fair Credit Reporting Act
of 1970, as amended, the Real Estate Settlement Procedures Act (RESPA), and
Regulation X, the Home Mortgage Disclosure Act and the Federal Debt Collection
Practices Act, as well as other federal and state statutes and regulations
affecting Delta's activities. Delta is also subject to the rules and regulations
of, and examinations by HUD and state regulatory authorities with respect to
originating, processing, underwriting and servicing loans. These rules and
regulations, among other things, impose licensing obligations on Delta,
establish eligibility criteria for mortgage loans, prohibit discrimination,
provide for inspections and appraisals of properties, require credit reports on
loan applicants, regulate assessment, collection, foreclosure and claims
handling, investment and interest payments on escrow balances and payment
features, mandate certain disclosures and notices to borrowers and, in some
cases, fix maximum interest rates, fees and mortgage loan amounts. Failure to
comply with these requirements can lead to loss of approved status, termination
or suspension of servicing contracts without compensation to the servicer,
demands for indemnifications or mortgage loans repurchases, certain rights of
rescission for mortgage loans, class action lawsuits and administrative
enforcement actions. Delta believes it is in compliance in all material respects
with applicable federal and state laws and regulations.
ENVIRONMENTAL MATTERS
To date, Delta has not been required to perform any investigation or clean up
activities, nor has it been subject to any environmental claims. There can be no
assurance, however, that this will remain the case in the future. In the
ordinary course of its business, Delta from time to time forecloses on
properties securing loans. Although Delta primarily lends to owners of
residential properties, there is a risk that Delta could be required to
investigate and clean-up hazardous or toxic substances or chemical releases at
such properties after acquisition by Delta, and may be held liable to a
governmental entity or to third parties for property damage, personal injury and
investigation and cleanup costs incurred by such parties in connection with the
contamination. In addition, the owner or former owners of a contaminated site
may be subject to common law claims by third parties based on damages and costs
resulting from environmental contamination emanating from such property.
EMPLOYEES
As of December 31, 1998 Delta had a total of 1,104 employees (full-time and
part-time). None of Delta's employees are covered by a collective bargaining
agreement. Delta considers its relations with its employees to be good.
ITEM 2. PROPERTIES
Delta's executive and administrative offices are located at 1000 Woodbury
Road, Woodbury, New York 11797, where Delta leases approximately 120,000 square
feet of office space at an aggregate annual rent of approximately $2.4 million.
The lease provides for certain scheduled rent increases and expires in 2008.
Delta also maintains a full service office in Atlanta, Georgia and Anaheim,
California, full processing offices in Chicago, Illinois, Warwick, Rhode Island
and Deerfield Beach, Florida, processing offices in Cleveland, Ohio and
Farmington Hills, Michigan, and business development offices in Delaware,
Missouri, New Jersey, Ohio, Pennsylvania and Virginia. Fidelity Mortgage
maintains fifteen retail mortgage origination offices in Florida (3), Georgia,
Illinois, Indiana, Missouri, North Carolina, Ohio (4), Pennsylvania (2) and
Tennessee; one telemarketing
16
hub in Ohio; and one corporate office in Ohio. The terms of the leases vary as
to duration and escalation provisions, with the latest expiring in 2003.
ITEM 3. LEGAL PROCEEDINGS
Because the nature of the Company's business involves the collection of
numerous accounts, the validity of liens and compliance with various state and
federal lending laws, the Company is subject, in the normal course of business,
to numerous claims and legal proceedings, including several class action
lawsuits set forth below. While it is impossible to estimate with certainty the
ultimate legal and financial liability with respect to such claims and actions,
the Company believes that the aggregate amount of such liabilities will not
result in monetary damages which in the aggregate would have a material adverse
effect on the financial condition or results of operations of the Company.
