<PAGE> 1
================================================================================
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, 1998
OR
[X] 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)
<TABLE>
<S> <C>
DELAWARE 88-0286042
(STATE OR OTHER JURISDICTION OF (I. R. S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
</TABLE>
1000 PARKWOOD CIRCLE, SUITE 600, 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 8, 1999, there were 30,566,660 shares of Common Stock,
$.01 par value per share, of the Registrant outstanding.
================================================================================
<PAGE> 2
MEGO MORTGAGE CORPORATION
INDEX
<TABLE>
<CAPTION>
Page
<S> <C> <C>
PART I FINANCIAL INFORMATION
Item 1. Condensed Financial Statements (unaudited)
Condensed Statements of Financial Condition at
August 31, 1998 and November 30, 1998..............................................................1
Condensed Statements of Operations for the Three Months Ended
November 30, 1997 and 1998.........................................................................2
Condensed Statements of Cash Flows for the Three Months Ended
November 30, 1997 and 1998 ........................................................................3
Condensed Statements of Stockholders' Equity for the Three Months Ended
November 30, 1998 .................................................................................4
Notes to Condensed Financial Statements............................................................5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations..........................................................................7
Item 3. Quantitative and Qualitative Disclosure About Market Risk.........................................18
PART II OTHER INFORMATION
Item 1. Legal Proceedings.................................................................................20
Item 5. Other Information.................................................................................20
Item 6. Exhibits and Reports on Form 8-K..................................................................20
SIGNATURE......................................................................................................21
</TABLE>
i
<PAGE> 3
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
MEGO MORTGAGE CORPORATION
CONDENSED STATEMENTS OF FINANCIAL CONDITION
(unaudited)
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
1998 1998
(thousands of dollars)
--------- ---------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 36,404 $ 30,010
Cash deposits, restricted 3,662 2,960
Loans held for sale, net of allowance for credit losses of $76 and $120
and valuation allowance of $10,901 and $4,586 10,975 18,883
Mortgage related securities, at fair value 34,830 34,927
Mortgage servicing rights 83 --
Other receivables 5,078 6,055
Property and equipment, net of accumulated depreciation of $1,181 and $1,328 1,813 1,711
Organizational costs, net of amortization 96 64
Prepaid debt expenses 2,790 2,625
Deferred federal income tax asset 5,376 6,707
Deferred state income tax asset 3,064 3,201
Other assets 364 697
--------- ---------
TOTAL ASSETS $ 104,535 $ 107,840
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes and contracts payable $ 16,345 $ 31,058
Accounts payable and accrued liabilities 16,431 8,405
Allowance for credit losses on loans sold with recourse 2,472 2,476
Subordinated debt 42,693 41,801
--------- ---------
Total liabilities 77,941 83,740
--------- ---------
Stockholders' equity:
Preferred Stock, $.01 par value per share
(Authorized-5,000,000 shares)
Issued and outstanding-62,500 at August 31, and November 30, 1998) 1 1
Common Stock, $.01 par value per share
(Authorized-50,000,000 shares;
Issued and outstanding-30,566,667 at August 31, and 30,566,660 at November 30, 1998) 306 306
Additional paid-in capital 122,143 122,143
Retained earnings (accumulated deficit) (95,856) (98,350)
--------- ---------
Total stockholders' equity 26,594 24,100
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 104,535 $ 107,840
========= =========
</TABLE>
See notes to condensed financial statements.
1
<PAGE> 4
MEGO MORTGAGE CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30,
-------------------------------
1997 1998
------------ --------------
(thousands of dollars, except
per share amounts)
<S> <C> <C>
REVENUES:
Gain on sale of loans $ 3,721 $ 172
Net unrealized (loss) gain on mortgage related securities (13,108) 270
Loan servicing income, net 1,194 240
Interest income 4,296 1,602
Less: interest expense (3,086) (1,764)
----------- ----------
Net interest income (expense) 1,210 (162)
----------- ----------
Net (losses) revenues (6,983) 520
----------- ----------
COSTS AND EXPENSES:
Net provision for credit losses 1,590 43
Depreciation and amortization 208 215
Other interest 77 42
General and administrative:
Payroll and benefits 5,686 1,979
Supplies and postage 366 71
Rent and lease expenses 321 359
Professional services 1,516 964
Insurance 369 185
Sub-servicing fees 661 22
Taxes and licensing fees 70 62
Communications 172 119
Bank and wire fees (15) 137
Travel and entertainment 469 109
Other 375 175
----------- ----------
Total costs and expenses 11,865 4,482
----------- ----------
(LOSS) BEFORE INCOME TAXES (18,848) (3,962)
INCOME TAXES (BENEFIT) -- (1,468)
----------- ----------
NET (LOSS) $ (18,848) $ (2,494)
=========== ==========
(LOSS) PER COMMON SHARE:
Basic:
-----
Net(loss) $ (1.53) $ (0.08)
=========== ==========
Weighted-average number of common shares 12,300,000 30,566,666
----------- ----------
Diluted:
-------
Net(loss) $ (1.53) $ (0.08)
=========== ===========
Weighted-average number of common shares and assumed 12,300,000 30,566,666
conversions ----------- -----------
</TABLE>
See notes to condensed financial statements.
