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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED AUGUST 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM
--------------- TO
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COMMISSION FILE NUMBER: 0-21689
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MEGO MORTGAGE CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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<S> <C> <C>
DELAWARE 88-0286042
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1000 PARKWOOD CIRCLE, SUITE 500, ATLANTA, GEORGIA 30339
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
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REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 770-952-6700
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.01 PAR VALUE
(TITLE OF CLASS)
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 the 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. Yes [X] No [ ]
As of October 15, 1997, 12,300,000 shares of the registrant's common stock
were outstanding. The aggregate market value of common stock held by
non-affiliates of the registrant as of October 15, 1997 was approximately
$116,877,352 based on a closing price of $14.875 for the common stock as
reported on the NASDAQ National Market on such date. For purposes of the
foregoing computation, all executive officers, directors and 5 percent
beneficial owners of the registrant are deemed to be affiliates. Such
determination should not be deemed to be an admission that such executive
officers, directors or 5 percent beneficial owners are, in fact, affiliates of
the registrant.
DOCUMENTS INCORPORATED BY REFERENCE
None
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PART I
ITEM 1. BUSINESS
GENERAL
Mego Mortgage Corporation (the "Company") is a specialized consumer finance
company that originates, purchases, sells, securitizes and services consumer
loans consisting primarily of conventional uninsured home improvement and debt
consolidation loans which are generally secured by liens on residential property
("Conventional Loans"). The Company historically has originated loans through
its network of independent correspondent lenders ("Correspondents") and home
improvement construction contractors ("Dealers"). In order to both broaden its
channels of origination and reduce its overall cost of loan acquisition, the
Company commenced direct origination of Conventional Loans in the first quarter
of fiscal 1998. To facilitate these new origination channels, the Company
expects to enter into contractual arrangements with third party financial
institutions for the acquisition of qualified consumer loan referrals. These
referrals do not conform to that institution's programs, but may be suitable for
approval and funding under the Company's product lines that are not available at
the referring institution. By making direct loans to the consumers, the Company
would avoid the payment of premiums which it incurs with the acquisition of
completed loans from its Correspondent network. It is anticipated that the
origination fees charged to consumers on the direct loans will adequately cover
the cost of the referrals and thereby place the Company on a positive cash flow
basis with respect to these direct loan originations. Until May 1996, the
Company originated only home improvement loans insured under the Title I credit
insurance program ("Title I Loans") of the Federal Housing Administration (the
"FHA"). Subject to certain limitations, the Title I program provides for
insurance of 90% of the principal balance of the loan, and certain other costs.
The Company began offering Conventional Loans through its Correspondents in May
1996 and through its Dealers in September 1996. Since May 1996, Conventional
Loans have accounted for an increasing portion of the Company's loan
originations. For the three months ended August 31, 1996 and the year ended
August 31, 1997, the Company originated $11.2 million and $428.8 million of
Conventional Loans, respectively, which constituted 22.5% and 81.4%,
respectively, of the Company's total loan originations during the respective
periods.
The profile of the Company's borrowers is typified by individuals who own
their homes and have verifiable income but may have limited access to
traditional financing sources due to insufficient home equity, limited credit
history or high ratios of debt service to income. These borrowers require or
seek a high degree of personalized service and prompt response to their loan
applications. As a result, the Company's borrowers generally are not averse to
paying higher interest rates that the Company receives in its loan programs as
compared to the interest rates charged by banks and other traditional financial
institutions. The Company has developed a proprietary credit index profile
("CIP") that includes as a significant component the credit evaluation score
methodology developed by Fair, Isaac and Company ("FICO") to classify borrowers
on the basis of likely future performance. The other components of the Company's
credit scoring system include debt-to-income ratio, employment history and
residence stability. The Company currently makes Conventional Loans only to
those borrowers with an "A" or "B" credit grade, representing the two lowest
credit risk levels, using the CIP. The Company also intends to expand its loan
product lines during the first quarter of fiscal 1998 to include the origination
of conventional residential first mortgage loans to those borrowers with a
credit grade ranging from "A" to "C." With respect to this new product line
increased emphasis will be placed on the underlying collateral value of the
residence with such value fully supported by independent appraisals. Borrowers
with a credit grade of "A" may borrow up to 90% of the underlying property's
appraisal value while borrowers with a credit grade of "B" or "C" will be
limited to loan amounts of up to 85% or up to 75% of the appraised value,
respectively. It is the Company's intention to pool these first mortgage loans
for eventual sale in the secondary market on a servicing released basis, without
recourse for credit losses, and thereby generate cash premiums. Prior to funding
any loans in this new product line, the Company will obtain forward purchase
commitments for this product line from reliable third party financial
institutions. The Company receives varying rates of interest based upon the
borrower's credit profile and income and assumed risk. For the years ended
August 31, 1996 and 1997, the loans originated by the Company had
weighted-average interest rates of 14.03% and 13.92%, respectively.
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The Company's loan originations increased to $526.9 million during the
fiscal year ended August 31, 1997 from $139.4 million during the fiscal year
ended August 31, 1996. The Company's revenues increased to $54.8 million for the
fiscal year ended August 31, 1997 from $23.6 million for the fiscal year ended
August 31, 1996. For the fiscal year ended August 31, 1997, the Company had net
income of $14.7 million compared to $6.9 million for the fiscal year ended
August 31, 1996. The Company has operated since March 1994, and expects to
continue to operate for the foreseeable future, on a negative cash flow basis.
The Company sells substantially all the loans it originates either through
securitizations at a yield below the stated interest rate on the loans,
generally retaining the right to service the loans and to receive any amounts in
excess of the yield to the purchasers, or through whole loan sales to third
party institutional purchasers. In connection with whole loan sales, the Company
either sells the loans on a servicing retained basis at a yield below the stated
interest rate on the loans or on a servicing released basis at a premium. The
Company has completed seven securitizations from March 1996 through August 1997,
and expects to sell a substantial portion of its loan production through
securitizations in the future. At August 31, 1997, the Company serviced $618.5
million of loans it had sold through whole loan sales and securitizations, and
$9.6 million of loans it owned.
RELATIONSHIP WITH MEGO FINANCIAL; SPIN-OFF
The Company was formed in June 1992 as a wholly-owned subsidiary of Mego
Financial Corp. ("Mego Financial"), a publicly traded company, and commenced
origination of loans in March 1994. In November 1996, the Company consummated an
underwritten initial public offering (the "IPO") of 2.3 million shares of its
common stock, $.01 par value (the "Common Stock"). As a result of the
consummation of the IPO, Mego Financial's ownership of the Company was reduced
to approximately 81.3% of the outstanding Common Stock. On September 2, 1997,
Mego Financial distributed all of its 10.0 million shares of the Company's
Common Stock to its shareholders in a tax-free spin-off (the "Spin-off"). In
order to fund the Company's past operations and growth, and in conjunction with
filing consolidated tax returns, the Company incurred debt and other obligations
("Intercompany Debt") to Mego Financial and its subsidiary Preferred Equities
Corporation ("PEC"). The amount of Intercompany Debt was $12.8 million at August
31, 1996 and $10.1 million at August 31, 1997. It is not anticipated that Mego
Financial will provide funds to the Company or guarantee the Company's
indebtedness in the future, although it may do so. The Company also has
agreements with PEC for the provision of management services and loan servicing.
See "Item 13. Certain Relationships and Related Transactions."
RECENT DEVELOPMENTS
In October 1997, the Company consummated a private placement (the "Private
Placement") of $40.0 million aggregate principal amount of its 12 1/2% Senior
Subordinated Notes due 2001 (the "Notes"), which increased the aggregate
principal amount of Notes outstanding from $40.0 million to $80.0 million. (The
$40.0 million of Notes sold in the Private Placement are referred to herein as
the "Additional Notes" and the original $40.0 million of outstanding Notes are
referred to herein as the "Existing Notes.") The Company used approximately
$29.0 million of the net proceeds of the Private Placement to reduce amounts
outstanding under the Company's lines of credit and $3.9 million of the net
proceeds to repay Intercompany Debt. The balance of such net proceeds has been
and will be used to originate and securitize loans. Prior to the consummation of
the Private Placement, the Company obtained consents pursuant to a solicitation
(the "Consent Solicitation") to amendments (the "Indenture Amendments") to the
indenture governing the Notes (the "Original Indenture" and, as amended, the
"Indenture"), which, among other things, permitted the issuance of the
Additional Notes and modified certain covenants applicable to the Company. In
connection with the Consent Solicitation, the Company made consent payments of
$10.00 cash per each $1,000 principal amount of Existing Notes to holders
thereof who properly furnished their consents to the amendments to the Original
Indenture.
Pursuant to the Spin-off, effective on September 2, 1997, Mego Financial
distributed all of its 10.0 million shares of the Company's Common Stock to its
shareholders. The Company believes that the Spin-off will not have a material
adverse effect on the Company's business or strategic plans.
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As of September 2, 1997, Jeffrey S. Moore became Chief Executive Officer of
the Company. See "Item 10. Directors and Executive Officers of the Company."
Additionally, the Company determined to change its fiscal year-end from August
31 to December 31, effective December 31, 1997.
In June and August 1997, the Company completed its first two non-monoline
insured securitizations pursuant to which it sold pools of loans amounting to
$104.6 million and $73.3 million, respectively. The Company will continue to
service the sold loans and is entitled to receive a servicing fee of 1.0% from
payments in respect of interest on the sold loans. From March 1996 to date, the
Company has completed seven securitizations pursuant to which it has sold loan
pools having an aggregate principal balance of approximately $531.3 million.
On September 10, 1997, the Company signed a commitment letter for a
revolving credit facility with a financial institution pursuant to which the
Company would receive an initial advance of up to $5.0 million secured by
certain residual interest and interest only securities at an annual interest
rate of the higher of (i) the prime rate as established by The Chase Manhattan
Bank, N.A., plus 2.5% or (ii) 9.0%. This credit facility could be increased to
an aggregate principal amount of up to $8.8 million with additional lender
participations. There can be no assurance that the Company will obtain such
revolving credit facility.
HOME IMPROVEMENT AND DEBT CONSOLIDATION LOAN INDUSTRY
Home Improvement
According to data released by the Commerce Department's Bureau of the
Census, expenditures for home improvement and repairs of residential properties
have exceeded $100.0 billion per year since 1992 with 1996 expenditures
estimated at $119.1 billion. The Company targets that portion of the estimated
$119.1 billion of those expenditures which are for owner-occupied single-family
properties where improvements are performed by professional remodelers. As the
costs of home improvements escalate, home owners are seeking financing as a
means to improve their property and maintain and enhance its value. The National
Association of Home Builders Economics Forecast in 1995 estimates that home
improvement expenditures will exceed $200.0 billion by the year 2003. Two types
of home improvement financing are available to borrowers: the Title I program
administered by the FHA, which is authorized to partially insure qualified
lending institutions against losses, and uninsured Conventional Loans where the
lender relies more heavily on the borrower's creditworthiness, debt capacity and
the underlying collateral. Both types of loans are generally secured with a real
estate mortgage lien on the property improved.
The conventional home improvement financing market for the Company's
products continues to grow, as many homeowners have limited access to
traditional financing sources due to insufficient home equity, limited credit
history or high ratios of debt service to income. Conventional Loan proceeds can
be used for a variety of improvements such as large remodeling projects, both
interior and exterior, kitchen and bath remodeling, room additions and in-ground
swimming pools. Borrowers also have the opportunity to consolidate a portion of
their outstanding debt in order to reduce their monthly debt service.
According to the FHA, the amount of single family Title I Loans originated
grew from $375.0 million during 1988 to $1.5 billion during 1996. Under Title I,
the payment of approximately 90% of the principal balance of a loan is insured
by the United States of America in the event of a payment default. The Title I
program generally limits the maximum amount of the loan to $25,000 and restricts
the type of eligible improvements and the use of the loan proceeds. Under Title
I, only property improvement loans to finance the alteration, repair or
improvement of existing single family, multifamily and non-residential
structures are allowed. The FHA does not review individual loans at the time of
approval. In the case of a Title I Loan less than $7,500, no equity is required
in the property to be improved and the loan may be unsecured. In May 1997, the
U. S. Department of Housing and Urban Development ("HUD") proposed modifications
to the Title I program which would eliminate the origination of Title I Loans
through Dealers.
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Debt Consolidation
A growing number of financial institutions, including the Company, are
originating loans wherein the proceeds are used to reduce outstanding consumer
finance obligations. These loans may also be made in conjunction with a home
improvement project where the borrower seeks to enhance the value of his
residence and ultimately reduce his monthly debt service obligations. These
consumer finance obligations are often in the form of unsecured credit card debt
which have high interest rates and relatively short term maturities. Under this
type of loan accommodation, the consumer uses the loan proceeds to consolidate
multiple outstanding obligations into a single loan. In turn, the consumer
receives the benefit of a lower interest rate and an extended loan maturity
thereby reducing the amount of monthly debt service obligations, and in certain
instances may receive a tax benefit arising from the borrowing. These loan
products are typically secured with a mortgage lien on the consumer's primary
residence. These liens are typically in a junior position and when combined with
first mortgage liens exceed the market value of the subject residence. The
Company makes debt consolidation loans to high credit quality qualified
borrowers who have demonstrated a credit history of honoring their financial
obligations on a timely basis in accordance with the Company's criteria. Within
the mortgage lending industry it is typical for loans to qualified borrowers to
be limited to the amount which, when added to the outstanding senior debt on the
property, will not exceed 125% of the market value of the property. For the
fiscal year ended August 31, 1997, the Company's portfolio of Conventional Loans
originated had a weighted-average loan-to-value ratio ("LTV") of 112%.
BUSINESS STRATEGY
The Company's strategic plan is to continue to expand its lending
operations while maintaining its credit quality. The Company's strategies
include: (i) expanding and diversifying its existing network of Correspondents
and Dealers; (ii) entering new geographic markets; (iii) expanding its current
loan products to offer complementary loan products; (iv) initiating direct
mortgage lending; (v) using securitizations to sell higher volumes of loans on
favorable terms; and (vi) developing alternative avenues of profitable loan
disposition. At August 31, 1997, the Company had developed a nationwide network
of 694 active Correspondents and 670 active Dealers. The Company's
Correspondents generally offer a wide variety of loans and its Dealers typically
offer home improvement loans in conjunction with debt consolidation. By offering
a more diversified product line, including Conventional Loans, and maintaining
its high level of service, the Company has increased the loan production from
its existing network of Correspondents and Dealers. The Company anticipates that
as it expands its lending operations, it will continue to realize economies of
scale thereby reducing its average loan origination costs and enhancing its
profitability. In addition, the Company intends to continue to sell the greater
portion of its loan production through securitizations as opportunities arise.
Through access to securitization, the Company believes that it has the ability
to sell higher volumes of loans on more favorable terms than in whole loan
sales. However, the Company has also commenced, to a lesser extent, whole loan
sales on either a servicing released or servicing retained basis. Sales on a
servicing released basis and some sales on a servicing retained basis enable the
Company to generate a cash premium at the time of sale. Over the long-term, the
Company will seek to reduce its dependency on outside funding sources.
Expansion of Correspondent Operations
The Company seeks to increase originations of loans from select
Correspondents. The Company has expanded its product line to include
Conventional Loans to meet the needs of its existing network of Correspondents.
Prior to May 1996, the Company originated only Title I Loans. This limited its
ability to attract the more sophisticated Correspondent that offered a multitude
of loan products and, accordingly, limited the Company's market penetration. The
Company began offering Conventional Loans to existing select Correspondents in
May 1996. In order to maintain the Company's customer service excellence, the
Company has gradually increased the number of Correspondents to which it has
offered Conventional Loans. Since the Company commenced offering Conventional
Loans, the loan production of the Company's Correspondent division has
significantly increased, comprising $460.4 million of originations during the
year ended August 31, 1997. The Company believes that it is well positioned to
expand this segment without any material increase in concentration or quality
risks.
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Expansion of Dealer Operations
The Company seeks to expand its Dealer network and maximize loan
originations from its existing network by offering a variety of innovative
products and providing consistent and prompt service at competitive prices. The
Company has provided conventional products, including unsecured conventional
home improvement loans, as well as its existing Title I product to its Dealers
in order to meet the needs of the diverse borrower market. The Company targets
Dealers that typically offer financing to their customers and attempts to retain
and grow these relationships by providing superior customer service,
personalized attention and prompt approvals and fundings. The Company has been
unable to fully meet the needs of its Dealers because of Title I program limits
on the amount and types of improvements which may be financed. The Company
intends to meet the needs of its Dealers with new Conventional Loan programs
complementing the Conventional Loan programs presently offered. These programs
allow for more expensive project financing such as in-ground swimming pools and
substantial remodeling as well as financing for creditworthy borrowers with
limited equity who are in need of debt consolidation and borrowers with marginal
creditworthiness and substantial equity in their property. With this strategy,
the Company believes it can achieve further market penetration of its existing
Dealer network and gain new Dealers and market share. In addition, the Company
believes that this strategy may offset the potential loss of Dealer Title I Loan
originations as a result of the new Title I proposed regulations which, if
adopted, could end Dealer participation in Title I originations.
Nationwide Geographic Expansion
The Company intends to continue to expand its Correspondent and Dealer
network on a nationwide basis and to enhance its value to its existing network.
The Company's strategy involves (i) focusing on geographic areas that the
Company currently underserves and (ii) tailoring the Company's loan programs to
better serve its existing markets and loan sources.
Product Extension and Expansion
The Company intends to continue to review its loan programs and introduce
complementary loan products that meet the needs of its customers. The Company
will also evaluate products or programs that it believes are complementary to
its current products for the purpose of enhancing revenue by leveraging and
enhancing the Company's value to its existing network of Correspondents and
Dealers. The Company believes that its introduction of new loan products will
enhance its relationship with its Dealers and Correspondents and enable it to
become a favored source for their various financing needs. Since it commenced
operations, the Company has originated Title I Loans from both its Dealers and
Correspondents. In May 1996, the Company broadened these activities to include
non-FHA insured home improvement loans and combination home improvement and debt
consolidation loans. Initially all of these loans, which permit loan amounts up
to $75,000 with fixed rates and 25-year maturities, were secured by a lien,
generally junior in priority, on the respective primary residence. In the first
quarter of fiscal 1997, the Company commenced offering pure debt consolidation
loans through its Correspondent Division and non-FHA insured loans through its
Dealer Division. The Company commenced offering unsecured conventional home
improvement loans limited to a maximum loan amount of $15,000 through its Dealer
Division in the second quarter of fiscal 1997.
Maximization of Flexibility in Loan Sales
The Company employs a two-pronged strategy for disposing of its loan
originations; through securitizations and, to a lesser extent, through whole
loan sales. By employing this dual strategy, the Company has the flexibility to
better manage its cash flow, diversify its exposure to the potential volatility
of the capital markets and maximize the revenues associated with the gain on
sale of loans given market conditions existing at the time of disposition. In
order to gain access to the securitization market, the Company relied on credit
enhancements provided by a monoline insurance carrier to guarantee the
outstanding senior interests issued in its first five securitization
transactions. In June and August 1997, the Company completed two senior
subordinated securitizations representing its first two non-monoline insured
transactions. The Company is approved by Federal National Mortgage Association
("FNMA") as a seller/servicer of Title I Loans, as a result of which the Company
is eligible to sell such loans to FNMA on a servicing retained basis. During
fiscal
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1997, $39.8 million of Title I Loans were sold to FNMA on a servicing retained
basis. The Company's strategy includes developing alternative avenues of loan
disposition. In furtherance of this strategy, in the third quarter of fiscal
1997, the Company commenced the sales of Conventional Loans on a servicing
released basis. These transactions enable the Company to generate a whole loan
cash premium at the time of sale.
LOAN PRODUCTS
The Company originates Conventional and Title I Loans. Both types of loans
are typically secured by a first or junior lien on the borrower's principal
residence, although the Company occasionally originates and purchases unsecured
home improvement loans with borrowers that have an excellent credit history. The
Company's loan products include: (i) fixed rate, Conventional Loans, secured by
single family residences, with terms and principal amounts ranging from 60 to
300 months and up to $75,000; and (ii) fixed rate, secured and unsecured Title I
Loans with terms and principal amounts ranging from 36 to 240 months and up to
$25,000. Borrowers use loan proceeds for a wide variety of home improvement
projects, such as exterior/interior remodeling, structural additions, roofing
and plumbing, as well as, with regard to Conventional Loans, luxury items such
as in-ground swimming pools. Debt consolidation loans, whereby the consumer is
reducing or retiring high-rate short-term consumer debt, have become an
increasing component of the Company's Conventional Loan originations. The
Company lends to borrowers of varying degrees of creditworthiness. See "Loan
Processing and Underwriting."
Conventional Loans
A Conventional Loan is a non-insured debt consolidation or home improvement
loan typically undertaken to retire consumer debt and/or pay for a home
improvement project. Virtually all of the Conventional Loans originated by the
Company are secured by a first or junior mortgage lien on the borrower's
principal residence. Underwriting for Conventional Loans varies according to the
Company's evaluation of the borrower's credit risk and income stability as well
as the underlying collateral. The Company will rely on the underlying collateral
and equity in the property for borrowers judged to be greater credit risks. The
Company targets the higher credit quality segment of borrowers. The Company
originally began originating Conventional Loans through its Correspondent
Division in the third quarter of fiscal 1996 and began offering such loan
products through its Dealer Division in the first quarter of fiscal 1997.
The Company has focused its Conventional Loan program on that segment of
the marketplace with higher credit quality borrowers who may have limited equity
in their residence after giving effect to the amount of senior liens. Most of
the Company's Conventional Loans have relatively high LTVs and, accordingly, in
such cases the collateral for such loans will not be sufficient to cover the
principal amount of the loans in the event of default. The Company relies
principally on the creditworthiness of the borrower and to a lesser extent on
the underlying collateral for repayment of its Conventional Loans. The portfolio
of Conventional Loans generated during the fiscal year ended August 31, 1997
indicates on average that the borrowers have received an "A-" grade under the
Company's CIP, have an average debt-to-income ratio of 37%, post funding, and
the subject properties are 100% owner occupied. On average, the market value of
the underlying property is $118,200 without added value from the respective home
improvement work, the amount of senior liens is $105,500 and the loan size is
$30,400. More than 99% of the loans comprising the Company's Conventional Loan
portfolio are secured by junior liens.
Title I Loan Program
The National Housing Act of 1934 (the "Housing Act"), Sections 1 and 2(a),
authorized the creation of the FHA and the Title I credit insurance program
("Title I"). Under the Housing Act, the FHA is authorized to insure qualified
lending institutions against losses on certain types of loans, including loans
to finance the alteration, repair or improvement of existing single family,
multi-family and nonresidential real property structures. Under Title I, the
payment of approximately 90% of the principal balance of a loan and certain
other amounts is insured by the United States of America in the event of a
payment default.
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The principal amount of a secured Title I Loan may not exceed $25,000, in
the case of a loan for the improvement of a single family structure, and
$60,000, in the case of a loan for the improvement of a multi-family structure.
Loans up to a maximum of $7,500 in principal amount may qualify as unsecured
Title I Loans.
Title I Loans are required to bear fixed rates of interest and, with
limited exceptions, be fully amortizing with equal weekly, biweekly, semimonthly
or monthly installment payments. Title I Loan terms may not be less than six
months nor more than 240 months in the case of secured Title I Loans or 120
months in the case of unsecured Title I Loans. Subject to other federal and
state regulations, the lender may establish the interest rate to be charged in
its discretion.
Title I generally provides for two types of Title I Loans, direct loans
("Direct Title I Loans") and dealer loans ("Dealer Title I Loans"). Direct Title
I Loans are made directly by a lender to the borrower and there is no
participation in the loan process by the contractor, if any, performing the
improvements. In the case of Dealer Title I Loans, the Dealer, a contractor
performing the improvements, assists the borrower in obtaining the loan,
contracts with the borrower to perform the improvements, executes a retail
installment contract with the borrower and, upon completion of the improvements,
assigns the retail installment contract to the Title I lender. Each Dealer must
be approved by the Title I lender in accordance with HUD requirements. Direct
Title I Loans are closed by the lender in its own name with the proceeds being
disbursed directly to the borrower prior to completion of the improvements. The
borrower is generally required to complete the improvements financed by a Direct
Title I Loan within six months of receiving the proceeds. In the case of Dealer
Title I Loans, the lender is required to obtain a completion certificate from
the borrower certifying that the improvements have been completed prior to
disbursing the proceeds to the Dealer.
The FHA charges a lender an annual fee equal to 50 basis points of the
original principal balance of a loan for the life of the loan. A Title I lender
or Title I sponsored lender is permitted to require the borrower to pay the
insurance premium with respect to the loan. In general, the borrowers pay the
insurance premiums with respect to Title I Loans originated through the
Company's Correspondents but not with respect to Title I Loans originated
through the Company's Dealers. Title I provides for the establishment of an
insurance coverage reserve account for each lender. The amount of insurance
coverage in a lender's reserve account is equal to 10% of the original principal
amount of all Title I Loans originated or purchased and reported for insurance
coverage by the lender less the amount of all insurance claims approved for
payment. The amount of reimbursement to which a lender is entitled is limited to
the amount of insurance coverage in the lender's reserve account.
LENDING OPERATIONS
The Company has two principal divisions for the origination of loans, the
Correspondent Division and the Dealer Division. The Correspondent Division
represents the Company's largest source of loan originations. Through its
Correspondent Division, the Company originates loans through a nationwide
network of Correspondents including financial intermediaries, mortgage
companies, commercial banks and savings and loan institutions. The Company
typically originates loans from Correspondents on an individual loan basis,
pursuant to which each loan is pre-approved by the Company and is purchased
immediately after the closing. The Correspondent Division conducts operations
from its headquarters in Atlanta, Georgia, with a vice president of operations
responsible for underwriting and processing. The Correspondent Division utilizes
eleven account executives supervised by the Vice President -- Correspondent
Marketing responsible for developing and maintaining relationships with
Correspondents. At August 31, 1997, the Company had a network of 694 active
Correspondents.
In addition to purchasing individual Direct Title I Loans and Conventional
Loans, from time to time the Correspondent Division purchases small portfolios
of loans from Correspondents. Each loan purchased is underwritten by Company
personnel prior to purchase in order to ensure compliance with the Company's
guidelines.
The Dealer Division originates loans through a network of Dealers,
consisting of home improvement construction contractors approved by the Company,
by acquiring individual retail installment contracts
7
<PAGE> 9
("Installment Contracts") from Dealers. An Installment Contract is an agreement
between the Dealer and the borrower pursuant to which the Dealer performs the
improvements to the property and the borrower agrees to pay in installments the
price of the improvements. Before entering into an Installment Contract with a
borrower, the Dealer assists the borrower in submitting a loan application to
the Company. If the loan application is approved, the Dealer enters into an
Installment Contract with the borrower, the Dealer assigns the Installment
Contract to the Company upon completion of the home improvements and the
Company, upon receipt of the requisite loan documentation (described below) and
completion of a satisfactory telephonic interview with the borrower, pays the
Dealer pursuant to the terms of the Installment Contract. The Dealer Division,
and to a limited extent, the Correspondent Division, maintains 19 branch offices
located in Waldwick, New Jersey; Kansas City, Missouri; Las Vegas, Nevada;
Austin, Texas: Oklahoma City, Oklahoma; Seattle, Washington; Waterford,
Michigan; Columbus, Ohio; Elmhurst, Illinois; Philadelphia, Pennsylvania;
Denver, Colorado; Richmond, Virginia; Scottsdale, Arizona; Patchogue, New York;
Woburn, Massachusetts; Dublin, California; Stuart, Florida; Miami Lakes,
Florida; and Brentwood, Tennessee; through which it conducts its marketing to
Dealers or Correspondents in the state in which the branch is located as well as
certain contiguous states. The Dealer Division is operated with a vice president
of operations responsible for loan processing and underwriting, two regional
managers, and 15 field representatives supervised by the Director of Dealer
Marketing who are responsible for marketing to Dealers. At August 31, 1997, the
Company had a network of 670 active Dealers doing business in 34 states and the
District of Columbia. The Company commenced offering Conventional Loans through
its Dealer Division during the first quarter of 1997.
Correspondents and Dealers qualify to participate in the Company's programs
only after a review by the Company's management of their reputations and
expertise, including a review of references and financial statements, as well as
a personal visit by one or more representatives of the Company. Title I requires
the Company to reapprove its Dealers annually and to monitor the performance of
those Correspondents that are sponsored by the Company. The Company's compliance
function is performed by a vice president of compliance, whose staff performs
periodic reviews of Correspondent and Dealer performance and may recommend to
senior management the suspension of a Correspondent or a Dealer. The Company
believes that its system of acquiring loans through a network of Correspondents
and Dealers and processing such loans through a centralized loan processing
facility has (i) assisted the Company in minimizing its level of capital
investment and fixed overhead costs and (ii) assisted the Company in realizing
certain economies of scale associated with evaluating and acquiring loans. The
Company does not believe that the loss of any particular Correspondent or Dealer
would have a material adverse effect upon the Company. See "Loan Processing and
Underwriting."
The Company pays its Correspondents premiums on the loans it purchases
based on the credit score of the borrower and the interest rate on the
respective loan. Additional premiums are paid to Correspondents based on the
volume of loans purchased from such Correspondents in a monthly period. During
fiscal 1996 and fiscal 1997, the Company originated $94.2 million and $460.4
million, respectively, of loans from Correspondents and paid total premiums of
$2.8 million or 3.0%, and $18.3 million or 4.0%, respectively, of such loans.
None of the Company's arrangements with its Dealers or Correspondents is on
an exclusive basis. Each relationship is documented by either a Dealer Purchase
Agreement or a Correspondent Purchase Agreement. Pursuant to a Dealer Purchase
Agreement, the Company may purchase from a Dealer loans that comply with the
Company's underwriting guidelines at a price acceptable to the Company. With
respect to each loan purchased, the Dealer makes customary representations and
warranties regarding, among other things, the credit history of the borrower,
the status of the loan and its lien priority if applicable, and agrees to
indemnify the Company with respect to such representations and warranties.
Pursuant to a Correspondent Purchase Agreement, the Company may purchase loans
through a Correspondent, subject to receipt of specified documentation. The
Correspondent makes customary representations and warranties regarding, among
other things, the Correspondent's corporate status, as well as regulatory
compliance, good title, enforceability and payments and advances of the loans to
be purchased. The Correspondent covenants to, among other things, keep Company
information confidential, provide supplementary information, maintain government
approvals
8
<PAGE> 10
with respect to Title I Loans and refrain from certain solicitations of the
Company's borrowers. The Correspondent also agrees to indemnify the Company for
misrepresentations or non-performance of its obligations.
The following table sets forth certain data regarding loan applications
processed and loans originated by the Company during the years indicated.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
---------------------------------------------------------------------
1995 1996 1997
------------------- -------------------- --------------------
<S> <C> <C> <C> <C> <C> <C>
TOTAL LOAN APPLICATIONS:
Number processed...................... 27,608 42,236 92,165
Number approved....................... 15,956 20,910 52,269
Approval ratio........................ 57.8% 49.5% 56.7%
LOAN ORIGINATIONS:
Principal balance of loans originated:
Correspondents:
Title I........................... $63,792,680 72.7% $ 82,596,197 59.3% $ 50,814,931 9.7%
Conventional...................... -- -- 11,582,108 8.3 409,603,281 77.7
----------- ----- ------------ ----- ------------ -----
Total Correspondents........... 63,792,680 72.7 94,178,305 67.6 460,418,212 87.4
----------- ----- ------------ ----- ------------ -----
Dealers:
Title I........................... 23,957,829 27.3 45,188,721 32.4 47,269,541 9.0
Conventional...................... -- -- -- -- 19,228,957 3.6
----------- ----- ------------ ----- ------------ -----
Total Dealers.................. 23,957,829 27.3 45,188,721 32.4 66,498,498 12.6
----------- ----- ------------ ----- ------------ -----
Total principal balance of
loans originated............. $87,750,509 100.0% $139,367,026 100.0% $526,916,710 100.0%
=========== ===== ============ ===== ============ =====
Number of loans originated:
Correspondents:
Title I........................... 3,437 59.1% 4,382 50.9% 2,445 12.0%
Conventional...................... -- -- 392 4.6 12,831 62.7
----------- ----- ------------ ----- ------------ -----
Total Correspondents........... 3,437 59.1 4,774 55.5 15,276 74.7
----------- ----- ------------ ----- ------------ -----
Dealers:
Title I........................... 2,381 40.9 3,836 44.5 3,893 19.0
Conventional...................... -- -- -- -- 1,296 6.3
----------- ----- ------------ ----- ------------ -----
Total Dealers.................. 2,381 40.9 3,836 44.5 5,189 25.3
----------- ----- ------------ ----- ------------ -----
Total number of loans
originated................... 5,818 100.0% 8,610 100.0% 20,465 100.0%
=========== ===== ============ ===== ============ =====
Average principal balance of loans
originated............................ $ 15,083 $ 16,187 $ 25,747
Weighted-average interest rate on loans
originated............................ 14.55% 14.03% 13.92%
Weighted-average term of loans
originated (months)................... 188 198 226
</TABLE>
LOAN PROCESSING AND UNDERWRITING
The Company's loan application and approval process generally is conducted
over the telephone with applications usually received at the Company's
centralized processing facility from Correspondents and Dealers by facsimile
transmission. Upon receipt of an application, the information is entered into
the Company's system and processing begins. All loan applications are
individually analyzed by employees of the Company at its loan processing
headquarters in Atlanta, Georgia. The information provided in loan applications
is first verified by, among other things, (i) written confirmations of the
applicant's income and, if necessary, bank deposits, (ii) a formal credit bureau
report on the applicant from a credit reporting agency, (iii) a title report,
(iv) if necessary, a real estate appraisal and (v) if necessary, evidence of
flood insurance. Loan applications are also reviewed to ascertain whether or not
they satisfy the Company's underwriting criteria, including loan-to-value
ratios, occupancy status, borrower income qualifications, employment stability,
purchaser requirements and necessary insurance and property appraisal
requirements.
