SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____________ to _____________
Commission File Number: 1-12109
DELTA FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 11-3336165
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1000 Woodbury Road, Suite 200, Woodbury, New York 11797
(Address of registrant's principal executive offices including ZIP Code)
(516) 364 - 8500
(Registrant's telephone number, including area code)
No Change
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities and 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 [ ]
As of September 30, 1998, 15,380,949 shares of the Registrant's common
stock, par value $.01 per share, were outstanding.
<PAGE>
INDEX TO FORM 10-Q
Page No.
PART I - FINANCIAL INFORMATION
Consolidated Balance Sheets as of September 30, 1998 and December 31, 1997. 1
Consolidated Statements of Income for the three months and nine months
ended September 30, 1998 and September 30, 1997............................ 2
Consolidated Statements of Cash Flows for the nine months ended
September 30, 1998 and September 30, 1997.................................. 3
Notes to Consolidated Financial Statements................................. 4
Management's Discussion and Analysis of Financial Condition and
Results of Operations...................................................... 8
New Accounting Pronouncements..............................................23
PART II - OTHER INFORMATION
Other Information..........................................................25
Signatures.................................................................27
<PAGE>
Part I - Financial Information
<TABLE>
<CAPTION>
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(Dollars in thousands, except for share data) 1998 1997
------------- ------------
<S> <C> <C>
Assets
Cash and interest-bearing deposits $ 42,922 $ 32,858
Accounts receivable 23,282 31,209
Loans held for sale 87,891 79,247
Accrued interest and late charges receivable 41,518 29,598
Capitalized mortgage servicing rights 30,683 22,862
Interest-only and residual certificates 197,839 167,809
Equipment, net 16,513 11,211
Cash held for advance payments 11,580 6,325
Prepaid and other assets 6,545 6,224
Goodwill 6,309 5,889
--------- ---------
Total assets $ 465,082 $ 393,232
========= =========
Liabilities and Stockholders' Equity
Liabilities:
Bank payable $ 1,793 $ 2,222
Warehouse financing and other borrowings 82,033 28,233
Senior Notes 149,366 149,307
Accounts payable and accrued expenses 14,317 15,503
Investor payable 53,859 40,852
Advance payment by borrowers for taxes and insurance 9,610 5,750
Income taxes payable 21,170 24,912
--------- ---------
Total liabilities $ 332,148 $ 266,779
--------- ---------
Stockholders' Equity:
Common stock,$.01 par value. Authorized
49,000,000 shares; at September 30, 1998,
15,475,549 shares issued and 15,380,949 shares
outstanding and at December 31, 1997, 15,372,688
shares issued and outstanding $ 155 $ 154
Additional paid-in capital 94,700 93,476
Retained earnings 39,278 32,823
Treasury stock, at cost (94,600 shares and 0 shares
at September 30, 1998 and December 31, 1997,
respectively) (1,199) ---
--------- ---------
Total stockholders' equity 132,934 126,453
--------- ---------
Total liabilities and stockholders' equity $ 465,082 $ 393,232
========= =========
See accompanying notes to consolidated financial statements.
1
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands, except per share data) 1998 1997 1998 1997
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Revenues:
Net gain on sale of mortgage loans $ 17,858 $ 24,733 $ 69,439 $ 60,502
Interest 10,569 5,246 6,841 17,144
Servicing fees 3,365 1,958 5,690 5,249
Origination fees 6,294 5,477 17,952 12,291
---------- ---------- ---------- ----------
Total revenues 38,086 37,414 99,922 95,186
---------- ---------- ---------- ----------
Expenses:
Payroll and related costs 15,250 11,543 41,737 28,555
Interest expense 8,521 5,670 23,213 12,761
General and administrative 9,222 6,521 24,814 15,332
---------- ---------- ---------- ----------
Total expenses 32,993 23,734 89,764 56,648
---------- ---------- ---------- ----------
Income before income taxes 5,093 13,680 10,158 38,538
Provision for income taxes 1,987 5,796 3,703 16,440
---------- ---------- ---------- ----------
Net income $ 3,106 $ 7,884 $ 6,455 $ 22,098
========== ========== ========== ==========
Per share data:
Net income per common
share - basic and diluted $ 0.20 $ 0.51 $ 0.42 $ 1.44
======= ======= ======= =======
Weighted-average number
of shares outstanding 15,414,210 15,372,288 15,387,923 15,354,810
========== ========== ========== ==========
See accompanying notes to consolidated financial statements.
2
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
(Dollars in thousands) 1998 1997
--------- ---------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 6,455 $ 22,098
Adjustments to reconcile net income to net cash used in
operating activities:
Provision for loan and recourse losses 75 75
Depreciation and amortization 3,091 1,791
Net increase in capitalized mortgage servicing rights (7,821) (7,974)
Decrease (increase) in deferred origination fees 1,108 (406)
Net increase in interest-only and residual certificates (30,030) (60,977)
Changes in operating assets and liabilities:
Decrease (increase) in accounts receivable 5,022 (17,922)
Increase in loans held for sale, net (9,775) (1,893)
Increase in accrued interest and late charges receivable (11,920) (7,068)
Increase in cash held for advance payments (5,255) (3,492)
Decrease in real estate owned --- 135
Increase in prepaid and other assets (321) (4,658)
(Decrease) increase in accounts payable and accrued expenses (1,238) 2,729
Increase in investor payable 13,007 6,838
Increase in advance payments by borrowers for taxes and ins. 3,860 3,136
(Decrease) increase in income taxes payable (837) 12,267
--------- ---------
Net cash used in operating activities (34,579) (55,321)
--------- ---------
Cash flows from investing activities:
Acquisition of Fidelity Mortgage --- (4,150)
Purchase of equipment (7,554) (5,529)
--------- ---------
Net cash used in investing activities (7,554) (9,679)
--------- ---------
Cash flows from financing activities:
Proceeds from (repayments of) warehouse financing and other
borrowings, net 53,800 (80,420)
Proceeds from issuance of Senior notes --- 149,275
Decrease in bank payable, net (429) (1,048)
Purchase of treasury stock (1,199) ---
Proceeds from exercise of stock options 25 ---
--------- ---------
Net cash provided by financing activities 52,197 67,807
--------- ---------
Net increase in cash and interest-bearing deposits 10,064 2,807
Cash and interest-bearing deposits at beginning of period 32,858 18,741
--------- ---------
Cash and interest-bearing deposits at end of period $ 42,922 $ 21,548
========= =========
Supplemental Information:
Cash paid during the period for:
Interest $ 26,850 $ 10,835
Income taxes $ 4,591 $ 18,626
See accompanying notes to consolidated financial statements.
3
</TABLE>
<PAGE>
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Organization
Delta Financial Corporation (the "Company") is a Delaware corporation which
was organized in August 1996. On October 31, 1996, in connection with its
initial public offering, the Company acquired all of the outstanding common
stock of Delta Funding Corporation ("Delta Funding"), a New York corporation
which had been organized on January 8, 1982 for the purpose of originating,
selling, servicing and investing in residential first and second mortgages. On
November 1, 1996, the Company completed an initial public offering of 4,600,000
shares of common stock, par value $.01 per share.
On February 11, 1997, the Company acquired Fidelity Mortgage Inc. and
Fidelity Mortgage (Florida), Inc. (together referred to herein as "Fidelity
Mortgage"), retail residential mortgage origination companies, for a combination
of cash and stock with a value of $6.3 million. These transactions were
accounted for under the purchase method of accounting. Accordingly, the results
of operations of Fidelity Mortgage from February 11, 1997 have been included in
the Company's consolidated financial statements. In connection with these
acquisitions the Company recorded goodwill of approximately $6.3 million, which
is being amortized on a straight-line basis over seven years. On October 1,
1997, the acquired operations were merged and have continued to operate as
Fidelity Mortgage. As a result of meeting certain production targets for the
twelve month period ended June 30, 1998, the sellers were paid an additional
$1.2 million of purchase price in the form of, and at a fair value equivalent to
101,361 shares of the Company's stock in August 1998. The additional
consideration has been recorded as additional goodwill and will be amortized
over the remaining life of the goodwill.