2
<PAGE> 5
MEGO MORTGAGE CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS
(unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30,
-------------------------------
1997 1998
--------- --------
(thousands of dollars)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) $ (18,848) $ (2,494)
--------- --------
Adjustments to reconcile net (loss) to net cash used in operating activities:
Loans originated for sale, net of loan fees (202,517) (15,434)
Proceeds from sale of loans 155,856 12,977
Payments on loans held for sale 443 816
Lower of cost or market adjustment -- (6,315)
Net provisions for estimated credit losses 1,590 43
Additions to mortgage related securities (1,980) --
Accretion of residual interest on mortgage related securities (2,838) (349)
Amortization of mortgage related securities 335 105
Write-off / sale of mortgage related securities (900) --
Market valuation of mortgage related securities 17,319 --
Payments on mortgage related securities 100 147
Additions to mortgage servicing rights (1,530) --
Amortization of mortgage servicing rights 611 7
Proceeds from sale of mortgage servicing rights -- 76
Depreciation and amortization expense 208 215
Additions to prepaid debt expense (2,879) (64)
Amortization of prepaid debt expense 243 229
Amortization / write-off of prepaid commitment fee 218 --
Changes in operating assets and liabilities:
Cash deposits, restricted (1,902) 702
Deferred income taxes (benefit) (2,148) (1,468)
Other assets, net 560 (1,342)
State income taxes payable (649) --
Other liabilities, net (737) (8,012)
--------- --------
Total adjustments (40,597) (17,667)
--------- --------
Net cash used in operating activities (59,445) (20,161)
--------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment -- (44)
-- --
--------- --------
Net cash used in investing activities -- (44)
--------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings on notes and contracts payable 204,074 14,873
Payments on notes and contracts payable (185,919) (170)
Issuance of subordinated debt 40,400 --
Payments on subordinated debt -- (867)
Amortization of premium of subordinated debt (8) (25)
--------- --------
Net cash provided by financing activities 58,547 13,811
--------- --------
NET DECREASE IN CASH AND CASH EQUIVALENTS (898) (6,394)
CASH AND CASH EQUIVALENTS--BEGINNING OF PERIOD 6,104 36,404
--------- --------
CASH AND CASH EQUIVALENTS--END OF PERIOD $ 5,206 $ 30,010
========= ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest $ 2,912 $ 290
========= ========
State income taxes $ -- $ 55
========= ========
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
Additional paid-in capital created from deferred tax asset $ 2,354 $ --
========= ========
</TABLE>
See notes to condensed financial statements.
3
<PAGE> 6
MEGO MORTGAGE CORPORATION
STATEMENTS OF STOCKHOLDERS' EQUITY
(UNAUDITED)
<TABLE>
<CAPTION>
PREFERRED STOCK COMMON STOCK
$.01 PAR VALUE $.01 PAR VALUE ADDITIONAL RETAINED
---------------- ------------------- PAID-IN EARNINGS
SHARES AMOUNT SHARES AMOUNT CAPITAL (DEFICIT) TOTAL
------ ------ ------ ------ ------- --------- -----
(thousands of dollars, except share amounts)
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at August 31, 1998 62,500 $ 1 30,566,667 $306 $122,143 $(95,856) $26,594
Retirement of common stock (7) -- -
Net loss for the three months ended
November 30, 1998 -- -- -- -- -- (2,494) (2,494)
------ --- ---------- ---- -------- -------- -------
Balance at November 30, 1998 62,500 $ 1 30,566,660 $306 $122,143 $(98,350) $24,100
====== === ========== ==== ======== ======== =======
</TABLE>
See notes to condensed financial statements.
4
<PAGE> 7
MEGO MORTGAGE CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED NOVEMBER 30, 1997 AND 1998
1. CONDENSED FINANCIAL STATEMENTS
In the opinion of management, when read in conjunction with the audited
Financial Statements for the years ended August 31, 1997 and 1998 that are
contained in the Form 10-K of Mego Mortgage Corporation filed with the
Securities and Exchange Commission for the fiscal year ended August 31, 1998,
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, 1998, the results of its operations for the three
months ended November 30, 1997 and 1998, the change in stockholders' equity for
the three months ended November 30, 1998 and the cash flows for the three months
ended November 30, 1997 and 1998. Certain reclassifications, including the
reclassification of commission and selling expenses of approximately $690,000
for the three months ended November 30, 1997 into their component expense
categories within general and administrative expenses, 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, 1998 are not necessarily indicative of the results to be expected
for the full year.
The Company records gain on sale of loans as required by Statement of
Financial Accounting Standards No. 125 ("SFAS 125") which, among other things,
requires management to estimate the fair value of certain mortgage related
securities and servicing assets utilizing future prepayment and loss
assumptions. Such assumptions will differ from actual results and the
differences could be material. Management utilizes assumptions based on a
variety of factors including historical trends, consultation with its financial
advisors and assumptions utilized by its peers. Historical trends may not be an
indication of future results, which may be affected by changes in interest
rates, credit quality, availability of alternative financing options and general
economic conditions. The application of SFAS 125 is required for all entities
with certain mortgage banking activities including originators and sellers of
mortgage loans. Management believes that its assumptions are similar to those
utilized by other subprime mortgage loan originators.
Capitalized terms not defined herein are defined in the Company's
audited Financial Statements for the years ended August 31, 1997 and 1998 that
are contained in the Form 10-K of Mego Mortgage Corporation filed with the
Securities and Exchange Commission for the fiscal year ended August 31, 1998.
2. 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 Equity + and Home Equity loans (Equity + and Home Equity loans are
together referred to as "Conventional Loans") which substantially exceeded the
levels that had been assumed for the applicable time frame. As a result of this
increase, the Company adjusted the assumptions previously utilized in
calculating the carrying value of its mortgage related securities as of November
30, 1997. The application of the revised assumptions to the Company's portfolio
of Conventional Loans backing its mortgage related securities caused the Company
to reduce the carrying value of such securities by approximately $10.2 million
at November 30, 1997. Additional negative adjustments of approximately $3.9
million to the carrying value of mortgage related securities backed by Title I
Loans and other sales were also recognized in the three months ended November
30, 1997, due to a higher level of defaults and prepayments than had been
previously assumed.
5
<PAGE> 8
After calculating the positive effect of accretion of interest, amortization of
cash flowing to mortgage related securities, and increased prepayment penalty
fees, the carrying value of the Company's mortgage related securities was
reduced to $94.3 million as of November 30, 1997 from $106.3 million as of
August 31, 1997. As a result of, among other things, the application of the
revised prepayment and loss assumptions, the Company recorded a $14.1 million
charge to earnings during the three months ended November 30, 1997. No such
charge has been recorded for the three months ended November 30, 1998.
