<PAGE>
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-K
(MARK ONE)
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 (NO FEE REQUIRED)
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 1-11785
----------------
SOUTHERN PACIFIC FUNDING CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
<TABLE>
<S> <C>
CALIFORNIA 33-0636924
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
4949 MEADOWS ROAD, SUITE 600 97035
LAKE OSWEGO, OR (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
</TABLE>
(503) 303-5400
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
COMMON STOCK, NO PAR VALUE
6.75% CONVERTIBLE SUBORDINATED NOTES DUE 2006
11 1/2 % SENIOR NOTES DUE 2004
(TITLE OF EACH CLASS)
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
NEW YORK STOCK EXCHANGE
(NAME OF EACH EXCHANGE ON WHICH REGISTERED)
----------------
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. [X]
As of March 12, 1998, the aggregate market value of common stock held by
nonaffiliates of the registrant was approximately $185,472,975 based on the
closing price of the registrant's Common Stock as reported on the New York
Stock Exchange. For purposes of this calculation, shares owned by officers,
directors and 5% stockholders known to the registrant have been deemed to be
owned by affiliates: this assumption is not deemed to be an admission by such
persons that they are affiliates of the registrant.
As of March 12, 1998, the shares outstanding of the registrant's class of
common stock were as follows: 20,734,300.
DOCUMENTS INCORPORATED BY REFERENCE
Part III, items 10, 11, 12 and 13, incorporate by reference Southern Pacific
Funding Corporation's definitive proxy statement to shareholders for the 1998
Annual Meeting of Stockholders which will be filed with the Commission no
later than 120 days after December 31, 1997.
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<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
PART I
Item 1. Business....................................................... 1
Item 2. Properties..................................................... 15
Item 3. Legal Proceedings.............................................. 16
Item 4. Submission of Matters to a Vote of Security Holders............ 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters........................................................ 16
Item 6. Selected Financial Data........................................ 17
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................... 19
Factors That May Affect Future Results......................... 23
Item 8. Financial Statements and Supplementary Data.................... 32
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure........................................... 53
PART III
Item 10. Directors and Executive Officers of the Registrant............. 53
Item 11. Executive Compensation......................................... 53
Item 12. Security Ownership of Certain Beneficial Owners and Management. 53
Item 13. Certain Relationships and Related Transactions................. 53
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-
K.............................................................. 53
Signatures..................................................... 56
</TABLE>
<PAGE>
PART I
ITEM 1. BUSINESS
GENERAL
Southern Pacific Funding Corporation ("SPFC" or the "Company") is a
specialty finance company engaged in the business of originating, purchasing
and selling non-conforming mortgage loans secured primarily by one-to-four
family residences. The majority of the Company's loans are made to owners of
single family residences who use the loan proceeds for purposes such as
mortgage refinancing, home purchase, debt consolidation, home improvements and
educational expenditures. The Company focuses primarily on lending to
individuals who have significant equity in the value of their homes but have
impaired or limited credit histories. As a result, the Company's customers are
less likely to qualify for loans from conventional mortgage lenders and
generally pay higher interest rates than interest rates charged by
conventional mortgage lenders.
The Company's origination strategy is to develop and maintain diversified
production channels that enable the Company to originate and purchase loans on
a consistent, low cost basis. The Company's total direct costs of production,
which include premiums paid on all loans originated or purchased, net of
origination fees collected, for the years ended December 31, 1996 and 1997
were 1.6% and 2.4%, respectively, of loans produced. The Company originates or
purchases loans in all 50 states, the District of Columbia and the United
Kingdom through its Wholesale Division, Strategic Alliance Program,
Correspondent Program and Consumer Loan Division.
The Company obtains the servicing rights on all loans it originates or
purchases. Through 1997 the Company outsourced substantially all its loan
servicing operations to Advanta Mortgage Corp. USA, ("Advanta"), which the
Company believes is the largest third-party servicer of non-conforming home
equity loans. This subservicing arrangement allowed the Company to increase
the volume of loans it originated and purchased without incurring an overhead
investment in a loan servicing operation, but subjected the Company to risks
associated with inadequate or untimely service.
To eliminate exposure to these risks and capture the revenues associated
with loan servicing, in December 1997 the Company purchased the loan servicing
operations of North American Mortgage Company ("NAMC"). The Company acquired
NAMC's servicing operations assets and retained its loan servicing employees.
This acquisition allowed the Company in mid-January 1998 to begin its own loan
servicing operations for all new loans originated and purchased. In the second
quarter of 1998, the Company plans to transfer to its internal servicing
department the servicing of the loans included in the Company's Series 97-4
securitization completed in December 1997. In addition, all non-securitized
loans originated and purchased in December 1997 and January 1998 will also be
transferred to its servicing operations. See "Factors That May Affect Future
Results--Risks of Servicing"
BUSINESS STRATEGY
Emphasize Low Cost Originations. The Company's origination strategy is to
develop and maintain diversified production channels that enable the Company
to originate or purchase mortgage loans on a consistent, low cost basis. The
Company's total direct costs of production include premiums paid to originate
or purchase loans, net of origination fees collected. The Company believes by
focusing its loan origination growth through its Wholesale Division and its
Consumer Loan Division, it will be able to reduce its overall costs of loan
production. In addition, the Company emphasizes an overhead cost control
structure to benefit from economies of scale while supporting the growth of
the Company.
Emphasize Strong Underwriting Policies and Procedures. The Company's
underwriters use underwriting standards developed by the Company that
emphasize both credit quality of the borrower and the collateral value of real
estate. All first lien loans originated or purchased by the Company are
underwritten or re-underwritten, undergo an appraisal review by the Company's
underwriters and are subject to further review from the Company's quality
control personnel. The Company monitors the performance of the loans it
originates and purchases with a view towards modifying underwriting procedures
as appropriate.
<PAGE>
Develop and Expand Production Channels. The Company seeks to increase loan
originations and purchases through the development of new branches for its
Wholesale Division and its Consumer Loan Division. This development will occur
by opening new offices and acquiring branch mortgage operations. The Company
also seeks to expand the Wholesale Division's loan originations by
establishing new independent mortgage broker relationships in both existing
and new markets.
Maximize Liquidity and Diversify Funding Sources. The Company intends to
continue to expand and diversify its short-term funding sources in order to
improve cash flow by seeking higher advance rates from its warehouse
facilities. In addition, the Company intends to improve its liquidity and
financial condition through optimizing securitization structures as well as
through the monetization of certain assets. The Company's asset monetization
alternatives include whole loan sales, sales of interest-only strips, and
financing and securitization of interest-only and residual certificates. The
Company continues to seek improved cash flow received from securitizations
through new securitization structures that enable the Company to receive cash
flow from a securitization faster than traditional monoline-insured credit-
enhanced structures. In addition, the Company will sell a portion of its 1998
loan production on a cash basis; thereby, monetizing a portion of reported
gain on sale results which will move the Company towards a positive cash flow
position.
Enhance Corporate and Operating Infrastructure. The Company continues to
invest in its information and operation systems. The Company has modified its
loan processing and underwriting platform to support its geographic expansion
and product diversification. The Company has also upgraded its secondary
marketing and financial accounting systems to provide additional analytical
and monitoring support as to the profitability and performance of each branch,
division and production channel.
LOAN ORIGINATIONS AND PURCHASES
Overview
The Company primarily originates and purchases non-conforming home equity
loans which are typically secured by a first mortgage on the borrower's
residence. The majority of the Company's loans are made to borrowers who use
the loan proceeds for purposes such as mortgage refinancing, home purchase,
debt consolidation, home improvements and educational expenditures. The
Company focuses primarily on lending to individuals who have significant
equity in the value of their homes but have impaired or limited credit
histories. As a result, the Company's customers are less likely to qualify for
loans from conventional mortgage lenders and generally pay higher interest
rates than interest rates charged by conventional mortgage lenders. The
Company originates or purchases loans in all 50 states, the District of
Columbia and the United Kingdom through its Wholesale Division, Correspondent
Program, Strategic Alliance Program and Consumer Loan Division.
The Company offers a wide range of loan products to meet the needs of
borrowers with varying credit profiles and borrowing needs. The Company's loan
products include fixed rate first mortgage loans, variable rate first mortgage
loans, fixed rate second mortgage loans and variations thereof. Historically,
the majority of the loans originated and purchased by the Company have been
variable rate first mortgage loans.
Wholesale Division. The Wholesale Division originates a majority of the
Company's loans. The Wholesale Division consists of approximately 153 account
executives located in 38 regional branch centers. These account executives
have established relationships with, and market directly to, licensed
independent mortgage brokers. Independent mortgage brokers identify potential
borrowers, assist borrowers in completing the loan application and submit the
loan application and other documents to the Company. All loans funded by the
Wholesale Division are underwritten to the Company's guidelines, which provide
the Company's underwriters with the flexibility to make exceptions to the
Company's underwriting criteria when an upgrade is warranted by a particular
loan applicant's situation, such as evidence of strong mortgage repayment
history relative to a weaker overall consumer credit repayment history. In
most cases, the Company conditionally approves loans submitted by an
independent mortgage broker within 24 hours from receipt of application and
funds loans within 21 days after approval. The Company believes its
competitive strength in maintaining and expanding independent mortgage broker
relationships is attributable to its ability to provide quality service,
including responsive execution and funding of loans, as well as offering a
broad range of loan products to applicants.
2
<PAGE>
By concentrating on wholesale mortgage banking through its network of
independent mortgage brokers, the Company believes it is able to originate
loans cost-effectively. The Company's direct costs to originate loans through
its network of independent mortgage brokers for the years ended December 31,
1996 and 1997 were 0.5% and 1.0% of the principal balance of loans originated
through the Wholesale Division, respectively. These costs include points paid
to brokers, net of miscellaneous fees collected. The Company is actively
seeking to geographically expand its Wholesale Division by using selected
demographic statistics and other criteria developed by the Company which are
intended to identify the most attractive markets for the Company's products.
The Company typically enters into a new market using its national sales team,
which initially penetrates a market, to recruit brokers for the Company's
wholesale network. Prior to purchasing loans from a new broker, the Company
conducts an investigation of the broker which typically includes verification
of current licenses and financial condition. The Company actively monitors the
independent mortgage brokers it uses to determine productivity and quality of
loans originated. The Company's sales strategy is to limit the number of sales
offices and personnel needed to generate and effectively process and
underwrite loans. As such, the Company typically opens a sales office only
after a minimum level of volume is achieved in a new market. By utilizing this
expansion strategy, the Company can maintain lower overhead expenses than
generally associated with competing companies utilizing a more extensive
retail branch office system. The Wholesale Division originated $267.4 million,
$529.0 million and $1,244.0 million of mortgage loans during the years ended
December 31, 1995, 1996 and 1997, respectively, representing 92.7%, 67.0% and
63.3% of the Company's total loan originations and purchases during the
respective periods.
The following table sets forth selected information relating to loan
originations by the Wholesale Division during the periods shown.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------
1995 1996 1997
-------- -------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Principal balance of loans................... $267,409 $529,026 $1,244,043
Average principal balance per loan........... $ 89 $ 117 $ 87
Percent of first mortgage loans.............. 83.2% 96.4% 99.3%
Weighted average interest rate............... 10.4% 10.5% 10.8%
Weighted average initial LTV ratio........... 76.4% 72.3% 73.1%
Direct cost of production.................... -- 0.52% 0.96%
</TABLE>
Correspondent Program. The Company purchased closed loans through its
Correspondent Program in 1995 through 1997. Effective March 1998, the
correspondent program was discontinued. Loans purchased through the
Correspondent Program were complete loan packages that had been underwritten
and funded by approved mortgage bankers or financial institutions. The Company
reunderwrote each loan submitted in the loan portfolio to ensure that all
loans complied with the Company's underwriting guidelines. As part of the
reunderwriting process, the Company's underwriters reviewed the appraisal and
the applicant's creditworthiness and ensured that all necessary compliance and
disclosure documentation was included in the loan package. Loans that did not
meet the Company's underwriting guidelines were not purchased. Through the
Correspondent Program, the Company purchased $21.1 million, $204.8 million,
and $280.4 million of mortgage loans during the years ended December 31, 1995,
1996 and 1997, respectively, representing 7.3%, 25.9% and 14.3% of the
Company's total loan originations and purchases during the respective periods.
3
<PAGE>
The following table sets forth selected information relating to the bulk
purchase of loans through the Correspondent Program during the periods shown.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------
1995 1996 1997
------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Principal balance of loans...................... $21,073 $204,799 $280,432
Average principal balance per loan.............. $ 69 $ 101 $ 97
Percent of first mortgage loans................. 81.7% 99.2% 99.8%
Weighted average interest rate.................. 10.9% 10.6% 10.4%
Weighted average initial LTV ratio.............. 72.9% 74.8% 74.6%
Direct cost of production....................... -- 4.53% 5.02%
</TABLE>
Strategic Alliances. The Company purchases loans through its Strategic
Alliance Program. Through the Strategic Alliance Program, the Company obtains
a committed source of loan production from select mortgage lenders who form
Strategic Alliances with the Company. To date, the Company has entered into
Strategic Alliances with six mortgage lenders. The Strategic Alliance Program
generally permits the Strategic Alliance partner to obtain financing support
from the Company and to securitize its qualifying loan production with the
Company's loan production. In return, the Company receives interest and fee
income, warrants to acquire an equity interest in the Strategic Alliance and
the right to acquire all of the Strategic Alliance's qualifying non-conforming
loan production. In addition, the Strategic Alliance Program provides the
Company with access to a broader network of independent mortgage broker
relationships. The Company reunderwrites all loans originated and submitted by
each Strategic Alliance for an initial period, generally 60 to 90 days. After
the initial period, the Strategic Alliance's loans are monitored through the
Company's quality control process. Through the Strategic Alliance Program, The
Company purchased $51.5 million and $289.7 million of mortgage loans during
the years ended December 31, 1996 and 1997, respectively, representing 6.5%
and 14.8% of the Company's total loan originations and purchases during the
respective periods.
The Company typically securitizes loans obtained from Strategic Alliances
and compensates the Strategic Alliances for such loans through the issuance of
a corporate note payable equal to the value of the interest-only and residual
certificates created by the Strategic Alliance loans, less a securitization
fee and a cash payment for the principal of the loans. If loans purchased
experience unfavorable performance resulting from prepayments, credit losses,
or interest rates, and such experience results in a write-down of the related
residual asset, the Company has recourse back to the Strategic Alliance for
the life of the loan. In a related transaction, the Company will typically
provide the Strategic Alliance with a working capital loan secured by the
Company's note payable. Currently, such loans can be in an amount up to 75% of
the outstanding note payable.
The following table sets forth selected information relating to loan
originations by Strategic Alliances during the periods shown:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------
1996 1997
------------ ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Principal balance of loans........................ $ 51,536 $ 289,747
Average principal balance per loan................ $ 87 $ 131
Percent of first mortgage loans................... 100% 99.9%
Weighted average interest rate.................... 11.0% 10.3%
Weighted average initial LTV ratio................ 80.5% 79.7%
Direct cost of production......................... -- 6.17%
</TABLE>
Consumer Loan Division. The Consumer Loan Division offers second mortgage
loans to credit-impaired borrowers and high LTV loans to borrowers with better
credit than the Company's average non-conforming borrower. The majority of the
loans originated by the Consumer Loan Division are fixed-rate, fully
amortizing
4
<PAGE>
loans secured by the owner-occupied one-to-four family residences. A high LTV
loan, together with other loans secured by the same property, may exceed the
value of such property by as much as 25%. The Consumer Loan Division
originates loans by marketing directly to potential borrowers using direct
mail advertising, telemarketing and radio advertising. The Consumer Loan
Division also originates loans through independent mortgage brokers. The
Consumer Loan Division currently has retail offices in Ontario, Pasadena,
Corona, Newport Beach and Covina, California. The Company believes that by
offering second lien mortgages it is able to diversify its loan production and
provide means for the Company's existing borrowers to utilize equity in their
homes for additional borrowings.
Loan processing, including underwriting, funding and closing for all
Consumer Loan Division loans is performed by the Consumer Loan Division's
dedicated, centralized underwriting and credit assessment staff. Applicants
for high LTV loans are evaluated primarily through a default and loss
predictive scoring system developed by Fair, Issacs & Co., a consulting firm
which specializes in consumer credit assessment. Based on the Fair, ISSACS &
Company ("FICO") scoring system, scores can range from 400 to 800 points.
Underwriting guidelines for the Company's more traditional non-conforming
second mortgage loans are not based on the FICO scoring system, but focus on
the borrower's credit profile and the value of the collateral property. Such
underwriting guidelines are substantially similar to the underwriting
guidelines used by the Company's other divisions. The Consumer Loan Division
performs or reviews appraisals for all loans.
The Company has in the past sold the majority of second lien mortgage loans
originated by the Consumer Loan Division on a whole loan basis. After an
assessment of the underlying risks and economics of high LTV loans, the
Company plans to examine the possibility of securitizing loans originated by
the Consumer Loan Division. The Consumer Loan Division originated $4.5 million
and $149.8 million of loans during the years ended December 31, 1996 and 1997,
respectively, representing 0.6% and 7.6% of the Company's total loan
originations and purchases during the respective periods.
The following table sets forth selected information relating to loan
originations by the Consumer Loan Division during the year ended December 31,
1997.
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31, 1997
-----------------
(DOLLARS IN
THOUSANDS)
<S> <C>
Principal balance of loans................................. $149,801
Average principal balance per loan......................... $ 38
Percent of first mortgage loans............................ 30.1%
Weighted average interest rate............................. 12.4%
Weighted average initial LTV ratio......................... 82.9%
Direct origination revenue................................. 0.88%
</TABLE>
5
<PAGE>
Geographic Distribution. The following table sets forth origination by
location of property during the periods shown:
GEOGRAPHIC DISTRIBUTION OF LOAN ORIGINATIONS AND PURCHASES
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
LOCATION 1995 1996 1997
-------- ------- ------- -------
<S> <C> <C> <C>
California....................................... 29.7% 25.0% 17.2%
United Kingdom................................... 0.0% 0.0% 6.7%
Florida.......................................... 1.0% 5.5% 6.4%
Texas............................................ 0.3% 1.4% 5.2%
Washington....................................... 8.8% 6.6% 5.1%
Oregon........................................... 13.6% 9.1% 4.5%
Illinois......................................... 1.6% 2.4% 4.5%
All other........................................ 45.0% 50.0% 50.4%
------- ------- -------
Total............................................ 100.0% 100.0% 100.0%
======= ======= =======
</TABLE>
1997 production percentages exclude commercial loan production of $53.9
million. The company's commercial loan division was sold in 1997.
LOAN PRODUCTION BY BORROWER RISK CLASSIFICATION
The following tables set forth information concerning the Company's non-
conforming first mortgage loan production by borrower risk classification for
loans secured by mortgages for the periods shown.
<TABLE>
<CAPTION>
PERCENT
OF
YEAR CREDIT TOTAL TOTAL WAC(1) WLTV(2)
---- ------ ---------- ------- ----- ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
1995 A $ 98,455 34.1% 11.4% 80.6%
A- 135,001 46.8 9.7 76.8
B 34,906 12.1 10.5 68.2
C 17,716 6.1 11.0 64.1
D 2,404 0.9 12.1 58.6
---------- ----- ---- ----
Totals........................... $ 288,482 100.0% 10.4% 76.1%
========== ===== ==== ====
1996 A $ 127,325 16.1% 10.6% 81.7%
A- 414,544 52.5 10.1 73.4
B 154,601 19.6 10.9 71.8
C 59,214 7.5 11.6 67.8
D 34,230 4.3 12.5 60.6
---------- ----- ---- ----
Totals........................... $ 789,914 100.0% 10.6% 73.5%
========== ===== ==== ====
1997 A $ 467,371 25.5% 10.7% 81.9%
A- $ 671,202 36.6 10.0 75.4
B $ 403,236 22.0 10.9 74.5
C $ 124,420 6.8 11.7 69.2
D $ 167,028 9.1 13.1 61.6
---------- ----- ---- ----
Totals (3)....................... $1,833,257 100.0% 10.8% 75.2%
========== ===== ==== ====
</TABLE>
- --------
(1) Weighted average coupon ("WAC")
(2) Weighted average initial LTV ratio ("WLTV").
(3) Does not include mortgage loan originations of $130,767 from the Company's
United Kingdom subsidiary and commercial loan originations of $53,900.
Commercial Loan Division was sold in 1997.
6
<PAGE>
UNDERWRITING
The Company has established classifications with respect to the credit
profiles of loans based on certain of the borrower's characteristics. Each
loan applicant is placed into one of five letter ratings ("A" through "D,"
with subratings within those categories), depending upon a number of factors
including the applicant's credit history and employment status. Terms of loans
made by the Company, as well as the maximum LTV ratio and debt service-to-
income coverage (calculated by dividing fixed monthly debt payments by gross
monthly income), vary depending upon the classification of the borrower. Loan
applicants with less favorable credit ratings generally are offered loans with
higher interest rates and lower LTV ratios than applicants with more favorable
credit ratings.
