<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-Q
[X]QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 1998
OR
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 0-23569
HEADLANDS MORTGAGE COMPANY
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
----------------
CALIFORNIA 94-2851992
(I.R.S. EMPLOYER
(STATE OR OTHER JURISDICTION IDENTIFICATION NO.)
OF INCORPORATION OR ORGANIZATION)
1100 LARKSPUR LANDING CIRCLE, SUITE 101
LARKSPUR, CALIFORNIA 94939
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(415) 461-6790
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
The number of shares of the Registrant's Common Stock outstanding on May 10,
1998 was 19,700,000.
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<PAGE>
HEADLANDS MORTGAGE COMPANY
FORM 10-Q
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
PART I -- FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets as of June 30, 1998 and December
31, 1997....................................................... 3
Consolidated Statements of Operations for the six and three
months ended June 30, 1998 and 1997........................... 4
Consolidated Statements of Stockholders' Equity................ 5
Consolidated Statements of Cash Flows for the six months ended
June 30, 1998 and 1997........................................ 6
Notes to Consolidated Financial Statements..................... 7
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.......................................... 11
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..... 17
PART II -- OTHER INFORMATION
Item 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 17
Signatures.............................................................. 18
</TABLE>
FORWARD-LOOKING STATEMENTS
When used in this Form 10-Q or future filings by the Company with the
Securities and Exchange Commission, in the Company's press releases or other
public or shareholder communications, or in oral statements made with the
approval of an authorized executive officer, the words or phrases "would be",
"will allow", "intends to", "will likely result", "are expected to", "will
continue", "is anticipated", "estimate", "project", or similar expressions are
intended to identify "forward-looking statements" within the meaning of the
Private Securities Litigation Reform Act of 1995.
The Company wishes to caution readers not to place undue reliance on any
such forward-looking statements, which speak only as of the date made, and to
advise readers that various factors, including regional and national economic
conditions, substantial changes in levels of market interest rates, credit and
other risks of lending and investment activities and competitive and
regulatory factors, could affect the Company's financial performance and could
cause the Company's actual results for future periods to differ materially
from those anticipated or projected. For a discussion of such factors that
could cause actual results to differ from those contained in forward-looking
statements, see "Risk Factors" in the Company's Annual Report on Form 10-K for
the fiscal year ended December 31, 1997.
The Company does not undertake, and specifically disclaims any obligation,
to update any forward-looking statements to reflect occurrences or
unanticipated events or circumstances after the date of such statements.
2
<PAGE>
PART I
ITEM 1. FINANCIAL STATEMENTS
HEADLANDS MORTGAGE COMPANY
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
-------------- ------------
<S> <C> <C>
ASSETS
Cash and cash equivalents.......................... $ 7,362,636 $ 4,322,701
Retained interests in securitizations.............. 40,742,193 32,552,277
Accounts receivable................................ 15,232,474 13,166,574
Accounts receivable from related parties........... 119,434 61,539
Mortgage loans held for sale, pledged.............. 899,536,421 651,080,189
Originated mortgage servicing rights, net.......... 27,930,460 26,127,391
Property, equipment and leasehold improvements,
net............................................... 12,639,902 7,715,431
Mortgage loans held for investment, net............ 304,882 824,307
Real estate owned, net............................. 287,405 118,772
Other assets....................................... 2,390,917 1,836,021
-------------- ------------
TOTAL ASSETS................................... $1,006,546,724 $737,805,202
============== ============
LIABILITIES AND
STOCKHOLDERS' EQUITY
Notes payable...................................... $ 834,177,708 $641,960,679
Notes payable to stockholders...................... -- 9,670,000
Stockholder distributions payable.................. 13,748,975 --
Accounts payable................................... 35,916,783 12,014,212
Accrued liabilities................................ 9,760,533 7,629,072
-------------- ------------
Total liabilities.............................. 893,603,999 671,273,963
-------------- ------------
Commitments and contingencies
Stockholders' equity:
Common Stock (no par value; 50,000,000 shares
authorized, 19,700,000 shares issued and
outstanding).................................... 91,808,446 1,000
Additional paid-in-capital-stock options......... 830,095 118,585
Retained earnings................................ 20,304,184 66,411,654
-------------- ------------
Total stockholders' equity..................... 112,942,725 66,531,239
-------------- ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY..... $1,006,546,724 $737,805,202
============== ============
</TABLE>
See accompanying notes to consolidated financial statements.