9
<PAGE> 11
The Company has developed the CIP as a statistical credit based tool to
predict likely future performance of a borrower. A significant component of this
customized system is the credit evaluation score methodology developed by FICO,
a consulting firm specializing in creating default predictive models through a
high number of variable components. A FICO score is calculated by a system of
scorecards. FICO uses actual credit data on millions of consumers, and applies
complex mathematical methods to perform extensive research into credit patterns
that forecast credit performance. The principal components of the FICO
predictive model include a consumer's credit payment history, outstanding debt,
availability and pursuit of new credit, and types of credit in use. Through this
scorecard process, FICO identifies distinctive credit patterns, which patterns
correspond to a likelihood that a consumer will make his loan payments as agreed
in the future. The score is based on all the credit-related data in the credit
report, not just negative data such as missed payments. The other components of
the CIP include debt-to-income analysis, employment stability, self employment
criteria, residence stability and occupancy status of the subject property. By
utilizing both scoring models in tandem, all applicants are considered on the
basis of their ability to repay the loan obligation while allowing the Company
to maintain its risk based pricing for each loan.
Based upon FICO score default predictors and the Company's internal CIP
score, loans are classified by the Company into gradations of ascending credit
risks and descending quality, from "A" credits to "D" credits, with subratings
within those categories. Quality is a function of both the borrower's
creditworthiness, and the extent of the value of the collateral, which is
typically a second lien on the borrower's primary residence. "A+" credits
generally have a FICO score greater than 680. An applicant with a FICO score of
less than 620 would be rated a "C" credit unless the loan-to-value ratio was 75%
or less which would raise the credit risk to the Company to a "B" or better
depending on the borrower's debt service capability. Depending on loan size,
typical loan-to-value ratios for approved "A" and "B" credits range from 90% to
125%, while loan-to-value ratios for approved "C" credits range from 60% up to
90% with extraordinary compensating factors.
The Company's underwriters review the applicant's credit history, based on
the information contained in the application as well as reports available from
credit reporting bureaus and the Company's CIP score, to determine the
applicant's acceptability under the Company's underwriting guidelines. Based on
the underwriter's approval authority level, certain exceptions to the guidelines
may be made when there are compensating factors subject to approval from a
corporate officer. The underwriter's decision is communicated to the
Correspondent or Dealer and, if approved, fully explains the proposed loan
terms. The Company endeavors to respond to the Correspondent or Dealer on the
same day the application is received.
The Company issues a commitment to purchase a pre-approved loan upon the
receipt of a fully completed loan package. Commitments indicate loan amounts,
fees, funding conditions, approval expiration dates and interest rates. Loan
commitments are generally issued for periods of up to 45 days in the case of
Correspondents and 90 days in the case of Dealers. Prior to disbursement of
funds, all loans are carefully reviewed by funding auditors to ensure that all
documentation is complete, all contingencies specified in the approval have been
met and the loan is closed in accordance with Company and regulatory procedures.
The Company also purchases loans from a limited number of Correspondents on
a wholesale basis whereby typically biweekly volume of closed loans is submitted
for purchase. Each loan is individually underwritten and audited by
Correspondent Division underwriting personnel prior to purchase.
Conventional Loans
The Company has implemented policies for its Conventional Loan program that
are designed to minimize losses by adhering to high credit quality standards or
requiring adequate loan-to-value levels. The Company will only make Conventional
Loans to borrowers with an "A" or "B" credit grade using the CIP. For the fiscal
year ended August 31, 1997, the Company's portfolio of Conventional Loans
originated had been evaluated on average as an "A-" credit risk and had a
weighted-average (i) FICO score of 670, (ii) gross debt-to-income ratio of 37%,
post funding, (iii) interest rate of 14.03% and (iv) loan-to-value ratio of
112%, as well as an average loan amount of $30,400. Substantially all of the
Conventional Loans originated to date by the Company are secured by first or
second mortgage liens on single family, owner occupied properties.
10
<PAGE> 12
Terms of Conventional Loans made by the Company, as well as the maximum
loan-to-value ratios and debt service to income coverage (calculated by dividing
fixed monthly debt payments by gross monthly income), vary depending upon the
Company's evaluation of the borrower's creditworthiness. Borrowers with lower
creditworthiness generally pay higher interest rates and loan origination fees.
As part of the underwriting process for Conventional Loans with an original
principal balance in excess of $35,000, the Company generally requires an
appraisal of the mortgaged property as a condition to the commitment to
purchase. If an appraisal is utilized, the Company requires the independent
appraiser to be state licensed and certified. The Company requires that all
independent appraisals be completed within the Uniform Standards of Professional
Appraisal Practice as adopted by the Appraisal Standards Board of the Appraisal
Foundation. Prior to originating a Conventional Loan, the Company audits the
appraisal for accuracy to ensure that the appraiser used sufficient care in
analyzing data to avoid errors that would significantly affect the appraiser's
opinion and conclusion. This audit includes a review of housing demand, physical
adaptability of the real estate, neighborhood trends and the highest and best
use of the real estate. In the event the audit reveals any discrepancies as to
the method and technique that are necessary to produce a credible appraisal, the
Company will perform additional property data research or may request a second
appraisal to be performed by an independent appraiser selected by the Company in
order to further substantiate the value of the subject property.
In lieu of requiring a new appraisal, for Conventional Loans with original
principal balances of less than $50,000, the Company may accept a HUD-1
settlement statement no older than 12 months, a broker's price opinion, a tax
assessment, an existing drive-by appraisal or a Uniform Residential Appraisal
Report no older than 12 months. With respect to Conventional Loans with an
original principal balance in excess of $35,000 but less than $40,000, the
Company may accept the stated value of the mortgaged property if the borrower
meets certain credit criteria.
The Company also requires a title report on all subject properties securing
its Conventional Loans to verify property ownership, lien position and the
possibility of outstanding tax liens or judgments. In the case of loans in the
first lien position, the Company requires a full title insurance policy
substantially in compliance with the requirements of the American Loan Title
Association.
The applicant is required to secure hazard insurance and may be required to
secure flood insurance if the mortgaged property has been identified by the
Federal Emergency Management Agency ("FEMA") as having special flood hazards.
Title I Loans
The Company makes Title I Loans to borrowers with an "A" to "C" credit
grade based on CIP score and lien position. For the fiscal year ended August 31,
1997, the Company's Title I portfolio had been evaluated as a "B+" credit risk
and had a weighted-average FICO score of 647. The Company's underwriting
guidelines for Title I Loans meet FHA's underwriting criteria. Completed loan
packages are sent to the Company's Underwriting Department for predisbursement
auditing and funding.
Subject to underwriting approval of an application forwarded to the Company
by a Dealer, the Company issues a commitment to purchase an Installment Contract
from a Dealer upon the Company's receipt of a fully completed loan package and
notice from the borrower of satisfactory work completion. Subject to
underwriting approval of an application forwarded to the Company by a
Correspondent, the Company issues a commitment to purchase a Title I Loan upon
the Company's receipt of a fully completed and closed loan package.
The Company's underwriting personnel review completed loan applications to
verify compliance with the Company's underwriting standards, FHA requirements
and federal and state regulations. In the case of Title I Loans acquired from
Dealers, the Company conducts a prefunding telephonic interview with the
property owner to determine that the improvements have been completed in
accordance with the terms of the Installment Contract and to the owner's
satisfaction. The Company utilizes a nationwide network of independent
inspectors to perform on-site inspections of improvements within the time frames
specified by the
11
<PAGE> 13
Title I program. Appraisals for Title I Loans, when necessary, are generally
prepared by pre-approved independent appraisers that meet the Company's
standards for experience, education and reputation.
Since the Company does not currently originate any Title I Loans with an
original principal balance in excess of $25,000, the FHA does not individually
review the Title I Loans originated by the Company.
QUALITY CONTROL
The Company employs various quality control personnel and procedures in
order to insure that loan origination standards are adhered to and regulatory
compliance is maintained while substantial growth is experienced in the
servicing portfolio.
In accordance with Company policy, the Quality Control Department reviews a
statistical sample of loans closed each month. This review is generally
completed within 60 days of funding and circulated to appropriate department
heads and senior management. Finalized reports are maintained in the Company's
files for a period of two years from completion. Typical review procedures
include reverification of employment and income, re-appraisal of the subject
property, obtaining separate credit reports and recalculation of debt-to-income
ratios. The statistical sample is intended to cover 10% of all new loan
originations with particular emphasis on new Correspondents and Dealers.
Emphasis will also be placed on those loan sources where higher levels of
delinquency are experienced, physical inspections reveal a higher level of
non-compliance, or payment defaults occur within the first six months of
funding. On occasion, the Quality Control Department may review all loans
generated from a particular loan source in the event an initial review
determines a higher than normal number of exceptions. The account selection of
the Quality Control Department is also designed to include a statistical sample
of loans by each underwriter and each funding auditor and thereby provide
management with information as to any aberration from Company policies and
procedures in the loan origination process.
Under the direction of the Vice President of Credit Quality and Regulatory
Compliance, a variety of review functions are accomplished. On a daily basis, a
sample of recently approved loans are reviewed to insure compliance with
underwriting standards. Particular attention is focused on those underwriters
who have developed a higher than normal level of exceptions. In addition to this
review, the Company has developed a staff of post-disbursement review auditors
which reviews 100% of recently funded accounts, typically within two weeks of
funding. All credit reports are analyzed, debt-to-income ratios recalculated,
contingencies monitored and loan documents inspected. Exception reports are
forwarded to the respective Vice Presidents of Production as well as senior
management. The Company also employs a Physical Inspection Group that is
responsible for monitoring the inspection of all homes which are the subject of
home improvement loans. Non-compliance is tracked by loan source and serves as
another method of evaluating a loan source relationship.
The Company has expended substantial amounts in developing its Quality
Control and Compliance Department. The Company recognizes the need to monitor
its operations continually as it experiences substantial growth. Feedback from
these departments provides senior management with the information necessary to
take corrective action when appropriate, including the revision and expansion of
its operating policies and procedures.
LOAN PRODUCTION TECHNOLOGY SYSTEMS
The Company utilizes a sophisticated computerized loan origination tracking
system that allows it to monitor the performance of Dealers and Correspondents
and supports the marketing efforts of the Dealer and Correspondent Divisions by
tracking the marketing activities of field sales personnel. The system automates
various other functions such as Home Mortgage Disclosure Act and HUD reporting
requirements and routine tasks such as decline letters and the flood
certification process. The system also affords management access to a wide range
of decision support information such as data on the approval pipeline, loan
delinquencies by source, and the activities and performance of underwriters and
funders. The Company uses intercompany electronic mail, as well as an
electronic-mail link with its affiliate, PEC, to facilitate communications and
has an electronic link to PEC that allows for the automated transfer of accounts
to PEC's servicing system.
12
<PAGE> 14
The Company is continually enhancing this system to provide for the
automation of the loan origination process as well as loan file indexing and
routing. These enhancements include electronic routing of loan application
facsimile transmissions, automated credit report inquiries and consumer credit
scoring along with on-screen underwriting and approval functions. These
enhancements will continue to (i) increase loan production efficiencies by
minimizing manual processing of loan documentation, (ii) enhance the quality of
loan processing by use of uniform electronic images of loan files and (iii)
facilitate loan administration and collections by providing easier access to
loan account information. In October 1997, the Company entered into a five-year
$986,000 equipment financing arrangement in order to facilitate these ongoing
enhancements.
The Company is currently in the process of conforming all of its
computerized systems to be year 2000 ("Y2000") compliant. Many of these systems
are already Y2000 compliant and the Company expects such systems to be in full
compliance before the end of 1999.
LOAN SERVICING
The Company's strategy has been to retain the bulk of the servicing rights
associated with the loans it originates. The Company's loan servicing activities
include responding to borrower inquiries, processing and administering loan
payments, reporting and remitting principal and interest to the whole loan
purchasers who own interests in the loans and to the trustee and others with
respect to securitizations, collecting delinquent loan payments, processing
Title I insurance claims, conducting foreclosure proceedings and disposing of
foreclosed properties and otherwise administering the loans. The Company's
various loan sale and securitization agreements allocate a portion of the
difference between the stated interest rate and the interest rate passed through
to purchasers of its loans to servicing revenue. Servicing fees are collected by
the Company out of monthly loan payments. Other sources of loan servicing
revenues include late charges and miscellaneous fees. The Company uses a
sophisticated computer based mortgage servicing system that it believes enables
it to provide effective and efficient administering of Conventional and Title I
Loans. The servicing system is an on-line real time system developed and
maintained by PEC. It provides payment processing and cashiering functions,
automated payoff statements, on-line collections, statement and notice mailing
along with a full range of investor reporting requirements. The Company has
entered into a subservicing agreement with PEC for the use of the system and
continuous support. The monthly investor reporting package includes a trial
balance, accrued interest report, remittance report and delinquency reports.
Formal written procedures have been established for payment processing, new loan
set-up, customer service, tax and insurance monitoring.
The Company is a HUD approved lender and a FNMA approved seller/servicer.
As such, it is subject to due diligence review of its policies, procedures, and
business, and is qualified to underwrite, sell and service Title I Loans on
behalf of the FHA and FNMA.
The Company's loan collection functions are organized into two areas of
operation: routine collections and management of nonperforming loans.
Routine collection personnel are responsible for collecting loan payments
that are less than 60 days contractually past due and providing prompt and
accurate responses to all customer inquiries and complaints. These personnel
report directly to the Company's Vice President of Loan Administration.
Borrowers are contacted on the due date for each of the first six payments in
order to encourage continued prompt payment. Generally, after six months of
seasoning, collection activity will commence if a loan payment has not been made
within five days of the due date. Borrowers usually will be contacted by
telephone at least once every five days and also by written correspondence
before the loan becomes 60 days delinquent. With respect to loan payments that
are less than 60 days late, routine collections personnel utilize a system of
mailed notices and telephonic conferences for reminding borrowers of late
payments and encouraging borrowers to bring their accounts current. Installment
payment invoices and return envelopes are mailed to each borrower on a monthly
basis. The Company has bilingual customer service personnel available.
Once a loan becomes 30 days past due, a collection supervisor generally
analyzes the account to determine the appropriate course of remedial action. On
or about the 45th day of delinquency, the supervisor determines if the property
needs immediate inspection to determine if it is occupied or vacant. Depending
upon the circumstances surrounding the delinquent account, a temporary
suspension of payments or a
13
<PAGE> 15
repayment plan to return the account to current status may be authorized by the
Vice President of Loan Administration. In any event, it is the Company's policy
to work with the delinquent customer to resolve the past due balance before
Title I claim processing or legal action is initiated.
Nonperforming loan management personnel are responsible for collecting
severely delinquent loan payments (over 60 days late), filing Title I insurance
claims or initiating legal action for foreclosure and recovery. Operating from
the Company's headquarters in Atlanta, Georgia, collection personnel are
responsible for collecting delinquent loan payments and seeking to mitigate
losses by providing various alternatives to further actions, including
modifications, special refinancing and indulgence plans. Title I insurance claim
personnel are responsible for managing Title I insurance claims, utilizing a
claim management system designed to track insurance claims for Title I Loans so
that all required conditions precedent to claim perfection are met. In the case
of Conventional Loans, a foreclosure coordinator will review all previous
collection activity, evaluate the lien and equity position and obtain any
additional information as necessary. The ultimate decision to foreclose, after
all necessary information is obtained, is made by an officer of the Company.
Foreclosure regulations and practices and the rights of the owner in default
vary from state to state, but generally procedures may be initiated if: (i) the
loan is 90 days (120 days under California law) or more delinquent; (ii) a
notice of default on a senior lien is received; or (iii) the Company discovers
circumstances indicating potential loss exposure.
Net loan servicing income was $873,000, $3.3 million, and $3.0 million for
the years ended August 31, 1995, 1996 and 1997, respectively, constituting 6.4%,
14.2% and 5.5%, respectively, of the Company's total revenues in such years. The
decrease in net loan servicing income from fiscal 1996 to fiscal 1997 was
primarily the result of the reclassification of net revenue as a result of the
adoption of SFAS 125 (as later defined) and increased interest advances and
reduced servicing fees related to the increase in delinquent serviced loans. As
of August 31, 1997, the Company increased the size of the loan portfolio it
services to approximately $628.1 million from approximately $214.2 million as of
August 31, 1996, an increase of approximately $413.9 million or 193.2%. As of
August 31, 1996, the size of the serviced loan portfolio increased from
approximately $92.3 million as of August 31, 1995, an increase of approximately
$121.9 million or 132.1%. The Company's loan servicing portfolio is subject to
reduction by normal amortization, prepayment of outstanding loans and defaults.
The following table sets forth certain information regarding the Company's
loan servicing for the fiscal years indicated:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
-------------------------------------
1995 1996 1997
--------- --------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Servicing portfolio at beginning of year................ $ 8,026 $ 92,286 $ 214,189
Additions to servicing portfolio........................ 87,751 139,367 526,917
Reductions in servicing portfolio(1).................... (3,491) (17,464) (113,038)
------- -------- --------
Servicing portfolio at end of year...................... $ 92,286 $ 214,189 $ 628,068
======= ======== ========
Servicing portfolio at end of year:
Company-owned loans:
Conventional....................................... $ -- $ 922 $ 8,661
Title I............................................ 3,720 3,776 902
------- -------- --------
Total Company-owned loans..................... 3,720 4,698 9,563
------- -------- --------
Sold and securitized loans:
Conventional....................................... -- 10,501 363,961
Title I............................................ 88,566 198,990 254,544
------- -------- --------
Total sold and securitized loans.............. 88,566 209,491 618,505
------- -------- --------
Total servicing portfolio..................... $ 92,286 $ 214,189 $ 628,068
======= ======== ========
</TABLE>
- ---------------
(1) Reductions result from scheduled payments, prepayments, loans sold with
servicing released, and write-offs during the period.
14
<PAGE> 16
The following table sets forth the Title I Loan and Conventional Loan
delinquency and Title I insurance claims experience of loans serviced by the
Company as of the dates indicated:
<TABLE>
<CAPTION>
AUGUST 31,
-------------------------------------
1995 1996 1997
------- -------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Delinquency period(1)
31 - 60 days past due................................. 2.58% 2.17% 1.54%
61 - 90 days past due................................. 0.73 0.85 0.80
91 days and over past due............................. 0.99 4.53(2) 3.07(2)
91 days and over past due, net of claims filed(3)..... 0.61 1.94 2.32
Outstanding claims filed with HUD(4).................... 0.38 2.59 0.75
Outstanding number of Title I insurance claims.......... 23 255 269
Total servicing portfolio............................... $92,286 $214,189 $628,068
Title I Loans serviced.................................. 92,286 202,766 255,446
Conventional Loans serviced............................. -- 11,423 372,622
Amount of FHA insurance available....................... 9,552 21,205 21,094(5)
Amount of FHA insurance available as a percentage of
Title I Loans serviced................................ 10.35% 10.46% 8.26%(5)
Losses on liquidated loans(6)........................... $ 16.8 $ 32.0 $ 201.0
</TABLE>
- ---------------
(1) Represents the dollar amount of delinquent loans as a percentage of the
total dollar amount of loans serviced by the Company (including loans owned
by the Company) as of fiscal year end. Conventional Loan delinquencies for
the years ended August 31, 1996 and 1997 represented 0.31% and 10.35%,
respectively, of the Company's total delinquencies. The Company did not
originate Conventional Loans until May 1996.
(2) During fiscal 1996 and the first two quarters of fiscal 1997, the processing
and payment of claims filed with HUD was delayed. Claims paid by HUD during
the third and fourth quarters of 1997 totaled $4.4 million and $2.4 million,
respectively.
(3) Represents the dollar amount of delinquent loans net of delinquent Title I
Loans for which claims have been filed with HUD and payment is pending as a
percentage of the total dollar amount of loans serviced by the Company
(including loans owned by the Company) as of the dates indicated.
(4) Represents the dollar amount of delinquent Title I Loans for which claims
have been filed with HUD and payment is pending as a percentage of total
dollar amount of total loans serviced by the Company (including loans owned
by the Company) as of the dates indicated.
(5) If all claims with HUD had been processed as of August 31, 1997, the amount
of FHA insurance available for serviced Title I Loans would have been
reduced to $16.5 million, which as a percentage of Title I Loans serviced
would have been 6.6%.
(6) On Title I Loans, a loss is recognized upon receipt of payment of a claim or
final rejection thereof. Claims paid in a period may relate to a claim filed
in an earlier period. Since the Company commenced its Title I lending
operations in March 1994, there has been no final rejection of a claim by
the FHA. Aggregate losses on liquidated Title I Loans related to 700 Title I
insurance claims made by the Company, as servicer, since commencing
operations through August 31, 1997. Losses on Title I Loans liquidated will
increase as the balance of the claims are processed by HUD. The Company has
received an average payment from HUD equal to 90% of the outstanding
principal balance of such Title I Loans, plus appropriate interest and
costs.
Sale of Loans
The Company customarily sells the loans it originates. In furtherance of
the Company's strategy to sell loans through securitizations, in March 1996,
August 1996, December 1996, March 1997, May 1997, June
15
<PAGE> 17
1997 and August 1997, the Company completed its first seven securitizations
pursuant to which it sold pools of $84.2 million, $48.8 million, $67.3 million,
$89.7 million, $63.5 million, $104.6 million and $73.3 million, respectively, of
loans. Pursuant to these securitizations, pass-through securities evidencing
interests in the pools of loans were sold in public offerings. The Company
continues to service the sold loans and is entitled to receive from payments in
respect of interest on the sold loans, not in default, a servicing fee equal to
1.25% of the balance of each loan with respect to the March 1996 transaction and
1.0% with respect to the other transactions. In addition, from each
securitization, the Company has received residual interest securities,
contractual rights, and in certain of the transactions, also received interest
only strip securities, all of which were recorded as mortgage related securities
on the Statements of Financial Condition. The residual interest securities and
the contractual rights represent the excess differential (after payment of any
servicing, interest and other fees, and the contractual obligations payable to
the note and certificate holders) between the interest paid by the obligors of
the sold loans and the yield on the sold notes, certificates and interest only
strip securities. Also, from the two securitizations completed during fiscal
1996 and the first two securitizations completed in fiscal 1997, the Company has
also received interest only strip securities. These interest only securities
yield annual rates between 0.45% and 1.00% calculated on the principal balance
of the loans not in default. The Company may be required to repurchase loans
that do not conform to the representations and warranties made by the Company in
the securitization agreements and, as servicer, may be required to advance
interest in connection with the securitizations.
The Company also sells the loans it originates through whole loan sales to
third party purchasers or, in the case of a third party purchaser not eligible
to own a Title I Loan, sells Title I Loan participation certificates backed by
Title I Loans. Whether the Company sells a loan or a loan participation, the
Company typically retains the right to service the loans for a servicing fee.
The Company typically sells loans for an amount approximating the then remaining
principal balance. The purchasers are entitled to receive interest at yields
below the stated interest rates of the loans. In connection with such sales, the
Company is typically required to deposit into a reserve account the excess
servicing spread received by it, less its servicing fee, up to a specified
percentage of the principal balance of the loans, to fund shortfalls in
collections that may result from borrower defaults. To a lesser extent, the
Company also sells whole loans with servicing released, which are sold at a
premium.
The following table sets forth certain data regarding loans securitized or
sold by the Company during the periods indicated with servicing retained, and
excluding loans sold with servicing released:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
---------------------------------
1995 1996 1997
------- -------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Principal amount of loans sold to third party purchasers.... $85,363 $137,908 $462,318
Gain on sales of loans to third party purchasers............ 12,233 16,539 43,154
Net unrealized gain on mortgage related securities.......... -- 2,697 3,518
Weighted-average stated interest rate on loans sold to third
party purchasers.......................................... 14.53% 14.09% 13.91%
Weighted-average pass-through interest rate on loans sold to
third party purchasers.................................... 8.36 7.50 7.36
Weighted-average excess spread retained on loans sold....... 6.17 6.59 6.55
</TABLE>
At August 31, 1995, 1996 and 1997, the Company's Statements of Financial
Condition reflected excess servicing rights of approximately $14.5 million,
$12.1 million and $0, respectively, mortgage related securities of approximately
$0, $22.9 million and $106.3 million, respectively, and mortgage servicing
rights of approximately $1.1 million, $3.8 million and $9.5 million,
respectively. As a result of the adoption of Statement of Financial Accounting
Standards ("SFAS") No. 125 ("SFAS 125"), effective January 1, 1997, excess
servicing rights have been reclassified as mortgage related securities which are
carried at fair market value. The Company derives a portion of its income by
realizing gains upon the whole loan sale of loans and sale of loan
participations due to the excess servicing rights or mortgage related securities
associated with such loans recorded at the time of sale and the capitalization
of mortgage servicing rights recorded at origination. Excess servicing rights or
mortgage related securities represent the excess of the interest rate payable by
a
16
<PAGE> 18
borrower on a loan over the interest rate passed through to the purchaser
acquiring an interest in the loan, less the Company's normal servicing fee and
other applicable recurring fees.
The Company records significant gains on sale of loans through
securitizations based in part on the estimated fair value of the mortgage
related securities retained by the Company and on the estimated value of
retained mortgage servicing rights related to such loans. In a securitization,
the Company retains a residual interest security and may retain an interest only
strip security. The fair value of the residual interest and interest only strip
security is the present value of the estimated net cash flows to be received
after considering the effects of prepayments and credit losses, and where
applicable net of FHA insurance recoveries on Title I Loans. In whole loan sales
with servicing retained, the Company recognizes as current revenue the present
value of the excess servicing rights expected to be realized over the
anticipated average life of loans sold (classified as interest only securities
and included in mortgage related securities subsequent to January 1, 1997) less
estimated future credit losses relating to the loans sold. Mortgage related
securities represent interests retained by the Company in loan sale transactions
comprised of the excess of the interest rate and principal payable by an obligor
on a sold loan over the interest rate and principal payable to purchasers, after
payment of servicing and other fees.
Capitalized mortgage servicing rights and mortgage related securities are
valued using prepayment, default and interest rate assumptions that the Company
believes are reasonable based on experience with its own portfolio, available
market data and ongoing consultation with industry participants. The amount of
revenue recognized by the Company upon the sale of loans or loan participations
will vary depending on the assumptions utilized. The weighted-average discount
rate used to determine the present value of the balance of capitalized excess
servicing rights, capitalized mortgage servicing rights and mortgage related
securities reflected on the Company's Statements of Financial Condition at
August 31, 1995, 1996 and 1997, was approximately 12.0%. The estimate of fair
value of mortgage servicing rights was based on a range of 100 to 125 basis
points per year servicing fee, reduced by estimated costs of servicing.
Periodically, interest earned on mortgage related securities is accrued and
the securities' valuations are adjusted to reflect market conditions. These
adjustments, which can be either positive or negative, are recorded as net
unrealized gain on mortgage related securities. Mortgage servicing rights are
amortized in proportion to, and over the period of estimated net servicing
income, as an offset against the excess servicing rights component of servicing
income accrued in connection with such loans. The mortgage servicing rights are
periodically evaluated for impairment, based on criteria established by the
Company at the time of origination. Although the Company believes that it has
made reasonable estimates of the mortgage related securities and mortgage
servicing rights likely to be realized, the rate of prepayment, rate of default,
and the estimates of the future costs of servicing utilized by the Company are
estimates and actual results may vary from such estimates. The gain recognized
by the Company upon the sale of loans will have been understated or overstated
if prepayments and/or defaults are less than or greater than anticipated,
respectively. Higher levels of future prepayments, and/or an increase in
delinquencies or liquidations, would result in a lower valuation of the mortgage
related securities and impairment of the mortgage servicing rights, thereby
adversely affecting the Company's earnings in the period of adjustment. The
Company has developed its assumptions based on experience with its own
portfolio, available market data and ongoing consultation with industry
participants. Rapid increases in interest rates or competitive pressures may
result in a reduction of future excess servicing income, thereby reducing the
gains recognized by the Company upon the sale of loans or loan participations in
the future.
The Company typically earns net interest income during the "warehouse"
period between the closing or assignment of a loan and its delivery to a
purchaser or pursuant to a securitization. On loans held for sale, the Company
earns interest at long-term rates, financed by lines of credit which bear
interest at short-term interest rates. Normally, short-term interest rates are
lower than long-term interest rates and the Company earns a positive spread on
its loans held for sale. The average warehouse period for a loan ranges from 6
to 90 days, and the balance of loans in the warehouse, net of allowance for
credit losses and deferred loan fees, was approximately $3.7 million, $4.6
million and $9.5 million as of August 31, 1995, 1996 and 1997, respectively. The
Company's interest income, net of interest expense was $473,000, $988,000 and
$3.1 million for the years ended August 31, 1995, 1996 and 1997, respectively.
17
<PAGE> 19
SEASONALITY
Home improvement loan volume tracks the seasonality of home improvement
contract work. Volume tends to build during the spring and early summer months,
particularly with regard to pool installations. A decline is typically
experienced in late summer and early fall until temperatures begin to drop. This
change in seasons precipitates the need for new siding, window and insulation
contracts. Peak volume is experienced in November and early December and
declines dramatically from the holiday season through the winter months. Debt
consolidation loan volume is not impacted by seasonal climate changes and, with
the exclusion of the holiday season, tends to be stable throughout the year.
COMPETITION
The consumer finance industry is highly competitive. Competitors in the
home improvement and debt consolidation loan business include mortgage banking
companies, commercial banks, credit unions, thrift institutions, credit card
issuers and finance companies. Certain of the Company's competitors are
substantially larger and have more capital and other resources than the Company.
The Company faces substantial competition within both the home improvement
and debt consolidation loan industry. The home improvement and debt
consolidation loan industry is dominated by widely diversified mortgage banking
companies, commercial banks, savings and loan institutions, credit card
companies, financial service affiliates of Dealers and unregulated financial
service companies, many of which have substantially greater personnel and
financial resources than those of the Company. At present, these types of
competitors dominate the home improvement and debt consolidation loan industry;
however, no one lender or group of lenders dominates the industry. According to
a report issued by HUD, the Company was the sixth largest lender of Title I
Loans, based on volume of loans originated, for the calendar quarter ended June
30, 1997. Due to the variance in the estimates of the size of the conventional
home improvement loan market, the Company is unable to accurately estimate its
competitive position in that market. The Company believes that Greentree
Financial Corp., The Money Store, First Plus Financial Inc., Associates First
Capital Corporation and Empire Funding Corp. are some of its largest direct
competitors. The Company competes principally by providing prompt, professional
service to its Correspondents and Dealers and, depending on circumstances, by
providing competitive lending rates.
Competition can take many forms including convenience in obtaining a loan,
customer service, marketing and distribution channels, amount and term of the
loan, and interest rates. In addition, the current level of gains realized by
the Company and its existing competitors on the sale of loans could attract
additional competitors into this market with the possible effect of lowering
gains on future loan sales owing to increased loan origination competition.
GOVERNMENT REGULATION
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 Equal Credit Opportunity Act of 1974, as amended
("ECOA"), the Fair Credit Reporting Act of 1970, as amended, the Real Estate
Settlement Procedures Act ("RESPA") and Regulation X, the Home Mortgage
Disclosure Act, the Federal Debt Collection Practices Act and the Housing Act,
as well as other federal and state statutes and regulations affecting the
Company's activities. 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 enforcements actions.
The Company presently is subject to the rules and regulations of, and
examinations by, HUD, FHA and other federal and state regulatory authorities
with respect to originating, underwriting, funding, acquiring, selling and
servicing consumer and mortgage loans. In addition, there are other federal and
state statutes and regulations affecting such activities. These rules and
regulations, among other things, impose licensing obligations on the Company,
establish eligibility criteria for loans, prohibit discrimination, provide for
inspection and appraisals of properties, require credit reports on prospective
borrowers, regulate payment
18
<PAGE> 20
features and, in some cases, fix maximum interest rates, fees and loan amounts.
The Company is required to submit annual audited financial statements to various
governmental regulatory agencies that require the maintenance of specified net
worth levels. The Company's affairs are also subject to examination, at all
times, by the Federal Housing Commissioner to assure compliance with FHA
regulations, policies and procedures. For more information regarding regulation
of the Company under Title I, see "Loan Products -- Title I Loan Program."
The Company is a HUD approved Title I mortgage lender and is subject to the
supervision of HUD. The Company is also a FNMA approved seller/servicer and is
subject to the supervision of FNMA. In addition, the Company's operations are
subject to supervision by state authorities (typically state banking or consumer
credit authorities), many of which generally require that the Company be
licensed to conduct its business. This normally requires state examinations and
reporting requirements on an annual basis.
The Federal Consumer Credit Protection Act ("FCCPA") requires a written
statement showing an annual percentage rate of finance charges and requires that
other information be presented to debtors when consumer credit contracts are
executed. The Fair Credit Reporting Act requires certain disclosures to
applicants concerning information that is used as a basis for denial of credit.
ECOA prohibits discrimination against applicants with respect to any aspect of a
credit transaction on the basis of sex, marital status, race, color, religion,
national origin, age, derivation of income from public assistance program, or
the good faith exercise of a right under the FCCPA.
The interest rates which the Company may charge on its loans are subject to
state usury laws, which specify the maximum rate which may be charged to
consumers. In addition, both federal and state truth-in-lending regulations
require that the Company disclose to its customers prior to execution of the
loans, all material terms and conditions of the financing, including the payment
schedule and total obligation under the loans. The Company believes that it is
in compliance in all material respects with such regulations.
EMPLOYEES
As of August 31, 1997, the Company had 405 employees, including 4 executive
officers, 83 managerial personnel, 23 marketing and sales specialists and 292
general administrative and support personnel and loan processors. None of the
Company's employees is represented by a collective bargaining unit. The Company
believes that its relations with its employees are satisfactory.
ITEM 2. PROPERTIES
The Company's corporate headquarters is located in 45,950 square feet of
office space at 1000 Parkwood Circle, Atlanta, Georgia. This lease is for an
initial six year term expiring August 2002 with a conditional option to extend
the term to August 2007. Monthly rentals are $73,711 plus a pro rata share of
any operating expense increase. This lease rate will escalate 2% per year
throughout the term of the lease. The Company also leases 10,478 square feet of
office space at its prior headquarters location in Atlanta, Georgia, at a rental
of $14,530 per month, plus a pro rata share of any operating expense increases,
pursuant to a lease that expires in March 1999. The Company also leases office
space on short-term or month-to-month leases in Waldwick, New Jersey; Kansas
City, Missouri; Austin, Texas; Oklahoma City, Oklahoma; Seattle, Washington;
Waterford, Michigan; Columbus, Ohio; Elmhurst, Illinois; Philadelphia,
Pennsylvania; Denver, Colorado; Richmond, Virginia; Scottsdale, Arizona;
Patchogue, New York; Woburn, Massachusetts; Dublin, California; Stuart, Florida;
Miami Lakes, Florida; and Brentwood, Tennessee.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of its business, the Company is, from time to time,
named in lawsuits. The Company believes that it has meritorious defenses to
these lawsuits and that resolution of these matters will not have a material
adverse effect on the business or financial condition of the Company.