The Company's underwriting guidelines are provided to all mortgage loan
brokers and mortgage bankers prior to accepting any loan application or bulk
purchase package. Upon receipt of a loan application from a mortgage loan
broker, the Company's underwriting staff determines if the loan meets the
Company's underwriting guidelines. To assess the credit quality of the loan,
the underwriter considers various factors, including the appraisal of the
collateral property and its value, the applicant's debt payment history,
credit profile and employment status, and the debt ratio and LTV ratio upon
completion of the loan.
Prior to approving a loan, the Company's underwriting staff determines the
applicant's creditworthiness and ability to service the loan. In addition, the
underwriting staff reviews the value of the underlying collateral based on an
original appraisal and also a review appraisal completed by a pre-approved
licensed independent appraiser. For properties valued over $500,000, the
review appraisal must be a full re-appraisal of the subject property.
Beginning in the second quarter of 1997, the Company amended its process to
require the underwriter to order the review appraisal for all loans from a
pre-approved licensed independent appraiser. The Company selects its review
appraisers based on professional experience, education, membership in related
professional organizations and by reviewing the review appraiser's experience
with the type of property being used as collateral. For loans purchased
through its Correspondent Program, the Company typically requested a second
review appraisal if the original review appraisal was completed by a review
appraiser not approved by the Company. All loans submitted for inclusion in a
securitization by Strategic Alliances are reunderwritten and re-appraised by
the Company's underwriters for an initial period. After that initial period,
loans submitted for inclusion in a securitization by Strategic Alliances are
checked on an ongoing basis by the Company's quality control personnel.
Verification of income and credit history is also required prior to closing
a loan. Generally, loan applicants are required to have two years of
employment with their current employer or two years of similar business
experience. Applicants who are salaried must provide current employment
information as well as recent employment history. The Company verifies this
information for salaried borrowers based on written confirmation from
employers, or a combination of a telephone confirmation from the employer and
the most recent pay stub or W-2 tax form. Self-employed applicants are
generally required to provide copies of complete federal income tax returns
filed for the most recent one to two years, depending on credit grade. A
merged credit report combining information gathered from two independent,
nationally recognized credit reporting agencies reflecting the applicant's
credit history is also used. Verification of information regarding the first
mortgage, if any, is also required, including balance, status and whether
local taxes, interest, insurance and assessments are included in the
applicant's monthly payment. All taxes and assessments not included in the
payment are required to be verified as current. Upon completion of the
underwriting process, the closing of the loan is scheduled with an independent
closing attorney who is responsible for closing the loan in accordance with
the Company's closing procedures.
Quality Control. The Company's quality control program is intended to (i)
monitor and improve the overall quality of loan production generated by the
Company's Wholesale Division and Consumer Loan Division or loans presented or
purchased from Strategic Alliances or the Company's Correspondent Program and
(ii) identify and communicate to management existing or potential underwriting
and loan packaging problems or areas of concern. The quality control review
examines compliance with the Company's underwriting guidelines
7
<PAGE>
and federal and state regulations. This is accomplished by focusing on the
accuracy of all credit and legal information, a collateral analysis (which may
include a review of the appraisal), employment or income verification, and
legal document review to ensure the necessary documents are in place.
The Company reviews each loan submitted for inclusion in a securitization
from Strategic Alliances for an initial period, generally 60 to 90 days. The
Company also reviews each loan submitted for purchase from new retail
branches, mortgage brokers or financial institutions with whom the Company
does not have an existing business relationship with as well as loans with
appraisals done by appraisers who are not on the Company's approved appraiser
list. The underwriting staff reunderwrites a sample of the Company's
originated and purchased loans chosen at random. The Company uses this ongoing
underwriting process to gauge the effectiveness of its underwriting guidelines
and to determine whether amendments to such guidelines are advisable.
Credit Management Review. The Company employs a credit management system and
procedures to amend and upgrade its credit management practices. The Company
continually monitors the performance of its loans, and tracks loans by
borrower category, loan originator (whether inside or outside the Company),
type of loan product, prepayments and effectiveness of servicing. The Company
uses the results of this monitoring to determine revisions to product
definitions, product mix, and underwriting guidelines and authorities, as may
be deemed necessary to reduce delinquencies, loan losses and prepayments.
The Company uses the foregoing categories and characteristics as
underwriting criteria only. The Company's underwriting guidelines provide the
flexibility to vary from these criteria. On a case-by-case basis, the
Company's underwriters may determine that the prospective mortgagor warrants a
debt service-to-income ratio, a pricing, an LTV variance or a waiver from
certain requirements of a particular risk category (collectively called an
"upgrade" or a "variance"). An upgrade or variance may generally be allowed if
the application reflects certain compensating factors, including, but not
limited to: low LTV ratio; a superior FICO score; a maximum of one 30-day late
payment on the mortgage loan during the last 12 months; stable income; and an
increased capacity to repay debt. Accordingly, the Company may classify
certain mortgage loan applications in a more favorable credit grade when an
upgrade is granted than other mortgage loan applications that, in the absence
of such compensating factors, would only satisfy the criteria of a less
favorable risk category.
Consumer Loan Division Underwriting Guidelines. All underwriting for all
Consumer Loan Division loans is performed by the Division's dedicated,
centralized underwriting and credit assessment staff. The Consumer Loan
Division has its own California-licensed appraiser who reviews appraisals for
California loans, and independent third-party appraisers are employed for
properties outside of California. The Consumer Loan Division's underwriters
use different underwriting guidelines for the Division's two different loan
products: high LTV loans and non-conforming loans.
Applicants for high LTV loans are evaluated primarily through a default and
loss predictive scoring system developed by FICO, a consulting firm which
specializes in consumer credit assessment. In the FICO scoring system, scores
can range from 400 to 800 points. Based on the applicant's FICO score, the
borrower is placed in a category of "A" to "D," different from the Company's
other A to D categories. "A+" category borrowers are borrowers with FICO
scores above 700, who may borrow up to $100,000 for a 300 month term. "A"
category borrowers are borrowers with FICO scores of 680 to 699, who may
borrow up to $75,000 for a 300 month term. "B+" category borrowers are
borrowers with FICO scores of 660 to 679, who may borrow up to $65,000 for a
300 month term. "B" category borrowers are borrowers with FICO scores of 640
to 659, who may borrow up to $45,000 for 300 month term. "C+" category
borrowers are borrowers with FICO scores of 620 to 639, who may borrow up to
$30,000 for a 180 month term.
Underwriting guidelines for non-conforming second mortgage loans are not
based on the FICO scoring system, but focus on the borrower's credit profile
and the value of the collateral property. Such underwriting guidelines are
substantially similar to the underwriting guidelines used by the Company's
other divisions and use the same A to D categories used by the other
divisions. Due to the limited size of second mortgage loans, underwriters
generally have more flexibility to grant upgrades or exceptions for second
mortgage loans based upon a borrower's length of ownership, length of
employment in the same job and general net worth.
8
<PAGE>
LOAN SALES AND SECURITIZATIONS
The Company sells substantially all loans originated and purchased through
either securitizations or whole loan sales. The means by which the loans are
sold is determined by comparing the market conditions for securitizations
versus whole loan sales and evaluating the risk characteristics of the loans.
Since the latter half of 1995, the Company has sold the vast majority of its
loans through securitizations. Recently, the Company began selling through
whole loan sales certain loans that do not meet the Company's risk objectives,
such as those with higher LTV's relative to the weighted average coupon and
new loan products for which the Company has limited loan performance history.
Whole loan sales generally permit the Company to sell its loans without future
recourse to the Company from the future performance of such loans.
The securitization process involves the pooling of mortgage loans and the
sale of such loans to a securitization trust which simultaneously sells the
senior interest in the form of asset-backed bonds to investors. The remaining
interest is issued to the Company in the form of interest-only and residual
certificates, which entitle the Company to receive Excess Spread over the life
of the loans in the securitization trust. For securitizations completed in
1997, the Company elected to sell a portion of its interest-only certificates
and retain the remaining certificates. The sale of interest-only certificates
permits the Company to partially offset negative cash flow associated with
selling loans through securitizations. The Company intends to consider the
sale of interest-only and residual certificates from future securitizations on
a case-by-case basis.
Each securitization, with the exception of the securitizations completed in
the second quarter of 1997, was insured by monoline insurance companies, which
guarantee the timely interest payment and ultimate principal payment of the
asset-backed bonds. The securitization completed in the second quarter of 1997
was structured as Senior/Sub Structures. In such a structure, several classes
of asset-backed bonds with a combined principal balance approximately equal to
the mortgage loans securitized are issued, each with a different seniority
interest in monthly payments collected from the mortgage loans or expected
maturity. Under the Senior/Sub Structure, the risk of nonpayment of interest
and principal on the asset-backed bonds is assumed by the investors.
The pooling and servicing agreements that govern the distribution of cash
flows from the loans included in the trusts require the overcollateralization
of the senior interests by using cash flows from interest-only and residual
certificates to reduce the outstanding principal balance of the senior
interests to a pre-set percentage of the mortgage loans. The
overcollateralization percentage may be adjusted over time according to the
delinquency and loss experience of the loans. The Company's delinquency and
loan loss experience is affected primarily by the following factors: (i) the
credit grade distribution of originated loan production; (ii) underwriting
guidelines; (iii) servicing; (iv) loss mitigation strategies; and (v) general
economic conditions. Where losses and delinquencies exceed predicted levels,
the cash flow from Excess Spread is used to increase or replenish the
overcollateralization account until such increased losses or delinquencies
have been reserved against. To the extent that a loss is realized on the
loans, losses will be paid first out of interest available to the interest-
only and residual certificates and ultimately out of the overcollateralization
amount available to the interest-only and residual certificates. If losses
exceed the amounts available to the interest-only and residual certificates,
the monoline insurance company policy will pay any further losses experienced
by holders of the senior interests in the related trust. Interest available to
the interest-only and residual certificates, when available, and distributions
from the overcollateralization amount will be used to reimburse the monoline
insurance company for any such payments.
Cash flows are generally described as either "in the trust" or "out of the
trust". Aggregate cash flows from the interest-only and residual certificates
received by the securitization trust are referred to as "in the trust" cash
flows. Cash flows that the Company receives from the securitization trust
after the overcollateralization requirements have been met are commonly
referred to as "out of the trust" cash flows. In determining the fair value of
the Company's interest-only and residual certificates, the Company discounts
the estimated "out of the trust" cash flows.
The majority of the Company's revenue is recognized as gain on sale of
receivables. The calculation of the gain on sale is determined in part by the
allocation of fair market value between the loans sold and the retained
9
<PAGE>
interest (interest-only receivable). The calculation of the fair value of the
interest-only strip receivable utilizes certain estimates of anticipated cash
flows made by management at the time loans are sold. The value of these
anticipated cash flows are impacted by various assumptions including: (i)
discount rate used to calculate present value; (ii) rate of prepayment; and
(iii) the provision or credit losses on loans sold. The rate of prepayment of
loans may be affected by a variety of economic and other factors, including
prevailing interest rates and the availability of alternative financing to
borrowers. The effect of those factors on loan prepayment rates may vary
depending on the type of loan. Estimates of prepayment rates are made based on
management's expectations of future prepayment rates, which are based, in part
on the historical rate of repayment of the Company's loans and other
considerations. There can be no assurance of the accuracy of management's
estimates. The timing of sales of the Company's loans may impact the Company's
earnings from quarter to quarter.
Specifically, the Company currently uses a 12% discount rate to calculate
present value of anticipated "out of the trust" cash flows. Prepayment
assumptions are applied to each discrete security and further to each product
(i.e. ARM's, Fixed and 2/28's) within each security. The estimated CPR varies
over time based upon the relative maturity of the loans included in each pool.
The estimated annual CPR is 4% at inception and increases in equal monthly
increments until the peak estimated CPR is achieved, generally within 12-23
months. Peak CPR's, range from 30% to 50% for ARMs, 40% for 2/28s and 23% for
fixed rate loans. These peaks are generally maintained through month 36.
Thereafter, peak CPR's are reduced in two twelve month steps at which time
terminal CPR's are reached. Terminal CPR's are estimated at 20% for ARM's and
2/28's and 15% for fixed rate loans. The Company estimates losses on loans
sold to the securitization trusts at rates ranging from .50% to .65% per year,
beginning in the second year of the securitization. The Company also
periodically provides for additional credit losses which may be incurred on
loans which the Company voluntarily purchases from the trusts.
The Company believes that the most significant risk to the fair value of its
interest-only and residual certificates is unanticipated prepayments. As such,
the Company requires a majority of the loans it originates or purchases to
carry prepayment riders. Approximately 68% of the loans sold to the
securitization trusts include riders that entitle the Company to collect
additional fees if the loans prepay during the prepayment penalty period,
generally three years. The prepayment penalty income represents a separate
cash flow to the Company and, as such, does not flow through the
securitization trust. Prepayment penalties are recorded as income only upon
receipt. The Company has not historically included the estimated cash flows
from prepayment penalties in the fair value of its interest-only and residual
certificates. Thereby, mitigating a portion of the risk related to
unanticipated prepayments.
The Company may be required either to repurchase or to substitute for loans
which do not conform to the representations and warranties made by the Company
in the pooling and servicing agreements entered into when the loans are pooled
and sold through securitizations.
HEDGING
The market value of fixed-rate mortgage loans has a greater sensitivity to
changes in market interest rates than adjustable-rate mortgage loans. As the
Company's production of fixed-rate mortgage loans has increased, the Company
has begun to implement various hedging strategies to mitigate the change in
market value of fixed-rate mortgage loans held for sale between the date of
origination and sale. Commencing in August 1995, these strategies have
included selling short and selling forward United States Treasury securities
and pre-funding loan originations in its securitizations. The Company
currently hedges its fixed-rate mortgage loans held for sale by selling
forward a combination of United States Treasury securities of various
maturities whose combined change in value due to a change in interest rates
closely approximates the change in value of the mortgage loans hedged. In the
future the Company may hedge its variable-rate mortgage loans and its
interest-only and residual certificates with hedging transactions which may
include forward sales of mortgage loans or mortgage-backed securities,
interest rate caps and floors and buying and selling of futures and options on
futures. The nature and quantity of hedging transactions are determined by the
Company's management based on various factors, including market conditions and
the expected volume of mortgage loan originations and purchases.
The Company believes that it has implemented a cost-effective hedging
program to provide a level of protection against changes in market value of
its fixed-rate mortgage loans held for sale. However, an effective
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<PAGE>
hedging strategy is complex and no hedging strategy can completely insulate
the Company from such changes. In addition, hedging involves transaction and
other costs, and such costs could increase as the period covered by the
hedging protection increases or in periods of rising and fluctuating interest
rates.
In addition, in connection with its securitizations the Company may use a
pre-funding mechanism to hedge future production of mortgage loans. In such
securitization transactions, investors deposit cash in a pre-funded amount
into the related trust to purchase the loans the Company would commit to sell
on a forward basis. This pre-funded amount is invested pending use in short
term obligations which pay a lower interest rate than the interest rate the
trust is obligated to pay certificate investors on the outstanding balance of
the pre-funded amount. The Company is required to deposit at the closing of
the related transaction an amount sufficient to make up the difference between
these rates.
As of December 31, 1996 and 1997, the Company had open hedge positions of
$32.6 million and $65.6 million, respectively, related to the sales of United
States Treasury securities in the forward market. The proceeds from the short
sale are shown net of the related liability in the accompanying balance sheets
at December 31, 1996 and 1997.
LOAN SERVICING AND DELINQUENCIES
Servicing. The Company currently originates or purchases all mortgage loans
on a servicing released basis, thereby acquiring the servicing rights. Through
December 1997, the Company contracted for the servicing of substantially all
the loans it originated, purchased and held for sale with Advanta under a
servicing agreement (as amended, the "Servicing Agreement") entered into
between the Company and Advanta in September 1995. In addition, Advanta has
serviced or subserviced each public securitization of the Company's loans
pursuant to the related pooling and servicing agreement. Servicing includes
collecting and remitting loan payments, making required advances, accounting
for principal and interest, holding escrow or impound funds for payment of
taxes and insurance, if applicable, making required inspections of the
mortgaged property, contacting delinquent borrowers and supervising
foreclosures and property dispositions in the event of unremedied defaults in
accordance with the Company's guidelines. Under the Servicing Agreement, the
Company is obligated to pay Advanta a monthly servicing fee on the declining
principal balance of each loan serviced and a set-up fee for each loan
delivered to Advanta for servicing.
Advanta is required to pay all expenses related to the performance of its
duties under the Servicing Agreement. However, Advanta is required to make
advances of taxes and required insurance premiums that are not collected from
borrowers with respect to any mortgage loan, only if it determines that such
advances are recoverable from the mortgagor, insurance proceeds or other
sources with respect to such mortgage loan. If such advances are made, Advanta
generally will be reimbursed prior to the Company receiving the remaining
proceeds. Advanta also will be entitled to reimbursement by the Company for
expenses incurred by it in connection with the liquidation of defaulted
mortgage loans and in connection with the restoration of mortgaged property.
If claims are not made or paid under applicable insurance policies or if
coverage thereunder has ceased, the Company will suffer a loss to the extent
that the proceeds from liquidation of the mortgaged property, after
reimbursement of Advanta's expenses in the sale, are less than the principal
balance of the related mortgage loan.
The Company may terminate the Servicing Agreement upon the occurrence of one
or more of the events specified in the Servicing Agreement generally relating
to Advanta's proper and timely performance of its duties and obligations under
the Servicing Agreement. Either the Company or Advanta may terminate the
Servicing Agreement without cause upon 90 days' prior written notice to the
other party. The Company will be required to pay certain fees to Advanta in
connection with transferring the servicing of loans to the Company's internal
servicing operations. Depending on the size of the loan pools transferred,
such fees could be substantial.
The pooling and servicing agreements governing the securitization process
generally provide that the Trustee may terminate all rights and obligations of
the servicer of the securitized loans upon written notice, provided that such
termination is at the direction of the monoline insurer for such
securitization or of the majority of holders of certificates thereof, with the
prior written consent of the monoline insurer, but not at the option of the
Company. The ability to effect such termination is restricted to specific
conditions described in the pooling and servicing agreements, which generally
include various loss and delinquency tests and failure to make payments,
including advances, within specific time periods.
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<PAGE>
As is customary in the mortgage loan servicing industry, the servicer is
entitled to retain any late payment charges, penalties and assumption fees
collected in connection with the mortgage loans, net of pre-payment penalties,
which accrue to the Company. The servicer receives any benefit derived from
interest earned on collected principal and interest payments between the date
of collection and the date of remittance to the Company and from interest
earned on tax and insurance escrow funds. The servicer is required to remit to
the Company no later than the 18th day of each month all principal and
interest collected from borrowers during the monthly reporting period.
The following table sets forth certain information regarding the servicing
portfolio of loans originated or purchased by the Company (inclusive of
securitized loans for which the Company has ongoing risk of loss), for the
periods shown.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------------------
1994 1995 1996 1997
--------- -------- --------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Beginning servicing portfolio.. $ 18,074 $ 68,721 $ 270,193 $ 908,220
Loans added to the servicing
portfolio..................... 190,297 288,482 789,914 2,017,924
Loans sold and principal
paydowns...................... (139,650) (87,010) (151,887) (448,950)
--------- -------- --------- ----------
Ending servicing portfolio... $ 68,721 $270,193 $ 908,220 $2,477,194
========= ======== ========= ==========
</TABLE>
The Company's acquisition in December 1997 of NAMC's loan servicing
operations allowed the Company in mid-January 1998 to begin its own loan
servicing operation for all new loans originated and purchased.
In the second quarter of 1998, the Company plans to transfer to its internal
servicing department the servicing of the loans included in the Company's
December 1997 securitization and of remaining loans originated and purchased
in December 1997 and January 1998. See "Factors That May Affect Future
Results--Risks of Servicing."
Delinquencies and Foreclosures. Commencing after the fifth day a loan
becomes late, information with regard to the loan is transferred from the
Servicer's servicing department to a dedicated collection department which is
responsible for contacting the borrower and bringing the loan to current
status. To increase effectiveness and efficiency in collections, the means and
timing of collection procedures vary in accordance with a behavioral model
based on the borrower's credit statistics, the size and type of loan and
responses to prior collection efforts undertaken. Generally, after the fifth
day a loan becomes late, a letter informing the borrower of the tardiness is
mailed and a telephone call is made to the borrower shortly thereafter. If the
borrower is not contacted or a voice message is left, a followup call or calls
are typically made until the reason for tardiness is ascertained and actions
required to bring the loan to current status are determined.