3
<PAGE>
HEADLANDS MORTGAGE COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- ---------------------------
1998 1997 1998 1997
------------- ------------- ------------- ------------
<S> <C> <C> <C> <C>
INCOME:
Net gain from sales of
mortgage loans....... $ 23,446,555 $ 10,040,343 $ 51,583,365 $ 17,931,283
Loan administration
income............... 3,462,995 2,273,458 6,513,990 4,660,028
Gain from sale of
mortgage servicing
rights............... -- 243,904 130,622 9,038,359
Production income..... 4,472,168 2,169,712 8,661,390 3,817,460
Interest income, net
of interest expense.. 6,053,643 3,028,952 10,967,327 5,370,245
Net unrealized gain in
valuation of retained
interests in
securitizations...... 248,678 595,040 26,700 595,040
------------- ------------- ------------- ------------
Total income ....... 37,684,039 18,351,409 77,883,394 41,412,415
EXPENSES:
Personnel............. 13,221,961 6,493,834 24,561,506 12,458,045
General and adminis-
trative.............. 6,155,063 3,625,577 12,064,443 6,744,354
Occupancy and rents... 912,661 549,603 1,715,701 1,069,752
Depreciation and
amortization of
property, equipment
and leasehold
improvements......... 1,283,933 593,301 2,283,888 1,222,227
Amortization and im-
pairment of origi-
nated mortgage ser-
vicing rights........ 3,921,845 1,377,492 7,210,516 1,897,469
------------- ------------- ------------- ------------
Total expenses...... 25,495,463 12,639,807 47,836,054 23,391,847
------------- ------------- ------------- ------------
Income before income
taxes.............. 12,188,576 5,711,602 30,047,340 18,020,568
Income taxes related
to earnings ....... 5,136,787 245,827 14,563,576 675,609
Income taxes related
to S corporation
conversion......... -- -- 18,487,965 --
------------- ------------- ------------- ------------
Net income (loss)... $ 7,051,789 $ 5,465,775 $ (3,004,201) $ 17,344,959
============= ============= ============= ============
PRO FORMA INFORMATION:
Income before income
taxes and pro forma
data................. $ 12,188,576 $ 5,711,602 $ 30,047,340 $ 18,020,568
Provision for
pro forma in-
come taxes .......... 5,136,787 2,418,160 31,128,333 7,568,639
------------- ------------- ------------- ------------
Pro forma net income
(loss)............. $ 7,051,789 $ 3,293,442 $ (1,080,993) $ 10,451,929
============= ============= ============= ============
Weighted average ba-
sic shares
outstanding........ 19,700,000 14,000,000 18,531,967 14,000,000
Pro forma loss per
share--Basic ...... $ 0.36 $ 0.24 $ (0.06) $ 0.75
============= ============= ============= ============
Weighted average di-
luted shares
outstanding........ 20,078,504 15,145,748 18,531,967 15,145,748
Pro forma loss per
share--Diluted .... $ 0.35 $ 0.22 $ (0.06) $ 0.69
============= ============= ============= ============
</TABLE>
See accompanying notes to consolidated financial statements.
4
<PAGE>
HEADLANDS MORTGAGE COMPANY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
ADDITIONAL
PAID-IN- TOTAL
SIX MONTHS ENDED JUNE COMMON CAPITAL RETAINED STOCKHOLDERS'
30, 1997 STOCK STOCK OPTIONS EARNINGS EQUITY
- --------------------- ----------- ------------- ------------ -------------
<S> <C> <C> <C> <C>
Balances at December 31,
1996................... $ 1,000 $ -- $ 29,143,241 $ 29,144,241
Net income.............. -- -- 17,344,959 17,344,959
----------- -------- ------------ ------------
Balances at June 30,
1997................... $ 1,000 $ -- $ 46,488,200 $ 46,489,200
=========== ======== ============ ============
<CAPTION>
ADDITIONAL
PAID-IN- TOTAL
SIX MONTHS ENDED JUNE COMMON CAPITAL RETAINED STOCKHOLDERS'
30, 1998 STOCK STOCK OPTIONS EARNINGS EQUITY
- --------------------- ----------- ------------- ------------ -------------
<S> <C> <C> <C> <C>
Balances at December 31,
1997................... $ 1,000 $118,585 $ 66,411,654 $ 66,531,239
Net loss as S corpora-
tion, including loss
related to establish-
ment of C corporation
deferred tax liabili-
ty..................... -- -- (23,308,385) (23,308,385)
Accrued distribution to
S corporation
stockholders........... -- -- (13,748,975) (13,748,975)
Constructive
recapitalization of S
corporation
undistributed
earnings............... 29,354,294 -- (29,354,294) --
Net proceeds of initial
public offering........ 62,453,152 -- -- 62,453,152
Stock option contribu-
tion to capital........ -- 711,510 -- 711,510
Net income as C corpora-
tion................... -- -- 20,304,184 20,304,184
----------- -------- ------------ ------------
Balances at June 30,
1998................... $91,808,446 $830,095 $ 20,304,184 $112,942,725
=========== ======== ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
5
<PAGE>
HEADLANDS MORTGAGE COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE SIX MONTHS ENDED
JUNE 30,
----------------------------
1998 1997
------------- -------------
<S> <C> <C>
Cash flows from operating activities:
Net (loss) income............................... $ (3,004,201) $ 17,344,959
Adjustments to reconcile net (loss) income to
net cash used in operating
activities:
Depreciation and amortization of property,
equipment and leasehold improvements......... 2,283,888 1,222,227
Amortization and impairment of originated
mortgage servicing rights.................... 7,210,516 1,897,469
Compensation from stock options............... 711,510 --
Gain from sale of mortgage servicing rights... (130,622) (9,038,359)
Net gain from sales of mortgage loans......... (51,583,365) (17,931,283)
Net purchase of retained interests in
securitizations.............................. (8,189,916) (743,601)
Increase in accounts receivable............... (2,123,795) (3,210,711)
Increase in mortgage loans held for sale,
pledged...................................... (196,872,867) (119,789,735)
Net (increase) decrease in originated mortgage
servicing rights............................. (8,882,963) 5,220,565
Increase in other assets...................... (554,896) (241,921)
Increase in accounts payable and accrued lia-
bilities..................................... 26,034,032 2,962,002
------------- -------------
Net cash used in operating activities....... (235,102,679) (122,308,388)
Net cash used in investing activities:
Purchase of property, equipment and leasehold
improvements.................................. (7,208,359) (4,759,960)
Net proceeds from mortgage loans held for in-
vestment...................................... 519,425 (136,594)
Net purchase of real estate owned.............. (168,633) 121,079
------------- -------------
Net cash used in investing activities....... (6,857,567) (4,775,475)
Net cash provided by financing activities:
Net draws on notes payable..................... 192,217,029 125,706,738
Repayment of notes payable to stockholders..... (9,670,000) --
Proceeds from sale of common stock............. 62,453,152 --
------------- -------------
Net cash provided by financing activities... 245,000,181 125,706,738
------------- -------------
Net increase (decrease) in cash.................. 3,039,935 (1,377,125)
Cash and cash equivalents beginning of period.... 4,322,701 2,701,333
------------- -------------
Cash and cash equivalents end of period.......... $ 7,362,636 $ 1,324,208
============= =============
Supplemental disclosures of cash flow informa-
tion:
Cash paid for interest......................... $ 22,568,506 $ 13,834,923
Cash paid for income taxes..................... 10,046,216 578,790
</TABLE>
See accompanying notes to consolidated financial statements.