19
<PAGE> 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's security holders
during the fourth quarter of the fiscal year ended August 31, 1997.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER
MATTERS
MARKET INFORMATION
The Company's Common Stock is traded in the over-the-counter market and
since the effective date of its IPO on November 19, 1996, prices have been
quoted on the Nasdaq National Market, under the symbol MMGC. The following table
sets forth the high and low sales prices of the Common Stock as reported on the
Nasdaq National Market:
<TABLE>
<CAPTION>
HIGH LOW
---- ----
<S> <C> <C>
FISCAL YEAR 1997:
First Quarter (November 19, 1996 - November 30, 1996)........ $ 12 $10 3/4
Second Quarter............................................... 15 3/4 10 1/8
Third Quarter................................................ 14 5/8 8
Fourth Quarter............................................... 13 1/2 9
FISCAL YEAR 1998:
First Quarter (through October 15, 1997)..................... 15 11 1/8
</TABLE>
As of October 15, 1997, there were 1,679 holders of record of the 12.3
million outstanding shares of Common Stock. The closing sales price for the
Common Stock, per share, on October 15, 1997 was $14 7/8.
Effective October 28, 1996, the number of authorized shares of Common Stock
was increased to 50 million with a par value of $.01 per share and a stock split
of 1,600 for 1 was recorded. In November 1996, the Company issued 2.3 million
shares of Common Stock in the IPO at $10.00 per share. On September 2, 1997,
Mego Financial distributed all of its 10.0 million shares of the Company's
Common Stock to Mego Financial shareholders in a tax-free Spin-off. See "Item 1.
Business -- Recent Developments."
The Company did not pay any dividends on the Common Stock during the fiscal
year ended August 31, 1997. The Company intends to retain future earnings for
the operation and expansion of its business and does not currently anticipate
paying cash dividends on the Common Stock. Any future determination as to the
payment of such cash dividends would depend on a number of factors including
future earnings, results of operations, capital requirements, the Company's
financial condition and any restrictions under credit agreements (including the
Indenture), existing from time to time, as well as such other factors as the
Board of Directors might deem relevant. No assurance can be given that the
Company will pay any dividends in the future.
ITEM 6. SELECTED FINANCIAL DATA
The selected Statements of Operations data and Statements of Financial
Condition data set forth below have been derived from the financial statements
of the Company. The financial statements as of August 31, 1996 and 1997 and for
each of the three years in the period ended August 31, 1997 have been audited by
Deloitte & Touche LLP, independent auditors, and are included elsewhere herein.
The financial statements as of August 31, 1994 and August 31, 1995 and for the
year ended August 31, 1994 have been audited by Deloitte & Touche LLP,
independent auditors, and are not included herein. Certain reclassifications
have been made to conform prior years with the current year presentation. The
selected financial information set forth below should be read in conjunction
with the financial statements, the related notes thereto and "Item 7.
20
<PAGE> 22
Management's Discussion and Analysis of Financial Condition and Results of
Operations" appearing elsewhere herein.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
---------------------------------------------
1994(1) 1995 1996 1997
------- ------- -------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
STATEMENTS OF OPERATIONS DATA:
Revenues:
Gain on sale of loans........................... $ 579 $12,233 $16,539 $45,123
Net unrealized gain on mortgage related
securities(2)................................ -- -- 2,697 3,518
Loan servicing income, net...................... -- 873 3,348 3,036
Interest income, net of interest expense of
$107, $468, $1,116 and $6,374................ 172 473 988 3,133
------- ------- ------- -------
Total revenues.......................... 751 13,579 23,572 54,810
------- ------- ------- -------
Costs and expenses:
Net provision for credit losses................. 96 864 55 6,300
Depreciation and amortization................... 136 403 394 672
Other interest.................................. 22 187 167 245
General and administrative:
Payroll and benefits......................... 975 3,611 5,031 11,181
Commissions and selling...................... 13 552 2,013 2,768
Credit reports............................... 13 133 367 1,387
Rent and lease expenses...................... 85 249 338 1,091
Professional services........................ -- 177 732 652
Servicing fees paid to affiliate............. 13 232 709 1,874
Management services by affiliate............. 442 690 671 967
FHA insurance................................ 11 231 572 558
Other........................................ 456 331 1,368 3,305
------- ------- ------- -------
Total costs and expenses................ 2,262 7,660 12,417 31,000
------- ------- ------- -------
Income (loss) before income taxes(3).............. (1,511) 5,919 11,155 23,810
Income taxes(3)................................... -- 2,277 4,235 9,062
------- ------- ------- -------
Net income (loss)................................. $(1,511) $ 3,642 $ 6,920 $14,748
======= ======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
AUGUST 31,
---------------------------------------------
1994(1) 1995 1996 1997
------- ------- -------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
STATEMENTS OF FINANCIAL CONDITION DATA:
Loans held for sale, net........................... $1,463 $ 3,676 $ 4,610 $ 9,523
Mortgage related securities(2)..................... -- -- 22,944 106,299
Excess servicing rights(2)......................... 904 14,483 12,121 --
Mortgage servicing rights.......................... -- 1,076 3,827 9,507
Total assets....................................... 5,122 24,081 50,606 154,200
Total liabilities.................................. 983 13,300 32,905 61,093
Subordinated debt.................................. -- -- -- 40,000
Total stockholders' equity......................... 4,139 10,781 17,701 53,107
</TABLE>
21
<PAGE> 23
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
---------------------------------------------
1994(1) 1995 1996 1997
------- ------- -------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
OPERATING DATA:
Loans originated................................... $8,164 $87,751 $139,367 $526,917
Weighted-average interest rate on loans
originated....................................... 14.18% 14.55% 14.03% 13.92%
Servicing portfolio at end of year:
Company-owned loans:
Conventional.................................. $ -- $ -- $ 922 $ 8,661
Title I....................................... 1,471 3,720 3,776 902
------ ------- -------- --------
Total Company-owned loans................ 1,471 3,720 4,698 9,563
------ ------- -------- --------
Sold and securitized loans:
Conventional.................................. -- -- 10,501 363,961
Title I....................................... 6,555 88,566 198,990 254,544
------ ------- -------- --------
Total sold and securitized loans......... 6,555 88,566 209,491 618,505
------ ------- -------- --------
Total servicing portfolio................ $8,026 $92,286 $214,189 $628,068
====== ======= ======== ========
Delinquency period(4):
31 - 60 days past due............................ 2.06% 2.58% 2.17% 1.54%
61 - 90 days past due............................ 0.48 0.73 0.85 0.80
91 days and over past due........................ 0.36 0.99 4.53(5) 3.07(5)
91 days and over past due, net of claims
filed(6)...................................... 0.26 0.61 1.94 2.32
Outstanding claims filed with HUD(7)............... 0.10 0.38 2.59 0.75
Amount of FHA insurance available.................. $ 813 $ 9,552 $ 21,205 $ 21,094(8)
Amount of FHA insurance available as a percentage
of Title I Loans serviced........................ 10.13% 10.35% 10.46% 8.26%(8)
Losses on liquidated loans(9)...................... $ -- $ 16.8 $ 32.0 $ 201.0
</TABLE>
- ---------------
(1) The Company commenced originating loans in March 1994.
(2) Mortgage related securities represent interests retained by the Company in
loan sale transactions and the excess of the interest rate payable by an
obligor on a sold loan over the yield to purchasers, after payment of
servicing and other fees. Pursuant to the implementation of SFAS 125, the
Company has reclassified, as of January 1, 1997, excess servicing rights as
interest only receivables which are carried as mortgage related securities.
(3) The results of operations of the Company were included in the consolidated
federal income tax returns filed by Mego Financial, through the date of the
Spin-off. Mego Financial allocated income taxes to the Company calculated on
a separate return basis. See "Item 13. Certain Relationships and Related
Transactions."
(4) Represents the dollar amount of delinquent loans as a percentage of the
total dollar amount of loans serviced by the Company (including loans owned
by the Company) as of fiscal year end. Conventional Loan delinquencies for
the years ended August 31, 1996 and 1997 represented 0.31% and 10.35%,
respectively, of the Company's total delinquencies. The Company did not
originate Conventional Loans until May 1996.
(5) During fiscal 1996 and the first two quarters of fiscal 1997, the processing
and payment of claims filed with HUD was delayed. Claims paid by HUD during
the third and fourth quarters of 1997 totaled $4.4 million and $2.4 million,
respectively. See "Item 1. Business -- Loan Servicing."
(6) Represents the dollar amount of delinquent loans net of delinquent Title I
Loans for which claims have been filed with HUD and payment is pending as a
percentage of the total dollar amount of loans serviced by the Company
(including loans owned by the Company) as of the dates indicated.
22
<PAGE> 24
(7) Represents the dollar amount of delinquent Title I Loans for which claims
have been filed with HUD and payment is pending as a percentage of total
dollar amount of total loans serviced by the Company (including loans owned
by the Company) as of the dates indicated.
(8) If all claims filed with HUD had been processed as of August 31, 1997, the
amount of FHA insurance available for serviced Title I Loans would have been
reduced to $16.5 million, which as a percentage of Title I Loans serviced
would have been 6.6%.
(9) On Title I Loans, a loss is recognized upon receipt of payment of a claim or
final rejection thereof. Claims paid in a period may relate to a claim filed
in an earlier period. Since the Company commenced its Title I lending
operations in March 1994, there has been no final rejection of a claim by
the FHA. Aggregate losses on liquidated Title I Loans related to 700 Title I
insurance claims made by the Company, as servicer, since commencing
operations through August 31, 1997. Losses on Title I Loans liquidated will
increase as the balance of the claims are processed by HUD. The Company has
received an average payment from HUD equal to 90% of the outstanding
principal balance of such Title I Loans, plus appropriate interest and
costs.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read in conjunction with
the Financial Statements, including the notes thereto, contained elsewhere
herein.
GENERAL
The Company began originating loans on March 1, 1994. The Company sells
substantially all the loans it originates either through securitizations at a
yield below the stated interest rate on the loans, generally retaining the right
to service the loans and to receive any amounts in excess of the yield to the
purchasers, or through whole loan sales to third party institutional purchasers.
In connection with whole loan sales, the Company either sells the loans on a
servicing retained basis at a yield below the stated interest rate on the loans
or on a servicing released basis. All sales on a servicing released basis and
some sales on a servicing retained basis are at a premium. Certain of the
regular interests of the related securitizations are sold, with the interest
only and residual class securities generally retained by the Company.
The Company recognizes revenue from the gain on sale of loans, unrealized
gain on mortgage related securities, interest income and servicing income.
Interest income, net, represents the interest received on loans in the Company's
portfolio prior to their sale, net of interest paid under its credit agreements.
The Company continues to service substantially all loans sold through August 31,
1997, however, during the third and fourth quarters of fiscal 1997, $59.2
million of loans were sold with servicing released. Net loan servicing income
represents servicing fee income and other ancillary fees received for servicing
loans less the amortization of capitalized mortgage servicing rights and through
January 1, 1997, the date of adoption of SFAS 125, excess servicing rights.
Mortgage servicing rights are amortized in proportion to and over the period of
estimated net servicing income. Excess servicing rights were amortized in
proportion to and over the estimated lives of the loans.
Gain on sale of loans includes the gain on sale resulting from
securitizations and whole loan sales. The gain on sale is determined by an
allocation of the cost of the securities based on the relative fair values of
the interests sold and the interests retained. In a securitization, the Company
retains a residual interest security and may retain an interest only strip
security. The fair value of the residual interest and interest only strip
security is the present value of the estimated net cash flows to be received
after considering the effects of estimated prepayments and credit losses, and
where applicable net of FHA insurance recoveries on Title I Loans. The net
unrealized gain on mortgage related securities represents the difference between
the allocated cost basis of the securities and the estimated fair value.
As the holder of the residual securities, the Company is entitled to
receive certain excess cash flows. These excess cash flows are calculated as the
difference between (a) principal and interest paid by borrowers and (b) the sum
of (i) pass-through interest and principal to be paid to the holders of the
regular securities and interest only securities, (ii) trustee fees, (iii)
third-party credit enhancement fees, (iv) servicing fees and
23
<PAGE> 25
(v) estimated loan pool losses. The Company's right to receive the excess cash
flows is subject to the satisfaction of certain reserve or overcollateralization
requirements which are specific to each securitization and are used as a means
of credit enhancement.
The Company carries interest only and residual securities at fair value. As
such, the carrying value of these securities is affected by changes in market
interest rates and prepayment and loss experiences of these and similar
securities. The Company estimates the fair value of the interest only and
residual securities utilizing prepayment and credit loss assumptions the Company
believes to be appropriate for each particular securitization. To the Company's
knowledge, there is no active market for the sale of these interest only and
residual securities. The range of values attributable to the factors used in
determining fair value is broad. Although the Company believes that it has made
reasonable estimates of the fair value of the mortgage related securities, the
rate of prepayments and default rates utilized are estimates, and actual
experience may vary from these estimates.
The present value of expected net cash flows from the sale of loans is
recorded at the time of sale as mortgage related securities. Mortgage related
securities are periodically revalued (marked to market), with a resulting charge
or credit to income, under the caption of net unrealized gain in the Company's
Statements of Operations, based on actual payments by the obligors and any
needed adjustments to the underlying assumptions of prepayment speeds, rate of
default and discount rate. The expected cash flows used to determine the value
of mortgage related securities have been reduced for potential losses, net of
FHA insurance recoveries on Title I Loans, under recourse provisions of the
sales agreements. The allowance for credit losses on loans sold with recourse
represents the Company's estimate of losses to be incurred in connection with
the recourse provisions of the sales agreements.
To determine the fair value of the mortgage related securities and mortgage
servicing rights, the Company projects net cash flows expected to be received
over the life of the loans. Such projections assume certain servicing costs,
prepayment rates and credit losses. As a result of the adoption of SFAS 125,
mortgage related securities are carried at fair market value and periodically
marked to market. As of August 31, 1997, mortgage related securities totaled
$106.3 million and mortgage servicing rights totaled $9.5 million.
The Company discounts cash flows on its loan sales at the rate it believes
an independent third-party purchaser would require as a rate of return. The cash
flows were discounted to present value using discount rates which averaged 12.0%
for the years ended August 31, 1995, 1996 and 1997. The Company has developed
its assumptions based on experience with its own portfolio, available market
data and ongoing consultation with its financial advisors.
There can be no assurance that the Company's estimates used to determine
the fair value of mortgage related securities and mortgage servicing rights will
remain appropriate for the life of the loans. If actual loan prepayments or
credit losses exceed the Company's estimates, the carrying value of the
Company's mortgage related securities and mortgage servicing rights may have to
be written down through a charge against earnings.
Total costs and expenses consist primarily of general and administrative
expenses, depreciation and amortization, and provision for credit losses. PEC, a
wholly-owned subsidiary of Mego Financial, provides loan servicing and
management services to the Company; the costs of which are charged to general
and administrative expenses. See "Item 13. Certain Relationships and Related
Transactions" and Note 16 of Notes to Financial Statements.
The Company continues to implement its business growth strategy through
both product line and geographic diversification and expansion of its
Correspondent and Dealer operations, in an effort to increase both loan
origination volume and servicing volume. See "Item 1. Business -- Business
Strategy." Implementation of this strategy has increased the Company's total
assets through growth in mortgage servicing assets and mortgage related
securities and has been funded through increased borrowings. While this growth
has increased the Company's revenues through increased gain on sales of loans,
loan servicing income and net interest income, it has also increased the general
and administrative expense and provision for credit losses associated with the
growth in loans originated and serviced. Continued increases in the Company's
total assets
24
<PAGE> 26
and increasing earnings can continue only so long as origination volumes
continue to exceed paydowns of loans serviced and previous period origination
volumes. Additionally, the fair value of mortgage related securities and
mortgage servicing rights owned by the Company may be adversely affected by
changes in the interest rate environment which could affect the discount rate
and prepayment assumptions used to value the assets. Any such adverse change in
assumptions could have a material adverse effect on the Company's results of
operations and financial condition.
RESULTS OF OPERATIONS
YEAR ENDED AUGUST 31, 1997 COMPARED TO YEAR ENDED AUGUST 31, 1996
The Company originated $526.9 million of loans during fiscal 1997 compared
to $139.4 million of loans during fiscal 1996, an increase of 278.1%. The
increase is a result of the overall growth in the Company's business, including
an increase in the number of active Correspondents and Dealers and an increase
in the number of states served. At August 31, 1997, the Company had 694 active
Correspondents and 670 active Dealers, compared to 310 active Correspondents and
435 active Dealers at August 31, 1996. Of the $526.9 million of loans originated
during fiscal 1997, $428.8 million were Conventional Loans and $98.1 million
were Title I Loans compared to $11.6 of Conventional Loans and $127.8 million of
Title I loans during fiscal 1996.
The following table sets forth certain data regarding loans originated by
the Company during the fiscal years ended August 31, 1996 and 1997.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
---------------------------------------------
1996 1997
-------------------- --------------------
<S> <C> <C> <C> <C>
PRINCIPAL AMOUNT OF LOANS ORIGINATED:
Correspondents:
Title I....................................... $ 82,596,197 59.3% $ 50,814,931 9.7%
Conventional.................................. 11,582,108 8.3 409,603,281 77.7
------------ ----- ------------ -----
Total Correspondents..................... 94,178,305 67.6 460,418,212 87.4
------------ ----- ------------ -----
Dealers:
Title I....................................... 45,188,721 32.4 47,269,541 9.0
Conventional.................................. -- -- 19,228,957 3.6
------------ ----- ------------ -----
Total Dealers............................ 45,188,721 32.4 66,498,498 12.6
------------ ----- ------------ -----
Total principal amount of loans
originated............................. $139,367,026 100.0% $526,916,710 100.0%
============ ===== ============ =====
NUMBER OF LOANS ORIGINATED:
Correspondents:
Title I....................................... 4,382 50.9% 2,445 12.0%
Conventional.................................. 392 4.6 12,831 62.7
------------ ----- ------------ -----
Total Correspondents..................... 4,774 55.5 15,276 74.7
------------ ----- ------------ -----
Dealers:
Title I....................................... 3,836 44.5 3,893 19.0
Conventional.................................. -- -- 1,296 6.3
------------ ----- ------------ -----
Total Dealers............................ 3,836 44.5 5,189 25.3
------------ ----- ------------ -----
Total number of loans originated......... 8,610 100.0% 20,465 100.0%
============ ===== ============ =====
</TABLE>
See Notes 2 and 5 of Notes to Financial Statements.
Total revenues increased 132.5% to $54.8 million for fiscal 1997 from $23.6
million for fiscal 1996. The increase was primarily the result of the increased
volume of loans originated and the sale of such loans.
Gain on sale of loans and net unrealized gain on mortgage related
securities increased 152.9% to $48.6 million during fiscal 1997 from $19.2
million during fiscal 1996. The increase was primarily due to increased loan
sales of $521.6 million during fiscal 1997 compared to $137.9 million during
fiscal 1996.
25
<PAGE> 27
The following table sets forth the principal balance of loans sold or
securitized, related gain on sale data and loans serviced for fiscal 1996 and
1997.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
AUGUST 31,
-----------------------
1996 1997
-------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
PRINCIPAL AMOUNT OF LOANS SOLD:
Title I............................................................ $127,414 $101,907
Conventional....................................................... 10,494 419,600
-------- --------
Total...................................................... $137,908 $521,507
======== ========
Gain on sale of loans................................................ $ 16,539 $ 45,123
======== ========
Net unrealized gain on mortgage related securities................... $ 2,697 $ 3,518
======== ========
PRINCIPAL AMOUNT OF LOANS SOLD:
Title I............................................................ $127,414 $101,907
Conventional....................................................... 10,494 360,411(1)
-------- --------
Total...................................................... $137,908 $462,318
======== ========
Gain on sale of loans................................................ $ 16,539 $ 43,154(2)
======== ========
Gain on sale of loans as a percentage of principal balance of loans
sold............................................................... 12.0% 9.3%(2)
======== ========
Gain on sale of loans plus net unrealized gain on mortgage related
securities as a percentage of principal balance of loans sold...... 13.9% 10.1%(2)
======== ========
LOANS SERVICED AT END OF YEAR (INCLUDING LOANS SECURITIZED, SOLD TO
INVESTORS, AND HELD FOR SALE):
Title I............................................................ $202,766 $255,446
Conventional....................................................... 11,423 372,622
-------- --------
Total servicing portfolio.................................. $214,189 $628,068
======== ========
</TABLE>
- ---------------
(1) Excludes $59.2 million of loans sold with servicing released during fiscal
1997.
(2) Excludes gains on sale of $2.0 million relating to whole loan sales of $59.2
million of loans sold with servicing released during fiscal 1997.
See Note 2 of Notes to Financial Statements.
Loan servicing income, net decreased 9.3% to $3.0 million during fiscal
1997 from $3.3 million during fiscal 1996. The decrease was primarily the result
of the reclassification of net revenue in compliance with SFAS 125, and
increased interest advances and reduced servicing fees related to $34.0 million
in delinquent serviced loans at August 31, 1997 compared to $16.2 million at
August 31, 1996.
Interest income on loans held for sale and mortgage related securities, net
of interest expense, increased 217.1% to $3.1 million during fiscal 1997 from
$988,000 during fiscal 1996. The increase was primarily the result of the
increase in the average size of the portfolio of loans held for sale, and the
increased mortgage related securities portfolio.
The Company intends to consider strategies to mitigate the interest rate
risks associated with the loan origination/warehousing function, funding its
portfolio of mortgage related securities, mortgage servicing rights, and
valuation of these assets. Implementation of interest rate risk management
strategies may decrease spreads, decrease gains on sale of loans, or otherwise
decrease revenues from those which might otherwise occur in a stable interest
rate environment without such strategies in place. The Company intends to
thoroughly analyze the cost of such strategies compared to the risks which would
be mitigated prior to implementation of any strategy.
The net provision for credit losses increased to $6.3 million for fiscal
1997 from $55,000 for fiscal 1996. The increase in the provision was directly
related to the increase in the volume of loans originated and the
26
<PAGE> 28
increased ratio of Conventional Loans to Title I Loans originated during fiscal
1997 compared to fiscal 1996. No allowance for credit losses on loans sold with
recourse is established on loans sold through securitizations, as the Company
has no recourse obligation under those securitization agreements for credit
losses and estimated credit losses on loans sold through securitizations are
considered in the Company's valuation of its residual interest securities. The
provision for credit losses is based upon periodic analysis of the portfolio,
economic conditions and trends, historical credit loss experience, borrowers'
ability to repay, collateral values, and estimated FHA insurance recoveries on
Title I Loans originated and sold. See Notes 2 and 5 of Notes to Financial
Statements.
Total general and administrative expenses increased 101.5% to $23.8 million
during fiscal 1997 compared to $11.8 million during fiscal 1996. The increase
was primarily a result of increased credit reports expense due to increased loan
origination volume, increased rent and lease expense due to facilities
expansion, increased loan servicing expenses due to an increase in loans
serviced, and increased payroll related to the hiring of additional
underwriting, loan processing, administrative, loan quality control and other
personnel as a result of the expansion of the Company's business.
Payroll and benefits expense increased 122.2% to $11.2 million during
fiscal 1997 from $5.0 million during fiscal 1996 primarily due to an increased
number of employees. The number of employees increased to 405 at August 31, 1997
from 170 at August 31, 1996 due to increased staff necessary to support the
business expansion and maintain quality control.
Commissions and selling expenses increased 37.5% to $2.8 million during
fiscal 1997 from $2.0 million during fiscal 1996, while loan originations
increased by $387.5 million or 278.1% to $526.9 million at August 31, 1997. The
sales network expanded to substantially all states, adding new personnel and
offices to further the loan origination growth strategy.
Credit reports expense increased 277.9% to $1.4 million during fiscal 1997
from $367,000 during fiscal 1996, due to increased loan origination volume to
$526.9 million during fiscal 1997 from $139.4 million during fiscal 1996.
Rent and lease expense increased 222.8% to $1.1 million during fiscal 1997
from $338,000 during fiscal 1996, due to increased expansion costs for the
corporate headquarters and additional branch offices.
Servicing fees paid to PEC increased 164.3% to $1.9 million during fiscal
1997 from $709,000 during fiscal 1996 due primarily to a larger loan servicing
portfolio.
Management services by affiliate increased 44.1% to $967,000 during fiscal
1997 from $671,000 during fiscal 1996. These expenses represent services
provided by PEC, including executive, accounting, legal, management information,
data processing, human resources, advertising and promotional materials.
Other general and administrative expenses increased 141.6% to $3.3 million
during fiscal 1997 from $1.4 million during fiscal 1996 due primarily to
increased expenses related to the ongoing expansion of facilities.
Income before income taxes increased to $23.8 million for fiscal 1997 from
$11.2 million for fiscal 1996; therefore, the provision for income taxes
increased to $9.1 million for fiscal 1997 compared to $4.2 million for fiscal
1996.
As a result of the foregoing, the Company's net income increased 113.1% to
$14.7 million for fiscal 1997 from $6.9 million for fiscal 1996.
YEAR ENDED AUGUST 31, 1996 COMPARED TO YEAR ENDED AUGUST 31, 1995
The Company originated $139.4 million of loans during fiscal 1996 compared
to $87.8 million of loans during fiscal 1995, an increase of 58.8%. The increase
is a result of the overall growth in the Company's business, including an
increase in the number of active Correspondents and Dealers and an increase in
the number of states served. At August 31, 1996, the Company had 310 active
Correspondents and 435 active Dealers, compared to 150 active Correspondents and
170 active Dealers at August 31, 1995. Of the
27
<PAGE> 29
$139.4 million of loans originated in fiscal 1996, $11.6 million were
Conventional Loans. The Company did not originate Conventional Loans during
fiscal 1995.
The following table sets forth certain data regarding loans originated by
the Company during fiscal 1995 and 1996.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
------------------------------------------------
1995 1996
--------------------- ----------------------
<S> <C> <C> <C> <C>
PRINCIPAL AMOUNT OF LOANS ORIGINATED:
Correspondents:
Title I.................................... $63,792,680 72.7% $ 82,596,197 59.3%
Conventional............................... -- -- 11,582,108 8.3
----- ------ -----
-----
Total Correspondents.................. 63,792,680 72.7 94,178,305 67.6
----- ------ -----
-----
Dealers -- Title I............................ 23,957,829 27.3 45,188,721 32.4
----- ------ -----
-----
Total principal amount of loans
originated.......................... $87,750,509 100.0% $139,367,026 100.0%
===== =========== =====
NUMBER OF LOANS ORIGINATED:
Correspondents:
Title I.................................... 3,437 59.1% 4,382 50.9%
Conventional............................... -- -- 392 4.6
----- ------ -----
-----
Total Correspondents.................. 3,437 59.1 4,774 55.5
----- ------ -----
-----
Dealers -- Title I............................ 2,381 40.9 3,836 44.5
----- ------ -----
-----
Total number of loans originated...... 5,818 100.0% 8,610 100.0%
===== =========== =====
</TABLE>
See Notes 2 and 5 of Notes to Financial Statements.
Total revenues increased 73.6% to $23.6 million for fiscal 1996 from $13.6
million for fiscal 1995. The increase was primarily the result of the increased
volume of loans originated and the sale of such loans. The following table sets
forth the principal balance of loans sold or securitized and related gain on
sale of data for fiscal 1995 and 1996.
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
AUGUST 31,
--------------------
1995 1996
------- --------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
PRINCIPAL AMOUNT OF LOANS SOLD:
Title I............................................................... $85,363 $127,414
Conventional.......................................................... -- 10,494
--------
Total......................................................... $85,363 $137,908
========
Gain on sale of loans................................................... $12,233 $ 16,539
Net unrealized gain on mortgage related securities...................... -- 2,697
--------
Gain on sale of loans and unrealized gain on mortgage related
securities............................................................ $12,233 $ 19,236
========
Gain on sale of loans as a percentage of principal balance of loans
sold.................................................................. 14.3% 12.0%
========
Gain on sale of loans and unrealized gain on mortgage related securities
as a percentage of principal balance of loans sold.................... 14.3% 13.9%
========
</TABLE>
See Note 2 of Notes to Financial Statements.
Loan servicing income, net increased 283.5% to $3.3 million for fiscal 1996
from $873,000 for fiscal 1995. The increase was primarily the result of a 61.6%
increase in the amount of loan sale activity in fiscal 1996 with the servicing
rights retained by the Company, to $137.9 million for fiscal 1996 from $85.4
million for fiscal 1995.
Interest income on loans held for sale and mortgage related securities, net
of interest expense, increased 108.9% to $988,000 during fiscal 1996 from
$473,000 during fiscal 1995. The increase was primarily the result
28
<PAGE> 30
of the increase in the average size of the portfolio of loans held for sale, and
the increased mortgage related securities portfolio.
The Company intends to consider strategies to mitigate the interest rate
risks associated with the loan origination/warehousing function, funding its
portfolio of mortgage related securities, mortgage servicing rights, and
valuation of these assets. Implementation of interest rate risk management
strategies may decrease spreads, decrease gains on sale of loans, or otherwise
decrease revenues from those which might otherwise occur in a stable interest
rate environment without such strategies in place. The Company intends to
thoroughly analyze the cost of such strategies compared to the risks which would
be mitigated prior to implementation of any strategy.
The net provision for credit losses decreased 93.6% to $55,000 for fiscal
1996 from $864,000 for fiscal 1995 due to the increased level of loans
securitized and sold in fiscal 1996 compared to fiscal 1995. No allowance for
credit losses on loans sold with recourse is established on loans sold through
securitizations, as the Company has no recourse obligation under those
securitization agreements for credit losses and estimated credit losses on loans
sold through securitizations are considered in the Company's valuation of its
residual interest securities. The provision for credit losses is based upon
periodic analysis of the portfolio, economic conditions and trends, historical
credit loss experience, borrowers' ability to repay, collateral values, and
estimated FHA insurance recoveries on loans originated and sold. Servicing costs
on a per loan basis may increase as problem Conventional Loans may require
greater costs to service. See Notes 2 and 5 of Notes to Financial Statements.
Total general and administrative expenses increased 90.2% to $11.8 million
for fiscal 1996 from $6.2 million for fiscal 1995. The increase was primarily a
result of increased payroll related to the hiring of additional underwriting,
loan processing, administrative, loan quality control and other personnel in
contemplation of the expansion of the Company's business and costs related to
the opening of additional offices.
Payroll and benefits expense increased 39.3% to $5.0 million for fiscal
1996 from $3.6 million for fiscal 1995. The number of employees increased from
105 as of fiscal year end 1995 to 170 as of fiscal year end 1996, due to
increased staff necessary to support the business expansion and improve quality
control.
Commissions and selling expenses increased 264.7% to $2.0 million for
fiscal 1996 from $552,000 for fiscal 1995 while loan originations increased by
$51.6 million from fiscal 1995 to 1996. The sales network expanded to
substantially all states, adding new personnel and offices to further the loan
origination growth strategy.
Credit reports expense increased 175.9% to $367,000 during fiscal 1996 from
$133,000 during fiscal 1995 due to an increase in loan origination volume to
$139.4 million during fiscal 1996 from $87.8 million during fiscal 1995.
Professional services increased 313.6% to $732,000 for fiscal 1996 from
$177,000 for fiscal 1995 due primarily to increased audit and legal services and
consultation fees.
Servicing fees paid to affiliate increased 205.6% to $709,000 for fiscal
1996 from $232,000 for fiscal 1995. The increase was a result of the increase in
the size of the loan portfolio serviced by PEC.
Management services by affiliate decreased 2.8% to $671,000 for fiscal 1996
from $690,000 for fiscal 1995. These expenses represent services provided by
PEC, including executive, accounting, legal, management information, data
processing, human resources, advertising and promotional materials.
During fiscal 1995 and 1996, the Company incurred interest expense to PEC
of $85,000 and $29,000, respectively, which amounts were included in other
interest expense. During fiscal 1995 and 1996, the Company paid PEC for
developing certain computer programming, incurring costs of $36,000 and $56,000,
respectively. See Note 16 of Notes to Financial Statements.
FHA insurance increased 147.6% to $572,000 for fiscal 1996 from $231,000
for fiscal 1995. The increase was primarily attributable to the increased volume
of loan originations and loans serviced.
29
<PAGE> 31
Other general and administrative expenses increased 313.3% to $1.4 million
for fiscal 1996 from $331,000 for fiscal 1995 primarily due to increased
expenses related to expansion of facilities and increased communications
expense. The Company is continually enhancing its loan production systems to
provide for the automation of the loan origination process. See "Item 1.
Business -- Loan Production Technology Systems."
Income before income taxes increased 88.5% to $11.2 million for fiscal 1996
from $5.9 million for fiscal 1995; therefore, the provision for income taxes
increased to $4.2 million for fiscal 1996 compared to $2.3 million for fiscal
1995.
As a result of the foregoing, net income increased 90.0% to $6.9 million
for fiscal 1996 from $3.6 million for fiscal 1995.
FINANCIAL CONDITION
AUGUST 31, 1997 COMPARED TO AUGUST 31, 1996
Cash and cash equivalents increased to $6.1 million at August 31, 1997 from
$443,000 at August 31, 1996, primarily as a result of the use of the proceeds
from the Company's Common Stock and debt offerings in November 1996, and other
borrowing proceeds, to acquire short term investments after repayment of debt.
Restricted cash deposits increased 54.0% to $6.9 million at August 31, 1997
from $4.5 million at August 31, 1996, primarily due to an increase in the
aggregate amount of loans securitized.
Loans held for sale, net, increased 106.6% to $9.5 million at August 31,
1997 from $4.6 million at August 31, 1996, primarily as a result of the
Company's increased loan originations and the timing of loan sales. See Notes 2
and 5 of Notes to Financial Statements.