Efforts to maintain verbal and written contact with the borrower continues
as long as the borrower remains contractually delinquent. After 62 days, a
notice to foreclose is mailed to borrowers who are generally considered to
have credit "A" to "B" profiles. A notice to foreclose to borrowers who have
"C" to "D" credit profiles is mailed in 32 days. If these collection measures
do not succeed, the loan is referred to the loss mitigation and foreclosure
department.
The loss mitigation department assesses the procedure to best minimize any
potential loss on the delinquent loan, including the possibility of a short
sale. If payment is not made by the 75th day after it was due, an appraisal of
the property is ordered. The cost of such appraisal is added to the Company's
basis in the loan. The foreclosure department then analyzes the Company's
basis in the loan, the value of the collateral property, the accrued interest,
the carrying costs of the property, and repairs required on the property
before foreclosure sale. After the reinstatement period has expired without
the default having been cured, the borrower or junior lienholder no longer has
the right to reinstate the loan and may be required to pay the loan in full to
prevent the scheduled foreclosure sale.
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<PAGE>
As a foreclosure sale becomes imminent, the servicer reviews the local
jurisdiction's foreclosure laws and the borrower's statutory rights. Local
counsel may be retained to represent the Company's interests. Depending on
local law, foreclosure is effected by judicial action or nonjudicial sale, and
is subject to various notice and filing requirements. In general, the
borrower, or any person having a junior encumbrance on the real estate, may
cure a monetary default by paying the entire amount in arrears plus other
designated costs and expenses incurred in enforcing the obligation during a
statutorily prescribed reinstatement period. Generally, state law controls the
amount of foreclosure expenses and costs, including attorneys fees, which may
be recovered by a lender. If the Company obtains the property in a
foreclosure, an expedited process begins to sell the property as rapidly as
possible.
Although foreclosure sales are typically public sales, third-party
purchasers rarely bid in excess of the lender's lien because of the difficulty
of determining the exact status of title to the property, the possible
deterioration of the property during the foreclosure proceedings and a
requirement that the purchaser pay for the property in cash or by cashier's
check. Thus, the foreclosing lender often purchases the property from the
trustee or referee for an amount equal to the sum of the principal amount
outstanding under the loan, accrued and unpaid interest and the expenses of
foreclosure. Depending on market conditions, the ultimate proceeds of the sale
may not equal the lender's investment in the property.
As the Company transfers its loan servicing operations in-house, the Company
will perform its own services with respect to delinquencies and foreclosures
on the loans handled by its internal loan servicing operation.
As of December 31, 1997, the Company has realized life-to-date losses of
$4.6 million on its loan portfolio of $2.5 billion. In valuing the Company's
interest-only and residual certificates, expectations with respect to
anticipated losses are considered. The Company continually monitors its credit
loss data and will adjust its credit loss assumptions as appropriate as its
portfolio and loss experience increases, and as the Company's loan portfolio
ages.
The following tables set forth the combined delinquency and foreclosure
experience of: (1) loans held for sale or securitization included in the
Company's servicing portfolio; and (2) securitized loans originated by the
Company but serviced by the Company, an affiliate of the Company, or by
Advanta for the periods indicated.
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
----------------------------------------------------------
1995 1996 1997
------------------ ------------------ --------------------
% OF % OF % OF
LOANS IN LOANS IN LOANS IN
SERVICING SERVICING SERVICING
AMOUNT PORTFOLIO AMOUNT PORTFOLIO AMOUNT PORTFOLIO
-------- --------- -------- --------- ---------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Loans serviced.......... $270,193 100.0% $908,220 100.0% $2,477,194 100.0%
30-59 days delinquent... 3,072 1.2 23,062 2.5 71,928 3.0
60-89 days delinquent... 1,409 0.5 15,883 1.7 27,095 1.0
90 days or more
delinquent............. 0.0 1,123 0.1 6,385 0.3
-------- ----- -------- ----- ---------- -----
Total Delinquencies(1).. $ 4,481 1.7 $ 40,068 4.4 105,408 4.3
======== ===== ======== ===== ========== =====
Delinquencies loans in
foreclosure and
bankruptcy............. $ 4,883 1.8 $ 22,402 2.5 126,032 5.1
Total real estate owned. 141 -- 1,227 0.1% 22,007 0.9%
</TABLE>
- --------
(1) Total delinquency figure excludes delinquent loans in Foreclosure and
Bankruptcy.
13
<PAGE>
COMPETITION
The Company is a relatively new entrant in the industry, is relatively small
compared to many of its competitors and faces intense competition in the
business of originating, purchasing and selling mortgage loans. Competition in
the industry takes many forms including convenience in obtaining a loan,
customer service, marketing and distribution channels, amount and term of the
loan. Traditional competitors in the financial services business include other
mortgage banking companies, commercial banks, credit unions, thrift
institutions, credit card issuers and finance companies. Most of these
competitors in the consumer finance business are substantially larger and have
considerably greater financial, technical and marketing resources than the
Company. In addition, many financial services organizations that are much
larger than the Company have formed national loan origination networks that
are substantially similar to the Company's loan origination programs. In
addition, the current level of gains realized by the Company and its
competitors on the sale of non-conforming loans could attract additional
competitors into this market with the possible effect of lowering gains on
future loan sales. The Company believes that its competitive strengths include
providing prompt, responsive service and flexible underwriting to independent
mortgage brokers.
REGULATION
The Company's operations are subject to extensive regulation, supervision
and licensing by federal, state and local government authorities. Regulated
matters include, without limitation, loan origination, credit activities,
maximum interest rates and finance and other charges, disclosure to customers,
the terms of secured transactions, the collection, repossession and claims
handling procedures utilized by the Company, multiple qualification and
licensing requirements for doing business in various jurisdictions and other
trade practices.
The Company's loan origination activities are subject to the laws and
regulations in each of the states in which those activities are conducted. The
Company's activities as a lender are also subject to various federal laws
including the Truth in Lending Act, the Real Estate Settlement Procedures Act,
the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, the Fair
Credit Reporting Act, the Fair Housing Act and the Federal Trade commission
Act.
The Truth in Lending Act ("TILA") and Regulation Z promulgated thereunder
contain disclosure requirements designed to provide consumers with uniform,
understandable information with respect to the terms and conditions of loans
and credit transactions in order to give consumers the ability to compare
credit terms. TILA also guarantees consumers a three day right to cancel
certain credit transactions including loans of the type originated by the
Company. A lender's failure to provide the requisite material disclosures may,
among other things, give rise to a borrower's right of rescission, if
applicable to the transaction and validly invoked. Management of the Company
believes that it is in compliance with TILA in all material respects.
In September 1994, the Riegle Community Development and Regulatory
Improvement Act of 1994 (the "Riegle Act") was enacted. The Riegle Act
contains, among other things, the Homeownership and Equity Protection Act of
1994 (the "High Cost Mortgage Act"), which makes certain amendments to TILA.
The High Cost Mortgage Act, which became effective with respect to loans
consummated after October 1, 1995, generally applies to closed-end loans
secured by a consumer's principal dwelling but not obtained for the purchase
or construction of the dwelling in which the loan has either (i) total points
and fees upon origination in excess of eight percent of the loan amount or
(ii) an annual percentage rate of more than ten percentage points higher than
United States Treasury securities of comparable maturity ("Covered Loans"). A
substantial majority of the loans originated or purchased by the Company are
not Covered Loans.
The High Cost Mortgage Act imposes additional disclosure requirements on
lenders originating Covered Loans and prohibits lenders from, among other
things, originating Covered Loans that are underwritten solely on the basis of
the borrower's home equity without regard to the borrower's ability to repay
the loan. The Company believes that only a small portion of loans it
originated are of the type that, unless modified, would be prohibited by the
High Cost Mortgage Act. The Company's underwriting criteria have always taken
into consideration the borrower's ability to repay.
14
<PAGE>
The High Cost Mortgage Act also prohibits lenders from including prepayment
fee clauses in Covered Loans to borrowers with a debt-to-income ratio in
excess of 50% or Covered Loans used to refinance existing loans originated by
the same lender. The Company will continue to collect prepayment fees on loans
originated prior to the effectiveness of the High Cost Mortgage Act and on
non-Covered Loans as well as on Covered Loans in permitted circumstances.
Because the High Cost Mortgage Act does not apply to loans consummated before
October 1, 1995, the level of prepayment fee revenue was not affected in 1995,
but the level of prepayment fee revenue may decline in future years. The High
Cost Mortgage Act imposes other restrictions on Covered Loans, including
restrictions on balloon payments and negative amortization features, which the
Company does not believe will have a material impact on its operations.
The Company is also required to comply with the Equal Credit Opportunity Act
of 1974, as amended ("ECOA"), which prohibits creditors from discriminating
against applicants on the basis of race, color, sex, age or marital status.
These bases are referred to as "prohibited bases." ECOA, as implemented by
Regulation B, prohibits creditors from discriminating on prohibited bases or
from considering certain types of information in rendering a credit decision.
It also requires certain disclosures by the lender regarding consumer rights
and requires lenders to advise applicants of the reasons for credit denial. In
instances where the applicant is denied credit or the rate or charge for loans
increases as a result of information obtained from consumer reports prepared
by a consumer reporting agency, another statute, the Fair Credit Reporting Act
of 1970, as amended, requires lenders to supply the applicant with the name
and address of the consumer reporting agency and the consumer has a right to
obtain the information contained in the consumer report. The Company is also
subject to the Real Estate Settlement Procedures Act and is required to file
an annual report with the Department of Housing and Urban Development pursuant
to the Home Mortgage Disclosure Act.
In the course of its business, the Company may acquire properties securing
loans that are in default. There is a risk that hazardous or toxic waste could
be found on such properties. In such event, the Company could be held
responsible for the cost of cleaning up or removing such waste, and such cost
could exceed the value of the underlying properties.
Because the Company's business is highly regulated, the laws, rules and
regulations applicable to the Company are subject to regular modification and
change. There are currently proposed various laws, rules and regulations
which, if adopted, could impact the Company. There can be no assurance that
these proposed laws, rules and regulations, or other such laws, rules or
regulations, will not be adopted in the future which could make compliance
much more difficult or expensive, restrict the Company's ability to originate,
broker, purchase or sell loans, further limit or restrict the amount of
commissions, interest and other charges earned on loans originated, brokered,
purchased or sold by the Company, or otherwise adversely affect the business
or prospects of the Company.
EMPLOYEES
At February 28, 1998, the Company employed 1,009 full-time employees. None
of the Company's employees is subject to a collective bargaining agreement.
The Company believes that its relations with its employees are satisfactory.
ITEM 2. PROPERTIES
In February 1998, the primary executive and administrative offices of the
Company and its subsidiaries were relocated. They are now located in leased
space at 4949 Meadows Road, Suite 600, Lake Oswego, Oregon, and consist of
approximately 44,000 square feet. The principal leases covering such space
commenced in November 1997 and run for five years. The current annual rent is
approximately $980,000. The Company has an option to renew the term for an
additional five years.
15
<PAGE>
The Company also leases an office facility located in Santa Rosa, California
which is used for the Company's loan servicing operations. Additionally, the
Company leases office space for each of its Wholesale Division Regional Branch
Centers, Consumer/Retail Offices, and Subsidiary's executive and
administrative offices. The aggregate base rental for these facilities is
approximately $3,200,000. These leases vary as to duration and have different
rent escalation provisions. In general, the leases extend through the year
2000 and provide for rent escalation tied to increases in the Consumer Price
Index or operating costs of the premises.
ITEM 3. LEGAL PROCEEDINGS
The Company, its subsidiary Oceanmark Financial Corporation, and members of
its board directors are defendants in a lawsuit in US District Court for the
Southern District of Florida. Oceanmark Bank, F.S.B. is the plaintiff. The
Company was served on March 9, 1998. The complaint relates to the Company's
acquisition of mortgages and notes of Oceanmark Bank beginning in 1995 and
ending with the Company's acquisition of the mortgage operations of Oceanmark
Bank and certain residual assets in May 1997 and events subsequent to the May
1997 acquisition. The complaint alleges, among other things, that employees of
Oceanmark Bank conspired with the Company to lower the purchase price of the
assets sold to the Company by Oceanmark Bank. The plaintiff seeks relief under
theories of racketeering, securities fraud, breach of contract, breach of
fiduciary duty, conspiracy, and negligence and requests compensatory and
punitive damages totaling more than $75 million.
The Company's management believes that the Oceanmark claims are without
merit and intends to defend the Company's position vigorously. Management
believes that the resolution of this matter will not have a material adverse
effect on the Company's financial condition, results of operations or
liquidity.
SPFC occasionally becomes involved in litigation arising in the normal
course of business. Management believes that any liability with respect to
such legal actions, individually or in the aggregate, will not have a material
adverse effect on the Company's financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND REGULATED STOCKHOLDER
MATTERS
The Company's Common Stock began to trade on the New York Stock Exchange
("NYSE") on June 13, 1996 under the symbol "SFC." The following table sets
forth the range of high and low last reported sale prices per share for the
Common Stock for the periods indicated as reported by the NYSE from the
completion of the Company's initial public offering on June 13, 1996.
<TABLE>
<CAPTION>
HIGH LOW
----- -----
<S> <C> <C>
1996
Second quarter................................................. 11.83 10.92
Third quarter.................................................. 18.42 10.17
Fourth quarter................................................. 22.67 17.33
1997
First quarter.................................................. 26.00 17.13
Second quarter................................................. 17.88 9.88
Third quarter.................................................. 20.47 13.44
Fourth quarter................................................. 16.63 10.56
</TABLE>
As of March 12, 1998, there were 69 holders of record of the Common Stock
who the Company believes held shares for in excess of 2,000 beneficial owners.
16
<PAGE>
The Company has never paid any cash dividends on its Common Stock. The
Company intends to retain all of its future earnings to finance its operations
and does not anticipate paying cash dividends in the foreseeable future. Any
decision made by the Company's Board of Directors to declare dividends in the
future will depend upon the Company's future earnings, capital requirements,
financial condition and other factors deemed relevant by the Company's Board
of Directors.
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
(Dollars in thousands, except per share data)
The selected data presented below under the captions "Statements of Earnings
Data," "Cash Flow Data" and "Balance Sheet Data" for, and as of each of the
years in the five-year period ended December 31, 1997 are derived from the
consolidated financial statements of Southern Pacific Funding Corporation and
Subsidiaries, which financial statements have been audited by KPMG Peat
Marwick LLP, independent auditors. The consolidated financial statements as of
December 31, 1996 and 1997 and for each of the years in the three year period
ended December 31, 1997, and the independent auditors report thereon, are
included elsewhere herein. The selected consolidated financial data should be
read in conjunction with those financial statements and the notes thereto and
with "Management's Discussion and Analysis of Financial Condition and Results
of Operations" included elsewhere herein.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------------
1993 1994 1995 1996 1997
-------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C>
STATEMENTS OF EARNINGS
DATA:
Revenues:
Gains on sales of
loans................ $ 1,218 $ 9,572 $ 16,329 $ 55,361 $ 148,404
Interest income....... 407 2,136 4,305 13,849 39,307
Securities valuation
and other income..... -- -- 1,666 4,265 1,634
-------- ---------- ---------- ---------- ----------
Total revenues...... 1,625 11,708 22,300 73,475 189,345
======== ========== ========== ========== ==========
Expenses:
Interest expense...... 175 886 3,414 7,800 27,613
Personnel and
commission expense... 475 2,156 4,190 10,997 45,028
General and
administrative
expense.............. 239 1,262 2,153 6,599 24,686
-------- ---------- ---------- ---------- ----------
Total expenses...... 889 4,304 9,757 25,396 97,327
======== ========== ========== ========== ==========
Earnings before taxes... 736 7,404 12,543 48,079 92,018
Income taxes............ 305 3,073 5,205 20,447 38,243
-------- ---------- ---------- ---------- ----------
Net earnings............ $ 431 $ 4,331 $ 7,338 $ 27,632 $ 53,775
======== ========== ========== ========== ==========
Net earnings per
share(1):
Basic................. $ -- $ 0.28 $ 0.47 $ 1.49 $ 2.59
Diluted............... $ -- $ 0.28 $ 0.47 $ 1.37 $ 2.23
Weighted average number
of shares
outstanding(1):
Basic................. $ -- 15,562,500 15,562,500 18,552,500 20,747,665
Diluted............... $ -- 15,562,500 15,562,500 20,511,936 25,358,202
CASH FLOW DATA:
(Used in) provided by
operating activities... $(17,711) $ 1,515 $ (85,207) $ (157,701) $ (145,756)
(Used in) investing
activities............. -- (43) (437) (8,554) (9,450)
Provided by (used in)
financing activities... 17,711 (1,222) 85,394 180,431 148,917
-------- ---------- ---------- ---------- ----------
Net increase (decrease)
in cash................ $ -- $ 250 $ (250) $ 14,176 $ (6,289)
======== ========== ========== ========== ==========
OPERATING DATA:
Mortgage loans
originated or
purchased:
Wholesale Division.... $ 38,642 $ 183,010 $ 267,409 $ 529,026 $1,244,043
Correspondent Program. 2,914 7,287 21,073 204,799 280,432
Consumer Loan
Division............. -- -- -- 4,553 149,801
Strategic Alliance
Program.............. -- -- -- 51,536 289,747
-------- ---------- ---------- ---------- ----------
Total............... $ 41,556 $ 190,297 $ 288,482 $ 789,914 $1,964,023
======== ========== ========== ========== ==========
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------------
1993 1994 1995 1996 1997
------- -------- -------- -------- ----------
<S> <C> <C> <C> <C> <C>
Average principal balance
per loan................... $ 127 $ 117 $ 87 $ 110 $ 84
Weighted average interest
rate:
Fixed rate................ 10.5% 10.1% 11.8% 11.5% 12.0%
Variable rate (2)......... 8.0% 8.8% 9.3% 10.1% 10.4%
Combined weighted average
initial LTV ratio.......... 67.7% 69.5% 76.1% 73.5% 75.0%
Percent of first mortgage
loans...................... 96.4% 98.0% 83.2% 98.9% 94.2%
Loan sales:
Loans sold through
securitizations.......... $ -- $ 70,173 $164,870 $657,353 $1,804,991
Whole loan sales.......... 23,410 121,362 58,595 -- 143,662
------- -------- -------- -------- ----------
Total................... $23,410 $191,535 $223,465 $657,353 $1,948,653
======= ======== ======== ======== ==========
DELINQUENCY DATA:
Total delinquent loans as a
percentage of loans
serviced(3)(4)............. 6.90% 0.76% 1.66% 4.41% 4.26%
Total loans in foreclosure
and bankruptcy as a
percentage of loans
serviced................... 0.00% 0.56% 1.81% 2.47% 5.09%
Net losses on foreclosed
loans as a percentage of
loans serviced............. 0.00% 0.00% 0.00% 0.00% 0.19%
FINANCIAL RATIOS:
Ratio of earnings to fixed
charges(5)................. 5.20x 9.36x 4.67x 7.13x 4.29x
Ratio of indebtedness to
total capitalization(6).... N/A 73.9% 25.2% 46.9% 55.7%
<CAPTION>
AS OF DECEMBER 31,
----------------------------------------
1994 1995 1996 1997
-------- -------- -------- ----------
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Loans held for sale......... $ 16,727 $ 80,264 $223,059 $ 264,385
Interest-only and residual
certificates............... 4,234 22,469 87,017 277,156
Total assets................ 21,296 117,215 340,377 589,345
Borrowings under warehouse
lines of credit............ -- 96,130 152,680 205,031
11 1/2% Senior Notes due
2004....................... -- -- -- 100,000
Convertible subordinated
notes...................... -- -- 75,000 75,000
Notes payable............... -- -- -- 3,307
Total liabilities........... 15,745 104,326 255,291 450,190
Shareholders' equity........ 5,551 12,889 85,086 139,155
</TABLE>
- --------
(1) For an explanation of the weighted average number of shares and earnings
used to compute basic and diluted earnings per share, for 1995, 1996 and
1997, see Note 3 of the Notes to the consolidated financial statements
included herein.
(2) Variable rates are based on rate at origination.
(3) Excludes loans in foreclosure.
(4) For the years ended December 31, 1996 and 1997 excludes loans in
bankruptcy.
(5) For the purpose of determining the ratio of earnings to fixed charges,
earnings consist of income before income taxes; fixed charges consist of
interest expense and amortization of bond issuance costs.
(6) Represents the ratio of (i) total debt, exclusive of warehouse financing,
to (ii) the sum of total shareholders' equity and total debt, exclusive of
warehouse financing.
