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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K/A
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
FOR THE FISCAL YEAR ENDED AUGUST 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 0-21689
MEGO MORTGAGE CORPORATION
(Exact name of registrant as specified in governing instrument)
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DELAWARE 88-0286042
(State of organization) (IRS Employer Identification No.)
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1000 PARKWOOD CIRCLE, SUITE 500 ATLANTA, GA 30339
(Address of Principal Executive Offices -- Zip Code)
Registrant's telephone number, including area code: (770) 952-6700
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
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TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
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Common Stock, $.01 per share Nasdaq Stock Market
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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 'CHECKMARK' No ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant (based upon the closing sale price on the Nasdaq Stock Market) on
December 11, 1998 was approximately $7,418,719. As of December 11, 1998, there
were 30,566,660 shares of common stock, $.01 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
None.
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MEGO MORTGAGE CORPORATION
TABLE OF CONTENTS
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PAGE
ITEM NO. NO.
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PART I
1. Business.................................................... 1
2. Properties.................................................. 22
3. Legal Proceedings........................................... 22
4. Submission of Matters to a Vote of Security Holders......... 23
PART II
5. Market for Registrant's Common Equity and Related
Stockholder Matters....................................... 24
6. Selected Financial Data..................................... 25
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 28
8. Financial Statements and Supplementary Data................. 54
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 54
PART III
10. Directors and Executive Officers of the Registrant.......... 55
11. Executive Compensation...................................... 57
12. Security Ownership of Certain Beneficial Owners and
Management................................................ 61
13. Certain Relationships and Related Transactions.............. 62
PART IV
14. Exhibits, Financial Statements, Schedules and Reports on
Form 8-K.................................................. 66
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PART I
ITEM 1. BUSINESS
This Annual Report contains certain forward-looking statements, within the
meaning of the Private Securities Litigation Reform Act of 1995, with respect to
the financial condition, results of operations and business of the Company,
including statements under the captions "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Business." These
forward-looking statements involve certain risks and uncertainties. There can be
no assurance that any of such matters will be realized. Factors that may cause
actual results to differ materially from those contemplated by such
forward-looking statements include, among others, the following: (i) competitive
pressures in the contract staffing and outsourcing industries; (ii) management
and integration of the operations of acquired businesses; (iii) the Company's
business and growth strategies and (iv) general economic conditions, including
the ability to recruit staff.
GENERAL
Mego Mortgage Corporation (the "Company") is a specialized consumer finance
company that funds, purchases, makes and sells consumer loans secured by deeds
of trust on single-family residences. Historically, the Company retained the
right to service a substantial portion of the loans it has 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 (including GNMA, FNMA, FHLMC)
that traditional lenders rely on in evaluating whether to make loans to
potential borrowers.
The Company's loan products are:
- 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 value of the
borrower's residence. The Company determines the loan amount based on the
loan-to-value ratio and the creditworthiness of the borrower. These loans
generally are used to purchase single-family residences and refinance
existing mortgages.
- 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 residence, 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.
The Company funds loans originated by its network of pre-approved mortgage
brokers which numbered over 169 mortgage brokers as of August 31, 1998. These
brokers submit loan packages to the Company which in turn funds loans made to
approved borrowers. The loans are made directly by the Company to the borrower.
Historically, the Company has produced substantially all of its loans by
purchasing previously closed loans from approved mortgage bankers and other
financial intermediaries and purchasing closed Title I loans from its network of
home improvement contractors. All loans produced by the Company are underwritten
and graded by the Company's personnel. The Company's current
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operating strategy is to sell substantially all of the loans it produces for
cash to institutional purchasers. The Company currently does not intend to
produce a material amount of Title I loans in the future.
The Company's loans are primarily produced by its wholesale division and,
to a lesser extent, is retail division. The wholesale division funds loans
originated by a network of pre-approved mortgage brokers. The wholesale division
also underwrites and purchases closed loans sometimes at a premium to their
principal amount from a nationwide network of independent mortgage bankers and
other qualified financial intermediaries. To diversify its loan production
channels, the Company, through its retail division, currently intends to resume
making direct-to-consumer loans during fiscal 1999. The retail division makes
loans directly to consumers charging fees to the borrower that are expected to
offset the Company's total cost of making the loan.
The Company historically has sold, in securitization transactions, a
substantial majority of the loans it produces on a servicing-retained basis
(which means the Company retains the right to service the loans and receives an
annual fee based on a fractional percentage of the outstanding principal balance
of the loans). Generally, sales on a servicing-released basis (which means the
servicing on the loan is sold or "released" to the purchaser of the loan) and
some sales on a servicing-retained basis are at a premium to the principal
amount of the loan. For additional details on the sale of loans in
securitization transactions, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Securitization Transactions."
The Company, during fiscal 1996 and 1997 and the first four months of
fiscal 1998, substantially expanded its operations. During these periods the
Company's loan production was $139.4 million (fiscal 1996), $526.9 million
(fiscal 1997) and $268.5 million (first four months of fiscal 1998). As the
Company expanded its business, the general and administrative expenses required
to support the expansion also increased from $11.8 million in fiscal 1996 to
$23.8 million in fiscal 1997 and $13.8 million in the first four months of
fiscal 1998. As a percentage of the total principal amount of loans produced,
general and administrative expenses during these periods represented 8.5% in
fiscal 1996, 4.5% in fiscal 1997 and 5.2% in the first four months of fiscal
1998.
Prior to January 1998, a substantial majority of the Company's loan
production was sold in securitization and similar transactions. The sale of
loans in securitization transactions typically results in negative cash flow
because the cash proceeds from the sale of the loans in a securitization
transaction is substantially less than the Company's total cost of producing the
loans sold. The combination of negative cash flow from the sale of loans in
securitization transactions and the level of general and administrative expenses
caused the Company, historically, to operate on a substantial negative cash flow
basis.
During fiscal 1996 and 1997 and the six months ended February 28, 1998, the
Company used $12.4 million, $72.4 million and $59.5 million of cash used in
operations, respectively. The cash was principally funded from the sale of $20.0
million of common stock and $40.0 million of subordinated debt in November 1996
and $40.0 million principal amount of subordinated debt in October 1997, as well
as its warehouse line of credit and other borrowings.
As a result of a $11.7 million loss in the Company's first quarter of
fiscal 1998 and continuing cash flow deficits, the Company violated certain
provisions of its old warehouse line. The warehouse lender requested in February
1998 that the Company, in order to
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avoid a default, repay a significant portion of the principal balance of the
line. Since a default on the warehouse line would have triggered, among other
things, a default on the Company's $80.0 million principal amount of outstanding
Old Notes, the Company agreed to periodically reduce the outstanding balance of
the old warehouse line from $55.0 million and the Company repaid the balance on
June 29, 1998.
To generate cash to reduce the outstanding amount of the warehouse line and
continue to operate, the Company began to liquidate, through sales for cash, its
mortgage loan portfolio and explore a number of alternatives to locate new
capital. In addition, because the old warehouse line was used to fund loans
produced by the Company prior to their sale, the Company greatly curtailed its
loan production beginning in January 1998. The cash received from the Company's
sale of loans was used to pay down the old warehouse line and other Company
borrowings and to pay general and administrative expenses to retain personnel
and maintain the Company's operations while it sought to locate new capital.
These matters, among others, raised substantial doubt in the opinion of the
Company's independent auditors with respect to the Company's ability to continue
as a going concern.
THE RECAPITALIZATION
General
The Company has historically operated on a negative cash flow basis
primarily due to substantial increases in loan production and general and
administrative expenses used to support the expansion of the Company's
operations and the significant negative cash flow from the Company's sale of a
substantial majority of its loan production in securitization transactions.
Continuing deficits in cash flow combined with a $32.5 million loss
recognized by the Company for the three months ended November 30, 1997 and a
$32.5 million loss recognized for the Company for the six months ended February
28, 1998 resulted in the Company's violation of certain covenants contained in
agreements with its warehouse lender and some of its other lenders. From January
1998, when the Company violated these covenants with its lenders, until the
completion of the recapitalization on July 1, 1998, the Company's principal
activities consisted of liquidating its portfolio of loans to reduce the
Company's borrowings, maintaining the systems and personnel necessary to enable
the Company to resume operations and exploring alternatives to raise new
capital.
Private Placements
In an effort to resume operations, the Company explored a number of
alternatives to raise new capital. These activities resulted in the Company's
recapitalization, completed on July 1, 1998, which provided the Company with
approximately $84.5 million of new equity. Two strategic partners, City National
Bank and Sovereign Bancorp, each purchased 10,000 shares of the Company's newly
designated Series A convertible preferred stock at a price of $1,000 per share.
In addition, City National Bank and Sovereign Bancorp were each granted an
option, which expires in December 2000, to acquire 6.67 million shares of common
stock at a price of $1.50 per share. City National Bank and Sovereign Bancorp
each has a right of first refusal to purchase the Company in the event the
Company's board of directors determines to sell the Company. In addition, one
other private investor purchased an aggregate of 5,000 shares of Series A
Convertible preferred stock at a purchase price of $1,000 per share and several
other investors purchased an aggregate of
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16.67 million shares of common stock at a purchase price of $1.50 per share. An
additional 1.6 million shares of common stock were issued to Friedman, Billings,
Ramsey & Co., Inc. ("FBR") as the placement agent's fees for the
recapitalization. In addition, the Company has paid FBR an advisory fee of
$416,667 in connection with the recapitalization and reimbursed FBR for
out-of-pocket expenses of approximately $250,000. These sales were made pursuant
to private placements.
The proceeds from the recapitalization were approximately $50.0 million.
Approximately $5.1 million was used to pay interest on the Company's outstanding
subordinated notes, $2.4 million was used to retire the old warehouse line, $1.6
million was used for the payment of loan and management fees and other
miscellaneous charges due to Mego Financial, and approximately $428,000 was used
for the payment of a portion of the costs of the recapitalization. The balance
will be used to fund, purchase and make new loans and for general and
administrative expenses and other corporate purposes.
Exchange Offer
As part of the recapitalization, the Company completed an exchange offer
(the "Exchange Offer") of 12 1/2% subordinated notes due 2001 (the "Current
Notes") and preferred stock for any and all of the outstanding $80.0 million
principal amount of the Company's 12 1/2% subordinated notes due 2001 (the "Old
Notes"). Pursuant to the Exchange Offer, the Company issued approximately 37,500
shares of Series A convertible preferred stock at a price of $1,000 per share
and $41.5 million principal amount of Current Notes in exchange for
approximately $79.0 million principal amount of the Old Notes. The Company
completed the purchase of all of the remaining Old Notes on October 1, 1998.
Management
Upon completion of the recapitalization, Jerome J. Cohen, Robert
Nederlander, Herbert B. Hirsch and Don A. Mayerson resigned as directors of the
Company and Champ Meyercord was elected the Company's Chairman of the board of
directors and Chief Executive Officer. Mr. Meyercord had been a special
consultant to the Company since May 1998. In addition, City National Bank and
Sovereign Bancorp each were granted the right to appoint one member to the
Company's board of directors and have the right to appoint an additional board
member if they exercise their option to purchase additional shares of common
stock. Upon completion of the recapitalization, David J. Vida, Jr. was appointed
to the board of directors at the request of City National Bank. Three private
investors each have the right to appoint one board member. Wm. Paul Ralser was
appointed to the board of directors at the request of an ad hoc committee of
holders of the Old Notes, and Hubert M. Stiles, Jr. was appointed to the board
of directors at the request of one of the two private investors. Sovereign
Bancorp and the other private investor have not exercised their right to appoint
a board member, but have exercised their right to have a representative attend
each board meeting. On August 14, 1998, Jeffrey S. Moore resigned as President
of the Company. Effective September 1, 1998, Mr. Ralser was elected the
President and Chief Operating Officer of the Company.
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Transactions with Strategic Partners
As part of the recapitalization, the Company and each of Sovereign Bancorp
and City Holding Company entered into the following agreements that the Company
believes will provide liquidity and increase the efficiency of the Company's
operations:
- Sovereign Bancorp and City National Bank each purchased 10,000 shares of
Series A convertible preferred stock at a price of $1,000 per share
- Sovereign Bancorp agreed to provide the Company up to $90.0 million in
borrowings under a warehouse line (the "Sovereign Warehouse Line") to
fund its loan production prior the sale of the loans
- Sovereign Bancorp agreed to purchase up to $100.0 million of the
Company's loans per quarter and has a right of first refusal to purchase
all other loans produced by the Company pursuant to a purchase agreement
(the "Flow Purchase Agreement")
- City National Bank purchased the Company's existing mortgage servicing
rights
- City Mortgage Services agreed to service all of the Company's mortgage
loans held for sale and loans sold on a servicing-retained basis by the
Company
- Sovereign Bancorp and City National Bank were each granted an option to
purchase 6.67 million shares of common stock at a price of $1.50 per
share
- Sovereign Bancorp and City National Bank each has a right of first
refusal to purchase a controlling voting interest or a majority of the
Company's assets if the board of directors determines to sell the Company
- City National Bank has appointed, and Sovereign Bancorp has the right to
appoint, one member to the board of directors. Each has the right to
appoint an additional member to the board of directors if they exercise
their option to purchase shares of common stock
STRATEGIC INITIATIVES
Our strategic initiatives have been substantially impacted by recent events
in the capital markets and their effect on the specialty finance industry. There
has been a significant reduction in the number of institutions willing to
provide warehouse facilities to mortgage lenders producing home equity and high
loan-to-value loans. Additionally, there has been a reduction in the number of
buyers of senior interests issued in securitization transactions backed by home
equity and high loan-to-value loans, and a concurrent increase in the yield (and
a reduction in the price) demanded by such buyers on the senior interests they
purchase. Finally, the number of institutional investors acquiring loans similar
to the Company's Home Equity and Equity + loans has declined, along with the
premiums, if any, these investors are willing to pay for these loans. These
events have substantially reduced the liquidity available to companies in our
business to make new loans. With these events in mind, we have redefined our
strategic initiatives.
OUR PRIMARY FOCUS WILL BE IN PRODUCING HOME EQUITY LOANS. We anticipate
reducing our reliance on Equity + loans with high loan-to-value ratios and
significantly increasing the percentage and amount of our business devoted to
the production of Home Equity loans by expanding our network of brokers and
bankers and acquiring other
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companies that produce Home Equity loans. The Company will produce Home Equity
loans solely for sale for cash, generally at premiums to their principal
amounts, to institutional purchasers in the secondary market without recourse
for credit losses or risk of prepayment. Based on our experience in the
industry, we believe that currently there are more buyers for Home Equity loans
than for Equity + loans.
DUAL PRODUCTION PLATFORMS SHOULD LOWER OUR TOTAL LOAN PRODUCTION COSTS.
While pursuing our broker and mortgage banker wholesale loan programs, we intend
to pursue loan production on a retail (direct-to-consumer) basis. Although a
retail loan platform is relatively expensive, we expect it to produce loans at a
lower cost than our wholesale platform. When the Company makes a loan directly
to a consumer, it typically receives loan fees and it avoids any premium due
when the Company purchases a loan from its network of mortgage bankers. The
Company expects its dual loan production platform strategy to lower its overall
cost of producing mortgage loans and improve its cash flow.
THE COMPANY INTENDS TO INCREASE PRODUCTION BY ACQUIRING OTHER MORTGAGE
LENDING COMPANIES. The Company intends to increase its loan production
significantly by acquiring companies that produce mortgage loans. Because the
Company raised cash in the recapitalization, it expects the current lack of
liquidity available to companies in the industry to create opportunities for the
Company in this area.
SELLING LOANS FOR CASH WILL BE THE COMPANY'S PRIMARY METHOD OF LOAN
DISPOSITION. The Company intends to sell substantially all of the loans it
produces for cash to institutional purchasers in the secondary market as our
primary loan disposition strategy. The Company expects this method of loan sales
to generate positive cash flow, because Home Equity and Equity + loans can
generally be sold for more than their principal amount. To this end, we are
expanding the number of institutions with which it has loan purchase and sale
relationships. The Company does not anticipate selling its loans in
securitization transactions. Securitization transactions tend to result in
negative cash flow, because the initial cash proceeds to the Company are less
than the Company's total cost of producing the loans to be sold.
THE COMPANY INTENDS TO CONTINUE TO IMPLEMENT COST SAVING MEASURES. We are
continuing an internal restructuring, which has resulted in a reduction of our
workforce from a peak of 475 employees in January 1998 to 134 employees as of
August 31, 1998 and 63 employees as of December 1, 1998. This reduction and
other cost saving measures the Company has taken, have significantly reduced our
monthly recurring general and administrative expenses from approximately $2.7
million in June 1998 (the month prior to completion of the recapitalization) to
approximately $800,000 in November 1998. In addition, the Company has reduced by
$4.7 million the annual interest expense on its outstanding subordinated notes
by issuing 37,500 shares of preferred stock and $41.5 million principal amount
of Current Notes in exchange for $79.0 million principal amount of Old Notes.
MORTGAGE INDUSTRY
Home Equity
A substantial number of residential homeowners are unable or unwilling to
obtain mortgage financing from conventional financing sources, whether for
reasons of credit impairment, income qualification, credit history, or a desire
to receive loan approval and funding more quickly than that offered by
conventional sources. Many of these homeowners have credit scores or debt ratios
that prohibit them from meeting the
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requirements of lenders who sell loans to FNMA or FHLMC. Such borrowers seek
loans that rely more heavily upon the borrower's equity in their home, and to a
lesser extent, upon the borrower's credit scores or debt ratios. Because the
properties securing such loans are the borrower's primary residence, the
borrower is less likely to default on payment than might be the case with
unsecured debt -- and in the event of the borrower's bankruptcy, the loan is
fully secured. Such loans rely more heavily on accurate appraisals of the
property prior to funding, and are generally made in loan-to-value ratios of
less than 80%.
Home Improvement
As the costs of home improvements escalate, home owners are seeking
financing to improve their property and maintain and enhance its value. The
National Association of Home Builders Economics Forecast in 1995 estimates that
home improvement expenditures will exceed $200.0 billion by the year 2003.
Lenders of home improvement financing typically rely more heavily on the
borrowers' creditworthiness, and ability to pay their debts than the value of
the collateral. These loans are secured by a real estate mortgage lien on the
property improved. The market for Equity + loans and Home Equity loans continues
to grow, as many homeowners have limited access to traditional financing sources
due to insufficient home equity, limited or impaired credit history or high
ratios of debt service-to-income. The loan proceeds can be used for a variety of
improvements such as large remodeling projects. Borrowers also have the
opportunity to consolidate a portion of their outstanding debt in order to
reduce their monthly debt service.
Debt Consolidation
An increasing number of financial institutions are originating loans to
borrowers who use the proceeds to reduce outstanding consumer finance
obligations. These loans may also be made in conjunction with a home improvement
project where the borrowers seek to enhance the value of their residence and
ultimately reduce their monthly debt service obligations. These consumer finance
obligations are often in the form of unsecured credit card debt which have high
interest rates and relatively short-term maturity dates. Under this type of
loan, the consumer uses the loan proceeds to consolidate multiple outstanding
debt into a single loan. In turn, the consumer receives the benefit of a lower
interest rate and an extended loan maturity date, often as high as 25 years,
reducing the amount of monthly debt service payments, and in certain instances
the interest paid may be tax deductible. These loan products are secured by a
mortgage lien on the consumer's primary residence. These liens are typically in
a junior position and when combined with first mortgage liens may exceed the
market value of the subject residence. Debt consolidation loans are typically
made to high creditworthy borrowers who have a credit history of honoring their
financial obligations on a timely basis. Within the specialty finance industry
it is typical for loans to qualified borrowers to be limited to the amount
which, when added to the outstanding senior liens on the property, will not
exceed 125% of the market value of the property.
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COMPANY LOAN PRODUCTS
The Company originates Home Equity loans and, to a lesser extent, Equity +
loans. Home Equity loans generally have a lower loan-to-value ratio than Equity
+ loans. When combined with other outstanding senior secured indebtedness on the
residence, Equity + loans may result in a combined loan-to-value ratio of up to
125%. During both fiscal 1997 and 1998, the Company's Equity + loans had an
average loan-to-value ratio of 112%. The Company lends to borrowers of varying
degrees of creditworthiness. See "-- Loan Processing and Underwriting." The
Company's primary loan products include the following:
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HOME EQUITY LOANS EQUITY + LOANS
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- - - fixed and adjustable rate - fixed rate
- - - typically secured by first liens, - secured by a junior lien on the
and to a lesser extent, second borrowers' principal residence
mortgage liens on the borrowers'
principal residences
- - - terms of up to 360 months - terms from 60 to 300 months
- - - principal amounts up to $500,000 - principal amounts up to $50,000
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Home Equity Loans
In furtherance of its strategy to expand its loan products, in December
1997 the Company commenced the production of Home Equity loans to borrowers with
a credit grade ranging from "A" to "D". Loan amounts may range up to a maximum
of $500,000 for "A" credit borrowers with maturities of up to 360 months. The
Company expects the average loan amount to be less than $100,000. The average
loan amount in this program for the fiscal year ended August 31, 1998 was
$60,019. In making Home Equity loans, the Company places increased emphasis on
the underlying collateral value of the residence which is fully supported by an
independent appraisal. The Company intends to pool its Home Equity loans for
eventual sale in the secondary market to institutional purchasers on a
servicing-released basis, without recourse for credit losses or risk of
prepayment, for cash premiums over the principal amount of the loan. To date,
substantially all of the Home Equity loans produced by the Company have been to
borrowers with "B" and "C" credit grades under the Company's underwriting
guidelines. The Company believes that there are several advantages to producing
Home Equity loans including:
- the existence of a more liquid secondary market than for Equity + loans
- the larger average principal amount of such loans which are typically two
times greater than that of a Equity + loan
- the lower total costs of producing Home Equity loans from mortgage
bankers and brokers than the Company's Equity + loans
Equity + Loans
An Equity + loan is a non-insured debt consolidation or home improvement
loan typically used to retire consumer debt and/or pay for a home improvement
project. All of the Equity + loans produced by the Company are secured by a
mortgage lien on the borrower's principal residence. The Company began producing
Equity + loans through its
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wholesale division in May 1996. Currently, Equity + loans are offered through
both the Company's wholesale and retail divisions. Debt consolidation loans
account for a major portion of the Company's Equity + loan production.
The Company has focused its Equity + loan program on higher credit quality
borrowers who may have limited equity in their residence after giving effect to
other debt secured by the residence. Most of the Company's Equity + loans have
loan-to-value ratios greater than 100% and, accordingly, the value of the
residence securing the loan generally will not be sufficient to cover the
principal amount of the loan in the event of default. The Company relies
principally on the creditworthiness and income stability of the borrower and, to
a lesser extent, on the underlying value of the borrower's residence for
repayment of its Equity + loans. For fiscal 1998, the average market value of
the residence securing the Equity + loans produced by the Company was
approximately $108,000 without added value from the respective home improvement
work, the amount of senior liens was approximately $88,500 and the Company's
loan amount was approximately $31,700.
LENDING OPERATIONS
Mortgage Brokers and Bankers
The Company produces loans through its wholesale and retail divisions. The
wholesale division represents the Company's largest source of loan production.
Through its wholesale division, the Company funds loans originated through a
nationwide network of licensed mortgage brokers and purchases loans from a
nationwide network of licensed mortgage bankers. Mortgage bankers produce
mortgage loans by lending their own funds to the borrower and closing the loan
in their own name. Mortgage brokers, like mortgage bankers, initiate the loan
application and process necessary underwriting documentation. However, unlike
mortgage bankers, mortgage brokers ordinarily do not fund loans with their own
money, but work as agents on behalf of investors, including mortgage bankers,
banks, savings and loans or investment bankers. The Company funds loans
originated by mortgage brokers by lending the Company's funds to the borrower
and closing the loan to the borrower in the Company's name.
The Company funds loans originated by mortgage brokers on an individual
loan basis, pursuant to which each loan is underwritten by the Company and is
closed in the Company's name. The Company's network of mortgage brokers earn
fees which are paid by the borrower at closing, and which are disclosed and
agreed to by the borrower as required by law. The Company purchases loans from
its network of mortgage bankers after underwriting closed loans or pools of
closed loans for compliance with the Company's underwriting criteria. When the
Company buys closed loans from mortgage bankers, the Company has historically,
and may in the future, pay premiums based upon the characteristics of the loans,
including the range of credit scores of the borrowers and the interest rates on
the loans. The wholesale division conducts operations from its headquarters in
Atlanta, Georgia. To build and maintain its network of mortgage bankers and
brokers, the wholesale division uses account executives responsible for
developing and maintaining relationships with mortgage bankers and brokers. At
August 31, 1998, the Company had a network of 169 active mortgage brokers and 56
active mortgage bankers.
Mortgage bankers and brokers qualify to participate in the Company's
programs only after a review by the Company's management of the mortgage
brokers' and mortgage bankers' respective reputations and expertise, including a
review of references and financial statements. The Company's compliance
department performs a periodic review of each
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mortgage banker and broker, recommending suspension or continuance of a
relationship with the mortgage banker or broker based upon the results of the
review. We do not believe that the loss of any particular mortgage banker or
broker would have a material adverse effect upon the Company.
None of the Company's arrangements with its mortgage bankers and brokers is
on an exclusive basis. Each relationship is documented by a written agreement,
in which the Company agrees to fund or purchase loans that comply with the
Company's underwriting guidelines. On each loan produced, the mortgage banker or
broker makes customary representations and warranties regarding, among other
things, the credit history of the borrower, the status of the loan and its lien
priority, if applicable, and agrees to indemnify the Company for breaches of any
representation or warranty. In the agreements, the mortgage banker or broker
makes customary representations and warranties regarding, among other things,
their corporate status, as well as regulatory compliance, title to the property,
enforceability, status of payments and advances on the loans. The mortgage
bankers and brokers agree, among other things, not to disclose confidential
information of the Company, to provide supplementary financial and licensing
information, maintain government approvals, and to refrain from soliciting the
Company's borrowers. Each agreement also contains provisions requiring that the
mortgage banker or broker indemnify the Company against material
misrepresentations or non-performance of its obligations.
Retail Loans
The Company commenced making direct-to-consumer Equity + loans in September
1997 and Home Equity loans in December 1997, although the Company's retail
channels are not being actively pursued. Marketing strategies typically used in
retail production include telemarketing, direct mail, television and radio
advertising, third-party loan programs and consumer trade shows. Telemarketing
services, both inbound and outbound, are outsourced to keep the cost of
originations to a minimum. A Company website is currently under construction and
may be used to provide consumer loan applications and information to the public
about the Company's products and services. As part of its business strategy, the
Company intends to acquire retail mortgage lending companies in fiscal 1999.
By making direct-to-consumer loans, the Company avoids the payment of
premiums that it pays when it purchases closed loans from its network of
mortgage bankers. The loan fees charged by the Company to consumers on the
direct loans are expected to cover the Company's total cost of the underwriting
and making the loan and place the Company on a positive cash flow basis with
respect to the production of direct-to-consumer loans.
10
<PAGE> 13
The following table provides information about the Company's loan
applications processed and loans produced during the periods indicated. As a
result of recent changes to the Company's business strategy, we do not believe
that this information is indicative of future loan applications and loans
produced.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
------------------------------------------------------
1996 1997 1998
---------------- ---------------- ----------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
TOTAL LOAN APPLICATIONS:
Number processed.............. 42,236 92,165 46,361
Number approved............... 20,910 52,269 24,876
Approved ratio................ 49.5% 56.7% 53.7%
LOAN PRODUCTION:
Principal balance of loans
produced:
Wholesale:
Title I.................... $ 82,596 59.3% $ 50,815 9.7% $ 7,081 2.1%
Equity + loans............. 11,582 8.3 409,603 77.7 289,354 85.4
-------- ----- -------- ----- -------- -----
Total Wholesale....... 94,178 67.6% 460,418 87.4% 296,435 87.5%
Dealers/Bankers/Brokers(1):
Title I.................... 45,189 32.4% 47,270 9.0% 11,619 3.4%
Equity + loans............. -- -- 19,229 3.6 14,051 4.2
Home Equity................ -- -- -- -- 8,940 2.6
-------- ----- -------- ----- -------- -----
Total
Dealers/Bankers/
Brokers.......... 45,189 32.4% 66,499 12.6% 34,610 10.2%
Retail:
Equity + loans............. -- -- -- -- $ 7,114 2.1%
Home Equity................ -- -- -- -- 783 0.2
-------- ----- -------- ----- -------- -----
Total Retail.......... -- -- -- -- $ 7,897 2.3%
-------- ----- -------- ----- -------- -----
Total principal
balance of loans
produced............ $139,367 100.0% $526,917 100.0% $338,942 100.0%
======== ===== ======== ===== ======== =====
Number of loans produced:
Wholesale:
Title I.................... 4,382 50.9% 2,445 12.0% 327 2.9%
Equity + loans............. 392 4.6 12,831 62.7 8,848 78.6
-------- ----- -------- ----- -------- -----
Total Wholesale....... 4,774 55.5% $ 15,276 74.7% 9,175 81.5%
Dealers/Bankers/Brokers (1):
Title I.................... 3,836 44.5% 3,893 19.0% 975 8.7%
Equity + loans............. -- -- 1,296 6.3 744 6.6
Home Equity................ -- -- -- -- 145 1.2
-------- ----- -------- ----- -------- -----
Total
Dealers/Bankers/
Brokers........... 3,836 44.5% 5,189 25.3% 1,864 16.5%
Retail:
Equity + loans............. -- -- -- -- 208 1.8%
Home Equity................ -- -- -- -- 17 0.2
-------- ----- -------- ----- -------- -----
Total Retail.......... -- -- -- -- 225 2.0%
-------- ----- -------- ----- -------- -----
Total number of loans
produced............ 8,610 100.0% 20,465 100.0% 11,264 100.0%
======== ===== ======== ===== ======== =====
</TABLE>
11
<PAGE> 14
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
------------------------------------------------------
1996 1997 1998
---------------- ---------------- ----------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Average principal balance of
loans produced................ $ 16 $ 26 $ 30
Weighted-average interest rate
on loans produced............. 14.03% 13.92% 13.89%
Weighted-average term of loans
produced (months)............. 198 226 235
</TABLE>
- - -------------------------
(1) The Company closed its dealer division, which purchased loans from home
improvement contractors, in February 1998.
LOAN PROCESSING AND UNDERWRITING
The Company's loan application and approval process generally is conducted
over the telephone with applications usually received from mortgage bankers,
mortgage brokers and consumers at the Company's centralized processing facility
in Atlanta, Georgia. After receiving an application, the information is entered
into the Company's system and processing begins. The information provided in
loan applications is first verified by, among other things, the following:
- written confirmations of the applicant's income and, if necessary, bank
deposits
- a formal credit bureau report on the applicant from a credit reporting
agency
- a title report
- a real estate appraisal, if necessary
- evidence of flood insurance, if necessary
Loan applications are then reviewed to determine whether or not they
satisfy the Company's underwriting criteria, including loan-to-value ratios,
occupancy status, borrower income qualifications, employment stability,
purchaser requirements and necessary insurance and property appraisal
requirements.
