<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
--------------- ------------------
Commission file number 1-12898
SOURCE ONE MORTGAGE SERVICES CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 38-2011419
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
27555 Farmington Road, Farmington Hills, Michigan 48334-3357
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (248) 488-7000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
<TABLE>
<S> <C>
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
8.42% CUMULATIVE PREFERRED STOCK, SERIES A NEW YORK STOCK EXCHANGE
9.375% QUARTERLY INCOME CAPITAL SECURITIES NEW YORK STOCK EXCHANGE
(SUBORDINATED INTEREST DEFERRED DEBENTURES, DUE 2025)
</TABLE>
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE
Indicated by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No .
--- ---
Indicate by check mark if disclosure of delinquent filers to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
THERE IS NO AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-AFFILIATES OF
THE REGISTRANT.
AS OF MARCH 27, 1998, THE NUMBER OF SHARES OF THE REGISTRANT'S COMMON STOCK
OUTSTANDING WAS 3,211,881.
DOCUMENTS INCORPORATED BY REFERENCE.
Portions of the Registrant's Annual Report to Shareholders for the year ended
December 31, 1997 (Parts I, II and IV).
<PAGE> 2
PART I
ITEM 1. BUSINESS
GENERAL
Source One Mortgage Services Corporation, a Delaware corporation (together
with its subsidiaries, the "Company" or "Source One"), is one of the largest
mortgage banking companies in the United States that is not affiliated with a
commercial bank. As of December 31, 1997, the Company had a mortgage loan
servicing portfolio totaling $26.5 billion, including $14.9 billion of loans
subserviced for others, which is serviced on behalf of approximately 234
institutional investors and numerous other security holders. As of December 31,
1997, the Company had 129 retail branch offices in 26 states and originated $4.4
billion in mortgage loans for the year then ended.
As a mortgage banker, the Company engages primarily in the business of
producing and selling conforming and subprime residential mortgage loans,
servicing conforming residential mortgage loans and subservicing residential
mortgage loans for third parties. The Company's primary sources of revenue are
net servicing revenue, net interest revenue, net gain on sale of mortgages, net
gain on sale of servicing, earnings from unconsolidated affiliate and other
revenue. The Company is also engaged, through certain of its subsidiaries, in
the sale of credit-related insurance products (such as life, disability, health,
accidental death and property and casualty insurance).
The Company was incorporated in 1972 and is the successor to Citizens Mortgage
Corporation which was organized in 1946. The Company is a wholly-owned
subsidiary of White Mountains Holdings, Inc. ("White Mountains") (formerly Fund
American Enterprises, Inc.) and its parent Fund American Enterprises Holdings,
Inc. ("Fund American"), a Delaware corporation organized in 1980, which was
formerly known as The Fund American Companies, Inc. and Fireman's Fund
Corporation.
The Company's principal executive offices are located at 27555 Farmington
Road, Farmington Hills, Michigan 48334-3357; its telephone number is (248)
488-7000.
INDUSTRY OVERVIEW
Mortgage banking is the business of serving as a financial intermediary in (i)
the origination and purchase of mortgage loans, (ii) the holding of such loans
while aggregating sufficient loans to form appropriate mortgage-backed security
pools, (iii) the subsequent sale of such loans through pools or directly to
investors, and (iv) the ongoing management or servicing of such loans during the
repayment period. Mortgage bankers generate revenue in each of the four stages
of the mortgage banking process.
MORTGAGE LOAN PRODUCTION
The Company produces residential mortgage loans through a system of retail
branch offices, a specialized marketing program, mortgage brokers and a
correspondent network of banks, thrift institutions and other mortgage lenders.
The existence of these mortgage production sources gives the Company the
flexibility to shift its production between those sources as market conditions
warrant and allows it to emphasize the production mode which is most
economically advantageous. Loans produced, whether through origination or
purchase, include conventional, conforming and subprime residential mortgage
loans as well as conforming mortgage loans which are either insured by the
Federal Housing Administration ("FHA") or partially guaranteed by the Veterans
Administration ("VA") (government loans). In evaluating loans purchased through
its correspondent network and loans originated through its broker network, the
Company applies the same quality standards as required for loans originated by
the Company itself. The Company's quality control department reviews a sample of
the loans purchased to determine compliance with Company standards.
It is a policy of the Company to primarily produce fixed rate mortgage loans.
Fixed rate mortgages tend to capture a larger share of the market in a declining
interest rate environment and are less susceptible to prepayment risk than
adjustable-rate mortgages. Accordingly, in a rising interest rate environment,
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
1
<PAGE> 3
consumer preference for adjustable-rate mortgages tends to increase, which could
have an adverse impact on the Company's mortgage production operations. However,
the possible adverse impact on mortgage production may be mitigated by the
positive impact on the Company's servicing portfolio. In 1997, fixed rate
mortgage originations accounted for approximately 88% of the Company's total
mortgage loan production as compared to 90% in 1996.
The following table sets forth selected information regarding the Company's
mortgage loan production:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------
(in millions)
Year ended December 31, 1997 1996 1995 1994 1993
- ----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
FHA/VA $ 2,985 $ 2,035 $ 1,565 $ 2,065 $ 3,453
Conventional 1,418 1,796 1,287 2,521 7,999
- ----------------------------------------------------------------------------------------------------------------------
Total production $ 4,403 $ 3,831 $ 2,852 $ 4,586 $ 11,452
- ----------------------------------------------------------------------------------------------------------------------
Retail branch originations $ 1,339 $ 1,590 $ 1,347 $ 2,005 $ 4,922
Correspondent network
acquisitions 2,552 1,640 1,157 1,081 2,643
Mortgage broker originations 390 369 196 696 1,708
Specialized marketing program
originations 122 232 152 804 2,179
- ----------------------------------------------------------------------------------------------------------------------
Total production $ 4,403 $ 3,831 $ 2,852 $ 4,586 $ 11,452
- ----------------------------------------------------------------------------------------------------------------------
</TABLE>
Mortgage loans originated by the Company are subject to a defined underwriting
process in order to assess each prospective borrower's ability to repay the loan
requested and the adequacy of each property as collateral. In addition, the
Company is subject to the underwriting guidelines of FHA, VA, the Federal Home
Loan Mortgage Corporation ("FHLMC" or "Freddie Mac") and the Federal National
Mortgage Association ("FNMA" or "Fannie Mae"), as well as specific contractual
requirements of institutional investors who have agreed to acquire mortgage
loans originated by the Company.
In response to increased industry competition for producing and servicing
conforming mortgage loans, the Company has decided to broaden its product line
by offering higher margin products. The Company has recently begun to produce
203(k) (FHA home improvement) loans, manufactured housing loans, subprime loans
and 125% loan-to-value ("125% LTV") second mortgage loans. The 203(k) loans and
the manufactured housing loans are being sold into agency pools with servicing
retained. The subprime and 125% LTV loans are being originated for a fee and
sold to third parties on a servicing released basis. The Company is currently
expanding its capability to service and subservice subprime loans and to
subservice 125% LTV loans. Although these higher margin products are a new focus
for the Company, they accounted for less than 2% of total production in 1997 and
are currently expected to account for less than 10% of total production in 1998.
RETAIL BRANCH OFFICES. As of December 31, 1997, the Company had 129
retail branch offices in 26 states. Each office has sales representatives who
originate mortgage loans through contacts with real estate brokers, builders,
developers and others, as well as through direct contact with homebuyers.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
2
<PAGE> 4
As of December 31, 1997, the Company's retail branch offices were located in the
following states:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------
Number Number Number
State of Offices State of Offices State of Offices
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
California 29 Florida 4 Tennessee 2
Washington 20 Missouri 4 Arkansas 1
New York 10 Ohio 4 Georgia 1
Texas 8 Oregon 4 Kansas 1
Arizona 6 Alaska 2 Maryland 1
Michigan 6 Kentucky 2 Rhode Island 1
Nevada 6 Massachusetts 2 Vermont 1
Illinois 5 New Jersey 2 Virginia 1
Colorado 4 Pennsylvania 2
- -------------------------------------------------------------------------------------------------------------------
</TABLE>
Most branch office originations are referred to regional operating centers
for preparation of loan documentation, evaluation of compliance with the
Company's underwriting conditions and closing of the loans.
CORRESPONDENT NETWORK. The Company conducts a program through which it agrees
to purchase mortgage loans from a network of banks, thrift institutions and
other mortgage lenders. The funding price for such loans is set by the Company
on a daily basis. In addition, the Company pays a premium for the release of
servicing rights, which is negotiated on a case-by-case basis. As of December
31, 1997 there were approximately 236 participants in the Company's
correspondent network, with no single participant or group of affiliated
participants accounting for more than 12% of the Company's total mortgage loan
originations.
MORTGAGE BROKERS. The Company conducts a program through which it closes loans
originated by a network of mortgage brokers. The funding price for such loans is
set by the Company on a daily basis. The mortgage broker receives compensation
equivalent to the difference between the Company's pricing schedule and the
closing price. As of December 31, 1997 there were approximately 425 active
participants in the Company's mortgage broker network, with no single broker or
group of affiliated brokers accounting for more than 1% of the Company's total
mortgage loan originations.
SPECIALIZED MARKETING PROGRAM. The Company also generates mortgage loan
originations primarily by responding to refinancing requests from the population
of loans currently serviced by the Company. The products currently offered by
the Specialized Marketing Program consist of purchase money first mortgages,
home equity lines of credit, closed-end second mortgages, refinancing and
relocation assistance.
SALES OF LOANS
The Company sells loans either through mortgage-backed securities issued
pursuant to programs of the Government National Mortgage Association ("GNMA" or
"Ginnie Mae"), FNMA and FHLMC or to private investors. Most loans are aggregated
in pools of $1.0 million or more, which are purchased by private investors after
having been guaranteed by GNMA, FNMA or FHLMC. Substantially all GNMA securities
are sold without recourse to the Company for loss of principal in the event of a
subsequent default by the mortgage borrower due to the underlying FHA and VA
insurance. Prior to December 1992, substantially all conventional securities
were sold with recourse to the Company to the extent of insufficient proceeds
from private mortgage insurance, foreclosure and other recoveries. Since
December 1992, conventional loans have been sold without recourse to the
Company.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
3
<PAGE> 5
The following table summarizes the principal amount of the Company's loans
sold:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Year Ended
December 31, 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------------
Principal Principal Principal
amount Percentage amount Percentage amount Percentage
(in millions) of total (in millions) of total (in millions) of total
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
GNMA $ 2,763 65.55% $ 1,678 42.82% $ 1,252 46.30%
FNMA 983 23.32 1,384 35.32 927 34.29
FHLMC 283 6.72 453 11.56 251 9.28
Other 186 4.41 404 10.30 274 10.13
- --------------------------------------------------------------------------------------------------------------------
Total loan sales $ 4,215 100.00% $ 3,919 100.00% $ 2,704 100.00%
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
Servicing agreements relating to mortgage-backed securities issued pursuant to
the programs of GNMA, FNMA and FHLMC require the Company to advance funds to
make the required payments to investors in the event of a delinquency by the
borrower. The Company expects that it would recover most funds advanced upon
cure of default by the borrower or at foreclosure. However, in connection with
VA partially guaranteed loans and certain conventional loans (which may be, at
most, partially insured by private mortgage insurers), funds advanced may not
cover losses due to potential declines in collateral value. The Company is
subject to limited amounts of principal risk with respect to these loans since
the insurer has the option to reimburse the servicer for the lower of fair
market value of the property or the mortgage loan outstanding, in addition to
the VA guarantee on the loan. In addition, most of the Company's servicing
agreements for mortgage-backed securities typically require the payment to
investors of a full month's interest on each loan although the loan may be paid
off (by optional prepayment or foreclosure) other than on a month-end basis. In
this instance, the Company is obligated to pay the investor interest at the
pass-through rate from the date of the loan payoff through the end of that
calendar month without reimbursement.
The Company, through private placements and public offerings, has also sold
mortgage loans through the issuance of mortgage pass-through certificates. The
Company issued $521.7 million of real estate mortgage investment conduit
("REMIC") certificates through December 31, 1990. The Company is the primary
servicer for these REMIC certificates, which were sold pursuant to five separate
trusts that have no recourse provisions. The Company has not issued any mortgage
pass-through certificates since 1990, however, the Company may offer additional
mortgage pass-through certificates in the future if economic and market
conditions warrant.
Historically, the Company's sales of loans have generated net gains. However,
if secondary market interest rates decline after the Company obtains a mandatory
forward commitment for a loan, the loan may not close and the Company may incur
a loss from the cost of covering its obligations under such commitment. If
secondary market interest rates increase after the Company commits to an
interest rate for a loan, and the Company has not obtained a forward commitment,
the Company may incur a loss when the loan is subsequently sold. To minimize
this risk, the Company obtains mandatory and optional forward commitments of up
to 120 days to sell mortgage-backed securities with respect to all loans which
have been funded and a substantial portion of loans in process ("pipeline")
which it believes will close.
The Company's risk management function closely monitors the mortgage loan
pipeline to determine appropriate forward commitment coverage on a daily basis.
In addition, the risk management area seeks to reduce counterparty risk by
committing to sell mortgage loans only to approved dealers, with no dealer
having in excess of 20% of current commitments. The Company currently transacts
business with seventeen approved dealers.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
4
<PAGE> 6
LOAN SERVICING
Mortgage loan servicing consists primarily of (i) collecting principal,
interest and funds to be escrowed for tax and insurance payments from mortgage
loan borrowers; (ii) remitting principal and interest to mortgage loan
investors; (iii) paying property taxes and insurance premiums on mortgaged
property; (iv) in some cases, advancing uncollected payments to mortgage loan
investors; (v) administering delinquent loans; (vi) supervising foreclosures in
the event of unremedied defaults; and (vii) performing all related accounting
and reporting activities. Servicing generates cash income in the form of fees,
which represent a percentage of the declining outstanding principal amount of
the loans serviced and are collected from each mortgage loan payment received
plus any late charges.
The Company currently retains the rights to service substantially all of the
conforming mortgage loans it produces, while selling the rights to service its
subprime and 125% LTV production. The Company is currently expanding its
capability to service and subservice subprime loans and to subservice 125% LTV
loans. In addition, the Company may acquire the rights to service or subservice
a mortgage loan portfolio without originating or acquiring the underlying
mortgage loans. The Company customarily makes such purchases of servicing rights
from banks, thrift institutions and other mortgage lenders. The fees paid to
acquire such servicing rights are negotiated on a case-by-case basis. The
Company purchased the rights to service $.04 billion, $2.8 billion and $4.7
billion of mortgage loans from third parties during 1997, 1996 and 1995,
respectively.
During 1996 and through 1997, the Company forged a new strategy with respect
to its servicing operations. A major focus of this strategy is reducing exposure
to interest rate risk, which increases with the size of an owned servicing
portfolio. To reduce the exposure, the Company took steps to reduce its owned
servicing portfolio and expand its subservicing business in the first quarter of
1997. In February 1997, the Company sold $17.0 billion of its nonrecourse
mortgage servicing portfolio to a third party for adjusted proceeds of $266.9
million and recognized a pretax loss of $4.3 million on the sale and related
assumption of subservicing. The Company recorded an additional loss of $3.7
million in the fourth quarter of 1997 in connection with the amendment of the
subservicing arrangement which extended the Company's subservicing
responsibilities for one additional year at less favorable terms than the
original agreement provided. The Company will continue to service these loans
pursuant to a subservicing agreement at least until March 1999, June 1999 and
August 1999 for FHLMC loans, GNMA loans and FNMA loans, respectively. The
subservicing period can be extended for a maximum of one year beyond these dates
at the option of the purchaser. During 1996 and 1995, the Company sold the
rights to service a total of $3.3 billion and $11.0 billion respectively, of
mortgage loans to third parties resulting in a pretax gain of $10.1 million and
$40.0 million, respectively.
In January 1998, the Company sold the rights to service approximately $1.1
billion of mortgage loans to third parties resulting in a pretax gain of
approximately $2.0 million. The Company has entered into agreements
to sell additional rights to service approximately $2.6 billion of mortgage
loans to third parties. The Company expects to close the sale of rights to
service approximately $2.1 billion of these mortgage loans by the end of March
1998 and the remainder during the second quarter of 1998 and expects to realize
pretax gains on the sales.
In 1994, the Company sold the rights to service $3.9 billion of mortgage
loans to a third party and continued to service these loans pursuant to a
subservicing agreement. The gain of $19.9 million was deferred and was being
recognized over the five-year life of the subservicing agreement. In the fourth
quarter of 1996, the third party sold the rights to service approximately $1.0
billion of these mortgage loans, representing approximately 25% of the total
loans subserviced by the Company for the third party. Accordingly, the Company
recognized an additional $2.4 million of the deferred gain in 1996, representing
approximately 25% of the deferred balance at the time of sale. In the fourth
quarter of 1997, the third party sold the rights to service the remaining
portfolio of loans. As a result, the Company recognized the $4.4 million
remaining balance of the deferred gain . In 1997 and 1996, the Company
recognized deferred gains totaling $6.9 million and $6.1 million, respectively,
as part of mortgage servicing revenue.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
5
<PAGE> 7
The following table summarizes the changes in the Company's mortgage loan
servicing portfolio, excluding loans sold but not transferred:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
(in millions)
Year ended December 31, 1997 1996 1995 1994 1993
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Servicing portfolio owned at
beginning of year $ 26,410 $ 27,792 $ 35,274 $ 38,403 $ 37,312
Mortgage loan production 4,403 3,831 2,852 4,586 11,452
Servicing acquisitions and other 36 2,789 4,674 3,707 6,368
- --------------------------------------------------------------------------------------------------------------------
Total servicing in 4,439 6,620 7,526 8,293 17,820
- --------------------------------------------------------------------------------------------------------------------
Regular payoffs 1,236 3,006 2,271 4,728 13,563
Sale of servicing 17,018 3,302 10,973 3,868 --
Principal amortization,
foreclosures and other 968 1,694 1,764 2,826 3,166
- --------------------------------------------------------------------------------------------------------------------
Total servicing out 19,222 8,002 15,008 11,422 16,729
- --------------------------------------------------------------------------------------------------------------------
Servicing portfolio owned 11,627 26,410 27,792 35,274 38,403
- --------------------------------------------------------------------------------------------------------------------
Subservicing portfolio 14,919 2,791 4,039 4,294 --
- --------------------------------------------------------------------------------------------------------------------
Balance at end of year $ 26,546 $ 29,201 $ 31,831 $ 39,568 $ 38,403
====================================================================================================================
</TABLE>
The Company closely monitors the rate of delinquencies and foreclosures
incident to its servicing portfolio. The following table summarizes the
Company's delinquency and foreclosure experience with respect to residential
mortgage loans serviced by the Company:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------
(% of total residential loans serviced
and subserviced)
December 31, 1997 1996 1995 1994 1993
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
31-59 days past due 4.77% 4.74% 3.99% 3.15% 3.41%
60-89 days past due .96 .95 .70 .54 .58
90 days or more past due .62 .55 .59 .38 .45
- ---------------------------------------------------------------------------------------------------------------------
Total delinquencies 6.35% 6.24% 5.28% 4.07% 4.44%
- ---------------------------------------------------------------------------------------------------------------------
Foreclosures 1.18% .93% .80% .77% .92%
- ---------------------------------------------------------------------------------------------------------------------
</TABLE>
The increase in delinquencies in 1997, 1996 and 1995, is primarily the result
of servicing portfolio acquisitions made by the Company during the fourth
quarters of 1996 and 1995. The delinquency rates of these portfolios, which the
Company acquired on favorable terms considered to be reflective of these higher
delinquency rates, were higher than the Company's historical average delinquency
rate. The Company has established an allowance for mortgage loan losses which
totaled $12.8 million and $15.4 million as of December 31, 1997 and 1996,
respectively. Excluding the allowance of $2.6 million included in the balance at
December 31, 1996 relating to a commercial real estate owned property the
Company sold during 1997, the allowance for losses on the Company's owned
servicing portfolio remained unchanged. In addition, the Company's valuation
allowance for its capitalized servicing asset which relates to its principal
recourse portfolio includes an $8.2 million and $7.3 million reserve at December
31, 1997 and 1996, respectively, for estimated losses on the corresponding
loans. Considering the significant decrease in the size of its owned servicing
portfolio during 1997, the Company believes that the allowances are adequate to
provide for estimated uninsured losses on its mortgage servicing portfolio.
The value of the Company's capitalized servicing asset is affected by changes
in mortgage interest rates. Interest rates directly influence prepayment rates
as well as other assumptions used in valuing the asset. In order to offset
changes in the value of its capitalized servicing asset and to mitigate the
effect on earnings of higher amortization and impairment which results from
increased prepayment activity, the Company invests in various financial
instruments. As interest rates decline, prepayment activity
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
6
<PAGE> 8
generally increases, thereby reducing the value of the capitalized servicing
asset, while the value of the financial instruments increases. Conversely, as
interest rates increase, the value of the capitalized servicing asset increases
while the value of such financial instruments decreases. The financial
instruments utilized by the Company include interest rate floor contracts
("floors") and principal-only ("P/O") swaps. With respect to the floors, the
Company is not exposed to losses in excess of its initial investment in the
floors. The Company's exposure to loss in the P/O swaps is related to changes in
the market value of the underlying P/O security over the life of the contract.