1. Several class-action lawsuits have been filed against a number of consumer
finance companies alleging that the compensation of mortgage brokers through the
payment of yield spread premiums violates various federal and state consumer
protection laws. The Company has been named in three such lawsuits:
a. In or about March 1997, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the
Eastern District of New York, alleging that the Company's compensation
of mortgage brokers by means of yield spread premiums violates, among
other things, the Real Estate Settlement Procedures Act ("RESPA"). The
complaint seeks (i) certification of a class of plaintiffs, (ii) an
injunction against payment of yield spread premiums by the Company and
(iii) unspecified compensatory and punitive damages (including
attorney's fees). On July 7, 1997, the Company filed an answer to the
plaintiff's amended complaint. In October 1998, the Company agreed to
an individual settlement with plaintiffs, and the lawsuit has been
dismissed with prejudice.
b. In or about February 1998, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the
Northern District of Mississippi - Greenville Division, alleging that
the Company's compensation or mortgage brokers by means of yield spread
premiums violates RESPA. The complaint seeks (i) certification of a
class of plaintiffs, and (ii) unspecified compensatory damages
(including attorney's fees). On March 31, 1998, the Company filed an
answer to the complaint. On December 1, 1998, the district court judge
denied plaintiff's motion for class certification. Plaintiff petitioned
the Fifth Circuit to accept its interlocutory appeal and, after the
Company submitted opposition papers, Plaintiff withdrew such petition.
The case is now proceeding on an individual basis.
c. In or about October 1998, the Company was served with a lawsuit filed
in the United States District Court for the Northern District of
Georgia, Atlanta Division, alleging that the Company's compensation of
mortgage brokers by means of yield spread premiums violates RESPA. The
complaint seeks (i) certification of a class of plaintiffs, and (ii)
unspecified compensatory and treble damages (including attorney's
fees). In November 1998, the Company filed an answer to the complaint
and Plaintiff filed a motion seeking class certification. In March
1999, the Company submitted its opposition to the motion for class
certification.
2. In or about September 1998, the Company received notice that it had been
named in a lawsuit filed in the Supreme Court of the State of New York, Nassau
County, alleging that the Company did not properly credit payments received from
borrowers to principal and interest. The complaint seeks (i) certification of a
class of plaintiffs, (ii) an accounting, (iii) unspecified compensatory and
punitive damages (including attorneys' fees), and (iv) injunctive relief, based
upon alleged (a) breach of contract, (b) unjust enrichment, (c) fraud, and (d)
deceptive trade practices. The Company's time to answer has been indefinitely
extended pending Plaintiff's determination as to whether to proceed with the
lawsuit.
17
3. In or about November 1998, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the Eastern
District of New York. In December 1998, plaintiffs filed an amended complaint
alleging that the Company had violated the Home Equity and Ownership Protection
Act, the Truth in Lending Act and New York State General Business Law ss. 349.
The complaint seeks (a) certification of a class of plaintiffs, (b) declaratory
judgment permitting rescission, (c) unspecified actual, statutory, treble and
punitive damages (including attorneys' fees), (d) certain injunctive relief, and
(e) declaratory judgment declaring the loan transactions as void and
unconscionable. In January 1999, the Company filed an answer to the amended
complaint. On December 7, 1998, Plaintiff filed a motion seeking a temporary
restraining order and preliminary injunction, enjoining Delta from conducting
foreclosure sales on 11 properties. The district court judge ruled that in order
to consider such a motion, Plaintiff must move to intervene on behalf of these
11 borrowers. Thereafter, Plaintiff moved to intervene on behalf of 3 of the 11
borrowers and sought the injunctive relief on their behalf. The Company opposed
the motions. On December 14, 1998, the district court judge granted the motion
to intervene and on December 23, 1998, the district court judge issued a
preliminary injunction enjoining the Company from proceeding with the
foreclosure sales of the three intervenors' properties. The Company has filed a
notice of appeal, and a motion for reconsideration of the December 23, 1998
order.
4. In or about January 1999, the Company received notice that it had been
named in a lawsuit filed in the Court of Common Pleas in Cuyahoga County, Ohio,
alleging that Delta had violated Ohio state law and breached its contract with
Plaintiff by assessing a prepayment penalty and certain other miscellaneous fees
when Plaintiff paid off his loan. The complaint seeks certification of two
classes of plaintiffs. The Company has not yet answered the complaint.
5. In or about March 1999, the Company received notice that it had been named
in a lawsuit filed in the Supreme Court of the State of New York, New York
County, alleging that Delta had improperly charged certain borrowers processing
fees. The complaint seeks (i) certification of a class of plaintiffs, (ii) an
accounting, and (iii) unspecified compensatory and punitive damages (including
attorneys' fees), based upon alleged (a) unjust enrichment, (b) fraud, and (c)
deceptive trade practices. The Company has not yet answered the complaint.
