<PAGE>
FILED PURSUANT TO RULE 424(b)(1)
REGISTRATION NO. 333-42933
PROSPECTUS
2,000,000 SHARES
[LOGO OF FLAGSTAR CAPITAL APPEARS HERE]
8.5% NONCUMULATIVE PREFERRED STOCK, SERIES A
(LIQUIDATION PREFERENCE $25.00 PER SHARE)
EXCHANGEABLE INTO PREFERRED STOCK OF FLAGSTAR BANK, FSB
----------
Flagstar Capital Corporation (the "Company"), originally organized in June
1995, is hereby offering 2,000,000 shares of its 8.5% Noncumulative
Exchangeable Preferred Stock, Series A, par value $25.00 per share (the
"Series A Preferred Shares"). The Company has been recently reorganized for
the purpose of acquiring, holding and managing real estate mortgage loans
("Mortgage Loans") that are intended to generate sufficient income to permit
the declaration of dividends on the Series A Preferred Shares at the stated
rate and to meet the operating expenses of the Company. Dividends on the
Series A Preferred Shares are payable at the rate
(Continued)
----------
SEE "RISK FACTORS" COMMENCING ON PAGE 12 FOR A DISCUSSION OF THE MATERIAL
RISKS THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE SERIES A
PREFERRED SHARES INCLUDING, AMONG OTHERS:
. A DECLINE IN THE PERFORMANCE OR CAPITAL LEVELS OF FLAGSTAR BANK, FSB (THE
"BANK") COULD RESULT IN AN AUTOMATIC EXCHANGE OF THE SERIES A PREFERRED
SHARES INTO SHARES OF PREFERRED STOCK OF THE BANK (THE "AUTOMATIC
EXCHANGE"), FORCING HOLDERS OF THE SERIES A PREFERRED SHARES TO ACCEPT AN
INVESTMENT IN THE BANK, WHICH CARRIES RISKS DIFFERENT FROM AN INVESTMENT IN
THE COMPANY.
. THE HAMMOND FAMILY MEMBERS, WHO AS THE CONTROLLING STOCKHOLDERS OF THE
BANK'S SOLE STOCKHOLDER, FLAGSTAR BANCORP, INC. ("FLAGSTAR"), CAN THEREBY
CONTROL BOTH THE COMPANY AND THE BANK, MAY HAVE INVESTMENT GOALS AND
STRATEGIES THAT DIFFER FROM THOSE OF THE HOLDERS OF THE SERIES A PREFERRED
SHARES.
. POTENTIAL CONFLICTS OF INTEREST WITH THE BANK, FLAGSTAR, OR HAMMOND FAMILY
MEMBERS, AS CONTROLLING STOCKHOLDERS, MAY RESULT IN DECISIONS BY THE COMPANY
THAT ARE NOT FULLY CONSISTENT WITH THE INTERESTS OF THE HOLDERS OF THE
SERIES A PREFERRED SHARES, INCLUDING THE PURCHASE OF MORTGAGE LOANS FROM THE
BANK RATHER THAN ELSEWHERE, THE COMPANY'S DETERMINATION TO HOLD RATHER THAN
SELL NONPERFORMING LOANS, AND THE POTENTIALLY DIFFERING CORPORATE GOALS OF
FLAGSTAR .
. THE COMPANY WILL BE DEPENDENT UPON THE BANK TO SELECT AND SERVICE THE LOAN
PORTFOLIO AND, BECAUSE THE BANK WILL SERVE AS THE COMPANY'S ADVISOR, TO
ADMINISTER THE COMPANY'S DAY-TO-DAY OPERATIONS.
. THE COMPANY'S PAYMENTS OF DIVIDENDS OR ITS OPERATIONS COULD BE SUBJECT TO
REGULATORY RESTRICTIONS BECAUSE OF ITS AFFILIATION WITH THE BANK.
. THE BANK MAY BE UNABLE TO PAY DIVIDENDS ON ITS PREFERRED STOCK FOLLOWING AN
AUTOMATIC EXCHANGE.
. A DECLINE IN INTEREST RATES COULD ADVERSELY AFFECT THE COMPANY'S ABILITY TO
PAY DIVIDENDS.
. THE COMPANY'S FAILURE TO QUALIFY AS A REAL ESTATE INVESTMENT TRUST (A
"REIT") COULD ADVERSELY AFFECT THE COMPANY'S FINANCIAL RESULTS AND ITS
ABILITY TO PAY DIVIDENDS.
. THE 41 PERCENT CONCENTRATION OF THE COMPANY'S MORTGAGE LOANS IN CALIFORNIA
AND MICHIGAN COULD INCREASE THE COMPANY'S RISK OF LOSS.
----------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION (THE "COMMISSION"), THE OFFICE OF THRIFT SUPERVISION (THE
"OTS"), THE FEDERAL DEPOSIT INSURANCE CORPORATION (THE "FDIC") OR ANY STATE
SECURITIES COMMISSION, NOR HAS THE COMMISSION, THE OTS, THE FDIC OR ANY STATE
SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS.
ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
----------
THE SERIES A PREFERRED SHARES, AND THE PREFERRED STOCK OF THE BANK INTO WHICH
THEY ARE EXCHANGEABLE, ARE NOT SAVINGS ACCOUNTS OR DEPOSITS OR OTHER OBLIGATIONS
OF THE BANK AND ARE NOT INSURED BY THE FDIC OR ANY OTHER GOVERNMENTAL AGENCY OR
OTHERWISE INSURED OR GUARANTEED.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
INITIAL PUBLIC UNDERWRITING PROCEEDS TO
OFFERING PRICE COMMISSION(1) COMPANY(2)
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Per Share.............................. $25.00 $0.8725 $24.1275
- --------------------------------------------------------------------------------
Total(3)............................... $50,000,000 $1,745,000 $48,255,000
</TABLE>
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- -------------------------------------------------------------------------------
(1) The Company and the Bank have agreed to indemnify the Underwriters against
certain liabilities, including liabilities under the Securities Act of
1933.
(2) Before deducting expenses payable by the Company estimated at
approximately $1.2 million.
(3) The Company has granted the Underwriters an option for 30 days to purchase
up to an additional 300,000 Series A Preferred Shares at the initial
public offering price per share, less underwriting commissions, solely to
cover over-allotments, if any. If such option is exercised in full, the
total initial public offering price, underwriting commission and proceeds
to Company will be $57.5 million, $2,006,750 million and $55,493,250
million, respectively.
----------
The Series A Preferred Shares are offered severally by the Underwriters, as
specified herein, subject to receipt and acceptance by them and subject to
their right to reject any order in whole or in part. It is expected that the
Series A Preferred Shares will be ready for delivery through the facilities of
The Depository Trust Company in New York, New York, on or about February 24,
1998 against payment therefor in immediately available funds.
----------
RONEY & CO. MCDONALD & COMPANY
SECURITIES, INC.
THE DATE OF THIS PROSPECTUS IS FEBRUARY 18, 1998
<PAGE>
(continued)
of 8.5% per annum of the liquidation preference (an amount equal to $2.125 per
annum per share), if, when and as declared by the Board of Directors of the
Company and, if declared, are payable quarterly in arrears on the last day of
March, June, September and December in each year, commencing March 31, 1998.
Dividends are not cumulative and therefore if no dividend is declared on the
Series A Preferred Shares by the Company for a quarterly dividend period,
holders of the Series A Preferred Shares will have no right to receive a
dividend for that period, and the Company will have no obligation to pay a
dividend for that period, whether or not dividends are declared and paid for
any future period. Dividends in each dividend period will accrue from the
first day of the period, whether or not declared or paid in the prior period.
The Series A Preferred Shares are not redeemable prior to March 1, 2003
(except upon the occurrence of a Tax Event as described herein). On and after
March 1, 2003, the Series A Preferred Shares may be redeemed for cash at the
option of the Company, in whole or in part, at a redemption price of $25.00
per share, plus the accrued and unpaid dividends for the most recent quarter,
if any, thereon, subject to the receipt of prior approval from the OTS or any
successor regulatory agency. The Series A Preferred Shares will not be subject
to any sinking fund or mandatory redemption and will not be convertible into
any other securities of the Company.
Prior to the offering, there has been no market for the Series A Preferred
Shares. The Series A Preferred Shares have been approved for quotation on the
Nasdaq Stock Market ("Nasdaq") under the symbol "FLGSP."
Under certain circumstances, each Series A Preferred Share will be exchanged
automatically (the "Automatic Exchange") for one newly issued share of
preferred stock (the "Bank Preferred Shares") of the Bank, a federally
chartered and federally insured stock savings bank, if the appropriate
regulatory agency directs in writing (a "Directive") an exchange of the Series
A Preferred Shares for Bank Preferred Shares because (i) the Bank has become
"undercapitalized" under prompt corrective action regulations, (ii) the Bank
is placed into conservatorship or receivership or (iii) the appropriate
federal regulatory agency, in its sole discretion and even if the Bank is not
"undercapitalized," anticipates the Bank's becoming "undercapitalized" in the
near term (the "Exchange Event"). CONSEQUENTLY, AN INVESTMENT IN SERIES A
PREFERRED SHARES COULD BE REPLACED BY AN INVESTMENT IN BANK PREFERRED SHARES
AT A TIME WHEN THE BANK'S FINANCIAL CONDITION IS DETERIORATING OR WHEN THE
BANK HAS BEEN PLACED INTO CONSERVATORSHIP OR RECEIVERSHIP. POTENTIAL INVESTORS
IN THE SERIES A PREFERRED SHARES, THEREFORE, SHOULD CAREFULLY CONSIDER THE
DESCRIPTION OF THE BANK SET FORTH ELSEWHERE IN THIS PROSPECTUS. In the event
of the Automatic Exchange, the Bank Preferred Shares would constitute a new
series of preferred shares of the Bank, would have the same dividend rights,
liquidation preference, redemption options and other attributes as the Series
A Preferred Shares, except that the Bank Preferred Shares would not be listed
on Nasdaq or any other quotation system, and would rank, in terms of cash
dividend payments and liquidation, equal to and without preference over any
outstanding shares of preferred stock of the Bank. Holders of Series A
Preferred Shares cannot exchange their Series A Preferred Shares for Bank
Preferred Shares voluntarily, and, absent the occurrence of the Automatic
Exchange, holders of Series A Preferred Shares will have no dividend, voting,
liquidation preference or other rights with respect to the Bank or any
security of the Bank. See "Description of Series A Preferred Shares--Automatic
Exchange."
The Bank is registering the Bank Preferred Shares with the OTS in
conjunction with this Offering, but does not intend to apply for listing of
the Bank Preferred Shares on any national securities exchange or for quotation
of the Bank Preferred Shares through Nasdaq. Consequently, there can be no
assurance as to the liquidity of the trading markets for the Bank Preferred
Shares, if issued, or that an active public market for the Bank Preferred
Shares would develop or be maintained.
All of the shares of the Company's common stock, par value $1.00 per share
(the "Common Stock"), are owned by the Bank. The Bank currently intends that,
so long as any Series A Preferred Shares are outstanding, it will maintain
direct or indirect ownership of at least a majority of the outstanding shares
of Common Stock of the Company.
The Company expects to qualify as a real estate investment trust (a "REIT")
for federal income tax purposes, commencing with the taxable year ending
December 31, 1998. Among the requirements to qualify as a REIT, no person is
permitted to own beneficially more than 5.0% of any series of preferred stock
of the Company, including the Series A Preferred Shares, with limited
exceptions.
---------------
THE INFORMATION CONTAINED HEREIN CONTAINS FORWARD-LOOKING STATEMENTS THAT
INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES. A NUMBER OF FACTORS, INCLUDING
THOSE DISCUSSED HEREIN, COULD CAUSE RESULTS TO DIFFER MATERIALLY FROM THOSE
ANTICIPATED BY SUCH FORWARD-LOOKING STATEMENTS. IN ADDITION, SUCH FORWARD-
LOOKING STATEMENTS ARE NECESSARILY DEPENDENT UPON ASSUMPTIONS, ESTIMATES AND
DATA THAT MAY BE INCORRECT OR IMPRECISE. ACCORDINGLY, ANY FORWARD-LOOKING
STATEMENTS INCLUDED HEREIN DO NOT PURPORT TO BE PREDICTIONS OF FUTURE EVENTS
OR CIRCUMSTANCES AND MAY NOT BE REALIZED. FORWARD-LOOKING STATEMENTS CAN BE
IDENTIFIED BY, AMONG OTHER THINGS, THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH
AS "INTENDS," "BELIEVES," "EXPECTS," "MAY," "WILL," "SHOULD," "SEEKS," "PRO
FORMA" OR "ANTICIPATES," OR THE NEGATIVES THEREOF, OR OTHER VARIATIONS THEREON
OF COMPARABLE TERMINOLOGY, OR BY DISCUSSIONS OF STRATEGY OR INTENTIONS.
---------------
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE SERIES A
PREFERRED SHARES. SUCH TRANSACTIONS MAY INCLUDE THE PURCHASE OF SERIES A
PREFERRED SHARES FOLLOWING THE PRICING OF THE OFFERING TO COVER A SYNDICATE
SHORT POSITION IN THE SERIES A PREFERRED SHARES OR FOR THE PURPOSE OF
MAINTAINING THE PRICE OF THE SERIES A PREFERRED SHARES, AND THE IMPOSITION OF
PENALTY BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING."
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
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<S> <C>
PROSPECTUS SUMMARY........................................................ 1
The Company............................................................. 1
The Bank................................................................ 2
Risk Factors............................................................ 2
Business and Strategy................................................... 4
The Formation........................................................... 6
The Offering............................................................ 8
Tax Status of the Company............................................... 9
Conflicts of Interest................................................... 10
Automatic Exchange...................................................... 10
RISK FACTORS.............................................................. 12
A Decline in the Performance or Capital Levels of the Bank Could Result
in an Automatic Exchange, Forcing Holders of the Series A Preferred
Shares to Accept an Investment in the Bank, Which Carries Risks
Different From an Investment in the Company............................ 12
The Hammond Family Members, Who as the Controlling Stockholders of
Flagstar Can Thereby Control Both the Company and the Bank, May Have
Investment Goals and Strategies That Differ From Those of the Holders
of the Series A Preferred Shares....................................... 13
Potential Conflicts of Interest With the Bank, Flagstar or Hammond
Family Members, as Controlling Stockholders of Flagstar, May Result in
Decisions by the Company That Are Not Fully Consistent With the
Interests of the Holders of the Series A Preferred Shares.............. 13
The Company Will Be Dependent Upon the Bank to Select and Service the
Loan Portfolio and, Because the Bank Will Serve as the Company's
Advisor, to Administer the Company's Day-to-Day Operations............. 15
Stockholders Could Be Forced to Surrender Their Stock Immediately Upon
the Occurrence of a Tax Event.......................................... 15
The Company's Payment of Dividends or Its Operations Could Be Subject to
Regulatory Restrictions Because of Its Affiliation With the Bank....... 15
The Bank May Be Unable to Pay Dividends on Its Preferred Stock Following
an Automatic Exchange.................................................. 16
Stockholders Could Suffer a Permanent Loss of Any Dividends Not Declared
by the Board of Directors.............................................. 16
The Company's Source of Cash to Fund Dividend Payments Depends Solely
Upon Payments Received From Its Mortgage Loans......................... 16
A Decline in Interest Rates Would Adversely Affect the Company's Ability
to Pay Dividends....................................................... 16
Delays by the Bank in Liquidating Defaulted Mortgage Loans Could Delay
Receipt of Proceeds by the Company Necessary to Fund Dividend
Payments............................................................... 17
Ability of the Company to Increase Leverage May Reduce the Company's
Ability to Fund Dividend Payments...................................... 17
The Company's Failure to Qualify as a REIT Could Adversely Affect the
Company's Financial Results and Ability to Pay Dividends............... 17
The Company Must Continue a High Level of Stockholder Distributions
(i.e., 95% of REIT Taxable Income) to Maintain REIT Qualification...... 18
The Company's Purchase of Mortgage Loans From the Bank May Be for an
Amount Other Than Fair Value........................................... 18
Legal Restrictions on Servicing and Collection Procedures for Mortgage
Loans May Limit the Company's Collection of Principal and Interest and
Adversely Affect the Company's Operations.............................. 18
The 41 Percent Concentration of the Company's Mortgage Loans in
California and Michigan Could Increase the Company's Risk of Loss...... 19
</TABLE>
i
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<TABLE>
<S> <C>
The Company Will Not Be Protected Against Loan Losses Arising From
Property Value Declines or Borrower Defaults............................ 19
Foreclosures on Mortgage Loans Could Expose the Company to Liability for
Environmental Problems in Collateral.................................... 19
THE COMPANY................................................................ 21
USE OF PROCEEDS............................................................ 22
CAPITALIZATION............................................................. 23
BUSINESS AND STRATEGY...................................................... 24
General.................................................................. 24
Distributions............................................................ 24
Liquidity and Capital Resources.......................................... 26
General Description of Mortgage Loans; Investment Policy................. 26
Acquisition of Initial Portfolio......................................... 27
Management Policies and Programs......................................... 28
Description of Designated Portfolio and Initial Portfolio................ 30
Servicing................................................................ 36
Employees................................................................ 37
Competition.............................................................. 38
Legal Proceedings........................................................ 38
MANAGEMENT................................................................. 39
Directors and Executive Officers......................................... 39
Independent Directors.................................................... 40
Audit Committee.......................................................... 41
Credit Committee......................................................... 41
Compensation of Directors and Officers................................... 41
Limitations on Liability of Directors and Officers....................... 41
Advisory Agreement....................................................... 42
Potential Conflicts of Interest.......................................... 42
Security Ownership of Certain Beneficial Owners.......................... 43
Security Ownership of Management......................................... 43
THE FORMATION.............................................................. 44
The Formation............................................................ 44
Benefits to the Bank..................................................... 44
DESCRIPTION OF SERIES A PREFERRED SHARES................................... 46
General.................................................................. 46
Dividends................................................................ 46
Automatic Exchange....................................................... 47
Voting Rights............................................................ 48
Redemption............................................................... 49
Rights Upon Liquidation.................................................. 50
Independent Director Approval............................................ 50
Restrictions on Ownership................................................ 51
DESCRIPTION OF CAPITAL STOCK............................................... 52
General.................................................................. 52
Common Stock............................................................. 52
Preferred Stock.......................................................... 52
Restrictions on Ownership and Transfer................................... 53
FEDERAL INCOME TAX CONSEQUENCES............................................ 55
Taxation of the Company.................................................. 55
Failure to Qualify as a REIT............................................. 59
Tax Treatment of Automatic Exchange...................................... 59
Taxation of United States Stockholders................................... 60
</TABLE>
ii
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<TABLE>
<S> <C>
Taxation of Foreign Stockholders......................................... 60
Information Reporting Requirements and Backup Withholding Tax............ 62
Other Tax Consequences................................................... 63
ERISA CONSIDERATIONS....................................................... 63
General.................................................................. 63
Plan Asset Regulation.................................................... 64
Effect of Plan Asset Status.............................................. 64
Prohibited Transactions.................................................. 65
Unrelated Business Taxable Income........................................ 65
INFORMATION REGARDING THE BANK............................................. 66
Operations of the Bank................................................... 66
Selected Consolidated Financial Data..................................... 68
Recent Developments...................................................... 71
UNDERWRITING............................................................... 73
EXPERTS.................................................................... 74
LEGAL MATTERS.............................................................. 74
ADDITIONAL INFORMATION..................................................... 74
GLOSSARY................................................................... 76
INDEX TO FINANCIAL STATEMENT............................................... F-1
ANNEX I--OFFERING CIRCULAR................................................. OC-1
</TABLE>
iii
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[THIS PAGE INTENTIONALLY LEFT BLANK]
<PAGE>
PROSPECTUS SUMMARY
The following summary is qualified in its entirety by, and should be read in
conjunction with, the more detailed information, risk factors and financial
statements, including the related notes, appearing elsewhere in this
Prospectus. Unless otherwise indicated, all information in this Prospectus
assumes that the over-allotment option described in "Underwriting" is not
exercised.
See "Glossary" commencing at page 76 for the definitions of certain
capitalized terms used in this Prospectus and not otherwise defined.
THE COMPANY
Flagstar Capital Corporation (the "Company") was incorporated in Michigan in
June 1995 and remained dormant until reorganized in December 1997 for the
purpose of acquiring, holding and managing real estate mortgage loans
("Mortgage Loans") that are intended to generate sufficient income to permit
the declaration of dividends on the Series A Preferred Shares at the stated
rate as well as to generate dividends to the holders of its common stock, par
value $1.00 per share (the "Common Stock"). The Company anticipates that all of
the loans that it will acquire upon consummation of this Offering (the "Initial
Portfolio") will consist of Mortgage Loans, which will be acquired as whole
loans solely from the Bank for an aggregate purchase price of approximately
$113 million. The Company has been formed by Flagstar Bank, FSB (the "Bank"), a
federally chartered savings bank, to provide the Bank and its parent holding
company and sole stockholder, Flagstar Bancorp, Inc. ("Flagstar"), with a means
of raising capital for bank regulatory purposes in a cost-effective manner. The
Bank currently intends that, so long as any Series A Preferred Shares are
outstanding, it will maintain direct or indirect ownership of at least a
majority of the outstanding shares of Common Stock of the Company. The Series A
Preferred Shares will be considered core capital of the Bank for purposes of
satisfying its minimum regulatory capital requirements, thus enabling the Bank
to expand its business through the retention of additional mortgage servicing
and the growth of its loan portfolio.
During 1997, the Bank originated or purchased approximately $7.9 billion in
Mortgage Loans and during the same period sold to secondary market investors
approximately $7.2 billion in Mortgage Loans. See "Information Regarding the
Bank--Recent Developments." From this Mortgage Loan production, the Bank has
selected a pool of approximately $131 million in Mortgage Loans as the
Designated Portfolio. See "Business and Strategy--Description of Designated
Portfolio and Initial Portfolio." No agreement between the Bank and the Company
yet exists with respect to such Mortgage Loans but, upon the consummation of
the Offering, the Company and the Bank will enter into a Mortgage Loan Purchase
and Warranties Agreement (the "Mortgage Purchase Agreement") to effectuate the
purchase. See "Business and Strategy--Acquisition of Initial Portfolio."
Agreements for the acquisition of additional assets, and Mortgage Loans in
particular, will be negotiated and executed under the supervision and with the
approval of the Company's Board of Directors, including the Independent
Directors; and no such agreements will be entered without such Board approval.
While no agreement yet exists, it is anticipated by management of the Company
that such acquisitions will be made from the Bank and will consist of Mortgage
Loans similar to those included in the Initial Portfolio, taking into account
market conditions which will exist at that time. See "Business and Strategy--
Management Policies and Programs--Asset Acquisition and Disposition Policies."
The issuance of the Series A Preferred Shares by the Company will provide the
Bank with a more cost-effective means of raising capital than if the Bank were
to issue preferred stock itself because the Company will elect to be treated as
a real estate investment trust ("REIT") for federal income tax purposes and
therefore will be able to deduct for federal income tax purposes the dividends
paid on the Series A Preferred Shares. Also, as a REIT, the Company will
generally not be subject to federal income tax to the extent that it
distributes its earnings to its stockholders and maintains its qualification as
a REIT. See "Federal Income Tax Consequences" for a discussion of the
requirements that the Company must satisfy to qualify as a REIT, and
"Description of Capital Stock--Restrictions on Ownership and Transfer" for
information regarding related restrictions on ownership of
1
<PAGE>
the Series A Preferred Shares. Notwithstanding qualification for taxation as a
REIT, the Company may still be subject to federal, state and local tax. See
"Risk Factors" and "Federal Income Tax Consequences."
The principal executive offices of the Company are located at 2600 Telegraph
Road, Bloomfield Hills, Michigan 48302 and its telephone number is (248) 338-
7700.
THE BANK
The Bank is a federally chartered stock savings bank which is also the
largest independent Michigan-based savings institution based on asset size as
of September 30, 1997, according to SNL Securities, Inc. The Bank is also one
of the largest originators of conforming single-family mortgage loans in the
United States for the nine-month period ended September 30, 1997 according to
Inside Mortgage Finance. The Bank is engaged in the business of providing a
full range of retail banking services in southern and western Michigan and in
originating, purchasing and servicing residential mortgage loans on a
nationwide basis. At September 30, 1997, the Bank conducted business from 19
bank branches and 10 regional wholesale/correspondent lending offices
nationwide. For 1996, the Bank ranked fourth in the United States among thrifts
and sixteenth in total mortgage loan production, according to SMR Research
Corp. All of the outstanding stock of the Bank is owned by Flagstar, a Michigan
corporation whose common stock is listed for trading on the Nasdaq Stock Market
("Nasdaq") under the symbol "FLGS."
As of September 30, 1997, the Bank had consolidated total assets of $2.0
billion, net loans of $1.8 billion, total deposits of $1.0 billion and total
stockholder's equity of $121.1 million. For the nine months ended September 30,
1997, the Bank's net earnings were $15.8 million and its return on average
assets and return on average equity (as annualized) were 1.34% and 21.53%,
respectively. At December 31, 1996, the Bank had consolidated total assets of
$1.3 billion, net loans of $1.1 billion, total deposits of $624.7 million and
total stockholder's equity of $77.9 million. For the year ended December 31,
1996, the Bank's net earnings were $17.1 million and its return on average
assets and return on average equity were 1.54% and 24.82%, respectively ($19.3
million, 1.73% and 27.97%, respectively, excluding the special deposit
insurance assessment imposed in September 1996 on all depository institutions
insured by the Savings Association Insurance Fund (the "SAIF")). See
"Information Regarding the Bank--Selected Consolidated Financial Data" and "--
Recent Developments." The Bank is a member of the Federal Home Loan Bank
("FHLB") of Indianapolis and is subject to examination, supervision and
regulation by the OTS and the FDIC.
The Bank's operations are segregated into two segments, mortgage banking and
retail banking, with most of the Bank's revenue (net interest income and non-
interest income) and earnings before income taxes attributable to the mortgage
banking segment. The Bank believes that its retail banking business provides a
strategic advantage through access to funding sources for mortgage origination
business which would not otherwise be available. These additional funding
sources include lower cost retail deposits, FHLB advances and escrowed funds.
The Bank believes it benefits as compared to mortgage originators with no
retail banking operations because it has access to a lower cost of funds.
RISK FACTORS
The purchase of the Series A Preferred Shares offered hereby is subject to
certain risks. See "Risk Factors" commencing on page 12. Among such risks are
the following:
. If the Bank suffers a decline in its capital or operating performance,
holders of the Series A Preferred Shares could be required to exchange
such shares for shares of the Bank Preferred Stock pursuant to the
Automatic Exchange. Such an exchange could cause the holders of the
Series A Preferred Shares to recognize taxable income and could place
them, as holders of the Bank Preferred Stock, in a less favorable
position if the Bank later liquidated. Further, following an Automatic
Exchange, the Bank may not be in a financial condition to pay any
dividends. Also, unlike the Series A Preferred Shares, the Bank
Preferred Stock would not be listed for trading on Nasdaq.
2
<PAGE>
. The Hammond family members, who are the controlling stockholders of
Flagstar and thereby indirectly control the Bank and the Company, may
have investment goals and strategies that differ from those of the
holders of the Series A Preferred Shares and thus cause the controlling
stockholders to direct the policies of the Company in a manner that is
contrary to the best interests of the holders of the Series A Preferred
Shares.
. The Company may face conflicts of interest in its dealings with the
Bank, which is its parent company; Flagstar, which is the parent company
of the Bank; and the Hammond family members, who are the controlling
stockholders of Flagstar. These conflicts may arise in the Company's
purchase of Mortgage Loans from the Bank, either as part of the Initial
Portfolio or thereafter, if the Company wishes to purchase Mortgage
Loans from elsewhere. Conflicts may also arise if the Company wishes to
hold nonperforming Mortgage Loans that the Bank wishes to sell pursuant
to the Servicing Agreement. In addition, the Company may face conflicts
of interest in its dealings with Flagstar, which may have goals for its
subsidiaries that differ from the Company's goals, and in its dealings
with the Hammond family members, whose goals may differ from those of
the holders of the Series A Preferred Shares.
. The financial performance of the Company will depend upon the Bank,
which, through the Servicing Agreement, will select and service the
Company's loan portfolio and, through the Advisory Agreement, will serve
as the Company's advisor and administer the day-to-day operations of the
Company. To the extent the Bank's officers and employees do not exercise
an appropriate level of diligence or fail to apply proper skills, the
Company's financial results could be adversely affected.
. If a Tax Event occurs, the Company will have the right to redeem the
shares of Series A Preferred Shares in whole but not in part.
. Because the Company will be a subsidiary of the Bank, which is subject
to continuous federal banking oversight and regulation, federal
regulators could impose restrictions on the Company's operations or
dividend payments at any time. Holders of the Series A Preferred Shares
could thereby be prevented from receiving dividends.
. If an Automatic Exchange occurs, and it results from the weakened
financial condition of the Bank, then the Bank may be unable to pay any
dividends for the foreseeable future on the shares of Bank Preferred
Stock that are received by the holders of the Series A Preferred Shares.
. The dividends on the Series A Preferred Shares are noncumulative, which
means that dividends which are not declared for payment by the Company's
Board of Directors are not accumulated for payment at a later time.
Instead, those dividends will never be paid. Thus, holders of the Series
A Preferred Shares will suffer a permanent loss of dividend income if
any of the expected quarterly dividends are not declared.
. Cash flow of the Company necessary to fund dividend payments will depend
solely upon payments received on Mortgage Loans. If Mortgage Loans
become nonperforming, the Company may not be able to pay dividends.
. A significant decline in the interest rate environment could prevent the
Company from generating sufficient cash for the payment of dividends on
the Series A Preferred Shares. The Company's ability to pay dividends
will depend upon its cash flow, which is based solely upon the interest
it is able to collect on the Mortgage Loans. If those loans prepay and
are replaced by lower-yielding Mortgage Loans, then the Company's cash
flow may be significantly restricted.
. Because the Company must rely solely upon cash flow from its Mortgage
Loans to fund its dividend payments on the Series A Preferred Shares,
any delay by the Bank in liquidating defaulted Mortgage Loans of the
Company could delay the Company's receipt of the proceeds. A significant
delay of a sufficiently large amount of such proceeds could delay or
eliminate any of the quarterly dividend payments otherwise due.
. If the Company incurs indebtedness, its financial results could be
adversely affected and its use of cash flow to service the debt could
prevent payment of dividends on the Series A Preferred Shares.
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. If the Company fails to qualify as a REIT, its income would become
subject to federal corporate income tax. As a result, its financial
results would be adversely affected and the amount of cash available to
pay dividends could be significantly reduced.
. To maintain its status as a REIT and thereby avoid corporate income tax
on its earnings, the Company must distribute as dividends each year at
least 95% of its REIT Taxable Income.
. The Company will not be obtaining any third party valuation of the
Mortgage Loans that will comprise the Initial Portfolio and thus will
rely upon the Bank to determine the amount that the Company will
actually pay for the Mortgage Loans.
. The Company is subject to the federal and state laws governing Mortgage
Loans, the violation of which could cause the Company to lose the right
to collect principal and interest on such loans and thereby adversely
affect the Company's financial performance.
. The Company will have a 41% concentration, by dollar volume, of its
Mortgage Loans in just two states, California and Michigan. Its risk of
loss from its Mortgage Loans is thereby increased to the extent that
adverse economic, political or business developments or natural hazards
occurring in those two states would affect the ability of property
owners there to make payments of principal and interest on the
underlying mortgages.
. The Company does not expect to obtain third party insurance against the
risks of borrower defaults and bankruptcies or against special hazard
losses that could cause the value of the properties underlying the
Mortgage Loans to decline in value. Thus, the Company would have an
increased risk of loss if the value of the property decreased below the
amount owing on the Mortgage Loans and the borrowers defaulted.
. Foreclosures on Mortgage Loans could expose the Company to environmental
liability on the underlying property and result in a significant adverse
financial effect if the amount of the liability exceeds the value of
such property.
BUSINESS AND STRATEGY
As a newly reorganized entity, the Company has no prior operating history. As
of the date hereof, it has $100 in assets, $100 in stockholder's equity and no
indebtedness. The Company's principal business objective is to acquire, hold
and manage Mortgage Loans purchased from the Bank. Simultaneously with the
consummation of the Offering, the Bank will purchase Common Stock for an
aggregate price equal to $63.0 million. The Company will use the total proceeds
of $113.0 million received in connection with both the Offering and such sale
of shares of Common Stock to the Bank to purchase a portfolio of Mortgage Loans
(the "Initial Portfolio") from a pool of mortgage loans designated by the Bank
and intended to reflect current market conditions and be generally
representative of the type of loans contained in the Bank's portfolio of loans
receivable (the "Designated Portfolio") pursuant to the terms of the Mortgage
Purchase Agreement to be executed at that time. If the Underwriters exercise
their option to purchase additional Series A Preferred Shares to cover over-
allotments, the Bank will purchase additional shares of Common Stock in the
same proportion to the aggregate public offering price of the additional Series
A Preferred Shares purchased pursuant to the Underwriters' over-allotment
option. The Company will use the additional proceeds from any such additional
sales of Series A Preferred Shares and shares of Common Stock to purchase
additional Mortgage Loans of the types described in "Business and Strategy--
Description of Designated Portfolio and Initial Portfolio." Simultaneously with
the consummation of the Offering (and upon exercise, if any, by the
Underwriters of their over-allotment option), the Bank will also purchase
additional shares of Common Stock for an aggregate price equal to the amount of
underwriting commissions and expenses incurred by the Company in connection
with the Offering (including without limitation any underwriting commissions
associated with the exercise of the Underwriters' over-allotment option) and
all expenses incurred by the Company in connection with its formation in order
to provide the Company with funds sufficient to pay such expenses. See "Use of
Proceeds."
Immediately after the completion of the Offering, the sale of the shares of
Common Stock to the Bank and the purchase by the Company of the Initial
Portfolio, the Company (assuming that (i) the Underwriters' over-
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allotment option is not exercised and (ii) there are $2.9 million in aggregate
offering and organizational expenses) will own $113.0 million in Mortgage Loans
and have $50.0 million in stated capital attributable to the Series A Preferred
Shares, $500,000 of stated capital attributable to the Common Stock and $62.5
million of additional paid-in capital. See "Capitalization."
The Company and the Bank believe, based on Bank management's experience in
purchasing, selling and evaluating mortgage loans, that the fair value of the
Initial Portfolio will approximately equal the amount (approximately $113.0
million) that the Company will pay for the Initial Portfolio. However, no third
party valuations of the Mortgage Loans constituting the Initial Portfolio have
been or will be obtained for purposes of the Offering. See "Risk Factors--The
Company's Purchase of Mortgage Loans from the Bank may be for an Amount Other
Than Fair Value."
The Company currently does not contemplate ownership of property other than
Mortgage Loans and anticipates that Mortgage Loans acquired in the future will
be whole loans purchased solely from the Bank. The Company's current policy
prohibits the acquisition of any Mortgage Loan that (i) is delinquent in the
payment of principal or interest; (ii) is or was at any time in the preceding
12 months (a) Classified, (b) in Nonaccrual Status, or (c) renegotiated due to
financial deterioration of the borrower; (iii) has been over 30 days past due
in the payment of principal or interest more than once during the preceding 12
months; or (iv) has failed to make the initial monthly payment on a timely
basis. Loans that are in Nonaccrual Status are generally loans that are past
due 90 days or more in principal or interest, and Classified loans are troubled
loans that are deemed "substandard" or "doubtful" under bank regulatory
guidelines and where the full collectibility of principal and interest on such
loans is unlikely to occur.
On January 16, 1998, the Designated Portfolio had an aggregate outstanding
principal balance of $131.0 million and was secured by first mortgages or deeds
of trust on single-family (one- to four-unit) residential properties. All
Mortgage Loans to be included in the Initial Portfolio will be purchased from
among the Mortgage Loans included in the Designated Portfolio in a manner that
approximates a proportionate basis. Such Mortgage Loans are whole loans,
represent first lien positions and have been acquired or originated in
accordance with the Bank's uniformly applicable Mortgage Loan purchasing and
underwriting standards. In general, substantially all the loans acquired or
originated by the Bank satisfy Federal National Mortgage Association ("FNMA" or
"Fannie Mae") and Federal Home Loan Mortgage Corporation ("FHLMC" or "Freddie
Mac") guidelines, except that the initial loan amount of certain Mortgage Loans
may exceed the maximum allowable loan amount. The weighted average interest
rate on the Mortgage Loans in the Designated Portfolio is 7.22%. The weighted
average Loan-To-Value Ratio of the Mortgage Loans in the Designated Portfolio
is 72.35%, with only 13.38% of the Designated Portfolio having a Loan-To-Value
Ratio greater than 80% (in which case the borrower is required to have mortgage
insurance as required by FNMA and FHLMC standards). For more information with
respect to the characteristics and types of Mortgage Loans included in the
Designated Portfolio, see "Business and Strategy--Description of Designated
Portfolio and Initial Portfolio."
The Company expects to use the proceeds received in connection with regular
principal payments or the repayment or disposition of Mortgage Loans to
purchase additional Mortgage Loans. The Company currently anticipates that all
of the Mortgage Loans that it may acquire in the future will be purchased
solely from the Bank and have the same characteristics as Mortgage Loans in the
Initial Portfolio. No arrangements or procedures are currently in place
regarding the acquisition by the Company of Mortgage Loans from unaffiliated
third parties. See "Business and Strategy--Management Policies and Programs."
The Company will enter into a Servicing Agreement with the Bank pursuant to
which the Bank will service the Mortgage Loans purchased by the Company and
hold documents relating to the Mortgage Loans as custodian on behalf of the
Company. The Servicing Agreement requires servicing in conformity with accepted
secondary market standards, with any servicing guidelines promulgated by the
Company and with FNMA and FHLMC guidelines and procedures. In its role as
servicer under the Servicing Agreement, the Bank will be entitled to
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receive customary fees in connection with the servicing of such Mortgage Loans.
The Company will not receive income from servicing loans. See "Business and
Strategy--Servicing."
The Company will also enter into an Advisory Agreement with the Bank pursuant
to which the Bank will administer the day-to-day operations of the Company. In
its role as advisor under the terms of the Advisory Agreement, the Bank will be
responsible for (i) monitoring the credit quality of Mortgage Loans held by the
Company and (ii) advising the Company with respect to the acquisition,
management, financing and disposition of the Company's Mortgage Loans. For
these services, the Bank will be entitled to receive an annual advisory fee of
$250,000. The Advisory Agreement may be terminated at any time for breach, at
the end of its initial five (5) year term or at any time thereafter upon proper
notice. Except in the case of a breach by the Company, the Bank is only
entitled to its fees and expenses through the date of any termination. See
"Management--Advisory Agreement."
With the exception of the amendment of the Mortgage Purchase, Servicing and
Advisory Agreements, the management policies related to maintenance of the
Company's qualification as a REIT, and the issuance of significant debt or
additional preferred stock, the Board of Directors of the Company may undertake
to change any policies of the Company by a simple majority vote without the
approval of the Independent Directors or approval of the holders of the Series
A Preferred Shares. See "Business and Strategy--Management Policies and
Programs."
THE FORMATION
The Formation. Prior to or simultaneously with the completion of the
Offering, the Company, Flagstar, and the Bank will engage in the transactions
described under "The Formation." These transactions are designed to (i)
facilitate the Offering, (ii) transfer the ownership of the Initial Portfolio
to the Company and (iii) enable the Company to qualify as a REIT for federal
income tax purposes commencing with its taxable year ending December 31, 1998.
The following chart outlines the relationship between the Company, the Bank and
Flagstar relevant to the Offering following completion of the Offering.
[FLOWCHART OF FLAGSTAR BANCORP, INC. APPEARS HERE]
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Benefits to the Bank. The Bank is required by the OTS to maintain certain
levels of capital for bank regulatory purposes. The Bank has informed the
Company that the Series A Preferred Shares will be treated as capital of the
Bank for regulatory purposes. The Bank has indicated to the Company that such
treatment, together with the Company's ability to deduct, for income tax
purposes, the dividends payable on the Series A Preferred Shares as a result of
the Company's qualification as a REIT, will provide the Bank with a more cost-
effective means of obtaining capital for regulatory purposes than if the Bank
were to issue preferred stock itself. The economic effect of this additional
capital of approximately $47 million (assuming no exercise of the Underwriters'
over allotment option and net of expenses of the Offering) is that the Bank
will be able to expand its interest earning assets to the extent permitted by
applicable federal banking regulations. Although there can be no assurance, the
Bank has informed the Company that the Bank intends that the anticipated
increase in interest-earning assets will have a favorable effect on its net
interest income. See "The Formation--Benefits to the Bank" for a further
discussion of the fees and other payments the Bank will derive as a result of
the Offering.
The Bank will realize certain other benefits from the Offering and the other
transactions constituting the formation of the Company, including (i) the
receipt by the Bank of the net proceeds from the sale of the Series A Preferred
Shares in connection with the sale to the Company of the Mortgage Loans and
(ii) the receipt of advisory and servicing fees under the Advisory Agreement
and the Servicing Agreement. It is also expected that the Bank will receive
dividends in respect of the Common Stock held by the Bank. See "The Formation--
Benefits to the Bank."
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THE OFFERING
For a more complete description of the terms of the Series A Preferred Shares
specified in the following summary, see "Description of Series A Preferred
Shares."
Issuer...................... Flagstar Capital Corporation, a Michigan
corporation created for the purpose of acquiring,
holding and managing Mortgage Loans.
Securities Offered.......... 2,000,000 shares of Series A Preferred Shares.
The Company has granted the Underwriters an
option for 30 days to purchase up to an
additional 300,000 Series A Preferred Shares at
the initial public offering price solely to cover
over-allotments, if any.
Ranking..................... With respect to the payment of dividends and
amounts upon liquidation, the Series A Preferred
Shares will rank senior to the Company's Common
Stock all of which is held by the Bank.
Additional shares of preferred stock of the
Company ranking senior to the Series A Preferred
Shares may not be issued without the approval of
holders of at least two-thirds of the Series A
Preferred Shares. Additional shares of preferred
stock ranking on a parity with the Series A
Preferred Shares may not be issued without the
approval of a majority of the Independent
Directors. See "Description of Series A Preferred
Shares--Independent Director Approval."
Use of Proceeds............. The proceeds to the Company from the Offering,
together with proceeds received in connection
with the concurrent sale of shares of Common
Stock to the Bank, will be used to pay the
expenses of the Offering and the formation of the
Company, with the remainder (currently estimated
by the Company to be approximately $113 million)
to be used to purchase Mortgage Loans for the
Initial Portfolio. See "Use of Proceeds."
Dividends................... Dividends on the Series A Preferred Shares are
payable at the rate of 8.5% per annum of the
liquidation preference (an amount equal to $2.125
per annum per share), if, when and as declared by
the Board of Directors. If declared, dividends
are payable quarterly in arrears on the last day
of March, June, September and December in each
year, commencing March 31, 1998. Dividends accrue
in each quarterly period from the first day of
such period, whether or not dividends are paid
with respect to the preceding period. Dividends
on the Series A Preferred Shares are not
cumulative and, accordingly, if no dividend is
declared on the Series A Preferred Shares by the
Company for a quarterly dividend period, holders
of the Series A Preferred Shares will have no
right to receive a dividend for that period, and
the Company will have no obligation to pay a
dividend for that period, whether or not
dividends are declared and paid for any future
period with respect to either the Series A
Preferred Shares or the Common Stock. If no
dividend is paid on the Series A Preferred Shares
for a quarterly dividend period, the payment of
dividends on the Common Stock (100% of which is
owned by the Bank) will be prohibited for that
period and
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at least the following three quarterly dividend
periods. See "Description of Series A Preferred
Shares--Dividends."
Liquidation Preference...... The liquidation preference for each Series A
Preferred Share is $25.00, plus an amount equal
to the current, quarterly accrued and unpaid
dividends, if any, thereon. See "Description of
Series A Preferred Shares--Rights Upon
Liquidation."
Redemption.................. The Series A Preferred Shares are not redeemable
prior to March 1, 2003 (except upon the
occurrence of a Tax Event as defined in
"Description of Series A Preferred Shares--
Redemption"). On and after March 1, 2003, the
Series A Preferred Shares may be redeemed for
cash at the option of the Company, in whole or in
part, at any time and from time to time, at a
redemption price of $25.00 per share, plus the
accrued and unpaid dividends for the most recent
quarter, if any, thereon. Upon the occurrence of
a Tax Event, the Company will have the right at
any time to redeem the Series A Preferred Shares
in whole (but not in part) at a redemption price
of $25.00 per share, plus the accrued and unpaid
dividends for the most recent quarter, if any,
thereon. The Series A Preferred Shares will not
be subject to any sinking fund or mandatory
redemption and will not be convertible into any
other securities of the Company. See "Description
of Series A Preferred Shares--Redemption."
Automatic Exchange.......... Upon the occurrence of the Automatic Exchange,
each Series A Preferred Share would be exchanged
automatically for one Bank Preferred Share. See
"Description of Series A Preferred Shares--
Automatic Exchange."
Voting Rights............... Holders of Series A Preferred Shares will not
have any voting rights in the Company except
under the specific circumstances set forth in the
Certificate of Designation and described herein.
In any matter on which the Series A Preferred
Shares may vote, each Series A Preferred Share
will be entitled to one vote. See "Description of
Series A Preferred Shares--Voting Rights."
Ownership Limits............ Ownership of more than 5% of any outstanding
series of preferred stock except as may
specifically be permitted by the Company,
including the Series A Preferred Shares offered
hereby, is prohibited to preserve the Company's
status as a REIT for federal income tax purposes.
See "Description of Capital Stock--Restrictions
on Ownership and Transfer."
Market for Series A
Preferred Shares............ The Series A Preferred Shares have been approved
for listing on Nasdaq under the symbol "FLGSP."
TAX STATUS OF THE COMPANY
The Company will elect to be taxed as a REIT under Sections 856 through 860
of the Code, commencing with its taxable year ending December 31, 1998. As a
REIT, the Company generally will not be subject to federal income tax on net
income and capital gains that it distributes to the holders of its Common Stock
and Preferred Stock, including the Series A Preferred Shares.
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A REIT is subject to a number of organizational and operational requirements,
including a requirement that it distribute to stockholders at least 95% of its
REIT Taxable Income (not including capital gains). Notwithstanding
qualification for taxation as a REIT, the Company may be subject to federal,
state or local tax. The Company has received an opinion from its tax counsel,
Kutak Rock, to the effect that the Company will be organized in conformity with
the requirements for qualification as a REIT, and its proposed method of
operation will enable it to satisfy the requirements under the Code for
qualification and taxation as a REIT. See "Risk Factors" and "Federal Income
Tax Consequences--Failure to Qualify as a REIT."
CONFLICTS OF INTEREST
The Company and the Bank have common officers and directors, which creates
and may continue to create conflicts of interest in the Company's dealings with
the Bank. The Bank may have interests which are not identical to those of the
Company. Consequently, conflicts of interest may arise with respect to
transactions, including without limitation, the Company's acquisition of the
Initial Portfolio; future acquisitions of Mortgage Loans from the Bank or its
affiliates; servicing of Mortgage Loans, particularly with respect to Mortgage
Loans that become Classified or are placed in Nonaccrual Status or which have
been over 30 days past due in the payment of principal or interest during the
preceding 12 months; future dispositions of Mortgage Loans to Flagstar and the
Bank; and the modification of the Advisory Agreement or the Servicing
Agreement.
It is the intention of the Company, Flagstar and the Bank that any agreements
and transactions between the Company, on the one hand, and the Bank (or
Flagstar or their affiliates if there should ever be any such agreements, none
of which is now contemplated) on the other hand, are fair to all parties and
consistent with market terms, such as the prices paid and received for Mortgage
Loans, including those in the Initial Portfolio, on their acquisition or
disposition by the Company or in connection with the servicing of such Mortgage
Loans. The Certificate of Designation establishing the Series A Preferred
Shares requires, among other things, that certain actions of the Company must
be approved by a majority of the Independent Directors. This requirement is
intended to promote fair dealings between the Company, Flagstar, the Bank and
their respective affiliates. However, there can be no assurance that such
agreements or transactions will be on terms as favorable to the Company as
those that could have been obtained from unaffiliated third parties. See "Risk
Factors--Potential Conflicts of Interest With the Bank, Flagstar or Hammond
Family Members, as Controlling Stockholders of Flagstar, May Result in
Decisions by the Company That Are Not Fully Consistent With the Interests of
the Holders of the Series A Preferred Shares" and "Business and Strategy--
Management Policies and Programs--Conflict of Interest Policies."
AUTOMATIC EXCHANGE
Under certain circumstances, each Series A Preferred Share would be exchanged
automatically for one newly issued Bank Preferred Share (i.e., the Automatic
Exchange) if directed by the appropriate regulatory agency in writing because
(i) the Bank has become "undercapitalized" under prompt corrective action
regulations, (ii) the Bank is placed into conservatorship or receivership or
(iii) the appropriate regulatory agency, in its sole discretion and even if the
Bank is not "undercapitalized," anticipates the Bank becoming
"undercapitalized" in the near term (the "Exchange Event"). CONSEQUENTLY, AN
INVESTMENT IN BANK PREFERRED SHARES AT A TIME WHEN THE BANK'S FINANCIAL
CONDITION IS DETERIORATING OR THE BANK HAS BEEN PLACED INTO CONSERVATORSHIP OR
RECEIVERSHIP. POTENTIAL INVESTORS IN THE SERIES A PREFERRED SHARES, THEREFORE,
SHOULD CAREFULLY CONSIDER THE DESCRIPTION OF THE BANK SET FORTH UNDER
"INFORMATION REGARDING THE BANK" AS WELL AS THE OFFERING CIRCULAR FILED WITH
THE OTS RELATING TO THE BANK PREFERRED SHARES (THE "OFFERING CIRCULAR"),
ATTACHED HERETO AS ANNEX I. See also "Description of Series A Preferred
Shares--Automatic Exchange." The Bank will be considered to be
"undercapitalized" under the "prompt corrective action" regulations established
pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991,
as amended ("FDICIA"), if it has (i) a core capital (or leverage) ratio of less
than 4.0%, (ii) a Tier 1 risk-based capital ratio of less than 4.0%, or (iii) a
total risk-based capital ratio of less than 8.0%. Tier 1 or core capital
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consists of common shareholders' equity, noncumulative perpetual preferred
stock, and minority interests in consolidated subsidiaries, less certain
intangible assets and investments in certain subsidiaries. Total capital
consists of core capital plus supplementary capital (which includes cumulative
perpetual preferred stock, qualifying subordinated debt, and a limited amount
of the allowances for loan and lease losses) to the extent such supplementary
capital does not exceed 100% of core capital, less certain equity investments.
For purposes of the "prompt corrective action" regulations, the Bank's capital
category is determined as of the most recent date (i) certain quarterly
financial reports are required to be filed with the regulators; (ii) a final
report of examination has been delivered to the Bank; or (iii) the Bank is
notified in writing by the OTS of its capital category or a change in such
category. At September 30, 1997 and at December 31, 1996 and 1995, the Bank's
core capital (or leverage) ratio was 5.95%, 6.01%, and 5.84%, respectively, its
Tier 1 risk-based capital ratio was 10.88%, 10.48% and 9.83%, respectively, and
its total risk-based capital ratio was 11.25%, 10.91%, and 10.12%,
respectively. After giving effect to the Offering, the capital ratios at
September 30, 1997 would have been 7.61%, 13.94% and 14.29%, respectively.
The Bank Preferred Shares would only be issued upon the occurrence of the
Automatic Exchange. The Bank Preferred Shares would not be registered with the
Commission but are being registered with the OTS.
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RISK FACTORS
In addition to the other information in this Prospectus, including the
Offering Circular attached to this Prospectus as Annex I, the following
factors should be carefully considered before investing in the Series A
Preferred Stock offered hereby.
The discussion in this Prospectus contains certain forward-looking
statements that involve risks and uncertainties, such as statements of the
Company's or the Bank's plans, objectives, expectations and intentions. The
cautionary statements made in this Prospectus, including the risk factors
discussed below, should be read as being applicable to all related forward-
looking statements wherever they appear in this Prospectus. The Company's and
the Bank's actual results could differ materially from those discussed here.
Factors that could cause or contribute to such differences include those
discussed below, as well as those discussed elsewhere herein or in the
documents attached hereto or incorporated by reference herein.
A DECLINE IN THE PERFORMANCE OR CAPITAL LEVELS OF THE BANK COULD RESULT IN AN
AUTOMATIC EXCHANGE, FORCING HOLDERS OF THE SERIES A PREFERRED SHARES TO ACCEPT
AN INVESTMENT IN THE BANK, WHICH CARRIES RISKS DIFFERENT FROM AN INVESTMENT IN
THE COMPANY
If the Automatic Exchange occurs, holders of the Series A Preferred Shares
could suffer a decline in the quality of their investment and also be required
to recognize taxable income. A decline in the performance and capital levels
of the Bank or the placement of the Bank into conservatorship or receivership
could trigger the Automatic Exchange, which would result in holders of the
Series Preferred Shares thereafter having an investment in the Bank rather
than in the Company. As a result, holders of Series A Preferred Shares would
become preferred stockholders of the Bank at a time when the Bank's financial
condition was deteriorating or when the Bank had been placed into
conservatorship or receivership. An investment in the Bank is also subject to
certain risks that are distinct from the risks associated with an investment
in the Company.
For example, an investment in the Bank would involve risks relating to the
capital levels of, and other regulatory requirements applicable to, the Bank
and the performance of the Bank's loan portfolio. Also, the Bank is subject to
the general risks inherent in equity investments in depository institutions.
If the Bank were ever liquidated, the claims of depositors and secured,
senior, general and subordinated creditors of the Bank would be entitled to a
priority of payment over the claims of holders of equity interests such as the
Bank Preferred Shares. As a result, if the Bank were to be placed into
receivership after the Automatic Exchange or if the Automatic Exchange were to
occur after receivership of the Bank, the holders of the Bank Preferred Shares
likely would receive, if anything, substantially less than the holders of the
Series A Preferred Shares would have received had the Series A Preferred
Shares not been exchanged for Bank Preferred Shares. Furthermore, there can be
no assurance that the Bank would be in a financial position, after the
occurrence of the Automatic Exchange, to make any dividend payments on the
Bank Preferred Shares. Potential investors in the Series A Preferred Shares
should carefully consider the risks with respect to an investment in the Bank
set forth in the Bank's Offering Circular attached to this Prospectus as Annex
I. See "Description of Series A Preferred Shares--Automatic Exchange."
In addition, as a result of the Automatic Exchange, holders of the Series A
Preferred Shares would be required to accept an equity instrument (i.e., the
Bank Preferred Shares) that would not have the same liquidity. Although the
Series A Preferred Shares will be listed on Nasdaq, the Bank does not intend
to apply for listing of the Bank Preferred Shares on any national securities
exchange or for quotation through Nasdaq. Consequently, there can be no
assurance as to the liquidity of the trading markets for the Bank Preferred
Shares, if issued, or that an active public market for the Bank Preferred
Shares would develop or be maintained. Therefore, the value of the Bank
Preferred Shares will not be readily determinable.
Also, by being required to participate in the Automatic Exchange, holders of
the Series A Preferred Shares would be required to recognize taxable gain or
loss upon their receipt of the Bank Preferred Shares. The amount of the gain
or loss would be measured by the difference between the basis of each such
holder in the Series A
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Preferred Shares and the fair market value of the Bank Preferred Shares
received in the Automatic Exchange. See "Federal Income Tax Consequences--Tax
Treatment of Automatic Exchange."
THE HAMMOND FAMILY MEMBERS, WHO AS CONTROLLING STOCKHOLDERS OF FLAGSTAR CAN
THEREBY CONTROL BOTH THE COMPANY AND THE BANK, MAY HAVE INVESTMENT GOALS AND
STRATEGIES THAT DIFFER FROM THOSE OF THE HOLDERS OF THE SERIES A PREFERRED
SHARES.
The Bank and the Company will be subject to the ultimate control of the
Bank's sole stockholder, Flagstar, and to the ownership of a controlling
interest in Flagstar by Thomas J. Hammond, Chairman and Chief Executive
Officer, and Mark T. Hammond, Vice Chairman and President, of Flagstar, the
Bank and the Company. Messrs. T. Hammond and M. Hammond, together with their
respective spouses and immediate family members, own approximately 60 percent
of the outstanding stock of Flagstar and are, thus, able to influence directly
or to control all aspects of the affairs of Flagstar and, thus, the Bank and
the Company. To the extent Hammond family members have investment goals or
strategies that differ from those of the holders of the Series A Preferred
Shares, the Hammond family would be able to direct the policies of the Company
in a manner that could be contrary to the best interests of the holders of the
Series A Preferred Shares.
POTENTIAL CONFLICTS OF INTEREST WITH THE BANK, FLAGSTAR OR HAMMOND FAMILY
MEMBERS, AS THE CONTROLLING STOCKHOLDERS OF FLAGSTAR, MAY RESULT IN DECISIONS
BY THE COMPANY THAT ARE NOT FULLY CONSISTENT WITH THE INTERESTS OF THE HOLDERS
OF THE SERIES A PREFERRED SHARES.
The Company is subject to various potential conflicts of interest arising
from its relationship with the Bank; with Flagstar, which is the sole
stockholder of the Bank; and with the Hammond family, who hold a controlling
stock interest in Flagstar. In making basic business decisions and resolving
any such conflicts, the Company may implement decisions or adopt policies and
procedures that are intended to satisfy the needs of any of these persons or
groups of persons. Although the Company expects to use its business judgment
in the decision-making process, there can be no assurance that the effect of
such decisions will be fully consistent with the interests of the holders of
the Series A Preferred Shares. However, the Company will, for so long as the
Bank owns at least 50 percent of the total equity of the Company, be a fully
consolidated subsidiary of the Bank. As such, the financial condition and
profitability of the Company will have a direct effect on the financial
condition and profitability of the Bank. While the relative sizes of the Bank
and the Company are different, the fact that any loss to the Company is also a
loss to the Bank would mean, in the judgment of management of the Company,
that the Bank has a significant interest in the continued financial health and
profitability of the Company. This commonality of interest will diminish
somewhat the relative significance of the conflicts that may arise between
these parties. Set forth below are examples where conflicts could possibly
arise between the interests of the Company, the Bank or Flagstar or its
controlling stockholders.
ACQUISITION OF INITIAL PORTFOLIO. The Company will acquire the Initial
Portfolio from the Bank rather than from unrelated third parties. Although
this purchase is being structured to take advantage of the underwriting
procedures of the Bank as to which the Company's officers are familiar, the
Company is not obtaining any third-party valuation to confirm whether it will
be paying fair value for these loans. See "--The Company's Purchase of
Mortgage Loans From the Bank May Be for an Amount Other Than Fair Value." If
the principal balance of the Mortgage Loans in the Initial Portfolio should
exceed the fair value of such loans, and if the Company should be required to
liquidate in the near or distant future, there can be no assurance that the
proceeds would be sufficient to make all stockholders whole. The holders of
the Series A Preferred Shares have a preference upon liquidation equal to the
Offering Price of $25.00 per share prior to any distribution to the Bank as
the holder of the Company's Common Stock. Thus if the liquidation proceeds
fall from the initial price paid of $113 million to less than $50 million, the
holders of Series A Preferred Shares would realize a loss of capital.
FUTURE ACQUISITIONS OF MORTGAGE LOANS. Additionally, the Company has
indicated that it may purchase Mortgage Loans in the future from the Bank,
although it is not obligated to do so. This arrangement will provide
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the Bank with another purchaser of its loan production, thereby facilitating
the mortgage banking operations of the Bank. However, by limiting its
acquisition of Mortgage Loans to those originated or purchased by the Bank,
the Company's portfolio will generally reflect the nature, scope and risks of
the Bank's portfolio rather than a more diverse portfolio if Mortgage Loans
were also purchased from other lenders. In addition, the Bank may seek to
exercise its influence over the affairs of the Company so as to cause the sale
of the Mortgage Loans owned by the Company and their replacement by lesser
quality loans purchased from the Bank or elsewhere. While the current asset
acquisition policies of the Company set minimum standards for purchases, and
certain aspects of those policies may be changed only with the approval of the
Independent Directors, there can be no assurance that the Bank would not be
able to cause the Company to own Mortgage Loans of a lesser quality than those
described as included in the Initial Portfolio.
SERVICING OF MORTGAGE LOANS. The Company also intends to rely upon the Bank
for the servicing of Mortgage Loans pursuant to a Servicing Agreement. See
"Business and Strategy--Servicing." This will become especially important as
the Bank services those loans that become Classified or are placed in
Nonaccrual Status or that have been over 30 days past due in the payment of
principal or interest during the preceding 12 months. While the Company
believes that the Bank will diligently pursue collection of nonperforming
loans, the Company also understands that the Bank must also devote its
resources to monitoring and curing nonperforming loans that it has sold in the
secondary market and as to some of which the Bank may have a repurchase
obligation. Because the Bank will not have a similar repurchase obligation
with respect to the Mortgage Loans it sells to the Company, it is possible
that the Bank's collection efforts on behalf of the Company will be thereby
affected. The ability of the Company to make timely payments of dividends on
the Series A Preferred Shares will depend in part upon prompt collection
efforts. See "--The Company's Source of Cash to Fund Dividend Payments Depends
Solely Upon Payments Received From Its Mortgage Loans."
FUTURE MODIFICATIONS OF THE ADVISORY OR SERVICING AGREEMENTS. Should the
Company seek to modify either the Advisory Agreement or the Servicing
Agreement that will be entered into with the Bank, it would rely upon its
officers who are also officers of the Bank. Thus, officers of the Company
would be responsible for taking positions with respect to such agreements
that, while in the best interests of the Company, would not be in the best
interests of the Bank. However, all such modifications require the approval of
the Independent Directors. See "Description of Series A Preferred Shares--
Independent Director Approval."
COMPETING GOALS OF FLAGSTAR OR THE CONTROLLING STOCKHOLDERS. As the parent
company and sole stockholder of the Bank, the goals of Flagstar for the group
of corporations under its control may not always be in accord with the
Company's of maintaining an appropriate portfolio of Mortgage Loans from which
to fund the regular payment of dividends on the Series A Preferred Shares.
Similarly, the goals of the controlling stockholders of Flagstar may differ
from those of the other stockholders of Flagstar and of the particular goals
of the Bank and the Company. There can, therefore, be no assurance that the
voting control represented by the ownership of the Bank by Flagstar and of
Flagstar by the controlling stockholders will not have a detrimental effect on
the Company. See "--The Hammond Family Members, Who as the Controlling
Stockholders of Flagstar Can Thereby Control Both the Company and the Bank,
May Have Investment Goals and Strategies That Differ From Those of the Holders
of the Series A Preferred Shares."
It is the intention of the Company and to its knowledge it is the intention
of the Bank, Flagstar and the controlling stockholders, that any agreements
and transactions between the Company, on the one hand, and the Bank (or their
affiliates if there ever should be any such agreement or transaction, none of
which are now contemplated) on the other hand, are fair to all parties and
consistent with market terms, such as the prices paid and received for
Mortgage Loans or in connection with the servicing of such Mortgage Loans.
However, there can be no assurance that such agreements or transactions will
be on terms as favorable to the Company as those that could have been obtained
from unaffiliated third parties. See "Business and Strategy--Management
Policies and Programs--Conflict of Interest Policies."
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THE COMPANY WILL BE DEPENDENT UPON THE BANK TO SELECT AND SERVICE THE LOAN
PORTFOLIO AND, BECAUSE THE BANK WILL SERVE AS THE COMPANY'S ADVISOR, TO
ADMINISTER THE COMPANY'S DAY-TO-DAY OPERATIONS
The Company's financial results will depend upon the selection, structuring
and monitoring of its Mortgage Loans, which in turn will depend solely upon
the diligence and skill of its officers (all of whom are also officers of the
Bank or its affiliates) and the officers and employees of the Bank. See
"Management." Through the Servicing Agreement, the Company will depend solely
upon the expertise of the Bank for purposes of servicing the Company's
Mortgage Loans. Further, through the Advisory Agreement, the Company will
depend solely upon the Bank to administer the day-to-day operations of the
Company. In addition, the Bank is and is expected to remain the sole holder of
the Company's common stock and therefore is expected to remain the sole
provider of services to the Company. Because of the Bank's ability to direct
the Company's adoption of these contracts, and because the Company's officers
and its directors other than the Independent Directors are also officers or
directors of the Bank, the Company is expected to be dependent upon the Bank
for all aspects of the Company's operations. To the extent the Bank's officers
and employees do not exercise an appropriate level of diligence or fail to
apply the proper skills, the Company's financial results could be adversely
affected. The Bank may subcontract all or a portion of its obligations under
the Advisory Agreement, and all or a portion of its obligations under the
Servicing Agreement, to one or more affiliates, and with the approval of the
Independent Directors, to non-affiliates, involved in the business of managing
or servicing Mortgage Loans. In the event the Bank subcontracts its
obligations in such a manner, the Company will be similarly dependent upon
such subcontractors for the success of the Company's business. See
"Management--Advisory Agreement" and "Business and Strategy--Servicing."
STOCKHOLDERS COULD BE FORCED TO SURRENDER THEIR STOCK IMMEDIATELY UPON THE
OCCURRENCE OF A TAX EVENT
At any time following the occurrence of a Tax Event (as defined under
"Description of Series A Preferred Shares--Redemption"), even if such Tax
Event occurs prior to March 1, 2003, the Company will have the right to redeem
the Series A Preferred Shares in whole but not in part. See "Description of
Series A Preferred Shares--Redemption." Upon the occurrence of a Tax Event, if
the Company does not redeem the Series A Preferred Shares, its ability to pay
dividends on the Series A Preferred Shares may be adversely affected.
THE COMPANY'S PAYMENT OF DIVIDENDS OR ITS OPERATIONS COULD BE SUBJECT TO
REGULATORY RESTRICTIONS BECAUSE OF ITS AFFILIATION WITH THE BANK
Holders of the Series A Preferred Shares would not receive some or all of
their quarterly dividend payments if the OTS determines, in its discretion, to
restrict or prevent such payments by the Company. Further, following the
Automatic Exchange, the OTS could similarly restrict or prevent dividend
payments by the Bank on the Bank Preferred Shares.
Because the Company is a subsidiary of the Bank, federal banking regulatory
authorities will have the right to examine the Company and its activities.
Under certain circumstances, including any determination that the Bank's
relationship to the Company results in an unsafe and unsound banking practice,
such regulatory authorities will have the authority to restrict the ability of
the Company to transfer assets, to make distributions to its stockholders
(including dividends to the holders of Series A Preferred Shares) or to redeem
shares of preferred stock, or even to require the Bank to sever its
relationship with or divest its ownership of the Company. While the Company
believes that dividends on the Series A Preferred Shares should not be
considered "capital distributions" for this purpose, there can be no
assurances that the OTS would agree with this position.
Payment of dividends on the Series A Preferred Shares by the Company could
also be subject to regulatory limitations if the Bank becomes
"undercapitalized" for purposes of the OTS prompt corrective action
regulations, which is currently defined as having a core capital (or leverage)
ratio of less than 4.0%, Tier 1 risk-based capital ratio of less than 4.0% and
a total risk-based capital ratio of less than 8.0%. At September 30, 1997, the
Bank's core capital (or leverage) ratio was 5.95%, its Tier 1 risk-based
capital ratio was 10.88% and its total risk-based capital ratio was 11.25%.
Such ratios, adjusted to give effect to the sale of Series A Preferred Shares
in the Offering, would have been 7.61%, 13.94% and 14.29%, respectively.
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THE BANK MAY BE UNABLE TO PAY DIVIDENDS ON ITS PREFERRED STOCK FOLLOWING AN
AUTOMATIC EXCHANGE
If the Automatic Exchange occurs, the Bank would likely be prohibited from
paying dividends on the Bank Preferred Shares. Under OTS regulations, the
ability of thrift institutions such as the Bank to make "capital
distributions" (defined to include payment of dividends, stock repurchases,
cash-out mergers and other distributions charged against the capital accounts
of an institution) varies depending primarily on the institution's earnings
and regulatory capital levels. See "Business and Strategy--Distributions."
Furthermore, in the event the Bank is placed into conservatorship or
receivership (whether before or after the Automatic Exchange), the Bank would
likely be unable to pay dividends on the Bank Preferred Shares. In addition,
in the event of a liquidation of the Bank, the claims of the Bank's depositors
and of its secured, senior, general and subordinated creditors would be
entitled to a priority of payment over the dividend and other claims of
holders of equity interests such as the Bank Preferred Shares issued pursuant
to the Automatic Exchange.
STOCKHOLDERS COULD SUFFER A PERMANENT LOSS OF ANY DIVIDENDS NOT DECLARED BY
THE BOARD OF DIRECTORS
If the Board of Directors does not declare a dividend on the Series A
Preferred Shares for any quarterly period, the holders of the Series A
Preferred Shares would not be entitled to recover such dividend whether or not
funds are or subsequently became available because the dividends are
noncumulative and thus are not payable if not declared. This provision is
required in order to qualify the Series A Preferred Stock as Tier 1 capital of
the Bank for regulatory capital purposes. The Board of Directors may
determine, in its business judgment, that it would be in the best interests of
the Company to pay less than the full amount of the stated dividends on the
Series A Preferred Shares or no dividends for any quarter notwithstanding that
funds are available. Factors that would generally be considered by the Board
of Directors in making this determination are the Company's financial
condition and capital needs, its ability to retain its tax status as a REIT,
the impact of legislation and regulations as then in effect or as may be
proposed, economic conditions, and such other factors as the Board may deem
relevant. To remain qualified as a REIT, the Company must distribute annually
at least 95% of its REIT Taxable Income (not including capital gains) to
stockholders. See "Federal Income Tax Consequences--Taxation of the Company--
Organizational Requirements."
THE COMPANY'S SOURCE OF CASH TO FUND DIVIDEND PAYMENTS DEPENDS SOLELY UPON
PAYMENTS RECEIVED FROM ITS MORTGAGE LOANS
An investment in the Series A Preferred Shares may be affected by, among
other things, a decline in real estate values. Neither the Bank nor Flagstar
guarantees the performance of the Mortgage Loans purchased from the Bank or
the payment of dividends to the holders of the Series A Preferred Shares. In
the event the Mortgage Loans held by the Company become nonperforming, the
Company may not have funds sufficient to pay dividends on the Series A
Preferred Shares.
A DECLINE IN INTEREST RATES WOULD ADVERSELY AFFECT THE COMPANY'S ABILITY TO
PAY DIVIDENDS
The Company's ability to pay dividends will depend upon its cash flow, which
is based solely upon the interest it is able to collect on its Mortgage Loans.
In a declining interest rate environment, the Company may be unable to
generate sufficient cash income to pay dividends on the Series A Preferred
Shares. This could occur if the interest rates on its adjustable rate Mortgage
Loans adjust to a lower rate that does not generate sufficient cash on a
regular basis, or if the Mortgage Loans are prepaid and replaced by Mortgage
Loans bearing lower interest rates.
The Company's income will consist primarily of interest payments on the
Mortgage Loans held by it. Approximately 70% of its Mortgage Loans will bear
interest at rates which adjust periodically. These include loans in the
Initial Portfolio that will have fixed rates for an initial three-year, five-
year or seven-year term but will, in each case, convert at the end of such
initial term to an interest rate that is adjustable once each year. If there
is a decline in interest rates (as measured by the indices upon which the
interest rates of the Mortgage Loans are based), then the Company will
experience a decrease in income available to be distributed to its
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stockholders. In such an interest rate environment, the Company may also
experience an increase in prepayments on its Mortgage Loans, both those with
adjustable and those with fixed rates, and may find it more difficult to
purchase additional Mortgage Loans bearing rates sufficient to support payment
of the dividends on the Series A Preferred Shares. Because the rate at which
dividends are required to be paid on the Series A Preferred Shares is fixed,
there can be no assurance that a declining interest rate environment would not
adversely affect the Company's ability to pay dividends on the Series A
Preferred Shares. In particular, because the amount required to meet the
dividend payments on the 8.5% Series A Preferred Shares, plus fees and
expenses of approximately $700,000, totals $5 million, if the weighted average
rate of interest on the Initial Portfolio declined to 4.42% and thus only
produced annual net earnings of $5 million, the Company would experience
difficulty in meeting its obligations to pay the preferred dividend. For
further information regarding the anticipated amounts available for
distribution to the holders of Series A Preferred Shares, see "Business and
Strategy--Distributions."
DELAYS BY THE BANK IN LIQUIDATING DEFAULTED MORTGAGE LOANS COULD DELAY RECEIPT
OF PROCEEDS BY THE COMPANY NECESSARY TO FUND DIVIDEND PAYMENTS
Substantial delays could be encountered in connection with the liquidation
of defaulted Mortgage Loans, with corresponding delays in the receipt of
related proceeds by the Company. Because the Company will depend solely upon
cash flow from its Mortgage Loans to fund dividend payments on the Series A
Preferred Shares, any delay in the receipt of such proceeds, if in a
sufficiently large amount, could delay or preclude any of the quarterly
dividend payments. An action to foreclose on a mortgaged property securing a
Mortgage Loan is regulated by state statutes and rules and is subject to many
of the delays and expenses of other lawsuits if defenses or counterclaims are
interposed, sometimes requiring several years to complete. Furthermore, in
some states an action to obtain a deficiency judgment is not permitted
following a nonjudicial sale of a mortgaged property. In the event of a
default by a mortgagor, these restrictions, among other things, may impede the
ability of the Company to foreclose on or sell the mortgaged property or to
obtain proceeds sufficient to repay all amounts due on the related Mortgage
Loan. In addition, the Bank will be entitled to deduct from collections
received all expenses reasonably incurred in attempting to recover amounts due
and not yet repaid on liquidated Mortgage Loans, including legal fees and
costs of legal action, real estate taxes and maintenance and preservation
expenses, thereby reducing amounts available to the Company.
ABILITY OF THE COMPANY TO INCREASE LEVERAGE MAY REDUCE THE COMPANY'S ABILITY
TO FUND DIVIDEND PAYMENTS
Although the Company does not currently intend to incur any indebtedness in
connection with the acquisition and holding of Mortgage Loans, the Company may
do so at any time (although indebtedness in excess of 20% of the aggregate
amount of net proceeds received in connection with the issuance of the Series
A Preferred Stock and Common Stock may not be incurred without the approval of
a majority of the Independent Directors of the Company). To the extent the
Company were to change its policy with respect to the incurrence of
indebtedness, the Company would be subject to risks associated with leverage,
including, without limitation, changes in interest rates, prepayment risk and
risks of various hedging strategies. Any of these risks could generate losses
sufficient to reduce or even eliminate the Company's net interest income.
Further, payments on indebtedness would reduce the amount of cash available to
pay dividends on the Series A Preferred Shares.
THE COMPANY'S FAILURE TO QUALIFY AS A REIT COULD ADVERSELY AFFECT THE
COMPANY'S FINANCIAL RESULTS AND ABILITY TO PAY DIVIDENDS
If in any taxable year the Company fails to qualify as a REIT, the Company
would not be allowed a deduction for distributions to stockholders in
computing its taxable income and would be subject to federal income tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. As a result, the amount available for distribution to
the Company's stockholders would be reduced for the year or years involved. In
addition, unless entitled to relief under certain statutory provisions, the
Company would also be disqualified from treatment as a REIT for the four
taxable years following the year during which qualification was lost. A
failure of the Company to qualify as a REIT would not, by itself, give the
Company the right to redeem the Series A Preferred Shares. See "Description of
Series A Preferred Shares--Redemption."
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The Company intends to operate so as to qualify as a REIT under the Code.
Although the Company believes that it will be owned and organized and will
operate in such a manner, and Kutak Rock will render certain opinions,
described under "Federal Income Tax Consequences" below, regarding the
Company's qualification as a REIT, no assurance can be given that the Company
will be able to operate in such a manner so as to qualify as a REIT or to
remain so qualified. Qualification as a REIT involves the application of
highly technical and complex Code provisions for which there are only limited
judicial or administrative interpretations. The determination of various
factual matters and circumstances, not entirely within the Company's control
and not addressed by the opinion of Kutak Rock, may affect the Company's
ability to qualify as a REIT. Although the Company is not aware of any
proposal in Congress to amend the tax laws in a manner that would materially
and adversely affect the Company's ability to operate as a REIT, no assurance
can be given that new legislation or new regulations, administrative
interpretations or court decisions will not significantly change the tax laws
in the future with respect to qualification as a REIT or the federal income
tax consequences of such qualification.
The Company is relying on the opinion of Kutak Rock, tax advisor to the
Company, regarding various issues affecting the Company's ability to qualify,
and retain qualification, as a REIT. Such opinion is not binding on the
Internal Revenue Service ("IRS").
Notwithstanding that the Company currently intends to operate in a manner
designed to qualify as a REIT, future economic, market, legal, tax or other
considerations may cause the Company to determine that it is in the best
interest of the Company and the holders of its Common Stock and Series A
Preferred Stock to revoke the REIT election. As long as any Series A Preferred
Shares are outstanding, any such determination by the Company may not be made
without the approval of a majority of the Independent Directors. The tax law
prohibits the Company from electing treatment as a REIT for the four taxable
years following the year of such revocation. See "Federal Income Tax
Consequences."
THE COMPANY MUST CONTINUE A HIGH LEVEL OF STOCKHOLDER DISTRIBUTIONS (I.E., 95%
OF REIT TAXABLE INCOME) TO MAINTAIN REIT QUALIFICATION
To obtain favorable tax treatment as a REIT qualifying under the Code, the
Company generally will be required each year to distribute as dividends to its
stockholders at least 95% of its REIT Taxable Income (excluding capital
gains). Failure to comply with this requirement would result in the Company's
income being subject to tax at regular corporate rates. In addition, the
Company will be subject to a 4% nondeductible excise tax on the amount, if
any, by which certain distributions considered as paid by it with respect to
any calendar year are less than the sum of 85% of its ordinary income for the
calendar year, 95% of its capital gains net income for the calendar year and
any undistributed taxable income from prior periods.
THE COMPANY'S PURCHASE OF MORTGAGE LOANS FROM THE BANK MAY BE FOR AN AMOUNT
OTHER THAN FAIR VALUE
No third party valuations of the Mortgage Loans constituting the Designated
Portfolio were obtained for purposes of the Offering, and there can be no
assurance that the fair value of the Initial Portfolio does not differ from
the purchase price payable by the Company. In addition, it is anticipated that
no third party valuations will be obtained in connection with future
acquisitions and dispositions of Mortgage Loans even in circumstances where
the transactions are with an affiliate of the Company. Accordingly, although
the Company and, to the Company's knowledge, the Bank intend that future
acquisitions or dispositions of Mortgage Loans will be on a fair value basis,
there can be no assurance that the consideration to be paid (or received) by
the Company to (or from) the Bank or any of their respective affiliates in
connection with future acquisitions or dispositions of Mortgage Loans will not
differ from the fair value of such Mortgage Loans.