RELATED ACTIVITIES
In conjunction with its mortgage origination and servicing activities, the
Company provides certain credit-related insurance products (such as life,
disability, health, accidental death and property and casualty insurance)
through subsidiaries. The insurance subsidiaries act as agents and receive fees
based on premium value, but do not assume any insurance risk. Insurance products
are sold through (i) solicitation at the time of mortgage application, (ii)
direct mail solicitation shortly after mortgage loan closing, (iii) solicitation
by a direct solicitor and (iv) resolicitation of the Company's servicing
portfolio on an annual basis. At certain locations, personal solicitation by
Company staff is permitted by state regulations which determine allowable
insurance sales practices. The fees recognized under these programs were as
follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
(in thousands)
Year ended December 31, 1997 1996 1995 1994 1993
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Insurance revenue $ 4,240 $ 4,554 $ 4,762 $ 4,582 $ 5,039
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
CERTAIN BUSINESS CONDITIONS
Changes in the economy or prevailing interest rates can have significant
effects, including material adverse effects, on the mortgage banking business
and the Company.
Inflation and changes in interest rates can have differing effects on various
aspects of the Company's business, particularly with respect to marketing gains
and losses from the sale of mortgage loans, mortgage loan production, the value
of the Company's servicing portfolio and net interest revenue. Historically, the
Company's loan originations and loan production income have increased in
response to falling interest rates and have decreased during periods of rising
interest rates. Periods of low inflation and falling interest rates tend to
reduce loan servicing income and the value of the Company's mortgage loan
servicing portfolio because prepayments of mortgages increase and the average
life of loan servicing rights is shortened. Conversely, periods of increasing
inflation and rising interest rates tend to increase loan servicing income and
the value of the Company's mortgage loan servicing portfolio because prepayments
of mortgages decline and the average life of loan servicing rights is
lengthened. To mitigate the Company's exposure to changes in market interest
rates, the Company utilizes various derivative financial instruments. Refer to
"Note 23 to the Consolidated Financial Statements" on pages 33-37 of the
Company's 1997 Annual Report to Shareholders, herein incorporated by reference.
COMPETITION
The Company competes nationally and locally with other mortgage bankers, state
and national banks, thrift institutions and insurance companies. National banks
and thrift institutions have substantially more flexibility in their loan
origination programs than the Company, which must originate loans meeting the
standards of the secondary market. Mortgage lenders compete primarily with
respect to price and service. Competition may also occur on mortgage terms and
closing costs. The Company competes, in part, by using its commissioned sales
force to maintain close relationships with real estate brokers, builders,
developers and members of its correspondent and broker networks. In the opinion
of management, no single mortgage lender dominates the industry.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
7
<PAGE> 9
REGULATION
The Company is subject to the rules and regulations of, and examinations by,
investors and insurers, including, FNMA, FHLMC, GNMA, FHA and VA with respect to
originating, selling and servicing mortgage loans. Lenders are required to
submit audited financial statements annually and to maintain specified net worth
levels which vary depending on the amount of loans serviced and annual
production. Mortgage loan origination activities are also subject to fair
housing laws, the Equal Credit Opportunity Act, the Federal Truth-in-Lending
Act, the Real Estate Settlement Procedures Act, the Fair Credit Reporting Act,
licensing laws, usury laws, the Home Mortgage Disclosure Act and the regulations
promulgated thereunder which, among other things, prohibit discrimination in
residential lending and require the disclosure of certain information to
borrowers. There are various other state laws and regulations affecting the
Company's mortgage banking and insurance operations. The Company's internal
audit and quality control departments monitor compliance with these laws and
regulations.
EMPLOYEES
As of December 31, 1997, the Company employed approximately 1,572 persons (of
whom approximately 370 were engaged in loan servicing activities and
approximately 1,202 were engaged in residential loan production activities,
administrative and managerial responsibilities).
None of the Company's employees are covered by a collective bargaining
agreement. Management believes that the Company's employee relations are good.
FORWARD-LOOKING STATEMENTS
From time to time, the Company may publish forward-looking statements relating
to such matters as anticipated financial performance, business prospects, new
products and similar matters. Such information is often subject to risks and
uncertainties. The Private Securities Litigation Reform Act of 1995 provides a
safe harbor for forward-looking statements. In order to comply with the terms of
the safe harbor, the Company notes that a variety of factors could cause its
actual results and experience to differ materially from the anticipated results
or other expectations expressed in its forward-looking statements. The risks and
uncertainties that may affect the operations, performance, development and
results of the Company's business include those discussed elsewhere herein (such
as loan servicing, competition and regulation).
ITEM 2. PROPERTIES
The Company owns its principal executive offices in Farmington Hills, Michigan
which house the majority of the Company's employees. The Company leases several
other office facilities and operating equipment under cancelable and
noncancelable agreements. Most leases contain renewal clauses.
ITEM 3. LEGAL PROCEEDINGS
Various claims have been made against the Company in the ordinary course of
business. Management believes that any liabilities which could result from such
claims would not materially affect the Company's financial position and results
of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
8
<PAGE> 10
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Reported on page 4 of the Company's 1997 Annual Report to Shareholders, herein
incorporated by reference.
ITEM 6. SELECTED FINANCIAL DATA
Reported on pages 3-4 of the Company's 1997 Annual Report to Shareholders,
herein incorporated by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Reported on pages 5-14 of the Company's 1997 Annual Report to Shareholders,
herein incorporated by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statements reported in the consolidated financial statements of the
Company and the notes thereto and the report thereon of KPMG Peat Marwick LLP,
independent auditors, appearing on pages 15-45 of the Company's Annual Report to
Shareholders, herein incorporated by reference. Selected Quarterly Financial
Data reported on page 46 of the Company's 1997 Annual Report to Shareholders,
herein incorporated by reference. The report of Ernst & Young LLP, independent
auditors, included as Exhibit 13(b) hereto.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On January 24, 1997, the Company, upon recommendation of the Audit Committee
of the Board of Directors of its ultimate parent, Fund American Enterprises
Holdings, Inc., appointed KPMG Peat Marwick LLP as its independent auditors for
the fiscal year ending December 31, 1997, to replace Ernst & Young LLP ("Ernst &
Young") effective upon the date of Ernst & Young's report on the consolidated
financial statements of the Company for the year ended December 31, 1996.
In connection with the audits of the two years ended December 31, 1996, there
were no disagreements with Ernst & Young on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope and procedures
which, if not resolved to their satisfaction, would have caused them to make
reference in connection with their opinion to the subject matter of the
disagreement.
The Company has requested Ernst & Young to furnish a letter addressed to the
Commission stating whether it agrees with the above statements. A copy of that
letter, dated March 27, 1997, is filed as Exhibit 16 (a) hereto.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
9
<PAGE> 11
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Board of Directors
(as of March 27, 1998)
Director
Name Age Since
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Michael C. Allemang 55 1993
Raymond Barrette 47 1998
Terry L. Baxter 52 1994
Robert R. Densmore 49 1986
Mark A. Janssen 39 1997
Francis X. Mohan 58 1997
James H. Ozanne 54 1996
Roger K. Taylor 45 1995
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
Mr. Allemang has served as a director, Executive Vice President and Chief
Financial Officer of the Company since November 1993. He was a director and Vice
President of Fund American Enterprises, Inc. from August 1992 to December 1993.
Mr. Allemang was formerly Senior Vice President of Fireman's Fund Insurance
Company ("Fireman's Fund") from 1991 to 1992 and served as Vice President and
Treasurer of Fund American from 1989 to 1991 and Vice President of Fireman's
Fund from 1986 to 1991.
Mr. Barrette has served as a director of the Company since February 1998. He
has served as Executive Vice President and Chief Financial Officer of Fund
American Enterprises Holdings, Inc. since November 1997. He holds the same
positions with, and is a director of White Mountains Holdings, Inc. He is
also a director of White Mountains Insurance Company and Fund American
Enterprises, Inc. From 1994 to 1996, he was an actuarial consultant with
Tillinghast-Towers Perrin. He joined Fireman's Fund Insurance Company in 1973
and held various positions with that company, including Chief Actuary and Chief
Financial Officer. Prior to his departure in 1993, he was a Director and
Executive Vice President of Fireman's Fund Insurance Company and President of
its Personal Insurance Division.
Mr. Baxter has served as a director of the Company since 1994. He served
as Chairman of the Company from June 1996 to March 1997. He has served as
President of White Mountains Holdings, Inc. since February 1997 and President of
Fund American Enterprises, Inc. from January 1994 to February 1997. He was the
Managing Director of the National Transportation Safety Board from 1990 to 1993,
and prior to that was Senior Vice President of the National Bank of Washington.
Mr. Baxter previously served as Assistant Director of The Office of Management
and Budget under President Reagan and was a Vice President of GEICO Corporation.
Mr. Baxter is also a director of Fund American Enterprises, Inc., Centricut,
LLC., Main Street America Holdings, Inc., White Mountains Holdings, Inc. and
White Mountains Insurance Company.
Mr. Densmore has served as a director of the Company since 1986. He has
served as Executive Vice President of the Company's Servicing Division since
1987. He was the Chief Financial Officer from 1978 to 1987. Mr. Densmore joined
the Company in 1976.
Mr. Janssen has served as a director of the Company since November 1997. He
has served as Executive Vice President - Production and Capital Markets since
1997. He has also served as Executive Vice President of Capital Markets from
1996 to 1997, Senior Vice President of Finance from 1992 to 1996, Corporate Vice
President and Controller from 1991 to 1992 and Vice President of the Financial
Division from 1988 to 1992. Mr. Janssen joined the Company in 1981.
Mr. Mohan has served as a director of the Company since November 1997. He
assumed the position of President and Chief Executive Officer of the Company in
September of 1997. Mr. Mohan was with
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
10
<PAGE> 12
Beneficial Corporation from 1963 to 1997. He held various positions which
included District Manager, Operating Vice President, Senior Vice President
and President of several Beneficial subsidiaries.
Mr. Ozanne has served as a director of the Company since August 1996. He has
served as Chairman of the Company since March 1997 and as President of Fund
American Enterprises, Inc. since February 1997. He is the founder and principal
of Greenrange Partners. He was Chairman, President & Chief Executive Officer of
Nations Financial Holdings Corporation (formerly U S WEST Capital Corporation)
from 1989 to 1996. From 1983 to 1989 he was Executive Vice President, Asset
Management and Consumer Groups, of General Electric Capital Corporation
("GECC"), Stamford, Connecticut and held other executive positions with GECC. He
is currently a director of Financial Security Assurance Holdings Ltd.("FSA"), a
publicly-held financial guaranty insurer with securities listed on the New York
Stock Exchange.
Mr. Taylor has served as a director of the Company since August 1995. He has
served as President of FSA since November 1997 and its Chief Operating Officer
since May 1993. He is also a member of FSA's management review committee for
structured transactions and its underwriting committee for municipal
transactions. Prior to joining FSA in 1990 as an advisor for its new municipal
bond insurance business, Mr. Taylor was an Executive Vice President, founder and
executive committee member of Financial Guaranty Insurance Company. He is also a
director of FSA.
COMMITTEES OF THE BOARD OF DIRECTORS
The major committees of the Board of Directors, committee membership and the
functions of those committees are described below.
EXECUTIVE COMMITTEE. The members of the Executive Committee are: James H.
Ozanne (Chairman), Terry L. Baxter and Francis X. Mohan.
The Executive Committee has been delegated all of the powers and authority of
the Board on all but such matters which are reserved to the Board by the
Delaware General Corporate Law.
AUDIT COMMITTEE. The members of the Audit Committee are: Roger K. Taylor
(Chairman) and Raymond Barrette.
The Audit Committee exercises the powers of the Board in the management of the
business and affairs of the Company regarding the accounting, reporting and
financial control practices of the Company. It reviews the qualifications of the
independent certified public accountants, makes recommendations to the Board as
to their selection, reviews the plan, fees and results of their audit and
reviews their non-audit services and related fees.
HUMAN RESOURCES COMMITTEE. The members of the Human Resources Committee
are: Terry L. Baxter (Chairman), James H. Ozanne and Roger K. Taylor.
The Human Resources Committee establishes compensation for executive officers
of the Company.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
11
<PAGE> 13
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------
EXECUTIVE OFFICERS (as of March 27, 1998)
Executive
Officer
Name Age Position Since
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Michael C. Allemang 55 Executive Vice President 1993
and Chief Financial Officer
John A. Courson 55 Senior Vice President; 1990
President and Chief Executive Officer
of Central Pacific Mortgage Company
Robert R. Densmore 49 Executive Vice President 1983
Mark A. Janssen 39 Executive Vice President 1996
and Secretary
Francis X. Mohan 58 President and 1997
Chief Executive Officer
- ---------------------------------------------------------------------------------------------------------------
</TABLE>
Mr. Courson has served as a Senior Vice President of the Company and President
and Chief Executive Officer of Central Pacific Mortgage Company ("Central
Pacific"), a wholly-owned subsidiary of the Company, since July 1990. Prior to
that he was President and Chief Operating Officer of Fundamental Mortgage
Corporation of Dallas, Texas.
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the
Company's directors and executive officers, and persons who own more than 10% of
a registered class of the Company's equity securities, to file with the
Securities and Exchange Commission initial reports of ownership and reports of
changes in ownership of the Company's equity securities. Officers, directors and
greater than 10% stockholders are required by the Securities and Exchange
Commission regulation to furnish the Company with copies of all Section 16(a)
forms they file.
To the Company's knowledge, based solely on a review of the copies of such
reports furnished to the Company and written representations that no other
reports were required, all Section 16(a) filing requirements applicable to its
officers, directors and greater than 10% beneficial owners were complied with
during the year ended December 31, 1997, except for Messrs. Mark A. Janssen,
Francis X. Mohan and Roger K. Taylor, each of whom inadvertently failed to file
on a timely basis a Form 3. Each of them subsequently filed a Form 3.
ITEM 11. EXECUTIVE COMPENSATION
COMPENSATION OF EXECUTIVE OFFICERS
The following table sets forth certain information regarding the salary,
incentive compensation and benefits paid by the Company to its Chief Executive
Officer, its four most highly compensated executive officers other than the
Chief Executive Officer and its executive officer who retired during 1997
(collectively, the "Named Executive Officers") during each of the three most
recent fiscal years.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
12
<PAGE> 14
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------
Annual Compensation Long Term Compensation
Awards Payouts
Other Long-term All
Annual Incentive Other
Name and Compensation SARs Plan Compensation
Principal Position Year Salary Bonus (a) (#) Payouts (b)
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Francis X. Mohan 1997 $ 63,466 $ 300,000 $ - - $ - $ -
President and Chief
Executive Officer
Robert R. Densmore 1997 $ 184,079 $ 30,000 $ - - $ - $ 4,800
Executive Vice President 1996 178,196 64,000 1,468 - 7,500
1995 166,748 34,500 10,698 - - 4,500
Michael C. Allemang 1997 $ 178,049 $ 30,000 $ - - $ - $ 4,800
Executive Vice President and 1996 172,136 62,000 9,000 - 7,500
Chief Financial Officer 1995 163,847 27,000 12,000 - - 4,500
Mark A. Janssen 1997 $ 152,043 $ 140,000 $ - - $ - $ 4,800
Executive Vice President 1996 125,033 75,000 9,000 - - 7,352
and Secretary 1995 109,160 22,000 12,000 - - 4,025
John A. Courson 1997 $ 212,056 $ 110,988 $ 12,000 - $ - $ 4,800
Senior Vice President; 1996 187,044 138,496 12,570 - - 7,500
President and Chief 1995 187,044 87,512 14,945 - - 4,500
Executive Officer of Central
Pacific
James A. Conrad (retired) 1997 $ 194,129 $ 50,724 $ - - $ - $310,365 (c)
1996 237,936 110,000 7,481 - - 7,500
1995 222,627 38,000 40,034 - - 4,500
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
(a) Amounts shown for 1997 consist of the following: (i) Mr. Courson:
reimbursement of automobile expenses. Amounts shown for 1996 consist of the
following: (i) Mr. Densmore: reimbursement of automobile expenses; (ii) Mr.
Allemang: reimbursement of automobile expenses; (iii) Mr. Janssen: reimbursement
of automobile expenses; (iv) Mr. Courson: interest reimbursement of $570 on
amounts paid to purchase investment contracts and reimbursement of automobile
expenses; (v) Mr. Conrad: interest reimbursement of $2,309 on amounts paid to
purchase investment contracts and reimbursement of automobile expenses. Amounts
shown for 1995 consist of the following: (i) Mr. Densmore: reimbursement of
automobile expenses; (ii) Mr. Allemang: reimbursement of automobile expenses;
(iii) Mr. Janssen: reimbursement of automobile expenses; (iv) Mr. Courson:
interest reimbursement of $2,945 on amounts paid to purchase investment
contracts and reimbursement of automobile expenses; (v) Mr. Conrad: interest
reimbursement of $32,578 on amounts paid to purchase investment contracts and
reimbursement of automobile expenses.
(b) Represents amounts allocated pursuant to the Company's employee stock
ownership plan ("ESOP"), except for (c) below.
(c) In addition to (b) above, amount includes: (i) payment of $305,565 pursuant
to the Agreement between Mr. Conrad and the Company.
INVESTMENT CONTRACTS AND STOCK APPRECIATION RIGHTS
In 1993, certain directors and executive officers of the Company exchanged all
their shares of the Company's Class B common stock for 1.558 units in an
investment contract and 1.558 units of Stock Appreciation Rights ("SAR") for
each Class B share held. The investment contract entitles the holder to receive
the lesser of $86.625 or the closing price of Fund American's common stock on
the day preceding exercise of the investment contract, multiplied by a factor of
1.223 in cash for each unit held. The units may be exercised at any time at the
option of the holder.
The SARs may be exercised at any time simultaneously with each exercised
investment contract unit at the option of the holders thereof. The value of each
SAR is equal to the difference between $86.625 and the closing price of Fund
American's common stock on the date preceding the exercise of the SAR multiplied
by a factor of 1.223. The following table summarizes SAR values as of December
31, 1997.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
13
<PAGE> 15
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END
OPTION/SAR VALUES
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------
Number of Securities underlying Value of unexercised
unexercised in-the-money
SARs at fiscal year end (b) SARs at fiscal year-end (b)
Shares acquired Value --------------------------- ---------------------------
Name on exercise (a) realized Exercisable Unexercisable Exercisable Unexercisable
- ----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
James A. Conrad 4,000 $ 181,835 0 0 $ 0 $ 0
Robert R. Densmore 12,000 772,980 0 0 0 0
John A. Courson 0 0 871 0 53,545 0
- ----------------------------------------------------------------------------------------------------------------------
</TABLE>
(a) Represents the number of investment contract units with respect to which
the SARs were exercised.
(b) The number and value of unexercised SARs are based on shares of Fund
American common stock.
PENSION BENEFITS
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Years of Service
------------------------------------------------------------------------------------------
Remuneration 15 20 25 30 35
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$ 125,000 $ 30,000 $ 40,000 $ 50,000 $ 60,000 $ 70,000
150,000 36,000 48,000 60,000 72,000 84,000
175,000 42,000 56,000 70,000 84,000 98,000
200,000 48,000 64,000 80,000 96,000 112,000
225,000 54,000 72,000 90,000 108,000 126,000
250,000 60,000 80,000 100,000 120,000 140,000
300,000 72,000 96,000 120,000 144,000 168,000
400,000 96,000 128,000 160,000 192,000 224,000
450,000 108,000 144,000 180,000 216,000 252,000
500,000 120,000 160,000 200,000 240,000 280,000
===================================================================================================================
</TABLE>
The gross annual benefit paid is computed as a straight-life annuity reduced
by .485% of average salary up to covered compensation; that is, the average of
social security wage bases for the 35 years prior to retirement. The annual
benefits shown in the above table are not reduced to reflect the limitations
imposed by the Internal Revenue Code, which limit the annual benefits payable
from qualified plans to any individual. The Company maintains a Supplemental
Retirement Plan which is a non-qualified, unfunded deferred compensation plan.
Under the plan, certain highly compensated employees affected by these
limitations will receive additional retirement income payments from the Company
so that their pension benefits will equal the amounts they would otherwise have
been were it not for the limitations.
Messrs. Mohan, Densmore, Allemang, Janssen and Courson participate in
retirement plans under which they are entitled to receive estimated annual
retirement benefits in accordance with the table shown above.
Participants in the retirement plans are eligible to receive normal retirement
benefits at age 65, reduced normal retirement benefits if qualified for early
retirement or a deferred vested benefit if they terminate employment prior to
retirement but after five years of service. In the fourth quarter of 1997, the
Company's Board of Directors approved certain amendments to the Company's
pension plan. The approved amendments included the expansion of eligibility
requirements for early retirement from age 55 with ten years of service to the
earlier of age 55 with ten years of service or age 50 with fifteen years of
service for retirements beginning on or after January 1, 1997.