3. RECENT EVENTS
In October 1997, the Company issued $40.0 million principal amount of
12.5% senior subordinated notes due in 2001 in a 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 repurchased
the balance of the senior subordinated notes in September and October 1998.
On December 1, 1998, the Company reduced its workforce, principally by
reducing the number of loan production and administrative personnel. As of
December 1, 1998, the Company had 63 employees as compared to 459 employees as
of December 1, 1997. The Company believes that its current staffing level is
adequate to meet its current needs.
As part of the Company's strategic initiatives, the Company had entered
into an agreement to purchase certain assets of LL Funding Corp., a
privately-held loan origination company headquartered in Columbia, Maryland.
Through December 31, 1998, the Company has purchased from LL Funding Corp.
approximately $16.2 million principal amount of loans at a purchase price of
102.75%. In addition, the Company has advanced approximately $1.3 million to LL
Funding Corp. to fund their operations, of which approximately $702,000 remained
outstanding as of December 31, 1998. On January 4, 1999, the Company terminated
the asset purchase agreement pursuant to provisions contained therein. LL
Funding Corp. has disputed the Company's right to terminate the asset purchase
agreement, and on January 11, 1999, the Company filed suit asking that the court
declare that the Company properly terminated the asset purchase agreement and is
not liable to LL Funding Corp. as a result of such termination.
6
<PAGE> 9
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, 1998.
GENERAL
The Company is a specialized consumer finance company that funds,
purchases, makes and sells consumer loans secured by deeds of trust on
one-to-four family residences. Historically, the Company has retained the right
to service a substantial portion of the loans we have sold. The Company's
borrowers generally do not qualify for traditional "A" credit mortgage loans.
Typically, their credit histories, income or other factors do not conform to the
lending criteria of government chartered agencies that traditional lenders rely
on in evaluating whether to make loans to potential borrowers.
The Company's loan products are:
- First mortgage loans and home equity loans ("Home Equity loans")
that typically are secured by first liens, and in some cases by
second liens, on the borrower's residence. In making Home Equity
loans, the Company relies primarily on the appraised values of
the borrowers' residences. The Company determines the loan amount
based on the appraised values and the creditworthiness of the
borrowers. These loans generally are used to purchase residences
and refinance existing mortgages.
- High loan-to-value loans ("Equity + loans") that are based on the
borrowers' credit. These loans typically are secured by second
liens on the borrowers' primary residences. The initial amount of
an Equity + loan, when added to other outstanding senior or
secured debt on the residences, resulted in a combined
loan-to-value ratio that averaged 112% during fiscal 1997 and
1998. The loan-to-value ratio on these loans may be as high as
125%. These loans generally are used to consolidate debt and make
home improvements.
Historically, a significant majority of the Company's loan production
was purchased from approved mortgage bankers and other financial intermediaries.
The Company also funds loans that are originated through its network of
pre-approved mortgage brokers. These brokers submit loan packages to the
Company, which in turn funds the loans to approved borrowers. All loans funded
or purchased by the Company are underwritten and graded
7
<PAGE> 10
by the Company's personnel. During the three months ended November 30, 1997 and
1998, the Company's loan production was comprised of the following:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
1997 1998
---- ----
<S> <C> <C>
Wholesale 91.9% 88.0%
Dealers 8.0 0.0
Retail 0.1 12.0
----- -----
Total 100.0% 100.0%
===== =====
</TABLE>
Additionally, certain of the loans historically produced by the Company
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. As
a result of prior losses, no FHA insurance remained with respect to the
Company's portfolio of Title I loans as of August 31, and November 30, 1998.
However, approximately $12.4 million (3.8% of the original Title I loan
balances) of FHA insurance remains available for collateral on the Company's
mortgage related securities as of November 30, 1998. During the three months
ended November 30, 1997 and 1998, the Company's loan production was comprised of
the following:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
1997 1998
---- ----
<S> <C> <C>
Equity + loans 93.9% 29.7%
Title I loans 6.1 0.0
Home Equity loans 0.0 70.3
----- -----
Total 100.0% 100.0%
===== =====
</TABLE>
The Company's operations, since January 1, 1998, have consisted
principally of the liquidation of its portfolio of loans, the proceeds from
which were used to reduce the Company's indebtedness. Due to recent substantial
changes to the Company's business and operating strategy, we believe that the
Company's historical financial and operating data are not likely to be
indicative of the Company's future performance and the Company's results of
operations for the three months ended November 30, 1998 are not comparable to
the three months ended November 30, 1997.
8
<PAGE> 11
LOAN PRODUCTION
The following table sets forth certain data regarding loans produced,
securitized, and serviced by the Company during the three months ended November
30, 1997 and 1998:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NOVEMBER 30,
------------------------------------------
1997 1998
------------------ -----------------
(dollars in thousands)
<S> <C> <C> <C> <C>
Principal balance of loans produced:
Wholesale (includes Bankers/Brokers):
Title I $ 4,902 2.5% $ 4 0.0%
Equity + loans 178,757 89.4 2,942 17.8
Home Equity -- -- 11,584 70.2
-------- ----- ------- -----
Total Wholesale 183,659 91.9 14,530 88.0
-------- ----- ------- -----
Dealers (1):
Title I 7,201 3.6 -- --
Equity + loans 8,754 4.4 -- --
-------- ----- ------- -----
Total Dealers 15,955 8.0 -- --
-------- ----- ------- -----
Retail:
Equity + loans 247 0.1 1,965 11.9
Home Equity -- -- 23 0.1
-------- ----- ------- -----
Total Retail 247 0.1 1,988 12.0
-------- ----- ------- -----
Total Principal Amount of Loans Produced $199,861 100.0% $16,518 100.0%
======== ===== ======= =====
NUMBER OF LOANS PRODUCED:
Wholesale (includes Bankers/Brokers):
Title I 225 3.3% 1 0.4%
Equity + loans 5,440 80.6 85 32.7
Home Equity -- -- 111 42.7
-------- ----- ------- -----
Total Wholesale 5,665 83.9 197 75.8
-------- ----- ------- -----
Dealers (1):
Title I 587 8.7 -- --
Equity + loans 489 7.3 -- --
-------- ----- ------- -----
Total Dealers 1,076 16.0 -- --
-------- ----- ------- -----
Retail:
Equity + loans 8 0.1 62 23.8
Home Equity -- -- 1 0.4
-------- ----- ------- -----
Total Retail -- 0.1 63 24.2
-------- ----- ------- -----
Total Number of Loans Produced 6,749 100.0% 260 100.0%
======== ===== ======= =====
LOANS SERVICED AT END OF PERIOD (INCLUDING LOANS
SECURITIZED, SOLD TO INVESTORS SERVICING
RETAINED AND HELD FOR SALE):
Title I $253,944 33.1% $ 2,599 12.4%
Conventional (Equity + and Home Equity loans) 513,403 66.9 18,404 87.6
-------- ----- ------- -----
Total Loans Serviced at End of Period (2) $767,347 100.0% $21,003 100.0%
======== ===== ======= =====
</TABLE>
(1) The Company closed its dealer division, which purchased loans from home
improvement contractors, in February 1998.