LEGAL RESTRICTIONS ON SERVICING AND COLLECTION PROCEDURES FOR MORTGAGE LOANS
MAY LIMIT THE COMPANY'S COLLECTION OF PRINCIPAL AND INTEREST AND ADVERSELY
AFFECT THE COMPANY'S OPERATIONS
Violations by the Company of applicable federal and state laws, policies and
principles may limit the ability of the Company to collect all or part of the
principal of or interest on the Mortgage Loans, may entitle the
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borrower to a refund of amounts previously paid and, in addition, could
subject the Company to damages and administrative sanctions. Applicable
federal and state laws may regulate interest rates or other charges or require
certain disclosures to borrowers. In addition, most states have other laws,
public policy and general principles of equity relating to the protection of
consumers, unfair and deceptive practices and practices which may apply to the
servicing and collection of the Mortgage Loans. Management of the Company
believes the laws of the states where it services Mortgage Loans do not impose
any uniquely unfavorable burdens or conditions.
THE 41 PERCENT CONCENTRATION OF THE COMPANY'S MORTGAGE LOANS IN CALIFORNIA AND
MICHIGAN COULD INCREASE THE COMPANY'S RISK OF LOSS
The Company's Mortgage Loans will be somewhat concentrated in California and
Michigan, which comprise in dollar amount 23.8% and 16.7%, respectively, of
the Designated Portfolio. Mortgage Loans secured by properties located in
California and Michigan may be subject to a greater risk of default than other
comparable Mortgage Loans in the event of adverse economic, political or
business developments or natural hazards that may affect California and
Michigan and the ability of property owners in California and Michigan to make
payments of principal and interest on the underlying mortgages. The Company
complies with general hazard insurance policy requirements of Fannie Mae or
Freddie Mac. The Company will not maintain, however, any special hazard
insurance policies which could mitigate any damages caused by natural
disasters (such as floods) which may occur in California, Michigan or any
other state in which collateral underlying a Mortgage Loan is located. In the
event of any such adverse economic, political or business development or
natural disaster that could occur in California or Michigan, the Company's
ability to pay dividends on the Series A Preferred Shares could be adversely
affected. Certain other geographic regions of the United States may from time
to time experience natural disasters or weaker regional economic conditions
and housing markets, and, consequently, may experience higher rates of loss
and delinquency on Mortgage Loans generally. Any concentration of the Mortgage
Loans in any other region may present risks in addition to those present with
respect to Mortgage Loans generally. See "Business and Strategy--Description
of Designated Portfolio and Initial Portfolio--Geographic Distribution" herein
for further information regarding the geographic concentration of the Mortgage
Loans in the Initial Portfolio.
THE COMPANY WILL NOT BE PROTECTED AGAINST LOAN LOSSES ARISING FROM PROPERTY
VALUE DECLINES OR BORROWER DEFAULTS
During the time it holds Mortgage Loans for which third party insurance is
not obtained, the Company will be subject to risks of borrower defaults and
bankruptcies and special hazard losses that are not covered by standard hazard
insurance (such as those occurring from floods unless flood insurance has been
obtained on an individual basis). The Company generally does not intend to
obtain credit enhancements such as mortgagor bankruptcy insurance or to obtain
special hazard insurance for its Mortgage Loans, other than standard hazard
insurance, which will in each case only relate to individual Mortgage Loans.
In addition, in the event of a default on any Mortgage Loan held by the
Company resulting from declining property values or worsening economic
conditions, among other factors, the Company would bear the risk of loss of
principal to the extent of any deficiency between (i) the value of the related
mortgaged property, plus any payments from an insurer and (ii) the amount
owing on the Mortgage Loan. Further, no assurance can be given that the values
of the properties securing the pool of Mortgage Loans have remained or will
remain at the levels existing on the dates of origination of such Mortgage
Loans.
FORECLOSURES ON MORTGAGE LOANS COULD EXPOSE THE COMPANY TO LIABILITY FOR
ENVIRONMENTAL PROBLEMS IN COLLATERAL
In the event that the Company is forced to foreclose on a defaulted Mortgage
Loan to recover its investment in such Mortgage Loan, the Company may be
subject to environmental liabilities in connection with the underlying real
property which could exceed the value of the real property. The Company
intends to exercise due diligence to discover potential environmental
liabilities prior to the acquisition of any property through foreclosure, and
such environmental liabilities are rare with respect to the exclusively
residential properties which
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will secure the Company's Mortgage Loans. Nonetheless it is possible that
hazardous substances or wastes, contaminants, pollutants or sources thereof
(as defined by state and federal laws and regulations) may be discovered on
properties during the Company's ownership or after a sale thereof to a third
party. If such hazardous substances are discovered on a property which the
Company has acquired through foreclosure or otherwise, the Company may be
required to remove those substances and clean up the property. There can be no
assurance that in such a case the Company would not incur full recourse
liability for the entire costs of any removal and clean-up, that the cost of
such removal and clean-up would not exceed the value of the property or that
the Company could recoup any of such costs from any third party. The Company
may also be liable to tenants and other users of neighboring properties. In
addition, the Company may find it difficult or impossible to sell the property
prior to or following any such clean-up.
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THE COMPANY
The Company was incorporated in Michigan in June 1995 and remained dormant
until reorganized in December 1997 for the purpose of acquiring, holding and
managing Mortgage Loans that will generate net income for distribution to
stockholders. For federal income tax purposes, the Company will elect to be
treated as a REIT and therefore will not be subject to tax on the interest and
fees earned on the Mortgage Loans if, among other things, it distributes at
least 95% of its taxable income to its stockholders as dividends. Further, as
a REIT, the Company will be entitled to a federal tax deduction for dividends
paid on its stock. See "Federal Income Tax Consequences." The Company has been
organized by the Bank to provide the Bank with a means of raising capital for
bank regulatory purposes in a cost-effective manner because the Company will
be able to deduct for federal income tax purposes the dividends payable on the
Series A Preferred Shares. The Series A Preferred Shares will be considered as
capital of the Bank for regulatory purposes.
The Company anticipates that approximately 100% of its portfolio will
consist of Mortgage Loans, all of which will initially and for the forseeable
future be acquired as whole loans from the Bank. The Bank will administer the
day-to-day operations of the Company under the Advisory Agreement.
All of the Common Stock of the Company is owned by the Bank, and all of the
common stock of the Bank is owned by Flagstar, a savings and loan holding
company organized under the laws of Michigan and registered as such under the
Home Owners Loan Act of 1933, as amended. The Bank conducts its business
through a network of 19 bank branches and 10 regional wholesale/correspondent
lending offices nationwide. As of and for the nine months ended September 30,
1997, the Bank had total assets of $2.0 billion, a return on average assets of
1.34% and a return on average equity of 21.53%.
The Series A Preferred Shares would be exchanged automatically on a one-for-
one basis for Bank Preferred Shares upon the occurrence of the Automatic
Exchange. Consequently, an investment in Series A Preferred Shares could be
replaced by an investment in Bank Preferred Shares at a time when the Bank's
financial condition is deteriorating or when the Bank has been placed into
conservatorship or receivership. Potential investors in the Series A Preferred
Shares, therefore, should carefully consider the description of the Bank set
forth under "Information Regarding the Bank" as well as the Bank's Offering
Circular, attached as Annex I. See also "Description of Series A Preferred
Shares--Automatic Exchange."
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USE OF PROCEEDS
The proceeds to the Company from the sale of the Series A Preferred Shares
offered hereby are expected to be $50.0 million (assuming the Underwriters'
over-allotment option is not exercised). Simultaneously with the consummation
of the Offering, the Bank will purchase shares of Common Stock for a price
equal to $63.0 million. The Company will use the aggregate proceeds of $113.0
million received in connection with both the Offering and the sale of shares
of Common Stock to the Bank to purchase the Initial Portfolio from the Bank
pursuant to the Mortgage Purchase Agreement to be executed at that time. See
"Business and Strategy."
If the Underwriters exercise their option to purchase additional Series A
Preferred Shares to cover over-allotments in the Offering, the Bank will
purchase additional shares of Common Stock for a price equal to approximately
1.26 times the aggregate initial public offering price of such additional
Series A Preferred Shares. The Company will use the additional proceeds from
any such additional sales of Series A Preferred Shares and shares of Common
Stock to purchase additional Mortgage Loans of the types described in
"Business and Strategy--Description of Designated Portfolio and Initial
Portfolio." The Company expects that it will purchase any such additional
Mortgage Loans within six months from the exercise by the Underwriters of
their over-allotment option. Pending such purchase, the Company will invest
such additional proceeds in mortgage-backed securities or short-term money
market investments.
Simultaneously with the consummation of the Offering, the Bank will also
purchase additional shares of Common Stock for a price equal to the aggregate
amount of underwriting commissions and expenses incurred by the Company in
connection with the Offering and all expenses incurred by the Company in
connection with its formation and the offering of the Series A Preferred
Shares (currently estimated by the Company to be approximately $2.9 million in
the aggregate) in order to provide the Company with funds sufficient to pay
such expenses. Simultaneously with the consummation of any sale of additional
Series A Preferred Shares in connection with the exercise by the Underwriters
of their over-allotment option, the Bank will also purchase additional shares
of Common Stock for a price equal to the aggregate amount of underwriting
commissions and expenses incurred by the Company in connection with the
exercise of such overallotment option in order to provide the Company with
funds sufficient to pay such expenses.
The following table illustrates the use of proceeds by the Company from the
sale of the Series A Preferred Shares offered hereby (assuming the
Underwriters' over-allotment option is not exercised) and the sale of shares
of Common Stock to the Bank described above.
<TABLE>
<S> <C>
Gross proceeds from the Offering of Series A Preferred
Shares..................................................... $ 50,000,000
Gross proceeds from the issuance of shares of Common Stock
to the Bank................................................ 65,900,000
Public Offering Expenses:
Underwriting commissions................................ 1,745,000
Other expenses of the formation and the Offering(1)..... 1,155,000(1)
============
Net proceeds to be applied to the purchase of Mortgage
Loans from the Bank........................................ $113,000,000
============
</TABLE>
- --------
(1) Assumes that expenses incurred by the Company in connection with its
formation and the Offering of the Series A Preferred Shares, other than
underwriting commissions, are approximately $1.2 million. If such expenses
are in excess of $1.2 million, the Bank will purchase additional shares of
Common Stock for a purchase price equal to such excess.
Neither the Bank nor any of its affiliates will receive any transaction fees
upon completion of the Offering, including any advance payment in respect of
servicing or advisory fees.
22
<PAGE>
CAPITALIZATION
The following table sets forth the capitalization of the Company as of
December 16, 1997 (the date of the most recent audited financial statement of
the Company) and as adjusted to reflect (i) the consummation of the Offering
(assuming the Underwriters' over-allotment option is not exercised) and (ii)
the transactions described in "The Formation--The Formation" and the use of
the net proceeds therefrom as described under "Use of Proceeds."
<TABLE>
<CAPTION>
DECEMBER 16, 1997
-------------------
ACTUAL AS ADJUSTED
------ ------------
<S> <C> <C>
DEBT
Total long-term debt................................... $-- $ --
---- ------------
STOCKHOLDERS' EQUITY
Preferred Stock (4,000,000 authorized, none issued and
outstanding; 4,000,000 shares authorized, 2,000,000
shares issued and outstanding, as adjusted)............. -- 50,000,000
Common Stock par value $1.00 per share (1,000,000 shares
authorized, 100 shares issued and outstanding; 500,000
shares issued and outstanding, as adjusted)............. 100 500,000
---- ------------
Additional paid-in capital............................... -- 62,500,000
---- ------------
Total stockholders' equity............................. 100 113,000,000
---- ------------
TOTAL CAPITALIZATION....................................... $100 $113,000,000
==== ============
</TABLE>
23
<PAGE>
BUSINESS AND STRATEGY
GENERAL
The Company's principal business objective is to acquire, hold and manage
Mortgage Loans selected from the Designated Portfolio to create the Initial
Portfolio that will generate net income for distribution to stockholders. The
Company does not expect to be in the business of selling or trading Mortgage
Loans. The Company will acquire the Initial Portfolio from the Bank for an
aggregate purchase price of approximately $113.0 million. See "The Formation."
In order to preserve its status as a REIT under the Code, substantially all
of the assets of the Company will consist of Mortgage Loans and other
qualified REIT real estate assets of the type set forth in Section
856(c)(6)(B) of the Code. See "Federal Income Tax Consequences."
DISTRIBUTIONS
The Company currently expects to pay an aggregate amount of dividends with
respect to its outstanding shares of capital stock equal to approximately 100%
of the Company's REIT Taxable Income (excluding capital gains). The Company
anticipates that none of the dividends on the Series A Preferred Shares and
none or no material portion of the dividends on the Common Stock will
constitute non-taxable return of capital.
The Company's income will consist primarily of interest payments on the
Mortgage Loans held by it. The Company anticipates that a majority of its
Mortgage Loans will bear interest at rates which adjust periodically. If there
is a decline in interest rates (as measured by the indices upon which the
interest rates of the Mortgage Loans are based), then the Company will
experience a decrease in income available to be distributed to its
stockholders. In addition, in such an interest rate environment, the Company
may experience an increase in prepayments on its Mortgage Loans and may find
it more difficult to purchase additional Mortgage Loans bearing rates
sufficient to support payment of the dividends on the Series A Preferred
Shares. In addition, certain Mortgage Loan products which the Company may
purchase could allow borrowers in such an interest rate environment to convert
an adjustable rate mortgage to a fixed rate mortgage, thus "locking in" a low
fixed interest rate. Because the rate at which dividends are required to be
paid on the Series A Preferred Shares is fixed, there can be no assurance that
a declining interest rate environment would not adversely affect the Company's
ability to pay dividends on the Series A Preferred Shares.
Dividends will be declared at the discretion of the Board of Directors after
considering the Company's distributable funds, financial requirements, tax
considerations and other factors. Both the cash available for distribution and
REIT Taxable Income of the Company will depend primarily upon the nature of
the Initial Portfolio. Further, the weighted average rate will be 7.15% for
fixed-rate Mortgage Loans and 7.25% for adjustable rate Mortgage Loans. If
these Mortgage Loans remain outstanding over a 12 month period, they are
expected to generate cash available for distribution of approximately $7.5
million, net of annual fees payable under the Advisory Agreement of $250,000
and annual fees payable under the Servicing Agreement (assuming no change in
the aggregate principal balance of Mortgage Loans in the Initial Portfolio) of
$423,750. Assuming the issuance of 2,000,000 Series A Preferred Shares in the
Offering, the estimated cash available for distribution will be approximately
$7.5 million, or $3.75 per share. Since the aggregate annual dividend payment
on the Series A Preferred Shares will be $4.3 million, based on the foregoing,
the Company anticipates that the balance of funds available for distribution
to the Bank as the holder of the Common Stock will be $3.2 million. The
Company currently intends to distribute an amount necessary to satisfy the
dividend rate of 8.5% of the Series A Preferred Shares. If any excess cash
remains available for distribution following payment of the dividends on the
Series A Preferred Shares, the Company intends to distribute such cash in the
form of dividends to the Bank as the holders of its common stock.
Although there can be no assurances, because (i) the Mortgage Loans are
interest bearing, (ii) the Series A Preferred Shares represent less than 50%
of the Company's capitalization and (iii) the Company does not anticipate
incurring any indebtedness, the Company currently expects that both its cash
available for distribution
24
<PAGE>
and its REIT Taxable Income will be in excess of amounts needed to pay
dividends on the Series A Preferred Shares. In particular, because the amount
required to meet the dividend payments on the 8.5% Series A Preferred Shares,
plus fees and expenses of approximately $700,000, totals $5 million, if the
weighted average rate of interest on the Initial Portfolio declined to 4.42%,
and thus only produced annual net earnings of $5 million, the Company would
experience difficulty in meeting its obligations to pay the preferred
dividend. Such cash flow restrictions could, if deemed appropriate by the
Company's Board of Directors, be temporarily addressed by borrowings, although
no current plans exist to do so.
The estimate of cash available for distribution is being made solely for
informational purposes and is not intended to be a projection or forecast of
the Company's results of operations or its liquidity, nor is the methodology
upon which the distribution was computed intended to be a basis for
determining future distributions. There can be no assurance that any
distributions will be made or that the estimated level of distributions will
be maintained by the Company. Actual results of operations, economic
conditions or other factors may differ materially from the assumptions used in
the estimate. The Company's actual results of operations will be affected by a
number of factors, including the revenue received from the Mortgage Loans, the
operating expenses of the Company, the rate of repayment on the Mortgage Loans
in the Initial Portfolio and the Company's ability to acquire Mortgage Loans
in the future with rates sufficient to generate similar revenue.
Federal income tax law requires that a REIT distribute annually at least 95%
of its REIT Taxable Income. See "Federal Income Tax Consequences -- Taxation
of the Company." The amount of distribution on an annual basis necessary to
maintain the Company's REIT status based on pro forma taxable income of the
Company for the twelve months ended December 31, 1998 is expected to be
approximately $7.5 million, which will be used to pay the $2.125 per share
stated dividend on the Series A Preferred Shares, with the remainder expected
to be paid as dividends on the Company's common stock. The estimated cash
available for distribution is anticipated to be in excess of the annual
distribution requirements applicable for REITs. Under certain circumstances,
the Company may be required to make distributions in excess of cash available
for distribution in order to satisfy such distribution requirements. For a
discussion of the tax treatment of distributions to holders of the Series A
Preferred Shares, see "Federal Income Tax Consequences."
There are several limitations which restrict the Company's ability to pay
dividends on the Common Stock, none of which should adversely affect either
the ability of the Company to pay dividends in respect of the Series A
Preferred Shares or the ability of the Company to maintain its status as a
REIT. First, under the Company's current dividend policy, the Company may not
make any distribution in respect of the Common Stock with respect to any year
to the extent that, after taking into account such proposed distribution,
total cash or property distributions on the Company's outstanding shares of
preferred stock and Common Stock with respect to that year would exceed 105%
of the Company's REIT Taxable Income (excluding capital gains) for that year
plus net capital gains of the Company for that year. This policy regarding the
limitations on payment of dividends in respect of Common Stock may not be
modified without the approval of a majority of the Independent Directors.
Second, if the Company fails to declare and pay full dividends on the Series
A Preferred Shares in any dividend period, the Company may not make any
dividend or other distributions with respect to the Common Stock until such
time as dividends on all outstanding Series A Preferred Shares have been (i)
declared and paid for three consecutive dividend periods and (ii) declared and
paid or declared and a sum sufficient for the payment thereof has been set
apart for payment for the fourth consecutive dividend period. See "Description
of Series A Preferred Shares--Dividends."
Third, Michigan law provides that no dividends (as well as other
distributions) may be paid on the capital stock of the Company if, after
giving it effect, the Company would not be able to pay its debts as they
become due in the usual course of business, or the Company's total assets
would be less than the sum of its total liabilities plus the amount that would
be needed, if the Company were to be dissolved at the time of the
distribution, to satisfy the preferential rights upon dissolution of
shareholders whose preferential rights are superior to those receiving the
distribution.
The OTS prompt corrective action regulations prohibit thrift institutions
such as the Bank from making "capital distributions" (defined to include a
transaction that the OTS or FDIC determines, by order or regulation,
25
<PAGE>
to be "in substance a distribution of capital") unless the institution is at
least "adequately capitalized" after the distribution. There can be no
assurances that either the OTS or the FDIC would not seek to restrict the
Company's payment of dividends on the Series A Preferred Shares under this
provision if the Bank were to fail to maintain its status as "adequately
capitalized." Currently, an institution is considered "adequately capitalized"
if it has a leverage (or core capital) ratio of at least 4.0%, a Tier 1 risk-
based capital ratio of at least 4.0%, and a total risk-based capital ratio of
at least 8.0%. At September 30, 1997, the Bank's core capital (or leverage)
ratio was 5.95%, Tier 1 risk-based capital ratio was 10.88% and total risk-
based capital ratio was 11.25%. Such ratios, adjusted to give effect to the
sale of Series A Preferred Shares in the Offering, would be 7.61%, 13.94% and
14.29%, respectively.
In addition, an Exchange Event may take place under circumstances in which
the Bank will not be considered "adequately capitalized" for purposes of the
OTS prompt corrective action regulations. Thus, at the time of the Automatic
Exchange, the Bank would likely be prohibited from paying dividends on the
Bank Preferred Shares. Further, the Bank's ability to pay dividends on the
Bank Preferred Shares following the Automatic Exchange also would be subject
to various restrictions under OTS regulations and resolution of the Bank's
board of directors. See "Information Regarding the Bank--Risk Factors--The
Company's Payment of Dividends or its Operations Could be Subject to
Regulatory Restriction Because of its Affiliation with the Bank." In the event
that the Bank did pay dividends on the Bank Preferred Shares, such dividends
would be paid out of the Bank's capital surplus.
Under certain circumstances, including any determination that the Bank's
relationship to the Company results in an unsafe and unsound banking practice,
regulatory authorities will have the authority to issue an order which
restricts the ability of the Company to make dividend payments to its
stockholders.
LIQUIDITY AND CAPITAL RESOURCES
The Company's principal liquidity need will be to fund the acquisition of
additional Mortgage Loans as Mortgage Loans held by the Company are repaid.
The acquisition of such additional Mortgage Loans will be funded with the
proceeds of principal repayments received by the Company on its portfolio of
Mortgage Loans. The Company does not anticipate that it will have any other
material capital expenditures. The Company believes that cash generated from
the payment of interest and principal on its Mortgage Loan portfolio will
provide sufficient funds to meet both operating requirements and payment of
dividends by the Company in accordance with the REIT Requirements for the
foreseeable future.
GENERAL DESCRIPTION OF MORTGAGE LOANS; INVESTMENT POLICY
The Company may from time to time acquire both conforming and nonconforming
Mortgage Loans consistent with its primary investment objective to acquire
Mortgage Loans primarily for income. Conforming Mortgage Loans comply with the
requirements for inclusion in a loan guarantee program sponsored by either the
FHLMC or FNMA. Under current regulations, the maximum principal balance
allowed on conforming Mortgage Loans ranges from $214,600 for one-unit
residential loans to $442,450 for four-unit residential loans. Nonconforming
Mortgage Loans are residential Mortgage Loans that do not qualify in one or
more respects for purchase by FNMA or FHLMC under their standard programs
solely because they exceed FHLMC or FNMA guidelines for the dollar limit of
such loans. The Company expects that approximately 65% of the Mortgage Loans
it purchases in the Initial Portfolio will be nonconforming solely because of
the large size of the loan. All of the Company's Mortgage Loans satisfy the
requirements for sale to national private mortgage conduit programs or other
investors in the secondary mortgage market.
Each Mortgage Loan will be evidenced by a promissory note secured by a
mortgage or deed of trust or other similar security instrument creating a
first lien on single-family (one- to four-unit) residential properties.
Residential real estate properties underlying Mortgage Loans consist of
individual dwelling units, individual condominium units, two- to four-family
dwelling units, planned unit developments and townhouses.
The Company currently expects that approximately 70% of the Mortgage Loans
to be acquired by it will be adjustable rate Mortgage Loans and that
approximately 30% of the Mortgage Loans will be fixed rate Mortgage Loans.
26
<PAGE>
ACQUISITION OF INITIAL PORTFOLIO
Simultaneously with the consummation of the Offering, the Company will
acquire the Initial Portfolio from Mortgage Loans owned by the Bank and
contained in the Designated Portfolio. The Company will undertake to select
Mortgage Loans for the Initial Portfolio in the same proportion and containing
the same risks and characteristics as the Mortgage Loans in the Designated
Portfolio described herein. Upon consummation of the Offering, the Company
will acquire the Initial Portfolio pursuant to the terms of a Mortgage Loan
Purchase and Warranties Agreement (the "Mortgage Purchase Agreement") that it
will enter into at that time with the Bank. Each Mortgage Loan will be
identified in a schedule appearing as an exhibit to the Mortgage Purchase
Agreement (a "Mortgage Loan Schedule") and will have been obtained from the
Designated Portfolio, provided it had not become disqualified. The Mortgage
Loan Schedule will specify, among other things, with respect to each Mortgage
Loan: the interest rate or interest rate formula and current interest rate,
the original principal amount and the unpaid principal balance as of the
purchase date, the monthly payment, maturity date, mortgagor, type of
mortgaged property, and location of the mortgaged property.
In addition, the Bank will deliver or cause to be delivered to the Company
the mortgage note with respect to each Mortgage Loan (together with all
amendments and modifications thereto) endorsed in blank, the original or
certified copy of the mortgage (together with all amendments and modifications
thereto) with evidence of recording indicated thereon, if available, and an
original or certified copy of an assignment of the mortgage in recordable
form. Such documents will initially be held by the Bank, acting as custodian
for the Company. Although the Company will have the right to record the
assignments of mortgage at any time, it does not currently anticipate doing
so. The Company believes that maintaining record title of the Mortgage Loans
in the name of the Bank will facilitate the servicing of the Mortgage Loans.
Once the assignments of mortgage are recorded, the Company's lien on the
mortgaged properties will date back to the date of the original mortgages and
rank ahead of any intervening mortgages granted by the borrowers.
The Bank will make certain customary representations and warranties with
respect to the Mortgage Loans in the Initial Portfolio for the benefit of the
Company, including, among other things: (i) the information provided with
respect to the Mortgage Loans is correct in all material respects; (ii) each
Mortgage Loan is subject to a valid first lien subject only to the lien for
current real property taxes and assessments not yet due and payable, generally
acceptable covenants, conditions, restrictions, rights of way, easements and
other matters of public record present at the time of origination and other
common matters; (iii) the validity of the mortgage documents; (iv) all
required payments have been made; and (v) each Mortgage Loan complies with
applicable federal and state laws, including, without limitation, usury,
truth-in-lending, real estate settlement procedures, consumer credit
protection, fair housing, equal credit opportunity and disclosure laws. See
"--Description of Designated Portfolio and Initial Portfolio." The Bank will
be obligated to repurchase any Mortgage Loan sold by it to the Company as to
which there is a material breach of any such representation or warranty,
unless the Bank elects to substitute a qualified Mortgage Loan for such
Mortgage Loan. The Bank will also indemnify the Company for damages or costs
resulting from any such breach. The repurchase price for any such Mortgage
Loan will be its outstanding principal amount plus accrued and unpaid interest
on the date of repurchase plus any premium paid by the Company. In addition,
under the terms of the Mortgage Purchase Agreement, the Company will acquire,
in addition to the Mortgage Loans included in the Initial Portfolio, (i) all
amounts, including payments of principal and interest (other than payments of
principal and interest due on or before February 23, 1998), held in one or
more accounts maintained for the benefit of or in the name of the Company
pursuant to the Servicing Agreement and (ii) all insurance policies relating
to the Mortgage Properties and the proceeds thereof. See "--Servicing."
MANAGEMENT POLICIES AND PROGRAMS
The Board of Directors has adopted the following policies to guide
administration of the Company and the Bank with respect to the acquisition and
disposition of assets, use of capital and leverage, credit risk management and
certain other activities. These policies, which are discussed below, may be
amended or revised from time to time at the discretion of the Board of
Directors without a vote of the Company's stockholders, including holders of
the Series A Preferred Shares. Except as specifically noted, each of the
following policies or programs of the Company may be changed by action of the
Board without the specific approval of the Independent Directors.
27
<PAGE>
The changes requiring Independent Director approval are primarily related to
the maintenance of the qualification of the Company as a REIT and the creation
of additional classes of preferred stock. See "Description of Series A
Preferred Shares--Independent Director Approval." See also "--Dividend
Policy." Notwithstanding this oversight, in performing its duties the Bank has
a high degree of autonomy.
Asset Acquisition and Disposition Policies. Subsequent to the acquisition of
the Initial Portfolio, the Company anticipates that it will from time to time
purchase additional Mortgage Loans from the Bank, although Mortgage Loans may
be acquired from unaffiliated third parties, out of proceeds received in
connection with the repayment or disposition of Mortgage Loans or the issuance
of additional shares of Common Stock and preferred stock. The Company
anticipates that additional Mortgage Loans purchased from the Bank or its
affiliates will be purchased on terms that are substantially identical to
those that could be obtained by the Company if such additional Mortgage Loans
were purchased from third parties unaffiliated with the Company. While the
Company's officers will initiate preparation of any such agreements, the
ultimate responsibility for the negotiation and approval of such transactions
is that of the Company's Board of Directors, including the Independent
Directors. As stated below, the Board of Directors intends to enter into such
transactions on terms and conditions which conform to those available
generally from unaffiliated parties. See "--Conflict of Interest Policies."
The Company currently anticipates that additional Mortgage Loans acquired by
the Company will be of the types described in "--Description of Designated
Portfolio and Initial Portfolio," although if the Bank develops additional
Mortgage Loan products, the Company may purchase such additional types of
Mortgage Loans. The Company currently anticipates that it will not acquire the
right to service any Mortgage Loan it acquires in the future and that the Bank
or an affiliate of the Bank will act to service such additional Mortgage
Loans. The Company anticipates that any servicing arrangement that it enters
into in the future with the Bank will contain fees and other terms that would
be substantially equivalent to those that would be contained in servicing
arrangements entered into with third parties unaffiliated with the Company.
The Company currently intends to maintain its entire portfolio of assets in
Mortgage Loans. The Company's current policy prohibits the acquisition of any
Mortgage Loan which (i) is delinquent in the payment of principal or interest
at the time of proposed acquisition; (ii) is or was at any time during the
preceding 12 months (a) Classified, (b) in Nonaccrual Status, or (c)
renegotiated due to financial deterioration of the borrower; or (iii) has
been, more than once during the preceding 12 months, more than 30 days past
due in the payment of principal or interest.
The Company may choose, at any time subsequent to its acquisition of any
Mortgage Loan, to require the Bank to dispose by sale to a third party any
Mortgage Loan, for any reason, including as a result of such mortgage loan
becoming Classified or being placed in Nonaccrual Status or having been, more
than once during the preceding 12 months, more than 30 days past due in the
payment of principal or interest.
Capital and Leverage Policies. To the extent that the Board of Directors
determines that additional funding is required, the Company may raise such
funds through additional equity offerings, debt financing or retention of cash
flow (after consideration of provisions of the Code requiring the distribution
by a REIT of at least 95% of its REIT Taxable Income and taking into account
taxes that would be imposed on undistributed taxable income), or a combination
of these methods.
The Company will have no debt outstanding following consummation of the
Offering, and the Company does not currently intend to incur any indebtedness.
However, the organizational documents of the Company do not contain any
limitation on the amount or percentage of debt, funded or otherwise, the
Company might incur. Notwithstanding the foregoing, the Company may not,
without the approval of a majority of the Independent Directors, incur debt
for borrowed money other than debt not in excess of 20% of the aggregate
amount of net proceeds received in connection with the issuance of all
outstanding preferred stock and Common Stock of the Company. Any such debt
incurred may include intercompany advances made by the Bank to the Company.
The Company may also issue additional series of preferred stock. However,
the Company may not issue additional shares of preferred stock senior to the
Series A Preferred Shares without the consent of holders of at least two-
thirds of the outstanding Series A Preferred Shares at that time, voting as a
single class, and the
28
<PAGE>
Company may not issue additional shares of preferred stock on a parity with
the Series A Preferred Shares without the approval of a majority of the
Company's Independent Directors. The Company does not currently intend to
issue any additional series of preferred stock unless it simultaneously issues
additional Common Stock to the Bank and the proceeds to be received from the
issuance of the Common Stock are approximately equal to the aggregate offering
price of such additional preferred stock plus the Company's expenses
(including underwriting commissions or placement fees) in connection with the
issuance of such additional shares of preferred stock. It is currently
anticipated that the Company will issue additional shares of preferred stock
if such issuance would provide the Bank with the most cost-effective means of
raising capital for bank regulatory purposes at the time. See "The Formation--
Benefits to the Bank."
Credit Risk Management Policies. The Company expects that each Mortgage Loan
acquired from the Bank or one of its affiliates in the future will be a whole
loan, will represent a first lien position and will be originated by the Bank
or such affiliate in the ordinary course of its real estate lending activities
based on the underwriting standards generally applied (at the time of
origination) for its own account by the Bank or the affiliate of the Bank
which originated the Mortgage Loan. See "--Description of Designated Portfolio
and Initial Portfolio--Underwriting Standards." The Company also expects that
all Mortgage Loans held by the Company will be serviced pursuant to the
Servicing Agreement, which requires servicing in conformity with accepted
secondary market standards, with any servicing guidelines promulgated by the
Company and with FNMA and FHLMC guidelines and procedures.
Conflict of Interest Policies. Because of the nature of the Company's
relationship with the Bank and its affiliates, it is likely that conflicts of
interest will arise with respect to certain transactions, including, without
limitation, the Company's transactions in Mortgage Loans with the Bank,
Flagstar or their respective affiliates and the modification of the Advisory
Agreement or the Servicing Agreement. It is the Company's policy that the
terms of any financial dealings with the Bank, Flagstar and their respective
affiliates will be consistent with those available from third parties in the
mortgage lending industry. In addition, neither the Advisory Agreement nor the
Servicing Agreement may be modified or terminated without the approval of a
majority of the Independent Directors.
Conflicts of interest between the Company and the Bank and its affiliates
may also arise in connection with making decisions that bear upon the credit
arrangements that the Bank or one of its affiliates may have with a mortgagor
under a Mortgage Loan. Conflicts could also arise in connection with actions
taken by the Bank as a controlling person in the Company. It is the intention
of the Company, the Bank and Flagstar that any agreements and transactions
between the Company, on the one hand, and Flagstar, the Bank or their
affiliates, on the other hand, including without limitation the Mortgage
Purchase Agreement and Servicing Agreement, are fair to all parties and are
consistent with market terms for such types of transactions. The Servicing
Agreement provides that (i) foreclosures and dispositions of the Mortgage
Loans are to be performed with a view to maximizing the recovery by the
Company as owner of the Mortgage Loans and (ii) the Bank shall service the
Mortgage Loans solely with a view toward the interests of the Company, and
without regard to the interests of the Bank or its affiliates. The requirement
in the Certificate of Designation establishing the Series A Preferred Shares
that actions of the Company to agree to modifications of the Mortgage
Purchasing Agreement, the Servicing Agreement or the Advisory Agreement be
approved by a majority of the Independent Directors is intended by the Company
to give greater assurance of fair dealings between the Company on the one hand
and Flagstar, the Bank and their respective affiliates on the other hand.
However, there can be no absolute assurance that any such agreement or
transaction will in all circumstances be on terms as favorable to the Company
as would have been obtained from unaffiliated third parties.
There are no provisions in the Company's Articles of Incorporation limiting
any officer, director, security holder or affiliate of the Company from having
any direct or indirect pecuniary interest in any Mortgage Loan to be acquired
or disposed of by the Company or in any transaction in which the Company has
an interest or from engaging in acquiring, holding and managing Mortgage
Loans. As described herein, it is expected that the Bank and its affiliates
will have direct interests in transactions with the Company (including without
limitation the sale of Mortgage Loans to the Company). However, it is not
currently anticipated that any of the officers or directors of the Company
will have any interests in such Mortgage Loans.
29
<PAGE>
Year 2000 Issues. The Company is aware of the issues associated with the
programming code in current computer systems as the year 2000 approaches.
While there is significant uncertainty in the computer software industry and
among software users as to the calculation of the actual impact of the change
from the 20th to the 21st century, it is clear that the potential cost to the
Company of problems of this sort among its records, which will be maintained
by the Bank, and among the records of its customers and suppliers could be
significant. The Bank will pursuant to the Advisory Agreement maintain the
records of the Company, including its computerized records, and will
ultimately be responsible for addressing any issues related to this problem.
The Bank has informed the Company that it is subject to comprehensive
supervision by federal bank regulators, which agencies have imposed clear
requirements for addressing the year 2000 problem upon the Bank. The Bank has
further informed the Company that it believes that it has taken or will take
all steps necessary to mitigate any material consequences from this potential
problem. As such, the Company intends to monitor the evolution of the problem
as the year 2000 approaches.
Other Policies. The Company intends to operate in a manner that will not
subject it to regulation under the Investment Company Act of 1940. The Company
does not intend (i) to invest in the securities of other issuers for the
purpose of exercising control over such issuers, (ii) to underwrite securities
of other issuers, (iii) to actively trade in loans or other investments, (iv)
to offer securities in exchange for property or (v) to make loans to third
parties, including, without limitation, officers, directors or other
affiliates of the Company. The Company may, under certain circumstances,
purchase the Series A Preferred Shares and other shares of its capital stock
in the open market or otherwise, provided, however, that the Company may not
redeem or repurchase any shares of its Common Stock for so long as any Series
A Preferred Shares are outstanding without the approval of a majority of the
Independent Directors. The Company has no present intention to repurchase any
shares of its capital stock, and any such action would be taken only in
conformity with applicable federal and state laws and regulations and the
requirements for qualifying as a REIT.
The Company intends to publish and distribute to stockholders, in accordance
with Exchange Act rules, annual reports containing financial statements
prepared in accordance with generally accepted accounting principles and
certified by the Company's independent public accountants. The Certificate of
Designation establishing the Series A Preferred Shares provides that the
Company shall maintain its status as a reporting company under the Exchange
Act for so long as any of the Series A Preferred Shares are outstanding.
The Company currently intends to make investments and operate its business
at all times in such a manner as to be consistent with the requirements of the
Code to qualify as a REIT. However, future economic, market, legal, tax or
other considerations may cause the Board of Directors, subject to approval by
a majority of Independent Directors, to determine that it is in the best
interests of the Company and its stockholders to revoke its REIT status.
DESCRIPTION OF DESIGNATED PORTFOLIO AND INITIAL PORTFOLIO
Information with respect to the Mortgage Loans in the Designated Portfolio
is presented as of January 16, 1998. The composition of the Initial Portfolio
actually purchased by the Company contemporaneously with the consummation of
the Offering will differ from the description of the Designated Portfolio only
to the extent it is discovered prior to the consummation of the Offering that
a Mortgage Loan included in the Designated Portfolio described herein (i) is
delinquent in the payment of principal or interest; (ii) is or was at any time
during the preceding 12 months (a) Classified, (b) in Nonaccrual Status, or
(c) renegotiated due to financial deterioration of the borrower; (iii) has
been, more than once during the preceding 12 months, more than 30 days past
due in the payment of principal or interest; or (iv) has failed to make the
initial monthly payment on a timely basis. In such event, a Mortgage Loan
similar in aggregate outstanding principal balance and product type will be
substituted for such non-purchased Mortgage Loan.
The Designated Portfolio was assembled by the Bank based upon the
development of criteria intended to reflect current market conditions and be
generally representative of the type of residential loans contained in the
Bank's portfolio of loans receivable with respect to fixed versus variable
rates, loan to value ratios, geographic
30
<PAGE>
distributions, and principal amounts, although no representation is made that
the Designated Portfolio mirrors in any or all respects the assets of the
Bank. In particular, excluded from the Designated Portfolio are loans not
secured by residential properties and those that are delinquent or in default.
In an effort to reduce the likelihood of prepayments, the Designated Portfolio
also excludes older loans or those with interest rates significantly higher
than such Portfolio's weighted average rate.
References herein to percentages of Mortgage Loans included in the Initial
Portfolio refer in each case to the percentage of the aggregate outstanding
principal balance of the Mortgage Loans in the Designated Portfolio as of
January 16, 1998, based on the outstanding principal balances of such Mortgage
Loans as of such date, after giving effect to scheduled monthly payments due
on or prior to such date, whether or not received.
The detailed information set forth in this Prospectus applies only to the
Designated Portfolio, and the Company's portfolio of Mortgage Loans in the
future may not have all of the characteristics described below.
General. The Designated Portfolio contains 677 Mortgage Loans. On January
16, 1998, the Mortgage Loans included in the Designated Portfolio had an
aggregate outstanding principal balance of $131.0 million.
Substantially all of the Mortgage Loans included in the Designated Portfolio
are whole loans, represent first lien positions, have been originated or
purchased and underwritten in conformity with standards generally applied by
the Bank in the normal course of its business at the time the Mortgage Loans
were originated. In general, substantially all the loans originated by the
Bank satisfy FNMA and FHLMC guidelines for sale in the secondary market,
except that the initial loan amount of certain Mortgage Loans may exceed the
maximum allowable loan amount.
All of the Mortgage Loans included in the Designated Portfolio were
originated during 1997 and 1998, and have original terms to stated maturity of
either 15 or 30 years. As of January 16, 1998, the average outstanding
principal balance of a Mortgage Loan was $193,515. The weighted average number
of months since origination of the Mortgage Loans included in the Designated
Portfolio (calculated as of January 16, 1998) was less than three months. The
weighted average Loan-to-Value Ratio (defined below) of the Mortgage Loans in
the Designated Portfolio was 72.35%; however, 13.38% of the Mortgage Loans
have Loan-to-Value Ratios of greater than 80%. "Loan-to-Value Ratio" means the
ratio (expressed as a percentage) of the original principal amount of such
Mortgage Loan to the lesser of (i) the appraised value at origination of the
underlying mortgaged property and (ii) if the Mortgage Loan was made to
finance the acquisition of property, the purchase price of the mortgaged
property. Substantially all Mortgage Loans included in the Designated
Portfolio have mortgage notes which contain "due-on-sale" provisions.
None of the Mortgage Loans included in the Designated Portfolio (i) is
delinquent in the payment of principal or interest as of January 16, 1998;
(ii) is or was at any time during the preceding 12 months (a) Classified, (b)
in Nonaccrual Status, or (c) renegotiated due to financial deterioration of
the borrower; (iii) was, more than once during the preceding 12 months, more
than 30 days past due in the payment of principal or interest; or (iv) has
failed to make the initial monthly payment on a timely basis. If, prior to the
acquisition of the Initial Portfolio, any Mortgage Loan included in the
description of the Designated Portfolio herein falls within any of the
foregoing categories, the Company will not purchase such Mortgage Loan but
will instead purchase a Mortgage Loan similar in aggregate outstanding
principal balance and product type which does not fall into any of these
categories.
The following types of Mortgage Loan products, each of which is more fully
described below, are included in the Designated Portfolio and are expected to
be included in the Initial Portfolio: Three-Year ARM, Five-Year ARM, Seven-
Year ARM, 15-year and 30-year fixed rate Mortgage Loans. All of these loans
are secured by one- to four-family residential properties.
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<PAGE>
The following table sets forth certain information with respect to each type
of Mortgage Loan included in the Designated Portfolio as of January 16, 1998:
TYPE OF MORTGAGE LOAN PRODUCT
<TABLE>
<CAPTION>
PERCENTAGE OF WEIGHTED
NUMBER OF AGGREGATE DESIGNATED AVERAGE
MORTGAGE PRINCIPAL PORTFOLIO REMAINING
TYPE LOANS BALANCE BY AGGREGATE TERM
---- --------- ------------ ------------- ----------
<S> <C> <C> <C> <C>
Fixed Rate...................... 365 $ 40,631,650 31.0% 290 months
Three-Year ARM.................. 134 40,203,612 30.7% 357 months
Five-Year ARM................... 86 25,335,279 19.3% 357 months
Seven-Year ARM.................. 92 24,839,175 19.0% 358 months
--- ------------ -----
Totals........................ 677 $131,009,716 100.0%
=== ============ =====
</TABLE>
Of the Mortgage Loans included in the Designated Portfolio, approximately
30% bear interest at fixed rates. The interest rates of the fixed rate
Mortgage Loans included in the Designated Portfolio range from 6.75% per annum
to 7.75% per annum. The weighted average interest rate of the fixed rate
Residential Mortgage Loans included in the Designated Portfolio is
approximately 7.15% per annum. The following tables contain certain additional
data with respect to the interest rates and terms of the fixed rate Mortgage
Loans included in the Designated Portfolio as of January 16, 1998:
INTEREST RATE OF FIXED RATE MORTGAGE LOANS
<TABLE>
<CAPTION>
PERCENTAGE OF
DESIGNATED
PORTFOLIO BY
NUMBER OF AGGREGATE WEIGHTED AGGREGATE
INTEREST MORTGAGE PRINCIPAL AVERAGE PRINCIPAL
RATE LOANS BALANCE RATE BALANCE
-------- --------- ----------- -------- -------------
<S> <C> <C> <C> <C>
6.75--6.99......................... 81 $ 8,484,875 6.81% 6.5%
7.00--7.249........................ 129 14,368,497 7.07% 11.0%
7.25--7.499........................ 105 11,619,949 7.30% 8.9%
7.50--7.749........................ 49 5,594,329 7.54% 4.2%
7.75--7.99......................... 1 564,000 7.75% 0.4%
--- ----------- ---- ----
Totals........................... 365 $40,631,650 7.15% 31.0%
=== =========== ==== ====
</TABLE>
32
<PAGE>
ORIGINAL TERM OF FIXED RATE MORTGAGE LOANS
<TABLE>
<CAPTION>
PERCENTAGE OF
DESIGNATED
WEIGHTED PORTFOLIO
NUMBER OF AGGREGATE AVERAGE BY AGGREGATE
ORIGINAL TERM MORTGAGE PRINCIPAL ORIGINAL PRINCIPAL
(IN MONTHS) LOANS BALANCE TERM BALANCE
------------- --------- ----------- -------- -------------
<S> <C> <C> <C> <C>
121--181........................... 165 $15,631,122 180 11.9%
301--361........................... 200 25,000,528 360 19.1%
--- ----------- ----- ----
Totals........................... 365 $40,631,650 290.3 31.0%
=== =========== ===== ====
</TABLE>
Of the Mortgage Loans included in the Designated Portfolio, approximately
70% bear interest at adjustable rates. The interest rates on the "adjustable
rate mortgages" or "ARMs" contained in the Initial Portfolio are, in the case
of the Three-Year ARMs, Five-Year ARMs and Seven-Year ARMs, tied to the
Treasury Index, and, in both cases, adjust periodically. ARMs are typically
subject to limitations on lifetime interest rates as well as periodic interest
rate adjustments. The current interest rates of the Mortgage Loans included in
the Designated Portfolio that are ARMs ranged from 6.00% per annum to 8.50%
per annum as of January 16, 1998. As of such date, the weighted average
current interest rate of the Mortgage Loans included in the Designated
Portfolio that are ARMs was approximately 7.25% per annum. The following table
contains certain additional data as of January 16, 1998 with respect to the
interest rates of the Mortgage Loans included in the Designated Portfolio that
are ARMs:
CURRENT INTEREST RATE OF ADJUSTABLE RATE MORTGAGE LOANS
<TABLE>
<CAPTION>
PERCENTAGE OF
DESIGNATED
PORTFOLIO
CURRENT NUMBER OF AGGREGATE WEIGHTED BY AGGREGATE
INTEREST MORTGAGE PRINCIPAL AVERAGE PRINCIPAL
RATE LOANS BALANCE RATE BALANCE
-------- --------- ----------- -------- -------------
<S> <C> <C> <C> <C>
6.0 --6.249%....................... 2 $ 621,247 6.08% 0.5%
6.25--6.499........................ 1 235,119 6.38% 0.2%
6.50--6.749........................ 11 2,770,218 6.61% 2.1%
6.75--6.999........................ 27 7,645,050 6.83% 5.8%
7.00--7.249........................ 92 26,333,730 7.05% 20.1%
7.25--7.499........................ 95 27,653,926 7.30% 21.1%
7.50--7.749........................ 63 18,457,533 7.55% 14.1%
7.75--7.999........................ 15 4,852,547 7.78% 3.7%
8.00--8.249........................ 4 937,279 8.00% 0.7%
8.25--8.499........................ 1 600,252 8.25% 0.5%
8.50--8.749........................ 1 271,165 8.50% 0.2%
--- ----------- ---- ----
Totals........................... 312 $90,378,066 7.25% 69.0%
=== =========== ==== ====
</TABLE>
"Gross Margin," with respect to a Mortgage Loan that is an ARM, means the
applicable fixed percentage which, when added to the applicable index, results
in the current interest rate paid by the borrower of such Mortgage Loan
(without taking into account any interest rate caps or minimum interest
rates). Gross Margin is inapplicable to fixed rate Mortgage Loans.
33
<PAGE>
The following table sets forth certain additional data as of January 16,
1998 with respect to the Gross Margins of the Mortgage Loans included in the
Designated Portfolio that are ARMs:
GROSS MARGIN ON MORTGAGE LOANS
<TABLE>
<CAPTION>
PERCENTAGE OF
DESIGNATED
NUMBER OF AGGREGATE PORTFOLIO BY
GROSS MARGIN MORTGAGE PRINCIPAL AGGREGATE
BALANCE LOANS BALANCE PRINCIPAL BALANCE
------------ --------- ----------- -----------------
<S> <C> <C> <C>
2.50--3.00.............................. 312 $90,378,066 69.0%
</TABLE>
The interest rate of each ARM loan included in the Designated Portfolio
adjusts at the times (each, a "Rate Adjustment Date") and in the manner
described below subject to lifetime interest rate caps, to minimum interest
rates and to maximum annual interest rate increases or decreases, each as
specified in the mortgage note relating to the ARM. Information set forth
below regarding interest rate caps and minimum interest rates applies to the
Designated Portfolio and is intended to apply to the Initial Portfolio in a
similar manner. Mortgage Loans purchased by the Company after consummation of
the Offering may be subject to different interest rate caps and minimum
interest rates.
Each ARM bears interest at its initial interest rate until its first Rate
Adjustment Date. Effective with each Rate Adjustment Date, the monthly
principal and interest payment on most of the adjustable rate Mortgage Loans
included in the Designated Portfolio and the Initial Portfolio will be
adjusted to an amount that will fully amortize the then-outstanding principal
balance of such Mortgage Loan over its remaining term to stated maturity and
that will be sufficient to pay interest at the adjusted interest rate. All of
the Mortgage Loans included in the Designated Portfolio and the Initial
Portfolio allow the mortgagor to prepay at any time some or all of the
outstanding principal balance of the Mortgage Loan without fee or penalty.
Three-Year ARM. The interest rate with respect to a Three-Year ARM is fixed
at an initial rate for the first 36 monthly payments and adjusts annually
thereafter on the date specified in the related mortgage note to a rate equal
to the then-current Treasury Index (defined below) plus the Gross Margin set
forth in such mortgage note, subject to a maximum annual interest rate
increase or decrease of 2%, a lifetime interest rate cap equal to the initial
interest rate with respect to such Mortgage Loan plus 6% and to a minimum
interest rate no less than the Gross Margin. The sum of the Treasury Index and
the Gross Margin is rounded upwards to the nearest 0.125%. The "Treasury
Index" with respect to each Three-Year ARM is the weekly average yield on U.S.
Treasury securities adjusted to a constant maturity of one year as published
by the Federal Reserve Board in Statistical Release H.15 (519) or any similar
publication, or as reported by any Federal Reserve Bank or by any U.S.
Government department or agency and made available to the Bank. Should the
Treasury Index not be published or become otherwise unavailable, the Bank will
select a comparable alternative index over which it has no control and which
is publicly available.
Five-Year ARM. The interest rate with respect to each Five-Year ARM is fixed
at an initial rate for the first 60 monthly payments and adjusts annually
thereafter on the date specified in the related mortgage note to a rate equal
to the then-current Treasury Index (defined below) plus the Gross Margin set
forth in such mortgage note, subject to a maximum annual interest rate
increase or decrease of 2%, a lifetime interest rate limitation equal to the
initial interest rate with respect to such Mortgage Loan plus 6% and a minimum
interest rate no less than the Gross Margin. The sum of the Treasury Index and
the Gross Margin is rounded upwards to the nearest 0.125%. The "Treasury
Index" with respect to each Five-Year ARM is the weekly average yield on U.S.
Treasury securities adjusted to a constant maturity of one year as published
by the Federal Reserve Board in Statistical Release H.15 (519) or any similar
publication, or as reported by any Federal Reserve Bank or by any U.S.
Government department or agency and made available to the Bank. Should the
Treasury Index not be published or become otherwise unavailable, the Bank will
select a comparable alternative index over which it has no control and which
is publicly available.
Seven-Year ARM. The interest rate with respect to each Seven-Year ARM is
fixed at an initial rate for the first 84 monthly payments and adjusts
annually thereafter on the date specified in the related mortgage note to a
rate equal to the then current Treasury Index (defined below) plus the Gross
Margin set forth in such mortgage
34
<PAGE>
note, subject to a maximum annual interest rate increase or decrease of 2%, a
lifetime interest rate cap equal to the initial interest rate with respect to
such Residential Mortgage Loan plus 6% and to a minimum no less than the Gross
Margin. The sum of the Treasury Index and the Gross Margin is rounded upwards
to the nearest 0.125%. The "Treasury Index" with respect to each Seven-Year
ARM is the weekly average yield on U.S. Treasury securities adjusted to a
constant maturity of one year as published by the Federal Reserve Board in
Statistical Release H.15 (519) or any similar publication, or as reported by
any Federal Reserve Bank or by any U.S. Government department or agency and
made available to the Bank. Should the Treasury Index not be published or
become otherwise unavailable, the Bank will select a comparable alternative
index over which it has no control and which is publicly available.
Fixed Rate Loans. The fixed rate Mortgage Loans which are included in the
Designated Portfolio and the Initial Portfolio or may be purchased by the
Company will generally have original terms to stated maturity of 15 or 30
years. The interest rates of these Mortgage Loans are fixed prior to
origination. The monthly principal and interest payment is calculated to fully
amortize the initial outstanding principal balance of such Mortgage Loan to
its stated maturity. The interest rates of the fixed rate Mortgage Loans
included in the Designated Portfolio range from 6.75% per annum to 7.75% per
annum. The weighted average interest rate of the fixed rate Mortgage Loans
included in the Initial Portfolio was approximately 7.15% per annum. The fixed
rate Mortgage Loans will be conventional, conforming loans originated
according to the guidelines established by FNMA or FHLMC, except that the
Initial Portfolio may contain Mortgage Loans that are otherwise conforming
loans except that the initial principal balance of the Mortgage Loan exceeds
the $214,600 maximum loan amount allowed under such guidelines (i.e., so-
called "jumbo loans").
Underwriting Standards. The Mortgage Loans in the Designated Portfolio have
been acquired on a basis consistent with secondary market standards or
originated in accordance with the Bank's underwriting standards. In general,
substantially all the loans originated by the Bank satisfy FHLMC and FNMA
guidelines, except that the initial loan amount of certain Mortgage Loans may
exceed the maximum allowable loan amount. FNMA and FHLMC loans are, in 1997,
limited to a maximum of $214,600 (to increase to $227,150 in 1998).
Approximately 65% of the Mortgage Loans in the Designated Portfolio exceed
such amount.
All mortgage loans originated or acquired by the Bank, whether through its
retail loan origination offices or through its wholesale or correspondent
networks, must satisfy the Bank's underwriting standards. The Bank permits a
few originating correspondent lenders operating under the Bank's delegated
underwriting program to perform initial underwriting reviews. The Bank employs
an automated underwriting process on most loans that is based upon data
provided through the Bank's initial loan data entry software and is available
from FNMA through its Desktop Underwriter(TM) software and from FHLMC through
its Loan Prospector(TM) software. This process incorporates credit scoring and
an appraisal evaluation system, which in turn employs rules-based and
statistical technologies to evaluate the borrower, property and the sale of
the loan in the secondary market. This process is intended to reduce
processing and underwriting time, to improve overall loan approval
productivity, to improve credit quality and to reduce potential investor
repurchase requests. Approximately one-third of loans underwritten by the Bank
are initially underwritten on a contractual basis by mortgage insurance
companies, in their capacity as contract underwriters. The contract
underwriter may be required to repurchase loans that are determined not to be
in compliance with such underwriting criteria.
Loans underwritten directly by the Bank are subject to a complete review of
all information prior to loan approval. This process involves the transfer of
loan data to the Bank by wholesalers or correspondents using loan data entry
software provided by the Bank plus certain other physical documentation or
through the physical transfer of loan files to the Bank. Further, the Bank has
introduced the use of video-based computer technology, known as LIVE(R), to
expedite the loan approval process by allowing its underwriters to conduct
face-to-face interviews with loan applicants using personal computers with
cameras mounted on them. This equipment is installed and can be used on an as-
needed or pre-scheduled basis in the offices of certain mortgage brokers.
Geographic Distribution. Approximately 23.8% and 16.7% of the residential
real estate properties underlying the Mortgage Loans included in the
Designated Portfolio are located in California and Michigan,
35
<PAGE>
respectively. Consequently, these Mortgage Loans may be subject to a greater
risk of default than other comparable Mortgage Loans in the event of adverse
economic, political or business developments and natural hazards in California
and Michigan that may affect the ability of residential property owners in
California and Michigan to make payments of principal and interest on the
underlying mortgages. Standard hazard insurance required to be maintained with
respect to Mortgage Loans held by the Company may not protect the Company
against losses occurring from tornados and other natural disasters.
Consequently, in the event of a natural disaster, the Company's ability to pay
dividends on the Series A Preferred Shares could be adversely affected as the
Company will not maintain special hazard insurance to protect against such
losses.
Loan-to-Value Ratios; Insurance. All of the Mortgage Loans in the Designated
Portfolio having Loan-to-Value Ratios of greater than 80%, which comprise
13.38% of the Designated Portfolio, are insured under primary mortgage
guaranty insurance policies. "Loan-to-Value Ratio" means the ratio (expressed
as a percentage) of the original principal amount of such Mortgage Loan to the
lesser of (i) the appraised value at origination of the underlying mortgaged
property and (ii) if the Mortgage Loan was made to finance the acquisition of
property, the purchase price of the mortgaged property. A standard hazard
insurance policy is required to be maintained by the mortgagor with respect to
each Mortgage Loan in an amount equal to the maximum insurable value of the
improvements securing such Mortgage Loan or the principal balance of such
Mortgage Loan, whichever is less. If the residential real estate property
underlying a Mortgage Loan is located in a flood zone, such Mortgage Loan may
also be covered by a flood insurance policy as required by law. No mortgagor
bankruptcy insurance will be maintained by the Company with respect to the
Mortgage Loans in the Initial Portfolio, nor will any Mortgage Loan be insured
by the Federal Housing Administration or guaranteed by the Veterans
Administration. The Company will not maintain any special hazard insurance
policy with respect to any Mortgage Loan which could mitigate damages caused
by any natural disaster. In addition, the standard hazard insurance required
to be maintained with respect to Mortgage Loans does not protect the Company
against losses occurring from natural disasters. In the event of any such
natural disaster, the Company's ability to pay dividends on the Series A
Preferred Shares could be adversely affected.
SERVICING
The Mortgage Loans included in the Initial Portfolio will be sold to the
Company by the Bank on a servicing retained basis. The Bank will service the
Mortgage Loans included in the Initial Portfolio pursuant to the terms of the
Servicing Agreement and will receive an annual servicing fee with respect to
each Mortgage Loan serviced for the Company of 0.375% of the outstanding
principal balance of such Mortgage Loans.
The Servicing Agreement requires the Bank to service the Company's Mortgage
Loans in a manner generally consistent with accepted secondary market
practices, with any servicing guidelines promulgated by the Company and with
FNMA and FHLMC guidelines and procedures. Further, the Servicing Agreement
requires the Bank to service the Mortgage Loans solely with a view toward the
interests of the Company, and without regard to the interests of the Bank or
its affiliates. The Bank will collect and remit principal and interest
payments, administer mortgage escrow accounts, submit and pursue insurance
claims and initiate and supervise foreclosure proceedings on the Mortgage
Loans it services. The Bank will also provide accounting and reporting
services required by the Company for such Mortgage Loans. The Bank must follow
such collection procedures as are customary in the industry, including
contacting delinquent borrowers and supervising foreclosures and property
dispositions in the event of unremedied defaults in accordance with servicing
guidelines promulgated by the Company. The Bank may, in its discretion,
arrange with a defaulting borrower a schedule for the liquidation of
delinquencies, provided that no primary mortgage guarantee insurance coverage
is adversely affected. The Bank may also be directed by the Company, at any
time during the servicing process, to dispose by sale to a third party of any
Mortgage Loan which becomes Classified, placed in Nonaccrual Status or which
has been, more than once during the preceding 12 months, more than 30 days
past due in the payment of principal and interest.
The Bank may from time to time subcontract all or a portion of its servicing
obligations under the Servicing Agreement to one or more of its affiliates or,
subject to approval of a majority of the Independent Directors, may
36
<PAGE>
subcontract all or a portion of its obligations under the Servicing Agreement
to an unrelated third party. At September 30, 1997, the Bank serviced mortgage
loans having an aggregate principal balance of approximately $6.2 billion
(including $2.0 billion in sub-servicing). The Bank will not, in connection
with subcontracting any of its obligations under the Servicing Agreement, be
discharged or relieved in any respect from its obligation to the Company to
perform its obligations under the Servicing Agreement.
The Servicing Agreement requires the Bank to pay all expenses related to the
performance of its duties under the Servicing Agreement. If such advances are
made, the Bank generally will be reimbursed by the Company out of proceeds
related to such Mortgage Loan. The Bank also will be entitled to reimbursement
by the Company for expenses incurred by it in connection with the liquidation
of defaulted Mortgage Loans serviced by it and in connection with the
restoration of mortgaged property. If claims are not made or paid under
applicable insurance policies or if coverage thereunder has ceased, the
Company will suffer a loss to the extent that the proceeds from liquidation of
the mortgaged property, after reimbursement of the Bank's expenses in the
sale, are less than the outstanding principal balance of the related Mortgage
Loan. The Bank will be responsible to the Company for any loss suffered as a
result of its failure to make and pursue timely claims or as a result of
actions taken or omissions made by it which cause the policies to be canceled
by the insurer.
In connection with any foreclosure proceedings that the Bank may institute,
the Bank may exercise any power of sale contained in any mortgage or deed of
trust, obtain a deed in lieu of foreclosure or otherwise acquire
title to a mortgaged property underlying a Mortgage Loan by operation of law
or otherwise in accordance with the terms of the Servicing Agreement.
The Company may terminate the Servicing Agreement upon the happening of one
or more events specified in the Servicing Agreement. Such events relate
generally to the Bank's proper and timely performance of its duties and
obligations under the Servicing Agreement. In addition, the Company may also
terminate the Servicing Agreement without cause upon 30 days' notice and
payment of a termination fee equal to 2% of the aggregate outstanding
principal amount of the loans then serviced under the Servicing Agreement. As
long as any Series A Preferred Shares remain outstanding, the Company may not
terminate, or elect not to renew, the Servicing Agreement without the approval
of a majority of the Independent Directors. As is customary in the mortgage
loan servicing industry, the Bank will be entitled to retain any late payment
charges and penalties collected in connection with the Mortgage Loans serviced
by it. In addition, the Bank will receive any benefit derived from interest
earned on collected principal and interest payments between the date of
collection and the date of remittance to the Company and from interest earned
on tax and insurance impound funds with respect to Mortgage Loans serviced by
it. The Servicing Agreement requires the Bank to remit to the Company no later
than the 20th day of each month all principal and interest due from borrowers
of Mortgage Loans serviced by it (unless deemed nonrecoverable by the Bank).
When any mortgaged property underlying a Mortgage Loan is conveyed by a
mortgagor, the Bank generally will enforce any "due-on-sale" clause contained
in the Mortgage Loan, to the extent permitted under applicable law and
governmental regulations. The terms of a particular Mortgage Loan or
applicable law, however, may provide that the exercise of the "due-on-sale"
clause is prohibited under certain circumstances related to the security
underlying the Mortgage Loan and the buyer's ability to fulfill the
obligations under the related mortgage note. Upon any assumption of a Mortgage
Loan by a transferee, a fee equal to a specified percentage of the outstanding
principal balance of the Mortgage Loan is typically required, which sum will
be retained by the Bank as additional servicing compensation.
As a result of the relationship between the Bank and the Company, certain
conflicts of interest may arise. See "Risk Factors--Potential Conflicts of
Interest With the Bank, Flagstar or Hammond Family Members, as Controlling
Stockholders of Flagstar, May Result in Decisions by the Company That Are Not
Fully Consistent With the Interests of the Holders of the Series A Preferred
Shares."
EMPLOYEES
The Company has five officers, each of whom is described further below under
"Management." The Company does not anticipate that it will require any
additional employees because it has retained the Bank to
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<PAGE>
perform certain functions pursuant to the Advisory Agreement described below
under "Management--The Advisory Agreement." It is currently anticipated that
all of the officers of the Company will also be officers or employees of
Flagstar, the Bank or their affiliates. The Company will maintain corporate
records and audited financial statements that are separate from those of the
Bank or any of its affiliates. None of the officers, employees or directors of
the Company will have any direct or indirect pecuniary interest in any
Mortgage Loan to be acquired or disposed of by the Company or in any
transaction in which the Company has an interest or will engage in acquiring,
holding and managing Mortgage Loans.
COMPETITION
The Company does not anticipate that it will engage in the business of
originating Mortgage Loans. It does anticipate that it will purchase Mortgage
Loans in addition to those in the Initial Portfolio and currently intends to
purchase all of these Mortgage Loans from the Bank or affiliates of the Bank.
LEGAL PROCEEDINGS
From time to time, the Company and its subsidiaries are parties to various
legal proceedings incident to its business. At September 30, 1997, there were
no legal proceedings which management anticipates would have a material
adverse effect on the Company.
Neither the Company, the Bank nor any of its affiliates is currently
involved in nor, to the Company's knowledge, currently threatened with any
material litigation with respect to the Mortgage Loans to be included in the
Initial Portfolio, other than routine litigation arising in the ordinary
course of business.
38
<PAGE>
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The Company's Board of Directors will be composed of seven members, two of
whom will be Independent Directors. These directors will serve until their
successors are duly elected and qualified. There is no current intention to
alter the number of directors comprising the Board of Directors. Pursuant to
the Certificate of Designation establishing the Series A Preferred Shares, the
Independent Directors are required to take into account the interests of both
the holders of the Series A Preferred Shares and the holders of the Common
Stock in assessing the benefit to the Company of any proposed action requiring
their consent. In considering the interests of the holders of the Series A
Preferred Shares, the Independent Directors shall owe the same duties which
the Independent Directors owe to holders of Common Stock. The Company
currently has five officers, each of whom are also directors. The Company has
no other employees and does not anticipate that it will require additional
employees. See "Business and Strategy--Employees".
The following table sets forth the name, age and position with the Company
of each person who is an executive officer or director of the Company or a
newly-elected director and also sets forth the expiration of each director's
term.
<TABLE>
<CAPTION>
POSITION WITH DIRECTOR
NAME AGE* THE COMPANY TERM TO EXPIRE
---- ---- ------------------------------------ --------------
<S> <C> <C> <C>
Thomas J. Hammond....... 54 Chairman and Chief Executive Officer 1999
Mark T. Hammond......... 32 Vice Chairman and President 1998
Joan H. Anderson........ 47 Director and Executive Vice 1999
President
Mary Kay McGuire........ 41 Director and Secretary 2000
Michael W. Carrie....... 43 Director, Executive Vice President 2000
and Chief Financial Officer
<CAPTION>
NEWLY ELECTED DIRECTORS:
- ------------------------
<S> <C> <C> <C>
Jack Christenson........ 57 Director 1998
Robert W. DeWitt........ 57 Director 1999
</TABLE>
- --------
*As of September 30, 1997
The following sets forth the business experience and other information for
each of the current directors of the Company.
THOMAS J. HAMMOND has served as Chairman of the Board of Directors and Chief
Executive Officer of the Bank since the Bank's formation in 1987 and served as
President of the Bank from 1987 to September 1995. Mr. Hammond has also served
as Chairman of the Board of Directors and Chief Executive Officer of Flagstar
since its formation in 1993. Mr. Hammond has over 29 years of experience in
the mortgage lending industry. After earning a BSBA and an MBA in finance, Mr.
Hammond began his career as a Staff Financial Analyst for Ford Motor Company
in 1966. Prior to founding the Bank in 1987, Mr. Hammond formed and managed a
series of companies in the financial services industry, including Hammond
Mortgage Corporation, Seller's & Homeowner's Uniform Receipt of Equity, Inc.
and First Security Mortgage Corporation (formerly known as Oak Hills Mortgage
Corporation) dating back to 1969. Mr. Hammond founded Hammond Mortgage
Corporation, a residential mortgage brokerage firm, in 1969. This company did
business nationwide and operated branches in eight different states and was
one of the country's largest FHA mortgage lenders prior to being sold to
Michigan National Bank in 1981. It eventually became known as Independence One
and is now part of Norwest Mortgage, Inc. Mr. Hammond is the father of Mark T.
Hammond, the Vice Chairman and President of the Bank.
MARK T. HAMMOND has served as President of the Bank since September 1995. He
has served as a member of the Bank's Board of Directors since 1991 and as its
Vice Chairman since 1993. Mr. Hammond has served as Vice Chairman of the Board
of Directors and President of Flagstar since January 1997. He has also served
as Executive Vice President of the Bank from 1991 to September 1995 in charge
of mortgage operations, wholesale lending and construction lending. From 1989
to 1991, he served as the Bank's Senior Vice President in charge
39
<PAGE>
of secondary marketing and mortgage production. Mr. Hammond was a loan officer
in 1987 for the Bank, worked part-time in the financial services industry from
1982 to 1986 and is a graduate of Wharton Business School. Mr. Hammond was
responsible for the national expansion of the Bank's loan production offices
and has played a lead role in the development and implementation of new
technology for the Bank. Mr. Hammond recently served on one of Fannie Mae's
regional advisory councils. Mr. Hammond is the son of Thomas J. Hammond, the
Chairman and Chief Executive Officer of the Bank.
JOAN H. ANDERSON has been the Bank's Executive Vice President in charge of
mortgage loan servicing, collections and real estate holdings since 1988. Ms.
Anderson is also an Executive Vice President of Flagstar, a position she has
held since 1994. She has also been a director of Flagstar since January 1997.
Ms. Anderson served as a Senior Vice President of the Bank from 1987 to 1988.
Prior to that time, she held various positions with mortgage lending companies
owned by Thomas J. Hammond and has worked in the financial services industry
since 1970.
MARY KAY MCGUIRE has been a Director of the Bank since September 1987. She
has also served as the Bank's Secretary since its formation in 1987, and
Senior Vice President of the Bank in charge of human resources, purchasing and
facilities management since 1988 and advertising since 1996. She also served
as a Vice President of the Bank from 1987 to 1988. Ms. McGuire has served with
Mr. Thomas Hammond since 1977 and has worked in the financial services
industry since 1974.
MICHAEL W. CARRIE has served as Chief Financial Officer of the Bank since
1993 and has been a director of Flagstar since 1997, and its Executive Vice
President in charge of financial planning, financial accounting, cash
management, investor reporting, regulatory accounting, loan funding and
information services since 1995. From 1993 to 1995 he served as Senior Vice
President of the Bank. From 1985 until 1993, he served as Vice President and
Manager of Financial Analysis of Standard Federal Bank, F.S.B., a major
regional federal savings bank. From July 1994 to February 1996, Mr. Carrie
also served as a director of Security Savings after its acquisition by the
Bank.
The business operations of the Company are to be performed by the Bank
pursuant to the Advisory Agreement, see "--Advisory Agreement." The Officers
and Directors of the Company will have oversight responsibilities with respect
to the activities performed by the Bank. The Company anticipates that the
Board of Directors will meet no less frequently than quarterly and that the
Board will receive reports on the condition of the Company's affairs from the
Officers, notwithstanding that such reports or related recommendations may
have been prepared by employees of the Bank.
INDEPENDENT DIRECTORS
The Company's Certificate of Designation establishing the Series A Preferred
Shares requires that, so long as any Series A Preferred Shares are
outstanding, certain actions by the Company be approved by a majority of the
Independent Directors of the Company. See "Description of Series A Preferred
Shares--Independent Director Approval." Upon consummation of the sale of the
Series A Preferred Shares by the Company pursuant to this Prospectus, the
election of Messrs. Christenson and DeWitt as Independent Directors will
become effective. For so long as there are only two Independent Directors, any
action that requires the approval of a majority of Independent Directors must
be approved by both Independent Directors.
If at any time the Company fails to declare and pay a quarterly dividend
payment on the Series A Preferred Shares, the number of directors then
constituting the Board of Directors of the Company will be increased by two at
the Company's next annual meeting and the holders of Series A Preferred
Shares, voting together with
40
<PAGE>
the holders of any other outstanding series of Preferred Stock as a single
class, will be entitled to elect two additional directors to serve on the
Company's Board of Directors. Any member of the Board of Directors elected by
holders of the Series A Preferred Shares will be deemed to be an Independent
Director for purposes of the actions requiring the approval of a majority of
the Independent Directors. See "Description of Series A Preferred Shares--
Voting Rights."
The following sets forth the business experience and other information for
each newly elected director of the Company.
JACK CHRISTENSON is President and owner of Jack Christenson, Inc., a
residential brokerage company which has been based in Troy, Michigan, since
1982 and which is one of Michigan's largest brokerage companies.
Mr. Christenson has over 20 years experience in the real estate brokerage
business and has been a member of various real estate associations as well as
a general partner of a former real estate investment trust.
ROBERT W. DEWITT is President and owner of DeWitt Building Co., Inc., a
residential and commercial building company based in Lathrup Village,
Michigan, since 1979. Mr. DeWitt has over 30 years experience in the
construction business and has held various positions on local and Michigan
boards of construction associations. Mr. DeWitt was founder and served as a
director for four years of American Building Traders, Inc., which provides
curriculum for job training utilizing adult education programs, and has been
director for the last four years of Contractors Assistance Program, an entity
co-funded by the State of Michigan to train small business contractors and
minority contractors.
AUDIT COMMITTEE
Upon consummation of the Offering, the Company will establish an audit
committee which will review the engagement and independence of its auditors.
The audit committee will also review the adequacy of the Company's internal
accounting controls. The audit committee will initially be comprised of
Messrs. Christenson and DeWitt.
CREDIT COMMITTEE
Upon consummation of the Offering, the Company will establish a credit
committee which will review and approve the acquisition of any additional
Mortgage Loans by the Company, will review the status of all Mortgage Loans
which have become Classified or have been placed in Nonaccrual Status, and
will review the terms and conditions upon which any such Loans are modified or
disposed of by the Company. The credit committee will initially be comprised
of Mmes. Anderson and McGuire.
COMPENSATION OF DIRECTORS AND OFFICERS
The Company intends to pay the Independent Directors of the Company fees for
their services as directors. Each Independent Director will receive a fee of
$1,200 for attendance (in person or by telephone) at each meeting of the Board
of Directors or Committee of the Board. However, multiple fees shall not be
paid for two or more meetings attended on the same day. The Company will not
pay any compensation to its officers or employees or to directors who are not
Independent Directors.
LIMITATIONS ON LIABILITY OF DIRECTORS AND OFFICERS
The Company's Articles of Incorporation eliminate, to the fullest extent
permitted by Michigan law, the personal liability of a director to the Company
or its stockholders for monetary damages for breach of such director's
fiduciary duty. The Company's Articles of Incorporation empower the Company to
indemnify, to the fullest extent permitted by Michigan law, any director or
officer of the Company. The Company's Articles of Incorporation also empower
the Company to purchase and maintain insurance to protect any director or
officer against any liability asserted against him or her, or incurred by him
or her, arising out of his or her status as such.
The by-laws of the Company (the "By-laws") permit indemnification of the
Company's directors and officers and specify that the right to indemnification
is a contract right, setting forth certain procedural and
41
<PAGE>
evidentiary standards applicable to the enforcement of a claim under the By-
laws. The By-laws also entitle any director or officer to be reimbursed for
the expenses of defending any claim against him or her arising out of his or
her status as such. The By-laws of the Company also provide that the Company
may enter into contracts with any director or officer in furtherance of the
indemnification provisions contained in the By-laws and allow the Company to
create a trust fund to ensure payment of amounts indemnified.
ADVISORY AGREEMENT
In connection with the consummation of the Offering and the formation of the
Company, the Company will enter into the Advisory Agreement with the Bank to
administer the day-to-day operations of the Company. The Bank will be
responsible for (i) monitoring the credit quality of the Mortgage Loans held
by the Company, (ii) advising the Company with respect to the acquisition,
management, financing and disposition of the Company's Mortgage Loans and
(iii) maintaining custody of the documents related to the Company's Mortgage
Loans. The Bank may, from time to time, subcontract all or a portion of its
obligations under the Advisory Agreement to one or more of its affiliates
involved in the business of managing Mortgage Loans or, with the approval of a
majority of the Board of Directors as well as a majority of the Independent
Directors, subcontract all or a portion of its obligations under the Advisory
Agreement to unrelated third parties. The Bank will not, in connection with
the subcontracting of any of its obligations under the Advisory Agreement, be
discharged or relieved in any respect from its obligations under the Advisory
Agreement.
Notwithstanding the above, the Company will control the activities of the
Bank under the Advisory Agreement and the Company's directors and officers
will maintain the continuing and exclusive authority to manage the operations
of the Company. The activities of the Bank under the Advisory Agreement are
subject to the "control and discretion of" and are performed "at the request
of the Board of Directors" of the Company, although no minimum standard of
time or attention is specified in the Advisory Agreement. The management of
the Company intend that the business affairs of the Company will be conducted
in the same manner and to the same standards as are applied to the business
affairs of the Bank. Furthermore, the Bank will continue to have a very
substantial equity interest in the Company in the form of the Common Stock
and, because it is anticipated that the Company will be treated as a
consolidated subsidiary of the Bank for accounting and bank regulatory
purposes, see "The Formation--Benefits to the Bank" and "Information Regarding
the Bank," the profitable conduct of the Company's business will be of
significant concern to the Bank and its Officers and Directors, as well.
The Bank has substantial experience in the mortgage lending industry, both
in the origination and in the servicing of mortgage loans. At September 30,
1997, the Bank held approximately $1.6 billion of residential mortgage loans.
In its residential mortgage loan business, the Bank originates and purchases
residential mortgage loans and sells substantially all such loans to
investors, primarily in the secondary market, while in many cases retaining
the rights to service such loans.
The Advisory Agreement has an initial term of five (5) years, and will be
renewed automatically for additional five-year periods unless notice of
nonrenewal is delivered to the Bank by the Company. The Advisory Agreement may
be terminated by the Company at any time after the initial five-year term upon
90 days' prior notice or at any time upon breach. As long as any Series A
Preferred Shares remain outstanding, any decision by the Company either not to
renew the Advisory Agreement or to terminate the Advisory Agreement must be
approved by a majority of the Board of Directors, as well as by a majority of
the Independent Directors. The Bank will be entitled to receive an annual
advisory fee equal to $250,000 with respect to the advisory and management
services it provides to the Company. Upon termination, the Bank is only
entitled to its fee ($250,000 annually) and expenses through the date of
termination.
As a result of the relationship between the Bank and the Company, certain
conflicts of interest may arise. See "Risk Factors--Potential Conflicts of
Interest With the Bank, Flagstar or Hammond Family Members, as Controlling
Stockholders of Flagstar, May Result in Decisions by the Company That Are Not
Fully Consistent With the Interests of the Holders of the Series A Preferred
Shares."
POTENTIAL CONFLICTS OF INTEREST
Each of the members of the Board of Directors and all of the members of the
Company's management, with the exception of the Independent Directors, also
hold similar positions with the Bank and, in some cases,
42
<PAGE>
Flagstar. Because the interests of the Company could in some circumstances
compete with those of the Bank, Flagstar or an affiliate of Flagstar, most
directors and all of the Company's management could be placed in situations
requiring a balancing of the best interests of the Company against those of
their other employers and the other companies that they serve as directors.