6
<PAGE>
HEADLANDS MORTGAGE COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.ORGANIZATION
Headlands Mortgage Company (the "Company") is a publicly held California
corporation which was organized in 1981, and completed an initial public
offering of common stock on February 4, 1998. The Company is a specialty
mortgage banking company in the business of originating, selling, securitizing
and servicing residential mortgage loans secured by one-to four-unit family
residences, and purchasing and selling mortgage servicing rights.
The Company is headquartered in Northern California, and has production
branches in California, Washington, Oregon, Nevada, Florida, New Jersey,
Virginia, Idaho, and Arizona. Loans are originated primarily through the
Company's wholesale division, through a network of independent mortgage loan
brokers approved by the Company, and also through its correspondent lending
and retail lending divisions. The mortgage loans are acquired by the Company
in one of the three following manners: (i) originated by an independent broker
and purchased by the Company, (ii) originated by a broker and funded by the
Company, or (iii) originated and funded by the Company in the ordinary course
of business. The market for the Company's mortgage banking operations is
predominantly California and the western United States.
The consolidated financial statements include Headlands Mortgage Company
("HMC"), and its wholly-owned subsidiary Headlands Mortgage Securities Inc.
("HMSI"). The activity of the subsidiary is related to the Company's
securitizations. All material intercompany balances and transactions have been
eliminated.
The Company diversified its residential mortgage loan sales activities in
1996 to include the securitization of such loans into Real Estate Mortgage
Investment Conduits ("REMICs") and Asset-Backed Securities ("ABS"). The
REMICs, which consist of pooled fixed-rate first-lien mortgages, were issued
by the Company to the public through the registration statement of the related
underwriter during 1996, and through the registration statement of HMSI during
1997 and 1998. The ABS, which consist of revolving home equity loans and
closed-end second mortgages, were issued by the Company through Headlands
Mortgage LLC (HMSI's predecessor) and the registration statement of the
related underwriter in 1996, and through the registration statement of HMSI
during 1997 and 1998.
The Company's executive offices are located in Larkspur, California, and its
loan servicing center is located in Santa Rosa, California. The Company's
source of servicing is from mortgage loans it has originated and sold.
2.BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been
prepared in conformity with generally accepted accounting principals and with
the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements. In the
opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation have been included.
Operating results for the six months ended June 30, 1998 are not necessarily
indicative of the results that may be expected for the year ended December 31,
1998. The financial information presented herein should be read in conjunction
with the consolidated financial statements and footnotes included in the
Headlands Mortgage Company Annual Report on Form 10-K for the year ended
December 31, 1997. Certain prior period amounts have been reclassified to
conform to current period presentation.
In preparing the financial statements, management is required to make
estimates and assumptions that affect the reported amounts of assets and
liabilities as of the dates of the balance sheets and revenues and expenses
for the periods presented. Actual results could differ significantly from
those estimates.
7
<PAGE>
HEADLANDS MORTGAGE COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
3.PRO FORMA INFORMATION
(a) Pro Forma Income Taxes
On January 31, 1998, the Company converted from an S corporation to a C
corporation. As a C corporation, the Company bears the tax obligation relating
to the net income earned for federal and state tax purposes.
The accompanying consolidated statements of operations for the six months
ended June 30, 1998 and 1997 reflect the income tax expense of the Company as
if it had been subject to federal and state C corporation income taxes for the
periods presented. The pro forma information also takes into consideration the
one-time, non-cash charge relating to deferred income taxes on historical
earnings resulting from termination of the Company's S corporation status.
(b) Pro Forma Earnings Per Share Data
The weighted average diluted shares for the six months ended June 30, 1998
did not include shares related to the Company's Stock Option Plan as they were
anti-dilutive for the period presented.
4.CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with an original
maturity of 90 days or less to be cash equivalents, including restricted cash
and cash equivalents in the amount of $3,612,292 and $2,053,613 at June 30,
1998 and December 31, 1997, respectively.
5.RETAINED INTERESTS IN SECURITIZATIONS
Retained interests in securitizations consist of assets generated by the
Company's loan securitizations. These assets were as follows at:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
----------- ------------
<S> <C> <C>
REMIC subordinate certificates................... $ 5,886,610 $ 6,310,052
ABS Interest-only residual interest.............. 19,311,152 16,264,219
ABS principal interest........................... 15,544,431 9,978,006
----------- -----------
$40,742,193 $32,552,277
=========== ===========
</TABLE>
6.MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale included net deferred fees and costs, and
consisted of the following at:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
------------ ------------
<S> <C> <C>
Mortgage loans................................. $845,669,268 $536,520,290
Home equity lines of credit.................... 44,577,187 107,800,278
Deferred costs, net of fees.................... 9,289,966 6,759,621
------------ ------------
$899,536,421 $651,080,189
============ ============
</TABLE>
8
<PAGE>
HEADLANDS MORTGAGE COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Company classifies REMIC and ABS securities as trading securities in
accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities" and carries them as current assets at market value.
