<PAGE> 1
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SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: NOVEMBER 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________ TO _________
COMMISSION FILE NUMBER: 0-21689
MEGO MORTGAGE CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 88-0286042
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1000 PARKWOOD CIRCLE, SUITE 500, ATLANTA, GEORGIA 30339
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(770) 952-6700
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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 [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of January 5, 1998, there were 12,300,000 shares of Common Stock,
$.01 par value per share, of the Registrant outstanding.
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<PAGE> 2
MEGO MORTGAGE CORPORATION
INDEX
<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
PART I FINANCIAL INFORMATION
Item 1. Condensed Financial Statements (unaudited)
Independent Accountants' Report..................................................... 1
Condensed Statements of Financial Condition at
August 31, 1997 and November 30, 1997............................................... 2
Condensed Statements of Operations for the Three Months Ended
November 30, 1996 and 1997 ........................................................ 3
Condensed Statements of Cash Flows for the Three Months Ended
November 30, 1996 and 1997 ......................................................... 4
Condensed Statements of Stockholders' Equity for the Three Months Ended
November 30, 1997 .................................................................. 5
Notes to Condensed Financial Statements............................................. 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................................... 10
PART II OTHER INFORMATION
Item 1. Legal Proceedings................................................................... 22
Item 6. Exhibits and Reports on Form 8-K.................................................... 22
SIGNATURE .................................................................................... 23
</TABLE>
i
<PAGE> 3
PART I FINANCIAL INFORMATION
ITEM 1. CONDENSED FINANCIAL STATEMENTS
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Stockholders of
Mego Mortgage Corporation
Atlanta, Georgia
We have reviewed the condensed statement of financial condition of Mego Mortgage
Corporation (the "Company") as of November 30, 1997, and the related condensed
statements of operations, stockholders' equity and cash flows for the three-
month period then ended. These condensed financial statements are the
responsibility of the Company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and of making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with generally accepted auditing standards, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole.
Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to such condensed financial statements for them to be in conformity with
generally accepted accounting principles.
DELOITTE & TOUCHE LLP
San Diego, California
January 9, 1998
1
<PAGE> 4
MEGO MORTGAGE CORPORATION
CONDENSED STATEMENTS OF FINANCIAL CONDITION
(unaudited)
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
1997 1997
---------- ------------
(thousands of dollars,
except per share amounts)
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 6,104 $ 5,206
Cash deposits, restricted 6,890 8,792
Loans held for sale, net of allowance for credit losses of $100 and $116 9,523 55,711
Mortgage related securities, at fair value 106,299 94,263
Mortgage servicing rights 9,507 10,426
Other receivables 7,945 7,862
Property and equipment, net of accumulated depreciation of $675 and $805 2,153 2,023
Organizational costs, net of amortization 289 241
Prepaid debt expenses 2,362 4,998
Prepaid commitment fee 2,333 2,115
Income tax benefit -- 9,301
Other assets 795 302
---------- ----------
TOTAL ASSETS $ 154,200 $ 201,240
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes and contracts payable $ 35,572 $ 53,727
Accounts payable and accrued liabilities 7,759 7,779
Allowance for credit losses on loans sold with recourse 7,014 8,583
Due to Mego Financial Corp. 9,653 6,153
Due to Preferred Equities Corporation 446 840
State income taxes payable 649 --
---------- ----------
Total liabilities 61,093 77,082
---------- ----------
Subordinated debt 40,000 80,392
---------- ----------
Stockholders' equity:
Preferred Stock, $.01 par value per share
(Authorized--5,000,000 shares) -- --
Common Stock, $.01 par value per share
(Authorized--50,000,000 shares;
Issued and outstanding--12,300,000 at August 31, and November 30, 1997) 123 123
Additional paid-in capital 29,185 31,539
Retained earnings 23,799 12,104
---------- ----------
Total stockholders' equity 53,107 43,766
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 154,200 $ 201,240
========== ==========
</TABLE>
See notes to condensed financial statements.
2
<PAGE> 5
MEGO MORTGAGE CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30,
------------------------------------
1996 1997
------------ ------------
(thousands of dollars, except
per share amounts)
<S> <C> <C>
REVENUES:
Gain on sale of loans $ 9,601 $ 3,721
Net unrealized loss on mortgage related securities (235) (13,108)
Loan servicing income, net 638 1,194
Interest income 1,000 4,296
Less: interest expense (645) (3,086)
------------ ------------
Net interest income 355 1,210
------------ ------------
Net revenues (losses) 10,359 (6,983)
------------ ------------
COSTS AND EXPENSES:
Net provision for credit losses 1,711 1,590
Depreciation and amortization 140 208
Other interest 47 77
General and administrative:
Payroll and benefits 1,816 5,207
Commissions and selling 583 690
Credit reports 153 272
Rent and lease expenses 271 293
Professional services 112 671
Servicing fees due to Preferred Equities Corporation 285 661
Management services fees due to Preferred Equities Corporation 242 242
FHA insurance 203 106
Other 784 1,848
------------ ------------
Total costs and expenses 6,347 11,865
------------ ------------
INCOME (LOSS) BEFORE INCOME TAXES 4,012 (18,848)
INCOME TAXES (BENEFIT) 1,533 (7,153)
------------ ------------
NET INCOME (LOSS) $ 2,479 $ (11,695)
============ ============
EARNINGS (LOSS) PER COMMON SHARE:
Primary:
Net income (loss) $ 0.24 $ (0.95)
============ ============
Weighted-average number of common shares and
common share equivalents outstanding 10,317,102 12,300,000
============ ============
Fully-diluted:
Net income (loss) $ 0.24 $ (0.95)
============ ============
Weighted-average number of common shares and
common share equivalents outstanding 10,319,051 12,300,000
============ ============
</TABLE>
See notes to condensed financial statements.