The Company has developed its credit index profile ("CIP") as a statistical
credit based tool to predict likely future performance of a borrower. A
significant component of the CIP system is the credit evaluation score
methodology developed by Fair Isaacs Company ("FICO"), a consulting firm
specializing in creating default predictive models using a number of variable
components. A FICO score is calculated by a system of scorecards. FICO uses
actual credit data on millions of consumers, and applies complex mathematical
methods to perform extensive research into credit patterns that attempt to
forecast consumer credit performance. The principal components of the FICO
predictive model include a consumer's credit payment history, outstanding debt,
availability and pursuit of new credit and types of credit in use. Through this
scorecard process, FICO identifies distinctive credit patterns, which correspond
to a likelihood that consumers will make their future loan payments. The score
is based on all the credit-related data in the credit report. The other major
components of the CIP include debt-to-income analysis, employment stability,
self employment criteria, residence stability and whether the applicants use the
premises as their primary residence. By using both scoring models
12
<PAGE> 15
together, all applicants are considered on the basis of their ability to repay
the loan obligation while allowing the Company to price the loan based on the
extent of the evaluated risk.
The Company's underwriters review the applicant's credit history, based on
the information contained in the application and reports available from credit
reporting bureaus and the Company's CIP score, to determine whether the
applicant meets the Company's underwriting guidelines. Based on the
underwriter's approval authority level, certain exceptions to the guidelines may
be made when there are compensating factors subject to approval from a more
senior designated authority. The underwriter's decision is communicated to the
broker, banker or consumer depending on the source of the loan and, if approved,
the proposed loan terms are fully explained. The Company attempts to respond
within 24 hours of receipt of a loan application.
Loan commitments are generally issued for periods of up to 30 days. Prior
to disbursement of funds, all loans are carefully reviewed by funding auditors
to ensure that all documentation is complete, all contingencies specified in the
approval have been met and the loan complies with Company and regulatory
procedures.
Home Equity Loans
The Company produces Home Equity loans through a mortgage banker and broker
loan source network as well as through the Company's retail division. Home
Equity loan mortgages produced under this program are limited to a first or
second lien position. Loan amounts are determined by taking a specific amount of
the collateral value of the property and adjusting the percentage based on the
creditworthiness of the borrower. For example, if the Company's guidelines set a
minimum loan-to-value ratio of 75% ($75,000 for a home with a collateral value
of $100,000), a more creditworthy borrower may be able to borrow in excess of
$75,000, and a less credit worthy borrower may only be able to borrow $65,000.
Full appraisals generated by approved licensed appraisers are required on all
loans within the Uniform Standards of Professional Appraisal Practice (the
"Uniform Standards of Appraisal"). Any loan amount of $250,000 or more would
require two independent appraisals. The credit grade will be determined by using
the CIP. In connection with Home Equity loans, the Company seeks commitments
from third party financial institutions to purchase the loans in accordance with
their respective guidelines, without recourse for credit losses or risk of
prepayment.
As part of the underwriting process, the Company requires an appraisal of
the residence that will be the collateral for the loan. The Company requires the
independent appraiser to be state licensed and certified. The Company requires
that all independent appraisals be completed within the Uniform Standards of
Appraisal as adopted by the Appraisal Standards Board of the Appraisal
Foundation. The Company audits the appraisal for accuracy to ensure that the
appraiser used sufficient care in analyzing data to avoid errors that would
significantly affect the appraiser's opinion and conclusion. This audit includes
a review of housing demand, physical adaptability of the real estate,
neighborhood trends and the highest and best use of the real estate. In the
event the audit reveals any discrepancies as to the method and technique that
the Company believes are necessary to produce a credible appraisal, the Company
will perform additional property data research or may request a second appraisal
to be performed by an independent appraiser selected by the Company in order to
further substantiate the value of the subject property.
13
<PAGE> 16
The Company may require a full title insurance policy substantially in
compliance with the requirements of the American Loan Title Association. The
applicant also is required to secure hazard insurance and may be required to
secure flood insurance if the mortgaged property has been identified by the
Federal Emergency Management Agency as having special flood hazards.
Equity + Loans
The Company has implemented policies for its Equity + loan program that are
designed to minimize losses by adhering to high credit quality standards. Based
on FICO score default predictors and the Company's internal CIP score, borrowers
are classified by the Company based on its belief of their credit risk and
quality, from "A" credits to "D" credits. Quality is a function of both the
borrowers' creditworthiness and the extent of the value of the collateral, which
is typically a second lien on the borrowers' primary residence. "A+" credits
generally have a FICO score greater than 700. An applicant with a FICO score of
less than 640 would be rated a "C" credit. Currently, the Company will not
approve an Equity + loan to a borrower with less than an "A" or "B" credit grade
using the CIP. All of the Equity + loans originated to date by the Company are
secured by first or second mortgage liens on single-family, owner occupied
properties.
Terms of Equity + loans produced by the Company, as well as the maximum
combined loan-to-value ratios and debt service to income coverage (calculated by
dividing fixed monthly debt payments by gross monthly income), vary depending
upon the Company's evaluation of the borrower's creditworthiness. In general,
Equity + loans have higher interest rates than Home Equity loans, but are
generally lower than rates changed on credit cards. Borrowers with lower
creditworthiness generally pay higher interest rates and loan origination fees.
QUALITY CONTROL
The Company employs various quality control personnel and procedures in
order to ensure that loan product standards are adhered to and regulatory
compliance is maintained.
In accordance with Company policy, the quality control department reviews a
statistical sample of loans produced each month. This review is generally
completed within 60 days and circulated to appropriate department heads and
senior management. Finalized reports generally are maintained in the Company's
files for a period of two years from completion. Typical review procedures
include reverification of employment and income, re-appraisal of the subject
property, obtaining separate credit reports and recalculation of debt-to-income
ratios. The statistical sample is intended to cover 10% of all new loan
products. Emphasis will also be placed on those loan sources where higher levels
of delinquency are experienced or payment defaults occur within the first six
months of funding. On occasion, the quality control department may review all
loans generated from a particular loan source in the event an initial review
determines a higher than normal number of exceptions. The account selection of
the quality control department is also designed to include a statistical sample
of loans by each processor, closer and underwriter, and provides management with
information as to any material difference from Company policies and procedures
in the loan production process.
On a daily basis, a sample of recently approved loans are reviewed to
insure compliance with underwriting guidelines and criteria. Particular
attention may be focused on those underwriters who have developed a higher than
normal level of exceptions.
14
<PAGE> 17
TECHNOLOGY SYSTEMS
The Company uses a computerized loan production tracking system that allows
us to monitor the performance of our wholesale and retail divisions. The system
automates various other functions such as Home Mortgage Disclosure Act and HUD
reporting requirements and routine tasks such as decline letters and the flood
certification process. The system also gives management access to a wide range
of decision support information including data on the approval pipeline and the
activities and performance of underwriters and loan funders. The Company uses
intercompany electronic mail for internal communications and for receiving loan
servicing, collection and delinquency information from City Mortgage Services on
each group of loans being serviced.
The Company's existing loan production system provides for the automation
of the loan production process as well as loan file indexing and routing. This
system includes automated credit report inquiries and consumer credit scoring,
along with on-screen underwriting and approval functions. The Company also uses
a system which allows for electronic routing of loan application facsimiles. The
Company recognizes that there have been significant advances made by a number of
mortgage production software vendors in the last year and intends to review a
number of the solutions provided by these vendors. It is the intention of the
Company to upgrade its automation infrastructure by the purchase of a new
system. This approach will shift the burden of development and maintenance of
the production system from the Company's in-house development staff to third
party vendors to allow the Company to focus its in-house development efforts to
its own unique business automation needs. Currently, the Company's existing loan
production system is not Year 2000 compliant. The cost for replacing the
Company's existing loan production system has been included in its plans and
estimated expenses for Year 2000 compliance. For additional details on Year 2000
compliance, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Year 2000."
LOAN SERVICING
The Company's strategy has historically been to retain the bulk of the
servicing rights associated with the loans it originates. As part of the
recapitalization, City Mortgage Services purchased the Company's existing loan
servicing rights and agreed to service all of the Company's loans held for sale
and loans sold on a servicing retained basis. The Company has an option,
contingent upon the delivery to City Mortgage Services of servicing on $1.0
billion of loans to purchase up to 20% equity position in a new entity to be
created should City National Bank determine to spin-off City Mortgage Services
into a separate entity. When the Company sold its loan servicing portfolio to
City Mortgage, the Company eliminated substantially all of its collections and
claim staff.
Among the Company's loan servicing activities performed by City Mortgage
Services are processing and administering loan payments, reporting and sending
principal and interest to the owners who own interests in the loans and to the
trustee of loans sold in securitization transactions, collecting delinquent loan
payments, processing Title I insurance claims, conducting foreclosure
proceedings and disposing of foreclosed properties and other loan administration
duties. In addition, under the loan servicing agreements, the Company is
entitled to receive a certain portion of the servicing fees collected by City
Mortgage Services. The Company will retain responsibility for certain functions
related to initial customer service and continued tax and insurance monitoring.
15
<PAGE> 18
The following table sets forth certain historical information regarding the
Company's loan servicing for the periods indicated:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
--------------------------------
1996 1997 1998
-------- --------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Servicing portfolio at beginning of period(2)... $ 92,286 $ 214,189 $ 628,068
Additions to servicing portfolio................ 139,367 526,917 338,942
Reductions in servicing portfolio(1)............ (17,464) (113,038) (935,788)
-------- --------- ---------
Servicing portfolio at end of period(2)......... $214,189 $ 628,068 $ 31,222
======== ========= =========
Servicing portfolio at end of period(2):
Company-owned loans:
Equity +...................................... $ 922 $ 8,661 $ 8,217
Title I....................................... 3,776 902 4,233
-------- --------- ---------
Total Company-owned loans............. 4,698 9,563 12,450
Loans sold in securitization transactions:
Equity +...................................... 10,501 363,961 --
Title I....................................... 198,990 254,544 18,772
-------- --------- ---------
Total loans sold in securitization
transactions....................... 209,491 618,505 18,772
-------- --------- ---------
Total servicing portfolio(2).......... $214,189 $ 628,068 $ 31,222
======== ========= =========
</TABLE>
- - ---------------
(1) Reductions resulted from scheduled payments, prepayments, loans sold with
servicing released, and writeoffs during the period.
(2) Not adjusted for the sale of the Company's mortgage servicing rights to City
Mortgage Services on August 1, 1998 as part of the recapitalization.
Excludes approximately $9.4 million of Equity + loans to be repurchased at
August 31, 1998.
16
<PAGE> 19
The following table sets forth the Title I Loan and Equity + loan
delinquency and Title I insurance claims experience of loans serviced by the
Company as of the dates indicated. The Company is not producing a significant
amount of Title I Loans.
<TABLE>
<CAPTION>
AUGUST 31,
--------------------------------
1996 1997 1998
-------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Equity + loan delinquency data(1):
31-60 days past due.......................... 0.44% 0.40% 7.14%
61-90 days past due.......................... 0.00 0.20 1.52
91 days and over past due.................... 0.00 0.34 24.83
Total past due................................. 0.44 0.94 33.49
Title I loan delinquency data(1):
31-60 days past due.......................... 2.27 3.19 7.88
61-90 days past due.......................... 0.90 1.68 2.39
91 days and over past due.................... 4.78(2) 7.06(2) 25.00
Total past due................................. 7.95 11.93 35.27
91 days and over past due,
net of claims filed(3).................... 2.05 5.20 8.54
Outstanding claims filed with HUD(4)........... 2.73 1.86 16.46
Amount of FHA insurance available for Title I
loans serviced............................... $ 21,205 $ 21,094 $ 14,134(5)
Amount of FHA insurance available as a
percentage of Title I loans serviced......... 10.46% 8.26% 61.44%(5)
Total delinquency data:
31-60 days past due.......................... 2.17 1.54 7.69
61-90 days past due.......................... 0.85 0.80 2.16
91 days and over past due.................... 4.53(7) 3.07(2) 24.95
Total past due................................. 7.55 5.41 34.88
91 days and over past due, net of claims
filed(6).................................. 1.94 2.32 7.56
Outstanding claims filed with HUD(7)........... 2.59 0.75 17.39
Outstanding number of Title I insurance claims
filed........................................ 255 269 207
Total servicing portfolio(9)................... $214,189 $628,068 $ 31,222
Title I loans serviced......................... 202,766 255,446 23,005
Equity + loans serviced(9)..................... $ 11,423 $372,622 $ 8,217
Home Equity loans serviced..................... -- -- --
Aggregate losses on liquidated loans(8)........ $ 32.0 $ 201.0 $1,368.0
</TABLE>
- - ---------------
(1) Represents the dollar amount of delinquent loans as a percentage of the
total dollar amount of each respective type of loan serviced by the Company
(including loans owned by the Company but excluding loans repurchased and
loans contained in securitization 1998-1) as of period end. Equity + loan
delinquencies represented 0.31% of the Company's total delinquencies for the
year ended August 31, 1996, 10.35% for the year ended August 31, 1997 and
17.39% for the year ended August 31, 1998 of the Company's total
delinquencies. The Company did not produce Equity + loans until May 1996.
The Company did not produce Home Equity loans until December 1997.
(2) During fiscal 1996 and the first two quarters of fiscal 1997, the processing
and payment of claims filed with HUD was delayed. Claims paid by HUD during
fiscal 1998 totaled $8.8 million.
17
<PAGE> 20
(3) Represents the dollar amount of delinquent Title I 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 Title I loans serviced
by the Company (including loans owned by the Company) as of the dates
indicated.
(4) Represents the dollar amount of delinquent Title I loans for which claims
have been filed with HUD and payment is pending as a percentage of the total
dollar amount of Title I loans serviced by the Company (including loans
owned by the Company) as of the dates indicated.
(5) If all claims filed with HUD had been processed and paid as of August 31,
1998, the amount of FHA insurance available for all serviced Title I loans
would have been reduced to $8.9 million, which as a percentage of Title I
loans serviced would have been 4.2%.
(6) Represents the dollar amount of delinquent loans net of delinquent Title I
loans for which claims have been filed with HUD and payment is pending as a
percentage of the total dollar amount of loans serviced by the Company
(including loans owned by the Company) as of the dates indicated.
(7) Represents the dollar amount of delinquent Title I loans for which claims
have been filed with HUD and payment is pending as a percentage of the total
dollar amount of total loans serviced by the Company (including loans owned
by the Company) as of the dates indicated.
(8) 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 1,227 Title
I insurance claims made by the Company, as servicer, since commencing
operations through August 31, 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.
(9) Excludes approximately $9.4 million of Equity + loans to be repurchased at
August 31, 1998.
SALE OF LOANS
The Company has historically sold on a servicing retained basis a
substantial majority of all loans it produced in securitization transactions.
The balance was sold for cash servicing released to institutional purchasers.
Currently, sales on a servicing-released basis, and some sales on a
servicing-retained basis, are sold at a premium to their principal balance. As
part of the sale of loans in securitization transactions, senior securities in
the related securitization are sold to institutional purchasers with a junior
subordinated interest in the transaction retained by or issued to the Company as
a mortgage related security. As part of its business strategy, the Company
intents to sell its loan production in the secondary market to institutional
purchasers for cash premiums and reduce its historically dependence on
securitization transactions as a method to sell loans. The Company will also
attempt to reduce the acquisition premiums paid to its network of mortgage
bankers of Equity + and Home Equity loans. During the year ended August 30,
1997, these cash acquisition premiums totaled $18.0 million or approximately
3.5% of the Company's total loan production and, for the year ended August 31,
1998, these premiums totaled $13.7 million or approximately 4.1% of the
Company's total loan production.
18
<PAGE> 21
Pursuant to the Flow Purchase Agreement entered into as part of the
recapitalization, the Company agreed to sell, and Sovereign Bancorp agreed to
buy, $100.0 million principal amount of Home Equity and Equity + loans, on a
quarterly basis, commencing in the calendar quarter beginning January 1, 1999.
Up to $200.0 million of the $400.0 million in principal amount of the loans the
Company is required to sell to Sovereign Bancorp on an annual basis can be
Equity + loans. The Flow Purchase Agreement, which is renewable every six
months, expires on December 31, 1998, but is renewable for additional six-month
periods until September 2001. Sovereign Bancorp has the exclusive right to
acquire the first $100 million of mortgage loans produced by the Company each
quarter during the term of the Flow Purchase Agreement. The Flow Purchase
Agreement does not require the Company to sell loans to Sovereign Bancorp at a
loss.
When the Company completed the recapitalization, the Company terminated its
existing master purchase agreement with a financial institution in which the
financial institution agreed to purchase up to $2.0 billion of loans over a
five-year period ending in September 2001. For additional details of the master
purchase agreement that was terminated, see "Certain Relationships and Related
Transactions."
The following table sets forth certain data regarding loans securitized or
sold by the Company during the periods indicated with servicing retained, and
excluding loans sold with servicing released:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
------------------------------
1996 1997 1998
-------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Principal amount of loans sold.................... $137,908 $462,318 $181,931
Gain (loss) on sales of loans(1).................. 16,539 45,123 (26,578)
Net unrealized gain (loss) on mortgage related
securities...................................... 2,697 3,518 (70,024)
Weighted-average stated interest rate on loans
sold(2)......................................... 14.09% 13.91% 11.77%
Weighted-averaged pass-through interest rate on
loans sold(2)................................... 7.50 7.36 6.77
Weighted-average excess spread retain on loans
sold(2)
6.59 6.55 5.00
</TABLE>
- - -------------------------
(1) Excludes gain on sale of $2.0 million relating to whole loan sales with
servicing released of $59.2 million during the year ended August 31, 1997.
Excludes gain on sale of $2.3 million relating to whole loan sales with
servicing released of $160.1 million during the year ended August 31, 1998.
(2) Includes all loans sold with servicing released or servicing retained.
COMPETITION
The Company faces intense competition in the business of originating and
selling Home Equity loans and, to a lesser extent, Equity + loans. The Company's
competitors include other consumer finance companies, mortgage banking
companies, commercial banks, credit unions, thrift institutions, credit card
issuers and insurance companies. Many of these entities are substantially
larger, have lower costs of capital and have considerably greater financial,
technical and marketing resources than the Company. In addition, many of the
financial services organizations that are much larger than the Company have
formed national loan production networks offering loan products that are
substantially similar to
19
<PAGE> 22
the Company's loan programs. The Company believes that Conti Mortgage Corp., The
Money Store, First Plus Financial Group, Associates First Capital Corporation,
and Household Finance Corporation are some of its largest direct competitors.
The Company competes principally by providing prompt, professional service to
its mortgage bankers, brokers and retail customers and, depending on
circumstances, by providing competitive lending rates.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, customer service, marketing and distribution
channels, amount and term of the loan, loan origination fees and interest rates.
Additional competition may lower the rates the Company can charge borrowers,
potentially lowering the gain on future loan sales. The Company may face
competition from, among others, government-chartered entities, such as FNMA,
FHLMA, and GNMA. The Company's competitors may expand their existing or new loan
purchase programs to include Home Equity loans. Entries of government-sponsored
entities into the Home Equity loan market could lower the interest rates the
Company is able to charge its borrowers and reduce or eliminate premiums on loan
sales. To the extent any of these competitors significantly expand their
activities in the Company's market, the Company could be materially adversely
affected. Fluctuations in interest rates and general economic conditions may
also affect the Company's competition. During periods of rising rates,
competitors that have locked in low borrowing costs may have a competitive
advantage. During periods of declining rates, competitors may solicit the
Company's customers to refinance their loans.
If the Company is unable to remain competitive in these areas, the volume
of the Company's loan production may be materially adversely affected as
borrowers seek out other lenders for their financing needs. Lower loan
production may have an adverse effect on the Company's ability to negotiate and
obtain sufficient financing under warehouse lines of credit upon acceptable
terms. Establishing a broker-sourced loan business typically requires a
substantially smaller commitment of capital and personnel resources than a
direct-sourced loan business. This relatively low barrier to entry permits new
competitors to enter the broker-sourced loan market quickly, particularly
existing direct-sourced lenders which can draw upon existing branch networks and
personnel in seeking to sell products through independent brokers. Competition
may be affected by fluctuations in interest rates and general economic
conditions. During periods of rising rates, competitors which have locked in low
borrowing costs may have a competitive advantage.
The Company has historically been dependent on certain of its competitors
to purchase loans not purchased by Sovereign Bancorp. If such competitors
refrained from purchasing the Company's loans and the Company were unable to
replace such purchasers, the Company's financial condition and results of
operations could be materially adversely affected. The Flow Purchase Agreement
between the Company and Sovereign Bancorp is expected to alleviate this
situation. See "-- Sale of Loans." The Company continues to seek other
purchasers who are not competitors of the Company.
GOVERNMENT REGULATION
The Company's lending activities are subject to the Truth in Lending Act
and Regulation Z (including the Home Ownership and Equity Protection Act of
1994), the Equal Credit Opportunity Act and Regulation B, the Fair Credit
Reporting Act, as amended, the Real Estate Settlement Procedures Act and
Regulation X, the Home Mortgage Disclosure Act of 1975, the Fair Debt Collection
Practices Act and the Fair
20
<PAGE> 23
Housing Act, as well as other federal and state statutes and regulations
affecting the Company's activities. Failure to comply with these requirements
can lead to loss of approved status, termination or suspension of servicing
contracts without compensation to the servicer, demands for indemnifications or
mortgage loan repurchases, certain rights of rescission for mortgage loans,
class action lawsuits and administrative enforcement actions.
The Company is subject to the rules and regulations of, and examinations
by, HUD, FHA and other federal and state regulatory authorities with respect to
originating, underwriting, funding, acquiring, selling and, to the extent that
it engages in servicing activities, servicing consumer and mortgage loans. In
addition, there are other federal and state statutes and regulations affecting
the Company's activities. These rules and regulations, among other things,
impose licensing obligations on the Company, establish eligibility criteria for
loans, prohibit discrimination, provide for inspection and appraisals of
properties, require credit reports on prospective borrowers, regulate payment
features and, in some cases, fix maximum interest rates, fees and loan amounts.
The Company is required to submit annual audited financial statements to various
governmental regulatory agencies that require the maintenance of specified net
worth levels. The Company's affairs are also subject to examination, at all
times, by the Federal Housing Commissioner to assure compliance with FHA
regulations, policies and procedures.
Although the Company is no longer originating a significant volume of Title
I Loans, the Company is a HUD approved Title I mortgage lender and is subject to
the supervision of HUD. In addition, the Company's operations are subject to
supervision by state authorities (typically state banking or consumer credit
authorities), many of which generally require that the Company be licensed to
conduct its business. This normally requires state examinations and reporting
requirements on an annual basis.
The Federal Consumer Credit Protection Act ("FCCPA") requires a written
statement showing an annual percentage rate of finance charges and requires that
other information be presented to debtors when consumer credit contracts are
executed. The Fair Credit Reporting Act requires certain disclosures to
applicants concerning information that is used as a basis for denial of credit.
The Equal Credit Opportunity Act prohibits discrimination against applicants
with respect to any aspect of a credit transaction on the basis of sex, marital
status, race, color, religion, national origin, age, derivation of income from
public assistance program, or the good faith exercise of a right under the
FCCPA.
The interest rates which the Company may charge on its loans are subject to
state usury laws, which specify the maximum rate which may be charged to
consumers. In addition, both federal and state truth-in-lending regulations
require that the Company disclose to its customers prior to execution of the
loans, all material terms and conditions of the financing, including the payment
schedule and total obligation under the loans. The Company believes that it is
in compliance in all material respects with such regulations.
SEASONALITY
The Company's production of Home Equity and Equity + 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
21
<PAGE> 24
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.
EMPLOYEES
As of December 1, 1998, the Company had 63 employees. None of the Company's
employees is represented by a collective bargaining agreement. The Company
believes that its relations with its employees are satisfactory.
ITEM 2. PROPERTIES
The Company leases 45,950 square feet of office space at 1000 Parkwood
Circle, Atlanta, Georgia, consisting of two full floors. The Company's corporate
headquarters have been consolidated into 22,975 square feet, consisting of one
floor at this location. The Company has subleased the other floor at this
location. The Company's lease is for an initial six-year term expiring August
2002 with a conditional option to extend the term to August 2007. The Company is
searching for alternative space for its corporate headquarters. If it finds
space, the Company expects to sublease the presently occupied space and relocate
its corporate headquarters. The Company also leases 10,478 square feet of office
space at its prior headquarters location in Atlanta, Georgia pursuant to a lease
that expires in March 1999. In addition, as of December 11, 1998 the Company
also leased office space on short-term or month-to-month leases in Phoenix,
Arizona; Dublin, California; Denver, Colorado; Ft. Lauderdale, Florida; Miami
Lakes, Florida; Elmhurst, Illinois; Woburn, Massachusetts; Waterford, Michigan;
Blue Springs, Missouri; Waldwick, New Jersey; Las Vegas, Nevada; Patchogue, New
York; Columbus, Ohio; Oklahoma City, Oklahoma; Bridgeville, Pennsylvania;
Brentwood, Tennessee; Austin, Texas; and Seattle, Washington. The Company
believes that all of its facilities are suitable and adequate for the current
conduct of its operations.
ITEM 3. LEGAL PROCEEDINGS
On February 23, 1998, an action was filed in the United States District
Court for the Northern District of Georgia by Robert J. Feeney, as a purported
class action against the Company and Jeffrey S. Moore, the Company's former
President and Chief Executive Officer. The complaint alleges, among other
things, that the defendants violated the federal securities laws in connection
with the preparation and issuance of certain of the Company's financial
statements. The named plaintiff seeks to represent a class consisting of
purchasers of the Common Stock between April 11, 1997 and December 18, 1997, and
seeks damages in an unspecified amount, costs, attorney's fees and such other
relief as the court may deem proper. On June 30, 1998, the plaintiff amended the
complaint to add additional plaintiffs to add as a defendant Mego Financial, the
Company's former parent, and to extend the class period through and including
May 20, 1998. On September 18, 1998, the Company filed a motion to dismiss the
complaint. The Company believes it has meritorious defenses to this lawsuit and
that resolution of this matter will not result in a material adverse effect on
the business or financial condition of the Company.
On October 2, 1998, an action was filed in the United States District Court
for the Western Division of Tennessee by Traci Parris, as a purported class
action against
22
<PAGE> 25
Mortgage Lenders Association, Inc., the Company and City Mortgage Services,
Inc., one of the Company's strategic partners. The complaint alleges, among
other things, that the defendants charged interest rates, origination fees and
loan brokerage commissions in excess of those allowed by law. The named
plaintiff seeks to represent a class of borrowers and seeks damages in an
unspecified amount, reform or nullification of loan agreements, injunction,
costs, attorney's fees and such other relief as the court may deem just and
proper. On October 27, 1998, the Company filed a motion to dismiss the
complaint. The Company believes it has meritorious defenses to this lawsuit and
that resolution of this matter will not result in a material adverse effect on
the business or financial condition of the Company.
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 and an administrative hearing will be held after
March 1999. The denial will not become final until the Company's appeal has been
resolved. The Company believes that it is capable of meeting such requirements
as the Commissioner may set to amend the Company's license application. If the
denial becomes final, the Company will not be able to make secondary mortgage
loans in the State of Texas at interest rates of greater than 10%. The Company
is not required to hold a secondary mortgage lender license in order to continue
to produce or acquire unregulated first mortgage loans in the state of Texas.
The Company believes that resolution of this matter will not result in a
material adverse effect on the business or financial condition of the Company.
In the ordinary course of its business, the Company is, from time to time,
named in lawsuits. The Company believes that it has meritorious defenses to
these lawsuits and that resolution of these matters will not have a material
adverse effect on the business or financial condition of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
23
<PAGE> 26
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company completed its initial public offering on November 19, 1996 and,
since that date, the common stock has traded on the Nasdaq Stock Market under
the symbol "MMGC." The following table sets forth the high and low sales prices
of the common stock as reported on the Nasdaq Stock Market for the periods
indicated.
<TABLE>
<CAPTION>
HIGH LOW
-------- --------
<S> <C> <C>
FISCAL YEAR 1997:
First Quarter (November 19, 1996 to November 30, 1996)... $12.00 $10.75
Second Quarter........................................... 15.75 10.125
Third Quarter............................................ 14.625 8.00
Fourth Quarter........................................... 13.50 9.00
FISCAL YEAR 1998:
First Quarter............................................ 15.00 9.5625
Second Quarter........................................... 10.25 3.00
Third Quarter............................................ 3.375 1.875
Fourth Quarter........................................... 2.0625 1.00
</TABLE>
As of December 14, 1998, there were 1,847 holders of record of the
Company's common stock.
The Company has never paid cash dividends on its common stock, and the
board of directors currently intends to retain any earnings for use in the
Company's business for the foreseeable future. Any future payment of dividends
will depend on the Company's financial condition, results of operations, cash
requirements and other factors that the board of directors believes are
important.
On July 1, 1998, the Company completed a private placement of 25,000 shares
of Series A convertible preferred stock and 18,266,667 shares of common stock to
a number of qualified institutional investors, as defined under Rule 144A under
the Securities Act, and to other accredited investors, as defined in Rule 501
under Regulation D ("Rule 501"). These sales were conducted pursuant to Rule 506
under Regulation D ("Rule 506"). The aggregate purchase price of the preferred
stock was $25.0 million, and the aggregate purchase price of the common stock
was $25.0 million.
FBR acted as the placement agent for the preferred stock and the common
stock. Under a placement agreement between FBR and the Company, the Company
issued FBR 1.6 million shares of common stock. This issuance was conducted
pursuant to Rule 506.
In addition, on July 1, 1998, the Company issued 37,500 shares of preferred
stock and $41.5 million principal amount of a new series of Current Notes in
exchange for approximately $79.0 million of Old Notes. This exchange offer was
conducted pursuant to Rule 506.