The Company has adopted policies in an effort to address this issue, see
"Business and Strategy--Management Policies and Programs--Conflict of Interest
Policies." However, there can be no assurance that the conflicts of interests
will not result in actions detrimental to the interests of the holders of the
Series A Preferred Shares. See "Risk Factors--Potential Conflicts of Interest
With the Bank, Flagstar or Hammond Family Members, as Controlling Stockholders
of Flagstar, May Result in Decisions by the Company That Are Not Fully
Consistent With the Interests of the Holders of the Series A Preferred
Shares."
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
As of the date hereof, all of the outstanding Common Stock of the Company is
owned by the Bank. Further, all of the outstanding stock of the Bank is owned
by Flagstar. As of the date hereof, outstanding common stock of Flagstar
consists of 13,670,000 shares, which entitles the holder thereof to one vote
per share on each matter on which stockholders of Flagstar are entitled to
vote. Beneficial ownership of the Company's Common Stock is not expected to
change as a result of the Offering.
The following table sets forth information, as of the date of this
Prospectus, regarding persons who beneficially own more than 5% of the Common
Stock of the Company by virtue of their ownership of the common stock of
Flagstar.
<TABLE>
<CAPTION>
NAME OF BENEFICIAL OWNER SHARES(1) PERCENTAGE
------------------------ --------- ----------
<S> <C> <C>
Thomas J. Hammond............................... 5,270,245 38.6%
Janet G. Hammond................................ 5,270,245 38.6%
Mark T. Hammond................................. 969,585(2) 7.1%
Catherine H. Rondeau............................ 966,585(2) 7.1%
Carrie C. Langdon............................... 966,585(2) 7.1%
</TABLE>
- --------
(1) Amount of shares includes amounts held by spouse, as to which the
respective person named herein disclaims beneficial ownership. In
accordance with Rule 13d-3 under the Securities Exchange Act of 1934, a
person is deemed to be the beneficial owner, for purposes of this table,
of any shares of the Common Stock if he or she has or shares voting or
investment power with respect to such security, or has a right to acquire
beneficial ownership at any time within 60 days from the date of such
determination. As used herein, "voting power" is the power to vote or
direct the voting of shares and "investment power" is the power to dispose
or direct the disposition of shares.
(2) Mark T. Hammond, Catherine H. Rondeau and Carrie C. Langdon are the
children of Thomas and Janet Hammond.
SECURITY OWNERSHIP OF MANAGEMENT
The following table sets forth information, as of the date of this
Prospectus, regarding the beneficial ownership by the directors and executive
officers and by all of the directors and executive officers of the Company as
a group of the Common Stock of the Company. Each of the persons named below
beneficially owns the Common Stock of the Company through their ownership in
Flagstar, which owns all the outstanding common stock of the Company's parent,
the Bank.
<TABLE>
<CAPTION>
NAME OF BENEFICIAL OWNER SHARES PERCENTAGE
------------------------ --------- ----------
<S> <C> <C>
Thomas J. Hammond............................ 5,270,245(1)(2) 38.6%
Mark T. Hammond.............................. 969,585(2) 7.1%
Michael W. Carrie............................ 8,392 *
Joan H. Anderson............................. 250 *
Mary Kay McGuire............................. 5,623(3) *
Jack Christenson............................. -- *
Robert W. DeWitt............................. 37,883 *
Directors and Executive Officers as a Group
(7 persons)................................. 6,291,978 46.0%
</TABLE>
- --------
* Less than 1%
(1) Includes 962,913 shares of common stock held by Mr. Thomas Hammond's wife,
Janet G. Hammond, and as to which Mr. Hammond disclaims beneficial
ownership. For the definition of "beneficial ownership," see the table
under "--Security Ownership of Certain Beneficial Owners."
(2) Includes shares held directly or by trust and shares held by his spouse,
as to which Mr. Mark Hammond disclaims beneficial ownership. Thomas J.
Hammond is the father of Mark T. Hammond.
(3) Amount of shares includes amounts held by spouse, as to which the
respective person disclaims beneficial ownership.
43
<PAGE>
THE FORMATION
THE FORMATION
Prior to or simultaneously with the completion of the Offering, the Company,
the Bank and its affiliates will engage in the transactions described below
which are designed (i) to facilitate the Offering, (ii) to transfer the
ownership of the Initial Portfolio to the Company and (iii) to enable the
Company to qualify as a REIT for federal income tax purposes commencing with
its taxable year ending December 31, 1998.
The transactions constituting the formation of the Company will include the
following:
. The Amended and Restated Articles of Incorporation of the Company
provide for authorized shares of preferred stock and authorized shares
of Common Stock, and the Company will file a Certificate of Designation
with the Secretary of State of the State of Michigan establishing the
terms of the Series A Preferred Shares.
. The Company will sell to the public 2,000,000 shares of Series A
Preferred Shares in the Offering.
. The Bank will acquire 500,000 shares of Common Stock for a purchase
price equal to $63 million plus an amount equal to the aggregate amount
of underwriting commissions and expenses of the Offering and the
formation of the Company.
. The Bank will sell the Initial Portfolio to the Company for an aggregate
purchase price equal to approximately $113 million pursuant to the terms
of the Mortgage Purchase Agreement.
. The Company will enter into the Advisory Agreement with the Bank
pursuant to which the Bank will manage the Mortgage Loans held by the
Company and administer the day-to-day operations of the Company. See
"Management--Advisory Agreement."
. The Company will enter into the Servicing Agreement with the Bank
pursuant to which the Bank will service the Mortgage Loans included in
the Initial Portfolio. See "Business and Strategy--Servicing."
The Bank currently owns, and following the completion of the Offering
intends to continue to own, all of the issued and outstanding shares of Common
Stock of the Company. The Bank currently intends that, so long as any Series A
Preferred Shares are outstanding, it will maintain direct or indirect
ownership of at least a majority of the outstanding shares of Common Stock of
the Company. Flagstar intends to maintain direct ownership of the Bank for the
foreseeable future.
In addition to its ownership of 100% of the Common Stock of the Company, the
Bank will also have responsibility for the day-to-day management and custody
of the Company's assets, under the terms of the Advisory Agreement, and will
have responsibility for servicing the Mortgage Loans as Bank under the
Servicing Agreement. See "Management--Advisory Agreement."
The Company and the Bank intend that the fair value of the Initial Portfolio
will approximately equal the amount (approximately $113 million) that the
Company will pay for the Initial Portfolio. However, no third party valuations
of the Mortgage Loans constituting the Initial Portfolio have been or will be
obtained for purposes of the Offering, and there can be no assurance that the
fair value of the Initial Portfolio will not differ from the purchase price to
be paid by the Company. See "Risk Factors--The Company's Purchase of Mortgage
Loans from the Bank May Be for an Amount Other Than Fair Value" and "--
Potential Conflicts of Interest With the Bank, Flagstar or Hammond Family
Members, as Controlling Stockholders of Flagstar, May Result in Decisions by
the Company That Are Not Fully Consistent With the Interests of the Holders of
the Series A Preferred Shares."
BENEFITS TO THE BANK
The Bank expects to realize the following benefits in connection with the
Offering and the formation of the Company:
44
<PAGE>
. The Bank is required by the OTS to maintain certain levels of capital
for regulatory purposes. The Bank has informed the Company that the
Series A Preferred Shares will be treated as capital of the Bank for
regulatory purposes, and that such additional capital will enable the
Bank to expand its business and increase its interest earning assets
such that it anticipates a favorable effect on its net interest income.
. As a result of the Company's qualification as a REIT, the dividends
payable on the Series A Preferred Shares will be deductible for income
tax purposes and will provide the Bank with a more cost-effective means
of obtaining regulatory capital than if the Bank were to issue preferred
stock itself.
. The Bank will receive approximately $113 million at the consummation of
the Offering (assuming no exercise by the Underwriters of their over-
allotment option) in connection with the sale of the Initial Portfolio
to the Company, approximately $47 million of which would represent new
funds after giving effect to the cost of the Offering and Bank's expense
of purchasing the Company's Common Stock.
. The Bank will be entitled to receive annual advisory and servicing fees
and annual dividends in respect of the Common Stock. For the first 12
months following completion of the Offering, these annual fees and
dividends are anticipated to be as follows:
<TABLE>
<S> <C> <C> <C>
Advisory Fee............ $ 250,000
Servicing Fee(1)........ 423,750
Common Stock Dividend(2) 3,200,000
----------
$3,873,750
========== === ===
</TABLE>
--------
(1) Assumes that for the first 12 months following completion of the
Offering, the Company holds Mortgage Loans with the same outstanding
principal balances as those Mortgage Loans included in the Initial
Portfolio. See "Business and Strategy--Servicing" for a description
of the basis upon which the servicing fees will be calculated.
(2) The amount of dividends to be paid in respect of the Common Stock is
expected to be equal to the excess of the Company's REIT Taxable
Income (excluding capital gains) over the amount of dividends paid in
respect of Series A Preferred Shares. The aggregate annual dividend
amount of the Series A Preferred Shares is $4.3 million. Assuming
that (i) the Mortgage Loans included in the Initial Portfolio are
held for the 12-month period following completion of the Offering,
(ii) principal repayments are reinvested in additional Mortgage Loans
with characteristics similar to those of the Mortgage Loans included
in the Initial Portfolio and (iii) interest rates remain constant
during such 12-month period, the Company anticipates that the Initial
Portfolio will generate REIT Taxable Income (excluding capital gains)
of approximately $7.5 million, after payment of servicing and
advisory fees, during such 12-month period. See "Description of
Series A Preferred Shares--Dividends."
. The Bank will also be entitled to retain any late payment charges and
penalties collected in connection with the Mortgage Loans serviced by
it. In addition, the Bank will receive any benefit derived from interest
earned on collected principal and interest payments between the date of
collection and the date of remittance to the Company and from interest
earned on tax and insurance escrow funds with respect to Mortgage Loans
serviced by it.
45
<PAGE>
DESCRIPTION OF SERIES A PREFERRED SHARES
The following summary sets forth the material terms and provisions of the
Series A Preferred Shares, and is qualified in its entirety by reference to
the terms and provisions of the Certificate of Designation establishing the
Series A Preferred Shares and the Company's Articles of Incorporation. See
"Description of Capital Stock" below.
GENERAL
The Series A Preferred Shares constitute an authorized series of the
preferred stock of the Company, which the Company is permitted to issue from
time to time in one or more series with such rights, preferences and
limitations as the Board of Directors or, if then constituted, a duly
authorized committee thereof, may determine. The Board of Directors has
authorized the Company to issue the Series A Preferred Shares.
When issued, the Series A Preferred Shares will be validly issued, fully
paid and nonassessable. The holders of the Series A Preferred Shares will have
no preemptive rights with respect to any shares of the capital stock of the
Company or any other securities of the Company convertible into or carrying
rights or options to purchase any such shares. The Series A Preferred Shares
will not be convertible into shares of Common Stock or any other class or
series of capital stock of the Company and will not be subject to any sinking
fund or other obligation of the Company for its repurchase or retirement.
The transfer agent, registrar and dividend disbursement agent for the Series
A Preferred Shares will be Registrar and Transfer Company, Cranford, New
Jersey. The registrar will send notices to shareholders of any meetings at
which holders of the Series A Preferred Shares have the right to elect
directors of the Company or to vote on any other matter.
DIVIDENDS
Holders of Series A Preferred Shares will be entitled to receive, when and
as declared by the Board of Directors out of assets of the Company legally
available therefor, cash dividends at the rate of 8.5% per annum of the
initial liquidation preference (equivalent to $2.125 per share per annum). If
declared, dividends on the Series A Preferred Shares will be payable quarterly
on March 31, June 30, September 30 and December 31 of each year, at such
annual rate, commencing on March 31, 1998. Dividends in each quarterly period
will accrue from the first day of such period, whether or not declared or paid
for the prior quarterly period. Each declared dividend will be payable to
holders of record as they appear on the stock register of the Company on such
record dates, not exceeding 45 days preceding the payment dates thereof, as
shall be fixed by the Board of Directors or a duly authorized committee
thereof. Dividends payable on the Series A Preferred Shares for any period
less than a full dividend period shall be computed on the basis of twelve 30-
day months, a 360-day year and the actual number of days elapsed in the
period. Dividends payable on the Series A Preferred Shares for each dividend
period shall be computed by dividing the rate per annum by four.
The right of holders of Series A Preferred Shares to receive dividends is
noncumulative. Accordingly, if the Board of Directors fails to declare a
dividend on the Series A Preferred Shares for a quarterly dividend period,
then holders of the Series A Preferred Shares will have no right to receive a
dividend for that period, and the Company will have no obligation to pay a
dividend for that period, whether or not dividends are declared and paid for
any future period with respect to either the Series A Preferred Shares or the
Common Stock. If the Company fails to pay or declare and set aside for payment
a quarterly dividend on the Series A Preferred Shares, holders of the Series A
Preferred Shares will be entitled to elect two directors. See "--Voting
Rights."
If full dividends on the Series A Preferred Shares for any dividend period
shall not have been declared and paid, or declared and a sum sufficient for
the payment thereof shall not have been set apart for such payments, no
dividends shall be declared or paid or set aside for payment and no other
distribution shall be declared or made or set aside for payment upon the
Common Stock or any other capital stock of the Company ranking junior to or on
a parity with the Series A Preferred Shares as to dividends or amounts upon
liquidation, nor shall any
46
<PAGE>
Common Stock or any other capital stock of the Company ranking junior to or on
a parity with the Series A Preferred Shares as to dividends or amounts upon
liquidation be redeemed, purchased or otherwise acquired for any consideration
(or any monies to be paid to or made available for a sinking fund for the
redemption of any such stock) by the Company (except by conversion into or
exchange for other capital stock of the Company ranking junior to the Series A
Preferred Shares as to dividends and amounts upon liquidation), until such
time as dividends on all outstanding Series A Preferred Shares have been (i)
declared and paid for three consecutive dividend periods and (ii) declared and
paid or declared and a sum sufficient for the payment thereof has been set
apart for payment for the fourth consecutive dividend period.
When dividends are not paid in full (or a sum sufficient for such full
payment is not set apart) upon the Series A Preferred Shares and the shares of
any other series of capital stock ranking on a parity as to dividends with the
Series A Preferred Shares, all dividends declared upon the Series A Preferred
Shares and any other series of capital stock ranking on a parity as to
dividends with the Series A Preferred Shares shall be declared pro rata so
that the amount of dividends declared per share on the Series A Preferred
Shares and such other series of capital stock shall in all cases bear to each
other the same ratio that full dividends, for the then-current dividend
period, per share on the Series A Preferred Shares (which shall not include
any accumulation in respect of unpaid dividends for prior dividend periods)
and full dividends, including required or permitted accumulations, if any, on
such other series of capital stock bear to each other.
For a discussion of the tax treatment of distributions to stockholders, see
"Federal Income Tax Consequences--Taxation of United States Stockholders" and
"--Taxation of Foreign Stockholders." For a discussion of certain potential
regulatory limitations on the Company's ability to pay dividends, see "Risk
Factors."
AUTOMATIC EXCHANGE
Each Series A Preferred Share will be exchanged automatically for one newly
issued Bank Preferred Share if the appropriate regulatory agency so directs in
writing because (i) the Bank has become "undercapitalized" under prompt
corrective action regulations established pursuant to FDICIA, (ii) the Bank is
placed into conservatorship or receivership or (iii) the appropriate
regulatory agency, in its sole discretion and even if the Bank is not
"undercapitalized," anticipates the Bank becoming "undercapitalized" in the
near term (i.e., the Exchange Event). Upon the Automatic Exchange, each holder
of Series A Preferred Shares would be unconditionally obligated to surrender
to the Bank the certificates representing each Series A Preferred Share of
such holder, and the Bank would be unconditionally obligated to issue to such
holder in exchange for each such Series A Preferred Share a certificate
representing one Bank Preferred Share. Any Series A Preferred Shares purchased
or redeemed by the Company prior to the Time of Exchange (as defined below)
would not be deemed outstanding and shall not be subject to the Automatic
Exchange.
The Bank will be considered to be "undercapitalized" under the "prompt
corrective action" regulations established pursuant to the Federal Deposit
Insurance Corporation Improvement Act of 1991, as amended ("FDICIA"), if it
has (i) a core capital (or leverage) ratio of less than 4.0%, (ii) a Tier 1
risk-based capital ratio of less than 4.0%, or (iii) a total risk-based
capital ratio of less than 8.0%. Tier 1 or core capital consists of common
shareholders' equity, noncumulative perpetual preferred stock, and minority
interests in consolidated subsidiaries, less certain intangible assets and
investments in certain subsidiaries. Total capital consists of core capital
plus supplementary capital (which includes cumulative perpetual preferred
stock, qualifying subordinated debt, and a limited amount of the allowances
for loan and lease losses) to the extent such supplementary capital does not
exceed 100% of core capital, less certain equity investments. For purposes of
the "prompt corrective action" regulations, the Bank's capital category is
determined as of the most recent date (i) certain quarterly financial reports
are required to be filed with the regulators; (ii) a final report of
examination has been delivered to the Bank; or (iii) the Bank is notified in
writing by the OTS of its capital category or a change in such category. At
September 30, 1997 and at December 31, 1996 and 1995, the Bank's core capital
(or leverage) ratio was 5.95%, 6.01%, and 5.84%, respectively, its Tier 1
risk-based capital ratio was 10.88%, 10.48% and 9.83%,
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respectively, and its total risk-based capital ratio was 11.25%, 10.91%, and
10.12%, respectively. After giving
effect to the Offering, the capital ratios at September 30, 1997 would have
been 7.61%, 13.94% and 14.29%, respectively.
The Automatic Exchange would occur as of 8:00 a.m. Eastern Time on the date
for such exchange set forth in the Directive, or, if such date is not set
forth in the Directive, as of 8:00 a.m. on the earliest possible date such
exchange could occur consistent with the Directive (the "Time of Exchange"),
as evidenced by the issuance by the Bank of a press release prior to such
time. As of the Time of Exchange, all of the Series A Preferred Shares would
be deemed cancelled without any further action by the Company, all rights of
the holders of Series A Preferred Shares as stockholders of the Company will
cease, and such persons would thereupon and thereafter be deemed to be and
would be for all purposes the holders of Bank Preferred Shares within 30 days
of such event, and the Bank will deliver to each such holder certificates for
Bank Preferred Shares upon surrender of certificates for Series A Preferred
Shares. Until such replacement stock certificates would be delivered (or in
the event such replacement certificates are not delivered), certificates
previously representing Series A Preferred Shares would be deemed for all
purposes to represent Bank Preferred Shares. All corporate action necessary
for the Bank to issue the Bank Preferred Shares will be completed upon
completion of the Offering. Accordingly, once the Directive would be issued,
no action would be required to be taken by holders of Series A Preferred
Shares, by the Bank or by the Company in order to effect the Automatic
Exchange as of the Time of Exchange.
Absent the occurrence of the Exchange Event, no shares of Bank Preferred
Shares will be issued. Upon the occurrence of the Exchange Event, the Bank
Preferred Shares to be issued as part of the Automatic Exchange would
constitute a newly issued series of preferred stock of the Bank and would
constitute 100% of the issued and outstanding shares of Bank Preferred Shares.
Holders of Bank Preferred Shares would have the same dividend rights,
liquidation preference, redemption options and other attributes as to the Bank
as holders of Series A Preferred Shares have as to the Company, except that
the Bank Preferred Shares would not be listed on Nasdaq and the Independent
Directors would not be members of, or have any role in, the Bank's Board of
Directors. Any accrued and unpaid dividends for the most recent quarter on the
Series A Preferred Shares as of the Time of Exchange would be deemed to be
accrued and unpaid dividends for the most recent quarter on the Bank Preferred
Shares. The Bank Preferred Shares would rank in terms of dividend payment and
liquidation equal to and without preference over any outstanding shares of
preferred stock of the Bank. The Bank intends to register the Bank Preferred
Shares solely with the OTS pursuant to an Offering Circular, a copy of which
is affixed to this Prospectus as Annex I and incorporated herein by reference.
The Bank Preferred Shares will not be registered with the Commission and would
be offered pursuant to an exemption from registration under Section 3(a)(5) of
the Securities Act of 1933, as amended (the "Securities Act"). The Bank does
not intend to apply for listing of the Bank Preferred Shares on any national
securities exchange or for quotation of the Bank Preferred Shares through the
Nasdaq National Market System. Absent the occurrence of the Exchange Event,
however, the Bank will not issue any Bank Preferred Shares, although the Bank
will be able to issue preferred stock in series. There can be no assurance as
to the liquidity of the trading markets for the Bank Preferred Shares, if
issued, or that an active public market for the Bank Preferred Shares would
develop or be maintained.
Holders of Series A Preferred Shares cannot exchange their Series A
Preferred Shares for Bank Preferred Shares on a voluntary basis or otherwise
compel such an exchange. In addition, absent the occurrence of the Automatic
Exchange, holders of Series A Preferred Shares will have no dividend, voting,
liquidation preference or other rights with respect to any security of the
Bank; such rights as are conferred by the Series A Preferred Shares exist
solely as to the Company.
VOTING RIGHTS
Except as expressly required by applicable law, or except as indicated
below, the holders of the Series A Preferred Shares will not be entitled to
vote. In the event the holders of Series A Preferred Shares are entitled to
vote as indicated below, each Series A Preferred Share will be entitled to one
vote on matters on which holders of the Series A Preferred Shares are entitled
to vote.
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If at the time of any annual meeting of the Company's stockholders for the
election of directors the Company has failed to pay or declare and set aside
for payment a quarterly dividend during any of the four preceding quarterly
dividend periods on any series of preferred stock of the Company, including
the Series A Preferred Shares, the number of directors then constituting the
Board of Directors of the Company will be increased by two, and the holders of
the Series A Preferred Shares, voting together with the holders of all other
series of preferred stock as a single class, will be entitled to elect such
two additional directors to serve on the Board of Directors at each such
annual meeting. Each director elected by the holders of shares of the
preferred stock shall continue to serve as such director until the later of
(i) the full term for which he or she shall have been elected or (ii) the
payment of four quarterly dividends on the preferred stock, including the
Series A Preferred Shares.
The affirmative vote or consent of the holders of at least two-thirds of the
outstanding shares of each series of preferred stock of the Company, including
the Series A Preferred Shares, voting as a single class without regard to
series, will be required (a) to create any class or series of stock which
shall have preference as to dividends or distribution of assets over any
outstanding series of preferred stock of the Company other than a series which
shall not have any right to object to such creation or (b) to alter or change
the provisions of the Company's Articles of Incorporation (including the
Certificate of Designation establishing the Series A Preferred Shares) so as
to affect adversely the voting powers, preferences or special rights of the
holders of a series of preferred stock of the Company; provided that if such
amendment shall not adversely affect all series of preferred stock of the
Company, such amendment need only be approved by at least two-thirds of the
holders of shares of all series of preferred stock adversely affected thereby.
REDEMPTION
The Series A Preferred Shares will not be redeemable prior to March 1, 2003
(except upon the occurrence of a Tax Event). On or after such date, the Series
A Preferred Shares will be redeemable at the option of the Company, in whole
or in part, at any time or from time to time on not less than 30 nor more than
60 days notice by mail, at a redemption price of $25.00 per share, plus the
accrued and unpaid dividends for the most recent quarter to the date of
redemption, if any, thereon. Any such redemption may only be effected with the
prior approval of the OTS (unless at such time such approvals are not
required). Unless full dividends on the Series A Preferred Shares have been or
contemporaneously are declared and paid or declared and a sum sufficient for
the payment thereof has been set apart for payment for the then current
dividend period, no Series A Preferred Shares shall be redeemed unless all
outstanding Series A Preferred Shares are redeemed and the Company shall not
purchase or otherwise acquire any Series A Preferred Shares; provided,
however, that the Company may purchase or acquire Series A Preferred Shares
pursuant to a purchase or exchange offer made on the same terms to holders of
all outstanding Series A Preferred Shares.
The Company will also have the right at any time, upon the occurrence of a
Tax Event and with the prior written approval of the OTS, to redeem the Series
A Preferred Shares, in whole (but not in part) at a redemption price of $25.00
per share, plus the accrued and unpaid dividends for the most recent quarter
to the date of redemption, if any, thereon. "Tax Event" means the receipt by
the Company of an opinion of a law firm or accounting firm experienced in such
matters to the effect that, as a result of (i) any amendment to, clarification
of, or change (including any announced prospective change) in the laws or
treaties (or any regulations thereunder) of the United States or any political
subdivision or taxing authority thereof or therein affecting taxation, (ii)
any judicial decision, official administrative pronouncement, published or
private ruling, regulatory procedure, notice or announcement (including any
notice or announcement of intent to adopt such procedures or regulations)
("Administrative Action") or (iii) any amendment to, clarification of, or
change in the official position or the interpretation of such Administrative
Action or any interpretation or pronouncement that provides for a position
with respect to such Administrative Action that differs from the theretofore
generally accepted position, in each case, by any legislative body, court,
governmental authority or regulatory body, irrespective of the manner in which
such amendment, clarification or change is made known, which amendment,
clarification, or change is effective or such pronouncement or decision is
announced on or after the date of issuance of the
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Series A Preferred Shares, there is more than an insubstantial risk that (a)
dividends paid or to be paid by the Company with respect to the capital stock
of the Company are not, or will not be, fully deductible by the Company for
federal income tax purposes or (b) the Company is, or will be, subject to more
than a de minimis amount of other taxes, duties or other governmental charges.
RIGHTS UPON LIQUIDATION
In the event of any voluntary or involuntary liquidation, dissolution or
winding up of the Company, the holders of the Series A Preferred Shares at the
time outstanding will be entitled to receive out of assets of the Company
available for distribution to stockholders, before any distribution of assets
is made to holders of Common Stock or any other class of stock ranking junior
to the Series A Preferred Shares upon liquidation, liquidating distributions
in the amount of $25 per share, plus the accrued and unpaid dividends for the
most recent quarter thereon, if any, to the date of liquidation.
After payment of the full amount of the liquidating distributions to which
they are entitled, the holders of Series A Preferred Shares will have no right
or claim to any of the remaining assets of the Company. In the event that,
upon any such voluntary or involuntary liquidation, dissolution or winding up,
the available assets of the Company are insufficient to pay the amount of the
liquidation distributions on all outstanding Series A Preferred Shares and the
corresponding amounts payable on all shares of other classes or series of
capital stock of the Company ranking on a parity with the Series A Preferred
Shares in the distribution of assets upon any liquidation, dissolution or
winding up of the affairs of the Company, then the holders of the Series A
Preferred Shares and such other classes or series of capital stock shall share
ratably in any such distribution of assets in proportion to the full
liquidating distributions to which they would otherwise be respectively
entitled.
For such purposes, the consolidation or merger of the Company with or into
any other entity, the consolidation or merger of any other entity with or into
the Company or the sale of all or substantially all of the property or
business of the Company shall not be deemed to constitute a liquidation,
dissolution or winding up of the Company.
INDEPENDENT DIRECTOR APPROVAL
The Certificate of Designation establishing the Series A Preferred Shares
requires that, so long as any Series A Preferred Shares are outstanding,
certain actions by the Company be approved by a majority of the Independent
Directors. For so long as there are only two Independent Directors, any action
that requires the approval of a majority of Independent Directors must be
approved by both Independent Directors. Messrs. Christenson and DeWitt are the
Company's initial Independent Directors. See "Management--Independent
Directors". In order to be considered "independent," a director must not,
prior to or during appointment, be a current director, officer or employee of
the Company, the Bank or any affiliate of the Bank or a person who owns more
than one percent of the Common Stock of Flagstar. In addition, members of the
Board of Directors elected by holders of preferred stock, including the Series
A Preferred Shares, will be deemed to be Independent Directors for purposes of
approving actions requiring the approval of a majority of the Independent
Directors.
The actions which may not be taken without the approval of a majority of the
Independent Directors include (i) the issuance of additional preferred stock
ranking on a parity with the Series A Preferred Shares; (ii) the incurrence of
debt for borrowed money in excess of 20% of the aggregate amount of net
proceeds received in connection with the issuance of preferred stock and
Common Stock; (iii) the modification of the general distribution policy or the
declaration of any distribution in respect of Common Stock for any year if,
after taking into account any such proposed distribution, total distributions
on the Series A Preferred Shares and the Common Stock would exceed an amount
equal to the sum of 105% of the Company's REIT Taxable Income (excluding
capital gains) for such year plus net capital gains of the Company for that
year; (iv) the acquisition of real estate assets other than Mortgage Loans
that (A) qualify as real estate assets under Section 856(c)(6)(B) of the Code,
(B) are rated investment grade or better by at least one nationally recognized
independent rating organization,
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(C) are not interest-only, principal-only or high-risk securities and (D)
represent interests in or obligations backed by pools of mortgage loans; (v)
the redemption of any shares of Common Stock; (vi) the termination or
modification of, or the election not to renew, the Advisory Agreement or any
Servicing Agreement or the subcontracting of any duties under the Advisory
Agreement or the Servicing Agreements to third parties unaffiliated with the
Bank; (vii) any dissolution, liquidation or termination of the Company prior
to March 1, 2003; (viii) any material amendment to or modification of the
Mortgage Purchase Agreement, including, without limitation, any amendment to
the representations, warranties and covenants contained in such agreement made
in connection with the acquisition of additional Mortgage Loans; and (ix) the
determination to revoke the Company's REIT status or the amendment of any of
the ownership limitations contained in the Articles of Incorporation. The
Certificate of Designation requires that, in assessing the benefits to the
Company of any proposed action requiring their consent, the Independent
Directors take into account the interests of both the holders of the Common
Stock and the holders of the preferred stock, including, without limitation,
holders of the Series A Preferred Shares. In considering the interests of both
the holders of preferred stock, including without limitation the holders of
the Series A Preferred Shares, the Independent Directors shall owe the same
duties which the Independent Directors owe to the holders of Common Stock.
RESTRICTIONS ON OWNERSHIP
For information regarding restrictions on ownership of the Series A
Preferred Shares, see "Description of Capital Stock--Restrictions on Ownership
and Transfer."
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DESCRIPTION OF CAPITAL STOCK
The following summary of the material terms and provisions of the capital
stock of the Company does not purport to be complete and is subject in all
respects to the applicable provisions of Michigan law and the Amended and
Restated Articles of Incorporation of the Company.
GENERAL
The Company is authorized to issue up to 1,000,000 shares of Common Stock
and 4,000,000 shares of preferred stock. Upon consummation of the Offering and
the transactions described in "The Formation," the Company will have
outstanding 500,000 shares of Common Stock, all of which will be held by the
Bank, and 2,000,000 shares of Preferred Stock.
COMMON STOCK
Dividends. Holders of Common Stock are entitled to receive dividends when,
as and if declared by the Board of Directors out of funds legally available
therefor, provided that, so long as any shares of preferred stock are
outstanding, no dividends or other distributions (including redemptions and
purchases) may be made with respect to the Common Stock unless full dividends
on the shares of all series of preferred stock, including accumulations in the
case of cumulative preferred stock, have been paid for the prior four
quarters. In order to remain qualified as a REIT, the Company must distribute
annually at least 95% of its annual REIT Taxable Income (not including capital
gains) to stockholders.
Voting Rights. Subject to the rights, if any, of the holders of any class or
series of preferred stock, all voting rights are vested in the Common Stock.
The holders of Common Stock are entitled to one vote per share. All of the
issued and outstanding shares of Common Stock are currently, and upon
consummation of the Offering will be, held by the Bank.
Rights Upon Liquidation. In the event of the liquidation, dissolution or
winding up of the Company, whether voluntary or involuntary, after there have
been paid or set aside for the holders of all series of Preferred Stock the
full preferential amounts to which such holders are entitled, the holders of
Common Stock will be entitled to share equally and ratably in any assets
remaining after the payment of all debts and liabilities.
PREFERRED STOCK
Subject to limitations prescribed by Michigan law and the Company's Amended
and Restated Articles of Incorporation, the Board of Directors or, if then
constituted, a duly authorized committee thereof is authorized to issue, from
the authorized but unissued shares of capital stock of the Company, preferred
stock in such classes or series as the Board of Directors may determine and to
establish, from time to time, the number of shares of preferred stock to be
included in any such class or series and to fix the designation and any
preferences, conversion and other rights, voting powers, restrictions,
limitations as to dividends, qualifications and terms and conditions of
redemption of the shares of any such class or series, and such other subjects
or matters as may be fixed by resolution of the Board of Directors.
Preferred stock, upon issuance against full payment of the purchase price
therefor, will be fully paid and nonassessable. The specific terms of a
particular class or series of preferred stock will be described in the
Certificate of Designation relating to that class or series.
A Certificate of Designation relating to each class or series of preferred
stock will set forth the preferences and other terms of such class or series,
including, without limitation, the following: (1) the title and stated value
of such class or series; (2) the number of shares of such class or series
offered and the liquidation preference per share of such class or series; (3)
the dividend rate(s), period(s), and/or payment date(s) or method(s) of
calculation thereof applicable to such class or series; (4) whether such class
or series of Preferred Stock is noncumulative or not and, if noncumulative,
the date from which dividends on such class or series shall
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accumulate; (5) the provision for a sinking fund, if any, for such class or
series; (6) the provision for redemption, if applicable, of such class or
series; (7) any limitations on direct or beneficial ownership and restrictions
on transfer, in each case as may be appropriate to preserve the status of the
Company as a REIT; (8) any voting rights of such class or series; (9) the
relative ranking and preferences of such class or series as to dividend rights
and rights upon liquidation, dissolution or winding up of the affairs of the
Company; (10) any limitations on issuance of any class or series of Preferred
Stock ranking senior to or on a parity with such class or series of Preferred
Stock as to dividend rights and rights upon liquidation, dissolution or
winding up of the affairs of the Company; and (11) any other specific terms,
preferences, rights, limitations or restrictions of such class or series.
RESTRICTIONS ON OWNERSHIP AND TRANSFER
The Company's Amended and Restated Articles of Incorporation contain certain
restrictions on the number of shares of Common Stock and preferred stock that
individual stockholders may own. For the Company to qualify as a REIT under
the Code, no more than 50% in number or value of its outstanding shares of
capital stock may be owned, directly or indirectly, by five or fewer
individuals (as defined in the Code to include certain entities) during the
last half of a taxable year (other than the first year) or during a
proportionate part of a shorter taxable year (the "Five or Fewer Test"). The
capital stock of the Company must also be beneficially owned by 100 or more
persons during at least 335 days of a taxable year or during a proportionate
part of a shorter taxable year (the "One Hundred Persons Test"). The ownership
by the Bank of 100% of the shares of Common Stock of the REIT will not
adversely affect the Company's REIT qualification because each stockholder of
Flagstar (the sole stockholder of the Bank) counts as a separate beneficial
owner for purposes of the Five or Fewer Test and the capital stock of Flagstar
is widely held. Further, the Articles of Incorporation of the Company contain
restrictions on the acquisition of preferred stock intended to ensure
compliance with the One Hundred Persons Test. Such provisions include a
restriction that if any transfer of shares of capital stock of the Company
would cause the Company to be beneficially owned by fewer than 100 persons,
such transfer shall be null and void and the intended transferee will acquire
no rights to the stock.
Subject to certain exceptions specified in the Company's Amended and
Restated Articles of Incorporation, no holder of preferred stock is permitted
to own (including shares deemed to be owned by virtue of the attribution
provisions of the Code) more than 5% (the "Ownership Limit") of any issued and
outstanding class or series of preferred stock. The Board of Directors may
(but in no event will be required to), upon request of a person to acquire up
to 9.9% of the class of preferred stock or, in the case of a corporation,
partnership, estate or trust, upon receipt of a ruling from the IRS or an
opinion of counsel satisfactory to it, waive the Ownership Limit with respect
to such holder if the holder's ownership will not then or in the future
jeopardize the Company's status as a REIT.
The Articles of Incorporation provide that shares of any class or series of
preferred stock owned, or deemed to be owned, by or transferred to a
stockholder in excess of the Ownership Limit (the "Excess Shares") will
automatically be transferred, by operation of law, to a trust for the
exclusive benefit of a charity to be named by the Company as of the day prior
to the day the prohibited transfer took place. Any distributions paid prior to
the discovery of the prohibited transfer are to be repaid by the original
transferee to the Company and by the Company to the trust; any vote of the
shares while the shares were held by the original transferee prior to the
Company's discovery thereof shall be void ab initio and the original
transferee shall be deemed to have given its proxy to the trustee. Any unpaid
distributions with respect to the original transferee will be rescinded as
void ab initio. In liquidation, the original transferee stockholder's ratable
share of the Company's assets would be limited to the price paid by the
original transferee for the Excess Shares or, if no value was given, the price
per share equal to the closing market price on the date of the purported
transfer. The trustee of the trust shall promptly sell the shares to any
person whose ownership is not prohibited, whereupon the interest of the trust
shall terminate. Proceeds of the sale shall be paid to the original transferee
up to its purchase price (or, if the original transferee did not purchase the
shares, the value on its date of acquisition) and any remaining proceeds shall
be paid to a charity to be named by the Company.
The constructive ownership rules of the Code are complex and may cause
preferred stock owned, directly or indirectly, by a group of related
individuals and/or entities to be deemed to be constructively owned by one
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individual or entity. As a result, the acquisition of less than 5% of a class
or series of issued and outstanding preferred stock (or the acquisition of an
interest in an entity that owns shares of such series of preferred stock) by
an individual or entity could cause that individual or entity (or another
individual or entity) to own constructively in excess of 5% of such class or
series of preferred stock, and thus subject such stock to the Ownership Limit.
Direct or constructive ownership in excess of the Ownership Limit, without the
approval of the Company as provided in its Amended and Restated Articles of
Incorporation, would cause ownership of the shares in excess of the limit to
be transferred to the trustee.
All certificates representing shares of preferred stock will bear a legend
referring to the restrictions described above.
The Ownership Limit provisions will not be automatically removed even if the
REIT Provisions (as defined herein) are changed so as to eliminate any
ownership concentration limitation or if the ownership concentration
limitation is increased. The Amended and Restated Articles of Incorporation
may not be amended to alter, change, repeal or amend any of the Ownership
Limit provisions without the prior approval of a majority of the Independent
Directors.
The Amended and Restated Articles of Incorporation require that any person
who beneficially owns 1% (or such lower percentage as may be required by the
Code or the Treasury Regulations) of the outstanding shares of any class or
series of preferred stock of the Company must provide certain information to
the Company within 30 days of June 30 and December 31 of each year. In
addition, each stockholder shall upon demand be required to disclose to the
Company in writing such information as the Company may request in order to
determine the effect, if any, of such stockholder's actual and constructive
ownership on the Company's status as a REIT and to ensure compliance with the
Ownership Limit.
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FEDERAL INCOME TAX CONSEQUENCES
THE FOLLOWING SUMMARY OF MATERIAL FEDERAL INCOME TAX CONSEQUENCES REGARDING
THE OFFERING IS BASED UPON CURRENT LAW, IS FOR GENERAL INFORMATION ONLY AND IS
NOT TAX ADVICE. THE INFORMATION SET FORTH BELOW, TO THE EXTENT THAT IT
CONSTITUTES SUMMARIES OF TAX MATTERS OR TAX CONCLUSIONS, HAS BEEN REVIEWED BY
KUTAK ROCK, AND IT IS THEIR OPINION THAT SUCH INFORMATION IS ACCURATE IN ALL
MATERIAL RESPECTS. THE DISCUSSION BELOW IS BASED ON EXISTING FEDERAL INCOME
TAX LAW, WHICH IS SUBJECT TO CHANGE, WITH POSSIBLE RETROACTIVE EFFECT. THE
DISCUSSION BELOW DOES NOT ADDRESS ALL ASPECTS OF TAXATION THAT MAY BE RELEVANT
IN THE PARTICULAR CIRCUMSTANCES OF EACH STOCKHOLDER OR TO CERTAIN TYPES OF
STOCKHOLDERS (INCLUDING INSURANCE COMPANIES, TAX-EXEMPT ENTITIES, FINANCIAL
INSTITUTIONS OR BROKER-DEALERS, FOREIGN CORPORATIONS AND PERSONS WHO ARE NOT
CITIZENS OR RESIDENTS OF THE UNITED STATES, EXCEPT TO THE EXTENT DISCUSSED)
SUBJECT TO SPECIAL TREATMENT UNDER THE FEDERAL INCOME TAX LAWS.
EACH PROSPECTIVE INVESTOR IS URGED TO SEEK INDIVIDUAL ADVICE CONCERNING THE
EFFECT ON HIM OR HER OF THE PURCHASE, OWNERSHIP AND SALE OF THE SERIES A
PREFERRED SHARES UNDER FEDERAL, STATE, LOCAL AND FOREIGN TAX LAWS INCLUDING
THE EFFECT OF POSSIBLE CHANGES IN TAX LAW.
TAXATION OF THE COMPANY
General. The Company will elect to be taxed as a REIT under Sections 856
through 860 of the Code and the applicable Treasury Regulations (the "REIT
Requirements" or the "REIT Provisions"), which are the requirements for
qualifying as a REIT, commencing with its taxable year ending December 31,
1998. The Company believes that, commencing with its taxable year ending
December 31, 1998, it will be organized, will operate and its capital stock
will be owned in such a manner as to qualify for taxation as a REIT under the
Code. The Company intends to continue to operate in such a manner, but no
assurance can be given that it will operate in a manner so as to qualify or
remain qualified.
The REIT Requirements are technical and complex. The following discussion
sets forth only the material aspects of those requirements. This summary is
qualified in its entirety by the applicable Code provisions, rules and
regulations promulgated thereunder, and administrative and judicial
interpretations thereof.
In the opinion of Kutak Rock, commencing with the Company's taxable year
ending December 31, 1998, the Company will be organized in conformity with the
requirements for qualification as a REIT, and its proposed method of operation
will enable it to meet the requirements for qualification and taxation as a
REIT under the Code. Such opinion is based on certain factual assumptions
relating to the organization and operation of the Company and is conditioned
upon certain representations made by the Company as to factual matters, such
as the organization and expected manner of operation of the Company. In
addition, this opinion is based upon the factual representations of the
Company concerning its business and Mortgage Loans set forth in this
Prospectus. Moreover, such opinion also states that the Company's
qualification and taxation as a REIT depends upon the its ability to meet,
through actual annual operating results, the distribution levels, diversity of
stock ownership and the various qualification tests imposed under the Code
discussed below, and that such results will not be reviewed by Kutak Rock on a
continuing basis. No assurance can be given that the actual results of the
Company's operation for any taxable year will satisfy such requirements. See
"--Failure to Qualify as a REIT."
If the Company qualifies for taxation as a REIT, it generally will not be
subject to federal corporate income taxes on that portion of its ordinary
income or capital gain that is currently distributed to stockholders. Such
treatment substantially eliminates the federal "double taxation" on earnings
(at the corporate and the stockholder levels) that generally results from
investment in a corporation.
Despite the REIT election, the Company may be subject to federal income and
excise tax as follows:
. First, the Company will be taxed at regular corporate rates on any
undistributed REIT Taxable Income, including undistributed net capital
gains.
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. Second, under certain circumstances, the Company may be subject to the
"alternative minimum tax" on certain of its items of tax preferences, if
any.
. Third, if the Company has (i) net income from the sale or other
disposition of "foreclosure property" that is held primarily for sale to
customers in the ordinary course of business or (ii) other nonqualifying
net income from foreclosure property, it will be subject to tax at the
highest corporate rate on such income.
. Fourth, if the Company has net income from prohibited transactions
(which are, in general, certain sales or other dispositions of property
held primarily for sale to customers in the ordinary course of business,
other than sales of foreclosure property and sales that qualify for a
statutory safe harbor), such income will be subject to a 100% tax.
. Fifth, if the Company should fail to satisfy the 75% gross income test
or the 95% gross income test (as discussed below), but has nonetheless
maintained its qualifications as a REIT because certain other
requirements have been met, it will be subject to a 100% tax on the net
income attributable to the greater of the amount by which the Company
fails the 75% or 95% test, multiplied by a fraction intended to reflect
the Company's profitability.
. Sixth, if the Company should fail to distribute, or fail to be treated
as having distributed, with respect to each calendar year at least the
sum of (i) 85% of its REIT ordinary income for such year, (ii) 95% of
its REIT capital gain net income for such year, and (iii) any
undistributed taxable income from prior periods, the Company would be
subject to a 4% excise tax on the excess of such required distribution
over the amounts actually distributed.
The Company does not now intend to acquire any appreciated assets from a
corporation generally subject to full corporate-level tax in a transaction in
which any gain on the transfer is not fully recognized. However, in the event
of such an acquisition, the Company could, under certain circumstances, be
subject to tax upon disposition of such assets.
If the Company were treated as a taxable mortgage pool, it would be subject
to certain provisions regarding the taxation of excess inclusions. A taxable
mortgage pool is any entity which has the following characteristics: (i)
substantially all of its assets are debt obligations and more than 50% of such
obligations are real estate mortgages; (ii) the entity is the obligor on debt
obligations which have two or more maturities; and (iii) the payments on the
liabilities of the entity bear a relationship to the payments on the debt
obligations held as assets. If the Company were to be treated as a taxable
mortgage pool, holders of Series A Preferred Shares would be subject to tax on
the excess inclusions generated by the Company. The Company does not expect to
incur any indebtedness, as described in those provisions and thus does not
expect to be treated as a taxable mortgage pool. Each potential holder of
Series A Preferred Shares should consult his tax advisor concerning the
application of these principles.
Organizational Requirements. The Code defines a REIT as a corporation,
trust, or association (i) that is managed by one or more trustees or
directors; (ii) the beneficial ownership of which is evidenced by transferable
shares, or by transferable certificates of beneficial interest; (iii) that
would be taxable as a domestic corporation, but for the REIT Requirements;
(iv) that is neither a financial institution nor an insurance company subject
to certain provisions of the Code; (v) the beneficial ownership of which is
held by 100 or more persons; (vi) not more than 50% in value of the
outstanding stock of which is owned, directly or indirectly, by five or fewer
individuals (as defined in the Code to include private foundations and certain
pension trusts and other entities) at any time during the last half of each
taxable year; (vii) that is not a bank, an insurance company or certain other
specified types of financial institutions; and (viii) that meets certain other
tests, described below, including those regarding the nature of its income and
assets. The Code provides that conditions (i) through (iv), inclusive, must be
met during the entire taxable year and that condition (v) must be met during
at least 335 days of a taxable year of 12 months, or during a proportionate
part of a taxable year of less than 12 months. Conditions (v) and (vi) will
not apply until after the first taxable year for which an election is made to
be taxed as a REIT. For purposes of condition (vi), certain tax-exempt
entities are generally treated as individuals, and the beneficiaries of a
pension trust that qualifies under Section 401(a) of the Code and that holds
shares of a REIT will be treated
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as holding shares of the REIT in proportion to their actuarial interests in
the pension trust. See "--Taxation of United States Stockholders--Treatment of
Tax-Exempt Stockholders."
In rendering its opinion, described above, counsel has concluded that
beneficial owners of both common and preferred shares of a corporation will be
considered for purposes of the 100 holder requirement. The Company expects
that the Series A Preferred Shares will be held by not less than 100
beneficial owners at all times such Shares are outstanding. Such ownership of
the Series A Preferred Shares would allow the Company to meet condition (v).
In determining whether condition (vi) above is met, shareholders of a
corporation are treated as owning their proportionate share of any stock held
by that corporation. The Company expects that the stock of the Company and of
Flagstar will at no time be held directly or indirectly by five or fewer
shareholders who are individuals, private foundations, pension trusts or other
relevant entities that in the aggregate own more than 50 percent by value of
the stock of the Company or Flagstar, respectively. Stock ownership of the
Company and Flagstar in accordance with the Company's expectation will satisfy
condition (vi) with respect to the Company. In addition, the Company's Amended
and Restated Articles of Incorporation include certain restrictions regarding
transfer of its shares, which restrictions are intended to assist the Company
in continuing to satisfy the share ownership requirements described in (v) and
(vi) above. Such transfer and ownership restrictions are described under
"Description of Capital Stock--Restrictions on Ownership and Transfer."
Moreover, in order to elect to be treated as a REIT, an entity must
distribute sufficient amounts to eliminate any earnings and profits
attributable to any year in which such entity was not a REIT. In addition, a
corporation may not elect to become a REIT unless its taxable year is the
calendar year. The Company expects to satisfy these requirements.
In the case of a REIT that is a partner in a partnership, Treasury
Regulations provide that the REIT will be deemed to own its proportionate
share of the assets of the partnership and will be deemed to be entitled to
the income of the partnership attributable to such share. In addition, the
character of the assets and gross income of the partnership will retain the
same character in the hands of the REIT as such income had in the hands of the
partnership for purposes of the REIT Requirements, including satisfying the
gross income tests and the assets test.
Income Tests. In order to maintain qualification as a REIT, the Company must
annually satisfy three gross income requirements. First, at least 75% of the
Company's gross income (excluding gross income from prohibited transactions)
for each taxable year must be derived directly or indirectly from investments
relating to real property or mortgages on real property (such as interest on
obligations secured by mortgages on real property, certain "rents from real
property" or as gain on the sale or exchange of such property and certain fees
with respect to agreements to make or acquire mortgage loans), from certain
types of temporary investments or certain other types of gross income. Second,
at least 95% of the Company's gross income (excluding gross income from
prohibited transactions) for each taxable year must be derived from such real
property investments as aforesaid and from dividends, interest, and gain from
the sale or other disposition of stock or securities and certain other types
of gross income, including certain income derived from interest rate swaps,
caps or similar financial instruments (or from any combination of the
foregoing).
For interest to qualify as "interest on obligations secured by mortgages on
real property or on interests in real property," the obligation must be
secured by real property having a fair market value at the time of acquisition
at least equal to the principal amount of the loan. The term "interest"
includes only an amount that constitutes compensation for the use or
forbearance of money. For example, a fee received or accrued by a lender which
is in fact a charge for services performed for a borrower rather than a charge
for the use of borrowed money is not includible as interest. However, amounts
earned as consideration for entering into agreements to make loans secured by
real property, although not interest, are otherwise treated as within the 75%
and 95% classes of gross income so long as the determination of those amounts
does not depend on the income or profits of any person. By statute, the term
interest does not include any amount based on income or profits except that
the Code provides that (i) interest "based on a fixed percentage or
percentages of receipts or sales" is not excluded and (ii) when the REIT makes
a loan that provides for interest based on the borrower's receipts or
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sales and the borrower leases under one or more leases based on income or
profits, only a portion of the contingent interest paid by the borrower will
be disqualified as interest.
Rents received or deemed to be received by the Company will qualify as
"rents from real property" in satisfying the gross income requirements for a
REIT described above only if certain statutory conditions are met that limit
rental income essentially to rentals on investment-type properties. In the
event that a REIT acquires by foreclosure property that generates income that
does not qualify as "rents from real property," such income may be treated as
qualifying for three years following foreclosure (which period may be extended
by the IRS) so long as (i) all leases entered into after foreclosure generate
only qualifying rent, (ii) only limited construction takes place and (iii)
within 90 days of foreclosure, any trade or business in which the property is
used is conducted by an independent contractor from which the REIT derives no
income. In the event the special foreclosure property rule applies to qualify
otherwise unqualified income, the net income that qualifies only under the
special rule for foreclosure property may be subject to tax, as described
above.
Relief Provisions. If the Company fails to satisfy one or both of the 75% or
95% gross income tests for any taxable year, it may nevertheless qualify as a
REIT for such year if it is entitled to relief under certain provisions of the
Code. These relief provisions will be generally available if the Company's
failure to meet such tests was due to reasonable cause and not due to willful
neglect, the Company attaches a schedule of the sources of its income to its
return, and any incorrect information on the schedule was not due to fraud
with intent to evade tax. It is not possible, however, to state whether in all
circumstances the Company would be entitled to the benefit of these relief
provisions. As discussed above in "--Taxation of the Company--General," even
if these relief provisions apply, a tax would be imposed with respect to the
excess net income.
Asset Tests. At the close of each quarter of each taxable year, the Company
must satisfy three tests relating to the nature of its assets. First, at least
75% of the value of the Company's total assets must be represented by real
estate assets (including stock or debt instruments held for not more than one
year that were purchased with the proceeds of a stock offering or long-term
(at least five years) debt offering of the Company), cash, cash items, and
government securities. Second, not more than 25% of the Company's total assets
may be represented by securities other than those in the 75% asset class.
Third, of the investments included in the 25% asset class, the value of any
one issuer's securities owned by the Company may not exceed 5% of the value of
the Company's total assets and the Company may not own more than 10% of any
one issuer's outstanding voting securities.
After initially meeting the asset tests at the close of any quarter, the
Company will not lose its status as a REIT if it fails to satisfy the asset
tests at the end of a later quarter solely by reason of changes in asset
values. If the failure to satisfy the asset tests results from an acquisition
of securities or other property during a quarter, the failure can be cured by
disposition of sufficient nonqualifying assets within 30 days after the close
of that quarter. The Company intends to maintain adequate records of the value
of its assets to ensure compliance with the asset tests, and to take such
action within 30 days after the close of any quarter as may be required to
cure any noncompliance but no assurance can be given that such asset tests
will be met.
Annual Distribution Requirements. In order to be treated as a REIT, the
Company is required to distribute dividends (other than capital gain
dividends) to its stockholders in an amount at least equal to (A) the sum of
(i) 95% of the Company's REIT Taxable Income (computed without regard to the
dividends paid deduction and the Company's net capital gain) plus (ii) 95% of
the net income, if any, from foreclosure property in excess of the special tax
on income from foreclosure property, minus (B) the sum of certain items of
noncash income. Such distributions must be paid in the taxable year to which
they relate or in the following taxable year if declared before the Company
timely files its tax return for such year and if paid on or before the first
regular dividend payment after such declaration. To the extent that the
Company does not distribute (or is not treated as having distributed) all of
its net capital gain or distributes (or is treated as having distributed) at
least 95%, but less than 100% of its REIT Taxable Income, as adjusted, it will
be subject to tax thereon at regular ordinary and capital gains corporate tax
rates. Furthermore, if the Company should fail to distribute during each
calendar year at least the sum of (i) 85% of its REIT ordinary income for such
year, (ii) 95% of its REIT capital gain net income for
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such year, and (iii) any undistributed taxable income from prior periods, the
Company would be subject to a 4% excise tax on the excess of such required
distribution over the amounts actually distributed. The Company intends to
make timely distributions sufficient to satisfy the annual distribution
requirement.
REIT Taxable Income is the taxable income of a REIT, which generally is
computed in the same fashion as the taxable income of any corporation, except
that (i) certain deductions are not available, such as the deduction for
dividends received, (ii) it may deduct dividends paid (or deemed paid) during
the taxable year, (iii) net capital gains and losses are excluded, and (iv)
certain other adjustments are made.
It is possible that, from time to time, the Company may not have sufficient
cash or other liquid assets to meet the 95% distribution requirement due to
timing differences between (i) the actual receipt of income and actual payment
of deductible expenses and (ii) the inclusion of such income and deduction of
such expenses in calculating the taxable income of the Company. In the event
that such an insufficiency or such timing differences occur, in order to meet
the 95% distribution requirement the Company may find it necessary to arrange
for borrowings or to pay dividends in the form of taxable stock dividends if
it is practicable to do so.
Under certain circumstances, the Company may be able to rectify a failure to
meet the distribution requirement for a year by paying "deficiency dividends"
to stockholders in a later year, which may be included in the Company's
deduction for dividends paid for the earlier year. Thus, the Company may be
able to avoid being taxed on amounts distributed as deficiency dividends;
however, the Company will be required to pay interest based upon the amount of
any deduction taken for deficiency dividends.
FAILURE TO QUALIFY AS A REIT
If the Company fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions described above do not apply, the Company will be
subject to tax (including any applicable alternative minimum tax) on its
taxable income at regular corporate rates. Distributions to stockholders in
any year in which the Company fails to qualify will not be deductible by the
Company nor will they be required to be made. In such event, to the extent of
current and accumulated earnings and profits, all distributions to
stockholders will be taxable as ordinary income, and subject to certain
limitations of the Code, corporate distributees may be eligible for the
dividends-received deduction. Unless entitled to relief under specific
statutory provisions, the Company will also be disqualified from taxation as a
REIT for the four taxable years following the year during which qualification
was lost, and will not be permitted to requalify unless it distributes any
earnings and profits attributable to the period when it failed to qualify. In
addition, it would be subject to tax on any built-in gains on property held
during the period during which it did not qualify if it sold such property
within 10 years of requalification. It is not possible to state whether in all
circumstances the Company would be entitled to such statutory relief.
TAX TREATMENT OF AUTOMATIC EXCHANGE
Upon the occurrence of the Automatic Exchange, the outstanding Series A
Preferred Shares would be automatically exchanged on a one-for-one basis for
Bank Preferred Shares. See "Description of Series A Preferred Shares--
Automatic Exchange." The Automatic Exchange would be a taxable exchange with
respect to which each holder of the Series A Preferred Shares who would have a
gain or loss, as the case may be, measured by the difference between the basis
of such holder in the Series A Preferred Shares and the fair market value of
the Bank Preferred Shares received in the Automatic Exchange. Because the Bank
Preferred Shares would not be listed on Nasdaq or on any exchange, each
individual holder would be required to determine the fair market value of Bank
Preferred Shares received to determine the tax effect of the Automatic
Exchange. Assuming that such holder's Series A Preferred Shares were held as
capital assets for more than one year prior to the Automatic Exchange, any
gain or loss would be long-term capital gain or loss. Long-term capital losses
are deductible, subject to certain limitations. The basis of the holder in the
Bank Preferred Shares will be the holder's fair market value at the time of
the Automatic Exchange.
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TAXATION OF UNITED STATES STOCKHOLDERS
As used herein, the term "United States Stockholder" means a holder of
Series A Preferred Shares that is for United States federal income tax
purposes (i) a citizen or resident of the United States, (ii) a corporation,
partnership, or other entity created or organized in or under the laws of the
United States or of any political subdivision thereof, or (iii) an estate or
trust the income of which is subject to United States federal income taxation
regardless of its source.
Distributions Generally. As long as the Company qualifies as a REIT,
distributions to a United States Stockholder up to the amount of the Company's
current or accumulated earnings and profits (and not designated as capital
gains dividends) will be taken into account as ordinary income and will not be
eligible for the dividends-received deduction for corporations. Distributions
that are designated by the Company as capital gain dividends will be treated
as long-term capital gain (to the extent they do not exceed the Company's
actual net capital gain) for the taxable year without regard to the period for
which the stockholder has held its stock. However, corporate stockholders may
be required to treat up to 20% of certain capital gains dividends as ordinary
income, pursuant to Section 291(d) of the Code. A distribution in excess of
current or accumulated earnings and profits will first be treated as a tax-
free return of capital, reducing the tax basis in the United States
Stockholder's Series A Preferred Shares, and a distribution in excess of the
United States Stockholder's tax basis in its Series A Preferred Shares will be
taxable gain realized from the sale of such shares. Dividends declared by the
Company in October, November or December of any year payable to a stockholder
of record on a specified date in any such month shall be treated as both paid
by the Company and received by the stockholder on December 31 of such year,
provided that the dividend is actually paid by the Company during January of
the following calendar year. Stockholders may not claim the benefit of any tax
losses of the Company on their own income tax returns.
The Company will be treated as having sufficient earnings and profits to
treat as a dividend any distribution by the Company up to the amount required
to be distributed in order to avoid imposition of the 4% excise tax discussed
under "--Taxation of the Company--General" and "--Taxation of the Company--
Annual Distribution Requirements" above. As a result, stockholders may be
required to treat as taxable dividends certain distributions that would
otherwise result in tax-free returns of capital. Moreover, any "deficiency
dividend" will be treated as a "dividend" (an ordinary dividend or a capital
gain dividend, as the case may be), regardless of the Company's earnings and
profits.
Losses incurred on the sale or exchange of Series A Preferred Shares held
for less than six months will be deemed a long-term capital loss to the extent
of any capital gain dividends received by the selling stockholder with respect
to such stock. In the event the Company elects to retain capital gains, the
Company may designate a portion of its undistributed gains. In that event the
Company will be required to pay a tax thereon. The holders of the Series A
Preferred Shares would be required to include such amounts in income but will
be entitled to a credit for a corresponding share of the capital gain paid by
the Company.
Treatment of Tax-Exempt Stockholders. Distributions from the Company to a
tax-exempt employee's pension trust or other domestic tax-exempt stockholder
will generally not constitute "unrelated business taxable income" unless the
stockholder has borrowed to acquire or carry its shares of the Company. A tax-
exempt employee's pension trust that holds more than 10% of the shares of the
capital stock of the Company may under certain circumstances be required to
treat a certain percentage of dividends as unrelated business taxable income
if the Company is "predominantly held" by qualified trusts. Under this
provision, a REIT is predominantly held by a qualified trust if: (i) at least
one qualified trust holds at least 25% of the interests of the REIT; or (ii)
one or more qualified trusts each own at least 10% of the interests in the
REIT and such qualified trusts, in the aggregate, own at least 50% of the
interests of the REIT. For these purposes, a qualified trust is any trust
defined under Section 401(a) of the Code and exempt from tax under Section
501(a) of the Code.
TAXATION OF FOREIGN STOCKHOLDERS
The rules governing United States income taxation of non-resident alien
individuals, foreign corporations, foreign partnerships, and foreign trusts
and estates holding Series A Preferred Shares (collectively, "Foreign
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Stockholders") are complex, and no attempt will be made herein to provide more
than a summary of such rules. A Foreign Stockholder should consult with its
own tax advisor to determine the effect of federal, state, and local and
country of tax residence income tax laws on an investment in the Company,
including any reporting requirements.
In general, a Foreign Stockholder will be subject to regular United States
income tax to the same extent as a United States Stockholder with respect to
income or gain derived from its investment in the Company if under all facts
and circumstances such income or gain is "effectively connected" with such
stockholder's conduct of a trade or business in the United States. See "--
Taxation of United States Stockholders." A corporate Foreign Stockholder that
receives income that is effectively connected with a United States trade or
business may also be subject to the branch profits tax under Section 884 of
the Code, which is payable in addition to the regular United States corporate
income tax. The following discussion will apply to a Foreign Stockholder whose
income or gain derived from investment in the Company is not so effectively
connected in light of the facts and circumstances.
The Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA")
significantly affects the federal income tax treatment of the sale or exchange
of shares in REITs held by a Foreign Stockholder. Under FIRPTA, gain or loss
realized on the sale or exchange of a "United States real property interest"
("USRPI") by a foreign taxpayer is treated by statute as effectively connected
with a U.S. trade or business as a matter of law, without regard to the
particular facts and circumstances. Shares of a corporation generally are
treated as a USRPI only if the fair market value of USRPIs owned by the
corporation equals or exceeds 50% of the fair market value of its total
assets. If at no time within the five years preceding the sale or exchange of
shares in the Company the shares constituted a USRPI, gain or loss on the sale
or exchange will not be treated as effectively connected with a U.S. trade or
business by reason of FIRPTA. While ownership of real property within the U.S.
(including ownership of interests in certain entities) is always a USRPI, a
loan secured by a mortgage on U.S. real property constitutes a USRPI only if
the amounts payable by the borrower are contingent on the income or receipts
of the borrower or the property or otherwise based on the property. Because
such contingent interest is not likely to be present in the residential
mortgage loans to be owned by the Company that are expected to represent
approximately 90% of the assets of the Company (although such interest is
fairly common in commercial loans) the Company believes it is unlikely that
its shares will be USRPIs or that it will derive significant gain from the
sale or exchange of USRPIs, although whether its shares are a USRPI or it
derives income from USRPIs will depend upon the facts as they ultimately
develop. A distribution of cash to a Foreign Stockholder that is not
attributable to gain from sales or exchanges by the Company of USRPIs and not
designated by the Company as a capital gain dividend is not subject to FIRPTA
but generally will be subject to the withholding of United States federal
income tax at a rate of 30%, unless (i) a lower treaty rate applies or (ii)
the Foreign Stockholder files an IRS Form 4224 with the withholding agent
certifying that the investment to which the distribution relates is
effectively connected to a United States trade or business of such Foreign
Stockholder. A Foreign Stockholder who receives a distribution that has been
subject to such withholding tax may file a claim for refund to the extent the
withholding has been imposed on a portion of such distributions representing
amounts in excess of current and accumulated earnings and profits. Under
FIRPTA, distributions of proceeds attributable to gain from the Company's sale
or exchange of a USRPI are subject to income tax at the normal capital gains
rates applicable to United States stockholders (subject to applicable
alternative minimum tax and a special alternative minimum tax in the case of a
nonresident alien individual). Also, these distributions may be subject to a
30% branch profits tax in the hands of a corporate Foreign Stockholder not
entitled to a treaty exemption or reduced rate of tax. Treasury Regulations
require the withholding of 35% of any distribution that could be designated by
the Company as a capital gain dividend. This amount is creditable against the
Foreign Stockholder's tax liability. It should be noted that the 35%
withholding tax rate on capital gain dividends is higher than the 28% maximum
rate on capital gains of individuals. Capital gain dividends not attributable
to gain on the sale or exchange of USRPIs are not subject to United States
taxation if there is no requirement of withholding.
If the shares of the Company do constitute a USRPI (or did so constitute
within the previous five years), gain or loss on the sale or exchange of the
shares will be treated as effectively connected with the conduct of a U.S.
trade or business unless one or more special rules apply to preclude U.S.
taxation.
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If the Company is a "domestically-controlled REIT," a sale of Series A
Preferred Shares by a Foreign Stockholder generally will not be subject to
United States taxation. A domestically controlled REIT is a REIT in which, at
all times during a specified testing period, less than 50% in value of its
shares is held directly or indirectly, under Code attribution rules, by
Foreign Stockholders. Because the Series A Preferred Shares will be publicly
traded, no assurance can be given that the Company will constitute a
domestically-controlled REIT or that it will be possible to ascertain whether
or not it is domestically-controlled.
If the Company is not a domestically-controlled REIT (and would otherwise be
treated as a United States holding company), a sale of Series A Preferred
Shares would be subject to tax under FIRPTA as a sale of a USRPI and gain or
loss would be effectively connected with a United States trade or business if
either (i) the Series A Preferred Shares were not "regularly traded" (as
defined by applicable Treasury Regulations) on an established securities
market (e.g., the Nasdaq National Market System, on which the Series A
Preferred Shares will be listed) during the quarter in which the Series A
Preferred Shares were sold or (ii) even if the Series A Preferred Shares were
"regularly traded", the selling stockholder held, directly or indirectly, more
than 5% of the Series A Preferred Shares during the five-year period ending on
the date of disposition. The applicable Treasury Regulations that define
"regularly traded" for this purpose may be interpreted to provide that a
security will not be "regularly traded" for any calendar quarter during which
100 or fewer persons (treating related persons as one person) in the aggregate
own 50% or more of such security or the quarterly trading volume is less than
7.5% of the average number of the issued and outstanding shares of such
security (2.5% if there are 2,500 or more stockholders of record). In the
event that the Series A Preferred Shares were not "regularly traded" and the
Company did not at that time constitute a domestically-controlled REIT, a
Foreign Stockholder (without regard to its ownership percentage of Series A
Preferred Shares) must treat as effectively connected with a United States
trade or business any gain or loss on any sale or other disposition of Series
A Preferred Shares that occurs within a calendar quarter during which the
Series A Preferred Shares were not "regularly traded" and the shares were a
USRPI.
If the gain on the sale of the Company's Series A Preferred Shares were
subject to taxation under FIRPTA, the Foreign Stockholder would be subject to
the same treatment as a United States Stockholder with respect to such gain
(subject to applicable alternative minimum tax and a special alternative
minimum tax in the case of a nonresident alien individual). Notwithstanding
the foregoing, capital gain from sale of shares of a REIT not subject to
FIRPTA will nonetheless be taxable to a Foreign Stockholder who is an
individual (under rules generally applicable to United States Stockholders) if
such person is in the United States for 183 days or more during the taxable
year of disposition and certain other conditions apply. In any event, a
purchaser of Series A Preferred Shares from a Foreign Stockholder will not be
required under FIRPTA to withhold on the purchase price if the purchased
Series A Preferred Shares are "regularly traded" on an established securities
market or if the Company is a domestically-controlled REIT. Otherwise, under
FIRPTA the purchaser of Series A Preferred Shares may be required to withhold
10% of the purchase price and remit such amount to the IRS.
Shares of the Company owned by a nonresident alien decedent are subject to
United States federal estate tax (which is imposed at rates up to 55%) unless
an estate tax treaty binding upon the United States provides otherwise.
INFORMATION REPORTING REQUIREMENTS AND BACKUP WITHHOLDING TAX
The Company will report to its stockholders and the IRS the amount of
dividends paid or deemed paid during each calendar year, and the amount of tax
withheld, if any.
United States Stockholders. Under certain circumstances, a United States
Stockholder of Series A Preferred Shares may be subject to backup withholding
at a rate of 31% on payments made with respect to, or cash proceeds of a sale
or exchange of, Series A Preferred Shares. Backup withholding will apply only
if the holder (i) fails to furnish the person required to withhold with its
Taxpayer Identification Number ("TIN") which, for an individual, would be his
or her Social Security Number, (ii) furnishes an incorrect TIN, (iii) is
notified by the IRS that it has failed properly to report payments of interest
and dividends, or (iv) under certain
62
<PAGE>
circumstances, fails to certify, under penalty of perjury, that it has
furnished a correct TIN and has not been notified by the IRS that it is
subject to backup withholding for failure to report interest and dividend
payments. Backup withholding will not apply with respect to payments made to
certain exempt recipients, such as corporations and tax-exempt organizations.
A United States Stockholder should consult with a tax advisor regarding
qualification for exemption from backup withholding and the procedure for
obtaining such an exemption. Backup withholding is not an additional tax.
Rather, the amount of any backup withholding with respect to a payment to a
United States Stockholder will be allowed as a credit against such United
States Stockholder's United States federal income tax liability and may
entitle such United States Stockholder to a refund, provided that the required
information is furnished to the IRS.
Foreign Stockholders. Additional issues may arise pertaining to information
reporting and backup withholding with respect to Foreign Stockholders, and a
Foreign Stockholder should consult with a tax advisor with respect to any such
information reporting and backup withholding requirements. Backup withholding
with respect to a Foreign Stockholder is not an additional tax. Rather, the
amount of any backup withholding with respect to a payment to a Foreign
Stockholder will be allowed as a credit against any United States federal
income tax liability of such Foreign Stockholder. If withholding results in an
overpayment of taxes, a refund may be obtained provided that the required
information is furnished to the IRS.
OTHER TAX CONSEQUENCES
The Company and its stockholders may be subject to state or local taxation
in various state or local jurisdictions, including those in which it or they
transact business or reside. The state and local tax treatment of the Company
and its stockholders may not conform to the federal income tax consequences
discussed above. Consequently, prospective stockholders should consult their
own tax advisors regarding the effect of state and local tax laws on an
investment in the Company.
ERISA CONSIDERATIONS
GENERAL
In evaluating the purchase of Series A Preferred Shares, a fiduciary of a
qualified profit-sharing, pension or stock bonus plan, including a plan for
self-employed individuals and their employees or any other employee benefit
plan subject to the Employee Retirement Income Security Act of 1974, as
amended ("ERISA"), a collective investment fund or separate account in which
such plans invest and any other investor using assets that are treated as the
assets of an employee benefit plan subject to ERISA (each, a "Plan" and
collectively, "Plans") should consider (a) whether the ownership of Series A
Preferred Shares is in accordance with the documents and instruments governing
such Plan; (b) whether the ownership of Series A Preferred Shares is solely in
the interest of Plan participants and beneficiaries and otherwise consistent
with the fiduciary's responsibilities and in compliance with the requirements
of Part 4 of Title I of ERISA, including, in particular, the diversification,
prudence and liquidity requirements of Section 404 of ERISA and the prohibited
transaction provisions of Section 406 of ERISA and Section 4975 of the Code;
(c) whether the Company's assets are treated as assets of the Plan; and (d)
the need to value the assets of the Plan annually. In addition, the fiduciary
of an individual retirement arrangement under Section 408 of the Code (an
"IRA") considering the purchase of Series A Preferred Shares should consider
whether the ownership of Series A Preferred Shares would result in a non-
exempt prohibited transaction under Section 4975 of the Code.
The fiduciary investment considerations summarized below provide a general
discussion that does not include all of the fiduciary investment
considerations relevant to Plans and, where indicated, IRAs. This summary is
based on the current provisions of ERISA and the Code and regulations and
rulings thereunder, and may be changed (perhaps adversely and with retroactive
effect) by future legislative, administrative or judicial actions. PLANS AND
IRAS THAT ARE PROSPECTIVE PURCHASERS OF SERIES A PREFERRED SHARES SHOULD
CONSULT WITH AND RELY UPON THEIR OWN ADVISORS IN EVALUATING THESE MATTERS IN
LIGHT OF THEIR OWN PARTICULAR CIRCUMSTANCES.
63
<PAGE>
PLAN ASSET REGULATION
Under Department of Labor regulations governing what constitutes the assets
of a Plan or IRA ("Plan Assets") for purposes of ERISA and the related
prohibited transaction provisions of the Code (the "Plan Asset Regulation," 29
C.F.R. Section 2510.3-101), when a Plan or IRA makes an equity investment in
another entity, the underlying assets of the entity will not be considered
Plan Assets if the equity interest is a "publicly-offered security".
For purposes of the Plan Asset Regulation, a "publicly-offered security" is
a security that is (a) "freely transferable," (b) part of a class of
securities that is "widely held," and (c) sold to the Plan or IRA as part of
an offering of securities to the public pursuant to an effective registration
statement under the Securities Act and part of a class of securities that is
registered under the Exchange Act within 120 days (or such later time as may
be allowed by the Commission) after the end of the fiscal year of the issuer
during which the offering of such securities to the public occurred. The
Series A Preferred Shares will be registered under the Securities Act of 1933,
as amended (the "Securities Act"), and the Exchange Act within the time
periods specified in the Plan Asset Regulation.
The Plan Asset Regulation provides that a security is "widely held" only if
it is a part of the class of securities that is owned by 100 or more investors
independent of the issuer and of one another. A security will not fail to be
"widely held" because the number of independent investors falls below 100
subsequent to the initial offering as a result of events beyond the control of
the issuer. The Company expects the Series A Preferred Shares to be "widely
held" upon the completion of the Offering.
The Plan Asset Regulation provides that whether a security is "freely
transferable" is a factual question to be determined on the basis of all the
relevant facts and circumstances. The Plan Asset Regulation further provides
that when a security is part of an offering in which the minimum investment is
$10,000 or less, as is the case with the Offering, certain restrictions
ordinarily will not, alone or in combination, affect the finding that such
securities are "freely transferable". The Company believes that any
restrictions imposed on the transfer of the Series A Preferred Shares are
limited to the restrictions on transfer generally permitted under the Plan
Asset Regulation and are not likely to result in the failure of the Series A
Preferred Shares to be "freely transferable".
A Plan should not acquire or hold the Series A Preferred Shares if the
Company's underlying assets will be treated as the assets of such Plan.
However, the Company believes that under the Plan Asset Regulation the Series
A Preferred Shares should be treated as "publicly-offered securities" and,
accordingly, the underlying assets of the Company should not be considered to
be assets of any Plan or IRA investing in the Series A Preferred Shares.
EFFECT OF PLAN ASSET STATUS
ERISA generally requires that the assets of a Plan be held in trust and that
the trustee, or an investment manager (within the meaning of Section 3(38) of
ERISA), have exclusive authority and discretion to manage and control the
assets of the Plan. As discussed above, the assets of the Company under
current law do not appear likely to be assets of the Plans receiving Series A
Preferred Shares as a result of the Offering. However, if the assets of the
Company were deemed to be assets of the Plans under ERISA, certain directors
and officers of the Company might be deemed fiduciaries with respect to the
Plans that invest in the Company and the prudence and other fiduciary
standards set forth in ERISA would apply to them and to all investments.
If the assets of the Company were deemed to be Plan Assets, transactions
between the Company and parties in interest or disqualified persons with
respect to the investing Plan or IRA could be prohibited transactions unless a
statutory or administrative exemption is available. In addition, investment
authority would also have been improperly delegated to such fiduciaries, and,
under certain circumstances, Plan fiduciaries who make the decision to invest
in the Series A Preferred Shares could be liable as co-fiduciaries for actions
taken by the Company that do not conform to the ERISA standards for
investments under Part 4 of Title I of ERISA.
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<PAGE>
PROHIBITED TRANSACTIONS
Section 406 of ERISA provides that Plan fiduciaries are prohibited from
causing the Plan to engage in certain types of transactions. Section 406(a)
prohibits a fiduciary from knowingly causing a Plan to engage directly or
indirectly in, among other things: (a) a sale or exchange, or leasing, of
property with a party in interest; (b) a loan or other extension of credit
with a party in interest; (c) a transaction involving the furnishing of goods,
services or facilities with a party in interest; or (d) a transaction
involving the transfer of Plan assets to, or use of Plan assets by or for the
benefit of, a party in interest. Additionally, Section 406 prohibits a Plan
fiduciary from dealing with Plan assets in its own interest or for its own
account, from acting in any capacity in any transaction involving the Plan on
behalf of a party (or representing a party) whose interests are adverse to the
interests of the Plan, and from receiving any consideration for its own
account from any party dealing with the Plan in connection with a transaction
involving Plan assets. Similar provisions in Section 4975 of the Code apply to
transactions between disqualified persons and Plans and IRAs and result in the
imposition of excise taxes on such disqualified persons.
If a prohibited transaction has occurred, Plan fiduciaries involved in the
transaction could be required to (a) undo the transaction, (b) restore to the
Plan any profit realized on the transaction and (c) make good to the Plan any
loss suffered by it as a result of the transaction. In addition, parties in
interest or disqualified persons would be required to pay excise taxes or
penalties.
If the investment constituted a prohibited transaction under Section
408(e)(2) of the Code by reason of the Company engaging in a prohibited
transaction with the individual who established an IRA or his beneficiary, the
IRA would lose its tax-exempt status. The other penalties for prohibited
transactions would not apply .
Thus, the acquisition of the Series A Preferred Shares by a Plan could
result in a prohibited transaction if an Underwriter, the Company, the Bank,
or any of their affiliates is a party in interest or disqualified person with
respect to the Plan. Any such prohibited transaction could be treated as
exempt under ERISA and the Code if the Series A Preferred Shares were acquired
pursuant to and in accordance with one or more "class exemptions" issued by
the Department of Labor, such as Prohibited Transaction Class Exemption
("PTCE") 75-1 (an exemption for certain transactions involving employee
benefit plans and broker-dealers (such as the Underwriters), reporting
dealers, and banks), PTCE 84-14 (an exemption for certain transactions
determined by an independent qualified professional asset manager), PTCE 90-1
(an exemption for certain transactions involving insurance company pooled
separate accounts), PTCE 91-38 (an exemption for certain transactions
involving bank collective investment funds), PTCE 95-60 (an exemption for
certain transactions involving an insurance company's general account) and
PTCE 96-23 (an exemption for certain transactions determined by a qualifying
in-house asset manager).
A Plan should not acquire the Series A Preferred Shares pursuant to the
Offering if such acquisition will constitute a non-exempt prohibited
transaction.