Eligible compensation for Messrs. Mohan, Densmore, Allemang, Janssen and
Courson includes base salary plus bonus received, but is limited to not more
than one and one-third of base salary in total. Benefits accrued under the
retirement plans are limited to eligible compensation of $160,000 for 1997 for
each of the Named Executive Officers.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
14
<PAGE> 16
Benefits under the retirement plans for a single person are computed on a
straight-life basis and benefits for a married person are generally computed on
a joint and 50% survivor basis, subject to each participant's right to elect
alternative survivor benefits. As of December 31, 1997, Messrs. Mohan, Densmore,
Allemang, Janssen and Courson had 0, 21, 4, 16 and 7 whole years of credited
service, respectively, for purposes of computing their benefits under the
retirement plans.
COMPENSATION OF DIRECTORS
Directors who are neither employees of the Company nor employees or directors
of Fund American (Mr. Taylor) receive an annual retainer of $10,000 (or in the
case of Messrs. Keller and Macklin, a pro rata amount for less than a full
year's service) and a fee of $1,500 for each board meeting attended. In
addition, the following amounts were paid during 1997: $8,750 to Mr. Ozanne
as a consultant to the Company prior to serving as Chairman of the Company,
$1,500 to Mr. Macklin as former Chairman of the Executive Committee, and
$25,000 to Mr. Baxter as a consultant to the Company.
EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS
In connection with the September 1997 retirement of James A. Conrad as
President and Chief Executive Officer of the Company and pursuant to a certain
agreement between him and the Company dated October 22, 1997, the Company agreed
to pay Mr. Conrad (who is currently 56 years of age) the following: (i) the
balance of his ESOP account and the portion of any contribution by the Company
to the ESOP which would have been allocated to this account had he retired as of
December 31, 1997; (ii) salary continuance of $20,371 per month through December
1998; (iii) his bonus under the Company's Executive Incentive Compensation Plan
for 1997 in accordance with established performance objectives; (iv) medical and
dental benefit coverage he would have received had he remained a full time
employee of the Company through December 31, 1998 and (v) pension benefits, to
commence on January 1, 1999, he would have received had he retired at age 62
(representing 19.9 years of credited service).
In connection with the employment of Mr. Mohan as President and Chief
Executive Officer of the Company, the Company and Mr. Mohan entered into an
employment agreement ("the Agreement"). The Agreement principally called for:
(i) Mr. Mohan to receive an annual base salary of $250,000; (ii) Mr. Mohan to
receive a bonus for 1997 equal to his base salary, provided he achieved specific
performance objectives; (iii) Mr. Mohan to receive additional payments of
$50,000 on November 1, 1997 and $200,000 on November 1, 1998 and 1999, provided
that he is an employee of the Company on those dates; (iv) Mr. Mohan to
participate in the Company's Long-Term Incentive Plan; (v) Mr. Mohan to
participate in an investment and option program; and (vi) in the event Mr. Mohan
is terminated without cause prior to December 31, 2000, Mr. Mohan to receive two
years of base salary and vest immediately in any options. Amounts relating to
1997 are included in the "Summary Compensation Table" on page 13.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Human Resources Committee of the Board of Directors establishes
compensation for executive officers of the Company. None of the members of the
Human Resources Committee, namely Terry L. Baxter, James H. Ozanne and Roger K.
Taylor, is, or was, an officer or employee of the Company or any of the
Company's subsidiaries.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
15
<PAGE> 17
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
As of March 27, 1998, there were two holders of the 3,211,881 shares of the
Company's issued and outstanding common stock, with each share entitled to one
vote, as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Title of Name and address of Number of Percent
Class beneficial owners shares owned of class
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Common stock White Mountains Holdings, Inc. 3,106,881 96.7%
80 South Main Street
Hanover, NH 03755
Fund American Enterprises Holdings, Inc. 105,000 3.3%
80 South Main Street
Hanover, NH 03755
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
The following table sets forth, as of March 27, 1998, beneficial ownership of
Fund American common stock by each director of the Company and each of the
current "Named Executive Officers" as defined herein.
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Title of Name of Number of Percent
Class beneficial owner shares owned (b) of class (c)
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Common stock (a) Michael C. Allemang 11 *
Raymond Barrette 1,585 *
Terry L. Baxter 140 *
John A. Courson - *
Robert R. Densmore - *
Mark A. Janssen - *
Francis X. Mohan - *
James H. Ozanne 640 *
Roger K. Taylor - *
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
* Represents less than 1% of the outstanding shares.
(a) Represents Fund American common stock pursuant to Item 403(b) of Regulation
S-K of the Securities Act of 1933.
(b) Except for Messrs. Barrette, Ozanne and Taylor, includes shares beneficially
owned by the Company's Employee Stock Ownership Plan and 401(k) Savings Plan
(whereby voting rights are exercised by the Plan's trustee and attributable
under the terms of the Plan to such person).
(c) Determined based on the beneficial ownership provisions specified in Rule
13d-3(d)(1) of the Exchange Act. Except to the extent indicated above, all
executive officers and directors have (or share with their spouses) sole voting
and investment power with respect to the shares for which they claim beneficial
ownership.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to the terms of a tax allocation agreement between the Company and
Fund American, Fund American has agreed to compensate the Company for the use of
certain accumulated unrealized losses associated with the Company's common
equity securities portfolio if such losses, when realized, can be utilized in
Fund American's consolidated tax returns.
During 1996, the Company sold $1.4 million of common equity securities to
White Mountains for cash proceeds of $.5 million. The Company recognized a $.9
million pretax loss from the sale.
In January 1997, the Company transferred $2.3 million of common equity
securities to White Mountains in exchange for 21,239 shares of the Company's
common stock held by White Mountains, which were retired by the Company. The
Company recognized a $.3 million pretax gain from the transfer in the first
quarter of 1997.
In March 1997, the Company issued 105,000 shares of its common stock to Fund
American for cash proceeds of $12.7 million. In addition, the Company issued
230,293 shares of its common stock to White
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
16
<PAGE> 18
Mountains in exchange for 1.0 million shares of the common stock of Financial
Security Assurance Holdings Ltd. ("FSA") valued at $27.8 million. The Company
issued an additional 650,827 shares of its common stock to White Mountains
effective in the second quarter of 1997 in exchange for 2.5 million shares of
FSA common stock, 2.0 million shares of FSA convertible redeemable preferred
stock and options to acquire 2.6 million shares of FSA common stock valued at
$78.5 million, net of associated tax liabilities and other adjustments.
In June 1997, the Company acquired an investment in U S WEST, Inc. ("U S
West") redeemable preferred stock from Fund American for cash proceeds of $49.3
million. The investment, which is classified as available for sale, is a fixed
maturity investment which is redeemable in September 2004 and may be redeemed at
the option of U S West beginning in September 1999. The discount on this
investment is being amortized over the anticipated life of the investment. The
carrying value of this investment, which approximates fair value, totaled $49.4
million as of December 31, 1997. The Company recognized income from this
investment of approximately $2.0 million in 1997.
During 1997, Mr. Conrad received $346,500 upon the exercise of 4,000
investment contract units, and Mr. Densmore received $1,039,500 upon the
exercise of 12,000 investment contract units. See discussion of "Investment
Contracts and Stock Appreciation Rights" on pages 13 and 14.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
17
<PAGE> 19
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
a. (1) Financial Statements
The Financial Statements applicable to Source One Mortgage
Services Corporation and consolidated subsidiaries have been
incorporated by reference herein from Source One Mortgage
Services Corporation's 1997 Annual Report to Shareholders as they
appear in the Index to Financial Statements and Financial
Statement Schedules appearing on page 20 of this Annual Report on
Form 10-K.
(2) Financial Statement Schedules
None.
(3) Exhibits
The exhibits required to be filed by Item 601 of Regulation S-K
and by this form are listed on page 22 of this Annual Report
on Form 10-K.
The management contracts and compensatory plans or arrangements
required to be filed as exhibits and included in such list of
exhibits are as follows:
Exhibit 10(a) Source One Mortgage Services Corporation Employee
Stock Ownership and 401(k) Savings Plan and Trust Agreement, as
amended and restated effective as of October 1, 1996
Exhibit 10(b) Form of Source One Mortgage Services Corporation
Voluntary Deferred Compensation Plan
Exhibit 10(c) First Amendment to Source One Mortgage Services
Corporation Voluntary Deferred Compensation Plan
Exhibit 10(d) Form of Source One Mortgage Services Corporation
Retirement Plan, as amended and restated
Exhibit 10(e) First Amendment to Source One Mortgage Services
Corporation Retirement Plan
Exhibit 10(f) Second Amendment to Source One Mortgage Services
Corporation Retirement Plan
Exhibit 10(g) Third Amendment to Source One Mortgage Services
Corporation Retirement Plan
Exhibit 10(h) Form of Source One Mortgage Services Corporation
Retirement Plan Trust Agreement
Exhibit 10(i) Source One Mortgage Services Corporation
Supplemental Retirement Plan
Exhibit 10(j) Source One Mortgage Services Corporation Stock
Appreciation Rights Plan
Exhibit 10(w) Investment Contract by and between Source One
Mortgage Services Corporation and James A. Conrad
Exhibit 10(x) Investment Contract by and between Source One
Mortgage Services Corporation and John A. Courson
Exhibit 10(y) Investment Contract by and between Source One
Mortgage Services Corporation and Robert R. Densmore
Exhibit 10(aa) Source One Mortgage Services Corporation Long Term
Incentive Plan
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
18
<PAGE> 20
Exhibit 10(ff) Incentive Agreement in the event of a sale of
Source One Mortgage Services Corporation among certain Senior
Officers of Source One Mortgage Services Corporation and Fund
American Enterprises, Inc.
Exhibit 10 (gg) Retirement Agreement dated June 5, 1996 between
Source One Mortgage Services Corporation and Robert W. Richards
Exhibit 10 (hh) Retirement Agreement dated October 22, 1997
between Source One Mortgage Services Corporation and James A.
Conrad
Exhibit 10 (jj) Employment Agreement by and between Source One
Mortgage Services Corporation and Francis X. Mohan
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
19
<PAGE> 21
Source One Mortgage Services Corporation and Subsidiaries
Index to Financial Statements and Financial Statement Schedules
(Item 14(a))
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------
Annual Report
page(s)*
- ----------------------------------------------------------------------------------------------------------------
<S> <C>
FINANCIAL STATEMENTS:
Consolidated statements of condition
as of December 31, 1997 and 1996..............................................................16
Consolidated statements of income for each of the
years ended December 31, 1997, 1996 and 1995..................................................17
Consolidated statements of comprehensive income for
each of the years ended December 31, 1997, 1996, and 1995.....................................18
Consolidated statements of stockholders' equity for each
of the years ended December 31, 1997, 1996 and 1995...........................................19
Consolidated statements of cash flows for each
of the years ended December 31, 1997, 1996 and 1995........................................20-21
Notes to consolidated financial statements...................................................22-45
OTHER FINANCIAL INFORMATION:
Report of independent auditors..................................................................15
Selected quarterly financial data (Unaudited) ..................................................46
- ----------------------------------------------------------------------------------------------------------------
</TABLE>
Schedules for which provision is made in Regulation S-X are not required under
the related instructions or are inapplicable and, therefore, have been omitted
or the information required is included in the consolidated financial statements
or notes thereto.
*Source One Mortgage Services Corporation's 1997 Annual Report to
Shareholders.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
20
<PAGE> 22
b. Reports on Form 8-K
The Company filed 7 reports on Form 8-K during the fourth quarter of 1997.
The dates and contents are described below:
October 23, 1997 Reported Distribution Date Statements for
October 25, November 1, November 1, and October 20, 1997
relating to the Source One Mortgage Services Corporation
Agency MBS Multi-Class Pass-Through Certificates Series
1987-2, 1988-1, 1988-2 and 1990-1, respectively
October 27, 1997 Reported Report to the Trustee and Report to the
Certificate Holders for the month of October 1997
relating to the Source One Mortgage Services Corporation
11 1/2% Mortgage Pass-Through Certificates, Series A
November 17, 1997 Third Amended and Restated Revolving Credit
Agreement dated as of July 25, 1997 by and among Source
One Mortgage Services Corporation, The Mortgage
Authority, Inc. and Central Pacific Mortgage Company
(subsidiaries of Source One Mortgage Services
Corporation), and the First National Bank of Chicago,
individually and as Administrative Agent and Certain
Other Lenders
Third Amended and Restated Security and Collateral Agency
Agreement dated as of July 25, 1997 by and among Source
One Mortgage Services Corporation, The Mortgage
Authority, Inc. and Central Pacific Mortgage Company
(subsidiaries of Source One Mortgage Services
Corporation), The First National Bank of Chicago (in its
capacity as administrative agent for the lenders) and
National City Bank, Kentucky, as collateral agent
November 25, 1997 Reported Distribution Date Statements for
November 25, December 1, December 1, and November 20,
1997 relating to the Source One Mortgage Services
Corporation Agency MBS Multi-Class Pass-Through
Certificates Series 1987-2, 1988-1, 1988-2 and 1990-1,
respectively
November 25, 1997 Reported Report to the Trustee and Report to the
Certificate Holders for the month of November 1997
relating to the Source One Mortgage Services Corporation
11 1/2% Mortgage Pass-Through Certificates, Series A
December 29, 1997 Reported Distribution Date Statements for
December 25, 1997, December 25, 1997, January 1, 1998,
January 1, 1998 and December 20, 1997 relating to the
Source One Mortgage Services Corporation Agency MBS
Multi-Class Pass-Through Certificates Series 1987-1,
1987-2, 1988-1, 1988-2 and 1990-1, respectively
December 29, 1997 Reported Report to the Trustee and Report to the
Certificate Holders for the month of December 1997
relating to the Source One Mortgage Services Corporation
11 1/2% Mortgage Pass-Through Certificates, Series A
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
21
<PAGE> 23
c. Exhibits
Exhibit No.
3(a) Restated Certificate of Incorporation of Source One Mortgage Services
Corporation (incorporated by reference to Exhibit 4(a) of the February
28, 1994 Current Report on Form 8-K, File No. 1-12898, formerly File
No. 33-8562)
(b) Certificate of Designation for Series A Preferred Stock of Source One
Mortgage Services Corporation (incorporated by reference to Exhibit
3(b) of the Annual Report on Form 10-K for the year ended December 31,
1993, File No. 1-12898)
(c) Amended and Restated Bylaws of Source One Mortgage Services Corporation
(incorporated by reference to Exhibit 4(d) of Amendment No. 1 to the
registration statement on Form S-3, Registration No. 33-71924)
4(a) Pooling and Servicing Agreement between Manufacturers Hanover Mortgage
Corporation (now "Source One Mortgage Services Corporation") and
National Bank of Detroit dated March 1, 1983 and relating to Mortgage
Pass-Through Certificates, Series A, 11 1/2% Pass-Through Rate
(incorporated by reference to Exhibit 4(a) of the Annual Report on Form
10-K for the year ended December 31, 1991, File No. 1-12898, formerly
File No. 33-8562)
(b) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated September 25, 1987 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1987-1 (incorporated by
reference to Exhibit 10(jj) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(c) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated January 28, 1988 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1987-2 (incorporated by
reference to Exhibit 10(kk) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(d) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated March 30, 1988 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1988-1 (incorporated by
reference to Exhibit 10(ll) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(e) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated June 28, 1988 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1988-2 (incorporated by
reference to Exhibit 10(mm) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(f) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated July 30, 1990 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1990-1 (incorporated by
reference to Exhibit 4(a) of the July 30, 1990 Current Report on Form
8-K, File No. 1-12898, formerly File No. 33-8562)
(g) Indenture between Fireman's Fund Mortgage Corporation (now "Source One
Mortgage Services Corporation") and National Bank of Detroit dated
September 15, 1986 (incorporated by reference to Exhibit 4(a) of the
registration statement on Form S-1, Registration No. 33-8562)
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
22
<PAGE> 24
(h) First Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and
National Bank of Detroit dated November 1, 1986 (incorporated by
reference to Exhibit 4(b) of the registration statement on Form S-1,
Registration No. 33-8562)
(i) Indenture between Fireman's Fund Mortgage Corporation (now "Source One
Mortgage Services Corporation") and The First National Bank of Chicago
dated November 21, 1988 (incorporated by reference to Exhibit 4(h) of
the Annual Report on Form 10-K for the year ended December 31, 1990,
File No. 1-12898, formerly File No. 33-8562)
(j) First Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and The
First National Bank of Chicago dated November 21, 1988 (incorporated by
reference to Exhibit 4(i) of the Annual Report on Form 10-K for the
year ended December 31, 1990, File No. 1-12898, formerly File No.
33-8562)
(k) Second Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and The
First National Bank of Chicago dated October 10, 1991 (incorporated by
reference to Exhibit 4(k) of the Annual Report on Form 10-K for the
year ended December 31, 1991, File No. 1-12898, formerly File No.
33-8562)
(l) Third Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and The
First National Bank of Chicago dated October 10, 1991 (incorporated by
reference to Exhibit 4(l) of the Annual Report on Form 10-K for the
year ended December 31, 1991, File No. 1-12898, formerly File No.
33-8562)
(m) Indenture between Source One Mortgage Services Corporation and The
First National Bank of Chicago dated May 7, 1992 (incorporated by
reference to Exhibit 19(a) of the Quarterly Report on Form 10-Q for the
quarter ended March 31, 1992, File No. 1-12898, formerly File No.
33-8562)
(n) Resolutions of the Chairman of the Board of Source One Mortgage
Services Corporation regarding the issuance of medium-term indebtedness
adopted pursuant to authority delegated by the Board of Directors of
Source One Mortgage Services Corporation (incorporated by reference to
Exhibit 19(b) of the Quarterly Report on Form 10-Q for the quarter
ended March 31, 1992, File No. 1-12898, formerly File No. 33-8562).
(Said resolutions establish the terms of the Medium-Term Notes, Series
B, of Source One Mortgage Services Corporation issuable under the
Indenture between Source One Mortgage Services Corporation and The
First National Bank of Chicago dated May 7, 1992)
(o) Resolutions of the Chairman of the Board of Source One Mortgage
Services Corporation regarding the issuance of a series of medium-term
notes, Series B, entitled "9% Debentures due June 1, 2012" adopted
pursuant to authority delegated by the Board of Directors of Source One
Mortgage Services Corporation (incorporated by reference to Exhibit (i)
of the Quarterly Report on Form 10-Q for the quarter ended June 30,
1992, File No. 1-12898, formerly File No. 33-8562). (Said resolutions
establish the terms of the 9% Debentures due June 1, 2012 of Source One
Mortgage Services Corporation issued under the Indenture between Source
One Mortgage Services Corporation and The First National Bank of
Chicago dated May 7, 1992)
(p) Indenture dated December 1, 1995 between Source One Mortgage Services
Corporation and IBJ Schroeder Bank & Trust Company, as trustee
(incorporated by reference to Exhibit (a)(1) of Amendment No. 4 to the
Report on Schedule 13E-4 filed with the Securities and Exchange
Commission on December 21, 1995)
(q) First Supplemental Indenture dated December 1, 1995 between Source One
Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company,
as trustee (incorporated by reference to Exhibit (a)(2) of Amendment
No. 4 to the Report on Schedule 13E-4 filed with the Securities and
Exchange Commission on December 21, 1995)
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
23
<PAGE> 25
(r) Form of 8.25% Debentures due 1996 (incorporated by reference to Exhibit
4(p) of the Annual Report on Form 10-K for the year ended December 31,
1992, File No. 1-12898, formerly File No. 33-8562)
(s) Form of Medium-Term Note, Series A (incorporated by reference to
Exhibit 4(q) of the Annual Report on Form 10-K for the year ended
December 31, 1992, File No. 1-12898, formerly File No. 33-8562)
(t) Form of 8.875% Notes due 2001 (incorporated by reference to Exhibit
4(r) of the Annual Report on Form 10-K for the year ended December 31,
1992, File No. 1-12898, formerly File No. 33-8562)
(u) Form of 9% Debentures due 2012 (incorporated by reference to Exhibit
4(s) of the Annual Report on Form 10-K for the year ended December 31,
1992, File No. 1-12898, formerly File No. 33-8562)
(v) Specimen Certificate for 8.42% Cumulative Preferred Stock, Series A, of
Source One Mortgage Services Corporation (incorporated by reference to
Exhibit 4(a) of the Quarterly Report on Form 10-Q for the quarter ended
September 30, 1994, File No. 1-12898)
(w) Form of 9.375% Quarterly Income Capital Securities (Subordinated
Interest Deferrable Debentures, Due 2025); included in the First
Supplemental Indenture dated December 1, 1995 between Source One
Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company,
as trustee (incorporated by reference to Exhibit (a)(2) of Amendment
No. 4 to the Report on Schedule 13E-4 filed with the Securities and
Exchange Commission on December 21, 1995)
10 Material Contracts
(a) Source One Mortgage Services Corporation Employee Stock Ownership and
401(k) Savings Plan and Trust Agreement (as amended and restated
effective as of October 1, 1996) (incorporated by reference to Exhibit
10(a) of the Annual Report on Form 10-K for the year ended December 31,
1996, File No. 1-12898)
(b) Form of Source One Mortgage Services Corporation Voluntary Deferred
Compensation Plan (incorporated by reference to Exhibit 10(e) of the
Annual Report on Form 10-K for the year ended December 31, 1993, File
No. 1-12898)
(c) First Amendment to Source One Mortgage Services Corporation Voluntary
Deferred Compensation Plan (incorporated by reference to Exhibit 10(g)
of the Annual Report on Form 10-K for the year ended December 31, 1994,
File No. 1-12898)
(d) Form of Source One Mortgage Services Corporation Retirement Plan, as
amended and restated (incorporated by reference to Exhibit 10(hh) of
the Annual Report on Form 10-K for the year ended December 31, 1990,
File No. 1-12898, formerly File No. 33-8562)
(e) First Amendment to Source One Mortgage Services Corporation Retirement
Plan (incorporated by reference to Exhibit 10(j) of the Annual Report
on Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(f) Second Amendment to Source One Mortgage Services Corporation Retirement
Plan (incorporated by reference to Exhibit 10(k) of the Annual Report
on Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(g) Third Amendment to Source One Mortgage Services Corporation Retirement
Plan (incorporated by reference to Exhibit 10(l) of the Annual Report
on Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(h) Form of Source One Mortgage Services Corporation Retirement Plan Trust
Agreement (incorporated by reference to Exhibit 10(d) of the
registration statement on Form S-1, Registration No. 33-8562)
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
24
<PAGE> 26
(i) Source One Mortgage Services Corporation Supplemental Retirement Plan
(incorporated by reference to Exhibit 10(n) of the Annual Report on
Form 10-K for the year ended December 31, 1989, File No. 1-12898,
formerly File No. 33-8562)
(j) Source One Mortgage Services Corporation Stock Appreciation Rights Plan
(incorporated by reference to Exhibit 10(c) of the Current Report on
Form 8-K dated November 11, 1993, File No. 1-12898, formerly File No.