24
<PAGE> 27
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below has been derived from our
audited financial statements. The financial data as of August 31, 1997 and 1998
and for each of the three years in the period ended August 31, 1998 have been
derived from financial statements audited by the Company's independent auditors,
whose report for the year ended August 31, 1997 included an explanatory
paragraph related to their substantial doubt about our ability to continue as a
going concern. The Company's financial statements are included elsewhere in this
Annual Report. The financial data as of August 31, 1994, 1995 and 1996 and for
the years ended August 31, 1994 and 1995 have been derived from audited
financial statements not included herein. We have reclassified certain items to
conform to prior years. You should read the selected financial information set
forth below in conjunction with the financial statements, the related notes, and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." However, due to recent substantial changes to our business and
operating strategy, we believe that our historical financial and operating data
are not likely to be indicative of our future performance and our results of
operation for fiscal 1998 are not comparable to fiscal 1997.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
------------------------------------------------------
1994 1995 1996 1997 1998
------ ------- ------- ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
Gain (loss) on sale of
loans.................... $ 579 $12,233 $16,539 $ 45,123 $ (26,578)
Net unrealized gain (loss)
on mortgage related
securities(1)............ -- -- 2,697 3,518 (70,024)
Loan servicing income,
net...................... -- 873 3,348 3,036 999
Interest income, net of
interest expense of $107,
$468, $1,116, $6,374 and
$13,162.................. 172 473 988 3,133 1,624
------ ------- ------- ----------- -----------
Total revenues
(losses)......... 751 13,579 23,572 54,810 (93,979)
------ ------- ------- ----------- -----------
Expenses:
Provision for credit losses,
net...................... 96 864 55 6,300 (3,198)
Depreciation and
amortization............. 136 403 394 672 1,013
Other interest.............. 22 187 167 245 439
General and administrative:
Payroll and benefits..... 975 3,611 6,328 13,052 18,582
Commissions and
selling(2)............. 13 552 -- -- --
Credit reports........... 13 133 367 1,387 510
Rent and lease
expenses............... 85 249 338 1,199 1,616
Professional services.... 548 1,043 1,771 2,271 4,783
Sub-servicing fees....... 13 232 709 1,874 2,160
Other services........... 128 340 665 1,352 2,068
Travel................... 261 107 677 1,005 1,159
FHA insurance premiums... 11 231 572 558 430
Other.................... (39) (292) 374 1,085 2,448
------ ------- ------- ----------- -----------
Total costs and
expenses......... 2,262 7,660 12,417 31,000 32,010
------ ------- ------- ----------- -----------
</TABLE>
25
<PAGE> 28
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
------------------------------------------------------
1994 1995 1996 1997 1998
------ ------- ------- ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
Income (loss) before income
taxes(3).................... (1,511) 5,919 11,155 23,810 (125,989)
Income tax expense
(benefit)(3)................ -- 2,277 4,235 9,062 (6,334)
------ ------- ------- ----------- -----------
Net income (loss)(3).......... (1,511) $ 3,642 $ 6,920 $ 14,748 $ (119,655)
====== ======= ======= =========== ===========
Net income (loss) per
share(4):
Basic....................... $ 1.25 $ (7.72)
=========== ===========
Diluted..................... $ 1.25 $ (7.72)
=========== ===========
Weighted-average number of
common shares(4)............ 11,802,192 15,502,926
=========== ===========
Weighted-average number of
common shares and assumed
conversions(4).............. 11,802,192 15,502,926
=========== ===========
</TABLE>
<TABLE>
<CAPTION>
AS OF AUGUST 31,
-------------------------------------------------
1994 1995 1996 1997 1998
------ ------- ------- -------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
STATEMENT OF FINANCIAL CONDITION
DATA:
Cash and cash equivalents......... $ 824 $ 752 $ 443 $ 6,104 $ 36,404(5)
Loans held for sale, net.......... 1,463 3,676 4,610 9,523 10,975(6)
Mortgage related securities(1).... -- -- 22,944 106,299 34,830
Excess servicing rights(1)........ 904 14,483 12,121 -- --
Mortgage servicing rights......... -- 1,076 3,827 9,507 83
Total assets...................... 5,122 24,081 50,606 156,554 104,535
Allowance for credit losses on
loans sold with recourse........ 66 886 920 7,014 2,472
Subordinated debt(7).............. -- -- -- 40,000 42,693
Total liabilities................. 983 13,300 32,905 103,447 77,941
Stockholders' equity.............. 4,139 10,781 17,701 53,107 26,594
</TABLE>
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
-------------------------------------------------
1994 1995 1996 1997 1998
------ ------- -------- -------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
OPERATING DATA:
Loan production................... $8,164 $87,751 $139,367 $526,917 $338,942
Weighted-average interest rate on
loan production................. 14.18% 14.55% 14.03% 13.92% 13.89%
Loans in servicing portfolio (end
of period):
Company-owned:
Equity +..................... $ -- $ -- $ 922 $ 8,661 $ 8,217
Title I...................... 1,471 3,720 3,776 902 4,233
------ ------- -------- -------- --------
Total
Company-owned(8)..... 1,471 3,720 4,698 9,563 12,450(6)
</TABLE>
26
<PAGE> 29
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
-------------------------------------------------
1994 1995 1996 1997 1998
------ ------- -------- -------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
Securitized:
Equity +..................... -- -- 10,501 363,961 --
Title I...................... 6,555 88,566 198,990 254,544 18,772
------ ------- -------- -------- --------
Total securitized....... 6,555 88,566 209,491 618,505 18,772
------ ------- -------- -------- --------
Total servicing
portfolio............ $8,026 $92,286 $214,189 $628,068 $ 31,222
====== ======= ======== ======== ========
Cash used in operations........... $4,402 $ 3,619 $ 12,440 $ 72,438 $ 39,723
====== ======= ======== ======== ========
</TABLE>
- - ---------------
(1) Mortgage related securities are junior subordinated interests retained by
the Company in pools of mortgage loans sold by the Company in securitization
transactions. SFAS No. 125, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities," required the Company,
as of January 1, 1997, to reclassify excess servicing rights (junior
subordinate interests retained by the Company in pools of mortgage loans
sold in transactions similar to a securitization) to mortgage related
securities. The fair value (the dollar amount on the Company's balance
sheet) of the Company's mortgage related securities was written down from
$106.3 million at the end of fiscal 1997 to $34.8 million at the end of
fiscal 1998. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and Notes 2, 4 and 17 to the Company's
financial statements.
(2) For fiscal 1996, 1997 and 1998, commissions and selling expenses of $2.0
million, $2.8 million and $2.0 million, respectively, have been reclassified
into its functional classifications within general and administrative
expenses.
(3) The results of the Company's operations were included in the consolidated
federal income tax returns filed by Mego Financial through September 2,
1997, the date the shares of common stock of the Company were distributed by
Mego Financial to its shareholders in a tax free spin-off. For more details
on this and other transactions with Mego Financial and its affiliates, see
"Certain Relationships and Related Transactions."
(4) Earnings per share for the fiscal years ended August 31, 1994, 1995 and 1996
are not presented because, during these years, the Company was a wholly
owned subsidiary of Mego Financial.
(5) As part of the recapitalization, the Company sold an aggregate of $50.0
million of common stock and Series A convertible preferred stock. For more
details, see "Business -- The Recapitalization."
(6) Loans held for sale, net includes a valuation reserve which reflects the
Company's best estimate of the amount that we expect to receive on the sale
of these loans.
(7) The Company sold $40.0 million principal amount of Old Notes in November
1996 and an additional $40.0 million principal amount of Old Notes in
October 1997. As part of the recapitalization, the Company issued $37.5
million of Series A convertible preferred stock and $41.5 million principal
amount of Current Notes in exchange for $79.0 million of Old Notes. The
Company purchased all of the Old Notes remaining outstanding as of October
31, 1998.
(8) Excludes approximately $9.4 million of Equity + loans to be repurchased. The
majority of the loans have been repurchased prior to November 30, 1998. The
amount on the Company's balance sheet as of August 31, 1998 is the amount
the Company expected to receive on the sale of these loans. For additional
details, see Note 3 to the Company's financial statements.
27
<PAGE> 30
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The purpose of Management's Discussion and Analysis of Financial Conditions
and Results of Operations is to provide a detailed explanation of the Company's
financial performance in fiscal 1996, 1997 and 1998, the factors that had a
significant impact on the Company's performance in those periods and a
description of any trends affecting financial performance during the periods
discussed. We also describe the amount of the Company's cash on hand at the end
of fiscal 1998, the amount that the Company owed to its lenders on that date,
and the additional amounts, if any, available to be borrowed by the Company. In
addition, we describe the major changes to the balance sheet. This information
is the primary basis for our belief that we have enough cash and borrowing
ability to carry out our business plan for fiscal 1999. You should read this
section in conjunction with the Company's financial statements, including the
notes to the financial statements.
During the last eight months of fiscal 1998, the Company's operations
consisted principally of:
(1) liquidating its portfolio of loans to repay outstanding debt;
(2) maintaining its systems and retaining personnel necessary to resume
operations while exploring alternatives to locate new capital; and
(3) designing and beginning to implement its strategic initiatives.
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 operation for fiscal 1998 are not comparable to fiscal
1997.
GENERAL
The Company substantially expanded its operations during fiscal 1996 and
1997 and the first four months of fiscal 1998. During these periods the
Company's loan production was $139.4 million (fiscal 1996), $526.9 million
(fiscal 1997) and $268.5 million (first four months of fiscal 1998). As it
expanded its business, the Company's general and administrative expenses
increased from $11.8 million in fiscal 1996 to $23.8 million in fiscal 1997 and
$13.8 million in the first four months of fiscal 1998.
During these periods, a substantial majority of the Company's loan
production was sold in securitization transactions. The sale of loans by the
Company in securitization transactions, as described below, typically results in
substantial negative cash flow, because the cash proceeds from the sale of loans
in a securitization transaction is substantially less the Company's total cost
of producing the loans sold. The combination of negative cash flow from the sale
of loans in securitization transactions and increases in general and
administrative expenses caused the Company, historically, to operate on a
substantial negative cash flow basis. The Company's negative cash flow from
operations was $12.4 million for fiscal 1996, $72.4 million for fiscal 1997 and
$49.7 million for the first four months of fiscal 1998.
As a result of a $11.7 million loss in the first quarter of fiscal 1998 and
continuing cash flow deficits, the Company violated certain provisions of its
warehouse line. In
28
<PAGE> 31
February 1998, the warehouse lender requested that the Company repay a
significant portion of the principal balance of the line or be declared in
default. Since a default on the warehouse line would have triggered, among other
things, a default on the Company's $80 million principal amount of outstanding
Old Notes, the Company agreed to reduce the outstanding balance of the warehouse
line from $55.0 million periodically. The Company repaid the balance on June 29,
1998.
To generate cash to reduce the outstanding balance of the warehouse line
and continue to operate, the Company began to liquidate, through sales for cash,
its mortgage loan portfolio and the warehouse lender refused to make further
advances under the line. In addition, because the Company's old warehouse line
was used to fund loans produced by the Company prior to their sale, the Company
substantially curtailed its loan production beginning in January 1998. The cash
received from the Company's sale of loans from its loan portfolio was used to
pay down the old warehouse line and other Company borrowings and to pay
substantial general and administrative expenses to retain personnel and maintain
the Company's operations while it sought to locate new capital.
On July 1, 1998, the Company completed the recapitalization. As part of the
recapitalization, the Company received $50.0 million in proceeds from the
private placement of approximately 16.67 million shares of common stock at a
price of $1.50 per share and 25,000 shares of Series A convertible preferred
stock at a price of $1,000 per share. In addition, the Company issued $37.5
million of Series A convertible preferred stock and $41.5 million principal
amount of Current Notes in exchange for approximately $79.0 million principal
amount of Old Notes. The recapitalization resulted in approximately $84.5
million of new equity.
SECURITIZATION TRANSACTIONS
Securitization transactions historically had been the main source of the
Company's revenue and income. In a securitization transaction, a specific group
of the Company's mortgage loans having similar characteristics, loan type
(Equity + or Title I) and loan amounts are pooled for sale. By selling loans in
a securitization transaction, the Company could sell a very large group of loans
at one time. The Company sold an average of $79.7 million of mortgage loans in
each of the five securitizations completed in fiscal 1997. However, the sale of
loans in a securitization transaction generates a significant cash flow deficit,
because the cash received by the Company from the sale of the loans is
significantly less than the Company's total cost of producing the loans sold.
The purchaser of the loans in a securitization transaction is a special
trust created:
(1) to purchase and hold title to the loans;
(2) to sell debt securities or ownership interests backed by the cash flow
to be received on the loans owned by the trust, i.e., the principal and interest
payments from the Company's borrowers; and
(3) to distribute payments over time to the holders of securities issued by
the trust.
Once the trust purchases the loans from the Company, it generally has no
recourse against the Company other than for breaches of certain representations
and warranties made by the Company at the time the loans were sold. Likewise,
after the trust purchases the loans from the Company, creditors of the Company
have no recourse against the loans
29
<PAGE> 32
in the event the Company experiences financial difficulties. The trust purchases
the loans from the Company with money it obtains by selling the securities.
The trust sells both senior "rated" securities and issues an unrated
subordinate residual security to the Company. Only qualified institutional
investors, such as insurance companies, banks and thrifts, can purchase the
senior securities sold by the trust.
Because the Company's Equity + loans are not insured and its Title I loans
have only limited FHA insurance, the trust, as the owner of these mortgage
loans, has credit risk. If the borrowers default on their loans, the trust (as
the owner of the loans) typically will lose its entire investment (except to the
extent of the limited FHA insurance on Title I loans). As a result of these
potential losses, the purchasers of the trust's senior securities are willing to
buy the securities only if they receive additional assurance that they will get
paid. This assurance is provided by a rating from the national rating agencies,
such as Standard & Poor's and Moody's.
As a general matter, the more predictable the cash flow to the senior
securities, the higher the rating on the senior securities and the lower the
yield that will be demanded by purchasers of the senior securities relative to
prevailing market yields. The lower the yield paid to the senior security
holders, the greater the positive spread (the "spread") between the interest
paid by the Company's borrowers on the mortgage loans in the trust and (i) the
interest costs of the senior securities sold and (ii) fees paid to the trustee
and the servicer for servicing the mortgage loans. In general, the greater the
spread, the greater the amount of cash flow in excess of the principal and
interest payments to the senior security holders the Company anticipates it will
receive on the mortgage related securities issued to the Company in the
securitization, and the greater their fair value. During fiscal 1997, the
Company sold $398.4 million principal amount of loans in securitization
transactions that had a weighted-average interest rate of 14.0% and in which the
senior securities sold had an initial weighted-average yield of 6.88%.
In order for the senior securities to gain a sufficiently high rating to
attract investors, the rating agencies require that the trust create various
forms of credit enhancement to increase the likelihood that the loans in the
trust will generate sufficient cash flow to pay the interest and principal
payments on the senior securities. Credit enhancement may be achieved in several
ways. The trust may purchase the loans the Company sells in the securitization
transaction for a combination of cash and by issuing the Company a subordinated
residual interest in the securitization. The security issued by the trust to the
Company receives cash flow only after required payments of interest and
principal have been made to the senior security holders, and absorbs any losses
from defaults or foreclosures on the loans in the trust. The junior subordinated
interests issued to the Company in securitization transactions are called
mortgage related securities. Another credit enhancement is a "guaranty," a form
of insurance issued by an insurance company. While some of the Company's
securitizations have included guaranty insurance, the Company has always
received a subordinate mortgage related security and has provided
over-collateralization as credit enhancement in order to achieve acceptable
ratings.
Credit enhancement may also be achieved through "over-collateralization."
National rating agencies will give higher ratings if the senior securities
receive assurance that they will be paid. This is achieved by requiring an
initial level of over-collateralization and by building more
over-collateralization through the trust's retaining cash flow (from the spread)
that would otherwise be paid to the Company on its mortgage related securities.
The initial over-collateralization is created by having the principal amount of
loans sold to
30
<PAGE> 33
the trust be greater than the principal amount (and cash proceeds from the sale)
of senior interests sold. In the five securitization transactions during fiscal
1997, the trusts purchased $398.4 million principal amount of loans from the
Company, but the trusts sold only $379.2 principal amount of senior securities.
As borrowers make their monthly mortgage loan payments to the servicer of
the loans in the trust, the payments are remitted by the servicer to a trustee
that collects these payments and make payments of interest and principal to the
holders of the senior securities pursuant to a pre-established schedule. The
priority of the payments is determined by the terms of an indenture.
The mortgage related securities owned by the Company, while offering the
potential of a substantially higher yield than the senior securities, have very
high credit risk. The Company's mortgage related securities absorb all losses
caused by defaults on the mortgage loans backing the securitization. The
Company's mortgage related securities are highly speculative and are subject to
the special risks.
Sample Securitization Transaction
In order to make the concept of negative cash flow that results from the
sale of mortgage loans in a securitization transaction more understandable, the
Company has provided the following example.
THE EXAMPLE BELOW ILLUSTRATES THE MECHANICS OF A SECURITIZATION AND THE
RESULTING NEGATIVE CASH FLOW BUT DOES NOT REFLECT (1) AN ACTUAL SALE OF MORTGAGE
LOANS BY THE COMPANY IN A SECURITIZATION TRANSACTION OR (2) THE ACTUAL AMOUNT OF
NEGATIVE CASH FLOW FROM THE DISPOSITION OF LOANS IN THIS MANNER. ACTUAL RESULTS
WILL BE MATERIALLY DIFFERENT FROM THE EXAMPLE.
This example is based on five general assumptions:
(1) mortgage bankers originated $100.0 million of mortgage loans having a
weighted average interest rate of 13.98%;
(2) the Company purchased from mortgage bankers for a premium of $4.0
million (the mortgage bankers received an aggregate of $104.0 million for the
loans);
(3) the Company sells the loans to the securitization trust for $97.0
million in cash, the trust sells $97.0 million of senior securities having a
weighted average interest rate of 6.88% and issues a subordinate mortgage
related security to the Company;
(4) the securitization process costs $1.0 million in fees and costs paid to
investment bankers, attorneys, accountants and others; and
(5) Standard & Poor's and Moody's require (A) an initial level of "over-
collateralization" of 3% ($3.0 million) of the original amount of loans sold in
the securitization and (B) that the level of over-collateralization must reach
6% of the original principal amount of loans ($6.0 million) before the cash flow
will be paid by the trustee to the holder of the subordinate mortgage related
security.
In this example, the sale of this pool of $100.0 million of mortgage loans
would result in negative cash flow of $8.0 million. The negative cash flow
results from the following factors:
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<PAGE> 34
- $104.0 million, representing the total cost of producing the loans sold
in the securitization minus
- $97.0 million is received by the trust from the sale of the senior
securities, all of which is paid to the Company, minus
- $1.0 million of fees and expenses.
The $3.0 million difference between the $100.0 million of mortgage loans
purchased by the trust and the $97.0 million of senior securities sold by the
trust creates the 3.0% initial over-collateralization. The senior securities
have the "protection" or credit enhancement of the cash flow, principal and
interest received on the $3.0 million of loans plus the spread initially equal
to $7.4 million per year. The spread represents 7.1% (the difference between
13.98%, the interest paid by borrower on the loans in the trust, and 6.88%, the
interest paid by the trust on the senior securities) on the $97.0 million of
loans plus 13.98% on the $3.0 million of loans in the over-collateralization
account. The trustee would retain the spread until the over-collateralization
reaches $6.0 million.
After the required level of over-collateralization is achieved, the trustee
pays all of the cash flow, after the payment of interest and principal to the
holders of the senior securities, to the Company's mortgage related securities.
Loan delinquencies and defaults reduce this over-collateralization. If the
amount in the account falls below 6.0% of the amount of loans sold to the trust,
the trustee stops the payment of cash to the Company's mortgage related
securities and retains it until the 6.0% level is again achieved.
Accounting for a Securitization Transaction
Under generally accepted accounting principles, the sale of mortgage loans
by the Company in securitization transactions requires the Company to recognize
revenue on the completion of the securitization transaction based on the
discounted present value of the estimated future cash flow stream ("gain on sale
accounting") to be received by the Company on its mortgage related securities.
As described in more detail later in this "Management's Discussion and Analysis
of Financial Condition and Results of Operation," the Company determines the
fair value of each of its mortgage related securities using prepayment,
delinquency, default and credit loss assumptions on the mortgage loans backing
each of its mortgage related securities that the Company believes to be
appropriate for the particular mortgage loans. The anticipated cash to be
received by the Company's mortgage related securities from the mortgage loans is
discounted to present value to establish the fair value of the mortgage related
securities shown on the Company's balance sheet.
Accounting for specialty finance companies that sell assets in
securitization transactions is particularly complex. The most complex item is
the source of the Company revenues. The Company gets its revenues from the
following items:
- Gain (loss) on the sale of loans;
- Unrealized gain (loss) on mortgage related securities retained in
securitization transactions;
- Interest income, net; and
- Loan servicing income, net.
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<PAGE> 35
Gain (Loss) on the Sale of Loans. Historically, the most significant
portion of the Company's revenues comes from Gain (loss) on the sale of loans.
One component is the Gain (loss) resulting from the sale of loans in
securitization transactions. Refer to the example the Company used earlier,
where the sale of $100.0 million of our loans in the securitization transaction
resulted in negative cash flow of $8.0 million. Assume the mortgage related
security issued by the trust to the seller of the loans from that securitization
had a fair value of $18.0 million (see discussion on "gain on sale" accounting
above). The seller then would have received a total of $115.0 million from the
securitization, consisting of $97.0 million in cash and a mortgage related
security having a fair value of $18.0 million. The total cost of the loans sold
in the securitization were $105.0 million, consisting of the total cost of
producing the loans of $104.0 million and $1.0 million in fees and expenses for
the securitization. In this example, the revenues recorded from this
securitization would be $10.0 million. This amount is divided between two
revenue items, Gain (loss) on sale of loans and Net unrealized gain (loss) on
mortgage related securities. The division of the revenues between these two
items is determined by allocating the total revenues of $10.0 million,
proportionately between the cash proceeds from the sale of the loans, in this
case $97.0 million (allocated to revenues from "Gain (Loss) on the Sale of
Loans"), and the fair value of the mortgage related security issued by the trust
to the seller of the loans in the securitization, in this case $18.0 million
(allocated to revenues from "Unrealized gain (loss) on mortgage related
securities").
Another component represents the gain (loss) on the sale of loans for cash.
It is equal to the Company's total cost (expense) of producing loans including
any premiums paid when the Company purchases loans from its network of mortgage
bankers, minus the amount received by the Company at the time the loans are sold
for cash to an institutional purchaser. For example, if the Company purchased a
$100,000 principal balance loan from a mortgage banker for $104,000 and sold
that loan to an institutional purchaser for $107,000, the Company would
recognize $3,000 of revenue from gain on the sale of loans.
Unrealized Gain (Loss) on Mortgage Related Securities Retained in
Securitization Transactions. Revenues from "Unrealized gain (loss) on mortgage
related securities" results from the allocation of total revenues from the sale
of mortgage loans in securitization transactions described immediately above and
from two other sources. Revenues from the amortization on the Company's mortgage
related securities generally is equal to the amount of cash flow received on the
Company's mortgage related securities. In addition, Unrealized gain (loss) on
mortgage related securities generates negative revenues equal to (i) the write
down, if any, of the fair value of the Company's mortgage related securities;
and (ii) positive revenues from the write up, if any, of those securities.
Interest Income, Net. Interest income, net, is the interest received by
the Company on its portfolio of mortgage loans prior to their sale plus
accretion interest on its mortgage related securities minus the Company's
interest expense on its borrowings including its subordinated debt, warehouse
line of credit and other borrowings.
Loan Servicing Income, Net. "Loan servicing income, net", are the fees
paid to the Company for servicing loans owned by the Company or loans sold with
servicing retained. The prepayment penalties, if any, received from the
Company's borrowers who repay their loans prior to their scheduled maturity date
are included in Loan servicing income, net. As discussed earlier in this
prospectus, the Company historically retained the servicing on a substantial
majority of loans it sold. The Company uses "net" as a part of the revenues
33
<PAGE> 36
from loan servicing because, under generally accepted accounting principles, the
amount of servicing fees earned is reduced by the amortization of the Company's
servicing rights. The Company values the anticipated servicing fees the Company
will receive for servicing a loan from inception until its anticipated maturity
and discounts the anticipated cash flow to its present value similar to the way
the Company determines the fair value of its mortgage related securities.
Historically, the Company's fee for servicing a loan was 1% of the loan's
outstanding principal balance. The fair value of the anticipated cash flow is
recorded on the Company's balance sheet as "Mortgage servicing rights." As
servicing revenues are received, the discounted present value of the future cash
flow is reduced. The amount of the reduction is the "amortization." Revenue from
mortgage servicing rights will not be significant in the future, because the
Company sold all of its servicing rights to City Mortgage Servicing as part of
the recapitalization.
Revision of Assumptions
As described immediately above, the most significant source of the
Company's revenues and income historically has resulted from the sale of loans
produced by the Company and sold in securitization transactions and the fair
value of the mortgage related security issued to the Company by the trusts. The
Company projects the anticipated cash flow to be received from the loans backing
its mortgage related securities based on assumptions of voluntary prepayment
speeds and losses. When prepayments, delinquencies, default and credit losses on
the mortgage loans backing the Company's mortgage related securities exceed the
Company's assumptions, the Company is required to modify its assumptions as to
the prepayments, delinquencies, defaults and credit loss rates on the mortgage
loans backing its mortgage related securities. This generally reduces the
anticipated cash flow to be received from the mortgage loans and results in a
write down in the fair value of the particular mortgage related securities. The
amount of the writedown is treated as negative revenues from Unrealized gain
(loss) on mortgage related securities.
The fair value of the Company's mortgage related securities are affected
by, among other things, changes in market interest rates and prepayment and loss
experiences of these and similar securities. The Company estimates the fair
value of its mortgage related securities using prepayment and credit loss
assumptions on the mortgage loans backing these securities that the Company
believes to be appropriate for the characteristics (weighted-average interest
rate, weighted-average maturity date, etc.) of the mortgage loans backing each
particular securitization. The Company discounts the projected cash flow at the
rate it believes an independent third-party purchaser would require as a rate of
return.
During the fiscal year ended August 31, 1998, the Company experienced
prepayment activity and delinquencies with respect to its securitized Equity +
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. The application of these revised assumptions to the
Company's portfolio of Equity + and Title I loans backing its mortgage related
securities caused the Company to adjust the carrying value of these securities
by approximately $72.1 million during fiscal 1998. The changes in prepayment and
credit loss assumptions also caused the Company to write down the fair value of
its mortgage servicing rights by $1.1 million during fiscal 1998. As discussed
earlier in this prospectus, the fair value of the Company's mortgage related
securities and the fair value of its mortgage servicing rights are determined in
a similar manner.
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<PAGE> 37
The Company has revised its assumptions based on information from a variety
of sources including, among other things, the Company's experience with its own
portfolio of loans, pertinent information from a variety of market sources and
consultations with its financial advisors. However, the Company has not obtained
an independent evaluation of the assumptions utilized in calculating the
carrying value of its mortgage related securities for any period subsequent to
August 31, 1997. To the Company's knowledge, there is no active market for the
sale of these securities. During the year ended August 31, 1998, negative
adjustments of approximately $72.1 million were recognized. See Note 4 to the
Company's financial statements.
Although the Company believes that it has made reasonable estimates of the
prepayment and default rates in determining the fair value of the Company's
mortgage related securities, the rate of prepayments and defaults utilized are
estimates, and actual experience will vary from these estimates and such
variances may be material. There can be no assurance that the revised prepayment
and loss assumptions used to determine the fair value of the Company's mortgage
related securities and mortgage servicing rights will remain appropriate for the
life of the loans backing such securities. If actual loan prepayments or credit
losses vary from the Company's estimates, the fair value of the Company's
mortgage related securities and mortgage servicing rights, if any, may have to
be further adjusted through a charge or credit to earnings.
The Company's revised prepayment assumptions used for Title I loans at
August 31, 1998 reflect an annualized rate of 23.0% for the life of the
portfolio. Actual annualized prepayment rates of the Title I loans backing the
Company's mortgage related securities were 22.5% for the fiscal year ended
August 31, 1998 and 22.7% for the six months ended August 31, 1998. These
revised loss assumptions for Title I loans at August 31, 1998 are based on a
historical "migration" analysis of delinquent loans that the Company anticipates
will become "defaulted loans." The new assumed default rate and the restricted
rates are shown below in the following model and historical default rates:
<TABLE>
<CAPTION>
HISTORICAL DEFAULT RATES
FOR THE PERIODS ENDED AUGUST 31, 1998
NEW ASSUMED ---------------------------------------
DELINQUENCY (DAYS) STATUS DEFAULT RATES 12 MONTHS 6 MONTHS 3 MONTHS
- - ------------------------- ------------- ----------- ---------- ----------
<S> <C> <C> <C> <C>
31 - 60....................... 5% 1.51% 1.69% 2.64%
61 - 90....................... 20-25 21.80 24.80 29.55
91 - 120...................... 50 43.02 46.43 54.78
121 - 150..................... 80 55.90 55.55 63.28
151 - 180..................... 95 59.25 59.85 68.34
Over 180...................... 100 100 100 100
</TABLE>
The Company assumes that a defaulted Title I loan will result in loss of
95.0% of the loan balance and that all Title I insurance has been exhausted. On
a cumulative basis, the new assumptions anticipate aggregate losses of 11.9% of
the original principal balance of Title I loans.
The prepayment assumptions for Equity + loans were also increased at the
end of fiscal 1998 to reflect an annualized prepayment rate of 4.5% in the first
month following the completion of the securitization with the annualized rate
increases in level monthly increments so that by the 18th month the annualized
prepayment rate is 18.75%. The annualized prepayment rate is maintained at that
level through the 36th month at which time it is assumed to decline in level
monthly increments to 15.25% by the 43rd month, and is maintained at 15.25% for
the remaining life of the portfolio. The weighted-average
35
<PAGE> 38
annualized prepayment speed for the loans backing the Company's mortgage related
securities was 17.4% during fiscal 1998 and 4.1% during fiscal 1997.
The loss assumptions for the Equity + loans backing the Company's mortgage
related securities have also been increased to reflect losses commencing in the
second month following a securitization and building in level monthly increments
until a 4.25% annualized loss rate is reached in the 15th month. The annualized
loss rate is maintained at that level through the 43rd month at which time it is
assumed to decline in level monthly increments to 4.0% at month 48 and is
maintained for the life of the portfolio. On a cumulative basis this model
assumes aggregate losses of approximately 16% of the initial principal balance
of Equity + loans backing the Company's mortgage related securities. The actual
losses on Equity + loans backing the Company's mortgage related securities
during fiscal 1998 were approximately 2.5% of the original principal balance.
The Company utilizes a 16% discount rate at August 31, 1998 to discount to
their present sale of the cash flow streams to be received by the Company on its
mortgage related securities. During fiscal 1996 and 1997, the Company used an
annual weighted-average discount rate of 12% for Title I and Equity + loans and
generally utilized annual prepayment assumptions ranging from 1% to 15%, annual
estimated losses of up to 1.75% on Equity + loans resulting in an aggregate loss
of 15%, and estimated losses on Title I loans based on the then current
migration analysis and assuming recoveries of 20% after exhaustion of insured
reserves.