3
<PAGE> 6
MEGO MORTGAGE CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30,
-------------------------------
1996 1997
---------- ----------
(thousands of dollars)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 2,479 $ (11,695)
---------- ----------
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Additions to mortgage servicing rights (1,209) (1,530)
Additions to excess servicing rights (11,349) --
Net unrealized loss on mortgage related securities 235 13,108
Net provisions for estimated credit losses 1,711 1,590
Depreciation and amortization expense 140 208
Amortization of prepaid debt expense 22 243
Amortization of prepaid commitment fee 105 218
Amortization of excess servicing rights 728 --
Amortization of mortgage servicing rights 247 611
Accretion of residual interest on mortgage related securities (551) (2,503)
Payments on mortgage related securities 211 100
Additions to deferred loan fees (298) (2,656)
Loans originated for sale, net of loan fees (62,462) (199,861)
Payments on loans held for sale 167 443
Proceeds from sale of loans 60,509 157,187
Changes in operating assets and liabilities:
Decrease (increase) in cash deposits, restricted 2,430 (1,902)
Decrease (increase) in other assets, net (833) 100
Decrease in state income taxes payable (818) (1,574)
Increase in federal income tax benefit -- (6,022)
Increase (decrease) in other liabilities, net 1,880 (377)
Additions to Due to Preferred Equities Corporation 850 1,155
Payments on Due to Preferred Equities Corporation (1,345) (761)
---------- ----------
Total adjustments (9,630) (42,223)
---------- ----------
Net cash used in operating activities (7,151) (53,918)
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (968) --
---------- ----------
Net cash used in investing activities (968) --
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings on notes and contracts payable 51,919 204,074
Payments on notes and contracts payable (64,454) (185,919)
Additions to Due to Mego Financial Corp 1,892 --
Payments on Due to Mego Financial Corp. (13,474) (3,500)
Payments on subordinated debt -- (8)
Issuance of subordinated debt 37,750 38,373
Proceeds from sale of common stock 20,658 --
---------- ----------
Net cash provided by financing activities 34,291 53,020
---------- ----------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 26,172 (898)
CASH AND CASH EQUIVALENTS--BEGINNING OF PERIOD 443 6,104
---------- ----------
CASH AND CASH EQUIVALENTS--END OF PERIOD $ 26,615 $ 5,206
========== ==========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest $ 758 $ 2,912
========== ==========
State income taxes $ 1,060 $ --
========== ==========
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
Addition to prepaid commitment fee and Due to Mego Financial Corp.
in connection with loan sale commitment received $ 3,000 $ --
========== ==========
Increase in deferred federal income tax asset due to Spin-off $ -- $ 2,354
========== ==========
</TABLE>
See notes to condensed financial statements.
4
<PAGE> 7
MEGO MORTGAGE CORPORATION
CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY
(unaudited)
<TABLE>
<CAPTION>
COMMON STOCK
$.01 PAR VALUE ADDITIONAL
------------------------ PAID-IN RETAINED
SHARES AMOUNT CAPITAL EARNINGS TOTAL
---------- ---------- ---------- ---------- ----------
(thousands of dollars, except per share amounts)
<S> <C> <C> <C> <C> <C>
Balance at August 31, 1997 12,300,000 $ 123 $ 29,185 $ 23,799 $ 53,107
Increase in additional paid-in capital
due to deferred federal income tax
asset due to Spin-off -- -- 2,354 -- 2,354
Net loss for the three months ended
November 30, 1997 -- -- -- (11,695) (11,695)
---------- ---------- ---------- ---------- ----------
Balance at November 30, 1997 12,300,000 $ 123 $ 31,539 $ 12,104 $ 43,766
========== ========== ========== ========== ==========
</TABLE>
See notes to condensed financial statements.
5
<PAGE> 8
MEGO MORTGAGE CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED NOVEMBER 30, 1996 AND 1997
1. CONDENSED FINANCIAL STATEMENTS
In the opinion of management, when read in conjunction with the audited
Financial Statements for the years ended August 31, 1996 and 1997, contained in
the Form 10-K of Mego Mortgage Corporation filed with the Securities and
Exchange Commission for the year ended August 31, 1997, the accompanying
unaudited Condensed Financial Statements contain all of the information
necessary to present fairly the financial position of Mego Mortgage Corporation
at November 30, 1997, the results of its operations for the three months ended
November 30, 1996 and 1997, the change in stockholders' equity for the three
months ended November 30, 1997 and the cash flows for the three months ended
November 30, 1996 and 1997. Certain reclassifications have been made to conform
prior periods with the current period presentation.
The preparation of financial statements in conformity with generally
accepted accounting principles ("GAAP") 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. In the
opinion of management, all material adjustments necessary for the fair
presentation of these statements have been included herein which are normal and
recurring in nature. The results of operations for the three months ended
November 30, 1997 are not necessarily indicative of the results to be expected
for the full year.