33-8562)
(k) Third Amended and Restated Revolving Credit Agreement dated as of July
25, 1997 by and among Source One Mortgage Services Corporation, The
Mortgage Authority, Inc. and Central Pacific Mortgage Company
(subsidiaries of Source One Mortgage Services Corporation), and the
First National Bank of Chicago, individually and as Administrative
Agent and Certain Other Lenders (incorporated by reference to Exhibit
10(a) of the Current Report on Form 8-K dated November 17, 1997, File
No. 1-12898)
(l) Third Amended and Restated Security and Collateral Agency Agreement
dated as of July 25, 1997 by and among Source One Mortgage Services
Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage
Company (subsidiaries of Source One Mortgage Services Corporation), The
First National Bank of Chicago (in its capacity as administrative agent
for the lenders) and National City Bank, Kentucky, as collateral agent
(incorporated by reference to Exhibit 10(b) of the Current Report on
Form 8-K dated November 17, 1997, File No. 1-12898)
(m) Federal Tax Sharing Agreement dated as of January 1, 1991, and
effective for taxable years beginning after December 31, 1990, by and
among Fund American Enterprises Holdings, Inc. and Source One Mortgage
Services Corporation (incorporated by reference to Exhibit 10(m) of the
Annual Report on Form 10-K for the year ended December 31, 1996, File
No. 1-12898)
(n) Eurocommercial Paper Program Agreement dated August 1, 1988 among
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and the Dealers named therein (incorporated by reference
to Exhibit 10(bb) of the September 22, 1988 Current Report on Form 8-K,
File No. 1-12898, formerly File No. 33-8562)
(o) Commercial Paper Dealer Agreement dated September 25, 1986 between
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and Shearson Lehman Commercial Paper Inc. (incorporated
by reference to Exhibit 10(cc) of the September 22, 1988 Current Report
on Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(p) Commercial Paper Dealer Agreement dated September 23, 1986 between
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and First Boston Corporation (incorporated by reference
to Exhibit 10(dd) of the September 22, 1988 Current Report on Form 8-K,
File No. 1-12898, formerly File No. 33-8562)
(q) Issuing and Paying Agency Agreement dated June 19, 1987 between
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and Manufacturers Hanover Trust Company (incorporated by
reference to Exhibit 10(s) of the Annual Report on Form 10-K for the
year ended December 31, 1990, File No. 1-12898, formerly File No.
33-8562)
(r) Amendment dated June 20, 1992 to Issuing and Paying Agency Agreement
dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now
"Source One Mortgage Services Corporation") and Manufacturers Hanover
Trust Company (incorporated by reference to Exhibit 10(x) of the Annual
Report on Form 10-K for the year ended December 31, 1992, File No.
1-12898, formerly File No. 33-8562)
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
25
<PAGE> 27
(s) Amendment dated August 1, 1988 to Issuing and Paying Agency Agreement
dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now
"Source One Mortgage Services Corporation") and Manufacturers Hanover
Trust Company (incorporated by reference to Exhibit 10(t) of the Annual
Report on Form 10-K for the year ended December 31, 1990, File No.
1-12898, formerly File No. 33-8562)
(t) Letter of Representations dated November 23, 1990 relating to Issuing
and Paying Agency Agreement dated September 18, 1986 between Fireman's
Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and Morgan Guaranty Trust Company of New York
(incorporated by reference to Exhibit 10(v) of the Annual Report on
Form 10-K for the year ended December 31, 1991, File No. 1-12898,
formerly File No. 33-8562)
(u) Depository Agreement dated June 16, 1993 between Source One Mortgage
Services Corporation and The First National Bank of Chicago
(incorporated by reference to Exhibit 10(a) of the Current Report on
Form 8-K dated February 28, 1994, File No. 1-12898, formerly File No.
33-8562)
(v) Stock Purchase Agreement dated December 15, 1995, between Source One
Mortgage Services Corporation and Fund American Enterprises, Inc.
(incorporated by reference to Exhibit 10(bb) of the Annual Report on
Form 10-K for the year ended December 31, 1995, File No. 1-12898)
(w) Investment Contract by and between Source One Mortgage Services
Corporation and James A. Conrad (incorporated by reference to Exhibit
10(dd) of the Annual Report on Form 10-K for the year ended December
31, 1993, File No. 1-12898)
(x) Investment Contract by and between Source One Mortgage Services
Corporation and John A. Courson (incorporated by reference to Exhibit
10(ee) of the Annual Report on Form 10-K for the year ended December
31, 1993, File No. 1-12898)
(y) Investment Contract by and between Source One Mortgage Services
Corporation and Robert R. Densmore (incorporated by reference to
Exhibit 10(ff) of the Annual Report on Form 10-K for the year ended
December 31, 1993, File No. 1-12898)
(z) Investment Services Agreement dated November 13, 1991 between Source
One Mortgage Services Corporation and Fund American Enterprises, Inc.
(incorporated by reference to Exhibit 10(rr) of the Annual Report on
Form 10-K for the year ended December 31, 1991, File No. 1-12898,
formerly File No. 33-8562)
(aa) Source One Mortgage Services Corporation Long Term Incentive Plan
(incorporated by reference to Exhibit 10(ii) of the Annual Report on
Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(bb) Loan Agreement dated August 10, 1995 by and between Source One Mortgage
Services Corporation and Comerica Bank, as amended by an Amendment No.
1 to Loan Agreement dated 1995 and by an Amendment No. 2 to Loan
Agreement dated July 10, 1996 (incorporated by reference to Exhibit
10(bb) of the Annual Report on Form 10-K for the year ended December
31, 1996, File No. 1-12898)
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
26
<PAGE> 28
(cc) FNMA/FHLMC/GNMA Mortgage Servicing Purchase and Sale Agreement dated
February 28, 1997, by and between Source One Mortgage Services
Corporation and Chemical Mortgage Company (incorporated by reference to
Exhibit 10(dd) of the Annual Report on Form 10-K for the year ended
December 31, 1996, File No. 1-12898)
(dd) Mortgage Loan Interim Subservicing Agreement made as of March 1, 1997,
by and between Chemical Mortgage Company and Source One Mortgage
Services Corporation (incorporated by reference to Exhibit 10(ee) of the
Annual Report on Form 10-K for the year ended December 31, 1996, File
No. 1-12898)
(ee) Mortgage Loan Subservicing Agreement, by and between Chemical Mortgage
Company and Source One Mortgage Services Corporation (incorporated by
reference to Exhibit 10(ff) of the Annual Report on Form 10-K for the
year ended December 31, 1996, File No. 1-12898)
(ff) Incentive Agreement in the event of a sale of Source One Mortgage
Services Corporation among certain Senior Officers of Source One
Mortgage Services Corporation and Fund American Enterprises, Inc.
(incorporated by reference to Exhibit 10(ll) of the Annual Report on
Form 10-K for the year ended December 31, 1995, File No. 1-12898)
(gg) Retirement Agreement dated June 5, 1996 between Source One Mortgage
Services Corporation and Robert W. Richards (incorporated by reference
to Exhibit 10(hh) of the Annual Report on Form 10-K for the year ended
December 31, 1996, File No. 1-12898)
(hh) Retirement Agreement dated October 22, 1997 between Source One Mortgage
Services Corporation and James A. Conrad*
(ii) Mortgage Loan Subservicing Agreement Extension Amendment, by and
between Chemical Mortgage Company and Source One Mortgage Services
Corporation*
(jj) Employment Agreement by and between Source One Mortgage Services
Corporation and Francis X. Mohan*
13 Annual Report to Security Holders
(a) Source One Mortgage Services Corporation 1997 Annual Report to
Shareholders. Such report, except for those portions which are expressly
incorporated by reference in this Annual Report on Form 10-K, is
furnished only for the information of the Commission and is not deemed
filed as part hereof*
(b) Audit opinion of Ernst & Young LLP*
16 (a) Letter of Ernst & Young LLP dated March 27, 1997 (incorporated by
reference to Exhibit 16(a) of the Annual Report on Form 10-K for the
year ended December 31, 1996, File No. 1-12898)
21 Subsidiaries of Source One Mortgage Services Corporation (incorporated
by reference to Exhibit 21 of the Annual Report on Form 10-K for the
year ended December 31, 1996, File No. 1-12898)
23 Consents of experts
(a) Consent of KPMG Peat Marwick LLP*
(b) Consent of Ernst & Young LLP*
(c) Consent of Coopers & Lybrand L.L.P. dated March 27, 1998 relating to
Financial Security Assurance Holdings Ltd.*
24 Powers of Attorney*
27 Financial Data Schedule*
99 The Consolidated Financial Statements of Financial Security
Assurance Holdings Ltd. and the related Report of Independent
Accountants as of December 31, 1997 and 1996 and for each of the three
years in the period ended December 31, 1997*
* Filed herewith
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
27
<PAGE> 29
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Source One Mortgage Services Corporation
Date: March 27, 1998 By: /s/ MICHAEL C. ALLEMANG
-----------------------
Michael C. Allemang
Executive Vice President,
Chief Financial Officer and
Director
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
*
- -----------------------
James H. Ozanne Chairman and Director March 27, 1998
President, Chief Executive Officer and
* Director (Principal Executive Officer) March 27, 1998
- -----------------------
Francis X. Mohan
Executive Vice President, Chief Financial
Officer and Director (Principal Financial
/s/MICHAEL C. ALLEMANG Officer and Principal Accounting Officer) March 27, 1998
- -----------------------
Michael C. Allemang
* Executive Vice President - Servicing and March 27, 1998
- ----------------------- Director
Robert R. Densmore
Executive Vice President, Production &
* Capital Markets, Secretary and Director March 27, 1998
- -----------------------
Mark A. Janssen
* Director March 27, 1998
- -----------------------
Terry L. Baxter
* Director March 27, 1998
- -----------------------
Raymond Barrette
* Director March 27, 1998
- -----------------------
Robert K. Taylor
*By: /s/MICHAEL C. ALLEMANG
Michael C. Allemang
As Attorney-in-fact for the persons indicated
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
Supplemental Information to be Furnished with Reports Filed Pursuant to
Section 15(d) of the Act by Registrants Which Have Not Registered Securities
Pursuant to Section 12 of the Act.
The Company does not have any voting securities registered under Section 12 of
the Act, and all of the Company's voting securities are held by two entities.
Accordingly, no proxy statement, form of proxy or other proxy soliciting
material has been, or will be, sent to more than 10 of the registrant's security
holders with respect to any annual or other meeting of security holders.
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
28
<PAGE> 30
EXHIBIT INDEX
Exhibit
No. Description
3(a) Restated Certificate of Incorporation of Source One Mortgage Services
Corporation (incorporated by reference to Exhibit 4(a) of the February
28, 1994 Current Report on Form 8-K, File No. 1-12898, formerly File
No. 33-8562)
(b) Certificate of Designation for Series A Preferred Stock of Source One
Mortgage Services Corporation (incorporated by reference to Exhibit
3(b) of the Annual Report on Form 10-K for the year ended December 31,
1993, File No. 1-12898)
(c) Amended and Restated Bylaws of Source One Mortgage Services Corporation
(incorporated by reference to Exhibit 4(d) of Amendment No. 1 to the
registration statement on Form S-3, Registration No. 33-71924)
4(a) Pooling and Servicing Agreement between Manufacturers Hanover Mortgage
Corporation (now "Source One Mortgage Services Corporation") and
National Bank of Detroit dated March 1, 1983 and relating to Mortgage
Pass-Through Certificates, Series A, 11 1/2% Pass-Through Rate
(incorporated by reference to Exhibit 4(a) of the Annual Report on Form
10-K for the year ended December 31, 1991, File No. 1-12898, formerly
File No. 33-8562)
(b) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated September 25, 1987 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1987-1 (incorporated by
reference to Exhibit 10(jj) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(c) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated January 28, 1988 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1987-2 (incorporated by
reference to Exhibit 10(kk) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(d) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated March 30, 1988 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1988-1 (incorporated by
reference to Exhibit 10(ll) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(e) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated June 28, 1988 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1988-2 (incorporated by
reference to Exhibit 10(mm) of the September 22, 1988 Current Report on
Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(f) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation
(now "Source One Mortgage Services Corporation") and the First National
Bank of Chicago dated July 30, 1990 and relating to Agency MBS
Multi-Class Pass-Through Certificates, Series 1990-1 (incorporated by
reference to Exhibit 4(a) of the July 30, 1990 Current Report on Form
8-K, File No. 1-12898, formerly File No. 33-8562)
(g) Indenture between Fireman's Fund Mortgage Corporation (now "Source One
Mortgage Services Corporation") and National Bank of Detroit dated
September 15, 1986 (incorporated by reference to Exhibit 4(a) of the
registration statement on Form S-1, Registration No. 33-8562)
<PAGE> 31
Exhibit
No. Description
(h) First Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and
National Bank of Detroit dated November 1, 1986 (incorporated by
reference to Exhibit 4(b) of the registration statement on Form S-1,
Registration No. 33-8562)
(i) Indenture between Fireman's Fund Mortgage Corporation (now "Source One
Mortgage Services Corporation") and The First National Bank of Chicago
dated November 21, 1988 (incorporated by reference to Exhibit 4(h) of
the Annual Report on Form 10-K for the year ended December 31, 1990,
File No. 1-12898, formerly File No. 33-8562)
(j) First Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and The
First National Bank of Chicago dated November 21, 1988 (incorporated by
reference to Exhibit 4(i) of the Annual Report on Form 10-K for the
year ended December 31, 1990, File No. 1-12898, formerly File No.
33-8562)
(k) Second Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and The
First National Bank of Chicago dated October 10, 1991 (incorporated by
reference to Exhibit 4(k) of the Annual Report on Form 10-K for the
year ended December 31, 1991, File No. 1-12898, formerly File No.
33-8562)
(l) Third Supplemental Indenture between Fireman's Fund Mortgage
Corporation (now "Source One Mortgage Services Corporation") and The
First National Bank of Chicago dated October 10, 1991 (incorporated by
reference to Exhibit 4(l) of the Annual Report on Form 10-K for the
year ended December 31, 1991, File No. 1-12898, formerly File No.
33-8562)
(m) Indenture between Source One Mortgage Services Corporation and The
First National Bank of Chicago dated May 7, 1992 (incorporated by
reference to Exhibit 19(a) of the Quarterly Report on Form 10-Q for the
quarter ended March 31, 1992, File No. 1-12898, formerly File No.
33-8562)
(n) Resolutions of the Chairman of the Board of Source One Mortgage
Services Corporation regarding the issuance of medium-term indebtedness
adopted pursuant to authority delegated by the Board of Directors of
Source One Mortgage Services Corporation (incorporated by reference to
Exhibit 19(b) of the Quarterly Report on Form 10-Q for the quarter
ended March 31, 1992, File No. 1-12898, formerly File No. 33-8562).
(Said resolutions establish the terms of the Medium-Term Notes, Series
B, of Source One Mortgage Services Corporation issuable under the
Indenture between Source One Mortgage Services Corporation and The
First National Bank of Chicago dated May 7, 1992)
(o) Resolutions of the Chairman of the Board of Source One Mortgage
Services Corporation regarding the issuance of a series of medium-term
notes, Series B, entitled "9% Debentures due June 1, 2012" adopted
pursuant to authority delegated by the Board of Directors of Source One
Mortgage Services Corporation (incorporated by reference to Exhibit (i)
of the Quarterly Report on Form 10-Q for the quarter ended June 30,
1992, File No. 1-12898, formerly File No. 33-8562). (Said resolutions
establish the terms of the 9% Debentures due June 1, 2012 of Source One
Mortgage Services Corporation issued under the Indenture between Source
One Mortgage Services Corporation and The First National Bank of
Chicago dated May 7, 1992)
(p) Indenture dated December 1, 1995 between Source One Mortgage Services
Corporation and IBJ Schroeder Bank & Trust Company, as trustee
(incorporated by reference to Exhibit (a)(1) of Amendment No. 4 to the
Report on Schedule 13E-4 filed with the Securities and Exchange
Commission on December 21, 1995)
(q) First Supplemental Indenture dated December 1, 1995 between Source One
Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company,
as trustee (incorporated by reference to Exhibit (a)(2) of Amendment
No. 4 to the Report on Schedule 13E-4 filed with the Securities and
Exchange Commission on December 21, 1995)
<PAGE> 32
Exhibit
No. Description
(r) Form of 8.25% Debentures due 1996 (incorporated by reference to Exhibit
4(p) of the Annual Report on Form 10-K for the year ended December 31,
1992, File No. 1-12898, formerly File No. 33-8562)
(s) Form of Medium-Term Note, Series A (incorporated by reference to
Exhibit 4(q) of the Annual Report on Form 10-K for the year ended
December 31, 1992, File No. 1-12898, formerly File No. 33-8562)
(t) Form of 8.875% Notes due 2001 (incorporated by reference to Exhibit
4(r) of the Annual Report on Form 10-K for the year ended December 31,
1992, File No. 1-12898, formerly File No. 33-8562)
(u) Form of 9% Debentures due 2012 (incorporated by reference to Exhibit
4(s) of the Annual Report on Form 10-K for the year ended December 31,
1992, File No. 1-12898, formerly File No. 33-8562)
(v) Specimen Certificate for 8.42% Cumulative Preferred Stock, Series A, of
Source One Mortgage Services Corporation (incorporated by reference to
Exhibit 4(a) of the Quarterly Report on Form 10-Q for the quarter ended
September 30, 1994, File No. 1-12898)
(w) Form of 9.375% Quarterly Income Capital Securities (Subordinated
Interest Deferrable Debentures, Due 2025); included in the First
Supplemental Indenture dated December 1, 1995 between Source One
Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company,
as trustee (incorporated by reference to Exhibit (a)(2) of Amendment
No. 4 to the Report on Schedule 13E-4 filed with the Securities and
Exchange Commission on December 21, 1995)
10 Material Contracts
(a) Source One Mortgage Services Corporation Employee Stock Ownership and
401(k) Savings Plan and Trust Agreement (as amended and restated
effective as of October 1, 1996) (incorporated by reference to Exhibit
10(a) of the Annual Report on Form 10-K for the year ended December 31,
1996, File No. 1-12898)
(b) Form of Source One Mortgage Services Corporation Voluntary Deferred
Compensation Plan (incorporated by reference to Exhibit 10(e) of the
Annual Report on Form 10-K for the year ended December 31, 1993, File
No. 1-12898)
(c) First Amendment to Source One Mortgage Services Corporation Voluntary
Deferred Compensation Plan (incorporated by reference to Exhibit 10(g)
of the Annual Report on Form 10-K for the year ended December 31, 1994,
File No. 1-12898)
(d) Form of Source One Mortgage Services Corporation Retirement Plan, as
amended and restated (incorporated by reference to Exhibit 10(hh) of
the Annual Report on Form 10-K for the year ended December 31, 1990,
File No. 1-12898, formerly File No. 33-8562)
(e) First Amendment to Source One Mortgage Services Corporation Retirement
Plan (incorporated by reference to Exhibit 10(j) of the Annual Report
on Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(f) Second Amendment to Source One Mortgage Services Corporation Retirement
Plan (incorporated by reference to Exhibit 10(k) of the Annual Report
on Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(g) Third Amendment to Source One Mortgage Services Corporation Retirement
Plan (incorporated by reference to Exhibit 10(l) of the Annual Report
on Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(h) Form of Source One Mortgage Services Corporation Retirement Plan Trust
Agreement (incorporated by reference to Exhibit 10(d) of the
registration statement on Form S-1, Registration No. 33-8562)
<PAGE> 33
Exhibit
No. Description
(i) Source One Mortgage Services Corporation Supplemental Retirement Plan
(incorporated by reference to Exhibit 10(n) of the Annual Report on
Form 10-K for the year ended December 31, 1989, File No. 1-12898,
formerly File No. 33-8562)
(j) Source One Mortgage Services Corporation Stock Appreciation Rights Plan
(incorporated by reference to Exhibit 10(c) of the Current Report on
Form 8-K dated November 11, 1993, File No. 1-12898, formerly File No.