(2) Basis of Presentation
The accompanying unaudited consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries. All significant
inter-company accounts and transactions have been eliminated in consolidation.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and the instructions to Form 10-Q. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to the rules and regulations of the Securities and Exchange
Commission. The accompanying unaudited consolidated financial statements and the
information included under the heading "Management's Discussion and Analysis of
Financial Condition and Results of Operations" should be read in conjunction
with the consolidated financial statements and related notes of the Company for
the year ended December 31, 1997. The results of operations for the three and
nine month periods ended September 30, 1998 are not necessarily indicative of
the results that will be expected for the entire year.
All adjustments which are, in the opinion of management, considered necessary
for a fair presentation of the financial position and results of operations for
the interim periods presented have been made. Certain prior period amounts in
the financial statements have been reclassified
4
to conform with the current year presentation.
(3) Fair Value Adjustments
During the second quarter of 1998, the Company recorded a $15.5 million
reduction in the carrying amount of its interest-only and residual certificates,
and also recorded a $1.9 million reduction in the carrying amount of its
capitalized mortgage servicing rights to reflect a provision for impairment (the
"fair value adjustments"). Both impairment provisions resulted from reductions
in the Company's estimates of the fair value of those assets. The reductions in
the estimated fair value resulted from a change in the prepayment assumptions
used by the Company to estimate the future cash flows to be derived from the
interest-only and residual certificates and the mortgage servicing rights.
As required by generally accepted accounting principles, at each reporting
period the Company estimates the fair value of its interest-only and residual
certificates and its capitalized mortgage servicing rights. The carrying amount
of the interest-only and residual certificates is adjusted to their current fair
value. For capitalized mortgage servicing rights, a valuation allowance is
recorded if the fair value is less than the carrying amount.
The fair values of both interest-only and residual certificates and
capitalized mortgage servicing rights are significantly affected by, among other
factors, prepayments of loans and the estimates of future prepayment rates. The
Company continually reviews its prepayment assumptions in light of company and
industry experience, and makes adjustments to those assumptions when such
experience indicates.
During 1997, the Company made certain changes in its prepayment assumptions,
principally increasing the estimated maximum prepayment rates for
adjustable-rate loan pools. The effect of that change in prepayment assumptions
did not materially affect the fair value of the interest-only and residual
certificates in 1997.
The Company's review of its prepayment experience and assumptions at June 30,
1998 indicated that the prepayment rates during 1998, particularly for
adjustable-rate mortgages, and in particular during the second quarter of 1998,
were higher than those historically experienced, or previously projected, by the
Company. The Company believes that these increases in prepayments were
attributable to the continuation, for a longer period than historically
experienced, of low interest rates, together with changes, to a flatter or
inverted curve, of the relationship between long-term and short-term interest
rates (the "yield curve").
As a result, at June 30, 1998, the Company adjusted its prepayment
assumptions, increasing the maximum prepayment rates for all loans, and changing
the rate at which prepayments are assumed to increase from the initial rate to
the maximum rate from a straight-line build-up to a "vector" curve. These
revised prepayment assumptions were used to estimate the fair value of the
interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in securitizations completed prior to the second
quarter of 1998, requiring the fair value adjustments described above. These
revised prepayment assumptions were also used in initially valuing and recording
the interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in its securitizations completed subsequent to
the first quarter of 1998.
5
The following table compares the prepayment assumptions used subsequent to
the first quarter of 1998 (the "new" assumptions) with those used at December
31, 1997 and through the first quarter of 1998 (the "old" assumptions):
- --------------------------------------------------------------------------------
Loan Type Curve Description Month 1 Speed Peak Speed
- --------------------------------------------------------------------------------
Old New Old New Old New
- --------------------------------------------------------------------------------
Fixed Rate Loans Ramp Vector 4.8% 4.8% 24% 31%
Six-Month LIBOR ARMs Ramp Vector 5.6% 10.0% 28% 50%
Hybrid ARMs Ramp Vector 5.6% 6.0% 28% 50%
- --------------------------------------------------------------------------------
The Company determined that no further adjustments to the prepayment or other
assumptions was necessary at September 30, 1998.
(4) Earnings Per Share
The following is a reconciliation of the denominators used in the
computations of basic and diluted earnings per share (EPS). The numerator for
calculating both basic and diluted EPS is net income.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- --------------------
(Dollars in thousands, except EPS data) 1998 1997 1998 1997
- ---------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Net income $3,106 $7,884 $6,455 $22,098
Weighted-average shares - basic 15,414,210 15,372,288 15,387,923 15,354,810
Basic EPS $0.20 $0.51 $0.42 $1.44
Weighted-average shares - basic 15,414,210 15,372,288 15,387,923 15,354,810
Incremental shares-options
and Fidelity additional shares --- 54,026 31,341 53,061
- ---------------------------------------------------------------------------------------------
Weighted-average shares - diluted 15,414,210 15,426,314 15,419,264 15,407,871
Diluted EPS $0.20 $0.51 $0.42 $1.44
</TABLE>
(5) Stock Repurchase Plan
On May 7, 1998, the Company's Board of Directors authorized a program to
repurchase up to two hundred thousand (200,000) shares of its issued and
outstanding common stock. No time limit has been placed on the duration of the
stock repurchase program. Subject to applicable securities laws, such purchases
will be made at times and in amounts as the Company deems appropriate and may be
discontinued at any time. The repurchases may be effected from time to time in
accordance with applicable securities laws, through solicited or unsolicited
transactions in the open market, on the New York Stock Exchange or in privately
negotiated transactions, subject to availability of shares at prices deemed
appropriate by the Company. Repurchased shares will be held as treasury shares
available for general corporate purposes, including, but not limited to,
satisfying the Company's contingent share obligations to the former shareholders
of Fidelity Mortgage, and in connection with Delta Financial's employee stock
plans.
6
During the quarter ended September 30, 1998, the Company repurchased in the
open market 80,000 shares of its common stock under its stock repurchase plan at
an average per share price of $11.57 per share. At September 30, 1998, the total
number of treasury shares held by the Company equalled 94,600. Given the
sector-wide focus on liquidity and conserving capital, the Board of Directors
decided in November 1998 to suspend the share repurchase program until its 1st
Quarter 1999 Board meeting, to be held in or about February 1999 (or such
earlier date as the Board may determine appropriate), at which time the Board
will reconsider whether to recommence repurchases.
7
<PAGE>
Management's Discussion and Analysis of Financial Condition and Results of
Operations
The following discussion should be read in conjunction with the Consolidated
Financial Statements of the Company and accompanying Notes to Consolidated
Financial Statements set forth therein.
General
Delta Financial Corporation engages in the consumer finance business by
originating, acquiring, selling and servicing non-conforming home equity loans.
Throughout its 17 years of operating history, the Company has focused on lending
to individuals who generally have impaired or limited credit profiles or higher
debt-to-income ratios and typically have substantial equity in their homes.
Through its wholly-owned subsidiary, Delta Funding Corporation, the Company
originates home equity loans indirectly through licensed mortgage brokers and
other real estate professionals who submit loan applications on behalf of the
borrower ("Brokered Loans") and also purchases loans from mortgage bankers and
smaller financial institutions that satisfy Delta's underwriting guidelines
("Correspondent Loans"). Delta Funding Corporation currently originates and
purchases the majority of its loans in 22 states, through its network of
approximately 1,150 brokers and correspondents.
Through its wholly-owned subsidiary, Fidelity Mortgage Inc., the Company
develops retail loan leads ("Retail Loans") primarily through its telemarketing
system and its network of 15 retail offices located in 9 states. Through a
strategic alliance between DFC Funding of Canada Limited, a wholly-owned
subsidiary of Delta Funding Corporation, and MCAP Mortgage Corporation, a
Canadian mortgage loan originator, the Company originates loans in Canada.
For the three months ended September 30, 1998, the Company originated and
purchased $476 million of loans, an increase of 34% over the $356 million of
loans originated and purchased in the comparable period in 1997. Of these
amounts, approximately $228 million were originated through its network of
brokers, $178 million were purchased from its network of correspondents, $67
million were originated through its retail network and $3 million were
originated through its Canadian network in the three months ended September 30,
1998, compared to $134 million, $171 million, $51 million and $0, respectively,
for the same period in 1997. These originations reflect the Company's strategy
to focus on broker and retail channels which are more profitable and less cash
intensive than correspondent loan purchases.