(2) Excludes approximately $2.6 million of loans to be repurchased at November
30, 1998.
9
<PAGE> 12
LOAN SALES
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, 1997 and 1998:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
NOVEMBER 30,
------------------------
1997 1998
--------- -------
(dollars in thousands)
<S> <C> <C>
Principal Amount of Loans Sold:
Title I $ 11,075 $ 810
Equity + 144,782 7,652
Home Equity -- 24
--------- -------
Total $ 155,857 $ 8,486
========= =======
Gain on sale of loans $ 3,721 $ 172
========= =======
Net unrealized (loss) gain on mortgage related securities (1) $ (13,108) $ 270
========= =======
PRINCIPAL AMOUNT OF LOANS SOLD (2):
Title I $ 11,075 $ 810
Equity + 106,421 12,143
Home Equity -- 24
--------- -------
Total $ 117,496 $12,977
========= =======
Gain on sale of loans (3) $ 2,790 $ 172
========= =======
Gain on sale of loans as a percentage of principal balance of loans sold (3) 2.4% 2.0%
========= =======
Gain on sale of loans plus net unrealized loss on mortgage related
securities as a percentage of principal balance of loans sold (3) (8.8)% 5.2%
========= =======
</TABLE>
- ----------
(1) The loss for the three months ended November 30, 1997 was a result of
the application of a negative adjustment to the carrying value of
mortgage related securities of $14.1 million during that period. No
such adjustment has been made to the carrying value of mortgage related
securities during the three months ended November 30, 1998.
(2) Excludes $38.4 million of loans sold with servicing released during the
three months ended November 30, 1997. Includes approximately $4.5
million principal amount of repurchased loans sold in the three months
ended November 30, 1998.
(3) Excludes gain on sale of $931,000 relating to whole loan sales of $38.4
million of loans sold with servicing released during the three months
ended November 30, 1997.
The percentage of gain on sale of loans can vary for several reasons,
including the relative amounts of Equity +, Home Equity 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 that are specific to each securitization and
are used as a means of credit enhancement.
10
<PAGE> 13
LOAN DELINQUENCIES
The following table sets forth the Title I, Equity + and Home Equity
Loan delinquencies and Title I insurance claims experience of loans serviced by
the Company as of the dates indicated:
<TABLE>
<CAPTION>
AUGUST 31, NOVEMBER 30,
1998 1998
------ ------
(dollars in thousands)
<S> <C> <C>
Delinquency period (1)
31-60 days past due 7.69% 4.86%
61-90 days past due 2.16 1.50
91 days and over past due 24.95 11.38
Total past due 34.88 17.74
91 days and over past due, net of claims filed (2) 7.56 --
Outstanding claims filed with HUD (3)(4) 17.39 18.06
Outstanding number of Title I insurance claims 207 160
Total servicing portfolio $ 31,222 $21,003
Title I Loans serviced 23,005 2,599
Conventional Loans serviced (Equity + and Home Equity loans) 8,217 18,404
Aggregate losses on liquidated loans (twelve and three months ended,
respectively) (5) $1,368.0 $ 47.9
</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.
(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,
1998, the amount of FHA insurance available for serviced Title I Loans
would have been reduced to $8.8 million.
(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 1,326 Title I insurance claims made by the Company, as
servicer, since commencing operations through November 30, 1998. 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.
11
<PAGE> 14
RESULTS OF OPERATIONS
Three Months Ended November 30, 1998 Compared to Three Months Ended November 30,
1997
As previously discussed, the Company reduced substantially its loan
production after January 1, 1998 as compared to the first four months of fiscal
1998. In the last eight months of fiscal 1998, the Company focused on (1)
liquidating its loan portfolio for cash to reduce its indebtedness while it
explored alternatives to raise new capital and (2) initiating new strategic
initiatives to return the Company to profitability. As a result, the Company
does not believe that its results for the three months ended November 30, 1998
are comparable to the Company's results for the three months ended November 30,
1997.
The Company produced $199.9 million of loans during the three months
ended November 30, 1997 compared to $16.5 million of loans during the three
months ended November 30, 1998, a decrease of 91.7%. The decrease is a result of
the curtailment in the Company's business while the Company has sought to pursue
its new strategic initiatives. The $16.5 million of loans produced during the
three months ended November 30, 1998 represents an increase of $14.6 million
over the fourth quarter of fiscal 1998.
Net Revenues. Net revenues (losses) increased $7.5 million to revenues
of $520,000 during the three months ended November 30, 1998 from losses of $7.0
million during the three months ended November 30, 1997. The loss for the three
months ended November 30, 1997 was primarily the result of a negative valuation
adjustment on the carrying value of the Company's mortgage related securities.