The Company is contractually bound by the Headlands Home Equity Loan (HHEL)
ABS Trusts to retain its principal interest and overcollateralization. While
the Company can sell these certificates, it would be considered a "Rapid
Amortization Event" under the terms of the trust, and would trigger rapid
amortization of the trust senior certificates.
7.PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Property, equipment and leasehold improvements, net, consist of the
following at:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
------------ ------------
<S> <C> <C>
Furniture and fixtures........................ $ 2,319,662 $ 1,483,317
Office equipment.............................. 23,834,470 17,940,908
Leasehold improvements........................ 1,373,718 1,063,892
Automobiles................................... 47,911 49,411
------------ ------------
27,575,761 20,537,528
Less accumulated depreciation and
amortization................................. (14,935,859) (12,822,097)
------------ ------------
$ 12,639,902 $ 7,715,431
============ ============
</TABLE>
8.MORTGAGE LOANS HELD FOR INVESTMENT
During the normal course of business, the Company is required from time to
time to repurchase certain loans from investors. Mortgage loans held for
investment consisted of residential real estate mortgage loans at June 30,
1998 and December 31, 1997. All properties are located in the state of
California. Interest rates on these mortgage loans are at variable and fixed
rates which range from 7.88% to 12.00% at June 30, 1998, and from 7.25% to
12.00% at December 31, 1997. The maturities range from 5 months to 24 years at
June 30, 1998, and from 11 months to 28 years at December 31, 1997.
9.REAL ESTATE OWNED
Real estate owned, net, consists of the following at:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
--------- ------------
<S> <C> <C>
Residential real estate at cost................... $ 443,985 $ 165,463
Less valuation allowance:
Balance at beginning of year.................... (46,691) (52,255)
Additions to allowance.......................... (216,121) (164,016)
Deductions related to real estate sold.......... 106,232 169,580
--------- ---------
Real estate owned, net............................ $ 287,405 $ 118,772
========= =========
</TABLE>
9
<PAGE>
HEADLANDS MORTGAGE COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
10.NOTES PAYABLE
Notes payable consist of the following at:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1998 1997
------------ ------------
<S> <C> <C>
Warehouse line of credit with banks, expiring on
November 4, 1999, $275 million at
June 30, 1998, and $215 million at December 31,
1997, bearing variable interest rates, including a
rate adjusted for compensating balances............ $238,406,304 $195,688,752
Master repurchase agreement with an investment
banker, secured by mortgage loans and expiring May
5, 1999, $250 million at June 30, 1998 and December
31, 1997, bearing variable interest rates ......... 28,887,298 174,542,715
Master repurchase agreement with an investment bank-
er, secured by morgage loans, bearing a variable
interest rate ..................................... 260,483,476 238,613,472
Master repurchase agreement with an investment
banker, secured by mortgage loans and expiring
December 11, 1998, bearing a variable interest rate
based on the LIBOR................................. 296,417,063 21,312,832
Warehouse line of credit with a major corporation
which was terminated on April 1, 1998, $15 million
at December 31, 1997, bearing variable interest
rates based on the LIBOR........................... -- 1,491,935
Master repurchase agreement with an investment bank-
er, secured by marketable securities, bearing a
variable interest rate based on the LIBOR.......... 2,711,545 2,949,223
Master repurchase agreement with an investment bank-
er, secured by marketable securities, bearing a
variable interest rate based on the LIBOR.......... 1,827,700 1,817,000
Master lease agreement with a leasing company, se-
cured by fixed assets of the Company, bearing vari-
ous interest rates based on the LIBOR.............. 5,444,322 5,544,750
------------ ------------
$834,177,708 $641,960,679
============ ============
</TABLE>
11.NOTES PAYABLE TO STOCKHOLDERS
The Company issued notes during 1996 to two of its stockholders. The
principal amount outstanding under the notes at December 31, 1997 was
$9,670,000. On February 5, 1998, the Company commenced trading shares of its
stock on the NASDAQ under the symbol HDLD. A portion of the proceeds received
from the sale of its stock to the public was used to repay the balance due
under the notes.
10
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Headlands Mortgage Company (the "Company") is primarily engaged in the
origination, purchase, sale, securitization and servicing of mortgage loans
secured by one- to four-unit family residences. The Company's total income
represents revenues derived from net gain from sales of mortgage loans, loan
administration income, gain from sales of mortgage servicing rights,
production income, net interest income and net unrealized gain in valuation of
retained interests in securitizations. The net gain from sales of mortgage
loans consists of two components: (i) gain on sale of mortgage loans sold
through securitizations, which is recognized based on the sum of the selling
price of the portion sold and the value of the portion retained less the
carrying value of the mortgage loans sold; and (ii) net gain on mortgage loans
sold through whole loan transactions, which is recognized based upon the
difference between the selling price and the carrying value of the mortgage
loans sold. If a whole loan is sold servicing released, the servicing release
premium is included in the net gain on the sale of the mortgage loan. Loan
administration income includes fees earned as servicer for mortgage loans
owned by investors, net of fees paid to the subservicer. The Company
recognizes gain on the sale of mortgage servicing rights which are sold
separately from the mortgage loans, based upon the difference between the
selling price, net of selling expenses, and the carrying value of the mortgage
loan servicing rights. Production income includes fees paid to the Company by
borrowers for the preparation, documentation and underwriting of mortgage
loans. Net interest income consists of the net spread between interest
received by the Company on its mortgage loans held for sale and interest paid
by the Company under its credit facilities. It also includes interest earned
on retained interests in securitizations net of interest expenses for the
related investment financing.