33-8562)
(k) Third Amended and Restated Revolving Credit Agreement dated as of July
25, 1997 by and among Source One Mortgage Services Corporation, The
Mortgage Authority, Inc. and Central Pacific Mortgage Company
(subsidiaries of Source One Mortgage Services Corporation), and the
First National Bank of Chicago, individually and as Administrative
Agent and Certain Other Lenders (incorporated by reference to Exhibit
10(a) of the Current Report on Form 8-K dated November 17, 1997,
File No. 1-12898)
(l) Third Amended and Restated Security and Collateral Agency Agreement
dated as of July 25, 1997 by and among Source One Mortgage Services
Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage
Company (subsidiaries of Source One Mortgage Services Corporation), The
First National Bank of Chicago (in its capacity as administrative agent
for the lenders) and National City Bank, Kentucky, as collateral agent
(incorporated by reference to Exhibit 10(b) of the Current Report on
Form 8-K dated November 17, 1997, File No. 1-12898)
(m) Federal Tax Sharing Agreement dated as of January 1, 1991, and
effective for taxable years beginning after December 31, 1990, by and
among Fund American Enterprises Holdings, Inc. and Source One Mortgage
Services Corporation (incorporated by reference to Exhibit 10(m) of the
Annual Report on Form 10-K for the year ended December 31, 1996, File
No. 1-12898)
(n) Eurocommercial Paper Program Agreement dated August 1, 1988 among
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and the Dealers named therein (incorporated by reference
to Exhibit 10(bb) of the September 22, 1988 Current Report on Form 8-K,
File No. 1-12898, formerly File No. 33-8562)
(o) Commercial Paper Dealer Agreement dated September 25, 1986 between
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and Shearson Lehman Commercial Paper Inc. (incorporated
by reference to Exhibit 10(cc) of the September 22, 1988 Current Report
on Form 8-K, File No. 1-12898, formerly File No. 33-8562)
(p) Commercial Paper Dealer Agreement dated September 23, 1986 between
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and First Boston Corporation (incorporated by reference
to Exhibit 10(dd) of the September 22, 1988 Current Report on Form 8-K,
File No. 1-12898, formerly File No. 33-8562)
(q) Issuing and Paying Agency Agreement dated June 19, 1987 between
Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and Manufacturers Hanover Trust Company (incorporated by
reference to Exhibit 10(s) of the Annual Report on Form 10-K for the
year ended December 31, 1990, File No. 1-12898, formerly File No.
33-8562)
(r) Amendment dated June 20, 1992 to Issuing and Paying Agency Agreement
dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now
"Source One Mortgage Services Corporation") and Manufacturers Hanover
Trust Company (incorporated by reference to Exhibit 10(x) of the Annual
Report on Form 10-K for the year ended December 31, 1992, File No.
1-12898, formerly File No. 33-8562)
<PAGE> 34
Exhibit
No. Description
(s) Amendment dated August 1, 1988 to Issuing and Paying Agency Agreement
dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now
"Source One Mortgage Services Corporation") and Manufacturers Hanover
Trust Company (incorporated by reference to Exhibit 10(t) of the Annual
Report on Form 10-K for the year ended December 31, 1990, File No.
1-12898, formerly File No. 33-8562)
(t) Letter of Representations dated November 23, 1990 relating to Issuing
and Paying Agency Agreement dated September 18, 1986 between Fireman's
Fund Mortgage Corporation (now "Source One Mortgage Services
Corporation") and Morgan Guaranty Trust Company of New York
(incorporated by reference to Exhibit 10(v) of the Annual Report on
Form 10-K for the year ended December 31, 1991, File No. 1-12898,
formerly File No. 33-8562)
(u) Depository Agreement dated June 16, 1993 between Source One Mortgage
Services Corporation and The First National Bank of Chicago
(incorporated by reference to Exhibit 10(a) of the Current Report on
Form 8-K dated February 28, 1994, File No. 1-12898, formerly File No.
33-8562)
(v) Stock Purchase Agreement dated December 15, 1995, between Source One
Mortgage Services Corporation and Fund American Enterprises, Inc.
(incorporated by reference to Exhibit 10(bb) of the Annual Report on
Form 10-K for the year ended December 31, 1995, File No. 1-12898)
(w) Investment Contract by and between Source One Mortgage Services
Corporation and James A. Conrad (incorporated by reference to Exhibit
10(dd) of the Annual Report on Form 10-K for the year ended December
31, 1993, File No. 1-12898)
(x) Investment Contract by and between Source One Mortgage Services
Corporation and John A. Courson (incorporated by reference to Exhibit
10(ee) of the Annual Report on Form 10-K for the year ended December
31, 1993, File No. 1-12898)
(y) Investment Contract by and between Source One Mortgage Services
Corporation and Robert R. Densmore (incorporated by reference to
Exhibit 10(ff) of the Annual Report on Form 10-K for the year ended
December 31, 1993, File No. 1-12898)
(z) Investment Services Agreement dated November 13, 1991 between Source
One Mortgage Services Corporation and Fund American Enterprises, Inc.
(incorporated by reference to Exhibit 10(rr) of the Annual Report on
Form 10-K for the year ended December 31, 1991, File No. 1-12898,
formerly File No. 33-8562)
(aa) Source One Mortgage Services Corporation Long Term Incentive Plan
(incorporated by reference to Exhibit 10(ii) of the Annual Report on
Form 10-K for the year ended December 31, 1994, File No. 1-12898)
(bb) Loan Agreement dated August 10, 1995 by and between Source One Mortgage
Services Corporation and Comerica Bank, as amended by an Amendment No.
1 to Loan Agreement dated 1995 and by an Amendment No. 2 to Loan
Agreement dated July 10, 1996 (incorporated by reference to Exhibit
10(bb) of the Annual Report on Form 10-K for the year ended December
31, 1996, File No. 1-12898)
<PAGE> 35
Exhibit
No. Description
(cc) FNMA/FHLMC/GNMA Mortgage Servicing Purchase and Sale Agreement dated
February 28, 1997, by and between Source One Mortgage Services
Corporation and Chemical Mortgage Company (incorporated by reference to
Exhibit 10(dd) of the Annual Report on Form 10-K for the year ended
December 31, 1996, File No. 1-12898)
(dd) Mortgage Loan Interim Subservicing Agreement made as of March 1, 1997,
by and between Chemical Mortgage Company and Source One Mortgage
Services Corporation (incorporated by reference to Exhibit 10(ee) of the
Annual Report on Form 10-K for the year ended December 31, 1996, File
No. 1-12898)
(ee) Mortgage Loan Subservicing Agreement, by and between Chemical Mortgage
Company and Source One Mortgage Services Corporation (incorporated by
reference to Exhibit 10(ff) of the Annual Report on Form 10-K for the
year ended December 31, 1996, File No. 1-12898)
(ff) Incentive Agreement in the event of a sale of Source One Mortgage
Services Corporation among certain Senior Officers of Source One
Mortgage Services Corporation and Fund American Enterprises, Inc.
(incorporated by reference to Exhibit 10(ll) of the Annual Report on
Form 10-K for the year ended December 31, 1995, File No. 1-12898)
(gg) Retirement Agreement dated June 5, 1996 between Source One Mortgage
Services Corporation and Robert W. Richards (incorporated by reference
to Exhibit 10(hh) of the Annual Report on Form 10-K for the year ended
December 31, 1996, File No. 1-12898)
(hh) Retirement Agreement dated October 22, 1997 between Source One Mortgage
Services Corporation and James A. Conrad*
(ii) Mortgage Loan Subservicing Agreement Extension Amendment, by and
between Chemical Mortgage Company and Source One Mortgage Services
Corporation*
(jj) Employment Agreement by and between Source One Mortgage Services
Corporation and Francis X. Mohan*
13 Annual Report to Security Holders
(a) Source One Mortgage Services Corporation 1997 Annual Report to
Shareholders. Such report, except for those portions which are expressly
incorporated by reference in this Annual Report on Form 10-K, is
furnished only for the information of the Commission and is not deemed
filed as part hereof*
(b) Audit opinion of Ernst & Young LLP*
16 (a) Letter of Ernst & Young LLP dated March 27, 1997 (incorporated by
reference to Exhibit 16(a) of the Annual Report on Form 10-K for the
year ended December 31, 1996, File No. 1-12898)
21 Subsidiaries of Source One Mortgage Services Corporation (incorporated
by reference to Exhibit 21 of the Annual Report on Form 10-K for the
year ended December 31, 1996, File No. 1-12898)
23 Consents of experts
(a) Consent of KPMG Peat Marwick LLP*
(b) Consent of Ernst & Young LLP*
(c) Consent of Coopers & Lybrand L.L.P. dated March 27, 1998 relating to
Financial Security Assurance Holdings Ltd.*
24 Powers of Attorney*
27 Financial Data Schedule*
99 The Consolidated Financial Statements of Financial Security
Assurance Holdings Ltd. and the related Report of Independent
Accountants as of December 31, 1997 and 1996 and for each of the three
years in the period ended December 31, 1997*
* Filed herewith
Source One Mortgage Services Corporation and Subsidiaries Form 10-K
<PAGE> 1
EXHIBIT 10 (hh)
RELEASE AND TERMINATION AGREEMENT
For value received, Source One Mortgage Services Corporation ("Source
One"), a Delaware corporation, and James A. Conrad ("Conrad"), mutually agree as
follows:
1. Resignation and Termination. Conrad hereby resigns from all positions
which he now holds with Source One and any subsidiary or other related or
affiliated corporation or other affiliated entity, including but not limited to
his positions as a director, officer, committee member, and employee of Source
One, effective as of the close of September 30, 1997 (the "Termination Date").
Moreover, all employment and other agreements, contracts, commitments and
understandings between Source One and Conrad, whether written, oral or
otherwise, other than this Agreement, are hereby terminated, ended and void as
of the Termination Date.
2. Consideration. In consideration of the release, covenant not to sue, and
other promises made by Conrad in paragraphs 4, 5, 6, 7, 8, 9, 10 and 11 of this
Agreement, and in full accord, satisfaction and discharge of any and all
obligations, agreements, contracts, commitments, understandings, or otherwise,
Source One agrees:
(a) to make supplemental payments (subject to applicable taxes and
withholding) to Conrad and his spouse, if she survives him, (in
addition to
<PAGE> 2
any amounts which Conrad and his spouse are entitled to receive
under the Source One Mortgage Services Corporation Retirement Plan
(the "Retirement Plan") and the related Source One Mortgage Services
Corporation Supplemental Retirement Plan (the "SRP")) commencing
January 1, 1999 (the "Early Retirement Date") in the amount of
$3,342.16 per month to Conrad for his lifetime and in the amount of
$1,671.08 per month to his spouse, if she survives him, for her
lifetime, provided, however, that Source One shall make such payments
only if Conrad elects under Article IV, Section 2(a), of the
Retirement Plan to have his Early Retirement Benefit (as defined in
the Retirement Plan) commence on the Early Retirement Date.
Notwithstanding the foregoing, if instead of the automatic qualified
joint and survivor annuity under Article IV, Section 6(d), of the
Retirement Plan Conrad should elect under Article IV, Section 6(b) of
such plan an optional form of benefit actuarially equivalent
to the lifetime annuity payable to him under such plan, the
supplemental payments to Conrad and his spouse, if she survives him,
under this Agreement shall be paid in the same manner and form as
such optional
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<PAGE> 3
form of benefit under the Retirement Plan, and the amounts of such
supplemental payments shall be adjusted so that they are
actuarially equivalent to the supplemental payments to Conrad for his
lifetime (not including the supplemental payments to his spouse, if
she survives him) described in the first sentence of this paragraph
(a). Actuarial equivalence shall be determined in the same manner it
is determined under the Retirement Plan. If Conrad should die before
the Early Retirement Date, Source One will make supplemental payments
to his spouse, if she survives him, and is living on the Early
Retirement Date, (in addition to any amounts which she is entitled to
receive under the Retirement Plan and SRP) commencing on the Early
Retirement Date in the amount of $1,671.08 per month for her
lifetime.
(b) To continue Conrad's regular salary through December 31, 1998.
(c) To continue to provide to Conrad the same life insurance,
medical/hospital coverage and dental coverage that he would be
entitled to had he remained a full time employee of Source One through
December 31, 1998.
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<PAGE> 4
(d) To continue Conrad's eligibility for a bonus under Source One's
Executive Incentive Compensation Plan for 1997 in accordance with the
performance objectives established by Source One's Board of Directors
on or about August 21, 1997.
(e) To pay Conrad, if Source One makes a contribution to the ESOP portion
of the Source One Mortgage Services Corporation Employee Stock
Ownership and 401(k) Plan for 1997, the excess of (i) the amount which
would have been allocated to his account under the ESOP portion of
such plan had he continued in employment with Source One at the rate
of annual salary being paid to him on the Termination Date over (ii)
the actual amount allocated to his account under the ESOP portion of
such plan for 1997.
(f) To treat Conrad as having attained the age of 60 years or more on
September 30, 1997 for purposes of the agreement dated July 1, 1992
between Conrad and Source One relating to a membership in the Oakland
Hills Country Club with the result that (i) paragraph 8 of such
agreement shall apply, (ii) Source One will transfer all of its right,
title and interest in, to and with respect to the Oakland Hills
Country Club membership to Conrad as of September 30, 1997, and (iii)
as of September 30, 1997 such membership shall be
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<PAGE> 5
deemed to be the sole and exclusive property of Conrad and the
agreement dated July 1, 1992 shall terminate and be of no further
force or effect. Conrad will be responsible for all expenses incurred
by him in connection with such membership after September 30, 1997.
It is understood and agreed that the foregoing payments and benefits are
good and valuable consideration for this Release and Termination Agreement, are
in addition to all other compensation and benefits which have already been paid,
or are owed, to Conrad, and do not constitute monies or benefits to which Conrad
is otherwise entitled as part of his prior employment with Source One.
3. Other Benefits. In accordance with applicable documents and current
policies with respect to retirees, Source One will (i) pay Conrad for his unused
vacation days determined as of the Termination Date, namely 11.5 days, (ii)
cause Conrad's account balances in the Source One Mortgage Services Corporation
Employee Stock Ownership and 401(k) Plan to be paid to Conrad in accordance with
the terms of such plan, (iii) continue to provide to Conrad from and after
January 1, 1999 Blue Cross and Blue Shield medical and hospital coverage and
life insurance coverage on the same basis such coverage is provided to other
retirees from Source One, and (iv) continue from and after January 1, 1999
dental coverage for Conrad and his spouse for up to three years at
-5-
<PAGE> 6
his expense if elected by him. Medical and dental coverage will be subject
to the same terms and conditions, including cost adjustments and other
modifications, and possible termination, which apply to such coverage for other
retirees. At Conrad's direction the amounts he will be required to pay for
medical and dental coverage will be deducted from his monthly retirement
payments.
4. Release by Conrad. In consideration of the payments and other items
specified in Paragraph 2, Conrad, on behalf of himself and his heirs, legal
representatives and assigns, hereby fully releases and forever discharges Source
One, and its subsidiaries, parent and ultimate parent companies, other related
companies and affiliates, divisions, units, successors, affiliates,
shareholders, directors, officers, agents, and employees, (hereinafter "the
Released Parties") of and from all actions, causes of action, claims, demands,
compensatory, exemplary, statutory and punitive damages, costs, suits, debts,
fees, charges, complaints, contracts, controversies, agreements, expenses,
promises, judgments, damages and liability, and any and all consequential
damages whatsoever, in law or in equity, which against the Released Parties,
Conrad, individually or in any representative capacity, had, now has or may or
shall have by reason of any matter, fact, representation, cause or thing of any
conceivable kind and character whatsoever, and which have occurred up to the
effective date of this Agreement, including
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<PAGE> 7
specifically, but not by way of limitation, any and all claims of
discrimination, wrongful discharge, breach of contract, fraud, promissory
estoppel, misrepresentation, retaliation, all claims under or in connection with
the Age Discrimination in Employment Act (ADEA), the Older Workers Benefit
Protection Act, Title VII of the Civil Rights Act of 1964, the Civil Rights Act
of 1991, the Employee Retirement Income Security Act of 1974, the Equal Pay Act,
the Michigan Elliott-Larsen Civil Rights Act, the Michigan Handicappers' Civil
Rights Act, the Michigan Workers Disability Compensation Act, The Americans with
Disabilities Act, any other Michigan and federal statutes and the common law of
the State of Michigan and the United States, actions based on tort, public
policy, defamation, or injuries incurred on the job or incurred as a result of
loss of employment, and any and all claims and demands of every conceivable kind
based upon or in connection with or involving Conrad's employment and the
termination of such employment. Notwithstanding the foregoing, nothing in this
Waiver and General Release shall constitute a waiver of any claim or right of
Conrad that may arise from events occurring after the date the Waiver and
General Release is executed by Conrad, nor of the right to file a charge with or
participate in an investigation conducted by the Equal Employment Opportunity
Commission. You are, however, waiving your right to any monetary recovery in
connection with such a charge.
-7-
<PAGE> 8
5. Complete Defense. In further consideration, Source One and Conrad do
hereby covenant and agree that this Release and Termination Agreement shall be a
full and complete defense to, and be used as a basis for an injunction against
any action, suit, or any other proceeding which may be instituted, prosecuted or
attempted by Conrad, his heirs, legal representatives, or assigns in breach
hereof.
6. Waiver of Rights To Sue or Proceed. In further consideration thereof,
Conrad, on behalf of himself, his heirs, legal representatives and assigns,
hereby covenants with the Released Parties that he will not sue or proceed in
any manner, whether at law or in equity, against any or all of them, for or on
account of any claim of any nature whatsoever, including but not limited to any
claim for injuries or compensatory, exemplary, statutory or punitive damages as
a result of the events arising out of or relating in any way to Conrad's
employment or the termination of Conrad's employment with Source One. If you
violate this Release and Termination Agreement by suing Source One, then you may
at Source One's option, be required to return all monies paid to you pursuant to
Paragraph 2 plus the monetary equivalent of benefits you received pursuant to
that paragraph, in which case Source One shall be released from its obligations
to make further payments and to continue providing benefits pursuant to
Paragraph 2.
-8-
<PAGE> 9
7. Waiver of Reinstatement and Reemployment. Conrad agrees and recognizes
that his relationship with Source One and its affiliates and successors has been
permanently and irrevocably severed and that neither Source One nor its
successors have any obligation, contractual or otherwise, to rehire, reemploy,
recall or hire him in the future.
8. Confidentiality of this Agreement. Conrad hereby agrees not to disclose
either the fact that he has entered into a release and termination agreement
with Source One or the terms of this Release and Termination Agreement,
including, but not limited to, the amounts paid, to any person or entity, except
his counsel or tax professional or accountant in the course of seeking tax or
financial or legal advice. Any such counsel or tax advisor must be advised of
this confidentiality provision, and agree to abide by it, prior to any
disclosure. In addition, Conrad agrees that such nondisclosure is a material
consideration for the Released Parties having entered into this Release and
Termination Agreement, and that any such disclosure shall be a material and
actionable breach of this Release and Termination Agreement.
The parties further agree that they will not allow anyone to have
access to or to view this Release and Termination Agreement, except as
authorized above.
9. Confidential Information. Conrad agrees that he will hold in a fiduciary
capacity for the benefit of the Fund American Group all Confidential Information
and shall not communicate or
-9-
<PAGE> 10
divulge any Confidential Information to, or use any Confidential
Information for the benefit of, any person (including himself) or entity other
than an entity in the Fund American Group. For purposes of this Agreement "Fund
American Group" means Fund American Enterprises Holdings, Inc. and any related
company, including Source One, and their respective agents, employees, directors
and officers. Also for purposes of this Agreement "Confidential Information"
shall mean (i) information, not generally known, about the Fund American Group's
clients, processes, services and products, whether written or not, including
information relating to research, accounting, marketing, merchandising, selling
and the identity of current and prospective customers and other client
information and (ii) any confidential information entrusted to the Fund American
Group by a client or customer thereof which the Fund American Group is obligated
to keep confidential. Conrad agrees that he will return to Source One as soon as
practicable after the Termination Date any documents or other written, recorded
or graphic matter containing, relating or referring to any Confidential
Information (and all copies thereof) in Conrad's possession or control.