The Company provides an allowance for credit losses, in an amount which, in
the Company's judgment, will be adequate to absorb losses on loans, after FHA
insurance recoveries on the Title I Loans, that may become uncollectible. The
Company's judgment in determining the adequacy of this allowance is based on its
continual review of its portfolio which utilizes historical experience and
current economic factors. These reviews take into consideration changes in the
nature and level of the portfolio, historical rates, collateral values, and
current and future economic conditions which may affect the obligors' ability to
pay, collateral values and overall portfolio quality. Changes in the allowance
for credit losses and the allowance for credit losses on loans sold with
recourse for the fiscal year ended August 31, 1997 consist of the following
(thousands of dollars):
<TABLE>
<S> <C>
Balance at August 31, 1996...................................... $ 1,015
Provision for credit losses................................... 23,048
Reductions to the provision due to securitizations or loans
sold without recourse...................................... (16,748)
Reductions due to charges to allowance for credit losses...... (201)
--------
Balance at August 31, 1997...................................... $ 7,114
========
</TABLE>
The allowance for credit losses and the allowance for credit losses on
loans sold with recourse consist of the following at these dates:
<TABLE>
<CAPTION>
AUGUST 31,
-------------------
1996 1997
------ ------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Allowance for credit losses............................ $ 95 $ 100
Allowance for credit losses on loans sold with
recourse............................................. 920 7,014
------ ------
Total........................................ $1,015 $7,114
====== ======
</TABLE>
See Notes 2 and 5 of Notes to Financial Statements.
Excess servicing rights decreased to $0 at August 31, 1997 from $12.1
million at August 31, 1996 due to the implementation of SFAS 125, which requires
the reclassification of excess servicing rights as mortgage
30
<PAGE> 32
related securities which are carried at fair market value. The excess cash flow
created through securitizations which had been recognized as excess servicing
rights on loans repurchased and securitized is included in the cost basis of the
mortgage related securities. Mortgage related securities were $106.3 million at
August 31, 1997 and $22.9 million at August 31, 1996. The increase was due to
the increased value of loans originated and securitized and the reclassification
of excess servicing rights. See Notes 2, 6 and 7 of Notes to Financial
Statements.
Mortgage servicing rights increased 148.4% to $9.5 million at August 31,
1997 from $3.8 million at August 31, 1996 as a result of increased loan
originations with subsequent loan sales with servicing retained to $462.4
million during fiscal 1997 from $137.9 million during fiscal 1996. See Notes 2
and 8 of Notes to Financial Statements.
Property and equipment, net, increased 148.9% to $2.2 million at August 31,
1997 from $865,000 at August 31, 1996 due to increased purchases of office
equipment related to facility expansion. See Notes 2 and 9 of Notes to Financial
Statements.
Other receivables increased to $7.9 million at August 31, 1997 from $59,000
at August 31, 1996, primarily as a result of a $7.6 million receivable from a
financial institution related to a whole loan sale on August 29, 1997. The funds
from the sale transaction were received in September 1997.
Prepaid debt expenses increased 993.5% to $2.4 million at August 31, 1997
from $216,000 at August 31, 1996 primarily due to debt expense related to the
$40.0 million of subordinated debt issued in November 1996. See Note 13 of Notes
to Financial Statements.
Prepaid commitment fee increased to $2.3 million at August 31, 1997 from $0
at August 31, 1996 due to the commitment fee related to the value of warrants
issued in conjunction with a loan purchase agreement for up to $2.0 billion of
loans with a financial institution. The commitment fee is being amortized as the
commitment for the purchase of loans is being utilized. See Note 3 of Notes to
Financial Statements.
Notes and contracts payable increased 150.6% to $35.6 million at August 31,
1997 from $14.2 million at August 31, 1996 due to increased borrowings by the
Company to fund loan originations as a result of the overall growth in the
Company's business. See Note 11 of Notes to Financial Statements.
Accounts payable and accrued liabilities increased 90.8% to $7.8 million at
August 31, 1997 from $4.1 million at August 31, 1996 primarily as a result of
the increased amounts due to investors on sold loans and the timing of accruals
and payments.
Allowance for credit losses on loans sold with recourse increased 662.4% to
$7.0 million at August 31, 1997 from $920,000 at August 31, 1996 primarily due
to increased loan sales. Recourse to the Company on sales of loans is governed
by the agreements between the purchasers and the Company. The allowance for
credit losses on loans sold with recourse represents the Company's estimate of
its probable future credit losses to be incurred over the lives of the loans
considering estimated future FHA insurance recoveries on Title I Loans. No
allowance for credit losses on loans sold with recourse is established on loans
sold through securitizations, as the Company has no recourse obligation under
those securitization agreements for credit losses and estimated credit losses on
loans sold through securitizations are considered in the Company's valuation of
its residual interest securities. See Notes 2 and 5 of Notes to Financial
Statements.
Stockholders' equity increased 200.0% to $53.1 million at August 31, 1997
from $17.7 million at August 31, 1996 as a result of the IPO and net income of
$14.7 million during fiscal 1997. See Notes 1, 2, 13 and 14 of Notes to
Financial Statements.
AUGUST 31, 1996 COMPARED TO AUGUST 31, 1995
Cash decreased 41.1% to $443,000 at August 31, 1996 from $752,000 at August
31, 1995 primarily as a result of the timing of loan originations, sales, and
borrowings.
Restricted cash deposits increased 76.7% to $4.5 million at August 31, 1996
from $2.5 million at August 31, 1995 due to increased volume of loans serviced
for others pursuant to agreements which restrict a
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small percentage of cash relative to the volume of loans serviced, as well as
loan payments collected from borrowers.
Loans held for sale, net increased 25.4% to $4.6 million at August 31, 1996
from $3.7 million at August 31, 1995 primarily as a result of increased loan
originations from $87.8 million for fiscal 1995 to $139.4 million for fiscal
1996, and the timing of loan sales. See Notes 2 and 5 of Notes to Financial
Statements.
Excess servicing rights decreased 16.3% to $12.1 million at August 31, 1996
from $14.5 million at August 31, 1995. Excess servicing rights are calculated
using prepayment, default and interest rate assumptions that the Company
believes market participants would use for similar rights. The Company believes
that the excess servicing rights recognized at the time of sale do not exceed
the amount that would be received if such rights were sold at fair market value
in the marketplace. The decrease in excess servicing rights was primarily a
result of loans sold with excess servicing rights recognized which were
reacquired and included in the fiscal 1996 securitizations as well as normal
amortization of such excess servicing rights. The excess cash flow created
through securitization which had been recognized as excess servicing rights on
loans reacquired and securitized are included in the cost basis of the mortgage
related securities. See Notes 2, 6 and 7 of Notes to Financial Statements.
Mortgage related securities were $22.9 million at August 31, 1996 as a
result of the Company's securitization transactions during fiscal 1996. There
was no corresponding asset at August 31, 1995. See Notes 2, 6 and 7 of Notes to
Financial Statements.
Mortgage servicing rights increased 255.7% to $3.8 million at August 31,
1996 from $1.1 million at August 31, 1995 as a result of additional loan
originations and the resulting increase in sales of loans with servicing
retained from $85.4 million during fiscal 1995 to $137.9 million during fiscal
1996. See Notes 2 and 8 of Notes to Financial Statements.
Property and equipment, net, increased 101.6% to $865,000 at August 31,
1996 from $429,000 at August 31, 1995 due to increased purchases of office
equipment related to facility expansion. See Notes 2 and 9 of Notes to Financial
Statements.
Notes and contracts payable increased 873.7% to $14.2 million at August 31,
1996 from $1.5 million at August 31, 1995 due to increased levels of mortgage
servicing rights and mortgage related securities created through loan
securitizations which were available for financing to meet the Company's cash
requirements. The Company had a $10.0 million revolving facility for the
financing of mortgage related securities. See Note 11 of Notes to Financial
Statements.
Accounts payable and accrued liabilities increased 81.6% to $4.1 million at
August 31, 1996 from $2.2 million at August 31, 1995, primarily as a result of
increases in accrued payroll, interest and other unpaid operational costs.
Allowances for credit losses and for loans sold with recourse increased
slightly by 3.8% to $920,000 at August 31, 1996 from $886,000 at August 31,
1995. Loans sold with recourse which were reacquired and included in the 1996
securitizations decreased the need for this allowance while increased loan sales
increased the allowance requirements. Recourse to the Company on sales of loans
is governed by the agreements between the purchasers and the Company. The
allowance for credit losses on loans sold with recourse represents the Company's
estimate of its probable future credit losses to be incurred over the lives of
the loans considering estimated future FHA insurance recoveries on Title I
Loans. No allowance for credit losses on loans sold with recourse is established
on loans sold through securitizations, as the Company has no recourse obligation
under those securitization agreements. Estimated credit losses on loans sold
through securitizations are considered in the Company's valuation of its
residual interest securities. See Notes 2 and 5 of Notes to Financial
Statements.
Due to Mego Financial increased 41.9% to $12.0 million at August 31, 1996
from $8.5 million at August 31, 1995. The increase was primarily attributable to
the increase in the federal tax provision owed to Mego Financial as a result of
the filing of a consolidated federal tax return.
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Stockholder's equity increased 64.2% to $17.7 million at August 31, 1996
from $10.8 million at August 31, 1995 as a result of net income of $6.9 million
during fiscal 1996. See Notes 1, 2, 13 and 14 of Notes to Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents were $6.1 million at August 31, 1997 compared to
$443,000 at August 31, 1996.
In November 1996, the Company consummated the IPO pursuant to which it
issued 2.3 million shares of Common Stock at $10.00 per share. Concurrently with
the IPO, the Company issued the $40.0 million of Existing Notes in an
underwritten public offering. The Company used approximately $13.9 million of
the aggregate net proceeds from these offerings to repay Intercompany Debt due
to Mego Financial and PEC and approximately $24.3 million to reduce the amounts
outstanding under the Company's lines of credit. The balance of the net proceeds
has been used to originate loans. In October 1997, the Company consummated the
Private Placement pursuant to which it issued $40.0 million of Additional Notes,
which increased the aggregate principal amount of the outstanding Notes from
$40.0 million to $80.0 million. The Company used approximately $3.9 million of
the net proceeds from the Private Placement to repay Intercompany Debt due to
Mego Financial and approximately $29.0 million to reduce the amounts outstanding
under the Company's lines of credit. The balance of the net proceeds has been
and will be used to originate loans. Prior to the Private Placement, the Company
obtained consents pursuant to the Consent Solicitation to amendments to the
Original Indenture, which among other things permitted the issuance of the
Additional Notes, modified certain covenants applicable to the Company and will
permit the issuance of an additional $70.0 million principal amount of the
Notes. In connection with the Consent Solicitation, the Company made consent
payments of $10.00 cash per $1,000 principal amount of Existing Notes to holders
thereof who properly furnished their consents to the amendments to the Original
Indenture.
The Company's cash requirements arise from loan originations, payments of
operating and interest expenses, overcollateralization requirements related to
securitization transactions and deposits to reserve accounts related to loan
sale transactions. Loan originations are initially funded principally through
the Company's $65.0 million warehouse line of credit pending the sale of loans
in the secondary market. Substantially all of the loans originated by the
Company are sold. Loans under the warehouse line of credit are repaid primarily
from the proceeds from the sale of loans in the secondary market. These proceeds
totaled approximately $85.0 million, $135.5 million and $522.0 million for the
fiscal years ended August 31, 1995, 1996 and 1997, respectively.
The Company has operated since March 1994, and expects to continue to
operate for the foreseeable future, on a negative cash flow basis. In connection
with securitizations and certain whole loan sales, the Company recognizes a gain
on sale of the loans upon the closing of the transaction and the delivery of the
loans, but does not receive the cash representing such gain until it receives
the excess servicing spread, which is payable over the actual life of the loans
sold. The Company is subject to overcollateralization requirements and incurs
significant expenses in connection with securitizations and incurs tax
liabilities as a result of the gain on sale.
The pooling and servicing agreements and sale and servicing agreements
relating to the Company's securitizations require the Company to build
over-collateralization levels through retention within each securitization trust
of excess servicing distributions and application thereof to reduce the
principal balances of the senior interests issued by the related trust or cover
interest shortfalls. This retention causes the aggregate unpaid principal amount
of the loans in the related pool to exceed the aggregate principal balance of
the outstanding investor securities. Such overcollateralization amounts serve as
credit enhancement for the related trust and therefore are available to absorb
losses realized on loans held by such trust. The Company continues to be subject
to the risks of default and foreclosure following the sale of loans through
securitizations to the extent excess servicing distributions are required to be
retained or applied to reduce principal or cover interest shortfalls from time
to time. Such retained amounts are predetermined by the entity issuing any
guarantee of the related interests as a condition to obtaining insurance or by
the rating agencies as a condition to obtaining
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their applicable rating thereon. In addition, such retention delays cash
distributions that otherwise would flow to the Company through its retained
interest, thereby adversely affecting the flow of cash to the Company.
Certain whole loan sale transactions require the subordination of certain
cash flows payable to the Company to the payment of scheduled principal and
interest due to the loan purchasers. In connection with certain of such sale
transactions, a portion of amounts payable to the Company from the excess
interest spread is required to be maintained in a reserve account to the extent
of the subordination requirements. The subordination requirements generally
provide that the excess interest spread is payable to the reserve account until
a specified percentage of the principal balances of the sold loans is
accumulated therein. Excess interest spread payable to the Company is subject to
being utilized first to replenish cash paid from the reserve account to fund
shortfalls in collections of interest from borrowers who default on the payments
on the loans until the Company's deposits into the reserve account equal the
specified percentage. The excess interest required to be deposited and
maintained in the respective reserve accounts is not available to support the
cash flow requirements of the Company. At August 31, 1997, amounts on deposit in
such reserve accounts totaled $6.9 million.
Adequate credit facilities and other sources of funding, including the
ability of the Company to sell loans in the secondary market, are essential for
the continuation of the Company's loan origination operations. Loan originations
are initially funded principally through the Company's $65.0 million warehouse
line of credit that was executed in June 1997, which replaced a previous $20.0
million warehouse line of credit. See Note 11 of Notes to Financial Statements.
At August 31, 1997, $8.5 million was outstanding under this warehouse line. In
excess of 98.5% of the aggregate loans originated by the Company through August
31, 1997 had been sold.
The $65.0 million warehouse line of credit, which is secured by loans prior
to sale, became effective in June 1997 and was increased from $40.0 million to
$55.0 million in September 1997 and to $65.0 million in October 1997. The
Company has the option of borrowing funds under the $65.0 million warehouse line
of credit, subject to certain conditions, at an annual rate equal to (i) the
higher of the corporate base rate of interest announced by The First National
Bank of Chicago from time to time or the weighted-average of rates on overnight
federal funds transactions, as published by the Federal Reserve Bank of New
York, plus 0.5%, (ii) the Federal Funds Funding Rate plus 1.75% or (iii) the
Eurodollar Base Rate. All of the Company's funding under the warehouse line of
credit currently bears interest at an annual rate equal to the Federal Funds
Funding Rate plus 1.75%, and expires June 26, 1998. The warehouse line of credit
may be increased to $90.0 million under certain circumstances if additional
lender commitments are made. The agreement requires the Company to maintain
minimum adjusted tangible net worth (defined as net worth less intangibles plus
subordinated debt) of $65.0 million plus 50% of the Company's cumulative net
income since November 30, 1996, plus all net proceeds received by the Company
through the sale or issuance of stock or additional subordinated notes. At
August 31, 1997, the Company's actual adjusted tangible net worth calculated
pursuant to the agreement was $88.1 million, and the required minimum adjusted
tangible net worth at that date was $71.1 million. Additionally, the following
material covenant restrictions exist: i) the ratio of total liabilities (not
including subordinated notes) divided by tangible net worth (including
subordinated notes) cannot exceed 3:1, and ii) total liabilities must be less
than the aggregate of 100% of cash plus 93% of loans held for sale plus 55% of
restricted cash and mortgage related securities. At August 31, 1997, the ratio
of total liabilities to tangible net worth was 0.69:1 and total liabilities were
$61.1 million, which was $16.1 million under the maximum amount allowed. See
Note 11 of Notes to Financial Statements.
In September 1996, the Company entered into a repurchase agreement with
another financial institution pursuant to which the Company pledged the interest
only certificates from its two 1996 securitizations in exchange for a $3.0
million advance. In April 1997, the Company entered into a pledge and security
agreement with the same financial institution providing for a revolving credit
facility of up to $11.0 million less any amounts outstanding under the
repurchase agreement. The amount available for borrowing under the facility was
increased to $15.0 million in June 1997 and $25.0 million in July 1997, with
respect to which $25.0 million was outstanding at August 31, 1997. This facility
is secured by a pledge of certain of the Company's interest only and residual
class certificates relating to securitizations carried as mortgage related
securities on the Company's Statements of Financial Condition, payable to the
Company pursuant to its securitization agreements. A portion of the loans under
the agreement bears interest at the one-month London
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Interbank Offering Rate ("LIBOR") + 3.5%, expires one year from the initial
advance, and requires the Company to maintain a minimum net worth of the greater
of $35.0 million, or following fiscal year end 1997, 80% of net worth as of
August 31, 1997. The portion of the credit line agreement applicable to a
repurchase agreement secured by insured interest only certificates bears
interest at one-month LIBOR + 2.0%. At August 31, 1997, the required net worth
was $35.0 million and the Company's actual net worth was $53.1 million.
Additionally, the agreement requires the Company to maintain a debt-to-net-worth
ratio not to exceed 2.5:1. At August 31, 1997, the ratio was 1.74:1.
On September 10, 1997, the Company signed a commitment letter for a
revolving credit facility with a financial institution pursuant to which the
Company would receive an initial advance of up to $5.0 million secured by
certain residual interest and interest only securities at an annual interest
rate of the higher of (i) the prime rate as established by The Chase Manhattan
Bank, N.A., plus 2.5% or (ii) 9.0%. This credit facility could be increased to
an aggregate principal amount of up to $8.8 million with additional lender
participations. There can be no assurance that the Company will obtain such
credit facility.
Certain material covenant restrictions exist in the Indenture governing the
Notes. These covenants include limitations on the Company's ability to incur
indebtedness, grant liens on its assets and to enter into extraordinary
corporate transactions. The Company may not incur indebtedness if, on the date
of such incurrence and after giving thereto, the Consolidated Leverage Ratio (as
defined below) would exceed 2:1, subject to certain exceptions. At August 31,
1997, the Consolidated Leverage Ratio was 1.65:1. The Consolidated Leverage
Ratio is the ratio of (i) total debt, including subordinated debt, but excluding
the Permitted Warehouse Indebtedness (as defined below), accounts payable
outstanding less than 60 days, and the tax sharing payable to Mego Financial by
the Company, to (ii) the consolidated net worth of the Company. The Permitted
Warehouse Indebtedness generally is the outstanding amount under the warehouse
line of credit agreement. At August 31, 1997, the Original Indenture provided
that the Permitted Warehouse Indebtedness could not exceed three times the
Company's consolidated tangible net worth. In addition, an increasing amount of
the Company's mortgage related securities are required to remain unpledged. At
August 31, 1997, that requirement was $39.9 million, and at that date $60.9
million of mortgage related securities were pledged and $45.4 million of
mortgage related securities were unpledged.
In addition, the Indenture Amendments provide, among other things, that the
Company may not incur Unsecured Senior Indebtedness (as defined in the
Indenture), if the Adjusted Consolidated Leverage Ratio (as defined below), on
the date of such incurrence after giving effect thereto, exceeds 1:1. The
Adjusted Consolidated Leverage Ratio is the ratio of (i) the amount of all
Unsecured Senior Indebtedness to (ii) the sum of (A) Consolidated Adjusted Net
Income (net income minus gain on sale of loans and net unrealized gain on
mortgage related securities plus provision for credit losses, depreciation and
amortization and amortization of excess servicing rights) from September 1, 1997
to the end of the most recent fiscal quarter and (B) the aggregate net proceeds
received by the Company from the issuance or sale of stock or debt securities
converted to stock, after September 1, 1997. Furthermore, the Indenture
Amendments imposed a limit on the amount of mortgage related securities that
must remain unpledged and removed the limitation on the amount of Permitted
Warehouse Indebtedness.
While the Company believes that it will be able to maintain its existing
credit facilities and obtain replacement financing as its credit arrangements
mature and additional financing, if necessary, there can be no assurance that
such financing will be available on favorable terms, or at all. The lack of
adequate capital may result in the curtailment of loan originations and thereby
impair the Company's revenue and income stream. At August 31, 1997, no
commitments existed for material capital expenditures.
In furtherance of the Company's strategy to sell loans through
securitizations, in March 1996, August 1996, December 1996, March 1997, May
1997, June 1997 and August 1997, the Company completed its first seven
securitizations pursuant to which it sold pools of loans of $84.2 million, $48.8
million, $67.3 million, $89.7 million, $63.5 million, $104.6 million and $73.3
million, respectively. The Company previously reacquired $77.7 million, $36.2
million, $67.3 million, $89.7 million, $63.5 million, $104.6 million and $73.3
million of such loans, respectively. Pursuant to these securitizations,
pass-through securities evidencing interests in the pools of loans were sold in
public offerings. The Company continues to service the
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sold loans and is entitled to receive from payments in respect of interest on
the sold loans, not in default, a servicing fee equal to 1.25% of the balance of
each loan with respect to the March 1996 transaction and 1.0% with respect to
the other transactions. In addition, from each securitization, the Company has
received residual interest securities, contractual rights, and in some of the
transactions, also received interest only strip securities, all of which were
recorded as mortgage related securities on the Statements of Financial
Condition. The residual interest securities and the contractual rights represent
the excess differential (after payment of any servicing, interest and other
fees, and the contractual obligations payable to the note and certificate
holders) between the interest paid by the obligors of the sold loans and the
yield on the sold notes, certificates, and interest only strip securities. Also,
from the two securitizations completed during fiscal 1996 and the first two
securitizations completed in fiscal 1997, the Company has also received interest
only strip securities. These interest only securities yield annual rates between
0.45% and 1.00% calculated on the principal balance of the loans not in default.
The Company may be required to repurchase loans that do not conform to the
representations and warranties made by the Company in the securitization
agreements and, as servicer, may be required to advance interest in connection
with the securitizations.
The values of and markets for the sale of the Company's loans are dependent
upon a number of factors, including general economic conditions, interest rates
and government regulations. Adverse changes in those factors may affect the
Company's ability to originate or sell loans in the secondary market for
acceptable prices within reasonable time frames. The ability of the Company to
sell loans in the secondary market is essential for continuation of the
Company's loan origination activities. A reduction in the size of the secondary
market for home improvement or debt consolidation loans would adversely affect
the Company's ability to sell its loans in the secondary market with a
consequent adverse impact on the Company's profitability and future
originations.
Securitization transactions may be affected by a number of factors, some of
which are beyond the Company's control, including, among other things,
conditions in the securities markets in general, conditions in the asset-backed
securitization market, the conformity of loan pools to rating agency
requirements and, to the extent that monoline insurance is used, the
requirements of such insurers. Adverse changes in the securitization market
could impair the Company's ability to originate and sell loans through
securitizations on a favorable or timely basis. Any such impairment could have a
material adverse effect upon the Company's results of operations and financial
condition. Furthermore, the Company's quarterly operating results can fluctuate
significantly as a result of the timing and level of securitizations.
In April 1995, the Company entered into a continuing agreement with a
financial institution pursuant to which an aggregate of approximately $694.7
million in principal amount of loans had been sold at August 31, 1997 for an
amount approximately equal to their remaining principal balances. Pursuant to
the agreement, the purchaser is entitled to receive interest at a variable rate
equal to the sum of 200 basis points and the one-month LIBOR rate as in effect
from time to time. The Company retained the right to service the loans and the
right to receive the excess interest. The Company is required to maintain a
reserve account equal to 25% of the principal amount of Title I Loans which are
more than 60 days delinquent plus 100% of the principal amount of Conventional
Loans which are more than 60 days delinquent. In the first quarter of fiscal
1997, the Company entered into an agreement with the same financial institution,
providing for the purchase of up to $2.0 billion of loans over a five-year
period. Pursuant to the agreement, Mego Financial issued to the financial
institution four-year warrants to purchase 1 million shares of Mego Financial's
common stock at an exercise price of $7.125 per share. The agreement also
provides that so long as the aggregate principal balance of loans purchased by
the financial institution and not resold to third parties exceeds $100.0 million
($150.0 million through September 30, 1997), the financial institution shall not
be obligated to purchase, and the Company shall not be obligated to sell, loans
under the agreement. The value of the warrants, estimated at $3.0 million (0.15%
of the commitment amount) as of the commitment date, is being amortized as the
commitment for the purchase of loans is utilized. The Company has agreed to pay
to Mego Financial the value of the warrants as described under "Item 13. Certain
Relationships and Related Transactions."
In May 1995 and June 1995, the Company reacquired from the same institution
an aggregate of approximately $25.0 million of Title I Loans for an amount equal
to their remaining principal balance, which were sold in May and June 1995 to a
financial institution for an amount equal to their remaining principal
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balance. Pursuant to the sale agreement, the purchaser is entitled to receive
interest at a rate equal to the sum of 190 basis points and the yield paid on
four-year Federal Government Treasury obligations at the time of the sale. The
Company retained the right to service the loans and the right to receive the
excess interest. The agreement requires the Company to maintain a reserve
account equal to 1.0% of the declining principal balance of the loans sold
pursuant to the agreement funded from the excess interest received by the
Company less its servicing fee to fund shortfalls in collections from borrowers
who default in the payment of principal or interest.
Net cash used in the Company's operating activities for the fiscal year
ended August 31, 1995, 1996 and 1997 was $11.8 million, $15.3 million and $70.4
million, respectively. During the fiscal year ended August 31, 1995, 1996 and
1997, cash provided by financing activities amounted to $12.0 million, $15.6
million and $77.7 million, respectively.
Prior to the consummation of the Company's IPO in November 1996, the
Company was dependent on Mego Financial to provide, among other things, (i)
funds for operations without interest and (ii) guarantees of the Company's
financing arrangements. Subsequent to the IPO, Mego Financial has advanced funds
to the Company to pay servicing fees owed to PEC and amounts due others.
Although it may do so, it is not anticipated that Mego Financial will advance
funds to the Company or guarantee the Company's financing arrangements in the
future.
The Company believes that, based upon current levels of loan originations
and loan sales, funds from operations and financing activities, borrowings under
its existing credit facilities and the net proceeds from the Private Placement
will be sufficient to satisfy its contemplated cash requirements for
approximately the next 12 months. Management anticipates that in the future the
Company may determine to raise funds through additional public or private
offerings of its debt or equity securities.
POSSIBLE TERMINATION OF SERVICING RIGHTS
As described in Note 8 of Notes to Financial Statements, the pooling and
servicing agreements and sale and servicing agreements relating to the Company's
securitization transactions contain provisions with respect to the maximum
permitted loan delinquency rates and loan default rates, which, if exceeded,
would allow the termination of the Company's right to service the related loans.
At August 31, 1997, the rolling three-month average annual default rates on the
pools of loans sold in the March 1996 and August 1996 securitization
transactions exceeded 6.5%, the permitted limit set forth in the related pooling
and servicing agreements. Accordingly, this condition could result in the
termination of the Company's servicing rights with respect to the pools of loans
by the trustee, the master servicer or the insurance company providing credit
enhancement for those transactions. Although the insurance company has indicated
that it has, and to its knowledge, the trustee and the master servicer have, no
present intention to terminate the Company's servicing rights, no assurance can
be given that one or more of such parties will not exercise its right to
terminate. In the event of such termination, there would be an adverse effect on
the valuation of the Company's mortgage servicing rights and the Company's
results of operations in the amount of the affected mortgage servicing rights
($2.4 million before tax at August 31, 1997) on the date of termination. The
Company has taken certain steps designed to reduce the default rates on these
pools of loans as well as its other loans. These steps include the hiring of a
divisional manager in charge of collection of delinquent loans, the hiring of
additional personnel to collect delinquent accounts, the assignment of
additional personnel specifically assigned to the collection of these pools of
loans and the renegotiation of the terms of certain delinquent accounts in these
pools of loans within the guidelines promulgated by HUD.
EFFECTS OF CHANGING PRICES AND INFLATION
The Company's operations are sensitive to increases in interest rates and
to inflation. Increased borrowing costs resulting from increases in interest
rates may not be immediately recoverable from prospective purchasers. The
Company's loans held for sale consist primarily of fixed-rate long term
obligations the interest rates of which do not increase or decrease as a result
of changes in interest rates charged to the Company. In addition, delinquency
and loss exposure may be affected by changes in the national economy. See Note 4
of Notes to Financial Statements.
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RECENT ACCOUNTING PRONOUNCEMENTS
Effective September 1, 1994, the Company adopted SFAS No. 122 "Accounting
for Mortgage Servicing Rights -- an amendment of SFAS No. 65" ("SFAS 122"),
which requires that a mortgage banking enterprise recognize as separate assets
the rights to service mortgage loans for others, regardless of how those
servicing rights are acquired. The effect of adopting SFAS 122 on the Company's
financial statements was to increase income before income taxes by $1.1 million
for the year ended August 31, 1995. The fair value of capitalized mortgage
servicing rights was estimated by taking the present value of expected net cash
flows from mortgage servicing using assumptions the Company believes market
participants would use in their estimates of future servicing income and
expense, including assumptions about prepayment, default and interest rates.
Capitalized mortgage servicing rights are amortized in proportion to and over
the period of estimated net servicing income. The estimate of fair value was
based on a 100 basis points per year servicing fee, reduced by estimated costs
of servicing, and using a discount rate of 12%. The Company has developed its
assumptions based on experience with its own portfolio, available market data
and ongoing consultation with its investment bankers.
The Financial Accounting Standards Board (the "FASB") has issued Statement
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of" ("SFAS 121"). SFAS 121 requires that long-lived assets
and certain identifiable intangibles be reviewed for impairment whenever events
or changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. SFAS 121 was effective for fiscal years beginning after
December 15, 1995. The adoption of SFAS 121 did not have a material adverse
effect on the Company's results of operation or financial condition.
The FASB has issued Statement No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), which establishes financial accounting and reporting
standards for stock-based employee compensation plans and for transactions in
which an entity issues its equity instruments to acquire goods or services from
nonemployees. SFAS 123 is generally effective for fiscal years beginning after
December 15, 1995. However, effective August 20, 1997, the Company converted all
outstanding employee stock options to stock appreciation rights ("SARs") which
resulted in additional compensation expense of $220,000; therefore, disclosure
under SFAS 123 is not applicable. The Company has elected to continue to apply
the provisions of Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees," and will provide pro forma
disclosure for SFAS 123 if applicable. See Note 17 of Notes to Financial
Statements.
SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" was issued by the FASB in June 1996. SFAS 125
provides accounting and reporting standards for transfers and servicing of
financial assets and extinguishments of liabilities. This statement also
provides consistent standards for distinguishing transfers of financial assets
that are sales from transfers that are secured borrowings. It requires that
liabilities and derivatives incurred or obtained by transferors as part of a
transfer of financial assets be initially measured at fair value. SFAS 125 also
requires that servicing assets be measured by allocating the carrying amount
between the assets sold and retained interests based on their relative fair
values at the date of transfer. Additionally, this statement requires that the
servicing assets and liabilities be subsequently measured by (a) amortization in
proportion to and over the period of estimated net servicing income or loss and
(b) assessment for asset impairment or increased obligation based on their fair
values. The statement requires that the Company's excess servicing rights be
measured at fair market value and be reclassified as interest only receivables
and accounted for in accordance with SFAS No. 115 "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115"). As required by the
statement, the Company adopted the new requirements effective January 1, 1997.
Implementation of the statement did not have any material impact on the
financial statements of the Company, as the book value of the Company's excess
servicing rights and mortgage related securities approximated fair value.
SFAS No. 128, "Earnings per Share" ("SFAS 128") was issued by the FASB in
March 1997, effective for financial statements issued after December 15, 1997.
SFAS 128 provides simplified standards for the computation and presentation of
earnings per share ("EPS"), making EPS comparable to international standards.
SFAS 128 requires dual presentation of "Basic" and "Diluted" EPS, by entities
with complex capital structures, replacing "Primary" and "Fully Diluted" EPS
under APB Opinion No. 15.
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<PAGE> 40
Basic EPS excludes dilution from Common Stock equivalents and is computed
by dividing income available to stockholders by the weighted-average number of
shares of Common Stock outstanding for the period. Diluted EPS reflects the
potential dilution from Common Stock equivalents, similar to fully diluted EPS,
but uses only the average stock price during the period as part of the
computation.
SEASONALITY
Home improvement loan volume tracks the seasonality of home improvement
contract work. Volume tends to build during the spring and early summer months,
particularly with regard to pool installations. A decline is typically
experienced in late summer and early fall until temperatures begin to drop. This
change in seasons precipitates the need for new siding, window and insulation
contracts. Peak volume is experienced in November and early December and
declines dramatically from the holiday season through the winter months. Debt
consolidation loan volume is not impacted by seasonal climate changes and, with
the exclusion of the holiday season, tends to be stable throughout the year.
SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
The foregoing Management's Discussion and Analysis of Financial Condition
and Results of Operations and Business sections contain certain forward-looking
statements and information relating to the Company that are based on the beliefs
of management as well as assumptions made by and information currently available
to management. Such forward-looking statements include, without limitation, the
Company's expectation and estimates as to the Company's business operations,
including the introduction of new products and future financial performance,
including growth in revenues and net income and cash flows. In addition,
included herein the words "anticipates," "believes," "estimates," "expects,"
"plans," "intends" and similar expressions, as they relate to the Company or its
management, are intended to identify forward-looking statements. Such statements
reflect the current views of the Company's management, with respect to future
events and are subject to certain risks, uncertainties and assumptions. In
addition, the Company specifically wishes to advise readers that the factors
listed under the caption "Liquidity and Capital Resources" could cause actual
results to differ materially from those expressed in any forward-looking
statement. Should one or more of these risks or uncertainties materialize, or
should underlying assumptions prove incorrect, actual results may vary
materially from those described herein as anticipated, believed, estimated or
expected.