The following table sets forth information relating to the delinquency and
loss experience of the mortgage loans serviced by the Company (primarily for the
securitization trusts, as described below) for the periods indicated. The
Company is not the holder of the securitization loans, but generally retains
interest-only or residual certificates issued by the securitization trusts, as
well as the servicing rights, the value of each of which may be adversely
affected by defaults.
8
Three Months Ended
-----------------------------
(Dollars in Thousands) September 30, June 30,
1998 1998
------------ ------------
Total Outstanding Principal Balance
(at period end)....................... $ 2,690,304 $ 2,391,719
Average Outstanding (1)................... $ 2,588,189 $ 2,285,348
DELINQUENCY (at period end)
30-59 Days:
Principal Balance..................... $ 128,623 $ 113,197
Percent of Delinquency(2)............. 4.78% 4.73%
60-89 Days:
Principal Balance..................... $ 51,098 $ 38,605
Percent of Delinquency(2)............. 1.90% 1.61%
90 Days or More:
Principal Balance..................... $ 35,884 $ 25,688
Percent of Delinquency(2)............. 1.33% 1.07%
Total Delinquencies:
Principal Balance..................... $ 215,605 $ 177,490
Percent of Delinquency(2)............. 8.01% 7.42%
FORECLOSURES
Principal Balance..................... $ 124,491 $ 110,462
Percent of Foreclosures by Dollar(2).. 4.63% 4.62%
REO (at end of period).................... $ 17,059 $ 13,648
Net Losses on Liquidated Loans............ $ (2,473) $ (2,044)
Percentage of Net Losses on Liquidated Loans
(based on Average Outstanding Balance)(3) (0.38%) (0.36%)
- ---------------
(1)Calculated by summing the actual outstanding principal balances at the end
of each month and dividing the total principal balance by the number of
months in the applicable period.
(2)Percentages are expressed based upon the total outstanding principal balance
at the end of the indicated period.
(3) Annualized.
Securitizations
As a fundamental part of its business and financing strategy, the Company
sells the majority of its loans through securitization and derives a substantial
portion of its income therefrom. In a securitization, the Company sells a pool
of loans it has originated or purchased to a special purpose REMIC trust for a
cash price. The trust, in turn, finances the pool of loans it has acquired by
issuing "pass-through certificates," which represent undivided ownership
interests in the trust. The holders of the pass-through certificates are
entitled to receive monthly distributions of all principal received on the
underlying mortgage loans and a specified amount of interest, determined at the
time of the offering of the certificates.
When the Company sells a pool of loans to the securitization trust, the
Company receives the following economic interests in the trust: (a) the
difference between the interest payments due on the loans sold to the trust and
the interest rate paid to the holders of pass-through certificates, less the
Company's contractual servicing fee and other costs and expenses of
administering the trust, the economic value of which is represented by
interest-only and residual certificates, and (b) the
9
right to service the loans on behalf of the trust and earn a contractual
servicing fee, as well as other ancillary servicing related fees paid by the
borrowers on the underlying loans.
Upon the securitization of a pool of loans, the Company (i) recognizes in
income, as origination fees, the unamortized origination fees included in the
investment in the loans sold, and (ii) recognizes a gain on sale of loans equal
to the difference between the amount of cash received by the Company from the
trust for the pool of loans and the investment in the loans remaining after the
allocation of portions of that investment to record the value of interest-only
and residual certificates and capitalized mortgage servicing rights received by
the Company in the securitization. The majority of the net gain on sale of
mortgage loans results from, and is initially realized in the form of, the
retention of interest-only and residual certificates.
In recording and accounting for interest-only and residual certificates and
capitalized mortgage servicing rights, the Company makes estimates of rates of
prepayments and defaults on the underlying pool of loans sold to the trust, and
the value of the collateral, which it believes reasonably reflect economic and
other conditions then in effect. The actual rate of prepayments, defaults and
the value of collateral will generally differ from the estimates used, due to
subsequent changes in economic and other conditions and the implicit imprecision
of estimates, and such differences often may be material. Prepayment and default
rates higher than those estimated would adversely affect the value of both the
capitalized mortgage servicing rights (actual mortgage servicing income will be
less, and significant changes could require an impairment of the capitalized
mortgage servicing rights) and the interest-only and residual certificates, for
which changes in fair value are recorded. Conversely, prepayment and default
rates lower than those estimated would increase the servicing income earned over
the life of the loans and positively impact the value of the interest-only and
residual certificates.
The Company has sold interest-only certificates created in securitizations
for cash proceeds in each of its six most recent quarterly securitization
transactions and intends to continue to sell the interest-only certificate as
long as the sale effectively maximizes cash flow and profitability.
Fair Value Adjustments
During the second quarter of 1998, the Company recorded a $15.5 million
reduction in the carrying amount of its interest-only and residual certificates,
and also recorded a $1.9 million reduction in the carrying amount of its
capitalized mortgage servicing rights to reflect a provision for impairment (the
"fair value adjustments"). Both impairment provisions resulted from reductions
in the Company's estimates of the fair value of those assets. The reductions in
the estimated fair value resulted from a change in the prepayment assumptions
used by the Company to estimate the future cash flows to be derived from the
interest-only and residual certificates and the mortgage servicing rights.
As required by generally accepted accounting principles, at each reporting
period the Company estimates the fair value of its interest-only and residual
certificates and its capitalized mortgage servicing rights. The carrying amount
of the interest-only and residual certificates is adjusted to their current fair
value. For capitalized mortgage servicing rights, a valuation allowance is
recorded if the fair value is less than the carrying amount.
The fair values of both interest-only and residual certificates and
capitalized mortgage
10
servicing rights are significantly affected by, among other factors, prepayments
of loans and the estimates of future prepayment rates. The Company continually
reviews its prepayment assumptions in light of company and industry experience,
and makes adjustments to those assumptions when such experience indicates.
During 1997, the Company made certain changes in its prepayment assumptions,
principally increasing the estimated maximum prepayment rates for
adjustable-rate loan pools. The effect of that change in prepayment assumptions
did not materially affect the fair value of the interest-only and residual
certificates in 1997.
The Company's review of its prepayment experience and assumptions at June 30,
1998 indicated that the prepayment rates during 1998, particularly for
adjustable-rate mortgages, and in particular during the second quarter of 1998,
were higher than those historically experienced, or previously projected, by the
Company. The Company believes that these increases in prepayments were
attributable to the continuation, for a longer period than historically
experienced, of low interest rates, together with changes, to a flatter or
inverted curve, of the relationship between long-term and short-term interest
rates (the "yield curve").
As a result, at June 30, 1998, the Company adjusted its prepayment
assumptions, increasing the maximum prepayment rates for all loans, and changing
the rate at which prepayments are assumed to increase from the initial rate to
the maximum rate from a straight-line build-up to a "vector" curve. These
revised prepayment assumptions were used to estimate the fair value of the
interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in securitizations completed prior to the second
quarter of 1998, requiring the fair value adjustments described above. These
revised prepayment assumptions were also used in initially valuing and recording
the interest-only and residual certificates and capitalized mortgage servicing
rights retained by the Company in its securitizations completed subsequent to
the first quarter of 1998.
The following table compares the prepayment assumptions used subsequent to
the first quarter of 1998 (the "new" assumptions) with those used at December
31, 1997 and through the first quarter of 1998 (the "old" assumptions):
- --------------------------------------------------------------------------------
Loan Type Curve Description Month 1 Speed Peak Speed
- --------------------------------------------------------------------------------
Old New Old New Old New
- --------------------------------------------------------------------------------
Fixed Rate Loans Ramp Vector 4.8% 4.8% 24% 31%
Six-Month LIBOR ARMs Ramp Vector 5.6% 10.0% 28% 50%
Hybrid ARMs Ramp Vector 5.6% 6.0% 28% 50%
- --------------------------------------------------------------------------------
The Company determined that no further adjustments to the prepayment or other
assumptions was necessary at September 30, 1998.