As of the date of this Report, the Company had 11 wholesale branches and a
network of approximately 5,600 mortgage brokers. In addition, the Company
initiated its correspondent and retail lending divisions in 1994 to access new
mortgage loan origination markets. These strategies were designed to expand
and diversify the Company's mortgage loan origination network and decrease the
Company's reliance on the California real estate market.
The Company has experienced significant growth in the last few years,
particularly since April 1, 1995. Management believes that this growth is
primarily attributable to (i) its changing mortgage loan product mix, (ii) the
Company's geographic expansion, (iii) the Company's further penetration into
its established markets, and (iv) the Company's increased access to additional
funding sources which has enabled the Company to accumulate larger pools of
mortgage loans for sales through securitizations.
In connection with its growth, the Company has continued to focus its
resources on developing mortgage loan production from borrowers, brokers and
correspondents by designing mortgage loan products to meet the evolving needs
of these customers. Any future growth will be limited by, among other things,
the Company's need for continued funding sources, access to capital markets,
sensitivity to economic slowdowns, ability to attract and retain qualified
personnel, fluctuations in interest rates and competition from other mortgage
lenders and from new market entrants.
The Company's primary source of mortgage loan servicing rights is from
mortgage loans originated or acquired and sold by the Company. Of the
Company's $4.8 billion of mortgage loans serviced at June 30, 1998, $3.8
billion were serviced for others and $1.0 billion were either mortgage loans
held for sale or other assets of the Company. Of the mortgage loans serviced
for others, approximately $1.7 billion were mortgage loans serviced for Fannie
Mae or Freddie Mac, $1.9 billion were mortgage loans included in securities
created by the Company, and $0.2 billion were mortgage loans serviced for
private investors. Of the total mortgage loans serviced for others at June 30,
1998 and 1997, respectively, 1.5% and 1.1% were 30 days or more delinquent. As
of June 30, 1998 and 1997, the Company had not purchased mortgage loan
servicing rights.
11
<PAGE>
TERMINATION OF S CORPORATION STATUS AND INCOME TAXES
On January 31, 1998, the Company's status as an S corporation terminated. In
connection with the termination of the Company's S corporation status, the
Company will distribute approximately $13.7 million, calculated as of January
31, 1998 to the stockholders of the Company prior to the S corporation
termination.
As an S corporation, the Company's income, whether or not distributed, was
taxed at the stockholder level for federal and state tax purposes. Upon
termination of its S corporation status, the Company became fully subject to
federal and state income taxes and recorded a deferred tax liability on its
consolidated balance sheets. The amount of the deferred tax liability recorded
as of the date of termination of the S corporation status depends upon timing
differences between tax and book accounting relating principally to
recognition of gains on sale of mortgage loans. The deferred tax liability
recognized was approximately $18.5 million (included in accounts payable), and
was recorded as a current tax expense on January 31, 1998. The provision for
pro forma income taxes on the consolidated statements of operations shows
results as if the Company had always been fully subject to federal and state
taxes at the tax rates effective for the periods presented, as well as the
recording of the deferred tax liability relating to the conversion to a C
corporation.
RESULTS OF OPERATIONS
Three and Six Months Ended June 30, 1998 Compared to Three and Six Months
Ended June 30, 1997
Summary. The financial results for the three and six months ended June 30,
1998 reflect the Company's ability to successfully originate mortgage loans,
and securitize and market them in the capital markets. Refinancing activity
accounted for approximately 59% and 50% of the mortgage loans originated by
the Company during the three months ended June 30, 1998 and 1997,
respectively, compared to 61% and 55% of the mortgage loans originated by the
Company during the six months ended June 30, 1998 and 1997, respectively.
Net income for the three months ended June 30, 1998 increased $1.6 million,
or 29%, to $7.1 million compared to net income of $5.5 million for the same
period in the prior year. The percentage increase in net income was less than
the percentage increase in revenue due to the Company's change in tax status
from an S corporation to a C corporation.
Income before income taxes for the three months ended June 30, 1998
increased $6.5 million, or 114%, to $12.2 million compared to income before
income taxes of $5.7 million for the same period in the prior year. The
percentage increase in income before income taxes was higher than the
percentage increase in revenue due to a relatively lower increase in operating
expenses during the three months ended June 30, 1998 compared to the three
months ended June 30, 1997.
Net loss for the six months ended June 30, 1998 decreased $20.3 million, or
117%, to $3.0 million compared to net income of $17.3 million for the same
period in the prior year. The decrease in net income from the prior year was
primarily due to the one-time non-cash deferred tax liability of $18.5 million
recognized by the Company at the C corporation commencement as described in
"Termination of S Corporation Status and Income Taxes" above. Additionally,
the Company was taxed as a C corporation for five months during the six months
ended June 30, 1998, compared to an S corporation tax status for the same
period in the prior year. These increased tax expenses of $32.4 million were
partially offset by an increase in income before income taxes.
Income before income taxes for the six months ended June 30, 1998 increased
$12.0 million, or 67%, to $30.0 million compared to income before income taxes
of $18.0 million for the same period of the prior year. The percentage
increase in income before income taxes was lower than the percentage increase
in revenue due to a relatively higher increase in operating expenses during
the six months ended June 30, 1998 compared to the six months ended June 30,
1997.
Revenue. Revenue for the three months ended June 30, 1998 increased $19.3
million, or 105%, to $37.7 million as compared to $18.4 million for the three
months ended June 30, 1997. Revenue for the six months ended June 30, 1998
increased $36.5 million, or 88%, to $77.9 million as compared to $41.4 million
for the six months ended June 30, 1997.