18
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following should be read in conjunction with the Selected Consolidated
Financial Data and Consolidated Financial Statements of the Company and the
accompanying notes for the years ended December 31, 1995, 1996, and 1997. This
report contains forward-looking statements within the meaning of Section 27A
of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Such statements are based on current
expectations and are subject to risks, uncertainties and assumptions,
including those discussed under "Factors That May Affect Future Results."
Should one or more of these risks or uncertainties materialize, or should
underlying assumptions prove incorrect, actual results may vary materially
from those anticipated, estimated or projected.
GENERAL
Overview
The Company is engaged in the business of originating, purchasing and
selling mortgage loans secured primarily by one-to-four family residences. The
majority of the Company's loans are made to owners of single family residences
who use the loan proceeds for mortgage refinancing, home purchase, debt
consolidation, home improvements and educational expenditures. The Company has
experienced significant growth in loan production primarily due to geographic
expansion, further penetration into established markets and the addition of
new loan production sources. As a result, the Company has experienced dramatic
increases in its results of operations.
Operating Cash Flow
Although the Company has recognized significant increases in its
profitability, the Company has operated and continues to operate on a negative
cash flow basis. The Company attributes this negative cash flow to three
primary factors: the timing of cash received in the gain on sale of loans in
securitizations; points or origination fees paid by the Company to acquire
loans; and operating and administrative expenses associated with the Company's
expansion.
The Company's primary source of revenue is the recognition of gains from the
sale of its loans through securitizations. In a securitization, the Company
recognizes a gain on sale at the time the loans are sold, but receives
corresponding cash flows, represented by Excess Spread, over the actual life
of loans. The Excess Spread represents the difference between all principal
and interest received from the loans sold and (i) all principal and interest
required to be passed through to the asset-backed bond investors, (ii) all
servicing fees and (iii) other recurring fees. At the time of the
securitization, the Company capitalizes the Excess Spread based upon certain
prepayment assumptions, transaction expenses and a discount rate that market
participants would use for similar financial instruments. The capitalized
assets are recorded on the Company's balance sheet as interest-only and
residual certificates. A gain or loss is recorded on the income statement
equal to the value of the interest-only and residual certifiactes created by
the securitization in excess of the cost basis of the loans and transaction
and hedging expenses.
Prior to the time the Company begins to receive cash flows from the Excess
Spread, a reserve position is created within each securitization trust which
uses cash flows from the Excess Spread to retire a portion of the
securitization bond debt until the spread between the outstanding principal
balance of the mortgage loans in the securitization trust and the
securitization bond debt equals the lesser of 2.0% to 4.6% percent of the
initial securitization bond debt principal balance or four to six percent of
the remaining principal balance (known as the "overcollateralization
requirement"). The cash flow generated by the Excess Spread is first used to
fund the amount of reserves required to fund the overcollateralization account
of each securitization. Typically, the overcollateralization requirement is
fully funded eight to 24 months from the date of securitization, although this
period may be shorter or longer subject to the structure and performance of
the loans in the securitization.
19
<PAGE>
In connection with the origination or purchase of loans, the Company may
either receive or pay origination fees. These fees, referred to as "points" or
"premiums" in the mortgage industry, are dependent on the source of loan
production and typically correspond to the amount of further processing
required for a loan to be funded and are determined as a percentage of the
loan amount. The Company can receive up to 8% in origination fees for retail
loan originations, and may pay up to 7% for loans purchased through the
Correspondent Program and Strategic Alliance Program. For the year ended
December 31, 1996 and 1997, the Company's direct costs to originate or
purchase loans were approximately 1.6% and 2.4%, respectively. The premiums
paid to acquire loans are reflected in the income statement as a reduction in
the amount of gain recognized from the sale of the loans.
The following table sets forth the average fee paid /(received) by the
Company through its origination channels:
<TABLE>
<CAPTION>
1996 1997
---- -----
<S> <C> <C>
Wholesale Division............................................. 0.52% 0.96%
Correspondent Program.......................................... 4.53% 5.02%
Consumer Loan Division......................................... -- (0.88)%
Strategic Alliances............................................ -- 6.17%
---- -----
Total weighted average....................................... 1.6% 2.4%
==== =====
</TABLE>
RESULTS OF OPERATIONS
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Total revenues increased $115.8 million or 157.7% to $189.3 million in 1997
from $73.5 million in 1996. During the same period, the Company's total
expenses increased $71.9 million or 283.1% to $97.3 million from $25.4
million. As a result, the Company's earnings increased $26.2 million or 94.6%
to $53.8 million in the year ended December 31, 1997 from $27.6 million in
1996.
The increase in revenues was primarily the result of increased gain on sale
of loans and increased interest income due to higher loan originations,
securitizations and whole loan sales. Gains on sales of loans increased $93.0
million or 168.1% to $148.4 million in 1997 from $55.4 million in 1996. This
increase was primarily the result of higher loan origination and purchase
volume which resulted in a higher level of loan securitizations and whole loan
sales.
During 1997, Wholesale Division loan originations increased $715.0 million
or 135.2% to $1,244.0 million compared to $529.0 million in the comparable
period in 1996, Correspondent purchases of loans increased $75.6 million or
36.9% to $280.4 million in 1997 compared to $204.8 million in 1996, Consumer
Loan Division loan originations increased $145.3 million to $149.8 million in
1997 compared to $4.6 million in 1996, Strategic Alliance loan originations
increased to $289.7 million in 1997 from $51.5 million in 1996 and commercial
loan originations increased to $53.9 million in 1997 from none in 1996. As a
result, total residential and commercial loan originations and purchases
increased $1,228 million or 155.5% to $2,017.9 million in 1997 from
$789.9 million in 1996. Total loans of $1,805.0 million were securitized in
1997 compared to $657.4 million of loans securitized 1996, with a weighted
average net gain on securitization of 7.9% and 8.4%, respectively.
Interest income increased $25.5 million or 183.8% to $39.3 million in 1997
from $13.8 million in 1996. The increase in interest income was primarily due
to a higher average balance of loans held for sale in 1997 resulting from the
increased loan origination and purchase volume during such period.
Securities valuation and other income decreased $2.7 million or 61.7% to
$1.6 million in 1997 from $4.3 million in 1996. In 1997, the accretion of the
interest-only and residual certificates using a discount rate of 12% was $18.2
million, while the fair value adjustment was $18.6 million, resulting in a net
reduction to income of $0.4 million. Prepayment penalty income amounted to
$3.4 million and other expense amounted to $1.4 million. In 1996, the
accretion of the interest-only and residual certificates using a discount rate
of 12% was $3.8 million, while the fair value adjustment was $0.6 million,
resulting in a net increase to income of $3.2 million. Prepayment penalty
income amounted to $0.7 million and other income amounted to $0.4 million.
Interest expense increased $19.8 million or 254.0% to $27.6 million in 1997
from $7.8 million in 1996. The increase in interest expense was attributable
to the interest costs associated with higher borrowings resulting from
20
<PAGE>
increased loan origination and purchase volume during the year ended December
31, 1997 and increased interest expense from $75 million in convertible
subordinated debentures issued in October 1996 and $100 million in senior
notes issued in November 1997.
Personnel and commission expense increased $34.0 million or 309.5% to $45.0
million in 1997 from $11.0 million in 1996. The increase in personnel and
commission expense was primarily due to new acquisitions and increased
staffing levels related to the Wholesale Division's growth and increased loan
originations. As of December 31, 1997 the Company operated 38 regional and
satellite offices and employed 1,030 persons as compared to 14 regional and
satellite offices and 370 employees as of December 31, 1996.
General and administrative expense, which consists primarily of occupancy,
supplies and other expenses, increased $18.1 million or 274.1% to $24.7
million in 1997 from $6.6 million in 1996. The increase in general and
administrative expense was primarily due to the expenses incurred in
association with the increase in the number of regional and satellite offices,
new acquisitions and increased loan origination and purchase volume.
Year Ended December 31, 1996 Compared to the Year Ended December 31, 1995
Total revenues increased $51.2 million or 229% to $73.5 million in 1996 from
$22.3 million in 1995. During the same period, the Company's total expenses
increased $15.6 million or 160% to $25.4 million from $9.8 million. As a
result, the Company's net earnings increased $20.3 million or 277% to $27.6
million in 1996 from $7.3 million in 1995.
The increase in revenues was primarily the result of increased gain on sale
of loans and increased interest income due to higher loan originations and
securitizations. Gains on sales of loans increased $39.0 million or 239% to
$55.4 million in 1996 from $16.3 million in 1995. This increase was primarily
the result of higher loan origination and purchase volume as well as a higher
volume of loans at the beginning of the period which resulted in a higher
level of loan securitization. In 1996, Wholesale Division loan originations
increased $261.6 million or 97.8% to $529.0 million compared to $267.4 million
in the comparable period in 1995, Correspondent Division purchases of loans
increased $183.7 million or 872% to $204.8 million in 1996 compared to $21.1
million in the comparable period in 1995, Consumer Loan Division loan
originations increased to $4.6 million in 1996 from $0 million in the
comparable period in 1995, and Strategic Alliance loan originations increased
to $51.5 million in 1996 from $0 million in the comparable period in 1995. As
a result, total loan originations and purchases increased $501.4 million or
174% to $789.9 million in 1996 from $288.5 million in the comparable period in
1995. Total loans of $657.4 million were securitized in 1996 compared to
$223.5 million of loans sold or securitized during the comparable period in
1995, with a weighted average gain on securitization of 8.4% in both years.
Interest income increased $9.5 million or 221.7% to $13.8 million in 1996
from $4.3 million in 1995. The increase in interest income was primarily due
to a higher average balance of loans held for sale in 1996 resulting from the
increased loan origination and purchase volume during such period, and a
higher balance of loans held for sale at the beginning of such period as
compared to the corresponding period in 1995.
Securities valuation and other income increased $2.6 million or 156.0% to
$4.3 million in 1996 from $1.7 million in 1995. The increase was primarily the
result of a $1.5 million or 88% increase in securities valuation adjustments
on interest-only and residual certificates to $3.2 million in 1996 from $1.7
million in 1995.
Total expenses increased $15.6 million or 160.3% to $25.4 million in 1996
from $9.8 million in 1995. The increase in expenses was primarily the result
of additional personnel and commission expenses, increases in interest expense
on loans held for sale, and higher operating expenses related to increased
loan origination and purchase volume in 1996 compared to 1995.
Interest expense increased $4.4 million or 128.4% to $7.8 million in 1996
from $3.4 million in 1995. The increase in interest expense was attributable
to the interest costs associated with a higher balance of loans held pending
sale during 1996 resulting from increased loan origination and purchase volume
during the year.
21
<PAGE>
Personnel and commission expense increased $6.8 million or 162.5% to $11.0
million in 1996 from $4.2 million in 1995. The increase in personnel and
commission expenses was primarily due to increases staffing levels related to
the Wholesale Division's growth and increased loan originations. As of
December 31, 1996, the Company operated 14 regional branch centers and
employed 370 persons as compared to 8 regional branch centers and 104
employees as of December 31, 1995. In addition, the Company started the
Consumer Loan Division which employed 45 persons as of December 31, 1996.
General and administrative expense, which consists primarily of occupancy,
supplies and other expenses, increased $4.4 million or 207% to $6.6 million in
1996 from $2.2 million in 1995. The increase in general and administrative
expense was primarily due to expenses incurred in association with the
increase in the number of regional branch centers to 14 in 1996 from 8 in 1995
and increased loan origination and purchase volume.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity. The Company anticipates that it will continue operating on a
negative cash flow basis as long as it continues to sell loans through
securitizations and it continues to retain interest-only and residual
certificates on the loans sold. To curtail this negative cash flow the Company
plans to sell loans through whole loan transactions combined with
resecuritizing some of its existing retained residuals and interest-only
certificates. The Company funds its cash requirements primarily through
capital market transactions, working capital, warehouse and residual
financings as well as whole loan sales and securitizations.
The Company relies in part upon short-term warehouse facilities to fund loan
originations and purchases. The Company has entered into five warehouse and
purchase facilities. Under these facilities, the Company has available $1,188
million warehouse lines of credit secured by the loans the Company originates
and purchases which are scheduled to expire between April 15, 1998 and
December 15, 1998.
The Company is required to comply with various operating and financial
covenants as defined in the agreements governing the facilities. Such
covenants include restrictions on (i) changes in the Company's business that
would materially and adversely affect the Company's ability to perform its
obligations under the facilities, (ii) selling any asset other than in the
ordinary course of business, (iii) guaranteeing the debt obligations of any
other entity, (iv) the use of proceeds from such facilities, including
delivery standard, LTV ("loan-to-value") and product mix and (v) the Company's
minimum net worth, debt to net worth ratio, profitability and minimum
borrowing base requirements. The continued availability of funds provided to
the Company under the facilities is subject to the Company's continued
compliance with the operating and financial covenants contained in such
agreements, the Company was in compliance with the covenants during 1997.
During the years ended December 31, 1995, 1996 and 1997, the Company
securitized $164.9 million, $657.4 million and $1,805.0 million, respectively.
The Company expects to continue to depend on its ability to securitize loans
in the secondary market to generate cash proceeds for repayment of its
warehouse lines and to create credit availability to purchase additional
loans. Several factors affect the Company's ability to complete
securitizations of its loans, including conditions in the securities markets
generally, conditions in the asset-backed securities market specifically, the
credit quality of the Company's portfolio of loans and the Company's ability
to obtain credit enhancement. Adverse changes in such factors may affect the
Company's results of operations, financial condition and ability to generate
sufficient cash flows needed to continue originating and purchasing loans at
increased levels.
RECENT ACCOUNTING DEVELOPMENTS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income". This Statement establishes standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general-purpose financial statements. This Statement shall be
effective for fiscal years beginning after December 15, 1997. Reclassification
of financial statements for earlier periods provided for comparative purposes
is required.
22
<PAGE>
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information". This Statement establishes standards
for the way that public business enterprises report information about
operating segments in annual financial statements and requires that
enterprises report selected information about operating segments in interim
financial reports issued to shareholders. This Statement shall be effective
for fiscal years beginning after December 15, 1997. In the initial year of
application, comparative information for earlier years is to be restated.
YEAR 2000
The Year 2000 issue is a flaw in many electronic data processing systems
which prevents them from processing year-date data accurately beyond the year
1999. This is the result of using a two-digit representation for the year, for
example "99" for "1999". This approach assumed that the first two digits of
the abbreviated date is "19". However, when the computer reaches 2000 it may
interpret "00" as the year 1900, possibly causing inaccurate data processing
or processing to stop altogether. The Company has reviewed its exposure to the
Year 2000 issue with respect to its data processing systems and determined the
cost of Year 2000 compliance will be immaterial to its financial condition and
results of operations. Additionally, the Company has reviewed its exposure to
Year 2000 issue with respect to material vendors such as Advanta and is
monitoring Advanta's Year 2000 compliance program to ensure timely completion.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Leverage; Asset Encumbrance; and Restrictive Covenants. The Company
currently is significantly leveraged. The degree to which the Company is
leveraged could have the following important consequences: (i) the Company may
be more vulnerable to adverse general economic and industry conditions; (ii)
the Company may find it more difficult to obtain financing for future working
capital, capital expenditures, acquisitions, general corporate purposes or
other purposes; and (iii) the Company will have to dedicate a substantial
portion of the Company's cash flows from operations to the payment of
principal and interest on indebtedness, thereby reducing the funds available
for operations and future business opportunities.
The instruments governing the indebtedness of the Company impose significant
operating and financial restrictions on the Company. Such restrictions will
affect, and in many respects significantly limit or prohibit, among other
things, the ability of the Company to incur additional indebtedness, pay
dividends, repay indebtedness prior to its stated maturity, sell assets or
engage in mergers or acquisitions. In addition, the indenture for the
Company's $100 million senior note offering completed in October 1997,
requires the Company to achieve, and thereafter maintain, a specified amount
of unencumbered interest-only and residual certificates, thereby precluding
the Company's ability to access residual financing until the Company reaches
predetermined levels in accordance with such indenture. All of these
restrictions could also limit the ability of the Company to effect future
financings, make needed capital expenditures, withstand a future downturn in
the business or the economy, or otherwise conduct necessary corporate
activities.
Changes in Valuations of Interest-Only and Residual Certificates. At
December 31, 1997, the Company's balance sheet reflected interest-only and
residual certificates of approximately $277.2 million valued by the Company in
accordance with Statement of Financial Accounting Standards ("SFAS") No. 125,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishment
of Liabilities" ("SFAS No. 125"). These assets are carried on the Company's
balance sheet at fair value. The Company uses an estimate of the present value
of expected future cash flows as an estimate of fair value. This estimate is
based upon what the Company believes are reasonable and supportable
assumptions and projections at the time of the estimate. However, the estimate
of fair value is updated monthly. The primary factors considered in developing
estimates of expected fair value are prepayment speeds, discount rate,
delinquency rates and credit losses. The Company estimates the expected cash
flows that it will receive over the life of a portfolio of loans. These
expected cash flows constitute the excess of the interest rate payable by the
obligors of loans over the interest rate passed through to the purchasers of
the related securities, less applicable recurring fees and credit losses. The
Company discounts the expected cash flows using an interest rate that market
participants would use for similar financial instruments.
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The Company has elected to carry these assets as trading securities. If actual
experience in the assumptions used in the determination of the carrying value
of the assets differs from the projections, or if valuation assumptions change
in the marketplace, the Company would be required to make a fair value
adjustment to the asset and record that adjustment in the Company's statement
of earnings. For example, if the Company experiences increased prepayments in
its loan portfolios, the fair value of the future cash flow would be adjusted
downward, and would have an adverse impact on the Company's earnings. The
valuation of such interest-only and residual certificates can fluctuate
widely. No assurance can be given that the loans securitized by the Company
will not experience significant prepayments or loan losses or as to whether,
and in what amounts, the Company in the future may have to write down the
value of its interest-only and residual certificates. If actual prepayments
occur more quickly than was projected at the time loans were sold, the
carrying value of the interest-only strips may have to be adjusted through a
charge to earnings in the period of adjustment. To the Company's knowledge,
there is no active market for the sale of these interest-only and residual
certificates. No assurance can be given that interest-only and residual
certificates could be sold at their reported value, if at all. A decline in
the value of the Company's interest-only and residual certificates could have
a material adverse effect on the Company's financial condition and results of
operations.
Dependence on Warehouse Financing. The Company relies upon short-term
warehouse facilities to fund loan originations and purchases. The Company
currently has warehouse lines of credit aggregating $1,188.2 million, of which
$205.0 million was outstanding at December 31, 1997. Such amounts are secured
by the loans the Company originates or purchases with such funds. The Company
is required to comply with various operating and financial covenants as
defined in the agreements governing such lines of credit. Such covenants
include restrictions on (i) changes in the Company's business that would
materially and adversely affect the Company's ability to perform its
obligations under the warehouse lines of credit, (ii) selling any asset other
than in the ordinary course of business, (iii) guaranteeing the debt
obligation of any other entity, (iv) the use of proceeds from such facilities,
including delivery standards, loan-to-value ratio ("LTV"), and product mix and
(v) the Company's minimum net worth, debt to net worth ratio, profitability
and borrowing base. The continued availability of funds provided to the
Company under these lines of credit is subject to the Company's continued
compliance with the operating and financial covenants contained in such
agreements. The Company currently has five warehouse facilities, two of which
are through its UK subsidiary, Southern Pacific Mortgage Limited. The
facilities consist of a $400 million facility that expires on April 15, 1998,
a $400 million facility that expires on April 15, 1998, a $164.7 million that
expires on July 7, 1998, a $100 million facility that expires August 21, 1998
and a $123.5 million facility that expires December 15, 1998. The Company
periodically negotiates renewal or replacement warehouse lines as considered
necessary. To the extent that the Company is not successful in maintaining or
replacing adequate warehouse financing, it would not be able to hold a large
volume of loans pending securitization and therefore would have to curtail its
loan production activities or sell loans either through whole loan sales or in
smaller securitizations, thereby having a material adverse effect on the
Company's financial condition and results of operations. There can be no
assurance that when the above-mentioned credit facilities expire or are paid
off that the Company will be able to renew or replace such facilities on
similar or commercially reasonable terms, or at all.
Dependence on Securitizations. The Company has pooled and sold through
securitizations substantially all of the loans which it originated or
purchased and, in the future, intends to pool and sell a significant portion
of its loans through securitizations. The Company relies significantly upon
securitizations to generate cash proceeds for repayment of its warehouse lines
and to create credit availability to purchase additional loans. Further, gains
on sales from the Company's securitizations represent a significant portion of
the Company's revenues. Several factors affect the Company's ability to
complete securitizations of its loans, including conditions in the securities
markets generally, conditions in the asset-backed securities market
specifically, the credit quality of the Company's portfolio of loans and the
Company's ability to obtain credit enhancement. If the Company were unable to
securitize profitably a sufficient number of its loans in a particular
financial reporting period, then the Company's revenues for such period would
decline which could result in lower income or a loss for such period. In
addition, unanticipated delays in closing a securitization could also increase
the Company's interest rate risk by increasing the warehousing period for its
loans. Any such delays could have a material adverse effect on the Company's
financial condition and results of operations.