ITEM 8. FINANCIAL STATEMENTS
The following Financial Statements of the Company are included herewith:
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Independent Auditors' Report........................................................... F-2
Statements of Financial Condition at August 31, 1996 and 1997.......................... F-3
Statements of Operations for the years ended August 31, 1995, 1996 and 1997............ F-4
Statements of Cash Flows for the years ended August 31, 1995, 1996 and 1997............ F-5
Statements of Stockholders' Equity for the years ended August 31, 1995, 1996 and
1997................................................................................. F-6
Notes to Financial Statements for the years ended August 31, 1995, 1996 and 1997....... F-7
</TABLE>
All schedules are omitted because of the absence of conditions under which they
are required or because the required information is included in the financial
statements.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
39
<PAGE> 41
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
<TABLE>
<CAPTION>
NAME AGE POSITION
- -------------------------- --- ---------------------------------------------------------
<S> <C> <C>
Jerome J. Cohen 69 Chairman of the Board
Jeffrey S. Moore 39 President, Chief Executive Officer and Director
Executive Vice President, Chief Financial Officer and
James L. Belter 50 Treasurer
Christopher M.G. DeWinter 32 Vice President -- Corporate Development
Robert Nederlander 64 Director
Herbert B. Hirsch 61 Director
Don A. Mayerson 70 Director
Spencer I. Browne 46 Director
Jeremy Wiesen 54 Director
</TABLE>
Jerome J. Cohen has been Chairman of the Board of the Company since April
1995 and served as Chief Executive Officer of the Company from June 1992 until
September 2, 1997. Mr. Cohen has been the President and a Director of Mego
Financial since January 1988. From April 1992 until June 1997, Mr. Cohen was a
Director of Atlantic Gulf Communities Inc., formerly known as General
Development Corporation, a publicly held company engaged in land development,
land sales and utility operations in Florida and Tennessee. Mr. Cohen does not
currently serve on a full time basis in his capacities with the Company.
Jeffrey S. Moore has been the President of the Company since April 1995 and
Chief Executive Officer since September 2, 1997. From December 1993 to September
1997, Mr. Moore served as the Company's Chief Operating Officer. In addition,
Mr. Moore was instrumental in the organization of the Company and has served as
a Director of the Company since its formation in June 1992. Prior to being
elected President, Mr. Moore served as an Executive Vice President of the
Company from June 1992 to March 1995. Mr. Moore was the founder and from August
1984 until March 1992, served as President, Chief Executive Officer and a
director of Empire Funding Corp., a privately-held, nationwide consumer finance
company specializing in originating, purchasing, selling and servicing FHA Title
I and other home improvement mortgage loans. Mr. Moore serves as a director of
the Title One Home Improvement Lenders Association and is a member of its
Legislative and Regulatory Affairs Committee.
James L. Belter has been Executive Vice President of the Company since
April 1995 and Chief Financial Officer and Treasurer since September 1996. Prior
to being elected Executive Vice President, Mr. Belter served as Senior Vice
President of the Company from October 1993 to March 1995. Prior to joining the
Company, from May 1989 to September 1993, Mr. Belter served as the President,
Chief Operating Officer and a director of Del-Val Capital Corporation, a
commercial finance company. From April 1985 to April 1989, Mr. Belter served as
Executive Vice President of Security Capital Credit Corporation, a commercial
finance company, where he was responsible for the formation of the company's
installment receivable lending division. From November 1976 to April 1985, Mr.
Belter served as a corporate Vice President of Barclays Business Credit, Inc.
where he managed a unit specializing in financing portfolios of consumer
contracts including residential second mortgages, home improvement contracts,
timeshare and land sales.
Christopher M.G. DeWinter has been Vice President -- Corporate Development
of the Company since July 1997. Prior to joining the Company, from January 1996
to June 1997 Mr. DeWinter served as a Vice President in the Financial
Institutions Group of Oppenheimer & Co., where he was involved with mergers and
acquisitions and debt and equity offerings. Prior to joining Oppenheimer & Co.,
from July 1994 to December 1995, Mr. DeWinter was with the real estate group of
First Empire State.
Robert Nederlander has been a Director of the Company since September 1996.
Mr. Nederlander has been the Chairman of the Board and Chief Executive Officer
of Mego Financial since January 1988. Mr. Nederlander has been Chairman of the
Board of Riddell Sports Inc. since April 1988 and was Riddell Sports Inc.'s
Chief Executive Officer from April 1988 through March 1993. From February 1992
until
40
<PAGE> 42
June 1992, Mr. Nederlander was also Riddell Sports Inc.'s interim President and
Chief Operating Officer. Since November 1981, Mr. Nederlander has been President
and a director of the Nederlander Organization, Inc., owner and operator of one
of the world's largest chains of legitimate theaters. He served as the Managing
General Partner of the New York Yankees from August 1990 until December 1991,
and has been a limited partner since 1973. Since October 1985, Mr. Nederlander
has been President of the Nederlander Television and Film Productions, Inc.;
Vice Chairman of the Board from February 1988 to early 1993 of Vacation Spa
Resorts, Inc., an affiliate of Mego Financial; and Chairman of the Board of
Allis-Chalmers Corp. from May 1989 to 1993 and from 1993 to 1996 as Vice
Chairman. Mr. Nederlander remains a director of Allis-Chalmers Corp. In 1995,
Mr. Nederlander became a director of Hospitality Franchise Systems Incorporated.
In October 1996, Mr. Nederlander became a director of News Communications, Inc.,
a publisher of community oriented free circulation newspapers. Mr. Nederlander
was a senior partner in the law firm of Nederlander, Dodge and Rollins in
Detroit, Michigan, from 1960 to 1989.
Herbert B. Hirsch has been a Director of the Company since the Company's
formation in June 1992. Mr. Hirsch has been the Senior Vice President, Chief
Financial Officer, Treasurer and a director of Mego Financial since January
1988. Mr. Hirsch served as Vice President and Treasurer of the Company from June
1992 to September 1996.
Don A. Mayerson has been a Director of the Company since the Company's
formation in June 1992. Mr. Mayerson has been the Secretary of Mego Financial
since January 1988 and the Executive Vice President and General Counsel of Mego
Financial since April 1988. Mr. Mayerson served as Vice President, General
Counsel and Secretary of the Company from June 1992 to September 1996.
Spencer I. Browne has been a Director of the Company since consummation of
the IPO in November 1996. For more than five years prior to September 1996, Mr.
Browne held various executive and management positions with several publicly
traded companies engaged in businesses related to the residential and commercial
mortgage loan industry. From August 1988 until September 1996, Mr. Browne served
as President, Chief Executive Officer and a director of Asset Investors
Corporation ("AIC"), a New York Stock Exchange ("NYSE") traded company he
co-founded in 1986. He also served as President, Chief Executive Officer and a
director of Commercial Assets, Inc., an American Stock Exchange traded company
affiliated with AIC, from its formation in October 1993 until September 1996. In
addition, from June 1990 until March 1996, Mr. Browne served as President and a
director of M.D.C. Holdings, Inc., a NYSE traded company and the parent company
of a major home builder in Colorado.
Jeremy Wiesen has been a Director of the Company since consummation of the
IPO in November 1996. Mr. Wiesen has been an Associate Professor of Business Law
and Accounting at the Leonard N. Stern School of Business at New York University
since 1972.
The Company's officers are elected annually by the Board of Directors and
serve at the discretion of the Board of Directors. The Company's directors hold
office until the next annual meeting of stockholders and until their successors
have been duly elected and qualified. The Company reimburses all directors for
their expenses in connection with their activities as directors of the Company.
Directors of the Company who are also employees of the Company do not receive
additional compensation for their services as directors other than the Chairman
who receives an annual fee of $30,000. Members of the Board of Directors of the
Company who are not employees of the Company receive an annual retainer fee of
$30,000 plus $1,500 for chairing a committee or $1,000 for serving as a member
of a committee. In addition, each Board member receives $1,000 for each Board
meeting (but only $500 for a Committee meeting held on the same day as a Board
meeting). Directors are also reimbursed for their expenses incurred in attending
meetings of the Board of Directors and its committees.
In August 1997, the Company entered into Consulting Agreements (the
"Consulting Agreements") with Don A. Mayerson and Herbert B. Hirsch, Directors
of the Company (the "Consultants"), which expire August 31, 1999. Pursuant to
such Consulting Agreements, Messrs. Mayerson and Hirsch shall receive an annual
consulting fee of $250,000 and $150,000, respectively. Each of the Consulting
Agreements further provides that the Company will indemnify and hold the
Consultants harmless, to the extent permitted by law, from any and all costs,
expenses or damages incurred by them as a result of any claim, suit, action or
judgment
41
<PAGE> 43
arising out of their activities as a consultant to the Company. In the event of
a change in control (as defined in the agreements) of the Company during the
term of the Consulting Agreements, the Company may, in its sole discretion, pay
each of the Consultants a lump sum equal to the annual consulting fees such
Consultant would have received through August 31, 1999. The Consulting
Agreements are not contingent upon such persons remaining as directors of the
Company.
Each of the Company's Directors and Messrs. Belter and DeWinter have orally
agreed with the Company to enter into agreements as of August 20, 1997 regarding
each such person's continued service with the Company and retention by the
Company as a consultant thereafter. Each of these agreements has a term
commencing on the termination of such person's existing consulting or employment
agreement or directorship, as the case may be, and terminating on August 31,
2004, unless earlier terminated as a result of death or disability. For the
period of each such person's service as a consultant under these agreements,
such person shall not receive any compensation but shall be deemed to have
continued in the service of the Company for purposes of determining vested
rights under, and the continued exercisability of, any SARs and options granted
by the Company before the execution of such agreements, and in any SARs or
options granted in the future unless otherwise expressly provided in the grants
of such SARs or options.
The Company has an Audit Committee, Executive Committee, Stock Option
Committee, Compensation Committee and Nominating Committee. The following is a
brief description of the Company's committees and identification of the members
thereof:
Audit Committee. The members of the Audit Committee are Robert
Nederlander, Jeremy Wiesen and Spencer I. Browne. The Audit Committee's
functions include recommending to the Board the engagement of the Company's
independent certified public accountants, reviewing with the accountants
the plan and results of their audit of the Company's financial statements
and determining the independence of the accountants.
Executive Committee. The members of the Executive Committee are Jerome
J. Cohen, Jeffrey S. Moore and Robert Nederlander. The Executive Committee
has the authority to exercise all of the powers of the Board to the extent
permitted by the Delaware General Corporation Law.
Stock Option Committee. The members of the Stock Option Committee are
Jeremy Wiesen and Spencer I. Browne. The Stock Option Committee has the
authority to approve the grant of options under the Company's Stock Option
Plan to any employee of the Company who, on the last day of the taxable
year of the Company, is (i) the Chief Executive Officer of the Company or
who is acting in such capacity, (ii) among the four highest compensated
officers of the Company and its affiliates (other than the Chief Executive
Officer), or (iii) otherwise considered to be a "Covered Employee" within
the meaning of Section 162(m) ("Section 162(m)") of the Internal Revenue
Code of 1986, as amended (the "Code").
Compensation Committee. The members of the Compensation Committee are
Robert Nederlander, Jeremy Wiesen and Spencer I. Browne. The Compensation
Committee has the authority to approve the compensation of the Company's
executive officers, except to the extent that such compensation is subject
to Section 162(m) of the Code. The Compensation Committee has a special
subcommittee consisting of Jeremy Wiesen and Spencer I. Browne, which
subcommittee has the authority to approve executive compensation and
agreements that are subject to Section 162(m) of the Code.
Nominating Committee. The members of the Nominating Committee are
Robert Nederlander, Jerome J. Cohen and Don A. Mayerson. The Nominating
Committee has the responsibility to recommend the nominees for election as
directors of the Company to the Board of Directors.
Mego Financial and the Company have restated certain of their previously
issued financial statements, including certain financial statements upon which
their independent auditors had rendered unqualified opinions. As a result of the
restatement of Mego Financial's financial statements and certain trading in Mego
Financial's common stock, the Securities and Exchange Commission (the "SEC") has
commenced a formal investigation to determine, among other things, whether Mego
Financial, and/or its officers and directors, violated applicable federal
securities laws in connection with the preparation and filing of Mego
Financial's previously issued financial statements or such trading. Certain of
such officers and directors are also officers
42
<PAGE> 44
and/or directors of the Company. Messrs. Moore, Belter, DeWinter, Browne and
Wiesen have never been officers or directors of Mego Financial. Possible
penalties for violation of federal securities laws include civil remedies, such
as fines and injunctions, as well as criminal sanctions. There can be no
assurance that Mego Financial and/or its officers and directors will not be
found to have violated the federal securities laws or that the Company will not
be affected by the investigation or any sanction.
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities and Exchange Act of 1934, as amended,
requires the Company's Directors and executive officers, and persons who own
more than ten percent of the Company's outstanding shares of Common Stock to
file with the SEC initial reports of ownership and reports of changes in
ownership of the Common Stock. Such persons are required by SEC regulations to
furnish the Company with copies of all such reports they file.
To the Company's knowledge, based solely on a review of the copies of such
reports furnished to the Company and written representations that no other
reports were required, all Section 16(a) filing requirements applicable to its
officers, Directors and greater than ten percent beneficial owners have been
satisfied.
KEY EMPLOYEES
Robert Bellacosa -- Mr. Bellacosa, age 56, has served as Vice
President -- Financial Management since October 1993 and Secretary since
September 1996. From May 1989 to October 1993, Mr. Bellacosa served as Senior
Vice President of Loan Administration and Financial Management for Del-Val
Capital Corp. From May 1985 to May 1989, he served as Vice President of Security
Capital Credit Corp. where he was responsible for loan administration of
commercial real estate and term receivable lending functions. From 1974 to 1985,
he served as Vice President for Aetna Business Credit, Inc. which was purchased
by Barclays American Business Credit, Inc. and was responsible for the
management of loan administration for special term receivables.
Jack Elrod -- Mr. Elrod, age 40, has served as Vice President -- Loan
Administration since May 1995. From March 1994 to May 1995, Mr. Elrod served as
a Senior Underwriter for ITT Financial Corporation. From March 1993 to March
1994, he served as Branch Manager for Commercial Credit Corporation and from
January 1977 to February 1993, he served as Assistant Vice President and
District Manager of Household Finance Corporation.
Samuel Schultz -- Mr. Schultz, age 47, has served as Vice
President -- Credit Quality since June 1996 and as Vice President of the
Company's Dealer Division Operations from December 1993 until June 1996. Mr.
Schultz was a consultant to the Company from June 1993 until December 1993. From
September 1990 to June 1993, he served as Vice President of Underwriting for
Empire Funding Corp., a nationwide consumer finance company specializing in the
purchase of FHA Title I and other home improvement mortgage loans. From February
1988 to September 1990, he served as a Senior Manager for Avco Financial
Services. From October 1985 to February 1988, he served as a Department Manager
for Associates Financial Services Inc. Prior to 1985, and since 1971, Mr.
Schultz's experience includes collections and originations of consumer finance
loans for Postal Finance, Turner Mortgage and other consumer finance companies.
John Kostelich -- Mr. Kostelich, age 34, has served as Vice
President -- Project Management since June 1996 and is responsible for
developing and implementing the Company's policies and procedures for new and
diversified loan products. In addition, he is responsible for the Correspondent
and Wholesale Operations and Sales Divisions. From June 1995 to June 1996, Mr.
Kostelich served as Director of Compliance for the Company. From 1985 to 1995,
he served in various positions for ITT Consumer Financial Corporation, including
Manager of Quality Control and Correspondent Support Operations, Senior
Compliance Officer, Assistant Vice President and Regional Manager and Branch
Manager.
Debra C. Turner -- Ms. Turner, age 37, has served as Vice
President -- Administration since October 1996 and is responsible for the
management of quality assurance and policy development and acts as liaison to
the President's office. From April 1996 to September 1996, Ms. Turner served as
the Southeast Division Operations Manager for Ameriquest Mortgage Corporation
where she was responsible for assisting in the
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<PAGE> 45
establishment and management of branch offices, training all sales and technical
staff and acting as liaison between branch and corporate offices. From October
1994 to April 1996, Ms. Turner served as Chase Manhattan Mortgage Corporation's
Retail Manager for the State of Georgia where she was responsible for, among
other things, establishing and managing branches throughout the State of
Georgia. From June 1991 to October 1994, she served as a Vice President for
Unity Mortgage Corporation where she was responsible for establishing retail
branches throughout the Southeast region and training all sales and technical
staff. From September 1990 to June 1991, Ms. Turner served as an Operations
Manager for Sears Mortgage Corporation. From April 1984 to September 1990, Ms.
Turner served in various capacities for American Residential Mortgage, a.k.a.
ICA Mortgage Corp., including Vice President -- National Production and
Southeast Division Operations Supervisor.
Robert H. Chastain -- Mr. Chastain, age 38, has served as Vice President --
Corporate Counsel since June 1997. From November 1993 to June 1997, Mr. Chastain
was an attorney with the firm of Aiken & Associates, Atlanta, Georgia. Prior to
joining Aiken & Associates, from March 1990 to November 1993, Mr. Chastain was
an attorney with the firm of Cashin, Morton & Mullins, Atlanta, Georgia. From
February 1984 to September 1988, he served as a law clerk and from October 1988
to March 1990 as an attorney with the firm of McCalla, Raymer, Padrick, Cobb &
Nichols, Atlanta, Georgia. Mr. Chastain's legal experience has focused on, among
other areas, loan workouts and foreclosures, asset securitizations and REMIC
trusts, FHA, FNMA and Federal Home Loan Mortgage Corporation ("FHLMC") loan
servicing, and general corporate and structured business arrangements. Mr.
Chastain has been licensed to practice law in the State of Georgia since 1988
and is a member of the Georgia Bar Association.
Bobbie Jeannotte -- Ms. Jeannotte, age 47, has served as Vice
President -- Human Resources since May 1997. From June 1996 to May 1997, Ms.
Jeannotte served as Vice President -- Human Resources for SunStar Acceptance
Corporation, a division of NationsBank, where she was responsible for
establishing a Human Resources department and overall management of the various
human resources functions. From December 1994 to June 1996, Ms. Jeannotte served
as Senior Vice President -- Human Resources for Fleet Finance, Inc. where she
was responsible for human resources, training and development and administration
services, supervising a staff of 15-20 employees. From June 1984 to June 1994,
Ms. Jeannotte served as the Assistant Vice President -- Human Resources for
Continental Insurance where she was responsible for human resources and training
and development areas along with providing advice and counsel with respect to
various human resource issues.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information concerning the annual and
long-term compensation earned by the Company's chief executive officer and each
of the two other executive officers whose annual salary and bonus during the
fiscal years presented exceeded $100,000 (the "Named Executive Officers").
<TABLE>
<CAPTION>
LONG-TERM
ANNUAL COMPENSATION COMPENSATION AWARDS
---------------------------------------------- -------------------------
OTHER NUMBER OF
FISCAL ANNUAL OPTIONS ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION(1) GRANTED(2) COMPENSATION
- --------------------------------------------- ------ -------- -------- --------------- ---------- ------------
<S> <C> <C> <C> <C> <C> <C>
Jerome J. Cohen(3)........................... 1995 $ 64,388 $ -- $ -- -- $ --
Chairman of the Board 1996 65,748 -- -- -- --
1997 150,000 -- 13,877 100,000 --
Jeffrey S. Moore............................. 1995 $200,003 $ -- $13,963 -- $ --
President, Chief Executive Officer 1996 200,003 86,084 13,625 -- --
and Director 1997 200,002 203,149 30,191 500,000 --
James L. Belter.............................. 1995 $150,003 $ 50,000 $ 1,510 -- $ --
Executive Vice President, Chief 1996 159,080 50,000 4,330 -- --
Financial Officer and Treasurer 1997 180,003 100,000 15,896 100,000 --
</TABLE>
- ---------------
(1) Other annual compensation consists of car allowances, contributions to
401(k) plans and moving expenses.
(2) Except for 100,000 SARs granted to Mr. Moore under the Company's 1997 Stock
Option Plan, which grant was subject to stockholder approval of the 1997
Stock Option Plan, represents SARs which were
44
<PAGE> 46
initially granted as options to purchase Common Stock under the Company's 1996
Stock Option Plan and subsequently converted into SARs in connection with the
Spin-off. In October 1997, the Board of Directors authorized the repurchase by
the Company of all outstanding SARs. See "Company Stock Option Plans" later
in this section.
(3) Mr. Cohen served as the Company's Chief Executive Officer from June 1992
until September 2, 1997. Mr. Cohen's compensation is included in the
management fees paid to PEC. See "Item 13. Certain Relationships and Related
Transactions."
OPTION GRANTS IN LAST FISCAL YEAR
The following table sets forth certain information concerning grants of
stock options or SARs made during the fiscal year ended August 31, 1997 to the
Named Executive Officers.
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE
--------------------------------------------------- VALUE AT ASSUMED
NUMBER OF PERCENT OF ANNUAL RATES OF
SECURITIES TOTAL STOCK PRICE APPRECIATION
UNDERLYING OPTIONS/SARS FOR
OPTIONS/SARS GRANTED TO EXERCISE OPTION TERM
GRANTED EMPLOYEES IN PRICE EXPIRATION --------------------------
NAME (#) FISCAL YEAR ($/SH) DATE 5%($) 10%($)
- -------------------------- ------------ ------------ -------- ---------- ---------- -----------
<S> <C> <C> <C> <C> <C> <C>
Jerome J. Cohen........... 100,000 8.9% $10.00 11/18/06 $ 710,000 $ 1,853,000
Chairman of the
Board
Jeffrey S. Moore.......... 500,000(1) 44.7 (2) (3) 3,834,000(4) 10,007,000(5)
President and
Chief Executive
Officer
James L. Belter........... 100,000 8.9 10.00 11/18/06 710,000 1,853,000
Executive Vice
President, Chief
Financial Officer
and Treasurer
</TABLE>
- ---------------
(1) Represents (i) 400,000 SARs granted under the Company's 1996 Stock Option
Plan and (ii) 100,000 SARs granted under the Company's 1997 Stock Option
Plan, which grant is subject to stockholder approval of the plan.
(2) Of such SARs, (i) 300,000 have an exercise price of $10.00 per share and
(ii) 200,000 have an exercise price of $12.00 per share.
(3) Of such SARs, (i) 300,000 expire on November 18, 2006 and (ii) 200,000
expire on August 19, 2007.
(4) The potential realizable value of the 300,000 SARs granted at an exercise
price of $10.00 per share would be $2,130,000 and the potential realizable
value of the 200,000 SARs granted at $12.00 per share would be $1,704,000
assuming a 5% annual appreciation in value.
(5) The potential realizable value of the 300,000 SARs granted at an exercise
price of $10.00 per share would be $5,559,000 and the potential realizable
value of the 200,000 SARs granted at an exercise price of $12.00 would be
$4,448,000 assuming a 10% annual appreciation in value.
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<PAGE> 47
AGGREGATED FISCAL YEAR-END OPTION/SAR VALUE TABLE
The following table sets forth certain information concerning unexercised
stock options/SARs held by the Named Executive Officers as of August 31, 1997.
No stock options/SARs were exercised by the Named Executive Officers during the
fiscal year ended August 31, 1997. In October 1997, the Board of Directors
authorized the repurchase by the Company of all outstanding SARs. See "Company
Stock Option Plans" later in this section.
<TABLE>
<CAPTION>
VALUE OF UNEXERCISED
NUMBER OF UNEXERCISED IN-THE-MONEY
OPTIONS/SARS HELD AT OPTIONS/SARS HELD AT
AUGUST 31, 1997 AUGUST 31, 1997(1)
----------------------------- -----------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------------------------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Jerome J. Cohen...................... -- 100,000 $-- $ 175,000
Jeffrey S. Moore..................... -- 500,000 -- 525,000(2)
James L. Belter...................... -- 100,000 -- 175,000
</TABLE>
- ---------------
(1) The closing sales price of the Company's Common Stock as reported on the
Nasdaq National Market on August 29, 1997 was $11.75. Value is calculated by
multiplying (a) the difference between $11.75 and each SAR exercise price by
(b) the number of shares of Common Stock underlying the SAR.
(2) Does not include 200,000 SARs granted at an exercise price of $12.00 per
share since such price was above the closing sale price of the Common Stock
on August 29, 1997.
EMPLOYMENT AGREEMENTS
In August 1997, the Company entered into an employment/consulting agreement
with Jerome J. Cohen, the Company's Chairman of the Board of Directors, which
expires in December 2002. During the term of the employment/consulting
agreement, Mr. Cohen shall receive an annual Chairman's fee of at least $30,000.
During the term of such agreement, Mr. Cohen shall also receive (i) an annual
consulting fee in the amount of $120,000 and (ii) an annual incentive bonus
equal to one and one-quarter percent (1.25%) of the Company's pre-Federal tax
(and after state and local tax) income for the prior calendar year; provided
that the incentive bonus payable in March 1998 shall be based solely on the
Company's pretax income for the period commencing September 1, 1997 and ending
December 31, 1997. The incentive bonus and any incentive bonus payments under
the employment/consulting agreement are subject to stockholder approval at such
time or times as required under Section 162(m) of the Code. The
employment/consulting agreement further provides that the Company will indemnify
and hold Mr. Cohen harmless, to the extent permitted by law, to and from any and
all costs, expenses or damages incurred by him as a result of any claim, suit,
action or judgment arising out of his activities as a consultant to the Company.
In the event of a change in control of the Company during the term of the
employment/consulting agreement, the Company may, in its sole discretion, pay
Mr. Cohen a lump sum equal to sum of (i) the annual consulting fees that would
have been received during the remaining term of such agreement and (ii) the
incentive bonuses that would have been received during the remaining term of
such agreement, increased by an assumed compounded growth in such income of 20%
per annum and appropriately discounted to present value.
The Company has entered into an employment agreement with Jeffrey S. Moore
effective as of the consummation of the Spin-off and terminating on December 31,
2000 (the "Initial Term"). Pursuant to the terms of such agreement, the term of
employment shall automatically be extended for additional one (1) year periods
unless the Company or Mr. Moore provides written notice to the other of an
intent to terminate the agreement at least 60 days prior to the expiration of
the calendar year, which termination shall be effective on the second
anniversary of the first day of the calendar year following such notification
(the "Extended Term," and together with the Initial Term shall be referred to as
the "Employment Term"). The agreement provides for an annual base salary of at
least $250,000, which base salary shall be increased during each year of the
Employment Term commencing on or after January 1, 1999, by the greater of (i)
$25,000 or (ii) an adjustment based on an increase in the Consumer Price Index
for All Urban Consumer for Atlanta, Georgia. During the Employment Term,
commencing in March 1998, Mr. Moore shall also be entitled to receive a
46
<PAGE> 48
bonus equal to one and one-quarter percent (1.25%) of the Company's pre-Federal
tax (and after state and local tax) income for the prior calendar year (the
"Incentive Bonus"); provided that the Incentive Bonus payable in March 1998
shall be based solely on the Company's pre-federal tax (and after state and
local tax) income for the period commencing September 1, 1997 and ending
December 31, 1997. The Incentive Bonus and any Incentive Bonus payments under
the agreement will be subject to stockholder approval at such time or times as
required under Section 162(m) of the Code and treasury regulations promulgated
thereunder. Mr. Moore shall also be entitled to receive for each calendar year
during the Employment Term, deferred compensation (the "Deferred Compensation")
in an amount equal to one percent (1.0%) of the amount of "Gain on sale of
loans," including the net gain on the whole loans, and any portion of the net
gain from sales of loans securitized transactions included in net unrealized
gain on mortgage related securities, resulting from the sales of conventional
home improvement loans, debt consolidation loans, Title I Loans and
nonconforming mortgage loans (collectively, the "Loans") and the net gain from
the sale of loans in any other form of transaction not included in the
foregoing; provided that the Deferred Compensation payable beginning March 1,
1998 shall be based solely on the Company's gain on sale of Loans for the period
commencing September 1, 1997 and ending December 31, 1997. The accrual of such
deferred compensation for each year shall be conditioned on the Company
achieving a percentage return on stockholders' equity of at least ten percent
(10%) during such year or an average of ten percent (10%) per year over the
previous two years. The Deferred Compensation due for any year shall be payable
in 24 equal installments commencing on March 1 of the following year. As with
the Incentive Bonus, the Deferred Compensation and Deferred Compensation
payments will be subject to stockholder approval at such time or times as
required under Section 162(m) of the Code and treasury regulations promulgated
thereunder. The agreement provides that the Company use its best efforts to
obtain stockholder approval of the Incentive Bonus and Deferred Compensation
provisions of the agreement at an annual meeting of the Company's stockholders
to occur no later than January 31, 1998. Mr. Moore shall also be entitled to
participate, to the extent eligible, in all benefit plans and programs as are
generally provided from time to time by the Company to its senior executives.
Upon termination for "cause," Mr. Moore shall only be entitled to receive his
base salary through the effective date of such termination. In the event Mr.
Moore's employment is terminated due to a non-extension of the term of the
employment agreement, the Company shall pay Mr. Moore $600,000 in twelve equal
monthly installments. In the event of a change in control as defined in the
employment agreement, the Company (or its successor) shall be required to pay
Mr. Moore $1.0 million within thirty (30) days following such change in control.
In addition, if (i) within sixty (60) days following a change in control Mr.
Moore voluntarily terminates his employment and is no longer employed by the
Company (or its successor) under another employment agreement, the Company shall
pay Mr. Moore (x) 125% of the prior year's or annualized current year's
Incentive Bonus, whichever is higher, if the change in control occurs during the
Initial Term of the Agreement, or (y) 125% of the annualized current year's
Incentive Bonus, if the change in control occurs after the Initial Term of the
Agreement, with either of such payments being payable 50% at termination and the
balance in twelve equal monthly installments, or (ii) within one (1) year
following a change in control the Company (or its successor) terminates the
employment agreement without cause, the Company shall pay Mr. Moore compensation
in aggregate amount no less than one year's base salary, and (x) 250% of the
annualized current year's Incentive Bonus, if the change in control occurs after
the Initial Term of the Agreement, or (y) 125% of the prior year's or annualized
current year's Incentive Bonus, whichever is greater, multiplied by the number
of full calendar years remaining to the end of the Initial Term of the Agreement
plus a fraction the numerator of which is the number of months during any
partial year remaining to the end of the Initial Term and the denominator of
which is twelve or by 2, whichever is greater, if the change of control occurs
during the Initial Term of the Agreement, with either of such payments being
payable 50% within 60 days of termination and the balance in twelve equal
monthly installments. Mr. Moore will be prohibited from competing with the
Company during the Employment Term and for a period of one (1) year following
the termination of his employment.
The Company has entered into employment agreements with James L. Belter,
the Company's Executive Vice President, Chief Financial Officer and Treasurer,
and Christopher M.G. DeWinter, the Company's Vice President -- Corporate
Development. Mr. Belter's employment agreement has an initial term which
commenced on September 1, 1997 and terminates on December 31, 1999 and Mr.
DeWinter's employment agreement has an initial term which commenced on July 1,
1997 and terminates on December 31, 1999.
47
<PAGE> 49
Mr. Belter's and Mr. DeWinter's agreements provide for annual base salaries of
$200,000 and $130,000, respectively. The agreements also provide that such
executives shall be entitled to receive discretionary performance bonuses based
on factors determined by the Company. Notwithstanding the foregoing, Mr. Belter
is guaranteed to receive a bonus of $100,000 for each of the first two years of
his employment agreement and Mr. DeWinter is guaranteed to receive a $75,000
bonus for the first year of his employment agreement. In the event the
executives are terminated without "cause," they will be entitled to receive a
lump sum payment equal to (i) the value of any unpaid salary through the
remainder of the employment term plus (ii) the guaranteed bonus, to the extent
not already paid for the year during which his employment was terminated. Upon
termination for "cause," each of Messrs. Belter and DeWinter shall only be
entitled to receive his base salary through the effective date of such
termination. The executives shall also be entitled to participate, to the extent
eligible, in all benefit plans and programs as are generally provided from time
to time by the Company to its senior executives.
COMPANY STOCK OPTION PLANS
Under the Company's Stock Option Plan (the "1996 Plan"), 925,000 shares of
Common Stock are reserved for issuance upon exercise of stock options. Such
shares are accompanied by SARs which become exercisable as determined by the
Board of Directors, or a Committee thereof, only if Mego Financial does not give
approval to the exercise of the option. The 1996 Plan is designed as a means to
retain and motivate key employees and directors. The Company's Board of
Directors, or a committee thereof, administers and interprets the 1996 Plan and
is authorized to grant options thereunder to all eligible employees and
directors of the Company, except that no incentive stock options (as defined in
Section 422 of the Code) may be granted to a director who is not also an
employee of the Company or a subsidiary.
The 1996 Plan provides for the granting of both incentive stock options and
nonqualified stock options. Options may be granted under the 1996 Plan on such
terms and at such prices as determined by the Company's Board of Directors, or a
committee thereof, except that the per share exercise price of incentive stock
options cannot be less than the fair market value of the Common Stock on the
date of grant. Each option is exercisable after the period or periods specified
in the related option agreement, but no option may be exercisable after the
expiration of ten years from the date of grant. Options granted to an individual
who owns (or is deemed to own) at least 10% of the total combined voting power
of all classes of stock of the Company must have an exercise price of at least
110% of the fair market value of the Common Stock on the date of grant and a
term of no more than five years. The 1996 Plan also authorizes the Company to
make or guarantee loans to optionees to enable them to exercise their options.
Such loans must (i) provide for recourse to the optionee, (ii) bear interest at
a rate no less than the prime rate of interest, and (iii) be secured by the
shares of Common Stock purchased. The Board of Directors has the authority to
amend or terminate the 1996 Plan, provided that no such action may impair the
rights of the holder of any outstanding option without the written consent of
such holder, and provided further that certain amendments of the 1996 Plan are
subject to stockholder approval. Unless terminated sooner, the 1996 Plan will
continue in effect until all options granted thereunder have expired or been
exercised, provided that no options may be granted ten years after commencement
of the 1996 Plan. In connection with the Spin-off, all options outstanding under
the 1996 Plan were converted into SARs. As of August 31, 1997, an aggregate of
915,000 SARs were issued and outstanding under the 1996 Plan. See Note 17 of
Notes to Financial Statements.
In August 1997, the Company's Board of Directors adopted, subject to
stockholder approval, the Company's 1997 Stock Option Plan (the "1997 Plan").
Under the 1997 Plan, as amended by the Board of Directors in October 1997, 2
million shares of Common Stock are reserved for issuance upon the exercise of
stock options and/or SARs granted under such plan. The Company's Board of
Directors, or a committee thereof, administers and interprets the 1997 Plan and
is authorized to grant options and/or SARs thereunder to any person who has
rendered services to the Company, except that no incentive stock options may be
granted to any person who is not also an employee of the Company or any
subsidiary. As of August 31, 1997, a total of 137,500 SARs had been granted
under the 1997 Plan subject to stockholder approval of that plan, of which (i)
100,000 SARs had been granted to Jeffrey S. Moore pursuant to the terms of his
employment
48
<PAGE> 50
agreement and (ii) 7,500 SARs were granted to each of the directors, other than
Jerome J. Cohen and Jeffrey S. Moore.