12
<PAGE>
Net gain from sales of mortgage loans increased $13.4 million, or 134%, to
$23.4 million for the three months ended June 30, 1998 compared to $10.0
million for the same period in the previous year. The increase was the result
of an increase in mortgage loans sold through securitizations and on a whole
loan basis. Mortgage loans either sold or securitized during the three months
ended June 30, 1998 increased $1,167.1 million, or 160%, to $1,895.6 million
from $728.5 million during the three months ended June 30, 1997, with a
weighted average net gain on sale as a percentage of mortgage loans sold or
securitized of 1.2% and 1.4%, respectively. The Company sold 72% of its loans
with servicing rights released during the three months ended June 30, 1998,
compared to 13% for the same period in the prior year. The Company retains
100% of the servicing rights on mortgage loans it sells through
securitizations.
Net gain from sales of mortgage loans increased $33.7 million, or 188%, to
$51.6 million for the six months ended June 30, 1998 compared to $17.9 million
for the same period in the previous year. The increase was the result of an
increase in mortgage loans sold through securitizations and on a whole loan
basis. Mortgage loans either sold or securitized during the six months ended
June 30, 1998 increased $2,003.9 million, or 152%, to $3,321.4 million from
$1,317.5 million during the six months ended June 30, 1997, with a weighted
average net gain on sale as a percentage of mortgage loans sold or securitized
of 1.6% and 1.4%, respectively. The Company sold 69% of its loans with
servicing rights released during the six months ended June 30, 1998, compared
to 17% for the same period in the prior year. The Company retains 100% of the
servicing rights on mortgage loans it sells through securitizations.
Loan administration income increased $1.2 million, or 52%, to $3.5 million
for the three months ended June 30, 1998 from $2.3 million for the three
months ended June 30, 1997. The increase was due primarily to a 19% increase
in the average monthly balance of mortgage loans serviced for others to $3.8
billion from $3.2 billion in the prior year. Additionally, the weighted
average service fee rate increased 0.04%, or 15%, to 0.31% at June 30, 1998
compared to 0.27% at June 30, 1997.
Loan administration income increased $1.8 million, or 38%, to $6.5 million
for the six months ended June 30, 1998 from $4.7 million for the six months
ended June 30, 1997. The increase was due primarily to a 23% increase in the
average monthly balance of mortgage loans serviced for others to $3.8 billion
from $3.1 billion in the prior year, as well as an increase on the weighted
average service fee rate noted in the previous paragraph.
The Company sold mortgage servicing rights relating to $0.3 billion and $1.5
billion of mortgage loan principal balances during the six months ended June
30, 1998 and 1997, respectively, resulting in a pre-tax gain of $0.1 million
and $9.0 million, respectively. These gains represent a 3 basis point and 60
basis point gain based on the outstanding principal balance of the underlying
mortgage loans for the six months ended June 30, 1998 and 1997, respectively.
Of the mortgage servicing rights sold during the six months ended June 30,
1998, 100% had capitalized values in accordance with SFAS 125, compared to 48%
during the same period in the prior year. The remaining 52% in the prior year
were mortgage servicing rights which were originated prior to 1995 and had no
capitalized value. Thus, the decrease in gain is due to a lower book value
related to the mortgage servicing rights sold during the six months ended June
30, 1997, partially offset by an increase in the weighted average sales price
of 34 basis points, or 31%, to 142 basis points for the six months ended June
30, 1998 compared to 108 basis points in the prior year. The increase in
weighted average sales price from the prior year is partially due to the type
and characteristics of servicing rights sold.
In general, the decision to sell, buy or retain mortgage servicing rights is
based upon the market for and value of mortgage servicing rights, and the
Company's current financial needs and objectives. The Company's ability to
sell its mortgage servicing rights under its various mortgage loan servicing
agreements with investors is generally subject to the consent of the
investors. In addition, under the mortgage loan servicing provisions governing
the Company's securitizations, the successor servicer is subject to prior
approval of the rating agencies rating the subject securities.
Production income increased $2.3 million, or 105%, to $4.5 million for the
three months ended June 30, 1998 from $2.2 million for the three months ended
June 30, 1997. The increase is due primarily to the growth in mortgage loan
originations and purchases, partially offset by a 5% decrease in per loan fees
collected during the three months ended June 30, 1998 over the same period in
the prior year. During the three months ended June 30, 1998, mortgage
13
<PAGE>
loan originations increased $1,227.1 million, or 149%, to $2,052.4 million
compared to $825.3 million during the three months ended June 30, 1997.
Production income increased $4.9 million, or 129%, to $8.7 million for the
six months ended June 30, 1998 from $3.8 million for the six months ended June
30, 1997. The increase is due primarily to the growth in mortgage loan
originations and purchases, partially offset by an 8% decrease in per loan
fees collected during the six months ended June 30, 1998 over the same period
in the prior year. During the six months ended June 30, 1998, mortgage loan
originations increased $2,064.4 million, or 136%, to $3,581.8 million compared
to $1,517.4 million during the six months ended June 30, 1997.
Net interest income increased $3.1 million, or 103%, to $6.1 million during
the three months ended June 30, 1998 from $3.0 million during the three months
ended June 30, 1997. Net interest income increased $5.6 million, or 104%, to
$11.0 million during the six months ended June 30, 1998 from $5.4 million
during the six months ended June 30, 1997. The increase in net interest income
was due to several factors: (i) a higher average balance of mortgage loans
held for sale during the three and six months ended June 30, 1998 compared to
the same periods in 1997; (ii) earnings on subordinate certificates retained
by the Company relating to securitizations; (iii) the Company's increase in
available cash to invest in the warehouse lines of credit thereby increasing
the margin between mortgage coupons and borrowing costs; and (iv) repayment of
the $9.7 million notes to shareholders during the first quarter of 1998.