We believe that due to recent substantial changes to the Company's business
and operating strategy, the Company's historical financial and operating data is
not likely to be indicative of the Company's future performance.
RESULTS OF OPERATIONS
Fiscal 1998 Compared to Fiscal 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 fiscal 1998 are comparable to the
Company's results for fiscal 1997.
The Company produced $338.9 million of loans during fiscal 1998 compared to
$526.9 million of loans during fiscal 1997, a decrease of 35.7%. The decrease is
due to a substantial reduction in the Company's loan production after January
1998 caused by the Company's inability to obtain funds to produce loans due to
its violation of covenants contained in the old warehouse line.
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<PAGE> 39
The Company's loan production by month during fiscal 1997 and 1998 is
illustrated in the chart below.
[Chart reflecting monthly loan production in fiscal 1997 and fiscal 1998 (in
millions of dollars) as follows:]
<TABLE>
<CAPTION>
fiscal year 1997 fiscal year 1998
<S> <C> <C>
September $13.6 $62.5
October $24.0 $71.2
November $24.9 $66.2
December $32.7 $68.6
January $34.5 $34.2
February $44.0 $24.5
March $52.9 $ 7.9
April $59.5 $ 1.4
May $61.6 $ 0.5
June $59.5 $ 0.2
July $55.4 $ 1.0
August $64.3 $ 0.6
</TABLE>
Net Revenues. Net revenues were negative $94.0 million during fiscal 1998
compared with positive $54.8 million during fiscal 1997. The Company's revenues
are determined largely by special accounting requirements that required the
Company in fiscal 1997 to recognize significant revenue on loans sold in
securitization transactions ("gain on sale") even though these transactions
generated negative cash flow.
We have separated below the following four components of the Company's
revenues in fiscal 1998 and compared them to the same four components of revenue
in fiscal 1997:
1. Revenues from gain (loss) on sale of loans
- in securitization transactions
- for cash
2. Revenues from net unrealized gain (loss) on mortgage related securities
3. Loan servicing income, net
4. Revenues from net interest income
37
<PAGE> 40
1. Revenues from Gain (loss) on sale of loans in fiscal 1998 were a
negative $26.6 million compared to a positive $45.1 million in fiscal 1997. The
table below shows the principal components of Gain (loss) on sale of loans in
each of these periods.
<TABLE>
<CAPTION>
COMPONENTS
OF GAIN (LOSS)
ON THE SALE OF LOANS
-------------------------
FISCAL 1997 FISCAL 1998
----------- -----------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Gain (loss) on the sale of loans in securitization
transactions........................................... 62,014 (6,187)
Gain on the sale of loans for cash....................... 833 11,775
Mark-to-market adjustment to loans held for sale......... -- (13,674)
Write off of loan origination costs...................... (12,573) (12,541)
Write off of commitment fee.............................. -- (2,849)
Amortization of commitment fee........................... (817) (734)
Write off of placement fee............................... (4,129) (1,153)
Interest expense......................................... (205) --
Write off of servicing................................... -- (1,215)
-------- ---------
Total.......................................... 45,123 (26,578)
======== =========
</TABLE>
Revenues from gain on the sale of loans in securitization transactions in
fiscal 1997 of $62.0 million resulted from the allocation of 79.4% of the $78.2
million total revenues earned by the Company on loans sold in these
transactions. The $16.2 million balance of these revenues was allocated to Net
unrealized gain (loss) on mortgage related securities. In fiscal 1997, the
Company sold $398.4 million principal amount of loans in securitization
transactions, with a total cost of production of $20.0 million. This includes
premiums of $18.4 million (3.5% of the principal amount of the Company's loans
produced) paid to the Company's network of mortgage bankers for closed loans. In
fiscal 1998, only $90.5 million principal amount of loans were sold in
securitization transactions. The substantially lower amount of loans sold in
securitization transactions in fiscal 1998 and the lower revenues from these
transactions resulted from the continuing cash flow deficits of the Company.
These deficits were principally due to substantial increases in the Company's
loan production in fiscal 1997, the sale of these loans in securitization
transactions and a major increase in general and administrative expenses.
Revenues from gain on the sale of loans for cash were $11.8 million in
fiscal 1998 compared to $833,000 in fiscal 1997. In fiscal 1998, the Company
sold $160.1 million principal amount of loans for cash as part of its plan to
continue operating while it was exploring alternatives for locating new capital.
The Company's total cost of producing these loans was $15.0 million in fiscal
1998 compared to $20.0 million in fiscal 1997 (representing 12.5% of the $160.1
million of the amount of loans sold for cash in that period). In fiscal 1997,
revenues from the sale of $99.0 million principal amount of loans for cash were
$833,000. The Company believes that its loan sales for cash in fiscal 1998 may
have been adversely impacted by the market's knowledge that the Company was
liquidating its loan portfolio to pay down the Company's lenders. The Company's
revenues from gain (loss) on the sale of loans for cash in fiscal 1998 were also
impacted by a lower of cost or market write down of $13.7 million of the
Company's $21.9 million principal
38
<PAGE> 41
amount of loans in its portfolio at the end of fiscal 1998. The loans in the
Company's portfolio at August 31, 1998 primarily had document deficiencies or
the borrowers were delinquent in their loan payments. The lower of cost or
market adjustment is based on the Company's estimate of the proceeds to be
received when these loans are sold. The Company believes that liquidity shortage
in the specialty finance industry may have also hurt the market value of these
loans.
As part of the recapitalization, the Company terminated its Master
Warehouse Agreement with Greenwich Capital Markets. This termination resulted in
negative revenues of $4.0 million from gain (loss) on sale of loans due to the
write off of a $2.85 million commitment fee. Negative revenues of $1.2 million
also resulted from payments to Greenwich Capital Markets in connection with
their sale of the Company's loans. For additional details, see "Certain
Relationships and Related Transactions."
2. Revenues from Net unrealized gain (loss) on mortgage related securities
were negative $70.0 million in fiscal 1998 compared to a positive $3.5 million
in fiscal 1997. Substantially all of fiscal 1998's negative revenues resulted
from a write down of $73.0 million in the fair value of the Company's mortgage
related securities. The write down was required because prepayment, delinquency,
default and credit loss rates on the Equity + and Title I loans backing these
securities substantially exceeded the assumptions the Company used to value its
mortgage related securities at the end of fiscal 1997. These loans were produced
by the Company in prior periods. Additionally, in response to recent adverse
changes in the liquidity and market value of these and other similar asset
backed residual interests, the Company increased the rate used to discount to
present value the anticipated cash flow to be received on its mortgage related
securities from 12% at the end of fiscal 1997 to 16% at the end of fiscal 1998.
The positive revenues of $3.5 million from Net unrealized gain (loss) on
mortgage related securities recorded in fiscal 1997 resulted from a write up of
$2.0 million in the fair value of the Company's mortgage related securities and
favorable cash flow from the Company's mortgage related securities.
In August 1998, the Company pooled approximately $90.5 million of loans
with approximately $239.6 million of loans from a second party to create a home
loan owner trust securitization. The Company was issued a residual interest
mortgage related security in this securitization calculated on the pro rata
share of the Company loans originated in the total pool. This residual interest
mortgage related security will be owned two-thirds by the Company and one-third
by Greenwich Capital Markets. Cash flow on the Company's residual interest
mortgage related security will be subordinated to recovery by Greenwich of: (1)
premium paid for in the acquisition of the pool; (2) upfront overcollaterization
of 1.25% of the total pool; (3) Greenwich's underwriting fee and (4) transaction
costs. The total of these recoveries will accrue interest at a 12% per annum
rate until recovered. The target overcollaterization level of 6% must be
achieved prior to recovery by Greenwich. See "Certain Relationships and Related
Transactions -- Relationship with Greenwich."
3. Loan servicing income, net, decreased from $3.0 million in fiscal 1997
to $1.0 million in fiscal 1998. The decrease was a result of negative revenues
of $1.1 million from a write down in the fair value of the Company's mortgage
servicing rights in the third quarter of fiscal 1998 due to an increase in the
Company assumptions of prepayment, delinquency, default and credit loss rates on
the loans in the Company's servicing portfolio, which reduced the discounted
present value of the Company's anticipated servicing revenues on those loans. In
addition, in fiscal 1998 the Company had negative loan
39
<PAGE> 42
servicing revenues of $703,000 from the loss on the sale of the Company's
servicing rights to City Mortgage Services as part of the recapitalization.
4. Revenues from net interest income decreased from $3.1 million in fiscal
1997 to $1.6 million in fiscal 1998. The table below shows the amount of the
Company's interest income and interest expense for fiscal 1997 and 1998.
<TABLE>
<CAPTION>
NET INTEREST INCOME
-------------------------
FISCAL 1997 FISCAL 1998
----------- -----------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Interest Income:
Short-term investments and accretion on mortgage related
securities........................................... $ 7,353 8,964
Loans held in portfolio pending sale.................... 2,038 5,492
Cash.................................................... 116 330
-------- --------
Total Interest Income........................... $ 9,507 $ 14,786
======== ========
Interest Expense:
Subordinated debt....................................... $ 4,266 $ 8,839
Old warehouse line...................................... 1,805 3,961
Other borrowings........................................ 303 362
-------- --------
Total Interest Expense.................................. $ 6,374 13,162
-------- --------
Net Interest Income............................. $ 3,133 $ 1,624
======== ========
</TABLE>
Interest income increased from $9.5 million in fiscal 1997 to $14.8 million
in fiscal 1998. The increase was due to the sale of the Company's 1998 loan
production in cash transactions over a period of time, compared to the sale of
fiscal 1997 loan production in quarterly securitization transactions. In
addition, the Company earned approximately $304,600 in interest in fiscal 1998
from the short-term investment of $50.0 million in proceeds from the
recapitalization.
Interest expense in fiscal 1998 was substantially higher than interest
expense in fiscal 1997 due primarily to additional interest expense of $3.5
million on the Company's subordinated debt as a result of the October 1997 sale
of $40.0 million principal amount of 12 1/2% subordinated notes. In addition,
the Company borrowed an aggregate of $15.0 million secured by certain of its
mortgage related securities in the first quarter of fiscal 1998. The principal
amount of these borrowings were outstanding for all of fiscal 1998 and for only
a portion of fiscal 1997.
Provision for Credit Losses. The net provision for credit losses decreased
$9.5 million to income of $3.2 million for fiscal 1998 from losses of $6.3
million for fiscal 1997. The decrease in the provision for credit losses was due
to the decrease in the volume of loans produced and the ratio of Equity + loans
to Title I loans produced during fiscal 1998 compared to fiscal 1997. An
allowance for credit losses is not established on loans sold in securitization
transactions, because the Company typically does not have recourse obligations
for these losses. Estimated credit losses on loans sold in securitization
transactions are considered in the Company's determination of the fair value of
its mortgage related 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.
40
<PAGE> 43
Total General and Administrative Expenses. Total general and
administrative expenses increased $10.0 million, or 42.0%, to $33.8 million
during fiscal 1998 from $23.8 million during fiscal 1997. The increase was
primarily a result of increased costs of professional services due to:
(1) increased outside legal and audit expenses associated with
additional securities filings;
(2) the recapitalization;
(3) amendments to existing debt agreements;
(4) increased loan servicing expenses due to an increase in loans
serviced; and
(5) increased payroll and benefits related to the hiring of additional
personnel to support the Company's expansion in the first quarter of fiscal
1998.
The substantial individual changes in general and administrative expenses
are discussed in more detail below.
Payroll and benefits expense increased $5.5 million, or 42.4%, to $18.6
million during fiscal 1998 from $13.1 million during fiscal 1997 primarily due
to an increased number of employees prior to January 1998 and expenses
associated with the reduction in the Company's workforce. Although the number of
employees decreased to 134 at August 31, 1998 from 405 at August 31, 1997, the
average number of employees employed was higher during fiscal 1998 than fiscal
1997.
Credit reports expense decreased $877,000, or 63.2%, to $510,000 during
fiscal 1998 from $1.4 million for fiscal 1997 due to the decrease in loan
production during the second half of fiscal 1998.
Rent and lease expenses increased $417,000, or 34.8%, to $1.6 million for
fiscal 1998 from $1.2 million for fiscal 1997 due to annual escalation in rent
and expiration of tenant discounts the Company enjoyed in fiscal 1997 for office
space at the Company's corporate offices.
Professional services increased $2.5 million, or 110.6%, to $4.8 million
for fiscal 1998 from $2.3 million for fiscal 1997 due to increased outside legal
and audit expenses associated with the Company's private placement of $40.0
million principal amount of Old Notes in fiscal 1997, additional securities
filings, amendments to existing debt agreements and higher consulting and
management services expenses. A substantial portion of the increase in
professional services was due to actions taken by the Company subsequent to
January 1, 1998 as a result of its adverse financial position and the
recapitalization.
Sub-servicing fees increased $286,000, or 15.3%, to $2.2 million for fiscal
1998 from $1.9 million for fiscal 1997 due primarily to a larger average loan
servicing portfolio, partially offset by a lower sub-servicing rate paid to the
sub-servicer in the latter part of fiscal 1998.
Other services increased $716,000, or 53.0%, to $2.1 million for fiscal
1998 from $1.4 million for fiscal 1997, due to higher telephone and overnight
mailing expenses.
FHA insurance expense decreased $128,000, or 22.9%, to $430,000 during
fiscal 1998 from $558,000 during fiscal 1997 due to decreased production of
insured Title I loans.
41
<PAGE> 44
Other general and administrative expenses increased $1.3 million, or
125.6%, to $2.4 million during fiscal 1998 from $1.1 million during fiscal 1997
due primarily to increased expenses related to the expansion of facilities
related to the Company's business expansion at the beginning of fiscal 1998.
The Company had a $126.0 million loss before income taxes for fiscal 1998
compared to income of $23.8 million for fiscal 1997. An income tax expense of
$9.1 million was provided for in fiscal 1997 while an income tax benefit of $6.3
million has been provided for in fiscal 1998.
As a result of the above, the Company incurred a net loss of $119.7 million
for fiscal 1998 compared to net income of $14.7 million for fiscal 1997.
Fiscal 1997 Compared to Fiscal 1996
The Company produced $526.9 million principal amount of loans during fiscal
1997 compared to $139.4 million of loans during fiscal 1996. The increase is a
result of the overall growth in the Company's business, including an increase in
the number of active mortgage bankers that sold the Company closed Equity +, and
to a lesser extent, Title I loans and home improvement contractors ("dealers")
that sold the Company closed Title I loans and an increase in the number of
states served. At August 31, 1996 and 1997, the Company's network consisted of
the following:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
AUGUST 31,
----------------------
1996 1997
---- ----
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Active mortgage bankers................................ 310 694
Active dealers......................................... 435 670
</TABLE>
The following table describes the types of loans produced by the Company
during fiscal 1996 and 1997:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
AUGUST 31,
------------------------
1996 1997
-------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Equity + loans....................................... $ 11,582 $428,832
Title I loans........................................ 127,785 98,085
-------- --------
Total...................................... $139,367 $526,917
======== ========
</TABLE>
42
<PAGE> 45
The following table sets forth certain data regarding loans produced by the
Company during fiscal 1996 and 1997:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
--------------------------------------
1996 1997
----------------- -----------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
PRINCIPAL AMOUNT OF LOANS PRODUCED:
Mortgage bankers:
Title I............................ $ 82,596 59.3% $ 50,815 9.7%
Equity +........................... 11,582 8.3 409,603 77.7
-------- ----- -------- -----
Total mortgage bankers........ 94,178 67.6 460,418 87.4
-------- ----- -------- -----
Dealers:
Title I............................ 45,189 32.4 47,270 9.0
Equity +........................... -- -- 19,229 3.6
-------- ----- -------- -----
Total dealers................. 45,189 32.4 66,499 12.6
-------- ----- -------- -----
Total principal amount of
loans produced............. $139,367 100.0% $526,917 100.0%
======== ===== ======== =====
NUMBER OF LOANS PRODUCED:
Mortgage bankers:
Title I............................ 4,382 50.9% 2,445 12.0%
Equity +........................... 392 4.6 12,831 62.7
-------- ----- -------- -----
Total mortgage bankers........ 4,774 55.5 15,276 74.7
-------- ----- -------- -----
Dealers:
Title I............................ 3,836 44.5 3,893 19.0
Equity +........................... -- -- 1,296 6.3
-------- ----- -------- -----
Total dealers................. 3,836 44.5 5,189 25.3
-------- ----- -------- -----
Total number of loans
produced................... 8,610 100.0% 20,465 100.0%
======== ===== ======== =====
</TABLE>
Net Revenues. Net revenues increased $31.2 million, or 132.5%, to $54.8
million for fiscal 1997 from $23.6 million for fiscal 1996. The increase was
primarily the result of the increased volume of loans produced and the principal
amount of loans sold.
Gain on sale of loans and net unrealized gain on mortgage related
securities together increased $29.4 million, or 152.9%, to $48.6 million during
fiscal 1997 from $19.2 million during fiscal 1996. The increase was primarily
due to increases in the principal amount of loans sold in securitization and
similar transactions of $521.6 million during fiscal 1997 compared to $137.9
million during fiscal 1996.
43
<PAGE> 46
The following table sets forth the principal balance of loans sold or
securitized and related gain on sale data for fiscal 1996 and 1997:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED AUGUST 31,
----------------------------
1996 1997
---------- ----------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
LOANS SOLD IN SECURITIZATION TRANSACTIONS:
Principal amount of loans sold:
Title I............................................ $127,414 $ 62,097
Equity +........................................... 10,494 360,411
-------- --------
Total principal amount..................... $137,908 $422,508
======== ========
Gain on sale of loans................................ $ 16,539 $ 41,132
======== ========
Net unrealized gain on mortgage related securities... $ 2,697 $ 3,524
======== ========
Gain on sale of loans as a percentage of principal
balance of loans sold.............................. 12.0% 9.7%
======== ========
Gain on sale of loans plus net unrealized gain on
mortgage related securities as a percentage of
principal balance of loans sold.................... 13.9% 10.6%
======== ========
LOANS SOLD FOR CASH WITH SERVICING RELEASED TO FNMA
AND OTHERS:
Principal amount of loans sold:
Title I............................................ $ -- $ 39,810
Equity +........................................... -- 59,189
-------- --------
Total principal amount..................... $ -- $ 98,999
======== ========
Gain on sale of loans................................ $ -- $ 3,991
======== ========
Net unrealized loss on mortgage related securities... $ -- $ (6)
======== ========
Gain on sale of loans as a percentage of principal
balance of loans sold.............................. 0.0% 4.0%
======== ========
Gain on sale of loans plus net unrealized loss on
mortgage related securities as a percentage of
principal balance of loans sold.................... 0.0% 4.0%
======== ========
LOANS SERVICED AT END OF YEAR:
Title I............................................ $202,766 $255,446
Equity +........................................... 11,423 372,622
-------- --------
Total servicing portfolio at end of
period.................................. $214,189 $628,068
======== ========
</TABLE>
For additional details on gain on the sale of Loans sold in securitization
transactions, see Note 2 to the Company's financial statements located later in
this prospectus.
Loan servicing income, net decreased $312,000, or 9.3%, to $3.0 million
during fiscal 1997 from $3.3 million during fiscal 1996. The decrease was
primarily the result of the reclassification of net revenue in compliance with
SFAS No. 125 and increased interest advances and reduced servicing fees related
to $34.0 million in delinquent loans serviced by the Company at August 31, 1997
compared to $16.2 million at August 31, 1996.
44
<PAGE> 47
Interest income on loans held for sale and mortgage related securities, net
of interest expense, increased $2.1 million, or 217.1%, to $3.1 million during
fiscal 1997 from $988,000 during fiscal 1996. The increase was primarily the
result of the increase in the average principal amount of the Company-owned
loans held for sale and the increased mortgage related securities portfolio.
Provision for Credit Losses. The net provision for credit losses increased
$6.2 million to $6.3 million for fiscal 1997 from $55,000 for fiscal 1996. The
increase in the provision was directly related to the increase in the volume of
loans produced and the increased ratio of Equity + loans to Title I loans
produced during fiscal 1997 compared to fiscal 1996. No allowance for credit
losses on loans sold with recourse is established on loans sold through in
securitization and similar transactions. The Company has no recourse obligation
for credit losses on loans sold. Estimated credit losses on loans sold are
considered in the Company's valuation of its mortgage related 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 produced and sold in securitization and similar transactions. For
details on mortgage related securities, see Notes 2 and 4 the Company's
financial statements.
Total General and Administrative Expenses. Total general and
administrative expenses increased $12.0 million, or 101.5%, to $23.8 million
during fiscal 1997 compared to $11.8 million during fiscal 1996. The increase
was primarily a result of increased credit reports expense due to increased loan
production volume, increased rent and lease expense due to facilities expansion,
increased loan servicing expenses due to an increase in loans serviced, and
increased payroll related to the hiring of additional underwriting, loan
processing, administrative, loan quality control and other personnel as a result
of the expansion of the Company's business.
Payroll and benefits expense increased $6.7 million, or 106.3%, to $13.1
million during fiscal 1997 from $6.3 million during fiscal 1996 primarily due to
an increased number of employees. The number of employees increased to 405 at
August 31, 1997 from 170 at August 31, 1996 due to increased staff necessary to
support the business expansion and maintain quality control.
Credit reports expense increased $1.0 million, or 277.9%, to $1.4 million
during fiscal 1997 from $367,000 during fiscal 1996 primarily due to increased
loan origination volume to $526.9 million during fiscal 1997 from $139.4 million
during fiscal 1996.
Rent and lease expenses increased $861,000, or 254.7%, to $1.2 million
during fiscal 1997 from $338,000 during fiscal 1996 primarily due to increased
expansion costs for the corporate headquarters and additional branch offices.
Professional services fees increased $500,000, or 28.2%, to $2.3 million
during fiscal 1997 from $1.8 million during fiscal 1996 primarily due to
increased audit and legal fees attributable to continued growth.
Sub-servicing fees paid increased $1.2 million, or 164.3%, to $1.9 million
during fiscal 1997 from $709,000 during fiscal 1996 due primarily to a larger
loan servicing portfolio.
Other services increased $687,000, or 103.3%, to $1.4 million during fiscal
1997 from $665,000 during fiscal 1996. These expenses represent executive,
accounting, legal,
45
<PAGE> 48
management information, data processing, human resources and advertising
services provided and promotional materials.
Travel expenses increased $328,000, or 48.4%, to $1.0 million during fiscal
1997 from $677,000 during fiscal 1996 due to increased travel needed to support
the Company's business expansion.
Other general and administrative expenses increased $711,000, or 190.1%, to
$1.1 million during fiscal 1997 from $374,000 during fiscal 1996 due primarily
to increased expenses related to the ongoing expansion of facilities.
Income before income taxes increased $12.7 million, or 113.4%, to $23.8
million for fiscal 1997 from $11.2 million for fiscal 1996. The provision for
income taxes increased to $9.1 million for fiscal 1997 compared to $4.2 million
for fiscal 1996.
As a result of the foregoing, the Company's net income increased $7.8
million, or 113.1%, to $14.7 million for fiscal year 1997 from $6.9 million for
fiscal 1996.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity Sources
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.
The Sovereign Warehouse Line was originally scheduled to terminate 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.
46
<PAGE> 49
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 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.
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
47
<PAGE> 50
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.
The Company believes that its financing sources are adequate to meet its
current needs.
Liquidity Uses
The Company's liquidity is primarily used to originate loans, pay operating
and interest expenses and historically, to fund the negative cash flow from the
sale of loans in securitization transactions. Substantially all of the loans
produced by the Company are sold. The Sovereign Warehouse Line is to be repaid
primarily from the proceeds from the sale of the loans collateralizing the line
in the secondary market. The Company resumed the production of new loans on July
1, 1998. The Company's cash requirements necessitate continued access to sources
of warehouse financing and sales of loans in the secondary market for premiums.
In the ordinary course of business, the Company makes representations and
warranties to the purchasers of mortgage loans and the related servicing rights
regarding compliance with laws, regulations and program standards and as to
accuracy of information. Under certain recourse provisions the Company may
become liable for certain damages or may be required to repurchase a loan if
there has been a breach of these representations or warranties. Pursuant to
recourse provisions under certain wholesale agreements, the Company was
obligated to repurchase Equity + and Title I loans with an aggregate principal
balance of approximately $9.4 million at August 31, 1998. These loans, which are
reflected in the Company's Statement of Financial Condition under Loans Held for
Sale, were valued utilizing the Company's estimate of the price to be received
upon their final disposition. Based on the estimated price, a lower of cost or
market allowance of $4.2 million was recorded for fiscal 1998, as a charge to
gain (loss) on sale of loans in the Company's Statement of Operations. An
additional lower of cost or market allowance of $6.7 million relating to the
$21.9 million principal balance of the Company's loans held for sale at August
31, 1998 was recorded for fiscal 1998, as a charge to gain (loss) on sale of
loans in the Company's Statement of Operations.
The Company generally expects to incur monthly operating expenses of
approximately $2.0 million. Until the Company begins to operate on a positive
cash flow basis, such monthly operating expenses are expected to be funded out
of the remaining proceeds of the recapitalization and from amounts borrowed
under the Company's credit facilities. The Company may effect a reduction in its
real-estate lease expenditures through the subletting of all or a portion of its
current office space. If the Company subleases all of its current office space,
the Company intends to relocate its corporate offices to another location
suitable for the Company's needs.
At August 31, 1998, no commitments existed for additional material capital
expenditures. However, the Company expects to incur additional costs in
connection with the implementation of its revised business strategy.
Specifically, the Company anticipates that it may need to hire additional
personnel in order to carry out its strategic plan. The
48
<PAGE> 51
hiring of such additional personnel would require the Company to incur
additional expenses.
Net cash used in the Company's operating activities was $72.4 million in
fiscal 1997 and $39.7 million in fiscal 1998. The Company used net cash of $1.7
million in fiscal 1997 and $329,000 in fiscal 1998, in investing activities,
substantially for office equipment and furnishing and data processing equipment.
Cash provided by financing activities amounted to $79.8 million in fiscal 1997
and $70.4 million in fiscal 1998. This resulted principally from the sale of
$40.0 million of Old Notes in October 1997, the sale of $20.0 million of common
stock and $40.0 million principal amount of Old Notes in November 1996 and the
sale of $50.0 million of common stock and preferred stock in the
recapitalization.
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.
Compensation for assuming these risks is reflected in interest income and
fee income. The following table provides information as of August 31, 1998 about
the Company's mortgage related securities and other financial instruments that
are sensitive to changes in interest rates. The table presents sensitivity
analysis associated with fluctuations in prepayment speeds, increase or decrease
in defaulted loans and the discount rates associated with valuing the
securities.
CHART DESCRIPTION
[Chart reflecting effect of changing interest rates on the Company's
assumptions with respect to default rates, discount rates and prepayment rates
on the Company's financial instruments with exposure to interest rate risk:]
<TABLE>
<CAPTION>
% Change in
Interest Rate Default Rate Discount Rate Prepayment Rate
- - -------------- ------------ ------------- ---------------
<S> <C> <C> <C>
+5% $ 8,742,665 $27,899,921 $31,972,595
+3% $19,619,236 $30,429,329 $32,645,484
+1% $25,715,408 $33,273,770 $33,509,045
0% $34,829,719 $34,829,719 $34,829,719
-1% $39,712,288 $36,484,374 $35,240,082
-3% $49,947,812 $40,122,559 $35,971,596
-5% $60,750,176 $44,262,566 $36,648,294
</TABLE>
49
<PAGE> 52
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 August 31, 1998 the net fair value of all financial instruments with
exposure to interest rate risk was approximately $34.8 million. The potential
decrease in fair value resulting from a hypothetical 5% shift in interest rates
would be approximately $26.1 million.
There are certain shortcomings inherent to the sensitivity analysis
presented. The model assumes interest rate increase 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. As such, the table considers prepayment risk. However, in the
event of a change in interest rates, actual loan prepayments may deviate
significantly from assumptions used in the table. 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.
EFFECTS OF CHANGING PRICES AND INFLATION
The Company's operations are sensitive to increases in interest rates and
to inflation. Increased borrowing costs resulting from increases in interest
rates may not be immediately recoverable from prospective purchasers. The
Company's loans held for sale consist primarily of fixed-rate long term
obligations the interest rates of which do not increase or decrease as a result
of changes in interest rates charged to the Company. In addition, delinquency
and loss exposure may be affected by changes in the national economy. See Note 4
to the Company's financial statements.
RECENT ACCOUNTING PRONOUNCEMENTS
SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" was issued by the FASB in June 1996. SFAS 125
provides accounting and reporting standards for transfers and servicing of
financial assets and extinguishments of liabilities. This statement also
provides consistent standards for distinguishing transfers of financial assets
that are sales from transfers that are secured borrowings. It requires that
liabilities and derivatives incurred or obtained by transferors as part of a
transfer of financial assets be initially measured at fair value. SFAS 125 also
requires that servicing assets be measured by allocating the carrying amount
between the assets sold and retained interests based on their relative fair
values at the date of transfer. Additionally, this statement requires that the
servicing assets and liabilities be subsequently measured by (a) amortization in
proportion to and over the period of estimated net servicing income or loss and
(b) assessment for asset impairment or increased obligation based on their fair
values. The statement requires that the Company's excess servicing rights be
measured at fair market value and be reclassified as interest only receivables
and
50
<PAGE> 53
accounted for in accordance with SFAS No. 115 "Accounting for Certain
Investments in Debt and Equity Securities". As required by the statement, the
Company adopted the new requirements effective January 1, 1997. Implementation
of the statement did not have any material impact on the financial statements of
the Company, as the book value of the Company's excess servicing rights and
mortgage related securities approximated fair value.
SFAS No. 128, "Earnings per Share" was issued by the FASB in March 1997,
effective for financial statements issued after December 15, 1997. SFAS 128
provides simplified standards for the computation and presentation of earnings
per share ("EPS"), making EPS comparable to international standards. SFAS 128
requires dual presentation of "Basic" and "Diluted" EPS, by entities with
complex capital structures, replacing "Primary" and "Fully Diluted" EPS under
APB Opinion No. 15.
Basic EPS excludes dilution from common stock equivalents and is computed
by dividing income available to stockholders by the weighted-average number of
shares of Common Stock outstanding for the period. Diluted EPS reflects the
potential dilution from Common Stock equivalents, similar to fully diluted EPS,
but uses only the average stock price during the period as part of the
computation.
In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive
Income", and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information". SFAS No. 130 establishes standards for reporting and
display of comprehensive income and its components in a full set of
general-purpose financial statements. SFAS No. 131 establishes standards of
reporting by publicly held business enterprises and disclosure of information
about operating segments in annual financial statements and, to a lesser extent,
in interim financial reports issued to shareholders. SFAS Nos. 130 and 131 are
effective for fiscal years beginning after December 15, 1997. As both SFAS Nos.