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In order to gain access to the securitization market, the Company has relied
on credit enhancements provided by monoline insurance companies to enable it
to obtain a "AAA/Aaa" rating for asset-backed bonds issued by the
securitization trust. The Company has also relied on credit enhancements from
the subordination of a class of securities issued by the securitization trust
to a senior class of securities of the same trust whereby
the senior certificate holders are protected against losses by having their
interests senior to the subordinate certificate holders' interests. Any
substantial reductions in the size or availability of the securitization
market for the Company's loans or changes in the securitization market's
acceptance of such credit enhancements could have a material adverse effect on
the Company's results of operations and financial condition.
Negative Earnings Impact of Increased Whole Loan Sales. The Company intends
to increase the percentage of loans it sells through whole loan sales as a
means of increasing its cash position as well as reducing certain risks
associated with the valuation of the interest only and residual certificates.
Whole loan sales generally permit the Company to sell its loans with limited
recourse to the Company from the future performance of such loans. However,
selling loans through whole loans sales generally provides the Company with a
significantly lower premium than the premium which is the estimated fair value
of the interest-only and residual certificates retained by the Company in
securitizations. Consequently, Selling an increasing portion of its loans
through whole-loan sales may have an adverse impact on the Company's earnings.
Ability to Service Outstanding Indebtedness. There can be no assurance that
the cash available from operations and financing activities will be sufficient
to enable the Company to make required interest and principal payments on its
debt obligations. The Company's ability to make scheduled payments of the
principal of, or to pay the interest on, or to refinance its indebtedness will
depend on its future operating performance, which to a certain extent is
subject to economic, financial, competitive, regulatory, and other factors
beyond its control. If the Company is unable to generate sufficient cash flow
to service its debt, it may be required to refinance all or a portion of its
existing debt, or to obtain additional financing. There can be no assurance
that any such refinancing would be possible or that any additional financing
could be obtained. Failure to obtain any such financing could have a material
adverse effect on the Company's financial condition and results of operations.
Although the Company has recognized significant increases in profitability,
it has operated and continues to operate on a negative cash flow basis. The
Company attributes this negative cash flow to three primary factors: the
timing of cash received in the gain on sale of loans in securitizations;
points or premiums paid by the Company to acquire loans; and operating and
administrative expenses associated with the Company's expansion. For the years
ended December 31, 1996 and 1997, the Company operated on a negative cash flow
basis using $157.7 million and $149.4 million, respectively, in operating
activities.
Limited History of Independent Operations; Recent and Planned Expansion. The
Company commenced operations in January 1993 as a division of Southern Pacific
Thrift and Loan and was an operating subsidiary of Imperial Credit Industries,
Inc. from April 1995 until March 1997. The Company's total revenues and net
earnings have grown significantly since inception, primarily due to increased
mortgage origination, purchasing and sales activities. The Company may
experience difficulties in integrating newly-acquired entities andnewly-
established relationships with its operations. The Company intends to continue
to pursue a growth strategy for the foreseeable future, primarily through the
growth and expansion of its Wholesale Division, the development of its
Consumer Loan Division and entering into Strategic Alliances. The Company has
acquired and is considering acquiring related businesses, some of which could
be material.
In certain cases the Company enters into arrangements to acquire new
businesses. These arrangements provide options to management of such
businesses to repurchase equity interests of the acquired company if certain
performance targets are met. The Company reports the results of operations of
these subsidiaries on a consolidated basis. The exercise of such options could
result in the deconsolidation of such subsidiaries which could result in a
decline in the Company's net earnings.
Each of these plans requires additional personnel, assets and cash
expenditures and there can be no assurance that the Company will be able to
successfully expand and operate such divisions and programs profitably. There
can be no assurance that the Company will anticipate and respond effectively
to all of the changing demands that its expanding operations will have on the
Company's management, information and
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operating systems and cash reserves and the failure of the Company to meet
challenges of any such expansion could have a material adverse effect on the
Company's results of operations and financial condition. The Company may face
unforeseen difficulties in its securitizations or whole-loan sales of loans
obtained through acquisitions of smaller lenders due to the different quality
control and underwriting standards employed by such lenders.
Risks of Servicing. The Company currently originates or purchases all
mortgage loans on a servicing released basis, thereby acquiring the servicing
rights. Through December 1997, the Company contracted for the servicing of
substantially all the loans it originated, purchased and held for sale with
Advanta under a servicing agreement (as amended, the "Servicing Agreement")
entered into between the Company and the Servicer in September 1995. In
addition, Advanta has serviced or subserviced each public securitization of
the Company's loans pursuant to the related pooling and servicing agreement.
The transfer of servicing files could lead to temporary disruptions in
servicing. When primary servicing of loans is transferred, there is generally
a rise in delinquencies associated with such transfer. Such increasing
delinquencies may result in losses to the Company. The servicing of mortgage
loans require special skill and diligence. The Company has limited experience
in servicing loans. Accordingly, there may be a greater risk of delinquencies
on the loans and, to the extent such delinquencies result in losses, a greater
risk of increased losses, than for a servicer with more experience servicing
the loans. In addition, the Company will be required to pay certain fees to
Advanta in connection with transferring the loans to the Company's servicing
operations. Depending on the size of the loan pools being transferred, the
fees that the Company would be obligated to pay Advanta could be substantial.
Many of the Company's borrowers require notices and reminders to keep their
loans current and to prevent delinquencies and foreclosures. A substantial
increase in the Company's delinquency rate or foreclosure rate could have a
material adverse effect on the Company's financial condition and results of
operations. See "Business--Loan Servicing and Delinquencies."
Advanta currently services the mortgage loans in each of the Company's
public securitizations. As stated above, in the second quarter of 1998 the
Company expects to transfer to its internal loan servicing operations the
servicing of the loan pool from its Series 97-4 securitization in December
1997 with respect to which the Company retained the master servicing rights.
In future securitizations, the Company expects to continue to be designated
the master servicer and to have such servicing performed by its internal
servicing operations. With respect to all mortgage loans in the Company's
securitizations, the related pooling and servicing agreements governing the
securitization process generally provide that, in certain circumstances, the
Trustee may terminate all rights and obligations of the servicer of the loans
upon written notice, provided that such termination is at the direction of the
monoline insurer for such securitization or of the majority of holders of
certificates thereof, with the prior written consent of the monoline insurer,
but not at the option of the Company. The ability to effect such termination
is restricted to specific conditions described in the pooling and servicing
agreements, which generally include various loss and delinquency tests and
failure to make payments, including advances, within specific time periods. If
a new servicer were selected with respect to any such securitization, the
change in servicing may result in greater delinquencies and losses on the
related loans, which would adversely impact the value of the interest-only and
residual certificates held by the Company in connection with such
securitization.
Delinquencies; Negative Impact on Cash Flow. The Company's cash flow is
adversely impacted by high delinquency rates in the Company's public
securitizations. Generally, provisions in the pooling and servicing agreements
entered into in connection with such securitizations require that amounts
retained as reserves in an overcollateralization account, which is funded
primarily by cash flow from the Excess Spread on the loans held in the trust,
be increased when the delinquency rates of the loans in such securitization
exceed specified limits. The Company has been required to increase the
overcollateralization account for five of its ten securitization trusts due to
its delinquency rates and other factors.
Delinquency and loss rates also affect the assumptions used by the Company
in computing the value of the Company's interest-only and residual
certificates and could affect the Company's ability to effect securitizations
in the capital markets. No assurance can be given that future delinquencies
will not increase or that any such increase will not have a material adverse
effect on the Company.
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Risks Related to Credit-Impaired Borrowers. Many of the Company's borrowers
have limited access to mortgage financing for a variety of reasons, including
unfavorable past credit experience. The Company is subject to various risks
associated with these borrowers, including, but not limited to, the risk that
borrowers will not satisfy their debt service payments, including payments of
interest and principal, and that the realizable value of the property securing
such loans will not be sufficient to repay the borrower's obligation to the
Company. The risks associated with the Company's business increase during an
economic downturn or recession. Any material decline in real estate values
increases the LTVs of the Company's existing loans, thereby weakening
collateral values and increasing the possibility of a loss in the event of
default. Furthermore, the rates of delinquencies and foreclosures and the
frequency and severity of losses generally increase during economic downturns
or recessions. Because the Company lends to borrowers who may be credit-
impaired, the actual rates of delinquencies, foreclosures and losses on such
loans could be higher under adverse economic conditions than those currently
experienced in the mortgage finance industry in general. In addition, in an
economic downturn or recession, the Company's servicing costs will increase.
Any sustained period of such increased losses could have a material adverse
effect on the Company's results of operations and financial condition.
Certain of the Company's loan products have high LTV ratios and, although
secured by real property, the collateral of such loans often will not be
sufficient to cover the principal amount of the loans in the event of default.
The principal balance of such a loan, inclusive of other loans secured by the
same property, often exceeds the value of the underlying property by as much
as 25%. Consequently, the Company is less likely to use foreclosure as a means
to mitigate its losses upon the default of such loans or to recover any
meaningful amounts in the event of a foreclosure. Losses not covered by the
value of the underlying properties could have a material adverse effect on the
Company's results of operations and financial condition. The Company believes
that the non-conforming loans it originates and purchases will experience
higher losses than conforming loans would experience. Loans made to non-
conforming borrowers may entail a higher risk of delinquency and higher losses
than loans made to borrowers who utilize conventional mortgage sources. While
the Company believes that the underwriting criteria it employs enable it to
mitigate the higher risks inherent in loans made to non-conforming borrowers,
no assurance can be given that such criteria or methods will protect the
Company from higher than anticipated losses. In the event that pools of loans
sold by the Company in which the Company retainsinterest-only and residual
certificates experience higher losses than anticipated, the Company's results
of operations or financial condition could be adversely affected.
Risks Related to Operations in the UK. In 1997 the Company began operations
in the United Kingdom through its wholly-owned subsidiary, Southern Pacific
Mortgage Limited. The Company's operations in the United Kingdom market are
subject to most of the same risks faced by the Company's US operations, as
well as the additional risks customarily associated with US corporations
conducting foreign activities. The Consumer Affairs Division of the Office of
Fair Trading (the "Office of Fair Trading") issued "Non-Status Lending
Guidelines for Lenders and Brokers" in July 1997 (the "Guidelines"), relating
to the conduct of business by non- conforming mortgage lenders and brokers in
the United Kingdom, including prepayment penalties, late fees and fees paid to
mortgage brokers. The Company plans to comply fully with the Guidelines and
any other applicable regulations in the United Kingdom. Failure to comply with
such guidelines and/or regulations can result in the suspension or revocation
of licenses of lenders in the United Kingdom. There can be no assurance that
the final form of any regulations promulgated in the United Kingdom will be
similar to the Guidelines. At the current time the Company is unable to
estimate the cost, if any, of complying with the Guidelines or any other
regulations, and there can be no assurance that the imposition of such costs
will not have a material adverse effect on the Company's business in the
United Kingdom. The Company is also exposed to fluctuations in foreign
currency exchange rates. To the extent that unfavorable fluctuations in
foreign currency exchange rates occur, the Company's results of operations
will be adversely affected. Additional risks in the United Kingdom include
fluctuations in foreign currency controls, expropriations, nationalization and
other economic, tax and regulatory policies of the United Kingdom government
as well as the laws and policies of the United States affecting foreign trade
and investment.
Credit Risk Associated with New Products. From time to time the Company
introduces new products. To the extent the Company securitizes new loan
products, it must make certain assumptions regarding the estimated
delinquencies, prepayments and foreclosures relating to such loans, and such
assumptions affect the gain on sale
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recorded by the Company upon the securitization of such loans. Although some
data for the mortgage loan industry in general is available to the Company in
preparing such assumptions, there can be no assurance that such data will be
similar to the Company's experience with the performance of new loan products.
There can be no assurance that the performance of these products will meet the
Company's estimates, have the expected impact on the value of Company's
interest-only and residual certificates or be sufficient to enable
securitization or whole-loan sales of such new products.
Beginning in the second quarter of 1996, the Company began offering a "2-28"
adjustable rate mortgage product. The 2-28 product has an initial fixed
interest rate for two years which is typically 100 to 200 basis points lower
than the fully-indexed interest rate. Since none of the 2-28 loans made by the
Company have reached the end of their initial two-year fixed interest rate
period, the Company does not have statistical experience as to the performance
of these loans once such initial period is over. The 2-28 product may be
subject to a number of risks, including increased prepayment due to the
increase of the interest rate to the fully-indexed level and increased
delinquencies as the higher adjustable interest rates take effect. In
addition, the Company's assumptions regarding prepayments or credit losses
used to assess loans may not simulate the actual performance of such loans.
For 1997, approximately 50.9% of the Company's loan production consisted of 2-
28 product. The occurrence of any of the foregoing risks could have a material
adverse effect on the Company's financial condition or results of operations.
In 1997, the Company began operations in the United Kingdom. The market for
non-conforming loans in the United Kingdom is relatively undeveloped and the
performance of such loans may be substantially different from the non-
conforming loan market in the United States. Although the Company believes
that there will be some correlation between the performance of non-conforming
loans in the United Kingdom to the same type of loans in the United States,
there can be no assurance that the performance of such loans will be similar
to the Company's experience with the performance of non-conforming loans in
the United States. Adverse performance of such loans could have a material
adverse effect on the Company's financial condition and results of operations.
Risk of Prepayments. The Company is subject to the significant risk that its
loans will be prepaid. Because of the higher risks associated with
nonconforming loans, the Company is able to charge higher interest rates on
its loans. However, as a borrower's credit improves, the borrower is often
able to refinance its loan at a lower interest rate. Furthermore, prepayments
are likely to increase with the Company's "2-28" adjustable rate product due
to the fully indexed rate after the initial two-year period. In an effort to
mitigate the prepayment risk, the Company imposes prepayment penalties on such
loans where legally permissible. However, many states do not permit prepayment
penalties. Consequently, approximately 32% of the Company's loans do not
contain prepayment penalties. Increased prepayments could have a material
adverse effect on the Company's financial condition and results of operations.
General Economic Conditions; Changes in Interest Rates. The Company's
business may be adversely affected by periods of economic slowdown or
recession which may be accompanied by decreased demand for consumer credit and
declining real estate values. Any material decline in real estate values
reduces the ability of borrowers to use home equity to support borrowings and
increases the LTV ratios of loans previously made by the Company, thereby
weakening collateral coverage and increasing the possibility of a loss in the
event of default. Further, delinquencies and foreclosures generally increase
during economic slowdowns or recessions. Because of the Company's focus on
borrowers who are unable or unwilling to obtain mortgage financing from
conventional mortgage sources, whether for reasons of credit impairment,
income qualification or credit history or a desire to receive funding on an
expedited basis, the actual rates of delinquencies, foreclosures and losses on
such loans could be higher under adverse economic conditions than those
currently experienced in the mortgage lending industry in general. Any
sustained period of such increased delinquencies, foreclosures or losses could
adversely affect the pricing of the Company's loan sales whether through whole
loan sales or securitizations and the value of the Company's interest-only and
residual certificates, which could have a material adverse effect on the
Company's financial condition or results of operations.
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Profitability may be directly affected by the level of and fluctuations in
interest rates which affect the Company's ability to earn a spread between
interest received on its loans held for sale and rates paid on the Company's
warehouse lines. The Company's profitability may be adversely affected during
any period of unexpected or rapid change in interest rates. A substantial and
sustained increase in interest rates could adversely affect the Company's
ability to originate and purchase loans and can result in increased loan
losses. A significant decline in interest rates could increase the level of
loan prepayments and require the Company to write down the value of its
interest-only and residual certificates, thereby adversely impacting the
Company's financial condition and results of operations. Variable-rate
mortgage loans (which include loans that typically have initial fixed rate
terms of up to two years) originated or purchased by the Company amounted to
$155.1 million, $528.9 million and $1,450.2 million in principal amount during
the years ended December 31, 1995, 1996 and 1997, respectively. Substantially
all such variable-rate mortgage loans are made at an initial interest rate
approximately 100 to 200 basis points below the fully indexed interest rate at
origination. Although these loans are underwritten assuming the fully indexed
rate at origination, borrowers may encounter financial difficulties as a
result of increases in the interest rate over the life of the loans.
The market value of fixed-rate mortgage loans has a greater sensitivity to
changes in market interest rates than adjustable-rate mortgage loans. The
Company has implemented various hedging strategies to mitigate the change in
market value of fixed-rate mortgage loans held for sale between the date of
origination and sale. Commencing in August 1995, these strategies have
included selling short and selling forward United States Treasury securities
and pre-funding loan originations in its securitizations. The Company
currently hedges its fixed-rate mortgage loans held for sale by selling
forward a combination of United States Treasury securities of various
maturities whose combined change in value due to a change in interest rates
closely approximates the change in value of the mortgage loans hedged. In the
future the Company may hedge its variable-rate mortgage loans and interest-
only and residual certificates with hedging transactions which may include
forward sales of mortgage loans or mortgage-backed securities, interest rate
caps and floors and buying and selling of futures and options on futures. The
nature and quantity of hedging transactions are determined by the Company's
management based on various factors, including market conditions and the
expected volume of mortgage loan originations and purchases. No assurance can
be given that such hedging transactions will offset the risks of changes in
interest rates, and it is possible that there will be periods during which the
Company could incur losses after accounting for its hedging activities. See
"Business--Hedging."
Risks Related to Representations and Warranties in Securitizations and Whole
Loan Sales. In connection with its securitizations, the Company transfers
loans originated or purchased by the Company to a trust in exchange for cash
and interest-only and residual certificates issued by the trust. The trustee
and the monoline insurance company, if any, with respect to such
securitization have recourse to the Company with respect to a breach of
representations or warranties made by the Company at the time such loans are
transferred. In connection with any such breach with respect to any loan, the
Company will be required either to (i) purchase such loan from the trust or
(ii) substitute such loan with a substantially similar one. While the Company
generally has recourse to the sellers of mortgage loans for any such breaches,
there can be no assurance of the sellers' abilities to honor their respective
obligations.
Agreements for bulk whole loan sales generally provide for recourse by the
purchaser against the Company in the event of a breach of a representation or
warranty made by the Company, any fraud or misrepresentation during the
mortgage loan origination process or upon early default on such mortgage
loans. To the extent the Company purchases loans, the Company generally limits
the potential remedies of such purchasers to the potential remedies the
Company receives from the persons from whom the Company purchased such
mortgage loans. However, in some cases, the remedies available to a purchaser
of mortgage loans from the Company may be broader than those available to the
Company against the sellers of such loans, and should a purchaser enforce its
remedies against the Company, the Company may not always be able to enforce
whatever remedies the Company may have against such sellers.
In the ordinary course of its business, the Company is subject to claims
made against it by borrowers, and by monoline insurance carriers and trustees
in the Company's securitizations, arising from, among other things,
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losses that are claimed to have been incurred as a result of alleged breaches
of contractual obligations, misrepresentations, errors and omissions of
employees, officers and agents of the Company (including its appraisers),
incomplete documentation and failures by the Company to comply with various
laws and regulations applicable to its business. Any claims asserted against
the Company may result in legal expenses or liabilities which could have a
material adverse effect on the Company's results of operations and financial
condition.
Dependence on Mortgage Brokers. The Company depends largely on mortgage
brokers, and to a lesser extent, financial institutions and mortgage bankers
for its originations and purchases of mortgage loans. The Company's
competitors also seek to establish relationships with such mortgage brokers,
financial institutions and mortgage bankers, none of whom (other than the
Strategic Alliances) is contractually obligated to continue to do business
with the Company. The Company's future results may become more exposed to
fluctuations in the volume and cost of loans available for purchase or
origination resulting from competition from other originators and purchasers
of such loans, market conditions and other factors.
Legislative or Regulatory Risks. Members of Congress and government
officials have from time to time suggested the elimination of the mortgage
interest deduction for federal income tax purposes, either entirely or in
part, based on borrower income, type of loan or principal amount. Because many
of the Company's loans are made to borrowers for the purpose of consolidating
consumer debt or financing other consumer needs, the competitive advantages of
tax deductible interest, when compared with alternative sources of financing,
could be eliminated or seriously impaired by such government action.
Accordingly, the reduction or elimination of these tax benefits could have a
material adverse effect on the demand for loans of the kind offered by the
Company.