The Company believes that it has meritorious defenses and intends to defend
each of these lawsuits, but cannot estimate with any certainty its ultimate
legal or financial liability, if any, with respect to the alleged claims.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The annual meeting of stockholders was held on May 19, 1998. At the meeting,
Sidney A. Miller and Martin D. Payson were elected as Class II Directors for a
term of three years. Hugh Miller, Richard Blass and Arnold B. Pollard continue
to serve as members of the Board of Directors.
Votes cast in favor of Mr. Miller's election totaled 14,884,446,
while 27,325 votes were withheld.
Votes cast in favor of Mr. Payson's election totaled 14,884,146,
while 27,625 votes were withheld.
The stockholders also voted to ratify the appointment of KPMG LLP as the
Company's independent public accountants for the fiscal year ending December 31,
1998. Votes cast in favor of this ratification were 14,903,146, while votes cast
against were 2,600 and abstentions totaled 6,025.
18
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PRICE RANGE OF COMMON STOCK
The Company's Common Stock was listed on the New York Stock Exchange (the
"NYSE") under the symbol "DFC" on November 1, 1996. The following table sets
forth for the periods indicated the range of the high and low closing sales
prices for the Company's Common Stock on the NYSE.
1998 HIGH LOW
- - ---- ---- ----
First Quarter ............................ $18.56 $ 9.56
Second Quarter ........................... 20.25 17.06
Third Quarter............................. 18.00 4.50
Fourth Quarter ........................... 7.75 3.13
1997 HIGH LOW
- - ---- ---- ----
First Quarter ............................ $24.00 $18.13
Second Quarter ........................... 20.50 13.38
Third Quarter............................. 22.13 18.81
Fourth Quarter ........................... 20.69 13.38
On March 24, 1998, the Company had approximately 95 stockholders of record.
This number does not include beneficial owners holding shares through nominee or
"street" names. The Company believes the number of beneficial stockholders is
approximately 2,400.
DIVIDEND POLICY
The Company did not pay any dividends in 1998 and, in accordance with its
present general policy, has no present intention to pay cash dividends.
19
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Income Statement Data: (DOLLARS IN THOUSANDS, EXCEPT FOR SHARE DATA)
Revenues:
Net gain on sale of mortgage loans............. $ 92,452 $ 86,307 $ 46,525 $ 15,383 $ 6,661
Interest....................................... 12,458 22,341 16,372 13,588 9,839
Servicing fees................................. 9,392 7,094 5,368 2,855 2,183
Origination fees (1) .......................... 25,273 18,108 5,266 4,309 3,114
---------- ---------- ---------- ---------- ----------
Total revenues............................ 139,575 133,850 73,531 36,135 21,797
---------- ---------- ---------- ---------- ----------
Expenses:
Payroll and related costs (1).................. 56,684 41,204 17,633 13,753 9,415
Interest....................................... 30,019 19,972 11,298 7,964 3,735
General & administrative (1)................... 34,376 21,524 11,112 9,832 6,638
---------- ---------- ---------- ---------- ----------
Total expenses........................... 121,079 82,700 40,043 31,549 19,788
---------- ---------- ---------- ---------- ----------
Income before income taxes and
extraordinary item............................. 18,496 51,150 33,488 4,586 2,009
Provision for income taxes(1)...................... 7,168 20,739 9,466 -- --
---------- ---------- ---------- ---------- ----------
Income before extraordinary item................... 11,328 30,411 24,022 4,586 2,009
Extraordinary item:................................