Net unrealized gain in valuation of retained interests in securitizations
decreased $0.4 million, or 67%, to $0.2 million for the three months ended
June 30, 1998 from $0.6 million during the three months ended June 30, 1997.
Net unrealized gain in valuation of retained interests in securitizations
decreased $0.6 million, or 100%, for the six months ended June 30, 1998
compared to the same period in the prior year.
Expenses. Operating expenses increased $12.9 million, or 102%, to $25.5
million during the three months ended June 30, 1998 from $12.6 million for the
three months ended June 30, 1997. Operating expenses increased $24.4 million,
or 104%, to $47.8 million during the six months ended June 30, 1998 from $23.4
million for the six months ended June 30, 1997. The increase in expense was
primarily the result of additional personnel required for the greater volume
of mortgage loan originations, higher general and administrative expenses
related to the increase in mortgage loan originations and an increase in
amortization and impairment of originated mortgage servicing rights relating
to the increase in the capitalized asset during the three and six months ended
June 30, 1998 as compared to the three and six months ended June 30, 1997.
Personnel expense increased $6.7 million, or 103%, to $13.2 million during
the three months ended June 30, 1998 from $6.5 million for the three months
ended June 30, 1997. Personnel expense increased $12.1 million, or 97%, to
$24.6 million during the six months ended June 30, 1998 from $12.5 million for
the six months ended June 30, 1997. The increase in personnel expense was due
primarily to increased staffing in the Company's mortgage loan originations
area. As of June 30, 1998, the Company employed 936 people compared to 582
people at June 30, 1997, a 61% increase. Additionally, personnel expense
includes volume-based compensation expenses which increased in direct
proportion with mortgage loan originations.
General and administrative expenses increased $2.6 million, or 72%, to $6.2
million during the three months ended June 30, 1998 from $3.6 million for the
three months ended June 30, 1997. General and administrative expenses
increased $5.4 million, or 81%, to $12.1 million during the six months ended
June 30, 1998 from $6.7 million for the six months ended June 30, 1997. The
increase in general and administrative expenses is due primarily to expenses
incurred in connection with the increase in loan originations, and includes
such items as office supplies, telephone, computers and postage.
Amortization and impairment of originated mortgage loan servicing rights
increased $2.5 million, or 179%, to $3.9 million for the three months ended
June 30, 1998, from $1.4 million for the three months ended June 30, 1997.
Amortization and impairment of originated mortgage loan servicing rights
increased $5.3 million, or 279%, to $7.2 million for the six months ended June
30, 1998, from $1.9 million for the six months ended June 30,
14
<PAGE>
1997. The increase in amortization and impairment of originated mortgage loan
servicing rights was due to two factors: (1) an increase in the related asset
of 26% from June 30, 1997, and (ii) additional impairment recognized by the
Company relating to an increase in prepayment rates.
FINANCIAL POSITION
June 30, 1998 Compared to December 31, 1997
The balance of mortgage loans held for sale is affected by the timing of
securitizations and whole loan sales. Mortgage loans held for sale increased
$248.4 million, or 38%, to $899.5 million at June 30, 1998 from $651.1 million
at December 31, 1997. The increase in mortgage loans held for sale resulted
primarily from mortgage loan originations and purchases of $3,581.8 million
and HELOC draws of $10.0 million during the six months ended June 30, 1998,
partially offset by sales into securities of $298.6 million and whole loan
sales of $3,022.8 million.
Notes payable under warehouse lines of credit increased $192.2 million, or
30%, to $834.2 million at June 30, 1998 from $642.0 million at December 31,
1997, reflecting the mortgage loan origination, purchase and sale activity
described above. The percentage increase in the borrowings under warehouse
lines of credit was less than the percentage increase in the mortgage loans
held for sale due to the Company's investment of available cash balances in
the mortgage loans held for sale.
Retained interests in securitizations increased $8.1 million, or 25%, to
$40.7 million at June 30, 1998 from $32.6 million at December 31, 1997. The
increase is due to interests retained by the Company in the securitization it
effected during the six months ended June 30, 1998 with an estimated market
value of $10.8 million and the increase in the Company's subordinate interest
in a previously issued security with an estimated market value of $1.5
million, partially offset by a reclassification of security related
liabilities of $4.1 million.
Accounts payable increased $23.9 million, or 199%, to $35.9 million at June
30, 1998 from $12.0 million at December 31, 1997. The increase resulted
primarily from the recognition of the C corporation deferred tax liability of
$18.5 million and the additional tax liability relating to the five months the
Company was taxed as a C corporation during the six months ended June 30,
1998.
Notes payable to shareholders of $9.7 million at December 31, 1997 were
repaid in full from proceeds of the initial public offering.
Originated mortgage servicing rights increased $1.8 million, or 7%, to $27.9
million at June 30, 1998 from $26.1 million at December 31, 1997. The increase
in originated mortgage servicing rights resulted from the sale of mortgage
loans with servicing rights retained with a relative fair value of $11.7
million during the six months ended June 30, 1998, partially offset by
amortization and impairment recorded of $7.2 million and capitalized servicing
sold with a net book value of $2.7 million.
Property, equipment and leasehold improvements, net, increased $4.9 million,
or 64%, to $12.6 million at June 30, 1998 from $7.7 million at December 31,
1997. As a result of the Company's ongoing commitment to modern technology,
this growth reflects the purchase of upgraded office equipment of $6.1
million, additional furniture and fixtures of $0.8 million and leasehold
improvements of $0.3 million. These increases were partially offset by
depreciation and amortization of $2.3 million.
Accrued liabilities increased $2.2 million, or 29%, to $9.8 million at June
30, 1998 from $7.6 million at December 31, 1997. The increase was due to the
general increase in operating expenses and the timing of payment of those
expenses.