130 and 131 deal with financial statement disclosure, the Company does not
anticipate the adoption of these new standards will have a material impact on
its financial position, results of operations or cash flows. The Company has not
yet determined what its reporting segments will be under SFAS No. 131.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"), which establishes accounting
and reporting standards for derivative instruments and for hedging activities.
It requires the entity to recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. The accounting for changes in fair value of these designated
derivatives ("hedge accounting") depends on the intended use and designation. An
entity that elects to apply hedge accounting is required to establish at the
inception of its hedge the method it will use for assessing the effectiveness of
the hedging derivative and the measurement approach for determining the
ineffective aspect of the hedge. Those methods must be consistent with the
entity's approach to managing risk. SFAS 133 is effective for the fiscal years
beginning after June 15, 1999. The Company has not yet evaluated the effect of
adopting SFAS 133.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by Mortgage Banking Enterprise" ("SFAS 134"), which allows the
reclassification of mortgage-related securities and other beneficial interests
retained after the securitization of mortgage loans held for sale from the
trading category, as required by FASB 115, to either available for sale or held
to maturity based upon the Company's ability and intent to hold those
investments. SFAS 134 is effective for the first quarter beginning after
December 15, 1998.
51
<PAGE> 54
The Company has not yet evaluated the effect of adopting SFAS 134. As of August
31, 1998, all mortgage-related securities are classified as trading securities.
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 August 31, 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 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.
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
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<PAGE> 55
disruption. Such a disruption would have a material adverse effect on 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 Bancorp, 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. The Company has not
yet received a significant number of responses from its vendors or other third
parties, and therefore 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 HUD
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.
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<PAGE> 56
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements are listed under Item 14(a) of this annual report
and are filed as part of this report on the pages indicated. The supplementary
data are included under Item 7 of this annual report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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<PAGE> 57
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information with respect to the
directors and executive officers of the Company as of December 1, 1998.
<TABLE>
<CAPTION>
NAME AGE POSITION
- - ---- --- --------
<S> <C> <C>
Champ Meyercord........................... 57 Chairman of the Board and Chief
Executive Officer
Wm. Paul Ralser........................... 57 President, Chief Operating Officer and
Director
J. Richard Walker......................... 51 Executive Vice President and Chief
Financial Officer
Spencer I. Browne......................... 48 Director
Hubert M. Stiles, Jr...................... 51 Director
David J. Vida, Jr......................... 32 Director
John D. Williamson, Jr.................... 63 Director
</TABLE>
Edward B. "Champ" Meyercord has been Chairman and Chief Executive Officer
of the Company since July 1998 and, prior thereto, he was a special consultant
to the Company since May 1998. From 1994 to 1998, Mr. Meyercord was a senior
investment banker with Greenwich Capital Markets, most recently as a co-head of
the Mortgage and Asset Backed Finance Group. In addition to his involvement with
asset backed securities, Mr. Meyercord was involved in the development of
financing vehicles for specialty finance companies. Greenwich Capital Markets
has performed investment banking services for the Company since 1994. Prior to
1994, Mr. Meyercord was a co-managing partner of Hillcrest Partners, a private
investment bank specializing in mergers and acquisitions for financial
institutions. Mr. Meyercord is a member of the Board of Directors of The
National Home Equity Mortgage Association.
Wm. Paul Ralser. Mr. Ralser has been a Director of the Company since June
1998 and President and Chief Operating Officer since September 1998. Mr. Ralser
has served as President and Chairman of the Board of First Fidelity Bancorp,
Inc. since June 1996. Since December 1994, Mr. Ralser has been President and
Chief Executive Officer of First Fidelity Thrift & Loan Association. From
October 1992 to December 1994, Mr. Ralser was Executive Vice President and
Director of Affordable Housing for Countrywide Funding Corporation
("Countrywide") and, from September 1986 until August 1992, he served as
President and Chief Executive Officer of Countrywide Thrift and Loan.
J. Richard Walker has been Executive Vice President and Chief Financial
Officer of the Company since October 1998. Since 1988, Mr. Walker has been a
principal of Walker & Mikloucich, P.C., an accounting firm. Since 1986, Mr.
Walker has been managing director of Vulcan Capital, Inc., formerly TVG
Associates, Inc., a business advisory services firm.
Spencer I. Browne has been a Director of the Company since consummation of
the initial public offering in November 1996. For more than five years prior to
September 1996, Mr. Browne held various executive and management positions with
several publicly traded companies engaged in businesses related to the
residential and commercial mortgage loan industry. From August 1988 until
September 1996, Mr. Browne served as President, Chief Executive Officer and a
Director of Asset Investors Corporation ("AIC"),
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<PAGE> 58
a New York Stock Exchange ("NYSE") traded company he co-founded in 1986. He also
served as President, Chief Executive Officer and a Director of Commercial
Assets, Inc., an American Stock Exchange traded company affiliated with AIC,
from its formation in October 1993 until September 1996. In addition, from June
1990 until March 1996, Mr. Browne served as President and a Director of M.D.C.
Holdings, Inc., a NYSE traded company and the parent company of a major home
builder in Colorado.
Hubert M. Stiles, Jr. Mr. Stiles has been a Director of the Company since
July 1998. Since September 1996, Mr. Stiles has been a money manager for and
President of T. Rowe Price Recovery Fund II Associates, L.L.C. Mr. Stiles has
been Vice President of T. Rowe Price Associates, Inc. and a money manager for
and President of T. Rowe Price Recovery Fund Associates, Inc. since May 1988.
David J. Vida, Jr. Mr. Vida has been a Director of the Company since June
1998. Since July 1996, Mr. Vida has been President of City Mortgage Services, a
division of City National Bank. Mr. Vida served as Chief Financial Officer of
Prime Financial Corp. from June 1994 until June 1996. From January 1992 to June
1996, Mr. Vida was a Senior Accountant for KPMG Peat Marwick LLP.
John D. Williamson, Jr. has been a Director of the Company since September
1998. Since January 1997, Mr. Williamson has been practicing law as a sole
practitioner, focusing on consulting, mediation and expert witnesses. From 1976
to January 1997, Mr. Williamson worked in various capacities at Transport Life
Insurance Company (a subsidiary of Travelers Group, Inc.) including Vice
Chairman of the Board from 1995 to 1997 and Chairman of the Board from 1995 to
1998.
SECTION 16(A) BENEFICIAL OWNERSHIP COMPLIANCE
Section 16(a) of the Exchange Act requires the Company's directors and
executive officers and persons who own more than ten percent of a registered
class of the Company's equity securities to file with the Securities and
Exchange Commission and the Nasdaq National Market initial reports of ownership
and reports of changes in ownership of common stock and other equity securities
of the Company. Such persons are required by the Commission to furnish the
Company with copies of all Section 16(a) forms that are filed.
To the Company's knowledge, based solely on review of the copies of such
reports furnished to the Company and written representations that no other
reports were required, for the fiscal year ended August 31, 1997, all Section
16(a) filing requirements applicable to its directors, executive officers and
greater than ten-percent beneficial owners were properly filed except that
Spencer I. Browne received 4,760 shares of the Company's common stock in
September 1997, as a result of the spin-off of the Company's common stock by
Mego Financial, which was not reported on his Form 4 until January 1998.
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<PAGE> 59
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth information concerning the annual and
long-term compensation earned by the Company's chief executive officer and the
other executive officer as of August 31, 1998 whose annual salary and bonus
during fiscal 1998 exceeded $100,000 (the "Named Executive Officers").
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
AWARDS
ANNUAL ------------
COMPENSATION NUMBER OF
FISCAL ------------------- OTHER ANNUAL OPTIONS ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS COMPENSATION(1) GRANTED(2) COMPENSATION(3)
- - --------------------------- ------ -------- -------- --------------- ------------ ---------------
<S> <C> <C> <C> <C> <C> <C>
Champ Meyercord(4)....... 1998 $ 63,462 $ -- $ -- 4,818,591 $ --
Chairman of the Board 1997 -- -- -- -- --
and Chief Executive 1996 -- -- -- -- --
Officer
James L. Belter(5)....... 1998 $212,519 $100,000(6) $ 9,919 -- $135,868
Executive Vice President 1997 180,003 100,000(6) 15,896 100,000 --
and Treasurer 1996 159,080 50,000(6) 4,330 -- --
</TABLE>
- - -------------------------
(1) Other annual compensation consisted of car allowances, contributions to
401(k) plans and moving expenses.
(2) See "-- Employment Agreements" and "-- Company Stock Option Plans" below.
(3) All other compensation consisted of funds received from the Company for
repurchase of outstanding SARs and stock options.
(4) Mr. Meyercord became Chief Executive Officer of the Company in August 1998.
(5) Mr. Belter resigned from the Company on November 30, 1998.
(6) Bonuses paid to Mr. Belter during fiscal years 1996 and 1997 were
discretionary bonuses determined by the board of directors. The bonus paid
during fiscal 1998 was paid pursuant to an employment contract entered into
with Mr. Belter in August 1997.
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<PAGE> 60
The following table sets forth certain information concerning grants of
stock options made during the fiscal year ended August 31, 1998 to the Named
Executive Officers.
OPTION GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
-------------------------------------------------
PERCENT OF POTENTIAL REALIZABLE VALUE AT
NUMBER OF TOTAL ASSUMED ANNUAL RATES OF
SECURITIES OPTIONS STOCK PRICE APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM
OPTIONS EMPLOYEES IN PRICE EXPIRATION -----------------------------
NAME GRANTED(#) FISCAL YEAR ($/SH) DATE 5%($) 10%($)
- - ---- ---------- ------------ -------- ---------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Champ Meyercord...... 4,818,591 80.1% $1.50 06/29/08 $11,773,465 $18,747,276
Chairman of the
Board and Chief
Executive Officer
James L. Belter...... -- -- -- -- -- --
Executive Vice
President and
Treasurer(1)
</TABLE>
- - -------------------------
(1) Mr. Belter resigned from the Company on November 30, 1998.
The following table sets forth certain information concerning unexercised
stock options held by the Named Executive Officers as of August 31, 1998. No
stock options were exercised by the Named Executive Officers during the fiscal
year ended August 31, 1998. See "-- Company Stock Option Plans."
AGGREGATED FISCAL YEAR-END OPTION VALUE TABLE
<TABLE>
<CAPTION>
VALUE OF UNEXERCISED
NUMBER OF UNEXERCISED IN-THE-MONEY OPTIONS
OPTIONS HELD AT HELD AT
AUGUST 31, 1998 AUGUST 31, 1998(1)
--------------------------- ---------------------------
EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Champ Meyercord.................. -- 4,818,591 $ -- $144,558
James L. Belter(2)............... 20,000 80,000 -- --
</TABLE>
- - -------------------------
(1) The closing sales price of the Company's common stock as reported on the
Nasdaq Stock Market on August 31, 1998 was $1.53. All options held by Mr.
Belter as of August 31, 1998 were granted at exercise prices in excess of
such market price.
(2) Mr. Belter resigned from the Company on November 30, 1998.
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<PAGE> 61
DIRECTOR COMPENSATION
The Company reimburses all directors for their expenses in connection with
their activities as directors of the Company. Directors of the Company who are
also employees of the Company do not receive additional compensation for their
services as directors. Members of the Board of Directors of the Company who are
not employees of the Company receive an annual retainer fee of $30,000 plus
$1,500 for chairing a committee or $1,000 for serving as a member of a
committee. In addition, each director receives $1,000 for each Board or
committee meeting (but only $500 for a committee meeting held on the same day as
a board meeting). Directors are also reimbursed for their expenses incurred in
attending meetings of the board of directors and its committees.
EMPLOYMENT AGREEMENTS
On June 23, 1998, the Company entered into an employment agreement with
Champ Meyercord (the "Meyercord Agreement") pursuant to which Mr. Meyercord
became the Chairman of the Board and Chief Executive Officer of the Company. The
initial term of the agreement terminates on December 31, 2001 and the agreement
will continue on a year-to-year basis unless terminated by either party. The
agreement provides for an initial annual base salary of $300,000. From the date
of the Meyercord Agreement until December 31, 1998, Mr. Meyercord is entitled to
a bonus of at least $250,000. For each subsequent calendar year during the term
of the agreement, Mr. Meyercord shall be entitled to receive bonuses pursuant to
a management incentive compensation plan for senior management to be established
by the Company. Pursuant to the Meyercord agreement, upon consummation of the
Exchange Offer, Mr. Meyercord was granted options to purchase 5% of the total
outstanding shares of common stock outstanding after the recapitalization on a
fully-diluted basis at an exercise price equal to the per share price in the
private placements. In addition, the Meyercord Agreement provides that upon
consummation of an offering of rights to purchase common stock, Mr. Meyercord
shall be granted options to purchase a number of shares of common stock equal to
5% of the number of shares of common stock issued in the offering at an exercise
price equal to price per share in the offering.
Upon termination of the agreement for "cause," Mr. Meyercord will be
entitled to receive his base salary through the effective date of termination
and any determined but unpaid incentive compensation for any bonus period ending
on or before the date of termination. In the event of termination "without
cause," Mr. Meyercord will be entitled to (1) any unpaid base salary through the
date of termination, (2) accrued but unpaid incentive compensation, if any, for
the bonus period ending on or before the date of termination, (3) the
continuation of any benefits through the expiration of the Meyercord Agreement
and (4) the payment, through the date of expiration of the Meyercord Agreement,
of his base salary and incentive compensation (in an amount equal to the
incentive compensation paid to Mr. Meyercord for the calendar year immediately
preceding termination). In the event of a change of control of the Company
accompanied within two years by either (1) termination of Mr. Meyercord's
employment by the Company "without cause" or (2) Mr. Meyercord's voluntarily
termination for "good reason," Mr. Meyercord will be entitled to the amounts
receivable upon a termination "without cause." In addition, upon a change of
control any vested stock options granted to Mr. Meyercord will accelerate and
become immediately vested. The Meyercord Agreement contains a non-competition
provision that generally prohibits Mr. Meyercord from
59
<PAGE> 62
competing with the Company during his employment by the Company and for the two-
year period following the termination of his employment for any reason.
The Company and Mr. Meyercord currently are engaged in discussions which
may result in revisions to the Meyercord Agreement, all of which would be
retroactive to July 1, 1998. The Company initiated these discussions, and the
discussions on behalf of the Company are handled by the Compensation Committee.
The Company is requesting that Mr. Meyercord agree to waive his right under the
Meyercord Agreement to an option to purchase 5% of the Company's common stock in
exchange for an option to be granted under a stock option plan to be adopted by
the Company subject to the Company's shareholders approving the plan and the
related grant to Mr. Meyercord. The Company also desires to make the Meyercord
Agreement subject to the laws of the State of Georgia and to restructure Mr.
Meyercord's noncompetition provision and his other restrictive covenants to
increase the likelihood that a court will enforce these provisions against Mr.
Meyercord. Mr. Meyercord through his attorney in turn has asked for certain
revisions to the Meyercord Agreement, including adding a provision which would
protect him from any excise tax liability and any related income tax liability
from a change in control of the Company, deleting a provision under which the
Company could delay the payment of his compensation if the Company was unable to
claim an income tax deduction for the compensation and clarifying certain
provisions related to his fringe and other benefits. It is not clear whether an
agreement will be reached on any revisions to the Meyercord Agreement or, if an
agreement is reached, when that agreement will be reached. Neither the Company
nor Mr. Meyercord have set a deadline for either reaching an agreement or
abandoning further discussions on revisions to the Meyercord Agreement.
During fiscal 1998, James Belter, the Company's Executive Vice President
and Chief Financial Officer until November 30, 1998, was employed pursuant to an
employment agreement entered into in August 1997. The employment agreement
provided that Mr. Belter was entitled to receive discretionary performance
bonuses based on factors determined by the Committee and the board of directors
in accordance with the Company's executive bonus pool program. Notwithstanding
the foregoing, Mr. Belter was guaranteed to receive a bonus of $100,000 for each
of the first two years of his employment agreement.
The Company intends to enter into employment agreements with certain other
members of senior management, including Messrs. Ralser and Walker.
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<PAGE> 63
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth, as of December 1, 1998, information with
respect to the beneficial ownership of the common stock by (1) each person known
by the Company to be the beneficial owner of more than 5% of the outstanding
shares of common stock, (2) each director of the Company, (3) the Company's
executive officers and (4) all directors and executive officers of the Company
as a group. Unless otherwise noted, the Company believes that all persons named
in the table have sole voting and investment power with respect to all shares of
common stock beneficially owned by them.
<TABLE>
<CAPTION>
NAME AND ADDRESS OF NUMBER OF SHARES PERCENTAGE
BENEFICIAL OWNER(1) BENEFICIALLY OWNED OWNERSHIP(2)
- - ------------------- ------------------ ------------
<S> <C> <C>
DIRECTORS AND EXECUTIVE OFFICERS:
Edward B. Meyercord............................... -- *
J. Richard Walker................................. -- *
Spencer I. Browne................................. 37,260 *
Wm. Paul Ralser................................... 20,000 *
Hubert M. Stiles, Jr.(3).......................... 6,666,667 21.8%
David J. Vida, Jr................................. -- *
John D. Williamson, Jr............................ -- *
All executive officers and directors of the
Company as a group (8 persons).................. 6,723,927 22.0%
OTHER LARGE STOCKHOLDERS:
Value Partners, Ltd.(4)........................... 14,666,740 32.4%
City National Bank(5)............................. 13,333,367 30.1%
Sovereign Bancorp(6).............................. 13,333,367 30.1%
Friedman, Billings, Ramsey Group, Inc.(7)......... 9,742,470 27.9%
Emanuel J. Friedman(7)(8)......................... 6,666,667 21.8%
T. Rowe Price Recovery Fund II, L.P.(3)........... 6,666,667 21.8%
</TABLE>
- - -------------------------
* Less than 1%.
(1) A person is deemed to be the beneficial owner of securities that can be
acquired by such person within 60 days from the date of this prospectus
upon the exercise of options and warrants. Each beneficial owner's
percentage ownership is determined by assuming that options and warrants
that are held by such person (but not those held by any other person) and
that are exercisable within 60 days from the date of this prospectus have
been exercised.
(2) Based on 30,566,660 shares of common stock outstanding as of December 1,
1998.
(3) The address of Mr. Stiles and T. Rowe Price Recovery Fund II, L.P. is 100
East Pratt Street, Baltimore, Maryland 21202. Represents shares
beneficially owned by T. Rowe Price Recovery Fund II, L.P., T. Rowe Price
Recovery Fund II Associates, L.L.C. and T. Rowe Price Associates, Inc. (of
which Mr. Stiles is a vice president).
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<PAGE> 64
Mr. Stiles disclaims beneficial ownership of these shares. Based on a
Schedule 13G filed with the SEC on July 10, 1998. The address of Value
Partners, Ltd. is 4514 Cole Avenue, Suite 808, Dallas, Texas 75205.
Represents shares issuable upon the conversion of 22,000 shares of
preferred stock.
(4) The address of Value Partners, Ltd. is 4514 Cole Avenue, Suite 808, Dallas
Texas 75205. Represents shares issuable upon the conversion of 22,000
shares of preferred stock.
(5) City National Bank's address is 25 Gatewater Road, Charleston, West
Virginia 25313. Represents (i) 6,666,700 shares issuable upon conversion of
preferred stock and (ii) 6,666,667 shares issuable upon exercise of
currently outstanding options.
(6) Sovereign Bancorp's address is 1130 Berkshire Boulevard, P.O. Box 12646,
Reading, Pennsylvania 19612. Represents (i) 6,666,700 shares issuable upon
conversion of preferred stock and (ii) 6,666,667 shares issuable upon
exercise of currently outstanding options.
(7) The address of Friedman, Billings, Ramsey Group, Inc. ("FBRG") is 1001 19th
Street North, Arlington, Virginia 22209. As of December 1, 1998, FBRG,
through its three wholly owned subsidiaries Friedman, Billings, Ramsey
Investment Management, Inc. ("Investment Management"), FBR Offshore
Management, Inc. ("Offshore Management") and Orkney Holdings, Inc.
("Orkney"), had sole voting and dispositive power with respect to 5,359,116
shares of common stock. This number does not include 6,666,667 shares of
common stock owned by Emanuel J. Friedman, as to which FBRG disclaims
beneficial ownership. Investment Management serves as general partner and
discretionary investment manager for FBR Ashton, L.P. ("Ashton") which, as
of December 1, 1998, owned 824,187 shares of common stock and 4,450 shares
of preferred stock (which are convertible into 2,966,681 shares of common
stock). Offshore Management serves as discretionary manager for FBR
Opportunity Fund, Ltd. ("Opportunity Fund") which, as of December 1, 1998,
owned 82,622 shares of Common Stock. Each of FBRG, Investment Management
and Offshore Management disclaims beneficial ownership of shares of common
stock owned by the other two entities. Orkney is a wholly-owned subsidiary
of FBRG which, as of December 1, 1998, owned 4,452,307 shares of common
stock and 2,125 shares of preferred stock (which are convertible into an
aggregate of 1,416,673 shares of common stock). Each of FBRG, Ashton,
Opportunity Fund and Orkney disclaims beneficial ownership of the shares of
common stock owned by the other three entities. In addition, Emanuel J.
Friedman, Eric F. Billings and W. Russell Ramsey are each control persons
with respect to FBRG
(8) Mr. Friedman's address is 1001 19th Street, Arlington, Virginia 22209.
Excludes 5,359,116 shares beneficially owned by FBRG, as to which Mr.
Friedman disclaims beneficial ownership. Mr. Friedman has notified the
Company that, until the earlier of (i) the first date on which he, together
with FBR and its affiliates, holds shares of common stock representing less
than 20% of the total issued and outstanding common stock or (ii) the date
on which he deposits his shares of common stock in a voting trust to be
voted by an unaffiliated third party, he waives the right to vote his
shares of common stock.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Listed below are transactions the Company has entered into with its
affiliates in the past three years. An "affiliate" generally is a person or
entity that is (1) "controlled by the Company," such as an officer of the
Company, (2) that "controls the Company" such as a director of a company, and in
the case of the Company, Mego Financial, the Company's former parent; or (3)
entities under "common control" with a company. PEC, a subsidiary of Mego
Financial, is an affiliate of Mego Financial because it is "controlled by" Mego
62
<PAGE> 65
Financial, and is an affiliate of the Company, because the directors that
controlled the Company until the completion of the recapitalization also
controlled Mego Financial.
RELATIONSHIP WITH GREENWICH
Champ Meyercord, the Company's Chairman of the Board and Chief Executive
Officer, was formerly a senior investment banker at Greenwich Capital Markets
("Greenwich"). In October 1996, Greenwich agreed to purchase from the Company
$2.0 billion of loans over a five year period. The Company has sold Greenwich
approximately $800 million in loans from the inception of the agreement. The
agreement with Greenwich was terminated in June 1998 and the Company has no
further obligation under the agreement.
In April 1997, the Company entered into a pledge and security agreement
with Greenwich 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. As of August 31, 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.
TAX SHARING AND INDEMNITY AGREEMENT
For taxable periods up to the date of the spin-off, the Company's results
of operations were includable in the tax returns filed by Mego Financial's
affiliated group for federal income tax purposes. Under a tax allocation and
indemnity agreement with Mego Financial, the Company recorded a liability to
Mego Financial for federal income taxes calculated on a separate company basis.
Under a prior tax sharing arrangement with Mego Financial, the Company recorded
a liability to Mego Financial for federal income taxes applied to the Company's
financial statement income after giving consideration to applicable income tax
law and statutory rates. In addition, both the agreement and the arrangement
provided that the Company and Mego Financial each will indemnify the other under
certain circumstances. The Company no longer files consolidated returns with
Mego Financial's affiliated group. The Company believes that all obligations
under the tax sharing agreement have been satisfied.
MANAGEMENT SERVICES AGREEMENT WITH PEC
Until the recapitalization; PEC, a subsidiary of Mego Financial, supplied
the Company on an as-needed basis with certain executive, accounting, legal,
management information, data processing, human resources, advertising services
and promotional personnel of PEC provided services to the Company on an "as
needed" basis. The Company paid management fees to PEC in an amount equal to the
direct and indirect expenses of PEC related to the services supplied by its
employees to the Company, including an allocable portion of the salaries and
expenses of these employees based upon the percentage of time these employees
spent performing services for the Company. This arrangement was formalized on
September 1, 1996 by execution of a management agreement (the "Management
Agreement"), in which PEC agreed to provide management services to the Company
for an aggregate annual fee of approximately $967,000. Effective
63
<PAGE> 66
January 1, 1998, the annual fee payable by the Company under the Management
Agreement was reduced to $528,000. The Management Agreement was terminated on
June 29, 1998.
For the years ended August 31, 1996, 1997 and 1998, approximately $671,000,
$967,000 and $617,000, respectively, of the salaries and expenses of these
employees of PEC were attributable to and paid by the Company in connection with
services supplied by these employees to the Company. In addition, during the
years ended August 31, 1996 and 1997, the Company paid PEC for developing
computer programming, incurring costs of $56,000 and $0, respectively. During
the year ended August 31, 1998, these costs were $0.
SUB-SERVICING AGREEMENT WITH PEC
Prior to September 1, 1996, PEC sub-serviced the Company's loans pursuant
to which it paid servicing fees of 50 basis points on the principal balance of
loans serviced per year. For the years ended August 31, 1996, 1997 and 1998, the
Company paid sub-servicing fees to PEC of approximately $709,000, $1.9 million
and $2.1 million, respectively. The Company entered into a servicing agreement
with PEC (the "Servicing Agreement"), effective as of September 1, 1996,
providing for the payment of servicing fees of 50 basis points on the principal
balance of loans serviced per year. For the years ended August 31, 1996, 1997
and 1998, the Company incurred interest expense in the amount of $29,000,
$16,000 and $0, respectively, related to fees payable to PEC for these services.
The interest rates were based on PEC's average cost of funds and equaled 10.68%
in 1996 and 10.48% in 1997. Effective September 1, 1997, the servicing fees were
reduced to 40 basis points per year and effective January 1, 1998, the servicing
fees were further reduced to 35 basis points per year. The Servicing Agreement
has been terminated as the mortgage servicing rights were transferred to City
National Bank.
FUNDING AND GUARANTEES BY MEGO FINANCIAL
In order to fund the Company's past operations and growth, and in
conjunction with filing consolidated returns, the Company borrowed money from
Mego Financial. As of August 31, 1996, 1997 and 1998, the amount of intercompany
debt owed to Mego Financial was $12.0 million, $9.7 million and $0,
respectively. Prior to the initial public offering, Mego Financial had
guaranteed the Company's obligations under the Company's credit agreements and
an office lease. The guarantees of the Company's credit agreements were released
on the completion of the initial public offering. The Company did not pay any
compensation to Mego Financial for such guarantees.
In November 1996, Greenwich agreed to purchase from the Company $2.0
billion of loans over a five year period. Pursuant to the agreement, Mego
Financial issued to Greenwich four-year warrants to purchase 1.0 million shares
of Mego Financial's common stock. The value of the warrants, estimated at $3.0
million (0.15% of the commitment amount) as of the commitment date (the "Warrant
Value") plus a $150,000 fee has been written off as the commitment for the
purchase of loans has been terminated.
On August 29, 1997, the Company and Mego Financial entered into the Payment
Agreement for the Company's repayment after the spin-off of (1) a portion of the
debt owed by the Company to Mego Financial as of May 31, 1997 and (2) debt owed
by the Company to Mego Financial as of August 31, 1997. Upon consummation of the
sale of the Old Notes in October 1997, $3.9 million was paid in accordance with
the Payment
64
<PAGE> 67
Agreement. In April 1998, the Company and Mego Financial entered into an
agreement (the "1998 Agreement") superseding the Payment Agreement. Pursuant to
the 1998 Agreement, the parties agreed to reduce the amounts owed to Mego
Financial and agreed to pay such amounts upon the occurrence of certain events.
In connection with the Recapitalization, the Company paid PEC $1.6 million to
satisfy fully all amounts owed to Mego Financial pursuant to the Payment
Agreement and the 1998 Agreement, and the 1998 Agreement was terminated.
RELATIONSHIPS WITH FBR
FBR served as placement agent for the private placements pursuant to a
placement agreement (the "Placement Agreement"). Under the terms of the
Placement Agreement, the Company paid FBR a fee 1.6 million shares of common
stock equal to 6.0% of the gross proceeds received by the Company from the sale
of the shares of common stock and preferred stock in the recapitalization. The
gross proceeds did not include $10.0 million of Common Stock acquired by an
affiliate of FBR. In addition, the Company has agreed, pursuant to the Placement
Agreement, to indemnify FBR against certain liabilities, including liabilities
under the Securities Act, and other liabilities incurred in connection with the
recapitalization. In addition, the Company paid to FBR an advisory fee of
$416,667 in connection with the recapitalization.
FBR was a managing underwriter for the Company's initial public offering
and the Company's public offering of $40.0 million of Old Notes, and was the
initial purchaser for the Company's private offering of another $40.0 million of
the Old Notes. FBR received compensation for such services and the Company
agreed to indemnify FBR against certain liabilities, including liabilities under
the Securities Act, and other liabilities arising in connection with such
offerings. In addition, FBR has in the past provided certain investment banking
services to the Company and affiliates of the Company.
THE RECAPITALIZATION
For a description of transactions with related parties in connection with
the recapitalization, see "Business -- The Recapitalization."
65
<PAGE> 68
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements and Schedules
1. The following financial statements are filed with this report on the pages
indicated:
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
MEGO MORTGAGE CORPORATION
Report of Independent Public Accountant..................... 68
Statements of Financial Condition at August 31, 1997 and
1998...................................................... 69
Statements of Operations for the years ended August 31,
1996, 1997 and 1998...................................... 70
Statements of Cash Flows for the years ended August 31,
1996, 1997 and 1998...................................... 71
Statements of Stockholders' Equity for the years ended
August 31, 1996, 1997 and 1998........................... 73
Notes to Consolidate Financial Statements................... 74
</TABLE>
2. The Company is not required to file any financial statement schedules.
3. Exhibits
See Item 14(c) below.
(b) On July 15, 1998, the Company filed a Current Report on Form 8-K
announcing completion of the recapitalization.
(c) Exhibits.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- - -------- -----------
<C> <C> <S>
3.1(1) -- Amended and Restated Certificate of Incorporation of the
Company.
3.2(1) -- By-laws of the Company, as amended.
4.1(1) -- Specimen Common Stock Certificate.
10.1(1) -- 1996 Stock Option Plan.
10.2(1) -- Office Lease by and between Mass Mutual and the Company
dated April 1996.
10.3(2) -- Credit Agreement between the Company and Textron Financial
Corporation dated October 22, 1997.