2. 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 the three months ended November 30,
1997, the Company's loan originations were comprised of 93.9% Conventional Loans
and 6.1% 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 5.
On September 2, 1997, Mego Financial distributed all of its 10 million
shares of the Company's Common Stock to Mego Financial shareholders in a
tax-free spin-off (the "Spin-off").
6
<PAGE> 9
MEGO MORTGAGE CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
FOR THE THREE MONTHS ENDED NOVEMBER 30, 1996 AND 1997
3. RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board (the "FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS
125") 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. SFAS 125 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 No. 115, "Accounting for Certain Investments in Debt and
Equity Securities." As required by SFAS 125, the Company adopted the new
requirements effective January 1, 1997, and applied them prospectively. SFAS 125
did not have any material impact on the financial statements of the Company, as
the book value of the Company's mortgage related securities approximated fair
value.
The following table reflects the components of mortgage related
securities as required by SFAS 125 at November 30, 1997 (thousands of dollars):
<TABLE>
<S> <C>
Interest only strip securities $ 5,410
Residual interest securities 71,631
Interest only receivables (formerly excess servicing rights) 17,222
-----------
Total mortgage related securities $ 94,263
===========
</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.
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 Accounting Principles Board ("APB") Opinion No.
15.
Basic EPS excludes dilution from common stock equivalents and is
computed by dividing income (loss) 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.
7
<PAGE> 10
MEGO MORTGAGE CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
FOR THE THREE MONTHS ENDED NOVEMBER 30, 1996 AND 1997
Data utilized in calculating pro forma earnings per share under SFAS 128
are as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
-----------------------------
1996 1997
------------ ------------
(thousands of dollars,
except share amounts)
<S> <C> <C>
BASIC:
Net income (loss) $ 2,479 $ (11,695)
============ ============
Weighted-average number of common shares 10,303,297 12,300,000
============ ============
DILUTED:
Net income (loss) $ 2,479 $ (11,695)
============ ============
Weighted-average number of common shares and common
share equivalents outstanding 10,317,102 12,300,000
============ ============
</TABLE>
The following table reconciles the net income (loss) applicable to
common stockholders, basic and diluted shares, and EPS for the following
periods:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30, THREE MONTHS ENDED NOVEMBER 30,
1996 1997
------------------------------------- ---------------------------------------
PER-SHARE PER-SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
---------- ---------- --------- ----------- ---------- ---------
(thousands of dollars, except per share amounts)
<S> <C> <C> <C> <C> <C> <C>
Net income (loss) $ 2,479 $ (11,695)
---------- ----------
BASIC EPS
Income (loss) applicable
to common stockholders 2,479 10,303,297 $ 0.24 (11,695) 12,300,000 $ (0.95)
========== ========
Effect of dilutive
securities:
Warrants -- -- -- --
Stock options -- 13,805 -- --
---------- ---------- ---------- ----------
DILUTED EPS
Income (loss) applicable
to common stockholders
and assumed conversions $ 2,479 10,317,102 $ 0.24 $ (11,695) 12,300,000 $ (0.95)
========== ========== ========= ========== ========== ========
</TABLE>
4. ADJUSTMENTS TO CARRYING VALUES OF MORTGAGE RELATED SECURITIES
During the three months ended November 30, 1997, the Company experienced
voluntary prepayment activity and delinquencies with regard to its securitized
Conventional Loans which substantially exceeded the levels which had been
assumed for this time frame. This acceleration in the speed of prepayment has
caused management, after consultation with its financial advisors, to adjust the
assumptions previously utilized in calculating the carrying value of its
mortgage related securities. The new voluntary prepayment speed assumptions
reflect an annualized rate of 3% in the first month following a securitization
with that annualized rate building in level monthly increments so that by the
15th month the annualized rate is at 17%. The annualized voluntary prepayment
rate is maintained at that level through the 36th month at which time it is
assumed to decline by 1/2% per month until the 42nd month. The 14% annualized
rate assumed at the 42nd month is maintained for the remaining life of the
portfolio.
The loss assumptions have also been modified to reflect losses
commencing in the third month following a securitization and building in level
monthly increments until a 2% annualized loss rate is achieved in the 18th
month.
8
<PAGE> 11
MEGO MORTGAGE CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued)
FOR THE THREE MONTHS ENDED NOVEMBER 30, 1996 AND 1997
The annualized loss rate is projected to remain at that level throughout the
remaining life of the portfolio. On a cumulative basis this model assumes
aggregate losses of approximately 9% of the original portfolio balance. Despite
the moderate change in the acceleration of assumed losses, after applying the
new voluntary prepayment speeds, the cumulative loss assumption of 9% results in
approximately the same level of loss as had been previously assumed.
The application of these new assumptions to the mortgage related
securities which have been generated from Conventional Loan securitizations
resulted in a negative adjustment to their carrying value of approximately $10.2
million. Additional negative adjustments of approximately $3.9 million to the
carrying value of mortgage related securities pertaining to Title I Loan
securitizations and other sales were also recognized in the quarter due to a
higher level of defaults and prepayments than had been previously assumed. After
calculating the effect of accretion of interest, amortization of cash flowing
residuals, and increased prepayment penalty fees, the carrying value of the
Company's mortgage related securities as of November 30, 1997 was reduced to
$94.3 million from $106.3 million as of August 31, 1997.