Gain on extinguishment of debt................. -- -- 3,168 -- --
---------- ---------- ---------- ---------- ----------
Net income......................................... $ 11,328 30,411 27,190 4,586 2,009
---------- ---------- ---------- ---------- ----------
Pro forma information (2)(3):
Provision for pro forma income taxes
before extraordinary item...................... N/A N/A 14,400 1,972 864
---------- ---------- ---------- ---------- ----------
Pro forma income before extraordinary item.......... $ 11,328 30,411 19,088 2,614 1,145
---------- ---------- ---------- ---------- ----------
Per share data(2)(4):
Earnings per common share -
basic and diluted........................ $ 0.74 1.98 1.46 0.21 0.09
Weighted average number of
shares outstanding....................... 15,382,161 15,359,280 13,066,485 12,629,182 12,629,182
Selected Balance Sheet Data:
Loans held for sale, net........................... $ 87,170 79,247 82,411 63,324 48,833
Capitalized mortgage servicing rights.............. 33,490 22,862 11,412 3,831 2,421
Interest-only and residual certificates............ 203,803 167,809 83,073 25,310 7,514
Total assets....................................... 481,907 393,232 231,616 139,293 98,589
Senior notes, warehouse financing and
other borrowings............................... 229,660 177,540 95,482 82,756 52,491
Investor payable................................... 63,790 40,852 20,869 13,444 11,091
Total liabilities.................................. 344,219 266,779 138,098 109,460 70,425
Stockholders' equity............................... 137,688 126,453 93,518 29,833 28,164
- - ---------------
(1) In connection with the February 1997 acquisition of Fidelity Mortgage, the
Company incurred additional expenses normally associated with a retail
operation. Fidelity Mortgage's loan origination points when recognized are
reported as origination fee income.
(2) Figures for December 31, 1998 and 1997 are actual; pro forma presentation
for the years 1996, 1995 and 1994.
(3) Prior to October 31, 1996, Delta Funding (a wholly-owned subsidiary) was
treated as an S corporation for Federal and state income tax purposes. The
pro forma presentation reflects a provision for income taxes as if the
Company had always been a C corporation at an assumed tax rate of 43%.
(4) Pro forma earnings per common share has been computed by dividing pro
forma net income by the sum of (a) 10,653,000 shares of the Company's
common stock received by the former shareholders in exchange for their
shares of Delta Funding, and (b) the effect of the issuance of 1,976,182
shares of the Company's common stock issued in the Company's initial
public offering to generate sufficient cash for certain S corporation
distributions paid to the former shareholders, which shares are treated as
if they had always been outstanding.
20
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED
FINANCIAL STATEMENTS OF THE COMPANY AND ACCOMPANYING NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS SET FORTH THEREIN.
GENERAL
Delta Financial Corporation (the "Company" or "Delta") engages in the
consumer finance business by originating, acquiring, selling and servicing
non-conforming home equity loans. Throughout its 17 year operating history, the
Company has focused on lending to individuals who generally have impaired or
limited credit profiles or higher debt-to-income ratios.
Through its wholly-owned subsidiary, Delta Funding Corporation ("Delta
Funding"), the Company originates home equity loans indirectly through licensed
mortgage brokers and other real estate professionals who submit loan
applications on behalf of the borrower ("Brokered Loans") and also purchases
loans from mortgage bankers and smaller financial institutions that satisfy
Delta's underwriting guidelines ("Correspondent Loans"). Delta Funding currently
originates and purchases the majority of its loans in 24 states, through its
network of approximately 1,400 brokers and correspondents. Through its
wholly-owned subsidiary, Fidelity Mortgage, the Company develops retail loan
leads ("Retail Loans") primarily through its telemarketing system and its
network of 15 retail offices located in 9 states. Through a strategic alliance
between DFC Funding of Canada Limited, an indirectly wholly-owned subsidiary of
Delta Funding Corporation, and MCAP Mortgage Corporation, a Canadian mortgage
loan originator, the Company originated loans in Canada. In February 1999, the
Company decided to close its Canadian business to focus exclusively on its
U.S.-based business.
CERTAIN ACCOUNTING CONSIDERATIONS
As a fundamental part of its business and financing strategy, Delta sells the
majority of its loans through securitization and derives a substantial portion
of its income therefrom. In a securitization, the Company sells a pool of loans
it has originated or purchased to a REMIC trust for a cash purchase price. The
trust, in turn, finances the purchase of the pool of loans it has acquired by
selling "pass-through certificates," or bonds, which represent undivided
ownership interests in the trust. Holders of the pass-through certificates are
entitled to receive monthly distributions of all principal received on the
underlying mortgages and a specified amount of interest, as determined at the
time of the trust offering.