UNRELATED BUSINESS TAXABLE INCOME
Plan fiduciaries should also consider the consequences of holding more than
10% of the Series A Preferred Shares if the Company is "predominantly held" by
qualified trusts. See "Federal Income Tax Consequences--Taxation of United
States Stockholders--Treatment of Tax-Exempt Stockholders".
65
<PAGE>
INFORMATION REGARDING THE BANK
The following is a summary of material information regarding the Bank. As an
integral part of this Prospectus, a copy of the Bank's offering circular filed
with the OTS relating to the Bank Preferred Shares to be issued upon the
Exchange Event (the "Offering Circular"), including exhibits, is attached
hereto as Annex I and is incorporated by reference herein. The following
discussion does not purport to be complete and is qualified in its entirety by
reference to the Offering Circular. All material information relating to the
Bank, including information relating to the Bank's financial position, can be
found in these documents.
OPERATIONS OF THE BANK
Flagstar Bank, FSB, a federally chartered stock savings bank, is the largest
independent Michigan-based savings institution based on asset size as of
September 30, 1997, according to SNL Securities. The Bank is also one of the
largest originators of conforming single-family mortgage loans in the United
States according to Inside Mortgage Finance. The Bank is engaged in the
business of providing a full range of retail banking services in southern and
western Michigan and in originating, purchasing and servicing residential
mortgage loans on a nationwide basis. For 1996, the Bank ranked fourth in the
United States among thrifts in mortgage loan originations and sixteenth in
total mortgage loan production according to SMR Research Corp. All of the
outstanding stock of the Bank is owned by Flagstar, a Michigan corporation
whose common stock is listed for trading on Nasdaq under the symbol "FLGS."
As of September 30, 1997, the Bank had consolidated total assets of $2.0
billion, net loans of $1.8 billion, total deposits of $1.0 billion and total
stockholder's equity of $121.1 million. For the nine months ended September
30, 1997, the Bank's net earnings were $15.8 million and its return on average
assets and return on average equity (as annualized) were 1.34% and 21.53%,
respectively. At December 31, 1996, the Bank had consolidated total assets of
$1.3 billion, net loans of $1.1 billion, total deposits of $624.7 million and
total stockholder's equity of $77.9 million. For the year ended December 31,
1996, the Bank's net earnings were $17.1 million and its return on average
assets and return on average equity were 1.54% and 24.82%, respectively ($19.3
million, 1.73% and 27.97%, respectively, excluding the special deposit
insurance assessment imposed on September 30, 1996 on all depository
institutions insured by the SAIF.
The Bank's operations are segregated into two segments, mortgage banking and
retail banking, with most of the Bank's revenue (net interest income and non-
interest income) and earnings before income taxes attributable to the mortgage
banking segment. The Bank believes that its retail banking business provides
it with a strategic advantage because it affords the Bank access to funding
sources for its mortgage origination business which would not otherwise be
available. These additional funding sources include low cost retail deposits,
FHLB advances and escrowed funds. The Bank benefits as compared to mortgage
originators with no retail banking operations because it has access to a lower
cost of funds and is therefore able to generate greater net interest income.
Retail Banking. The Bank (which was formerly known as First Security Savings
Bank, FSB) provides a full range of retail banking services to consumers and
small businesses in southern and western Michigan. The Bank operates a network
of 19 bank branches (including four opened in 1997) located in southern and
western Michigan counties. Beginning with the acquisition of Security Savings
Bank, F.S.B. ("Security Savings") and its seven bank branches in 1994, the
Bank has focused on expanding its branch network in these markets in order to
increase its access to retail deposit funding sources. The Bank believes that
this also provides a greater opportunity for cross-marketing of consumer
banking services to the Bank's mortgage customers in Michigan and for taking
advantage of opportunities that the Bank believes exist for community banks in
Michigan as a result of the substantial consolidation that has occurred in the
banking industry. See "Business and Strategy."
Mortgage Banking. The Bank's mortgage banking operations, which have
historically generated substantially all of the Bank's earnings, originate
residential mortgages through 33 retail loan origination offices located in
Michigan (21), California (9), Florida (2) and Ohio (1). In addition, the Bank
originates mortgage
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<PAGE>
loans on a wholesale basis through a network of approximately 1,800
independent mortgage brokers nationwide (who originate such loans using the
Bank's underwriting systems and standards and close such loans using funds
advanced by the Bank). This network is serviced by sixty account executives,
who are organized among 10 regional wholesale/correspondent lending offices
and five wholesale/correspondent satellite offices. The Bank also purchases
mortgage loans on a regular basis from independent mortgage lenders,
commercial banks, savings and loan associations and other financial
institutions with whom the Bank has established a correspondent relationship.
See "Business and Strategy."
For the nine months ended September 30, 1997, the Bank produced
approximately $4.8 billion in mortgage loans through wholesale and
correspondent networks and $529.9 million through the Bank's retail network.
During the years ended December 31, 1996 and 1995, the Bank's mortgage loan
production totaled $6.8 billion and $5.2 billion, respectively. Of these
amounts, approximately $6.1 billion was produced during the year ended
December 31, 1996 through the Bank's wholesale and correspondent loan
production network and $685.3 million was produced through the Bank's retail
network ($4.6 billion and $632.7 million, respectively, during 1995).
The Bank sells a substantial portion of its loan production into the
secondary market, principally by securitizing pools of loans through programs
offered by government-sponsored enterprises such as the Federal National
Mortgage Association ("FNMA" or "Fannie Mae") and the Federal Home Loan
Mortgage Corporation ("FHLMC" or "Freddie Mac") and through sales to private
investors. In addition, the Bank originates and sells loans conforming to the
underwriting criteria of the Federal Housing Authority ("FHA") and the
Department of Veterans Affairs ("VA"). Generally, the Bank retains the
servicing rights to many of the loans that it sells, but also realizes
additional income by selling servicing rights on an individual and a bulk
basis to other mortgage Banks. At September 30, 1997 and at December 31, 1996
and 1995, the Bank's loan servicing portfolio totaled $4.1 billion, $4.8
billion and $6.8 billion, respectively (net of loans subserviced for others),
substantially all of which related to conventional loans.
The Bank makes extensive use of advanced technology and automated processes
in order to enhance the competitiveness and reduce the cost of its mortgage
origination operations. The Bank was one of the first mortgage lenders to
utilize video conferencing for loan production. In 1996, the Bank began full-
scale operational use of automated underwriting system technologies, including
Fannie Mae's Desktop Underwriter(TM) and Freddie Mac's Loan Prospector(TM) (of
which the Bank is currently one of the largest users), and has combined the
two technologies into its LIVE(R) video conferencing and underwriting system.
The Bank believes that the LIVE(R) system, which permits a loan underwriter to
interview and complete a loan application and approve a loan for a prospective
borrower in one session during a live video conference, provides it with a
significant competitive edge in writing mortgage loans. During 1997,
substantially all of its mortgage loan production has been underwritten using
automated systems, which the Bank believes reduces overhead, enhances customer
service and facilitates conformity of the Bank's loan production with FHLMC
and FNMA underwriting guidelines.
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SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial and other data of the Bank herein, as of
and for the nine months ended September 30, 1997 and 1996 and each of the five
years in the period ended December 31, 1996, have been derived from the
Consolidated Financial Statements of the Bank and the unaudited financial
statements of the Bank contained in Annex I. In the opinion of management all
adjustments (which consist of normal recurring accruals) necessary for a fair
presentation of the results of operations for such periods have been included.
The results of operations for the nine months ended September 30, 1997 are not
necessarily indicative of the results that may be expected for the entire
year.
<TABLE>
<CAPTION>
AT OR FOR THE
NINE MONTHS
ENDED
SEPTEMBER 30, AT OR FOR THE YEARS ENDED DECEMBER 31,
--------------- -------------------------------------------
1997 1996 1996 1995 1994 1993 1992
------- ------- ------- ------- ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
SUMMARY OF OPERATIONS:
Interest income......... $84,789 $57,679 $76,179 $71,304 $35,112 $29,760 $18,735
Interest expense........ 54,597 34,121 45,967 41,443 14,482 12,052 9,227
------- ------- ------- ------- ------- ------- -------
Net interest income..... 30,192 23,558 30,212 29,861 20,630 17,708 9,508
Provision for losses.... 3,730 1,140 2,604 238 290 644 380
------- ------- ------- ------- ------- ------- -------
Net interest income
after provision for
losses................. 26,462 22,418 27,608 29,623 20,340 17,064 9,128
Non-interest income Loan
administration income.. 5,543 11,110 11,859 14,248 13,261 7,786 2,340
Net gain on loan
sales................. 9,269 4,536 4,511 2,872 (1,132) 7,015 6,900
Net gain on sales of
mortgage servicing
rights................ 25,472 20,917 35,129 13,356 28,489 13,385 3,021
Other income............ 3,158 5,085 6,803 4,626 2,065 5,468 6,162
------- ------- ------- ------- ------- ------- -------
Total.................. 43,442 41,648 58,302 35,102 42,683 33,654 18,423
------- ------- ------- ------- ------- ------- -------
Non-interest expense
Compensation and bene-
fits.................. 19,303 18,443 25, 479 18,538 18,609 7,984 5,184
Other expense.......... 25,730 27,809(1) 33,060(1) 21,311 18,975 13,308 7,298
------- ------- ------- ------- ------- ------- -------
Total.................. 45,033 46,252 58,539 39,849 37,584 21,292 12,482
------- ------- ------- ------- ------- ------- -------
Earnings before federal
income taxes........... 24,871 17,814 27,371 24,876 25,439 29,426 15,069
Provision for federal
income taxes........... 9,043 6,387 10,258 9,348 9,302 10,405 5,275
------- ------- ------- ------- ------- ------- -------
Net earnings............ $15,828 $11,427(1) $17,113(1) $15,528 $16,137 $19,021 $ 9,794
======= ======= ======= ======= ======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
AT SEPTEMBER 30, AT DECEMBER 31,
---------------- ----------------------------------------------------
1997 1996 1995 1994 1993 1992
---------------- ---------- ---------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
SUMMARY OF FINANCIAL
CONDITION:
Total assets............ $2,033,199 $1,296,810 $1,044,851 $722,469 $467,629 $304,758
Loans receivable:
Mortgage loans avail-
able for sale......... 1,363,822 840,767 620,455 205,480 389,073 218,266
Loans held for invest-
ment.................. 444,552 273,579 305,590 429,800 26,906 21,637
Less: Allowance for
losses................ (4,950) (3,500) (2,102) (1,871) (901) (550)
---------- ---------- ---------- -------- -------- --------
Total loans, net....... 1,803,424 1,110,846 923,943 633,409 415,078 239,353
Mortgage servicing
rights................ 51,713 30,064 27,957 18,179 17,563 11,108
Deposits............... 1,012,121 624,732 529,218 308,497 190,761 181,171
FHLB advances.......... 718,878 389,801 191,156 200,750 55,000 --
Stockholder's equity... 121,055 77,899 61,003 47,925 35,114 16,767
</TABLE>
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<PAGE>
<TABLE>
<CAPTION>
AT OR FOR THE
NINE MONTHS ENDED
SEPTEMBER 30, AT OR FOR THE YEARS ENDED DECEMBER 31,
---------------------- -------------------------------------------------------------
1997 1996 1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
PERFORMANCE RATIOS(2):
Return on average
assets................. 1.34% 1.38% 1.54% 1.64% 3.19% 4.39% 3.72%
Return on average
equity................. 21.53% 22.61% 24.82% 29.52% 35.79% 69.56% 84.78%
Interest rate spread.... 2.27% 2.13% 2.13% 2.36% 3.37% 3.39% 2.04%
Net interest margin..... 2.83% 3.21% 3.07% 3.46% 4.63% 4.55% 3.92%
Ratio of average
interest earning assets
to average interest
bearing liabilities.... 111% 123% 120% 123% 139% 137% 158%
Ratio of non-interest
expense to average
assets................. 3.80% 5.58%(3) 5.25%(3) 4.20% 7.43% 4.92% 4.71%
Efficiency ratio (4).... 59.8% 69.5% 64.7% 59.3% 58.3% 41.5% 44.7%
Dividend payout ratio... -- 8.75% 5.84% 15.78% 19.83% 4.21% 7.66%
ASSET QUALITY DATA:
Net charge-offs to
average loans
outstanding(2)......... 0.22% 0.03% 0.13% 0.00% 0.08% 0.08% 0.09%
Non-performing assets to
total assets at end of
period................. 3.04% 3.37% 3.16% 1.25% 0.42% 0.60% 0.94%
Non-performing loans to
total loans at end of
period................. 2.44% 3.50% 2.75% 1.15% 0.27% 0.37% 0.85%
Allowance for losses to
total loans at end of
period................. 0.27% 0.33% 0.31% 0.23% 0.29% 0.22% 0.23%
Allowance for losses to
non-performing loans at
end of period.......... 11.23% 9.56% 11.43% 19.67% 107.59% 58.17% 26.84%
CAPITAL RATIOS:
Tangible Capital........ 5.73% 6.22% 5.58% 5.19% 5.54% 7.41% 5.35%
Core Capital............ 5.95% 6.75% 6.01% 5.84% 6.63% 7.41% 5.35%
Total Risk-based
Capital................ 11.25% 11.96% 10.91% 10.12% 12.08% 13.84% 13.40%
Average equity-to-
average assets......... 6.20% 6.09% 6.19% 5.54% 8.91% 6.32% 5.14%
MORTGAGE ORIGINATION AND
SERVICING DATA:
Mortgage loans
originated or
purchased.............. $5,287,711 $5,283,843 $6,791,665 $5,195,605 $3,720,173 $6,220,415 $2,984,076
Mortgage loans sold..... $4,518,451 $5,285,538 $6,581,897 $4,760,806 $3,551,319 $6,034,828 $2,888,564
Mortgage loans serviced
for others(5).......... $4,143,352 $6,946,080 $4,801,581 $6,788,530 $5,691,421 $6,198,311 $3,091,399
Capitalized value of
mortgage servicing
rights (6)............. 1.25% 0.60% 0.63% 0.41% 0.32% 0.28% 0.36%
OTHER DATA:
Full-time equivalent
employees.............. 1,110 1,179 1,310 1,142 869 971 584
Number of branches...... 19 15 15 13 9 1 1
Number of
wholesale/correspondent
lending centers........ 10 10 10 9 6 5 4
</TABLE>
(footnotes on following page)
69
<PAGE>
- --------
(1) Includes the special deposit insurance assessment imposed on SAIF-insured
institutions during September 1996. The Bank's assessment was $3.4
million, before taxes. If such assessment had not been imposed, the Bank's
net earnings would have been approximately $13.6 million for the nine
months ended September 30, 1996 and its return on average assets and
return on average equity for the period would have been 1.64% and 26.90%,
respectively. If such assessment had not been imposed, the Bank's net
earnings would have been approximately $19.3 million for the year ended
December 31, 1996 and its return on average assets and return on average
equity for the period would have been 1.73% and 27.97%, respectively.
(2) Ratios are annualized where applicable.
(3) Excluding the special SAIF assessment of $3.4 million, before taxes,
incurred during 1996, mentioned in footnote 1 above, such ratio would have
been 5.17% for the nine months ended September 30, 1996 and 4.94% for the
year ended December 31, 1996.
(4) Computed as non-interest expense (excluding amortization of core deposit
premiums) divided by the sum of net interest income and non-interest
income. Excluding the special SAIF assessment of $3.4 million, before
taxes, incurred during 1996, mentioned in footnote 1 above, such ratio
would have been 64.3% for the nine months ended September 30, 1996 and
60.8% for the year ended December 31, 1996.
(5) Amount excludes loans being subserviced for others, which is servicing of
loans subsequent to the sale of the related mortgage servicing rights but
prior to their delivery, of $2.0 billion, $2.1 billion, $3.6 billion and
$536.3 million at September 30, 1997 and 1996 and December 31, 1996 and
1995, respectively. There was no subservicing in prior years.
(6) Reflects percentage of book value of mortgage servicing rights to loans
serviced for others (excluding subservicing).
70
<PAGE>
RECENT DEVELOPMENTS
The following table presents selected financial data for the periods
indicated. The selected consolidated financial and other data as of and for
the three months ended December 31, 1997 and 1996 and the year ended December
31, 1997 are unaudited and are derived from the Bank's internal consolidated
financial statements which, in the opinion of management, contain all
adjustments which are necessary for a fair presentation of the results for
such periods. The information set forth below should be read in conjunction
with the Bank's Consolidated Financial Statements and Notes thereto and
"Management's Discussion and Analysis of Changes in Financial Condition and
Results of Operations," each as set forth in the Offering Circular contained
in Annex I attached hereto and incorporated herein by reference.
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED AT OR FOR THE YEAR ENDED
DECEMBER 31, DECEMBER 31,
1997 1996 1997 1996(4)
------------- ------------- ------------ -------------
(in thousands, except per share amount)
<S> <C> <C> <C> <C>
SUMMARY OF OPERATIONS:
Interest income......... $ 37,963 $ 18,500 $ 122,752 $ 76,179
Interest expense........ 25,436 11,846 80,033 45,967
------------- ------------- ------------ ------------
Net interest income..... 12,527 6,654 42,719 30,212
Provision for losses.... 1,285 1,464 5,015 2,604
Non-interest income..... 16,089 16,654 59,531 58,302
Non-interest expense.... 17,201 12,287 62,234 58,539
------------- ------------- ------------ ------------
Earnings before federal
tax provision.......... 10,130 9,557 35,001 27,371
Provision for federal
income taxes........... 4,175 3,871 13,218 10,258
------------- ------------- ------------ ------------
Net earnings............ $ 5,955 $ 5,686 $ 21,783 $ 17,113
============= ============= ============ ============
SUMMARY OF FINANCIAL
CONDITION:
Total assets............ $ 1,901,034 $ 1,296,810
Loans receivable........ 1,655,259 1,110,846
Mortgage servicing
rights................. 83,845 30,064
Deposits................ 1,110,165 624,732
FHLB advances........... 482,378 389,801
Stockholders' equity.... 126,410 77,899
PERFORMANCE RATIOS:(1)
Return on average
assets................. 1.17% 2.02% 1.29% 1.54%
Return on average
equity................. 18.74% 30.84% 20.69% 24.82%
Interest rate spread.... 1.69% 2.05% 2.10% 2.13%
Net interest margin..... 2.55% 2.65% 2.74% 3.07%
Efficiency ratio........ 57.1% 52.7% 59.7% 64.7%
ASSET QUALITY DATA:
Net charge-offs to
average loans
outstanding............ 0.15% 0.39% 0.20% 0.13%
Non-performing assets to
total assets........... 3.29% 3.16%
Non-performing loans to
total loans............ 2.67% 2.75%
Allowance for losses to
total loans............ 0.33% 0.31%
Allowance for losses to
non-performing loans... 12.41% 11.43%
BANK REGULATORY CAPITAL
RATIOS:
Tangible capital........ 5.40% 5.58%
Core capital............ 5.62% 6.01%
Total risk-based
capital................ 11.74% 10.91%
MORTGAGE ORIGINATION AND
SERVICING DATA:
Mortgage loans
originated or
purchased.............. $ 2,585,388 $ 1,507,822 $ 7,873,099 $ 6,791,665
Mortgage loans sold..... $ 2,703,943 $ 1,296,359 $ 7,222,394 $ 6,581,897
Mortgage loans serviced
for others (2)......... N/A N/A $ 6,412,797 $ 4,801,581
Value of mortgage
servicing rights (3)... N/A N/A 1.31% 0.63%
</TABLE>
(1) Ratios are annualized where appropriate.
(2) Amount excludes subservicing of $3.6 billion at December 31, 1996.
(3) Reflects percentage of book value of mortgage servicing rights to loans
serviced for others (excluding subservicing).
(4) The 1996 earnings reflect the one time SAIF assessment of $3.4 million
($2.2 million after tax) paid in September 1996. Without this assessment,
earnings would have been $19.3 million and return on average equity,
return on average assets and the efficiency ratio would be 27.97%, 1.73%,
and 60.8%, respectively.
71
<PAGE>
Comparison of Results of Operations for the Three Months Ended December 31,
1997 and 1996
The Bank's net earnings for the three months ended December 31, 1997 were
$6.0 million, an increase of approximately $300,000 or 5.3%, from net earnings
of $5.7 million for the three months ended December 31, 1996. This increase in
net earnings was due to increases in net interest income, offset by an
increase in non-interest expense. The Bank's net interest income increased
$5.8 million, or 86.6%, to $12.5 million for the three months ended December
31, 1997, from $6.7 million reported for the three months ended December 31,
1996, caused by a substantial growth in average earning assets. Non-interest
expense increased $4.9 million, or 39.8%, to $17.2 million for the three
months ended December 31, 1997, from $12.3 million reported for the three
months ended December 31, 1996. This increase was the result of an increase in
compensation and benefits of $1.4 million and an increase in other expenses of
$3.5 million. The increased employee count associated with the bank branch
expansion and normal recurring salary adjustments account for the increased
compensation costs while the increase in other expenses is a direct result of
the increased costs associated with the foreclosed real estate portfolio.
Comparison of Results of Operations for the Years Ended December 31, 1997 and
1996
The Bank's net earnings for the year ended December 31, 1997 were $21.8
million, an increase of $4.7 million, or 27.5% from net earnings of $17.1
million for the year ended December 31, 1996. Excluding the one-time SAIF
assessment paid by the Bank in 1996, net earnings for 1996 would have been
$19.3 million.
The increase in net earnings for 1997 was due to increases in net interest
income and non-interest income, offset by increases in non-interest expense,
the provision for losses, and the provision for federal income taxes. The
Bank's net interest income increased $12.5 million, or 41.4%, to $42.7 million
for the year ended December 31, 1997, from $30.2 million for the year ended
December 31, 1996, caused by substantial growth in the amount of average
earning assets offset in part by a decrease in the net interest margin (from
3.07% to 2.74%). Non-interest income increased $1.2 million, or 2.1%, to $59.5
million for the year ended December 31, 1997, from $58.3 million in 1996. The
majority of this increase resulted from increased gains reported on loan sales
offset by decreases in gains from mortgage servicing rights sold, loan
administration income, and loan fee income. Non-interest expense increased
$3.7 million, or 6.3% to $62.2 million for 1997, from $58.5 million in 1996.
This increase was the result of a 16.2% increase in mortgage loan production
in 1997, an increase in bank branch locations opened in 1997 and increased
costs associated with the foreclosed real estate portfolio.
The Bank's provision for losses also increased by $2.4 million, or 92.3%, to
$5.0 million for 1997 from $2.6 million for 1996. The increase in the
provision increased the Bank's allowance for losses to $5.5 million at
December 31, 1997 (or 12.41% of non-performing loans) compared to $3.5 million
at December 31, 1996 (or 11.43% of non-performing loans). The increased
provision reflects a higher level of non-performing loans compared to December
31, 1996 ($44.3 million versus $30.6 million) and a higher level of charge-
offs in 1997 versus 1996 ($3.0 million versus $1.2 million). See "Management's
Discussion and Analysis of Changes in Financial Condition and Results of
Operations--Financial Condition--Allowance for Losses" of the Bank as set
forth in the Offering Circular contained in Annex I and incorporated herein by
reference. The Bank had net charge-offs to average loans outstanding of 0.20%
in 1997 compared to 0.13% during 1996.
72
<PAGE>
UNDERWRITING
Subject to the terms and conditions of the underwriting agreement dated
February 18, 1998 (the "Underwriting Agreement") among the Company, the Bank
and the underwriters named below (the "Underwriters"), the Company has agreed
that the Company will sell to each of the Underwriters, and the Underwriters
have severally agreed to purchase from the Company, the respective number of
Series A Preferred Shares set forth opposite its name below:
<TABLE>
<CAPTION>
NUMBER OF SHARES
OF SERIES A
UNDERWRITER PREFERRED SHARES
----------- ----------------
<S> <C>
Roney & Co., L.L.C. ..................................... 1,000,000
McDonald & Company Securities, Inc. ..................... 1,000,000
---------
Total.................................................. 2,000,000
=========
</TABLE>
The Underwriting Agreement provides that the obligations of the Underwriters
to pay for and accept delivery of the shares are subject to the approval of
certain legal matters by counsel and to certain other conditions. Under the
terms and conditions of the Underwriting Agreement, the Underwriters are
committed to purchase and pay for all the Series A Preferred Shares offered
hereby, if any are purchased.
If the Underwriting Agreement is terminated, except in certain limited
cases, the Underwriting Agreement provides that the Company will reimburse the
Underwriters for all accountable out-of-pocket expenses incurred by them in
connection with the proposed purchase and sale of the Series A Preferred
Shares up to a maximum of $100,000. Upon the purchase by the Underwriters of
at least 2,000,000 shares, the Company will not reimburse the Underwriters for
any out-of-pocket expenses.
The Company and the Underwriters have agreed that the Underwriters will
purchase the 2,000,000 Series A Preferred Shares offered hereunder at a price
to the public of $25.00 per share less underwriting discounts and commissions
of $0.8725 per share. The Underwriters propose to offer the Series A Preferred
Shares in part directly to the public at the initial public offering price set
forth on the cover page of this Prospectus, and in part to certain securities
dealers at such price less a concession of $0.50 per share. The Underwriters
may allow, and such dealers may reallow, a concession not in excess of $0.40
per share to certain brokers and dealers. After the Series A Preferred Shares
are released for sale to the public, the offering price and other selling
terms may from time to time be varied by the Underwriters.
The Company has granted the Underwriters an option exercisable for 30 days
after the date of this Prospectus to purchase up to an aggregate of 300,000
additional Series A Preferred Shares solely to cover over-allotments, if any.
If the Underwriters exercise their over-allotment option, the Underwriters
have severally agreed, subject to certain conditions, to purchase
approximately the same percentage thereof that the number of Series A
Preferred Shares to be purchased by each of them, as shown in the foregoing
table, bears to the 2,000,000 Series A Preferred Shares offered hereby.
The Company has agreed that, during the period beginning from the date of
this Prospectus and continuing to and including the date 90 days after the
date of this Prospectus, it will not offer, sell, contract to sell or
otherwise dispose of any securities of the Company which are substantially
similar to the Series A Preferred Shares or which are convertible or
exchangeable into securities which are substantially similar to the Series A
Preferred Shares offered in connection with the Offering.
73
<PAGE>
The Underwriters have informed the Company that they do not expect sales to
accounts over which the Underwriters exercise discretionary authority to
exceed five percent of the total number of Series A Preferred Shares offered
by them.
Prior to the Offering, there has been no public market for the Series A
Preferred Shares.
The Company has filed an application to list the Series A Preferred Shares,
subject to official notice of issuance, on Nasdaq. The Underwriters have
advised the Company that they intend to make a market in the Series A
Preferred Shares prior to commencement of trading on Nasdaq, but are not
obligated to do so and may discontinue any such market making at any time
without notice.
The Company and the Bank have agreed to indemnify the several Underwriters
against certain liabilities, including liabilities under the Securities Act.
Certain of the Underwriters or their affiliates have provided from time to
time, and expect to provide in the future, investment or commercial banking
services to affiliates of the Company, for which such Underwriters or their
affiliates have received or will receive customary fees and commissions.
EXPERTS
The balance sheet of Flagstar Capital Corporation as of December 16, 1997
included in this Prospectus has been so included in reliance on the report of
Grant Thornton LLP, independent certified public accountants, given on the
authority of said firm as experts in auditing and accounting.
LEGAL MATTERS
The validity of the Series A Preferred Shares offered hereby will be passed
upon for the Company by Kutak Rock, Washington, D.C. Certain tax matters
described under "Federal Income Tax Consequences" will be passed upon for the
Company by Kutak Rock. Certain legal matters will be passed upon for the
Underwriters by Honigman Miller Schwartz and Cohn, Detroit, Michigan.
ADDITIONAL INFORMATION
The Company has filed with the Commission a registration statement (of which
this Prospectus is a part) on Form S-11 (the "Registration Statement") under
the Securities Act, with respect to the Series A Preferred Shares offered
hereby. This Prospectus does not contain all the information set forth in the
Registration Statement, certain portions of which have been omitted as
permitted by the rules and regulations of the Commission. Statements contained
in this Prospectus as to the content of any contract or other document are not
necessarily complete, and in each instance reference is made to the copy of
such contract or other document filed as an exhibit to the Registration
Statement, each such statement being qualified in all respects by such
reference. For further information regarding the Company and the Series A
Preferred Shares offered hereby, reference is made to the Registration
Statement and the exhibits thereto.
The Registration Statement and the exhibits forming a part thereof filed by
the Company with the Commission can be inspected at and copies can be obtained
from the Commission, Room 1024, Judiciary Plaza, 450 Fifth Street, N.W.,
Washington, D.C. 20549, or at the following regional offices of the
Commission: 7 World Trade Center, 13th Floor, Suite 1300, New York, New York
10048 and Citicorp Center, 500 West Madison Street, 14th Floor, Suite 1400,
Chicago, Illinois 60661 and at the offices of the National Association of
Securities Dealers, 1735 K Street, N.W., Washington, D.C. 20006. Copies of
such materials can be obtained from the Public Reference Section of the
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed
74
<PAGE>
rates. Such material may also be accessed electronically by means of the
Commission's home page on the Internet at "http://www.sec.gov."
The Certificate of Designation establishing the rights, preferences and
limitations of the Series A Preferred Shares provides that the Company shall
maintain its status as a reporting company under the Exchange Act for so long
as any of the Series A Preferred Shares are outstanding.
75
<PAGE>
GLOSSARY
"Advisor" means the Bank in its role as advisor under the Advisory
Agreement.
"Advisory Agreement" means the agreement between the Bank and the Company
pursuant to which the Bank will (i) administer the day-to-day operations of
the Company, (ii) monitor the credit quality of the Mortgage Loans held by the
Company, (iii) advise the Company with respect to the acquisition, management,
financing and disposition of the Company's Mortgage Loans and (iv) maintain
custody of the documents related to the Company's Mortgage Loans.
"ARM" or "adjustable rate mortgage" means a Mortgage Loan that features
adjustments of the underlying interest rate at predetermined times based on an
agreed margin to an established index. An ARM is usually subject to periodic
interest rate and/or payment caps and a lifetime interest rate cap.
"Articles of Incorporation" means the Amended and Restated Articles of
Incorporation of the Company.
"Automatic Exchange" means the automatic exchange on a share-for-share basis
of Series A Preferred Shares for Bank Preferred Shares upon the occurrence of
the Exchange Event.
"Bank" means Flagstar Bank, FSB, a savings bank organized under the laws of
the United States, and the parent of the Company.
"Bank Preferred Shares" means the newly issued series of preferred stock of
the Bank for which the Series A Preferred Shares will be exchanged
automatically upon the occurrence of the Exchange Event.
"Board of Directors" means the board of directors of the Company.
"By-laws" means the by-laws of the Company.
"Classified" means a loan which, for financial institution regulatory
purposes, is designated as "substandard," "doubtful" or "loss." For such
purposes, a "substandard" asset is one that is deemed inadequately protected
by the current net worth and paying capacity of the obligor or of the
collateral pledged, if any, because the asset has a well-defined weakness or
weaknesses that jeopardize the liquidation of the debt. An asset classified as
"doubtful" has all the weaknesses inherent in one classified "substandard,"
with the added characteristic that the weaknesses make collection or
liquidation in full, on the basis of currently existing facts, conditions and
values, highly questionable and improbable. Assets classified as "loss" are
considered uncollectible.
"Code" means the Internal Revenue Code of 1986, as amended.
"Commission" means the United States Securities and Exchange Commission.
"Common Stock" means the common stock, par value $1.00 per share, of the
Company.
"Company" means Flagstar Capital Corporation, a Michigan corporation.
"Designated Portfolio" means the pool of Mortgage Loans from which the
Company will purchase from the Bank those Mortgage Loans that will comprise
the Initial Portfolio.
"Directive" means the writing issued by the appropriate regulatory agency
directing the Automatic Exchange.
"DOL" means the United States Department of Labor.
"ERISA" means the Employee Retirement Income Security Act of 1974, as
amended.
76
<PAGE>
"Excess Shares" means the shares of any class or series of preferred stock
owned, or deemed to be owned, by or transferred to a stockholder in excess of
the Ownership Limit.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Exchange Event" means an occurrence by which the appropriate regulatory
agency directs in writing an exchange of the Series A Preferred Shares for
Bank Preferred Shares because (i) the Bank becomes "undercapitalized" under
prompt corrective action regulations established pursuant to FDICIA, (ii) the
Bank is placed into conservatorship or receivership or (iii) the appropriate
regulatory agency, in its sole discretion and even if the Bank is not
"undercapitalized," anticipates the Bank becoming "undercapitalized" in the
near term.
"FHLMC" or "Freddie Mac" means the Federal Home Loan Mortgage Corporation.
"Five-Year ARM" means an ARM in which the interest rate adjusts annually
beginning in the month in which the 60th payment is due.
"FIRPTA" means the Foreign Investment in Real Property Tax Act of 1980, as
amended.
"Five or Fewer Test" means the Code requirement that not more than 50% in
value of the Company's outstanding stock may be owned, directly or indirectly,
by five or fewer individuals (as defined in the Code).
"Flagstar" means Flagstar Bancorp, Inc., a Michigan corporation and the
parent of the Bank.
"FNMA" or "Fannie Mae" means the Federal National Mortgage Association.
"FNMA Required Net Yield" means (i) with respect to any Mortgage Loan with
an original term of 20, 25 or 30 years, FNMA's required net yield for 30-year
fixed rate mortgages (covered by 60-day mandatory commitments) that was in
effect 45 days prior to the effective date of any conversion of such Mortgage
Loan and (ii) with respect to any Mortgage Loan with an original term of 15
years, FNMA's required net yield for 15-year fixed rate mortgages (covered by
60-day mandatory commitments) that was in effect 45 days prior to the
effective date of any conversion of such Mortgage Loan.
"Foreign Stockholders" means holders of Series A Preferred Shares that are
for United States federal income tax purposes (i) non-resident alien
individuals, (ii) foreign corporations and foreign partnerships or (iii)
foreign trusts and estates.
"Gross Margin" means, with respect to a Mortgage Loan that is an ARM, the
applicable fixed percentage which, when added to the applicable index,
calculates to the current interest rate paid by the borrower of the adjustable
rate Mortgage Loan (without taking into account any interest rate caps or
minimum interest rates). Gross Margin is inapplicable to fixed rate loans.
"Independent Directors" means the members of the Board of Directors who,
prior to their appointment, were not current directors, officers or employees
of the Company, Flagstar, the Bank or any affiliate of the Bank or of any
person or persons that, in the aggregate, own more than one percent of the
common stock of Flagstar.
"Initial Portfolio" means the portfolio of Mortgage Loans purchased by the
Company from the Bank upon or simultaneously with the closing of the Offering.
"IRA" means an individual retirement arrangement under Section 408 of the
Code.
"IRS" means the United States Internal Revenue Service.
"LIBOR" means the London Inter-Bank Offered Rate.
77
<PAGE>
"Lifetime interest rate cap" means, with respect to Mortgage Loans that are
ARMs, the maximum interest rate that may accrue during any period over the
term of such Mortgage Loan as stated in the governing instruments evidencing
such Mortgage Loan.
"Loan-to-Value Ratio" means, with respect to any Mortgage Loan, the ratio
(expressed as a percentage) of the original principal amount of such Mortgage
Loan to the lesser of (i) the appraised value at origination of the mortgaged
property underlying such Mortgage Loan and (ii) if the Mortgage Loan was made
to finance the acquisition of property, the purchase price of the mortgaged
property.
"Mortgage Loans" means whole loans secured by a first mortgage or deed of
trust on single-family (one- to four-unit) residential real estate properties
none of which have been originated under or are insured by or guaranteed by
either the Federal Housing Administration or the Veterans' Administration.
"Mortgage Purchase Agreement" means the Mortgage Loan Purchase and
Warranties Agreement between the Company and the Bank.
"Nonaccrual Status" means a loan on which, in the opinion of management,
principal or interest is not likely to be paid in accordance with the terms of
the loan agreement or on which the principal or interest is past due 90 days
or more and collateral, if any, is insufficient to cover principal and
interest.
"Offering" means the offering of Series A Preferred Shares pursuant to the
Prospectus.
"Offering Circular" means the registration statement on Form OC pursuant to
which the Bank Preferred Shares are being registered with the OTS.
"One Hundred Persons Test" means the Code requirement that the capital stock
of the Company be owned by 100 or more persons during at least 335 days of a
taxable year or during a proportionate part of a shorter taxable year.
"OTS" means the Office of Thrift Supervision, Department of the Treasury.
"Ownership Limit" means the provision in the Company's Articles of
Incorporation limiting any person from owning (including shares deemed to be
owned by the attribution provisions of the Code) more than 5% of any issued
and outstanding class or series of preferred stock of the Company without the
prior approval of the Company.
"Periodic interest rate cap" means, with respect to ARMs, the maximum change
in the coupon rate permissible under the terms of the loan at each coupon
adjustment date. Periodic interest rate caps limit both the speed by which the
coupon rate can adjust upwards in a rising interest rate environment and the
speed by which the coupon rate can adjust downwards in a falling rate
environment.
"Plan" means a pension, profit-sharing, retirement or other employee benefit
plan.
"Plan Asset Regulation" means the DOL regulations determining the assets of
a Plan for purposes of ERISA and the related prohibited transaction excise tax
provisions of the Code.
"Prime Rate" for any date means the lowest prime rate as published in the
"Money Rates" table of The Wall Street Journal for that date.
"Prospectus" means this prospectus, as the same may be amended.
"Rate Adjustment Date" means, with respect to any ARM, a date on which the
interest rate on such ARM adjusts.
78
<PAGE>
"Registration Statement" means the registration statement filed by the
Company with the Commission on Form S-11 with respect to the Series A
Preferred Shares.
"REIT" means a real estate investment trust as defined pursuant to the REIT
Provisions, or any successor provisions thereof.
"REIT Provisions" and "REIT Requirements" means Sections 856 through 860 of
the Code and the applicable Treasury Regulations.
"REIT Taxable Income" shall have the meaning set forth in "Federal Income
Tax Consequences--Taxation of the Company--Annual Distribution Requirements."
"Securities Act" means the Securities Act of 1933, as amended.
"Series A Preferred Shares" means the shares of preferred stock of the
Company offered hereby.
"Servicing Agreement" means the servicing agreement entered into by the Bank
and the Company with respect to the Mortgage Loans.
"Seven-Year ARM" means an ARM that adjust annually beginning in the month in
which the 84th monthly payment is due.
"Tax Event" means the receipt by the Company of an opinion of a law or
accounting firm experienced in such matters to the effect that, as a result of
(i) any amendment to, clarification of, or change (including any announced
prospective change) in the laws or treaties (or any regulations thereunder) of
the United States or any political subdivision or taxing authority thereof or
therein affecting taxation, (ii) any judicial decision, official
administrative pronouncement, ruling, regulatory procedure, notice or
announcement (including any notice or announcement of intent to adopt such
procedures or regulations) ("Administrative Action") or (iii) any amendment
to, clarification of, or change in the official position or the interpretation
of such Administrative Action or judicial decision or any interpretation or
pronouncement that provides for a position with respect to such Administrative
Action or judicial decision that differs from the theretofore generally
accepted position, in each case, by any legislative body, court, governmental
authority or regulatory body, irrespective of the manner in which such
amendment, clarification or change is made known, which amendment,
clarification, or change is effective or such pronouncement or decision is
announced on or after the date of issuance of the Series A Preferred Shares,
there is more than an insubstantial risk that (a) dividends payable by the
Company with respect to the capital stock of the Company are not, or will not
be, fully deductible for United States federal income tax purposes or (b) the
Company is, or will be, subject to more than a de minimis amount of other
taxes, duties or other governmental charges.
"Three-Year ARM" means an ARM that adjusts annually beginning in the month
in which the 36th monthly payment is due.
"TIN" means Taxpayer Identification Number.
"Treasury Index" means the weekly average yield on U.S. Treasury securities
adjusted to a constant maturity of one year as published by the Federal
Reserve Board in Statistical Release H.15 (519) or any similar publication or,
if not so published, as reported by any Federal Reserve Bank or by any U.S.
Government department or agency.
"Treasury Regulations" means the income tax regulations promulgated under
the Code.
"Underwriters" means those underwriters to which the Company will sell the
Series A Preferred Shares pursuant to the terms of the Underwriting Agreement.
79
<PAGE>
"Underwriting Agreement" means the underwriting agreement by and among the
Company, the Bank and the Underwriters.
"United States Stockholders" means holders of Series A Preferred Shares that
are for United States federal income tax purposes (i) citizens or residents of
the United States, (ii) corporations, partnerships, or other entities created
or organized in or under the laws of the United States or of any political
subdivisions thereof, or (iii) an estate or trust the income of which is
subject to United States federal income taxation regardless of its source.
"USRPI" means United States real property interest.
80
<PAGE>
INDEX TO FINANCIAL STATEMENT
<TABLE>
<S> <C>
Report of Independent Certified Public Accountants......................... F-2
Balance Sheet of Flagstar Capital Corporation as of December 16, 1997...... F-3
Note to Financial Statement................................................ F-4
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors of Flagstar Capital Corporation:
We have audited the accompanying balance sheet of Flagstar Capital
Corporation (the "Company") as of December 16, 1997. This financial statement
is the responsibility of the Company's management. Our responsibility is to
express an opinion on this financial statement based on our audit.
We conducted our audit 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 statement is free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statement. 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 our audit provides a reasonable basis for
our opinion.
In our opinion, the balance sheet referred to above presents fairly, in all
material respects, the financial position of Flagstar Capital Corporation as
of December 16, 1997, in conformity with generally accepted accounting
principles.
/s/ Grant Thornton LLP
Southfield, Michigan
December 19, 1997
F-2
<PAGE>
FLAGSTAR CAPITAL CORPORATION
BALANCE SHEET
DECEMBER 16, 1997
<TABLE>
<S> <C>
ASSETS
Cash..................................................................... $100
====
STOCKHOLDER'S EQUITY
Common Stock, par value $1.00 share, 1,000,000 shares authorized; 100
shares issued and outstanding........................................... $100
====
</TABLE>
The Note to the Financial Statement is an integral part of this Statement.
F-3
<PAGE>
FLAGSTAR CAPITAL CORPORATION
NOTE TO FINANCIAL STATEMENT
1. ORGANIZATION
Flagstar Capital Corporation (the "Company"), a wholly-owned subsidiary of
Flagstar Bank, FSB (the "Bank"), was incorporated on June 28, 1995 in the
State of Michigan.
The Company intends to invest in mortgage-related assets financed by common
and preferred stock offerings and expects to generate income for distribution
to its future preferred and common stockholders primarily from the net
interest income derived from its investments in mortgage-related assets. The
Company intends to purchase these mortgage-related assets from the Bank at
their estimated fair values. These assets will be recorded in the Company's
financial statements at the Bank's historical cost basis which will
approximate their estimated fair values. The Company intends to operate in a
manner that permits it to elect, and it intends to elect, to be subject to tax
as a real estate investment trust for federal income tax purposes. The Company
has not had any operations as of December 16, 1997.
The Company intends to sell preferred stock in an underwritten public
offering. The cost of this public offering will be paid by the Company out of
proceeds from a sale of common stock to the Bank. If the public offering is
not consummated, the Bank will pay any offering costs.
F-4
<PAGE>
ANNEX I
OFFERING CIRCULAR
2,000,000 SHARES
FLAGSTAR BANK, FSB
8.5% NONCUMULATIVE PREFERRED STOCK, SERIES A
(LIQUIDATION PREFERENCE $25.00 PER SHARE)
The 8.5% Noncumulative Preferred Stock, par value $25.00 per share (the
"Bank Preferred Shares"), of Flagstar Bank, FSB (the "Bank") will be issued
only upon the automatic exchange (the "Automatic Exchange") of the 8.5%
Noncumulative Exchangeable Preferred Stock, Series A (the "Series A Preferred
Shares") of Flagstar Capital Corporation (the "Company"), a wholly owned
subsidiary of the Bank, upon the occurrence of certain events. See "Offering
Circular Summary--The Offering." Dividends on the Bank Preferred Shares will
be payable at the same rate as the Series A Preferred Shares if, when and as
declared by the Board of Directors of the Bank. For a description of the terms
of the Bank Preferred Shares, see "Description of the Bank Preferred Shares"
herein.
The Bank Preferred Shares rank, in priority of payment of dividends and
rights upon the voluntary or involuntary dissolution, liquidation or winding
up of the Bank, junior to all claims of the Bank's creditors, including the
claims of the Bank's depositors. The Bank Preferred Shares rank superior and
prior to the issued and outstanding common stock of the Bank with respect to
dividend rights and rights upon voluntary or involuntary dissolution,
liquidation or winding up of the Bank, and to all other classes and series of
equity securities of the Bank hereafter issued, other than any class or series
expressly designated as being on parity with or senior to the Bank Preferred
Shares. The common stock of the Bank is the only class of equity securities
currently outstanding.
The Series A Preferred Shares have been registered with the Securities and
Exchange Commission (the "Commission") and an application will be filed to
list the Series A Preferred Shares on the Nasdaq Stock Market ("Nasdaq") under
the symbol "FLGSP". In the event the Series A Preferred Shares are exchanged
into Bank Preferred Shares, the Bank does not intend to apply for listing of
the Bank. Preferred Shares on any national securities exchange or for
quotation through Nasdaq.
AN INVESTMENT IN THE BANK PREFERRED SHARES INVOLVES A HIGH DEGREE OF RISK.
INVESTORS SHOULD CAREFULLY CONSIDER THE RISK FACTORS AND OTHER CONSIDERATIONS
RELATING TO THE BANK AND THE BANK PREFERRED SHARES. SEE "RISK FACTORS"
BEGINNING ON PAGE OC-14.
----------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE OFFICE OF
THRIFT SUPERVISION (THE "OTS"), THE FEDERAL DEPOSIT INSURANCE CORPORATION (THE
"FDIC"), THE COMMISSION OR ANY OTHER FEDERAL AGENCY, OR BY ANY STATE
SECURITIES COMMISSION, NOR HAS THE COMMISSION, THE OTS, THE FDIC, OTHER AGENCY
OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF
THIS OFFERING CIRCULAR. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL
OFFENSE.
THE SECURITIES OFFERED HEREBY ARE NOT SAVINGS ACCOUNTS OR DEPOSITS OR OTHER
OBLIGATIONS OF THE BANK AND ARE NOT INSURED BY THE FDIC OR ANY OTHER
GOVERNMENTAL AGENCY OR OTHERWISE INSURED.
The date of this Offering Circular is February 18, 1998.
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
-----
<S> <C>
Forward-Looking Information............................................. OC-3
Available Information................................................... OC-3
Offering Circular Summary............................................... OC-4
Risk Factors............................................................ OC-14
Flagstar Capital Corporation............................................ OC-22
Use of Proceeds......................................................... OC-22
Capitalization.......................................................... OC-23
Selected Consolidated Financial and Other Data.......................... OC-24
Management's Discussion and Analysis of Changes in Financial Condition
and Results of Operations.............................................. OC-26
Business................................................................ OC-46
Regulation.............................................................. OC-67
Management.............................................................. OC-73
Description of the Bank Preferred Shares................................ OC-79
Automatic Exchange...................................................... OC-82
Experts................................................................. OC-82
Legal Matters........................................................... OC-83
Index to Financial Statements........................................... F-1
</TABLE>
OC-2
<PAGE>
FORWARD-LOOKING INFORMATION
THE INFORMATION CONTAINED HEREIN CONTAINS FORWARD-LOOKING STATEMENTS THAT
INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES. A NUMBER OF FACTORS, INCLUDING
THOSE DISCUSSED BELOW, COULD CAUSE RESULTS TO DIFFER MATERIALLY FROM THOSE
ANTICIPATED BY SUCH FORWARD-LOOKING STATEMENTS. IN ADDITION, SUCH FORWARD-
LOOKING STATEMENTS ARE NECESSARILY DEPENDENT UPON ASSUMPTIONS, ESTIMATES AND
DATA THAT MAY BE INCORRECT OR IMPRECISE. ACCORDINGLY, ANY FORWARD-LOOKING
STATEMENTS INCLUDED HEREIN DO NOT PURPORT TO BE PREDICTIONS OF FUTURE EVENTS
OR CIRCUMSTANCES AND MAY NOT BE REALIZED. FORWARD-LOOKING STATEMENTS CAN BE
IDENTIFIED BY, AMONG OTHER THINGS, THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH
AS "INTENDS," "BELIEVES," "EXPECTS," "MAY," "WILL," "SHOULD," "SEEKS," "PRO
FORMA" OR "ANTICIPATES," OR THE NEGATIVES THEREOF, OR OTHER VARIATIONS THEREON
OF COMPARABLE TERMINOLOGY, OR BY DISCUSSIONS OF STRATEGY OR INTENTIONS.
AVAILABLE INFORMATION
Flagstar Bank, FSB (the "Bank") is not subject to the information reporting
requirements of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). However, the Bank is wholly owned by Flagstar Bancorp, Inc.
("Flagstar"), which is subject to the requirements of the Exchange Act and, in
accordance therewith, files reports and other information with the Commission.
Such reports and other information may be inspected without charge and copied
at prescribed rates at the public reference facilities maintained by the
Commission at 450 Fifth Street, N.W., Room 1024, Washington, D.C. 20549 and at
the Commission's Regional Offices at Seven World Trade Center, Suite 1300, New
York, New York 10048 and 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. In addition, the Commission maintains a web site that contains
reports, proxy and information statements and other information regarding the
electronic filings of Flagstar. The address of the Commission's web site is
"http://www.sec.gov."
The Bank has filed with the OTS a Registration Statement on Form OC
(including any amendments thereto, the "Form OC") with respect to the
securities covered by this Offering Circular. This Offering Circular does not
contain all of the information set forth in the Form OC, certain items of
which are contained in exhibits to the Form OC as permitted by the rules and
regulations of the OTS. For further information with respect to the Bank and
the securities offered hereby, reference is made to the Form OC, including the
exhibits filed as a part thereof. Statements contained in this Offering
Circular as to the contents of any contract or other document referred to are
not necessarily complete, and in each instance reference is made to the copy
of such contract or other document filed as an exhibit to the Form OC, each
such statement being qualified in all respects by such reference. The Form OC
and the exhibits thereto may be inspected without charge and copied at
prescribed rates at the public reference facilities maintained by the OTS at
1700 G Street, N.W., Washington, D.C. 20552. Information regarding the Bank is
also available through the web site of the OTS. The address of the OTS' web
site is "http://www.ots.ustreas.gov."
OC-3
<PAGE>
OFFERING CIRCULAR SUMMARY
The following summary is qualified in its entirety by, and should be read in
conjunction with the more detailed information, risk factors and financial
statements, including the related notes, appearing elsewhere in the Offering
Circular. Unless otherwise indicated, all information in this Offering Circular
assumes that the over-allotment option granted to the Underwriters has not been
exercised. Terms used but not defined herein are defined elsewhere in this
Offering Circular.
THE BANK
Flagstar Bank, FSB, a federally chartered stock savings bank, is the largest
independent Michigan-based savings institution based on asset size as of
September 30, 1997, according to SNL Securities. The Bank is also one of the
largest originators of conforming single-family mortgage loans in the United
States according to Inside Mortgage Finance. The Bank is engaged in the
business of providing a full range of retail banking services in southern and
western Michigan and in originating, purchasing and servicing residential
mortgage loans on a nationwide basis. For 1996, the Bank ranked fourth in the
United States among thrifts in mortgage loan originations and sixteenth in
total mortgage loan production according to SMR Research Corp. All of the
outstanding stock of the Bank is owned by Flagstar Bancorp, Inc. ("Flagstar"),
a Michigan corporation whose common stock is listed for trading on the Nasdaq
Stock Market ("Nasdaq") under the symbol "FLGS."
As of September 30, 1997, the Bank had consolidated total assets of $2.0
billion, net loans of $1.8 billion, total deposits of $1.0 billion and total
stockholder's equity of $121.1 million. For the nine months ended September 30,
1997, the Bank's net earnings were $15.8 million and its return on average
assets and return on average equity (as annualized) were 1.34% and 21.53%,
respectively. At December 31, 1996, the Bank had consolidated total assets of
$1.3 billion, net loans of $1.1 billion, total deposits of $624.7 million and
total stockholder's equity of $77.9 million. For the year ended December 31,
1996, the Bank's net earnings were $17.1 million and its return on average
assets and return on average equity were 1.54% and 24.82%, respectively ($19.3
million, 1.73% and 27.97%, respectively, excluding the special deposit
insurance assessment imposed on September 30, 1996 on all depository
institutions insured by the Savings Association Insurance Fund (the "SAIF")).
The Bank's operations are segregated into two segments, mortgage banking and
retail banking, with most of the Bank's revenue (net interest income and non-
interest income) and earnings before income taxes attributable to the mortgage
banking segment. The Bank believes that its retail banking business provides it
with a strategic advantage because it affords the Bank access to funding
sources for its mortgage origination business that would not otherwise be
available. These additional funding sources include lower cost retail deposits,
Federal Home Loan Bank ("FHLB") advances and escrowed funds. The Bank benefits
as compared to mortgage originators with no retail banking operations because
it has access to a lower cost of funds and is therefore able to generate
greater net interest income. See "Business."
Retail Banking. The Bank (which was formerly known as First Security Savings
Bank, FSB) provides a full range of retail banking services to consumers and
small businesses in southern and western Michigan. The Bank operates a network
of 19 bank branches (including four opened in 1997) located in southern and
western Michigan counties. Beginning with the acquisition of Security Savings
Bank, F.S.B. ("Security Savings") and its seven bank branches in 1994, the Bank
has focused on expanding its branch network in these markets in order to
increase its access to retail deposit funding sources. The Bank believes that
this also provides a greater opportunity for cross-marketing of consumer
banking services to the Bank's mortgage customers in Michigan and for taking
advantage of opportunities that the Bank believes exist for community banks in
Michigan as a result of the substantial consolidation that has occurred in the
banking industry. See "Business."
OC-4
<PAGE>
Mortgage Banking. The Bank's mortgage banking operations, which have
historically generated substantially all of the Bank's earnings, originate
residential mortgages through 33 retail loan origination offices located in
Michigan (21), California (9), Florida (2) and Ohio (1). In addition, the Bank
originates mortgage loans on a wholesale basis through a network of
approximately 1,800 independent mortgage brokers nationwide (who originate such
loans using the Bank's underwriting systems and standards and close such loans
using funds advanced by the Bank). This network is serviced by sixty account
executives, who are organized among 10 regional wholesale/correspondent lending
offices and five wholesale/correspondent satellite offices. The Bank also
purchases mortgage loans on a regular basis from independent mortgage lenders,
commercial banks, savings and loan associations and other financial
institutions with whom the Bank has established a correspondent relationship.
See "Business."
For the nine months ended September 30, 1997, the Bank produced approximately
$4.8 billion in mortgage loans through wholesale and correspondent networks and
$529.9 million through the Bank's retail network. During the years ended
December 31, 1996 and 1995, the Bank's mortgage loan production totaled $6.8
billion and $5.2 billion, respectively. Of these amounts, approximately $6.1
billion was produced during the year ended December 31, 1996 through the Bank's
wholesale and correspondent loan production network and $685.3 million was
produced through the Bank's retail network ($4.6 billion and $632.7 million,
respectively, during 1995).
The Bank sells a substantial portion of its loan production into the
secondary market, principally by securitizing pools of loans through programs
offered by government-sponsored enterprises such as the Federal National
Mortgage Association ("FNMA" or "Fannie Mae") and the Federal Home Loan
Mortgage Corporation ("FHLMC" or "Freddie Mac") and through sales to private
investors. In addition, the Bank originates and sells loans conforming to the
underwriting criteria of the Federal Housing Authority ("FHA") and the
Department of Veterans Affairs ("VA"). Generally, the Bank retains the
servicing rights to many of the loans that it sells, but also realizes
additional income by selling servicing rights on an individual and a bulk basis
to other mortgage servicers. At September 30, 1997 and at December 31, 1996 and
1995, the Bank's loan servicing portfolio totaled $4.1 billion, $4.8 billion
and $6.8 billion, respectively (net of loans subserviced for others),
substantially all of which related to conventional loans.
The Bank makes extensive use of advanced technology and automated processes
in order to enhance the competitiveness and reduce the cost of its mortgage
origination operations. The Bank was one of the first mortgage lenders to
utilize video conferencing for loan production. In 1996, the Bank began full-
scale operational use of automated underwriting system technologies, including
Fannie Mae's Desktop Underwriter(TM) and Freddie Mac's Loan Prospector(TM) (of
which the Bank is currently one of the largest users), and has combined the two
technologies into its LIVESM video conferencing and underwriting system. The
Bank believes that the LIVESM system, which permits a loan underwriter to
interview and complete a loan application and approve a loan for a prospective
borrower in one session during a live video conference, provides it with a
significant competitive edge in writing mortgage loans. During 1997,
substantially all of its mortgage loan production has been underwritten using
automated systems, which the Bank believes reduces overhead, enhances customer
service and facilitates conformity of the Bank's loan production with FHLMC and
FNMA underwriting guidelines.
Business Strategy. The Bank's strategy consists of the following key
elements:
. continue to expand the Bank's branch network into the demographically
desirable communities adjacent to the Bank's current markets in southern
and western Michigan in order to gain access to additional low cost
retail funding sources;
. cross-sell retail banking services to the Bank's large Michigan base of
existing mortgage customers;
. benefit from economies of scale by increasing the size of its loan
servicing portfolio through the continued origination and purchase of
large volumes of mortgage loans on a diversified, nationwide basis;
OC-5
<PAGE>
. as market conditions permit, retain more of its mortgage loan production
volume or mortgage servicing rights, or both;
. utilize advanced technology and automated processes throughout the Bank's
business to improve customer service, reduce costs of loan production and
servicing and increase efficiencies.
Recent Operating Results. The Bank's operations have grown significantly over
the past five years. Between year-end 1992 and year-end 1996, the Bank's annual
mortgage loan production volume grew from $3.0 billion to $6.8 billion, its
assets grew from $304.8 million to $1.3 billion and its loan servicing
portfolio (net of loans subserviced for others) grew from $3.1 billion to a
peak of $6.8 billion at December 31, 1995 before decreasing to $4.8 billion at
December 31, 1996 as a result of significant sales of servicing rights during
1996. Over this period, net earnings increased from $9.8 million in 1992 to
$17.1 million in 1996 ($19.3 million before the special deposit insurance
assessment imposed on September 30, 1996, on all SAIF-insured institutions).
Net earnings decreased in 1994 and 1995 compared to 1993 as a result of several
factors, including higher levels of compensation and expense relating to
expansion that the Bank undertook in 1993 in response to the record levels of
refinancing activity and its acquisition of Security Savings in 1994. For the
three years ended December 31, 1996, 1995 and 1994, the Bank reported a return
on average equity of 24.82%, 29.52% and 35.79%, respectively, and a return on
average assets of 1.54%, 1.64% and 3.19%, respectively.
Net earnings for the nine months ended September 30, 1997 were $15.8 million,
a $4.4 million increase from the $11.4 million in net earnings reported for the
nine months ended September 30, 1996 ($13.6 million before the SAIF
assessment). The increase resulted primarily from the Bank's increase in
average assets which totaled $1.6 billion for the nine months ended September
30, 1997, an increase of $500.0 million, or 45.5%, from $1.1 billion for the
nine months ended September 30, 1996.
Historically, the Bank has incurred minimal losses from charge-offs in
connection with its residential mortgage loan production. Net charge-offs as a
percentage of average loans outstanding increased from 0.09% in 1992 to 0.13%
in 1996. Net charge-offs further increased to 0.22% for the nine months ended
September 30, 1997. Over this period, non-performing assets as a percentage of
total assets ranged from 0.94% in 1992 to a low of 0.42% in 1994, increased to
1.25% at December 31, 1995, to 3.16% at December 31, 1996 and finally to 3.04%
at September 30, 1997. Non-performing assets totaled $3.0 million in 1994,
$13.0 million in 1995, $41.0 million in 1996 and $61.7 million at September 30,
1997. As a result of the increase in non-performing assets during 1997, the
Bank increased its provision for losses to $3.7 million for the nine months
ended September 30, 1997 from $2.6 million for all of 1996. At September 30,
1997, the Bank's allowance for losses was equal to 0.27% of total loans and
11.23% of non-performing loans compared to 0.31% and 11.43%, respectively, at
December 31, 1996. The 1996 and 1997 increases in non-performing assets
resulted primarily from increased repurchases of delinquent residential
mortgage loans from secondary market investors. Although the Bank generally
does not sell loans with recourse, it typically is required to repurchase
loans, including delinquent and defaulted loans, which were not underwritten
strictly in compliance with the underwriting standards of secondary market
investors. As the volume of the Bank's new loan production has increased
substantially over the past several years (totalling $24.9 billion in mortgage
loan production from 1992 through 1996), the aggregate amount of loan
delinquencies and foreclosures has also increased, thereby increasing the
number of loans potentially subject to repurchase. In addition, during 1996 two
of the largest secondary market purchasers of loans implemented automated
underwriting review systems which enabled them to review delinquent loans on a
much faster basis, thereby accelerating the process of returning to the Bank
loans originated in prior periods.
It has been the Bank's experience that non-performing loans do not
necessarily result in an ultimate loss to the Bank. Approximately 92% of the
Bank's non-performing loans at September 30, 1997 were single-family
residential mortgage loans (88% at December 31, 1996), which generally
represent minimal risk of ultimate loss because of the nature of the underlying
collateral, private mortgage insurance for loans with over-80% loan-to-value
("LTV") ratios and insurance or guarantees on certain loans from the FHA and
VA. In addition, the Bank
OC-6
<PAGE>
may also have the right to sell the repurchased loan back to the broker or
correspondent which originated it, or to seek indemnity from the applicable
mortgage insurance company in the case of loans which are underwritten on a
contract basis for the Bank by such insurers.
The Bank anticipates that its level of loan repurchases and non-performing
assets may continue to be above historical levels through 1998 as a result of
the factors described above. However, although there can be no assurance, the
Bank believes that several actions it has taken during 1996 and 1997, including
a tightening of credit standards and the implementation of automated
underwriting systems (which the Bank believes, in most cases, significantly
reduce the ability of secondary market investors to require repurchases of
loans absent material misrepresentation), should result in a decline of the
level of loan repurchases over time. See "Management's Discussion and Analysis
of Changes in Financial Condition and Results of Operations--Comparison of
Financial Condition at September 30, 1997 and December 31, 1996--Allowance for
Losses" and "Business--Asset Quality."
MANAGEMENT
The Bank's senior management team consists of four individuals with extensive
experience in the financial services industry, particularly residential
mortgage loan origination. The Chairman, Chief Executive Officer and founder,
Thomas J. Hammond, has over 29 years of experience in various aspects of
residential lending and has been the Chief Executive Officer of the Bank since
its inception in 1987. Prior to organizing the Bank, Mr. Hammond organized,
owned and managed a series of financial services related companies, including
Hammond Mortgage Corporation, which was sold to Michigan National Bank in 1981.
The President, Mark T. Hammond, has worked in various positions at the Bank for
the past 10 years, including Senior Vice President of the Bank in charge of
secondary marketing and loan production and Executive Vice President
responsible for mortgage operations. Joan H. Anderson, who is Executive Vice
President in charge of mortgage loan servicing, collections and real estate
holdings, has 27 years of banking and mortgage-related experience and has
managed numerous aspects of the Bank's mortgage banking operations since
joining the Bank in 1987. Michael W. Carrie, who is Chief Financial Officer of
the Bank, has 13 years of experience in banking and mortgage lending, both with
the Bank and previously with Standard Federal Bank, F.S.B., a major regional
federal savings bank.
CONFLICTS OF INTEREST
The Hammond family members, who are the controlling stockholders of Flagstar
and thereby indirectly control the Bank, may have investment goals and
strategies that differ from those of the holders of the Series A Preferred
Shares and thus cause the controlling stockholders to direct the policies of
the Bank in a manner that is contrary to the best interests of the holders of
the Series A Preferred Shares. See "Risk Factors--The Hammond Family Members,
Who as Controlling Stockholders of Flagstar Can Thereby Control the Bank, May
Have Investment Goals and Strategies That Differ From Those of the Holders of
the Series A Preferred Shares."
THE OFFERING
Securities Offered.......... 2,000,000 Bank Preferred Shares.
Automatic Exchange.......... The Bank Preferred Shares are to be issued, if
ever, in connection with an exchange of the
Series A Preferred Shares of Flagstar Capital
Corporation, a wholly owned subsidiary of the
Bank (the "Automatic Exchange"). See "Automatic
Exchange."
Ranking..................... The Bank Preferred Shares rank senior to the
Bank's common stock, par value $0.01 per share
(the "Common Stock") and junior to all claims of
the Bank's creditors, including the claims of the
Bank's depositors. Additional shares of preferred
stock ranking senior to the Bank Preferred Shares
may not be issued without the approval of holders
of at least 2/3 of the Bank Preferred Shares.
OC-7
<PAGE>
Dividends................... Dividends on the Bank Preferred Shares are
payable at the rate of 8.5% per annum of the
initial liquidation preference (an amount equal
to $2.125 per annum per share), if, when, and as
declared by the Board of Directors of the Bank.
If declared, dividends are payable quarterly in
arrears on the last day of March, June, September
and December in each year, or, if such day is not
a business day, on the next business day.
Dividends on the Bank Preferred Shares are not
cumulative and, accordingly, if no dividend is
declared on the Bank Preferred Shares by the Bank
for a quarterly dividend period, holders of the
Bank Preferred Shares will have no right to
receive a dividend for that period, and the Bank
will have no obligation to pay a dividend for
that period, whether or not dividends are
declared and paid for any future period.
Upon the Automatic Exchange of Series A Preferred
Shares for Bank Preferred Shares, any accrued and
unpaid dividends for the most recent quarter of
the Series A Preferred Shares at the time of the
Automatic Exchange will be deemed to be accrued
and unpaid dividends on the Bank Preferred
Shares. See "Description of the Bank Preferred
Shares--Dividends." The Bank's ability to pay
cash dividends is subject to regulatory and other
restrictions described herein.
Liquidation Preference...... The liquidation preference for each Bank
Preferred Share is $25.00, plus an amount equal
to the accrued and unpaid dividends for the most
recent quarter, if any, thereon for the then-
current dividend period to the date fixed for
liquidation. See "Description of the Bank
Preferred Shares--Rights Upon Liquidation."
Redemption.................. The Bank may not redeem the Bank Preferred Shares
before March 1, 2003. After such date, the Bank
Preferred Shares may be redeemed for cash at the
option of the Bank, in whole or in part, at any
time and from time to time, at the redemption
price of $25.00 per share, plus the accrued and
unpaid dividends for the most recent quarter
thereon, to the date fixed for redemption, if
any, thereon. Redemption of the Bank Preferred
Shares will be subject to compliance with
applicable regulatory and other restrictions. See
"Description of the Bank Preferred Shares--
Redemption."
Voting Rights............... Holders of Bank Preferred Shares will not have
any voting rights, except as expressly provided
herein. On any matter on which holders of the
Bank Preferred Shares may vote, each Bank
Preferred Share will be entitled to one vote. See
"Description of the Bank Preferred Shares--Voting
Rights."
Use of Proceeds............. The Bank Preferred Shares will only be issued in
connection with an Automatic Exchange for the
Series A Preferred Shares. The proceeds from the
sale of the Series A Preferred Shares will be
used by Flagstar Capital Corporation to purchase
a portfolio of mortgage assets and to pay
expenses associated with the formation and
offering of the Series A Preferred Shares. The
conversion of Series A Preferred Shares into Bank
Preferred Shares will produce no proceeds to the
Bank. See "Use of Proceeds."
OC-8
<PAGE>
Absence of a Public There is currently no public market for the Bank
Market...................... Preferred Shares as such shares have not been
issued and such shares will not be listed on any
securities exchange or for quotation through
Nasdaq.
RISK FACTORS
See "Risk Factors" for a discussion of the risk factors relating to the Bank
and the Bank Preferred Shares.
OC-9
<PAGE>
SUMMARY SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
The following table presents summary selected consolidated financial and
other data as of and for the nine months ended September 30, 1997 and 1996 and
each of the five years in the period ended December 31, 1996. The information
set forth below should be read in conjunction with the Consolidated Financial
Statements and the Notes thereto and "Management's Discussion and Analysis of
Changes in Financial Condition and Results of Operations." The Consolidated
Statements of Financial Condition as of December 31, 1996 and 1995, and the
Consolidated Statements of Earnings for each of the three years in the period
ended December 31, 1996, are included elsewhere in this Prospectus. The
selected consolidated financial and other data as of September 30, 1997 and for
the nine months ended September 30, 1997 and 1996 are unaudited and are derived
from the Bank's internal consolidated financial statements which, in the
opinion of management, contain all adjustments (consisting only of normal
recurring adjustments) which are necessary for a fair presentation of the
results for such periods. The results of operations for the nine months ended
September 30, 1997 are not necessarily indicative of the results of operations
to be obtained for the entire year.
<TABLE>
<CAPTION>
AT OR FOR THE
NINE MONTHS
ENDED SEPTEMBER
30, AT OR FOR THE YEARS ENDED DECEMBER 31,
--------------- -------------------------------------------
1997 1996 1996 1995 1994 1993 1992
------- ------- ------- ------- ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
SUMMARY OF OPERATIONS:
Interest income......... $84,789 $57,679 $76,179 $71,304 $35,112 $29,760 $18,735
Interest expense........ 54,597 34,121 45,967 41,443 14,482 12,052 9,227
------- ------- ------- ------- ------- ------- -------
Net interest income..... 30,192 23,558 30,212 29,861 20,630 17,708 9,508
Provision for losses.... 3,730 1,140 2,604 238 290 644 380
------- ------- ------- ------- ------- ------- -------
Net interest income
after provision for
losses................. 26,462 22,418 27,608 29,623 20,340 17,064 9,128
Non-interest income
Loan administration
income................ 5,543 11,110 11,859 14,248 13,261 7,786 2,340
Net gain on loan
sales................. 9,269 4,536 4,511 2,872 (1,132) 7,015 6,900
Net gain on sales of
mortgage servicing
rights................ 25,472 20,917 35,129 13,356 28,489 13,385 3,021
Other income........... 3,158 5,085 6,803 4,626 2,065 5,468 6,162
------- ------- ------- ------- ------- ------- -------
Total.................. 43,442 41,648 58,302 35,102 42,683 33,654 18,423
------- ------- ------- ------- ------- ------- -------
Non-interest expense
Compensation and
benefits.............. 19,303 18,443 25,479 18,538 18,609 7,984 5,184
Other expense.......... 25,730 27,809(1) 33,060(1) 21,311 18,975 13,308 7,298
------- ------- ------- ------- ------- ------- -------
Total.................. 45,033 46,252 58,539 39,849 37,584 21,292 12,482
------- ------- ------- ------- ------- ------- -------
Earnings before federal
income taxes........... 24,871 17,814 27,371 24,876 25,439 29,426 15,069
Provision for federal
income taxes........... 9,043 6,387 10,258 9,348 9,302 10,405 5,275
------- ------- ------- ------- ------- ------- -------
Net earnings............ $15,828 $11,427(1) $17,113(1) $15,528 $16,137 $19,021 $ 9,794
======= ======= ======= ======= ======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
AT SEPTEMBER 30, AT DECEMBER 31,
---------------- ----------------------------------------------------
1997 1996 1995 1994 1993 1992
---------------- ---------- ---------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
SUMMARY OF FINANCIAL
CONDITION:
Total assets............ $2,033,199 $1,296,810 $1,044,851 $722,469 $467,629 $304,758
Loans receivable:
Mortgage loans
available for sale.... 1,363,822 840,767 620,455 205,480 389,073 218,266
Loans held for
investment............ 444,552 273,579 305,590 429,800 26,906 21,637
Less: Allowance for
losses................ (4,950) (3,500) (2,102) (1,871) (901) (550)
---------- ---------- ---------- -------- -------- --------
Total loans, net....... 1,803,424 1,110,846 923,943 633,409 415,078 239,353
Mortgage servicing
rights................. 51,713 30,064 27,957 18,179 17,563 11,108
Deposits................ 1,012,121 624,732 529,218 308,497 190,761 181,171
FHLB advances........... 718,878 389,801 191,156 200,750 55,000 --
Stockholder's equity.... 121,055 77,899 61,003 47,925 35,114 16,767
</TABLE>
OC-10
<PAGE>
<TABLE>
<CAPTION>
AT OR FOR THE
NINE MONTHS ENDED
SEPTEMBER 30, AT OR FOR THE YEARS ENDED DECEMBER 31,
---------------------- -------------------------------------------------------------
1997 1996 1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
PERFORMANCE RATIOS(2):
Return on average
assets................. 1.34% 1.38% 1.54% 1.64% 3.19% 4.39% 3.72%
Return on average
equity................. 21.53% 22.61% 24.82% 29.52% 35.79% 69.56% 84.78%
Interest rate spread.... 2.27% 2.13% 2.13% 2.36% 3.37% 3.39% 2.04%
Net interest margin..... 2.83% 3.21% 3.07% 3.46% 4.63% 4.55% 3.92%
Ratio of average
interest earning assets
to average interest
bearing liabilities.... 111% 123% 120% 123% 139% 137% 158%
Ratio of non-interest
expense to average
assets................. 3.80% 5.58%(3) 5.25%(3) 4.20% 7.43% 4.92% 4.71%
Efficiency ratio(4)..... 59.8% 69.5% 64.7% 59.3% 58.3% 41.5% 44.7%
Dividend payout ratio... -- 8.75% 5.84% 15.78% 19.83% 4.21% 7.66%
ASSET QUALITY DATA:
Net charge-offs to
average loans
outstanding(2)......... 0.22% 0.03% 0.13% 0.00% 0.08% 0.08% 0.09%
Non-performing assets to
total assets at end of
period................. 3.04% 3.37% 3.16% 1.25% 0.42% 0.60% 0.94%
Non-performing loans to
total loans at end of
period................. 2.44% 3.50% 2.75% 1.15% 0.27% 0.37% 0.85%
Allowance for losses to
total loans at end of
period................. 0.27% 0.33% 0.31% 0.23% 0.29% 0.22% 0.23%
Allowance for losses to
non-performing loans at
end of period.......... 11.23% 9.56% 11.43% 19.67% 107.59% 58.17% 26.84%
CAPITAL RATIOS:
Tangible Capital........ 5.73% 6.22% 5.58% 5.19% 5.54% 7.41% 5.35%
Core Capital............ 5.95% 6.75% 6.01% 5.84% 6.63% 7.41% 5.35%
Total Risk-based
Capital................ 11.25% 11.96% 10.91% 10.12% 12.08% 13.84% 13.40%
Average equity-to-
average assets......... 6.20% 6.09% 6.19% 5.54% 8.91% 6.32% 5.14%
MORTGAGE ORIGINATION AND
SERVICING DATA:
Mortgage loans
originated or
purchased.............. $5,287,711 $5,283,843 $6,791,665 $5,195,605 $3,720,173 $6,220,415 $2,984,076
Mortgage loans sold..... $4,518,451 $5,285,538 $6,581,897 $4,760,806 $3,551,319 $6,034,828 $2,888,564
Mortgage loans serviced
for others(5).......... $4,143,352 $6,946,080 $4,801,581 $6,788,530 $5,691,421 $6,198,311 $3,091,399
Capitalized value of
mortgage servicing
rights(6).............. 1.25% 0.60% 0.63% 0.41% 0.32% 0.28% 0.36%
OTHER DATA:
Full-time equivalent
employees.............. 1,110 1,179 1,310 1,142 869 971 584
Number of branches...... 19 15 15 13 9 1 1
Number of
wholesale/correspondent
lending centers........ 10 10 10 9 6 5 4
</TABLE>
- --------
(1) Includes the special deposit insurance assessment imposed on SAIF-insured
institutions during September 1996. The Bank's assessment was $3.4 million,
before taxes. If such assessment had not been imposed, the Bank's net
earnings would have been approximately $13.6 million for the nine months
ended September 30, 1996 and its return on average assets and return on
average equity for the period would have been 1.64% and 26.90%,
respectively. If such assessment had not been imposed, the Bank's net
earnings would have been approximately $19.3 million for the year ended
December 31, 1996 and its return on average assets and return on average
equity for the period would have been 1.73% and 27.97%, respectively.
(2) Ratios are annualized where applicable.
(3) Excluding the special SAIF assessment of $3.4 million, before taxes,
incurred during 1996, mentioned in footnote 1 above, such ratio would have
been 5.17% for the nine months ended September 30, 1996 and 4.94% for the
year ended December 31, 1996.
(4) Computed as non-interest expense (excluding amortization of core deposit
premiums) divided by the sum of net interest income and non-interest
income. Excluding the special SAIF assessment of $3.4 million, before
taxes, incurred during 1996, mentioned in footnote 1 above, such ratio
would have been 64.3% for the nine months ended September 30, 1996 and
60.8% for the year ended December 31, 1996.
(5) Amount excludes loans being subserviced for others, which is servicing of
loans subsequent to the sale of the related mortgage servicing rights but
prior to their delivery, of $2.0 billion, $2.1 billion, $3.6 billion and
$536.3 million at September 30, 1997 and 1996 and December 31, 1996 and
1995, respectively. There was no subservicing in prior years.
(6) Reflects percentage of book value of mortgage servicing rights to loans
serviced for others (excluding subservicing).
OC-11
<PAGE>
RECENT DEVELOPMENTS
The following table presents selected financial data for the periods
indicated. The selected consolidated financial and other data as of and for the
three months ended December 31, 1997 and 1996 and the year ended December 31,
1997 are unaudited and are derived from the Bank's internal consolidated
financial statements which, in the opinion of management, contain all
adjustments which are necessary for a fair presentation of the results for such
periods. The information set forth below should be read in conjunction with the
Consolidated Financial Statements and the Notes thereto and "Management's
Discussion and Analysis of Changes in Financial Condition and Results of
Operations" included elsewhere herein.