As part of the Company's cost saving measures, in January 1998, the
Company completed an internal restructuring, resulting in a reduction of
approximately 20% of its workforce, primarily as a result of the substantial
reduction of the Dealer Division. The Dealer Division generated approximately
4.7% and 8.0% of Conventional and total loan originations, respectively, in the
three months ended November 30, 1997, but accounted for a disproportionately
higher amount of the Company's costs. The Company will continue to originate
Title I Loans through its Correspondent Division, intended solely for sale to
Fannie Mae.
5. PRIVATE PLACEMENT
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 $38.4 million, after deducting discounts, but before deducting
expenses, 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 the balance to provide capital to originate and securitize
loans and for working capital. These Additional Notes are subject to the
Indenture governing all of the Company's senior 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 additional Note
will receive Exchange Notes having a principal amount equal to that of the
tendered Additional Note. Interest on each Exchange Note will accrue from the
last interest payment date on which interest was paid on the tendered Additional
Notes in exchange therefor or, if no interest has been paid on such Additional
Notes, from the date of its original issue.
9
<PAGE> 12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
The following Management's Discussion and Analysis of Financial
Condition and Results of Operations section contains 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 loan programs and 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. Also, the Company specifically advises
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.
The following discussion and analysis should be read in conjunction with
the Condensed Financial Statements, including the notes thereto, contained
elsewhere herein and in the Company's Form 10-K for the fiscal year ended August
31, 1997.
GENERAL
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 three months ended November 30, 1997.
To facilitate these new origination channels, the Company has entered 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 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 November 30, 1996 and 1997, the Company originated $31.1 million and
$187.8 million of Conventional Loans, respectively, which constituted 49.7% and
93.9%, respectively, of the Company's total loan originations during the
respective periods.
10
<PAGE> 13
The following table sets forth certain data regarding loans originated,
sold, securitized, and serviced by the Company during the three months ended
November 30, 1996 and 1997.
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED NOVEMBER 30,
---------------------------------------------
1996 1997
-------------------- --------------------
(thousands of dollars)
<S> <C> <C> <C> <C>
PRINCIPAL AMOUNT OF LOANS ORIGINATED:
Correspondents:
Title I $ 19,165 30.7% $ 4,902 2.5%
Conventional 30,851 49.4 178,757 89.4
-------- -------- -------- --------
Total Correspondents 50,016 80.1 183,659 91.9
-------- -------- -------- --------
Dealers:
Title I 12,239 19.6 7,201 3.6
Conventional 207 0.3 8,754 4.4
-------- -------- -------- --------
Total Dealers 12,446 19.9 15,955 8.0
-------- -------- -------- --------
Retail:
Title I -- -- -- --
Conventional -- -- 247 0.1
-------- -------- -------- --------
Total Retail -- -- 247 0.1
-------- -------- -------- --------
Total Principal Amount of Loans
Originated $ 62,462 100.0% $199,861 100.0%
======== ======== ======== ========
NUMBER OF LOANS ORIGINATED:
Correspondents:
Title I 942 30.8% 225 3.3%
Conventional 1,076 35.1 5,440 80.6
-------- -------- -------- --------
Total Correspondents 2,018 65.9 5,665 83.9
-------- -------- -------- --------
Dealers:
Title I 1,034 33.8 587 8.7
Conventional 10 0.3 489 7.3
-------- -------- -------- --------
Total Dealers 1,044 34.1 1,076 16.0
-------- -------- -------- --------
Retail:
Title I -- -- -- --
Conventional -- -- 8 0.1
-------- -------- -------- --------
Total Retail -- -- 8 0.1
-------- -------- -------- --------
Total Number of Loans Originated 3,062 100.0% 6,749 100.0%
======== ======== ======== ========
LOANS SERVICED AT END OF PERIOD
(INCLUDING LOANS SECURITIZED,
SOLD TO INVESTORS AND HELD FOR SALE):
Title I $225,896 84.5% $253,944 33.1%
Conventional 41,590 15.5 513,403 66.9
-------- -------- -------- --------
Total Loans Serviced at End of Period $267,486 100.0% $767,347 100.0%
======== ======== ======== ========
</TABLE>
The Company is obligated under certain agreements for the sale of loans
and certain loan agreements to maintain various minimum net worth requirements.
At November 30, 1997, the most restrictive of these agreements requires the
Company to maintain a minimum adjusted tangible net worth of $65.0 million plus
any issuance of capital stock or other capital instruments since June 1997, plus
50% of the Company's cumulative net income since November 30, 1996. At November
30, 1997, the Company's minimum adjusted tangible net worth requirement was
$111.5 million, and the Company's adjusted tangible net worth, which by
definition in the loan agreement includes subordinated debt, was $116.8 million.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources" for further information.
11
<PAGE> 14
The Company recognizes revenue from 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, plus accretion of interest related to mortgage
related securities, net of interest paid under its credit agreements. The
Company continues to service substantially all loans sold through November 30,
1997, however, during the three months ended November 30, 1997, $38.4 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 Statement of Financial Accounting Standards
("SFAS") No. 125 ("SFAS 125"), the amortization of 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.