On October 22, 1997, the Board of Directors authorized the repurchase by
the Company of all of the SARs granted under the 1996 Plan and 1997 Plan at a
purchase price of $1.00 for each SAR granted at an exercise price of $10.00 to
$11.00 per share and $0.70 for each SAR granted at an exercise price of $12.00
per share. In addition, in October 1997, options to purchase an aggregate of
1,052,500 shares were granted under the 1997 Plan at an exercise price of $14.75
per share, subject to stockholder approval of the 1997 Plan. Of the total
aggregate options granted, Jeffrey S. Moore was granted options to purchase
500,000 shares, Jerome J. Cohen was granted options to purchase 100,000 shares,
and James L. Belter was granted options to purchase 100,000 shares; all of which
were granted subject to stockholder approval of the 1997 Plan. See Note 18 of
Notes to Financial Statements for additional information.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Company's Compensation Committee was formed by the Board of Directors
in August 1997. The Compensation Committee is comprised of Robert Nederlander,
Spencer I. Browne and Jeremy Wiesen, non-employee directors. The Compensation
Committee has a special subcommittee consisting of Jeremy Wiesen and Spencer I.
Browne, which subcommittee has the authority to approve executive compensation
and agreements that are subject to Section 162(m) of the Code. Jerome J. Cohen,
Chairman of the Board and former Chief Executive Officer, participated in
deliberations concerning compensation of executive officers during fiscal 1997.
Mr. Cohen's compensation was determined by the Board of Directors of Mego
Financial.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth, as of October 15, 1997, information with
respect to the beneficial ownership of the Common Stock by (i) each person known
by the Company to be the beneficial owner of more than 5% of the outstanding
shares of Common Stock, (ii) each Director of the Company, (iii) each of the
Named Executive Officers and (iv) all directors and executive officers of the
Company as a group. Unless otherwise noted, the Company believes that all
persons named in the table have sole voting and investment power with respect to
all shares of Common Stock beneficially owned by them.
<TABLE>
<CAPTION>
AMOUNT AND
NATURE OF PERCENTAGE
NAME AND ADDRESS OF BENEFICIAL OWNER (1) BENEFICIAL OWNERSHIP OWNERSHIP
- ------------------------------------------------------------- -------------------- ----------
<S> <C> <C>
Robert Nederlander(2)........................................ 974,541 7.9%
Eugene I. Schuster and Growth Realty Inc. ("GRI")(3)......... 920,409 7.5
Jerome J. Cohen(4)........................................... 529,534 4.3
Jeffrey S. Moore (5)......................................... 15,242 *
James L. Belter (5).......................................... 6,408 *
Herbert B. Hirsch(6)......................................... 803,994 6.5
Don A. Mayerson(7)........................................... 396,392 3.2
Spencer I. Browne (8)........................................ 5,000 *
Jeremy Wiesen (9)............................................ -- --
FBR Ashton, Limited Partnership and affiliates (10).......... 791,179 6.4
All executive officers and directors of the Company as a
group (9 persons) (11)..................................... 2,731,111 22.2
</TABLE>
- ---------------
* Less than 1%.
(1) A person is deemed to be the beneficial owner of securities that can be
acquired by such person within 60 days from October 15, 1997 upon the
exercise of options and warrants. Each beneficial owner's percentage
ownership is determined by assuming that options and warrants that are held
by such person (but not those held by any other person) and that are
exercisable within 60 days from October 15, 1997 have been exercised.
49
<PAGE> 51
(2) Seventh Avenue, 21st Floor, New York, New York 10019. Does not include
47,600 shares of Common Stock owned by the Robert E. Nederlander
Foundation, an entity organized and operated exclusively for charitable
purposes (the "Foundation"), of which Mr. Nederlander is President. Mr.
Nederlander disclaims beneficial ownership of the shares owned by the
Foundation.
(3) Fisher Building, Detroit, Michigan 48202. These shares are held of record
by GRI, a wholly-owned subsidiary of Venture Funding, Ltd. of which Mr.
Schuster is a principal shareholder, Director and Chief Executive Officer.
(4) N. E. 125th Street, Suite 206, North Miami, Florida 33161. Excludes 52,507
shares of Common Stock owned by Mr. Cohen's spouse and 238,000 shares of
Common Stock owned by a trust for the benefit of his children over which
Mr. Cohen does not have any investment or voting power, as to which he
disclaims beneficial ownership. Also excludes 14,280 shares of Common Stock
owned by the Rita and Jerome J. Cohen Foundation, Inc., an entity organized
and operated exclusively for charitable purposes (the "Cohen Foundation"),
of which Mr. Cohen is President. Mr. Cohen disclaims beneficial ownership
of the shares owned by the Cohen Foundation.
(5) Parkwood Circle, Suite 500, Atlanta, Georgia 30339.
(6) East Flamingo Road, Las Vegas, Nevada 89109.
(7) N. E. 125th Street, Suite 206, North Miami, Florida 33161.
(8) Holly Street, Denver, Colorado 80220.
(9) East 68th Street, New York, New York 10021.
(10) 19th Street North, Arlington, VA 22209. Based upon a Schedule 13D dated
September 8, 1997 filed jointly with the Securities and Exchange
Commission. Includes 712,636 shares of Common Stock as to which FBR Ashton,
Limited Partnership ("Ashton") has sole voting and dispositive power,
50,163 shares as to which FBR Opportunity Fund, Ltd. Class A ("Opportunity
Fund") has sole voting and dispositive power, and 28,380 shares as to which
Mr. Emanuel J. Friedman has sole voting and dispositive power. Friedman,
Billings, Ramsey Investment Management, Inc. ("Investment Management")
serves as general partner and discretionary investment manager to Ashton;
FBR Offshore Management, Inc. ("Offshore Management") serves as
discretionary manager to Opportunity Fund. Mr. Friedman serves as portfolio
manager for Ashton and Opportunity Fund. Ashton, Opportunity Fund and Mr.
Friedman each disclaims beneficial ownership of shares owned by the others.
Investment Management, Offshore Management and Mr. Friedman each disclaims
beneficial ownership of shares owned by the others.
(11) See Notes (2)-(9).
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Company has entered into the following transactions with its affiliates
in the past three years. The Company believes that each of these transactions is
on terms at least as favorable to the Company as those which could have been
negotiated with an unaffiliated third party.
TAX SHARING AND INDEMNITY AGREEMENT
For taxable periods up to the date of the Spin-off, the results of
operations of the Company are includable in the tax returns filed by Mego
Financial's affiliated group for federal income tax purposes. Under a tax
allocation and indemnity agreement with Mego Financial currently in effect, the
Company records a liability to Mego Financial for federal income taxes
calculated on a separate company basis. Under a prior tax sharing arrangement
with Mego Financial, the Company recorded a liability to Mego Financial for
federal income taxes applied to the Company's financial statement income after
giving consideration to applicable income tax law and statutory rates. In
addition, both the agreement and the arrangement provide that the Company and
Mego Financial each will indemnify the other under certain circumstances.
Following the Spin-off, the Company will remain liable for any amounts payable
to Mego Financial pursuant to the tax sharing
50
<PAGE> 52
agreements in effect prior to the date of the Spin-off. From and after the date
of the Spin-off, the Company no longer will file consolidated returns with Mego
Financial's affiliated group but will file separate consolidated returns with
the Company's subsidiaries.
MANAGEMENT SERVICES PROVIDED BY PEC
The Company and PEC were parties to a management services arrangement (the
"Management Arrangement") pursuant to which certain executive, accounting,
legal, management information, data processing, human resources, advertising and
promotional personnel of PEC provided services to the Company on an as needed
basis. The Management Arrangement provided for the payment by the Company of a
management fee to PEC in an amount equal to the direct and indirect expenses of
PEC related to the services rendered by its employees to the Company, including
an allocable portion of the salaries and expenses of such employees based upon
the percentage of time such employees spend performing services for the Company.
For the years ended August 31, 1995, 1996 and 1997, approximately $690,000,
$671,000 and $967,000, respectively, of the salaries and expenses of certain
employees of PEC were attributable to and paid by the Company in connection with
services rendered by such employees to the Company. In addition, during the
years ended August 31, 1995, 1996 and 1997, the Company paid PEC for developing
certain computer programming, incurring costs of $36,000, $56,000 and $0,
respectively.
The Company has entered into a formal management services agreement with
PEC, effective as of September 1, 1996, pursuant to which PEC has agreed to
provide the following services to the Company for an aggregate annual fee of
approximately $967,000 payable monthly: strategic planning, management and tax,
accounting and finance, legal, management information systems, insurance
management, human resources, and purchasing. Either party has the right to
terminate all or any of these services upon 90 days' notice with a corresponding
reduction in fees. Such agreement currently remains in effect. The Company
anticipates that adjustments will be made under the management agreement to
reduce the fee payable by the Company for the portion allocated to Jerome J.
Cohen's compensation upon stockholder approval of Mr. Cohen's
employment/consulting agreement.
SERVICING AGREEMENT WITH PEC
Prior to September 1, 1996, the Company had an arrangement with PEC
pursuant to which it paid servicing fees of 50 basis points on the principal
balance of loans serviced per year. For the years ended August 31, 1995, 1996
and 1997, the Company paid servicing fees to PEC of approximately $232,000,
$709,000 and $1.9 million, respectively. The Company has entered into a
servicing agreement with PEC, effective as of September 1, 1996, providing for
the payment of servicing fees of 50 basis points on the principal balance of
loans serviced per year. Such agreement currently remains in effect. For the
years ended August 31, 1995, 1996 and 1997, the Company incurred interest
expense in the amount of $85,000, $29,000 and $16,000, respectively, related to
fees payable to PEC for these services. The interest rates were based on PEC's
average cost of funds and equaled 11.8% in 1995, 10.68% in 1996 and 10.48% in
1997.
FUNDING AND GUARANTEES BY MEGO FINANCIAL
In order to fund the Company's past operations and growth, and in
conjunction with filing consolidated returns, the Company incurred Intercompany
Debt to Mego Financial. As of August 31, 1995, 1996 and 1997, the amount of
Intercompany Debt owed to Mego Financial was $8.5 million, $12.0 million and
$9.7 million, respectively. Prior to the IPO, Mego Financial had guaranteed the
Company's obligations under the Company's credit agreements and new office
lease. The guarantees of the Company's credit agreements were released upon
consummation of the IPO. The Company did not pay any compensation to Mego
Financial for such guarantees.
In the first quarter of fiscal 1997, the Company entered into an agreement
with a financial institution, providing for the purchase by the financial
institution of $2.0 billion of loans over a five year period. Pursuant to the
agreement, Mego Financial issued to the financial institution four-year warrants
to purchase 1 million shares of Mego Financial's common stock. The value of the
warrants, estimated at $3.0 million (0.15% of the
51
<PAGE> 53
commitment amount) as of the commitment date (the "Warrant Value") plus a
$150,000 fee, are being amortized as the commitment for the purchase of loans is
utilized. The Company has agreed to pay Mego Financial the Warrant Value as it
is amortized as described below. As of August 31, 1997, $817,000 of the Warrant
Value and such fee had been amortized.
On August 29, 1997, the Company and Mego Financial entered into an
agreement (the "Payment Agreement") with respect to the Company's repayment
after the Spin-off of (i) a portion of the debt owed by the Company to Mego
Financial as of May 31, 1997 aggregating approximately $3.4 million (the "May
Amounts") and (ii) debt owed by the Company to Mego Financial as of August 31,
1997 in addition to the May Amounts (the "Excess Amounts"). The May Amounts
consist of a portion of the debt owed by the Company to Mego Financial as of May
31, 1997 in respect of funds advanced by Mego Financial to the Company through
such date, the portion of the Warrant Value amortized through such date and
amounts owed under the tax allocation and indemnification agreement between Mego
Financial and the Company as of such date. The Excess Amounts consist of funds
advanced by Mego Financial to the Company during the period commencing June 1,
1997 and ending August 31, 1997 (the "Excess Period"), the portion of the
Warrant Value amortized during the Excess Period and amounts accrued under the
tax allocation and indemnification agreement during the Excess Period. Pursuant
to the Payment Agreement, the Company agreed to repay the May Amounts upon the
earlier to occur of (i) the first consummation after the date of the agreement
of a public or private debt or equity transaction by the Company of at least
$25.0 million in amount or (ii) August 31, 1998. The Company repaid the May
Amounts with a portion of the net proceeds of the Private Placement. The Company
further agreed to repay the Excess Amounts upon the earlier to occur of (i) the
second consummation after the date of the agreement of a public or private debt
or equity transaction by the Company of at least $25.0 million in amount or (ii)
August 31, 1998. The amount of the amortization of the Warrant Value for each of
the months of September, October, November and December 1997 will be payable
January 31, 1998. Commencing in January 1998, the unpaid balance of the Warrant
Value will continue to be amortized on a monthly basis and the amount of such
amortization will be due and payable within 30 days from the end of each fiscal
quarter.
Under the Payment Agreement, Mego Financial may, but is not obligated to,
make advances to PEC on behalf of the Company. Advances, if any, by Mego
Financial on behalf of the Company to PEC will be due and payable within 30 days
after the close of the month in which such advance was made. Under the Payment
Agreement, any amount owed by the Company to Mego Financial that is not paid
when due will bear interest from such due date until paid at the rate of 10.0%
per annum.
Although Mego Financial may provide funds to the Company or guarantee the
Company's indebtedness or other obligations in the future, it is not anticipated
that it will do so and it has no obligation to do so.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K
(a) Certain documents filed as part of Form 10-K. See Item 8 above for a
list of financial statements included as part of this Annual Report on Form
10-K.
(b) Reports on Form 8-K. A report on Form 8-K dated August 20, 1997 was
filed on September 4, 1997. Such report related to the Spin-off transaction on
September 2, 1997 and the change in fiscal year-end from August 31 to December
31, effective December 31, 1997. A report on Form 8-K dated September 22, 1997
was filed on October 14, 1997 pursuant to subsection(d) of Rule 135(c) under the
Securities Act. A report on Form 8-K dated October 15, 1997 was filed on October
30, 1997 pursuant to subsection (d) of Rule 135(c) under the Securities Act.
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<PAGE> 54
(c) Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
-------- ------------------------------------------------------------------------
<C> <S>
3.1(4) Amended and Restated Certificate of Incorporation of the Company.
3.2(4) By-laws of the Company, as amended.
4.1(4) Specimen Common Stock Certificate.
10.1(4) 1996 Stock Option Plan.
10.2(1) Agreement for Line of Credit and Commercial Promissory Note between the
Company and First National Bank of Boston, dated January 4, 1994.
10.3(1) Agreement between the Company and Hamilton Consulting, Inc., dated
January 31, 1994.
10.4(1) Loan Purchase and Sales Agreement dated March 22, 1994, between the
Company as Buyer, and Southwest Beneficial Finance, Inc. as Seller.
10.5(1) Master Loan Purchase and Servicing Agreement dated as of August 26,
1994, between the Company as Seller, and First National Bank of Boston,
as Purchaser.
10.6(2) Master Loan Purchase and Servicing Agreement dated April 1, 1995, by and
between Greenwich Capital Financial Products, Inc. and the Company.
10.7(2) Participation and Servicing Agreement dated May 25, 1995, by and between
Atlantic Bank, N.A. and the Company.
10.8(2) Warehousing Credit and Security Agreement, dated as of August 11, 1995,
between the Company and First National Bank of Boston.
10.9(4) Form of Tax Allocation and Indemnity Agreement between the Company and
Mego Financial Corp.
10.10(4) Loan Program Sub-Servicing Agreement between the Company and Preferred
Equities Corporation dated as of September 1, 1996.
10.11(4) Servicing Agreement by and among Mego Mortgage FHA Title I Loan Trust
1996-1, First Trust of New York, National Association, as Trustee,
Norwest Bank Minnesota, N.A., as Master Servicer and the Company, as
Servicer dated as of March 21, 1996.
10.12(4) Loan Purchase Agreement between Financial Asset Securities Corp., as
Purchaser, and the Company, as Seller, dated as of March 21, 1996.
10.13(3) Indemnification Agreement among MBIA Insurance Corporation, as Insurer,
the Company, as Seller and Greenwich Capital Markets, Inc. as
Underwriter, dated as of March 29, 1996.
10.14(4) Pooling and Servicing Agreement, dated as of March 21, 1996, among the
Company, Financial Asset Securities Corp., as Depositor, First Trust of
New York, National Association, as Trustee and Contract of Insurance
Holder and Norwest Bank Minnesota, N.A., as Master Servicer.
10.15(3) Insurance Agreement among MBIA Insurance Corporation, as Insurer,
Norwest Bank Minnesota, N.A., as Master Servicer, the Company, as
Seller, Servicer and Claims Administrator, Financial Asset Securities
Corp., as Depositor, Greenwich Capital Financial Products, Inc., and
First Trust of New York, National Association, as Trustee and Contract
of Insurance Holder, dated as of March 21, 1996.
10.16(3) Credit Agreement dated as of June 28, 1996 between the Company and First
National Bank of Boston as Agent.
10.17(4) Loan Purchase Agreement dated as of August 1, 1996 between Financial
Asset Securities Corp., and the Company, as Seller.
</TABLE>
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<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
-------- ------------------------------------------------------------------------
<C> <S>
10.18(4) Pooling and Servicing Agreement dated as of August 1, 1996 between
Financial Asset Securities Corp., as Purchaser, and the Company, as
Seller.
10.19(3) Amendment No. 1 to Warehousing Credit and Security Agreement dated as of
August 9, 1996 between the Registrant and First National Bank of Boston.
10.20(4) Office Lease by and between MassMutual and the Company dated April 1996.
10.21(3) Amendment to Master Loan Purchase and Servicing Agreement between
Greenwich Capital Financial Products, Inc. and the Company dated
February 1, 1996.
10.22(3) Amendment No. 2 to Master Loan Purchase and Servicing Agreement between
Greenwich Capital Financial Products, Inc. and the Company dated July 1,
1996.
10.23(4) Services and Consulting Agreement between the Company and Preferred
Equities Corporation dated as of September 1, 1996.
10.24(3) Employment Agreement between the Company and Jeffrey S. Moore dated
January 1, 1994.
10.25(3) Form of Indenture dated November 22, 1996 between the Company and the
Indenture Trustee.
10.26(4) Master Repurchase Agreement dated as of September 4, 1996 between the
Company and Greenwich Capital Markets, Inc.
10.27(4) Letter Agreement dated October 1, 1996 between the Company and Greenwich
Capital Markets, Inc.
10.28(4) Amended and Restated Master Loan Purchase and Servicing Agreement dated
as of October 1, 1996 among the Company, Mego Financial Corp. and
Greenwich Capital Markets, Inc.
10.29(4) Form of Agreement between the Company and Mego Financial Corp.
10.30(4) Commitment letter between the Company and Greenwich Capital Markets,
Inc. dated September 17, 1996.
10.31(5) Loan Purchase Agreement dated as of November 1, 1996 between Financial
Asset Securities Corp. and the Company.
10.32(5) Pooling and Servicing Agreement dated as of November 1, 1996 among
Financial Asset Securities Corp., the Company, Norwest Bank Minnesota,
N.A. and First Trust of New York, National Association.
10.33(5) Home Loan Purchase Agreement dated as of March 1, 1997 between Financial
Asset Securities Corp. and the Company.
10.34(5) Sale and Servicing Agreement dated as of March 1, 1997 among Mego
Mortgage Home Loan Owner Trust 1997-1, Financial Asset Securities Corp.,
the Company, Norwest Bank Minnesota, N.A. and First Trust of New York,
National Association.
10.35(5) Trust Agreement dated as of March 1, 1997 among Financial Asset
Securities Corp., the Company, Wilmington Trust Company and First Trust
of New York, National Association.
10.36(5) Home Loan Purchase Agreement dated as of May 1, 1997 between Financial
Asset Securities Corp. and the Company.
10.37(5) Sale and Servicing Agreement dated as of May 1, 1997 among Mego Mortgage
Home Loan Owner Trust 1997-2, Financial Asset Securities Corp., the
Company, Norwest Bank Minnesota N.A. and First Trust of New York,
National Association.
10.38(5) Trust Agreement dated as of May 1, 1997 among Financial Asset Securities
Corp., the Company, Wilmington Trust Company and First Trust of New
York, National Association.
</TABLE>
54
<PAGE> 56
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
-------- ------------------------------------------------------------------------
<C> <S>
10.39(5) Home Loan Purchase Agreement dated as of June 14, 1997 between Financial
Asset Securities Corp. and the Company.
10.40(5) Sale and Servicing Agreement dated as of June 14, 1997 among Mego
Mortgage Home Loan Owner Trust 1997-3, Financial Asset Securities Corp.,
the Company, Norwest Bank Minnesota N.A. and First Trust of New York,
National Association.
10.41(5) Trust Agreement dated as of June 14, 1997 among Financial Asset
Securities Corp., the Company, Wilmington Trust Company and First Bank
National Association.
10.42 Agreement between Mego Financial Corp. and the Company, dated August 29,
1997.
27.1 Financial Data Schedule.
</TABLE>
- ---------------
(1) Filed as part of the Form 10-K for the fiscal year ended August 31, 1994 of
Mego Financial Corp. and incorporated herein by reference.
(2) Filed as part of the Form 10-K for the fiscal year ended August 31, 1995 of
Mego Financial Corp. and incorporated herein by reference.
(3) Filed as part of the Registration Statement on Form S-1 filed by the
Company, as amended (File No. 333-13421), and incorporated herein by
reference.
(4) Filed as part of the Registration Statement on Form S-1 filed by the
Company, as amended (File No. 333-12443), and incorporated herein by
reference.
(5) Filed as part of the Form 10-Q for the quarter ended May 31, 1997 filed by
the Company and incorporated herein by reference.
(d) Financial Statement schedules required by Regulation S-X. No financial
statement schedules are included because of the absence of the conditions under
which they are required or because the information is included in the financial
statements or the notes thereto.
55
<PAGE> 57
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
MEGO MORTGAGE CORPORATION
(Registrant)
Date: October 30, 1997 By: /s/ JEFFREY S. MOORE
------------------------------------
Jeffrey S. Moore, President,
Chief Executive Officer and Director
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ---------------------------------- --------------------------------------- -----------------
<S> <C> <C>
/s/ JEROME J. COHEN Chairman of the Board October 30, 1997
- ----------------------------------
Jerome J. Cohen
/s/ JEFFREY S. MOORE President, Chief Executive Officer and October 30, 1997
- ---------------------------------- Director
Jeffrey S. Moore
/s/ JAMES L. BELTER Executive Vice President, Chief October 30, 1997
- ---------------------------------- Financial Officer and Treasurer
James L. Belter
/s/ ROBERT NEDERLANDER Director October 30, 1997
- ----------------------------------
Robert Nederlander
/s/ HERBERT B. HIRSCH Director October 30, 1997
- ----------------------------------
Herbert B. Hirsch
/s/ DON A. MAYERSON Director October 30, 1997
- ----------------------------------
Don A. Mayerson
/s/ SPENCER I. BROWNE Director October 30, 1997
- ----------------------------------
Spencer I. Browne
/s/ JEREMY WIESEN Director October 30, 1997
- ----------------------------------
Jeremy Wiesen
</TABLE>
56
<PAGE> 58
MEGO MORTGAGE CORPORATION
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE NO.
--------
<S> <C>
Independent Auditors' Report....................................................... F-2
Financial Statements:
Statements of Financial Condition at August 31, 1996 and 1997...................... F-3
Statements of Operations -- Years Ended August 31, 1995, 1996 and 1997............. F-4
Statements of Cash Flows -- Years Ended August 31, 1995, 1996 and 1997............. F-5
Statements of Stockholders' Equity -- Years Ended August 31, 1995, 1996 and 1997... F-6
Notes to Financial Statements...................................................... F-7
</TABLE>
F-1
<PAGE> 59
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Mego Mortgage Corporation
Atlanta, Georgia
We have audited the accompanying statements of financial condition of Mego
Mortgage Corporation (the "Company") as of August 31, 1996 and 1997, and the
related financial statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended August 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these 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, such financial statements present fairly, in all material
respects, the financial position of Mego Mortgage Corporation at August 31, 1996
and 1997, and the results of its operations and its cash flows for each of the
three years in the period ended August 31, 1997 in conformity with generally
accepted accounting principles.
DELOITTE & TOUCHE LLP
San Diego, California
October 17, 1997, except for the third and fourth paragraphs of Note 18 as to
which the date is
October 22, 1997
F-2
<PAGE> 60
MEGO MORTGAGE CORPORATION
STATEMENTS OF FINANCIAL CONDITION
ASSETS
<TABLE>
<CAPTION>
AUGUST 31.
----------------------
1996 1997
------- --------
(THOUSANDS OF DOLLARS,
EXCEPT PER SHARE
AMOUNTS)
<S> <C> <C>
Cash and cash equivalents............................................. $ 443 $ 6,104
Cash deposits, restricted............................................. 4,474 6,890
Loans held for sale, net of allowance for credit losses of $95 and
$100................................................................ 4,610 9,523
Mortgage related securities, at fair value............................ 22,944 106,299
Excess servicing rights............................................... 12,121 --
Mortgage servicing rights............................................. 3,827 9,507
Other receivables..................................................... 59 7,945
Property and equipment, net of accumulated depreciation of $279 and
$675................................................................ 865 2,153
Organizational costs, net of amortization............................. 482 289
Prepaid debt expenses................................................. 216 2,362
Prepaid commitment fee................................................ -- 2,333
Other assets.......................................................... 565 795
------- --------
Total assets................................................ $50,606 $154,200
======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes and contracts payable......................................... $14,197 $ 35,572
Accounts payable and accrued liabilities............................ 4,066 7,759
Allowance for credit losses on loans sold with recourse............. 920 7,014
Due to Mego Financial Corp.......................................... 11,994 9,653
Due to affiliated company........................................... 819 446
State income taxes payable.......................................... 909 649
------- --------
Total liabilities........................................... 32,905 61,093
------- --------
Subordinated debt..................................................... -- 40,000
------- --------
Stockholders' equity:
Common stock, $.01 par value per share (authorized -- 50,000,000
shares; issued and outstanding -- 10,000,000 and 12,300,000)..... 100 123
Additional paid-in capital.......................................... 8,550 29,185
Retained earnings................................................... 9,051 23,799
------- --------
Total stockholders' equity.................................. 17,701 53,107
------- --------
Total liabilities and stockholders' equity.................. $50,606 $154,200
======= ========
</TABLE>
See notes to financial statements.
F-3
<PAGE> 61
MEGO MORTGAGE CORPORATION
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
----------------------------------------
1995 1996 1997
---------- ---------- ----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE
AMOUNTS)
<S> <C> <C> <C>
REVENUES:
Gain on sale of loans.............................. $ 12,233 $ 16,539 $ 45,123
Net unrealized gain on mortgage related
securities...................................... -- 2,697 3,518
Loan servicing income, net......................... 873 3,348 3,036
Interest income.................................... 941 2,104 9,507
Less: interest expense............................. (468) (1,116) (6,374)
------- ------- -----------
Net interest income........................... 473 988 3,133
------- ------- -----------
Total revenues............................. 13,579 23,572 54,810
------- ------- -----------
COST AND EXPENSES:
Net provision for credit losses.................... 864 55 6,300
Depreciation and amortization...................... 403 394 672
Other interest..................................... 187 167 245
General and administrative:
Payroll and benefits............................ 3,611 5,031 11,181
Commissions and selling......................... 552 2,013 2,768
Credit reports.................................. 133 367 1,387
Rent and lease expenses......................... 249 338 1,091
Professional services........................... 177 732 652
Servicing fees paid to affiliate................ 232 709 1,874
Management services by affiliate................ 690 671 967
FHA insurance................................... 231 572 558
Other........................................... 331 1,368 3,305
------- ------- -----------
Total costs and expenses................... 7,660 12,417 31,000
------- ------- -----------
Income before income taxes........................... 5,919 11,155 23,810
Income taxes......................................... 2,277 4,235 9,062
------- ------- -----------
Net income........................................... $ 3,642 $ 6,920 $ 14,748
======= ======= ===========
EARNINGS PER COMMON SHARE:
Primary:
- -----------------------------------------------------
Net income......................................... $ 1.25
===========
Weighted-average number of common shares and common
share equivalents outstanding................... 11,802,192
===========
Fully diluted:
- -----------------------------------------------------
Net income......................................... $ 1.25
===========
Weighted-average number of common shares and common
share equivalents outstanding................... 11,802,192
===========
</TABLE>
See notes to financial statements.
F-4
<PAGE> 62
MEGO MORTGAGE CORPORATION
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
AUGUST 31,
------------------------------------
1995 1996 1997
-------- --------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.................................................................... $ 3,642 $ 6,920 $ 14,748
-------- --------- ---------
Adjustments to reconcile net income to net cash used in operating activities:
Additions to mortgage servicing rights...................................... (1,176) (3,306) (7,184)
Additions to excess servicing rights........................................ (14,098) (20,563) --
Net unrealized gain on mortgage related securities.......................... -- (2,697) (3,518)
Additions to mortgage related securities.................................... -- -- (64,987)
Net provisions for estimated credit losses.................................. 864 55 6,300
Deferred income taxes (benefit)............................................. 230 673 (3,267)
Depreciation and amortization expense....................................... 403 394 672
Amortization of prepaid debt expense........................................ 50 163 817
Amortization of prepaid commitment fee...................................... -- -- 684
Amortization of excess servicing rights..................................... 519 2,144 --
Amortization of mortgage servicing rights................................... 100 555 1,504
Accretion of residual interest on mortgage related securities............... -- (243) (4,796)
Payments on mortgage related securities..................................... -- 1,547 1,111
Amortization of mortgage related securities................................. -- -- 956
Loans originated for sales, net of loan fees................................ (87,751) (139,367) (526,917)
Payments on loans held for sale............................................. 131 504 431
Proceeds from sale of loans................................................. 84,952 135,483 514,413
Changes in operating assets and liabilities:
Increase in cash deposits, restricted..................................... (2,532) (1,942) (2,416)
Decrease (increase) in other assets, net.................................. 325 1,056 (1,813)
Increase (decrease) in state income taxes payable......................... 264 670 (260)
Increase in other liabilities, net........................................ 1,959 1,827 3,531
Additions to due to affiliated company.................................... 3,581 2,100 3,810
Payments on due to affiliated company..................................... (3,305) (1,281) (4,183)
-------- --------- ---------
Total adjustments....................................................... (15,484) (22,228) (85,112)
-------- --------- ---------
Net cash used in operating activities................................. (11,842) (15,308) (70,364)
-------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment............................................ (274) (608) (1,688)
Proceeds from the sale of property and equipment.............................. -- -- 4
-------- --------- ---------
Net cash used in investing activities................................. (274) (608) (1,684)
-------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings on notes and contracts payable....................... 77,178 146,448 511,878
Payments on notes and contracts payable....................................... (76,357) (133,709) (490,503)
Additions in Due to Mego Financial............................................ 10,836 8,368 13,020
Payments on Due to Mego Financial............................................. (2,613) (5,500) (15,094)
Issuance of subordinated debt, net............................................ -- -- 37,750
Proceeds from sale of common stock............................................ -- -- 20,658
Increase in additional paid-in capital........................................ 3,000 -- --
-------- --------- ---------
Net cash provided by financing activities............................. 12,044 15,607 77,709
-------- --------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS............................ (72) (309) 5,661
CASH AND CASH EQUIVALENTS -- BEGINNING OF YEAR.................................. 824 752 443
-------- --------- ---------
CASH AND CASH EQUIVALENTS -- END OF YEAR........................................ $ 752 $ 443 $ 6,104
======== ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest.................................................................... $ 618 $ 964 $ 5,212
======== ========= =========
State income taxes.......................................................... $ 3 $ 25 $ 1,691
======== ========= =========
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
In connection with the securitization of loans and creation of mortgage
related securities, the Company retained an interest only security and a
residual interest security.................................................. $ -- $ 20,096 $ --
======== ========= =========
Addition to prepaid commitment fee and due to Mego Financial in connection
with loan sale commitment received.......................................... $ -- $ -- $ 3,000
======== ========= =========
</TABLE>
See notes to financial statements.
F-5
<PAGE> 63
MEGO MORTGAGE CORPORATION
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
<TABLE>
<CAPTION>
COMMON STOCK
$.01 PAR VALUE ADDITIONAL RETAINED
------------------ PAID-IN EARNINGS
SHARES AMOUNT CAPITAL (DEFICIT) TOTAL
---------- ------ ---------- --------- -------
(THOUSANDS OF DOLLARS, EXCEPT SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
Balance at September 1, 1994.................... 10,000,000 $100 $ 5,550 $(1,511) $ 4,139
Additional paid-in capital...................... -- -- 3,000 -- 3,000
Net income for the year ended August 31, 1995... -- -- -- 3,642 3,642
---------- ---- ------- ------- -------
Balance at August 31, 1995...................... 10,000,000 100 8,550 2,131 10,781
Net income for the year ended August 31, 1996... -- -- -- 6,920 6,920
---------- ---- ------- ------- -------
Balance at August 31, 1996...................... 10,000,000 100 8,550 9,051 17,701
Sale of common stock, net of issuance costs..... 2,300,000 23 20,635 -- 20,658
Net income for the year ended August 31, 1997... -- -- -- 14,748 14,748
---------- ---- ------- ------- -------
Balance at August 31, 1997...................... 12,300,000 $123 $ 29,185 $23,799 $53,107
========== ==== ======= ======= =======
</TABLE>
See notes to financial statements.