10.4(2) -- Excess Yield and Servicing Rights and Assumption Agreement
between the Company and Greenwich Capital Markets, Inc.
dated January 22, 1998
10.5(2) -- Agreement between the Company and Preferred Equities
Corporation, dated February 9, 1998, regarding assignment of
rights related to the Loan Program Sub-Servicing Agreement
to Greenwich Capital Markets, Inc.
</TABLE>
66
<PAGE> 69
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- - -------- -----------
<C> <C> <S>
10.6(2) -- Amendment to Excess Yield and Servicing Rights and
Assumption Agreement between the Company and Greenwich
Capital Markets, Inc. dated February 10, 1998
10.7(2) -- Second Amendment to Excess Yield and Servicing Rights and
Assumption Agreement between the Company and Greenwich
Capital Markets, Inc. dated February, 1998
10.8(3) -- Preferred Stock Purchase Agreement dated as of June 9, 1998
between City National Bank of West Virginia and Mego
Mortgage Corporation
10.9(3) -- Stock Option Agreement dated as of June 29, 1998 by Mego
Mortgage Corporation in favor of City National Bank of West
Virginia
10.10(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and City National Bank of
West Virginia
10.11(3) -- Bulk Servicing Purchase Agreement dated as of June 26, 1998
between City National Bank of West Virginia and Mego
Mortgage Corporation
10.12(3) -- Servicing Agreement dated as of June 26, 1998 between Mego
Mortgage Corporation and City Mortgage Services
10.13(3) -- Subservicing Agreement dated as of June 29, 1998 between
Mego Mortgage Corporation and City Mortgage Services
10.14(3) -- City Mortgage Services Option Agreement dated as of June 29,
1998 between City National Bank of West Virginia and Mego
Mortgage Services
10.15(3) -- Right of First Refusal Agreement dated as of June 29, 1998
among City National Bank of West Virginia, Sovereign
Bancorp, Inc. and Mego Mortgage Corporation
10.16(3) -- Preferred Stock Purchase Agreement dated as of June 9, 1998
between Mego Mortgage Corporation and Sovereign Bancorp,
Inc.
10.17(3) -- Stock Option Agreement Dated as of June 29, 1998 by Mego
Mortgage Corporation in favor of Sovereign Bancorp, Inc.
10.18(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation in favor of Sovereign
Bancorp, Inc.
10.19(4) -- Participation Agreement dated as of June 29, 1998 between
Mego Mortgage Corporation and Sovereign Bank
10.20(4) -- Master Mortgage Loan Purchase Agreement dated as of June 29,
1998 between Sovereign Bank and Mego Mortgage Corporation
10.21(4) -- Form of Custodian Agreement dated as of June 29, 1998 among
Sovereign Bank, State Street Bank and Trust Company and Mego
Mortgage Corporation
10.22(4) -- Common Stock Purchase Agreement dated as of June 9, 1998
between Mego Mortgage Corporation and Emanuel J. Friedman
10.23(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and Emanuel J. Friedman
10.24(4) -- Indenture dated as of June 29, 1998 between Mego Mortgage
Corporation and American Stock Transfer & Trust Company, as
Trustee
</TABLE>
67
<PAGE> 70
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- - -------- -----------
<C> <C> <S>
10.25(4) -- Form of Note issued pursuant to Indenture dated as of June
29, 1998 between Mego Mortgage Corporation and American
Stock Transfer & Trust Company, as Trustee
10.26(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and Friedman, Billings,
Ramsey & Co., Inc., as placement agent
10.27(4) -- Registration Rights Agreement dated as of June 29, 1998
between Mego Mortgage Corporation and Friedman, Billings,
Ramsey & Co., Inc., as placement agent
10.28(4) -- Certificate of Designations, Preferences and Rights of
Series A Convertible Preferred Stock of Mego Mortgage
Corporation
10.29(3) -- Co-Sale Agreement dated as of June 29, 1998 among Mego
Mortgage Corporation, Emanuel J. Friedman, Friedman,
Billings, Ramsey & Co., Inc., City National Bank of West
Virginia and Sovereign Bancorp, Inc.
10.30(4) -- Employment Agreement dated June 23, 1998 between Mego
Mortgage Corporation and Edward B. "Champ" Meyercord
21.1(5) -- Subsidiaries of the Registrant
27.1(5) -- Financial Data Schedule (for SEC purposes only)
</TABLE>
- - -------------------------
(1) Filed as part of the Registration Statement on Form S-1 filed by the
Company, as amended (File No. 333-12443), and incorporated herein by
reference.
(2) Filed as part of the Form 10-Q for the quarter ended February 28, 1998 and
incorporated herein by reference.
(3) Filed as part of the Form 10-Q for the quarter ended May 31, 1998 and
incorporated herein by reference.
(4) Filed as part of the Form 10-Q/A for the quarter ended May 31, 1998.
(5) Previously filed.
68
<PAGE> 71
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Mego Mortgage Corporation
Atlanta, Georgia
We have audited the accompanying statements of financial condition of Mego
Mortgage Corporation (the "Company") as of August 31, 1997 and 1998, and the
related financial statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended August 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of Mego Mortgage Corporation at August 31, 1997
and 1998, and the results of its operations and its cash flows for each of the
three years in the period ended August 31, 1998 in conformity with generally
accepted accounting principles.
DELOITTE & TOUCHE LLP
San Diego, California
December 14, 1998
69
<PAGE> 72
MEGO MORTGAGE CORPORATION
STATEMENTS OF FINANCIAL CONDITION
<TABLE>
<CAPTION>
AUGUST 31,
-----------------------
1997 1998
---------- ----------
(THOUSANDS OF DOLLARS,
EXCEPT PER SHARE
AMOUNTS)
<S> <C> <C>
ASSETS
Cash and cash equivalents.................................. $ 6,104 $ 36,404
Cash deposits, restricted.................................. 6,890 3,662
Loans held for sale, net of allowance for credit losses of
$100 and $76 and valuation allowance of $0 and $10,901... 9,523 10,975
Mortgage related securities, at fair value................. 106,299 34,830
Mortgage servicing rights.................................. 9,507 83
Other receivables.......................................... 7,945 5,078
Property and equipment, net of accumulated depreciation of
$675 and $1,181.......................................... 2,153 1,813
Organizational costs, net of amortization.................. 289 96
Prepaid debt expenses...................................... 2,362 2,790
Prepaid commitment fee..................................... 2,333 --
Deferred federal income tax asset.......................... 2,354 5,376
Deferred state income tax asset............................ -- 3,064
Other assets............................................... 795 364
-------- --------
Total assets..................................... $156,554 $104,535
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes and contracts payable.............................. $ 35,572 $ 16,345
Accounts payable and accrued liabilities................. 20,212 16,431
Allowance for credit losses on loans sold with
recourse.............................................. 7,014 2,472
State income taxes payable............................... 649 --
Subordinated debt........................................ 40,000 42,693
-------- --------
Total liabilities................................ 103,447 77,941
-------- --------
Commitments and contingencies (Note 16)
Stockholders' equity:
Convertible Preferred stock, $.01 par value per share
(authorized -- 5,000,000 shares; issued and
outstanding -- 0 and 62,500).......................... -- 1
Common stock, $.01 par value per share (authorized --
400,000,000 shares; issued and
outstanding -- 12,300,000 and 30,566,667)............. 123 306
Additional paid-in capital............................... 29,185 122,143
Retained earnings (accumulated deficit).................. 23,799 (95,856)
-------- --------
Total stockholders' equity....................... 53,107 26,594
-------- --------
Total liabilities and stockholders' equity....... $156,554 $104,535
======== ========
</TABLE>
See notes to financial statements.
70
<PAGE> 73
MEGO MORTGAGE CORPORATION
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
-----------------------------------------
1996 1997 1998
--------- ------------- -------------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE
AMOUNTS)
<S> <C> <C> <C>
REVENUES:
Gain (loss) on sale of loans................ $16,539 $ 45,123 $ (26,578)
Net unrealized gain (loss) on mortgage
related securities....................... 2,697 3,518 (70,024)
Loan servicing income, net.................. 3,348 3,036 999
Interest income............................. 2,104 9,507 14,786
Less: interest expense...................... (1,116) (6,374) (13,162)
------- ----------- -----------
Net interest income...................... 988 3,133 1,624
------- ----------- -----------
Total revenues (losses)............. 23,572 54,810 (93,979)
------- ----------- -----------
COST AND EXPENSES:
Net provision (benefit) for credit losses... 55 6,300 (3,198)
Depreciation and amortization............... 394 672 1,013
Other interest.............................. 167 245 439
General and administrative:
Payroll and benefits..................... 6,328 13,052 18,582
Credit reports........................... 367 1,387 510
Rent and lease expenses.................. 338 1,199 1,616
Professional services.................... 1,771 2,271 4,783
Sub-servicing fees....................... 709 1,874 2,160
Other services........................... 665 1,352 2,068
FHA insurance............................ 572 558 430
Travel................................... 677 1,005 1,159
Other.................................... 374 1,085 2,448
------- ----------- -----------
Total costs and expenses............ 12,417 31,000 32,010
------- ----------- -----------
Income (Loss) Before Income Taxes............. 11,155 23,810 (125,989)
Income Tax Expense (Benefit).................. 4,235 9,062 (6,334)
------- ----------- -----------
Net Income (Loss)............................. $ 6,920 $ 14,748 $ (119,655)
======= =========== ===========
EARNINGS PER COMMON SHARE:
Basic:
Net income (loss)........................ $ 1.25 $ (7.72)
=========== ===========
Weighted-average number of common
shares................................. 11,802,192 15,502,926
=========== ===========
Diluted:
Net income (loss)........................ $ 1.25 $ (7.72)
=========== ===========
Weighted-average number of common shares
and assumed conversions................ 11,802,192 15,502,926
=========== ===========
</TABLE>
See notes to financial statements.
71
<PAGE> 74
MEGO MORTGAGE CORPORATION
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
---------------------------------
1996 1997 1998
--------- --------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)............................ $ 6,920 $ 14,748 $(119,655)
--------- --------- ---------
Adjustments to reconcile net income to net
cash used in operating activities:
Loans originated for sales, net of loan
fees.................................... (139,367) (526,917) (365,694)
Proceeds from sale of loans............... 135,483 514,413 360,303
Payments on loans held for sale........... 504 431 2,191
Lower of cost or market adjustment........ -- -- 10,901
Net provisions (benefit) for estimated
credit losses........................... 55 6,300 (3,198)
Additions to mortgage related
securities.............................. -- (135,549) (22,469)
Accretion of residual interest on mortgage
related securities...................... (243) (6,207) (8,467)
Write-off/sale of mortgage related
securities.............................. -- 67,040 27,573
Market valuation of mortgage related
securities.............................. (2,697) 5,612 73,390
Payments on mortgage related securities... 1,547 801 1,442
Additions to excess servicing rights...... (20,563) (3,887) --
Amortization of excess servicing rights... 2,144 956 --
Additions to mortgage servicing rights.... (3,306) (7,184) (3,529)
Amortization of mortgage servicing
rights.................................. 555 1,504 3,166
Proceeds from sale of mortgage servicing
rights.................................. -- -- 4,137
Write-off /valuation of mortgage servicing
rights.................................. -- -- 3,870
Gain on disposal of fixed assets.......... -- -- (16)
Depreciation and amortization expense..... 394 672 1,013
Additions to prepaid debt expenses, net... -- -- (4,066)
Amortization of prepaid debt expense...... 163 684 1,387
Additions to prepaid commitment fee,
net..................................... -- -- (1,250)
Amortization/write-off of prepaid
commitment fee.......................... -- 817 3,583
Changes in operating assets and
liabilities:
Cash deposits, restricted............... (1,942) (2,416) 3,228
Deferred income taxes (benefit)......... 673 (3,267) (6,086)
Other assets, net....................... 1,056 (1,813) 5,017
State income taxes payable.............. 670 (260) (649)
Other liabilities, net.................. 5,514 1,084 (5,845)
--------- --------- ---------
Total adjustments.................... (19,360) (87,186) 79,932
--------- --------- ---------
Net cash used in operating
activities........................ (12,440) (72,438) (39,723)
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment........... (608) (1,688) (345)
Proceeds from the sale of property and
equipment................................. -- 4 16
--------- --------- ---------
Net cash used in investing
activities........................ (608) (1,684) (329)
--------- --------- ---------
</TABLE>
72
<PAGE> 75
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
---------------------------------
1996 1997 1998
--------- --------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings on notes and
contracts payable......................... 146,448 511,878 334,143
Payments on notes and contracts payable...... (133,709) (490,503) (353,370)
Issuance of subordinated debt................ -- 37,750 40,400
Repurchase of subordinated debt.............. -- -- (125)
Amortization of premium of subordinated
debt...................................... -- -- (82)
Sale of common stock......................... -- 20,658 25,000
Sale of preferred stock...................... -- -- 25,000
Payment of issuance costs.................... -- -- (614)
--------- --------- ---------
Net cash provided by financing
activities........................ 12,739 79,783 70,352
--------- --------- ---------
NET (DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS.................................. (309) 5,661 30,300
CASH AND CASH EQUIVALENTS -- BEGINNING OF
YEAR......................................... 752 443 6,104
--------- --------- ---------
CASH AND CASH EQUIVALENTS -- END OF YEAR....... $ 443 $ 6,104 $ 36,404
========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid during the year for:
Interest.................................. $ 964 $ 5,212 $ 12,380
State income taxes........................ $ 25 $ 1,691 $ 506
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:
Additional paid-in capital created from
deferred tax asset........................ $ -- $ -- $ 2,354
Forgiveness of due to Mego Financial
liability................................. $ -- $ -- $ 6,153
Record liability to repurchase loans from
City Mortgage Services.................... $ -- $ -- $ 9,255
Exchange of Subordinated Notes for
Subordinated Notes........................ $ -- $ -- $ 41,500
Exchange of Subordinated Notes for Preferred
Stock..................................... $ -- $ -- $ 37,500
Placement agent service fee paid in common
stock..................................... $ -- $ -- $ 2,400
Addition to prepaid commitment fee and due to
Mego Financial in connection with loan
sale commitment received.................. $ -- $ 3,000 $ --
In connection with the securitization of
loans and creation of mortgage related
securities, the Company retained an
interest only security and a residual
interest security......................... $ 20,096 $ -- $ --
</TABLE>
See notes to financial statements.
73
<PAGE> 76
MEGO MORTGAGE CORPORATION
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
<TABLE>
<CAPTION>
CONVERTIBLE
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 September 1,
1995.................... -- $ -- 10,000,000 $100 $ 8,550 $ 2,131 $ 10,781
Net income................ -- -- -- -- -- 6,920 6,920
------- ---- ---------- ---- -------- --------- ---------
Balance at August 31,
1996.................... -- -- 10,000,000 100 8,550 9,051 17,701
Sale of common stock, net
of issuance costs....... -- -- 2,300,000 23 20,635 -- 20,658
Net income................ -- -- -- -- -- 14,748 14,748
------- ---- ---------- ---- -------- --------- ---------
Balance at August 31,
1997.................... -- -- 12,300,000 123 29,185 23,799 53,107
Increase in additional
paid-in capital due to
adjustment of deferred
federal income tax asset
related to Spin-off..... -- -- -- -- 2,354 -- 2,354
Increase in additional
paid-in capital due to
settlement of amount
payable to Mego
Financial Corp. related
to Spin-off............. -- -- -- -- 6,153 -- 6,153
Sale of common stock, net
of issuance costs....... -- -- 18,266,667 183 26,854 -- 27,037
Sale of Series A
convertible preferred
stock and exchange of
Senior Subordinated
Notes for Series A
convertible preferred
stock, net of issuance
costs................... 62,500 1 -- -- 57,597 -- 57,598
Net loss.................. -- -- -- -- -- (119,655) (119,655)
------- ---- ---------- ---- -------- --------- ---------
Balance at August 31,
1998.................... 62,500 $ 1 30,566,667 $306 $122,143 $ (95,856) $ 26,594
======= ==== ========== ==== ======== ========= =========
</TABLE>
See notes to financial statements.
74
<PAGE> 77
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
1. NATURE OF OPERATIONS
Mego Mortgage Corporation (the "Company") was incorporated on June 12,
1992, in the State of Delaware. 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. These loans are used to, among other
things, purchase one-to-four family residences, refinance existing mortgages,
consolidate debt and finance home improvements. The Company's loan products are:
- Home Equity loans, primarily secured by first liens, and to a
substantially lesser extent by second liens, on the borrower's residence.
The Company's Home Equity loans are made to borrowers who, because of
their credit history, income or other factors, do not conform to the
lending criteria of government-chartered agencies (including GNMA, FHLMC
or FNMA) mortgage guarantee or purchase programs. As a result, the
Company's borrowers pay a higher rate of interest and are able to borrow
a lesser amount of the appraised value of their residences than
conforming borrowers.
- Equity + loans, typically secured by a second lien on the borrower's
primary residence. The initial principal amount of an Equity + loan when
added to the other outstanding senior secured debt on the residence may
result in a loan to value ("LTV") of up to 125%.
Historically, a significant majority of the Company's loan production was
purchased from approved mortgage bankers and other financial intermediaries. The
Company funds loans that are originated through its network of over 169
pre-approved mortgage brokers as of August 31, 1998. 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 by the
Company's personnel. Effective in January 1998, the Company's operating strategy
was to sell substantially all of its loan production for cash to institutional
purchasers.
Certain of the loans 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"). Prior to May 1996, the
Company produced only Title I loans. 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 produced 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, 1998. In May 1996, the Company commenced the production of Equity + home
improvement loans, generally secured by residential real estate, and debt
consolidation loans ("Equity + loans") through its network of mortgage bankers
and mortgage brokers.
During fiscal 1995, all loans produced were Title I loans. During fiscal
1996, 91.7% of loans produced were Title I loans and 8.3% of loans produced were
Equity + loans. The Company's loan production during the fiscal year ended
August 31, 1997 was comprised of 81.4% Equity + loans and 18.6% Title I loans.
In December 1997, the Company
75
<PAGE> 78
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
commenced the origination of Home Equity loans. The Company's loan production
during the fiscal year ended August 31, 1998 was comprised of 91.6% Equity +
loans, 5.5% Title I loans, and 2.9% Home Equity loans.
The Company was a wholly owned subsidiary of Mego Financial Corp. ("Mego
Financial") 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 the
IPO, Mego Financial's ownership in the Company was reduced from 100% at August
31, 1996 to 81.3%. Concurrently with the IPO, 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 were used to
repay borrowings and provide funds for production 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").
The proceeds from the Private Placement were used to repay borrowings, including
borrowings from Mego Financial, and to provide funds for loan production, the
securitizations of loans and working capital. The $80.0 million of 12.5% Senior
Subordinated Notes due in 2001 are herein referred to as old notes (the "Old
Notes").
On September 2, 1997, Mego Financial distributed all of its 10 million
shares of the Company's Common Stock to its stockholders in a tax-free spin-off
("Spin-off").
On July 1, 1998, the Company completed a series of transactions to
recapitalize the Company (the "Recapitalization"). Pursuant to the
Recapitalization, the Company raised approximately $84.5 million of additional
equity, net of issuance costs. Two strategic partners each purchased 10,000
shares of the Company's newly-designated Series A Convertible Preferred Stock
(the "Preferred Stock") at a purchase price of $1,000 per share. The purchasers
have each been granted an option, which expires in December 2000, to acquire
6.67 million shares of the Company's Common Stock, subject to adjustment. The
number and price of the Company's Common Stock purchasable upon exercise of the
option is subject to adjustment from time to time upon the occurrence of: (1)
mergers and reclassifications; (2) dividends, subdivisions, combinations; (3)
adjustments for issuance below option price; (4) adjustments for issuances below
fair market value; (5) special rules and (6) other actions affecting capital
stock. The Preferred Stock will be mandatorily converted into Common Stock on
June 18, 2000. Each purchaser has a right of first refusal to purchase the
Company in the event the Company's Board of Directors determines to sell the
Company. In addition, other private investors purchased an aggregate of 5,000
shares of Preferred Stock at a purchase price of $1,000 per share and 16.67
million shares of Common Stock at a purchase price of $1.50 per share. All of
the foregoing sales were made pursuant to private placements.
As part of the Recapitalization, the Company completed an offer to exchange
(the "Exchange Offer") new subordinated notes and Preferred Stock, subject to
certain limitations, for any and all of the outstanding Old Notes. The Exchange
Offer was conditioned upon at least $76.0 million aggregate principal amount of
Old Notes being tendered for exchange and conditioned upon at least $30.0
million shares of Common
76
<PAGE> 79
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Stock and Preferred Stock being sold in the offerings. The Company would not
have consummated the Exchange Offer if less than $30.0 million was raised in the
offerings. Pursuant to the Exchange Offer, the Company issued approximately
37,500 shares of Preferred Stock at an issuance price of $1,000 per share, and
$41.5 million principal amount of new 12.5% Subordinated Notes due 2001 (the
"Current Notes") in exchange for approximately $79.0 million principal amount of
Old Notes. The balance of the Old Notes was repurchased by the Company in
September and October 1998. The proceeds of the Recapitalization was $50.0
million. The proceeds were used to repay indebtedness, including $1.6 million to
a subsidiary of Mego Financial, $5.1 million of interest on the Old Notes and
$2.4 million on the warehouse line of credit, to provide capital to originate
loans and for other general corporate uses.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash and Cash Equivalents -- Cash and cash equivalents consist of cash on
hand and on deposit at financial institutions and short term investments with
original maturities of 90 days or less when purchased.
Cash Deposits, Restricted -- Restricted cash represents cash on deposit
which is restricted in accordance with the loan sale agreements and funds
received from collection of loans which have not yet been disbursed to the
purchasers of such loans in accordance with the loan sale agreements.
Loans Held for Sale -- Loans held for sale are carried at the lower of
aggregate cost or market value in the accompanying Statements of Financial
Condition, net of allowance for credit losses.
Allowance for Credit Losses -- Provision for credit losses relating to
unsold loans is recorded as expense in amounts sufficient to maintain the
allowance at a level considered adequate to provide for anticipated probable
losses resulting from liquidation of outstanding loans. The provision for credit
losses is based upon periodic analysis of the portfolio, economic conditions and
trends, historical credit loss experience, borrowers' ability to repay,
collateral values, and estimated FHA insurance recoveries on loans produced.
Valuation Allowance -- Provision for decreases in the market value relating
to unsold loans is recorded as expense in amounts sufficient to maintain the
allowance at a level considered adequate to provide for anticipated probable
losses from liquidation of outstanding loans. The provision for valuation is
based upon the estimated fair market value of the portfolio primarily derived
from recent sale data in the marketplace.
Loan Origination Costs and Fees -- Loan origination costs and fees
including non-refundable loan origination fees and incremental direct costs
associated with loan production are deferred in compliance with Statement of
Financial Accounting Standards ("SFAS") No. 91 "Accounting for Nonrefundable
Fees and Costs associated with Originating or Acquiring Loans and Indirect
Direct Costs of Leases." ("SFAS 91") and recorded as expense or income upon the
sale of the related loans.
77
<PAGE> 80
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Mortgage Related Securities -- In fiscal 1996, the Company securitized a
majority of loans produced into the form of a REMIC. A REMIC is a trust issuing
multi-class securities with certain tax advantages to investors and which
derives its cash flow from a pool of underlying mortgages. Certain of the senior
classes of the REMIC are sold, and an interest only strip and a subordinated
residual class are retained by the Company. The subordinated residual class is
in the form of residual certificates which are classified as residual interest
securities. The documents governing the Company's securitizations require the
Company to establish initial over-collateralization or build
over-collateralization levels through retention of distributions by the REMIC
trust otherwise payable to the Company as the residual interest holder. This
over-collateralization causes the aggregate principal amount of the loans in the
related pool and/or cash reserves to exceed the aggregate principal balance of
the outstanding investor certificates. Such excess amounts serve as credit
enhancement for the related REMIC trust. To the extent that borrowers default on
the payment of principal or interest on the loans, losses will reduce the over-
collateralization and cash flows otherwise payable to the residual interest
security holder to the extent that funds are available. If payment defaults
exceed the amount of over-collateralization, as applicable, the insurance policy
maintained by the related REMIC trust will pay any further losses experienced by
holders of the senior interests in the related REMIC trust. The Company does not
have any recourse obligations for credit losses in the REMIC trust.
In fiscal 1997, the Company completed five securitizations, including two
non-monoline securitizations, two owner's trust securitizations and a combined
REMIC grantor trust securitization.
The two non-monoline securitizations completed in June and August 1997,
were accomplished on a senior subordinated basis without insurance as a credit
enhancement and were generally collateralized by Equity + home improvement and
debt consolidation mortgage loans with typically high loan-to-value ratios. The
other three securitization transactions were insured and collateralized by a
combination of Title I and Equity + loans. The two monoline owner's trust
securitizations were completed in March and May 1997. The REMIC/grantor trust
securitization, completed in December 1996, placed all secured Title I loans and
those Equity + loans which qualified with a loan-to-value ratio of 125% or less,
into the REMIC pool. The grantor trust pool was comprised of unsecured Title I
loans and other Equity + loans which did not qualify for the REMIC pool.
In August 1998, the Company pooled approximately $90.5 million (27.4%) of
its loans with an additional $239.6 million (72.6%) from a second party to
create a home loan owner trust securitization. The Company is to receive a
residual interest in this securitization calculated on a pro rata share of the
Company loans originated in the total pool. This residual interest will be owned
two-thirds by the Company and one-third by another financial institution.
Cashflow on the Company's residual interest will be subordinated to recovery by
the financial institution of: (1) premium paid for in the acquisition of the
pool; (2) upfront overcollateralization of 1.25% of the total pool; (3) the
financial institution's underwriting fee and (4) transaction costs. The total of
these recoveries will accrue interest at a 12% per annum rate until recovered.
The target
78
<PAGE> 81
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
overcollateralization level of 6% must be achieved prior to the financial
institution receiving any recoveries.
Pursuant to these securitizations, various classes of mortgage-backed notes
and certificates were issued and sold to the public. The Company received
residual interest securities, servicing rights and, in some of the transactions,
interest only strip securities, all of which (except for the servicing rights)
were recorded as mortgage related securities on the Statements of Financial
Condition. The residual interest securities and the servicing rights represent
the excess differential (after payment of any subservicing, 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. The
Company has also received interest only strip securities from the first two
securitizations completed in fiscal 1996 and the first two securitizations
completed in fiscal 1997. These interest only securities yield annual rates
between 0.45% and 1.00% calculated on the principal balances of loans not in
default. The Company may be required to repurchase loans that do not conform to
the representations and warranties made by the Company in the securitization
agreements and as servicer, may be required to advance interest in connection
with the securitizations. Effective January 1, 1997, the Company prospectively
adopted SFAS 125 (as defined below).
In accordance with the provisions of SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115"), the Company classifies
residual interest securities, interest only strip securities and interest only
receivables as trading securities which are recorded at fair value with any
unrealized gains or losses recorded in the results of operations in the period
of the change in fair value. Valuations at origination and at each reporting
period are based on discounted cash flow analyses. The cash flows are estimated
as the excess of the weighted-average coupon on each pool of loans securitized
over the sum of the pass-through interest rate, servicing fees, a trustee fee,
an insurance fee and an estimate of annual future credit losses, net of Federal
Housing Administration ("FHA") insurance recoveries, related to the loans
securitized, over the life of the loans. These cash flows are projected over the
life of the loans using prepayment, default, and loss assumptions that the
Company believes market participants would use for similar financial instruments
and are discounted using an interest rate that the Company believes a purchaser
unrelated to the seller of such a financial instrument would require. The
valuation includes consideration of characteristics of the loans including loan
type and size, interest rate, origination date, and term. The Company also uses
other available information such as externally prepared reports on prepayment
rates and industry default rates of the type of loan portfolio under review. To
the Company's knowledge, there is no active market for the sale of these
mortgage related securities. The range of values attributable to the factors
used in determining fair value is broad. Although the Company believes that it
has made reasonable estimates of the fair value of the mortgage related
securities, the rate of prepayments, discount and default rates utilized are
estimates, and actual experience may differ.
Revenue Recognition-Gain(Loss) on Sale of Loans -- Gain on sale of loans
includes the gain on sale of mortgage related securities and the gain(loss) on
sale of loans held for sale. In accordance with SFAS 125 (as discussed below)
the gain on sale of mortgage
79
<PAGE> 82
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
related securities is determined by an allocation of the cost of the securities
based on the relative fair value of the securities sold and the securities
retained. In sales of loans through securitization transactions, the Company
retains residual interest securities and may retain interest only strip
securities. The fair value of the interest only strip securities and residual
interest securities is the present value of the estimated cash flow to be
received after considering the effects of estimated prepayments and credit
losses. The interest only strip securities and residual interest securities are
included in mortgage related securities on the Company's Statements of Financial
Condition. Market valuation adjustments on loans held for sale and loans
reacquired under recourse provisions are included in the gain(loss) on sale of
loans.
In discounting cash flows related to loan sales, the Company defers
servicing income at annual rates of 1% to 1.25% and discounts cash flows on its
sales at the rate it believes a purchaser would require as a rate of return. The
cash flows were discounted to present value using discount rates which
approximated 12% for each of the years ended August 31, 1996 and 1997 and 16%
for the year ended August 31, 1998. The Company has developed its assumptions
based on experience with its own portfolio, available market data and ongoing
consultation with its investment bankers.
In determining expected cash flows, management considers economic
conditions at the date of sale. In subsequent periods, these estimates may be
revised as necessary using the original discount rate, and any losses arising
from prepayment and loss experience will be recognized as realized.
Mortgage Servicing Rights -- The fair value of capitalized mortgage
servicing rights is estimated by calculating the present value of expected net
cash flows from mortgage servicing rights using assumptions the Company believes
market participants would use in their estimates of future servicing income and
expense, including assumptions about prepayment, default and interest rates.
Mortgage servicing rights are amortized in proportion to and over the period of
estimated net servicing income. The estimate of fair value was based on a 125,
100 and 100 basis points per annum, respectively, servicing fee reduced by
estimated costs of servicing for the years ended August 31, 1996, 1997 and 1998.
The estimated net cash flow from servicing utilized a discount rate of 12% for
the fiscal years ending August 31, 1996 and 1997, and 16% for the year ended
August 31, 1998. At August 31, 1997 and 1998, the book value of mortgage
servicing rights approximated fair value. The Company periodically reviews
mortgage servicing rights to determine impairment. This review is performed on a
disaggregated basis, based upon loan type and date of origination. Impairment is
recognized in a valuation allowance for each pool in the period of impairment.
The Company has developed its assumptions based on experience with its own
portfolio, available market data and ongoing consultation with its investment
bankers.