Historically, the Company has utilized securitizations as its primary
method of loan disposition with the resulting interest only and residual
interest securities retained by the Company. It has also sold loans to third
party purchasers on both servicing retained and servicing released basis. On
certain loan sale transactions to third party purchasers, the Company has not
only retained servicing rights but also retained the rights to receive any
amounts in excess of the guaranteed yield to the purchasers. In the three months
ended November 30, 1997, the Company recorded loan sales of $155.9 million, of
which $38.4 million were sold with servicing released. The Company intends to
dispose of a majority of its loan originations on an ongoing basis through whole
loan sales on a servicing released basis, at a premium, as opposed to
securitizations. This method of loan disposition is expected to enhance the
Company's cash flow.
The following table sets forth the principal balance of loans sold or
securitized and related gain on sale data for the three months ended November
30, 1996 and 1997:
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
NOVEMBER 30,
---------------------------
1996 1997
--------- ---------
(thousands of dollars)
<S> <C> <C>
PRINCIPAL AMOUNT OF LOANS SOLD:
Title I $ 33,388 $ 11,075
Conventional 27,121 144,782
--------- ---------
Total $ 60,509 $ 155,857
========= =========
Gain on sale of loans $ 9,601 $ 3,721
========= =========
Net unrealized loss on mortgage related securities $ (235) $ (13,108) (3)
========= =========
PRINCIPAL AMOUNT OF LOANS SOLD (1):
Title I $ 33,388 $ 11,075
Conventional 27,121 106,421 (1)
--------- ---------
Total $ 60,509 $ 117,496
========= =========
Gain on sale of loans $ 9,601 $ 2,790 (2)
========= =========
Gain on sale of loans as a percentage of
principal balance of loans sold 15.9% 2.4% (2)
========= =========
Gain on sale of loans plus net unrealized
loss on mortgage related securities as a
percentage of principal balance of loans sold 15.5% (8.8)%(2)
========= =========
</TABLE>
- ----------
(1) Excludes $38.4 million of loans sold with servicing released.
(2) Excludes gain on sale of $931,000 relating to whole loan sales of $38.4
million of loans sold with servicing released.
12
<PAGE> 15
(3) The loss is a result of the application of a negative adjustment to the
carrying value of mortgage related securities of $14.1 million.
The percentage of gain on sale of loans can vary for several reasons,
including the relative amounts of Conventional and Title I Loans, each of which
type of loan has different (i) estimated prepayment rates, (ii) weighted-average
interest rates, (iii) weighted-average maturities, and (iv) estimated future
default rates. Typically, the gain on sale of loans through securitizations is
higher than on whole loan sales.
As the holder of residual securities issued in securitizations, 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
(v) estimated loan pool losses. The Company's right to receive the excess cash
flows is subject to the satisfaction of certain reserve or
over-collateralization requirements which are specific to each securitization
and are used as a means of credit enhancement.
Delinquencies -- 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, NOVEMBER 30,
1997 1997
----------- -----------
(thousands of dollars)
<S> <C> <C>
Delinquency period (1)
31-60 days past due 1.54% 2.08%
61-90 days past due 0.80 0.77
91 days and over past due 3.07 3.26
91 days and over past due, net of claims filed (2) 2.32 2.30
Outstanding claims filed with HUD (3) 0.75 0.96
Outstanding number of Title I insurance claims 269 425
Total servicing portfolio $ 628,068 $ 767,347
Title I Loans serviced 255,446 253,944
Conventional Loans serviced 372,622 513,403
Amount of FHA insurance available 21,094 20,572 (4)
Amount of FHA insurance available as a percentage of Title I
Loans serviced 8.26% 8.10%(4)
Losses on liquidated loans (twelve and three months
ended, respectively) (5) $ 201 $ 5
</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 the dates indicated. Conventional Loan
delinquencies represented 10.35% and 18.0%, respectively, of the
Company's total delinquencies at August 31, 1997 and November 30, 1997.
(2) 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 total loans serviced by
the Company (including loans owned by the Company) as of the dates
indicated.
(3) 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.
(4) If all claims filed with HUD had been processed as of November 30, 1997,
the amount of FHA insurance available for serviced Title I Loans would
have been reduced to $13.5 million, which as a percentage of Title I
Loans serviced would have been 5.5%.
13
<PAGE> 16
(5) 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 802 Title I insurance claims made by the Company, as
servicer, since commencing operations through November 30, 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.
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 November 30, 1997, the rolling three-month average
annual default rates on the pools of loans sold in the March 1996, August 1996
and December 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 ($3.2 million before tax at November
30, 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 new vice president 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.
The pooling and servicing agreements and sale and servicing agreements
also require that certain delinquency and default rates not exceed certain
thresholds. If these thresholds are exceeded, higher levels of
over-collateralization are required which can cause a delay in cash receipts to
the Company as a holder of the residual interest, causing an adverse valuation
adjustment to the carrying value of the residual security.
Delinquencies of loans serviced by the Company have also decreased the
amount of loan servicing income recorded during the three months ended November
30, 1997 as the Company's loan servicing income has been reduced by the amount
of interest advanced to the owners of these loans, which advances the Company
expects to recover.
Delinquencies have increased to $46.9 million at November 30, 1997 from
$34.0 million at August 31, 1997. Since the Company began originating Title I
Loans in 1994, an increasing level of delinquencies has appeared as expected on
such loans less than two years old. Conventional Loan delinquencies represented
10.35% and 18.0%, respectively, of the Company's total delinquencies at August
31, 1997 and November 30, 1997.