11
Results of Operations
Three Months Ended September 30, 1998 Compared to the Three Months Ended
September 30, 1997
Revenues
Total revenues for the three months ended September 30, 1998 increased $0.7
million, or 2%, to $38.1 million from $37.4 million for the comparable period in
1997. This increase was primarily attributable to increases in interest from
interest only and residual certificates (see "Interest Income" below), servicing
fees and, to a lesser extent, interest on loans held for sale, and origination
fees, partially offset by a decrease in the net gain recognized on the sale of
mortgage loans.
For the three months ended September 30, 1998, the Company originated and
purchased $476 million of mortgage loans, representing a 34% increase from $356
million of mortgage loans originated and purchased for the three months ended
September 30, 1997. The Company completed a $475 million securitization during
the three months ended September 30, 1998 compared to a $340 million
securitization in the corresponding period of the prior year, representing a 40%
increase. Total loans serviced at September 30, 1998 increased 69% to $2.7
billion from $1.6 billion at September 30, 1997.
Net Gain on Sale of Mortgage Loans. Net gain on sale of mortgage loans
represents (1) the sum of (a) the fair value of the residual certificates
retained by the Company in a securitization for each period and the market value
of the interest-only certificates sold in connection with each securitization,
and (b) the fair value of capitalized mortgage servicing rights associated with
loans securitized in each period, (2) less the (x) premiums paid to originate or
acquire mortgage loans, (y) costs associated with securitizations and (z) any
hedge loss (gain) associated with a particular securitization.
For the three months ended September 30, 1998, net gain on sale of mortgage
loans decreased $6.9 million, or 28%, to $17.8 million from $24.7 million for
the three months ended September 30, 1997. This decrease was primarily due to a
lower weighted average net gain on sale ratio, but was partially offset by an
increase in the amount of loans securitized in the third quarter of 1998
compared to the same period in 1997. The weighted average net gain on sale
ratio, which is calculated by dividing the net gain on sale by the total amount
of loans securitized, was 3.8% compared to 7.3% for the three months ended
September 30, 1997.
Net gain on sale of loans decreased primarily because of (a) the impact of a
hedging loss during the third quarter of 1998 resulting from lower interest
rates that was not offset by a higher gain on sale due to substantially wider
spreads demanded by asset-backed investors who purchase the pass-through
certificates issued by the securitization trusts, and (b) the Company's change
to more conservative prepayment assumptions used in initially valuing the
residual certificates and capitalized mortgage servicing rights acquired in the
third quarter 1998 securitization (see "-Fair Value Adjustments" above),
Interest Income. Interest income primarily represents the sum of (1) the
difference between the distributions the Company receives on its interest-only
and residual certificates and the adjustments recorded to reflect changes in the
fair value of the interest-only and residual certificates, (2) interest earned
on loans held for sale, and (3) interest earned on cash collection
12
balances.
Interest income for the three months ended September 30, 1998 increased
$5.3 million, or 102%, to $10.5 million from $5.2 million in the comparable
period in 1997. The increase in interest income was primarily due to higher
levels in both the interest earned on interest-only and residual certificates
and the interest earned on loans held for sale. However, interest income from
loans held for sale was reduced, in part, by a decline, from 10.9% to 10.1%, in
the weighted average coupon rate on the mortgage loans, reflecting both a lower
interest rate environment and the Company's shift to higher credit quality
loans.
Servicing Fees. Servicing fees represent all contractual and ancillary
servicing revenue received by the Company less (1) the offsetting amortization
of the capitalized mortgage servicing rights, and any adjustments recorded to
reflect any impairment in the fair value of capitalized mortgage servicing
rights and (2) prepaid interest shortfalls.
Servicing fees for the three months ended September 30, 1998 increased
$1.4 million, or 70%, to $3.4 million from $2.0 million in the comparable period
in 1997. This increase was primarily due to the increase in the aggregate size
of the Company's servicing portfolio. During the three months ended September
30, 1998, the average balance of mortgage loans serviced by the Company
increased 73% to $2.6 billion from $1.5 billion during the comparable period in
1997.
Origination Fees. Origination fees represent fees earned on brokered and
retail originated loans. Origination fees for the three months ended September
30, 1998 increased $0.8 million, or 15%, to $6.3 million from $5.5 million in
the comparable period in 1997. The increase is primarily the result of increased
brokered and retail loan originations.
Expenses
Total expenses increased $9.3 million, or 39%, to $33.0 million for three
months ended September 30, 1998, from $23.7 million for the comparable period in
1997. The increase in expenses was primarily the result of (1) increased
interest expense due to (a) higher interest cost associated with increased
borrowings under the Company's warehouse facilities to finance the increased
loan origination and purchase activities, and (b) the issuance in July 1997 of
$150 million aggregate principal amount of 9.5% Senior Notes due 2004 (the
"Senior Notes"), (2) an increase in the Company's personnel to support its
higher level of loan originations, and (3) costs associated with the Company's
expanded retail, broker and correspondent divisions.
Payroll and Related Costs. Payroll and related costs include salaries,
benefits and payroll taxes for all employees. Payroll and related costs
increased $3.7 million, or 32%, to $15.2 million for the three months ended
September 30, 1998 from $11.5 million for the comparable period in 1997. This
increase is primarily due to staff increases related to an increase in the
Company's loan originations and the costs associated with the Company's broker,
correspondent and Fidelity Mortgage retail division. As of September 30, 1998,
the Company employed 1,041 full- and part-time employees, compared to 850 full-
and part-time employees as of September 30, 1997.
Interest Expense. Interest expense includes borrowing costs to finance loan
originations and purchases under (i) the Company's credit facilities, and (ii)
the Senior Notes.
For the three months ended September 30, 1998, interest expense increased
$2.8 million, or 49%, to $8.5 million from $5.7 million for the comparable
period in 1997. The increase in
13
interest expense was attributable to (i) an increase in loan production,
which increased the level of debt needed throughout the third quarter of 1998
to finance the inventory of loans held for sale prior to their securitization
and (ii) the Company's issuance in July 1997 of the Senior Notes.
General and Administrative Expenses. General and administrative expenses
consist primarily of office rent, insurance, telephone, depreciation, goodwill
amortization, travel and entertainment expenses, license fees, legal and
accounting fees, postage expenses, office supplies, credit reporting, repairs
and maintenance, advertising and promotional expenses and the provision for loan
losses on the inventory of loans held for sale and recourse loans.
For the three months ended September 30, 1998, general and administrative
expenses increased $2.7 million, or 42%, to $9.2 million from $6.5 million for
the comparable period in 1997. This increase was primarily attributable to an
increase in expenses associated with (i) the Company's increased loan
originations and purchases and (ii the Company's increasing the number of
Fidelity Mortgage retail branch offices from eleven to fifteen.
Income Taxes. Income taxes are accounted for under SFAS No. 109, "Accounting
for Income Taxes." Deferred tax assets and liabilities are recognized on the
income reported in the financial statements regardless of when such taxes are
paid. These deferred taxes are measured by applying current enacted tax rates.
The Company recorded tax provisions of $2.0 million and $5.8 million for the
three month periods ended September 30, 1998 and 1997, respectively. Income
taxes provided a 39.0% effective tax rate for the three months ended September
30, 1998, compared to a 42.4% assumed effective tax rate for the three months
ended September 30, 1997. The reduction in the effective tax rate is primarily
attributable to the Company's expansion into lower tax rate states and local
jurisdictions and to the benefits for permanent book/tax differences.
Nine Months Ended September 30, 1998 Compared to the Nine Months Ended
September 30, 1997
Revenues
Total revenues for the nine months ended September 30, 1998 increased $4.7
million, or 5%, to $99.9 million from $95.2 million for the comparable period in
1997. The increase in revenue was primarily attributable to the increase in the
net gain on sale recognized by the Company, which reflects the increase in the
Company's level of loan originations, purchases and securitizations. Revenue
also increased in origination fees as a direct result of increased broker and
retail loan origination volume. These increases were partially offset by the
fair value adjustments the Company made to its interest-only and residual
certificates and capitalized mortgage servicing rights in the second quarter of
1998. (See "-Fair Value Adjustments" above).