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED AT OR FOR THE YEAR ENDED
DECEMBER 31, DECEMBER 31,
1997 1996 1997 1996(4)
------------- ------------- ------------ -------------
<S> <C> <C> <C> <C>
(in thousands, except per share amount)
SUMMARY OF OPERATIONS:
Interest income......... $ 37,963 $ 18,500 $ 122,752 $ 76,179
Interest expense........ 25,436 11,846 80,033 45,967
------------- ------------- ------------ ------------
Net interest income..... 12,527 6,654 42,719 30,212
Provision for losses.... 1,285 1,464 5,015 2,604
Non-interest income..... 16,089 16,654 59,531 58,302
Non-interest expense.... 17,201 12,287 62,234 58,539
------------- ------------- ------------ ------------
Earnings before federal
tax provision.......... 10,130 9,557 35,001 27,371
Provision for federal
income taxes........... 4,175 3,871 13,218 10,258
------------- ------------- ------------ ------------
Net earnings............ $ 5,955 $ 5,686 $ 21,783 $ 17,113
============= ============= ============ ============
SUMMARY OF FINANCIAL
CONDITION:
Total assets............ $ 1,901,034 $ 1,296,810
Loans receivable........ 1,655,259 1,110,846
Mortgage servicing
rights................. 83,845 30,064
Deposits................ 1,110,165 624,732
FHLB advances........... 482,378 389,801
Stockholders' equity.... 126,410 77,899
PERFORMANCE RATIOS:(1)
Return on average
assets................. 1.17% 2.02% 1.29% 1.54%
Return on average
equity................. 18.74% 30.84% 20.69% 24.82%
Interest rate spread.... 1.69% 2.05% 2.10% 2.13%
Net interest margin..... 2.55% 2.65% 2.74% 3.07%
Efficiency ratio........ 57.1% 52.7% 59.7% 64.7%
ASSET QUALITY DATA:
Net charge-offs to
average loans
outstanding............ 0.15% 0.39% 0.20% 0.13%
Non-performing assets to
total assets........... 3.29% 3.16%
Non-performing loans to
total loans............ 2.67% 2.75%
Allowance for losses to
total loans............ 0.33% 0.31%
Allowance for losses to
non-performing loans... 12.41% 11.43%
BANK REGULATORY CAPITAL
RATIOS:
Tangible capital........ 5.40% 5.58%
Core capital............ 5.62% 6.01%
Total risk-based
capital................ 11.74% 10.91%
MORTGAGE ORIGINATION AND
SERVICING DATA:
Mortgage loans
originated or
purchased.............. $ 2,585,388 $ 1,507,822 $ 7,873,099 $ 6,791,665
Mortgage loans sold..... $ 2,703,943 $ 1,296,359 $ 7,222,394 $ 6,581,897
Mortgage loans serviced
for others (2)......... N/A N/A $ 6,412,797 $ 4,801,581
Value of mortgage
servicing rights (3)... N/A N/A 1.31% 0.63%
</TABLE>
- --------
(1) Ratios are annualized where appropriate.
(2) Amount excludes subservicing of $3.6 billion at December 31, 1996.
(3) Reflects percentage of book value of mortgage servicing rights to loans
serviced for others (excluding subservicing).
(4) The 1996 earnings reflect the one time SAIF assessment of $3.4 million
($2.2 million after tax) paid in September 1996. Without this assessment,
earnings would have been $19.3 million and return on average equity, return
on average assets and the efficiency ratio would be 27.97%, 1.73%, and
60.8%, respectively.
OC-12
<PAGE>
COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED DECEMBER 31,
1997 AND 1996.
The Bank's net earnings for the three months ended December 31, 1997 were
$6.0 million, an increase of approximately $300,000 or 5.3%, from net earnings
of $5.7 million for the three months ended December 31, 1996. This increase in
net earnings was due to increases in net interest income, offset by an increase
in non-interest expense. The Bank's net interest income increased $5.8 million,
or 86.6%, to $12.5 million for the three months ended December 31, 1997, from
$6.7 million reported for the three months ended December 31, 1996, caused by a
substantial growth in average earning assets. Non-interest expense increased
$4.9 million, or 39.8%, to $17.2 million for the three months ended December
31, 1997, from $12.3 million reported for the three months ended December 31,
1996. This increase was the result of an increase in compensation and benefits
of $1.4 million and an increase in other expenses of $3.5 million. The
increased employee count associated with the bank branch expansion and normal
recurring salary adjustments account for the increased compensation costs while
the increase in other expenses is a direct result of the increased costs
associated with the foreclosed real estate portfolio.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1997 AND
1996.
The Bank's net earnings for the year ended December 31, 1997 were $21.8
million, an increase of $4.7 million, or 27.5% from net earnings of $17.1
million for the year ended December 31, 1996. Excluding the one-time SAIF
assessment paid by the Bank in 1996, net earnings for 1996 would have been
$19.3 million.
The increase in net earnings for 1997 was due to increases in net interest
income and non-interest income, offset by increases in non-interest expense,
the provision for losses, and the provision for federal income taxes. The
Bank's net interest income increased $12.5 million, or 41.4%, to $42.7 million
for the year ended December 31, 1997, from $30.2 million for the year ended
December 31, 1996, caused by substantial growth in the amount of average
earning assets offset in part by a decrease in the net interest margin (from
3.07% to 2.74%). Non-interest income increased $1.2 million, or 2.1%, to $59.5
million for the year ended December 31, 1997, from $58.3 million in 1996. The
majority of this increase resulted from increased gains reported on loan sales
offset by decreases in gains from mortgage servicing rights sold, loan
administration income, and loan fee income. Non-interest expense increased $3.7
million, or 6.3% to $62.2 million for 1997, from $58.5 million in 1996. This
increase was the result of a 16.2% increase in mortgage loan production in
1997, an increase in bank branch locations opened in 1997 and increased costs
associated with the foreclosed real estate portfolio.
The Bank's provision for losses also increased by $2.4 million, or 92.3%, to
$5.0 million for 1997 from $2.6 million for 1996. The increase in the provision
increased the Bank's allowance for losses to $5.5 million at December 31, 1997
(or 12.41% of non-performing loans) compared to $3.5 million at December 31,
1996 (or 11.43% of non-performing loans). The increased provision reflects a
higher level of non-performing loans compared to December 31, 1996 ($44.3
million versus $30.6 million) and a higher level of charge-offs in 1997 versus
1996 ($3.0 million versus $1.2 million). See "Management's Discussion and
Analysis of Changes in Financial Condition and Results of Operations--Financial
Condition--Allowance for Losses." The Bank had net charge-offs to average loans
outstanding of 0.20% in 1997 compared to 0.13% during 1996.
OC-13
<PAGE>
RISK FACTORS
An investment in the Bank Preferred Shares involves a high degree of risk.
In addition to the other information in this Offering Circular, investors
should carefully consider the following factors before investing in the Bank
Preferred Shares offered hereby.
The discussion in this Offering Circular contains certain forward-looking
statements that involve risks and uncertainties, such as statements of the
Bank's plans, objectives, expectations, and intentions. The cautionary
statements made in this Offering Circular, including the risk factors
discussed below, should be read as being applicable to all related forward-
looking statements wherever they appear in the Offering Circular. The Bank's
actual results could differ materially from those discussed here. Factors that
could cause or contribute to such differences include those discussed below,
as well as those discussed elsewhere herein or in the documents attached
hereto or incorporated by reference herein.
BANK'S UNCERTAIN FINANCIAL CONDITION AT TIME OF THE AUTOMATIC EXCHANGE
The Bank Preferred Shares will be issued in the Automatic Exchange for the
Series A Preferred Shares only if (i) the Bank becomes "undercapitalized"
under prompt corrective action regulations, (ii) the Bank is placed into
conservatorship or receivership or (iii) the appropriate federal regulatory
agency, in its sole discretion, anticipates the Bank becoming
"undercapitalized" in the near term. As a result, holders of Series A
Preferred Shares would become stockholders of the Bank at a time when the
Bank's financial condition was deteriorating or when the Bank had been placed
into conservatorship or receivership. In the event of receivership of the
Bank, the claims of depositors and secured, senior, general and subordinated
creditors of the Bank would be entitled to a priority of payment over the
claims of holders of equity interests such as the Bank Preferred Shares. As a
result of such subordination, either if the Bank were to be placed into
receivership after the Automatic Exchange or if the Automatic Exchange were to
occur after receivership of the Bank, the holders of the Bank Preferred Shares
likely would receive, if anything, substantially less than the holders of the
Series A Preferred Shares would have received had the Series A Preferred
Shares not been exchanged for Bank Preferred Shares.
BANK PREFERRED SHARES WILL NOT BE LISTED ON NASDAQ
Although the Series A Preferred Shares will be listed on Nasdaq, the Bank
does not intend to apply for listing of the Bank Preferred Shares, for which
the Series A Preferred Shares will be exchanged automatically on a one-for-one
basis upon the occurrence of an Automatic Exchange Event on any national
securities exchange or Nasdaq. Consequently, there can be no assurance as to
the liquidity of the trading markets for the Bank Preferred Shares, if issued,
or that an active public market for the Bank Preferred Shares would develop or
be maintained.
DIVIDEND AND OTHER REGULATORY RESTRICTIONS ON OPERATIONS OF THE BANK
Federal regulatory authorities regularly examine the Bank and its
activities. Under certain circumstances, including any determination that the
Bank's activities constitute an unsafe and unsound banking practice, such
regulatory authorities will have the authority to restrict the ability of the
Bank to transfer assets, to make distributions to its stockholders (including
dividends to the holders of Bank Preferred Shares, as described below), or to
redeem shares of preferred stock. Furthermore, in the event the Bank is placed
into conservatorship or receivership, the Bank would be unable to pay
dividends on the Bank Preferred Shares. In addition, in the event of a
liquidation of the Bank, the claims of the Bank's depositors and of its
secured, senior, general and subordinated creditors would be entitled to a
priority of payment over the dividend and other claims of holders of equity
interests such as the Bank Preferred Shares issued pursuant to the Automatic
Exchange.
Payment of dividends on the Bank Preferred Shares could also be subject to
regulatory limitations if the Bank became "undercapitalized" for purposes of
the OTS prompt corrective action regulations, which is currently defined as
having a core capital (or leverage) ratio of less than 4.0%, a Tier 1 risk-
based capital ratio of less than 4.0% and a total risk-based capital ratio of
less than 8.0%. At September 30, 1997, the Bank was in
OC-14
<PAGE>
compliance with all of its regulatory capital requirements. As of that date,
the Bank's core capital (or leverage) ratio was 5.95%, its Tier 1 risk-based
capital ratio was 10.88% and its total risk-based capital ratio was 11.25%.
Such ratios, adjusted to give effect to the sale of Series A Preferred Shares
in the offering, would be 7.61%, 13.94% and 14.29%, respectively.
Under OTS regulations, the ability of thrift institutions such as the Bank
to make "capital distributions" (defined to include payment of dividends,
stock repurchases, cash-out mergers and other distributions charged against
the capital accounts of an institution) varies depending primarily on the
institution's earnings and regulatory capital levels. The OTS retains general
discretion to prohibit any otherwise permitted capital distribution on general
safety and soundness grounds and must be given 30 days advance notice of all
capital distributions. Dividends on the Bank Preferred Shares in excess of the
Bank's net income would be treated as "capital distributions" by the OTS, in
which case the Bank's payment of such dividends would be subject to
restrictions under the OTS capital distribution regulations. Under these
regulations, institutions are divided into tiers. Tier 1 institutions are
those in compliance with their "fully phased-in" capital requirements and
which have not been notified by the OTS that they are "in need of more than
normal supervision." Tier 1 institutions may make capital distributions
without regulatory approval of up to the greater of (i) 100% of net income for
the calendar year to date, plus up to one-half of the institution's surplus
capital (i.e., the excess of capital over the fully phased-in requirement) at
the beginning of the calendar year in which the distribution is made or (ii)
75% of net income for the most recent four quarters. Tier 1 institutions that
make capital distributions under the foregoing rules must continue to meet the
applicable capital requirements on a pro forma basis after giving effect to
such distributions. Tier 1 institutions may seek OTS approval to pay dividends
beyond these amounts.
The category of Tier 2 institutions, which are defined as institutions that
are in compliance with their current, but not their "fully phased-in" capital
requirements, is no longer relevant because all deductions from capital
requirements have been fully phased-in as of July 1, 1996.
Tier 3 institutions have capital levels below their current required minimum
levels and may not make any capital distributions without the prior written
approval of the OTS.
As of September 30, 1997, the Bank had sufficient levels of capital to be a
Tier 1 institution. However, the OTS retains discretion under its capital
distribution regulations to treat an institution that it believes is in need
of more than normal supervision (after written notice) as a Tier 3
institution. Moreover, deteriorating collateral values or general economic
conditions could result in recognition of losses on the Bank's loan and REO
portfolios and a consequent reduction in capital.
THE HAMMOND FAMILY MEMBERS, WHO AS CONTROLLING STOCKHOLDERS OF FLAGSTAR CAN
THEREBY CONTROL THE BANK, MAY HAVE INVESTMENT GOALS AND STRATEGIES THAT DIFFER
FROM THOSE OF THE HOLDERS OF THE SERIES A PREFERRED SHARES.
The Bank will be subject to the ultimate control of the Bank's sole
stockholder, Flagstar, and to the ownership of a controlling interest in
Flagstar by Thomas J. Hammond, Chairman and Chief Executive Officer, and Mark
T. Hammond, Vice Chairman and President, of Flagstar and the Bank. Messrs. T.
Hammond and M. Hammond, together with their respective spouses and immediate
family members, own approximately 60 percent of the outstanding stock of
Flagstar and are, thus, able to influence directly or to control all aspects
of the affairs of Flagstar and, thus, the Bank. To the extent Hammond family
members have investment goals or strategies that differ from those of the
holders of the Series A Preferred Shares, the Hammond family would be able to
direct the policies of the Bank in a manner that could be contrary to the best
interests of the holders of the Series A Preferred Shares.
DIVIDENDS NOT CUMULATIVE
Dividends on the Bank Preferred Shares are not cumulative. Consequently, if
the Board of Directors does not declare a dividend on the Bank Preferred
Shares for any quarterly period, the holders of the Bank Preferred Shares
would not be entitled to recover such dividend whether or not funds are or
subsequently become available. The Board of Directors may determine, in its
business judgment, that it would be in the best interests of the Bank to pay
less than the full amount of the stated dividends on the Bank Preferred Shares
or no dividends for
OC-15
<PAGE>
any quarter notwithstanding that funds are available. Factors that would be
considered by the Board of Directors in making this determination are the
Bank's financial condition and capital needs, the impact of legislation and
regulations as then in effect or as may be proposed, economic conditions, and
such other factors as the Board may deem relevant.
The Bank Preferred Shares will be issued upon an Automatic Exchange of the
Series A Preferred Shares. Each Series A Preferred Share will be exchanged
automatically for one Bank Preferred Share if the appropriate regulatory
agency directs in writing an Automatic Exchange of the Series A Preferred
Shares for Bank Preferred Shares because (i) the Bank becomes
"undercapitalized" under prompt corrective action regulations established
pursuant to FDICIA, (ii) the Bank is placed into conservatorship or
receivership or (iii) the appropriate regulatory agency, in its sole
discretion, anticipates the Bank's becoming "undercapitalized" in the near
term. The OTS' prompt corrective action regulations prohibit "capital
distributions" (including dividends) unless an institution is at least
"adequately capitalized." Thus, at the time of the Automatic Exchange, by
regulation, the Bank may not be permitted to pay dividends on the Bank
Preferred Shares. In addition, the Bank's ability to pay dividends on the Bank
Preferred Shares even if the Bank were "adequately capitalized" following the
Automatic Exchange would be subject to various restrictions under OTS
regulations.
EARNINGS AND ASSET VALUE DECLINES FROM INTEREST RATE FLUCTUATIONS
Changes in interest rates can have a variety of effects on the Bank's
business. In particular, changes in interest rates may impact the volume of
mortgage loan originations, the interest spread on mortgage loans held for
sale, the amount of gain or loss on the sale of mortgage loans and mortgage
servicing rights and the market value of the Bank's mortgage servicing
portfolio.
During periods of declining interest rates, such as occurred during 1993,
the Bank typically experiences an increase in mortgage loan originations,
particularly those due to the refinancing of existing mortgages. In addition,
during a declining interest rate environment, the Bank may experience an
increase in prepayments on its residential mortgage loans. As the Bank
replaces these prepaid mortgage loans with newly originated loans, the new
origination interest rates may be lower than the original mortgage interest
rate. Since the dividend rate on the Bank Preferred Stock is fixed, there can
be no assurance that new origination mortgage loans in a declining interest
rate environment will provide enough income to pay dividends. On the other
hand, an increase in, or stabilization of, interest rates for an extended
period of time would adversely affect refinancing demand which could also have
an adverse effect on the Bank's loan origination volume.
The Bank's net interest income or loss is the difference between the
interest income it earns on the loans it originates or purchases as well as on
other interest-earning assets and the interest expense it pays on its
interest-bearing liabilities to fund such interest-earning assets. The Bank
principally funds its interest-earning assets from deposits and borrowings
from the Federal Home Loan Bank of Indianapolis. The profitability of the
Bank's mortgage loan originations is in part a function of the spread between
long-term interest rates (the rates on the loans the Bank holds, whether for
investment or for sale in the secondary market) and short-term interest rates
(the rates at which the Bank funds such mortgage loans). Since 1994, the
Bank's interest rate spread has declined from 3.37% for the year ended
December 31, 1994 to 2.27% for the nine months ended September 30, 1997 in
large part because of the decrease in the prevailing spread between long-term
and short-term interest rates. There can be no assurance that future changes
in interest rates will not further decrease this spread, which may adversely
affect the Bank's level of net interest income.
In its retail banking operations, the Bank is subject to interest rate risk
on loans held in its portfolio arising from mismatches (i.e., the interest
sensitivity gap) between the dollar amount of repricing or maturing assets and
liabilities, which is measured in terms of the ratio of the interest rate
sensitivity gap to total assets. More assets repricing or maturing than
liabilities over a given time frame is considered asset-sensitive and is
reflected as a positive gap, and more liabilities repricing or maturing than
assets over a given time frame is considered liability-sensitive and is
reflected as a negative gap. An asset-sensitive position (i.e., a positive
gap) will generally enhance earnings in a rising interest rate environment and
will negatively impact earnings in a falling interest rate environment. A
liability-sensitive position (i.e., a negative gap) will generally enhance
earnings in a falling interest
OC-16
<PAGE>
rate environment and negatively impact earnings in a rising interest rate
environment. Fluctuations in interest rates are not predictable or
controllable. Although the Bank has attempted to structure its asset and
liability management strategies to mitigate the impact on net interest income
of changes in market interest rates, there can be no assurance that a sudden
or significant change in prevailing interest rates will not have a material
adverse effect on the Bank's operating results. See "Management's Discussion
and Analysis of Changes in Financial Condition and Results of Operations--
Asset/Liability Management--Interest Rate Sensitivity Analysis."
In its mortgage banking operations, the Bank is exposed to interest rate
risk from the time the interest rate on a mortgage loan application is
committed to by the Bank through the time the Bank sells or commits to sell
the mortgage loan. On a daily basis, the Bank analyzes various economic and
market factors and, based upon these analyses, projects the amount of mortgage
loans it expects to sell for delivery at a future date. The actual amount of
loans sold will be a percentage of the number of mortgage loans on which the
Bank has issued binding commitments (and thereby locked in the interest rate)
but has not yet closed ("pipeline loans") to actual closings. If interest
rates change in an unanticipated fashion, the actual percentage of pipeline
loans that close may differ from the projected percentage. The resultant
mismatching of commitments to fund mortgage loans and commitments to sell
mortgage loans may have an adverse effect on the results of operations in any
such period. For instance, a sudden increase in interest rates can cause a
higher percentage of pipeline loans to close than projected. To the degree
that this is not anticipated, the Bank will not have made commitments to sell
these additional pipeline loans and may incur significant losses upon their
sale as the market rate of interest will be higher than the mortgage interest
rate committed to by the Bank on such additional pipeline loans. To the extent
that the hedging strategy utilized by the Bank is not successful, the Bank's
profitability may be adversely affected. See "Business--Secondary Marketing."
The market value of, and earnings from, the Bank's mortgage loan servicing
portfolio may be adversely affected by declines in interest rates. If mortgage
interest rates decline and mortgage loan prepayments therefore increase due to
refinancing activity, the income stream from the Bank's current mortgage loan
servicing portfolio may decline. In that case, the Bank may be required to
amortize the portfolio more quickly or reduce the carrying value of its
mortgage loan servicing portfolio, which would adversely affect the Bank's
operating results and financial condition. See "Business--Mortgage Loan
Servicing."
POTENTIAL LOSS OF ACCESS TO AND INCREASED COST OF FUNDING SOURCES
The Bank's principal sources of funding for its operations have been
deposits placed with the Bank and, to a lesser extent, borrowings from the
FHLB and funds held in escrow for mortgage loan servicing purposes.
Historically, the Bank's cost of funds associated with deposits has generally
been lower than its cost to borrow from the FHLB. To the extent the Bank is
unable to fund its asset growth through the maintenance and growth of its
deposit base, it may have to rely to a greater extent on borrowings from the
FHLB or other sources. If the cost of non-deposit funds is higher than the
cost of deposits placed with the Bank, the Bank's net interest income and
profitability would be adversely affected. At September 30, 1997, the Bank had
an $850.0 million line of credit with the FHLB, of which $718.9 million had
been drawn and was outstanding.
There can be no assurance that the Bank will be successful in retaining
access to funds at the level or cost necessary to continue originations of
single-family mortgage loans at their current volume and level of
profitability. To the extent that the Bank is not successful in maintaining
the availability of its current funding sources, by retaining existing
deposits and attracting new deposits and by maintaining its line of credit
with the FHLB, it may have to curtail its origination of single-family
mortgage loans. A reduction in the Bank's origination of single-family
mortgage loans could have a material effect on the Bank's gain on mortgage
loan sales and sales of mortgage servicing rights. See "Management's
Discussion and Analysis of Changes in Financial Condition and Results of
Operations--Liquidity and Capital Resources" and "Business--Funding Sources."
POSSIBLE LOSS OF ACCESS TO SECONDARY MORTGAGE MARKET
The ability of the Bank to continue the mortgage banking segment of its
operations, which generated a significant portion of the Bank's pre-tax
earnings for the year ended December 31, 1996 and the nine months ended
September 30, 1997, and has historically generated substantially all of the
Bank's earnings, is dependent upon the Bank's continued access to an active
secondary market in which to sell its single-family mortgage loans.
OC-17
<PAGE>
The Bank currently sells substantially all of the mortgage loans that it
originates through its mortgage banking operations. The Bank's ability to
readily sell mortgage loans is dependent upon the availability of an active
secondary market for single-family mortgage loans, which in turn depends in
part upon the continuation of programs currently offered by Fannie Mae,
Freddie Mac and other institutional and non-institutional investors. These
entities account for a substantial portion of the secondary market in
residential mortgage loans. Some of the largest participants in the secondary
market, including Freddie Mac and Fannie Mae, are government-sponsored
enterprises whose activities are governed by federal law. Any future changes
in those laws could limit the activity of such government sponsored
enterprises or change the terms on which they acquire loans, which in turn
could adversely affect the Bank's operations. The Bank expects that it will
continue to remain eligible to participate in such programs but any
significant impairment of such eligibility could materially and adversely
affect its operations. Further, the criteria for loans to be accepted under
such programs may be changed from time to time by the sponsoring entity. The
profitability of participating in specific programs may vary depending on a
number of factors, including the administrative costs to the Bank of
originating and purchasing qualifying loans.
There can be no assurance that the Bank will continue to have ready access
to an active secondary market for the sale of its single-family mortgage loans
or that it can continue to originate the types of loans for which such a
market exists. Any significant change in the secondary market level of
activity or underwriting criteria of Fannie Mae, Freddie Mac or other
institutional or non-institutional investors could have a material adverse
effect on the Bank's results of operations.
POTENTIAL LOSS FROM LOAN DELINQUENCIES AND DEFAULTS ON LOANS
From the time that the Bank funds the mortgage loans it originates to the
time it sells such loans, generally 10 to 40 days, the Bank is at risk for any
loan defaults. Once the Bank sells the mortgage loans it originates, the risk
of loss from loan defaults and foreclosure generally passes to the purchaser
or insurer of the loans. In connection with the sale, the Bank typically makes
certain representations and warranties to the purchasers and insurers of such
loans. Such representations and warranties generally relate to the origination
and servicing of loans in substantial conformance with the laws of the state
of origination and applicable investor guidelines and program eligibility
standards. The Bank relies upon its underwriting department to ascertain
compliance with individual investor standards prior to sale of the loans in
the secondary market, and it relies upon its quality control department to
test sold loans on a sample basis for compliance. See "Business--Underwriting"
and "--Quality Control." The purchasers of such loans will typically conduct a
more detailed review of such loans following acquisition to determine whether
such loans were originated in compliance with the purchaser's underwriting
guidelines and program eligibility standards.
If a loan defaults and there has been a breach of the Bank's representations
and warranties, the Bank becomes liable for the unpaid principal and interest
on the defaulted mortgage loan and may be required to repurchase the loan.
During 1996, the Bank sold approximately $6.6 billion in single family
mortgage loans in the secondary market, of which approximately $10.4 million
(0.16% of loans sold) were repurchased during 1996. Total repurchases of
single family mortgage loans by the Bank during 1996 of $54.8 million also
included $32.7 million related to loans sold in 1995 (0.69% of such loans) and
$11.7 million related to loans sold prior to 1995. Of the $54.8 million of
mortgage loans repurchased during 1996, $15.0 million were non-performing at
the time of repurchase, $10.1 million were non-performing at December 31, 1996
and $3.7 million had been foreclosed and were held as other repossessed assets
at such date. These amounts represented significant increases over 1995, when
the Bank repurchased an aggregate of $4.5 million of single family residential
mortgage loans. This increase in loan repurchases resulted primarily from the
Bank's increased volume of loan production in 1996 and also the accelerated
review by certain secondary market investors of delinquent and other loans,
which in turn accelerated the process of returning to the Bank loans
originated in prior periods that did not comply with the underwriting
standards of such investors. See "Business--Asset Quality." Primarily as a
result of these increases in repurchases of non-performing loans from
secondary market investors, the Bank's level of non-performing assets
increased from 1.25% of total assets at December 31, 1995 to 3.16% at December
31, 1996. Although the Bank increased its provision for losses from $238,000
in 1995 to $2.6 million in 1996, its ratio of allowance for losses to non-
performing loans declined from 107.59% at December 31, 1994 to 19.67% at
December 31, 1995, 11.43% at December 31, 1996 and 11.23% at September 30,
1997.
OC-18
<PAGE>
The increase in non-performing loans at September 30, 1997 from the amount
at December 31, 1996 resulted primarily from the repurchase of $52.3 million
in mortgage loans from secondary market investors during the first nine months
of 1997. Approximately $14.7 million of the loans repurchased in 1997 were
non-performing, $2.0 million were delinquent, and $5.8 million were
immediately classified to a real estate owned status when repurchased. Loan
repurchases are an ongoing part of the Bank's operations since all loans sold
in the secondary market are generally subject to detailed underwriting reviews
by the ultimate purchaser. Although the Bank generally does not sell loans
with recourse, it typically is required to repurchase loans, including
defaulted and delinquent loans, that were not underwritten in strict
compliance with the underwriting standards of secondary market investors. As
the volume of the Bank's loan production has increased substantially over the
past several years, the aggregate amount of loan delinquencies and
foreclosures has also increased, thereby increasing the number of loans
potentially subject to repurchase.
The Bank believes that its risk of loss arising from its non-performing
loans, including loans acquired through repurchase from individual investors
after initial sale in the secondary market, has not materially increased as a
result of either the increase in repurchased loans or the overall increase in
non-performing loans. During 1997, 57.2% of the loans repurchased were
performing loans but were required to be repurchased for reasons (such as
failure to meet all of the secondary market investor's criteria for mortgagor
eligibility or failure to meet the investor's program eligibility
requirements) that the Bank believes do not significantly affect the ultimate
collectibility of such loans or significantly increase the Bank's exposure to
losses. A portion of the repurchased loans are eligible for resale in the
secondary market to other investors, and the Bank does not believe that the
remaining repurchased loans that are currently non-performing or that have
been foreclosed, present any risks of ultimate loss that are significantly
different than the Bank has historically experienced. Of the Bank's $44.1
million of non-performing loans at September 30, 1997, $40.5 million, or
91.8%, were single family residential mortgage loans, which generally
represent minimal risk of ultimate loss because of the nature of the
collateral securing the loans, the presence of private mortgage insurance for
loans with over-80% LTV ratios, or the presence of insurance or guarantees on
certain loans from the FHA or VA. At September 30, 1997, $19.5 million of such
loans were the subject of bankruptcy proceedings by the mortgagor; however, it
has been the Bank's experience that such proceedings usually result in full
repayment to the Bank and present minimal risk of loss because the imposition
of judicial scrutiny and related enforcement powers supersede the less
comprehensive collection methods normally available to the Bank.
For the reasons discussed under "Management's Discussion and Analysis of
Changes in Financial Condition and Results of Operations," the Bank expects
that the level of its loan repurchases may continue to be above historical
levels for the remainder of 1997 and during 1998. The Bank has historically
incurred minimal losses from charge-offs in connection with its residential
mortgage loan production and does not expect that these increases in loan
repurchases and non-performing assets will result in materially increased
levels of losses in the future (see "Management's Discussion and Analysis of
Changes in Financial Condition and Results of Operations--Financial
Condition--Allowance for Losses"); however, there can be no assurance that
this will continue to be the case.
The Bank is also affected by loan delinquencies and defaults on mortgage
loans that it services. At September 30, 1997, approximately 3.41% of the
loans being serviced by the Bank were delinquent (including foreclosures).
Under certain types of servicing contracts, the servicer must advance all or
part of the scheduled payments to the owner of the loan, even when loan
payments are delinquent. Also, to protect their liens on mortgaged properties,
owners of loans usually require the servicer to advance mortgage and hazard
insurance and tax payments on schedule even if sufficient escrow funds are not
available. The servicer will be reimbursed by the mortgage owner or from
liquidation proceeds for payments advanced that the servicer is unable to
recover from the mortgagor, although the timing of such reimbursement is
typically uncertain. In the interim, the servicer must absorb the cost of
funds advanced. Further, the servicer must bear the costs of attempting to
collect on delinquent and defaulted loans. The Bank also foregoes servicing
income from the time a loan becomes delinquent until foreclosure, at which
time such amounts, if any, may be recovered.
OC-19
<PAGE>
GEOGRAPHIC CONCENTRATIONS IN LOANS HELD FOR INVESTMENT AND SERVICING PORTFOLIO
Historically, the Bank's single-family mortgage loan portfolio held for
investment has been concentrated in certain geographic regions, particularly
Michigan, based upon the location of the property collateralizing the mortgage
loan. Because borrowers of single-family mortgage loans usually reside on the
collateral property, changes in economic and business conditions in the area
in which the property is located can affect the borrower and thus have an
effect on the performance of the loan. As of September 30, 1997, approximately
28.6% of the Bank's single-family mortgage loans held for investment and of
the mortgage loans serviced by the Bank (as measured by unpaid principal
balance) were collateralized by property located in Michigan. As a result,
unfavorable or worsened economic conditions in Michigan could have a material
adverse effect on the Bank's financial condition and results of operations.
Although the Bank continues to diversify its loan portfolio geographically to
minimize this risk, there can be no assurance that the Bank will be successful
in this effort. See "Business--Lending."
In addition to risks associated with a geographic concentration of its loan
portfolio, the Bank's results of operations can be affected by the Bank's
concentration of credit to particular borrowers. The Bank currently provides
warehouse lines of credit ranging up to $11.0 million to certain mortgage
companies. At September 30, 1997, the Bank had issued a total of $121.5
million in such lines of credit, under which $53.3 million in borrowings were
outstanding. Repayment of such loans is dependent upon the retention of value
of the collateral securing the loan and therefore could be subject to a
greater extent to adverse conditions in the economy. The Bank seeks to
minimize these risks by granting warehouse lines of credit generally to
borrowers with which the Bank has had substantial favorable business
experience, by monitoring each credit drawdown for prompt repayment and by
requiring collateral with a value in excess of the amount of the outstanding
borrowings. At September 30, 1997, none of these loans were non-performing or
classified. See "Business--Lending--Mortgage Banking Operations."
SEASONAL NATURE OF MORTGAGE BANKING BUSINESS
The mortgage banking industry is generally subject to seasonal trends. These
trends reflect the general national pattern of sales and resales of homes,
although refinancings tend to be less seasonal and more closely related to
changes in interest rates. Sales and resales of homes typically peak during
the spring and summer seasons and decline to lower levels from mid-November
through February. In addition, delinquency rates typically rise in the winter
months, which results in higher servicing costs.
EXPANSION OF RETAIL BANKING BRANCHES
The Bank intends to grow and expand its retail banking operations through
the acquisition or establishment of additional bank branches. This expansion
is expected to be in communities across southern and western Michigan. If the
Bank is unable to generate a customer base within these communities because of
consumer loyalty to other financial institutions or for other reasons, the
Bank will have incurred construction or building acquisition costs and
liabilities under lease agreements as well as related branch overhead expenses
without an appropriate return on its investment. See "Business--Properties"
regarding the Bank's branch expansion plans.
DEPENDENCE ON KEY PERSONNEL
The growth and development of the Bank to date have been largely dependent
on certain key employees, the loss of whom could have a material adverse
effect. The key employees of the Bank are Thomas J. Hammond, Chief Executive
Officer; Mark T. Hammond, President; Michael W. Carrie, Executive Vice
President and Chief Financial Officer; and Joan H. Anderson, Executive Vice
President. The Bank does not carry "key person" life insurance on the lives of
its officers. See "Management."
HIGHLY COMPETITIVE NATURE OF RETAIL AND MORTGAGE BANKING BUSINESS
The Bank competes in the retail banking business primarily with commercial
banks and thrift institutions, many of which have a substantial presence in
the same markets as the Bank. Competitors for deposits include thrift
institutions, commercial banks, credit unions, full service and discount
broker dealers, and other investment alternatives, such as mutual funds, money
market funds, and savings bonds or other government securities. The
OC-20
<PAGE>
Bank and its peers compete primarily on price at which products are offered
and on customer service, with the Bank generally offering deposit rates equal
to or greater than prevailing market rates. See "Management's Discussion and
Analysis of Changes in Financial Condition and Results of Operations--
Financial Condition." In addition, the Bank offers extended hours in its bank
branches to attract a retail base of deposits.
The Bank competes in the mortgage banking business for mortgage originations
with thrift institutions, commercial banks, insurance companies, and mortgage
companies, many of which operate nationwide mortgage origination networks
similar to that of the Bank. Primary competitive factors include service
quality, relationships with builders, mortgage brokers, real estate brokers
and investors, technology, product offerings and rates and fees. Many of the
Bank's competitors are, or are affiliated with, organizations with
substantially larger asset and capital bases (including regional and multi-
national banks and bank holding companies). The Bank has positioned itself
with a product mix that attracts business from mortgage companies, credit
unions and thrifts that may not have sufficient loan origination volume to
obtain preferential pricing directly in the secondary market.
BANK'S EXPOSURE TO REGULATORY AND LEGISLATIVE CHANGES AND CIVIL LAWSUITS
The Bank, as a federally chartered savings bank, is subject to extensive
regulation, supervision and examination by the OTS and the FDIC. Such
regulation and supervision establishes a comprehensive framework of activities
in which a savings institution may engage and is intended primarily for the
protection of depositors and the SAIF, which is administered by the FDIC. In
addition, Flagstar, as a registered savings and loan holding company, is
subject to the regulation and supervision of the OTS. The regulatory structure
also gives the regulatory authorities extensive discretion in connection with
their supervisory and enforcement activities. Any change in such regulation,
whether by the OTS, the FDIC, the Board of Governors of the Federal Reserve
Board (the "Federal Reserve Board") or the U.S. Congress, could have a
significant impact on the Bank and its operations. See "Regulation."
The Bank's lending activities, including its mortgage banking operations,
are subject to the rules and regulations of the FHA, VA, Fannie Mae, Freddie
Mac, the Government National Mortgage Association ("GNMA") and other
regulatory agencies with respect to originating, processing, underwriting,
selling, and servicing mortgage loans. In addition, there are other federal
and state statutes and regulations affecting such activities. These rules and
regulations, among other things, impose licensing obligations on the Bank,
prohibit discrimination and establish underwriting guidelines which include
provisions for inspections and appraisals, require credit reports on
prospective borrowers and fix maximum loan amounts. Moreover, lenders such as
the Bank are required annually to submit audited financial statements to
Fannie Mae, Freddie Mac, and GNMA and to comply with each regulatory entity's
own financial requirements. The Bank's business is also subject to examination
by Fannie Mae, Freddie Mac and GNMA to assure compliance with applicable
regulations, policies and procedures.
Mortgage loan origination activities are subject to the provisions of
various federal and state statutes including, among others, the Equal Credit
Opportunity Act, the Federal Truth in Lending Act, the Real Estate Settlement
Procedures Act, the Fair Housing Act, and the regulations promulgated
thereunder, which, among other provisions, prohibit discrimination, prohibit
unfair and deceptive trade practices, and require the disclosure of certain
basic information to mortgagors concerning credit terms and settlement costs,
and otherwise regulate terms and conditions of credit and the procedures by
which credit is offered and administered. Many of the aforementioned
regulatory requirements are designed to protect the interests of consumers,
while others protect the owners or insurers of mortgage loans. Failure to
comply with these requirements can lead to loss of approved status,
termination of servicing contracts without compensation to the servicer,
demands for indemnification or loan repurchases, class action lawsuits and
administrative enforcement actions.
In addition, certain states require that interest be paid to mortgagors on
funds deposited by them in escrow to cover mortgage-related payments such as
property taxes and insurance premiums. Federal legislation has in the past
been introduced that revised escrow regulations and established a uniform
escrow calculation
OC-21
<PAGE>
methodology in all states. If other states enact legislation relating to
payment of, or increases in the rate of, interest on escrow balances, or if
such legislation were retroactively applied to loans in the Bank's servicing
portfolio, the Bank's earnings would be adversely affected.
In recent years, mortgage originators have been subject to class action
lawsuits that allege violations of federal and state laws and regulations,
including the propriety of collecting and paying various fees and charges and
the calculation of escrow amounts. Class action lawsuits may continue to be
filed in the future against mortgage originators generally. There can be no
assurance that the Bank will not be the subject of such lawsuits in the
future. In the event of an unfavorable court judgment in such lawsuits, if
any, the Bank's results of operations could be adversely affected. See
"Business--Legal Proceedings."
There are various other state and local laws and regulations affecting the
Bank's operations. The Bank is licensed in those states that require licensing
to originate, purchase and/or service mortgage loans.
FLAGSTAR CAPITAL CORPORATION
In 1997, the Bank reorganized Flagstar Capital Corporation (the "Company")
for the purpose of acquiring, holding and managing real estate mortgage loans.
All of the Company's common stock is owned by the Bank. It is expected that
all of its mortgage loans will be acquired from the Bank. The Company will
enter into an agreement with the Bank pursuant to which the Bank will service
mortgage loans. The Company will be the issuer of the Series A Preferred
Shares which, under certain circumstances, would be exchanged for the Bank
Preferred Shares.
USE OF PROCEEDS
The Bank Preferred Shares are to be issued, if ever, in connection with an
Automatic Exchange of the Series A Preferred Shares, which shares were sold
pursuant to an effective registration statement filed with the Commission. The
proceeds from the sale of the Series A Preferred Shares were used by the
Company to purchase a portfolio of mortgage loans. The automatic exchange of
Series A Preferred Shares into Bank Preferred Shares will produce no proceeds
to the Bank.
OC-22
<PAGE>
CAPITALIZATION
The following table sets forth the actual capital of the Bank at September
30, 1997 and as adjusted as of such date to give effect to (i) the issuance of
the Series A Preferred Shares by Flagstar Capital Corporation and (ii) an
Automatic Exchange of the Series A Preferred Shares into Bank Preferred Shares
of the Bank. This table should be read in conjunction with the Consolidated
Financial Statements of the Bank and the notes thereto included elsewhere in
this Offering Circular.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, 1997
----------------------------------------
HISTORICAL AS ADJUSTED(2) AS ADJUSTED(3)
---------- -------------- --------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Long-term debt(1)..................... $152,500 $152,500 $152,500
-------- -------- --------
Minority Interest in capital stock of
consolidated subsidiary.............. -- 50,000(4) --
Stockholder's Equity:
Preferred Stock 8.5% Noncumulative
Preferred Stock, Series A, $25.00
par value, 4,000,000 shares
authorized; issued and outstanding,
2,000,000 as adjusted.............. -- -- 50,000
Common Stock, $1.00 par value,
1,000,000 shares authorized,
500,000 shares issued and
outstanding........................ 3,000 3,000 3,000
Additional paid-in capital.......... 28,111 25,193(5) 25,193(5)
Retained earnings................... 89,944 89,944 89,944
-------- -------- --------
Total stockholders' equity........ 121,055 118,137 168,137
-------- -------- --------
Total capitalization............ $273,555 $320,637 $320,637
======== ======== ========
Regulatory capital ratios:
Tangible Capital.................... 5.73% 7.39% 7.87%
Core Capital........................ 5.95% 7.61% 8.08%
Tier 1 Risk-Based Capital........... 10.88% 13.94% 14.81%
Total Risk-Based Capital(3)......... 11.25% 14.29% 14.52%
</TABLE>
- --------
(1) Reflects FHLB advances maturing more than one year from September 30,
1997.
(2) Adjusted to give effect to the issuance of the Series A Preferred Shares
by the Company.
(3) Adjusted to give effect to the Automatic Exchange of the Series A
Preferred Shares into Bank Preferred Shares.
(4) All of the preferred stock of Flagstar Capital Corporation, while
outstanding, is eligible as permanent regulatory capital of the Bank and,
as such, is includable in the core capital accounts of the Bank at up to a
maximum of 25% of the Bank's total core (or leverage) capital.
(5) Offering expenses are estimated to be $2.9 million.
OC-23
<PAGE>
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
The following table presents selected consolidated financial and other data
as of and for the nine months ended September 30, 1997 and 1996 and each of
the five years in the period ended December 31, 1996. The information set
forth below should be read in conjunction with the Consolidated Financial
Statements and the Notes thereto and "Management's Discussion and Analysis of
Financial Condition and Results of Operations." The Consolidated Statements of
Financial Condition as of December 31, 1996 and 1995, and the Consolidated
Statements of Earnings for each of the three years in the period ended
December 31, 1996, are included elsewhere in this Prospectus. The selected
consolidated financial and other data as of September 30, 1997 and for the
nine months ended September 30, 1997 and 1996 are unaudited and are derived
from the Bank's internal consolidated financial statements which, in the
opinion of management, contain all adjustments (consisting only of normal
recurring adjustments) which are necessary for a fair presentation of the
results for such periods. The results of operations for the nine months ended
September 30, 1997 are not necessarily indicative of the results of operations
to be obtained for the entire year.
<TABLE>
<CAPTION>
AT OR FOR THE
NINE MONTHS
ENDED
SEPTEMBER 30, AT OR FOR THE YEARS ENDED DECEMBER 31,
--------------- -------------------------------------------
1997 1996 1996 1995 1994 1993 1992
------- ------- ------- ------- ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
SUMMARY OF OPERATIONS:
Interest income......... $84,789 $57,679 $76,179 $71,304 $35,112 $29,760 $18,735
Interest expense........ 54,597 34,121 45,967 41,443 14,482 12,052 9,227
------- ------- ------- ------- ------- ------- -------
Net interest income..... 30,192 23,558 30,212 29,861 20,630 17,708 9,508
Provision for losses.... 3,730 1,140 2,604 238 290 644 380
------- ------- ------- ------- ------- ------- -------
Net interest income af-
ter provision for loss-
es..................... 26,462 22,418 27,608 29,623 20,340 17,064 9,128
Non-interest income
Loan administration in-
come.................. 5,543 11,110 11,859 14,248 13,261 7,786 2,340
Net gain on loan sales.. 9,269 4,536 4,511 2,872 (1,132) 7,015 6,900
Net gain on sales of
mortgage servicing
rights................. 25,472 20,917 35,129 13,356 28,489 13,385 3,021
Other income............ 3,158 5,085 6,803 4,626 2,065 5,468 6,162
------- ------- ------- ------- ------- ------- -------
Total.................. 43,442 41,648 58,302 35,102 42,683 33,654 18,423
------- ------- ------- ------- ------- ------- -------
Non-interest expense
Compensation and bene-
fits.................. 19,303 18,443 25,479 18,538 18,609 7,984 5,184
Other expense.......... 25,730 27,809(1) 33,060(1) 21,311 18,975 13,308 7,298
------- ------- ------- ------- ------- ------- -------
Total.................. 45,033 46,252 58,539 39,849 37,584 21,292 12,482
------- ------- ------- ------- ------- ------- -------
Earnings before federal
income taxes........... 24,871 17,814 27,371 24,876 25,439 29,426 15,069
Provision for federal
income taxes........... 9,043 6,387 10,258 9,348 9,302 10,405 5,275
------- ------- ------- ------- ------- ------- -------
Net earnings............ $15,828 $11,427(1) $17,113(1) $15,528 $16,137 $19,021 $ 9,794
======= ======= ======= ======= ======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
AT SEPTEMBER 30, AT DECEMBER 31,
---------------- ----------------------------------------------------
1997 1996 1995 1994 1993 1992
---------------- ---------- ---------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
SUMMARY OF FINANCIAL
CONDITION:
Total assets............ $2,033,199 $1,296,810 $1,044,851 $722,469 $467,629 $304,758
Loans receivable:
Mortgage loans avail-
able for sale......... 1,363,822 840,767 620,455 205,480 389,073 218,266
Loans held for invest-
ment.................. 444,552 273,579 305,590 429,800 26,906 21,637
Less: Allowance for
losses................ (4,950) (3,500) (2,102) (1,871) (901) (550)
---------- ---------- ---------- -------- -------- --------
Total loans, net....... 1,803,424 1,110,846 923,943 633,409 415,078 239,353
Mortgage servicing
rights................. 51,713 30,064 27,957 18,179 17,563 11,108
Deposits................ 1,012,121 624,732 529,218 308,497 190,761 181,171
FHLB advances........... 718,878 389,801 191,156 200,750 55,000 --
Stockholder's equity.... 121,055 77,899 61,003 47,925 35,114 16,767
</TABLE>
OC-24
<PAGE>
<TABLE>
<CAPTION>
AT OR FOR THE
NINE MONTHS
ENDED
SEPTEMBER 30, AT OR FOR THE YEARS ENDED DECEMBER 31,
---------------------- -------------------------------------------------------------
1997 1996 1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
PERFORMANCE RATIOS(2):
Return on average as-
sets................... 1.34% 1.38% 1.54% 1.64% 3.19% 4.39% 3.72%
Return on average equi-
ty..................... 21.53% 22.61% 24.82% 29.52% 35.79% 69.56% 84.78%
Interest rate spread.... 2.27% 2.13% 2.13% 2.36% 3.37% 3.39% 2.04%
Net interest margin..... 2.83% 3.21% 3.07% 3.46% 4.63% 4.55% 3.92%
Ratio of average inter-
est earning assets to
average interest bear-
ing liabilities........ 111% 123% 120% 123% 139% 137% 158%
Ratio of non-interest
expense to average as-
sets................... 3.80% 5.58%(3) 5.25%(3) 4.20% 7.43% 4.92% 4.71%
Efficiency ratio(4)..... 59.8% 69.5% 64.7% 59.3% 58.3% 41.5% 44.7%
Dividend payout ratio... -- 8.75% 5.84% 15.78% 19.83% 4.21% 7.66%
ASSET QUALITY DATA:
Net charge-offs to
average loans
outstanding(2)......... 0.22% 0.03% 0.13% 0.00% 0.08% 0.08% 0.09%
Non-performing assets to
total assets at end of
period................. 3.04% 3.37% 3.16% 1.25% 0.42% 0.60% 0.94%
Non-performing loans to
total loans at end of
period................. 2.44% 3.50% 2.75% 1.15% 0.27% 0.37% 0.85%
Allowance for losses to
total loans at end of
period................. 0.27% 0.33% 0.31% 0.23% 0.29% 0.22% 0.23%
Allowance for losses to
non-performing loans at
end of period.......... 11.23% 9.56% 11.43% 19.67% 107.59% 58.17% 26.84%
CAPITAL RATIOS:
Tangible Capital........ 5.73% 6.22% 5.58% 5.19% 5.54% 7.41% 5.35%
Core Capital............ 5.95% 6.75% 6.01% 5.84% 6.63% 7.41% 5.35%
Total Risk-based Capi-
tal.................... 11.25% 11.96% 10.91% 10.12% 12.08% 13.84% 13.40%
Average equity-to-aver-
age assets............. 6.20% 6.09% 6.19% 5.54% 8.91% 6.32% 5.14%
MORTGAGE ORIGINATION AND
SERVICING DATA:
Mortgage loans
originated or
purchased.............. $5,287,711 $5,283,843 $6,791,665 $5,195,605 $3,720,173 $6,220,415 $2,984,076
Mortgage loans sold..... $4,518,451 $5,285,538 $6,581,897 $4,760,806 $3,551,319 $6,034,828 $2,888,564
Mortgage loans serviced
for others(5).......... $4,143,352 $6,946,080 $4,801,581 $6,788,530 $5,691,421 $6,198,311 $3,091,399
Capitalized value of
mortgage servicing
rights(6).............. 1.25% 0.60% 0.63% 0.41% 0.32% 0.28% 0.36%
OTHER DATA:
Full-time equivalent em-
ployees................ 1,110 1,179 1,310 1,142 869 971 584
Number of branches...... 19 15 15 13 9 1 1
Number of
wholesale/correspondent
lending centers........ 10 10 10 9 6 5 4
</TABLE>
- --------
(1) Includes the special deposit insurance assessment imposed on SAIF-insured
institutions during September 1996. The Bank's assessment was $3.4
million, before taxes. If such assessment had not been imposed, the Bank's
net earnings would have been approximately $13.6 million for the nine
months ended September 30, 1996 and its return on average assets and
return on average equity for the period would have been 1.64% and 26.90%,
respectively. If such assessment had not been imposed, the Bank's net
earnings would have been approximately $19.3 million for the year ended
December 31, 1996 and its return on average assets and return on average
equity for the period would have been 1.73% and 27.97%, respectively.
(2) Ratios are annualized where applicable.
(3) Excluding the special SAIF assessment of $3.4 million, before taxes,
incurred during 1996, mentioned in footnote 1 above, such ratio would have
been 5.17% for the nine months ended September 30, 1996 and 4.94% for the
year ended December 31, 1996.
(4) Computed as non-interest expense (excluding amortization of core deposit
premiums) divided by the sum of net interest income and non-interest
income. Excluding the special SAIF assessment of $3.4 million, before
taxes, incurred during 1996, mentioned in footnote 1 above, such ratio
would have been 64.3% for the nine months ended September 30, 1996 and
60.8% for the year ended December 31, 1996.
(5) Amount excludes loans being subserviced for others, which is servicing of
loans subsequent to the sale of the related mortgage servicing rights but
prior to their delivery, of $2.0 billion, $2.1 billion, $3.6 billion and
$536.3 million at September 30, 1997 and 1996 and December 31, 1996 and
1995, respectively. There was no subservicing in prior years.
(6) Reflects percentage of book value of mortgage servicing rights to loans
serviced for others (excluding subservicing).
OC-25
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF CHANGES IN FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Bank's operations are segregated into two segments, mortgage banking and
retail banking. The mortgage banking operation commenced in 1987 and involves
the origination and purchase of single-family residential mortgage loans on a
nationwide basis and residential construction loans on a regional basis, the
sale of such loans, usually on a pooled and securitized basis, in the
secondary market, and the servicing of mortgage loans for investors as well as
the Bank's own loan portfolio. The retail banking operation involves
attracting deposits from the general public and originating consumer,
commercial and commercial real estate loans, primarily through the Bank's
branch network. A significant portion of the deposits attracted by the Bank
through its branch network and from wholesale sources is used to support the
mortgage banking operations.
The tables below set forth certain information for the Bank's businesses for
the periods shown. Prior to the Bank's acquisition of a longstanding community
institution in 1994, the Bank did not have material retail banking operations.
In addition, during May 1997, Flagstar consummated the initial public offering
of its common stock and invested approximately $27.3 million in net proceeds
into the Bank.
REVENUES
<TABLE>
<CAPTION>
RETAIL MORTGAGE
BANKING OPERATION BANKING OPERATION COMBINED
----------------- ----------------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
NINE MONTHS ENDED:
September 30, 1997............ $16,097 $57,537 $73,634
September 30, 1996............ 9,309 55,897 65,206
YEAR ENDED:
December 31, 1996............. 13,791 74,723 88,514
December 31, 1995............. 12,390 52,573 64,963
December 31, 1994............. 1,432 61,881 63,313
EARNINGS (LOSS) BEFORE INCOME TAXES
<CAPTION>
RETAIL MORTGAGE
BANKING OPERATION BANKING OPERATION COMBINED
----------------- ----------------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
NINE MONTHS ENDED:
September 30, 1997............ $ 8,429 $16,442 $24,871
September 30, 1996............ 1,164 (1) 16,650 17,814
YEAR ENDED:
December 31, 1996............. 3,305 (1) 24,066 27,371
December 31, 1995............. 3,549 21,327 24,876
December 31, 1994............. (2,127)(2) 27,566 25,439
</TABLE>
- --------
(1) The earnings before income taxes of the retail banking operation for the
nine months ended September 30, 1996 and for the year ended December 31,
1996 were each adversely affected by the one-time SAIF assessment of $3.4
million before taxes ($2.2 million, net of taxes) imposed as of September
30, 1996.
(2) The retail banking operation began with the acquisition of Security
Savings Bank on July 1, 1994. See "Business--Lending--Retail Banking
Operations."
The Bank's earnings are primarily dependent upon four revenue sources: its
net interest income, which is the difference between interest earned on
interest-earning assets (including loans held for sale in the Bank's mortgage
banking operations as well as loans held for investment) and interest paid on
interest-bearing
OC-26
<PAGE>
liabilities; fee income from servicing mortgages held by investors; gains
realized on sales of mortgage loans; and gains realized on the sale of
mortgage servicing rights. These revenues are in turn significantly affected
by factors such as changes in prevailing interest rates and in the yield curve
(that is, the difference between prevailing short-term and long-term interest
rates), as well as changes in the volume of mortgage originations nationwide
and prepayments of outstanding mortgages.
Since 1993 there has been a gradual flattening of the yield curve which has
had the effect of reducing the Bank's net interest spread. In order to offset
this change, the Bank has pursued a strategy of expanding its retail banking
branch network in order to gain greater access to lower-cost retail deposits
and reduce its reliance on wholesale funding sources and other borrowings. The
Bank does not use warehouse loans from commercial lending sources.
In addition, changes in prevailing interest rates have had a significant
effect on the Bank's mortgage loan production volume. The Bank's mortgage loan
production volume more than doubled between 1992 and 1993 (from $3.0 billion
to $6.2 billion) principally as a result of the record level of refinancing
activity that occurred in 1993 following the sudden decline in interest rates.
Excluding the 1993 surge in refinancing activity, the Bank's mortgage loan
origination volume has grown steadily and significantly each year, from $3.0
billion in 1992 to $6.8 billion in 1996 and $5.3 billion during the first nine
months of 1997. This in turn has contributed to the yearly growth in net
interest income and loan administration income, as well as the substantial
gains on loan sales and gains on sales of mortgage servicing rights, that the
Bank has been able to recognize during this period.
RESULTS OF OPERATIONS
Overview of Operating Results.
Nine Months Ended September 30, 1997 Compared to the Nine Months ended
September 30, 1996. Net earnings increased to $15.8 million in 1997 from $11.4
million in the same period in 1996. These increased earnings were the result
of a $6.6 million increase in net interest income, a $1.8 million increase in
non-interest income, and a decrease in non-interest expenses of $1.3 million,
offset by a $2.6 million increase in the provision for losses and a $2.6
million increase in the provision for federal income taxes. The increase in
net earnings resulted primarily from the Bank's increase in average assets
which totaled $1.6 billion for the nine months ended September 30, 1997, an
increase of approximately $500 million or 45.5% from $1.1 billion for the nine
months ended September 30, 1996. In addition, the nine months ended September
30, 1996 were influenced by the one-time SAIF assessment of $2.2 million
(after tax).
1996 Compared to 1995. Net earnings for 1996 were $17.1 million, a 10.3%
increase from the $15.5 million reported in 1995. Excluding the effect of the
one-time SAIF assessment of $2.2 million (after tax) in 1996, net earnings
would have been $19.3 million, a 24.5% increase over the 1995 period. The
increase in net earnings resulted from increases in net gains on loan sales
and sales of mortgage servicing rights (up $23.4 million, or 144.4%), and an
approximate $300,000, or 1.0%, increase in net interest income. The increase
in net interest income resulted primarily from a 14.0% increase in average
interest-earning assets reflecting continued strong growth in the Bank's loan
production volume, offset in part by a decrease in the net interest spread
caused by a continued flattening of the yield curve. These increases in net
interest income and non-interest income were offset by increases in the
provision for losses, higher compensation and benefit expenses, reflecting
staff increases and merit raises, and an increase in general and
administrative expenses resulting from increased loan production levels and
expansion of the Bank's branch network.
1995 Compared to 1994. Net earnings decreased by 3.7% to $15.5 million in
1995 from $16.1 million in 1994 as a result of an $11.2 million reduction in
the level of gains on loan sales and sales of mortgage servicing rights ($16.2
million in 1995 compared to $27.4 million in 1994) and an increase in other
non-interest expenses of $2.3 million (from $19.0 million in 1994 to $21.3
million in 1995), which more than offset a substantial increase in net
interest income (from $20.6 million to $29.9 million) and significant
increases in loan
OC-27
<PAGE>
administration income. The reduction in gains on sales of mortgage servicing
in part resulted from an approximate $300 million decrease in unpaid principal
balance of the mortgage loans underlying the mortgage servicing rights sold as
well as the sale of currently originated higher coupon mortgage servicing
rights sold in 1995.
Net Interest Income.
Nine Months Ended September 30, 1997 Compared to the Nine Months Ended
September 30, 1996. Net interest income for the period ended September 30,
1997 increased $6.6 million, or 28.0%, to $30.2 million as compared to $23.6
million for the period ended September 30, 1996. This increase was caused
primarily by an approximate $400 million increase in average interest-earning
assets between the comparable periods. Average interest-earning assets
increased to $1.4 billion for the nine months ended September 30, 1997 from
$1.0 billion for the nine months ended September 30, 1996. At the same time,
the Bank's interest rate spread increased from 2.13% in the 1996 period to
2.27% in the 1997 period. The Bank's net interest margin decreased from 3.21%
in the 1996 period to 2.83% in the 1997 period.
The decrease in the Bank's net interest margin was a direct result of the
leveraged asset growth employed by the Bank. The ratio of average interest-
earning assets to average interest-bearing liabilities decreased to 111% for
the period ended September 30, 1997, as compared to 123% for the period ended
September 30, 1996. This decrease occurred as a result of the Bank's funding
the total asset growth of approximately $500 million with interest-bearing
liabilities. Additionally, the Bank was forced to replace $39.8 million of non
interest- bearing liabilities (i.e., escrow accounts and undisbursed payments
on loans serviced for others) with interest-bearing liabilities. The Bank's
interest rate spread was positively affected by an increase in the spread
between short-term funding liabilities and longer-term assets.
1996 Compared to 1995. Net interest income increased approximately $300,000,
or 1.0%, to $30.2 million for the year ended December 31, 1996, from $29.9
million for the year ended December 31, 1995. This increase was due primarily
to a $121.3 million increase in average interest-earning assets between the
comparable periods, offset in part by the related increase in interest-bearing
liabilities necessary to fund such growth. At the same time, the Bank's
interest rate spread declined from 2.36% for the year ended December 31, 1995
to 2.13% for 1996, which resulted in a decrease in the Bank's net yield on
interest-earning assets to 3.07% for the year ended December 31, 1996 from
3.46% for 1995. This decrease was caused by a slight compression in the yield
curve for interest- earning assets priced off of 10-year and 15-year U. S.
Treasury securities as compared to funding sources priced off of the one-year
U. S. Treasury Securities.
1995 Compared to 1994. Net interest income for the year ended December 31,
1995 increased $9.3 million, or 45.2%, to $29.9 million as compared to $20.6
million in net interest income for the year ended December 31, 1994. This
increase was caused primarily by substantial increases in interest earning
assets. Average earning assets were $864.0 million and $445.6 million for the
years ended December 31, 1995 and 1994, respectively. At the same time, the
Bank's interest rate spread declined from 3.37% for the year ended December
31, 1994 to 2.36% for 1995 and the net interest margin declined from 4.63% to
3.46% during such periods. These decreases resulted primarily from the
substantial growth in the Bank's average assets between 1994 and 1995. In
order to fund such growth, the Bank significantly increased its use of
brokered deposits, which typically have a higher interest rate than retail
deposits, and FHLB advances, which are subject to daily repricing. The average
cost of such funding sources increased from 4.79% and 4.44%, respectively, in
1994 to 6.21% and 6.35%, respectively, in 1995. During the same periods, the
average yields on the Bank's loans increased by 32 basis points, from 8.00% in
1994 to 8.32% in 1995. In addition, as a result of the asset growth, the ratio
of average interest-earning assets to average interest-bearing liabilities
decreased to 123% for the year ended December 31, 1995, as compared to 139%
for the year ended December 31,1994, and the ratio of non-interest bearing
funding sources to interest-earning assets declined. The Bank's interest rate
spread and net interest margin were also adversely affected by a significant
compression in the yield curve between short-term funding liabilities and
longer-term assets.
OC-28
<PAGE>
Average Balances, Interest Rates and Yields. Net interest income is affected
by (i) the difference ("interest rate spread") between rates of interest
earned on interest-earning assets and rates of interest paid on interest-
bearing liabilities and (ii) the relative amounts of interest-bearing
liabilities and interest-earning assets. When the total of interest-earning
assets approximates or exceeds the total of interest-bearing liabilities, any
positive interest rate spread will generate net interest income. Financial
institutions have traditionally used interest rate spreads as a measure of net
interest income. Another indication of an institution's net interest income is
its "net yield on interest-earning assets" or "net interest margin," which is
net interest income divided by average interest-earning assets.
The following table sets forth certain information relating to the Bank's
consolidated average interest-earning assets and interest-bearing liabilities
and reflects the average yield on assets and average cost of liabilities for
the periods indicated. Such yields and costs are derived by dividing income or
expense by the average monthly balance of assets or liabilities, respectively,
for the periods presented. During the periods indicated, non-accruing loans,
if any, are included in the net loan category. Average balances are derived
from month-end average balances. Management does not believe that the use of
month-end average balances instead of average daily balances has caused any
material difference in the information presented.
<TABLE>
<CAPTION>
FOR THE NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------------------------------------
1997 1996
------------------------------ ------------------------------
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE INTEREST YIELD/COST BALANCE INTEREST YIELD/COST
---------- -------- ---------- ---------- -------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Loans receivable, net.. $1,396,010 $83,029 7.93% $ 952,395 $56,430 7.90%
FHLB stock............. 25,957 1,654 8.52% 19,844 975 6.57%
Other.................. 2,448 106 5.79% 7,138 274 5.13%
---------- ------- ---------- -------
Total.................. 1,424,415 84,789 7.94% 979,377 57,679 7.85%
------- -------
Non-interest-earning
assets................. 155,610 126,367
---------- ----------
Total assets........... $1,580,025 $1,105,744
========== ==========
Interest-bearing
liabilities:
Demand Deposits........ $ 65,715 1,061 2.16% $ 73,154 1,723 3.15%
Savings Deposits....... 70,888 2,164 4.08% 28,050 282 1.34%
Certificates of
deposit............... 704,825 31,757 6.02% 434,587 20,069 6.17%
FHLB advances.......... 427,310 18,774 5.87% 243,564 11,226 6.16%
Other.................. 19,451 841 5.78% 18,837 821 5.83%
---------- ------- ---------- -------
Total interest-bearing
liabilities........... 1,288,189 54,597 5.67% 798,192 34,121 5.72%
Non-interest-bearing
liabilities........... 193,814 240,176
---------- ----------
Total liabilities...... 1,482,003 1,038,368
Equity................. 98,022 67,376
---------- ----------
Total liabilities and
equity................ $1,580,025 $1,105,744
========== ==========
Net interest-earning
assets................ $ 136,226 $ 181,185
========== ==========
------- -------
Net interest income.... $30,192 $23,558
======= =======
Interest rate spread.... 2.27% 2.13%
Net interest margin..... 2.83% 3.21%
Ratio of average
interest-earning assets
to interest-bearing
liabilities............ 111% 123%
</TABLE>
(continued)
OC-29
<PAGE>
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------------------------------------------------
1996 1995 1994
------------------------------ ---------------------------- ----------------------------
AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE INTEREST YIELD/COST BALANCE INTEREST YIELD/COST BALANCE INTEREST YIELD/COST
---------- -------- ---------- -------- -------- ---------- -------- -------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Loans receivable, net.. $ 964,257 $74,588 7.74% $835,600 $69,543 8.32% $419,147 $33,533 8.00%
FHLB stock............. 18,776 1,471 7.83% 16,304 1,285 7.88% 9,534 553 5.80%
Other.................. 2,230 120 5.38% 12,098 476 3.93% 16,871 1,026 6.08%
---------- ------- -------- ------- -------- -------
Total.................. 985,263 76,179 7.73% 864,002 71,304 8.25% 445,552 35,112 7.88%
---------- ------- -------- ------- -------- -------
Non-interest-earning as-
sets................... 129,005 85,686 60,254
---------- -------- --------
Total assets.......... $1,114,268 $949,688 $505,806
========== ======== ========
Interest-bearing liabil-
ities:
Demand deposits........ $ 86,650 2,499 2.88% $ 63,844 1,824 2.86% $ 27,892 773 2.77%
Savings deposits....... 18,933 428 2.26% 10,119 228 2.25% 5,385 127 2.36%
Certificates of depos-
it.................... 446,808 27,504 6.16% 371,756 23,071 6.21% 169,986 8,137 4.79%
FHLB advances.......... 247,204 14,291 5.78% 237,535 15,072 6.35% 83,912 3,726 4.44%
Other.................. 21,227 1,245 5.87% 19,703 1,248 6.33% 34,267 1,719 5.03%
---------- ------- -------- ------- -------- -------
Total interest-bearing
liabilities............ 820,822 45,967 5.60% 702,957 41,443 5.89% 321,442 14,482 4.51%
Non-interest-bearing li-
abilities.............. 224,484 194,128 139,278
---------- -------- --------
Total liabilities..... 1,045,306 897,085 460,720
Equity................. 68,962 52,603 45,086
---------- -------- --------
Total Liabilities and
Equity................ $1,114,268 $949,688 $505,806
========== ======== ========
Net interest-earning as-
sets................... $ 164,441 $161,045 $124,110
========== ======== ========
------- ------- -------
Net interest income..... $30,212 $29,861 $20,630
======= ======= =======
Interest rate spread.... 2.13% 2.36% 3.37%
Net interest margin..... 3.07% 3.46% 4.63%
Ratio of average
interest-earning assets
to interest-bearing
liabilities............ 120% 123% 139%
</TABLE>
Rate/Volume Analysis. The following table analyzes net interest income in
terms of changes in the volume of interest-earning assets and interest-bearing
liabilities and changes in yields and rates. The table reflects the extent to
which changes in the interest income and interest expense are attributable to
changes in volume (changes in volume multiplied by prior year rate) and
changes in rate (changes in rate multiplied by prior year volume). Changes
attributable to the combined impact of volume and rate have been allocated
proportionately to changes due to volume and changes due to rate.
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED SEPTEMBER 30, FOR THE YEARS ENDED DECEMBER 31,
------------------------ ---------------------------------------------------
1997 VS. 1996 1996 VS. 1995 1995 VS. 1994
------------------------ ------------------------ -------------------------
RATE VOLUME NET RATE VOLUME NET RATE VOLUME NET
------ ------- ------- ------- ------- ------ ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
INTEREST INCOME:
Loans receivable, net... $ 315 $26,284 $26,599 $(5,663) $10,708 $5,045 $ 2,693 $33,317 $36,010
FHLB stock.............. 380 299 679 (9) 195 186 339 393 732
Other................... 12 (180) (168) 32 (388) (356) (260) (290) (550)
------ ------- ------- ------- ------- ------ ------- ------- -------
Total.................. $ 707 $26,403 $27,110 $(5,640) $10,515 $4,875 $ 2,772 $33,420 $36,192
------ ------- ------- ------- ------- ------ ------- ------- -------
INTEREST EXPENSE:
Deposits................ $ 173 $12,735 $12,908 $ (199) $ 5,507 $5,308 $ 5,319 $10,767 $16,086
FHLB advances........... (923) 8,471 7,548 (1,395) 614 (781) 4,525 6,821 11,346
Other................... (7) 27 20 (100) 97 (3) 258 (729) (471)
------ ------- ------- ------- ------- ------ ------- ------- -------
Total.................. $ (757) $21,233 $20,476 $(1,694) $ 6,218 $4,524 $10,102 $16,859 $26,961
------ ------- ------- ------- ------- ------ ------- ------- -------
Net Change in Net
Interest Income........ $1,464 $ 5,170 $ 6,634 $(3,946) $ 4,297 $ 351 $(7,330) $16,561 $ 9,231
====== ======= ======= ======= ======= ====== ======= ======= =======
</TABLE>
OC-30
<PAGE>
Provision For Losses.
Nine Months Ended September 30, 1997 Compared to Nine Months Ended September
30, 1996. The provision for losses increased to $3.7 million for the 1997
period from $1.1 million for the same period in 1996. The Bank's determination
of its provision for losses reflects its consideration of the potential loss
that may arise from loans in its portfolio or which it services for others.
The increase in the provision reflected the increase in the level of non-
performing loans to $44.1 million at September 30, 1997, from $30.6 million at
December 31, 1996, an increase of approximately $13.5 million, or 44.1%, and
the increase in the level of net charge-offs to 0.22% (annualized) of average
loans outstanding in the 1997 period from 0.03% in the 1996 period. See
"Business--Asset Quality."
1996 Compared to 1995. The provision for losses increased to $2.6 million
for 1996 from approximately $238,000 for 1995. The Bank's determination of its
provision for losses reflects its consideration of the potential loss that may
arise from loans in its portfolio or which it services for others. See
"Business--Asset Quality." The increase in the provision reflected the
increase in the level of non-performing loans to $30.6 million at December 31,
1996, from $10.7 million at December 31, 1995, an increase of approximately
$19.9 million, or 186%, and the increase in the level of net charge-offs to
0.13% of average loans in 1996 from 0.00% in 1995. Single family residential
mortgage loans comprised approximately $27.0 million, or 88%, of non-
performing loans at December 31, 1996 compared to 94% at December 31, 1995.
See "--Financial Condition--Allowance for Losses" and "Business-Asset
Quality".
1995 Compared to 1994. The provision for losses decreased to $238,000 in
1995 from $290,000 in 1994. This decrease was not significant based on the
minimal amount of net charge-offs during 1995.
Non-Interest Income.
Nine Months Ended September 30, 1997 Compared to Nine Months Ended September
30, 1996. Non-interest income increased $1.8 million, or 4.3%, to $43.4
million in the 1997 period, from $41.6 million for the 1996 period. This
increase resulted from an increase in net gain on loan sales, and an increase
in net gain on the sales of mortgage servicing rights, offset by decreases in
loan administration fees and other fees and charges during the 1997 period.
1996 Compared to 1995. Non-interest income increased $23.2 million, or
66.1%, to $58.3 million for 1996, from $35.1 million for 1995. The majority of
this increase resulted from increased net gains on loan sales and sales of
mortgage servicing rights.
1995 Compared to 1994. Non-interest income for the year ended December 31,
1995 decreased $7.6 million, or 17.8%, to $35.1 million from $42.7 million for
the year ended December 31, 1994. The majority of the decrease was attributed
to a decrease in the net gains on mortgage loan sales and sales of mortgage
servicing rights, together with a slight decrease in the volume of mortgage
servicing rights sold.
Loan Administration.
Nine Months Ended September 30, 1997 Compared to the Nine Months Ended
September 30, 1996. Loan administration fee income decreased $5.6 million, or
50.5%, to $5.5 million for the 1997 period, from $11.1 million for the 1996
period. This decrease was the direct result of the decrease in the amount of
mortgage loans serviced for others from $6.9 billion to $4.1 billion. The
decline in mortgage loans serviced for others reflects the Bank's sale of
higher coupon mortgage servicing rights in a low interest rate environment,
because of the relatively higher value of such rights and the greater
likelihood of prepayments in such a portfolio. Since a number of these loans
were sold, loan administration volume, and correspondingly loan administration
income, decreased.
1996 Compared to 1995. Loan administration income decreased $2.3 million or
16.2%, to $11.9 million for 1996, from $14.2 million for 1995. This decrease
resulted primarily from a decrease in mortgage loans
OC-31
<PAGE>
serviced. At December 31, 1996, the unpaid principal balance of loans serviced
for others decreased $2.0 billion, or 29.4%, to $4.8 billion, from $6.8
billion at December 31, 1995. At December 31, 1996 and 1995, the weighted
average servicing fee on loans serviced for others was 0.289% (i.e., 28.9
basis points) and 0.287%, respectively.
1995 Compared to 1994. Loan administration income for the year ended
December 31, 1995 increased $900,000, or 6.8%, to $14.2 million from $13.3
million for the year ended December 31, 1994. This increase was attributable
to an increase in loans being serviced, of $1.1 billion, or 19.3% from $5.7
billion at December 31, 1994 to $6.8 billion at December 31, 1995. The
weighted average servicing fee on loans serviced for others (excluding
subserviced loans) was 0.287% at December 31, 1995 and 1994.
Net Gain on Loan Sales.
Nine Months Ended September 30, 1997 Versus the Nine Months Ended September
30, 1996. For the 1997 period, net gain on loan sales reported was $9.3
million versus $4.5 million in the 1996 period. The 1997 period contained the
sale of $4.5 billion in loans versus $5.3 billion sold in the 1996 period. The
reduced amount of loan sales was attributable to the Bank's decision to retain
more loans for its own portfolio. The Bank's ability to recognize more gain in
1997 despite the reduced sale volume is, in management's opinion, a reflection
of the more stable interest rate environment in 1997 and the Bank's effective
hedging.
1996 Compared to 1995. For 1996, net gain on loan sales increased $1.6
million, or 55.2%, to $4.5 million, from $2.9 million for 1995. These higher
levels of gains were attributable to increases in the amount of loans sold.
For 1995 versus 1996, the principal balance of the loans sold increased from
$4.8 billion to $6.6 billion.
1995 Compared to 1994. For the year ended December 31, 1995, net gain on
loan sales increased $4.0 million to $2.9 million, from a $1.1 million loss.
The increase in the gain on the mortgage loans sold was principally the result
of the increase in the volume of loans sold in the year ended 1995 of $1.2
billion, from $3.6 billion in 1994 to $4.8 billion in 1995.
Net Gain on Sales of Mortgage Servicing Rights.
Nine Months Ended September 30, 1997 Versus the Nine Months Ended September
30, 1996. For the 1997 period, net gain on sales of mortgage servicing rights
was $25.5 million versus $20.9 million in the 1996 period. The 1997 period
contained $3.6 billion in bulk sales and the sale of $582 million in loans
sold servicing released (i.e., a total of $4.2 billion) versus $3.5 billion in
bulk sales and $706 million in loans sold servicing released (i.e., a total of
$4.2 billion) in the 1996 period. The bulk servicing sold in 1997 was aged
product which was being carried at a lower book value and generated a higher
gain than the bulk servicing sold in the 1996 period.
1996 Compared to 1995. For 1996, net gain on sales of mortgage servicing
rights increased $21.7 million, or 161.9%, to $35.1 million, from $13.4
million for 1995. This increase primarily resulted from the increased amount
of mortgage servicing rights sold. These higher levels of gains were
attributable to increases in the amount of mortgage servicing rights sold. For
1995 versus 1996, the principal balance of the loans underlying the mortgage
servicing rights sold increased from $2.3 billion to $6.5 billion. The $21.7
million increase in the gain on sale of mortgage servicing rights reflects
$22.6 million attributable to the $4.2 billion increase in the volume of
mortgage servicing rights sold, less $900,000 attributable to an increase in
the cost of the mortgage servicing rights sold.
1995 Compared to 1994. For the year ended December 31, 1995, net gain on
sales of mortgage servicing rights decreased $15.1 million, or 53.0%, to $13.4
million, from $28.5 million for 1994. The gain on sale of mortgage servicing
rights decreased approximately $3.0 million due to a $300 million decrease in
the principal balance of the loans underlying the mortgage servicing rights
sold, from $2.6 billion to $2.3 billion, and approximately $12.1 million due
to decreases in the selling prices of such rights and an increase in the cost
of the servicing rights sold. The decreases in the selling prices were due to
the sale of currently originated lower
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<PAGE>
coupon mortgage servicing rights during 1995. The increase in the cost of the
servicing rights was principally due to the adoption in mid-1995 of Statement
of Financial Accounting Standards ("SFAS") No. 122, which required mortgage
servicing rights to be capitalized whether they are originated or purchased by
the Bank.
Mortgage servicing rights originated or acquired by the Bank are capitalized
pursuant to SFAS No. 122, "Accounting for Mortgage Servicing Rights," which
the Bank adopted in May 1995. The value of mortgage servicing rights
capitalized are periodically evaluated in relation to the estimated discounted
net future servicing revenues. See Note 3 of Notes to Consolidated Financial
Statements. At September 30, 1997, December 31, 1996 and 1995, the estimated
fair value of the mortgage servicing rights in excess of their stated book
value was approximately $8.7 million, $23.9 million and $42.4 million,
respectively. See Note 7 of Notes to Consolidated Financial Statements.
Other Fees and Charges.
Nine Months Ended September 30, 1997 Compared to the Nine Months Ended
September 30, 1996. Other fees and charges decreased $1.9 million, or 37.3%,
to $3.2 million for the 1997 period from $5.1 million for same period in 1996.
This decrease was due to a decrease in certain loan origination fees and
certain mortgage loan servicing fees.
1996 Compared to 1995. For 1996, other fees and charges, which includes
certain loan fees and charges, deposit-related fees and escrow waiver fees,
increased $2.2 million, or 47.8% to $6.8 million from $4.6 million for 1995.
This increase was a result of an overall increase in mortgage loan
originations in 1996 as compared to 1995.
1995 Compared to 1994. Other fees and charges increased $2.5 million, or
119.0%, to $4.6 million for 1995 from $2.1 million for 1994. This increase was
attributable to an increase in underwriting fees in 1995 as compared to 1994
and an overall increase in mortgage loan originations in 1995.
Non-Interest Expense. The following table sets forth components of the
Bank's non-interest expense, prior to allocation of expenses related to loan
originations that are deferred pursuant to SFAS No. 91, "Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases." As required by SFAS No. 91, mortgage loan
fees and certain direct origination costs (principally compensation and
benefits) are capitalized and amortized rather than immediately expensed.
Certain other expenses associated with loan production, however, are not
required to be capitalized. These expense amounts are reflected on the Bank's
statement of earnings net of the portion that must be capitalized under SFAS
No. 91. However, management believes that the analysis of the components of
non- interest expense on a "gross" basis (i.e., prior to the deferral of
capitalized loan origination costs) more clearly reflects the changes in total
overhead costs associated with increased loan production. See Note 3 of Notes
to Consolidated Financial Statements for further information.