10. No Disparaging Statements. Conrad agrees that he will not make any
statement to any third party disparaging or criticizing, or otherwise take
action to cast aspersions on, the management, business, affairs or property of
any of the Fund American Group.
-10-
<PAGE> 11
11. No Soliciting of Employees. Conrad agrees that he will not solicit or
cause to be solicited for employment on behalf of himself or on behalf of any
person or entity (other than Source One or another member of the Fund American
Group) any person who is employed by Source One or any other member of the Fund
American Group at the time Conrad engages in the solicitation.
12. Purpose and Intent. Conrad understands and agrees that this Release and
Termination Agreement is entered into for the purpose of avoiding further
controversy with respect to any and all past, present, or future claims,
demands, actions, obligations, damages, fees, interests, losses and expenses of
any nature whatsoever arising from or by reason of any matter, act, omission or
thing of any kind, whether known or unknown, foreseen or unforeseen, having
occurred up to the effective date of this Agreement. The parties intend that
this Agreement will irrevocably bar any action or claim whatsoever by Conrad
against the Released Parties for any injuries or damages, whether known or
unknown, sustained or to be sustained, as a result of the Released Parties'
acts, omissions and conduct having occurred up to the effective date of this
Agreement, including, but not limited to, the termination of Conrad's
employment.
13. Waiting and Revocation Periods. Conrad expressly acknowledges that he
has been advised and instructed that he has the right to consult an attorney
and that he should review the terms of this Agreement with counsel of his own
selection. Conrad
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<PAGE> 12
further confirms that he has had more than twenty-one (21) days within
which to consider the terms of this Agreement, that he has had the opportunity
to review this Agreement with counsel of his own choice, that he has had ample
time to study this Agreement, that he has carefully read the terms of this
Agreement and is fully aware of the Agreement's contents and legal effects, and
that he executes this Agreement voluntarily and of his own free will. Conrad
expressly acknowledges that this Agreement constitutes a knowing and voluntary
waiver under the Older Workers Benefit Protection Act and that this Waiver and
General Release complies with the provisions of the Older Workers Benefit
Protection Act. Conrad understands and agrees that this Agreement is revocable
by any party for seven (7) days following the signing of this Agreement by both
parties, and that this Agreement shall not become effective or enforceable until
that revocation period has expired. This Agreement automatically becomes
enforceable and effective on the eighth (8th) day after the date this Agreement
is signed by all of the parties. This Agreement may be revoked by a writing sent
certified mail by either party post-marked no later than the seventh (7th) day
after the Agreement is signed by the last party (unless that day is a Sunday or
a holiday, in which event the period is extended to the next day there is mail
service).
14. Entire Agreement. This Release and Termination Agreement contains the
entire agreement of the parties and
-12-
<PAGE> 13
supersedes all other agreements, written or otherwise. This Release and
Termination Agreement cannot be altered or amended except in writing, which
writing must be signed by Conrad and by the Chairman of Source One. In no event
shall this Release and Termination Agreement be modified by any oral statements,
agreements, commitments or understandings.
15. Free Act and Deed. Source One and Conrad acknowledge that they have
reviewed this Release and Termination Agreement, understand its terms, and
execute this Agreement as their free act and deed. Conrad further acknowledges
that he has been afforded the opportunity to review this Release and Termination
Agreement with counsel of his own choice and that he knowingly and voluntarily
approves this Release and Termination Agreement.
16. Choice of Law and Severability. This Release and Termination
Agreement shall be construed in accordance with the law of Michigan. If any
provision of this Agreement shall for any reason be held invalid or
unenforceable, such invalidity or unenforceability shall not affect any other
provision hereof, but this Agreement shall, in such event, be construed as if
such invalid and/or unenforceable provision had ever been contained herein.
17. Effective Date. The effective date of this Agreement is the eighth
(8th) day after the date this Agreement is signed by all of the parties.
-13-
<PAGE> 14
Conrad has executed this Release and Termination Agreement this _____ day of
___________, 1997.
THIS IS A RELEASE READ BEFORE SIGNING:
WITNESSED:
- ----------------------------- -------------------------------
James A. Conrad
- -----------------------------
SOURCE ONE MORTGAGE SERVICES
CORPORATION
WITNESSED:
By
- ----------------------------- --------------------------
- ----------------------------- Its Chairman
Dated:
----------------------
-14-
<PAGE> 1
Exhibit 10(ii)
MORTGAGE LOAN SUBSERVICING AGREEMENT
EXTENSION AMENDMENT
THIS MORTGAGE LOAN SUBSERVICING AGREEMENT EXTENSION AMENDMENT ("Amendment") is
dated as of December 11, 1997, by and between CHEMICAL MORTGAGE COMPANY, an
Ohio corporation, with offices at 200 Old Wilson Bridge Road, Worthington, Ohio
43085-8500 ("Servicer") and SOURCE ONE MORTGAGE SERVICES CORPORATION, a
Delaware corporation, with offices located at 27555 Farmington Road, Farmington
Hills, Michigan 48334-3357 ("Subservicer").
WHEREAS, Servicer and Subservicer entered into a Mortgage Loan Subservicing
Agreement ("Subservicing Agreement") to perform the administration and
subservicing of certain mortgage loans the Servicing to which was purchased by
the Servicer from the Subservicer pursuant to a FNMA/FHLMC/GNMA Mortgage
Servicing Purchase and Sale Agreement ("Sale Agreement") between Servicer and
Subservicer, dated as of February 28, 1997; and
WHEREAS, the Servicer and Subservicer desire to amend the Subservicing
Agreement and Sale Agreement as follows:
A. Pursuant to Section 7 of the Subservicing Agreement, the Servicer
elects to extend the term of the Subservicing Agreement for one (1) year
as follows: for that portion of the Servicing which pertains to GNMA
Mortgage Loans to May 31, 1999; for that portion of the Servicing which
pertains to FNMA Mortgage Loans to July 31, 1999; and, for that portion of
Servicing which pertains to FHLMC Mortgage Loans to March 15, 1999;
provided, however, that notwithstanding the one hundred fifty (150) day
minimum servicing period set forth in Section 7 of the Subservicing
Agreement, in the event Servicer changes to first-of-the-month cut-off for
the GNMA Mortgage Loans, the termination date for the Servicing of GNMA
Mortgage Loans may be revised downward or upward by up to five (5)
calendar days. Nothing in this paragraph shall affect Servicer's existing
rights, pursuant to the terms and provisions of the Subservicing
Agreement, to terminate Subservicer earlier for cause due to a breach of
the Subservicing Agreement, as amended by the terms and provisions of this
Amendment.
B. Paragraph 1.23 Subservicing Fee is hereby amended to provided that
effective June 1, 1998, the compensation to be paid to Subservicer under
the Subservicing Agreement for subservicing any Mortgage Loan in existence
on the first day of each month shall be $1.42 per Mortgage Loan.
C. Subservicer has a long-term compensation plan which is acceptable to
Servicer for the purpose of retaining key employees of Subservicer
throughout the term of the Subservicing Agreement, as amended by this
Amendment. This long-term compensation plan is attached as Exhibit B.
<PAGE> 2
D. On or before January 15, 1998, Subservicer agrees to provide Servicer
with an initial high level strategic business plan reflecting
Subservicer's overall servicing objectives. On or before April 15, 1998,
and quarterly thereafter, Subservicer shall provide Servicer with updates
reflecting the execution of its business plan. Such business plan and
results must be acceptable to Servicer in its reasonable discretion.
E. Subservicer will cooperate in providing adequate support according to
generally accepted practices of sellers of mortgage loan servicing in sale
transactions. Such support shall include but not be limited to the
following:
1. Performing the data mapping process, commencing in November 1997
and thereafter as reasonably requested by Servicer, for the transfer
of servicing responsibilities.
2. Providing Servicer with conversion tapes, at Subservicer's cost,
commencing in January 1998 and quarterly thereafter.
3. At Servicer's request, transferring the Servicing of any
delinquent Mortgage Loan (i) which Servicer sells to a third party
purchaser or (ii) which Servicer buys from an Investor as a result
of the delinquency of the Mortgage Loan, from the appropriate
Investor's account to Servicer's account.
F. No interest will be paid by Servicer after the Approval Date on the
Document Holdback portion of the Purchase Price which is described in the
Sale Agreement.
G. Subservicer will supply acceptable evidence to Servicer by December
31, 1997 that all of its investor accounting problems (e.g., any and all
outstanding reconciliations and reconciling items, whether pertaining to
custodial or clearing account reconciliations, proof of cash, pool to
security, expected cash, cash outages on GNMA Mortgage Loans with Coopers
& Lybrand, etc.) have been brought current and fully resolved.
Additionally, commencing November 30, 1997, Subservicer shall provide
Servicer with those reports described on Exhibit A, attached hereto and
incorporated herein. Finally, subject to the ability of Transamerica to
perform, by December 31, 1997, Subservicer will provide Servicer with
evidence that all of the Mortgage Loans are covered by Transamerica
"delinquency search only" tax service contracts effective through the
Transfer Date. On the Transfer Date, such Transamerica contracts will
become full service Transamerica contracts as described in the Sale
Agreement. Subservicer will immediately fund all identified cash
shortages. Any unidentified cash shortages can be researched by
Subservicer up to sixty (60) days from the date of the outage. Any
shortages not identified within the sixty (60) days will be immediately
funded by Subservicer. Procedures and/or technology enhancements will be
developed by Subservicer to ensure that issues that may cause recurring
unidentified shortages can be identified and funded immediately by
Subservicer.
2
<PAGE> 3
H. Systems used by Subservicer to satisfy the requirements of the
Subservicing Agreement containing or calling on a calendar function
including, without limitation, any function indexed to the CPU clock, and
any function providing specific dates or days, or calculating spans of
dates or days, shall record, store, process, provide and where
appropriate, insert true and accurate dates and calculations for dates and
spans including and following, January 1, 2000. As part of its
maintenance obligations, Subservicer shall assure that its system will
have no lesser functionality with respect to records containing dates on
or after January 1, 2000 than it had with respect to dates prior to
January 1, 2000.
I. That all other terms of the Subservicing Agreement and Sale Agreement
remain in full force and effect and that only the amended provisions
listed above shall constitute changes or additions to the Subservicing
Agreement and Sale Agreement.
IN WITNESS WHEREOF, each of the undersigned parties to this Amendment has
caused this Amendment to be duly executed in its corporate name by one of its
duly authorized officers, all as of the date first written above.
SERVICER:
ATTEST: CHEMICAL MORTGAGE COMPANY
/s/ Ellen M. Clifford
--------------------- By: [SIG]
---------------------------
Title: Senior Vice President
------------------------
Date: December 11, 1997
-------------------------
SUBSERVICER:
ATTEST: SOURCE ONE MORTGAGE SERVICES
CORPORATION
/s/ June Jacobs
--------------------- By: [SIG]
---------------------------
Title: President & CEO
------------------------
Date: 12-12-97
-------------------------
3
<PAGE> 4
EXHIBIT A
SOURCE ONE
INVESTOR REPORTS
Fannie Mae
- ----------
Proof of Custodials
Proof of Security
FNMA Completed Laser Schedules
Freddie Mac
- -----------
Proof of Custodials (listing all reconciling items and month originated)
Loan Reconciliation Detail Report (listing all edits)
Ginnie Mae
- ----------
Trial Balance
Comparison Report detailing discrepancies between 11710A and corresponding T/B
Test of Expected P&I and Pool to Security
Summary report of all pools with cash or security differences greater and less
than $50 sorted by range code
A 1,000 - over B 100.01 - 999.99 C 50.01 - 100.00 D (50) - 50
E (50.01) - (100) F (100) - (999.99) G (1,000) & less Total
The 11714 remittance advice
A listing of funds forwarded to GNMA (with GNMA required information per
Memorandum #97-27 as unclaimed funds, with date forwarded and also returned if
applicable.
Copy of the 1041 and K1 forms following the year end filing with the IRS.
Reconciliation of YTD Interest.
<PAGE> 1
EXHIBIT 10(jj)
EMPLOYMENT AGREEMENT
Frank Mohan James Ozanne
Brewster, New York Chairman, Source One Mortgage
Dear Frank,
I am very pleased to offer you the position of President and Chief Executive
Officer of Source One Mortgage Corporation. As we agreed you will begin
employment on or before October 1, 1997. The following are the key terms of
your employment:
1. Base salary of $250,000.
2. Short term annual bonus based on specific performance objectives with a
maximum payout if all objectives are achieved of 100% of base salary.
The 1997 award will not be prorated.
3. Payments to compensate you for your existing in the money stock options,
stock grants and company car of $50,000 on November 1, 1997 and
$200,000 each on November 1, 1998 and November 1, 1999. You must be
employed by the company at each payment date in order to collect the
payment.
4. Participation in our long term incentive plan which is now being
revised. The key elements are as follows:
Tied to and based on Source One book value
Valuation based on three year average ROE
Three three year traunches to be issued - 1998-00, 1999-01 and
2000-02
Payouts range from 0 to 12% ROE to 100% at a 15% ROE, 200% at a
20% ROE and 300% at a 25% ROE. Payments capped at 300%
You will receive share grants equal to $150,000 of book value
for each of the three traunches.
5. You will participate in an investment and option program identical in
terms to the program in which I participate. You will have an
opportunity to invest up to $150,000 in Source One stock at book
value. Each dollar of investment will entitle you to five times that
amount of five year options with strike prices at book value plus 4%
per year.
6. If you are terminated without cause prior to December 31, 2000 you will
receive two years of base pay and any options will vest immediately.
Frank, I look forward to working with you. If you find the terms of this
letter acceptable please initial and return a copy to me.
Sincerely,
James H. Ozanne
<PAGE> 1
EXHIBIT 13a
TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS
Back in 1946, Source One Mortgage Services Corporation laid the foundation for
the Company that has evolved today. Just as a house that was built in 1946
would undergo renovations, so too has Source One.
We started with four employees in a one-room office and, over the years, have
upgraded to a 1,500 employee Company. What has always remained the same,
however, is the foundation on which the Company was built. Our goal of
providing a home for every loan has been apparent all along.
Worthy goals are not achieved overnight and we're still working on the goal
of providing a home for every loan. To that end, we've made some changes and
some additions in 1997.
It's true that our last year was a period of significant change for the
Company.
It was the first year of our operation under a strategic plan adopted to
position us to return low ROE capital to our parent company while
simultaneously shaping a more profitable business with the capital remaining
in the Company.
The sale of a $17 billion portfolio to Chase Mortgage for $267 million in
February set the stage for the year. This transaction both liquified a
low-return servicing asset and reduced our exposure to swings in interest
rates. In conjunction with the sale, we negotiated the subservicing rights to
this portfolio and began seeking other subservicing partners.
Change isn't easy, making this a difficult year for the management and
employees of Source One. We reduced our work force, added new products
quickly, changed our focus from conventional to government originations, made
changes in top management and our Board of Directors, all while we were
completely restructuring our sales organization.
We spent significant time and money renovating the Company in 1997 and have a
major challenge before us in 1998 to execute the plan for which the
groundwork was laid last year.
We still have a lot of work to do, but in our judgement, we have the people
and the plan to make Source One profitable again. Early 1998 results are
solidly in the black.
OPERATING RESULTS
After a very slow start, our mortgage loan production grew 15% in 1997 to
$4.4 billion. Unfortunately, we concluded the year with a net loss of $13.5
million compared with a net loss of $4.3 million the year before.
We realized several strategic gains during the year including the reduction
of our term debt with the proceeds received from the $17 billion servicing
rights sale in February. We repurchased $119.6 million of 8.875% medium term
notes due October 15, 2001. This repurchase resulted in a $6.0 million after
tax loss. However, it reduces our future borrowing costs and frees up $138
million of assets that were being used to secure the noteholders.
STRATEGIC DIRECTION
The key to our success in 1998 is the addition of new products to supplement
our conventional, FHA and VA loans. We now have in place a revamped,
revitalized and streamlined sales organization with special, stand alone
business units targeting sub-prime, 125% loan to value (125% LTV), 203(k) and
manufactured housing products. The most important step in adding new,
higher-margin products was the establishment of an exclusive sub-prime/125%
LTV operation in Lagrangeville, New York.
We have also consolidated similar or overlapping backroom functions that
handle the loans both before and after they have been closed. The
consolidation has reduced the number of times a loan is handled and moved
within the Company.
We continue to aggressively pursue subservicing business. To date, we have
only been able to secure modest contracts for current and flow business. The
marketplace appears to accept that the Company is no longer a candidate for
sale to another firm and that attitude change should have a positive impact
on our subservicing efforts.
Preliminary 1998 profitability projections are very positive. All of our
production and support people exhibit a renewed enthusiasm about the business
and we see a strong commitment to meet or exceed our 1998 Business Plan.
1
<PAGE> 2
TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS
SENIOR MANAGEMENT AND BOARD
There were several significant management and Board of Directors changes
during 1997.
James H. Ozanne was named Chairman in March. He joined us from his role as
President at Fund American Enterprises, Inc., and board member of Source One.
James A. Conrad, former President and CEO, elected to take early retirement
as did Lawrence J. Brady, Senior Vice President, Residential Division.
Mark A. Janssen, Executive Vice President, previously responsible for Capital
Markets, saw his duties expanded to include the Production Division. He was
also named Secretary of the Company and a member of the Board of Directors.
Allan L. Waters, Gordon S. Macklin and Robert P. Keller all elected to resign
from the Board of Directors in order to pursue other activities.
Raymond Barrette, Executive Vice President and Chief Financial Officer of
Fund American Enterprises Holdings, Inc., joined the Board. We look forward
to a long and mutually beneficial association.
Susan L. Bowen, Senior Vice President, was named to oversee the sales and
operations functions of the Production Division.
Kathleen DeFrances was promoted to Senior Vice President in charge of the
Residential Division.
Pablo Sanchez joined the Company as a Senior Vice President responsible for
our newly formed Sub-prime Unit. He joins the firm from his association with
Beneficial.
And, Frank Mohan was named President and CEO in September. With 35 years of
experience as a senior consumer finance executive, Mohan arrived with a
mandate to add more profitable products to our business mix and to return the
overall Company to profitability. (The challenge continues, and we're making
excellent headway.)
IN CONCLUSION
Our renovation efforts are just coming to fruition; metaphorically speaking,
the paint has yet to dry.
We realize 1998 will be a challenge. But, we are staffed and collectively
committed to successfully accomplish the difficult goals we've set for
ourselves.
We have in place efficient production and servicing units which can originate
and service not only conventional loans, but manufactured housing, sub-prime,
government, 203(k) and 125% LTV products.
Our Sub-prime Unit has strategically and impactfully enlisted the support of
our Production Division and they will consciously focus their respective
efforts toward writing higher margin sub-prime loans.
We extend a genuine and sincere thanks to all of our dedicated employees who
have stood by the Company during its difficult transition. Their diligence
toward providing the highest quality service to both our mortgage and
subservicing customers has given us the solid base from which we can continue
to grow.
Our collective thanks to our Board of Directors for its support and
direction.
And last, but certainly not least, a respectful thanks to our customers who
have made all the years possible.