F-6
<PAGE> 64
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
1. NATURE OF OPERATIONS
Mego Mortgage Corporation (the "Company") was incorporated on June 12,
1992, in the State of Delaware. The Company, through its loan correspondents and
home improvement contractors, is primarily engaged in the business of
originating, selling, servicing and pooling home improvement and debt
consolidation loans, certain of which qualify under the provisions of Title I of
the National Housing Act which is administered by the U.S. Department of Housing
and Urban Development ("HUD"). Pursuant to the Title I credit insurance program,
90% of the principal balances of the loans are U.S. government insured ("Title I
Loans"), with cumulative maximum coverage equal to 10% of all Title I Loans
originated by the Company. In May 1996, the Company commenced the origination of
conventional home improvement loans, generally secured by residential real
estate, and debt consolidation loans ("Conventional Loans") through its network
of loan correspondents and dealers. During fiscal 1995, all loans originated
were Title I Loans. During fiscal 1996, 91.7% of loans originated were Title I
Loans and 8.3% of loans originated were Conventional Loans. The Company's loan
originations during the fiscal year ended August 31, 1997 were comprised of
81.4% Conventional Loans and 18.6% Title I Loans.
The Company was formed as a wholly-owned subsidiary of Mego Financial Corp.
("Mego Financial") and remained so until November 1996, when the Company issued
2.3 million shares of its Common Stock, $.01 par value per share (the "Common
Stock"), in an underwritten public offering (the "IPO") at $10.00 per share. As
a result of this transaction, Mego Financial's ownership in the Company was
reduced from 100% at August 31, 1996 to 81.3%. Concurrently with the Common
Stock offering, the Company issued $40.0 million of 12.5% Senior Subordinated
Notes due in 2001 in an underwritten public offering. The proceeds from the
offerings received by the Company have been used to repay borrowings and provide
funds for originations and securitizations of loans. In October 1997, the
Company issued an additional $40.0 million of 12.5% Senior Subordinated Notes
due in 2001 in a private placement (the "Private Placement"). See Note 13 for
further discussion.
On September 2, 1997, Mego Financial distributed all of its 10 million
shares of the Company's Common Stock to its shareholders in a tax-free spin-off
("Spin-off").
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash Deposits, Restricted -- Restricted cash represents cash on deposit
which is restricted in accordance with the loan sale agreements and
untransmitted funds received from collection of loans which have not as yet been
disbursed to the purchasers of such loans in accordance with the loan sale
agreements.
Loans Held for Sale -- Loans held for sale are carried at the lower of
aggregate cost or market value in the accompanying Statements of Financial
Condition, net of allowance for credit losses. Loan origination fees and direct
origination costs are deferred in compliance with Statement of Financial
Accounting Standards ("SFAS") No. 91 "Accounting for Nonrefundable Fees and
Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases" ("SFAS 91"), with no amortization recorded in the interim period prior
to sale.
Mortgage Related Securities -- In fiscal 1996, the Company securitized a
majority of loans originated into the form of a REMIC. A REMIC is a trust
issuing multi-class securities with certain tax advantages to investors and
which derives its cash flow from a pool of underlying mortgages. Certain of the
senior classes of the REMIC are sold, and an interest only strip and a
subordinated residual class are retained by the Company. The subordinated
residual class is in the form of residual certificates which are classified as
residual interest securities. The documents governing the Company's
securitizations require the Company to establish initial over-collateralization
or build over-collateralization levels through retention of distributions by the
REMIC trust otherwise payable to the Company as the residual interest holder.
This over-collateralization causes the
F-7
<PAGE> 65
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
aggregate principal amount of the loans in the related pool and/or cash reserves
to exceed the aggregate principal balance of the outstanding investor
certificates. Such excess amounts serve as credit enhancement for the related
REMIC trust. To the extent that borrowers default on the payment of principal or
interest on the loans, losses will reduce the over-collateralization and cash
flows otherwise payable to the residual interest security holder to the extent
that funds are available. If payment defaults exceed the amount of over-
collateralization, as applicable, the insurance policy maintained by the related
REMIC trust will pay any further losses experienced by holders of the senior
interests in the related REMIC trust. The Company does not have any recourse
obligations for credit losses in the REMIC trust.
In fiscal 1997, the Company completed two non-monoline securitizations of a
total of five securitizations completed during fiscal 1997. The Company also
completed two owner's trust securitizations, and a combined REMIC and grantor
trust securitization in fiscal 1997.
The two transactions, completed in June and August 1997, were accomplished
on a senior subordinated basis without insurance as a credit enhancement and
were generally collateralized by conventional home improvement and debt
consolidation mortgage loans with typically high loan-to-value ratios. The other
three insured securitization transactions were collateralized by a combination
of Title I and Conventional Loans. The two owner's trust securitizations were
completed in March and May 1997. These securitizations were comprised of Title I
and Conventional Loans. The REMIC/grantor trust securitization, completed in
December 1996, placed all secured Title I Loans and those Conventional Loans
which qualified with a loan-to-value ratio of 125% or less, into the REMIC pool,
and the grantor trust pool was comprised of unsecured Title I Loans and other
Conventional Loans which did not qualify for the REMIC pool.
Pursuant to these securitizations, various classes of home loan
asset-backed notes and certificates were issued and sold in public offerings.
The Company has received residual interest securities, contractual rights, and
in certain of the transactions, also received interest only strip securities,
all of which were recorded as mortgage related securities on the Statements of
Financial Condition. The residual interest securities and the contractual rights
represent the excess differential (after payment of any servicing, interest and
other fees, and the contractual obligations payable to the note and certificate
holders) between the interest paid by the obligors of the sold loans and the
yield on the sold notes, certificates, and interest only strip securities. Also,
from the two securitizations completed in fiscal 1996 and the first two
securitizations completed in fiscal 1997, the Company has also received interest
only strip securities. These interest only strip securities yield annual rates
between 0.45% and 1.00% calculated on the principal balance of loans not in
default. The Company may be required to repurchase loans that do not conform to
the representations and warranties made by the Company in the securitization
agreements and as servicer, may be required to advance interest in connection
with the securitizations.
The Company adopted SFAS No. 115, "Accounting for Certain Investments in
Debt and Equity Securities" ("SFAS 115") on September 1, 1995. There was no
cumulative financial statement impact as a result of adopting SFAS 115.
In accordance with the provisions of SFAS 115, the Company classifies
residual interest securities and interest only securities as trading securities
which are recorded at fair value with any unrealized gains or losses recorded in
the results of operations in the period of the change in fair value. Valuations
at origination and at each reporting period are based on discounted cash flow
analyses. The cash flows are estimated as the excess of the weighted-average
coupon on each pool of loans securitized over the sum of the pass-through
interest rate, servicing fees, a trustee fee, an insurance fee and an estimate
of annual future credit losses, net of Federal Housing Administration ("FHA")
insurance recoveries, related to the loans securitized, over the life of the
loans. These cash flows are projected over the life of the loans using
prepayment, default, and loss assumptions that the Company believes market
participants would use for similar financial instruments and are discounted
using an interest rate that the Company believes a purchaser unrelated to the
seller of such a financial
F-8
<PAGE> 66
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
instrument would require. During fiscal 1995, 1996 and 1997, the Company
generally utilized annual prepayment assumptions ranging from 1% to 15%, annual
estimated loss factor assumptions of up to 1.75%, and annual weighted-average
discount rates of 12% for Title I and Conventional Loans. The valuation includes
consideration of characteristics of the loans including loan type and size,
interest rate, origination date, and term. The Company also uses other available
information such as externally prepared reports on prepayment rates and industry
default rates of the type of loan portfolio under review. To the Company's
knowledge, there is no active market for the sale of these mortgage related
securities. The range of values attributable to the factors used in determining
fair value is broad. Although the Company believes that it has made reasonable
estimates of the fair value of the mortgage related securities, the rate of
prepayments and default rates utilized are estimates, and actual experience may
vary.
In accordance with SFAS No. 125 "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities" as later described in this
footnote, existing and future excess servicing rights have been measured at fair
market value and have been reclassified, as of January 1, 1997, as interest only
receivables and carried as mortgage related securities and accounted for in
accordance with SFAS 115.
Revenue Recognition-Gain on Sale of Loans -- Gain on sale of loans includes
the gain on sale of mortgage related securities and the gain on sale of loans
held for sale. In accordance with Emerging Issues Task Force ("EITF") Issue No.
88-11, the gain on sale of mortgage related securities is determined by an
allocation of the cost of the securities based on the relative fair value of the
securities sold and the securities retained. In sales of loans through
securitization transactions, the Company retains residual interest securities
and may retain interest only strip securities. The fair value of the interest
only strip securities and residual interest securities is the present value of
the estimated cash flow to be received after considering the effects of
estimated prepayments and credit losses. The interest only strip securities and
residual interest securities are included in mortgage related securities on the
Company's Statements of Financial Condition.
In discounting cash flows related to loan sales, the Company defers
servicing income at annual rates of 1% to 1.25% and discounts cash flows on its
sales at the rate it believes a purchaser would require as a rate of return. The
cash flows were discounted to present value using discount rates which
approximated 12% for each of the years ended August 31, 1995, 1996 and 1997. The
Company has developed its assumptions based on experience with its own
portfolio, available market data and ongoing consultation with its investment
bankers.
In determining expected cash flows, management considers economic
conditions at the date of sale. In subsequent periods, these estimates may be
revised as necessary using the original discount rate, and any losses arising
from prepayment and loss experience will be recognized as realized.
Mortgage Servicing Rights -- At August 31, 1995, effective September 1,
1994, the Company adopted the provisions of SFAS No. 122 "Accounting for
Mortgage Servicing Rights -- an amendment of SFAS No. 65" ("SFAS 122") which
requires that a mortgage banking enterprise recognize as separate assets the
rights to service mortgage loans for others however those servicing rights are
acquired. The effect of adopting SFAS 122 on the Company's financial statements
was to increase income before income taxes by $1.1 million for the year ended
August 31, 1995. The fair value of capitalized mortgage servicing rights is
estimated by calculating the present value of expected net cash flows from
mortgage servicing rights using assumptions the Company believes market
participants would use in their estimates of future servicing income and
expense, including assumptions about prepayment, default and interest rates.
Mortgage servicing rights are amortized in proportion to and over the period of
estimated net servicing income. The estimate of fair value was based on a 100,
125 and 100 basis points per annum, respectively, servicing fee reduced by
estimated costs of servicing for the years ended August 31, 1995, 1996 and 1997.
The estimated net cash flow from servicing utilized a discount rate of 12% for
all three years. At August 31, 1995, 1996 and 1997, the book value of mortgage
servicing rights approximated fair value. The Company periodically reviews
mortgage servicing rights to determine impairment. This review is performed on a
disaggregated basis, based upon loan type and date of
F-9
<PAGE> 67
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
origination. Impairment is recognized in a valuation allowance for each pool in
the period of impairment. The Company has developed its assumptions based on
experience with its own portfolio, available market data and ongoing
consultation with its investment bankers. Effective January 1, 1997, the Company
prospectively adopted SFAS 125 (as defined below) which supersedes SFAS 122.
Allowance for Credit Losses -- Provision for credit losses relating to
unsold loans is recorded as expense in amounts sufficient to maintain the
allowance at a level considered adequate to provide for anticipated losses
resulting from liquidation of outstanding loans. The provision for credit losses
is based upon periodic analysis of the portfolio, economic conditions and
trends, historical credit loss experience, borrowers' ability to repay,
collateral values, and estimated FHA insurance recoveries on loans originated.
Property and Equipment -- Property and equipment is stated at cost and is
depreciated over its estimated useful life (generally five years) using the
straight-line method. Costs of maintenance and repairs that do not improve or
extend the life of the respective assets are recorded as expense.
Organizational Costs -- Organizational costs associated with the
organization of the operations of the Company, which commenced loan originations
on March 1, 1994, are being amortized over a five year period. These
organizational costs are comprised of costs to incorporate, legal, accounting
and other professional fees associated with the organization of the Company.
Such amortization is included in depreciation and amortization expense on the
Statements of Operations. Accumulated amortization related to organizational
costs was $289,000, $482,000 and $675,000 during the years ended August 31,
1995, 1996 and 1997, respectively.
Loan Origination Costs and Fees -- Loan origination costs and fees
including non-refundable loan origination fees and incremental direct costs
associated with loan originations are deferred and amortized over the lives of
the loans. Unamortized loan origination costs and fees are recorded as expense
or income upon the sale of the related loans.
Allowance for Credit Losses on Loans Sold with Recourse -- Recourse to the
Company on sales of loans is governed by the agreements between the purchasers
and the Company. The allowance for credit losses on loans sold with recourse
represents the Company's estimate of the fair value of its future credit losses
to be incurred over the lives of the loans, considering estimated future FHA
insurance recoveries on Title I Loans. No allowance for credit losses on loans
sold with recourse is established on loans sold through securitizations or on
whole loan sales with servicing released, as the Company has no recourse
obligation for credit losses under those securitization agreements or whole loan
sale agreements and estimated credit losses on loans sold through
securitizations are considered in the Company's valuation of its residual
interest securities. Proceeds from the sale of loans with recourse provisions
were $85.0 million, $118.1 million and $415.5 million during the years ended
August 31, 1995, 1996 and 1997, respectively.
Interest Income -- Interest income is recorded as earned. Interest income
represents the interest earned on loans held for sale during the period prior to
their securitization or other sale, mortgage related securities, and short term
investments. In accordance with EITF Issue No. 89-4, the Company computes an
effective yield based on the carrying amount of each mortgage related security
and its estimated future cash flow. This yield is then used to accrue interest
income on the mortgage related security.
During the period that a Title I Loan is 30 days through 270 days
delinquent, the Company accrues interest at the HUD guaranteed rate of 7% in
lieu of the contractual rate of the loan. When a Title I Loan becomes over 270
days contractually delinquent, it is placed on non-accrual status and interest
is recognized only as cash is received. Interest income on Conventional Loans
greater than 90 days delinquent is generally recognized on a cash basis.
F-10
<PAGE> 68
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
Loan Servicing Income -- Fees for servicing loans originated or acquired by
the Company and sold with servicing rights retained are generally based on a
stipulated percentage of the outstanding principal balance of such loans and are
recognized when earned. Interest received on loans sold, less amounts paid to
investors, is reported as loan servicing income. Capitalized mortgage servicing
rights are amortized in proportion to and over the period of estimated servicing
income. Late charges and other miscellaneous income are recognized when
collected. Costs to service loans are recorded to expense as incurred.
Income Taxes -- The Company has filed consolidated federal income tax
returns with its parent, Mego Financial. Income taxes for the Company are
provided for on a separate return basis. As part of a tax sharing arrangement,
the Company has recorded a liability to Mego Financial for federal income taxes
applied to the Company's financial statement income after giving consideration
to applicable income tax law and statutory rates. The Company accounts for taxes
under SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires
an asset and liability approach. For periods after September 2, 1997, (after the
Spin-off), the Company will file separate consolidated federal income tax
returns.
The provision for income taxes includes deferred income taxes, which result
from reporting items of income and expense for financial statement purposes in
different accounting periods than for income tax purposes. The Company also
provides for state income taxes at the rate of 6% of income before income taxes.
Recently Issued Accounting Standards -- The Financial Accounting Standards
Board (the "FASB") has issued Statement No. 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to be Disposed of" ("SFAS 121").
SFAS 121 requires that long-lived assets and certain identifiable intangibles be
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. SFAS 121 was
effective for fiscal years beginning after December 15, 1995. There was no
material effect upon adoption on results of operations or financial condition at
August 31, 1997.
At August 31, 1995, effective September 1, 1994, the Company adopted SFAS
122, which requires that a mortgage banking enterprise recognize as separate
assets the rights to service mortgage loans for others, regardless of how those
servicing rights are acquired. The effect of adopting SFAS 122 on the Company's
financial statements was to increase income before income taxes by $1.1 million
for the year ended August 31, 1995. The fair value of capitalized mortgage
servicing rights was estimated by taking the present value of expected net cash
flows from mortgage servicing using assumptions the Company believes market
participants would use in their estimates of future servicing income and
expense, including assumptions about prepayment, default and interest rates.
Capitalized mortgage servicing rights are amortized in proportion to and over
the period of estimated net servicing income. The estimate of fair value was
based on a 100 basis points per year servicing fee, reduced by estimated costs
of servicing, and using a discount rate of 12%. The Company has developed its
assumptions based on experience with its own portfolio, available market data
and ongoing consultation with its investment bankers.
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), which establishes financial accounting and reporting
standards for stock-based employee compensation plans. Those plans include all
arrangements by which employees receive shares of stock or other equity
instruments of the employer or the employer incurs liabilities to employees in
amounts based on the price of the stock. This statement also applies to
transactions in which an entity issues its equity instruments to acquire goods
or services from nonemployees. Those transactions must be accounted for based on
the fair value of the consideration received or the fair value of the equity
instruments issued, whichever is more reliably measurable. SFAS 123 is effective
for fiscal years beginning after December 15, 1995. However, effective August
20, 1997, the Company converted all outstanding employee stock options to stock
appreciation rights ("SARs") which resulted in additional compensation expense
of $220,000; therefore, disclosure under SFAS 123 is not applicable. The Company
has elected to continue to apply the provisions of
F-11
<PAGE> 69
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
Accounting Principles Board ("APB") Opinion No. 25 "Accounting for Stock Issued
to Employees", and will provide pro forma disclosure for SFAS 123 if applicable.
See Note 17.
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities" ("SFAS 125") was issued by the FASB in June
1996 and supersedes SFAS 122, effective January 1, 1997. SFAS 125 provides
accounting and reporting standards for transfers and servicing of financial
assets and extinguishments of liabilities. This statement also provides
consistent standards for distinguishing transfers of financial assets that are
sales from transfers that are secured borrowings. It requires that liabilities
and derivatives incurred or obtained by transferors as part of a transfer of
financial assets be initially measured at fair value. SFAS 125 also requires
that servicing assets be measured by allocating the carrying amount between the
assets sold and retained interests based on their relative fair values at the
date of transfer. Additionally, this statement requires that the servicing
assets and liabilities be subsequently measured by (a) amortization in
proportion to and over the period of estimated net servicing income or loss and
(b) assessment for asset impairment or increased obligation based on their fair
values. The statement requires the Company's excess servicing rights be measured
at fair market value and be reclassified as interest only receivables, carried
as mortgage related securities, and accounted for in accordance with SFAS 115.
As required by the statement, the Company adopted the new requirements effective
January 1, 1997, and applied them prospectively. The statement had no material
impact on the financial statements of the Company. The book value of the
Company's mortgage related securities approximates fair value.
The following table reflects the components of mortgage related securities
as required by SFAS 125 as follows:
<TABLE>
<CAPTION>
AUGUST 31,
--------------------
1996 1997
------- --------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Interest only strip securities.......................... $ 4,602 $ 6,398
Residual interest securities............................ 18,342 84,597
Interest only receivables (formerly excess servicing
rights)............................................... -- 15,304
------- --------
Total mortgage related securities............. $22,944 $106,299
======= ========
</TABLE>
All mortgage related securities are classified as trading securities and
are recorded at their estimated fair values. Changes in the estimated fair
values are recorded in current operations.
The FASB issued SFAS No. 128, "Earnings per Share" ("SFAS 128") in March
1997, effective for financial statements issued after December 15, 1997. The
statement provides simplified standards for the computation and presentation of
earnings per share ("EPS"), making EPS comparable to international standards.
SFAS 128 requires dual presentation of "Basic" and "Diluted" EPS, by entities
with complex capital structures, replacing "Primary" and "Fully Diluted" EPS
under APB Opinion No. 15.
Basic EPS excludes dilution from Common Stock equivalents and is computed
by dividing income available to common stockholders by the weighted-average
number of common shares outstanding for the period. Diluted EPS reflects the
potential dilution from Common Stock equivalents, similar to fully diluted EPS,
but uses only the average stock price during the period as part of the
computation.
F-12
<PAGE> 70
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
Data utilized in calculating pro forma earnings per share under the SFAS
128 statement are as follows:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
-------------------------------------------
1995 1996 1997
----------- ----------- -----------
<S> <C> <C> <C>
BASIC:
Net income........................................ $ 3,642,000 $ 6,920,000 $14,748,000
========== ========== ==========
Weighted-average number of common shares.......... 10,000,000 10,000,000 11,802,192
========== ========== ==========
DILUTED:
Net income........................................ $ 3,642,000 $ 6,920,000 $14,748,000
========== ========== ==========
Weighted-average number of common shares and
common share equivalents outstanding........... 10,000,000 10,000,000 11,802,192
========== ========== ==========
</TABLE>
The following tables reconcile the net income applicable to common
stockholders, basic and diluted shares, and EPS for the following periods:
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31, 1995 YEAR ENDED AUGUST 31, 1996
----------------------------------- -----------------------------------
PER-SHARE PER-SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
---------- ---------- --------- ---------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net income.................... $3,642,000 $6,920,000
---------- ---------
BASIC EPS
Income applicable to common
stockholders................ 3,642,000 10,000,000 $0.36 6,920,000 10,000,000 $0.69
---------- ===== ---------- =====
Effect of dilutive securities:
Warrants.................... -- -- -- --
Stock options............... -- -- -- --
---------- ---------- --------- ----------
DILUTED EPS
Income applicable to common
stockholders and assumed
conversions................. $3,642,000 10,000,000 $0.36 $6,920,000 10,000,000 $0.69
========== ========== ===== ========= ========== =====
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31, 1997
------------------------------------
PER-SHARE
INCOME SHARES AMOUNT
----------- ---------- ---------
<S> <C> <C> <C>
Net income.................................................. $14,748,000
-----------
BASIC EPS
Income applicable to common stockholders.................... 14,748,000 11,802,192 $1.25
---------- =====
Effect of dilutive securities:
Warrants.................................................. -- --
Stock options............................................. -- --
----------- -----------
DILUTED EPS
Income applicable to common stockholders and assumed
conversions............................................... $14,748,000 11,802,192 $1.25
=========== =========== =====
</TABLE>
Stock Split -- The accompanying financial statements retroactively reflect
a 1,600 for 1 stock split, an increase in authorized shares of Common Stock to
50 million and the establishment of a $.01 par value per share effective October
28, 1996.
F-13
<PAGE> 71
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
Reclassification -- Certain reclassifications have been made to conform
prior years with the current year presentation.
Use of Estimates -- The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
3. FAIR VALUES OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosure about Fair Value of Financial Instruments" ("SFAS
107"), requires disclosure of estimated fair value information for financial
instruments, whether or not recognized in the Statements of Financial Condition.
Fair values are based upon estimates using present value or other valuation
techniques in cases where quoted market prices are not available. Those
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. In that regard, the derived
fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. SFAS 107 excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements. Accordingly, the aggregate fair
value amounts presented do not represent the underlying value of the Company.
Estimated fair values, carrying values and various methods and assumptions
used in valuing the Company's financial instruments at August 31, 1996 and 1997
are set forth below:
<TABLE>
<CAPTION>
AUGUST 31, 1996 AUGUST 31, 1997
--------------------------- ---------------------------
CARRYING ESTIMATED FAIR CARRYING ESTIMATED FAIR
VALUE VALUE VALUE VALUE
-------- -------------- -------- --------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
FINANCIAL ASSETS:
Cash and cash equivalents(a).............. $ 443 $ 443 $ 6,104 $ 6,104
Loans held for sale, net(b)............... 4,610 5,371 9,523 11,414
Mortgage related securities(c)............ 22,944 22,944 106,299 106,299
Excess servicing rights(c)................ 12,121 12,121 -- --
Mortgage servicing rights(c).............. 3,827 3,827 9,507 9,507
FINANCIAL LIABILITIES:
Notes and contracts payable(d)............ 14,197 14,197 35,572 35,572
Subordinated debt(a)...................... -- -- 40,000 40,000
</TABLE>
- ---------------
(a) Carrying value was used as the estimate of fair value.
(b) Since it is the Company's business to sell loans it originates, the fair
value was estimated by using outstanding commitments from investors adjusted
for non-qualified loans and the collateral securing such loans.
(c) The fair value was estimated by discounting future cash flows of the
instruments using discount rates, default, loss and prepayment assumptions
based upon available market data, opinions from investment bankers and
portfolio experience.
(d) Notes payable generally are adjustable rate, indexed to the prime rate;
therefore, carrying value approximates fair value. Contracts payable
represent capitalized equipment leases with a weighted-
F-14
<PAGE> 72
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
average interest rate of 9.48%, at August 31, 1996 and 9.32% at August 31,
1997, which approximates fair value.
At August 31, 1996 and 1997, the Company had $59.6 million and $190.5
million, respectively, in outstanding commitments to originate and purchase
loans. A fair value of the commitments was estimated at $6.8 million at August
31, 1996 and $14.9 million at August 31, 1997 by calculating a theoretical gain
or loss on the sale of a funded loan adjusted for an estimate of loan
commitments not expected to fund, considering the difference between investor
yield requirements and the committed loan rates. The estimated fair value is not
necessarily representative of the actual gain to be recorded on such loan sales
in the future.
In the first quarter of fiscal 1997, the Company entered into an agreement
with a financial institution, providing for the purchase of up to $2.0 billion
of loans over a 5 year period. At August 31, 1997, $1.5 billion of loans
remained to be purchased under this commitment and the estimated fair value of
such commitment was $308.5 million by calculating a theoretical gain or loss on
the sale of a funded loan adjusted for an estimate of loan commitments not
expected to fund, considering the difference between investor yield requirements
and the committed loan rates. The estimated fair value is not necessarily
representative of the actual gain to be recorded on such loan sales in the
future. Pursuant to the agreement, Mego Financial issued to the financial
institution four-year warrants to purchase 1 million shares of Mego Financial's
common stock at an exercise price of $7.125 per share. The value of the warrants
of $3.0 million plus a $150,000 fee (0.15% of the commitment amount) as of the
commitment date (the "Warrant Value"), are being amortized as the commitment for
the purchase of loans is utilized. The Company has agreed to pay Mego Financial
the value of the warrants. At August 31, 1997, $2.3 million remained outstanding
as a prepaid commitment fee.
The fair value estimates made at August 31, 1996 and 1997 were based upon
pertinent market data and relevant information on the financial instruments at
that time. These estimates do not reflect any premium or discount that could
result from the sale of the entire portion of the financial instruments. Because
no market exists for a substantial portion of the financial instruments, fair
value estimates may be based upon judgments regarding future expected loss
experience, current economic conditions, risk characteristics of various
financial instruments and other factors. These estimates are subjective in
nature and involve uncertainties and matters of significant judgment and
therefore cannot be determined with precision. Changes in assumptions could
significantly affect the estimates. The Company had no other off-balance sheet
instruments at August 31, 1996 and 1997.
Fair value estimates are based upon existing on- and off-balance sheet
financial instruments without attempting to estimate the value of anticipated
future business and the value of assets and liabilities that are not considered
financial instruments. For instance, the Company has certain fee-generating
business lines (e.g., its loan servicing operations) that were not considered in
these estimates since these activities are not financial instruments. In
addition, the tax implications related to the realization of the unrealized
gains and losses can have a significant effect on fair value estimates and have
not been considered in any of the estimates.
4. CONCENTRATIONS OF RISK
Availability of Funding Source -- The Company funds substantially all of
the loans which it originates or purchases with borrowings through its financing
facilities and internally generated funds, as well as public and private sales
of debt and equity securities. These borrowings are in turn repaid with the
proceeds received by the Company from selling such loans through loan sales or
securitizations. Any failure to renew or obtain adequate financing under its
financing facilities, or other borrowings, or any substantial reduction in the
size of or pricing in the markets for the Company's loans, could have a material
adverse effect on the Company's operations. To the extent that the Company is
not successful in maintaining or replacing existing financings, it
F-15
<PAGE> 73
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
would have to curtail its loan production activities or sell loans earlier than
is optimal, thereby having a material adverse effect on the Company's results of
operations and financial condition.
Dependence on Securitizations -- In 1996 and 1997, the Company pooled and
sold through securitizations an increasing percentage of the loans that it
originated. The Company derives a significant portion of its income by
recognizing gains on sale of loans through securitizations which are due in part
to the fair value, recorded at the time of sale, of residual interests and
interest only securities retained. Adverse changes in the securitization market
could impair the Company's ability to sell loans through securitizations on a
favorable or timely basis. Any such impairment could have a material adverse
effect upon the Company's results of operations and financial condition.
The Company has relied on credit enhancement and over-collateralization to
generally achieve the "AAA/Aaa" rating for the senior interests in its
securitizations. The credit enhancement has generally been in the form of an
insurance policy issued by an insurance company insuring the timely repayment of
senior interests in each of the trusts. The Company's last two securitizations
were completed without the requirement of an insurance policy. There can be no
assurance that the Company will be able to obtain credit enhancement in any form
from the current insurer or any other provider of credit enhancement on
acceptable terms or that future securitizations will be similarly rated. A
downgrading of the insurer's credit rating or its withdrawal of credit
enhancement could have a material adverse effect on the Company's results of
operations and financial condition.
Geographic Concentrations -- The Company's servicing portfolio and loans
sold with recourse are geographically diversified within the United States. The
Company services mortgage loans in all 50 states and the District of Columbia.
At August 31, 1996, 36% of the dollar value of loans serviced had been
originated in California, and 13% in Florida. At August 31, 1997, 26% of the
dollar value of loans serviced had been originated in California and 15% in
Florida. No other state accounted for more than 10% of the servicing portfolio
for either period. The risk inherent in such concentrations is dependent upon
regional and general economic stability which affects property values and the
financial stability of the borrowers.
Credit Risk -- The Company is exposed to on-balance sheet credit risk
related to its loans held for sale and mortgage related securities. The Company
is exposed to off-balance sheet credit risk related to loans which the Company
has committed to originate and loans sold under recourse provisions. The
outstanding balance of loans sold with recourse provisions totaled $88.6
million, $81.5 million and $88.2 million at August 31, 1995, 1996 and 1997,
respectively.
Off-Balance Sheet Activities -- These financial instruments consist of
commitments to extend credit to borrowers and commitments to purchase loans from
others. As of August 31, 1995, 1996 and 1997, the Company had outstanding
commitments to extend credit or purchase loans in the amounts of $53.4 million,
$59.6 million and $190.5 million, respectively. These commitments do not
represent the expected total cash outlay of the Company, as historically only
40% of these commitments result in loan originations or purchases. The
prospective borrower or seller is under no obligation as a result of the
Company's commitment. The Company's credit and interest rate risk is therefore
limited to those commitments which result in loan originations and purchases.
The commitments are made for a specified fixed rate of interest, therefore the
Company is exposed to interest rate risk, to the extent changes in market
interest rates change prior to the origination and prior to the sale of the
loan.
Additionally, in the first quarter of fiscal 1997, the Company entered into
an agreement with a financial institution, providing for the purchase of up to
$2.0 billion of loans over a 5 year period. At August 31, 1997, $1.5 billion of
loans remained to be purchased from the Company under this commitment.
Interest Rate Risk -- The Company's profitability is in part determined by
the difference, or "spread," between the effective rate of interest received on
the loans originated or purchased by the Company and the
F-16
<PAGE> 74
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
interest rates payable under its financing facilities during the warehousing
period and yield required by investors on loan sales and securitizations. The
spread can be adversely affected after a loan is originated or purchased and
while it is held during the warehousing period by increases in the interest rate
demanded by investors in securitizations or sales. In addition, because the
loans originated and purchased by the Company have fixed rates, the Company
bears the risk of narrowing spreads because of interest rate increases during
the period from the date the loans are originated or purchased until the closing
of the sale or securitization of such loans. Additionally, the fair value of
mortgage related securities, mortgage servicing rights and excess servicing
rights owned by the Company may be adversely affected by changes in the interest
rate environment which could effect the discount rate and prepayment assumptions
used to value the assets. Any such adverse change in assumptions could have a
material adverse effect on the Company's results of operations and financial
condition.
5. LOANS HELD FOR SALE, ALLOWANCE FOR CREDIT LOSSES, LOAN ORIGINATIONS, AND
LOANS SERVICED
Loans held for sale, net of allowance for credit losses, consist of the
following:
<TABLE>
<CAPTION>
AUGUST 31,
-------------------
1996 1997
------ ------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Loans held for sale...................................... $4,699 $9,345
Deferred loan fees....................................... 6 278
Less allowance for credit losses......................... (95) (100)
------ ------
Total.................................................. $4,610 $9,523
====== ======
</TABLE>
The Company recognizes revenue from the gain on sale of loans, unrealized
gain on mortgage related securities, interest income and loan servicing income.
Interest income, net, represents the interest received on loans in the Company's
portfolio prior to their sale, net of interest paid under its debt agreements.
Net loan servicing income represents servicing fee income and other ancillary
fees received for servicing loans less the amortization of capitalized mortgage
servicing rights and excess servicing rights through January 1, 1997, which was
the date of adoption of SFAS 125. Mortgage servicing rights are amortized in
proportion to and over the period of estimated net servicing income, and excess
servicing rights were amortized in proportion to and over the estimated lives of
the loans.
The Company primarily sells loans through securitizations, and also sells
whole loans to third party purchasers. Certain of the regular interests of the
related securitizations are sold, with the interest only and residual interest
securities retained by the Company. The Company sells its loans through whole
loan sales to third party purchasers, generally retaining the right to service
the loans and to receive any amounts in excess of the guaranteed yield to the
purchasers. The Company also sells its loans through whole loan sales to third
party purchasers on a servicing released basis pursuant to which the Company
receives a cash premium.
The Company provides an allowance for credit losses, in an amount which in
the Company's judgment will be adequate to absorb losses after FHA insurance
recoveries on the Title I Loans, that may become uncollectible. The Company's
judgment in determining the adequacy of this allowance is based on its continual
review of its portfolio of loans which utilizes historical experience and
current economic factors. These reviews take into consideration changes in the
nature and level of the portfolio, historical rates, collateral values, current
and future economic conditions which may affect the obligors' ability to pay and
F-17
<PAGE> 75
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
overall portfolio quality. Changes in the allowance for credit losses and the
allowance for credit losses on loans sold with recourse consist of the
following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST
31,
-----------------------------
1995 1996 1997
---- ------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year.................................... $ 96 $ 960 $ 1,015
Provision for credit losses..................................... 864 1,510 23,048
Reductions to the provision due to securitizations or loans sold
without recourse.............................................. -- (1,455) (16,748)
Reductions due to charges to allowance for credit losses........ -- -- (201)
---- ------- --------
Balance at end of year.......................................... $960 $ 1,015 $ 7,114
==== ======= ========
Allowance for credit losses..................................... $ 74 $ 95 $ 100
Allowance for credit losses on loans sold with recourse......... 886 920 7,014
---- ------- --------
Total................................................. $960 $ 1,015 $ 7,114
==== ======= ========
</TABLE>
During fiscal 1996 and 1997, $113.9 million and $398.3 million,
respectively, of loans sold under recourse provisions were repurchased and
securitized as further described in Note 2. Reductions to the provision due to
reacquisition and securitization represent the allowance for credit losses on
loans sold with recourse transferred to the cost basis of the mortgage related
securities as a result of these transactions.