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED SEPTEMBER 30, FOR THE YEARS ENDED DECEMBER 31,
------------------------ ----------------------------------
1997 1996 1996 1995 1994
-------- -------------- ---------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Compensation and bene-
fits................... $ 31,836 $ 30,327 $ 40,450 $ 30,809 $ 25,424
Commissions............. 9,802 9,339 12,367 11,102 9,340
Occupancy and equip-
ment................... 9,764 8,687 12,092 8,873 7,339
Advertising............. 1,190 654 943 597 1,110
Core deposit premium am-
ortization............. 968 968 1,290 1,330 651
Federal deposit insur-
ance premiums.......... 305 4,184 4,435 1,122 803
Other................... 18,873 14,636 20,300 13,669 11,943
-------- -------- ---------- ---------- ----------
Subtotal................ 72,738 68,795 91,877 67,502 56,610
Less: deferral of capi-
talized loan origina-
tion costs............. (27,705) (22,543) (33,338) (27,653) (19,026)
-------- -------- ---------- ---------- ----------
Total................... $ 45,033 $ 46,252 $ 58,539 $ 39,849 $ 37,584
======== ======== ========== ========== ==========
</TABLE>
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<PAGE>
Nine Months Ended September 30, 1997 Compared to the Nine Months Ended
September 30, 1996. Non-interest expense, before the capitalization of direct
loan origination costs, increased $3.9 million, or 5.7%, to $72.7 million from
$68.8 million for the same period in 1996. Excluding the one-time SAIF
assessment of $3.4 million, before taxes, charged to the Bank on September 30,
1996, the Bank had a $7.3 million, or 11.2%, increase in other expenses. This
increase was primarily caused by increased compensation and benefits of $1.5
million, increased general and administrative expenses of $4.2 million, and
increased occupancy and equipment costs of $1.1 million.
Compensation and benefits totaled $31.8 million, and $30.3 million for the
1997 and 1996 periods, respectively. The increase in the 1997 period was
primarily a result of an increase in the average number of full-time
equivalent employees along with normal cost of living salary adjustments.
Increased general and administrative expenses and occupancy and equipment
expenses for 1997 were attributable to an increased number of bank branches,
from 15 in 1996, to 19 at September 30, 1997. Additionally, an increased
amount of contract underwriting expenses were recorded.
1996 Compared to 1995. Non-interest expense for 1996 increased $18.7
million, or 47.0%, to $58.5 million, from $39.8 million for 1995. The largest
contributing factors to this increase were higher compensation and benefits
and general and administrative expenses.
Compensation and benefits, excluding the capitalization of direct loan
origination costs, increased by $9.7 million, or 31.5%, to $40.5 million 1996
from $30.8 million for 1995. The increase in compensation and benefits was
attributable to an increase in the number of full-time equivalent employees
and increased salaries of senior management and staff. The number of full-time
equivalent employees of the Bank increased to 1,310 persons at December 31,
1996 from 1,142 persons at December 31, 1995.
Higher general and administrative expenses also contributed to the increased
non-interest expense for 1996 as compared to the same period in 1995. The
increase in general and administrative expenses reflected an increase in
overall activity because of increased mortgage loan production recorded during
1996 of $6.8 billion compared to $5.2 billion for 1995. This increase in
general and administrative expenses was also a result of an increase in the
number of the Bank's bank branches from 13 at December 1995 to 15 at December
31, 1996.
In addition, general and administrative expense for 1996 reflects the one-
time special assessment imposed by the FDIC pursuant to federal legislation
adopted on such date. See "Regulation--Federal Deposit Insurance." Such
assessment affected all thrifts, including the Bank, whose deposits were
insured by the SAIF administered by the FDIC and was imposed to capitalize the
SAIF to the same extent as the Bank Insurance Fund and thereby eliminate the
disparity in related premiums charged by the two Funds. Based upon notice
received from the FDIC, the Bank's special assessment totaled $3.4 million, or
$2.2 million, net of tax. In 1997, subsequent to such assessment, the Bank's
annual premium expense for FDIC deposit insurance has been approximately 6.5
basis points (charged against the Bank's insurable deposit base) as compared
to 23 basis points prior to the assessment.
1995 Compared to 1994. Non-interest expense for the year ended December 31,
1995 increased $2.2 million, or 5.9%, to $39.8 million from $37.6 million for
the year ended 1994. This increase was primarily a result of increased
compensation and benefits and increased general and administrative expenses.
Compensation and benefits totaled $30.8 million, and $25.4 million for the
years ended December 31, 1995 and 1994 respectively. This increase was
primarily a result of an increase in the number of full-time equivalent
employees from 869 persons to 1,142 persons at December 31, 1994 and 1995,
respectively. Increased general and administrative expenses for 1995 were
attributable to an increase in the number of branches from 9 at December 31,
1994 to 13 at December 31, 1995. The increase in general and administrative
expenses corresponded to an increase in mortgage loan originations of $1.5
billion, or 40.5%, from $3.7 billion for 1994 to $5.2 billion for 1995.
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<PAGE>
Non-interest expense also increased as a result of the Bank's acquisition of
Security Savings on July 1, 1994, a $226 million thrift located in Jackson,
Michigan. Among the costs of acquisition was the continued employment of
approximately 100 former employees of Security Savings. In addition, Security
Savings also had a main office as well as a six-branch network and the Bank's
retention of the main office and branches following the acquisition
contributed to the $2.7 million, or 58.7%, increase in occupancy and equipment
expense from 1993 to 1994.
Federal Income Taxes.
Nine Months Ended September 30, 1997 Compared to the Nine Months Ended
September 30, 1996. Federal income tax expense for the nine months ended
September 30, 1997 increased to $9.0 million from $6.4 million for the nine
months ended September 30, 1996. The Bank's effective rate for the 1997 period
was 36.4% versus 35.9% for the 1996 period. See Note 10 of Notes of
Consolidated Financial Statements.
1996 Compared to 1995. Federal income tax expense for 1996 increased to
$10.3 million from $9.3 million for 1995. The Bank's effective rate for 1996
was 37.5% versus 37.6% for 1995.
1995 Compared to 1994. Federal income tax expense totaled $9.3 million and
$9.3 million for the years ended December 31, 1995 and 1994, respectively. The
effective rate was 37.6% and 36.6% for 1995 and 1994, respectively. The
increase in effective rate was due to a higher amount of non-deductible
expenses.
COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 1997 AND DECEMBER 31, 1996
Assets. The Bank's assets totaled $2.0 billion at September 30, 1997, an
increase of approximately $700 million, or 53.8%, as compared to $1.3 billion
at December 31, 1996. This increase was primarily due to increases in mortgage
loans available for sale and loans held for investment, Federal Home Loan Bank
stock, accrued interest receivable, repossessed assets, and mortgage servicing
rights, offset in part by decreases in cash and cash equivalents and other
assets. This increase in assets was due to the Bank's ability to leverage its
capital, which increased from $77.9 million at December 31, 1996 to $121.1
million at September 30, 1997 primarily due in part to a net earnings growth
of 38.6% during the nine months ended September 30, 1997 as compared to the
same period in 1996 and in part to the Bank's receipt of $27.3 million from
Flagstar as a result of Flagstar's initial public offering consummated in May
1997.
Loans Receivable. Mortgage loans available for sale and loans held for
investment increased approximately $700 million or 63.6%, from $1.1 billion at
December 31, 1996 to $1.8 billion at September 30, 1997. Mortgage loans
available for sale increased $559.2 million, or 66.5%, to $1.4 billion at
September 30, 1997, from $840.8 million at December 31, 1996. Loans held for
investment increased $171.0 million, or 62.5%, from $273.6 million at December
31, 1996 to $444.6 million at September 30, 1997. These increases were
attributable to the increased leverage ability provided by proceeds from the
Bank's initial public offering and the Bank's decision to hold larger portions
of its mortgage loan production for longer periods.
Allowance for Losses. The allowance for losses totaled $5.0 million at
September 30, 1997, an increase of $1.5 million, or 42.9%, from $3.5 million
at December 31, 1996. The allowance for losses as a percentage of non-
performing loans was 11.23% and 11.43% at September 30, 1997 and December 31,
1996, respectively. The Bank's non-performing loans totaled $44.1 million and
$30.6 million at September 30, 1997 and December 31, 1996, respectively. The
allowance for losses as a percentage of total loans was 0.27% and 0.31% at
September 30, 1997 and December 31, 1996, respectively. The increase in the
dollar amount of the allowance for losses was based upon management's
assessment of relevant factors, including the types and amounts of non-
performing loans, historical and anticipated loss experience on such types of
loans, and current and projected economic conditions.
The increase in non-performing loans at September 30, 1997 from the amount
at December 31, 1996 resulted primarily from the repurchase of $52.3 million
in mortgage loans from secondary market investors during the first nine months
of 1997. Approximately $14.7 million of the loans repurchased in 1997 were
non-
OC-35
<PAGE>
performing, $2.0 million were delinquent, and $5.8 million were immediately
classified to a real estate owned status when repurchased. Loan repurchases
are an ongoing part of the Bank's operations since all loans sold in the
secondary market are generally subject to detailed underwriting reviews by the
ultimate purchaser. Although the Bank generally does not sell loans with
recourse, it typically is required to repurchase loans, including defaulted
and delinquent loans, which were not underwritten in strict compliance with
the underwriting standards of secondary market investors. As the volume of the
Bank's loan production has increased substantially over the past several
years, the aggregate amount of loan delinquencies and foreclosures has also
increased, thereby increasing the number of loans potentially subject to
repurchase.
The Bank believes that its risk of loss arising from its non-performing
loans, including loans acquired through repurchase from individual investors
after initial sale in the secondary market, has not materially increased as a
result of either the increase in repurchased loans or the overall increase in
non-performing loans. During 1997, 57.2% of the loans repurchased were
performing loans but were required to be repurchased for reasons (such as
failure to meet all of the secondary market investor's criteria for mortgagor
eligibility or failure to meet the investor's program eligibility
requirements) that do not significantly affect the ultimate collectibility of
such loans or significantly increase the Bank's exposure to losses. A portion
of the repurchased loans are eligible for resale in the secondary market to
other investors, and the Bank does not believe that the remaining repurchased
loans that are currently non-performing or that have been foreclosed present
risks of ultimate loss that are significantly different than the Bank has
historically experienced. Of the Bank's $44.1 million of non-performing loans
at September 30, 1997, $40.5 million, or 91.8%, were single family residential
mortgage loans, which generally represent minimal risk of ultimate loss
because of the nature of the collateral securing the loans, the presence of
private mortgage insurance for loans with over-80% LTV ratios, and the
presence of insurance or guarantees on certain loans from the FHA or VA. At
September 30, 1997, $19.5 million of such loans were the subject of bankruptcy
proceedings by the mortgagor; however, it has been the Bank's experience that
such proceedings usually result in full repayment to the Bank and present
minimal risk of loss because the imposition of judicial scrutiny and related
enforcement powers supersede the less comprehensive collection methods
normally available to the Bank.
Accrued Interest Receivable. Accrued interest receivable increased from $6.6
million at December 31, 1996 to $12.3 million at September 30, 1997 as the
Bank's total loan portfolio increased. The Bank typically collects interest
income in the following month after it is earned.
Repossessed Assets. Repossessed assets increased from $10.4 million at
December 31, 1996 to $17.7 million at September 30, 1997 as the Bank's non-
performing loans were foreclosed upon by the Bank. This 70.2% increase is the
direct result of the increased amount of non-performing loans and loan
repurchases made during the period.
FHLB Stock. Holdings of FHLB stock increased from $19.7 million at December
31, 1996 to $36.9 million at September 30, 1997 as the Bank's total mortgage
loan portfolio increased. As a member of the FHLB, the Bank is required to
hold shares of FHLB stock in an amount at least equal to 1% of the aggregate
unpaid principal balance of its home mortgage loans, home purchase contracts
and similar obligations at the beginning of each year, or 1/20th of its FHLB
advances, whichever is greater.
Mortgage Servicing Rights. Mortgage servicing rights totaled $51.7 million
at September 30, 1997, an increase of $21.6 million, or 71.8%, from $30.1
million at December 31, 1996. For the nine months ended September 30, 1997,
$5.3 billion of mortgage servicing rights were originated, and $5.9 billion
were sold, prepaid, or amortized resulting in a net decrease of approximately
$600 million. The increase in mortgage servicing rights at September 30, 1997
despite the excess of mortgage servicing rights sold over mortgage servicing
rights originated during the nine months ended September 30, 1997 reflects the
Bank's capitalization beginning in May 1995 of mortgage servicing rights
arising from loans originated as well as purchased, pursuant to the Bank's
adoption of SFAS No. 122, "Accounting for Mortgage Servicing Rights." Mortgage
servicing rights sold during the nine months ended September 30, 1997 included
rights related to loans originated prior to May 1995 and therefore not
capitalized by the Bank.
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<PAGE>
Other Assets. Other assets decreased $7.2 million, or 13.5%, to $46.2
million at September 30, 1997, from $53.4 million at December 31, 1996. The
majority of this decrease was attributable to the collection of receivables
recorded in conjunction with the sales of mortgage servicing rights completed
during 1996. Upon a sale of mortgage servicing rights, the Bank receives a
down payment from the purchaser equivalent to approximately 20% of the total
purchase price and records a receivable account for the balance of the
purchase price due. In connection with the sale of mortgage servicing rights,
the Bank had receivables of $30.0 million at September 30, 1997. The balance
due is paid upon transfer by the Bank of the related mortgage loan servicing
documents, usually within 180 days after the initial closing.
Liabilities. The Bank's total liabilities increased approximately $700
million, or 58.3%, to $1.9 billion at September 30, 1997, from $1.2 billion at
December 31, 1996. This increase was primarily attributable to an increase in
the Bank's deposit accounts, FHLB advances, liabilities for checks issued,
offset in part by a decrease in the amount of undisbursed payments on loans
serviced for others, escrow accounts, and the amount of federal income taxes
payable.
Deposit Accounts. Deposit accounts increased $375.3 million, or 60.1%, to
$1.0 billion at September 30, 1997, from $624.7 million at December 31, 1996.
This increase reflects the Bank's deposit growth strategy through both its
branch network and the secondary market. The number of bank branches increased
from 15 at December 31, 1996 to 19 at September 30, 1997. The bank branches
have generated $119.7 million in net new deposits, a 29.0% increase, since
December 31, 1996. At September 30, 1997, the Bank's certificates of deposit
totaled $877.3 million, or 86.7% of total deposits and carried an average
balance of $41,502 and a weighted average cost of 6.04%. Approximately $480.4
million of the certificates of deposit were brokered deposits or deposits
garnered through secondary markets and carried a weighted average cost of
6.03%.
FHLB Advances. FHLB advances increased $329.1 million, or 84.4%, to $718.9
million at September 30, 1997, from $389.8 million at December 31, 1996. The
Bank relies upon such advances as a source of funding for the origination or
purchase of loans which are later sold into the secondary market. The
outstanding balance of FHLB advances fluctuates from time to time depending
upon the Bank's current inventory of loans held for sale and the availability
of lower cost funding from its deposit base and its escrow accounts.
Undisbursed Payments. Undisbursed payments on loans serviced for others
decreased $25.0 million, or 40.7%, to $36.4 million at September 30, 1997,
from $61.4 million at December 31, 1996. These amounts represent payments
received from borrowers for interest, principal and related loan charges,
which have not been remitted to the respective investors. These balances
fluctuate with the size of the servicing portfolio and decrease during a time
of low payoff or refinance volume.
Liability for Checks Issued. Liability for checks issued increased $9.3
million, or 23.4%, to $49.1 million at September 30, 1997, from $39.8 million
at December 31, 1996. These amounts represent checks issued to acquire
mortgage loans which have not cleared for payment. These balances fluctuate
with the size of the mortgage pipeline, increasing in lower interest rate
scenarios and decreasing during a time of low origination or refinance volume.
Federal Income Taxes Payable. Federal income taxes payable decreased $6.0
million, or 26.7%, to $16.5 million at September 30, 1997, from $22.5 million
at December 31, 1996. This decrease was primarily attributable to the timing
of payments and a decrease in the current tax liability.
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 1996 AND DECEMBER 31, 1995
Assets. The Bank's assets totaled $1.3 billion at December 31, 1996, an
increase of approximately $300 million, or 30.0%, as compared to $1.0 billion
at December 31, 1995. This increase was primarily due to increases in mortgage
loans held for sale, premises and equipment, mortgage servicing rights, and
other assets, offset in part by decreases in loans held for investment.
OC-37
<PAGE>
Loans Receivable. Mortgage loans available for sale and mortgage loans held
for investment increased, in the aggregate, $163.0 million from $798.7 million
at December 31, 1995 to $961.7 million at December 31, 1996. Mortgage loans
available for sale increased $220.3 million, or 35.5%, to $840.8 million at
December 31, 1996, from $620.5 million at December 31, 1995. Mortgage loans
held for investment decreased $57.3 million, or 32.2%, from $178.2 million at
December 31, 1995 to $120.9 million at December 31, 1996. See "Business--
Lending." Loans held for investment decreased $32.0 million, or 10.5%, to
$273.6 million at December 31, 1996, from $305.6 million at December 31, 1995.
Loans held for investment include both loans originated for the Bank's own
portfolio through the retail banking operation and loans with characteristics
that do not conform to underwriting standards for sale as conforming loans in
the secondary market. See "Business--Lending."
Allowance For Losses. The allowance for losses totaled $3.5 million at
December 31, 1996, an increase of $1.4 million, or 66.7%, from $2.1 million at
December 31, 1995. The allowance for losses as a percentage of non-performing
loans was 11.43% and 19.67% at December 31, 1996 and 1995, respectively. The
Bank's non-performing loans totaled $30.6 million and $10.7 million at
December 31, 1996 and 1995, respectively, and, as a percentage of total loans,
were 2.75% and 1.15% at December 31, 1996 and 1995, respectively. The increase
in the allowance for losses was based upon management's assessment of relevant
factors, including the types and amounts of non-performing loans, historical
and anticipated loss experience on such types of loans, and current and
projected economic conditions. Management also considered the likelihood that
the Bank would be required to repurchase additional loans from secondary
market investors over the next year at levels above the Bank's historical
experience, as discussed below.
The increase in non-performing loans at December 31, 1996 resulted primarily
from the repurchase of $54.8 million in mortgage loans from secondary market
investors during 1996 (compared to $4.5 million during 1995). Such loans
included approximately $10.3 million of loans sold during 1996, $32.7 million
of loans sold in 1995 and $11.8 million of loans sold prior to 1995.
Approximately $10.1 million of the loans repurchased in 1996 were non-
performing at December 31, 1996 and $3.7 million had been foreclosed and were
held as other repossessed assets. Loan repurchases are an ongoing part of the
Bank's operations since all loans sold in the secondary market are generally
subject to detailed underwriting reviews by the ultimate purchaser. Although
the Bank generally does not sell loans with recourse, it typically is required
to repurchase loans, including defaulted and delinquent loans, that were not
underwritten in strict compliance with the underwriting standards of secondary
market investors. As the volume of the Bank's new loan production has
increased substantially over the past several years, the aggregate amount of
loan delinquencies and foreclosures has also increased, thereby increasing the
number of loans potentially subject to repurchase. In addition, during 1996
two of the largest secondary market purchasers of loans implemented automated
underwriting review systems which enabled them to review delinquent and other
loans on a much faster basis, thereby accelerating the process of returning to
the Bank loans originated in prior periods.
The Bank believes that its risk of loss arising from its non-performing
loans, including loans acquired through repurchase from individual investors
after initial sale in the secondary market, has not materially increased as a
result of either the increase in repurchased loans or the overall increase in
non-performing loans. In most cases the repurchased loans were required to be
repurchased for reasons (such as failure to meet all of the secondary market
investor's criteria for mortgagor eligibility or failure to meet the
investor's program eligibility requirements) that do not significantly affect
the ultimate collectibility of such loans or significantly increase the Bank's
exposure to losses. A substantial majority of the repurchased loans are
eligible for resale in the secondary market to other investors, and the Bank
does not believe that the remaining repurchased loans that are currently non-
performing or that have been foreclosed present risks of ultimate loss that
are significantly different than the Bank has historically experienced. Of the
Bank's $30.6 million of non-performing loans at December 31, 1996, $27.0
million, or 88%, were single family residential mortgage loans, which
generally represent minimal risk of ultimate loss because of the nature of the
collateral securing the loans, private mortgage insurance for loans with over-
80% LTV ratios and insurance or guarantees on certain loans from the FHA or
VA. At December 31, 1996, approximately $8.0 million of such loans were the
subject of bankruptcy proceedings by the mortgagor; however, it has been the
Bank's experience that such proceedings usually result
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<PAGE>
in full repayment to the Bank and present minimal risk of loss because the
imposition of judicial scrutiny and related enforcement powers supersede the
less comprehensive collection methods normally available to the Bank. For
further information regarding the Bank's asset quality, see "Business--Asset
Quality."
FHLB Stock. Holdings of FHLB stock increased from $17.8 million at December
31, 1995 to $19.7 million at December 31, 1996 as the Bank's total mortgage
loan portfolio increased. As a member of the FHLB, the Bank is required to
hold shares of FHLB stock in an amount at least equal to 1% of the aggregate
unpaid principal balance of its home mortgage loans, home purchase contracts
and similar obligations at the beginning of each year, or 1/20th of its FHLB
advances, whichever is greater. See "Regulation--Regulation of the Bank--
Federal Home Loan Bank System."
Premises and Equipment. Premises and equipment, net of accumulated
depreciation, totaled $20.8 million at December 31, 1996, an increase of $2.9
million, or 16.2%, from $17.9 million at December 31, 1995. This increase
reflects the Bank's investment in technology, along with the expansion of the
retail deposit branch offices, and the increased national presence in the
mortgage acquisition area. See "Business--Technology," "--Lending" and "--
Retail Loan Production."
Mortgage Servicing Rights. Mortgage servicing rights totaled $30.1 million
at December 31, 1996, an increase of $2.1 million, or 7.5%, from $28.0 million
at December 31, 1995. For the year ended December 31, 1996, $5.6 billion of
loans underlying mortgage servicing rights were originated and purchased, and
$7.6 billion were reduced through sales, prepayments, and amortization
(including a $3 billion sale of mortgage servicing rights in December 1996)
resulting in a net decrease at year-end of $2 billion. However, because of
sales during 1996 of servicing acquired during earlier periods, the mortgage
servicing portfolio at December 31, 1996 contained a greater percentage of
capitalized servicing rights which were reflected as assets on the Bank's
statement of financial condition (reflecting largely servicing rights
originated after the Bank's mid-1995 adoption of SFAS No. 122, "Accounting for
Mortgage Servicing Rights") than it did at December 31, 1995. See "Business--
Lending."
Other Assets. Other assets increased $32.7 million, or 158.0%, to $53.4
million at December 31, 1996, from $20.7 million at December 31, 1995. The
majority of this increase was attributable to receivables recorded in
conjunction with a sale of approximately $700 million in mortgage servicing
rights during September 1996 and a $3.0 billion sale of mortgage servicing
rights in December 1996. Upon a sale of mortgage servicing rights, the Bank
receives a down payment from the purchaser equivalent to approximately 20% of
the total purchase price and records a receivable account for the balance of
the purchase price due. In connection with the sale of mortgage servicing
rights during 1996, the Bank had receivables of $35.7 million at December 31,
1996. The balance due is paid upon transfer by the Bank of the related
mortgage loan servicing documents, usually within 180 days after the initial
closing. See "Business--Mortgage Loan Servicing."
Liabilities. The Bank's total liabilities increased approximately $200
million, or 20.0%, to $1.2 billion at December 31, 1996, from $1.0 billion at
December 31, 1995. This increase was primarily attributable to an increase in
the Bank's deposit portfolio as well as changes in the amount of escrows held
on mortgage loans, and the amount of FHLB advances, offset in part by a
decrease in the amount of undisbursed payments on loans serviced for others
and the amount of liability for checks issued.
Deposits. Deposit accounts increased $95.5 million, or 18.0%, to $624.7
million at December 31, 1996, from $529.2 million at December 31, 1995. This
increase reflects the Bank's deposit growth strategy through its branch
network and its pricing strategy. The number of bank branches has increased
from 13 at December 31, 1995 to 15 at December 31, 1996. The Bank's aggressive
pricing strategy attracts one-year certificates of deposit and brokered funds.
The Bank relies upon both its retail customer base and nationwide advertising
of its deposit rates to attract deposits through the pricing of deposits at up
to 0.25% over the prevailing market rate. At December 31, 1996, the Bank's
certificates of deposit totaled $500.6 million, with an average balance of
$26,235 and a weighted average cost of 5.95%. Of such amount, approximately
$212.6 million were brokered deposits with a weighted average cost of 5.88%.
See "Business--Funding Sources."
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<PAGE>
FHLB Advances. FHLB advances increased $198.6 million, or 103.9%, to $389.8
million at December 31, 1996, from $191.2 million at December 31, 1995. The
Bank relies upon such advances as a source of funding for the origination or
purchase of loans for sale in the secondary market. See "Capitalization." The
outstanding balance of FHLB advances fluctuates from time to time depending
upon the Bank's current inventory of loans held for sale and the availability
of lower cost funding from its retail deposit base and its escrow accounts.
The increase in the outstanding balance of FHLB advances from December 31,
1995 to December 31, 1996 was attributable to an increase in the amount of
loans held for sale. See "--Liquidity and Capital Resources."
Undisbursed Payments. Undisbursed payments on loans serviced for others
increased $1.4 million, or 2.3%, to $61.4 million at December 31, 1996, from
$60.0 million at December 31, 1995. The month-end average amount of these
funds was $67.3 million and $49.6 million during 1996 and 1995, respectively.
These amounts represent payments received from borrowers for interest,
principal and related loan charges that have not been remitted. These balances
fluctuate with the size of the servicing portfolio and increase during a time
of high payoff or refinance volume.
Escrow Accounts. The amount of funds in escrow accounts decreased $27.9
million, or 31.4%, to $61.0 million at December 31, 1996, from $88.9 million
at December 31, 1995. The average of the month end balances in these accounts
was $82.3 million and $86.5 million during 1996 and 1995, respectively. These
accounts are maintained on behalf of mortgage customers and include funds
earmarked for real estate taxes, homeowner's insurance, and other insurance
product liabilities. These balances fluctuate with the size of the servicing
for others portfolio and also depend upon the scheduled payment dates for the
related expenses.
Liability for Checks Issued. The liability for checks issued decreased $46.0
million, or 53.6%, to $39.8 million at December 31, 1996, from $85.8 million
at December 31, 1995. This liability reflects the outstanding amount of checks
the Bank has written in conjunction with acquiring mortgage loans. This
account grows or contracts in conjunction with the amount of loans that are in
the Bank's mortgage pipeline.
Federal Income Taxes Payable. Federal income taxes payable increased $7.9
million, or 54.1%, to $22.5 million at December 31, 1996, from $14.6 million
at December 31, 1995. This increase was primarily attributable to the timing
of payments and an increase in the current tax liability.
Other Liabilities. Other liabilities increased $5.0 million, or 42.0%, to
$16.9 million at December 31, 1996, from $11.9 million at December 31, 1995.
This liability primarily reflects amounts received in conjunction with
acquiring mortgage loans, but not yet applied. This account grows or contracts
in conjunction with the amount of loans that are in the Bank's mortgage
pipeline.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity. Liquidity refers to the ability or the financial flexibility to
manage future cash flows to meet the needs of depositors and borrowers and
fund operations on a timely and cost-effective basis. The Bank is required by
OTS regulations to maintain minimum levels of liquid assets. This requirement,
which may be changed at the direction of the OTS depending upon economic
conditions and deposit flows, is based upon a percentage of deposits and
short-term borrowings. The required minimum ratio is currently 4.0%. While the
Bank's liquidity ratio varies from time to time, the Bank has generally
maintained liquid assets substantially in excess of the minimum requirements.
The Bank's average daily liquidity ratios were 8.5% and 21.5% during September
1997 and December 1996, respectively.
A significant source of cash flow for the Bank is the sale of mortgage loans
available for sale. Additionally, the Bank receives funds from net interest
income, mortgage loan servicing fees, loan principal repayments, advances from
the FHLB, deposits from customers and cash generated from operations. Mortgage
loans sold during the nine months ended September 30, 1997, totaled $4.5
billion, a decrease of approximately $800 million, or 15.1%, from $5.3 billion
sold during the comparable 1996 period. This decrease in mortgage loan sales
was directly attributable to the growth achieved in comparable periods. The
Bank sold 84.9% and 98.1% of
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<PAGE>
its mortgage loan originations during the nine months ended September 30, 1997
and 1996, respectively. Mortgage loans sold during 1996 totaled $6.6 billion,
compared to $4.8 billion and $3.6 billion during 1995 and 1994, respectively.
The fluctuation in this activity was directly related to the amount of
mortgage loan originations. The Bank sold 96.9%, 91.6%, and 95.5% of its
mortgage loan originations during 1996, 1995 and 1994, respectively.
The Bank typically uses FHLB advances to fund its daily operational
liquidity needs and to assist in funding loan originations. The Bank will
continue to use this source of funds unless a more stable source of funds
becomes available. FHLB advances are used because of their flexibility. These
funds are typically borrowed for up to 90 days with no prepayment penalty, of
which $718.9 million was outstanding at September 30, 1997. Such advances are
repaid with the proceeds from the sale of mortgage loans held for sale. The
Bank currently has an authorized line of credit equal to $850 million. This
line is collateralized by non-delinquent mortgage loans. To the extent the
amount of retail deposits or customer escrow accounts can be increased, the
Bank expects that they will eventually replace FHLB advances as a funding
source.
At September 30, 1997, the Bank had outstanding rate-lock commitments to
lend $823.2 million for mortgage loans, along with outstanding commitments to
make other types of loans totaling $35.9 million. Because such commitments may
expire without being drawn upon, they do not necessarily represent future cash
commitments. Also, as of September 30, 1997, the Bank had outstanding
commitments to sell $1.1 billion of mortgage loans. These commitments will be
funded within 90 days. Total commercial and consumer unused collateralized
lines of credit totaled $108.1 million at September 30, 1997. Such commitments
include $121.5 million in warehouse lines of credit to various mortgage
companies, of which $53.3 million was drawn upon as of September 30, 1997.
Capital Resources. At September 30, 1997, the Bank exceeded all applicable
regulatory minimum capital requirements. For a detailed discussion of the
regulatory capital requirements to which the Bank is subject, and for a
tabular presentation of compliance with such requirements, see "Regulation--
Regulation of the Bank--Regulatory Capital" and Note 13 of Notes to Financial
Statements.
ASSET/LIABILITY MANAGEMENT
The Bank has sought to manage its exposure to changes in interest rates by
matching more closely the effective maturities or repricing characteristics of
the Bank's interest-earning assets and interest-bearing liabilities. The
matching of the Bank's assets and liabilities may be analyzed by examining the
extent to which its assets and liabilities are interest rate sensitive and by
monitoring the expected effects of interest rate changes on its net interest
income.
An asset or liability is interest rate sensitive within a specific time
period if it will mature or reprice within that time period. If the Bank's
assets mature or reprice more quickly or to a greater extent than its
liabilities, the Bank's net portfolio value and net interest income would tend
to increase during periods of rising interest rates but decrease during
periods of falling interest rates. If the Bank's assets mature or reprice more
slowly or to a lesser extent than its liabilities, its net portfolio value and
net interest income would tend to decrease during periods of rising interest
rates but increase during periods of falling interest rates. Because the Bank
sells a significant portion of its loan production in the secondary market,
its interest rate risk is somewhat mitigated. The Bank has pursued certain
strategies designed to decrease the vulnerability of its earnings to material
and prolonged changes in interest rates in connection with its banking
operations.
As part of its overall interest rate risk policy, the Bank has focused on
the development of a long-term deposit base to support its asset growth as
well as its ability to sell residential mortgage loans in the secondary market
while retaining both the mortgage servicing rights and the generally non-
interest bearing escrow accounts. In addition to its deposit base and funds
from the escrow accounts, the Bank also uses FHLB advances as a means to match
efficiently maturities of funding sources with the expected selling time of
the related loans.
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<PAGE>
Management believes that this approach to loan originations allows the Bank to
respond to customer demand while minimizing interest rate and credit risk
without significantly increasing operating expenses.
Interest Rate Sensitivity Analysis. The matching of assets and liabilities
may be analyzed by examining the extent to which such assets and liabilities
are "interest rate sensitive" and by monitoring an institution's interest rate
sensitivity "gap." An asset or liability is said to be interest rate sensitive
within a specific period if it will mature or reprice within that period. The
interest rate sensitivity "gap" is the difference between the amount of
interest-earning assets maturing or repricing within a specific time period
and the amount of interest-bearing liabilities maturing or repricing within
that time period. A gap is considered positive when the amount of interest
rate sensitive assets exceeds the amount of interest rate sensitive
liabilities, and is considered negative when the amount of interest rate
sensitive liabilities exceeds the amount of interest rate sensitive assets.
During a period of rising interest rates, a negative gap would be expected to
adversely affect net interest income while a positive gap would be expected to
result in an increase in net interest income, while conversely during a period
of declining interest rates, a negative gap would be expected to result in an
increase in net interest income and a positive gap would be expected to
adversely affect net interest income. At September 30, 1997, the Bank's
cumulative one-year interest rate gap position was a positive $55.3 million,
or 3.00% of total interest earning assets. This is a one-day position which is
continually changing and is not necessarily indicative of the Bank's position
at any other time. The Bank's current one-year gap is within the guidelines
established by management and approved by the Board of Directors. Management
considers numerous factors when establishing these guidelines, including
current interest rate margins, capital levels, and any guidelines provided by
the OTS.
Different types of assets and liabilities with the same or similar
maturities may react differently to changes in overall market rates or
conditions, and thus changes in interest rates may affect net interest income
positively or negatively even if an institution were perfectly matched in each
maturity category. Additionally, the gap analysis does not consider the many
factors as Banking interest rate moves. While the interest rate sensitivity
gap is a useful measurement and contributes toward effective asset and
liability management, it is difficult to predict the effect of changing
interest rates solely on that measure, without accounting for alterations in
the maturity or repricing characteristics of the balance sheet that occur
during changes in market interest rates. During periods of rising interest
rates, the Bank's assets tend to have prepayments that are slower than those
in an interest rate sensitivity gap and would increase the negative gap
position. Conversely, during a period of falling interest rates, the Bank's
assets would tend to prepay faster than originally expected thus decreasing
the negative gap. In addition, some of the Bank's assets, such as adjustable
rate mortgages, have caps on the amount by which their interest rates can
change in any single period, and therefore may not reprice as quickly as
liabilities in the same maturity category.
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<PAGE>
The following table sets forth the amounts of interest-earning assets and
interest-bearing liabilities outstanding at September 30, 1997 which are
expected to mature or reprice in each of the time periods shown.
<TABLE>
<CAPTION>
DUE DUE
WITHIN 12 MONTHS ONE TO FIVE YEARS
----------------- -------------------
AMOUNT RATE AMOUNT RATE AMOUNT RATE
----------- ----- ---------- ----- ---------- -------
<S> <C> <C> <C> <C> <C> <C>
INTEREST-EARNING ASSETS
(1):
Mortgage loans held for
investment............. $ 272,667 7.93% $ 199,537 7.94% $ 38,095 7.21%
Mortgage loans held for
sale................... 1,363,822 7.76% 462,642 7.80% 163,758 7.43%
Other mortgage loans.... 18,641 10.48% 18,641 10.48% -- --
Construction loans..... 37,812 9.31% 37,812 9.31% -- --
Commercial real estate
loans................. 19,347 9.00% 6,921 9.53% 12,426 8.71%
Commercial loans....... 56,216 8.83% 55,574 8.81% 642 10.10%
Consumer loans......... 34,919 10.34% 26,656 10.29% 6,167 10.50%
FHLB stock.............. 36,925 5.00% 36,925 5.00% -- --
Other investments....... 539 5.57% 39 -- 500 6.00%
----------- ----- ---------- ----- ---------- ------
Total.................. $ 1,840,888 7.88% $ 844,747 8.00% $ 221,588 7.56%
----------- ---------- ----------
INTEREST-BEARING LIABIL-
ITIES (2):
Savings Deposits........ $ 78,879 4.67% $ 11,832 4.67% $ 50,285 4.67%
Certificates of Depos-
its.................... 877,261 5.98% 496,468 5.99% 380,793 5.96%
Demand deposits......... 55,981 2.20% 55,981 2.20% -- --
----------- ----- ---------- ----- ---------- ------
Total deposits......... 1,012,121 5.66% 564,281 5.58% 431,078 5.81%
FHLB advances........... 718,878 5.88% 705,378 5.89% 13,500 5.32%
----------- ----- ---------- ----- ---------- ------
Total.................. $ 1,730,999 5.75% $1,269,659 5.75% $ 444,578 5.80%
----------- ---------- ----------
OFF-BALANCE SHEET:
Commitments to sell
loans.................. $(1,148,000) 7.13% $1,046,694 7.13% $ (78,431) 7.00%
Commitments to originate
loans.................. 576,209 7.58% (566,488) 7.38% 48,607 7.38%
----------- ---------- ----------
Total.................. $ (571,791) $ 480,206 $ (29,824)
----------- ---------- ----------
Interest rate spread.... 2.13%
Excess (Deficiency) of
repricing earning
assets over (to)
interest-bearing
liabilities (Interest
sensitivity gap)....... $ 109,890(3) $ 55,294 $ (252,814)
=========== ========== ==========
Cumulative excess (defi-
ciency) of repricing
earning assets over
(to) interest-bearing
liabilities (Cumulative
gap)................... $ 55,294 $ (197,520)
========== ==========
Cumulative gap as a per-
centage of total inter-
est-earning assets..... 3.00% (10.73%)
========== ==========
</TABLE>
(continued)
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<PAGE>
<TABLE>
<CAPTION>
DUE FROM FIVE TO DUE AFTER
TEN YEARS TEN YEARS TOTAL
----------------- --------------- ----------------
AMOUNT RATE AMOUNT RATE AMOUNT RATE
--------- ------ --------- ---- ---------- -----
<S> <C> <C> <C> <C> <C> <C>
INTEREST-EARNING
ASSETS(1):
Mortgage loans held for
investment............. $ 9,527 7.60% $ 25,508 9.03% $ 272,667 7.93%
Mortgage loans held for
sale................... 78,877 7.62% 658,545 7.82% 1,363,822 7.76%
Other mortgage loans.... -- -- -- -- 18,641 10.48%
Construction loans.... -- -- -- -- 37,812 9.31%
Commercial real estate
loans................ -- -- -- -- 19,347 9.00%
Commercial loans...... -- -- -- -- 56,216 8.83%
Consumer loans........ 2,096 10.50% -- -- 34,919 10.34%
FHLB stock.............. -- -- -- -- 36,925 5.00%
Other investments....... -- -- -- -- 539 5.57%
--------- ------ --------- ---- ---------- -----
Total................. $ 90,500 7.68% $ 684,053 7.87% $1,840,888 7.88%
INTEREST-BEARING
LIABILITIES(2):
Savings Deposits........ $ 16,762 4.67% -- -- $ 78,879 4.67%
Certificates of
Deposits............... -- -- -- -- 877,261 5.98%
Demand deposits......... -- -- -- -- 55,981 2.20%
--------- ------ --------- ---- ---------- -----
Total deposits........ $ 16,762 4.67% 1,012,121 5.66%
FHLB advances........... -- -- -- -- 718,878 5.88%
--------- ------ --------- ---- ---------- -----
Total................. $ 16,762 4.67% $1,730,999 5.75%
OFF-BALANCE SHEET:
Commitments to sell
loans.................. $(102,509) 7.01% $(865,754) 7.15% $ --
Commitments to originate
loans.................. 57,073 7.45% 460,808 7.62% --
--------- --------- ----------
Total................. $ (45,436) $(404,946) --
Interest rate spread....
Excess (Deficiency) of
repricing earning
assets over (to)
interest-bearing
liabilities (Interest
sensitivity gap)....... $ 28,302 $ 279,107 $ 109,889
Cumulative excess
(deficiency) of
repricing earning
assets over (to)
interest-bearing
liabilities (Cumulative
gap)................... $(169,218) $ 109,889 $ 109,889
Cumulative gap as a
percentage of total
interest-earning
assets................. (9.19)% 5.97%
</TABLE>
- --------
(1) Fixed-rate loans are distributed based on their contractual maturity
adjusted for projected or anticipated prepayments, and variable rate loans
are distributed based on the interest rate reset date and contractual
maturity adjusted for prepayments. Mortgage loans are presented assuming a
15.94% annual prepayment rate.
(2) Passbook savings are presented assuming a 15% annual decay rate. Demand
deposits are presented in the earliest repricing period since amounts in
these accounts are subject to withdrawal on demand. Savings certificates
are distributed assuming no withdrawal prior to maturity.
(3) This excess of earning assets has the effect of increasing the indicated
spread by 0.34% and does not include off-balance sheet items.
EFFECT OF NEW ACCOUNTING STANDARDS
The Financial Accounting Standards Board ("FASB") has issued SFAS No. 128,
"Earnings Per Share," which is effective for financial statements issued after
December 15, 1997. Early adoption of the standard is not permitted. The new
standard eliminates primary and fully diluted earnings per share and requires
presentation of
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<PAGE>
basic and diluted earnings per share together with disclosure of how the per
share amounts were computed. The adoption of this new standard is not expected
to have a material impact on the disclosure of earnings per share in the
financial statements.
In June 1997, the FASB issued SFAS No. 130, "Reporting of Comprehensive
Income," which establishes standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains, and
losses) in a full set of financial statements. This statement also requires
that all items that are required to be recognized under accounting standards
as components of comprehensive income be reported in a financial statement
that is displayed with the same prominence as other financial statements. This
statement is effective for fiscal years beginning after December 15, 1997.
Earlier application is permitted. Reclassification of financial statements for
earlier periods provided for comparative purposes is required. The Bank does
not anticipate that adoption of SFAS No. 130 will have a material effect on
the Bank.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information," which establishes standards for the
way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to stockholders. This statement also establishes standards for
related disclosures about products and services, geographic areas, and major
customers. This statement requires the reporting of financial and descriptive
information about an enterprise's reportable operating segments. This
statement is effective for financial statements for periods beginning after
December 15, 1997. In the initial year of application, comparative information
for earlier years is to be restated. The Bank does not anticipate that the
adoption of SFAS No. 131 will have a material effect on the Bank.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and Notes thereto presented herein
have been prepared in accordance with generally accepted accounting
principles, which require the measurement of financial position and operating
results in terms of historical dollars without considering the changes in the
relative purchasing power of money over time due to inflation. The impact of
inflation is reflected in the increased cost of the Bank's operations. Unlike
most industrial companies, nearly all the assets and liabilities of the Bank
are monetary in nature. As a result, interest rates have a greater impact on
the Bank's performance than do the effects of general levels of inflation.
Interest rates do not necessarily move in the same direction or to the same
extent as the prices of goods and services.
YEAR 2000 PROBLEM
The Bank is aware of the current concerns throughout the business community
of reliance upon computer software programs that do not properly recognize the
year 2000 in date formats, often referred to as the "Year 2000 Problem." The
Year 2000 Problem is the result of software being written using two digits
rather than four digits to define the applicable year (i.e., "98" rather than
"1998"). A failure by a business to properly identify and correct a Year 2000
Problem in its operations could result in system failures or miscalculations.
In turn, this could result in disruptions of operations, including among other
things a temporary inability to process transactions, send invoices or
otherwise engage in routine business transactions on a day-to-day basis.
Operations of the Bank depend upon the successful operation on a daily basis
of its computer software programs. The Bank relies upon software purchased
from third party vendors rather than internally generated software. In its
analysis of the software, and based upon its ongoing discussions with these
vendors, the Bank has determined that most of its software already reflects
changes necessary to avoid the Year 2000 Problem. The Bank expects to update
during 1998 any remaining software that could be affected by the Year 2000
Problem to eliminate remaining concerns. This update is not expected to have
any adverse material financial impact on the Bank.
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<PAGE>
BUSINESS
GENERAL
Flagstar Bank, FSB, is a federally chartered stock savings bank which is
also the largest independent Michigan-based savings institution based on asset
size as of September 30, 1997, according to SNL Securities. The Bank is also
one of the largest originators of conforming single-family mortgage loans in
the United States according to Inside Mortgage Finance. The Bank is engaged in
the business of providing a full range of retail banking services in southern
and western Michigan and in originating, purchasing and servicing residential
mortgage loans on a nationwide basis. For 1996, the Bank ranked fourth in the
United States among thrifts in mortgage loan originations and sixteenth in
total mortgage loan production according to SMR Research Corp. All of the
outstanding stock of the Bank is owned by Flagstar, a Michigan corporation
whose common stock is listed for trading on Nasdaq under the symbol "FLGS."
As of September 30, 1997, the Bank had consolidated total assets of $2.0
billion, net loans of $1.8 billion, total deposits of $1.0 billion and total
stockholder's equity of $121.1 million. For the nine months ended September
30, 1997, the Bank's net earnings were $15.8 million and its return on average
assets and return on average equity (as annualized) were 1.34% and 21.53%,
respectively. At December 31, 1996, the Bank had consolidated total assets of
$1.3 billion, net loans of $1.1 billion, total deposits of $624.7 million and
total stockholder's equity of $77.9 million. For the year ended December 31,
1996, the Bank's net earnings were $17.1 million and its return on average
assets and return on average equity were 1.54% and 24.82%, respectively ($19.3
million, 1.73% and 27.97%, respectively, excluding the special deposit
insurance assessment imposed on September 30, 1996 on all depository
institutions insured by the Savings Association Insurance Fund (the "SAIF")).
The Bank's operations are segregated into two segments, mortgage banking and
retail banking, with most of the Bank's revenue (net interest income and non-
interest income) and earnings before income taxes attributable to the mortgage
banking segment. The Bank believes that its retail banking business provides
it with a strategic advantage because it affords the Bank access to funding
sources for its mortgage origination business that would not otherwise be
available. These additional funding sources include lower cost retail
deposits, FHLB advances and escrowed funds. The Bank benefits as compared to
mortgage originators with no retail banking operations because it has access
to a lower cost of funds and is therefore able to generate greater net
interest income.
The Bank did not have any significant retail banking operations prior to
1994. See "--Lending--Retail Banking Operations." For further information, see
Note 17 of Notes to Consolidated Financial Statements.
BUSINESS STRATEGY
The Bank's strategy consists of the following key elements:
-- continue to expand the Bank's branch network into demographically
desirable communities adjacent to the Bank's current markets in southern
and western Michigan in order to gain access to additional lower-cost
retail funding sources;
-- cross-sell retail banking services to the Bank's large Michigan customer
base of present mortgage customers;
-- benefit from economies of scale by increasing the size of the loan
servicing portfolio through the continued origination and purchase of
large volumes of mortgage loans on a diversified, nationwide basis;
-- as market conditions warrant, retain more of its mortgage loan
production volume or mortgage servicing rights, or both; and
-- utilize advanced technology and automated processes throughout the
Bank's business to improve customer service, reduce costs of loan
production and servicing and increase efficiencies.
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<PAGE>
TECHNOLOGY
The Bank makes extensive use of advanced technology and automated processes
in order to enhance the competitiveness and reduce the cost of its mortgage
origination operations. The Bank was one of the first mortgage lenders to
utilize video conferencing for loan production. In 1996, the Bank began full-
scale operational use of automated underwriting system technologies, including
Fannie Mae's Desktop Underwriter(TM) and Freddie Mac's Loan Prospector(TM) (of
which the Bank is currently one of the largest users), and has combined the
two technologies into its LIVE(R) video conferencing and underwriting system.
The Bank believes that this system, which permits a loan underwriter to
interview and complete a loan application and approve a loan for a prospective
borrower in one session during a live video conference, will give it a
significant competitive edge in writing mortgage loans. During 1997,
substantially all of the Bank's mortgage loan production is being underwritten
using automated systems, which it believes reduces overhead, increases
customer service and facilitates conformity with underwriting guidelines.
LENDING
The Bank originates or acquires loans through its retail banking operations
or through the wholesale, correspondent and retail loan production outlets of
its mortgage banking operations. Loans are either held for investment in the
Bank's portfolio or held available for sale in the secondary market. Wholesale
mortgage loan production involves the origination of loans by a nationwide
network of independent mortgage brokers with funding provided directly by the
Bank (i.e., table funding) and the transfer of such loans to the Bank upon
closing. Correspondent mortgage loan production occurs through the purchase of
loans by the Bank from independent mortgage lenders, commercial banks, savings
and loan associations and other financial intermediaries that originate loans
in their own name using their own source of funds. Retail mortgage loan
production for mortgage banking operations occurs through the Bank's loan
centers. For the nine months ended September 30, 1997, the Bank's combined
wholesale and correspondent loan production totaled $4.8 billion and its
retail mortgage loan production totaled $529.9 million.
In addition to mortgage loan production, the Bank engages to a limited
extent in the origination of commercial, commercial real estate, construction
and consumer loans, primarily through its branches and loan centers.
The following table sets forth selected data relating to the composition of
the Bank's loan portfolio by type of loan at the dates indicated. This table
includes mortgage loans available for sale and mortgage loans held for
investment. At September 30, 1997, the Bank had no concentrations of loans
exceeding 10% of total loans that are not otherwise disclosed below.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, AT DECEMBER 31,
------------------ ------------------------------------------------------------------------------------------
1997 1996 1995 1994 1993 1992
------------------ ------------------ ---------------- ---------------- ---------------- ----------------
AMOUNT % AMOUNT % AMOUNT % AMOUNT % AMOUNT % AMOUNT %
---------- ------ ---------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Single-family.... $1,625,217 90.68% $ 934,226 84.62% $784,980 85.68% $554,087 87.91% $384,819 93.36% $217,360 90.95%
Construction..... 37,812 2.11% 59,270 5.37% 48,933 5.34% 25,499 4.05% 19,864 4.82% 20,181 8.44%
Consumer loans... 34,919 1.95% 33,608 3.04% 39,331 4.29% 19,271 3.06% 11 -- % 18 0.01%
Commercial real
estate.......... 19,347 1.08% 13,565 1.23% 30,504 3.33% 23,383 3.71% 864 0.21% 1,199 0.50%
Commercial....... 56,216 3.14% 46,212 4.19% 8,576 0.94% 7,546 1.20% 6,167 1.50% 239 0.10%
Other mortgage... 18,641 1.04% 17,128 1.55% 3,877 0.42% 453 0.07% 478 0.11% -- -- %
---------- ------ ---------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total........... 1,792,152 100.00% 1,104,009 100.00% 916,201 100.00% 630,239 100.00% 412,203 100.00% 238,997 100.00%
====== ====== ====== ====== ====== ======
Add (deduct):
Deferred loan
fees........... 5,100 3,179 1,621 970 1,243 680
Premiums
(discounts).... 11,122 7,158 8,223 4,071 2,533 226
Allowance for
losses......... (4,950) (3,500) (2,102) (1,871) (901) (550)
---------- ---------- -------- -------- -------- --------
Total........... $1,803,424 $1,110,846 $923,943 $633,409 $415,078 $239,353
========== ========== ======== ======== ======== ========
</TABLE>
OC-47
<PAGE>
In its wholesale and correspondent lending, the Bank competes nationwide by
offering a wide variety of mortgage products designed to respond to consumer
needs and tailored to address market competition. The Bank primarily
originates conforming, fixed rate 30-year mortgage loans, which collectively
represented 62.6% of its total mortgage loan production for the nine month
period ended September 30, 1997, and 62.2% for the year ended December 31,
1996. In addition, the Bank offers other products, such as adjustable-rate, 5-
year and 7-year balloons and jumbo mortgages as well as loans supported by
various FHA and Veteran's Administration programs. Mortgage loans originated
are primarily for the purchase of single-family residences, although such
loans are also originated for refinancing of existing mortgages.
Approximately 78% of the mortgage loans originated during 1993 were
refinancings of outstanding mortgage loans. In 1995 and 1996, approximately
36% and 46% of loans originated, respectively, were refinancings. For the nine
months ended September 30, 1997, approximately 44% of loans were refinancings.
The Bank's loan production has, since 1992, increased each successive year,
after excluding the unusual level of refinancing in 1993 that occurred in
response to a low level of interest rates available to consumers over an
extended period of time. To achieve these increases, the Bank has expanded its
wholesale loan production division from 18 employees in 1993 to 95 employees
at September 30, 1997.
In addition to single-family mortgage loans, the Bank relies upon its
wholesale and correspondent loan production networks for the origination or
purchase of single-family residential construction and consumer loans. Its
retail loan production arises through its branches, which originate
commercial, consumer, commercial real estate and construction loans, and its
loan centers, which originate consumer and home equity loans.
Set forth below is a table summarizing the Bank's loan production of single-
family mortgage loans, which comprise the bulk of its loan production, and
other loans for the periods noted.
<TABLE>
<CAPTION>
FOR THE
NINE MONTHS
ENDED FOR THE YEARS ENDED DECEMBER 31,
SEPTEMBER 30, --------------------------------
1997 1996 1995 1994
------------- ---------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Single-family:
Retail......................... $ 529,887 $ 685,288 $ 632,696 $ 705,723
Wholesale...................... 3,080,269 5,435,701 4,562,909 3,014,450
Correspondent.................. 1,677,555 670,676 -- --
---------- ---------- ---------- ----------
Total single-family.......... 5,287,711 6,791,665 5,195,605 3,720,173
Construction..................... 48,166 79,022 101,532 68,383
Consumer......................... 28,270 43,354 52,199 13,389
Commercial real estate........... -- 5,648 6,725 10,319
Commercial....................... 8,258 1,412 1,681 2,580
---------- ---------- ---------- ----------
Total originations........... $5,372,405 $6,921,101 $5,357,742 $3,814,844
========== ========== ========== ==========
</TABLE>
The following table sets forth the origination of single-family mortgage
loans for the periods presented by the nature of loan:
<TABLE>
<CAPTION>
FOR THE
NINE MONTHS
ENDED FOR THE YEARS ENDED DECEMBER 31,
SEPTEMBER 30, --------------------------------
1997 1996 1995 1994
------------- ---------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Government (GNMA)............... $ 416,119 $ 425,137 $ 285,293 $ 222,794
Conventional (FNMA and FHLMC)... 4,620,605 6,238,174 4,831,108 3,426,620
Jumbo/Non-conforming............ 250,987 128,354 79,204 70,759
---------- ---------- ---------- ----------
Total originations............ $5,287,711 $6,791,665 $5,195,605 $3,720,173
========== ========== ========== ==========
</TABLE>
OC-48
<PAGE>
The following table sets forth certain information at December 31, 1996
regarding the dollar amount of loans held for investment based on their
contractual terms to maturity, including scheduled repayments of principal.
The table does not include any estimate of prepayments, which significantly
shorten the average life of a mortgage loan and may cause the Bank's repayment
experience to differ from that shown below.
<TABLE>
<CAPTION>
DUE AFTER DUE AFTER DUE AFTER
DUE DURING THE YEAR 3 THROUGH 5 5 THROUGH 10 10 THROUGH 15 DUE AFTER 15
ENDING DECEMBER 31, YEARS AFTER YEARS AFTER YEARS AFTER YEARS AFTER
------------------------ DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1997 1998 1999 1996 1996 1996 1996 TOTAL
-------- ------- ------- ------------ ------------ ------------- ------------ --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgage loans held for
investment............. $ 3,331 $ 3,602 $ 3,896 $ 8,428 $24,773 $39,995 $19,771 $103,796
Construction............ 59,270 -- -- -- -- -- -- 59,270
Consumer................ 3,116 3,461 3,849 8,578 14,604 -- -- 33,608
Commercial real estate.. 2,680 2,971 3,312 4,602 -- -- -- 13,565
Commercial.............. 44,035 1,279 898 -- -- -- -- 46,212
Other mortgage.......... 2,076 $ 2,330 2,620 5,918 4,184 -- -- 17,128
-------- ------- ------- ------- ------- ------- ------- --------
Total.................. $114,508 $13,643 $14,575 $27,526 $43,561 $39,995 $19,771 $273,579
======== ======= ======= ======= ======= ======= ======= ========
</TABLE>
The following table sets forth at December 31, 1996, the dollar amount of
all loans held for investment that are due one year or more after December 31,
1997, that have predetermined interest rates and have floating or adjustable
interest rates.
<TABLE>
<CAPTION>
PREDETERMINED FLOATING OR
RATE ADJUSTABLE RATES TOTAL
------------- ---------------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Mortgage loans held for investment..... $ 59,724 $44,072 $103,796
Construction........................... 59,270 -- 59,270
Consumer............................... 28,107 5,501 33,608
Commercial real estate................. 7,694 5,871 13,565
Commercial............................. 11,765 34,447 46,212
Other mortgage......................... 17,128 -- 17,128
-------- ------- --------
Total................................. $183,688 $89,891 $273,579
======== ======= ========
</TABLE>
Retail Banking Operations. The Bank's retail banking operation constitutes a
growing part of its overall operations. The principal aspects of retail
banking include deposit-gathering and consumer, residential, and commercial
lending. The Bank began to emphasize its retail banking operations upon its
acquisition in 1994 of Security Savings, a federal savings bank located in
Jackson, Michigan. Security Savings was a long standing community institution
which received its charter in 1936. At the time of acquisition, Security
Savings had $226.0 million in assets and six retail banking branches in
southern Michigan with deposits of $197.2 million. Security Savings was merged
into Flagstar Bank on February 1, 1996.
The Bank generally has authority to originate and purchase loans
collateralized by real estate located throughout the United States. Consistent
with its emphasis on being a community-oriented financial institution, the
Bank concentrates the lending activities of its retail banking operations in
the southern and western Michigan market areas of its branches.
The Bank's loan originations for its retail banking operations are derived
from a number of sources, including referrals by realtors, depositors and
borrowers, as well as walk-in customers. The Bank's solicitation programs
consist of advertisements in local media, in addition to occasional
participation in various community organizations and events. The Bank's loan
personnel in its retail banking operations are salaried, and the Bank does not
compensate these loan personnel on a commission basis for loans originated.
Loan applications are accepted at all of the Bank's branch offices.
OC-49
<PAGE>
Under applicable law, with certain limited exceptions, outstanding loans and
extensions of credit by a savings institution to a person at one time shall
not exceed 15% of the institution's unimpaired capital and surplus. Loans and
extensions of credit fully secured by readily marketable collateral may
comprise an additional 10% of unimpaired capital and surplus. Applicable law
additionally authorizes savings institutions to make loans to one borrower,
for any purpose, in an amount not to exceed $500,000 or in an amount not to
exceed the lesser of $30,000,000 or 30% of unimpaired capital and surplus to
develop residential housing, provided: (i) the purchase price of each single-
family dwelling in the development does not exceed $500,000; (ii) the savings
institution is and continues to be in compliance with its fully phased-in
regulatory capital requirements; (iii) the loans comply with applicable loan-
to-value requirements; (iv) the aggregate amount of loans made under this
authority does not exceed 150% of unimpaired capital and surplus; and (v) the
Director of OTS, by order, permits the savings institution to avail itself of
this higher limit. Under these limits, the Bank's loans to one borrower were
limited to $18.2 million at September 30, 1997. At that date, the Bank had no
lending relationships in excess of the loans-to-one-borrower limit.
Interest rates charged by the Bank on loans are affected principally by
competitive factors, the demand for such loans and the supply of funds
available for lending purposes. These factors are, in turn, affected by
general economic conditions, monetary policies of the federal government,
including the Federal Reserve Board, legislative tax policies and government
budgetary matters.
Single-Family Mortgage Lending. The Bank's retail banking operation has
historically invested its deposits in single-family, residential real estate
loans. At September 30, 1997, single-family mortgage loans totaled
approximately $296.3 million, or 66.6% of the Bank's loans held for
investment.
The Bank acquired a portion of its fixed rate single-family mortgage loans
held for investment through its 1994 acquisition of Security Savings. In each
case, such loans are secured by first mortgages on single-family, owner-
occupied residential real property located in the Bank's market area. At
September 30, 1997, $155.9 million, or 52.6%, of the Bank's portfolio of
mortgage loans held for investment consisted of fixed-rate mortgage loans.
The Bank also originates residential mortgage loans with adjustable rates
("ARMs"). As of September 30, 1997, $140.4 million, or 47.4%, of single-family
mortgage loans in the Bank's portfolio of mortgage loans held for investment
carried adjustable rates. Such loans are primarily for terms of 30 years,
although the Bank does occasionally originate ARMs for other terms, in each
case amortized on a monthly basis with principal and interest due each month.
The interest rates on these mortgages are adjusted once a year, with a maximum
adjustment of 2.0% per adjustment period and a maximum aggregate adjustment of
6.0% over the life of the loan. Rate adjustments on the Bank's adjustable-rate
loans are indexed to a rate that adjusts annually based upon changes in an
index based on the weekly average yield on U.S. Treasury securities adjusted
to a constant comparable maturity of one year, as made available by the
Federal Reserve Board, and the adjusted interest rate is equal to such
Treasury rate plus a spread, typically 3.0%. The adjustable-rate mortgage
loans offered by the Bank provide for initial rates of interest below the
rates that would prevail when the index used for repricing is applied.
The retention of adjustable-rate loans in the Bank's portfolio helps reduce
the Bank's exposure to increases in prevailing market interest rates. However,
there are unquantifiable credit risks resulting from potential increases in
costs to borrowers in the event of upward repricing of adjustable-rate loans.
It is possible that during periods of rising interest rates, the risk of
default on adjustable-rate loans may increase due to increases in interest
costs to borrowers. Further, although adjustable-rate loans allow the Bank to
increase the sensitivity of its interest-earning assets to changes in interest
rates, the extent of this interest sensitivity is limited by the initial
fixed-rate period before the first adjustment and the lifetime interest rate
adjustment limitations. Accordingly, there can be no assurance that yields on
the Bank's adjustable-rate loans will fully adjust to compensate for increases
in the Bank's cost of funds.
OC-50
<PAGE>
Commercial and Commercial Real Estate Lending. The Bank originates
commercial loans on a selected basis and in limited amounts for retention in
its portfolio. At September 30, 1997, the Bank had $2.9 million in commercial
loans associated with its retail banking operations, which comprised 0.65% of
its loans held for investment and are primarily inventory and other business
loans to small businesses in the Bank's southern and western Michigan market
area.
Warehouse lines are granted under the Bank's commercial lending program and
are a major component of the Bank's commercial lending strategy. Warehouse
lines of credit are used by correspondents to fund loan production which for
the most part are acquired by the Bank. At September 30, 1997 the aggregate
amount of warehouse lines of credit granted by the Bank to its correspondents
was $121.5 million of which $53.3 million was outstanding.
Also as part of the Bank's retail banking operations, the Bank makes
commercial real estate loans in its southern and western Michigan market area.
At September 30, 1997, there were $19.3 million in commercial real estate
loans outstanding, which comprised 4.34% of total loans held for investment
and 1.07% of total loans. Such loans are generally made to small businesses in
the Bank's southern and western Michigan market area.
Commercial real estate loans are generally underwritten in amounts of up to
80% of the appraised value of the underlying property. Appraisals on
properties securing commercial real estate loans originated by the Bank are
performed by an independent fee appraiser designated by the Bank before the
loan is made. All appraisals for commercial real estate loans are reviewed by
the Bank's management.
Underwriting procedures include an analysis of the property, borrower,
market and levels of risks. Underwriting procedures require verification of
the borrower's credit history, financial statements, references and income
projections for the property. All commercial real estate loans in excess of
$500,000 must be approved by the Bank's Executive Loan Committee. The Bank's
commercial real estate loans are secured by the property and, in many
circumstances, require the borrower to be personally liable for all or a
portion of the loan. The Bank's lending policy requires that commercial real
estate properties securing loans be inspected at least annually. In addition,
the Bank reviews updated financial information regarding the borrower on a
regular basis.
Commercial and commercial real estate loans generally present a higher level
of risk than do loans secured by one- to four-family residences. This greater
risk is due to several factors, including the concentration of large amounts
of principal in a limited number of loans and borrowers, the effects of
general economic conditions on commercial properties, and the difficulty of
evaluating and monitoring these types of loans. Furthermore, the repayment of
loans secured by commercial real estate is typically dependent upon the
successful operation of the related real estate project. If the cash flow from
the project is reduced (for example, if leases are not obtained or renewed),
the borrower's ability to repay the loan may be impaired.
Consumer Loans. The Bank originates consumer loans secured by passbook
savings accounts, personal property or home equity. At September 30, 1997, the
Bank's consumer loans totaled $34.9 million, or 7.85%, of the Bank's loans
held for investments, of which $24.9 million were home equity loans.
Consumer loans tend to be originated at higher interest rates than mortgage
loans and for shorter terms. However, consumer loans generally involve more
risk than single-family mortgage loans. Repossessed collateral for a defaulted
loan may not provide an adequate source of repayment of the outstanding loan
balance as a result of damage, loss or depreciation, and the remaining
deficiency often does not warrant further substantial collection efforts
against the borrower. In addition, loan collections are dependent on the
borrower's continuing financial stability and thus are more likely to be
adversely affected by job loss, divorce, illness or personal bankruptcy.
Further, the application of various federal and state laws, including federal
and state bankruptcy and insolvency laws, may limit the amount that may be
recovered. In underwriting consumer loans, the Bank considers the borrower's
credit history, an analysis of the borrower's income and ability to repay the
loan, and the value of the collateral.
OC-51
<PAGE>
Mortgage Banking Operations. The Bank actively participates in the mortgage
banking market, ranking fourteenth in the United States in total mortgage loan
production for 1997. Mortgage banking generally involves the origination or
purchase of single-family mortgage loans for sale in the secondary mortgage
market. The secondary mortgage market and its evolution have been
significantly influenced by two government-sponsored enterprises, Fannie Mae
and Freddie Mac, and one government agency, GNMA (collectively, the
"Agencies"). Through these entities, the United States government provides
support and liquidity to the market for residential mortgage debt.
Mortgage originators sell their loans directly to Fannie Mae and Freddie Mac
either as whole loans or, more typically, as pools of loans used to
collateralize mortgage-backed securities ("MBS") issued or guaranteed by these
entities. Similarly, the originators can issue MBS collateralized by pools of
loans that are guaranteed by GNMA. In order to arrange these sales or obtain
these guarantees, the originator must underwrite its loans to conform
("conforming loans") with standards established by Fannie Mae and Freddie Mac
or by the FHA or VA in the case of GNMA. All loans other than FHA and VA loans
("government loans") are considered conventional loans. Loans with principal
balances exceeding Agency guidelines ("jumbo loans"), currently those in
excess of $214,600, are typically sold to private investors.
Mortgage bankers operate in a highly competitive market. The underwriting
guidelines and servicing requirements set by the participants in the secondary
markets are standardized. As a result, mortgage banking products (i.e.,
mortgage loans and the servicing of these loans) have become difficult to
differentiate. Therefore, mortgage bankers compete primarily on the basis of
price or service, making effective cost management essential. Mortgage bankers
generally seek to develop cost efficiencies in one of two ways: economies of
scale or specialization. Large, full-service national or regional mortgage
bankers such as the Bank have sought economies of scale through an emphasis on
wholesale originations and the introduction of automated processing systems.
The Bank pursues its loan production strategy as part of its mortgage
banking operations through the Bank's wholesale, correspondent and retail loan
production outlets and, to a limited extent, through direct solicitation of
commercial banks, savings associations and credit unions.
Wholesale Loan Production. Under its wholesale operations, the Bank funds
mortgage loans originated by a network of approximately 1,800 independent
mortgage brokers nationwide. Approximately 1,200 of these brokers originate
mortgage loans for the Bank on a monthly basis and 1,800 originate mortgage
loans for the Bank on a quarterly basis. This network is maintained by the
Bank's approximately sixty regional account executives, who are compensated
through a salary and commission package. Many of the larger brokers are
provided with loan data entry software by the Bank for the entry of loan
applicant data in a format familiar to the Bank's underwriters and for
transmission to the Bank's automated underwriting systems for review. All
loans originated through brokers are underwritten according to the Bank's
standards.
The Bank's underwriters or contract representatives review the loan data
provided by the loan applicant, including the review of appropriate loan
documentation, and request additional information as necessary from the
broker. To speed the information gathering phase of underwriting and thus the
loan approval process, the Bank is utilizing an interview process referred to
as LIVE (R) underwriting, which involves an interview of the potential
borrower directly by a Bank underwriter using its proprietary combination of
computer video technology and automated underwriting technology. Loans
originated by such brokers are typically funded directly by the Bank through
table funding arrangements. In most cases, the loan is closed in the broker's
name and thereafter transferred to the Bank together with related mortgage
servicing rights for which the Bank generally pays a servicing release premium
that is included in the loan price paid to the broker by the Bank. Broker
participants in this program are prequalified on the basis of
creditworthiness, mortgage lending experience and reputation. Each broker is
subject to annual and ongoing reviews by the Bank.
Correspondent Loan Production. In addition, the Bank acquires mortgage loans
from mortgage lenders, commercial banks, savings and loan associations and
other financial intermediaries. Correspondents have a separate approval
process and higher net worth requirements than wholesale brokers and use their
own source of
OC-52
<PAGE>
funds to close loans. The prices of such loan acquisitions are separately
negotiated. Warehouse lines of credit, obtained from either the Bank or other
parties, may be used by the mortgage lenders to finance their respective
mortgage loan originations. At September 30, 1997, the aggregate amount of
warehouse lines of credit granted by the Bank to its correspondents was $121.5
million, of which $53.3 million was outstanding. Independent lenders who
obtain warehouse lines of credit from the Bank are not required by the terms
of such lines to sell their loan production to the Bank. All loans acquired
from correspondents are expected to satisfy the Bank's underwriting standards
and may be subject to repurchase by the correspondent in the event of default
of the loan due to fraud or misrepresentation in the origination process and
for certain other reasons, including the failure to satisfy underwriting
requirements imposed by the Bank.
Retail Loan Production. The Bank's retail loan production involves the
origination of loans through its loan centers. The Bank has 33 loan centers
located in Michigan, Ohio, California and Florida. These loan centers
originate primarily single-family mortgage loans and, to a lesser extent,
construction and home equity loans. Such loan centers generally provide the
Bank with a source of loan production at a lower cost per loan than loans
acquired through brokers or correspondents because the cost of operating such
branches is more than offset by cost savings through the Bank's ability to
avoid payment of the servicing release premium for the related mortgage
servicing rights. Managers of loan centers and loan officers are compensated
solely on a commission basis as measured by loan production.
To encourage loan production, the Bank allows managers of loan centers to
elect to operate their respective centers as "100% offices," subject to
approval by the Bank. Such offices are treated for incentive compensation
purposes as free-standing operations where each office is responsible for its
own operating expenses. Each office is required to satisfy minimum loan
production levels. The manager receives compensation based on the office's
profitability. As of September 30, 1997, eight loan centers were operated as
100% offices.
Construction Lending. The Bank also engages in construction lending
involving loans to individuals for construction of one- to four-family
residential housing primarily located within the Bank's southern Michigan
market area, with such loans converting to permanent financing upon completion
of construction. At September 30, 1997, the Bank's portfolio of loans held for
investment included $37.8 million of net loans secured by properties under
construction, or 8.50% of loans held for investment. These loans may be
construction/permanent loans structured to become permanent loans upon the
completion of construction, or may be interim construction loans structured to
be repaid in full upon completion of construction and receipt of permanent
financing. All construction loans are secured by a first lien on the property
under construction. Loan proceeds are disbursed in increments as construction
progresses and as inspections warrant. Construction/permanent loans may have
adjustable or fixed interest rates and are underwritten in accordance with the
same terms and requirements as the Bank's permanent mortgages, except the
loans generally provide for disbursement in stages during a construction
period of up to nine months, during which period the borrower is required to
make interest-only monthly payments. Monthly payments of principal and
interest commence one month from the date the loan is converted to permanent
financing. Borrowers must satisfy all credit requirements that would apply to
the Bank's permanent mortgage loan financing prior to receiving construction
financing for the subject property.
Construction financing generally is considered to involve a higher degree of
risk of loss than long-term financing on improved, occupied real estate. Risk
of loss on a construction loan is largely dependent upon the accuracy of the
initial estimate of the property's value at completion of construction or
development and the estimated cost (including interest) of construction.
During the construction phase, a number of factors could result in delays and
cost overruns. If the estimate of construction costs proves to be inaccurate,
the Bank may be required to advance funds beyond the amount originally
committed to permit completion of the development. If the estimate of value
proves to be inaccurate, the Bank may be confronted, at or prior to the
maturity of the loan, with a project having value which is insufficient to
assure full repayment. The ability of the developer to sell developed lots or
completed dwelling units will depend on, among other things, demand, pricing,
availability of comparable properties and economic conditions. The Bank has
sought to minimize this risk by limiting construction lending to qualified
borrowers in the Bank's southern Michigan market area, by requiring the
involvement of qualified builders, and by limiting the aggregate amount of
outstanding construction loans.
OC-53
<PAGE>
SECONDARY MARKETING
The Bank sells a significant portion of the mortgage loans that it
originates or purchases through its mortgage and retail banking operations
while retaining the servicing rights to such loans. During the nine months
ended September 30, 1997 and year ended December 31, 1996, the Bank originated
$5.3 billion and $6.8 billion in total mortgage loans, respectively, and sold
$4.5 billion and $6.6 billion of mortgage loans, respectively, in the
secondary market. Mortgage loans are aggregated into pools and sold, or are
sold as individual mortgage loans, to investors principally at prices
established at the time of sale or under forward sales commitments. Conforming
conventional mortgage loans are generally pooled and exchanged under the
purchase and guarantee programs sponsored by Fannie Mae and Freddie Mac and
GNMA for Fannie Mae MBS, Freddie Mac MBS or GNMA MBS, respectively. A limited
number of mortgage loans (i.e. non-conforming loans) are sold to other
institutional and non-institutional investors. For the nine months ended
September 30, 1997, a significant portion of such loans were exchanged for
Fannie Mae and Freddie Mac securities. The remainder were sold to other
institutional and non-institutional investors.
The Bank exchanges and sells mortgage loans on a non-recourse basis. In
connection with the Bank's loan exchanges and sales, the Bank makes
representations and warranties customary in the industry relating to, among
other things, compliance with laws, regulations and program standards, and to
accuracy of information. In the event of a breach of those Bank
representations and warranties, the Bank typically corrects such flaws. If the
flaws cannot be corrected, the Bank may be required to repurchase such loans.
See "--Asset Quality." In cases where loans are acquired from a broker or
correspondent and there have been material misrepresentations made to the
Bank, the Bank has the right to resell the flawed loan back to the broker or
correspondent. Otherwise, such loans are refinanced or the Bank is indemnified
against loss on such loans by the broker. In addition, the Bank relies upon
contract underwriters for a portion of its loan production, and these
underwriters must indemnify the Bank for loans that are eventually determined
to have been flawed upon origination.
The following table sets forth the activity in the Bank's mortgage loans
available for sale and its loans held for investment in its portfolio.
<TABLE>
<CAPTION>
FOR THE NINE
MONTHS ENDED FOR THE YEARS ENDED DECEMBER 31,
SEPTEMBER 30, -------------------------------------
1997 1996 1995 1994
------------- ----------- ----------- -----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
AVAILABLE FOR SALE:
Beginning balance....... $ 840,767 $ 620,455 $ 205,480 $ 389,073
Originations(1)......... 5,337,574 6,850,277 5,251,510 3,752,650
Repurchases............. 52,293 54,788 4,477 2,683
Sales(1)................ (4,513,434) (6,599,568) (4,780,198) (3,670,002)
Amortization............ (214,525) (74,683) (244,144) (161,225)
Transfers to repossessed
assets or mortgage-
backed securities...... (12,491) (10,502) (1,781) (1,438)
Transfers (to) from held
for investment......... (126,362) -- 185,111 (106,261)
----------- ----------- ----------- -----------
Ending balance........ $ 1,363,822 $ 840,767 $ 620,455 $ 205,480
=========== =========== =========== ===========
HELD FOR INVESTMENT:
Beginning balance....... $ 273,579 $ 305,590 $ 429,800 $ 26,906
Originations(1)......... 84,704 129,446 162,147 236,700
Amortization............ (40,093) (161,382) (101,246) (79,002)
Transfers to repossessed
assets................. -- (75) -- (1,367)
Acquired through
acquisition............ -- -- -- 140,302
Transfers (to) from
available for sale..... 126,362 -- (185,111) 106,261
----------- ----------- ----------- -----------
Ending balance........ $ 444,552 $ 273,579 $ 305,590 $ 429,800
=========== =========== =========== ===========
</TABLE>
- --------
(1) Originations and sales are presented at cost, including deferred loan
origination fees and costs, premiums and discounts.
OC-54
<PAGE>
The Bank assesses the interest rate risk associated with outstanding
commitments that it has extended to fund loans and hedges the interest rate
risk of these commitments based upon a number of factors, including the
remaining term of the commitment, the interest rate at which the commitment
was provided, current interest rates and interest rate volatility. These
factors are monitored on a daily basis, and the Bank adjusts its hedging on a
daily basis as needed. The Bank hedges its "available for sale" mortgage loan
portfolio and its interest rate risk inherent in its unfunded mortgage
commitments (its "mortgage pipeline") primarily through the use of forward
sale commitments. Under such commitments, the Bank enters into commitments
with terms of not more than 90 days to sell these loans to Freddie Mac and
Fannie Mae. In addition, the Bank occasionally establishes futures positions
in U.S. Treasury bonds under which the Bank contracts to sell notional
principal contracts. At September 30, 1997, the Bank did not have any open
futures positions. See "Management's Discussion and Analysis of Changes in
Financial Condition and Results of Operations--Results of Operations--Net Gain
on Loan Sales and Sales of Mortgage Servicing Rights."
ASSET QUALITY
The Bank is exposed to certain credit risks related to the value of the
collateral that secures loans held in its portfolio and the ability of
borrowers to repay their loans during the term thereof. The Bank has an Asset
Classification Committee, which is comprised of senior officers of the Bank,
that closely monitors the loan and real estate owned portfolios for potential
problems on a continuing basis and reports to the Board of Directors of the
Bank at regularly scheduled meetings. This committee reviews the
classification of assets and reviews the allowance for losses. This committee
reviews all assets and periodically reports its findings directly to the Board
of Directors of the Bank. The asset classification policy sets forth certain
requirements with respect to how to classify certain assets. The Bank also has
a Quality Control Department, the function of which is to provide to the Board
of Directors of the Bank an independent ongoing review and evaluation of the
quality of the process by which lending assets are generated.
Non-performing assets consist of non-accrual loans and real estate owned.
Loans are usually placed on non-accrual status when the loan is past due 90
days or more, or the ability of a borrower to repay principal and interest is
in doubt. Real estate acquired by the Bank as a result of foreclosure is
classified as real estate owned until such time as it is sold. The Bank
generally tries to sell the property at a price no less than its net book
value, but will consider discounts where appropriate to expedite the return of
the funds to an earning status. When such property is acquired, it is recorded
at the lower of cost or market. Any required write-down of the loan to its
appraised fair market value upon foreclosure is charged against the allowance
for losses.
The Bank establishes an allowance for loan losses based upon a quarterly or
more frequent evaluation by management of various factors including the
estimated market value of the underlying collateral, the growth and
composition of the loan portfolio, current delinquency trends and prevailing
and prospective economic conditions, including property values, employment and
occupancy rates, interest rates and other conditions that may affect
borrowers' abilities to comply with repayment terms. If actual losses exceed
the amount of the allowance for loan losses, earnings could be adversely
affected. As the Bank's provision for loan losses is based on management's
assessment of the general risk inherent in the loan portfolio based on all
relevant factors and conditions, the allowance for loan losses represents
general, rather than specific, reserves.