The Company's domestic 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 a substantial portion of its
operations. The Company's consumer lending activities are subject to the
Federal Truth-in-Lending Act and Regulation Z (including the Home Ownership
and Equity Protection Act of 1994), the Federal Equal Credit Opportunity Act
and Regulation B, as amended ("ECOA"), the Fair Credit Reporting Act of 1970,
as amended, the Federal Real Estate Settlement Procedures Act ("RESPA") and
Regulation X, the Fair Housing Act, the Home Mortgage Disclosure Act, the
Federal Debt Collection Practices Act, and the Federal Trade Commission Act,
as well as other federal and state statutes and regulations affecting the
Company's activities. The Company is also subject to the rules and regulations
of and examinations by the Department of Housing and Urban Development ("HUD")
and state regulatory authorities with respect to originating, processing,
underwriting, selling, securitizing and servicing loans. These rules and
regulations, among other things, impose licensing obligations on the Company,
establish eligibility criteria for mortgage loans, prohibit discrimination,
unfair or deceptive acts, 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
loan repurchases, certain rights of rescission for mortgage loans, class
action lawsuits and administrative enforcement actions, and should the Company
fail to comply with the Truth-in-Lending Act, borrowers could have their loan
transactions rescinded. There can be no assurance that more restrictive laws,
rules and regulations will not be adopted in the future that could make
compliance more difficult or expensive.
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. These lawsuits might result in a similar suit being
brought against the Company or the publicity generated by such suits might
result in legislation that affects the manner in which the Company conducts
its relationships with mortgage brokers, either of which could have a material
adverse effect on the Company's financial condition and results of operations.
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Control by Existing Shareholder; Limitations Imposed. ICII beneficially owns
approximately 47% of the outstanding common stock of the Company. Although the
percentage ownership by ICII is less than 50%, ICII will continue to be able
to control the election of at least a majority of the members of the Company's
Board of Directors and to determine all corporate actions for the foreseeable
future. The Company's Board of Directors will independently approve ordinary
corporate transactions, including, but not limited to, financing arrangements
between the Company and ICII or its affiliates. Under the Company's bylaws, as
long as ICII directly owns at least 25% of the Company's outstanding voting
stock, the Audit Committee of the Company's Board of Directors (consisting of
directors independent of both management and ICII) must independently approve
all transactions between the Company and ICII.
Competition. As a purchaser and originator of mortgage loans, the Company
faces intense competition, primarily from mortgage banking companies,
commercial banks, credit unions, thrift institutions and finance companies. In
addition, Government Sponsored Entities Freddie Mac and Fannie Mae have
expressed interest in expanding into nonconforming lending. Many of these
competitors are substantially larger and have more capital and other resources
than the Company. Competition can take many forms, including convenience in
obtaining a loan, customer service, marketing distribution channels and loan
pricing. Furthermore, the current level of gains realized by the Company and
its competitors on the sale of the type of loans they originate and purchase
is attracting and may continue to attract additional competitors into this
market with the possible effect of lowering gains that may be realized on the
Company's loan sales. In addition, the Company expects that it will face
increasing competition in the area of whole loan sales because the Company and
several of its competitors have announced their intention to increase whole
loan sales. 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 customers to
refinance their loans.
Environmental Liabilities. In the course of its business, the Company may
acquire real property securing loans that are in default. There is a risk that
hazardous substances or waste, contaminants, pollutants or sources thereof
could be discovered on such properties after acquisition by the Company. In
such event, the Company might be required to remove such substances from the
affected properties at its sole cost and expense. There can be no assurances
that the cost of such removal would not substantially exceed the value of the
affected properties or the loans secured by such properties or that the
Company would have adequate remedies against the prior owners or other
responsible parties, or that the Company would not find it difficult or
impossible to sell the affected real properties either prior to or following
any such removal.
Dependence on a Limited Number of Key Personnel. The Company's growth and
development to date have been largely dependent upon the services of Robert W.
Howard and Bernard A. Guy, Chief Executive Officer and President of the
Company, respectively.
The Company does not have life insurance on any of its key personnel. The
Company has entered into employment agreements with Messrs. Howard and Guy.
The loss of Messrs. Howard's or Guy's services for any reason could have a
material adverse effect on the Company.
Change of Control. Certain of the Company's credit or other borrowing
agreements contain restrictions providing for repurchase or repayment of the
Company's debt at a premium in the event of a change in control of the
Company.
If such a change of control were to occur, it is unlikely that the Company
would be able to both repurchase and repay all of its obligations under credit
or other borrowing agreements that would become payable upon the occurrence of
such change of control, unless it could obtain alternate financing. There can
be no assurance that the Company would be able to obtain any such financing on
commercially reasonable terms or at all.
31
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
SOUTHERN PACIFIC FUNDING CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996 AND 1997
(WITH INDEPENDENT AUDITORS' REPORT THEREON)
32
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Southern Pacific Funding Corporation:
We have audited the accompanying consolidated balance sheets of Southern
Pacific Funding Corporation and subsidiaries as of December 31, 1996 and 1997,
and the related consolidated statements of earnings, shareholders' equity, and
cash flows for each of the years in the three-year period ended December 31,
1997. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Southern Pacific Funding Corporation and subsidiaries as of December 31,
1996 and 1997, and the consolidated results of their operations and their cash
flows for each of the years in the three-year period ended December 31, 1997
in conformity with generally accepted accounting principles.
KPMG Peat Marwick LLP
Portland, Oregon
January 29, 1998
33
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------
1996 1997
------------ ------------
<S> <C> <C>
Assets
Cash................................................ $ 14,175,566 $ 7,886,412
Loans held for sale................................. 223,059,102 264,384,993
Interest-only and residual certificates............. 87,016,900 277,156,343
Accrued interest receivable......................... 3,181,449 4,568,977
Premises and equipment, net......................... 3,036,388 7,660,691
Goodwill, net of accumulated amortization of $0 and
$448,375 at
December 31, 1996 and 1997, respectively 4,742,571 6,615,080
Other assets........................................ 5,165,048 21,072,897
------------ ------------
Total assets.................................... $340,377,024 $589,345,393
============ ============
Liabilities and Shareholders' Equity
Liabilities:
Borrowings under warehouse lines of credit.......... $152,680,395 $205,031,055
Notes Payable....................................... -- 3,431,972
Deferred tax liability.............................. 18,445,495 48,074,988
Long term debt...................................... 75,000,000 175,000,000
Other liabilities................................... 9,164,901 18,652,471
------------ ------------
Total liabilities............................... 255,290,791 450,190,486
Shareholders' equity:
Preferred stock, $.01 par value, 5,000,000 shares
authorized; none issued or outstanding at December
31, 1996 and 1997.................................. -- --
Common stock, no par value, 75,000,000 shares
authorized; 20,737,500 and 20,760,450 shares issued
and outstanding at December 31, 1996 and 1997,
respectively....................................... 53,798,099 54,100,622
Contributed capital................................. 247,500 247,500
Translation adjustment.............................. -- (8,745)
Retained earnings................................... 31,040,634 84,815,530
------------ ------------
Total shareholders' equity........................ 85,086,233 139,154,907
------------ ------------
Total liabilities and shareholders' equity........ $340,377,024 $589,345,393
============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
34
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
CONSOLIDATED STATEMENTS OF EARNINGS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------------
1995 1996 1997
----------- ----------- ------------
<S> <C> <C> <C>
Revenues:
Gains on sales of loans................. $16,328,621 $55,360,515 $148,403,866
Interest income......................... 4,304,760 13,848,976 39,306,759
Securities valuation and other income... 1,666,682 4,265,285 1,634,175
----------- ----------- ------------
Total revenues........................ 22,300,063 73,474,776 189,344,800
=========== =========== ============
Expenses:
Interest................................ 3,413,652 7,799,986 27,613,103
Personnel and commission expense........ 4,190,566 10,996,713 45,027,704
General and administrative expense...... 2,153,220 6,599,474 24,685,987
----------- ----------- ------------
Total expenses........................ 9,757,438 25,396,173 97,326,794
=========== =========== ============
Earnings before taxes..................... 12,542,625 48,078,603 92,018,006
Income taxes.............................. 5,205,190 20,446,614 38,243,110
----------- ----------- ------------
Net earnings.......................... $ 7,337,435 $27,631,989 $ 53,774,896
=========== =========== ============
Net earnings per share:
Basic................................... $ .47 $ 1.49 $ 2.59
Diluted................................. $ .47 $ 1.37 $ 2.23
Weighted average number of shares
outstanding .............................
Basic 15,562,500 18,552,500 20,747,665
Diluted................................. 15,562,500 20,511,936 25,358,202
</TABLE>
See accompanying notes to consolidated financial statements.
35
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
COMMON STOCK
---------------------- CONTRIBUTED TRANSLATION RETAINED SHAREHOLDERS'
SHARES AMOUNT CAPITAL ADJUSTMENT EARNINGS EQUITY
---------- ----------- ----------- ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31,
1994................... 15,562,500 -- 789,591 -- 4,761,693 5,551,284
Net earnings, 1995...... -- -- -- -- 7,337,435 7,337,435
---------- ----------- --------- ------ ----------- ------------
Balance, December 31,
1995................... 15,562,500 -- 789,591 -- 12,099,128 12,888,719
Effect of contribution
transaction............ -- -- (542,091) -- (8,690,483) (9,232,574)
Proceeds from initial
public offering of
5,175,000 shares of
common stock, net of
offering expenses of
$4,810,911............. 5,175,000 $53,798,099 -- -- -- 53,798,099
Net earnings, 1996...... -- -- -- -- 27,631,989 27,631,989
---------- ----------- --------- ------ ----------- ------------
Balance, December 31,
1996................... 20,737,500 53,798,099 $ 247,500 -- $31,040,634 $ 85,086,233
Exercise of stock
options for 22,950
shares of common stock. 22,950 302,523 -- -- -- 302,523
Translation adjustment.. -- -- -- (8,745) -- (8,745)
Net earnings, 1997...... -- -- -- -- 53,774,896 53,774,896
---------- ----------- --------- ------ ----------- ------------
Balance, December 31,
1997................... 20,760,450 54,100,622 $ 247,500 (8,745) $84,815,530 $139,154,907
========== =========== ========= ====== =========== ============
</TABLE>
See accompanying notes to consolidated financial statements.
36
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
1995 1996 1997
------------ ------------- -------------
<S> <C> <C> <C>
Cash flows from operating
activities:
Net earnings...................... $ 7,337,435 $ 27,631,989 $ 53,774,896
Adjustments to reconcile net
income to net cash used in
operating activities:
Depreciation and amortization.... 51,488 615,258 2,714,870
Amortization of discount on note
payable......................... -- -- 163,972
Translation adjustment .......... -- -- (8,745)
Securities valuation ............ -- (4,265,285) 427,799
Deferred tax expense............. -- 20,446,614 29,629,493
Changes in certain assets and
liabilities, net of effect of
acquisitions and contribution
transaction:
Mortgage loans held for sale... (63,536,648) (143,632,836) (41,325,891)
Net change in interest only and
residual certificates......... (18,235,099) (71,493,840) (186,767,242)
Loans held under repurchase
agreement..................... (12,800,565) 12,800,565 --
Accrued interest receivable.... (928,119) (2,204,075) (1,387,528)
Other assets................... (282,831) (1,387,556) (12,465,420)
Other liabilities.............. 3,186,942 3,787,856 9,487,570
------------ ------------- -------------
Net cash used in operating
activities........................ (85,207,397) (157,701,310) (145,756,226)
------------ ------------- -------------
Cash flows used in investing
activities:
Purchases of premises and
equipment....................... (436,853) (3,028,897) (5,649,989)
Purchase of interest-only and
residual certificates........... -- -- (3,800,000)
Payment for acquisitions......... -- (5,000,000) --
Payment for long-term investment
and loan commitment............. -- (525,000) --
------------ ------------- -------------
Net cash used in investment
activities:....................... (436,853) (8,553,897) (9,449,989)
------------ ------------- -------------
Cash flows from financing
activities:
Net change in:
Borrowings under warehouse lines
of credit....................... 96,130,120 56,550,275 52,350,660
Borrowings from SPTL............. (12,940,537) 322,053 --
Due to affiliates................ 1,585,150 (1,504,984) --
Bank overdraft................... 619,517 (619,517) --
Proceeds from long term debt..... -- 72,162,436 96,263,878
Proceeds from issuance of common
stock........................... -- 53,798,099 302,523
Contribution transaction......... -- (277,589) --
------------ ------------- -------------
Net cash provided by (used in)
financing activities.............. 85,394,250 180,430,773 148,917,061
------------ ------------- -------------
Net change in cash................. (250,000) 14,175,566 (6,289,154)
Cash at beginning of year......... 250,000 -- 14,175,566
------------ ------------- -------------
Cash at end of year.............. $ -- $ 14,175,566 $ 7,886,412
============ ============= =============
Supplementary information:
Interest paid.................... $ 2,129,369 $ 6,330,097 $ 25,540,511
Taxes paid....................... $ -- $ 1,213,252 $ 9,105,917
</TABLE>
See accompanying notes to consolidated financial statements.
37
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE-YEAR PERIOD ENDED DECEMBER 31, 1997
1. ORGANIZATION
Southern Pacific Funding Corporation ("SPFC" or the "Company") is the
successor to the Residential Lending Division of Southern Pacific Thrift and
Loan ("SPTL"). The Company originates and acquiresnon-conforming single-family
residential loans, including loans secured by second mortgages. In October
1994, Imperial Credit Industries, Inc. ("ICII") incorporated the Company as
part of a strategic decision to form a separate subsidiary through which to
operate SPTL's Residential Lending Division. In April 1995, ICII caused SPTL
to contribute (the "Contribution Transaction") to SPFC certain customer lists
of SPTL's Residential Lending Division to the ongoing operations of such
division. In addition, in April 1995 all employees of SPTL's Residential
Lending Division became employees of SPFC. The Company completed an initial
public offering of its Common Stock in June 1996. At December 31, 1997, upon
completion of three secondary offerings, ICII owned approximately 46.9% of the
Company's outstanding Common Stock.
2. BASIS OF PRESENTATION
The consolidated financial statements include the accounts of SPFC and its
majority and wholly owned subsidiaries. These subsidiaries include National
Capital Funding, Inc., Oceanmark Financial Corporation, Home America Financial
Services, Inc. and Hallmark America Corp. which are located throughout the
United States and Southern Pacific Mortgage Limited which is the Company's
United Kingdom operation. All significant intercompany accounts and
transactions have been eliminated in consolidation.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at the lower of aggregate cost or
market. These loans are pledged against the Company's lines of credit. The
cost of mortgage loans held for sale is the cost of the mortgage loans reduced
or increased by the net deferred fees or costs associated with originating or
acquiring the loan and increased by costs that are recognized upon sale. On an
ongoing basis, management of the Company monitors the loan portfolio and
considers such factors as historical loan loss experience, underlying
collateral values, known problem loans, assessment of economic conditions,
including changes in interest rates, and other appropriate data to identify
risks in the loan portfolio.
Interest-only and Residual Certificates
Assets reflected in the accompanying consolidated balance sheets as
interest-only and residual certificates in real estate mortgage investment
conduits (REMICs) are recorded as a result of the Company's securitization of
loans through various trust vehicles. The Company considers its obligations
under recourse provisions in connection with its securitizations in valuing
its interest-only and residual certificates. The Company estimates future cash
flows from these interest-only and residual certificates and values them
utilizing assumptions that it believes are consistent with those that would be
utilized by an unaffiliated third party purchaser and records them as trading
securities at fair value. Unrealized gains and losses are included in gains on
sales of loans in the accompanying financial statements. The initial and
subsequent changes in the unrealized gains and losses are included in
securities valuation and other income. To the Company's knowledge, there is no
active market for the sale of these interest-only and residual certificates.
The fair value of interest-only and residual certificates is determined by
computing the present value of the excess of the weighted average coupon on
the loans sold over the sum of: (1) the coupon on the senior interests, (2) a
base servicing fee paid to the loan servicer, (3) expected losses to be
incurred on the portfolio of loans sold
38
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
over the lives of the loans, and (4) fees payable to the trustee and monoline
insurer. Prepayment assumptions used in the present value computation are
based on recent evaluations of the actual prepayments of the Company's
servicing portfolio or on market prepayment rates on new portfolios, taking
into consideration the current interest rate environment and its expected
impact on prepayment rates. The cash flows expected to be received by the
Company are discounted at an interest rate that the Company believes an
unaffiliated third-party purchaser would require as a rate of return on such a
financial instrument. To the extent that actual future excess cash flows are
different from estimated excess cash flows, the fair value of the Company's
interest-only and residual certificates will be adjusted monthly with
corresponding adjustments made to earnings in that period.
In certain of its securitizations, the Company provided an initial
overcollateralization on the securities sold and in all its securitizations
the Company builds overcollateralization as cash flows projected as described
above are used by the trustee to reduce the outstanding balance of the
securities sold by the Company.
The Company currently uses a 12% discount rate to calculate present value of
anticipated "out of the trust" cash flows that it anticipates receiving from
the securitization trust after overcollateralization requirements have been
achieved. Prepayment assumptions are applied to each discrete security and
further to each product (i.e. ARM's, Fixed and 2/28's) within each security.
The estimated CPR varies over time based upon the relative maturity of the
loans included in each pool. The estimated annual CPR is 4% at inception and
increases in equal monthly increments until the peak estimated CPR is
achieved, generally within 12-23 months. Peak CPR's, range from 30% to 50% for
ARM's, 40% for 2/28's and 23% for fixed rate loans. These peaks are generally
maintained through month 36. Thereafter, peak CPR's are reduced in two twelve
month steps at which time terminal CPR's are reached. Terminal CPR's are
estimated at 20% for ARM's and 2/28's and 15% for fixed rate loans. The
Company also periodically provides for additional credit losses which may be
incurred on loans which the Company voluntarily purchases from the trusts.
Gains on Sales of Loans
Gains on sales of loans are determined by deducting from the gross proceeds
of the sales or securitizations the allocated basis in the loans sold or
securitized and related transaction costs. The initial fair value ofinterest-
only and residual certificates is included as proceeds in calculating gains on
sales of loans.
Interest Income
Interest income includes interest earned on mortgage loans held for sale.
Interest expense includes interest paid on the Company's outstanding warehouse
lines of credit, the Company's convertible subordinated debentures and the
Company's senior notes.
Securities Valuation and Other Income
Securities valuation and other income includes the change in unrealized
gains and losses on interest-only and residual certificates.
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation or
amortization. Depreciation is recorded using the straight-line method over the
estimated useful lives of individual assets (three to five years). Leasehold
improvements are amortized over the terms of the related leases or the
estimated useful lives of improvements, whichever is shorter.
39
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Dividends
The Company intends to retain all of its future earnings to finance its
operations. The subsidiaries of the Company are restricted from paying
dividends to the Company or any of its subsidiaries due to covenants in the
Company's senior note agreement.
Goodwill
Goodwill, which represents the excess of purchases price over fair value of
net assets acquired, is amortized on a straight-line basis over the expected
periods to be benefited, generally 15 years. The Company assesses the
recoverability of this intangible asset by determining whether the
amortization of the goodwill balance over its remaining life can be recovered
through undiscounted future operating cash flows of the acquired operation.
(See Note 14).
Long-Term Investments
Long-term investments, included in other assets, are carried at cost and
consist of preferred stock in Hallmark Government, Inc. of $360,000 at
December 31, 1997.
Deferred Income Taxes
The accompanying financial statements reflect income taxes for SPFC as if it
had been a separate entity for all years presented. SPFC accounts for income
taxes under the asset and liability method of accounting for income taxes.
Under the asset and liability method, deferred tax assets and liabilities are
recognized for the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities
and their respective tax bases. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. Under the asset and liability method, the effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
Use of Estimates
Management has made a number of estimates and assumptions relating to the
reporting of assets, liabilities, revenues and expenses and the disclosure of
contingent assets and liabilities to prepare these financial statements in
conformity with generally accepted accounting principles. Actual results could
differ from those estimates.
Net Earnings Per Share
In February 1997, the FASB issued SFAS No. 128, Earnings Per Share. SFAS No.
128 establishes standards for computing and presenting earnings per share
(EPS). It simplifies the standards in APB Opinion No. 15, Earnings per Share,
for computing EPS by replacing primary earnings per share with basic earnings
per share and by alterning the calculation of diluted EPS, which replaces
fully diluted EPS. SFAS No. 128 is effective for financial statements issued
for periods ending after December 15, 1997, including interim periods. All
prior period EPS figures have been restated to conform to the provisions of
the Statement.