Property and Equipment -- Property and equipment is stated at cost and is
depreciated over its estimated useful life (generally five years) using the
straight-line method. Costs of maintenance and repairs that do not improve or
extend the life of the respective assets are recorded as expense.
80
<PAGE> 83
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Organizational Costs -- Organizational costs associated with the
organization of the Company, which commenced loan production on March 1, 1994,
are being amortized over a five year period. These organizational costs are
comprised of costs to incorporate, and legal, accounting and other professional
fees. Such amortization is included in depreciation and amortization expense on
the Statements of Operations. Accumulated amortization related to organizational
costs was $482,000, $675,000 and $867,000 during the years ended August 31,
1996, 1997 and 1998, respectively.
Allowance for Credit Losses on Loans Sold with Recourse -- Recourse to the
Company on sales of loans is governed by the agreements between the purchasers
and the Company. The allowance for credit losses on loans sold with recourse
represents the Company's estimate of the fair value of its probable future
credit losses to be incurred, 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 with servicing released, as the Company
has no recourse obligation for credit losses under those whole loan sale
agreements. Estimated credit losses on loans sold through securitizations are
considered in the Company's valuation of its mortgage related securities.
Proceeds from the sale of loans with recourse provisions were $118.1 million,
$415.5 million and $146.4 million during the years ended August 31, 1996, 1997
and 1998, respectively.
Loan Servicing Income -- Fees for servicing loans produced or acquired by
the Company and sold with servicing rights retained are generally based on a
stipulated percentage of the outstanding principal balance of such loans and are
recognized when earned. Interest received on loans sold, less amounts paid to
investors, is reported as loan servicing income. Capitalized mortgage servicing
rights are amortized in proportion to and over the period of estimated servicing
income. Late charges and other miscellaneous income are recognized when
collected. Costs to service loans are recorded to expense as incurred.
Interest Income -- Interest income is recorded as earned. Interest income
represents the interest earned on loans held for sale during the period prior to
their securitization or other sale, mortgage related securities, and short term
investments. The Company computes an effective yield based on the carrying
amount of each mortgage related security and its estimated future cash flow.
This yield is then used to accrue interest income on the mortgage related
security.
During the period that a Title I loan is 30 days through 270 days
delinquent, the Company previously accrued interest at the HUD guaranteed rate
of 7% in lieu of the contractual rate of the loan. When a Title I loan becomes
over 270 days contractually delinquent, it is placed on non-accrual status and
interest is recognized only as cash is received. As the HUD reserve was depleted
in fiscal 1998, the Company ceased the accrual of interest on delinquent Title I
loans. During the year ended August 31, 1997, interest income on Equity + and
Home Equity loans greater than 90 days delinquent was recognized on a cash
basis. During the year ended August 31, 1998, interest income on Equity + and
Home Equity loans greater than 30 days delinquent was recognized on a cash
basis.
81
<PAGE> 84
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Income Taxes -- The Company has historically filed consolidated federal
income tax returns with its former parent, Mego Financial. Income taxes for the
Company were provided for on a separate return basis. As part of a tax sharing
arrangement, the Company had recorded a liability to Mego Financial for federal
income taxes applied to the Company's financial statement income after giving
consideration to applicable income tax law and statutory rates. This liability
was forgiven by Mego Financial at the time of the Recapitalization. The Company
accounts for taxes under SFAS No. 109, "Accounting for Income Taxes" ("SFAS
109"), which requires an asset and liability approach. For the period after
September 2, 1997 (after the Spin-off), the Company is in the process of filing
separate consolidated federal tax returns for the tax year ended February 28,
1998.
The provision for income taxes includes deferred income taxes, which result
from reporting items of income and expense for financial statement purposes in
different accounting periods than for income tax purposes. The Company also
provides for state income taxes at the rate of 6% of income before income taxes.
Recently Issued Accounting Standards -- In June 1997, The Financial
Accounting Standards Board (the "FASB") issued SFAS No. 130, "Reporting
Comprehensive Income" ("SFAS 130"), and SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information", ("SFAS 131"). SFAS No. 130
establishes standards for reporting and display of comprehensive income and its
components in a full set of general-purpose financial statements. SFAS No. 131
establishes standards of reporting by publicly-held business enterprises and
disclosure of information about operating segments in annual financial
statements and, to a lesser extent, in interim financial reports issued to
shareholders. SFAS Nos. 130 and 131 are effective for fiscal years beginning
after December 15, 1997. As both SFAS Nos. 130 and 131 deal with financial
statement disclosure, the Company does not anticipate the adoption of these new
standards will have a material impact on its financial position, results of
operations or cash flows. The Company has not yet determined what its reporting
segments will be under SFAS 131.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"), which establishes accounting
and reporting standards for derivative instruments and for hedging activities.
It requires the entity to recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. The accounting for changes in fair value of these designated
derivatives ("Hedge Accounting") depends on the intended use and designation. An
entity that elects to apply Hedge Accounting is required to establish at the
inception of its hedge the method it will use for assessing the effectiveness of
the hedging derivative and the measurement approach for determining the
ineffective aspect of the hedge. Those methods must be consistent with the
entity's approach to managing risk. SFAS 133 is effective for the fiscal years
beginning after June 15, 1999. The Company has not yet evaluated the effect of
adopting SFAS 133.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by Mortgage Banking Enterprise" ("SFAS 134"), which allows the
reclassification of mortgage-related securities and other beneficial interests
retained after the securitization of mortgage loans
82
<PAGE> 85
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
held for sale from the trading category, as required by FASB 115, to either
available for sale or held to maturity based upon the Company's ability and
intent to hold those investments. SFAS 134 is effective for the first quarter
beginning after December 15, 1998. The Company has not yet evaluated the effect
of adopting SFAS 134. As of August 31, 1998, all mortgage-related securities are
classified as trading securities.
Stock Split -- The accompanying financial statements retroactively reflect
a 1,600 for 1 stock split, an increase in authorized shares of Common Stock to
50 million and the establishment of a $.01 par value per share effective October
28, 1996.
Reclassification -- Certain reclassifications have been made to conform
prior years with the current year presentation.
Use of Estimates -- The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
3. LOANS HELD FOR SALE, ALLOWANCE FOR CREDIT LOSSES, LOAN ORIGINATIONS, AND
LOANS SERVICED
Loans held for sale, net of allowance for credit losses and allowance for
valuation, consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
----------------------
1997 1998
------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Loans held for sale.............................. $9,345 $ 21,860
Deferred loan fees............................... 278 93
Less allowance for credit losses................. (100) (76)
Less allowance for valuation to lower of cost or
market......................................... -- (10,902)
------ --------
Total.................................. $9,523 $ 10,975
====== ========
</TABLE>
The Company provides an allowance for credit losses in an amount that the
Company believes will be adequate to absorb probable losses after FHA insurance
recoveries on the Title I loans. The Company bases its belief on its continual
review of its portfolio of loans, historical experience and current economic
factors. These reviews take into consideration changes in the nature and level
of the portfolio, historical rates, collateral values, current and future
economic conditions which may affect the obligors' ability to pay and overall
83
<PAGE> 86
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
portfolio quality. Changes in the allowance for credit losses and the allowance
for credit losses on loans sold with recourse consist of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
-------------------------------
1996 1997 1998
-------- --------- --------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year................ $ 960 $ 1,015 $ 7,114
Net provision (benefit) for credit losses... 1,510 23,048 (3,198)
Reductions to the provision due to
securitizations or loans sold without
recourse.................................. (1,455) (16,748) (0)
Reductions due to charges to allowance for
credit losses............................. -- (201) (1,368)
------- -------- -------
Balance at end of year...................... $ 1,015 $ 7,114 $ 2,548
======= ======== =======
Allowance for credit losses................. $ 95 $ 100 $ 76
Allowance for credit losses on loans sold
with recourse............................. 920 7,014 2,472
------- -------- -------
Total............................. $ 1,015 $ 7,114 $ 2,548
======= ======== =======
</TABLE>
During fiscal 1997 and 1998, $398.3 million and $0, respectively, of loans
sold under recourse provisions were repurchased and securitized as further
described in Note 2. Reductions to the provision due to securitizations or loans
sold without recourse represent amounts transferred to the valuation basis of
the mortgage related securities and reductions in the allowance due to a lack of
recourse provisions on loans sold without recourse. Loans produced and serviced
consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
-----------------------
1997 1998
---------- ----------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Loan production:
Title I.......................................... $ 98,085 $ 18,701
Equity +......................................... 428,832 310,518
Home Equity...................................... -- 9,723
-------- --------
Total.................................... $526,917 $338,942
======== ========
Loans serviced (including notes securitized, sold
to investors, and held for sale):
Title I.......................................... $255,446 $ 23,005
Equity +......................................... 372,622 8,217
-------- --------
Total.................................... $628,068 $ 31,222
======== ========
</TABLE>
84
<PAGE> 87
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
4. MORTGAGE RELATED SECURITIES
Mortgage related securities consist of interest only strips and residual
interest certificates of FHA Title I and Equity + mortgage-backed securities
collateralized by loans produced, purchased and serviced by the Company.
Mortgage related securities are classified as trading securities and are
recorded at estimated fair value. Changes in the estimated fair value are
recorded in current operations. Mortgage related securities consist of the
following:
<TABLE>
<CAPTION>
AUGUST 31,
-----------------------
1997 1998
---------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Interest only strip securities.................. $ 6,398 $ 2,748
Residual interest securities.................... 84,597 28,189
Interest only receivables (formerly excess
servicing rights)............................. 15,304 3,893
-------- -------
Total................................. $106,299 $34,830
======== =======
</TABLE>
Activity in total mortgage related securities consist of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
AUGUST 31,
-----------------------
1997 1998
---------- ----------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Balance at beginning of year....................... $ 22,944 $106,299
Additions due to securitizations, at cost.......... 135,549 22,469
Net unrealized (loss).............................. (5,612) (73,390)
Accretion of residual interest..................... 6,207 8,467
Write-off/sale of mortgage related securities...... (67,040) (27,573)
Net transfers from excess servicing rights......... 15,052 --
Principal reductions............................... (801) (1,442)
-------- --------
Balance at end of year............................. $106,299 $ 34,830
======== ========
</TABLE>
During the year ended August 31, 1998, the Company experienced
significantly higher prepayment activity and delinquencies with regard to its
securitized Equity + and Title I loans than the levels which had been assumed.
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 Equity + loan prepayment speed assumptions reflect an annualized rate
of 4.5% in the first month following securitization with that annualized rate
building in level monthly increments so that by the 18th month the annualized
rate is 18.75%. The annualized prepayment rate is maintained at that level
through the 36th month at which
85
<PAGE> 88
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
time it is assumed to decline in level monthly increments to 15.25% by the 43rd
month, and is maintained at 15.25% for the remaining life of the portfolio. The
loss assumptions for Equity + loans have also been increased to reflect losses
commencing in the second month following a securitization and building in level
monthly increments until a 4.25% annualized loss rate is achieved in the 15th
month. The annualized loss rate is maintained at that level through the 43rd
month at which time it is assumed to decline in level monthly increments to 4.0%
at month 48 and is maintained for the life of the portfolio. On a cumulative
basis this model assumes aggregate losses of approximately 16% of the original
portfolio balance.
The estimated loss on Title I loans is reduced by recoveries on defaulted
loans of 5%-10% assuming the Title I insurance has been exhausted. On a
cumulative basis, this assumes aggregate losses of approximately 11.92% of the
original principal balance. The prepayment speed utilized for Title I loans is
23% for the remaining life of the portfolio. The loss assumptions for Title I
loans are based on the aging of each portfolio and a historical migration
analysis resulting in the following estimated default rates:
<TABLE>
<CAPTION>
DELINQUENCY STATUS (IN DAYS) ESTIMATED DEFAULT RATES
- - ---------------------------- -----------------------
<S> <C>
Current........................................... 5%
31-60............................................. 5%
61-90............................................. 20-25%
91-120............................................ 50%
121-150........................................... 80%
151-180........................................... 95%
Over 180.......................................... 100%
</TABLE>
The Company utilized a 16% discount rate at August 31, 1998 to calculate
the present value of cash flow streams. Taken in conjunction with the above
prepayment and loss assumptions, management believes these valuations reflect
current market values. Because of the inherent uncertainty of the valuations,
those estimated market values may differ from values that would have been used
had a ready market for the securities existed, and the difference could be
material. The Company has not obtained an independent validation of the
assumptions utilized in calculating the carrying value of mortgage related
securities for any period subsequent to August 31, 1997.
During fiscal 1996 and 1997, the Company generally utilized annual
prepayment assumptions ranging from 1% to 15%, annual estimated loss factor
assumptions of up to 1.75%, and annual weighted average discount rates of up to
12% for Title I and Equity + loans.
The Company has pledged certain of its interest only and residual class
certificates, that are included in its mortgage related securities, pursuant to
the pledge and security agreement with a financial institution. The Company has
also pledged certain residual interests and interest only securities pursuant to
revolving credit facility with another financial institution.
86
<PAGE> 89
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
5. EXCESS SERVICING RIGHTS
Activity in excess servicing rights for the year ended August 31, 1997
consist of the following (thousands of dollars):
<TABLE>
<S> <C>
Balance at beginning of year................................ $ 12,121
Plus additions.............................................. 3,887
Less amortization........................................... (956)
Less amounts related to loans repurchased, securitized and
transferred to mortgage related securities................ (15,052)
--------
Balance at end of year...................................... $ --
========
</TABLE>
As of August 31, 1997 and 1998, interest only receivables consisted of
excess cash flows on serviced loans totaling $88.2 million, and $87.4 million,
yielding weighted-average interest rates of 12.5%, and 12.2% and net of normal
servicing and pass-through fees with weighted-average pass-through yields to the
investor of, 8.8%, and 9.5% respectively. These loans were sold under recourse
provisions as described in Note 2 and the interest only receivables are included
in Mortgage Related Securities in the Company's Statement of Financial
Condition.
6. MORTGAGE SERVICING RIGHTS
Activity in mortgage servicing rights consist of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
--------------------------------
1996 1997 1998
-------- --------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year................ $1,076 $ 3,827 $ 9,507
Plus additions.............................. 3,306 7,184 3,529
Less amortization........................... (555) (1,504) (3,166)
Less write-down of valuation................ -- -- (3,870)
Less sale of servicing rights............... -- -- (5,917)
------ ------- -------
Balance at end of year...................... $3,827 $ 9,507 $ 83
====== ======= =======
</TABLE>
The Company had no valuation allowance for mortgage servicing rights during
fiscal 1996, 1997 or 1998, as the cost basis of mortgage servicing rights
approximated fair value.
The Company also entered into an agreement with City Mortgage Services in
June 1998, to acquire and service the majority of the mortgage loans that the
Company owned at the date of the Recapitalization at 90% of its carrying value.
As a result, the Company recorded an impairment of $703,225, which is reflected
in the accompanying Statement of Operations as a charge to Loan Servicing
Income. In addition, the Company and City Mortgage Services entered into an
agreement in June, 1998 for City Mortgage Services to service all of the
mortgage loans produced or purchased by the Company after the Recapitalization.
87
<PAGE> 90
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
7. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
----------------------
1997 1998
-------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Office equipment and furnishings................. $1,702 $ 1,768
EDP equipment.................................... 948 1,226
Building improvements............................ 144 --
Vehicles......................................... 34 --
------ -------
2,828 2,994
Less accumulated depreciation.................... (675) (1,181)
------ -------
Total.................................. $2,153 $ 1,813
====== =======
</TABLE>
Included in property and equipment as of August 31, 1997 and 1998 are
various capitalized leases totaling $1.5 million and $1.8 million, net of
accumulated amortization of approximately $532,000 and $1.1 million,
respectively.
8. OTHER ASSETS
Other assets consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
-----------
1997 1998
---- ----
(THOUSANDS
OF DOLLARS)
<S> <C> <C>
Accrued income from securitizations....................... $537 $111
Software costs, net of amortization (See Note 15)......... 92 31
Deposits and impounds..................................... 80 81
Other..................................................... 86 141
---- ----
Total........................................... $795 $364
==== ====
</TABLE>
88
<PAGE> 91
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
9. NOTES AND CONTRACTS PAYABLE
Notes and contracts payable consist of the following:
<TABLE>
<CAPTION>
AUGUST 31,
----------------------
1997 1998
--------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Note payable -- warehouse line of credit........... $ 8,500 $ --
Notes payable -- revolving lines of credit......... 24,976 9,961
Term Note.......................................... -- 4,615
Contracts payable.................................. 2,096 1,769
------- -------
Total.................................... $35,572 $16,345
======= =======
</TABLE>
Loan production was initially funded principally through the Company's
$40.0 million warehouse line of credit that was executed in June 1997 and
increased to $65.0 million in October 1997. This line accrued interest at the
lower of one month LIBOR plus 1.5% or the Federal Funds rate plus 0.25%. At
August 31, 1997, $8.5 million was outstanding under this warehouse line of
credit. This line was paid off with the proceeds of the Recapitalization.
Loan sale transactions generally require the subordination of certain cash
flows payable to the Company to the payment of scheduled principal and interest
due to the loan purchasers. In connection with certain of such sale
transactions, a portion of amounts payable to the Company from the excess
interest spread is required to be maintained in a reserve account to the extent
of the subordination requirements. The subordination requirements generally
provide that the excess interest spread is payable to the reserve account until
a specified percentage of the principal balances of the sold loans is
accumulated therein. The excess interest required to be deposited and maintained
in the respective reserve accounts is not available to support the cash flow
requirements of the Company. At August 31, 1997 and 1998, amounts on deposit in
such reserve accounts totaled $6.9 million and $3.7 million, respectively, and
are included in Cash Deposits -- Restricted on the Statement of Financial
Position.
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 terminates on December 29, 1998 and is
renewable, at Sovereign's option, in six-month intervals. 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. The Sovereign Warehouse
Line includes certain material covenants including maintenance of books and
records, provide financial statements and reports, maintain its existence and
properties, maintain adequate fidelity bond coverage and insurance and provide
timely notice of material proceedings. As of August 31, 1998, the Company had
not utilized the Sovereign Warehouse Line.
89
<PAGE> 92
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
In April 1997, the Company entered into a pledge and security agreement
with another financial institution for an $11.0 million revolving credit
facility. The amount which can be borrowed under the agreement was increased to
$15.0 million in June 1997 and $25.0 million in July 1997. This facility is
secured by a pledge of certain of the Company's interest only and residual class
certificates carried as mortgage related securities on the Company's Statements
of Financial Condition. A portion of the advances under the credit line
agreement accrues interest at one-month LIBOR + 3.5% (9.1% at August 31, 1998),
expiring one year from the initial advance. The remaining advances accrue
interest at one-month LIBOR + 2.0% (7.64% at August 31, 1998). The maturity of
this facility was extended to December 31, 1998. As of August 31, 1998,
approximately $10.0 million was outstanding under the agreement.
Certain material covenants 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 as
2.93:1. On December 2, 1998, the Company obtained a waiver for the minimal
required net worth and debt-to-net worth ratio for the period that the Company
was not in compliance. 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.
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 funded $5.0 million of this credit facility and is seeking a
participatory lender for the balance of the credit facility. As of August 31,
1998, a participatory lender has not been obtained. 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). In May, 1998 this loan converted to a term loan with monthly
amortization derived from the cashflow 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). The final maturity of this loan is October, 2002. As
of August 31, 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 detailed 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
90
<PAGE> 93
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
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.
At August 31, 1997 and 1998, contracts payable consisted of $2.1 million
and $1.8 million, respectively, in obligations under lease purchase arrangements
secured by property and equipment, bearing a weighted-average interest rate of
9.25% at August 31, 1998.
Scheduled maturities of the Company's contracts payable of $1.8 million at
August 31, 1998 are as follows:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
--------------------------------
TOTAL 1999 2000 2001 2002 2003
- - ------ ---- ---- ---- ---- ----
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C> <C>
$1,769 $534 $525 $425 $268 $17
</TABLE>
10. SUBORDINATED DEBT
In November 1996, the Company consummated the IPO, pursuant to which it
issued 2.3 million shares of Common Stock at $10.00 per share. Concurrently with
the IPO, the Company issued $40.0 million of its Old 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 Preferred Equities Corporation ("PEC") and approximately $24.3
million to reduce the amounts outstanding under the Company's lines of credit.
The balance of the net proceeds has been used to originate loans. At August 31,
1997, $40.0 million principal amount of Old Notes were outstanding. Prepaid debt
expenses related to these notes was $2.4 million at August 31, 1997, and it was
being amortized over the term of the Old Notes. In October 1997, the Company
issued an additional $40.0 million of Old Notes in a private placement, which
increased the aggregate principal amount of outstanding Old Notes from $40.0
million to $80.0 million. The Company used the net proceeds to repay $3.9
million of debt due to Mego Financial, to reduce by $29.0 million the amounts
outstanding under the Company's lines of credit, and to provide capital to
originate and securitize loans. The Old Notes were subject to the Indenture
governing all of the Company's subordinated notes.
As part of the Recapitalization, the Company completed an offer to exchange
(the "Exchange Offer") new subordinated notes and Preferred Stock, subject to
certain limitations, for any and all of the outstanding $80.0 million principal
amount of the Company's Old Notes. The Exchange Offer was conditioned upon at
least $76.0 million aggregate principal amount of Old Notes being tendered for
exchange and conditioned upon at least $30.0 million shares of Common Stock and
Preferred Stock being sold in the offerings. The Company would not have
consummated the Exchange Offer if less than $30.0 million was raised in the
offerings. Pursuant to the Exchange Offer, the Company issued approximately
37,500 shares of Preferred Stock at $1,000 per share, and $41.5 million
principal amount of new 12.5% Subordinated Notes due 2001 (the "Current
91
<PAGE> 94
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Notes") in exchange for approximately $79.0 million principal amount of Old
Notes. The balance of the Old Notes were retired in September and October 1998.
Certain material covenant restrictions exist in the Indenture governing the
Current Notes. These covenants include limitations on the Company's ability to
incur indebtedness, grant liens on its assets and to enter into extraordinary
corporate transactions. The Company may not incur indebtedness if, on the date
of such incurrence and after giving effect thereto, the Consolidated Leverage
Ratio would exceed 1.5:1, subject to certain exceptions. At August 31, 1998, the
Consolidated Leverage Ratio, as defined herein, was 2.4:1 and the Company could
not incur any additional indebtedness other than permitted indebtedness.
11. INCOME TAXES
As described in Note 2, prior to the Spin-off, the Company recorded a
liability to Mego Financial for federal income taxes at the statutory rate
(currently 34%). State income taxes are computed at the appropriate state rate
(6%) net of any available operating loss carryovers and are recorded as state
income taxes payable. Income tax expense (benefit) has been computed as follows:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
--------------------------------
1996 1997 1998
-------- -------- ----------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Income (loss) before income taxes.......... $11,155 $23,810 $(125,989)
======= ======= =========
Federal income taxes at 34% of income...... $ 3,793 $ 8,095 (40,683)
Lost benefits due to change in control..... -- -- 27,142
Valuation allowance........................ -- -- 7,715
State income taxes, net of federal income
tax benefit.............................. 442 943 (553)
Other...................................... -- 24 45
------- ------- ---------
Income tax expense (benefit)............... $ 4,235 $ 9,062 $ (6,334)
======= ======= =========
Income tax expense (benefit) is comprised
of the following:
Current.................................. $ 3,562 $12,319 $ (405)
Deferred................................. 673 (3,257) (5,929)
------- ------- ---------
Total............................ $ 4,235 $ 9,062 $ (6,334)
======= ======= =========
</TABLE>
92
<PAGE> 95
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Deferred income taxes reflect the net tax effects of (a) temporary
differences between the carrying amount of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes, (b) temporary
differences between the timing of revenue recognition for book purposes and
income tax purposes and (c) operating loss and tax credit carry forwards. The
tax effects of significant items comprising the Company's net deferred tax asset
are as follows:
<TABLE>
<CAPTION>
AUGUST 31,
----------------------
1997 1998
------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C>
Deferred tax assets:
Realized gain on mortgage related securities....... $2,373 $ 9,838
Net operating loss carry forward................... -- 6,002
Receivable due from carrybacks and payments........ -- 2,511
Other.............................................. 91 --
------ --------
2,464 18,351
------ --------
Deferred tax liabilities:
Provision for loan loss............................ -- 2,196
Difference between book and tax carrying value of
assets.......................................... 110 --
------ --------
110 2,196
------ --------
Net deferred tax asset before valuation.............. 2,354 16,155
------ --------
Less valuation allowance............................. -- (7,715)
------ --------
Net deferred tax asset............................... $2,354 $ 8,440
====== ========
</TABLE>
Beginning September 1, 1997, the Company filed a separate tax return for
both federal and state tax purposes. On July 1, 1998, the Company had a change
in control as defined by Section 382 of the Internal Revenue Code. As a result
of this change in control, no material tax benefit is available to the Company
attributed to losses incurred prior to July 1, 1998. Accordingly, a deferred tax
asset has not been recorded for losses incurred prior to this date.
The Company has provided a partial valuation allowance against the net
deferred tax assets recorded as of August 31, 1998 due to uncertainties as to
their ultimate realization. The net operating loss generated subsequent to July
1, 1998 will expire in the year 2018. In the event of any future ownership
changes, Section 382 of the Internal Revenue Code imposes certain restrictions
on the amount of net operating loss carry forwards that can be used in any year
by the Company.
12. STOCKHOLDERS' EQUITY
General In November 1996, additional paid-in capital was increased by $20.6
million due to the sale of 2.3 million shares of Common Stock, net of issuance
costs, in the IPO.
Prior to the Spin-off, the Company filed a consolidated federal income tax
return with Mego Financial's affiliated group under a Tax Allocation and
Indemnity Agreement ("Tax
93
<PAGE> 96
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Agreement"). As a result of the Spin-Off, $2.4 million due to Mego Financial
under the Tax Agreement was recorded as a deferred tax asset and as additional
paid-in capital. Additionally, in April 1998, an agreement was made to adjust by
$6.2 million the income tax portion of a payable that the Company owed Mego
Financial under the Tax Agreement. The final settlement of the $6.2 million is
recorded as an additional capital contribution as if the settlement occurred on
the date of Spin-off.
In July 1998, the Company issued 62,500 shares of Preferred Stock and
approximately 18.27 million shares of Common Stock in the Recapitalization. As a
result, additional paid-in capital increased by $84.5 million.
Earnings Per Share Data utilized in calculating actual earnings per share
under SFAS 128 is as follows:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
-------------------------------
1997 1998
------------- ---------------
<S> <C> <C>
BASIC:
Net income (loss)......................... $14,748,000 $(119,655,000)
=========== =============
Weighted-average number of common
shares................................. 11,802,192 15,502,926
=========== =============
DILUTED:
Net income (loss)......................... $14,748,000 $(119,655,000)
=========== =============
Weighted-average number of common shares
and assumed conversions................ 11,802,192 15,502,926
=========== =============
</TABLE>
The following tables reconcile the net income applicable to Common
Stockholders, basic and diluted shares, and EPS for the following periods:
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31, 1997 YEAR ENDED AUGUST 31, 1998
------------------------------------ --------------------------------------
PER-SHARE PER-SHARE
INCOME SHARES AMOUNT INCOME SHARES AMOUNT
----------- ---------- --------- ------------- ---------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net income (loss)..... $14,748,000 $(119,655,000)
----------- -------------
BASIC EPS
Income (loss)
applicable to Common
Stockholders........ 14,748,000 11,802,192 $1.25 (119,655,000) 15,502,926 $(7.72)
----------- ---------- ----- ------------- ---------- ------
Effect of dilutive
securities:
Warrants............ -- -- -- -- -- --
Stock options....... -- -- -- -- -- --
----------- ---------- ------------- ----------
DILUTED EPS
Income (loss)
applicable to Common
Stockholders and
assumed
conversions......... $14,748,000 11,802,192 $1.25 $(119,655,000) 15,502,926 $(7.72)
=========== ========== ===== ============= ========== ======
</TABLE>
Stock options after the years ended August 31, 1997 and 1998 are
anti-dilutive. The earnings per share for the year ended August 31, 1996 is not
presented because the Company was a wholly-owned subsidiary of Mego Financial
Corporation.
94
<PAGE> 97
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
13. STOCK OPTIONS
The Company has several stock option plans ("1996 Stock Option Plan" and
"1997 Stock Option Plan", collectively the "Stock Option Plans") for officers
and employees which provide for both incentive stock options and non-qualified
incentive options. The Company's Board of Directors (the "Board") determines the
option price (not to be less than fair value for incentive stock options) at the
date of grant. The options generally expire ten years from the date of grant and
as a result of a change in control of the Company, in conjunction with the
recapitalization, all options outstanding on June 28, 1998 became fully
exercisable. All other options granted subsequent to the recapitalization, are
exercisable at various points in time ranging from fully exercisable at grant
date to 33% increments over 3 years. In addition, the Board is authorized to
grant stock appreciation rights ("SARs") under the Stock Option Plans to any
person who has rendered services to the Company.
During August 1997, all stock options outstanding under the 1996 Stock
Option Plan were converted into SARs. As of August 31, 1997, an aggregate of
915,000 SARs were issued and outstanding under the 1996 Stock Option Plan. As a
result no SFAS 123 disclosures were required for the fiscal year ended August
31, 1997.
In October 1997, the Board voted to purchase all of the outstanding SARs
under the Stock Option Plans at $1.00 per share for SARs previously held at
$10.00 to $11.00 per share and $0.70 per share for SARs held at $12.00 per
share. During the year ended August 31, 1998, $761,250, (excluding payroll tax
items) was expensed related to the purchase of SARs.
Additionally, in October 1997, the Board voted, subject to stockholder
approval, to amend the Company's 1997 Stock Option Plan to increase the number
of shares of stock reserved for issuance upon the exercise of options to
purchase Common Stock granted from one million to two million shares.
95
<PAGE> 98
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
A summary of the stock options granted under the Stock Option Plans as of
August 31, 1997 and 1998 and the changes during the years ending on those dates
is presented below:
<TABLE>
<CAPTION>
AS OF AUGUST 31, 1997 AS OF AUGUST 31, 1998
----------------------------- ------------------------------
SHARES WEIGHTED-AVERAGE SHARES WEIGHTED AVERAGE
(000) EXERCISE PRICE (000) EXERCISE PRICE
---------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C>
Outstanding at
beginning of
year............... 0 $ 0 0 $ 0
Granted.............. 915,000 10.22 19,354,425 2.23
Exercised............ 0 0 0 0
Forfeited............ 915,000 10.22 620,000 14.75
Outstanding at end of
year............... 0 0 18,734,425 1.81
Options Exercisable
at year end........ 0 0 582,500 11.57
Weighted-average fair
value of options
granted during the
year............... $6,115,516 $24,238,512
</TABLE>
The following table summarizes information about stock options outstanding
at August 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------- ------------------------------
NUMBER WEIGHTED-AVERAGE NUMBER
RANGE OF OUTSTANDING REMAINING WEIGHTED-AVERAGE EXERCISABLE WEIGHTED-AVERAGE
EXERCISE PRICES AT 8/31/98 CONTRACTUAL LIFE EXERCISE PRICE AT 8/31/98 EXERCISE PRICE
--------------- ----------- ---------------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C> <C>
1.50 18,291,925 4.01 1.50 140,000 14.75
14.75 442,500 5.08 14.75 442,500 1.50
</TABLE>
SFAS 123 establishes financial accounting and reporting standards for
stock-based employee compensation plans and for transactions in which an entity
issues its equity instruments to acquire goods or services from non-employees.