For the nine months ended September 30, 1998, the Company originated and
purchased $1.3 billion of mortgage loans, representing a 52% increase from $858
million of mortgage loans originated and purchased for the nine months ended
September 30, 1997. The Company completed three securitizations totaling $1.3
billion during the nine months ended September 30, 1998 compared to three
securitizations totaling $835 million in the corresponding period in the prior
year, representing a 56% increase. Total loans serviced at September 30, 1998
increased 69% to $2.7 billion from $1.6 billion at September 30, 1997.
14
Net Gain on Sale of Mortgage Loans. For the nine months ended September 30,
1998, net gain on sale of mortgage loans increased $8.9 million, or 15%, to
$69.4 million from $60.5 million for the nine months ended September 30, 1997.
This increase was primarily due to the increase in the amount of loans
securitized for the none months ended September 30, 1998 compared to the same
period in 1997, but was partially offset by a lower weighted average net gain on
sale ratio. The weighted average net gain on sale ratio was 5.3% compared to
7.2% for the nine months ended September 30, 1997.
Net gain on the sale of loans increased less than the overall increase in
loan securitizations primarily due to (a) the Company's change to more
conservative prepayment assumptions used in initially valuing the residual
certificates and capitalized mortgage servicing rights acquired subsequent to
the first quarter of 1998 (see "-Fair Value Adjustments" above), and (b) the
impact of a hedging loss during the third quarter of 1998 resulting from lower
interest rates that was not offset by a higher gain on sale due to substantially
wider spreads demanded by asset-backed investors who purchase the pass-through
certificates issued by securitization trusts.
Interest Income. Interest income for the nine months ended September 30, 1998
decreased $10.3 million to $6.8 million from $17.1 million in the comparable
period in 1997. The decrease in interest income was primarily due to the $15.5
million fair value adjustment made during the second quarter of 1998 to the
interest-only and residual certificates previously discussed (see "-Fair Value
Adjustments" above). The effect of that adjustment was partially offset by
increases in interest income (a) from interest-only and residual certificates
income, and (b) from bank deposits resulting from a higher average balance held
in securitization trust accounts by the Company. In addition, interest on loans
held for sale increased due to higher average balances, partially offset by a
decline, from 11.1% to 10.2%, in the weighted average coupon rate on the
mortgage loans, reflecting both a lower interest rate and the Company's shift to
higher credit quality loans.
Servicing Fees. Servicing fees for the nine months ended September 30, 1998
increased $0.4 million, or 8%, to $5.7 million from $5.3 million in the
comparable period in 1997. This increase was primarily due to an increase in the
aggregate size of the Company's servicing portfolio, partially offset by the
recording of the $1.9 million provision for the Company's capitalized mortgage
servicing rights. (See "-Fair Value Adjustments" above). During the nine months
ended September 30, 1998, the average balance of mortgage loans serviced by the
Company increased 92% to $2.3 billion from $1.2 billion during the comparable
period in 1997.
Origination Fees. Origination fees for the nine months ended September 30,
1998 increased $5.7 million, or 46%, to $18.0 million from $12.3 million in the
comparable period in 1997. The increase is primarily the result of increased
broker and retail loan originations.
Expenses
Total expenses increased $33.1 million, or 58%, to $89.7 million for the nine
months ended September 30, 1998, from $56.6 million for the comparable period in
1997. This increase was primarily the result of (1) increased interest expense,
(2) increase in the Company's personnel to support its higher level of loan
originations, and (3) costs associated with the Company's expanded retail,
broker and correspondent divisions.
Payroll and Related Costs. For the nine months ended September 30, 1998,
payroll and related costs expense increased $13.2 million, or 46%, to $41.7
million from $28.5 million for the
15
comparable period in 1997. This increase is primarily due to staff
increases related to an increase in the Company's loan originations and the
costs associated with the Company's broker, correspondent and Fidelity Mortgage
retail division, which only reflects expenses from February 11, 1997. As of
September 30, 1998, the Company employed 1,041 full-and part-time employees
compared to 850 full- and part-time employees as of September 30, 1997.
Interest Expense. For the nine months ended September 30, 1998, interest
expense increased $10.5 million, or 82%, to $23.2 million from $12.7 million for
the comparable period in 1997. The increase in interest expense was attributable
to (1) an increase in loan production, which increased the level of debt needed
throughout the first nine months of 1998 to finance the inventory of loans held
for sale prior to their securitizations, and (2) the Company's issuance in July
1997 of the Senior Notes.
General and Administrative Expenses. For the nine months ended September 30,
1998, general and administrative expenses increased $9.5 million, or 62%, to
$24.8 million from $15.3 million for the comparable period in 1997. This
increase was primarily attributable (1) an increase in expenses associated with
the Company's increased loan originations and purchases, and (2) the expansion
costs associated with the Company's increasing the number of Fidelity Mortgage
retail branch offices from five to fifteen.
Income Taxes. The Company recorded a tax provision of $3.7 million and $16.4
million for the nine months ended September 30, 1998 and 1997, respectively.
Income taxes provided a 36.5% effective tax rate for the nine months ended
September 30, 1998, compared to a 42.7% assumed effective tax rate for the nine
months ended September 30, 1997. The reduction in the effective tax rate is
primarily attributable to the Company's expansion into lower tax rate states and
local jurisdictions and to the benefits for permanent book/tax differences.
Financial Condition
September 30, 1998 compared to December 31, 1997
Cash and interest-bearing deposits increased $10.1 million, or 31%, to $42.9
million at September 30, 1998 from $32.8 million at December 31, 1997. The
increase was primarily the result of additional monies held in securitization
trust accounts by the Company, acting as servicer for its ongoing securitization
program.
Accounts receivable decreased $7.9 million, or 25%, to $23.3 million at
September 30, 1998 from $31.2 million at December 31, 1997. The decrease was
primarily attributable to the receipt of a federal tax refund partially offset
by an increase in reimbursable servicing advances made by the Company, acting as
servicer on its securitizations, related to a higher average servicing
portfolio. The Company's servicing portfolio increased 50% to $2.7 billion as of
September 30, 1998 from $1.8 billion as of December 31, 1997.
Loans held for sale increased $8.7 million, or 11%, to $87.9 million at
September 30, 1998 from $79.2 million at December 31, 1997. This increase was
the result of a lower percentage of loans securitized compared to loans
originated and purchased, in the nine months ended September 30, 1998, as
compared to the fourth quarter of 1997.
Accrued interest and late charges receivable increased $11.9 million, or 40%,
to $41.5 million at September 30, 1998 from $29.6 million at December 31, 1997.
This increase was primarily due
16
to a higher loan servicing portfolio which resulted in increased
reimbursable interest advances made by the Company, acting as servicer on its
securitizations.
Capitalized mortgage servicing rights increased $7.8 million, or 34%, to
$30.7 million at September 30, 1998, from $22.9 million at December 31, 1997.
This increase was directly attributable to the Company's capitalizing the fair
market value of its servicing assets, totaling $15.2 million, resulting from the
Company's completion of three securitizations during the first nine months of
1998, partially offset by the amortization of capitalized mortgage servicing
rights and the fair value adjustment to the capitalized mortgage servicing
rights (see "-Fair Value Adjustments" above).
Interest-only and residual certificates increased $30.0 million, or 18%, to
$197.8 million at September 30, 1998 from $167.8 million at December 31, 1997.
This increase is primarily attributable to the Company's receipt of residual
certificates valued and recorded at $70.0 million from its securitizations
during the nine months ended September 30, 1998. The increase was offset by the
effect of the fair value adjustment and normal amortization due to cash
distributions.
Equipment, net, increased $5.3 million, or 47%, to $16.5 million at September
30, 1998 from $11.2 million at December 31, 1997. The increase was primarily due
to capital expenditures related to new technology and expansion.
Cash held for advance payments increased $5.3 million, or 84%, to $11.6
million at September 30, 1998 from $6.3 million at December 31, 1997. The
increase was primarily due to a higher average loan servicing portfolio
resulting in additional monies held in escrow trust accounts by the Company
acting as a servicer.
Warehouse financing and other borrowings increased $53.8 million, or 191%, to
$82.0 million at September 30, 1998 from $28.2 million at December 31, 1997.