40
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The following illustrates the reconciliation of the numerators and
denominators of the basic and diluted earnings per share (EPS) computations:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1995
-----------------------------------
WEIGHTED PER SHARE
INCOME AVERAGE SHARES AMOUNT
---------- -------------- ---------
<S> <C> <C> <C>
Basic EPS
Net income available to common
shareholders........................... $7,337,435 15,562,500 $0.47
Effect of dilutive securities:
Stock options......................... -- --
Convertible subordinated notes........ -- --
---------- ----------
Diluted EPS............................. $7,337,435 15,562,500 $0.47
========== ========== =====
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1996
------------------------------------
WEIGHTED PER SHARE
INCOME AVERAGE SHARES AMOUNT
----------- -------------- ---------
<S> <C> <C> <C>
Basic EPS
Net Income available to common
shareholders.......................... $27,631,989 18,552,500 $1.49
Effect of dilutive securities:
Stock options........................ 481,422
Convertible subordinated notes....... $ 510,078 1,478,014
----------- ----------
Diluted EPS............................ $28,142,067 20,511,936 $1.37
=========== ========== =====
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1997
------------------------------------
WEIGHTED PER SHARE
INCOME AVERAGE SHARES AMOUNT
----------- -------------- ---------
<S> <C> <C> <C>
Basic EPS
Net Income available to common
shareholders.......................... $53,774,896 20,747,665 $2.59
Effect of dilutive securities:
Stock options........................ 1,459,277
Convertible subordinated notes....... 2,864,198 3,151,260
----------- ----------
Diluted EPS............................ $56,639,094 25,358,202 $2.23
=========== ========== =====
</TABLE>
Foreign Currency Translation
All assets and liabilities of the U.K. subsidiaries are translated into U.S.
dollars at the rate in effect as of the date of the financial statements.
Income and expense items are translated at the weighted average exchange rate
for the period. The resulting translation adjustments are recorded as a
component of shareholder's equity.
5. PREMISES AND EQUIPMENT
Premises and equipment consisted of the following at December 31, 1996 and
1997:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1997
---------- ----------
<S> <C> <C>
Premises and equipment............................... $3,634,193 $9,938,813
Less accumulated depreciation and amortization....... (597,805) (2,278,122)
---------- ----------
$3,036,388 $7,660,691
========== ==========
</TABLE>
41
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
6. FAIR VALUE OF FINANCIAL INSTRUMENTS
The table below summarizes the information about the fair value of the
financial instruments recorded on the Company's financial statements at
December 31, 1996 and 1997:
<TABLE>
<CAPTION>
DECEMBER 31, 1996 DECEMBER 31, 1997
------------------------- -------------------------
CARRY FAIR CARRY FAIR
VALUE VALUE VALUE VALUE
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Cash....................... $ 14,175,566 $ 14,175,566 $ 7,886,412 $ 7,886,412
Loans held for sale........ 223,059,102 231,981,466 264,384,993 274,960,393
Interest-only and residual
certificates.............. 87,016,900 87,016,900 277,156,343 277,156,343
Notes Payable.............. -- -- 3,431,972 3,431,972
Long Term Debt............. 75,000,000 75,000,000 175,000,000 175,000,000
Borrowings under warehouse
lines of credit........... 152,680,395 152,680,395 205,031,055 205,031,055
</TABLE>
Because no market exists for certain of the Company's assets and
liabilities, fair value estimates are based on judgments regarding credit
risk, investor expectations of future economic conditions, normal cost of
administration and other risk characteristics, including interest rate and
prepayment risk. These estimates are subjective in nature and involve
uncertainties and matters of judgment and therefore cannot be determined with
precision. Changes in assumptions could significantly affect the estimates.
The methodology and assumptions utilized to estimate the fair value of the
Company's financial instruments, including the off balance sheet instruments
disclosed in Note 15, are as follows:
Loans held for sale. The Company has estimated the fair values reported
based on recent sales and securitizations.
Interest-only and residual certificates. Fair value determined using
estimated discounted future cash flows taking into consideration anticipated
prepayment rates, loss experience and prepayment penalties.
The Company currently uses a 12% discount rate to calculate present value of
anticipated "out of the trust" cash flows that it anticipates receiving from
the securitization trust after overcollateralization requirements have been
achieved. Prepayment assumptions are applied to each discrete security and
further to each product (i.e. ARM's, Fixed and 2/28's) within each security.
The estimated CPR varies over time based upon the relative maturity of the
loans included in each pool. The estimated annual CPR is 4% at inception and
increases in equal monthly increments until the peak estimated CPR is
achieved, generally within 12-23 months. Peak CPR's, range from 30% to 50% for
ARM's, 40% for 2/28's and 23% for fixed rate loans. These peaks are generally
maintained through month 36. Thereafter, peak CPR's are reduced in two twelve
month steps at which time terminal CPR's are reached. Terminal CPR's are
estimated at 20% for ARM's and 2/28's and 15% for fixed rate loans. The
Company also periodically provides for additional credit losses which may be
incurred on loans which the Company voluntarily purchases from the trusts.
Borrowings under warehouse lines of credit. The carrying value reported
approximates fair value due to the short-term nature of the borrowings and the
variable interest rates charged on the borrowings.
Commitments to originate loans and loans in process. Many loan commitments
are expected to, and typically do, expire without being drawn upon. As the
rates and terms of the commitments to lend and loans in process are
competitive with others in which the Company operates, the values disclosed in
Note 15 are determined to be a reasonable estimate of fair value.
42
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Notes Payable. The carrying value reported approximates fair value due to
the nature of the borrowings.
Long Term Debt. The carrying value reported approximates fair value based on
the current debt rates.
Hedging Transactions. The Company regularly securitizes and sells fixed and
variable-rate mortgage loans. To offset the effects of interest rate
fluctuations on the value of its fixed-rate loans held for sale, the Company
in certain cases will hedge its interest rate risk related to loans held for
sale by selling U.S. Treasury securities short or in the forward market.
As of December 31, 1996 and 1997, the Company had open hedge positions of
$32.6 million and $65.6 million respectively, related to the sales of United
States Treasury securities in the forward market. The proceeds from the short
sale are shown net of the related liability in the accompanying balance sheet
at December 31, 1996 and 1997.
8. RELATED PARTY TRANSACTIONS
Intracompany Cost Allocations
During 1995 and 1996, the Company accrued allocated expenses for ICII that
are included as part of personnel and commission expense and general and
administrative expenses of $256,000 and $292,000, respectively. No
administrative services are being provided by ICII or SPTL, effective January
1, 1997.
Borrowings from Affiliates
The average borrowings from affiliates and interest rates used to determine
the weighted average interest on borrowings for the years ended December 31,
1995, 1996 and 1997 are as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------------
1995 1996 1997
----------- ---------- ----------
<S> <C> <C> <C>
Average borrowings...................... $34,777,138 $3,890,267 $1,250,000
Interest rate........................... 3.69% 6.25% 12.00%
Interest on borrowings.................. $ 1,284,282 $ 230,236 $ 125,000
</TABLE>
SPTL
In March 1996, the Company entered into a $10 million revolving credit and
term loan agreement with SPTL (the "SPTL Agreement") which was scheduled to
expire on September 30, 1996. Advances under the SPTL Agreement were
collateralized by the Company's interest-only and residual certificates (other
than such interests retained by SPTL pursuant to the Contribution Transaction)
and bore interest at 2% above LIBOR. In April, 1996 the Company repaid all
borrowings outstanding under the SPTL Agreement and it was canceled.
ICII
On July 17, 1997, the Company borrowed $15 million from ICII due on October
17, 1997 and bore interest at a rate of 12%. The $15 million was repaid on
August 11, 1997 along with $125,000 in interest.
Loan Servicing
From the point of commencement of operations until March 1994, SPTL served
as the loan servicer for the Company and the Company was allocated its pro
rata portion of SPTL's loan servicing expenses. In March 1994,
43
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
ICII assumed the role of loan servicer for a servicing fee of approximately
$7.50 per loan per month, so that the Company could complete its first
securitization. In September 1995, the Company began to utilize the services
of Advanta, an independent loan servicer, as the master servicer. Fees charged
by Advanta are $25 per loan and 37.5 basis points per annum on the declining
principal balance of each loan serviced, paid monthly, respectively, which
fees are higher than those previously paid to ICII due to the additional
collection activities performed by Advanta.
Consulting Agreements
In June 1996, the Company entered into a five-year consulting agreement with
The Dewey Consulting Group, owned by one of the Company's directors, John D.
Dewey. Under the agreement, Mr. Dewey has agreed to assist the Company in the
development of strategic alliances with selected mortgage lenders, including
the identification of potential strategic alliance participants. The Company
has agreed to compensate Mr. Dewey based upon actual strategic alliances
entered into and loan production and earnings resulting from those alliances
which amounts to .015% of the Company's share of warrants, interest-only cash
received, and interest-only strips. No amounts were paid in 1996 or owing at
December 31, 1996, $254,122 was paid in 1997 and $335,619 was owing at
December 31, 1997.
Other
The Company has outstanding receivables from Hallmark Government, Inc. of
$7,153,800, collateralized by first mortgage loans.
9. LONG TERM OBLIGATIONS
Long Term Debt at December 31, 1996 and 1997 consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1996 1997
---------- ------------
<S> <C> <C>
Senior Notes, interest at 11.5%, due semi-annually,
principal due November 1, 2004.................... $ -- $100,000,000
Convertible subordinated debentures, interest at
6.75%, due semi-annually, principal due
October 15, 2006.................................. 75,000,000 75,000,000
</TABLE>
Interest on the senior notes is payable semi-annually. Debt issuance costs
of $3,647,368 at December 31, 1997 are included in other assets. These costs
have been deferred and are being amortized over seven years using the interest
method.
The Convertible subordinated debentures are convertible into 3,151,125
shares of common stock, for a conversion price of $23.80 per share, at any
time prior to maturity. Interest on the debentures is payable semi-annually.
Debt issuance costs of $2,794,220 and $2,521,360 at December 31, 1996 and
1997, respectively, are included in other assets. These costs have been
deferred and are being amortized over ten years using the interest method.
Notes Payable at December 31, 1997 represents a payable to Oceanmark Bank
for the purchase of Mortgage Division Assets and has a face amount of
$3,800,000. The note bears no interest and has a 36 month term. Principal is
payable in three equal installments of $1,266,667 at 12 months, 24 months and
36 months. The note was initially recorded at its present value of $3,268,000,
discounted at 7%. The discount will be amortized over the term of the note
using the interest method.
44
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
10. INCOME TAXES
For the 1996 period through the effective date of the IPO in June 1996, SPFC
is included in a consolidated tax return filing with ICII. For the 1996 period
subsequent to the IPO and 1997, SPFC will file a separate tax return on a
stand-alone basis.
SPFC's income taxes were as follows for the years ended December 31, 1996
and 1997:
<TABLE>
<CAPTION>
1995 1996 1997
---------- ----------- -----------
<S> <C> <C> <C>
Current:
Federal................................. $2,731,115 $ 3,680,000 $ 7,341,259
State................................... 602,452 772,000 1,272,358
---------- ----------- -----------
Total current......................... 3,333,567 4,452,000 8,613,617
Deferred:
Federal................................. 1,533,378 11,461,414 24,977,663
State................................... 338,245 4,533,200 4,651,830
---------- ----------- -----------
Total deferred........................ 1,871,623 15,994,614 29,629,493
---------- ----------- -----------
Total income taxes........................ $5,205,190 $20,446,614 $38,243,110
========== =========== ===========
</TABLE>
The following table shows the tax effects of temporary differences which
give rise to the primary components of SPFC's net deferred tax liability at
December 31, 1996 and 1997.
<TABLE>
<CAPTION>
1996 1997
----------- -----------
<S> <C> <C>
Deferred tax liabilities:
Interest-only and residual certificates........... $18,445,495 $48,074,988
=========== ===========
</TABLE>
A reconciliation of the income tax provision and the amount computed by
applying the statutory Federal corporate income tax rate to income before
income taxes are as follows for the years ended December 31, 1996 and 1997:
<TABLE>
<CAPTION>
1995 1996 1997
---- ---- ----
<S> <C> <C> <C>
Statutory U.S. Federal income tax rate.................... 35.0% 35.0% 35.0%
Increases in rate resulting from state income taxes, net
of Federal benefit....................................... 6.5 7.5 6.5
---- ---- ----
Effective income tax rate................................. 41.5% 42.5% 41.5%
==== ==== ====
</TABLE>
At the effective date of the IPO, the Company entered into a tax agreement
with ICII whereby, among other things, ICII will indemnify and hold the
Company harmless from any tax liability attributable to periods ending on or
before the effective date of the IPO in excess of such taxes as the Company
has already paid or recognized.
45
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
11. EMPLOYEE BENEFIT PLANS
Profit Sharing and 401(k) Plan
Prior to October 1, 1997, employees of SPFC were eligible to participate in
the ICII 401(k) plan. The ICII 401(k) plan matched a portion of the employee
pretax contribution. Effective October 1, 1997 employees of SPFC are eligible
to participate in the SPFC 401(k) plan which came into effect at that time.
Employees may elect to enroll in the plan on the first day of any month,
provided that they have been employed by SPFC for at least six months.
Employees may contribute up to 15% of their compensation to the SPFC 401(k)
Plan and SPFC will match 50% of the first 6% of employee pretax contributions.
SPFC matching contributions are made as of December 31st each year. SPFC
recorded 401(k) matching expense of approximately $26,000, $111,000 and
$433,148 for the years ended December 31, 1995, 1996, and 1997, respectively.
12. STOCK OPTIONS
Effective November 1, 1995, the Company reserved and granted options for
1,942,200 shares of Company common stock pursuant to the 1995 Senior
Management Stock Option Plan (the "Senior Management Plan"). All of the
options granted under the Senior Management Plan have been issued to senior
management personnel at an exercise price of $7.00 per share, the fair value
on the date of grant. The options vest ratably over a five-year period
commencing one year after the date of grant.
Also effective November 1, 1995, the Company adopted the 1995 Stock Option,
Deferred Stock and Restricted Stock Plan (the "Stock Option Plan"), which
provides for the grant of qualified incentive stock options, incentive stock
options, and awards consisting of deferred stock, restricted stock, stock
appreciation rights and limited stock appreciation rights. The Stock Option
Plan authorizes the grant of options to purchase, and awards of, an aggregate
of 1,942,200 shares of Company common stock. If an option granted under the
Stock Option Plan expires or terminates, or an award is forfeited, the shares
subject to any unexercised portion of such option or award will again become
available for the issuance of further options or awards under the Stock Option
Plan.
All share data related to shares issued and outstanding have been restated
to give retroactive recognition to a 4,150 for one stock split effective April
1, 1996 and a three for two stock split effective January 23, 1997.
The Company applies APB Opinion No. 25 in accounting for its Plans and,
accordingly, no compensation cost has been recognized for its stock options in
the financial statements. Had the Company determined compensation cost based
on the fair value at the grant date for its stock options under SFAS No. 123,
the Company's net earnings would have been reduced to the pro forma amounts
indicated below:
<TABLE>
<CAPTION>
1995 1996 1997
---------- ----------- -----------
<S> <C> <C> <C>
Net Earnings:
As reported............................ $7,337,435 $27,631,989 $53,774,896
Pro forma.............................. 7,105,518 26,266,703 50,612,358
Net Earnings Per Share:
As reported: Basic..................... $ 0.47 $ 1.49 $ 2.59
Diluted........................... $ 0.46 $ 1.37 $ 2.23
Pro forma: Basic....................... $ 0.47 $ 1.42 $ 2.44
Diluted........................... $ 0.46 $ 1.31 $ 2.11
</TABLE>
46
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Stock option activity during the period indicated is as follows:
<TABLE>
<CAPTION>
NUMBER OF WEIGHTED AVERAGE
SHARES EXERCISE PRICE
--------- ----------------
<S> <C> <C>
Balance at December 31, 1994........................ -- --
Granted........................................... 1,942,200 $7.00
Exercised......................................... -- --
Forfeited......................................... -- --
Expired........................................... -- --
--------- -----
Balance at December 31, 1995........................ 1,942,200 7.00
Granted........................................... 1,078,500 12.57
Exercised......................................... -- --
Forfeited......................................... (113,250) 11.90
Expired........................................... -- 0.00
--------- -----
Balance at December 31, 1996........................ 2,907,450 8.85
Granted........................................... 868,750 11.15
Exercised......................................... (22,950) 11.39
Forfeited......................................... (276,300) 13.07
Expired........................................... -- --
--------- -----
Balance at December 31, 1997........................ 3,476,950 9.09
</TABLE>
At December 31, 1997, there were 384,500 additional shares available for
grant under the Stock Option Plan. The per share weighted-average fair value
of stock options granted during 1995, 1996 and 1997 was $15.74, $13.34 and
$11.17, respectively, on the date of grant using the Black Scholes option
pricing model with the following weighted-average assumptions: expected
dividend yield 0.00%, risk free interest rate of 5.42%, an expected life of 6
years and an annualized volatility rate of 66.57%.
At December 31, 1997, the range of exercise prices and weighted-average
remaining contractual life of outstanding options was $7.00--$15.00 and 8.20
years and $15.01-$20.00 and 8.80 years, respectively.
At December 31, 1996 and 1997 there were 388,440, and 1,129,830 options,
respectively exercisable.
13. SHORT TERM BORROWINGS
Lines of Credit
The Company has obtained five lines of credit from investment banks, for the
purpose of fundingone-to-four family residential first and second mortgage
loans, which is subject to certain operating and financial covenants and
collateral requirements. Total borrowings under the warehouse lines are
limited to $988.2 million and the lines are scheduled to expire between April
15, 1998 and December 14, 1998.
As of December 31, 1996 and 1997, $152,680,395 and $205,031,055,
respectively, were outstanding on the lines of credit, on which interest was
charged based on the type of loan funded. Interest expense incurred for the
years ended December 31, 1995, 1996 and 1997 amounted to approximately
$131,000, $6,409,061 and $19,544,258, respectively with weighted average
interest rates ranging from 5.7% to 8.3% for 1997.
Residual Facility
In May, 1997 the Company entered into a residual financing facility of $30
million that allowed the Company to obtain debt secured by interest-only and
residual certificates. The Company drew upon $29.4 million of this facility
and repaid the full amount on November 4, 1997.
47
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
14. ACQUISITIONS
In 1996, the Company purchased 95% of the common stock of a diversified
financial services company for $5,000,000 in cash. The amount in excess of the
fair value of net assets acquired is $4,742,571. The Company acquired net
assets of $5,000,000 consisting primarily of goodwill of $4,742,571. The
results of operations of the acquired company have been included in the
consolidated financial statements since the date of acquisition.
In May 1997, the Company purchased certain assets of a diversified financial
services company in exchange for a $3,800,000 note payable (see Note 9). The
amount in excess of the fair value of the net assets acquired was $2,320,884
which has been recorded as goodwill in the accompanying financial statements.
In addition, the Company acquired interest-only and residual certificates for
cash of $3.8 million.
In December 1997, the Company purchased the loan servicing operation of NAMC
for $400,000. The Company acquired NAMC's servicing operations assets and
retained its loan servicing employees.
15. LOAN SERVICING
Through December 1997 the company contracted for the servicing of
substantially all loans it originated, purchased and held for sale with
Advanta. This arrangement allowed the Company to increase the volume of loans
it originated and purchased without incurring the overhead investment in
servicing operations. As with any external service provider, the Company is
subject to risks associated with inadequate or untimely services. The Company
regularly reviews the delinquency of its servicing portfolio. Many of the
Company's borrowers require notices and reminders to keep their loans current
and to prevent delinquencies and foreclosures. A substantial increase in the
Company's delinquency rate or foreclosure rate could adversely affect its
ability to profitably access the capital markets for its financing needs,
including future securitizations.
As of December 31, 1997 the Company's servicing portfolio (inclusive of
securitized loans where the Company has ongoing risk of loss) was
approximately $2.5 million. Through that date substantially all of the
Company's loan servicing had either been outsourced or subcontracted to
Advanta.
The Company's acquisition in December 1997 of NAMC's loan servicing
operations allowed the Company in mid-January 1998 to begin its own loan
servicing operation for all new loans originated and purchased. In the second
quarter of 1998, the Company plans to transfer to its internal servicing
department the servicing of the loans included in the Company's December 1997
securitization and of remaining loans originated and purchased in December
1997 and January 1998.
16. COMMITMENTS AND CONTINGENCIES
Financial Instruments with Off Balance Sheet Risk
The Company is a party to financial instruments with off balance sheet risk
in the normal course of business. These financial instruments include
agreements to fund fixed and variable-rate mortgage loans and loans in
process. For agreements to fund fixed-rate loans, the contract amounts
represent exposure to loss from market fluctuations as well as credit loss.
The Company controls the credit risk of its agreements to fund fixed and
variable-rate loans through credit approvals, limits and monitoring
procedures.
Agreements to fund mortgage loans are agreements to lend to customers as
long as there is no violation of any condition established in the contracts.