When the Company sells a pool of loans to a securitization trust, it receives
the following economic interests in the trust: (a) the difference between the
interest payments due on the loans sold to the trust and the interest rate paid
to the pass-through certificateholders, less the Company's contractual servicing
fee and other costs and expenses of administering the trust, represented by
interest-only and residual certificates, and (b) the right to service the loans
on behalf of the trust and earn a servicing fee, as well as other ancillary
servicing related fees directly from the borrowers on the underlying loans.
The Company's net investment in the pool of loans sold at the date of the
securitization represents the amount originally paid to originate or acquire the
loan adjusted for (i) any direct loan origination costs incurred (an increase)
and loan origination fees received (a decrease) in connection with the loans,
which are treated as a component of the initial investment in a loan under
Statement of Financial Accounting Standards ("SFAS") No. 91, "Accounting for
Non-Refundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases," and (ii) the principal payments received, and
the amortization of the net loan fees or costs, during the period the Company
held the loans prior to their securitization. The Company's investment in the
loans also reflects adjustments for any gains (a decrease in the investment) or
losses (an increase in the investment) the Company has incurred on treasury rate
lock contracts which the Company has typically used to hedge against the effects
of changes in interest rates during the period it holds the loans prior to their
securitization. (See "Hedging.")
Upon the securitization of a pool of loans, the Company (i) recognizes in
income, as origination fees, the unamortized origination fees included in the
investment in the loans sold, and (ii) recognizes a gain on sale of loans
21
equal to the difference between cash received from the trust and the
investment in the loans remaining after the allocation of portions of that
investment to record interest-only and residual certificates and mortgage
servicing rights received in the securitization. The majority of the net gain on
sale of mortgage loans results from, and is initially realized in the form of,
the retention of interest-only and residual certificates.
The Company sold interest-only certificates created in each of the 1998
securitizations for cash proceeds and intends to continue to sell the
interest-only certificate as long as the sale effectively maximizes cash flow
and profitability.
The interest-only and residual certificates received by the Company upon the
securitization of a pool of loans are accounted for as trading securities under
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities." In accordance with SFAS No. 115, the amount initially allocated to
the interest-only and residual certificates at the date of a securitization
reflects the fair value of those interests. The amount recorded for the
certificates is reduced for distributions thereon which the Company receives
from the related trust, and is adjusted for subsequent changes in the fair value
of interest-only and residual certificates, which are reflected in the statement
of operations. The Company assesses the fair value of interest-only and residual
certificates based upon updated estimates of prepayment and default rates
relating to loan groups comprised of loans of similar types, terms, credit
quality, interest rates, geographic location and value of loan collateral, which
represent the predominant risk characteristics that would affect prepayments and
default rates.
The Company values the mortgage servicing rights it retains in a
securitization under the provisions of SFAS No. 125, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities." In
accordance with SFAS No. 125, the amount of the investment in the loans
allocated to the retained servicing rights is measured at the allocated carrying
amount of such servicing rights, based on the fair value of the servicing
rights. The fair value of the servicing rights is determined by discounting to a
present value (using a discount rate which management believes reflects the rate
market participants would utilize in purchasing similar loan servicing rights)
the estimated future contractual and ancillary servicing fees the Company will
receive and the estimated costs of servicing the loans. Those estimates are
based on the stated terms of the transferred loans adjusted for estimates of
future prepayment rates made on the basis of interest rate conditions and the
availability of alternative financing, and estimates of future defaults among
those loans, each of which would terminate the servicing of the loan and thus
negatively affect servicing income. The fair value of the servicing rights,
which is classified on the balance sheet as "capitalized mortgage servicing
rights," is then amortized over the period of the estimated net future cash
flows from the servicing income. SFAS No. 125 also requires that the capitalized
mortgage loan servicing rights be assessed periodically to determine if there
has been any impairment of the value of the asset, based on the date of the
assessment. The Company performs this assessment based on the same prepayment
and default estimates used to value interest-only and residual certificates. A
valuation allowance is provided for the capitalized servicing rights relating to
any loan group for which the recorded investment exceeds the fair value of the
servicing rights.