OC-55
<PAGE>
The following table sets forth information with respect to the Bank's non-
performing assets at the dates indicated. No loans were recorded as
restructured loans within the meaning of SFAS No. 15 at the dates indicated.
The increase in the mortgage loan category is attributable in large part to
the Bank's required repurchase of non-performing loans from Freddie Mac and
Fannie Mae but also resulted from the effects of a significant increase in
loan originations in the previous three years. See "Management's Discussion
and Analysis of Changes in Financial Condition and Results of Operations--
Financial Condition--Allowance for Losses."
<TABLE>
<CAPTION>
AT AT DECEMBER 31,
SEPTEMBER 30, ------------------------------------
1997 1996 1995 1994 1993 1992
------------- ------- ------- ------ ------ ------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Loans accounted for on a
non-accrual basis:
Mortgage loans held for
investment.............. $40,513 $27,017 $10,096 $1,477 $1,314 $1,179
Construction........... 2,026 2,801 -- 140 140 650
Commercial............. 1,009 476 464 57 88 210
Consumer............... 531 327 126 65 7 10
------- ------- ------- ------ ------ ------
Total non-performing
loans............... 44,079 30,621 10,686 1,739 1,549 2,049
Real estate owned.......... 17,659 10,363 2,359 1,271 1,249 802
------- ------- ------- ------ ------ ------
Total non-performing
assets.............. $61,738 $40,984 $13,045 $3,010 $2,798 $2,851
======= ======= ======= ====== ====== ======
</TABLE>
If non-accrual loans at September 30, 1997 had been current according to
their original terms and had been outstanding throughout 1997, or since
origination if originated during the year, interest income on these loans for
1997 would have been $4.5 million. Interest actually recognized on these loans
during 1997 was not significant.
At September 30, 1997, the Bank did not have any loans which are not
currently classified as non-accrual, 90 days past due or restructured and
where known information about possible credit problems of borrowers caused
management to have serious concerns as to the ability of the borrowers to
comply with present loan repayment terms. At September 30, 1997, the Bank had
$3.6 million of impaired loans within the meaning of SFAS No. 114, as amended
by SFAS No. 118.
Historically, the Bank has incurred minimal losses from its residential
mortgage loan production. Net charge-offs as a percentage of average loans
outstanding declined from 0.09% in 1992 to 0.00% in 1995, rose during 1996 to
0.13%, and continued on that upward trend in 1997 to 0.22% at September 30,
1997. Over this period non-performing assets as a percentage of total assets
ranged from 0.94% in 1992 to a low of 0.42% in 1994 and increased to 3.04% at
September 30, 1997. The increases in 1997 and 1996 resulted primarily from
increased repurchases of delinquent residential mortgage loans from secondary
market investors. Although the Bank generally does not sell loans with
recourse, it typically is required to repurchase delinquent and defaulted
loans that were not underwritten strictly in compliance with the underwriting
standards of secondary market investors. As the volume of the Bank's new loan
production has increased over the past several years, the level of loan
delinquencies and foreclosures has also increased, thereby increasing the
number of loans potentially subject to repurchase. In addition, during 1996
two of the largest secondary market purchasers of loans implemented automated
underwriting review systems which enabled them to review delinquent loans on a
much faster basis, thereby accelerating the process of returning to the Bank
loans originated in prior periods.
It has been the Bank's experience that non-performing loans do not
necessarily result in an ultimate loss to the Bank. Approximately 92% of the
Bank's non-performing loans at September 30, 1997 were residential mortgage
loans (88% at December 31, 1996), which generally represent minimal risk of
ultimate loss because of low loan-to-value ratios, private mortgage insurance
for loans with over-80% loan-to-value ratios and insurance on certain loans
from the FHA and VA. In addition, the Bank may also have the right to sell the
repurchased loan back to the broker or correspondent which originated the loan
or to seek indemnity from the applicable mortgage insurance company in the
case of loans which are underwritten on a contract basis for the Bank by such
insurers.
OC-56
<PAGE>
The Bank anticipates that its level of loan repurchases and non-performing
assets may continue to be above historical levels during 1997 as a result of
the factors described above. As a result of several actions taken by the Bank
during 1997, however, including a tightening of credit standards and the
implementation of automated underwriting systems (which do not permit
secondary market investors to require repurchase of loans absent material
misrepresentation), the Bank anticipates that the level of loan repurchases
will decline over time.
The Bank experienced an increase in its non-performing construction loans
from December 31, 1995 to September 30, 1997 from zero to $2.0 million. This
increase was the result of a significant increase in the single family
residential construction loans originated in the period subsequent to December
31, 1994. During the years ended December 31, 1994 and 1995 the origination of
such loans increased from $68.4 million to $101.5 million, respectively.
During the nine months ended September 30, 1997, the Bank originated $48.2
million of construction loans. The non-performing construction loans resulted
from a particular construction lending program that was determined to be
problematic. The program has been discontinued and, with the exception of two
loans totaling approximately $450,000, all other loans originated under the
program have been paid off.
The Bank's repossessed assets were $17.7 million at September 30, 1997,
compared with $10.4 million and $2.4 million at December 31, 1996 and 1995,
respectively, representing an increase of 333.3% from December 31, 1995 to
1996, and 70.2% from December 31, 1996 to September 30, 1997. Total non-
accrual loans increased from $10.7 million at December 31, 1995 to $30.6
million at December 31, 1996, to $44.1 million at September 30, 1997 of which
single family loans increased from $10.1 million to $27.0 million to $40.5
million over the respective dates. Each of these increases is consistent with
the Bank's experience with non-performing loans and is generally the result of
the significantly higher loan origination volume in the period beginning in
1993 which has resulted in a higher dollar volume of non-performing loans,
defaults and subsequently repossessed assets. However, as a proportion of
loans originated, this dollar volume is well within management's acceptable
levels.
The Bank's allowance for loan losses increased to $4.95 million at September
30, 1997 from $3.50 million at December 31, 1996. The Bank's ratio of
allowance for losses to non-accrual loans, however, declined to 11.23% at
September 30, 1997 from 11.43% at December 31, 1996. Because 91.8% of the non-
accrual loans at September 30, 1997 were single-family mortgages, the
allowance required is lower. Of the remaining 8.2% of non-accrual loans, 4.5%
is represented by $2.0 million of construction loans. Historically, the Bank's
experience with loan losses on single family loans held in portfolio or
repurchased from investors has been low. The high collateral value, private
mortgage insurance and the ability to seek recoveries from the correspondent
lenders have resulted in a consistently low charge-off record and consequently
management believes that the allowance for losses is adequate to cover the
losses currently inherent in the loan portfolio. Future changes in economic
conditions or interest rates, however, could require additional reserves.
The Bank's allowance for losses increased to $3.5 million at December 31,
1996 from $2.1 million at December 31, 1995. The Bank's ratio of allowance for
losses to non-accrual loans, however, declined to 11.43% at December 31, 1996
from 19.67% at December 31, 1995.
The following table sets forth an analysis of the Bank's consolidated
allowance for losses and ratio of net charge-offs for the periods indicated.
<TABLE>
<CAPTION>
FOR THE
NINE MONTHS ENDED
SEPTEMBER 30, FOR THE YEARS ENDED DECEMBER 31,
------------------- -------------------------------------
1997 1996 1996 1995 1994 1993 1992
--------- -------- ------- ------ ------ ----- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at beginning of
period................. $ 3,500 $ 2,102 $ 2,102 $1,871 $ 901 $ 550 $ 345
Charge-offs, net of
recoveries............. (2,280) (216) (1,206) (7) (321) (293) (175)
Provision............... 3,730 1,140 2,604 238 290 644 380
Provision acquired in
acquisition............ -- -- -- -- 1,001 -- --
--------- -------- ------- ------ ------ ----- -----
Balance at end of
period................. $ 4,950 $ 3,026 $ 3,500 $2,102 $1,871 $ 901 $ 550
========= ======== ======= ====== ====== ===== =====
Ratio of net charge-offs
to average loans
outstanding during the
period................. 0.22% 0.03% 0.13% 0.00% 0.08% 0.08% 0.09%
========= ======== ======= ====== ====== ===== =====
</TABLE>
OC-57
<PAGE>
The following table sets forth the breakdown of the allowance for losses by
loan category at the dates indicated. Management believes that the allowance
can be allocated by category only on an approximate basis, and therefore
allocation of the allowance to each category is not necessarily indicative of
future losses and does not restrict the use of the allowance to absorb losses
in any category. The unallocated portion of the allowance represents an amount
that is not specifically allocable to one of the held for investment loan
portfolios.
<TABLE>
<CAPTION>
AT DECEMBER 31,
--------------------------------------------------------------
AT SEPTEMBER 30, 1997 1996 1995 1994
------------------------- -------------------- -------------------- --------------------
PERCENT OF PERCENT OF PERCENT OF PERCENT OF
LOANS IN EACH LOANS IN EACH LOANS IN EACH LOANS IN EACH
CATEGORY TO CATEGORY TO CATEGORY TO CATEGORY TO
AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS
---------- -------------- ------ ------------- ------ ------------- ------ -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgages:
Available for sale..... $ 2,000 75.62% $1,000 75.45% $ 248 67.00% $ 289 32.34%
Held for investment.... 300 16.15% 200 10.85% 78 19.25% 531 55.74%
Construction............ 400 2.10% 400 5.32% 367 5.28% 191 4.01%
Consumer................ 300 1.94% 300 3.02% 393 4.25% 193 3.03%
Commercial.............. 400 3.12% 200 4.15% 43 0.93% 38 1.19%
Commercial real estate.. 100 1.07% 100 1.21% 305 3.29% 234 3.69%
Unallocated............. 1,450 -- % 1,300 -- % 668 -- % 395 -- %
---------- ---------- ------ ------ ------ ------ ------ ------
Total allowance for
losses................. $ 4,950 100.00% $3,500 100.00% $2,102 100.00% $1,871 100.00%
========== ========== ====== ====== ====== ====== ====== ======
</TABLE>
At September 30, 1997, the Bank's percentage of allowance for losses to
loans for its mortgage loans held for investment and its construction,
consumer, commercial and commercial real estate loans held for investment were
0.11%, 1.06%, 0.86%, 0.71% and 0.52%, respectively.
UNDERWRITING
The Bank's mortgage loans are underwritten either in accordance with
applicable Fannie Mae, Freddie Mac and FHA/VA guidelines or with requirements
set by other investors.
All mortgage loans originated or acquired by the Bank, whether through its
retail loan origination offices or through its wholesale or correspondent
networks, must satisfy the Bank's underwriting standards. The Bank permits a
few originating correspondent lenders operating under the Bank's delegated
underwriting program to perform initial underwriting reviews. The Bank employs
an automated underwriting process on most loans that is based upon data
provided through the Bank's initial loan data entry software and is available
from Fannie Mae through its Desktop Underwriter(TM) software and from Freddie
Mac through its Loan Prospector(TM) software. This process incorporates credit
scoring and an appraisal evaluation system, which in turn employs rules-based
and statistical technologies to evaluate the borrower, property and the sale
of the loan in the secondary market. This process is intended to reduce
processing and underwriting time, to improve overall loan approval
productivity, to improve credit quality and to reduce potential investor
repurchase requests. Approximately one-third of loans underwritten by the Bank
are initially underwritten on a contractual basis by mortgage insurance
companies, in their capacity as contract underwriters. The contract
underwriter may be required to repurchase loans that are determined not to be
in compliance with such underwriting criteria.
Loans underwritten directly by the Bank are subject to a complete review of
all information prior to loan approval. This process involves the transfer of
loan data to the Bank by wholesalers or correspondents using loan data entry
software provided by the Bank plus certain other physical documentation or
through the physical transfer of loan files to the Bank. Further, the Bank has
introduced the use of video-based computer technology, known as LIVESM, to
expedite the loan approval process by allowing its underwriters to conduct
face-to-face
OC-58
<PAGE>
interviews with loan applicants using personal computers with cameras mounted
on them. These facilities are installed and can be used on an as-needed or
pre-scheduled basis in the offices of certain mortgage brokers. See "--
Technology."
To a limited extent, the Bank delegates underwriting authority to select
correspondent lenders who meet financial strength, delinquency, underwriting
and quality control standards. The lenders may be required to agree to
repurchase loans that later become delinquent or to indemnify the Bank from
loss.
QUALITY CONTROL
The Bank maintains a quality control department that, among other things,
reviews compliance and quality assurance issues relating to loan production
and underwriting. For its production compliance process, the Bank randomly
selects a statistical sample of, generally, at least 5% of all loans closed
each month. This review includes a credit scoring and re-underwriting of such
loans; ordering second appraisals on 10% of the sample; reverifying funds,
employment and final applications; and reordering credit reports on the entire
sample. In addition, a full underwriting review is conducted on loans that go
into default during the first twelve months from the date of origination.
Document and file reviews are also undertaken to ensure regulatory compliance.
The Bank also monitors the performance of delegated underwriters through
quality assurance reports prepared by its quality control department, FHA/VA
reports and audits, reviews and audits by regulatory agencies, investor
reports and mortgage insurance Bank audits. Deficiencies in loans are
generally corrected; otherwise, the Bank may exercise its option to require
that the loan be repurchased by the originating broker or correspondent, or
the Bank may insist that the broker who originated the loan indemnify the Bank
against any losses.
MORTGAGE LOAN SERVICING
The Bank derives a significant portion of its revenues from the servicing of
mortgage loans for others. For the nine months ended September 30, 1997 and
the year ended December 31, 1996, the Bank realized net servicing fee revenue
from its mortgage loan servicing operations of $5.5 million and $11.9 million,
respectively, which represented 12.7% and 20.4% of the Bank's non-interest
income for the respective periods. Servicing arises in connection with
mortgage loans originated or purchased and then sold in the secondary market
with mortgage servicing rights retained.
Mortgage loan servicing includes collecting payments of principal and
interest from borrowers, remitting aggregate mortgage loan payments to
investors, accounting for principal and interest payments, holding escrow
funds for payment of mortgage related expenses such as taxes and insurance,
making advances to cover delinquent payments, inspecting the mortgaged
premises as required, contacting delinquent mortgagors, supervising
foreclosures and property dispositions in the event of unremedied defaults,
and other miscellaneous duties related to loan administration. The Bank
collects servicing fees from monthly mortgage payments generally ranging from
0.25% (i.e., 25 basis points) to 0.75% (i.e., 75 basis points) of the
declining principal balances of the loans per annum. At September 30, 1997 and
December 31, 1996, the weighted average servicing fee earned on this portfolio
was 0.273% and 0.289%, respectively.
The Bank services mortgage loans nationwide. The broad geographic
distribution of the Bank's servicing portfolio reflects the national scope of
the Bank's originations and loan acquisitions. The Bank actively monitors the
geographic distribution of its servicing portfolio to maintain a mix that it
deems appropriate to balance its risks and makes adjustments as it deems
necessary. At September 30, 1997, the Bank's servicing portfolio consisted of
$5.3 million of FHA/VA servicing and $4.1 billion of conventional servicing
(excluding subservicing). Such amounts are in addition to loans serviced by
the Bank which were recorded on its books as loans receivable (i.e., available
for sale and held for investment).
The value of the Bank's mortgage servicing rights ("MSRs") is subject to
prepayment risk in the event that declining interest rates provide borrowers
with refinancing opportunities. At September 30, 1997 and
OC-59
<PAGE>
December 31, 1996, the amounts of the MSRs recorded on the Bank's books were
$51.7 million and $30.1 million, respectively, and their estimated fair values
were $60.4 million and $54.0 million, respectively. For further information,
see Note 7 of Notes to Consolidated Financial Statements. During the nine
months ended September 30, 1997, the Bank sold MSRs for gains amounting to
$25.5 million.
Gains on the sale of MSRs are affected by changes in interest rates as well
as the amount of MSRs capitalized at the time of the loan origination or MSR
acquisition. Purchasers of MSRs analyze a variety of factors, including
prepayment sensitivity, to assess the purchase price they are willing to pay.
Lower market interest rates prompt an increase in prepayments as consumers
refinance their mortgages at lower rates of interest. As prepayments increase,
the life of the servicing portfolio is reduced, decreasing the servicing fee
revenue that will be earned over the life of that portfolio and the price
third party purchasers are willing to pay. The fair value of servicing is also
influenced by the supply and demand of servicing available for purchase at any
point in time. Conversely, as interest rates rise, prepayments generally
decrease, resulting in an increase in the value of the servicing portfolio as
well as the gains on sales of MSRs.
The following table sets forth information regarding the mortgage loan
servicing portfolio.
<TABLE>
<CAPTION>
FOR THE
NINE MONTHS
ENDED FOR THE YEARS ENDED
SEPTEMBER 30, DECEMBER 31,
------------- ---------------------
1997 1996 1995
------------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C>
Balance at beginning of period.............. $4,801,581 $6,788,530 $5,691,421
Add: Servicing acquisitions
Originated................................ 538,426 563,355 87,370
Purchased................................. 4,740,264 5,070,190 4,133,015
---------- ---------- ----------
Total additions......................... 5,278,690 5,633,545 4,220,385
---------- ---------- ----------
Less:
Prepayments/Amortizations................. 1,718,811 1,146,564 851,188
Sales(1).................................. 4,218,108 6,473,930 2,272,088
---------- ---------- ----------
Total Reductions........................ 5,936,919 7,620,494 3,123,276
---------- ---------- ----------
Balance at end of period.................... $4,143,352 $4,801,581 $6,788,530
========== ========== ==========
Composition at end of period:
GNMA...................................... $ 5,299 $ 6,458 $ 7,217
Fannie Mae/Freddie Mac.................... 3,931,738 4,658,056 6,638,435
Other Private............................. 206,315 137,067 142,878
---------- ---------- ----------
Subtotal................................ 4,143,352 4,801,581 6,788,530
Subservicing on sold servicing rights(2).... 2,027,578 3,619,373 536,324
---------- ---------- ----------
Total servicing for others.............. $6,170,930 $8,420,954 $7,324,854
========== ========== ==========
Loans receivable, net(3)................ $1,803,424 $1,110,836 $ 923,943
========== ========== ==========
</TABLE>
- --------
(1) The actual release or transfer of servicing does not necessarily take
place during the same period as the related sale of MSRs.
(2) Reflects mortgage servicing rights sold by the Bank but as to which the
purchaser has not yet taken delivery. The Bank's costs of subservicing are
generally equivalent to the fees charged by the Bank for this service.
(3) Represents loans which the Bank also services, including loans available
for sale.
The Bank originates and purchases MSRs nationwide. The broad geographic
distribution of the Bank's MSR portfolio reflects the national scope of the
Bank's mortgage loan originations and MSR acquisitions. The ten largest states
accounted for 76.5% of the total number of mortgage loans serviced and 73.0%
of the dollar value
OC-60
<PAGE>
of the mortgage loans serviced, at September 30, 1997, while the largest
volume by state was Michigan with 35.0% and 28.6% of the mortgage loans
serviced by number and value, respectively.
The Bank's mortgage servicing portfolio includes servicing for adjustable
rate, balloon payment and fixed rate fully amortizing loans. At September 30,
1997, 2.3% of the mortgage servicing rights related to adjustable rate loans,
which had a weighted average coupon rate of 7.869%; 19.3% related to fixed
rate balloon payment loans, which had a weighted average coupon rate of
7.263%; and the remaining 78.4% related to fixed rate fully amortizing loans,
which had a weighted average coupon rate of 8.067%. At that date, the Bank's
mortgage servicing portfolio had an aggregate weighted average coupon rate of
7.905%. The following table sets forth, as of September 30, 1997, the
percentage of fixed-rate, single-family mortgage loans being serviced for
others by the Bank, by interest rate category.
<TABLE>
<CAPTION>
PERCENTAGE OF
COUPON RANGE PORTFOLIO
------------ -------------
<S> <C>
Less than 7.00%............................................. 2.66%
7.00-- 8.00%............................................... 36.32%
8.01-- 9.00%............................................... 57.15%
9.01--10.00%............................................... 3.30%
10.01--11.00%............................................... 0.50%
11.01--12.00%............................................... 0.05%
12.01 & above............................................... 0.02%
------
100.00%
======
</TABLE>
The following table sets forth information regarding the mortgage loan
servicing portfolio, broken down by state.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, 1997
------------------------------------------------------
PERCENTAGE OF
NUMBER OF TOTAL NUMBER PERCENTAGE OF
MORTGAGE LOANS OF MORTGAGE TOTAL DOLLAR
SERVICED LOANS SERVICED AMOUNT AMOUNT
-------------- -------------- ---------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Michigan................ 15,675 34.99% $1,183,217 28.56%
Ohio.................... 3,932 8.78% 220,750 5.33%
California.............. 3,740 8.35% 549,417 13.26%
Texas................... 2,050 4.58% 172,043 4.15%
Florida................. 2,032 4.54% 153,761 3.71%
Illinois................ 1,748 3.90% 179,660 4.34%
Colorado................ 1,485 3.31% 157,588 3.80%
Washington.............. 1,250 2.79% 152,939 3.69%
Georgia................. 1,222 2.73% 106,404 2.57%
New York................ 1,145 2.56% 136,529 3.30%
Maryland................ 1,072 2.39% 116,290 2.81%
Oregon.................. 949 2.12% 110,894 2.68%
Missouri................ 633 1.41% 44,812 1.08%
Utah.................... 598 1.33% 63,812 1.54%
New Jersey.............. 555 1.24% 63,608 1.53%
Indiana................. 535 1.19% 42,098 1.02%
Minnesota............... 504 1.13% 40,214 0.97%
Virginia................ 483 1.08% 56,485 1.36%
Pennsylvania............ 469 1.05% 43,805 1.06%
North Carolina.......... 468 1.04% 36,063 0.87%
Tennessee............... 451 1.01% 37,128 0.90%
Other................... 3,803 8.48% 475,835 11.47%
------ ------ ---------- ------
Total................. 44,799 100.00% $4,143,352 100.00%
====== ====== ========== ======
</TABLE>
OC-61
<PAGE>
At September 30, 1997, the Bank was servicing 44,799 mortgage loans for
others with an aggregate unpaid principal balance of $4.1 billion (excluding
subservicing). Of such loans, 2.30% were delinquent and an additional 1.11%
were in foreclosure. The following table presents certain information
regarding the number of delinquent single family mortgage loans as of the
dates indicated.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, AT DECEMBER 31,
---------------- -----------------
1997 1996 1995 1994
---------------- ----- ----- -----
<S> <C> <C> <C> <C>
30-59 Days Past Due.......................... 1.36% 2.52% 1.77% 0.81%
60-89 Days Past Due.......................... 0.30% 0.51% 0.24% 0.09%
90+ days Past Due............................ 0.64% 0.25% 0.14% 0.02%
Loans in foreclosure......................... 1.11% 0.88% 0.40% 0.23%
----- ----- ----- -----
Total...................................... 3.41% 4.16% 2.55% 1.15%
===== ===== ===== =====
</TABLE>
The Bank is materially affected by loan delinquencies and defaults on loans
that it services for others. Under a portion of its servicing contracts, the
Bank must forward all or part of the scheduled payments to the owner of the
loan, even when loan payments are delinquent. At September 30, 1997, the
Bank's delinquency rates on loans serviced for Freddie Mac and Fannie Mae were
3.00% and 3.96%, respectively. Also, to protect their liens on mortgage
properties, owners of loans usually require a servicer to advance scheduled
mortgage and hazard insurance and tax payments even if sufficient escrow funds
are not available. The Bank is generally reimbursed by the mortgage owner or
from liquidation proceeds for payments advanced that the servicer is unable to
recover from the mortgagor, although the timing of such reimbursement is
typically uncertain. In the interim, the Bank absorbs the cost of funds
advanced during the time the advance is outstanding. Further, the Bank bears
the costs of collection activities on delinquent and defaulted loans.
FUNDING SOURCES
The Bank funds its operations through its retail deposit base, the funds
available in escrow accounts held in connection with its mortgage loan
servicing operations, and FHLB advances. See "Management's Discussion and
Analysis of Financial Condition and Results of Operation--Liquidity and
Capital Resources."
Deposits are a significant source of the Bank's funds for lending,
investment activities and general operational purposes. In addition to
deposits, the Bank derives funds from loan principal and interest repayments,
sales of loans, mortgage loan servicing income and sales of mortgage servicing
rights.
The Bank attracts deposits principally from its primary market area in
Michigan by offering a variety of deposit instruments, including checking
accounts, money market accounts, regular savings accounts and certificates of
deposit. Deposit terms vary according to the minimum balance required and the
interest rate. Maturities, terms, service fees and withdrawal fees are
established on a periodic basis. Management of the Bank generally reviews its
deposit mix and pricing on a daily basis. In determining the characteristics
of its deposit accounts, the Bank considers the rates offered by competing
institutions in the Bank's market areas, the acquisition of brokered funds,
liquidity requirements, growth goals and federal regulations.
The Bank competes for deposits with other institutions in its market area
and nationwide (through print advertisements and a commercial wire service) by
offering deposit instruments that are competitively priced and by providing
customer service through convenient and attractive offices, knowledgeable and
efficient staff and hours of service that meet customers' needs. Most of the
Bank's depositors are Michigan residents.
Among deposits which the Bank attracts and retains are brokered deposits,
which are pools of deposits purchased from a broker acting as an agent for
depositors seeking the highest certificate of deposit rates offered by insured
financial institutions and its certificates of deposit. At September 30, 1997,
the Bank had $877.3 million in certificates of deposit, of which $480.4
million, or 54.8%, were brokered deposits. Because brokered deposits are
inherently interest-rate sensitive, the Bank is subject to the risk of a
significant outflow of funds in
OC-62
<PAGE>
the event of a sudden increase in interest rates. Further, the Bank's net
earnings may be adversely affected by attempts by the Bank to match interest
rates to stem any such outflow of funds. The Bank believes that this risk is
appropriately mitigated by the availability of its $850 million FHLB line of
credit, as to which its maximum outstanding month-end balance for the nine
months ended September 30, 1997 was $718.9 million. Based upon the Bank's
current cost of its funds, the Bank does not believe that reliance on the FHLB
as a short-term replacement funding source would have a significant adverse
effect on its financial condition. For the nine months ended September 30,
1997, the average cost of funds for the Bank's deposits, including brokered
deposits, and its FHLB advances were 5.55% and 5.87%, respectively. Further,
the Bank believes its reliance on brokered funds will diminish as the Bank
develops its retail deposit base through its existing and future branch
network.
The following table sets forth by account types the aggregate amount and
weighted average rate of the Bank's deposits.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, AT DECEMBER 31,
------------------- -----------------------------------------------------
1997 1996 1995 1994
------------------- ----------------- ----------------- -----------------
WEIGHTED WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE AVERAGE
AMOUNT RATE AMOUNT RATE AMOUNT RATE AMOUNT RATE
---------- -------- -------- -------- -------- -------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Transaction Accounts:
Non-interest bearing
accounts.............. $ 21,321 -- % $ 36,935 -- % $ 13,171 -- % $ 13,691 -- %
Interest bearing ac-
counts................ 34,660 3.04% 29,973 3.56% 29,239 3.05% 49,226 2.96%
---------- -------- -------- --------
Subtotal............... 55,981 2.20% 66,908 1.60% 42,410 2.22% 62,917 2.35%
Passbook savings ac-
counts................. 78,879 4.67% 57,211 4.30% 38,094 2.25% 9,744 2.25%
Certificates of depos-
it..................... 877,261 6.04% 500,613 5.95% 448,714 6.27% 235,836 5.47%
---------- -------- -------- --------
Total deposits......... $1,012,121 5.72% $624,732 5.34% $529,218 5.73% $308,497 4.74%
========== ======== ======== ========
</TABLE>
The following table indicates the amount of the Bank's certificates of
deposit by time remaining until maturity as of September 30, 1997.
<TABLE>
<CAPTION>
CERTIFICATES
MATURITY PERIOD OF DEPOSIT
--------------- --------------
(IN THOUSANDS)
<S> <C>
Three months or less...................................... $129,844
Over three through six months............................. 168,644
Over six through 12 months................................ 197,980
Over 12 months............................................ 380,793
--------
Total................................................... $877,261
========
</TABLE>
The Bank considers all its certificates of deposit to be highly interest-
rate sensitive regardless of amount.
OC-63
<PAGE>
Savings deposits in the Bank at September 30, 1997 were represented by the
various types of savings programs described below.
<TABLE>
<CAPTION>
PERCENTAGE
INTEREST MINIMUM MINIMUM BALANCE OF TOTAL
RATE* TERM CATEGORY AMOUNT (IN THOUSANDS) DEPOSITS
- -------- -------------------- ----------------------------- ------- -------------- ----------
<S> <C> <C> <C> <C> <C>
N/A............. None Non-interest bearing accounts $ 50 $ 21,321 2.11%
3.04%........... None Demand/NOW accounts 50 34,660 3.42%
4.67%........... None Passbook accounts 50 78,879 7.79%
---------- ------
$ 134,860 13.32%
<CAPTION>
CERTIFICATES OF DEPOSIT
-----------------------------
<S> <C> <C> <C> <C> <C>
5.99%........... 3 months or less Fixed-term, fixed-rate $500 $ 129,844 12.84%
5.98%........... Over 3 to 12 months Fixed-term, fixed-rate 500 366,625 36.23%
6.08%........... Over 12 to 24 months Fixed-term, fixed-rate 500 221,106 21.85%
6.06%........... Over 24 to 36 months Fixed-term, fixed-rate 500 95,995 9.48%
6.24%........... Over 36 to 48 months Fixed-term, fixed-rate 500 37,264 3.68%
6.53%........... Over 48 to 60 months Fixed-term, fixed-rate 500 24,578 2.42%
6.46%........... Over 60 months Fixed-term, fixed-rate 500 1,849 .18%
---------- ------
877,261 86.68%
---------- ------
$1,012,121 100.00%
========== ======
</TABLE>
- --------
* Represents weighted average interest rate.
The following table sets forth the change in dollar amount of deposits in
the various types of accounts offered by the Bank between the dates indicated.
<TABLE>
<CAPTION>
INCREASE
BALANCE AT (DECREASE) FROM BALANCE AT INCREASE
SEPTEMBER 30, % OF DECEMBER 31, DECEMBER 31, % OF (DECREASE) FROM
1997 DEPOSITS 1996 1996 DEPOSITS DECEMBER 31, 1995
------------- -------- --------------- ------------ -------- -----------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Non-interest bearing
accounts............... $ 21,321 2.11% $(15,614) $ 36,935 5.91% $23,764
Demand and NOW
accounts............... 34,660 3.42% 4,687 29,973 4.80% 734
Passbook savings........ 78,879 7.79% 21,668 57,211 9.16% 19,117
Other time deposits..... 877,261 86.68% 376,648 500,613 80.13% 51,899
---------- ------ -------- -------- ------ -------
$1,012,121 100.00% $387,389 $624,732 100.00% $95,514
========== ====== ======== ======== ====== =======
</TABLE>
<TABLE>
<CAPTION>
BALANCE AT INCREASE BALANCE AT
DECEMBER 31, % OF (DECREASE) FROM DECEMBER 31, % OF
1995 DEPOSITS DECEMBER 31, 1994 1994 DEPOSITS
------------ -------- ----------------- ------------ --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Non-interest bearing
accounts............... $ 13,171 2.49% $ (520) $ 13,691 4.44%
Demand and NOW
accounts............... 29,239 5.52% (19,987) 49,226 15.96%
Passbook savings........ 38,094 7.20% 28,350 9,744 3.16%
Other time deposits..... 448,714 84.79% 212,878 235,836 76.44%
-------- ------ -------- -------- ------
Total................. $529,218 100.00% $220,721 $308,497 100.00%
======== ====== ======== ======== ======
</TABLE>
OC-64
<PAGE>
The following table sets forth the time deposits in the Bank classified by
rates at the dates indicated.
<TABLE>
<CAPTION>
AT SEPTEMBER 30, AT DECEMBER 31,
1997 1996
---------------- ---------------
(IN THOUSANDS)
<S> <C> <C>
2.01-4.00%................................ $ 137 $ 1,019
4.01-6.00%................................ 433,646 298,879
6.01-8.00%................................ 442,930 198,610
8.01% and over............................ 548 2,105
-------- --------
Total................................... $877,261 $500,613
======== ========
</TABLE>
The following table sets forth the amount and maturities of time deposits at
September 30, 1997.
<TABLE>
<CAPTION>
AMOUNT DUE
---------------------------------------------------
LESS THAN 1-
ONE YEAR 2 YEARS 2-3 YEARS AFTER 3 YEARS TOTAL
--------- -------- --------- ------------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
2.01-4.00%........ $ 125 $ -- $ 12 $ -- $ 137
4.01-6.00%........ 248,295 130,364 33,970 21,017 433,646
6.01-8.00%........ 209,632 111,777 61,141 60,380 442,930
8.01-over......... 309 76 44 119 548
-------- -------- ------- ------- --------
Total........... $458,361 $242,217 $95,167 $81,516 $877,261
======== ======== ======= ======= ========
</TABLE>
Deposits have historically been the primary source of funds for the Bank's
lending and general operating activities. However, the Bank also utilizes the
FHLB to provide both short-term and long-term borrowings and also relies to a
limited extent on short-term reverse repurchases of pools of single-family
mortgage loans for advance funding of securitized loans.
The Bank's principal source of borrowings has been FHLB advances. The Bank
is authorized to use advances from the FHLB to supplement its supply of funds
and to satisfy deposit withdrawal requirements. The Federal Home Loan Bank
System functions as a twelve-bank central reserve bank providing credit for
savings institutions and certain other member financial institutions. As a
member of the FHLB System, the Bank is required to own stock in the FHLB and
is authorized to apply for advances, which are made pursuant to several
different programs with their own interest rates and range of maturities.
Advances from the FHLB are secured by the Bank's stock in the FHLB and a
portion of the Bank's mortgage loan portfolio.
The following table sets forth certain information regarding the borrowings
of the Bank as of or for the period indicated.
<TABLE>
<CAPTION>
AT OR FOR THE YEARS ENDED
AT OR FOR THE NINE MONTHS DECEMBER 31,
ENDED SEPTEMBER 30, ----------------------------
1997 1996 1995 1994
------------------------- -------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
FHLB Advances
Balance outstanding at
period-end........... $718,878 $389,801 $191,156 $200,750
Maximum outstanding at
any month-end........ 718,878 $389,801 $315,000 $200,750
Monthly average
balance.............. 427,310 $247,204 $237,535 $ 83,912
Average interest
rate................. 5.87% 5.78% 6.35% 4.44%
</TABLE>
See Note 9 of Notes to Consolidated Financial Statements for additional
information.
EMPLOYEES
As of September 30, 1997, the Bank and its subsidiaries had 1,110 full-time
equivalent employees, none of whom were represented by a collective bargaining
agreement. Management of the Bank considers their relationship with such
employees to be satisfactory.
OC-65
<PAGE>
PROPERTIES
The Bank's principal executive offices are located at 2600 Telegraph Road,
Bloomfield Hills, Michigan 48302 in leased facilities. At September 30, 1997,
the Bank maintained 19 branches, 33 loan centers, 10 correspondent service
centers, 5 wholesale/correspondent satellite offices, 1 mortgage loan
servicing center, and three corporate operations offices. Other than nine of
the branches and one of the loan centers, the Bank leased its operating
premises. See Note 6 of Notes to Consolidated Financial Statements. See
"Business--Business Strategy."
SUBSIDIARY ACTIVITIES
The Bank is a federally chartered, stock savings bank headquartered in
Bloomfield Hills, Michigan. See "Business." The Bank owns five subsidiaries:
FSSB Mortgage Corporation ("Mortgage"), Mortgage Affiliated Services, Inc.
("MAS"), Mid-Michigan Service Corporation ("Mid-Michigan"), SSB Funding
Corporation ("Funding"), and Flagstar Capital Corporation ("Capital").
Mortgage and Funding are currently inactive subsidiaries. MAS provides
appraisal and document preparation services, primarily in conjunction with the
Bank's loan closings. Mid-Michigan is engaged in the business of leasing and
sub-leasing commercial real estate. Capital purchases Bank loans and holds
them for investment purposes.
LEGAL PROCEEDINGS
From time to time, the Bank and its subsidiaries are parties to various
legal proceedings incident to its business. At September 30, 1997, there were
no legal proceedings which management anticipates would have a material
adverse effect on the Bank.
OC-66
<PAGE>
REGULATION
GENERAL
The Bank is chartered as a federal savings bank under the Home Owners' Loan
Act, as amended (the "HOLA"), which is implemented by regulations adopted and
administered by the OTS. As a federal savings bank, the Bank is subject to
regulation, supervision and regular examination by the OTS. The OTS also has
extensive enforcement authority over all savings institutions and their
holding companies, including the Bank and Flagstar Bancorp, Inc. Federal
banking laws and regulations control, among other things, the Bank's required
reserves, investments, loans, mergers and consolidations, payment of dividends
and other aspects of the Bank's operations. The deposits of the Bank are
insured by the SAIF administered by the FDIC to the maximum extent provided by
law ($100,000 for each depositor). In addition, the FDIC has certain
regulatory and examination authority over OTS-regulated savings institutions
and may recommend enforcement actions against savings institutions to the OTS.
The supervision and regulation of the Bank is intended primarily for the
protection of the deposit insurance fund and depositors rather than for
holders of the Bank's stock or for Flagstar Bancorp, Inc. as the holder of the
stock of the Bank.
The following discussion is intended to be a summary of certain statutes,
rules and regulations affecting the Bank. A number of other statutes and
regulations have an impact on its operations. The following summary of
applicable statutes and regulations does not purport to be complete and is
qualified in its entirety by reference to such statutes and regulations.
REGULATION OF THE BANK
Proposed Legislation. Legislation currently pending before the United States
Congress would, if enacted, require all federal savings institutions (such as
the Bank) to convert to a national bank or a state bank or savings bank
charter. In addition, the proposed changes would require the Bank's parent,
Flagstar Bancorp, Inc., to be regulated as a bank holding company or a
"Financial Services" holding company. If the pending legislation were to be
adopted in its current form, it would eliminate certain advantages now enjoyed
by federal savings institutions, such as unrestricted interstate branching.
The Bank cannot predict whether or in what form the proposed legislation
will be enacted. However, based upon the provisions of the currently pending
legislation, the management of the Bank does not believe that the enactment of
such legislation would have a material adverse effect on its financial
condition or results of operations.
Business Activities. The Bank derives its lending and investment powers from
the HOLA and the regulations of the OTS thereunder. Under these laws and
regulations, the Bank may invest in mortgage loans secured by residential and
commercial real estate, commercial and consumer loans, certain types of
commercial paper and debt securities, and certain other assets. The Bank may
also establish service corporations that may engage in activities not
otherwise permissible for the Bank, including certain real estate equity
investments and securities and insurance brokerage. These investment powers
are subject to various limitations.
Branching. Subject to certain limitations, OTS regulations currently permit
a federally chartered savings institution like the Bank to establish branches
in any state of the United States, provided that the federal savings
institution qualifies as a "domestic building and loan association" under the
Internal Revenue Code. See "--Qualified Thrift Lender Test." The authority for
a federal savings institution to establish an interstate branch network would
facilitate a geographic diversification of the institution's activities.
However, recently proposed federal legislation could, if enacted, restrict the
Bank's ability to open branches in states other than Michigan. See "--Proposed
Legislation."
Regulatory Capital. The OTS has adopted capital adequacy regulations that
require savings institutions such as the Bank to meet three minimum capital
standards: a "core" capital requirement of 3% of adjusted total assets, a
"tangible" capital requirement of 1.5% of adjusted total assets, and a "risk-
based" capital requirement
OC-67
<PAGE>
of 8% of total risk-based capital to total risk-weighted assets. In addition,
the OTS has adopted regulations imposing certain restrictions on savings
institutions that have a total risk-based capital ratio of less than 8%, a
ratio of Tier 1 capital to risk-weighted assets of less than 4% or a ratio of
Tier 1 capital to total assets of less than 4% (or 3% if the institution is
rated Composite 1 under the CAMEL examination rating system). See "--Prompt
Corrective Regulatory Action."
The core capital, or "leverage ratio," requirement mandates that a savings
institution maintain core capital equal to at least 3% of its adjusted total
assets. "Core capital" includes common stockholders' equity (including
retained earnings), noncumulative perpetual preferred stock and related
surplus, minority interests in the equity accounts of fully consolidated
subsidiaries and certain nonwithdrawable accounts and pledged deposits and is
generally reduced by the amount of the savings institution's intangible
assets, with limited exceptions for permissible mortgage servicing rights
("MSRs"), purchased credit card relationships and certain intangible assets
arising from prior regulatory accounting practices. Core capital is further
reduced by the amount of a savings institution's investments in and loans to
subsidiaries engaged in activities not permissible for national banks. At
September 30, 1997, the Bank had no such investments.
The risk-based capital standards of the OTS require maintenance of core
capital equal to at least 4% of risk-weighted assets and total capital equal
to at least 8% of risk-weighted assets. For purposes of the risk-based capital
requirement, "total capital" includes core capital plus supplementary capital,
provided that the amount of supplementary capital does not exceed the amount
of core capital. Supplementary capital includes preferred stock that does not
qualify as core capital, nonwithdrawable accounts and pledged deposits to the
extent not included in core capital, perpetual and mandatory convertible
subordinated debt and maturing capital instruments meeting specified
requirements and a portion of the institution's loan and lease loss allowance.
The risk-based capital requirement is measured against risk-weighted assets,
which equal the sum of each asset and the credit-equivalent amount of each
off-balance sheet item after being multiplied by an assigned risk weight,
which range from 0% to 100% as assigned by the OTS capital regulations based
on the risks the OTS believes are inherent in the type of asset. Comparable
risk weights are assigned to off-balance sheet assets.
The OTS risk-based capital regulation also includes an interest rate risk
("IRR") component that requires savings institutions with greater than normal
IRR, when determining compliance with the risk-based capital requirements, to
maintain additional total capital. The OTS has, however, indefinitely deferred
enforcement of its IRR requirements.
The following table sets forth the Bank's compliance with its regulatory
capital requirements at September 30, 1997.
<TABLE>
<CAPTION>
CAPITAL
THE BANK'S CAPITAL REQUIREMENTS EXCESS CAPITAL
------------------- --------------- ---------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
------------------- ------- ------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Tangible capital........... $ 116,218 5.73% $30,425 1.50% $85,793 4.23%
Core capital............... $ 121,055 5.95% $60,996 3.00% $60,059 2.95%
Total Risk-based capital... $ 125,695 11.25% $89,413 8.00% $36,282 3.25%
</TABLE>
Prompt Corrective Regulatory Action. Under the Federal Deposit Insurance
Corporation Improvement Act of 1991 ("FDICIA"), the federal banking regulators
are required to take prompt corrective action in respect of depository
institutions that do not meet certain minimum capital requirements, including
a leverage limit and a risk-based capital requirement. All institutions,
regardless of their capital levels, are restricted from making any capital
distribution or paying any management fees that would cause the institution to
become undercapitalized. As required by FDICIA, banking regulators, including
the OTS, have issued regulations that classify insured depository institutions
by capital levels and provide that the applicable agency will take various
prompt corrective actions to resolve the problems of any institution that
fails to satisfy the capital standards.
OC-68
<PAGE>
Under the joint prompt corrective action regulations, a "well-capitalized"
institution is one that is not subject to any regulatory order or directive to
meet any specific capital level and that has or exceeds the following capital
levels: a total risk-based capital ratio of 10%, a Tier 1 risk-based capital
ratio of 6%, and a ratio of Tier 1 capital to total assets ("leverage ratio")
of 5%. An "adequately capitalized" institution is one that does not qualify as
"well capitalized" but meets or exceeds the following capital requirements: a
total risk-based capital of 8%, a Tier 1 risk-based capital ratio of 4%, and a
leverage ratio of either (i) 4% or (ii) 3% if the institution has the highest
composite examination rating. An institution not meeting these criteria is
treated as "undercapitalized," "significantly undercapitalized," or
"critically undercapitalized" depending on the extent to which its capital
levels are below these standards. An institution that falls within any of the
three "undercapitalized" categories will be subject to certain severe
regulatory sanctions required by FDICIA and the implementing regulations. As
of September 30, 1997, the Bank was "well-capitalized" as defined by the
regulations.
Federal Deposit Insurance. The Bank is required to pay assessments, based on
a percentage of its insured deposits, to the FDIC for insurance of its
deposits by the SAIF.
Under the FDIC's risk-based deposit insurance assessment system, the
insurance assessment rate for an insured depository institution depends on the
assessment risk classification assigned to the institution. Institutions are
assigned by the FDIC to one of three capital groups--well-capitalized,
adequately capitalized, or undercapitalized--and, within each capital
category, to one of three supervisory subgroups.
In order to recapitalize the SAIF and to equalize the deposit insurance
premiums paid by SAIF-insured institutions and institutions with deposits
insured by the Bank Insurance Fund, Congress enacted the Deposit Insurance
Funds Act of 1996 (the "1996 Act"), which authorized the FDIC to impose a one-
time special assessment on all institutions with SAIF-assessable deposits in
the amount necessary to recapitalize the SAIF to the statutorily designated
reserve ratio of 1.25% of insured deposits. Institutions were assessed at the
rate of 65.7 basis points per $100 of each institution's SAIF-assessable
deposits as of March 31, 1995. The 1996 Act provides the amount of the special
assessment will be deductible for federal income tax purposes for the taxable
year in which the special assessment is paid.
As a result of the recapitalization of the SAIF by the 1996 Act, the FDIC
reduced the insurance assessment rate for SAIF-assessable deposits for periods
beginning on October 1, 1996. For 1997, the FDIC set the effective insurance
assessment rates for SAIF-insured institutions, such as the Bank, at zero to
27 basis points. In addition, SAIF-insured institutions will be required,
until December 31, 1999, to pay assessments to the FDIC at an annual rate of
between 6.0 and 6.5 basis points to help fund interest payments on certain
bonds issued by the Financing Corporation ("FICO"), an agency of the federal
government established to recapitalize the predecessor to the SAIF. During
this period, BIF member banks will be assessed for payment of the FICO
obligations at one-fifth the annual rate applicable to SAIF member
institutions. After December 31, 1999, BIF and SAIF members will be assessed
at the same rate (currently estimated at approximately 2.4 basis points) to
service the FICO obligations.
The 1996 Act also provides that the FDIC may not assess regular insurance
assessments for the SAIF unless required to maintain or to achieve the
designated reserve ratio of 1.25%, except for such assessments on those
institutions that are not classified as "well-capitalized" or that have been
found to have "moderately severe" or "unsatisfactory" financial, operational
or compliance weaknesses. The Bank is classified as "well-capitalized" and has
not been found by the OTS to have such supervisory weaknesses.
Qualified Thrift Lender Test. The HOLA and OTS regulations require all
savings institutions to satisfy one of two Qualified Thrift Lender ("QTL")
tests or to suffer a number of sanctions, including restrictions on
activities. To qualify as a QTL, a savings institution must either (i) be
deemed a "domestic building and loan association" under the Internal Revenue
Code (the "Code") by maintaining at least 60% of its total assets in specified
types of assets, including cash, certain government securities, loans secured
by and other assets related to residential real property, educational loans,
and investments in premises of the institution or (ii) satisfy the
OC-69
<PAGE>
HOLA's QTL test by maintaining at least 65% of "portfolio assets" in certain
"Qualified Thrift Investments." For purposes of the HOLA's QTL test, portfolio
assets are defined as total assets less intangibles, property used by a
savings institution in its business and liquidity investments in an amount not
exceeding 20% of assets. Qualified Thrift Investments consist of (a) loans,
equity positions or securities related to domestic, residential real estate or
manufactured housing, (b) 50% of the dollar amount of residential mortgage
loans subject to sale under certain conditions, and (c) loans to small
businesses, student loans and credit card loans. In addition, subject to a 20%
of portfolio assets limit, savings institutions are able to treat as Qualified
Thrift Investments 200% of their investments in loans to finance "starter
homes" and loans for construction, development or improvement of housing and
community service facilities or for financing small business in "credit needy"
areas.
A savings institution must maintain its status as a QTL on a monthly basis
in at least nine out of every 12 months. An initial failure to qualify as a
QTL results in a number of sanctions, including the imposition of certain
operating restrictions and a restriction on obtaining additional advances from
its Federal Home Loan Bank. If a savings institution does not requalify under
the QTL test within the three-year period after it fails the QTL test, it
would be required to terminate any activity not permissible for a national
bank and repay as promptly as possible any outstanding advances from its
Federal Home Loan Bank. In addition, the holding Bank of such an institution
would similarly be required to register as a bank holding Bank with the
Federal Reserve Board. At September 30, 1997, the Bank qualified as a QTL.
Safety and Soundness Standards. FDICIA, as amended by the Riegle Community
Development and Regulatory Improvement Act of 1994, requires the OTS, together
with the other federal bank regulatory agencies, to prescribe standards, by
regulation or guideline, relating to internal controls, information systems
and internal audit systems, loan documentation, credit underwriting, interest
rate risk exposure, asset growth, asset quality, earnings, stock valuation,
and compensation, fees and benefits and such other operational and managerial
standards as the agencies deem appropriate. The OTS and the federal bank
regulatory agencies have adopted a set of guidelines prescribing safety and
soundness standards pursuant to the statute. The safety and soundness
guidelines establish general standards relating to internal controls and
information systems, internal audit systems, loan documentation, credit
underwriting, interest rate exposure, asset growth, and compensation, fees and
benefits. In general, the guidelines require, among other things, appropriate
systems and practices to identify and manage the risks and exposures specified
in the guidelines. The guidelines prohibit excessive compensation as an unsafe
and unsound practice and describe compensation as excessive when the amounts
paid are unreasonable or disproportionate to the services performed by an
executive officer, employee, director or principal stockholder.
In addition, on July 10, 1995, the OTS and the federal bank regulatory
agencies proposed guidelines for asset quality and earnings standards. Under
the proposed standards, a savings institution would be required to maintain
systems, commensurate with its size and the nature and scope of its
operations, to identify problem assets and prevent deterioration in those
assets as well as to evaluate and monitor earnings and ensure that earnings
are sufficient to maintain adequate capital and reserves. Management believes
that the asset quality and earnings standards, in the form proposed by banking
agencies, would not have a material effect on the operations of the Bank.
Limitations on Capital Distributions. OTS regulations impose limitations
upon capital distributions by savings institutions, such as cash dividends,
payments to repurchase or otherwise acquire its shares, payments to
stockholders of another institution in a cash-out merger and other
distributions charged against capital. A savings institution must give notice
to the OTS at least 30 days before declaration of a proposed capital
distribution to its holding company, and capital distributions in excess of
specified earnings or by certain institutions are subject to approval by the
OTS. A savings institution that has capital in excess of all regulatory
capital requirements before and after a proposed capital distribution and that
is not otherwise restricted in making capital distributions, may, after prior
notice but without the approval of the OTS, make capital distributions during
a calendar year equal to the greater of (a) 100% of its net income to date
during the calendar year plus the amount that would
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reduce by one-half its "surplus capital ratio" (the excess capital over its
fully phased-in capital requirements) at the beginning of the calendar year,
or (b) 75% of its net income for the previous four quarters. Any additional
capital distributions would require prior OTS approval.
The OTS has proposed regulations that would simplify the existing procedures
governing capital distributions by savings institutions. Under the proposed
regulations, the approval of the OTS would be required only for capital
distributions by an institution that is deemed to be in troubled condition or
that is undercapitalized or would be undercapitalized after the capital
distribution. A savings institution would be able to make a capital
distribution without notice to or approval of the OTS if it is not held by a
savings and loan holding company, is not deemed to be in troubled condition,
has received either of the two highest composite supervisory ratings and would
continue to be adequately capitalized after such distribution. Notice would
have to be given to the OTS by any institution that is held by a savings and
loan holding company or that had received a composite supervisory rating below
the highest two composite supervisory ratings. An institution's capital rating
would be determined under the prompt corrective action regulations. See "--
Prompt Corrective Regulatory Action."
Under OTS regulations, the Bank would not be permitted to pay dividends on
its capital stock if its regulatory capital would thereby be reduced below the
amount then required for the liquidation account established for the benefit
of certain depositors of the Bank at the time of the Conversion. In addition,
under the OTS's prompt corrective action regulations, the Bank would be
prohibited from paying dividends if the Bank were classified as
"undercapitalized" under such rules. See "--Prompt Corrective Regulatory
Action."
In addition to the foregoing, earnings of the Bank appropriated to bad debt
reserves and deducted for federal income tax purposes are not available for
payment of dividends or other distributions to the Bank without payment of
taxes at the then current tax rate by the Bank on the amount of earnings
removed from the reserves for such distributions.
Consumer Credit Regulation. The Bank's mortgage lending activities are
subject to the provisions of various federal and state statutes, including,
among others, the Truth in Lending Act, the Equal Credit Opportunity Act, the
Real Estate Settlement Procedures Act, the Fair Housing Act, and the
regulations promulgated thereunder. These statutes and regulations, among
other provisions, prohibit discrimination, prohibit unfair and deceptive trade
practices, require the disclosure of certain basic information to mortgage
borrowers concerning credit terms and settlement costs, and otherwise regulate
terms and conditions of credit and the procedures by which credit is offered
and administered. Many of the above regulatory requirements are designed to
protect the interests of consumers, while others protect the owners or
insurers of mortgage loans. Failure to comply with these requirements can lead
to administrative enforcement actions, class action lawsuits and demands for
restitution or loan rescission.
Transactions with Affiliates. The Bank is subject to restrictions imposed by
Sections 23A and 23B of the Federal Reserve Act on extensions of credit to,
and certain other transactions with, its holding company and other affiliates,
and on investments in the stock or other securities thereof. Such restrictions
prevent Flagstar and such other affiliates from borrowing from the Bank unless
the loans are secured by specified collateral, and require such transactions
to have terms comparable to terms of arm's-length transactions with third
persons. Further, such secured loans and other transactions and investments by
the Bank are generally limited in amount as to Flagstar and as to any other
affiliate to 10% of the Bank's capital and surplus and as to Flagstar and all
other affiliates to an aggregate of 20% of the Bank's capital and surplus.
Loans to Directors, Executive Officers and Principal Stockholders. The
Bank's ability to extend credit to its directors, executive officers, and 10%
stockholders, as well as to entities controlled by such persons, is governed
by the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and
Regulation O of the Federal Reserve Board thereunder. Among other things,
these provisions require that an institution's extensions of credit to
insiders (a) be made on terms that are substantially the same as, and follow
credit underwriting procedures that are not less stringent than, those
prevailing for comparable transactions with unaffiliated persons
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and that do not involve more than the normal risk of repayment or present
other unfavorable features and (b) not exceed certain limitations on the
amount of credit extended to such persons, individually and in the aggregate,
which limits are based, in part, on the amount of the institution's capital.
In addition, extensions of credit in excess of certain limits must be approved
by the institution's Board of Directors.
Reserve Requirements. Pursuant to regulations of the Federal Reserve Board,
all FDIC-insured depository institutions must maintain average daily reserves
against their transaction accounts. No reserves are required to be maintained
on the first $4.7 million of transaction accounts, and reserves equal to 3%
must be maintained on the next $47.8 million of transaction accounts, plus
reserves equal to 10% on the remainder. These percentages are subject to
adjustment by the Federal Reserve Board. Because required reserves must be
maintained in the form of vault cash or in a non-interest-bearing account at a
Federal Reserve Bank, the effect of the reserve requirement is to reduce the
amount of the institution's interest-earning assets. As of September 30, 1997,
the Bank met its reserve requirements.
Liquidity Requirements. The Bank is required by OTS regulation to maintain
an average daily balance of liquid assets (cash, certain time deposits,
bankers' acceptances, highly rated corporate debt and commercial paper,
qualifying mortgage-related securities and mortgage loans, securities of
certain mutual funds, and specified United States government, state or federal
agency obligations) equal to the monthly average of not less than a specified
percentage (currently 4%) of its net withdrawable short-term savings deposits
plus short-term borrowings. The average daily liquidity ratio of the Bank for
the month ended September 30, 1997 was 8.49%.
Federal Home Loan Bank System. The Federal Home Loan Bank System consists of
12 district Federal Home Loan Banks subject to supervision and regulation by
the Federal Housing Finance Board ("FHFB"). The Federal Home Loan Banks
provide a central credit facility primarily for member institutions. As a
member of the FHLB, the Bank is required to acquire and hold shares of capital
stock in the FHLB in an amount at least equal to 1% of the aggregate unpaid
principal of its home mortgage loans, home purchase contracts, and similar
obligations at the beginning of each year, or 1/20 of its advances
(borrowings) from the FHLB, whichever is greater. The Bank was in compliance
with this requirement, with an investment in FHLB stock at September 30, 1997
of $36.9 million. Long-term FHLB advances may only be made for the purpose of
providing funds for residential housing finance.
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MANAGEMENT
EXECUTIVE OFFICERS AND DIRECTORS
The Board of Directors of the Bank is divided into three classes. Directors
of the Bank each serve for three year terms or until their successors are
elected and qualified, with one-third of the directors being elected at each
annual meeting of shareholders.
The executive officers of the Bank also serve as executive officers of
Flagstar. Since the formation of Flagstar, none of the Bank's executive
officers have received compensation from Flagstar in their capacity as such.
The following table sets forth the name, age and position with the Bank of
each person who is an executive officer or director of the Bank and also sets
forth the expiration of each director's term.
<TABLE>
<CAPTION>
DIRECTOR TERM
NAME AGE(1) POSITION WITH THE BANK TO EXPIRE
---- ------ ---------------------- -------------
<S> <C> <C> <C>
Thomas J. Hammond....... 54 Chairman and Chief Executive 1999
Officer
Mark T. Hammond......... 32 Vice Chairman and President 1998
Mary Kay McGuire........ 41 Director, Senior Vice President 1997
and Secretary
Ronald I. Nichols, 63 Director 1997
Sr. ...................
Charles Bazzy........... 68 Director 1998
William B. Bortels...... 62 Director 1998
Harry S. Ellman......... 50 Director 1999
<CAPTION>
EXECUTIVE OFFICERS WHO
ARE NOT DIRECTORS:
----------------------
<S> <C> <C> <C>
Michael W. Carrie....... 43 Executive Vice President, Chief N/A
Financial Officer and Treasurer
Joan H. Anderson........ 47 Executive President N/A
</TABLE>
- --------
(1) As of September 30, 1997
Thomas J. Hammond has served as Chairman of the Board of Directors and Chief
Executive Officer of the Bank since the Bank's formation in 1987 and served as
President of the Bank from 1987 to September 1995. Mr. Hammond has also served
as Chairman of the Board of Directors and Chief Executive Officer of Flagstar
since its formation in 1993. In addition, Mr. Hammond has served as Chairman
of the Board of Directors and Chief Executive Officer of the Company, a
subsidiary whose common stock is wholly owned by the Bank, since the Company's
organization in 1997. Mr. Hammond has over 29 years of experience in the
mortgage lending industry. After earning a BSBA and an MBA in finance, Mr.
Hammond began his career as a Staff Financial Analyst for Ford Motor Company
in 1966. Prior to founding the Bank in 1987, Mr. Hammond formed and managed a
series of companies in the financial services industry, including Hammond
Mortgage Corporation, Seller's & Homeowner's Uniform Receipt of Equity, Inc.
and First Security Mortgage Corporation (formerly known as Oak Hills Mortgage
Corporation) dating back to 1969. Mr. Hammond founded Hammond Mortgage
Corporation, a residential mortgage brokerage firm, in 1969. This Bank did
business nationwide and operated branches in eight different states and was
one of the country's largest FHA mortgage lenders prior to being sold to
Michigan National Bank in 1981. It eventually became known as Independence One
and is now part of Norwest Mortgage, Inc. Mr. Hammond is the father of Mark T.
Hammond, the Vice Chairman and President of the Bank.
Mark T. Hammond has served as President of the Bank since September 1995. He
has served as a member of the Bank's Board of Directors since 1991 and as its
Vice Chairman since 1993. Mr. Hammond has served as
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Vice Chairman of the Board of Directors and President of Flagstar since
January 1997. Mr. Hammond also serves as the Vice Chairman of the Board of
Directors and President of the Company, a position he has held since its
organization in 1997. He has also served as Executive Vice President of the
Bank from 1991 to September 1995 in charge of mortgage operations, wholesale
lending and construction lending. From 1989 to 1991, he served as the Bank's
Senior Vice President in charge of secondary marketing and mortgage
production. Mr. Hammond was a loan officer in 1987 for the Bank, worked part-
time in the financial services industry from 1982 to 1986 and is a graduate of
Wharton Business School. Mr. Hammond was responsible for the national
expansion of the Bank's loan production offices and has played a lead role in
the development and implementation of new technology for the Bank. Mr. Hammond
recently served on one of Fannie Mae's regional advisory councils. Mr. Hammond
is the son of Thomas J. Hammond, the Chairman and Chief Executive Officer of
the Bank.
Mary Kay McGuire has been a Director of the Bank since September 1987. She
has also served as the Bank's Secretary since its formation in 1987, and
Senior Vice President of the Bank in charge of human resources, purchasing and
facilities management since 1988 and advertising since 1996. She also served
as a Vice President of the Bank from 1987 to 1988. In addition, Ms. McGuire is
a Director of the Company. Prior to that time, Ms. McGuire served with Mr.
Thomas Hammond since 1977 and has worked in the financial services industry
since 1974.
Ronald I. Nichols, Sr. has served as a Director of the Bank since 1988. He
has been President of Nichols Sales Associates, Inc. located in Bloomfield
Hills, Michigan since 1969.
Charles Bazzy has served as a Director of the Bank since 1988. He has been a
manufacturer's sales representative for and principal of Charles Bazzy &
Associates located in Bloomfield Hills, Michigan. Prior to 1988, he was a
planning and development manager for Ford Motor Company and was with Ford
Motor Company for 33 years.
William B. Bortels has been a Director of the Bank since 1991. He has been a
self-employed single-family home builder in Brighton, Michigan since 1964.
Harry S. Ellman has served as a Director of the Bank since 1990. He has been
a title insurance agent and attorney with Fidelity Title Co. located in
Bingham Farms, Michigan since 1987. He is also a member of the State Bar of
Michigan, the Building Industry Association of Southeast Michigan and is a
past chairman of the Income Producing Committee of the Mortgage Bankers'
Association.
EXECUTIVE OFFICERS OF THE BANK WHO ARE NOT DIRECTORS
Michael W. Carrie has served as Chief Financial Officer of the Bank since
1993 and has been a director of Flagstar since 1997, and its Executive Vice
President in charge of financial planning, financial accounting, cash
management, investor reporting, regulatory accounting, loan funding and
information services since 1995. Mr. Carrie has also served as a Director of
the Company since its organization in 1997. From 1993 to 1995 he served as
Senior Vice President of the Bank. From 1985 until 1993, he served as Vice
President and Manager of Financial Analysis of Standard Federal Bank, F.S.B.,
a major regional federal savings bank. From July 1994 to February 1996, Mr.
Carrie also served as a director of Security Savings after its acquisition by
the Bank.
Joan H. Anderson has been the Bank's Executive Vice President in charge of
mortgage loan servicing, collections and real estate holdings since 1988. Ms.
Anderson is also an Executive Vice President of Flagstar, a position she has
held since 1994. She has also been a director of Flagstar since January 1997.
Prior to Ms. Anderson's service on Flagstar's Board of Directors, she served
on the Bank's board from 1987 until 1997. Ms. Anderson has also served on the
Board of Directors of the Company since its organization in 1997. Ms. Anderson
served as a Senior Vice President of the Bank from 1987 to 1988. Prior to that
time, she held various positions with mortgage lending companies owned by
Thomas J. Hammond and has worked in the financial services industry since
1970.
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<PAGE>
KEY EMPLOYEES OF THE BANK
The Bank has eleven Senior Vice Presidents, many of whom have been with the
Bank since its formation in 1987. The Senior Vice Presidents in charge of
treasury management, administration, risk management and underwriting
previously worked for Hammond Mortgage Bank, Thomas Hammond's prior Bank,
during the 1970's.
COMMITTEES OF THE BOARD OF DIRECTORS
The Board of Directors of the Bank holds regular monthly meetings and
special meetings as needed. During the year ended December 31, 1996, the
Bank's Board met 12 times. No director attended fewer than 75% in the
aggregate of the total number of such Board meetings held while such director
was a member during the year ended December 31, 1996 and the total number of
meetings held by committees on which such director served during such year.
The Bank's full Board of Directors acts as a compensation committee for the
Bank and met 12 times in this capacity during 1996 to examine the performance
and approve the compensation of the officers.
The Bank's Audit Committee consists of directors Bazzy (Chairman), Nichols
and Bortels and performs the functions of the Bank's audit committee. The
Audit Committee is responsible for reviewing the Bank's auditing programs,
overseeing the quarterly regulatory reporting process, overseeing internal
compliance audits as necessary, receiving and reviewing the results of each
external audit, reviewing management's response to auditors' recommendations,
and reviewing management's reports on cases of financial misconduct by
employees, officers or directors. The Audit Committee met 12 times in 1996.
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EXECUTIVE COMPENSATION
Summary Compensation Table. The following table sets forth the cash and
noncash compensation for each of the last three years awarded to or earned by
certain executive officers of the Bank for services rendered in all capacities
to the Bank and its subsidiaries.
<TABLE>
<CAPTION>
OTHER
ANNUAL ALL OTHER
COMPEN- COMPEN-
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS SATION SATION(1)
--------------------------- ---- ---------- -------- ------- ---------
<S> <C> <C> <C> <C> <C>
Thomas J. Hammond............... 1996 $1,000,000(2) $793,580 -- $49,300(5)
Chairman of the Board and Chief 1995 529,600 737,102 -- 56,340(6)
Executive Officer 1994 529,600 616,301 -- 43,580(7)
Mark T. Hammond(3).............. 1996 $ 405,002 $ 12,600 -- $23,418(5)
Vice Chairman of the Board and 1995 298,369 12,779 -- 32,491(6)
President 1994 276,694 17,450 -- 23,683(7)
Michael W. Carrie(4)............ 1996 $ 204,314 $ 8,568 -- $11,700(5)
Executive Vice President and 1995 160,640 8,042 -- 18,900(6)
Chief Financial Officer 1994 147,577 5,143 -- 8,477(7)
Joan H. Anderson................ 1996 $ 149,450 $ 10,080 -- $27,300(5)
Executive Vice President 1995 137,169 10,989 -- 23,978(6)
1994 120,738 27,450 -- 20,988(7)
</TABLE>
- --------
(1) Executive officers of the Bank receive certain perquisites and other
personal benefits. In each case, the amount of such benefits received by
each executive officer in each of the years 1996, 1995 and 1994 did not
exceed $50,000 or 10% of such executive officer's salary and bonus.
(2) In conjunction with the adoption of the 1997 Incentive Compensation Plan
as of May 1, 1997, Thomas J. Hammond's annual salary was reduced to
$600,000.
(3) Mark T. Hammond was elected President of the Bank and the Bank in
September 1995.
(4) Michael W. Carrie joined the Bank and the Bank in January 1993 as Chief
Financial Officer. He assumed his current position as Executive Vice
President in November 1995.
(5) Includes payments to Thomas J. Hammond, Mark T. Hammond, Michael W. Carrie
and Joan H. Anderson of $13,200, $14,400, $0 and $14,400, respectively,
for Board fees, $4,500, $3,219, $4,500 and $4,500, respectively, in 401(k)
contributions, and $31,600, $5,799, $7,200 and $8,400, respectively, in
term life insurance premium equivalent payments.
(6) Includes payments to Thomas J. Hammond, Mark T. Hammond, Michael W. Carrie
and Joan H. Anderson of $25,200, $25,200, $9,600 and $15,600,
respectively, for Board fees, $4,500, $3,500, $4,500 and $2,378,
respectively, in 401(k) contributions and $26,640, $3,791, $4,800 and
$6,000, respectively, in term life insurance premium equivalent payments
for such persons.
(7) Includes payments to Thomas J. Hammond, Mark T. Hammond, Michael W. Carrie
and Joan H. Anderson of $17,400, $17,400, $4,000 and $13,400,
respectively, for Board fees, $4,500, $4,500, $2,077 and $3,988,
respectively, in 401(k) contributions, and $21,680, $1,783, $2,400 and
$3,600, respectively, in term life insurance premium equivalent payments.
DIRECTOR COMPENSATION
Directors of the Bank receive fees of $1,200 for each meeting attended.
During 1996, directors' fees for each director of the Bank totaled $14,400
plus a $1,200 bonus. The directors do not receive any additional compensation
for serving on committees.
CERTAIN BENEFIT PLANS AND AGREEMENTS
Thrift Plan. The Bank maintains a defined contribution plan, which is
designed to qualify under Sections 401(a) and 401(k) of the Code (the "Thrift
Plan"). The Thrift Plan permits each participant to make before-tax
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contributions, through regular salary reduction, in amounts ranging up to 6%
of the participant's annual salary, not to exceed $9,500 in total annual
contributions. The Bank makes matching contributions up to 3% of each eligible
participant's monthly salary. Participants are at all times 100% vested in
their entire account balances under the Thrift Plan attributed to their
contributions, and vest 100% after seven years as to the Bank's contribution.
The Thrift Plan is intended to comply with all the rights and protection
afforded employees pursuant to the Employee Retirement Income Security Act of
1974, as amended.
Employment Agreements. The Bank entered into separate employment agreements
pursuant to which Thomas J. Hammond will serve as Chief Executive Officer of
the Bank and Mark T. Hammond will serve as President of the Bank. In such
capacities, Messrs. Hammond and Hammond are responsible for overseeing all
operations of the Bank, and for implementing the policies adopted by the Board
of Directors. In addition, the Bank entered into separate employment
agreements with Mr. Carrie in his capacity as Executive Vice President and
Chief Financial Officer and Ms. Anderson in her capacity as Executive Vice
President. All such employment agreements are referred to herein collectively
as "Employment Agreements" and all persons who have entered into such
Employment Agreements are referred to herein as "Employees."
The Board of Directors of the Bank each believe that the Employment
Agreements assure fair treatment of the Employees in relation to their career
with the Bank by providing them with a limited form of financial security
while committing such persons to future employment with the Bank for the term
of their respective agreements. In the event that any Employee prevails over
the Bank in a legal dispute as to an Employment Agreement, he or she will be
reimbursed for his or her legal and other expenses.
The terms of the agreements are three years for Messrs. Hammond, Hammond and
Carrie and Ms. Anderson. The agreements provide for annual base salaries of
$600,000, $405,000, $203,314, and $149,450, respectively. On each anniversary
date from the date of commencement of the Employment Agreements, the term of
the Employee's employment under the Employment Agreements will be extended for
an additional one-year period beyond the then effective expiration date, upon
a determination by the Board of Directors that the performance of the Employee
has met the required performance standards and that such Employment Agreements
should be extended. The Employment Agreements provide the Employee with a
salary review by the Board of Directors not less often than annually, as well
as with inclusion in any discretionary bonus plans, retirement and medical
plans, customary fringe benefits, vacation and sick leave.
The Employment Agreements terminate upon the Employee's death or disability,
and are terminable by the Bank for "just cause" as defined in the Employment
Agreements. In the event of termination for just cause, no severance benefits
are available. If the Bank terminates the Employee without just cause, the
Employee will be entitled to a continuation of his or her salary and benefits
from the date of termination through the remaining term of such Employee's
Employment Agreement, plus an additional 12-month period, and, at the
Employee's election, either cash in an amount equal to the cost to the
Employee of obtaining health, life, disability, and other benefits which the
Employee would have been eligible to participate in through the Employment
Agreement's expiration date or continued participation in such benefit plans
through the agreement's expiration date, provided the Employee continued to
qualify for participation therein. If the Employment Agreements are terminated
due to the Employee's "disability" (as defined in the Employment Agreements),
the Employee will be entitled to a continuation of his or her salary and
benefits for up to 180 days following such termination. In the event of the
Employee's death during the term of the Employment Agreement, his or her
estate will be entitled to receive his or her salary through the last day of
the calendar month in which the Employee's death occurred. The Employee is
able to terminate voluntarily his or her Employment Agreement by providing 90
days' written notice to the Board of Directors of the Bank, in which case the
Employee is entitled to receive only his compensation, vested rights and
benefits up to the date of termination.
The Employment Agreements contain provisions stating that in the event of
the Employee's involuntary termination of employment in connection with, or
within one year after, any change in control of the Bank or Flagstar Bancorp,
Inc., other than for "just cause," the Employee will be paid within 10 days of
such termination an amount equal to the difference between (i) 2.99 times his
or her "base amount," as defined in Section
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280G(b)(3) of the Code, and (ii) the sum of any other parachute payments, as
defined under Section 280G(b)(2) of the Code, that the Employee receives on
account of the change in control. "Control" generally refers to the
acquisition, by any person or entity, of the ownership or power to vote more
than 25% of the Bank's or Flagstar's voting stock, the control of the election
of a majority of the Bank's or Flagstar's directors, or the exercise of a
controlling influence over the management or policies of the Bank or Flagstar.
In addition, under the Employment Agreements, a change in control occurs when,
during any consecutive two-year period, directors of the Bank or Flagstar at
the beginning of such period cease to constitute at least a majority of the
Board of Directors of the Bank or Flagstar. The amount determined using the
forgoing formula would also be paid (i) in the event of an Employee's
voluntary termination of employment within 30 days following a change in
control, or (ii) in the event of the Employee's voluntary termination of
employment within one year following a change in control, upon the occurrence,
or within 90 days thereafter, of certain specified events following the change
in control, which have not been consented to in writing by the Employee,
including (i) the requirement that the Employee perform his or her principal
executive functions more than 50 miles from his or her primary office, (ii) a
reduction in the Employee's base compensation as then in effect, (iii) the
failure of Flagstar or the Bank to increase the Employee's salary or to pay
the Employee discretionary bonuses, (iv) the failure of Flagstar or the Bank
to continue to provide the Employee with compensation and benefits, including
material vacation, fringe benefits, stock option and retirement plans, (v) the
assignment to the Employee of duties and responsibilities which are other than
those normally associated with his or her position with the Bank and Flagstar,
(vi) a material reduction in the Employee's authority and responsibility, and
(vii) in the case of an employee who is also a director, the failure to re-
elect the Employee to Flagstar's or the Bank's Board of Directors. The
aggregate payments that would be made to Messrs. Thomas J. Hammond, Mark T.
Hammond and Carrie and Ms. Anderson, assuming termination of employment, other
than for just cause, within one year of the change in control at January 1,
1998, would be approximately $3.0 million, $851,000, $476,000 and $438,000,
respectively. These provisions may have an anti-takeover effect by making it
more expensive for a potential acquirer to obtain control of the Bank or
Flagstar. For more information regarding anti-takeover matters, see
"Description of the Bank Preferred Shares."
Whole Life Insurance Policy. The Bank also pays the premiums of variable
whole life insurance policies which are available to all officers of the Bank.
The beneficiary of each such policy is the estate of the officer, except that
the Bank is the beneficiary to the extent of all premiums paid by the Bank for
such policy.
TRANSACTIONS WITH MANAGEMENT
The Bank offers loans to its directors, officers and employees. These loans
currently are made in the ordinary course of business with the same
collateral, interest rates and underwriting criteria as those of comparable
transactions prevailing at the time and do not involve more than the normal
risk of collectibility or present other unfavorable features. Under federal
law, the Bank's loans to directors and executive officers are required to be
made on substantially the same terms, including interest rates, as those
prevailing for comparable transactions and must not involve more than the
normal risk of repayment or present other unfavorable features. At September
30, 1997, all of the Bank's loans to directors and executive officers
satisfied these requirements.
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DESCRIPTION OF THE BANK PREFERRED SHARES
The following summary sets forth the material terms and provisions of the
Bank Preferred Shares, and is qualified in its entirety by reference to the
terms and provisions of the Certificate of Designation establishing the Bank
Preferred Shares and the Bank's charter, as amended, the forms of which have
been filed with the OTS as exhibits to the registration statement of which
this Offering Circular forms a part.
GENERAL
The Bank Preferred Shares form an initial series of preferred stock of the
Bank, which preferred stock may be issued from time to time in one or more
series with such rights, preferences and limitations as are determined by the
Bank's Board of Directors or, if then constituted, a duly authorized committee
thereof. The Board of Directors has authorized the Bank to issue the Bank
Preferred Shares.
When issued, the Bank Preferred Shares will be validly issued, fully paid
and nonassessable. The holders of the Bank Preferred Shares will have no
preemptive rights with respect to any shares of the capital stock of the Bank
or any other securities of the Bank convertible into or carrying rights or
options to purchase any such shares. The Bank Preferred Shares will not be
convertible into shares of Common Stock or any other class or series of
capital stock of the Bank and will not be subject to any sinking fund or other
obligation of the Bank for their repurchase or retirement.
The transfer agent, registrar and dividend disbursement agent for the Bank
Preferred Shares will be Registrar and Transfer Company, Cranford, New Jersey.
The registrar for the Bank Preferred Shares will send notices to shareholders
of any meetings at which holders of such shares have the right to elect
directors of the Bank or to vote on any other matter.
DIVIDENDS
Holders of Bank Preferred Shares shall be entitled to receive, if, when,
and, as declared by the Board of Directors of the Bank out of assets of the
Bank legally available therefor, cash dividends at the rate of 8.5% per annum
of the initial liquidation preference (equivalent to $2.125 per share per
annum). If declared, dividends on the Bank Preferred Shares shall be payable
quarterly in arrears on the last day of March, June, September, and December
of each year, or, if such day is not a business day, on the next business day,
at such annual rate. Dividends in each quarterly period will accrue from the
first day of such period. Each declared dividend shall be payable to holders
of record as they appear at the close of business on the stock register of the
Bank on such record dates, not exceeding 45 days preceding the payment dates
thereof, as shall be fixed by the Board of Directors of the Bank or a duly
authorized committee thereof. Upon the exchange of Series A Preferred Shares
for Bank Preferred Shares, any accrued and unpaid dividends for the most
recent quarter of the Series A Preferred Shares at the time of the conversion
will be deemed to be accrued and unpaid dividends for the most recent quarter
on the Bank Preferred Shares.
The right of holders of Bank Preferred Shares to receive dividends is
noncumulative. Accordingly, if the Board of Directors fails to declare a
dividend on the Bank Preferred Shares for a quarterly dividend period, then
holders of the Bank Preferred Shares will have no right to receive a dividend
for that period, and the Bank will have no obligation to pay a dividend for
that period, whether or not dividends are declared and paid for any future
period with respect to either the preferred stock or the Common Stock. If the
Bank fails to declare and pay or declare and set aside for payment a quarterly
dividend on the Bank Preferred Shares, holders of the preferred stock of the
Bank, including the Bank Preferred Shares, will be entitled to elect two
directors. See "--Voting Rights."