Such agreements generally have fixed expiration dates or other termination
clauses. Since some agreements may expire without being drawn upon, the total
agreement amounts do not necessarily represent future cash requirements. As of
December 31, 1997, the Company had agreements to fund loans of approximately
$43.0 million.
48
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Sales of Loans and Servicing Rights
In the ordinary course of business, SPFC is exposed to liability from
representations and warranties made to purchasers and insurers of mortgage
loans and the purchasers of servicing rights. Under certain circumstances,
SPFC is required to repurchase mortgage loans if there has been a breach of a
representation or warranty. For loans which have been securitized, the Company
includes an estimate of credit loss, using a risk free rate, in determining
its discounted recourse liability. On a periodic basis, the Company reviews
its assumptions in light of historical experience and economic trends to
evaluate their reasonableness in measuring the fair value of recorded assets.
The Company's servicing agreement with Advanta provides that if the Company
desires to terminate the agreement without cause upon 90 days' written notice,
the Company will be required to pay Advanta an amount equal to 1.0% of the
aggregate principal balance of the mortgage loans being serviced by Advanta at
that time. The agreement also provides that a transfer service fee of $100 per
loan shall be paid to Advanta for any mortgage loan for which the Company
transfers servicing from Advanta to another servicer, without terminating the
agreement.
Litigation
The Company, its subsidiary Oceanmark Financial Corporation, and members of
its board directors are defendants in a lawsuit in US District Court for the
southern District of Florida. Oceanmark Bank, F.S.B. is the plaintiff. The
Company was served on March 9, 1998. The complaint relates to the Company's
acquisition of mortgages and notes of Oceanmark Bank beginning in 1995 and
ending with the Company's acquisition of the mortgage operations of Oceanmark
Bank and certain residual assets in May 1997 and events subsequent to the May
1997 acquisition. The complaint alleges, among other things, that employees of
Oceanmark Bank conspired with the Company to lower the purchase price of the
assets sold to the Company by Oceanmark Bank. The plaintiff seeks relief under
theories of racketeering, securities fraud, breach of contract, breach of
fiduciary duty, conspiracy, and negligence and requests compensatory and
punitive damages totaling $75 million.
The Company's management believes that the Oceanmark claims are without
merit and intends to defend the Company's position vigorously. Management
believes that the resolution of this matter will not have a material adverse
effect on the Company's financial condition, results of operations or
liquidity.
SPFC occasionally becomes involved in litigation arising in the normal
course of business. Management believes that any liability with respect to
such legal actions, individually or in the aggregate, will not have a material
adverse effect on the Company's financial position or results of operations.
Operating Leases
The Company leases premises and equipment under operating leases with
various expiration dates. Minimum annual rental payments at December 31, 1997
were as follows:
<TABLE>
<S> <C>
1998............................................................ $4,190,910
1999............................................................ 3,917,316
2000............................................................ 3,092,437
2001............................................................ 2,666,172
2002............................................................ 2,057,852
----------
Total......................................................... 15,924,687
==========
</TABLE>
49
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Rent expense amounted to $309,607, $484,416 and $2,394,621 for the years
ended December 31, 1995, 1996 and 1997, respectively.
17. CONSOLIDATING CONDENSED FINANCIAL INFORMATION
Following is consolidating condensed financial information of SPFC, the
Subsidiary Guarantors of the 11 1/2% Senior Notes due 2004 issued in November
1997 and the Subsidiary which is not a Subsidiary Guarantor:
CONSOLIDATING BALANCE SHEET
<TABLE>
<CAPTION>
AS DECEMBER 31, 1997
-----------------------------------------------------
NON-
SUBSIDIARY GUARANTOR
SPFC GUARANTORS SUBSIDIARY SUBTOTAL ELIMINATIONS TOTAL
------------ ------------ ----------- ------------ ------------- ------------
<S> <C> <C> <C> <C> <C> <C>
Assets
Cash.................... $ 408,286 $ 2,047,362 $ 5,430,764 $ 7,886,412 $ -- $ 7,886,412
Loans held for sale..... 133,110,124 61,330,849 67,991,237 262,432,210 1,952,783 264,384,993
Interest-only and
residual certificates.. 277,156,343 -- -- 277,156,343 -- 277,156,343
Investment in
subsidiaries........... 11,220,645 -- -- 11,220,645 (11,220,645) --
Other assets............ 104,244,775 53,563,593 1,507,189 159,315,557 (119,397,912) 39,917,645
------------ ------------ ----------- ------------ ------------- ------------
Total assets......... $526,140,173 $116,941,804 $74,929,190 $718,011,167 $(128,665,774) $589,345,393
============ ============ =========== ============ ============= ============
Liabilities and
Shareholders' Equity
Borrowings of credit
under warehouse line... $143,789,768 $ -- $61,241,287 $205,031,055 $ -- $205,031,055
Deferred tax liability.. 44,111,149 4,213,931 (211,030) 48,114,050 (39,062) 48,074,988
Convertible subordinated
notes.................. 175,000,000 -- -- 175,000,000 -- 175,000,000
Other liabilities....... 29,454,384 95,414,744 14,111,962 138,981,090 (116,896,647) 22,084,443
------------ ------------ ----------- ------------ ------------- ------------
Total liabilities.... 392,355,301 99,628,675 75,142,219 567,126,195 (116,935,709) 450,190,486
============ ============ =========== ============ ============= ============
Shareholders' equity:
Common stock........... 54,100,644 25,343 -- 54,125,987 (25,365) 54,100,622
Contributed capital.... 247,500 11,649,637 -- 11,897,137 (11,649,637) 247,500
Translation
adjustment............ -- -- (8,745) (8,745) -- (8,745)
Retained earnings...... 79,436,728 5,638,149 (204,284) 84,870,593 (55,063) 84,815,530
------------ ------------ ----------- ------------ ------------- ------------
Total shareholders'
equity.............. 133,784,872 17,313,129 (213,029) 150,884,972 (11,730,065) 139,154,907
------------ ------------ ----------- ------------ ------------- ------------
Total liabilities and
shareholders'
equity.............. $526,140,173 $116,941,804 $74,929,190 $718,011,167 $(128,665,774) $589,345,393
============ ============ =========== ============ ============= ============
</TABLE>
50
<PAGE>
SOUTHERN PACIFIC FUNDING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
CONSOLIDATING STATEMENT OF EARNINGS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1997
-------------------------------------------------
NON-
SUBSIDIARY GUARANTOR
SPFC GUARANTORS SUBSIDIARY SUBTOTAL ELIMINATIONS TOTAL
------------ ----------- ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Revenues:
Gains on sales of
loans................ $118,230,144 $27,091,191 $3,082,531 $148,403,866 $ -- $148,403,866
Interest income....... 36,941,438 9,213,663 2,916,618 49,071,719 (9,764,960) 39,306,759
Securities valuation
and other income..... (2,766,667) 4,511,716 (110,874) 1,634,175 -- 1,634,175
------------ ----------- ---------- ------------ ----------- ------------
Total revenues...... 152,404,915 40,816,570 5,888,275 199,109,760 (9,764,960) 189,344,800
------------ ----------- ---------- ------------ ----------- ------------
Expenses:
Interest on other
borrowings........... 26,074,145 8,958,966 2,344,952 37,378,063 (9,764,960) 27,613,103
Personnel and
commission Expense... 28,091,560 15,184,601 1,751,543 45,027,704 -- 45,027,704
General and
administrative
Expense.............. 15,430,810 7,020,069 2,140,983 24,591,862 94,125 24,685,987
------------ ----------- ---------- ------------ ----------- ------------
Total expenses...... 69,596,515 31,163,636 6,237,478 106,997,629 (9,670,835) 97,326,794
============ =========== ========== ============ =========== ============
Earnings before taxes... 82,808,400 9,652,934 (349,203) 92,112,131 (94,125) 92,018,006
Income taxes............ 34,412,306 4,014,785 (144,919) 38,282,172 (39,062) 38,243,110
------------ ----------- ---------- ------------ ----------- ------------
Net earnings........ $ 48,396,094 $ 5,638,149 $ (204,284) $ 53,829,959 $ (55,063) $ 53,774,896
============ =========== ========== ============ =========== ============
</TABLE>
51
<PAGE>
CONSOLIDATING STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1997
------------------------------------------------------
NON-
SUBSIDIARY GUARANTOR
SPFC GUARANTORS SUBSIDIARY SUBTOTAL ELIMINATIONS TOTAL
------------ ----------- ------------ ------------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Net cash provided by
(used in) operating
activities............. $(95,039,704) $ 4,276,336 $(55,180,048) $(145,943,416) $187,190 $(145,756,226)
Net cash used in
investing activities... (3,096,096) (5,723,418) (630,475) (9,449,989) -- (9,449,989)
Cash flows from
financing activities:
Net changes in:
Borrowings under
warehouse lines of
credit............. (8,890,627) -- 61,241,287 52,350,660 -- 52,350,660
Proceeds from long
term debt.......... 96,263,878 96,263,878 96,263,878
Other............... 302,523 187,190 -- 489,713 (187,190) 302,523
------------ ----------- ------------ ------------- -------- -------------
Net cash provided by
(used in) financing ac-
tivities............... 87,675,774 187,190 61,241,287 149,104,251 (187,190) 148,917,061
Net change in cash...... (10,460,026) (1,259,892) 5,430,764 (6,289,154) -- (6,289,154)
Cash at beginning of
period................. 14,175,566 -- -- 14,175,566 -- 14,175,566
------------ ----------- ------------ ------------- -------- -------------
Cash at end of year..... $ 3,715,540 $(1,259,892) $ 5,430,764 $ 7,886,412 $ -- $ 7,886,412
============ =========== ============ ============= ======== =============
</TABLE>
52
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to Directors and Executive Officers of the Company
is incorporated herein by reference to the Company's Proxy Statement which
will be filed with Commission pursuant to Regulation 14A within 120 days after
December 31, 1997.
ITEM 11. EXECUTIVE COMPENSATION
Information with respect to Executive Compensation is incorporated herein by
reference to the Company's Proxy Statement which will be filed with the
Commission pursuant to Regulation 14A within 120 days after December 31, 1997.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with respect to Security Ownership of Certain Beneficial Owners
and Management is incorporated herein by reference to the Company's Proxy
Statement which will be filed with the Commission pursuant to Regulation 14A
within 120 days after December 31, 1997.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with respect to Certain Relationships and Related Transactions
is incorporated herein by reference to the Company's Proxy Statement which
will be filed with the Commission pursuant to Regulation 14A within 120 days
after December 31, 1997.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Financial Statements, Financial Statement Schedules and Exhibits.
(1) Financial Statements
The following consolidated financial statements of Southern Pacific Funding
Corporation are included in Part II, Item 8 of this report
<TABLE>
<CAPTION>
PAGE(S)
-------
<S> <C>
Independent Auditor's Report........................................... 33
Consolidated Balance Sheets--December 31, 1996 and 1997.............. 34
Consolidated Statements of Earnings--Years ended December 31, 1995,
1996, and 1997...................................................... 35
Consolidated Statements of Shareholder's Equity--Years ended December
31, 1995, 1996, and 1997............................................ 36
Consolidated Statements of Cash Flows--Years ended December 31, 1995,
1996, and 1997...................................................... 37
Notes to Consolidated Financial Statements........................... 38
</TABLE>
(2) Financial Statement Schedules
None required.
53
<PAGE>
(3) Exhibits
<TABLE>
<C> <S>
3.1** Certificate of Incorporation of the Company, as amended
3.2** Bylaws of the Company, as amended
4.1 Form of Indenture incorporated by reference to Exhibit 4.1 of the
Company's Registration Statement No. 333-14627 on Form S-1
4.2 Form of Notes incorporated by reference to Exhibit 4.2 of the
Company's Registration Statement No. 333-14627 on Form S-1
10.1** 1995 Senior Management Stock Option Plan and Form of Senior Management
Stock Option Agreement
10.2** 1995 Stock Option, Deferred Stock and Restricted Stock Plan and Form
of Stock Option Agreement
10.3** Services Agreement effective June 13, 1996 by and between the
Registrant and Imperial Credit Industries, Inc.
10.4** Tax Agreement effective June 13, 1996 by and between the Registrant
and Imperial Credit Industries, Inc.
10.5** Loan Servicing Agreement dated September 14, 1995 by and between the
Registrant and Advanta Mortgage Corp. USA
10.6** Whole Loan Financing Program dated March 21, 1995 by and among the
Registrant, DLJ Mortgage Capital, Inc. And Bankers Trust Company
10.7** Master Repurchase Agreement dated August 5, 1995 by and between the
Registrant and Oceanmark Bank
10.8** Revolving Credit and Term Loan Agreement by and between Registrant and
Southern Pacific Thrift and Loan Association
10.9** Wet Inc., Interim and Pre-Sale Funding Facility dated November 17,
1995 by and between the Registrant and Lehman Commercial Paper, Inc.
10.10** Telemarketing Agreement dated March 25, 1995 by and among the
Registrant, Results Technologies, Inc. And Tele-Quote, Inc.
10.11** Office Lease Agreement dated September 13, 1995 by and between the
Registrant and Property Reserve, Inc.
10.12** Office Lease Agreement dated November 29, 1995 by and between the
Registrant and Property Reserve, Inc.
10.13** Sublease dated January 23, 1996 by and between the Registrant and
Property Reserve, Inc.
10.14** Office Building Lease dated January 23, 1996 by and between the
Registrant and Property Reserve, Inc.
10.15** Employment Agreement effective January 1, 1996 by and between the
Registrant and Robert W. Howard
10.16** Employment Agreement effective January 1, 1996 by and between the
Registrant and Bernard A. Guy
10.17** Contribution Agreement effective April 1, 1995 by and among the
Registrant, Imperial Credit Industries, Inc., and Southern Pacific
Thrift and Loan Association, Inc.
10.18* Consulting and Noncompetition Agreement, dated May 15, 1996, by and
between the Registrant and the Dewey Consulting Group
10.20* Amendment to Loan Servicing Agreement, dated August 12, 1996, by and
between the Registrant and Advanta Mortgage Corp. USA
10.21* Registration Rights Agreement, dated October 17, 1996, between the
Registrant and Imperial Credit Industries, Inc.
10.22* Master Loan and Security Agreement, dated as of October 22, 1996,
between the Registrant and Morgan Stanley Mortgage Capital, Inc.
</TABLE>
54
<PAGE>
<TABLE>
<C> <S>
11.1 Statement re: computation of per share earnings
12.1 Statement re: computation of ratios
23.1 Consent of KPMG Peat Marwick LLP
27.1 Financial Data Schedule
27.2 Financial Data Schedule
</TABLE>
- --------
* Previously filed in connection with Registration Statement No. 333-1418 and
hereby incorporated by reference
** Previously filed in connection with Registration Statement No. 333-3270 and
hereby incorporated by reference
Portions of these exhibits have been omitted and are subjected to a
confidential treatment request filed with the Securities Exchange
Commission pursuant to Rule 46.
55
<PAGE>
SIGNATURES
Pursuant to the requirements of the of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
SOUTHERN PACIFIC FUNDING CORPORATION
/s/ Robert W. Howard
By: _________________________________
Robert W. Howard
Chief Executive Officer and
Director
Date: March 31, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ Robert W. Howard Chief Executive Officer and March 31, 1998
____________________________________ Director (principal
Robert W. Howard executive officer
/s/ Bernard A. Guy President and Director March 31, 1998
____________________________________
Bernard A. Guy
/s/ Peter Makowiecki Chief Financial Officer March 31, 1998
____________________________________
Peter Makowiecki
/s/ Timothy Breedlove Senior Vice President and March 31, 1998
____________________________________ Controller (principal
Timothy Breedlove financial and accounting
officer)
/s/ H. Wayne Snavely Director and Chairman of the March 31, 1998
____________________________________ Board
H. Wayne Snavely
/s/ A. Van Ruiter Director March 31, 1998
____________________________________
A. Van Ruiter
/s/ John Dewey Director March 31, 1998
____________________________________
John Dewey
/s/ Frank Willey Director March 31, 1998
____________________________________
Frank Willey
/s/ Stephen J. Shugerman Director March 31, 1998
____________________________________
Stephen J. Sugerman
</TABLE>
56
<PAGE>
EXHIBIT 11.1
EPS-Calc
Southern Pacific Funding Corporation
Statement Regarding Computation of Net Income per Share
<TABLE>
<CAPTION>
Year ended December 31,
1997 1996
---- ----
<S> <C> <C>
Diluted net income per share:
Net income............................................................................... $53,774,896 $27,631,989
Add: Interest on convertible subordinated debentures (net of taxes)...................... 2,864,198 510,078
Adjusted net incomes..................................................................... 56,639,094 28,142,067
Weighted average number of shares outstanding............................................ 20,747,665 18,552,500
Net effect of dilutive stock options-based on treasury stock method...................... 4,610,537 1,959,436
------------------- ------------------
Total average shares..................................................................... 25,358,202 20,511,936
Diluted net income per share............................................................. $ 2.23 $ 1.37
=================== ==================
Basic net income per share:
Net income............................................................................... $53,774,896 $27,631,989
Weighted average number of shares outstanding............................................ 20,747,665 18,552,500
Basic net income per share............................................................... $ 2.59 $ 1.49
=================== ==================
</TABLE>
<PAGE>
EXHIBIT 12.1
Southern Pacific Funding Corporation
Statement Regarding Computation of Ratios
<TABLE>
<CAPTION>
Year ended December 31,
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Income from continuing operations $ 430,492 $ 4,331,201 $ 7,337,435 $ 27,631,989 $ 53,774,896
Add:
Provision for taxes 305,392 3,072,560 5,205,190 20,446,614 38,243,110
Fixed charges 175,238 886,055 3,413,652 7,843,329 27,987,320
------------------------------------------------------------------
480,630 3,958,615 8,618,842 28,289,943 66,230,430
------------------------------------------------------------------
Earnings before taxes and fixed 911,122 8,289,816 15,956,277 55,921,932 120,005,326
charges
==================================================================
Fixed charges
Amortization of bond
issuance costs -- -- -- 43,343 374,217
Interest and debt expense 175,238 886,055 3,413,652 7,799,986 27,613,103
==================================================================
Total fixed charges 175,238 886,055 3,413,652 7,799,986 27,613,103
==================================================================
Ratio of earnings to fixed charges 5.20 9.36 4.67 7.13 4.29
==================================================================
</TABLE>
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
The Board of Directors
Southern Pacific Funding Corporation:
We consent to incorporation by reference in the registration statements (No.
333-11075 and No. 333-11189) on Forms S-8 of Southern Pacific Funding
Corporation of our report dated January 29, 1998, relating to the consolidated
balance sheets of Southern Pacific Funding Corporation and subsidiaries as of
December 31, 1996 and 1997, and the related consolidated statements of
earnings, shareholders' equity, and cash flows for each of the years in the
three-year period ended December 31, 1997, which report appears in the
December 31, 1997, annual report on Form 10-K of Southern Pacific Funding
Corporation. We also consent to the reference to our firm under the heading
"Selected Consolidated Financial and Other Data" in the Form 10-K.
KPMG Peat Marwick LLP
Portland, Oregon
March 31, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEETS AND CONSOLIDATED STATEMENTS OF EARNINGS FOUND IN THE
COMPANY'S 10-K FOR THE YEAR-TO-DATE, AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 7,886
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 573,798
<PP&E> 9,939
<DEPRECIATION> 2,278
<TOTAL-ASSETS> 589,345
<CURRENT-LIABILITIES> 275,190
<BONDS> 175,000
0
0
<COMMON> 54,101
<OTHER-SE> 85,054
<TOTAL-LIABILITY-AND-EQUITY> 589,345
<SALES> 148,404
<TOTAL-REVENUES> 189,345
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 69,714
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 27,613
<INCOME-PRETAX> 92,018
<INCOME-TAX> 38,243
<INCOME-CONTINUING> 53,775
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 53,775
<EPS-PRIMARY> 2.59
<EPS-DILUTED> 2.23
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE BALANCE
SHEETS AND STATEMENTS OF INCOME FOUND ON PAGES 3 AND 4 OF THE COMPANY'S FORM
10-Q FOR THE YEAR-TO-DATE, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 14,176
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 323,165
<PP&E> 3,634
<DEPRECIATION> 598
<TOTAL-ASSETS> 340,377
<CURRENT-LIABILITIES> 255,291
<BONDS> 0
0
0
<COMMON> 53,798
<OTHER-SE> 31,288
<TOTAL-LIABILITY-AND-EQUITY> 340,377
<SALES> 55,361
<TOTAL-REVENUES> 73,475
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 17,596
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 7,800
<INCOME-PRETAX> 48,079
<INCOME-TAX> 20,447
<INCOME-CONTINUING> 27,632
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 27,632
<EPS-PRIMARY> 1.49
<EPS-DILUTED> 1.37
</TABLE>