Once a loan becomes 30 days past due, a collection supervisor generally
analyzes the account to determine the appropriate course of remedial action. It
is the Company's policy to consult with the delinquent customer to resolve the
past due balance before Title I claim processing or legal action is initiated.
RESULTS OF OPERATIONS
Three Months Ended November 30, 1997 compared to Three Months Ended
November 30, 1996
The Company originated $199.9 million of loans during the three months
ended November 30, 1997 compared to $62.5 million of loans during the three
months ended November 30, 1996, an increase of 220.0%. The increase is a result
of the overall growth in the Company's business, including an increase in the
number of active
14
<PAGE> 17
Correspondents. At November 30, 1997, the Company had 763 active Correspondents
and 614 active Dealers, compared to 402 active Correspondents and 459 active
Dealers at November 30, 1996. Of the $199.9 million of loans originated during
the three months ended November 30, 1997, $187.8 million were Conventional Loans
and $12.1 million were Title I Loans compared to $31.1 million of Conventional
Loans and $31.4 million of Title I Loans during the three months ended November
30, 1996.
Net revenues (losses) decreased to ($7.0) million during the three
months ended November 30, 1997 from revenues of $10.4 million during the three
months ended November 30, 1996. The decrease was primarily the result of the
downward valuation adjustment which is reflected in the net unrealized loss on
mortgage related securities. See Note 4 of Notes to Condensed Financial
Statements.
The combined gain on sale of loans and net unrealized gain (loss) on
sale of mortgage related securities decreased to a loss of $9.4 million during
the three months ended November 30, 1997 from a gain of $9.4 million during the
three months ended November 30, 1996. The decrease was primarily due to the
downward valuation adjustment, causing the net unrealized loss on mortgage
related securities. See Note 4 of Notes to Condensed Financial Statements.
Loan servicing income, net, increased 87.2% to $1.2 million during the
three months ended November 30, 1997 from $638,000 during the three months ended
November 30, 1996. The increase was primarily the result of the increase in the
servicing portfolio of $767.3 million at November 30, 1997 from $267.5 million
at November 30, 1996.
Interest income on loans held for sale and mortgage related securities,
net of interest expense, increased $855,000 to $1.2 million during the three
months ended November 30, 1997 from $355,000 during the three months ended
November 30, 1996. The increase was primarily the result of the increase in the
average size of the portfolio of loans held for sale and mortgage related
securities.
The net provision for credit losses decreased 7.1% to $1.6 million for
the three months ended November 30, 1997 from $1.7 million for the three months
ended November 30, 1996. The slight decrease in the provision was directly
related to a lower level of loans sold in the three months ended November 30,
1997 compared to November 30, 1996 in transactions which require such provision.
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.
Total general and administrative expenses increased to $10.0 million
during the three months ended November 30, 1997 compared to $4.4 million during
the three months ended November 30, 1996. The increase was primarily a result of
increased professional services due to increased legal expenses, increased
credit reports expense due to increased loan origination volume, 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 $3.4 million to $5.2 million
during the three months ended November 30, 1997 from $1.8 million during the
three months ended November 30, 1996 primarily due to an increased number of
employees. The number of employees increased to 468 at November 30, 1997 from
206 at November 30, 1996 due to increased staff necessary to support the
business expansion and maintain quality control. See Note 4 of Notes to
Condensed Financial Statements for discussion of the recent reduction in
workforce.
Credit reports expense increased 77.8% to $272,000 for the three months
ended November 30, 1997 from $153,000 for the three months ended November 30,
1996, due to increased loan origination volume to $199.9 million during the
three months ended November 30, 1997 from $62.5 million during the three months
ended November 30, 1996.
15
<PAGE> 18
Professional services increased $559,000 to $671,000 during the three
months ended November 30, 1997 from $112,000 for the three months ended November
30, 1996, due to increased legal expenses.
Servicing fees paid to Preferred Equities Corporation ("PEC") increased
to $661,000 for the three months ended November 30, 1997 from $285,000 for the
three months ended November 30, 1996 due primarily to a larger loan servicing
portfolio.
Other general and administrative expenses increased $1.1 million to $1.8
million during the three months ended November 30, 1997 from $784,000 during the
three months ended November 30, 1996 due primarily to increased expenses related
to the ongoing expansion of facilities.
Income (loss) before income taxes decreased to a loss of $18.8 million
for the three months ended November 30, 1997 from income of $4.0 million for the
three months ended November 30, 1996, therefore, the provision for income taxes
decreased to an income tax benefit of $7.2 million for the three months ended
November 30, 1997 from an income tax expense of $1.5 million for the three
months ended November 30, 1996.
As a result of the foregoing, the Company incurred a net loss of $11.7
million for the three months ended November 30, 1997 compared to net income of
$2.5 million for the three months ended November 30, 1996.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents were $5.2 million at November 30, 1997
compared to $6.1 million at August 31, 1997. The Company's principal cash
requirements relate to loan originations and require continued access to sources
of debt financing and sales in the secondary market of loans.