Sincerely,
Francis X. Mohan James H. Ozanne
------------------------ ----------------------
Francis X. Mohan James H. Ozanne
President and CEO Chairman
March 27, 1998
2
<PAGE> 3
SELECTED CONSOLIDATED FINANCIAL DATA
& CORPORATE INFORMATION*
<TABLE>
<CAPTION>
INCOME STATEMENT DATA (in thousands, except per share amounts)
- -------------------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Total revenue $ 93,874 $ 148,680 $ 148,595 $ 142,493 $ 173,564
Total expenses 105,021 143,553 105,313 137,215 111,387
- -------------------------------------------------------------------------------------------------------------------------------
(Loss) income before income taxes, extraordinary
loss and cumulative effect of accounting change (11,147) 5,127 43,282 5,278 62,177
Income tax (benefit) expense (3,617) 9,453 16,132 4,474 22,056
- -------------------------------------------------------------------------------------------------------------------------------
(Loss) income before extraordinary loss and
cumulative effect of accounting change (7,530) (4,326) 27,150 804 40,121
Extraordinary loss on retirement of debt (5,975) - (902) - -
Cumulative effect of accounting change (a) - - - (44,296) -
- -------------------------------------------------------------------------------------------------------------------------------
Net (loss) income $ (13,505) $ (4,326) $ 26,248 $ (43,492) $ 40,121
- -------------------------------------------------------------------------------------------------------------------------------
Basic net (loss) income per common share (b):
Before extraordinary loss and cumulative
effect of accounting change $ (3.78) $ (3.57) $ 7.55 $ (1.65) $ 9.48
Basic net (loss) income per common share (5.79) (3.57) 7.20 (14.21) 9.48
- -------------------------------------------------------------------------------------------------------------------------------
Cash dividends per common share (c) $ - $ - $ - $ - $ 6.39
Cash dividends declared on common shares - - - - 26,616
Payment for common shares repurchased 2,638 - 120,000 122,000 -
Insurance of common shares 119,040 - - - -
- -------------------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME STATEMENT DATA (d)
- -------------------------------------------------------------------------------------------------------------------------------
Net (loss) income $ ( 13,505) $ (4,326) $ 26,248 $ (43,492) $ 40,121
Other comprehensive income (loss) 41,102 546 3,519 (3,779) 23,731
- -------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) $ 27,597 $ (3,780) $ 29,767 $ (47,271) $ 63,852
- -------------------------------------------------------------------------------------------------------------------------------
Basic comprehensive income (loss) per
common share (b) $ 8.03 $ (3.33) $ 8.57 $ (15.28) $ 15.09
- -------------------------------------------------------------------------------------------------------------------------------
OPERATING DATA
- -------------------------------------------------------------------------------------------------------------------------------
Total mortgage loan production (in millions) $ 4,403 $ 3,831 $ 2,852 $ 4,586 $ 11,452
Servicing portfolio at end of year (e):
Balance (in millions) $ 26,546 $ 29,201 $ 31,831 $ 39,568 $ 38,403
Number of loans serviced (f) 438,261 478,779 494,051 543,428 518,972
Weighted average interest rate (f) 8.45% 8.48% 8.33% 8.14% 8.53%
Weighted average net servicing fee (f) (g) .420% .422% .419% .410% .432%
Percent delinquent (f) 6.35% 6.24% 5.28% 4.07% 4.44%
Percent in process of foreclosure 1.18% .93% .80% .77% .92%
Servicing rights acquisitions (in millions) $ 36 $ 2,789 $ 4,674 $ 3,707 $ 6,368
Sale of servicing rights (in millions) $ 17,018 $ 3,302 $ 10,973 $ 3,868 $ -
Number of employees at end of year 1,572 1,682 1,680 2,055 3,060
- -------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA (in thousands)
December 31,
- -------------------------------------------------------------------------------------------------------------------------------
Mortgage loans receivable $ 519,247 $ 314,937 $ 381,028 $ 210,472 $1,298,506
Capitalized servicing (net) (h) 181,025 410,939 397,071 530,450 666,666
Total assets 1,304,690 1,131,054 1,135,029 1,210,012 2,647,153
Senior debt 686,906 643,262 661,846 647,251 1,959,643
Subordinated debt 55,153 54,535 54,786 - -
Total liabilities 849,641 816,297 812,785 733,925 2,095,153
Total stockholders' equity 455,049 314,757 322,244 476,087 552,000
- -------------------------------------------------------------------------------------------------------------------------------
</TABLE>
*See accompanying notes to selected consolidated financial data.
3
<PAGE> 4
NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA
& CORPORATE INFORMATION
(a) The 1994 amount reflects the cumulative after tax effect, as of January
1, 1994, of a change in the methodology used to measure impairment of the
purchased mortgage servicing rights asset.
(b) Basic net (loss) income and basic comprehensive income (loss) per common
share amounts for all years presented are based on the weighted average
number of common shares outstanding.
(c) Cash dividends per common share were computed based on the total number
of common shares outstanding as of the dividend record dates.
(d) Comprehensive income includes net income (loss) and the net change in
after tax unrealized investment gain (refer to Note 1 to the consolidated
financial statements for further discussion).
(e) Includes loans subserviced for others having a principal balance of $14.9
billion, $2.8 billion, $4.0 billion and $4.3 billion as of December 31,
1997, 1996, 1995 and 1994, respectively, except as noted.
(f) Excludes interim servicing of loans having a principal balance of $1,651
million and $4,190 million as of December 31, 1994 and 1993, respectively.
(g) Excludes loans subserviced for others as noted in (d) above.
(h) Reflects a $68.1 million cumulative pretax effect adjustment to the
purchased mortgage servicing rights asset as of January 1, 1994 relating
to a change in the methodology used to measure its impairment.
FORM 10-K
The financial information contained in this report substantially conforms
with the information required in the "Form 10-K" Annual Report filed by the
Company with the Securities and Exchange Commission at the end of March 1998.
Certain supplemental information appears in such Form 10-K that is not
necessarily disclosed within this document. Copies of such Form 10-K (without
exhibits) are available, without charge, upon request to the Corporate
Secretary's Office, Source One Mortgage Services Corporation, 27555
Farmington Road, Farmington Hills, Michigan 48334-3357 (telephone: (248)
488-7000).
BUSINESS
The Company primarily engages in the business of producing and selling
conforming and subprime residential mortgage loans, servicing conforming
residential mortgage loans and subservicing residential mortgage loans for
third parties. In response to increased industry competition for producing
and servicing conforming mortgage loans, the Company has decided to broaden
its product line by offering higher margin products. The Company has recently
begun to produce 203(k) (FHA home improvement) loans, manufactured housing
loans, subprime loans and 125% loan-to-value ("125% LTV") second mortgage
loans. The 203(k) loans and the manufactured housing loans are being sold
into agency pools with servicing retained. The subprime and 125% LTV loans
are being originated for a fee and sold to third parties on a servicing
released basis. The Company is currently expanding its capability to service
and subservice subprime loans and to subservice 125% LTV loans. Although
these higher margin products are a new focus for the Company, they accounted
for less than 2% of total production in 1997 and are currently expected to
account for less than 10% of total production in 1998. The Company's primary
sources of revenue are net servicing revenue, net interest revenue, net gain
on sale of mortgages, net gain on sale of servicing, earnings from
unconsolidated affiliate and other revenue.
The Company is also engaged, through certain of its subsidiaries, in the sale
of credit-related insurance products (such as life, disability, health,
accidental death and property and casualty insurance).
MARKET FOR STOCK AND RELATED MATTERS
There is no established public trading market for the Company's common stock.
As of March 31, 1998, there were two holders of the 3,211,881 shares of the
Company's issued and outstanding common stock, White Mountains Holdings, Inc.
("White Mountains") (formerly Fund American Enterprises, Inc.), and its
parent Fund American Enterprises Holdings, Inc. ("Fund American").
No cash dividends on common stock were declared for the years ended December
31, 1997, 1996 or 1995. The Company's secured credit agreement contains
covenants which limit its ability to pay dividends or make distributions on
its capital in excess of preferred stock dividend and subordinated debt
interest requirements each year. In addition, the Company must comply with
certain financial covenants provided in its secured credit agreement,
including restrictions relating to tangible net worth and leverage. The
Company is currently in compliance with all such covenants.
4
<PAGE> 5
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1997 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1996
SUMMARY - The Company reported a net loss of $13.5 million for the year ended
December 31, 1997 compared to a net loss of $4.3 million for the year ended
December 31, 1996. The 1997 net loss includes a $9.2 million pretax
extraordinary loss on the early retirement of the Company's medium-term debt,
a $8.0 million pretax loss on the sale of servicing to a third party and the
related assumption of subservicing, a $3.0 million pretax charge relating to
loans held for investment identified as held for sale, $3.1 million of pretax
restructuring and compensation charges and a $17.7 million pretax increase in
the valuation allowances for impairment of the Company's capitalized
servicing asset. These amounts are partially offset by a $11.3 million net
gain on financial instruments and $9.5 million pretax equity in earnings of
an unconsolidated affiliate. The 1996 net income includes a $29.1 million
pretax charge for the write-off of the Company's goodwill and other
intangible assets, and a $.9 million pretax charge for impairment of its
capitalized servicing asset. These amounts are partially offset by a $10.1
million pretax gain on the sale of servicing to a third party and a $9.9
million pretax net gain on financial instruments.
The Company reported comprehensive income of $27.6 million for the year ended
December 31, 1997 compared to a comprehensive loss of $3.8 million for the
year ended December 31, 1996. Comprehensive income includes net income (loss)
and the net change in after tax unrealized investment gain (refer to Note 1
to the consolidated financial statements for further discussion). The
Company's 1997 unrealized investment gains are associated primarily with its
investment in Financial Security Assurance Holdings Ltd. ("FSA"), an
unconsolidated affiliate, which it acquired during 1997 (refer to Note 2 to
the consolidated financial statements for further discussion). The Company's
1996 unrealized investment gains are associated with its investment in common
equity securities.
The Company's total mortgage servicing portfolio decreased to $26.5 billion
as of December 31, 1997 from $29.2 billion as of December 31, 1996. As part
of the Company's corporate strategy to minimize exposure to interest rate
risk inherent in its servicing asset, the Company took steps to reduce the
size of its owned servicing portfolio and expand its subservicing business
in the first quarter of 1997. In February 1997, the Company sold $17.0
billion of its nonrecourse mortgage servicing portfolio to a third party for
adjusted proceeds of $266.9 million and recognized a pretax loss of $8.0
million on the sale and the related assumption of subservicing. The following
table illustrates the change in the Company's mortgage servicing portfolio
mix primarily as a result of the sale:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------
December 31, (in millions) 1997 1996
- --------------------------------------------------------------------------
<S> <C> <C>
Mortgage servicing portfolio owned $11,627 $26,410
Mortgage servicing portfolio subserviced for others 14,919 2,791
- --------------------------------------------------------------------------
Total mortgage servicing portfolio $26,546 $29,201
- --------------------------------------------------------------------------
</TABLE>
The Company is continuing its efforts to expand its subservicing business.
Concurrent with the above strategy, the Company also continued to act on its
strategy to optimize returns on its owned servicing portfolio by buying and
selling mortgage servicing rights based on the underlying risk and return
characteristics. The Company purchased the rights to service $.04 billion and
$2.8 billion of mortgage loans from third parties during 1997 and 1996,
respectively. During 1996, the Company sold the rights to service $3.3
billion of mortgage loans for net proceeds of $55.9 million and a pretax gain
of $10.1 million. Additional sales transactions may occur in the future when
management deems it to be economically advantageous.
Total mortgage production for the years ended December 31, 1997 and 1996 was
$4.4 billion and $3.8 billion, respectively. Production related to
refinancing activity made up 40% of total production for 1997 as compared to
33% for 1996. The increase in mortgage loan production in 1997 reflects
overall lower market interest rates during 1997 and a corresponding increase
in refinance activity from 1996.
Mortgage loan payoffs for each of the years ended December 31, 1997 and 1996
were $3.0 billion. The average prepayment rate of the Company's total
servicing portfolio was 10.5% for each of the years ended December 31, 1997
and 1996. The Company's prepayment experience is significantly influenced by
fluctuations in mortgage interest rates,
5
<PAGE> 6
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
although the effect is not immediate. While overall, mortgage interest rates
were lower during 1997 than in 1996, there was a significant decline in rates
in December of 1997. Therefore, the average prepayment rates for 1997 do not
fully reflect the decrease in interest rates as of year end 1997. The average
prepayment rates for the months of January and February 1998 were 11.6% and
21.9%, respectively.
REVENUE - Mortgage servicing revenue decreased to $95.0 million in 1997 from
$139.6 million in 1996. The decrease in mortgage servicing revenue is
primarily due to the February 1997 servicing sale, slightly offset by
increased subservicing revenue generated as a result of the sale. The
subservicing fees, however, are significantly lower than the servicing fees
earned on the Company's owned servicing portfolio. Amortization of
capitalized servicing decreased $7.8 million during the year ended December
31, 1997 from the comparable 1996 period. Amortization includes a $17.7
million and $.9 million increase in the valuation allowances for impairment
of the Company's capitalized servicing asset in 1997 and 1996, respectively.
Excluding the effects of these charges, amortization expense decreased to
$46.5 million in 1997 from $71.0 million in 1996. This decrease in
amortization expense is primarily the result of a smaller servicing asset due
to the February 1997 servicing sale. The impairment charge in 1997 is
primarily a result of increased market consensus prepayment rates and a
corresponding decrease in the fair value of the Company's capitalized
servicing asset from year end 1996.
In 1994, the Company sold the rights to service $3.9 billion of mortgage
loans to a third party and continued to service these loans pursuant to a
subservicing agreement. The gain of $19.9 million was deferred and was being
recognized over the five-year life of the subservicing agreement. In the
fourth quarter of 1996, the third party sold the rights to service
approximately $1.0 billion of these mortgage loans, representing
approximately 25% of the total loans subserviced by the Company for this
third party. Accordingly, the Company recognized an additional $2.4 million
of the deferred gain in 1996, representing approximately 25% of the deferred
balance at the time of sale. In the fourth quarter of 1997, the third party
sold the rights to service the remaining portfolio of loans. As a result, the
Company recognized the $4.4 million remaining balance of the deferred gain.
In 1997 and 1996, the Company recognized deferred gains totaling $6.9 million
and $6.1 million, respectively, as part of mortgage servicing revenue in the
consolidated statements of income.
The Company invests in various financial instruments in order to offset
changes in the value of its capitalized servicing asset and to mitigate the
effect on earnings of higher amortization and impairment of the asset which
results from increased prepayment activity that can occur with decreases in
market interest rates. As interest rates decline, prepayment activity
generally increases, thereby reducing the value of the capitalized servicing
asset, while the value of the financial instruments increases. Conversely, as
interest rates increase, the value of the capitalized servicing asset
increases, while the value of the financial instruments decreases. The
financial instruments utilized by the Company include interest rate floor
contracts ("floors") and principal-only ("P/O") swap transactions.
The floors are derivative contracts which derive their value from differences
between the floor rate specified in the contract and market interest rates.
The cash flow from the floors is equal to the difference between the floor
rate and the prevailing interest rate applied to the notional amount.
Payments are made to the Company only when the prevailing interest rates are
below the floor rate. To the extent that prevailing interest rates decrease,
the value of the floors increases, even if interest rates do not fall below
the floor rate. To the extent that prevailing interest rates increase, the
value of the floors decreases. However, the Company is not exposed to losses
in excess of its initial investment in the floors.
The P/O swaps are derivative contracts, the value of which is determined by
changes in the value of the referenced P/O strip security. The payments
received by the Company under the P/O swaps relate to the cash flows of the
referenced P/O security. The payments made by the Company are based upon a
notional amount tied to the market price and the remaining balance of the
referenced P/O security multiplied by a floating rate indexed to the London
Interbank Offered Rates for U.S. dollar deposits ("LIBOR").
The Company recognized a net gain on its financial instruments of $11.3
million and $9.9 million for the years ended
6
<PAGE> 7
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OOPERATIONS
December 31, 1997 and 1996, respectively. The 1997 net gain includes
$2.0 million in realized losses from the sale of financial instruments
slightly offset by net cash flows received and $13.3 million in unrealized
gains due to a net increase in the fair value of the various financial
instruments. The 1996 net gain includes $8.1 million in realized gains from
the sale of financial instruments and net cash flows received and $1.8
million in unrealized gains due to a net increase in the fair value of the
various financial instruments. As of December 31, 1997 and 1996, the carrying
value of the financial instruments was $20.7 million and $8.0 million,
respectively, and is included in investments in the consolidated statements
of condition (refer to Note 11 to the consolidated financial statements for
further discussion).
Interest income increased to $45.8 million in 1997 from $40.8 million in
1996. The increase in interest income is primarily the result of interest
income earned on the outstanding receivable balance from the February 1997
servicing sale, an increase in interest income from pool loan purchases due
to a higher average asset balance and income earned on an investment acquired
in the second quarter of 1997. This increase was slightly offset by a
decrease in conventional mortgage loan production and the corresponding
decrease in the average conventional mortgage loans receivable inventory.
Interest expense decreased slightly to $35.4 million in 1997 from $36.0
million in 1996. This decrease is primarily due to the retirement of
medium-term notes and long-term debentures during 1996, the early retirement
of medium-term notes in 1997 and a reduction in debt from the cash proceeds
received from the 1997 servicing sale. This decrease was almost entirely
offset by a decrease in interest expense credits received on escrow and
custodial funds held in trust accounts resulting from the decrease in the
Company's owned servicing portfolio and an increase in short-term borrowings
necessary to fund increased production.
In 1997, the Company realized a $.3 million gain from the transfer of its
remaining common equity securities to White Mountains in exchange for shares
of the Company's common stock held by White Mountains, which were then
retired by the Company. The 1996 realized loss of $.9 million was a result of
the Company selling certain common equity securities to White Mountains for
cash. All of the equity securities involved in such transactions were
actively traded, readily marketable, listed on a national exchange and, for
purposes of such transactions, were valued at their closing prices on the day
preceding the date of each transaction.
The Company realized a net investment loss of $1.0 million for the year ended
December 31, 1997 compared to a net investment gain of $.6 million for the
year ended December 31, 1996. These amounts include the write-down of certain
investments to realizable value offset by certain realized gains related to a
partnership investment.
In mid-March 1997, the Board of Directors of Fund American and several of its
subsidiaries approved a corporate restructuring plan that strengthened the
Company by increasing its stockholders' equity. The most significant part of
the plan was the contribution of the Company's investment in FSA by its
direct parent. The Company recognized $9.5 million of equity in earnings of
FSA for the year ended December 31, 1997 (refer to Notes 2 and 10 to the
consolidated financial statements for further discussion).
Net gain on mortgage sales decreased to $21.5 million in 1997 from $38.3
million in 1996. This decrease is primarily due to decreased capitalized
originated mortgage servicing rights ("OMSR") income as a result of a change
in the Company's mortgage loan production mix which included a
proportionately higher volume of correspondent production, which generates
lower OMSR income. At this time, the Company is uncertain if future
originations will continue to be comprised of a proportionately higher volume
of correspondent production. The decrease in the 1997 gain also reflects a
$3.0 million pretax charge relating to mortgage loans held for investment
which were identified for sale and marked down from amortized cost to current
market value during the second quarter of 1997 (refer to Note 7 to the
consolidated financial statements for further discussion).
The Company recorded a $4.3 million pretax loss from the sale of $17.0
billion of nonrecourse mortgage servicing rights and the related assumption
of subservicing in the first half of 1997. The Company recorded an
additional loss of $3.7 million in the fourth quarter of 1997 in connection
with the amendment of the subservicing arrangement which extended the
Company's subservicing responsibilities for one additional year at less
favorable terms than the original agreement provided. The Company will
continue to service these loans pursuant to a subservicing agreement at
least until March 1999, June 1999 and August 1999 for Federal Home Loan
Mortgage Corporation ("FHLMC") loans,
7
<PAGE> 8
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Government National Mortgage Association ("GNMA") loans and Federal
National Mortgage Association ("FNMA") loans, respectively. The subservicing
period can be extended for one additional year beyond these dates at the
option of the purchaser. During 1996, the Company sold the rights to service
$3.3 billion of its mortgage servicing portfolio and realized a pretax gain
of $10.1 million.
EXPENSES - Salaries and employee benefits expense was $54.8 million and $56.3
million for the years ended December 31, 1997 and 1996, respectively.
Generally accepted accounting principles ("GAAP") require certain loan
origination revenues to be netted against direct loan origination costs.
Since salaries and employee benefits expense is the largest component of loan
origination costs, approximately 90% of loan origination revenues are
accounted for as a reduction to salaries and benefits expense as indicated in
the following table:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996
- --------------------------------------------------------------------------
<S> <C> <C>
Unadjusted salaries and employee benefits expense $74,405 $76,114
GAAP net origination revenues (19,611) (19,820)
- --------------------------------------------------------------------------
GAAP salaries and employee benefits expense $54,794 $56,294
- --------------------------------------------------------------------------
</TABLE>
The slight decrease in loan origination revenues, reflecting lower retail
mortgage loan production during the year ended December 31, 1997 as compared
to the same 1996 period, slightly offset the decrease in unadjusted salaries
and employee benefits expense. The decrease in unadjusted salaries and
employee benefits expense primarily reflects decreased headcount as a result
of the Company's restructuring plan implemented in the second quarter of
1997, partially offset by higher loan officer commissions associated with
the increase in total mortgage loan production in 1997 and an increase in
the long term incentive plan accrual.
The provision for loan losses was $8.6 million and $10.3 million for the
years ended December 31, 1997 and 1996, respectively. The decrease in the
1997 provision is primarily due to lower loss volumes resulting from the
decrease in the Company's owned servicing portfolio, a decrease in the
average loss per loan and lower loss volumes on certain California
residential mortgage loans in 1997. In addition, the 1997 provision includes
a $.4 million charge related to the sale of a commercial real estate owned
property in the second quarter of 1997. A valuation allowance of $2.6
million was included in the December 31, 1996 allowance for loan losses and
$.9 million was charged to the 1996 provision for this property.
In the fourth quarter of 1996, the Company wrote off the remaining carrying
value of goodwill and certain other intangible assets totaling $29.1
million. It is the Company's policy to account for goodwill and other
intangible assets at the lower of amortized cost or fair value. On an
ongoing basis, management reviews the valuation and amortization of these
assets. As a part of its ongoing review, management estimates the fair value
of the Company's intangible assets, taking into consideration any events and
circumstances which might have diminished their value. During 1996, the
Company had been re-evaluating the recoverability of goodwill and certain
other intangible assets and considered the impact of the following factors
on its forecast of future operations (i) increased competition and industry
consolidation which had adversely impacted the value of the Company's
mortgage loan production and servicing operation; (ii) the attainment of a
definitive agreement in the fourth quarter of 1996 to sell approximately
$17.0 billion of the Company's mortgage servicing portfolio at essentially
book value and (iii) a reduction in interest rates in the fourth quarter of
1996. Based on such valuation, the Company had determined that its projected
results would not support the future amortization of the Company's remaining
goodwill and certain other intangible assets of $29.1 million at December
31, 1996 and, therefore, wrote-off such assets.