Loans serviced and originated consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
---------------------
1996 1997
-------- --------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Amount of Title I Loan originations.................................... $127,785 $ 98,085
Amount of Conventional Loan originations............................... 11,582 428,832
-------- --------
Total........................................................ $139,367 $526,917
======== ========
Loans serviced (including notes securitized, sold to investors, and
held for sale):
Title I.............................................................. $202,766 $255,446
Conventional......................................................... 11,423 372,622
-------- --------
Total........................................................ $214,189 $628,068
======== ========
</TABLE>
6. MORTGAGE RELATED SECURITIES
Mortgage related securities consist of interest only strips and residual
interest certificates of FHA Title I and Conventional Loan asset-backed
securities collateralized by loans originated, purchased and serviced by the
Company.
F-18
<PAGE> 76
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
Mortgage related securities are classified as trading securities and are
recorded at estimated fair value. Changes in the estimated fair value are
recorded in current operations. Mortgage related securities consist of the
following as required by SFAS 125:
<TABLE>
<CAPTION>
AUGUST 31,
--------------------
1996 1997
------- --------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Interest only strip securities.......................... $ 4,602 $ 6,398
Residual interest securities............................ 18,342 84,597
Interest only receivables (formerly excess servicing
rights)............................................... -- 15,304
------- --------
Total......................................... $22,944 $106,299
======= ========
</TABLE>
Activity in mortgage related securities consist of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
AUGUST 31,
--------------------
1996 1997
------- --------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Balance at beginning of year............................ $ -- $ 22,944
Additions due to securitizations, at cost............... 20,096 61,100
Net unrealized gain..................................... 2,697 3,518
Accretion of residual interest.......................... 243 4,796
Net transfers from excess servicing rights.............. -- 15,052
Principal reductions.................................... (92) (1,111)
------- --------
Balance at end of year.................................. $22,944 $106,299
======= ========
</TABLE>
The Company had no mortgage related securities at August 31, 1995.
7. EXCESS SERVICING RIGHTS
Activity in excess servicing rights consist of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
--------------------------------
1995 1996 1997
------- ------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year......................... $ 904 $14,483 $ 12,121
Plus additions....................................... 14,098 20,563 3,887
Less amortization.................................... (519) (2,144) (956)
Less amounts related to loans repurchased,
securitized and transferred to mortgage related
securities......................................... -- (20,781) (15,052)
------- ------- --------
Balance at end of year............................... $14,483 $12,121 $ --
======= ======= ========
</TABLE>
As of August 31, 1995, 1996 and 1997, excess servicing rights, which are
reported as mortgage related securities in the Company's Statements of Financial
Condition, consisted of excess cash flows on serviced loans totaling $88.6
million, $81.5 million and $88.2 million, yielding weighted-average interest
rates of 13.3%, 12.8% and 12.5% and net of normal servicing and pass-through
fees with weighted-average pass-through yields to the investor of 8.4%, 8.1% and
8.8%, respectively. These loans were sold under recourse provisions as described
in Note 2.
During fiscal 1996 and 1997, $113.9 million and $398.3 million,
respectively, of loans sold were repurchased and securitized as further
described in Note 2. Excess servicing rights related to the loans
F-19
<PAGE> 77
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
repurchased and securitized of $20.8 million and $71.9 million, respectively,
were transferred to the cost basis of the mortgage related securities as a
result of these transactions at August 31, 1996 and 1997.
Of the Title I Loans sold in the year ended August 31, 1995, $56.9 million
of such loans were sold to a purchaser, in a series of sales commencing on April
21, 1995, under a continuing sales agreement which provides for the yield to the
purchaser to be adjusted monthly to a rate equal to 200 basis points (2%) per
annum over the one-month London Interbank Offered Rate. During 1996 and 1997
Title I and Conventional Loans were sold subject to this agreement. ("LIBOR").
LIBOR was 5.875% per annum at August 31, 1996 and 5.688% per annum at August 31,
1997. The principal balance of Title I and Conventional Loans subject to the
LIBOR adjustment was $29.3 million at August 31, 1996 and $48.6 million at
August 31, 1997. The effect of an increase or decrease in LIBOR of 100 basis
points (1%) applied to those loans would be a decrease or increase,
respectively, to the Company's future pre-tax income of approximately $956,000
at August 31, 1996 and $1.9 million at August 31, 1997.
8. MORTGAGE SERVICING RIGHTS
Activity in mortgage servicing rights consist of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST
31,
----------------------------
1995 1996 1997
------ ------ ------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year............................. $ -- $1,076 $3,827
Plus additions........................................... 1,176 3,306 7,184
Less amortization and reductions......................... (100) (555) (1,504)
------ ------ -------
Balance at end of year................................... $1,076 $3,827 $9,507
====== ====== =======
</TABLE>
The Company had no valuation allowance for mortgage servicing rights during
fiscal 1995, 1996 or 1997, as the cost basis of mortgage servicing rights
approximated fair value.
The pooling and servicing agreements relating to the securitization
transactions contain provisions with respect to the maximum permitted loan
delinquency rates and loan default rates, which, if exceeded, would allow the
termination of the Company's right to service the related loans. At August 31,
1997, the default rates on the March 1996 and August 1996 securitization pooling
and servicing agreements exceeded the permitted level. The mortgage servicing
rights for these agreements were approximately $2.4 million at August 31, 1997.
In the event of such termination, there would be an adverse effect on the
valuation of the Company's mortgage servicing rights.
9. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
-----------------
1996 1997
------ ------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Office equipment and furnishings........................... $ 640 $1,702
EDP equipment.............................................. 470 948
Building improvements...................................... -- 144
Vehicles................................................... 34 34
------ ------
1,144 2,828
Less accumulated depreciation.............................. (279) (675)
------ ------
Total............................................ $ 865 $2,153
====== ======
</TABLE>
F-20
<PAGE> 78
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
10. OTHER ASSETS
Other assets consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
-----------------
1996 1997
------ ------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Accrued income from securitizations........................ $ 203 $ 537
Software costs, net of amortization (See Note 16).......... 154 92
Deposits and impounds...................................... 99 80
Other...................................................... 109 86
------ ------
Total.................................................... $ 565 $ 795
====== ======
</TABLE>
11. NOTES AND CONTRACTS PAYABLE
Notes and contracts payable consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
-------------------
1996 1997
------- -------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Note payable -- warehouse line of credit................. $ 3,265 $ 8,500
Note payable -- revolving line of credit................. 10,000 24,976
Other.................................................... 932 2,096
------- -------
Total.......................................... $14,197 $35,572
======= =======
</TABLE>
Loan originations are initially funded principally through the Company's
new $40.0 million warehouse line of credit that was executed in June 1997 and
increased to $65.0 million in October 1997, which replaces a previous $20.0
million warehouse line of credit. At August 31, 1997, $8.5 million was
outstanding under this new warehouse line of credit. In excess of 98.5% of the
aggregate loans originated by the Company through August 31, 1997 had been sold.
Net cash used in the Company's operating activities was funded primarily from
the reinvestment of proceeds from the sale of loans in the secondary market
totaling approximately $522.0 million during fiscal 1997. The loan sale
transactions generally required the subordination of certain cash flows payable
to the Company to the payment of scheduled principal and interest due to the
loan purchasers. In connection with certain of such sale transactions, a portion
of amounts payable to the Company from the excess interest spread is required to
be maintained in a reserve account to the extent of the subordination
requirements. The subordination requirements generally provide that the excess
interest spread is payable to the reserve account until a specified percentage
of the principal balances of the sold loans is accumulated therein. The excess
interest required to be deposited and maintained in the respective reserve
accounts is not available to support the cash flow requirements of the Company.
At August 31, 1997, amounts on deposit in such reserve accounts totaled $6.9
million.
The new $40.0 million warehouse line of credit was increased effective
October 17, 1997 to $65.0 million, bears interest at the lower of the one-month
LIBOR + 1.50% or the Federal Funds rate plus 0.25%, expires June 15, 1998, and
is secured by loans prior to sale. The agreement requires the Company to
maintain adjusted minimum tangible net worth of $65.0 million plus 50% of the
Company's cumulative net income since November 30, 1996, plus all net proceeds
received by the Company through the sale or issuance of stock or additional
subordinated notes. At August 31, 1997, the adjusted tangible net worth as
defined in the agreement was $88.1 million, and the required minimum adjusted
tangible net worth at that date was $71.1 million. Additionally, the following
material covenant restrictions exist: i) the ratio of total liabilities (not
including subordinated notes) divided by adjusted tangible net worth (including
subordinated notes) cannot exceed 3:1, and ii) total liabilities must be less
than the aggregate of 100% of cash plus 93% of loans
F-21
<PAGE> 79
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
held for sale plus 55% of restricted cash and mortgage related securities. At
August 31, 1997, the ratio of total liabilities to adjusted tangible net worth
was 0.69:1 and total liabilities were $61.1 million, which was $16.1 million
under the maximum amount allowed.
In April 1997, the Company entered into a pledge and security agreement
with another financial institution for an $11.0 million revolving credit
facility. The amount which can be borrowed under the agreement was increased to
$15.0 million in June 1997 and $25.0 million in July 1997. This facility is
secured by a pledge of certain of the Company's interest only and residual class
certificates relating to securitizations carried as mortgage related securities
on the Company's Statements of Financial Condition, payable to the Company
pursuant to its securitization agreements. A portion of the loans under the
credit line agreement bears interest at one-month LIBOR + 3.5%, expiring one
year from the initial advance, and requires the Company to maintain a minimum
net worth requirement of the greater of $35.0 million, or 80% of net worth,
following fiscal year end 1997. The portion of the credit line agreement
applicable to a repurchase agreement secured by insured interest only
certificates is at one-month LIBOR + 2.0%. At August 31, 1997, the required net
worth was $35.0 million and the Company's actual net worth was $53.1 million.
Additionally, the agreement requires the Company to maintain a debt-to-net-worth
ratio not to exceed 2.5:1. At August 31, 1997, the ratio was 1.74:1.
Certain material covenant restrictions exist in the Indenture governing the
Notes. These covenants include limitations on the Company's ability to incur
indebtedness, grant liens on its assets and to enter into extraordinary
corporate transactions. The Company may not incur indebtedness if, on the date
of such incurrence and after giving effect thereto, the Consolidated Leverage
Ratio would exceed 2:1, subject to certain exceptions. At August 31, 1997, the
Consolidated Leverage Ratio was 1.65:1. The Consolidated Leverage Ratio is the
ratio of (i) total debt, including subordinated debt, but excluding the
Permitted Warehouse Indebtedness (as defined below), accounts payable
outstanding less than 60 days, and the tax sharing payable to Mego Financial by
the Company, to (ii) the consolidated net worth of the Company. The Permitted
Warehouse Indebtedness generally is the outstanding amount under the warehouse
line of credit agreement. At August 31, 1997, this ratio was 0.06:1. In
addition, an increasing amount of the Company's mortgage related securities are
required to remain unpledged. At August 31, 1997, that requirement was $39.9
million, and at that date $60.9 million of mortgage related securities were
pledged, and $45.4 million of mortgage related securities were unpledged. See
Note 18.
At August 31, 1996 and 1997, contracts payable consisted of $932,000 and
$2.1 million, respectively, in obligations under lease purchase arrangements
secured by property and equipment, bearing a weighted-average interest rate of
9.32% at August 31, 1997.
Scheduled maturities of the Company's contracts payable of $2.1 million at
August 31, 1997 are as follows:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
----------------------------------------
TOTAL 1998 1999 2000 2001 2002
- ------ ---- ---- ---- ---- ----
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
$2,096 $554 $536 $522 $413 $71
</TABLE>
F-22
<PAGE> 80
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
12. INCOME TAXES
As described in Note 2, prior to the Spin-off, the Company recorded a
liability to Mego Financial for federal income taxes at the statutory rate
(currently 34%). State income taxes are computed at the appropriate state rate
(6%) net of any available operating loss carryovers and are recorded as state
income taxes payable. Income tax expense has been computed as follows:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
------------------------------
1995 1996 1997
------ ------- -------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Income before income taxes............................. $5,919 $11,155 $23,810
====== ======= =======
Federal income taxes at 34% of income.................. $2,013 $ 3,793 $ 8,095
State income taxes, net of federal income tax
benefit.............................................. 234 442 943
Other.................................................. 30 -- 24
------ ------- -------
Income tax expense..................................... $2,277 $ 4,235 $ 9,062
====== ======= =======
Income tax expense is comprised of the following:
Current.............................................. $2,047 $ 3,562 $12,319
Deferred............................................. 230 673 (3,257)
------ ------- -------
Total........................................ $2,277 $ 4,235 $ 9,062
====== ======= =======
</TABLE>
Deferred income taxes reflect the net tax effects of (a) temporary
differences between the carrying amount of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes, (b) temporary
differences between the timing of revenue recognition for book purposes and
income tax purposes and (c) operating loss and tax credit carryforwards. The tax
effects of significant items comprising the Company's net deferred tax
(liability) asset, included in Due to Mego Financial, are as follows:
<TABLE>
<CAPTION>
AUGUST 31,
-------------------
1996 1997
------ ------
(THOUSANDS OF
DOLLARS)
<S> <C> <C>
Deferred tax assets:
Realized gain on mortgage related securities................. $ 386 $2,373
Other........................................................ -- 91
------ ------
386 2,464
------ ------
Deferred tax liabilities:
Difference between book and tax carrying value of assets..... 98 110
Unrealized gain on mortgage related securities............... 1,025 --
Other........................................................ 166 --
------ ------
1,289 110
------ ------
Net deferred tax (liability) asset................... $ (903) $2,354
====== ======
</TABLE>
13. SUBORDINATED DEBT
In November 1996, the Company consummated the IPO, pursuant to which it
issued 2.3 million shares of Common Stock at $10.00 per share. Concurrently with
the IPO, the Company issued the Existing Notes in the amount of $40.0 million
due in 2001 in an underwritten public offering. The Company used approximately
$13.9 million of the aggregate net proceeds from these offerings to repay
intercompany debt due to Mego Financial and Preferred Equities Corporation
("PEC") and approximately $24.3 million to reduce the amounts outstanding under
the Company's lines of credit. The balance of the net proceeds has been used to
originate loans. The balance at August 31, 1997 for these notes was $40.0
million. Prepaid debt expenses
F-23
<PAGE> 81
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
related to these notes were $2.4 million at August 31, 1997 and are being
amortized over the term of the Existing Notes. See Note 18 for a description of
subsequent subordinated debt issuance.
14. ADDITIONAL PAID-IN CAPITAL
In 1995, Mego Financial contributed $3.0 million to the Company as
additional paid-in capital. In November 1996, additional paid-in capital was
increased by $20.6 million due to the sale of 2.3 million shares of Common
Stock, net of issuance costs, in the IPO. See Notes 1 and 13.
15. COMMITMENTS AND CONTINGENCIES
The Company leases an office under the terms of an operating lease that
expires March 31, 1999. During fiscal 1995, 1996 and 1997, the Company's rent
expense related to this lease was $154,000, $164,000 and $161,000, respectively.
In April 1996, the Company executed an operating lease for its main offices in a
second location which it occupied in late 1996. The 1996 lease commenced
September 1, 1996 and expires August 31, 2002. The Company's rent expense
related to this lease was $827,000 for the fiscal year ended August 31, 1997.
Future minimum payments under these operating leases at August 31, 1997 are set
forth below (thousands of dollars):
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
<S> <C>
1998.............................................................. $1,080
1999.............................................................. 1,025
2000.............................................................. 942
2001.............................................................. 961
2002.............................................................. 814
------
Total................................................... $4,822
======
</TABLE>
Additionally, in October 1997, the Company entered into a five year
$986,000 equipment financing arrangement which will result in annual payments of
approximately $248,000 per year.
In the general course of business, the Company, at various times, has been
named in lawsuits. The Company believes that it has meritorious defenses to
these lawsuits and that resolution of these matters will not have a material
adverse affect on the business or financial condition of the Company.
16. RELATED PARTY TRANSACTIONS
During the years ended August 31, 1995, 1996 and 1997, PEC, a wholly-owned
subsidiary of Mego Financial, provided certain services to the Company including
loan servicing and collection for a cost of $232,000, $709,000 and $1.9 million,
respectively. In addition, PEC provided services including executive,
accounting, legal, management information, data processing, human resources,
advertising and promotional materials (management services) totaling $690,000,
$671,000 and $967,000, which amounts were included in general and administrative
expenses for the years ended August 31, 1995, 1996 and 1997, respectively.
Included in other interest expense for the years ended August 31, 1995, 1996 and
1997, are $85,000, $29,000 and $16,000, respectively, related to advances from
PEC.
During the years ended August 31, 1995, 1996 and 1997, the Company paid PEC
for developing certain computer programming (see Note 10), incurring costs of
$36,000, $56,000 and $0, respectively. The Company is amortizing these costs
over a five year period. During fiscal 1995, 1996 and 1997, amortization of
$26,000, $29,000 and $62,000, respectively, was included in expense. The
Company's agreement with PEC regarding loan servicing and collection services
charges the Company an annual rate of 0.5% of outstanding loans serviced by PEC
calculated and paid on a monthly basis. The costs charged to the Company for
management
F-24
<PAGE> 82
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
services provided by PEC represent an estimate of the costs incurred by PEC
which would have been incurred by the Company had it been operating as a stand
alone entity.
Management believes the allocation methodologies and contractual
arrangements for services performed by PEC have been reasonable and are
representative of an approximation of the expense the Company would have
incurred had it operated as a stand alone entity performing such services.
At August 31, 1995, 1996 and 1997, the Company had a non-interest bearing
liability to Mego Financial of $8.5 million, $12.0 million and $9.7 million,
respectively, for federal income taxes and cash advances. On August 29, 1997,
the Company and Mego Financial entered into an agreement (the "Payment
Agreement") with respect to the Company's repayment after the Spin-off of (i) a
portion of the debt owed by the Company to Mego Financial as of May 31, 1997
aggregating approximately $3.4 million (the "May Amounts") and (ii) debt owed by
the Company to Mego Financial as of August 31, 1997 in addition to the May
Amounts (the "Excess Amounts"). The May Amounts consist of a portion of the debt
owed by the Company to Mego Financial as of May 31, 1997 in respect of funds
advanced by Mego Financial to the Company through such date, the portion of the
Warrant Value amortized through such date and amounts owed under the tax
allocation and indemnification agreement between Mego Financial and the Company
as of such date. The Excess Amounts consist of funds advanced by Mego Financial
to the Company during the period commencing June 1, 1997 and ending August 31,
1997 (the "Excess Period"), the portion of the Warrant Value amortized during
the Excess Period and amounts accrued under the tax allocation and
indemnification agreement during the Excess Period. Pursuant to the Payment
Agreement, the Company has agreed to repay the May Amounts upon the earlier to
occur of (i) the first consummation after the date of the agreement of a public
or private debt or equity transaction by the Company of at least $25.0 million
in amount or (ii) August 31, 1998. The Company further agreed to repay the
Excess Amounts upon the earlier to occur of (i) the second consummation after
the date of the agreement of a public or private debt or equity transaction by
the Company of at least $25.0 million in amount or (ii) August 31, 1998. The
amount of the amortization of the Warrant Value for each of the months of
September, October, November and December 1997 will be payable January 31, 1998.
Commencing in January 1998, the unpaid balance of the Warrant Value will
continue to be amortized on a monthly basis and the amount of such amortization
will be due and payable within 30 days from the end of each fiscal quarter.
At August 31, 1996 and 1997, the Company had a non-interest bearing
liability to PEC of $819,000 and $446,000, respectively, relating to charges for
services to the Company. Under the Payment Agreement, Mego Financial may, but is
not obligated to, make advances to PEC on behalf of the Company. Advances, if
any, by Mego Financial on behalf of the Company to PEC will be due and payable
within 30 days after the close of the month in which such advance was made.
Under the Payment Agreement, any amount owed by the Company to Mego Financial
that is not paid when due will bear interest from such due date until paid at
the rate of 10.0% per annum. In October 1997, $3.9 million was paid to Mego
Financial, which included the May Amounts.
F-25
<PAGE> 83
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
Activity in Due to Mego Financial consist of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
----------------------------------
1995 1996 1997
------- ------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year....................... $ -- $ 8,453 $ 11,994
Provision for federal income taxes................. 2,013 3,566 7,630
Cash advances from Mego Financial.................. 9,053 5,475 5,123
Repayment of advances.............................. (2,613) (5,500) (15,094)
------- ------- --------
Balance at end of year............................. $ 8,453 $11,994 $ 9,653
======= ======= ========
Average balance during the year.................... $ 2,275 $11,874 $ 6,876
======= ======= ========
</TABLE>
The Company anticipates issuing Common Stock and subordinated debt to
support its cash flow needs in the future. Although it may do so, Mego Financial
is not anticipated to provide funds to the Company or guarantee its indebtedness
and it has no obligation to do so.
17. STOCK OPTIONS
In November 1996 and August 1997, the Company authorized the reservation of
925,000 and 1 million shares, respectively, of Common Stock for issuance upon
the exercise of options to purchase Common Stock granted under the Company's
1996 Stock Option Plan and 1997 Stock Option Plan. Effective August 20, 1997,
the Company converted all outstanding employee stock options to SARs which
resulted in additional compensation expense of approximately $220,000. See Note
18.
18. SUBSEQUENT EVENTS
In October 1997, the Company issued $40.0 million of 12.5% Senior
Subordinated Notes ("Additional Notes") due in 2001 in the Private Placement
which increased the aggregate principal amount of outstanding 12.5% Senior
Subordinated Notes from $40.0 million to $80.0 million. The Company used the net
proceeds of the Private Placement to repay $3.9 million of debt due to Mego
Financial, $29.0 million to reduce the amounts outstanding under the Company's
lines of credit, and to provide capital to originate and securitize loans. These
Additional Notes are subject to the Indenture governing all of the Company's
subordinated notes.
The Company has entered into a registration rights agreement with Friedman,
Billings, Ramsey & Co., Inc. ("Registration Rights Agreement") pursuant to which
the Company agreed, for the benefit of the holders of the Additional Notes, at
the Company's cost, (i) to file a registration statement (the "Exchange Offer
Registration Statement") with respect to a registered offer to exchange the
Additional Notes ("Exchange Offer") for notes of the Company with terms
identical in all material respects to the Additional Notes ("Exchange Notes")
(except that the Exchange Notes will not contain terms with respect to transfer
restrictions or interest rate increases) with the Securities and Exchange
Commission on or before November 28, 1997 and (ii) to use its best efforts to
cause the Exchange Offer Registration Statement to be declared effective under
the Securities Act on or before January 12, 1998. Promptly after the Exchange
Offer Registration Statement has been declared effective, the Company will offer
the Exchange Notes in exchange for surrender of the Additional Notes. The
Company will keep the Exchange Offer open for not less than 30 days (or longer
if required by applicable law) after the date notice of the Exchange Offer is
mailed to the holders of the Additional Notes. For each Additional Note validly
tendered to the Company pursuant to the Exchange Offer and not withdrawn by the
holder thereof, the holder of such Notes will receive Exchange Notes having a
principal amount equal to that of the tendered Additional Notes. Interest on
each Exchange Note will accrue from the last interest payment date on which
interest was paid on the tendered Additional
F-26
<PAGE> 84
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
Notes in exchange therefor or, if no interest has been paid on such Additional
Notes, from the date of its original issue.
On October 22, 1997 the Board of Directors ("the Board") of the Company
voted, subject to stockholder approval, to amend the Company's 1997 Stock Option
Plan to increase the number of shares of stock reserved for issuance upon the
exercise of options to purchase Common Stock granted from one million to two
million shares.
Additionally, the Board voted to repurchase all of the outstanding SARs.
The SARs will be bought at $1.00 per share for those SARS previously held at
$10.00 to $11.00 per share and $0.70 per share for those SARS previously held at
$12.00 per share. Effective October 22, 1997, new employee stock options were
granted at fair market value which was $14.75 per share on October 21, 1997 in
the amount of 1,052,500 options, issued subject to stockholder approval of the
1997 Stock Option Plan. In addition to the accrued compensation expense of
$220,000 recorded in fiscal 1997 (See Note 17), the Company will incur an
additional $761,250 of expense, excluding payroll tax items, related to the
purchase of the SARs in the first quarter of fiscal 1998.
On August 20, 1997, the Company's Board of Directors determined to change
the Company's fiscal year-end from August 31 to December 31, effective December
31, 1997 and accordingly filed a Current Report on Form 8-K on September 4,
1997. The Company intends to file a Transition Report on Form 10-K for the four
month transition period ended December 31, 1997.
19. QUARTERLY FINANCIAL DATA (UNAUDITED)
The following tables reflect quarterly financial data for the Company.
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
-----------------------------------------------------
NOVEMBER 30, FEBRUARY 29, MAY 31, AUGUST 31,
1995 1996 1996 1996
------------ ------------ ---------- ----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
REVENUES:
Gain on sale of loans and mortgage related
securities................................... $ 5,965 $ 4,845 $ 2,151 $ 6,275
Interest income, net........................... 138 (3) 403 450
Financial income and other..................... 891 870 1,288 299
---------- ---------- ---------- ----------
Total revenues....................... 6,994 5,712 3,842 7,024
---------- ---------- ---------- ----------
EXPENSES:
Operating expenses............................. 2,805 2,882 3,305 3,203
Net provision for credit losses................ 297 200 (524) 82
Interest....................................... 47 31 42 47
---------- ---------- ---------- ----------
Total expenses....................... 3,149 3,113 2,823 3,332
---------- ---------- ---------- ----------
Income before income taxes..................... 3,845 2,599 1,019 3,692
Income tax expense............................. 1,538 1,040 255 1,402
---------- ---------- ---------- ----------
Net income..................................... $ 2,307 $ 1,559 $ 764 $ 2,290
========== ========== ========== ==========
EARNINGS PER SHARE:
Primary........................................ $ 0.23 $ 0.16 $ 0.08 $ 0.23
========== ========== ========== ==========
Fully-diluted.................................. $ 0.23 $ 0.16 $ 0.08 $ 0.23
========== ========== ========== ==========
WEIGHTED-AVERAGE NUMBER OF SHARES OUTSTANDING:
Primary........................................ 10,000,000 10,000,000 10,000,000 10,000,000
========== ========== ========== ==========
Fully-diluted.................................. 10,000,000 10,000,000 10,000,000 10,000,000
========== ========== ========== ==========
</TABLE>
F-27
<PAGE> 85
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEARS ENDED AUGUST 31, 1995, 1996 AND 1997
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
-----------------------------------------------------
NOVEMBER 30, FEBRUARY 28, MAY 31, AUGUST 31,
1996 1997 1997 1997
------------ ------------ ---------- ----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
REVENUES:
Gain on sale of loans and mortgage related
securities................................... $ 9,366 $ 8,966 $ 15,532 $ 14,777
Interest income, net........................... 355 526 1,137 1,115
Financial income and other..................... 638 560 726 1,112
---------- ---------- ---------- ----------
Total revenues....................... 10,359 10,052 17,395 17,004
---------- ---------- ---------- ----------
EXPENSES:
Operating expenses............................. 4,589 5,352 6,274 8,240
Net provision for credit losses................ 1,711 (800) 4,108 1,281
Interest....................................... 47 51 122 25
---------- ---------- ---------- ----------
Total expenses....................... 6,347 4,603 10,504 9,546
---------- ---------- ---------- ----------
Income before income taxes..................... 4,012 5,449 6,891 7,458
Income tax expense............................. 1,533 2,078 2,619 2,832
---------- ---------- ---------- ----------
Net income..................................... $ 2,479 $ 3,371 $ 4,272 $ 4,626
========== ========== ========== ==========
EARNINGS PER SHARE:
Primary........................................ $ 0.24 $ 0.27 $ 0.35 $ 0.38
========== ========== ========== ==========
Fully-diluted.................................. $ 0.24 $ 0.27 $ 0.35 $ 0.38
========== ========== ========== ==========
WEIGHTED-AVERAGE NUMBER OF SHARES OUTSTANDING:
Primary........................................ 10,317,102 12,476,069 12,379,368 12,300,000
========== ========== ========== ==========
Fully-diluted.................................. 10,319,051 12,544,291 12,379,368 12,300,000
========== ========== ========== ==========
</TABLE>
F-28
<PAGE> 1
EXHIBIT 10.42
AGREEMENT
This Agreement is made as of the 29th day of August, 1997, between MEGO
FINANCIAL CORP. ("Mego Financial") and MEGO MORTGAGE CORPORATION ("Mego
Mortgage").
WHEREAS, Mego Financial presently is the owner and holder of
10,000,000 shares of the common stock of Mego Mortgage which Mego Financial will
distribute to its shareholders on September 2, 1997 (the "Spin-off"); and
WHEREAS, Mego Mortgage is and will be indebted to Mego Financial as
hereinafter set forth, and the parties are desirous of agreeing to a payment
date or dates for all of such indebtedness which will survive the Spin-off; and
WHEREAS, Mego Financial and Mego Mortgage have entered into a Tax
Allocation and Indemnification Agreement (the "Tax Agreement") dated November
19, 1996, pursuant to which Mego Mortgage was indebted to Mego Financial in the
amount of $2,898,450.53 as of May 31, 1997, (the "May Tax Amount"); and
WHEREAS, as of August 31, 1997, Mego Mortgage will be indebted to Mego
Financial under the Tax Agreement for an additional amount (the "Excess Tax
Amount") in excess of the May Amount; and
WHEREAS, on October 27, 1996, Mego Financial issued a warrant (the
"Warrant") to Greenwich Capital Markets, Inc. to purchase 1,000,000 shares of
the common stock of Mego Financial at an exercise price of $7.125 per share,
which Warrant was provided for the benefit of Mego Mortgage in order to obtain
from Greenwich a commitment (the "Commitment") to purchase $2 Billion of loans
from Mego Mortgage; and
WHEREAS, the Warrant was valued at $3,000,000 (the "Warrant Value") at the
time of issuance by Oppenheimer & Co., Inc., which Warrant Value was accepted by
Mego Financial and Mego Mortgage; and
WHEREAS, the Warrant Value is being amortized on the books and recorded
on the financial statements of Mego Mortgage over the five year life of the
Commitment or sooner, as the Commitment is used; and
WHEREAS, it was agreed between Mego Financial and Mego Mortgage that Mego
Mortgage was indebted to Mego Financial for the amount of the Warrant Value, of
which $489,000 was amortized on the books of Mego Mortgage and is payable to
Mego Financial, as of May 31, 1997 (the "May Warrant Amount") and an additional
1
<PAGE> 2
amount of which will have been amortized and will be payable on August 31,
1997, (the "Excess Warrant Amount"); and
WHEREAS, in addition to the May Tax Amount and the May Warrant Amount, Mego
Mortgage was indebted to Mego Financial as of May 31, 1997 for advances made by
Mego Financial on behalf of Mego Mortgage to Preferred Equities Corporation
("Preferred") and others, aggregating $50,731.72 (the "May Miscellaneous
Amount") and will be indebted to Mego Financial as of August 31, 1997 for an
additional amount (the "Excess Miscellaneous Amount") in excess of the May
Miscellaneous Amount for additional advances made by Mego Financial on behalf
of Mego Mortgage to Preferred.
NOW THEREFORE, in consideration of the mutual covenants and promises
contained herein the parties hereto agree as follows:
1. The statements in the preamble hereto are true and correct.
2. The aggregate of the May Tax Amount, the May Warrant Amount and the May
Miscellaneous Amount aggregating $3,438,182.25 will be due and payable by Mego
Mortgage to Mego Financial upon the first consummation after the date hereof of
a public or private debt or equity transaction of Mego Mortgage of at least
$25,000,000 in amount, or on August 31, 1998, whichever is earlier.
3. The Aggregate of the Excess Tax Amount, the Excess Warrant Amount and the
Excess Miscellaneous Amount will be due and payable by Mego Mortgage to Mego
Financial upon the second consummation after the date hereof of a public or
private debt or equity transaction of Mego Mortgage of at least $25,000,000 in
amount, or on August 31, 1998, whichever is earlier.
4. The unpaid balance of the Warrant Value due to Mego Financial from Mego
Mortgage will continue to become due in the amount being amortized for each of
the months of September, October, November, and December, 1997, and will be
payable January 31, 1998. Commencing in January,1998, the unpaid balance of the
Warrant Value due to Mego Financial from Mego Mortgage will continue to be
amortized on a monthly basis and will be due and payable within 30 days from
the end of each fiscal quarter.
5. Advances, if any, by Mego Financial on behalf of Mego Mortgage, to
Preferred, made after August 31, 1997, will be due and payable within thirty
days after the close of the month in which such advance was made.
6. Any amount not paid when due shall bear interest from such due date at the
rate of 10% per annum until paid.
7. This Agreement shall be for the benefit of and binding upon the parties
hereto, their respective successors and assigns.
2
<PAGE> 3
IN WITNESS WHEREOF, the parties hereto have executed and
delivered this agreement as of the day and year first above written.
MEGO MORTGAGE CORPORATION
By: /s/ JEROME J. COHEN
------------------------------
Jerome J. Cohen
Chairman of the Board &
Chief Executive Officer
MEGO FINANCIAL CORP.
By: /s/ DON A. MAYERSON
------------------------------
Don A. Mayerson
Executive Vice President
General Counsel
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> AUG-31-1997
<PERIOD-START> SEP-01-1996
<PERIOD-END> AUG-31-1997
<CASH> 12,994
<SECURITIES> 0
<RECEIVABLES> 9,623
<ALLOWANCES> 100
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 2,828
<DEPRECIATION> 675
<TOTAL-ASSETS> 154,200
<CURRENT-LIABILITIES> 0
<BONDS> 35,572
0
0
<COMMON> 123
<OTHER-SE> 52,984
<TOTAL-LIABILITY-AND-EQUITY> 154,200
<SALES> 0
<TOTAL-REVENUES> 54,810
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 31,000
<LOSS-PROVISION> 6,300
<INTEREST-EXPENSE> 245
<INCOME-PRETAX> 23,810
<INCOME-TAX> 9,062
<INCOME-CONTINUING> 14,748
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 14,748
<EPS-PRIMARY> 1.25
<EPS-DILUTED> 1.25
</TABLE>