No valuation adjustments were recorded in the three months ended November 30,
1998.
Gain on sale of loans decreased $3.5 million to $172,000 during the
three months ended November 30, 1998 from $3.7 million during the three months
ended November 30, 1997. The decrease was primarily the result of a lower volume
of loans sold in the three months ended November 30, 1998 of $8.5 million
compared to $155.9 million in the three months ended November 30, 1997.
Net unrealized gain (loss) on mortgage related securities increased
$13.4 million to a gain of $270,000 during the three months ended November 30,
1998 from a loss of $13.1 million during the three months ended November 30,
1997. The increase was the result of a $14.1 million downward valuation
adjustment relating to the Company's mortgage backed securities during the three
months ended November 30, 1997. No valuation adjustments were recorded in the
three months ended November 30, 1998.
Loan servicing income, net, decreased $954,000 to $240,000 during the
three months ended November 30, 1998 from $1.2 million during the three months
ended November 30, 1997. The decrease was primarily the result of the decrease
in the Company's servicing portfolio to $21.0 million at November 30, 1998 from
$767.3 million at November 30, 1997 due to the sale of the Company's servicing
rights to City Mortgage Services, Inc. ("City Mortgage Services") during the
fourth quarter of fiscal 1998.
Interest income on loans held for sale and mortgage related securities,
net of interest expense, decreased $1.4 million to an expense of $162,000 during
the three months ended November 30, 1998 from income of $1.2 million during the
three months ended November 30, 1997. The decrease was primarily the result of
the decrease in the average size of the portfolio of loans held for sale to
$14.9 million for the three months ended November 30, 1998 from $32.6 million
for the three months ended November 30, 1997.
Provision for Credit Losses. The net provision for credit losses
decreased $1.5 million to $43,000 for the three months ended November 30, 1998
from $1.6 million for the three months ended November 30, 1997. The decrease was
primarily due to a lower level of loans sold with recourse in the three months
ended November 30, 1998 compared to November 30, 1997. 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
12
<PAGE> 15
portfolio, economic conditions and trends, historical credit loss experience,
borrowers' ability to repay, collateral values, and estimated FHA insurance
recoveries on Title I loans produced and sold.
Total General and Administrative Expenses. Total general and
administrative expenses decreased $5.8 million to $4.2 million during the three
months ended November 30, 1998 compared to $10.0 million during the three months
ended November 30, 1997. The decrease was primarily a result of decreased
payroll and benefits expenses as a result of the Company's downsizing since
January 1998, decreased professional services expenses due to lower legal and
consulting fees, decreased loan servicing expenses due to a decrease in loans
serviced due to the sale of the Company's servicing rights to City Mortgage
Services during fiscal 1998 and lower travel and entertainment expenses due to
the reduction in the Company's business.
Payroll and benefits expense decreased $3.7 million to $2.0 million
during the three months ended November 30, 1998 from $5.7 million during the
three months ended November 30, 1997 primarily due to a decreased number of
employees. The number of employees decreased to 63 at November 30, 1998 from 459
at November 30, 1997 due to a reduction in the Company's business during fiscal
1998.
Supplies and postage expense decreased $295,000 to $71,000 during the
three months ended November 30, 1998 from $366,000 during the three months ended
November 30, 1997 primarily due to mass mailing expenses in the three months
ended November 30, 1997 in connection with the Company's marketing plans which
were not present in the three months ended November 30, 1998.
Professional services decreased $552,000 to $964,000 during the three
months ended November 30, 1998 from $1.5 million for the three months ended
November 30, 1997 due to lower legal expenses and reduced usage of outside
consultants.
Insurance expenses decreased $184,000 to $185,000 during the three
months ended November 30, 1998 from $369,000 for the three months ended November
30, 1997 primarily due to lower FHA insurance expenses due to a lower level of
loans insured under FHA in the three months ended November 30, 1998.
Sub-servicing fees paid to third parties (Mego Financial in the three
months ended November 30, 1997 and City Mortgage Services in the three months
ended November 30, 1998) to service the Company's portfolio of loans held for
sale decreased $639,000 to $22,000 for the three months ended November 30, 1998
from $661,000 for the three months ended November 30, 1997 due primarily to the
sale of the Company's servicing rights to City Mortgage Services in the fourth
quarter of fiscal 1998.
Travel and entertainment expenses decreased $360,000 to $109,000 during
the three months ended November 30, 1998 from $469,000 during the three months
ended November 30, 1997 due primarily to the reduction in the Company's
business.
Loss Before Income Taxes. Loss before income taxes was $4.0 million
for the three months ended November 30, 1998 compared to $18.8 million for the
three months ended November 30, 1997. The provision for income taxes decreased
to an income tax benefit of $1.5 million for the three months ended November 30,
1998 while no such income tax benefit was provided for in the restated three
months ended November 30, 1997.
As a result of the foregoing, the Company incurred a net loss of $2.5
million for the three months ended November 30, 1998 compared to a net loss of
$18.8 million for the three months ended November 30, 1997.
13
<PAGE> 16
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents were $30.0 million at November 30, 1998
compared to $36.4 million at August 31, 1998. The Company's principal cash
requirements arise from loan production and payments of operating and interest
expenses.
The Company currently has four significant sources of financing and
liquidity: (1) the balance of the proceeds from the sale of Preferred Stock and
common stock in the recapitalization; (2) the new Sovereign warehouse line of
$90.0 million; (3) the flow purchase agreement; and (4) sales of loans in the
institutional whole loan market.
Certain material covenant restrictions exist in the Indenture governing
the Current Notes. These covenants include limitations on the Company's ability
to incur certain types of additional indebtedness, grant liens on its assets and
to enter into extraordinary corporate transactions. The Company may not incur
this additional indebtedness if, on the date of such incurrence and after giving
effect thereto, the Consolidated Leverage Ratio (as defined therein) would
exceed 1.5:1, subject to certain exceptions. At November 30, 1998, the
Consolidated Leverage Ratio was 2.0:1 and the Company could not incur any
additional indebtedness other than permitted indebtedness.