In recording and accounting for mortgage servicing rights and interest-only
and residual certificates, the Company makes estimates of rates of prepayments
and defaults, and the value of collateral, which it believes reasonably reflect
economic and other relevant conditions then in effect. The actual rate of
prepayments, defaults and the value of collateral will generally differ from the
estimates used due to subsequent changes in economic and other relevant
conditions and the implicit imprecision of estimates, and such differences can
be material. Prepayment and default rates, which are higher than those
estimated, would adversely affect the value of both the mortgage servicing
rights (actual mortgage servicing income will be less, and significant changes
could require an impairment of the capitalized mortgage servicing rights) and
the interest-only and residual certificates, for which changes in fair value are
recorded in operations. Conversely, prepayment and default rates, which are
lower than those estimated, would increase the servicing income earned over the
life of the loans and positively impact the value of the interest-only and
residual certificates.
There are currently two methods used to calculate the present value of the
residual interests, the "cash-in" and "cash-out" methods. The "cash-in" method
assumes value as the residual cash flow is received by the securitization trust
even if it is used to create an overcollateralization provision. In contrast,
the "cash-out" method assumes value at the time the residual cash flow is
actually received by the residual certificate holder (Delta) from the
securitization trust, which is only after the required overcollateralization
provision has been met. As the Company
22
receives residual cash flows from the securitization trust, generally 8 to 15
months following the primary issuance, these two methods will create
dramatically different values. The Company uses the more conservative "cash-out"
method, which calculates value at the time the residual cash flow is actually
received by Delta.
The Financial Accounting Standards Board ("FASB") and the Securities and
Exchange Commission have issued proposals relating to SFAS No. 125 that would
require companies to use the "cash-out" (more conservative), not the "cash-in"
(more aggressive), method in accounting for the value of the retained interest
(residual) in securitizations and overcollateralization assets. This would
result in one-time residual asset write-downs for companies that currently use
the "cash-in" method. The Company has always used the more conservative
"cash-out" method for accounting and will not be susceptible to a write-down as
a result of this proposed accounting change.
FAIR VALUE ADJUSTMENTS
During the second quarter of 1998, the Company recorded a $15.5 million
reduction in the carrying amount of its interest-only and residual certificates,
and also recorded a $1.9 million reduction in the carrying amount of its
capitalized mortgage servicing rights to reflect a provision for impairment (the
"fair value adjustments"). Both impairment provisions resulted from reductions
in the Company's estimates of the fair value of those assets. The reductions in
the estimated fair value resulted from a change in the prepayment assumptions
used by the Company to estimate the future cash flows to be derived from the
interest-only and residual certificates and the mortgage servicing rights.
As required by generally accepted accounting principles, at each reporting
period the Company estimates the fair value of its interest-only and residual
certificates and its capitalized mortgage servicing rights. The carrying amount
of the interest-only and residual certificates is adjusted to their current fair
value. For capitalized mortgage servicing rights, a valuation allowance is
recorded if the fair value of such rights is less than the carrying amount.
The fair values of both interest-only and residual certificates and
capitalized mortgage servicing rights are significantly affected by, among other
factors, prepayments of loans and estimates of future prepayment rates. The
Company continually reviews its prepayment assumptions in light of company and
industry experience and makes adjustments to those assumptions when such
experience indicates.
During 1997, the Company made certain changes in its prepayment assumptions,
principally increasing the estimated maximum prepayment rates for
adjustable-rate loan pools. The effect of that change in prepayment assumptions
did not materially affect the fair value of the interest-only and residual
certificates in 1997.
The Company's review of its prepayment experience and assumptions at June 30,
1998 indicated that the prepayment rates during 1998, particularly for
adjustable-rate mortgages ("ARMs"), and in particular during the second quarter
of 1998, were higher than those historically experienced, or previously
projected, by the Company. The Company believes that these increases in
prepayment rates were attributable to the continuation, for a longer period than
historically experienced, of low interest rates, together with changes, to a
flatter or inverted curve, of the relationship between long-term and short-term
interest rates (the "yield curve").