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 $40.0 million of senior subordinated notes (the
"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 in additional senior subordinated notes ("Additional Notes"),
which increased the aggregate principal amount of the outstanding subordinated
notes from $40.0 million to $80.0 million. See Note 5 of Notes to Condensed
Financial Statements. 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 and for working capital. Prior to the
Private Placement, the Company obtained consents to certain amendments to the
original indenture governing the notes ("Indenture Amendments"), 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 of principal amount of senior subordinated notes. In
connection with the consent solicitation, the Company made consent payments of
$10.00 cash per $1,000 principal amount totaling $392,000 of the 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, over-collateralization 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 $60.5 million and $155.9 million for the three months
ended November 30, 1996 and 1997, respectively.
The Company has operated since March 1994 on a negative cash flow basis,
although the Company is implementing measures intended to place it on at least a
cash flow neutral basis for the calendar year 1998. In connection with
securitizations and certain whole loan
16
<PAGE> 19
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
over-collateralization requirements and incurs significant expenses in
connection with securitizations and incurs tax liabilities as a result of the
gain on sale.
The Company anticipates only limited use of securitizations during 1998
due to the negative cash flow implications of this method of loan disposition.
Alternatively, during 1998 the Company anticipates generating an increased
volume of whole loan sales on a servicing released basis, at a premium, in order
to enhance its cash flow.
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 over-collateralization 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 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 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 November 30, 1997, amounts on
deposit in such reserve accounts totaled $8.8 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. At November 30, 1997, $36.8 million was outstanding under this
warehouse line. In excess of 94.2% of the aggregate loans originated by the
Company through November 30, 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
November 30, 1997, the Company's actual adjusted tangible net worth calculated
pursuant to the agreement was $116.8 million, and the required minimum adjusted
tangible net worth at that date was $111.5 million. Additionally, the following
material covenant
17
<PAGE> 20
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 November 30, 1997, the ratio of total
liabilities to tangible net worth was 0.66:1 and total liabilities were $77.1
million, which was $23.1 million under the maximum amount allowed.
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 to $25.0 million in July 1997, with
respect to which $10.0 million was outstanding at November 30, 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 Condensed 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 Interbank
Offering Rate ("LIBOR") + 3.5%, is due and payable on December 31, 1998, 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 November 30, 1997, the required net worth was $35.0
million and the Company's actual net worth was $43.8 million. Although, the
agreement requires the Company to maintain a debt-to-net-worth ratio not to
exceed 2.5:1; and at November 30, 1997, the ratio was 2.76:1. The provision has
been waived by the financial institution until April 30, 1998.
In October 1997, the Company entered into a revolving credit/term loan
facility with a financial institution pursuant to which the Company received an
initial advance of $5.0 million which can be increased to $8.8 million with
additional lender commitments. The loan is secured by certain interest only and
residual interest certificates generated from the Company's March 1997
securitization. The facility has a final maturity date of October 31, 2002, and
bears interest at the higher of (i) the prime rate as established by the Chase
Manhattan Bank plus 2.5%, or (ii) 9.0%.
Certain material covenant restrictions exist in the indenture governing
the senior subordinated 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 November 30, 1997, the Consolidated Leverage Ratio was
2.93:1. Accordingly, the Company presently cannot incur additional debt other
than Permitted Warehouse Indebtedness until the 2:1 ratio has been met through
additional earnings or infusion of equity. 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 is the outstanding amount under the warehouse line of
credit agreement. In addition, an increasing amount of the Company's mortgage
related securities are required to remain unpledged. At November 30, 1997, that
requirement was $47.6 million, and at that date $32.6 million of mortgage
related securities were pledged, and $61.7 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 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.
18
<PAGE> 21
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 November 30, 1997, no
commitments existed for material capital expenditures.
In furtherance of the Company's earlier strategy to sell loans primarily
through securitizations, beginning in March 1996 through August 1997, the
Company completed its first seven securitizations pursuant to which it sold
pools of loans aggregating $531.3 million. The Company previously reacquired an
aggregate of $512.3 million of such 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 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.
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. The Company anticipates that a majority of its
loan originations in 1998 will be disposed of through whole loan sales on a
servicing released basis. This method of loan disposition is anticipated to
generate cash sale premiums and further the Company's strategy to achieve at
least a cash flow neutral basis from operations in 1998.
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.
In April 1995, the Company entered into a continuing agreement with a
financial institution pursuant to which an aggregate of approximately $833.3
million in principal amount of loans had been sold at November 30, 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 on loans not yet sold by the institution which amounted to
$153.0 million at November 30, 1997. 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.
During the three months ended November 30, 1996, 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
19
<PAGE> 22
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.
Net cash used in the Company's operating activities for the three months
ended November 30, 1996 and 1997 was $7.2 million and $53.9 million,
respectively. During the three months ended November 30, 1996 and 1997, cash
provided by financing activities amounted to $34.3 million and $53.0 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, with an emphasis on whole loan sales at a premium,
funds from operations and financing activities, sales of loans, borrowings under
its existing credit facilities and the net proceeds from the Private Placement
Offering 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
FINANCIAL CONDITION
November 30, 1997 compared to August 31, 1997
Cash and cash equivalents decreased 14.7% to $5.2 million at November
30, 1997 from $6.1 million at August 31, 1997 primarily as a result of increased
loan originations during the period and an increased level of loans held for
sale at November 30, 1997.
Restricted cash deposits increased 27.6% to $8.8 million at November 30,
1997 from $6.9 million at August 31, 1997 primarily due to the number of loans
sold and securitized in prior periods.