As part of the recapitalization, the Company executed a new warehouse
line of credit for up to $90.0 million with Sovereign Bancorp (the "Sovereign
Warehouse Line"), which replaced the Company's existing warehouse line of
credit. The Sovereign Warehouse Line originally terminated on December 29, 1998
and is renewable, at Sovereign's option, in six-month intervals for up to five
years. During December 1998, the Sovereign Warehouse Line was extended through
August 1999. The Sovereign Warehouse Line may be increased with certain consents
and contains pricing/fees which vary by product and the dollar amount
outstanding. The Sovereign Warehouse Line is to be secured by specific loans
held for sale and includes certain material covenants including maintaining
books and records, providing financial statements and reports, maintaining its
properties, maintaining adequate insurance and fidelity bond coverage and
providing timely notice of material proceedings. As of November 30, 1998, the
Company had approximately $14.9 million outstanding under the Sovereign
Warehouse Line.
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 that 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 borrowings under the
credit line agreement accrues interest at one-month LIBOR + 3.5% (9.1% at August
31, 1998 and 8.5% at November 30, 1998) with the remaining borrowings under the
credit line accrues interest at one-month LIBOR + 2.0% (7.6% at August 31, 1998
and 7.0% at November 30, 1998), expiring one year from the initial advance. As
of August 31, 1998 and November 30, 1998, approximately $10.0 million was
outstanding under the agreement. The agreement, which was originally scheduled
to mature in December 1998, was extended until December 1999. Certain material
covenant restrictions exist in the credit agreement governing the April 1997
revolving line of credit. These covenants include limitations to incur
additional indebtedness, provide adequate collateral and achieve certain
financial tests. These tests include achieving a minimal net worth (as defined
therein) and that the debt-to-net worth ratio (as defined therein) shall not
exceed 2.5:1. As of August 31, 1998, the Company's net worth was $15.9 million
below the minimal required and the debt-to-net worth ratio was 2.93:1. On
December 2, 1998, the Company obtained an amendment to the agreement whereby the
financial institution waived its right to declare an event of default of
borrower due to the Company's failure to comply with the minimal required net
worth as of August 31, 1998. Additionally, the minimal net worth test was
amended such that the Company is required to maintain a net worth equal to or
greater than 75% of the Company's net worth as of the end of the preceding
fiscal quarter. Additionally, the Company agreed to pay down the outstanding
borrowings from $10.0 million at August 31, 1998 to $6.0 million at December 31,
1998 and subsequently agreed to pay the remaining $6.0 million in equal monthly
payments during calendar 1999. As of November 30, 1998, the Company's net worth
was $4.2 million above the minimal required and the debt-to-net worth ratio was
2.86:1.
14
<PAGE> 17
In October 1997, the Company entered into a credit agreement with
another financial institution for an $8.8 million revolving line of credit. This
institution initially funded $5.0 million of this credit facility. The facility
is secured by a pledge of certain of the Company's mortgage related securities.
The loan balance under this agreement bears interest at the prime rate plus 2.5%
(11.0% at August 31, 1998 and 10.5% at November 30, 1998). In May 1998, this
loan converted into a term loan with monthly amortization derived from the cash
flow generated from the respective mortgage related certificates. This term loan
bears interest at the prime rate plus 2.5% (11.0% at August 31, 1998 and 10.5%
at November 30, 1998). This facility matures in October 2002. As of August 31,
1998 and November 30, 1998, approximately $4.6 million was outstanding under the
agreement. The credit agreement governing the October 1997 revolving line of
credit includes certain material covenants. These covenants include restrictions
relating to extraordinary corporate transactions, maintenance of adequate
insurance and achieving certain financial tests. These tests include achieving a
minimal consolidated adjusted tangible net worth (as defined therein) and that
the consolidated adjusted leverage ratio (as defined therein) shall not exceed
3:1. As of August 31, 1998, the Company's consolidated adjusted tangible net
worth was $54.1 million below the minimum required and the consolidated adjusted
leverage ratio was 0.53:1. On December 9, 1998, the Company agreed to
temporarily amend the borrowing base definition for the period from September
30, 1998 through April 30, 1999 to increase the borrowing base from 50% to 55%.
After April 30, 1999, the borrowing base will return to 50%. The minimum
consolidated tangible net worth covenant was also adjusted, commencing
retroactively, as of September 30, 1998 and the Company agreed to paydown the
line by approximately $405,000 (the amount exceeding the applicable maximum
amount of tranche credit) and pay an accommodation fee of $10,000. As of
November 30, 1998, the Company's consolidated adjusted tangible net worth was
$44.4 million above the minimum required and the consolidated adjusted leverage
ratio was 0.66:1.
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,
1998, no commitments existed for material capital expenditures.
Net cash used in the Company's operating activities for the three
months ended November 30, 1997 and 1998 was $59.4 million and $20.2 million,
respectively. During the three months ended November 30, 1997 and 1998, cash
provided by financing activities amounted to $58.5 million and $13.8 million,
respectively.
FINANCIAL CONDITION
November 30, 1998 Compared to August 31, 1998
Cash and cash equivalents decreased $6.4 million to $30.0 million at
November 30, 1998 from $36.4 million at August 31, 1998 primarily as a result of
payment of general and administrative expenses and commitments to repurchase
loans.
Restricted cash deposits decreased $702,000 to $3.0 million at November
30, 1998 from $3.7 million at August 31, 1998 primarily due to the number of
loans sold and securitized in prior periods.
Loans held for sale, net of allowance for credit losses and valuation
allowance, increased $7.9 million to $18.9 million at November 30, 1998 from
$11.0 million at August 31, 1998 primarily as a result of the Company's loan
production of approximately $16.5 million and loan sales of approximately $8.5
million during the three months ended November 30, 1998.