Those transactions must be accounted for based on the fair value of the
considerations received or the fair value of the equity instruments issued,
whichever is more reliably measured. The Company elected to continue to apply
the provisions of Accounting Principles Bulletin ("APB") Opinion 25 as permitted
by SFAS 123 and accordingly, provides pro forma disclosure.
The fair value of each option granted during the year ended August 31, 1998
is estimated on the date of grant using the Black-Scholes option-pricing model
with the following assumptions: (1) dividend yield of zero; (2) expected
volatility of 48.9%; (3) risk-free interest rate of 5.45% and; (4) expected life
of two to ten years. The weighted average fair value of the options granted
during the year ended August 31, 1998 was $24,238,512. As of August 31, 1998,
there were 18,734,425 options outstanding which have an exercise price ranging
from $1.50 to $14.75 per common share and a weighted average contractual life of
4.21 years.
96
<PAGE> 99
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
14. RETIREMENT PLAN
The Company participates in a defined contribution plan (the "Plan") with a
plan year end of December 31st. During fiscal 1996 and 1997, the Company
participated in PEC's defined contribution plan. Effective January 1, 1998, the
Company established its owned defined contribution plan. Employees may
contribute between 1% and 15% of their gross salary. The Company's matching
contribution equals 25% of the first 6% of gross salary that the participant
elects to contribute to the Plan. In addition, the Company may elect to make an
additional matching contribution or qualified nonelective contribution, as
defined in the Plan document, at its discretion. For the years ended August 31,
1996, 1997 and 1998, the Company contributed approximately $14,116, $24,779 and
$80,391 respectively, to the Plan.
15. RELATED PARTY TRANSACTIONS
Preferred Equity Corporation (PEC) During the years ended August 31, 1996,
1997 and 1998, PEC, a wholly owned subsidiary of Mego Financial, provided
certain services to the Company including loan servicing and collection for a
cost of $709,000, $1.9 million and $2.2 million, respectively, which is included
in general and administrative expense. In addition, PEC provided services
including executive, accounting, legal, management information, data processing,
human resources, advertising and promotional materials (management services)
totaling $671,000, $967,000 and $617,000, which were included in general and
administrative expenses for the years ended August 31, 1996, 1997 and 1998,
respectively. Included in other interest expense for the years ended August 31,
1996, 1997 and 1998, are $29,000, $16,000 and $0 respectively, related to
advances from PEC.
During the year ended August 31, 1996, the Company paid PEC for developing
certain computer programming (see Note 8), incurring costs of $56,000. No such
costs were incurred during the years ended August 31, 1997 and 1998. The Company
is amortizing these costs over a five year period. During fiscal 1996, 1997 and
1998, amortization of $29,000, $62,000 and $62,000, respectively, was included
in expense. As of August 31, 1998, the Company had terminated the management
services and loan servicing agreement with PEC.
Management believes the allocation methodologies and contractual
arrangements for services performed by PEC have been reasonable and are
representative of an approximation of the expense the Company would have
incurred had it operated as a stand alone entity performing such services.
Mego Financial Corporation In April 1998, an agreement was made to reduce
by $5.3 million the income tax portion of a payable that the Company owed Mego
Financial under a Tax Allocation and Indemnity Agreement dated November 19,
1996. The Company filed a consolidated federal tax return with Mego Financial's
affiliated group prior to the Spin off under such Tax Allocation and Indemnity
Agreement. The final settlement of the amount payable is recorded as an
additional capital contribution as if the settlement occurred on the date of the
Spin off.
97
<PAGE> 100
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
At August 31, 1996, 1997 and 1998, the Company had a non-interest bearing
liability to Mego Financial of $12.0 million, $9.7 million and $0, respectively,
for federal income taxes and cash advances which is included in Accounts Payable
in the accompanying Statements of Financial Position.
Activity in Due to Mego Financial consists of the following:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
--------------------------------
1996 1997 1998
--------- -------- ---------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C>
Balance at beginning of year............... $ 8,453 $11,994 $ 9,653
Provision for federal income taxes......... 3,566 7,630 (5,284)
Cash advances from Mego Financial.......... 5,475 5,123 --
Forgiveness of advances.................... -- -- (869)
Repayment of advances...................... (5,500) (15,094) (3,500)
-------- ------- --------
Balance at end of year..................... $ 11,994 $ 9,653 $ 0
======== ======= ========
Average balance during the year............ $ 11,874 $ 6,876 $ 3,624
======== ======= ========
</TABLE>
Greenwich Capital Markets Champ Meyercord, the Company's Chairman of the
Board and Chief Executive Officer, was formerly a senior investment banker at
Greenwich Capital Markets ("Greenwich"). In October 1996, Greenwich agreed to
purchase $2.0 billion of loans over a five year period from the Company. The
Company has sold Greenwich approximately $800.0 million in loans from the
inception of the agreement. The agreement with Greenwich was terminated in June
1998 and the Company has no further obligation under the agreement.
In April 1997, the Company entered into a pledge and security agreement
with Greenwich for an $11.0 million revolving credit facility. The amount which
could be borrowed under the agreement was increased to $15.0 million in June
1997 and to $25.0 million in July 1997. As of August 31, 1998, approximately
$10.0 million was outstanding under the agreement. Amounts borrowed under this
facility are secured by certain of the Company's mortgage related securities.
The Company was in default under the first credit facility as a result of a
default under the indenture governing the Old Notes. The default was waived on
December 2, 1998 effective August 31, 1998. The revolving credit facility
matures on December 31, 1998.
Friedman, Billings, Ramsey & Co., Inc. Friedman, Billings, Ramsey & Co.,
Inc. ("FBR") served as placement agent for the Old Notes pursuant to a placement
agreement (the "Placement Agreement"). Under the terms of the Placement
Agreement, the Company paid the placement agent a fee of 1.6 million shares of
common stock representing 6.0% of the gross proceeds received by the Company
from the shares of Common Stock and Preferred Stock in the Recapitalization. The
gross proceeds did not include $10.0 million of common stock acquired by an
affiliate of FBR received by the Company from the shares of common stock and
preferred stock in the Recapitalization. In addition, the Company has agreed,
pursuant to the Placement Agreement, to indemnify
98
<PAGE> 101
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
the Placement Agent against certain liabilities, including liabilities under the
Securities Act, and other liabilities incurred in connection with the
Recapitalization.
According to FBR, as of December 1, 1998, Friedman, Billings, Ramsey Group,
Inc. ("FBRG"), through its three wholly owned subsidiaries, Friedman, Billings,
Ramsey Investment Management, Inc. ("Investment Management"), FBR Offshore
Management, Inc. ("Offshore Management") and Orkney Holdings, Inc. ("Orkney"),
had sole voting and dispositive power with respect to 5,359,116 shares of Common
Stock. FBR has advised the Company that it may at any time hold long or short
positions in such securities. Investment Management serves as general partner
and discretionary investment manager for FBR Ashton, L.P. ("Ashton") which, as
of December 1, 1998, owned 824,187 shares of Common Stock. Offshore Management
serves as discretionary manager for FBR Opportunity Fund, Ltd. ("Opportunity
Fund") which, as of December 1, 1998, owned 82,622 shares of Common Stock. Each
of FBRG, Investment Management and Offshore Management disclaims beneficial
ownership of shares of Common Stock owned by the other two entities. Orkney is a
wholly owned subsidiary of FBRG which, as of December 1, 1998, owned 4,452,307
shares of Common Stock and 2,125 shares of Preferred Stock (which are
convertible into an aggregate of 1,416,673 shares of Common Stock). Each of
FBRG, Ashton, Opportunity Fund and Orkney disclaims beneficial ownership of
shares of Common Stock owned by the other three entities. In addition, Emmanuel
J. Friedman, Eric F. Billings and W. Russell Ramsey are each control persons
with respect to FBR. In addition, Emmanuel J. Friedman owns and has shared
voting and dispositive power with his wife over an additional 6,766,667 shares
of Common Stock.
In addition, FBR was a managing underwriter for the Company's initial
public offering and the Company's offering of the Current Notes, and was the
purchaser of Current Notes. FBR received compensation for such services and the
Company agreed to indemnify FBR against certain liabilities, including
liabilities under the Securities Act, and other liabilities arising in
connection with such offerings. In addition, FBR has in the past provided
certain investment banking services to the Company and affiliates of the
Company.
During fiscal 1998, the Company paid FBR 1.6 million shares of common stock
for its fee in conjunction with the Recapitalization. Additionally, the Company
has reimbursed FBR for out of pocket expenses totaling approximately $250,000.
FBR is also entitled to a cash fee of $416,667 in connection with the
recapitalization.
Sovereign Bancorp and City Mortgage Services
As a result of their investment in the Company in the Recapitalization,
both Sovereign Bancorp and City Mortgage Services have a substantial ownership
position in the Company. As part of the Recapitalization, the Company, entered
into agreements with Sovereign Bancorp, for a new $90.0 million warehouse line,
(subject to the availability of collateral), and a mortgage loan purchase and
sale commitment. As of August 31, 1998, the Company had not utilized the
Sovereign warehouse line.
99
<PAGE> 102
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
The Company also entered into an agreement with City Mortgage services to
acquire and service all of the mortgage loans that the Company owned at the date
of the Recapitalization at 90% of its carrying value for approximately $5.9
million. The Company, as a result, recorded an impairment of $703,225, which is
reflected in the accompanying Statement of Operations as a charge to Loan
Servicing Income. In addition, the Company and City Mortgage Services entered
into an agreement for City Mortgage Services to acquire and service all of the
mortgage loans produced or purchased by the Company after the Recapitalization
on a servicing retained basis. During August 1998, the Company paid City
Mortgage Services approximately $9,000 to service the Company's loans.
Other
In June 1998, the Company retained Spencer I. Browne, a member of the
Company's Board of Directors, as a special consultant to the Company. In
connection with certain business development activities of the Company during
the period beginning May 15, 1998 and ending December 31, 1998, the Company has
paid a total of approximately $177,500 to Strategic Asset Management, LLC for
Mr. Browne's services and reimbursement of out of pocket expenses. In addition,
the Company has tentatively agreed to grant Mr. Browne options to purchase
500,000 shares of the Company's common stock. The stock options have an exercise
price of equal to the cost of common stock in the Recapitalization of $1.50 per
share. During this period, Mr. Browne continued as a Director of the Company.
16. COMMITMENTS AND CONTINGENCIES
Leases. The Company leases office space and equipment under operating
leases that expire at various dates through February 2003. The office space
lease is subject to an annual rent escalation of 2%. During fiscal 1996, 1997
and 1998, the Company's rent expense totaled $338,000, $1.2 million and $1.6
million respectively. Future minimum payments at August 31, 1998 under these
operating leases are set forth below (thousands of dollars):
<TABLE>
<CAPTION>
FOR THE YEARS ENDED AUGUST 31,
- - ------------------------------
<S> <C>
1999........................................................ $1,478
2000........................................................ 1,336
2001........................................................ 1,208
2002........................................................ 844
2003........................................................ 15
------
Total............................................. $4,881
======
</TABLE>
Litigation. On February 23, 1998, an action was filed in the United States
District Court for the Northern District of Georgia by Robert J. Feeney, as a
purported class action against the Company and its former President and Chief
Executive Officer. The complaint alleges, among other things, that the
defendants violated the federal securities laws in connection with the
preparation and issuance of certain of the Company's financial statements. The
named plaintiff seeks to represent a class consisting of purchasers of the
Common Stock between April 11, 1997 and December 18, 1997, and seeks damages in
an unspecified amount, costs, attorney's fees and such other relief as the court
may deem just and proper. Although the Company believes that it has meritorious
defenses and will
100
<PAGE> 103
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
vigorously defend the action, no assurance can be given as to its outcome or
effect on the Company's financial condition.
In the general course of business, the Company, at various times, has been
named in lawsuits. The Company believes that it has meritorious defenses to
these lawsuits and that resolution of these matters will not have a material
adverse affect on the business or financial condition, results of operation or
cash flows of the Company.
Other Commitments. In the first quarter of fiscal 1997, the Company
entered into an agreement with Greenwich Capital Markets providing for the
purchase of up to $2.0 billion of loans over a 5 year period. Pursuant to the
agreement, Mego Financial issued to Greenwich Capital Markets four-year warrants
to purchase 1 million shares of Mego Financial's Common Stock at an exercise
price of $7.125 per share. The value of the warrants of $3.0 million plus a
$150,000 fee (0.15% of the commitment amount) as of the commitment date (the
"Warrant Value"), were being amortized as the commitment for the purchase of
loans was utilized.
In December, 1997, an agreement was reached with Greenwich Capital Markets
in regards to various modifications to the master purchase agreement, in return
for which the Company agreed to pay $1.0 million in December 1997, with a
further $1.0 million to be paid in quarterly installments in 1998.
As part of the Recapitalization, the Company terminated its existing master
purchase agreement with Greenwich Capital Markets. In connection with the
termination of this master purchase agreement, the remaining unamortized prepaid
commitment fees totaling approximately $2.8 million were written-off and are
reflected as a loss on the sale of loans in the Company's Statement of
Operations.
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosure about Fair Value of Financial Instruments" ("SFAS
107"), requires disclosure of estimated fair value information for financial
instruments, whether or not recognized in the Statements of Financial Condition.
Fair values are based upon estimates using present value or other valuation
techniques in cases where quoted market prices are not available. Those
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. In that regard, the derived
fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. SFAS 107 excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements. Accordingly, the aggregate fair
value amounts presented do not represent the underlying value of the Company.
101
<PAGE> 104
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
Estimated fair values, carrying values and various methods and assumptions
used in valuing the Company's financial instruments at August 31, 1997 and 1998
are set forth below:
<TABLE>
<CAPTION>
AUGUST 31, 1997 AUGUST 31, 1998
------------------------- -------------------------
CARRYING ESTIMATED FAIR CARRYING ESTIMATED FAIR
VALUE VALUE VALUE VALUE
-------- -------------- -------- --------------
(THOUSANDS OF DOLLARS)
<S> <C> <C> <C> <C>
FINANCIAL ASSETS:
Cash and cash
equivalents(a)....... $ 6,104 $ 6,104 $36,404 $36,404
Loans held for sale,
net(b)............... 9,523 11,414 10,975 10,975
Mortgage related
securities(c)........ 106,299 106,299 34,830 34,830
Mortgage servicing
rights(c)............ 9,507 9,507 83 83
FINANCIAL LIABILITIES:
Notes and contracts
payable(d)........... 35,572 35,572 16,345 16,345
Subordinated debt(e).... 40,000 40,000 42,693 32,020
</TABLE>
- - -------------------------
(a) Carrying value was used as the estimate of fair value as of August 31,
1997.
(b) Since it is the Company's business to sell loans it makes, the fair value
was estimated by using outstanding commitments from investors adjusted for
non-qualified loans and the collateral securing such loans.
(c) The fair value was estimated by discounting future cash flows of the
instruments using discount rates, default, loss and prepayment assumptions
based upon available market data, opinions from investment bankers and
portfolio experience. As part of the Recapitalization, an agreement was
reached with City Mortgage Services for the sale of the Mortgage Servicing
Rights at 90% of their computed carrying value. The Company, as a result,
recorded an impairment of $703,225, which is reflected in the accompanying
Statement of Operations as a charge to Loan Servicing Income.
(d) Notes payable generally are adjustable rate, indexed to the prime rate;
therefore, carrying value approximates fair value. Contracts payable
represent capitalized equipment leases with a weighted-average interest
rate of 9.32% at August 31, 1997 and 9.25% at August 31, 1998, which
approximates fair value.
(e) The fair value was calculated based upon estimated market prices obtained
from investment bankers.
At August 31, 1997 and 1998, the Company had $190.5 million and $3.6
million, respectively, in outstanding commitments to originate and purchase
loans. The fair value of the commitments was estimated at $14.9 million at
August 31, 1997 and $145,000 at August 31, 1998. The fair values were calculated
based on a theoretical gain or loss on the sale of a funded loan adjusted for an
estimate of loan commitments not expected to fund, considering the difference
between investor yield requirements and the committed loan
102
<PAGE> 105
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
rates. The estimated fair value is not necessarily representative of the actual
gain to be recorded on such loan sales in the future.
The fair value estimates made at August 31, 1997 and 1998 were based upon
pertinent market data and relevant information on the financial instruments at
that time. These estimates do not reflect any premium or discount that could
result from the sale of the entire portion of the financial instruments. Because
no market exists for a substantial portion of the financial instruments, fair
value estimates are based upon judgments regarding future expected loss
experience, current economic conditions, risk characteristics of various
financial instruments and other factors. These estimates are subjective in
nature and involve uncertainties and matters of significant judgment and
therefore cannot be determined with precision. Changes in assumptions could
significantly affect the estimates. The Company had no other off-balance sheet
instruments at August 31, 1997 and 1998.
Fair value estimates are based upon existing on-and off-balance sheet
financial instruments without attempting to estimate the value of anticipated
future business and the value of assets and liabilities that are not considered
financial instruments. [For instance, the Company has certain fee-generating
business lines (e.g., its loan servicing operations) that were not considered in
these estimates since these activities are not financial instruments.] In
addition, the tax implications related to the realization of the unrealized
gains and losses can have a significant effect on fair value estimates and have
not been considered in any of the estimates.
18. CONCENTRATIONS OF RISK
Availability of Funding Source -- The Company funds substantially all of
the loans which it produces or purchases with borrowings through its financing
facilities and internally generated funds, as well as public and private sales
of debt and equity securities. These borrowings are in turn repaid with the
proceeds received by the Company from selling such loans through loan sales or
securitizations. Any failure to renew or obtain adequate financing under its
financing facilities, or other borrowings, or any substantial reduction in the
size of or pricing in the markets for the Company's loans, could have a material
adverse effect on the Company's operations. To the extent that the Company is
not successful in maintaining or replacing its existing financing, it would have
to curtail its loan production activities or sell loans earlier than is optimal,
thereby having a material adverse effect on the Company's financial condition,
results of operations and cash flows.
Dependence on Securitizations -- In 1996, 1997 and to a lesser extent in
1998, the Company pooled and sold through securitizations a significant
percentage of the loans that it produced. The Company historically has derived a
significant portion of its income by recognizing gains on sale of loans through
securitizations. Adverse changes in the securitization market could impair the
Company's ability to sell loans through securitizations on a favorable or timely
basis. Any such impairment could have a material adverse effect upon the
Company's financial condition , results of operations and cash flows.
The Company has relied on credit enhancement and over-collateralization to
generally achieve the "AAA/Aaa" rating for the senior interests in its
securitizations. The credit
103
<PAGE> 106
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
enhancement has generally been in the form of an insurance policy issued by an
insurance company insuring the timely repayment of senior interests in each of
the trusts. The Company's last three securitizations were completed without the
requirement of an insurance policy. There can be no assurance that the Company
will be able to obtain credit enhancement in any form from the current insurer
or any other provider of credit enhancement on acceptable terms or that future
securitizations will be similarly rated. A downgrading of the insurer's credit
rating or its withdrawal of credit enhancement could have a material adverse
effect on the Company's financial condition, results of operations and cash
flows.
Geographic Concentrations -- The Company's servicing portfolio and loans
sold with recourse are geographically diversified within the United States. At
August 31, 1997 and 1998, 26% of the loans in the Company's portfolio had been
produced in California, and 15% in Florida. No other state accounted for more
than 10% of the servicing portfolio for either period. The risk inherent in such
concentrations is dependent upon regional and general economic stability which
affects property values and the financial stability of the borrowers.
Credit Risk -- The Company is exposed to on-balance sheet credit risk
related to its loans held for sale and mortgage related securities. The Company
is exposed to off-balance sheet credit risk related to loans which the Company
has committed to originate and loans sold under recourse provisions. The
outstanding balance of loans sold with recourse provisions totaled $88.2 million
and $87.4 million at August 31, 1997 and 1998, respectively.
Off-Balance Sheet Activities -- These financial instruments consist of
commitments to extend credit to borrowers and commitments to purchase loans from
others. As of August 31, 1997 and 1998, the Company had outstanding commitments
to extend credit or purchase loans in the amounts of $190.5 million and $3.6
million, respectively. These commitments do not represent the expected total
cash outlay of the Company, as historically only 40% of these commitments result
in loan production or purchases. The prospective borrower or seller is under no
obligation as a result of the Company's commitment. The Company's credit and
interest rate risk is therefore limited to those commitments which result in
loan production and purchases. The commitments are made for a specified fixed
rate of interest, therefore the Company is exposed to interest rate risk, to the
extent changes in market interest rates change prior to the origination and
prior to the sale of the loan.
Interest Rate Risk -- The Company's profitability is in part determined by
the difference, or "spread," between the effective rate of interest received on
the loans produced or purchased by the Company and the interest rates payable
under its financing facilities during the warehousing period and yield required
by investors on loan sales and securitizations. The spread can be adversely
affected after a loan is produced or purchased and while it is held during the
warehousing period by increases in the interest rate demanded by investors in
securitizations or sales. In addition, because the loans produced and purchased
by the Company have fixed rates, the Company bears the risk of narrowing spreads
because of interest rate increases during the period from the date the loans are
104
<PAGE> 107
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
produced or purchased until the closing of the sale or securitization of such
loans. Additionally, the fair value of mortgage related securities and mortgage
servicing rights owned by the Company may be adversely affected by changes in
the interest rate environment which could effect the discount rate and
prepayment assumptions used to value the assets. Any such adverse change in
assumptions could have a material adverse effect on the Company's financial
condition, results of operations and cash flows.
19. SUBSEQUENT EVENTS
In September and October 1998, the Company repurchased the remaining
$250,000 and $651,000, respectively, principal amounts of the Old Notes issued
November 22, 1996 for 101% of the principal balance and accrued interest at
13.5%.
On October 2, 1998, an action was filed in the United States District Court
for the Western Division of Tennessee by Traci Parris, as a purported class
action against Mortgage Lenders Association Inc., the Company and City Mortgage
Services, Inc., one of the Company's strategic partners. The complaint alleges,
among other things that the defendants charged interest rates, origination fees,
and loan brokerage commissions in excess of those allowed by law. The named
plaintiff seeks to represent a class of borrowers and seeks damages in an
unspecified amount, reform or nullification of loan agreements, injunction,
costs, attorney's fees and such other relief as the court may deem just and
proper. On October 27, 1998, the Company filed a motion to dismiss the
complaint, The Company believes it has meritorious defenses to this lawsuit and
that any resolution of this matter will not result in a material adverse effect
on the business or financial condition of the Company.
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 and an administrative hearing has been set for
December 3, 1998. The denial will not become final until the Company's appeal
has been resolved. The Company believes that it is capable of meeting such
requirements as the Commissioner may set to amend the Company's license
application. If the denial becomes final, the Company will not be able to make
secondary mortgage loans in the State of Texas at interest rates greater than
10%. The Company is not required to hold a secondary mortgage lender license in
order to continue to produce or acquire first mortgage loans. The Company
believes that any resolution of this matter will not result in a material
adverse effect on the business or financial condition of the Company.
On December 1, 1998, the Company completed a 39.4% reduction in its
workforce, the majority of which were loan production and administrative
personnel. The Company believes that its remaining workforce is adequate to meet
its needs for the foreseeable future.
As part of the Company's strategic initiatives, the Company has entered
into an agreement to purchase certain assets of LL Funding Corp., a
privately-held loan origination company headquartered in Columbia, Maryland. LL
Funding Corp. will serve
105
<PAGE> 108
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
as part of the Company's loan origination platform. This acquisition, which is
subject to customary closing conditions, is expected to close in early 1999.
There can be no assurance that this transaction will be consummated in early
1999, or at all. The purchase price is estimated to be 7.5 million shares of
Common Stock and includes contractual payments dependent upon certain production
levels in future periods. The acquisition is to be accounted for as a purchase.
Through December 11, 1998, the Company has purchased from LL Funding Corp.
approximately $13.2 million principal amount of loans at a purchase price of
102.75%. In addition, the Company has advanced approximately $553,000 to LL
Funding Corp. to fund their operations, of which approximately $100,500 remained
outstanding as of December 11, 1998.
20. QUARTERLY FINANCIAL DATA (UNAUDITED)
The following tables reflect quarterly financial data for the Company.
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
--------------------------------------------------
NOVEMBER 30, FEBRUARY 29, MAY 31, AUGUST 31,
1995 1996 1996 1996
------------ ------------ ------- ----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenues:
Gain on sale of loans and net
unrealized gain on mortgage
related securities.............. $5,965 $4,845 $2,151 $6,275
Interest income (expense), net..... 138 (3) 403 450
Loan servicing income, net......... 891 870 1,288 299
------ ------ ------ ------
Total revenues............. 6,994 5,712 3,842 7,024
------ ------ ------ ------
Expenses:
Operating expenses................. 2,805 2,882 3,305 3,203
Net provision (benefit) for credit
losses.......................... 297 200 (524) 82
Interest........................... 47 31 42 47
------ ------ ------ ------
Total expenses............. 3,149 3,113 2,823 3,332
------ ------ ------ ------
Income before income taxes........... 3,845 2,599 1,019 3,692
Income tax expense................... 1,538 1,040 255 1,402
------ ------ ------ ------
Net income........................... $2,307 $1,559 $ 764 $2,290
====== ====== ====== ======
</TABLE>
106
<PAGE> 109
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
-------------------------------------------------------
NOVEMBER 30, FEBRUARY 28, MAY 31, AUGUST 31,
1996 1997 1997 1997
------------ ------------ ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenues:
Gain on sale of loans and
net unrealized gain on
mortgage related
securities............... $ 9,366 $ 8,966 $ 15,532 $ 14,777
Interest income, net........ 355 526 1,137 1,115
Loan servicing income,
net...................... 638 560 726 1,112
----------- ----------- ----------- -----------
Total revenues...... 10,359 10,052 17,395 17,004
----------- ----------- ----------- -----------
Expenses:
Operating expenses.......... 4,589 5,352 6,274 8,240
Net provision (benefit) for
credit losses............ 1,711 (800) 4,108 1,281
Interest.................... 47 51 122 25
----------- ----------- ----------- -----------
Total expenses...... 6,347 4,603 10,504 9,546
----------- ----------- ----------- -----------
Income before income taxes.... 4,012 5,449 6,891 7,458
Income tax expense............ 1,533 2,078 2,619 2,832
----------- ----------- ----------- -----------
Net income.................... $ 2,479 $ 3,371 $ 4,272 $ 4,626
=========== =========== =========== ===========
Earnings per share:
Basic....................... $ 0.24 $ 0.27 $ 0.35 $ 0.38
=========== =========== =========== ===========
Diluted..................... $ 0.24 $ 0.27 $ 0.35 $ 0.38
=========== =========== =========== ===========
Weighted-average number of
shares outstanding:
Basic....................... 10,317,102 12,476,069 12,379,368 12,300,000
=========== =========== =========== ===========
Diluted..................... 10,319,051 12,544,291 12,379,368 12,300,000
=========== =========== =========== ===========
</TABLE>
107
<PAGE> 110
MEGO MORTGAGE CORPORATION
NOTES TO FINANCIAL STATEMENTS (Continued)
FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
-------------------------------------------------------
NOVEMBER 30, FEBRUARY 28, MAY 31, AUGUST 31,
1997 1998 1998 1998
------------ ------------ ----------- -----------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenues:
Loss on sale of loans and
net unrealized gain
(loss) on mortgage
related securities....... $ (9,387) $ (5,564) $ (44,731) $ (36,920)
Interest income (expense),
net...................... 1,210 684 132 (402)
Loan servicing income,
net...................... 1,194 1,310 (1,367) (138)
----------- ----------- ----------- -----------
Total revenues
(losses)......... (6,983) (3,570) (45,966) (37,460)
----------- ----------- ----------- -----------
Expenses:
Operating expenses.......... 10,198 9,265 7,984 7,322
Net provision (benefit) for
credit losses............ 1,590 706 108 (5,602)
Interest.................... 77 150 103 109
----------- ----------- ----------- -----------
Total expenses...... 11,865 10,121 8,195 1,829
----------- ----------- ----------- -----------
Loss before income taxes...... (18,848) (13,691) (54,161) (39,289)
Income tax expense
(benefit)................... (7,153) 7,153 -- (6,334)
----------- ----------- ----------- -----------
Net (loss).................... $ (11,695) $ (20,844) $ (54,161) $ (32,955)
=========== =========== =========== ===========
Loss per share:
Basic....................... $ (0.95) $ (1.69) $ (4.40) $ (1.32)
=========== =========== =========== ===========
Diluted..................... $ (0.95) $ (1.69) $ (4.40) $ (1.32)
=========== =========== =========== ===========
Weighted-average number of
shares outstanding:
Basic....................... 12,300,000 12,300,000 12,300,000 25,007,247
=========== =========== =========== ===========
Diluted..................... 12,300,000 12,300,000 12,300,000 25,007,247
=========== =========== =========== ===========
</TABLE>
108
<PAGE> 111
SIGNATURES
Pursuant to requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized on this 15th day of
December, 1998.
MEGO MORTGAGE CORPORATION
(Registrant)
By: /s/ EDWARD B. MEYERCORD
-----------------------------------
Edward B. Meyercord,
Chairman and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities indicated on this 15th day of December, 1998.
<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<C> <S>
/s/ EDWARD B. MEYERCORD Chairman and Chief Executive Officer
- - --------------------------------------- (Principal Executive Officer)
Edward B. Meyercord
/s/ WM. PAUL RALSER Director, President and Chief Operating
- - --------------------------------------- Officer
Wm. Paul Ralser
/s/ J. RICHARD WALKER Executive Vice President and Chief
- - --------------------------------------- Financial Officer (Principal Financial
J. Richard Walker Officer)
/s/ SPENCER I. BROWNE Director
- - ---------------------------------------
Spencer I. Browne
/s/ HUBERT M. STILES, JR. Director
- - ---------------------------------------
Hubert M. Stiles, Jr.
/s/ JOHN D. WILLIAMSON, JR. Director
- - ---------------------------------------
John D. Williamson, Jr.
</TABLE>
109