This increase was primarily related to the operating cash deficit and, to a
lesser extent, the amount of loans held for sale and to fund purchases of
equipment.
The aggregate principal balance of the Senior Notes totaled $149.4 million at
September 30, 1998, net of unamortized bond discount. The Senior Notes accrue
interest at a rate of 9.5% per annum, payable semi-annually on February 1 and
August 1. The Company did not have any Senior Notes outstanding prior to July
1997.
Accounts payable and accrued expenses decreased $1.2 million, or 8%, to $14.3
million at September 30, 1998 from $15.5 million at December 31, 1997. This
decrease was primarily attributable to a payment of interest on Senior Notes,
partially offset by the timing of various operating accruals.
Investor payable increased $13.0 million, or 32%, to $53.9 million at
September 30, 1998 from $40.9 million at December 31, 1997. This increase was
primarily due to a 50% increase in the Company's portfolio of serviced loans.
Investor payable is comprised of all principal collected on mortgage loans and
accrued interest. Variability in this account is primarily due to the principal
payments collected within a given collection period.
Advance payments by borrowers for taxes and insurance increased $3.8 million,
or 66%, to $9.6 million at September 30, 1998 from $5.8 million at December 31,
1997. This increase is primarily due to a higher average loan servicing
portfolio and the timing of payments collected
17
and disbursed resulting in additional monies held in escrow trust accounts
by the Company acting as a servicer.
Stockholders' equity increased $6.4 million, or 5%, to $132.9 million at
September 30, 1998 from $126.5 million at December 31, 1997. This increase is
due to net income of $6.4 million for the nine month period ending September 30,
1998, and the issuance of $1.2 million of the Company's common stock paid to the
sellers of Fidelity Mortgage in August 1998, partially offset by the Company's
repurchase of 94,600 shares of its common stock for $1.2 million.
Liquidity and Capital Resources
The Company has historically operated on a negative cash flow basis
primarily due to increases in the volume of loan purchases and originations and
the growth of its securitization program. In recent quarters, however the
Company has reduced its negative cash flow, and expects to continue to do so for
the foreseeable future, as a result of aggregate annual increased cash inflows
from the Company's retained interest-only and residual certificates,
advantageous changes in the securitizations structures the Company has used and
a greater concentration on less cash-intensive broker and retail originations.
Since the second quater of 1997, the company has sold the senior interest-only
certificates in each of its securitizations and, in the Comany's three most
recent securitizations, it has successfully increased the amount of senior
interest-only certificates offered to investors, compared to prior
securitizations.
For the nine months ended September 30, 1998 and 1997, the Company had
operating cash deficits of $34.6 million and $55.3 million, respectively. The
improvement in the Company's operating cash deficit from 1997 compared to 1998
was primarily due to increased cash inflows from the Company's retained
interest-only and residual certificates, changes in the securitization
structures that the Company has utilized, a tax refund, an increase in the
Company's restricted cash held for securitization trust accounts and a lower
percentage of correspondent loan purchases, partially offset by the semi-annual
Senior Note interest payment.
Currently, the Company's primary cash requirements include the funding of (i)
mortgage originations and purchases pending their pooling and sale, (ii) the
points and expenses paid in connection with the acquisition of correspondent
loans, (iii) interest expense on its Senior Notes and warehouse and other
financings, (iv) fees, expenses and tax payments incurred in connection with its
securitization program, and (v) ongoing administrative and other operating
expenses. The Company has relied upon a few lenders to provide the primary
credit facilities for its loan originations and purchases. The Company must be
able to sell loans and obtain adequate credit facilities and other sources of
funding in order to continue to originate and purchase loans.
Historically, the Company has utilized various financing facilities and an
equity financing to offset negative operating cash flows and support the
continued growth of its loan originations and purchases, securitizations and
general operating expenses. On July 23, 1997, the Company completed its offering
of the Senior Notes. A portion of the Senior Notes proceeds were used to pay
down various financing facilities with the remainder used to fund the Company's
growth in loan originations and purchases and its ongoing securitization
program. The Company's primary sources of liquidity continue to be warehouse and
other financing facilities, securitizations and, subject to market conditions,
sales of whole loans and additional debt and equity securities.
To accumulate loans for securitization, the Company borrows money on a
short-term basis
18
through warehouse lines of credit. The Company currently has three warehouse
facilities for this purpose. One warehouse facility is a $400 million committed
credit line with a variable rate of interest and a maturity date of February
1999. This facility was converted from an uncommitted to a committed line during
the three months ended March 31, 1997 and the maturity date was extended from
February 1998 to February 1999 during the three months ended March 31, 1998. The
Company's second warehouse facility is a syndicated $150 million committed
revolving line with a variable rate of interest and a maturity date of June
1999. This facility was increased from $140 million to $150 million during the
three months ended June 30, 1998. The Company's third warehouse facility is a
$200 million committed commercial paper conduit with a variable rate of interest
and a maturity date of September 1999. The outstanding balance on the $400
million facility as of September 30, 1998 was $75.6 million. The Company had no
outstanding balances for the $150 million facility as of September 30, 1998. The
Company utilized $36.1 million of the $200 million facility as of September 30,
1998.
The Company has in the past obtained financing facilities for interest-only
and residual certificates acquired as part of its securitizations. As of
September 30, 1998, the Company did not have any indebtedness secured by
interest-only and residual certificates. In addition, the Company is limited by
the terms of the indenture governing the Senior Notes as to the amount of future
indebtedness permitted to be secured by interest-only and residual certificates.
The Company is required to comply with various operating and financial
covenants as provided in the agreements described above which are customary for
agreements of their type. The Company does not believe that its existing
financial covenants will restrict its operations or growth. The continued
availability of funds provided to the Company under these agreements is subject
to the Company's continued compliance with these covenants. Management believes
that the Company is in compliance with all such covenants under these agreements
as of September 30, 1998.
The Company purchased a total of 94,600 shares of its common stock during the
nine months ended September 30, 1998, under the Company's ongoing stock
repurchase program, at a total cost of $1.2 million. All of the repurchased
shares were purchased in open market transactions at then prevailing market
prices.
Interest Rate Risk
Among the Company's primary market risk exposure is interest rate risk.
Profitability may be directly affected by the level of, and fluctuation in,
interest rates, which affect the Company's ability to earn a spread between
interest received on its loans and the costs of its borrowings, which are tied
to various United States Treasury maturities, commercial paper rates and the
London Inter-Bank Offered Rate ("LIBOR"). The profitability of the Company is
likely to be adversely affected during any period of unexpected or rapid changes
in interest rates. A substantial and sustained increase in interest rates could
adversely affect the Company's ability to purchase and originate loans. A
significant decline in interest rates could increase the level of loan
prepayments thereby decreasing the size of the Company's loan servicing
portfolio. To the extent servicing rights and interest-only and residual classes
of certificates have been capitalized on the books of the Company, higher than
anticipated rates of loan prepayments or losses could require the Company to
write down the value of such servicing rights and interest-only and residual
certificates, adversely impacting earnings. As previously discussed, the fair
value adjustments that
19
the Company recorded in the second quarter of 1998 were primarily attributable
to the Company's change in prepayment assumptions to reflect higher than
originally anticipated rates of prepayments. (See "-Fair Value Adjustments"
above). In an effort to mitigate the effect of interest rate risk, the Company
has reviewed its various mortgage products and has identified and modified those
that have proven historically more susceptible to prepayments. However, there
can be no assurance that such modifications to its product line will effectively
mitigate interest rate risk in the future.
Fluctuating interest rates also may affect the net interest income earned by
the Company resulting from the difference between the yield to the Company on
loans held pending sales and the interest paid by the Company for funds borrowed
under the Company's warehouse facilities, although the Company undertakes to
hedge its exposure to this risk by using treasury rate lock contracts. (See
"Hedging" below).