As a result, at June 30, 1998, the Company adjusted its prepayment
assumptions, increasing the maximum prepayment rates for all loans, and changing
the rate at which prepayments are assumed to increase from the initial rate to
the maximum rate from a straight-line build-up to a "vector" curve. These
revised prepayment assumptions were used to estimate the fair value of the
interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in securitizations completed prior to the second
quarter of 1998, requiring the fair value adjustments described above. These
revised prepayment assumptions were also used in initially valuing and recording
the interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in its securitizations completed subsequent to
the first quarter of 1998.
The Company assumes prepayment rates and defaults based upon the seasoning of
its existing securitization loan portfolio. The following table compares the
prepayment assumptions used subsequent to the first quarter of 1998 (the "new"
assumptions) with those used at December 31, 1997 and through the first quarter
of 1998 ( the "old" assumptions):
23
- - --------------------------------------------------------------------------------
LOAN TYPE Curve Description Month 1 Speed Peak Speed
- - --------------------------------------------------------------------------------
New Old New Old New Old
- - --------------------------------------------------------------------------------
Fixed Rate Loans Vector Ramp 4.8% 4.8% 31% 24%
Six-Month LIBOR ARMs Vector Ramp 10.0% 5.6% 50% 28%
Hybrid ARMs Vector Ramp 6.0% 5.6% 50% 28%
- - --------------------------------------------------------------------------------
In addition, in the fourth quarter of 1998, the Company increased its loss
reserve initially established for both fixed- and adjustable-rate loans sold to
the securitizations trusts to approximately 2.00% of the issuance amount
securitized from approximately 1.90% of the issuance amount. The Company made
this change to better reflect what management believes its loss experience will
be, as the Company anticipates slower prepayment rates and a flat to slight
moderate rise in home values as compared to the past few years, which may have
an adverse effect on the Company's non-performing loans. This change resulted in
approximately a $2.8 million reduction in the Company's value of the residual
and interest-only certificates. An annual discount rate of 12.0% was utilized in
determining the present value of cash flows from residual certificates, using
the "cash-out" method, which are the predominant form of retained interests at
both December 31, 1998 and 1997.
The Company uses the same prepayment assumptions in estimating the fair value
of its mortgage servicing rights.
To date, aggregate actual cash flows from the Company's securitization trusts
have either met or exceeded management's expectations and the Company determined
that no further adjustments to the prepayment or default assumptions was
necessary at December 31, 1998.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1997
GENERAL
The Company's net income for the year ended December 31, 1998 was $11.3
million, or $0.74 per share, compared to $30.4 million, or $1.98 per share, for
the year ended December 31, 1997. Comments regarding the components of net
income are detailed in the following paragraphs.
REVENUES
Total revenues increased $5.7 million, or 4%, to $139.6 million for the
twelve months ended December 31, 1998, from $133.9 million for the comparable
period in 1997. The increase in revenue was primarily attributable to increases
in origination fees and the net gains recognized on the sale of mortgage loans,
reflecting the growth in the Company's level of loan originations and purchases
and securitizations. In addition, servicing fees increased due to an increase in
the aggregate size of the Company's loan servicing portfolio. These increases
were significantly offset by a decline in interest income primarily due to the
fair value adjustments made to the Company's interest-only and residual
certificates and capitalized mortgage servicing rights in the second and fourth
quarters of 1998 (see "--Fair Value Adjustments") and a larger than normal hedge
loss which was not offset by a higher gain on sale because asset-backed
investors who purchase the pass-through certificates issued by securitization
trusts demanded wider spreads (see "net gain on sale of mortgage loans").
The Company originated and purchased $1.73 billion of mortgage loans for the
twelve months ended December 31, 1998, representing a 38% increase from $1.25
billion of mortgage loans originated and purchased for the comparable period in
1997. The Company completed four securitizations and loan sales in 1998 totaling
$1.73 billion, compared to four securitizations totaling $1.24 billion in 1997.
Total loans serviced increased 60% to $2.95 billion at December 31, 1998 from
$1.84 billion at December 31, 1997.
24
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans
represents (1) the sum of (a) the fair value of the interest-only and residual
certificates retained by the Company in a securitization for each period and the
market value of the interest-only certificates sold in connection with each
securitization, (b) the fair value of capitalized mortgage servicing rights
associated with loans securitized in each period, and (c) premiums earned on the
sale of whole loans on a servicing-released basis, (2) less the (x) premiums
paid to originate or acquire mortgage loans, (y) costs associated with
securitizations and (z) any hedge loss (gain) associated with a particular
securitization.