Loans held for sale, net, increased to $55.7 million at November 30,
1997 from $9.5 million at August 31, 1997 primarily as a result of the Company's
increased loan originations and the timing of loan sales, with no securitization
transaction during the three months ended November 30, 1997.
Changes in the allowance for credit losses and the allowance for credit
losses on loans sold with recourse for the three months ended November 30, 1997
consist of the following (thousands of dollars):
<TABLE>
<S> <C>
Balance at August 31, 1997 $ 7,114
Provision for credit losses 1,702
Reductions to the provision due to securitizations or
loans sold without recourse (112)
Reductions due to charges to allowance for credit losses (5)
-------
Balance at November 30, 1997 $ 8,699
=======
</TABLE>
20
<PAGE> 23
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, NOVEMBER 30,
1997 1997
------------ ------------
(thousands of dollars)
<S> <C> <C>
Allowance for credit losses $ 100 $ 116
Allowance for credit losses on loans sold with recourse 7,014 8,583
------------ ------------
Total $ 7,114 $ 8,699
============ ============
</TABLE>
Mortgage related securities decreased $12.0 million to $94.3 million
from $106.3 million at August 31, 1997 primarily due to the revaluation
adjustments to the carrying value. See Note 4 of Notes to Condensed Financial
Statements.
Prepaid debt expenses increased $2.6 million to $5.0 million at November
30, 1997 from $2.4 million at August 31, 1997 primarily due to the debt expense
related to the additional $40.0 million of subordinated debt issued in October
1997.
The income tax benefit was $9.3 million at November 30, 1997 comprised
of federal and state income taxes, while no such benefit was previously
reported. Prior to the Spin-off, income taxes were included in the Due to Mego
Financial category since Mego Financial filed a consolidated tax return.
Other assets decreased 62.0% to $302,000 at November 30, 1997 from
$795,000 at August 31, 1997 primarily due to a reclassification of accrued fees
on securitizations to other receivables of $537,000.
Notes and contracts payable increased 51.0% to $53.7 million at November
30, 1997 from $35.6 million at August 31, 1997 due to the increased borrowings
by the Company to fund loan originations as a result of the overall growth in
the Company's business.
Allowance for credit losses on loans sold with recourse increased 22.4%
to $8.6 million at November 30, 1997 from $7.0 million at August 31, 1997
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.
Due to Mego Financial Corp. decreased 36.3% to $6.2 million at November
30, 1997 from $9.7 million at August 31, 1997. The decrease was primarily
attributable to the payment of federal income taxes owed to Mego Financial as a
result of the filing of a consolidated federal tax return and repayment of
advances made by Mego Financial to the Company.
Due to Preferred Equities Corporation increased 88.3% to $840,000 at
November 30, 1997 from $446,000 at August 31, 1997 due primarily to the timing
of payment of management and servicing fees.
Stockholders' equity decreased 17.6% to $43.8 million at November 30,
1997 from $53.1 million at August 31, 1997 as a result of the net loss of $11.7
million during the three months ended November 30, 1997, partially offset by an
increase in additional paid-in capital related to federal income tax benefit
which was a result of the Spin-off.
21
<PAGE> 24
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1996, the Financial Accounting Standards Board (the "FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting
for Transfer and Servicing of Financial Assets and Extinguishments of
Liabilities," ("SFAS 125") which provides accounting and reporting standards for
transfers and servicing of financial assets and extinguishments of liabilities.
As required by the statement, the Company adopted the new requirements effective
January 1, 1997 and applied them prospectively. No material impact resulted from
the implementation of SFAS 125. See Note 3 of Notes to Condensed Financial
Statements.
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. See Note 3 of Notes to Condensed Financial Statements
for further discussion and SFAS 128 pro forma calculations.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
No significant developments in any litigation previously reported
occurred during the three month period ended November 30, 1997.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
<TABLE>
<CAPTION>
EXHIBIT NUMBER DESCRIPTION
-------------- -----------
<S> <C>
27.1 Financial Data Schedule (for SEC use only).
</TABLE>
No reports on Form 8-K were filed during the period, except as previously
reported in the Company's Form 10-K for the year ended August 31, 1997.
22
<PAGE> 25
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MEGO MORTGAGE CORPORATION
By:/s/ James L. Belter
--------------------------------------------
James L. Belter
Executive Vice President
Treasurer and Chief Financial Officer
Date: January 14, 1998
23
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> AUG-31-1998
<PERIOD-START> SEP-01-1997
<PERIOD-END> NOV-30-1997
<CASH> 13,998
<SECURITIES> 0
<RECEIVABLES> 55,827
<ALLOWANCES> 116
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 2,828
<DEPRECIATION> 805
<TOTAL-ASSETS> 201,240
<CURRENT-LIABILITIES> 0
<BONDS> 53,727
0
0
<COMMON> 123
<OTHER-SE> 43,643
<TOTAL-LIABILITY-AND-EQUITY> 201,240
<SALES> 0
<TOTAL-REVENUES> (6,983)
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 11,865
<LOSS-PROVISION> 1,590
<INTEREST-EXPENSE> 77
<INCOME-PRETAX> (18,848)
<INCOME-TAX> (7,153)
<INCOME-CONTINUING> (11,695)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (11,695)
<EPS-PRIMARY> (0.95)
<EPS-DILUTED> (0.95)
</TABLE>