Hedging
The Company originates and purchases mortgage loans and then sells them
primarily through securitizations. At the time of securitization and delivery of
the loans, the Company recognizes gain on sale based on a number of factors
including the difference, or "spread" between the interest rate on the loans and
the interest rate paid to asset-backed investors who purchase pass-through
certificates issued by securitization trusts, which historically was generally
related to the interest rate on treasury securities with maturities
corresponding to the anticipated life of the loans. If interest rates rise
between the time the Company originates or purchases the loans and the time the
loans are sold at securitization, the excess spread narrows, resulting in a loss
in value of the loans. The Company has implemented a strategy to protect against
such losses and to reduce interest rate risk on loans originated and purchased
that have not yet been securitized through the use of treasury rate lock
contracts with various durations (which are similar to selling a combination of
United States Treasury securities), which equate to a similar duration of the
underlying loans. The nature and quantity of hedging transactions are determined
by the Company based upon various factors including, without limitation, market
conditions and the expected volume of mortgage originations and purchases. The
Company will enter into treasury rate lock contracts through one of its
warehouse lenders and/or one of the investment bankers which underwrite the
Company's securitizations. These contracts are designated as hedges in the
Company's records and are closed out when the associated loans are sold through
securitization.
If the value of the hedges decrease, offsetting an increase in the value of
the loans, the Company, upon settlement with its counterparty, will pay the
hedge loss in cash and realize the corresponding increase in the value of the
loans as part of its net gain on sale of mortgage loans and its corresponding
interest-only and residual certificates. Conversely, if the value of the hedges
increase, offsetting a decrease in the value of the loans, the Company, upon
settlement with its counterparty, will receive the hedge gain in cash and
realize the corresponding decrease in the value of the loans through a reduction
in the value of the corresponding interest-only and residual certificates.
Up to and including the second quarter of 1998, the Company believes that
its hedging strategy of using treasury rate lock contracts was the most
effective way to manage its interest rate risk on loans prior to securitization.
However, in the third quarter of 1998, asset-backed investors, responding to
lower treasury yields and global financial market volatility, demanded
20
substantially wider spreads over treasuries than historically experienced for
newly issued asset-backed securities. As a result, Delta's hedge loss resulting
from lower interest rates was not offset by a higher gain on sale as the Company
has historically seen. Because the Company's third quarter securitization closed
on September 30, 1998, the Company had no hedge outstanding as of that date.
Given the Company's belief that the volatile market experienced in the
third quarter would likely continue well into the fourth quarter - and, as a
result, that the amount of the spreads demanded by asset-backed securitization
investors would be difficult to predict - the Company has not, to date, hedged
any of its warehoused loans pending securitization in the fourth quarter;
believing that its historical hedging strategy would continue to be largely
ineffective in the current environment. The Company will continue to review and
determine how best to mitigate risk pending securitization.
Information Services Year 2000 Project
The Year 2000 issue centers on the inability of certain computer hardware
and software systems and associated applications to correctly recognize and
process dates beyond December 31, 1999. Many computer programs used by the
Company, its suppliers and outside service providers were developed using only
six digits to define the date field (two fields each for the month, day and
year) and may recognize "00" as the year 1900, rather than the year 2000. Due to
the nature of financial information, if corrective action is not taken,
calculations that rely on the integrity of the date field for the processing of
information could be significantly misstated.
STATE OF READINESS
The Company has implemented a detailed Year 2000 Plan (the "Plan") to
evaluate the Year 2000 readiness of the computer systems that support the
operation of the Company including vendor computer systems. This Plan is
expected to conclude in June 1999 with all systems year 2000 compliant.
The Plan includes upgrading the origination system software, upgrading the
loan servicing software, upgrading the accounting system software, upgrading the
wide area network software, assessing the proper integration of all systems and
communicating with vendors and liquidity providers to ascertain their Year 2000
compliance.
To date the accounting system is Year 2000 compliant and all vendors and
liquidity providers have been contacted regarding their readiness. Results of
system tests conducted by the Company and other service providers will continue
to be carefully monitored to ensure that all issues have been identified and
addressed.
The Company believes it has developed an effective Plan to address the Year
2000 issue and that based on the available information, the execution of the
Plan will not have any significant or material impact to the Company's ability
to operate before, during or after the transition to the new millennium.
However, the Company has no control over the process of third parties in
addressing their own Year 2000 issues and, if the necessary changes are not
effected or are not completed in a timely manner, or if unanticipated problems
arise, there may be a material impact on the Company's financial condition and
result of operations.
21
COST TO ADDRESS THE COMPANY'S YEAR 2000 ISSUES
The Company's costs to resolve the Year 2000 issue are not expected to have
a material financial impact on the Company and are expected to be less than $1
million, which the Company intends to fund from its current operations. However,
as stated above, there can be no assurance that all such costs have been
identified, or that there may not be some unforeseen cost which may have a
material adverse effect on the Company's financial condition and results of
operations.
RISK OF YEAR 2000 ISSUES
To date, the Company has not identified any system which presents a
material risk of failing to be Year 2000 complaint in a timely manner, or for
which a suitable alternative cannot be implemented. However, as the Company
progresses with its Plan, systems or equipment may be identified which present a
material risk of business interruption. Such disruption may include the
inability to process customer accounting transactions; the inability to process
loan applications; the inability to reconcile and record daily activity; the
inability to track delinquencies; or the inability to generate checks or to
clear funds. In addition, if any of the Company's liquidity providers should
fail to achieve the Year 2000 compliance and they experience a disruption of
their own businesses which prevents them from fulfilling their obligations, the
Company may be materially impacted.
To the extent that the risks posed by the Year 2000 issue, which are beyond
the Company's control, are pervasive in data processing, utility and
telecommunication services worldwide, the Company cannot predict with certainty
that it will remain materially unaffected by issues related to the Year 2000
problem.
CONTINGENCY PLANS
As part of the Plan implemented by the Company, periodic assessments are
made to determine that all Year 2000 issues will be addressed prior to the new
millennium. If this assessment determines that any systems are not Year 2000
compliant, and will not become Year 2000 compliant in a timely manner, then a
contingency plan to implement a suitable alternative will be put in place. At
this time all systems are expected to be compliant and no contingency plan is in
place.
22
<PAGE>
New Accounting Pronouncements
SFAS No. 130
SFAS No. 130, "Reporting on Comprehensive Income" was issued in June 1997 and
is effective for fiscal years beginning after December 15, 1997. SFAS No. 130
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. The Statement requires all items that are
required to be recognized under accounting standards as components of
comprehensive income to be reported in a financial statement that is displayed
with the same prominence as other financial statements. The Company has
determined that the implementation of the requirements of SFAS No. 130 will not
affect the Company's net income, cash flows or financial position.
SFAS No. 131
SFAS No. 131 "Disclosures about Segments of an Enterprise and Related
Information" was issued in June 1997 and is effective for fiscal years beginning
after December 15, 1997. SFAS No. 131 establishes standards for the way that
public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. The Statement requires a public business enterprise to report a
measure of segment profit or loss, certain specific revenue and expense items
and segment assets. The Company has determined that the implementation of the
requirements of SFAS No.131 will not affect the Company's net income, cash flows
or financial position.
SFAS No. 133
In June 1998, SFAS No. 133 was issued, "Accounting for Derivative Instruments
and Hedging Activities." SFAS No. 133 is effective for fiscal years that begin
after June 15, 1999, and in general requires that entities recognize all
derivative financial instruments as assets or liabilities, measured at fair
value, and include in earnings the changes in the fair value of such assets and
liabilities. SFAS No. 133 also provides that changes in the fair value of assets
or liabilities being hedged with recognized derivative instruments be recognized
and included in earnings. The Company has not yet completed its evaluation of
SFAS No. 133, and therefore at this time cannot predict what, if any, effect its
adoption will have on the Company's results of operations or financial position.
SFAS No. 134
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise". SFAS No. 134 conforms the
accounting for securities retained after the securitization or mortgage loans by
a mortgage banking enterprise with the accounting for securities retained after
the securitization of other types of assets by a nonmortgage banking enterprise.
SFAS No. 134 is effective for the first quarter beginning after December 15,
1998. Management of the Company believes the implementation of SFAS No. 134 will
not have a material impact on the Company's financial condition or results of
operations.