If full dividends on the Bank Preferred Shares for any dividend period shall
not have been declared and paid, or declared and a sum sufficient for the
payment thereof shall not have been set apart for such payments, no dividends
shall be declared and paid or set aside for payment and no other distribution
shall be declared or
OC-79
<PAGE>
made or set aside for payment upon the Common Stock or any other capital stock
of the Bank ranking junior to or on a parity with the Bank Preferred Shares as
to dividends or amounts upon liquidation, nor shall any Common Stock or any
other capital stock of the Bank ranking junior to or on a parity with the Bank
Preferred Shares as to dividends or amounts upon liquidation be redeemed,
purchased or otherwise acquired for any consideration (or any monies to be
paid to or made available for a sinking fund for the redemption of any such
stock) by the Bank, except by conversion into, or exchange for, other capital
stock of the Bank ranking junior to the Bank Preferred Shares as to dividends
and amounts upon liquidation), until such time as dividends on all outstanding
Bank Preferred Shares have been (i) declared and paid or declared and a sum
sufficient for the payment thereof has been set apart for payment for three
consecutive dividend periods and (ii) declared and paid or declared and a sum
sufficient for the payment thereof has been set apart for payment for the
fourth consecutive dividend period.
If any Bank Preferred Shares are outstanding, no full dividends shall be
declared and paid or set apart for payment and no other distribution shall be
declared and made or set aside for payment on any series of capital stock of
the Bank ranking, as to dividends, on a parity with or junior to the Bank
Preferred Shares for any dividend period unless full dividends have been or
contemporaneously are declared and paid, or declared and a sum sufficient for
the payment thereof is set apart for such payments on the Bank Preferred
Shares, for the then-current dividend period. When dividends are not paid in
full (or a sum sufficient for such full payment is not set apart) upon the
Bank Preferred Shares and the shares of any other series of capital stock
ranking on a parity as to dividends with the Bank Preferred Shares, all
dividends declared upon Bank Preferred Shares and any other series of capital
stock ranking on a parity as to dividends with the Bank Preferred Shares shall
be declared pro rata so that the amount of dividends declared per share on the
Bank Preferred Shares and such other series of capital stock shall in all
cases bear to each other the same ratio that full dividends, for the then-
current dividend period, per share on the Bank Preferred Shares, which shall
not include any accumulation in respect of unpaid dividends for prior dividend
periods, and full dividends, including required or permitted accumulations, if
any, on such other series of capital stock bear to each other.
REDEMPTION
The Bank Preferred Shares will not be redeemable prior to March 1, 2003. On
or after such date, the Bank Preferred Shares will be redeemable at the option
of the Bank, in whole or in part, at any time or from time to time on not less
than 30 nor more than 60 days' notice by mail, at a redemption price of $25.00
per share, plus the accrued and unpaid dividends for the most recent quarter
to the date of redemption, if any, thereon.
Any such redemption must comply with the prompt corrective action and
capital distribution regulations of the OTS, which may prohibit a redemption
or require the OTS' prior approval of a redemption. Unless full dividends on
the Bank Preferred Shares have been, or contemporaneously are, declared and
paid or declared and a sum sufficient for the payment thereof has been set
apart for payment for the then current dividend period, no Bank Preferred
Shares shall be redeemed unless all outstanding Bank Preferred Shares are
redeemed and the Bank shall not purchase or otherwise acquire any Bank
Preferred Shares; provided, however, that the Bank may purchase or acquire
Bank Preferred Shares pursuant to a purchase or exchange offer made on the
same terms to holders of all outstanding Bank Preferred Shares.
VOTING RIGHTS
Except as expressly required by applicable law, or except as indicated
below, the holders of the Bank Preferred Shares will not be entitled to vote.
In the event the holders of Bank Preferred Shares are entitled to vote as
indicated below, each Bank Preferred Share will be entitled to one vote on
matters on which holders of the Bank Preferred Shares are entitled to vote.
If at the time of any annual meeting of the Bank's stockholders, the Bank
has declared and failed to pay or declared and failed to set aside for payment
a quarterly dividend during any of the four preceding quarterly
OC-80
<PAGE>
dividend periods on any series of preferred stock of the Bank, including the
Bank Preferred Shares, the number of directors then constituting the Board of
Directors of the Bank will be increased by two (if not already increased by
two due to a default in preference dividends), and the holders of the Bank
Preferred Shares, voting together as a single class with the holders of all
other series of preferred stock as a single class will be entitled to elect
such two additional directors to serve on the Bank's Board of Directors at
each such annual meeting. Each director elected by the holders of shares of
the preferred stock shall continue to serve as such director until the later
of (i) the expiration of the term of such director or (ii) the payment of four
consecutive quarterly dividends on the Bank Preferred Shares.
The affirmative vote or consent of the holders of at least 66 2/3% of the
outstanding shares of each series of preferred stock of the Bank, including
the Bank Preferred Shares, voting as a single class without regard to series,
will be required (a) to create any class or series of stock which shall have
preference as to dividends or distribution of assets over any outstanding
series of preferred stock of the Bank other than a series which shall not have
any right to object to such creation or (b) to alter or change the provisions
of the Bank's Charter (including the Certificate of Designation establishing
the Bank Preferred Shares) so as to adversely affect the voting powers,
preferences or special rights of the holders of a series of preferred stock of
the Bank; provided that if such amendment shall not adversely affect all
series of preferred stock of the Bank, such amendment need only be approved by
at least 66 2/3% of the holders of shares of all series of preferred stock
adversely affected thereby.
RIGHTS UPON LIQUIDATION
In the event of any voluntary or involuntary liquidation, dissolution or
winding up of the Bank, the holders of the Bank Preferred Shares at the time
outstanding will be entitled to receive or have funds set aside for such
payments out of assets of the Bank available for distribution to stockholders,
before any payment or distribution of assets is made to holders of Common
Stock or any other class of stock ranking junior to the Bank Preferred Shares
upon liquidation, liquidating distributions in the amount of $25.00 per share,
plus the accrued and unpaid dividends for the most recent quarter thereon, if
any, to the date of liquidation.
After receipt of payment of the full amount of the liquidating distributions
to which they are entitled, the holders of Bank Preferred Shares will have no
right or claim to any of the remaining assets of the Bank. In the event that,
upon any such voluntary or involuntary liquidation, dissolution or winding up,
the available assets of the Bank are insufficient to pay the amount of the
liquidation distributions on all outstanding Bank Preferred Shares and the
corresponding amounts payable on all shares of other classes or series of
capital stock of the Bank ranking on a parity with the Bank Preferred Shares
in the distribution of assets upon any liquidation, dissolution or winding up
of the affairs of the Bank, then the holders of the Bank Preferred Shares and
such other classes or series of capital stock shall share ratably in any such
distribution of assets in proportion to the full liquidating distributions to
which they would otherwise be respectively entitled.
For such purposes, the consolidation or merger of the Bank with or into any
other entity or the sale, lease or conveyance of all or substantially all of
the property or business of the Bank, shall not be deemed to constitute
liquidation, dissolution or winding up of the Bank.
APPROVAL OF INDEPENDENT DIRECTORS
The Bank's Certificate of Designation establishing the Bank Preferred Shares
requires that, so long as any Bank Preferred Shares are outstanding, certain
actions by the Bank be approved by a majority of the Independent Directors of
the Bank. At any time that there are only two Independent Directors, any
action that requires the approval of a majority of Independent Directors must
be approved by both Independent Directors. "Independent Director" means any
director of the Bank who (i) is not a current director, officer or employee of
the Bank, of Flagstar Capital Corporation or of any affiliate of the Bank; and
(ii) is not a person or persons that, in the aggregate, own more than one
percent of the Common Stock of Flagstar. In addition, any members of the Board
of Directors of the Bank elected by holders of preferred stock, including the
Bank Preferred Shares, will be
OC-81
<PAGE>
deemed to be independent directors for purposes of approving actions requiring
the approval of a majority of the Independent Directors. The actions which
require the prior approval of a majority of the Independent Directors include:
(i) the issuance of a series of preferred stock on a parity with the Bank
Preferred Shares; and
(ii) the redemption of any shares of Common Stock.
In assessing the benefits to the Bank of any proposed action requiring their
consent, the Independent Directors shall take into account the interests of
holders of both the Common Stock and the preferred stock, including, without
limitation, the holders of the Bank Preferred Shares. In considering the
interests of the holders of the preferred stock, including without limitation
holders of the Bank Preferred Shares, the Independent Directors shall owe the
same duties which the Independent Directors owe to holders of Common Stock.
CERTAIN DEFINITIONS
"Bank Preferred Shares" means the 2,000,000 shares of the 8.5% Noncumulative
Bank Preferred Shares of the Bank.
"FDIC" means the Federal Deposit Insurance Corporation or any successor
thereto.
"FHLB" means any of the regional Federal Home Loan Banks.
"OTS" means the Office of Thrift Supervision or any successor thereto.
"Person" means any individual, corporation, limited liability Bank,
partnership, joint venture, association, joint-stock Bank, trust,
unincorporated organization or government or any agency or political
subdivisions thereof.
"Regulatory Capital Requirements" means the minimum amount of capital
required to meet each of the industry-wide regulatory capital requirements
applicable to the Bank pursuant to 12 U.S.C. Section 1464(t) and 12 C.F.R.
Section 567 (and any amendment to either thereof) or any successor law or
regulation, or such higher amount of capital as the Bank, individually, is
required to maintain in order to meet any individual minimum capital standard
applicable to the Bank pursuant to 12 U.S.C. Section 1464(s) and 12 C.F.R.
Section 567.3 (and any amendment to either such Section) or any successor law
or regulation.
AUTOMATIC EXCHANGE
The Bank Preferred Shares are to be issued, if ever, in connection with an
exchange of the Series A Preferred Shares. The Series A Preferred Shares are
subject to an automatic exchange in whole and not in part, on a share-for-
share basis, into Bank Preferred Shares if the appropriate regulatory agency
directs in writing an exchange of the Series A Preferred Shares for Bank
Preferred Shares because (i) the Bank becomes "undercapitalized" under prompt
corrective action regulations established pursuant to FDICIA, (ii) the Bank is
placed into conservatorship or receivership or (iii) the appropriate
regulatory agency, in its sole discretion, anticipates the Bank's becoming
"undercapitalized" in the near term (an "Exchange Event"). The Bank has
registered with the OTS a total of 2,300,000 Bank Preferred Shares to cover an
Exchange Event, if necessary, of the 2,000,000 Series A Preferred Shares
offered by the Company and the over-allotment of 300,000 shares of Bank
Preferred Shares granted to the underwriters of the Series A Preferred Shares.
EXPERTS
The Consolidated Financial Statements of the Bank and subsidiaries as of
December 31, 1996 and 1995, and for each of the three years in the period
ended December 31, 1996, have been audited by Grant Thornton
OC-82
<PAGE>
LLP, independent certified public accountants, as indicated in their report
with respect thereto and are included herein in reliance upon the authority of
said firm as experts in auditing and accounting.
LEGAL MATTERS
The legality of the securities offered by this Offering Circular and certain
other legal matters will be passed upon for the Bank by Kutak Rock,
Washington, D.C. Certain legal matters will be passed upon for the
Underwriters by Honigman Miller Schwartz and Cohn, Detroit, Michigan.
OC-83
<PAGE>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Certified Public Accountants........................ F-2
Consolidated Statements of Financial Condition as of September 30, 1997
(unaudited) and December 31, 1996 and 1995............................... F-3
Consolidated Statements of Earnings for the Nine Months Ended September
30, 1997 (unaudited) and September 30, 1996 (unaudited) and for the Years
Ended December 31, 1996, 1995 and 1994................................... F-4
Consolidated Statements of Stockholder's Equity for the Nine Months Ended
September 30, 1997 (unaudited) and for the Years Ended December 31, 1996,
1995 and 1994............................................................ F-5
Consolidated Statements of Cash Flows for the Nine Months Ended September
30, 1997 (unaudited) and September 30, 1996 (unaudited) and for the Years
Ended December 31, 1996, 1995 and 1994................................... F-6
Notes to Consolidated Financial Statements................................ F-8
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors Flagstar Bank, FSB
We have audited the accompanying consolidated statements of financial
condition of Flagstar Bank, FSB and Subsidiaries as of December 31, 1996 and
1995, and the related consolidated statements of earnings, stockholder's
equity and cash flows for each of the three years in the period ended December
31, 1996. 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 a reasonable assurance about whether the consolidated 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, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Flagstar Bank, FSB and Subsidiaries as of December 31, 1996 and 1995, and
the results of their consolidated operations and their consolidated cash flows
for each of the three years in the period ended December 31, 1996, in
conformity with generally accepted accounting principles.
As described in notes 3 and 7, in May 1995, the Company adopted Statement of
Financial Accounting Standards No. 122, "Accounting for Certain Mortgage
Servicing Rights".
/s/ Grant Thornton LLP
Detroit, Michigan
March 3, 1997 (except for Note 18
as to which the date is May 5, 1997)
F-2
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(IN THOUSANDS)
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, ----------------------
1997 1996 1995
------------- ---------- ----------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
Cash and cash equivalents................ $ 43,633 $ 44,187 $ 29,119
Loans receivable
Mortgage loans held for sale........... 1,363,822 840,767 620,455
Loans held for investment.............. 444,552 273,579 305,590
Less allowance for losses.............. (4,950) (3,500) (2,102)
---------- ---------- ----------
1,803,424 1,110,846 923,943
Federal Home Loan Bank stock........... 36,925 19,725 17,800
Other investments...................... 539 887 818
---------- ---------- ----------
Total earning assets................. 1,840,888 1,131,458 942,551
Accrued interest receivable.............. 12,273 6,626 4,307
Repossessed assets....................... 17,659 10,363 2,359
Premises and equipment................... 20,789 20,753 17,875
Mortgage servicing rights................ 51,713 30,064 27,957
Other assets............................. 46,244 53,359 20,673
---------- ---------- ----------
Total assets......................... $2,033,199 $1,296,810 $1,044,851
========== ========== ==========
LIABILITIES AND STOCKHOLDER'S EQUITY
Liabilities
Deposit accounts....................... $1,012,121 $ 624,732 $ 529,218
Federal Home Loan Bank advances........ 718,878 389,801 191,156
---------- ---------- ----------
Total interest bearing liabilities... 1,730,999 1,014,533 720,374
Accrued interest payable............... 8,117 2,712 2,215
Undisbursed payments on loans serviced
for others............................ 36,426 61,445 60,012
Escrow accounts........................ 56,055 61,009 88,863
Liability for checks issued............ 49,080 39,813 85,849
Federal income taxes payable........... 16,526 22,506 14,604
Other liabilities...................... 14,941 16,893 11,931
---------- ---------- ----------
Total liabilities.................... 1,912,144 1,218,911 983,848
Commitments and Contingencies (Notes 4,
6, 7, 12 and 16)........................ -- -- --
STOCKHOLDER'S EQUITY
Common stock--$10 par value, 1,000,000
shares authorized 300,000 shares issued
and outstanding at September 30, 1997,
December 31, 1996 and December 31,
1995.................................... 3,000 3,000 3,000
Additional paid in capital............... 28,111 783 --
Retained earnings........................ 89,944 74,116 58,003
---------- ---------- ----------
Total stockholder's equity........... 121,055 77,899 61,003
---------- ---------- ----------
Total liabilities and stockholder's
equity.............................. $2,033,199 $1,296,810 $1,044,851
========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these Statements.
F-3
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
------------------- -----------------------
1997 1996 1996 1995 1994
--------- --------- ------- ------- -------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
INTEREST INCOME
Loans............................ $ 83,029 $ 56,430 $74,588 $69,543 $33,533
Other............................ 1,760 1,249 1,591 1,761 1,579
--------- --------- ------- ------- -------
84,789 57,679 76,179 71,304 35,112
--------- --------- ------- ------- -------
INTEREST EXPENSE
Deposits......................... 34,982 22,074 30,431 25,123 9,037
FHLB advances.................... 18,774 11,226 14,291 15,072 3,726
Other............................ 841 821 1,245 1,248 1,719
--------- --------- ------- ------- -------
54,597 34,121 45,967 41,443 14,482
--------- --------- ------- ------- -------
Net interest income.............. 30,192 23,558 30,212 29,861 20,630
Provision for losses............. 3,730 1,140 2,604 238 290
--------- --------- ------- ------- -------
Net interest income after
provision for losses............ 26,462 22,418 27,608 29,623 20,340
NON-INTEREST INCOME
Loan administration.............. 5,543 11,110 11,859 14,248 13,261
Net gain (loss) on loan sales.... 9,269 4,536 4,511 2,872 (1,132)
Net gain on sales of mortgage
servicing rights................ 25,472 20,917 35,129 13,356 28,489
Other fees and charges........... 3,158 5,085 6,803 4,626 2,065
--------- --------- ------- ------- -------
43,442 41,648 58,302 35,102 42,683
--------- --------- ------- ------- -------
NON-INTEREST EXPENSE
Compensation and benefits........ 19,303 18,443 25,479 18,538 18,609
Occupancy and equipment.......... 9,764 8,687 12,092 8,873 7,339
General and administrative....... 15,966 19,122 20,968 12,438 11,636
--------- --------- ------- ------- -------
45,033 46,252 58,539 39,849 37,584
--------- --------- ------- ------- -------
Earnings before federal income
taxes........................... 24,871 17,814 27,371 24,876 25,439
Provision for federal income
taxes........................... 9,043 6,387 10,258 9,348 9,302
--------- --------- ------- ------- -------
NET EARNINGS..................... $ 15,828 $ 11,427 $17,113 $15,528 $16,137
========= ========= ======= ======= =======
</TABLE>
The accompanying notes are an integral part of these Statements.
F-4
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONAL TOTAL
COMMON PAID IN UNREALIZED RETAINED STOCKHOLDER'S
STOCK CAPITAL GAINS EARNINGS EQUITY
------ ---------- ---------- -------- -------------
<S> <C> <C> <C> <C> <C>
Balance at January 1,
1994...................... $3,000 $ -- $ 126 $31,988 $ 35,114
Net earnings............. -- -- -- 16,137 16,137
Sale of marketable
securities.............. -- -- (126) -- (126)
Dividends paid........... -- -- -- (3,200) (3,200)
------ ------- ----- ------- --------
Balance at December 31,
1994...................... 3,000 -- -- 44,925 47,925
Net earnings............. -- -- -- 15,528 15,528
Dividend paid............ -- -- -- (2,450) (2,450)
------ ------- ----- ------- --------
Balance at December 31,
1995...................... 3,000 -- -- 58,003 61,003
Net earnings............. -- -- -- 17,113 17,113
Additional paid in
capital................. -- 783 -- -- 783
Dividend paid............ -- -- -- (1,000) (1,000)
------ ------- ----- ------- --------
Balance at December 31,
1996...................... 3,000 783 -- 74,116 77,899
Net earnings
(unaudited)............. -- -- -- 15,828 15,828
Additional capital
provided by parent
(unaudited)............. -- 27,328 -- -- 27,328
------ ------- ----- ------- --------
Balance at September 30,
1997...................... $3,000 $28,111 $ -- $89,944 $121,055
====== ======= ===== ======= ========
</TABLE>
The accompanying notes are an integral part of these Statements.
F-5
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
------------------------ -------------------------------------
1997 1996 1996 1995 1994
----------- ----------- ----------- ----------- -----------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
OPERATING ACTIVITIES
Net earnings........... $ 15,828 $ 11,427 $ 17,113 $ 15,528 $ 16,137
Adjustments to
reconcile net earnings
to net cash (used in)
provided by operating
activities Provision
for losses............ 3,730 1,140 2,604 238 290
Depreciation and
amortization.......... 12,006 12,309 17,326 11,041 9,005
Net (gains) loss on the
sale of assets........ (737) 66 (27) (493) (569)
Net (gains) loss on
loan sales............ (9,269) (4,536) (4,511) (2,872) 1,132
Gain on sales of
mortgage servicing
rights................ (25,472) (20,917) (35,129) (13,356) (28,489)
Provision (benefit) for
deferred federal
income taxes.......... 6,125 692 (773) 3,415 2,813
Proceeds from sales of
loans held for sale... 4,522,703 5,302,867 6,604,080 4,783,070 3,668,870
Originations and
repurchases of loans
held for sale, net of
principal repayments.. (5,051,262) (5,333,546) (6,830,383) (5,011,843) (3,594,108)
Increase in accrued
interest receivable... (5,647) (1,672) (2,319) (1,214) (1,027)
Decrease (increase) in
other assets.......... 6,145 (22,306) (34,451) (9,379) (473)
Increase (decrease) in
accrued interest
payable............... 5,405 (610) 497 1,254 343
Increase (decrease) in
liability for checks
issued................ 9,268 (47,582) (46,037) 46,496 (7,421)
(Decrease) increase in
federal taxes
payable............... (12,105) 3,445 8,675 3,710 1,616
(Decrease) increase in
other liabilities..... (1,952) 6,242 4,962 7,324 (723)
(Decrease) in
unrealized gains...... -- -- -- -- (126)
----------- ----------- ----------- ----------- -----------
Net cash (used in)
provided by operating
activities........... (525,234) (92,981) (298,373) (167,081) 67,270
INVESTING ACTIVITIES
Cash used to acquire
Security Savings Bank,
FSB, (Security), net
of cash received...... -- -- -- -- (23,869)
Principal repayments
from assets acquired
from Security......... -- -- -- -- 3,251
Proceeds from the
disposition of assets
acquired from
Security.............. -- -- -- -- 74,300
Net decrease in
liabilities acquired
from Security......... -- -- -- -- (2,918)
Principal repayment
from other
investments........... 8 13 31 32 --
Maturity of other
investments........... 340 400 400 -- --
Purchase of other
investments........... -- (500) (500) -- --
Originations of loans
held for investment,
net of principal
repayments............ (170,973) 51,345 31,936 (60,891) (157,698)
Principal repayments
from mortgage-backed
securities............ -- -- -- -- 163
Proceeds from the sale
of mortgage-backed
securities............ -- -- -- -- 5,176
Purchase of Federal
Home Loan Bank Stock.. (17,200) (2,700) (1,925) (5,034) (2,438)
Initial investment in
FSSB Mortgage
Corporation........... -- 783 783 -- --
Proceeds from the
disposition of
repossessed assets.... 5,824 920 1,813 675 1,796
Net decrease in real
estate held for
investment............ -- -- -- -- 505
Acquisitions of
premises and
equipment............. (6,811) (6,232) (7,539) (6,546) (6,591)
Proceeds from the
disposition of
premises and
equipment............. 2,628 -- -- -- 37
Increase in mortgage
servicing rights...... (56,607) (50,861) (63,499) (31,106) (15,616)
Proceeds from the sale
of mortgage servicing
rights................ 53,650 50,222 85,203 29,040 38,183
----------- ----------- ----------- ----------- -----------
Net cash (used in)
provided by investing
activities........... (189,141) 43,390 46,703 (73,830) (85,719)
FINANCING ACTIVITIES
Net increase (decrease)
in deposit accounts... 387,389 47,889 95,514 220,402 (79,651)
Net increase (decrease)
in Federal Home Loan
Bank advances......... 329,077 8,700 198,645 (9,594) 140,750
Net (disbursement)
receipt of payments of
loans serviced for
other................. (25,019) (8,874) 1,433 25,023 (22,213)
Net receipt of escrow
payments.............. (4,954) 3,129 (27,854) 10,993 33
Additional capital
provided by parent.... 27,328 -- -- -- --
Dividends paid to
stockholder........... -- (1,000) (1,000) (2,450) (3,200)
----------- ----------- ----------- ----------- -----------
Net cash provided by
financing
activities........... 713,821 49,844 266,738 244,374 35,719
----------- ----------- ----------- ----------- -----------
Net (decrease) increase
in cash and cash
equivalents........... (554) 254 15,068 3,463 17,270
Beginning cash and cash
equivalents........... 44,187 29,119 29,119 25,656 8,386
----------- ----------- ----------- ----------- -----------
Ending cash and cash
equivalents........... $ 43,633 $ 29,374 $ 44,187 $ 29,119 $ 25,656
=========== =========== =========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these Statements.
F-6
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS--(CONTINUED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
-------------------- -------------------------
1997 1996 1996 1995 1994
---------- --------- ------- -------- --------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Supplemental disclosure of cash
flow information:
Loans held for sale transferred
to loans held for investment.. $ 126,362 $ -- $ -- $ -- $106,261
========== ========= ======= ======== ========
Loans held for investment
transferred to loans held for
sale.......................... $ -- $ -- $ -- $185,111 $ --
========== ========= ======= ======== ========
Loans receivable transferred to
repossessed assets............ $ 12,491 $ 3,142 $10,577 $ 1,781 $ 1,367
========== ========= ======= ======== ========
Total interest payments made on
deposits and other
borrowings.................... $ 49,182 $ 34,731 $45,470 $ 40,189 $ 14,139
========== ========= ======= ======== ========
Federal income taxes paid...... $ 15,000 $ 2,300 $ 2,300 $ 2,500 $ 6,280
========== ========= ======= ======== ========
</TABLE>
Supplemental schedule of acquisitions:
Flagstar Bank, FSB acquired Security Savings Bank, FSB, in Jackson, Michigan,
at the close of business June 30, 1994 (Note 15).
<TABLE>
<S> <C> <C>
Security Savings Bank Acquisition............................ $25,729
Cash paid for common stock
Fair value of assets acquired, including $77,538 which were
subsequently disposed....................................... $225,934
Fair value of liabilities acquired, including $2,918 which
were subsequently repaid.................................... 209,241
--------
Fair value of net assets acquired............................ 16,693
-------
Core deposit premium......................................... $ 9,036
=======
</TABLE>
The accompanying notes are an integral part of these Statements.
F-7
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--NATURE OF BUSINESS
Flagstar Bank, FSB (formerly First Security Savings Bank, FSB) (the "Bank")
is a federally chartered stock savings bank and a member of the Federal Home
Loan Bank System ("FHLB"). The Bank is a subsidiary of Flagstar Bancorp, Inc.
("Flagstar"). The Bank provides retail banking services in southern and
western Michigan and mortgage lending services nationwide.
In January 1996, the Bank changed its name from First Security Savings Bank,
FSB to Flagstar Bank, FSB.
NOTE 2--CORPORATE STRUCTURE
The following is a listing of the subsidiaries of Bank:
The Bank acquired the stock of Security Savings Bank, F.S.B. ("Security")
a federally chartered stock savings bank and a member of the Federal Home
Loan Bank System ("FHLB") on June 30, 1994. This acquisition was accounted
for using the purchase method of accounting. Security was held as a
subsidiary of the Bank from June 30, 1994 to February 1, 1996. For
regulatory reporting purposes, the Bank and Security filed a consolidated
Thrift Financial Report ("TFR"). On February 1, 1996, Security was merged
with and into the Bank. The consolidation took place to take advantage of
name recognition and operating efficiencies.
Security owned two subsidiaries, Mid Michigan Service Corporation
("MMSC") and SSB Funding Corporation ("Funding"). MMSC is a Michigan
corporation is engaged in leasing and sub-leasing commercial real estate
and Funding is a finance subsidiary; both subsidiaries are currently
inactive.
The Bank owns three other subsidiaries, Boston Credit Corporation
("BCC"), Mortgage Affiliated Services, Inc. ("MAS"), and FSSB Mortgage
Corporation ("Mortgage"). BCC and Mortgage are currently inactive and MAS
is an appraisal and document preparation company. During the first quarter
of 1996, FSSB Mortgage Corporation was acquired by the Bank from Flagstar.
This organizational change did not have a significant impact on the
operations of the Bank.
Subsequent to September 30, 1997 the Bank capitalized two additional
subsidiaries, Flagstar Capital Corporation ("Capital") and Flagstar Credit
Corporation ("Credit"). Capital will purchase mortgage loans from the Bank
and hold them for investment purposes. Credit is expected to enter into
agreements with various private mortgage insurance companies for the
purpose of participating in mortgage reinsurance or similar transactions.
NOTE 3--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following summarizes the significant accounting policies of the Bank and
subsidiaries (the "Group") applied in the preparation of the accompanying
consolidated financial statements.
Principles of Consolidation
The consolidated financial statements include the accounts of the Group. All
significant intercompany balances and transactions have been eliminated.
The accompanying consolidated financial statements and information as of
September 30, 1997 and for the nine months ended September 30, 1997 and 1996
are unaudited, and include all adjustments (consisting of only normal
recurring adjustments), that are necessary, in the opinion of management, for
a fair presentation. Results of operations for the interim periods are not
necessarily indicative of the results of operations for the full years.
F-8
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Statement of Cash Flows
For purposes of the statements of cash flows, the Group considers its
investment in overnight deposits to be cash equivalents.
Loans Receivable
The Group originates loans which are designated to be held for investment or
sale during the origination process. Mortgage loans held for sale are carried
at the lower of aggregate cost or estimated market value. Management
periodically reviews the portfolio and makes necessary adjustments for market
value. Net unrealized losses are recognized in a valuation allowance by
charges to earnings. Gains or losses recognized upon the sale of loans are
determined using the specific identification method. Mortgage loans held for
investment are carried at amortized cost. The Group has both the intent and
the ability to hold all mortgage loans held for investment for the foreseeable
future.
Allowance for Losses
The allowance is maintained at a level adequate to absorb losses inherent in
the loan portfolio. Management determines the adequacy of the allowance by
applying projected loss ratios to the risk ratings of loans both individually
and by category. The projected loss ratios incorporate such factors as recent
loss experience, current economic conditions, the risk characteristics of the
various categories and concentrations of loans, transfer risk and other
pertinent factors.
Loans which are deemed uncollectible are charged off and deducted from the
allowance. The provision for losses and recoveries on loans previously charged
off are added to the allowance. In addition, a specific provision is made for
expected loan losses to reduce the recorded balances of loans receivable to
their estimated net realizable value. Such specific provision is based on
management's estimate of net realizable value considering the current and
anticipated operating or sales environment. These estimates of collateral
value are particularly susceptible to market changes that could result in
adjustments to the results of earnings in the future. Recovery of the carrying
value of such loans or such loan or the underlying collateral is dependent to
a great extent on economic, operating and other conditions that may be beyond
the Group's control.
The Group adopted Statement of Financial Accounting Standards ("SFAS") No.
114 (as amended by SFAS No. 118), "Accounting by Creditors for Impairment of a
Loan", effective January 1, 1995, which addresses the accounting by creditors
for the impairment of certain loans. The provisions of SFAS 114 do not apply
to large groups of smaller-balance homogeneous loans that are collectively
evaluated for impairment and loans that are measured at fair value or at the
lower of cost or fair value. The Group considers its residential mortgage loan
portfolio to represent a pool of smaller balance homogeneous loans.
Commercial, commercial real estate, construction and consumer loan portfolios
are specifically reviewed for impairment. The adoption had no effect on the
recorded allowance for losses.
The Group considers a loan impaired when it is probable, in the opinion of
management, that interest and principal may not be collected according to the
contractual terms of the loan agreement. Consistent with this definition, the
Group considers all non-accrual loans (with the exception of residential
mortgages) to be impaired. Impaired loans which have risk characteristics that
are unique to an individual borrower, are evaluated on a loan-by-loan basis.
However, impaired loans that have risk characteristics in common with other
impaired loans, (such as loan type, geographical location or other
characteristics that would cause the ability of the borrowers to meet
contractual obligations to be similarly affected by changes in economic or
other conditions), are aggregated and historical statistics, such as average
recovery period and average amount recovered, along with a composite effective
interest rate are used as a means of measuring those impaired loans. Loan
impairment is measured by estimating the expected future cash flows and
discounting them at the respective effective interest rate or by valuing the
underlying collateral.
F-9
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Loan Origination Fees, Commitment Fees and Related Costs
Loan fees received are accounted for in accordance with SFAS No. 91,
"Accounting for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases". Mortgage loan fees and
certain direct origination costs are capitalized. On loans held for sale, the
net fee or cost is recognized at the time the loan is sold. For mortgage loans
held for investment, the deferred amount is accounted for as an adjustment to
interest income using a method that approximates the interest method.
Repossessed Assets
Repossessed assets include one-to-four family residential property,
commercial property, and one-to-four family homes under construction. At the
date of foreclosure, real estate properties acquired in settlement of loans
are recorded at the lower of cost or net realizable value. Valuations are
periodically performed by management, and a charge to earnings is made if the
carrying value of a property exceeds its estimated fair value. Costs of
holding repossessed assets, principally taxes and legal fees, are expensed as
incurred.
Federal Income Taxes
The Group accounts for income taxes on the asset and liability method.
Deferred tax assets and liabilities are recorded based on the difference
between the tax bases of assets and liabilities and their carrying amounts for
financial reporting purposes. Current taxes are measured by applying the
provisions of enacted tax laws to taxable income to determine the amount of
taxes receivable or payable.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation.
Land is carried at historical cost. Depreciation is calculated on the
straight-line method over the estimated useful lives of the assets as follows:
<TABLE>
<S> <C>
Office buildings............................................. 31 years
Computer hardware and software............................... 3 to 5 years
Furniture, fixtures and equipment............................ 5 to 7 years
Automobiles.................................................. 3 years
</TABLE>
During March 1995, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of". This Statement requires that long-lived
assets and goodwill related to those assets to be held and used by an entity
and certain identifiable intangibles be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an
asset may not be recoverable. The Group adopted SFAS No. 121 effective January
1, 1996. Adoption of this Statement did not have an impact on the financial
condition or results of operations of the Group.
Mortgage Servicing Rights
Mortgage servicing rights ("MSR") represent the cost of acquiring the right
to service mortgage loans. These costs are initially capitalized and
subsequently amortized in proportion to, and over the period of, the estimated
net loan servicing income.
In May 1995, the Group adopted SFAS No. 122, "Accounting for Mortgage
Servicing Rights". This requires the capitalization of a mortgage servicing
asset for every origination whether it be originated or purchased. SFAS No.
122 also dictates prescribed rules for the amortization, periodic valuation,
and the required valuation adjustment. Prior to adoption, a value was
capitalized for purchased mortgage servicing rights. This capitalization was
in accordance with SFAS No. 65, "Accounting for Certain Mortgage Banking
Practices".
F-10
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The value of the mortgage servicing rights are periodically evaluated in
relation to the estimated discounted net future servicing revenues. The
portfolio is aggregated into stratifications based on loan term and type, and
note rate. Estimates of remaining loan lives and prepayment rates are
incorporated into this analysis. Changes in these estimates could materially
change the estimated fair value and any valuation allowance. Valuation
adjustments are recorded when the fair value of the servicing asset is less
than the amortized book value on a stratum basis. Any valuation adjustment is
recorded as an offset to the asset.
Loan Sales
The Bank sells its held for sale mortgage loans to secondary market
investors on a non-recourse basis. At the time of the sale, the Bank makes
certain representations and warranties to the investors. Should an investor
determine that a breach of such representations or warranties occurred, the
Bank may be required to repurchase loans from the investor. Such
representations and warranties generally relate to the fact that the loans
have been underwritten in accordance with the investor's guidelines and that
the loans conform to the laws of the state of origination. Gain or loss on the
sale of such loans is recognized upon consummation of the sale.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect reported amounts of assets and liabilities and the
disclosure 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.
The financial condition of a financial services company, and to some extent,
its operating performance, is dependent to a significant degree upon estimates
and appraisals of value, evaluations of creditworthiness and assumptions about
future events and economic conditions. Recent history has demonstrated that
these estimates, appraisals, evaluations and assumptions are subject to rapid
change, and that such changes can materially affect the reported financial
condition of a financial services company and its financial performance, and
may result in restrictions on an institution's ability to continue to operate
in its customary manner.
Reclassifications
Certain amounts within the accompanying consolidated financial statements
and the related notes have been reclassified to conform to the 1997
presentation.
Recently Issued Accounting Standards
The FASB has issued SFAS No. 128, "Earnings Per Share," which is effective
for financial statements issued after December 31, 1997. Early adoption of the
standard is not permitted. The standard eliminates primary and fully diluted
earnings per share and requires presentation of basic and diluted earnings per
share together with disclosure of how the per share amounts were computed. The
adoption of this new standard is not expected to have a material impact on the
Group.
In June 1997, the FASB issued SFAS No. 130, "Reporting of Comprehensive
Income" ("SFAS 130"), which establishes standards for reporting and display of
comprehensive income and its components (revenues, expense, gains, and losses)
in a full set of financial statements. This statement also requires that all
items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that
is displayed with the same prominence as other financial statements. This
statement is effective for fiscal years beginning after December 15, 1997.
Earlier application is permitted. Reclassification of financial statements for
earlier periods provided for comparative purposes is required. The Group does
not anticipate that adoption of SFAS 130 will have a material effect on the
Group.
F-11
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information" ("SFAS 131"), which establishes
standards for the way that public business enterprises report information
about operating segments in annual financial statements and requires that
those enterprises report selected information about operating segments in
interim financial reports issued to stockholders. This statement also
establishes standards for related disclosures about products and services,
geographic areas, and major customers. This statements requires the reporting
of financial and descriptive information about an enterprise's reportable
operating segments. This statement is effective for financial statements for
periods beginning after December 15, 1997. In the initial year of adoption,
comparative information for earlier years is to be restated. The Group does
not anticipate that the adoption of SFAS 131 will have a material effect on
the Group.
NOTE 4--LOANS RECEIVABLE
The loan portfolio is summarized as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, --------------------
1997 1996 1995
------------- ---------- --------
<S> <C> <C> <C>
Held for sale--mortgage loans............ $1,363,822 $ 840,767 $620,455
Held for investment Mortgage loans....... 296,258 120,924 178,246
Commercial real estate loans............. 19,347 13,565 30,504
Commercial loans......................... 56,216 46,212 8,576
Construction loans....................... 37,812 59,270 48,933
Consumer loans........................... 34,919 33,608 39,331
---------- ---------- --------
444,552 273,579 305,590
---------- ---------- --------
1,808,374 1,114,346 926,045
Less allowance for losses................ (4,950) (3,500) (2,102)
---------- ---------- --------
Total.................................. $1,803,424 $1,110,846 $923,943
========== ========== ========
</TABLE>
In 1994, the Group classified a number of loans as held for investment in a
manner similar to SFAS No. 115 ("SFAS 115"), "Accounting for Certain
Investments in Debt and Equity Securities". In 1995, the FASB released the
"Guide to Implementation of Statement 115" (the "Guide"). Upon review of the
Guide, the Group reassessed the prior classifications and reclassified
approximately $185.0 million of mortgage loans to held for sale from held for
investment.
Activity in the allowance for losses is summarized as follows (in
thousands):
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
--------------------- -----------------------
1997 1996 1996 1995 1994
---------- --------- ------- ------ ------
<S> <C> <C> <C> <C> <C>
Balance, beginning of
period.................... $ 3,500 $ 2,102 $ 2,102 $1,871 $ 901
Allowance for losses of
Security at date of
acquisition............... -- -- -- -- 1,001
Provision charged to
earnings.................. 3,730 1,140 2,604 238 290
Charge-offs, net of
recoveries................ (2,280) (216) (1,206) (7) (321)
---------- --------- ------- ------ ------
Balance, end of period..... $ 4,950 $ 3,026 $ 3,500 $2,102 $1,871
========== ========= ======= ====== ======
</TABLE>
The Group has no commitments to make additional advances on restructured or
other nonperforming loans. Loans on which interest accruals have been
discontinued totaled approximately $30.6 million at December 31, 1996, $10.7
million at December 31, 1995 and $1.7 million at December 31, 1994. Interest
that would have been accrued on such loans totaled approximately $2,668,000,
$862,000, and $245,000 at December 31, 1996, 1995,
F-12
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
and 1994, respectively. At September 30, 1997 and 1996, loans on which
interest accruals have been discontinued totaled approximately $44.1 million
and $31.7 million, respectively. Interest that would have been accrued on such
loans totaled approximately $4.5 million and $2.8 million at September 30,
1997 and 1996, respectively.
At September 30, 1997 the recorded investment in impaired loans, pursuant to
SFAS No. 114, totaled $3.6 million and the average outstanding balance for the
nine months ended September 30, 1997 was $3.5 million. No allowance for losses
was required on these loans because the measured values of the loans exceeded
the recorded investments in the loans. Interest income recognized on impaired
loans during the nine months ended September 30, 1997, was not material. At
December 31, 1996, the recorded investment in impaired loans totaled $3.9
million and the average outstanding balance for the year ended December 31,
1996 was $3.1 million.
NOTE 5--REPOSSESSED ASSETS
Repossessed assets include the following (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, --------------
1997 1996 1995
------------- ------- ------
<S> <C> <C> <C>
One-to-four family............................. $17,479 $10,133 $2,179
Commercial properties.......................... 180 230 180
------- ------- ------
Repossessed assets, net........................ $17,659 $10,363 $2,359
======= ======= ======
</TABLE>
NOTE 6--PREMISES AND EQUIPMENT
Premises and equipment balances are as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, -----------------
1997 1996 1995
------------- -------- -------
<S> <C> <C> <C>
Land........................................ $ 703 $ 3,330 $ 3,330
Office buildings............................ 6,496 2,643 2,312
Computer hardware and software.............. 16,307 15,283 10,856
Furniture, fixtures and equipment........... 12,007 11,045 8,460
Automobiles................................. 454 571 568
-------- -------- -------
35,967 32,872 25,526
Less accumulated depreciation............... (15,178) (12,119) (7,651)
-------- -------- -------
Premises and equipment, net................. $ 20,789 $ 20,753 $17,875
======== ======== =======
</TABLE>
Depreciation expense amounted to approximately $4.3 million and $3.2 million
for the nine month periods ended September 30, 1997 and 1996 and approximately
$4.6 million, $3.1 million, and $2.1 million for the years ended December 31,
1996, 1995 and 1994, respectively.
Lease rental expense totaled approximately $2.8 million and $3.1 million for
the nine months ended September 30, 1997 and 1996 and $4.1 million, $3.3
million and $3.1 million for the years ended 1996, 1995 and 1994,
respectively. The following outlines the Bank's minimum contractual lease
obligations as of December 31, 1996 (in thousands):
<TABLE>
<S> <C>
1997............................................................... $2,603
1998............................................................... 1,834
1999............................................................... 1,357
2000............................................................... 1,079
2001............................................................... 463
------
Total............................................................ $7,336
======
</TABLE>
F-13
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Bank has committed to the development of additional software and systems
to be utilized in the mortgage banking segment. The amount committed to the
project amounted to approximately $1.8 million, of which approximately $1.6
million was paid through September 30, 1997.
NOTE 7--MORTGAGE SERVICING RIGHTS
Not included in the accompanying consolidated financial statements are
mortgage loans serviced for others. The unpaid principal balances of these
loans, including subservicing of $2.0 billion at September 30, 1997, $3.6
billion at December 31, 1996 and $536.3 million at December 31, 1995, are
summarized as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, ---------------------
1997 1996 1995
------------- ---------- ----------
<S> <C> <C> <C>
Mortgage loans serviced for:
FHLMC and FNMA........................ $3,931,738 $4,658,056 $6,638,435
MSHDA................................. 58,078 47,505 31,055
GNMA.................................. 5,299 6,458 7,217
Other investors....................... 2,175,815 3,708,935 648,147
---------- ---------- ----------
$6,170,930 $8,420,954 $7,324,854
========== ========== ==========
</TABLE>
Custodial accounts maintained in connection with the above mortgage
servicing rights were approximately $80.6 million at September 30, 1997 and
$106.3 million and $131.4 million at December 31, 1996 and 1995 respectively.
These amounts include payments for principal, interest, taxes, and insurance
collected on behalf of the individual investor.
As discussed in Note 3, the Group adopted SFAS 122 in May 1995. The effect
of the adoption was to increase earnings by approximately $1.5 million before
taxes for 1995.
The following is an analysis of the changes in the mortgage servicing rights
(in thousands):
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
-------------------- ---------------------------
1997 1996 1996 1995 1994
--------- --------- -------- -------- -------
<S> <C> <C> <C> <C> <C>
Balance, beginning of
period................. $ 30,064 $ 27,957 $ 27,957 $ 18,179 $17,563
Additions............... 56,607 50,861 63,499 31,106 15,616
Sales................... (28,028) (29,218) (50,075) (15,684) (9,475)
Amortization............ (6,930) (8,177) (11,317) (5,644) (5,525)
--------- --------- -------- -------- -------
Balance, end of period.. $ 51,713 $ 41,423 $ 30,064 $ 27,957 $18,179
========= ========= ======== ======== =======
</TABLE>
At December 31, 1996 and 1995, the estimated fair value of the mortgage loan
servicing portfolio was approximately $54.0 and $70.4 million, respectively.
The estimated fair value at September 30, 1997 was approximately $60.4
million. The estimated fair value in excess of book value was approximately
$8.7 million at September 30, 1997 and $23.9 million and $42.4 million at
December 31, 1996 and 1995, respectively.
F-14
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 8--DEPOSIT ACCOUNTS
The deposit accounts are as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, -----------------
1997 1996 1995
AMOUNT AMOUNT AMOUNT
------------- -------- --------
<S> <C> <C> <C>
Demand, NOW and money market accounts...... $ 55,981 $ 66,908 $ 42,410
Passbook savings........................... 78,879 57,211 38,094
Certificates of deposit.................... 877,261 500,613 448,714
---------- -------- --------
Total deposit accounts................... $1,012,121 $624,732 $529,218
========== ======== ========
</TABLE>
Non interest-bearing deposits included in the demand, NOW and money market
accounts balances at December 31, 1996 and 1995 were approximately $36.9
million and $13.2 million, respectively and $21.3 million at September 30,
1997.
The aggregate amount of certificates of deposit with a minimum denomination
of $100,000 was approximately $279.5 million and $223.4 million at December
31, 1996 and 1995, respectively and $445.6 million at September 30, 1997.
The following indicates the scheduled maturities of the Bank's certificates
of deposit as of September 30, 1997:
<TABLE>
<CAPTION>
SEPTEMBER 30,
1997
-------------
<S> <C>
Three months or less........................................ $129,844
Over three through six months............................... 168,644
Over six through twelve months.............................. 197,980
One to two years............................................ 221,106
Thereafter.................................................. 159,687
--------
Total..................................................... $877,261
========
</TABLE>
Interest expense on deposit accounts is summarized as follows (in
thousands):
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
------------------- -----------------------
1997 1996 1996 1995 1994
--------- --------- -------- ------- ------
<S> <C> <C> <C> <C> <C>
Demand, NOW and money
market accounts.................. $ 2,636 $ 1,778 $ 2,499 $ 1,824 $ 773
Passbook savings................. 664 282 428 228 127
Certificates of deposit.......... 31,682 20,014 27,504 23,071 8,137
--------- --------- -------- ------- ------
Total.......................... $ 34,982 $ 22,074 $ 30,431 $25,123 $9,037
========= ========= ======== ======= ======
</TABLE>
F-15
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 9--FHLB ADVANCES
The following indicates certain information related to the FHLB advances (in
thousands):
<TABLE>
<CAPTION>
FOR THE NINE
MONTHS ENDED FOR THE YEARS ENDED DECEMBER 31,
SEPTEMBER 30, ----------------------------------
1997 1996 1995 1994
------------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Maximum outstanding at
any month end.......... $718,878 $ 389,801 $ 315,000 $ 200,750
Average balance......... 427,310 247,204 237,535 83,912
Average interest rate... 5.87% 5.78% 6.35% 4.44%
</TABLE>
The Bank has the authority and approval from the FHLB to utilize a total of
$850 million in collateralized borrowings. Advances at December 31, 1996
principally matured during 1997. Advances at September 30, 1997 principally
mature during 1997, 1998, and 1999. Pursuant to collateral agreements with the
FHLB, advances are collateralized by non-delinquent single-family residential
mortgage loans.
NOTE 10--FEDERAL INCOME TAXES
Components of the provision for federal income taxes consists of the
following (in thousands):
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
------------------- ----------------------
1997 1996 1996 1995 1994
--------- --------- ------- ------ ------
<S> <C> <C> <C> <C> <C>
Current provision................. $ 2,918 $ 5,695 $11,031 $5,933 $6,489
Deferred provision................ 6,125 692 (773) 3,415 2,813
--------- --------- ------- ------ ------
$ 9,043 $ 6,387 $10,258 $9,348 $9,302
========= ========= ======= ====== ======
</TABLE>
The Group's effective tax rates differ from the statutory federal tax rates.
The following is a summary of such differences (in thousands):
<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE YEARS ENDED
ENDED SEPTEMBER 30, DECEMBER 31,
-------------------- ---------------------
1997 1996 1996 1995 1994
--------- --------- ------- ------ ------
<S> <C> <C> <C> <C> <C>
Provision at statutory federal
income tax rate.............. $ 8,705 $ 6,218 $ 9,580 $8,707 $8,904
Increase (decrease) resulting
from:
Amortization of deposit
premium.................... 340 340 450 450 225
Other, net.................. (2) (171) 228 191 173
--------- --------- ------- ------ ------
Provision at effective federal
income tax rate.............. $ 9,043 $ 6,387 $10,258 $9,348 $9,302
========= ========= ======= ====== ======
</TABLE>
F-16
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The details of the net tax liability are as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, ------------------
1997 1996 1995
------------- -------- --------
<S> <C> <C> <C>
Deferred tax assets:
Mark-to-market adjustments on earning
assets................................ $ 990 $ 1,130 $ 1,031
Interest not accrued................... 1,589 934 255
Other.................................. 334 218 9
-------- -------- --------
Total................................ 2,913 2,282 1,295
-------- -------- --------
Deferred tax liabilities:
Deferred fees.......................... (1,785) (1,112) (567)
Bad debt reserves...................... (9) (704) (1,246)
Mortgage loan servicing rights......... (17,427) (10,199) (9,724)
Purchase accounting valuation
adjustments........................... (360) (555) (835)
Premises and equipment................. (773) (885) (463)
Other.................................. (41) (226) (623)
-------- -------- --------
Total................................ (20,395) (13,681) (13,458)
-------- -------- --------
Net deferred tax liability............... (17,482) (11,399) (12,163)
Currently (payable)/receivable........... 956 (11,107) (2,441)
-------- -------- --------
Net tax liability........................ $(16,526) $(22,506) $(14,604)
======== ======== ========
</TABLE>
Flagstar files a consolidated federal income tax return on a calendar year
basis. Through its tax year ended December 31, 1995, the Bank has determined
its deduction for bad debts based on the reserve method in lieu of the
specific charge-off method. Under the reserve method, the Bank has established
and maintained a reserve for bad debts against which actual loan losses are
charged. As a qualifying thrift institution, the Bank has calculated its
addition to its bad debt reserve under either, (1) the "percentage of taxable
income" method or (2) the "experience" method. The Bank used the percentage of
taxable income method in determining its bad debt reserve addition for its
1995, 1994 and 1993 tax years.
During August 1996, the President signed the Small Business Job Protection
Act of 1996 ("the Jobs Act") which contains certain provisions that require
all savings banks and thrifts to account for bad debts for income tax
reporting purposes in the same manner as banks. The effect on a large thrift
such as the Bank is that it must change its tax method of accounting for
determining its allowable bad debt deduction from the reserve method to the
specific charge-off method. Consequently, the bad debt deduction based on a
percentage of taxable income or the experience method is no longer allowed for
years beginning after December 31, 1995.
The bad debt reserves maintained for tax purposes and accumulated after 1987
are subject to recapture as part of the change. Base year reserves (generally
pre-1988 bad debt reserves) will not be recaptured unless the Bank, or a
successor institution, liquidates, redeems shares or pays a dividend in excess
of earnings and profits. The recapture will generally be taken into account
ratably over six years beginning with the 1996 tax year. The Bank may defer
the recapture up to an additional two years if it meets certain residential
lending requirements during tax years beginning before January 1, 1998.
Income taxes have been provided for the temporary difference between the
allowance for losses and the increase in the bad debt reserve maintained for
tax purposes since the 1987 base year. The cumulative amount of this
difference at December 31, 1995 was approximately $3.5 million for the Bank.
As a result of the Jobs Act,
F-17
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
the cumulative difference of $3.5 million will be recaptured. Management
believes that the Bank has met the conditions to defer the recapture of the
reserve during 1996 and 1997. The Jobs Act had no effect on the base year
reserves of the Bank. Consequently, the Bank has not provided deferred taxes
of approximately $1.4 million on the balance of its tax bad debt reserves as
of the 1987 base year.
NOTE 11--EMPLOYEE BENEFITS
The Group maintains a 401(k) plan for its employees. Under the plan,
eligible employees may contribute up to 6% of their compensation up to a
maximum of $9,000 annually. The Group currently provides a matching
contribution up to 3% of an employee's annual compensation. The Group's
contributions vest at a rate such that an employee is fully vested after seven
years of service. The Group's contributions to the plan for the years ended
December 31, 1996, 1995 and 1994 were approximately $594,000, $493,000, and
$371,000, respectively. The Group's contributions to the plan for the nine
months ended September 30, 1997 and 1996 were $579,000 and $452,000,
respectively. The Group may also make discretionary contributions to the plan;
however, none have been made.
NOTE 12--CONTINGENCIES
The Group is involved in certain lawsuits incidental to its operations.
Management, after review with its legal counsel, is of the opinion that
settlement of such litigation will not have a material effect on the Group's
financial condition.
A substantial part of the Bank's business has involved the origination,
purchase, and sale of mortgage loans. During the past several years, numerous
individual claims and purported consumer class action claims were commenced
against a number of financial institutions, their subsidiaries and other
mortgage lending institutions generally seeking civil statutory and actual
damages and rescission under the federal Truth in Lending Act (the "TILA"), as
well as remedies for alleged violations of various state unfair trade
practices laws restitution or unjust enrichment in connection with certain
mortgage loan transactions.
The Bank has a substantial mortgage loan servicing portfolio and maintains
escrow accounts in connection with this servicing. During the past several
years, numerous individual claims and purported consumer class action claims
were commenced against a number of financial institutions, their subsidiaries
and other mortgage lending institutions generally seeking declaratory relief
that certain of the lenders' escrow account servicing practices violate the
Real Estate Settlement Practices Act and breach the lenders' contracts with
borrowers. Such claims also generally seek actual damages and attorney's fees.
In addition to the foregoing, mortgage lending institutions have been
subjected to an increasing number of other types of individual claims and
purported consumer class action claims that relate to various aspects of the
origination, pricing, closing, servicing, and collection of mortgage loans and
that allege inadequate disclosure, breach of contract, or violation of state
laws. Claims have involved, among other things, interest rates and fees
charged in connection with loans, interest rate adjustments on adjustable-rate
loans, timely release of liens upon payoffs, the disclosure and imposition of
various fees and charge, and the placing of collateral protection insurance.
While the Bank has had various claims similar to those discussed above
asserted against it, management does not expect these claims to have a
material adverse effect on the Bank's financial condition, results of
operations, or liquidity.
F-18
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 13--REGULATORY MATTERS
The Financial Institutions Reform Recovery and Enforcement Act of 1989
("FIRREA"), which instituted major reforms in the operation and supervision of
the savings and loan industry, contains provisions for capital standards.
These standards require savings institutions to have a minimum regulatory
tangible capital (as defined in the regulation) equal to 1.50% of adjusted
total assets and a minimum 3.00% core capital (as defined) of adjusted total
assets. Additionally, savings institutions are required to meet a total risk-
based capital requirement of 8.00%.
The Bank is also subject to the provisions of the Federal Deposit Insurance
Corporation Improvement Act of 1991 ("FDICIA"). FDICIA includes significant
changes to the legal and regulatory environment for insured depository
institutions, including reductions in insurance coverage for certain kinds of
deposits, increased supervision by the Federal regulatory agencies, increased
reporting requirements for insured institutions, and new regulations
concerning reporting on internal controls, accounting and operations.
FDICIA's prompt corrective action regulations define specific capital
categories based on an institutions' capital ratios. The capital categories,
in declining order, are "well" capitalized, "adequately capitalized",
"undercapitalized", "significantly undercapitalized", and "critically
undercapitalized." Institutions categorized as "undercapitalized" or worse are
subject to certain restrictions, including the requirement to file a capital
plan with OTS, and increased supervisory monitoring, among other things. Other
restrictions may be imposed on the institution either by the OTS or by the
FDIC, including requirements to raise additional capital, sell assets, or sell
the entire institution.
The following chart delineates the categories as defined in the FDICIA
legislation:
<TABLE>
<CAPTION>
TIER 1 TOTAL
CORE RISK-BASED RISKED-BASED
CAPITAL CAPITAL CAPITAL
-------------- -------------- --------------
<S> <C> <C> <C>
"Well capitalized"............ 5.0% 6.0% 10.0%
"Adequately capitalized"...... 4.0% 4.0% 8.0%
"Undercapitalized"............ Less than 4.0% Less than 4.0% Less than 8.0%
"Significantly
undercapitalized"............ Less than 3.0% Less than 3.0% Less than 6.0%
</TABLE>
At September 30, 1997, Bank's consolidated Core, Tier 1 risk-based, and
Total risk-based capital ratios were 5.95%, 10.88% and 11.25%, respectively.
These ratios place the Bank in the "well capitalized" category.
The following is a calculation of Bank's consolidated regulatory capital (in
thousands) at September 30, 1997:
<TABLE>
<CAPTION>
TIER 1 TOTAL
GAAP TANGIBLE CORE RISK-BASED RISK-BASED
CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL
-------- -------- -------- ---------- ----------
<S> <C> <C> <C> <C> <C>
GAAP capital, as
reported............... $121,055 $121,055 $121,055 $121,055 $121,055
Nonallowable assets:
Core deposit premium.. (4,837)
Other assets.......... (310)
Additional capital
items:
General valuation
allowance............ 4,950
-------- -------- -------- --------
Regulatory capital...... 116,218 121,055 121,055 125,695
Minimum capital
requirement %.......... 1.50% 3.00% 4.00% 8.00%
Minimum capital
requirement $.......... 30,425 60,996 44,521 89,413
-------- -------- -------- --------
Regulatory capital--
excess................. $ 85,793 $ 60,059 $ 76,534 $ 36,282
======== ======== ======== ========
</TABLE>
F-19
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
At December 31, 1996, Bank's consolidated Core, Tier 1 risk-based, and Total
risk-based capital ratios were 6.01%, 10.48% and 10.91%, respectively. These
ratios place Bank in the "well capitalized" category.
The following is a calculation of Bank's consolidated regulatory capital (in
thousands) at December 31, 1996:
<TABLE>
<CAPTION>
TIER 1 TOTAL
GAAP TANGIBLE CORE RISK-BASED RISK-BASED
CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL
------- -------- ------- ---------- ----------
<S> <C> <C> <C> <C> <C>
GAAP capital, as
reported................. $77,899 $77,899 $77,899 $77,899 $77,899
Nonallowable assets:
Core deposit premium.... (5,805)
Other assets............ (313)
Additional capital items:
General valuation
allowance.............. 3,500
------- ------- ------- -------
Regulatory capital........ 72,094 77,899 77,899 81,086
Minimum capital
requirement %............ 1.50% 3.00% 4.00% 8.00%
Minimum capital
requirement $............ 19,365 38,904 51,872 59,458
------- ------- ------- -------
Regulatory capital--
excess................... $52,729 $38,995 $26,027 $21,628
======= ======= ======= =======
</TABLE>
At December 31, 1995, Bank's consolidated Core, Tier 1 risk-based, and Total
risk-based capital ratios were 5.84%, 9.83% and 10.12%, respectively. These
ratios place Bank in the "well capitalized" category.
The following is a calculation of Bank's consolidated regulatory capital (in
thousands) at December 31, 1995:
<TABLE>
<CAPTION>
TIER 1 TOTAL
GAAP TANGIBLE CORE RISK-BASED RISK-BASED
CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL
------- -------- ------- ---------- ----------
<S> <C> <C> <C> <C> <C>
GAAP capital, as
reported................. $61,003 $61,003 $61,003 $61,003 $61,003
Nonallowable assets:
Core deposit premium.... (7,095)
Other assets............ (306)
Additional capital items:
General valuation
allowance.............. 2,102
------- ------- ------- -------
Regulatory capital........ 53,908 61,003 61,003 62,799
Minimum capital
requirement %............ 1.50% 3.00% 4.00% 8.00%
Minimum capital
requirement $............ 15,566 31,346 24,828 49,655
------- ------- ------- -------
Regulatory capital--
excess................... $38,342 $29,657 $36,175 $13,144
======= ======= ======= =======
</TABLE>
The OTS risk-based capital regulation also includes an interest rate risk
(IRR) component that requires savings institutions with greater than normal
IRR, when determining compliance with the risk-based capital requirements, to
maintain additional total capital. The OTS has, however, indefinitely deferred
enforcement of its IRR requirements. Under the regulation, a savings
institution's IRR is measured in terms of the sensitivity of its "net
portfolio value" to changes in interest rates. A savings institution is
considered to have a "normal" level of IRR exposure if the decline in its net
portfolio value after an immediate 200 basis point increase or decrease in
market interest rates is less than 2% of the current estimated economic value
of its assets. If the OTS determines in the future to enforce the regulation's
IRR requirements, a savings institution with a greater than normal IRR would
be required to deduct from total capital, for purposes of calculating its
risk-based capital
F-20
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
requirement, an amount equal to one half the difference between the
institution's measured IRR and 2%, multiplied by the economic value of the
institution's total assets. Management does not believe that this regulation,
when enforced, will have a material impact on Bank.
The United States Congress has passed legislation that resulted in an
assessment on all Savings Association Insurance Fund ("SAIF") insured deposits
in order to recapitalize the SAIF Fund. This one-time assessment amounted to
approximately 66 basis points on SAIF assessable deposits held as of March 31,
1995. The assessment was payable no later than November 30, 1996 and amounted
to approximately $3.4 million for Bank. Such amount was charged to earnings at
September 30, 1996.
NOTE 14--CONCENTRATIONS OF CREDIT
Properties collateralizing loans receivable are geographically disbursed
throughout the United States. As of September 30, 1997, approximately 29% of
these properties are located in Michigan (measured by principal balance), and
another 50% are located in the states of California, Colorado, Ohio, Florida,
Illinois, Texas, Maryland, Washington, Oregon, New York, and Georgia. No other
state contains more than 2% of the properties collateralizing these loans.
NOTE 15--CORPORATE ACQUISITION
The Bank entered into a definitive agreement on November 16, 1993 to acquire
all of the outstanding stock of Security Savings Bank, F.S.B. of Jackson,
Michigan for $35 per share or approximately $25.9 million. As part of this
agreement, Security maintained its corporate identity and became an operating
subsidiary of the Bank. The completion of this acquisition was finalized on
June 30, 1994, at the close of business. Had Security been a part of the Bank
for all of 1994, the Bank's earnings would have been reduced by $581,000.
In conjunction with Bank's acquisition of Security, a deposit premium was
capitalized in the amount of $9.0 million or 4.67%. This premium, which is
included in other assets, is being amortized over seven years on a straight-
line method. The premium, net of amortization, totals $4.8 million at
September 30, 1997, $5.8 million at December 31, 1996 and $7.1 million at
December 31, 1995. Amortization of the deposit premium amounted to
approximately $970,000 for the nine month periods ended September 30, 1997 and
1996 and $1.3 million for the years ended December 31, 1996 and 1995,
respectively.
NOTE 16--FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107 issued by the Financial Accounting Standards Board,
"Disclosures about Fair Value of Financial Instruments", requires the
disclosure of fair value information about financial instruments, whether or
not recognized in the statement of financial condition, where it is
practicable to estimate that value. In cases where quoted market prices are
not available, fair values are based on estimates using present value or other
valuation techniques. Because assumptions used in these valuation techniques
are inherently subjective in nature, the estimated fair values cannot always
be substantiated by comparison to independent market quotes and, in many
cases, the estimated fair values could not necessarily be realized in an
immediate sale or settlement of the instrument.
The fair value estimates presented herein are based on relevant information
available to management as of September 30, 1997, December 31, 1996, and 1995.
Management is not aware of any factors that would significantly affect these
estimated fair value amounts. As these reporting requirements exclude certain
financial instruments and all non-financial instruments, the aggregate fair
value amounts presented herein do not represent management's estimate of the
underlying value of the Group. Additionally, such amounts exclude intangible
asset values such as the value of core deposit intangibles.
F-21
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The following methods and assumptions were used by the Group to estimate the
fair value of each class of financial instruments and certain non-financial
instruments for which it is practicable to estimate that value:
Cash and cash equivalents: The carrying amount of cash and cash equivalents
approximates fair value.
Loans receivable: This portfolio consists of single family mortgage loans
held for sale and investment, collateralized commercial lines of credit,
commercial real estate loans, builder development project loans, consumer
credit obligations, and single family home construction loans. Mortgage loans
held for sale and investment are valued using fair values attributable to
similar mortgage loans. The fair value of the other loans are valued based on
the fair value of obligations with similar credit characteristics.
Other investments: The carrying amount of other investments approximates
fair value.
FHLB stock: No secondary market exists for FHLB stock. The stock is bought
and sold at par by the FHLB. The recorded value, therefore, is the fair value.
The amount of stock required to be purchased is based on total assets and is
determined annually.
Deposit Accounts: The fair value of demand deposits and savings accounts
approximates the carrying amount. The fair value of fixed-maturity
certificates of deposit is estimated using the rates currently offered for
deposits with similar remaining maturities.
FHLB Advances: Rates currently available to the Group for debt with similar
terms and remaining maturities are used to estimate the fair value of the
existing debt.
Mortgage Servicing Rights: See Note 3 for a description of the method used
to value the mortgage servicing rights.
Financial instruments with off-balance-sheet risk: The fair value of
financial futures contracts, forward delivery contracts and fixed rate
commitments to extend credit are based on current market prices.
The following tables set forth the fair value of the Group's financial
instruments:
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, ------------------------------------------
1997 1996 1995
---------------------- -------------------- --------------------
CARRYING CARRYING FAIR CARRYING FAIR
VALUE FAIR VALUE VALUE VALUE VALUE VALUE
---------- ---------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Financial instruments:
Assets:
Cash and cash
equivalents........... $ 43,633 $ 43,633 $ 44,187 $ 44,187 $ 29,119 $ 29,119
Mortgage loans held for
sale.................. 1,363,822 1,387,381 840,767 850,455 620,455 621,585
Loans held for
investment............ 439,602 432,134 270,079 274,168 303,488 308,712
Other investments...... 539 539 887 887 818 818
Federal Home Loan Bank
stock................. 36,925 36,925 19,725 19,725 17,800 17,800
Liabilities:
Deposits:
Demand deposits and
savings accounts..... (134,860) (134,860) (124,119) (124,119) (80,504) (80,504)
Certificates of
deposit.............. (877,261) (875,619) (500,613) (500,718) (448,714) (451,500)
FHLB advances.......... (718,878) (717,826) (389,801) (389,635) (191,156) (190,800)
Off-balance sheet
items:
Financial futures...... -- -- -- -- -- --
Forward delivery
contracts............. -- 3,239 -- (9,868) -- (9,366)
Commitments to extend
credit................ -- 11,969 5,362 -- 1,789
Non-financial
instruments:
Unrealized gains on
mortgage servicing
rights
(see Note 7).......... -- 8,700 -- 23,900 -- 42,400
</TABLE>
F-22
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Group enters into certain financial instruments with off-balance-sheet
risk in the ordinary course of business to reduce its exposure to changes in
interest rates. The Group utilizes only traditional financial instruments for
this purpose and does not enter into instruments such as leveraged derivatives
or structured notes. The financial instruments used for hedging interest rate
risk include financial futures contracts and forward delivery contracts. A
hedge is an attempt to reduce risk by creating a relationship whereby any
losses on the hedged asset or liability are expected to be counterbalanced in
whole or part by gains on the hedging financial instrument. Thus, market risk
resulting from a particular off-balance-sheet instrument is normally offset by
other on or off-balance-sheet transactions. The Group seeks to manage credit
risk by limiting the total amount of arrangements outstanding, both by
counterparty and in the aggregate, by monitoring the size and maturity
structure of the financial instruments, by assessing the creditworthiness of
the counterparty, and by applying uniform credit standards for all activities
with credit risk.
Financial Instruments With Off-Balance-Sheet Risk
Notional principal amounts indicated in the following table represent the
extent of the Group's involvement in particular classes of financial
instruments and generally exceed the expected future cash requirements
relating to the instruments.
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, -------------
1997 1996 1995
------------- ------ ------
(IN MILLIONS)
<S> <C> <C> <C>
Forward delivery contracts...................... $1,148 $ 665 $ 511
Commitments to extend credit.................... 967 695 489
</TABLE>
All of the Group's financial instruments with off-balance sheet risk expire
within one year.
Financial Futures Contracts: There were no Treasury futures contracts
outstanding at December 31, 1996, December 31, 1995, or September 30, 1997.
Gains or losses on futures transactions are recorded on the specific
identification method in response to adjustments in the fair market value of
the instruments. During 1996 and 1995, the Group recorded losses on financial
futures amounting to approximately $90,000 and $1.3 million, respectively. For
the nine month period ended September 30, 1997 the Group recorded
approximately a $72,000 gain on financial futures and for the same period
ended September 30, 1996, the Group recorded a loss on financial futures of
approximately $200,000.
Forward Delivery Contracts: Forward delivery contracts are entered into to
sell single family mortgage loans:
FORWARD DELIVERY CONTRACTS
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, -------------
1997 1996 1995
------------- ------ ------
(IN MILLIONS)
<S> <C> <C> <C>
Types
Fixed.......................................... $1,128 $ 633 $ 470
Balloon........................................ -- 23 30
Variable....................................... 20 9 11
------ ------ ------
$1,148 $ 665 $ 511
====== ====== ======
</TABLE>
Substantially all forward delivery contracts are entered into with the
FHLMC, FNMA or GNMA.
F-23
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Commitments to Extend Credit: The Group's exposure to credit loss for
commitments to extend credit is represented by the contractual amount of those
agreements. The Group uses the same credit policies in making funding
commitments as it does for on-balance-sheet instruments. These commitments
generally have fixed expiration dates or other termination clauses. Because
commitments may expire without being drawn upon, the total contract amounts do
not necessarily represent future cash requirements.
<TABLE>
<CAPTION>
DECEMBER 31,
SEPTEMBER 30, -------------
1997 1996 1995
------------- ------ ------
(IN MILLIONS)
<S> <C> <C> <C>
Single family.................................... $823 $ 585 $ 409
Other............................................ 144 110 80
---- ------ ------
Total.......................................... $967 $ 695 $ 489
==== ====== ======
Fixed............................................ $899 $ 670 $ 459
Variable......................................... 68 25 30
---- ------ ------
Total.......................................... $967 $ 695 $ 489
==== ====== ======
</TABLE>
NOTE 17--SEGMENT INFORMATION
The Group operates in both the mortgage banking and retail banking segments.
Following is a presentation of financial information by business segment for
the period indicated.
<TABLE>
<CAPTION>
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997
------------------------------------------------
RETAIL MORTGAGE
BANKING BANKING
SEGMENT SEGMENT ELIMINATIONS COMBINED
--------- ----------- -------------------------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Revenues.................. $ 16,097 $ 57,537 $ -- $ 73,634
Earnings before income
taxes.................... 8,429 16,442 -- 24,871
Depreciation and
amortization of
intangibles.............. 1,851 10,155 -- 12,006
Capital expenditures...... 882 4,031 -- 4,913
Identifiable assets....... 571,464 1,675,840 (214,105) 2,033,199
Intersegment income
(expense)................ 14,987 (14,987) -- --
<CAPTION>
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996
------------------------------------------------
RETAIL MORTGAGE
BANKING BANKING
SEGMENT SEGMENT ELIMINATIONS COMBINED
--------- ----------- -------------------------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Revenues.................. $ 9,309 $ 55,897 $ -- $ 65,206
Earnings before income
taxes.................... 1,164 16,650 -- 17,814
Depreciation and
amortization of
intangibles.............. 1,106 11,203 -- 12,309
Capital expenditures...... 110 6,145 -- 6,255
Identifiable assets....... 358,677 886,211 (175,796) 1,069,092
Intersegment income
(expense)................ 12,306 (12,306) -- --
</TABLE>
F-24
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS ENDED DECEMBER 31, 1996
----------------------------------------------
RETAIL MORTGAGE
BANKING BANKING
SEGMENT SEGMENT ELIMINATIONS COMBINED
--------- ---------- ------------ ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Revenues.................... $ 13,791 $ 74,723 $ -- $ 88,514
Earnings before income
taxes...................... 3,305 24,066 -- 27,371
Depreciation and
amortization of
intangibles................ 1,589 15,737 -- 17,326
Capital expenditures........ 312 7,215 -- 7,527
Identifiable assets......... 387,201 1,112,260 (202,651) 1,296,810
Intersegment income
(expense).................. 14,186 (14,186) -- --
<CAPTION>
FOR THE NINE MONTHS ENDED DECEMBER 31, 1995
----------------------------------------------
RETAIL MORTGAGE
BANKING BANKING
SEGMENT SEGMENT ELIMINATIONS COMBINED
--------- ---------- ------------ ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Revenues.................... $ 12,390 $ 52,573 $ -- $ 64,963
Earnings before income
taxes...................... 3,549 21,327 -- 24,876
Depreciation and
amortization of
intangibles................ 1,728 9,313 -- 11,041
Capital expenditures........ 1,665 4,967 -- 6,632
Identifiable assets......... 307,620 782,559 (45,328) 1,044,851
Loans transferred to
(from)..................... (185,111) 185,111 -- --
Intersegment income
(expense).................. (4,153) 4,153 -- --
<CAPTION>
FOR THE NINE MONTHS ENDED DECEMBER 31, 1994
----------------------------------------------
RETAIL MORTGAGE
BANKING BANKING
SEGMENT SEGMENT ELIMINATIONS COMBINED
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(IN THOUSANDS)
<S> <C> <C> <C> <C>
Revenues.................... $ 1,432 $ 61,881 $ -- $ 63,313
Earnings before income tax-
es......................... (2,127) 27,566 -- 25,439
Depreciation and
amortization of
intangibles................ 746 8,259 -- 9,005
Capital expenditures........ 664 5,927 -- 6,591
Identifiable assets......... 416,023 479,830 (173,384) 722,469
Loans transferred to
(from)..................... 106,261 (106,261) -- --
Intersegment income (ex-
pense)..................... (2,358) 2,358 -- --
</TABLE>
Revenues are comprised of net interest income (before the provision for
credit losses) and non-interest income. Non-interest expenses are fully
allocated to each segment. The intersegment income (expense) consists of
interest expense incurred or charged by the mortgage banking segment on
intersegment borrowing.
NOTE 18--INITIAL PUBLIC OFFERING OF FLAGSTAR BANCORP, INC.
Stock Offering
Flagstar completed an initial public offering in May 1997 of 5,500,000
shares of common stock, including 3,080,000 shares being sold by the
shareholders of Flagstar. Such sale resulted in proceeds to the Bank of $27.3
million.
F-25
<PAGE>
FLAGSTAR BANK, FSB AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Stock Option and Purchase Plans, and Other Compensation Plans
In 1997, Flagstar's Board of Directors adopted resolutions to implement
various stock option and purchase plans and deferred and incentive
compensation plans effective upon the completion of the common stock offering.
The purpose of the Stock Option Plan ("Option Plan") is to provide an
additional incentive to directors and employees by facilitating their purchase
of Common Stock. The Option Plan will have a term of 10 years from the date of
its approval by Flagstar stockholders, after which no awards may be made,
unless the plan is earlier terminated by the Board of Directors of Flagstar.
Pursuant to the Option Plan, a number of shares equal to 10% of the shares of
Common Stock (1,345,000 shares) that are to be outstanding following the
Offering would be reserved for future issuance by Flagstar.
It is intended that options granted under the Option Plan will constitute
both incentive stock options ("ISOs") and non-incentive stock options ("non-
ISOs"). ISOs are options that comply with certain restrictions pursuant the
Internal Revenue Code of 1986, as amended (the "Code") and thereby provide
favorable tax treatment to recipients, although they do not generally result
in tax deductions to Flagstar. Non-ISO's are stock options that fail to
qualify as ISO, either at the time of grant or upon exercise.
The exercise price for ISOs may not be less than 100% of the fair market
value of the shares on the date of the grant. Non-ISOs may be granted with any
exercise price, although a recipient will recognize taxable income upon the
receipt of a non-ISO with an exercise price that is substantially less than
its fair market value. It is anticipated that Flagstar will account for the
Option Plan in accordance with the provisions of APB No. 25, "Accounting for
Stock issued to Employees" and adopt the disclosure requirements of SFAS No.
123.
Under the Employee Stock Purchase Plan ("Purchase Plan") eligible
participants, upon providing evidence of a purchase of Flagstar's common
shares from any third party and on the open market, would receive a payment
from Flagstar equal to 15% of the full price of the shares. The Purchase Plan
includes limitations on the maximum reimbursement to a participant during a
year. The Purchase Plan has not been designed to comply with the requirements
of the Internal Revenue Code with respect to employee stock purchase plans.
The Incentive Compensation Plan ("Incentive Plan") is payable only in the
form of cash from the Bank's general assets. The Incentive Plan is
administered by a committee which decides from year to year which employees of
Flagstar will be eligible to participate in the Incentive Plan and the size of
the bonus pool.
The Deferred Compensation Plan allows employees to defer up to 25% of their
annual compensation and directors to defer all of their compensation. Funds
deferred remain the property of Flagstar and are placed in a trust.
Participants may direct that their deferred amounts be invested in stock of
Flagstar. Upon withdrawal, the participant has the option of receiving the
stock or the proceeds of its sale at the market price at the time of
withdrawal.
F-26
<PAGE>
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NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY REPRE-
SENTATIONS OTHER THAN THOSE CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR
MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE RELIED UPON AS HAVING
BEEN AUTHORIZED. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SO-
LICITATION OF ANY OFFER TO BUY ANY SECURITIES OTHER THAN THE SECURITIES TO
WHICH IT RELATES OR AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY SUCH
SECURITIES IN ANY CIRCUMSTANCES IN WHICH SUCH OFFER OR SOLICITATION IS UNLAW-
FUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER
SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THERE HAS BEEN NO
CHANGE IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR THAT INFORMATION
CONTAINED IS CORRECT AS OF ANY TIME SUBSEQUENT TO THIS DATE.
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TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
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<S> <C>
Table of Contents.......................................................... i
Prospectus Summary......................................................... 1
Risk Factors............................................................... 12
The Company................................................................ 21
Use of Proceeds............................................................ 22
Capitalization............................................................. 23
Business and Strategy...................................................... 24
Management................................................................. 39
The Formation.............................................................. 44
Description of Series A Preferred Shares................................... 46
Description of Capital Stock............................................... 52
Federal Income Tax Consequences............................................ 55
ERISA Considerations....................................................... 63
Information Regarding the Bank............................................. 66
Underwriting............................................................... 73
Experts.................................................................... 74
Legal Matters.............................................................. 74
Additional Information..................................................... 74
Glossary................................................................... 76
Index to Financial Statement............................................... F-1
Annex I - Offering Circular................................................ OC-1
</TABLE>
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THROUGH AND INCLUDING MARCH 15, 1998 (THE 25TH DAY AFTER THE COMMENCEMENT OF
THE OFFERING), ALL DEALERS EFFECTING TRANSACTIONS IN THE REGISTERED
SECURITIES, WHETHER OR NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED
TO DELIVER A PROSPECTUS. THIS IS IN ADDITION THE OBLIGATION OF DEALERS TO
DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR
UNSOLD ALLOTMENTS OR SUBSCRIPTIONS.
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2,000,000 SHARES
[LOGO OF FLAGSTAR CAPITAL APPEARS HERE]
8.5% NONCUMULATIVE EXCHANGEABLE PREFERRED STOCK, SERIES A
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PROSPECTUS
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RONEY & CO.
MCDONALD & COMPANY
SECURITIES, INC.
FEBRUARY 18, 1998
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