Net gain on sale of mortgage loans increased $6.2 million, or 7%, to $92.5
million for the twelve months ended December 31, 1998, from $86.3 million for
the comparable period in 1997. The increase was primarily due to a 40% increase
in the amount of loans securitized or sold on a whole loan basis to $1.73
billion in 1998, compared to $1.24 billion of loans securitized in 1997, but was
partially offset by a lower weighted average net gain on sale ratio. The
weighted average net gain on sale ratio was 5.4% in 1998 compared to 7.0% in
1997.
Net gain on the sale of loans increased less than the overall increase in
loan securitizations primarily due to (a) the Company's change to more
conservative prepayment assumptions used in initially valuing the residual
certificates and capitalized mortgage servicing rights acquired subsequent to
the first quarter of 1998 (see "--Fair Value Adjustments"), and (b) the impact
of a hedging loss during the third quarter of 1998 resulting from lower interest
rates that was not offset by a higher gain on sale due to substantially wider
spreads demanded by asset-backed investors who purchase the pass-through
certificates issued by securitization trusts.
INTEREST INCOME. Interest income primarily represents the sum of (1) the
difference between the distributions the Company receives on its interest-only
and residual certificates and the adjustments recorded to reflect changes in the
fair value of the interest-only and residual certificates, (2) interest earned
on loans held for sale, and (3) interest earned on cash collection balances.
Interest income decreased $9.9 million, or 44%, to $12.4 million for the
twelve months ended December 31, 1998, from $22.3 million for the comparable
period in 1997. The decrease in interest income was primarily due to the $15.5
million and $2.8 million fair value adjustments made during the second and
fourth quarters of 1998 to the interest-only and residual certificates
previously discussed (see "--Fair Value Adjustments"). The effect of that
adjustment was partially offset by increases in (a) interest-only and residual
certificates income, (b) interest on loans held for sale due to higher average
balances, partially offset by a decline, from 11.0% to 10.2%, in the weighted
average coupon rate on the mortgage loans, reflecting both a lower interest rate
environment and the Company's shift to higher credit quality loans and (c)
interest on bank deposits resulting from a higher average balance held in
securitization trust accounts by the Company.
SERVICING FEES. Servicing fees represent all contractual and ancillary
servicing revenue received by the Company less (1) the offsetting amortization
of the capitalized mortgage servicing rights, and any adjustments recorded to
provide valuation allowances for the impairment in mortgage servicing rights
(see "--Certain Accounting Considerations"), and (2) prepaid interest
shortfalls.
Servicing fees increased $2.3 million, or 32%, to $9.4 million for the twelve
months ended December 31, 1998, from $7.1 million for the comparable period in
1997. The increase was primarily due to an increase in the aggregate size of the
Company's servicing portfolio, partially offset by the recording of the $1.9
million provision for the Company's capitalized mortgage servicing rights. (See
"--Fair Value Adjustments"). The average balance of mortgage loans serviced by
the Company increased 77% to $2.44 billion for the twelve months ended December
31, 1998, from $1.38 billion for the comparable period in 1997.
ORIGINATION FEES. Origination fees represent fees earned on brokered and
retail originated loans. Origination fees increased $7.2 million, or 40%, to
$25.3 million for the twelve months ended December 31, 1998, from $18.1 million
for the comparable period in 1997. The increase was primarily the result of (a)
a 75% increase in broker originated loans and (b) a 67% increase in retail
originated loans.
EXPENSES
Total expenses increased $38.4 million, or 46%, to $121.1 million for the
twelve months ended December 31, 1998, from $82.7 million for the comparable
period in 1997. The increase was primarily the result of (1) an
25
increase in the Company's personnel to support its higher level of loan
originations, (2) an increase in general and administrative costs associated
with the Company's expanded retail, broker and correspondent divisions and (3)
an increase in interest expense associated with (a) the growth in the Company's
loan originations and (b) the $150 million aggregate principal amount of 9.5%
Senior Notes due 2004 issued in July 1997 (the "Senior Notes").
PAYROLL AND RELATED COSTS. Payroll and related costs include salaries,
benefits and payroll taxes for all