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, 1998
consist of the following (thousands of dollars):
15
<PAGE> 18
<TABLE>
<S> <C>
Balance at August 31, 1998 $2,548
Provision for credit losses 43
Increase due to adjustment to allowance for credit losses 5
------
Balance at November 30, 1998 $2,596
======
</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, NOVEMBER 30,
1998 1998
------ ------
(thousands of dollars)
<S> <C> <C>
Allowance for credit losses $ 76 $ 120
Allowance for credit losses on loans sold with recourse 2,472 2,476
------ ------
Total $2,548 $2,596
====== ======
</TABLE>
Changes in the valuation allowance on loans held for sale for the three
months ended November 30, 1998 consist of the following (thousands of dollars):
<TABLE>
<S> <C>
Balance at August 31, 1998 $10,901
Provision for valuation changes 433
Reductions to the allowance on loans sold (6,748)
--------
Balance at November 30, 1998 $ 4,586
=======
</TABLE>
Other receivables increased $977,000 to $6.1 million at November 30,
1998 from $5.1 million at August 31, 1998 primarily due to net advances to LL
Funding Corp., an increase in the receivable from a securitization trustee and
an increase in the receivable from the Company's loan sub-servicer (City
Mortgage Services). The increase in the receivable from a securitization trustee
and City Mortgage Services reflect timing of payments.
Notes and contracts payable increased $14.7 million to $31.1 million at
November 30, 1998 from $16.3 million at August 31, 1998 due to borrowings on the
Sovereign Warehouse Line by the Company to fund loan production in the three
months ended November 30, 1998.
Accounts payable and accrued liabilities decreased $8.0 million to $8.4
million at November 30, 1998 from $16.4 million at August 31, 1998 primarily due
to the repurchase of loans of approximately $7.0 million and settlement on loans
serviced of approximately $1.0 million in the three months ended November 30,
1998. As of November 30, 1998, the Company had remaining repurchase commitments
of approximately $2.6 million.
Subordinated debt decreased $892,000 to $41.8 million at November 30,
1998 from $42.7 million at August 31, 1998 due to the repurchase of the
remaining Old Notes during September and October, 1998.
Stockholders' equity decreased $2.5 million to $24.1 million at
November 30, 1998 from $26.6 million at August 31, 1998 primarily as a result of
the net loss of $2.5 million during the three months ended November 30, 1998.
16
<PAGE> 19
SEASONALITY
The Company's production of Home Equity and Equity + (Conventional)
loans is seasonal to the extent that borrowers used the proceeds for home
improvement contract work. The Company's production of loans for this purpose
tends to build during the spring and early summer months, particularly where the
proceeds are used for 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. While the
Company does not have substantial experience making loans to borrowers who
intend to use the proceeds to purchase a residence, management believes that the
market for such loans will follow the home sale cycle, higher in the spring
through early fall than during the remainder of the year.
IMPACT OF THE YEAR 2000 ISSUE
The term "Year 2000 issue" is a general term used to describe the
various problems that may result from the improper processing of dates and
date-sensitive calculations by computers and other machinery as the year 2000 is
approached and reached. These problems generally arise from the fact that most
of the world's computer hardware and software have historically used only two
digits to identify the year in a date, often meaning that the computer will fail
to distinguish dates in the "2000's" from dates in the "1900's." These problems
may also arise from other sources as well, such as embedded computer chips
contained in devices and special codes in software that make use of the date
field.
The Company has developed plans to address the Year 2000 issue. The
Company's present Year 2000 plan consists of five phases:
(1) inventory of business critical information technology assets;
(2) assessment of repair requirements;
(3) repair or replacement;
(4) testing of systems; and
(5) creation of contingency plans in the event of Year 2000 failures.
As of November 30, 1998, the Company had completed the first and second
phases of the Year 2000 plan for its own business critical information
technology assets including its accounting systems, loan origination systems,
word and data processing systems, customer telephone service center, and
business machines. The Company is relying upon the representations of third
party vendors as to the Year 2000 readiness of certain of its software, its
business machines, such as copiers and facsimile machines, and of facilities,
such as physical office locations. The Company does not have plans for testing
embedded computer chips contained in devices, or in special codes in software
that make use of the date field incidental to their operation.
All five phases of the Company's Year 2000 plan are expected to be
completed by August 31, 1999. Based on information currently available, the
Company's costs to remedy its own critical information technology assets are
estimated to be approximately $225,000. These costs will cover hardware and
software upgrades, systems consulting and computer maintenance. The Company
plans to charge these costs to expense as incurred, and it believes such costs
will not have a material effect on its liquidity or financial condition. As of
November 30, 1998, the Company had spent approximately $57,000 to purchase or
upgrade portions of its own hardware/software. As part of its Year 2000 plan,
the Company has accelerated the schedule of implementation of certain of the
Company's previously planned information technology projects. Therefore, the
Company does not expect to defer any specific information technology project as
a result of the implementation of its Year 2000 plan.
17
<PAGE> 20
Until system testing is substantially in process, the Company cannot
fully estimate the risks of the Year 2000 issue. To date, the Company has not
identified any of its own business critical information technology assets that
it believes present a material risk of not being Year 2000 compliant or for
which a suitable alternative cannot be implemented. However, as the Company's
Year 2000 plan proceeds into subsequent phases, it is possible that the Company
may identify assets that do present a risk of a Year 2000-related disruption.
Such a disruption would have a material adverse effect on the Company's
financial condition and results of operations. Because the Company has not begun
system testing, and, accordingly, has not fully assessed its risks from
potential Year 2000 failures, the Company has not yet developed specific Year
2000 contingency plans.