23
Risk Factors
Except for historical information contained herein, certain matters discussed
in this Form 10-Q are "forward-looking statements" as defined in the Private
Securities Litigation Reform Act (PSLRA) of 1995, which involve risk and
uncertainties that exist in the Company's operations and business environment,
and are subject to change on various important factors. The Company wishes to
take advantage of the "safe harbor" provisions of the PSLRA by cautioning
readers that numerous important factors discussed below, among others, in some
cases have caused, and in the future could cause the Company's actual results to
differ materially from those expressed in any forward-looking statements made
by, or on behalf of, the Company. The following include some, but not all, of
the factors or uncertainties that could cause actual results to differ from
projections:
* A general economic slowdown.
* The Company's ability or inability to continue its practice of
securitization of mortgage loans held for sale.
* The Company's ability or inability to obtain adequate warehouse and
other financing facilities.
* Increases in prepayments or loan losses that could require the Company
to write down further the value of its interest-only and residual
certificates and its capitalized mortgage servicing rights, adversely
affecting earnings.
* The effects of interest rate fluctuations and the Company's ability or
inability to hedge effectively against such fluctuations in interest
rates; the effects of changes in monetary and fiscal policies, laws and
regulations, other activities of governments, agencies, and similar
organizations, social and economic conditions, unforeseen inflationary
pressures and monetary fluctuation.
* Increased competition within the Company's markets.
* The unanticipated expenses of assimilating newly-acquired businesses
into the Company's structure; as well as the impact of unusual expenses
from ongoing evaluations of business strategies, asset valuations,
acquisitions, divestitures and organizational structures.
* Unpredictable delays or difficulties in the development of new product
programs.
* Rapid or unforeseen escalation of the cost of regulatory compliance
and/or litigation, including but not limited to, environmental
compliance, licenses, adoption of new, or changes in accounting
policies and practices and the application of such policies and
practices.
* Risks associated with the Year 2000 (see "-Year 2000" above).
24
<PAGE>
Part II - Other Information
Item 1. Legal Proceedings
Because the nature of the Company's business involves the collection of
numerous accounts, the validity of liens and compliance with state and federal
lending laws, the Company is subject to numerous claims and legal actions in the
ordinary course of its business. While it is impossible to estimate with
certainty the ultimate legal and financial liability with respect to such claims
and actions, the Company believes that the aggregate amount of such liabilities
will not result in monetary damages which in the aggregate would have a material
adverse effect on the financial condition or results of the Company.
Several class-action lawsuits have been filed against a number of consumer
finance companies alleging that the compensation of mortgage brokers through the
payment of yield spread premiums violates various federal and state consumer
protection laws. The Company has been named in two such lawsuits:
a. In or about March 1997, the Company received notice that it had been
named in a lawsuit filed in the United States District Court for the
Eastern District of New York, alleging that the Company's
compensation of mortgage brokers by means of yield spread premiums
violates, among other things, the Real Estate Settlement Procedures
Act ("RESPA"). The complaint seeks (i) certification of a class of
plaintiffs, (ii) an injunction against payment of yield spread
premiums by the Company and (iii) unspecified compensatory and
punitive damages (including attorney's fees). On July 7, 1997, the
Company filed an answer to the plaintiff's amended complaint. In
October 1998, the Company agreed to an individual settlement with
plaintiffs, and the lawsuit has been dismissed with prejudice.
b. In or about February 1998, the Company received notice that it had
been named in a lawsuit filed in the United States District Court
for the Northern District of Mississippi - Greenville Division,
alleging that the Company's compensation or mortgage brokers by
means of yield spread premiums violates RESPA. The complaint seeks
(I) certification of a class of plaintiffs, and (ii) unspecified
compensatory damages (including attorney's fees). On March 31, 1998,
the Company filed an answer to the complaint. In September and
October 1998, briefs were submitted by both sides in connection with
plaintiff's motion for class certification, and a hearing is
expected to occur on the motion in December 1998. Management
believes that Company has meritorious defenses and intends to defend
this suit, but the Company cannot estimate with any certainty its
ultimate legal or financial liability, if any, with respect to the
alleged claims.
c. In or about October 1998, the Company was served with a lawsuit
filed in the United States District Court for the Northern District
of Georgia, Atlanta Division, alleging that the Company's
compensation of mortgage brokers by means of yield spread premiums
violates RESPA. The complaint seeks (i) certification of a class of
plaintiffs, and (ii) unspecified compensatory and treble damages
(including attorney's fees). Management believes that Company has
meritorious defenses and intends to defend this suit, but the
Company has not yet answered
25
and cannot estimate with any certainty its ultimate legal
or financial liability, if any, with respect to the alleged claims.
In or about September 1998, the Company received notice that it had been
named in a lawsuit filed in the Supreme Court of the State of New York, Nassau
County, alleging that the Company did not properly credit payments received from
borrowers to principal and interest. The complaint seeks (i) certification of a
class of plaintiffs, (ii) an accounting, (iii) unspecified compensatory and
punitive damages (including attorneys' fees), and (iv) injunctive relief, based
upon alleged (a) breach of contract, (b) unjust enrichment, (c) fraud, and (d)
deceptive trade practices. Management believes that Company has meritorious
defenses and intends to defend this suit, but the Company has not yet answered
and cannot estimate with any certainty its ultimate legal or financial
liability, if any, with respect to the alleged claims.
Item 2. Changes in Securities. None
Item 3. Defaults Upon Senior Securities. None
Item 4. Submission of Matters to a Vote of Security Holders. None
Item 5. Other Information. None
Item 6. Exhibits and Current Reports on Form 8-K:
(a) Exhibits: 11.1 Statement re: Computation of Per Share Earnings.
27 Financial Data Schedule.
(b) Reports on Form 8-K: None.
26
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, as
amended, the Registrant has duly caused this Report on Form 10-Q to be signed on
its behalf by the undersigned, thereunto duly authorized.
DELTA FINANCIAL CORPORATION
(Registrant)
Date: November 12, 1998 By:/s/ HUGH MILLER
-----------------------------------
Hugh Miller
President & Chief Executive Officer
By:/s/ RICHARD BLASS
-----------------------------------
Richard Blass
Senior Vice President and
Chief Financial Officer
27
<TABLE>
<CAPTION>
Exhibit 11.1. Statement Re: Computation of Per Share Earnings
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands, except EPS data) 1998 1997 1998 1997
- ----------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Basic Earnings Per Share
Net (loss) income $ 3,106 $ 7,884 $ 6,455 $ 22,098
======== ======== ======== ========
Weighted average number of common
and common equivalent shares: 15,414,210 15,372,288 15,387,923 15,354,810
Basic earnings per share $ 0.20 $ 0.51 $ 0.42 $ 1.44
======== ======== ======== ========
Diluted Earnings Per Share
Net income $ 3,106 $ 7,884 $ 6,455 $ 22,098
======== ======== ======== ========
Weighted average number of common
and common equivalent shares:
----------------------------------
Average number of shares outstanding 15,414,210 15,372,288 15,387,923 15,354,810
Net effect of dilutive stock options
based on the treasury method &
Fidelity additional shares --- 54,026 31,341 53,061
Total average shares: 15,414,210 15,426,314 15,419,264 15,407,871
========== ========== ========== ==========
Diluted earnings per share $ 0.20 $ 0.51 $ 0.42 $ 1.44
======== ========= ======== ========
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
BALANCE SHEETS AND STATEMENTS OF INCOME FOUND IN THE COMPANY'S FORM 10-Q
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS
</LEGEND>
<MULTIPLIER> 1000
<S>
<C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 42,922
<SECURITIES> 197,839
<RECEIVABLES> 183,696
<ALLOWANCES> 322
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 23,106
<DEPRECIATION> 6,593
<TOTAL-ASSETS> 465,082
<CURRENT-LIABILITIES> 0
<BONDS> 149,366
0
0
<COMMON> 155
<OTHER-SE> 132,779
<TOTAL-LIABILITY-AND-EQUITY> 465,082
<SALES> 0
<TOTAL-REVENUES> 99,922
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 66,476
<LOSS-PROVISION> 75
<INTEREST-EXPENSE> 23,213
<INCOME-PRETAX> 10,518
<INCOME-TAX> 3,703
<INCOME-CONTINUING> 6,455
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 6,455
<EPS-PRIMARY> 0.42
<EPS-DILUTED> 0.42
</TABLE>