Stockholders' equity increased $46.4 million, or 70%, to $112.9 million at
June 30, 1998 from $66.5 million at December 31, 1997. This increase is due to
net proceeds from the Company's initial public offering of $62.5 million,
15
<PAGE>
additional paid in capital relating to stock options granted of $0.7 million,
and earnings as a C corporation of $20.3 million, offset by the recognition of
a stockholder distribution of $13.8 million, and the loss as an S corporation
of $23.3 million (which includes the recognition of the deferred tax
liability).
LIQUIDITY AND CAPITAL RESOURCES
The Company's principal liquidity requirements include the funding or
payment of: (i) mortgage loan originations and purchases; (ii) investments and
overcollateralization requirements in connection with its securitization
program; (iii) fees and expenses incurred in connection with securitizations;
(iv) advances of delinquent principal and interest payments and escrow
balances required to be made as a mortgage loan servicer; and (v) ongoing
administrative and other operating expenses.
The Company must be able to sell mortgage loans and obtain adequate credit
facilities and other sources of funding in order to continue to originate and
purchase mortgage loans. As a result of increased loan originations and
purchases, the Company used cash of $235.1 million for operating activities
during the six months ended June 30, 1998.
The Company used cash of $7.2 million for the purchase of property,
equipment and leasehold improvements during the six months ended June 30,
1998. The increase during 1998 represents upgrades to office equipment, the
purchase of additional furniture and fixtures, and leasehold improvements.
The Company had cash flow from financing activities relating to the proceeds
from the sale of Common Stock of $62.5 million and repayment of notes to
shareholders of $9.7 million. Additionally, the Company utilizes short-term
warehouse facilities and repurchase agreements to fund mortgage loan
originations and purchases. Thus, the increase in loan production, combined
with the other two financing activities, resulted in cash provided by
financing activities of $245.0 million during the six months ended June 30,
1998.
The Company increased its mortgage loan warehousing facility during the six
months ended June 30, 1998 to $275.0 million from $230.0 million at December
31, 1997. The facility extends through November 4, 1999. At June 30, 1998, the
outstanding balance under the Warehouse Facility was $238.4 million.
In addition to the Warehouse Facility, the Company makes regular use of
certain uncommitted lines of credit, short-term credit facilities and purchase
and sale agreements (such as repurchase or "gestation" agreements) provided by
major investment banks. Amounts outstanding under these various facilities at
June 30, 1998 were $585.8 million. The Company terminated one of its warehouse
lines of credit with a major corporation during the six months ended June 30,
1998.
The Company decreased its servicing secured line of credit during the six
months ended June 30, 1998 to $3.0 million from $15.0 million at December 31,
1997. This line of credit expires on November 4, 1998. At June 30, 1998, the
Company had no outstanding balance under this line of credit.
The Company has a master lease agreement with a leasing company for
borrowing arrangements relating to fixed assets. At June 30, 1998, the Company
had $5.4 million outstanding under this agreement.
RECENT ACCOUNTING PRONOUNCEMENTS
In June, 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"), which amends the disclosure requirements
of Statement No. 52, "Foreign Currency Translations" and of Statement No. 107,
"Disclosures about Fair Value of Financial Instruments." SFAS 133 supersedes
Statements No. 80 "Accounting for Future Contracts", No. 105 "Disclosure of
Information about Financial Instruments with Off-Balance Sheet Risk and
Financial Instruments with Concentrations of Credit Risk" and No. 119,
"Disclosure about Derivative Financial Instruments and Fair Value of Financial
Instruments." Under the provisions of SFAS 133, the Company is required to
recognize all derivatives as either assets or liabilities in the statement of
financial
16
<PAGE>
condition and measure those instruments at fair value. If certain conditions
are met, a derivative may be specifically designated as (a) a hedge of the
exposure to changes in the fair value of a recognized asset or liability or an
unrecognized firm commitment, (b) a hedge of the exposure to variable cash
flows of a forecasted transaction, or (c) a hedge of the foreign currency
exposure of a net investment in a foreign operation, an unrecognized firm
commitment, an available-for-sale security or a foreign-currency-denominated
forecasted transaction. The accounting for changes in the fair value of a
derivative (that is, gain and losses) depends on the intended use of the
derivative and the resulting operation. SFAS 133 is effective for all fiscal
quarters of fiscal years beginning June 15, 1999, with early application
encouraged, but it is permitted only as of the beginning of any fiscal quarter
that begins after the issuance of the statement. SFAS 133 should not be
applied retroactively to financial statements of prior periods. The Company
does not expect that the adoption of SFAS 133 will have a material impact on
its financial condition.
ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not required.
PART II
ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K
(a)Exhibits filed with this report are as follows:
27.1Financial data schedule
(b)The Company filed the following report on Form 8-K during the quarter ended
June 30, 1998:
None
17
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HEADLANDS MORTGAGE COMPANY
Date: August 13, 1998 By: /s/ Gilbert J. MacQuarrie
-------------------------
Gilbert J. MacQuarrie
Executive Vice President and CFO
(SIGNING IN THE CAPACITY OF (I) DULY
AUTHORIZED OFFICER OF THE REGISTRANT
AND (II) PRINCIPAL FINANCIAL OFFICER
OF THE REGISTRANT)
18
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<PERIOD-TYPE> 12-MOS 12-MOS
<FISCAL-YEAR-END> DEC-31-1998 DEC-31-1997
<PERIOD-START> APR-01-1998 JAN-01-1997
<PERIOD-END> JUN-30-1998 DEC-31-1997
<CASH> 7,362,636 4,322,701
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