As of August 31, 1998, the Company had begun to make inquiry of
substantially all of its strategic partners, vendors and third party entities
with which it has material relationships, and had begun to compile data related
to their Year 2000 plans. The Company's reliance upon certain third parties,
vendors and strategic partners for loan servicing, investor reporting, document
custody and other functions, means that their failure to adequately address the
Year 2000 issue could have a material adverse impact on the Company's operations
and financial results. The Company has received assurances from its two major
strategic partners, City Mortgage Services and Sovereign Bank, NA, that they
have implemented plans to address the Year 2000 issue. The Company has not
evaluated these plans or assurances for their accuracy and adequacy, or
developed contingency plans in the event of their failure. As of December 31,
1998, the Company had received responses from approximately 20% of its Year 2000
inquiries. Of those responses, approximately 76% indicated that they had some
plan to address the Year 2000 issue. Because the Company has not yet received a
significant number of responses from its vendors or other third parties,
potential risks related to their failure to address Year 2000 issues are not
known at this time.
The Company also relies upon certain government entities (such as the
U.S. Dept. Of Housing and Urban Development and various state regulatory
agencies), utility companies, telecommunication service companies and other
service providers outside of the Company's control. There can be no assurance
that such suppliers, government entities, or other third parties will not suffer
a Year 2000 business disruption. Such failures would have a material adverse
effect on the Company's financial condition and results of operations.
In addition, the Company's credit risk associated with its borrowers
may increase as a result of borrowers' individual Year 2000 issues. Negative
impact of Year 2000 issues upon borrowers may result in borrowers' inability to
pay, increases in delinquent loans, and a loss of residual income to the
Company. While at this time, it is not possible to calculate the potential
impact of such increased delinquent loans; it is believed that increased
delinquencies would have a material adverse impact on the financial condition of
the Company.
Because of uncertainties, the actual effects of the Year 2000 issue on
the Company may be different from the Company's current assessment. The effect
on the Company's results of operations if the Company, its strategic partners,
vendors or other third parties are not fully Year 2000 compliant is not
reasonably estimable. The description of the Company's Year 2000 plans contain
"forward-looking" statements about matters that are inherently difficult to
predict. Those statements include statements regarding the intent, belief or
current expectations of the Company and its management. Some of the important
factors that affect these statements have been briefly described. Such
forward-looking statements involve risks and uncertainties that may affect
future developments such as, for example, the ability to deal with the Year 2000
issue, including problems that may arise on the part of third parties. If the
repairs and modifications required to make the Company Year 2000 ready are not
made or are not completed on a timely basis, the resulting problems would have a
material adverse impact on the operations and financial condition of the
Company.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company's various business activities generate liquidity, market
and credit risk:
- liquidity risk is the possibility of being unable to meet all
present and future financial obligations in a timely manner.
- market risk is the possibility that changes in future market
rates or prices will make the Company's positions less valuable.
- credit risk is the possibility loss from a customer's failure to
perform according to the terms of the transaction.
18
<PAGE> 21
Compensation for assuming these risks is reflected in interest income
and fee income.
Although the Company is exposed to credit loss in the event of
non-performance by the borrowers, this exposure is managed through credit
approvals, review and monitoring procedures into the extent possible restricting
the period during which unpaid balances are allowed to accumulate.
As of November 30, 1998 the net fair value of all financial instruments
with exposure to interest rate risk was approximately $34.9 million. The
potential decrease in fair value resulting from a hypothetical 5% increase in
interest rates would be approximately $26.1 million.
There are certain shortcomings inherent to the Company's sensitivity
analysis. The model assumes interest rate changes are instantaneous parallel
shifts in the yield curve. In reality, changes are rarely instantaneous.
Although certain assets and liabilities may have similar maturities or periods
to repricing, they may not react in line with changes in market interest rates.
Also, the interest rates on certain types of assets and liabilities may
fluctuate with changes in market interest rates while interest rates on other
types of assets may lag behind changes in market rates. Prepayments on the
Company's mortgage related instruments are directly affected by a change in
interest rates. However, in the event of a change in interest rates, actual loan
prepayments may deviate significantly from the Company's assumptions. Further,
certain assets, such as adjustable rate loans, have features, such as annual and
lifetime caps that restrict changing the interest rates both on a short term
basis and over the life of the asset. Finally, the ability of certain borrowers
to make scheduled payments on their adjustable rate loans may decrease in the
event of an interiors rate increase.
19
<PAGE> 22
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On October 8, 1998, the Office of the Consumer Credit Commissioner of
the State of Texas issued a denial of the Company's application for licensing as
a secondary mortgage lender. On October 20, 1998, the Company filed an appeal of
the Commissioner's decision. An administrative hearing, originally set for
December 3, 1998, was postponed and no new hearing date has been scheduled.
No significant developments in any other litigation previously reported
occurred during the three month period ended November 30, 1998.
ITEM 5. OTHER INFORMATION
As part of the Company's strategic initiatives, the Company had entered
into an agreement to purchase certain assets of LL Funding Corp., a
privately-held loan origination company headquartered in Columbia, Maryland.
Through December 31, 1998, the Company has purchased from LL Funding Corp.
approximately $16.2 million principal amount of loans at a purchase price of
102.75%. In addition, the Company has advanced approximately $1.3 million to LL
Funding Corp. to fund their operations, of which approximately $702,000 remained
outstanding as of December 31, 1998. On January 4, 1999, the Company terminated
the asset purchase agreement pursuant to provisions contained therein. LL
Funding Corp. has disputed the Company's right to terminate the asset purchase
agreement, and on January 11, 1999, the Company filed suit asking that the court
declare that the Company properly terminated the asset purchase agreement and is
not liable to LL Funding Corp. as a result of such termination.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
EXHIBIT NUMBER DESCRIPTION
27.1 Financial Data Schedule (for SEC use only).
A report on Form 8-K dated September 2, 1998, was filed on September
16, 1998, to report that Jeffrey Moore had resigned as a director of the Company
and as its President and that William Paul Ralser had been appointed to replace
Mr. Moore as President of the Company and as the Company's Chief Operating
Officer.
20
<PAGE> 23
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/ J. Richard Walker
--------------------------------
J. Richard Walker
Executive Vice President
Chief Financial Officer
Date: January 14, 1999
--------------------
21
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