In April 1997, the Company's management approved and implemented a
restructuring plan designed to reduce its operating costs in order to
improve its financial performance. As part of this plan, the Company reduced
its work force, primarily in overhead areas, by approximately 100 employees
during the second quarter of 1997 to bring its overhead costs in line with
its production and servicing operations. As a result, the Company recognized
restructuring charges totaling $1.7 million during the second quarter of
1997. The amount includes approximately $1.6 million of employee separation
costs, including severance payments, health care coverage and postemployment
education benefits and $.1 million of miscellaneous expenses. As of December
31, 1997, $.1
8
<PAGE> 9
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
million of these charges remained accrued in the Company's consolidated
statement of condition.
Other operating expenses were $26.6 million and $34.3 million for the year
ended December 31, 1997 and 1996, respectively. The decrease in 1997 is
primarily due to the elimination of amortization expense related to goodwill
and certain other intangible assets which were written off at year end 1996.
The Company's income tax provision for the year ended December 31, 1997
includes an additional provision for the effect of the February 1997
servicing sale. The 1996 provision was adversely impacted by the write-off of
goodwill and other intangible assets at year end 1996. The total pretax
write-off of these assets was $29.1 million and the related tax benefit was
$3.2 million.
The Company recognized an extraordinary loss of $6.0 million, net of income
tax benefit, on the early retirement of $119.6 million of its outstanding
8.875% medium-term notes due October 15, 2001 in the second quarter of 1997.
During the fourth quarter of 1996, the Company established a team to
coordinate the identification, evaluation and implementation of changes to
computer systems and applications necessary to achieve a year 2000 date
conversion with no effect on customers or disruption to business operations.
These actions are necessary to ensure that the systems and applications will
recognize and process the year 2000 and beyond. Currently, the project is
substantially complete and unit tested, with an estimated completion date in
early 1998. At that time, testing of the full system will begin and is
estimated to be complete well before the end of 1998. The cost of achieving
year 2000 compliance is estimated to be less than $2.0 million above the cost
of normal software upgrades and replacements. As of December 31, 1997
approximately $1.0 million had been spent on the project.
The Company has initiated formal communications with all of its significant
business partners to determine the extent to which the Company's interface
systems are vulnerable to those third parties' failure to remedy their own
year 2000 issues. There is no guarantee that the systems of other companies
on which the Company's systems rely will be converted on a timely basis and
will not have an adverse effect on the Company's systems.
YEAR ENDED DECEMBER 31, 1996 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1995
SUMMARY - The Company reported a net loss of $4.3 million for the year ended
December 31, 1996 as compared to net income of $26.2 million for the year
ended December 31, 1995. The 1996 net loss reflects a $29.1 million pretax
charge for the write-off of the Company's goodwill and other intangible
assets and a $.9 million pretax charge for impairment of its capitalized
servicing asset. These amounts were partially offset by a $10.1 million
pretax gain on the sale of servicing to a third party and a $9.9 million
pretax net gain on financial instruments. The 1995 net income includes a
$28.0 million pretax charge for impairment of the capitalized servicing
asset, $40.0 million of pretax gains on the sale of servicing to third
parties and a $.8 million pretax net gain on financial instruments.
The Company reported a comprehensive loss (which includes net income (loss)
and the net change in after tax unrealized investment gain) of $3.8 million
for the year ended December 31, 1996 as compared to comprehensive income of
$29.8 million for the year ended December 31, 1995. The Company's 1996 and
1995 unrealized investment gains are associated with its investment in common
equity securities.
The Company's total mortgage servicing portfolio decreased to $29.2 billion
as of December 31, 1996 from $31.8 billion as of December 31, 1995. The
Company continued to act on its corporate strategy to optimize returns on its
owned servicing portfolio by buying and selling mortgage servicing rights
based on the underlying risk and return characteristics. The Company
purchased the rights to service $2.8 billion and $4.7 billion of mortgage
loans from third parties during 1996 and 1995, respectively. During 1996, the
Company sold the rights to service $3.3 billion of mortgage loans for net
proceeds of $55.9 million and a pretax gain of $10.1 million. During 1995,
the Company sold a total of $11.0 billion in servicing rights to third
parties for net proceeds of $199.1 million and a pretax gain of $40.0
million.
Total mortgage production for the years ended December 31, 1996 and 1995 was
$3.8 billion and $2.9 billion, respectively. Production related to
refinancing activity made up 33% of total mortgage loan production for 1996 as
9
<PAGE> 10
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
compared to 23% for 1995. The increase in mortgage loan production in 1996
reflects overall lower market interest rates during 1996 and a corresponding
increase in refinancing activity from 1995 levels.
Mortgage loan payoffs for the years ended December 31, 1996 and 1995 were
$3.0 billion and $2.3 billion, respectively. The average prepayment rate of
the Company's total servicing portfolio was 10.5% for the year ended December
31, 1996 as compared to 8.3% for 1995. The Company's prepayment experience is
significantly influenced by fluctuations in mortgage interest rates, although
the effect is not immediate. A steady decline in market interest rates for
mortgage loans during 1995 in addition to average lower interest rates in
1996 contributed to the increase in mortgage loan prepayments during 1996.
REVENUE - Mortgage servicing revenue decreased to $139.6 million in 1996 from
$141.9 million in 1995. This decrease is primarily due to a lower average
servicing portfolio balance during 1996 compared to 1995. This decrease was
partially offset by the recognition of a portion of the Company's deferred
gain on the 1994 sale of servicing rights. Amortization of capitalized
servicing decreased $9.4 million during the year ended December 31, 1996 from
the comparable 1995 period. Amortization includes a $.9 million and $28.0
million increase in the valuation allowances for impairment of the Company's
capitalized servicing asset in 1996 and 1995, respectively. Excluding the
effects of these charges, amortization expense increased to $71.0 million
from $53.4 million for the years ended December 31, 1996 and 1995,
respectively. The increase in amortization expense is primarily due to higher
market consensus prepayment rates as well as a higher average servicing asset
balance during 1996 as compared to 1995. The impairment charge in 1995 is a
result of increased market consensus prepayment rates and a corresponding
decrease in the fair value of the Company's capitalized servicing asset from
year end 1994.
In 1994, the Company sold the rights to service $3.9 billion of mortgage
loans to a third party and continued to service these loans pursuant to a
subservicing agreement. The gain of $19.9 million was deferred and was being
recognized over the five-year life of the subservicing agreement. In the
fourth quarter of 1996, the third party sold the rights to service
approximately $1.0 billion of these mortgage loans, and as a result, the
Company recognized an additional $2.4 million of the deferred gain. In 1996
and 1995, the Company recognized deferred gains totaling $6.1 million and
$4.2 million, respectively, as part of mortgage servicing revenue in the
consolidated statements of income.
For the year ended December 31, 1996, the Company recognized a $9.9 million
gain on its financial instruments as compared to a gain of $.8 million in
1995. The 1996 gain includes $8.1 million in realized gains from the sale of
financial instruments and net cash flows received and $1.8 million in
unrealized gains due to a net increase in the fair market value of various
financial instruments. The 1995 gain includes unrealized gains due to a net
increase in the fair market value of the financial instruments. As of
December 31, 1996 and 1995, the carrying value of the financial instruments
was $8.0 million and $3.5 million, respectively, and is included in
investments in the consolidated statements of condition (refer to Note 11 to
the consolidated financial statements for further discussion).
Interest income increased to $40.8 million in 1996 from $37.7 million in
1995. The increase in interest income is indicative of the increase in
production levels experienced in 1996 as compared to 1995. Interest expense
increased to $36.0 million in 1996 from $27.3 million in 1995. This increase
is due to the increase in short-term borrowings necessary to fund production
as well as the additional expense related to the $56.0 million in principal
amount of subordinated debentures issued in December 1995.
The Company had net realized losses on the sale and exchange of securities
with affiliates of $.9 million and $2.2 million for the years ended December
31, 1996 and 1995, respectively. The 1996 loss was a result of the Company
selling its then remaining common equity securities to White Mountains for
cash. The 1995 loss resulted from the transfer of $27.0 million of certain
common equity securities to White Mountains in exchange for shares of the
Company's common stock held by White Mountains, which were then retired by
the Company. All of the equity securities involved in such transactions were
actively traded, readily marketable, listed on a national exchange and, for
purposes of such transactions, valued at their closing prices on the day
preceding the date of each transaction.
The net realized investment gain of $.6 million for the year ended December
31, 1996 includes a $1.4 million gain on
10
<PAGE> 11
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
the return of a partnership investment, offset by the writedown of
certain investments to realizable value. The net realized loss of $.5 million
for the year ended December 31, 1995 primarily reflects net losses realized
on the sale of the Company's common equity securities to third parties.
Net gain on sale of mortgages increased to $38.3 million in 1996 from $24.0
million in 1995. The increase reflects increased production and related
mortgage sales volumes in 1996.
Other revenue was $18.1 million and $15.6 million for the years ended
December 31, 1996 and 1995, respectively. The increase in other revenue,
which consists primarily of insurance commissions and brokerage fees, was
directly related to the increase in production volumes.
EXPENSES - Salaries and employee benefits expense was $56.3 and $51.3 million
for the years ended December 31, 1996 and 1995, respectively. Generally
accepted accounting principles ("GAAP") require loan origination revenues to
be netted against direct loan origination costs. Since salaries and employee
benefits expense is the largest component of loan origination costs,
approximately 90% of loan origination fees are accounted for as a reduction
to salaries and employee benefits expense as illustrated in the following
table:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------
Year ended December 31, (in thousands) 1996 1995
- --------------------------------------------------------------------------
<S> <C> <C>
Unadjusted salaries and employee benefits expense $76,114 $68,807
GAAP net origination revenues (19,820) (17,550)
- --------------------------------------------------------------------------
GAAP salaries and employee benefits expense $56,294 $51,257
- --------------------------------------------------------------------------
</TABLE>
An increase in loan origination revenues, reflecting higher retail mortgage
loan production in 1996, slightly offsets the increase in unadjusted salaries
and employee benefits expense. Excluding the effects of loan origination
revenues, salaries and employee benefits expense increased 11% in 1996 as
compared to 1995. This increase reflects the additional personnel expenses
and loan officer commissions associated with the Company's increased mortgage
loan production in 1996.
The provision for loan losses increased to $10.3 million in 1996 from $7.0
million in 1995. This increase is attributable to a higher average loss per
loan, higher loss volumes relating to certain California residential mortgage
loans and increased losses due to servicing portfolios acquired by the
Company during the fourth quarters of 1995 and 1996. The delinquency rates of
these acquired portfolios were higher than the Company's historical average
delinquency rate. The Company purchased these portfolios for prices which
were reflective of these higher delinquency rates. In addition, the 1996
provision includes a $.9 million charge to increase the valuation allowance
of a certain commercial real estate owned property. The valuation allowance
for this property totaled $2.6 million at December 31, 1996.
In the fourth quarter of 1996, the Company wrote off the remaining carrying
value of goodwill and certain other intangible assets totaling $29.1 million.
Other operating expenses, which consist primarily of loan processing expenses
and general office expenses, increased to $34.3 million in 1996 from $32.8
million in 1995. Loan processing expenses tend to decrease or increase with
mortgage loan production. Accordingly, the increase in other operating
expenses in 1996 reflects higher mortgage loan production in 1996 compared to
1995.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary cash flow requirements relate to funding mortgage loan
production and investments in mortgage servicing rights. To meet these
financing needs, the Company relies on short-term credit facilities, medium
and long-term debt, early funding programs, cash flow from operations and
until the investment downgrade described below, commercial paper borrowings.
The Company also generates cash from the sale of servicing. Management
believes capital resources will be sufficient to meet the Company's operating
needs as well as to fund maturing medium and long-term debt.
11
<PAGE> 12
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In July 1997, the Company amended and restated its secured revolving credit
agreement to reflect a reduction in its borrowing requirements resulting from
the cash proceeds received from the 1997 servicing sale. The provisions of
the amended agreement decreased the Company's revolving credit facility from
$750.0 million to $500.0 million, reduced borrowing costs by lowering the
facility fee and will allow the Company to use proceeds from the servicing
sale to pay additional dividends on its common stock of up to $75.0 million.
The provisions also granted the Company the option to increase the size of
the facility up to $750.0 million, with bank concurrence (refer to Note 23 to
the consolidated financial statements). In order to fund increased production
volumes and replace commercial paper financing no longer available as a
result of the downgrade of the Company's debt rating as described below, the
Company exercised its right under the agreement to request additional
commitments in December 1997. With bank concurrence, the Company obtained
additional commitments of $100.0 million which increased the available
revolving facility to $600.0 million. Borrowings under the facility are
secured primarily by the Company's mortgage loans receivable and pool loan
purchases. The revolving credit facility expires on July 24, 1998. As of
December 31, 1997, the Company had $559.0 million outstanding under this
facility. As of December 31, 1996, the Company had no borrowings outstanding
under the previous facility, however, the Company had $347.2 million of
commercial paper borrowings outstanding.
The Company must comply with certain financial covenants provided in its
secured revolving credit facility, including restrictions relating to
tangible net worth and leverage. In addition, the secured facility contains
certain covenants which limit the Company's ability to pay dividends or make
distributions of its capital in excess of preferred stock dividend and
subordinated debt interest requirements each year. The Company is currently
in compliance with all such covenants.
The Company's $60.0 million unsecured revolving credit agreement was not
extended in July 1997. This agreement was designed to give the Company
benefit for escrow funds held in custodial banks. The Company continues to
receive this benefit by replacing borrowings under this facility with
borrowings under the bid loan provision of the Company's secured credit
agreement. The Company's total bank facility borrowing capacity was not
reduced by the termination of the unsecured agreement because borrowings
under this agreement reduced the Company's ability to borrow up to the
maximum amount under its secured credit facility. As of December 31, 1996,
there was $45.0 million outstanding under the Company's unsecured agreement.
The Company has a $650.0 million domestic commercial paper program. In
November 1997, the Company's commercial paper rating was downgraded by
Moody's from Prime-3 to Not Prime. In addition, in April 1997, the Company's
commercial paper rating was downgraded by Standard & Poors from A-2 to A-3.
As a result of the rating downgrade in November, the Company is not able to
issue commercial paper and has replaced its commercial paper borrowings with
borrowings under its $600.0 million revolving credit facility.
The Company amended a short-term borrowing agreement in April 1997 which it
had entered into August 1996. The provisions of the amended agreement
increased the Company's facility from $25.0 million to $50.0 million. As a
result of the rating downgrade in November 1997, the Company is not able to
borrow under this agreement. As of December 31, 1996, there was $15.0 million
outstanding under the original agreement.
Central Pacific Mortgage Company ("Central Pacific"), a wholly-owned
subsidiary of the Company, entered into a new unsecured revolving credit
agreement in May 1997 under which it can borrow up to $15.0 million through
June 1, 1998. Central Pacific amended this agreement in December 1997 to
change certain reporting requirements and financial covenants. Borrowings
under the agreement are guaranteed by the Company. As of December 31, 1997,
there was $10.5 million outstanding under this agreement. As of December 31,
1996, there were no borrowings outstanding under the previous agreement which
allowed for borrowings up to $10.0 million.
Central Pacific must comply with certain financial covenants provided in its
revolving credit agreement, including restrictions relating to tangible net
worth and leverage. As guarantor, these covenants apply to the Company.
Central Pacific is currently in compliance with all such covenants.
12
<PAGE> 13
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Effective December 8, 1995, the Company exchanged and retired 2,239,061
shares of its 8.42% cumulative preferred stock, Series A, for $56.0 million
principal amount of 9.375% subordinated interest deferrable debentures
("subordinated debentures"), due December 31, 2025. Interest on the
subordinated debentures is paid quarterly in arrears at the annual rate of
9.375% on the last business day of each March, June, September and December.
The first interest payment was made on December 29, 1995 for the period from
November 1, 1995 (the last regular dividend payment date with respect to the
preferred stock) through December 8, 1995 at the annual rate of 8.42% and
from December 9, 1995 through December 31, 1995 at the annual rate of 9.375%.
The purpose for the exchange was to improve the Company's after-tax cash flow
since the interest payable on the subordinated debentures is deductible for
federal income tax purposes, whereas dividends payable on the preferred stock
are not.
The subordinated debentures are redeemable at the option of the Company, in
whole or in part, at any time on or after May 1, 1999. On or after such date,
the subordinated debentures may be redeemed at the option of the Company at a
price equal to 100% of the principal amount redeemed ($25 for each $25
principal amount of subordinated debenture), plus accrued and unpaid interest
to the date fixed for redemption.
In June 1992, the Company issued $100.0 million of 9% debentures due June
2012 under terms of a $250.0 million shelf registration statement filed with
the Securities and Exchange Commission ("SEC") in April 1992. The debentures
may not be redeemed by the Company prior to maturity. The proceeds were used
for general corporate purposes.
Under a $200.0 million shelf registration statement filed with the SEC in
November 1988, the Company issued $40.0 million of medium-term notes in 1989,
with a total weighted average interest rate of 9.65% due 1996, and in October
1991, the Company issued $160.0 million of 8.875% medium-term notes due
October 2001. During 1995, the Company repurchased and retired $10.3 million
of the medium-term notes due in 1996 and $21.6 million of the medium-term
notes due in 2001. During 1996, the Company repaid the remaining $29.7
million of the medium-term notes due in 1996 on their maturity dates. In May
1997, the Company repurchased and retired $119.6 million of the medium-term
notes due in 2001.
In 1986, the Company issued $125.0 million of 8.25% debentures due November
1, 1996. The Company repurchased and retired $50.4 million of these
debentures during 1995 and repaid the remaining $74.6 million on their
maturity date in 1996.
The Company has a dividend policy which may result in the payment of
dividends on the Company's common stock, dependent upon the earnings, cash
position and capital needs of the Company, limitations in credit agreements,
general business conditions and other factors deemed relevant by the
Company's Board of Directors. The Company did not declare any dividends on
its common stock during 1997, 1996 or 1995 (refer to Note 23 to the
consolidated financial statements).
Quarterly cash dividends are paid on preferred stock at an annual rate of
8.42% or $2.105 per share, if declared by the Board of Directors, in arrears
on the first day of each February, May, August and November. The Company paid
cash dividends totaling $3.7 million, $3.7 million and $8.4 million on its
preferred stock for the years ended December 31, 1997, 1996 and 1995,
respectively.
The preferred stock is not redeemable prior to May 1, 1999. On or after such
date, the preferred stock may be redeemed at the option of the Company at a
price of $25 per share, plus accrued and unpaid dividends to the redemption
date.
In January 1997, the Company transferred its remaining common equity
securities with a market value of $2.6 million to White Mountains in exchange
for 21,239 shares of the Company's common stock held by White Mountains,
which were retired by the Company.
In February 1997, the Company sold $17.0 billion of its nonrecourse mortgage
servicing portfolio to a third party for adjusted proceeds of $266.9 million.
The Company has used the proceeds of $242.6 million received from the sale
through December 31, 1997 to reduce outstanding short-term debt and to retire
$119.6 million of its 8.875% medium-term notes. The remaining balance of
$27.3 million, including accrued interest, is reflected as a receivable from
sale of servicing in the consolidated statement of condition as of December
31, 1997. The Company is currently evaluating its
13
<PAGE> 14
MANAGEMENT'S DISCUSSION & ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
options as to how it will utilize the remaining proceeds from the sale.
These options include: (i) purchasing additional mortgage servicing rights
from third parties; (ii) further reducing its outstanding indebtedness; (iii)
reducing its outstanding preferred or common shareholders' equity or (iv) any
combination of the foregoing.
In March 1997, the Board of Directors of Fund American approved a corporate
restructuring plan involving several of its subsidiaries including the
Company. In accordance with this plan, the Company contracted to receive
capital infusions from White Mountains of approximately $139 million
(approximately $119 million net of associated tax liabilities and other
adjustments) consisting primarily of common stock, convertible redeemable
preferred stock and options to acquire common stock of FSA. During the first
quarter of 1997, the Company issued 230,293 shares of its common stock to its
White Mountains in exchange for 1.0 million shares of FSA common stock valued
at $27.8 million and issued 105,000 shares of its common stock to Fund
American for cash proceeds of $12.7 million. During the second quarter of
1997, the Company recorded the remaining contribution by White Mountains of
$78.5 million of contracted net assets consisting of 2.5 million shares of
FSA common stock, 2.0 million shares of FSA convertible redeemable preferred
stock and options to acquire 2.6 million shares of FSA common stock in
exchange for 650,827 shares of the Company's common stock. The capital
infusions were undertaken to improve the Company's debt ratings and reduce
the Company's borrowing costs.
During 1996, the Company sold the rights to service a total of $3.3 billion
of mortgage loans to a third party for net proceeds of $55.9 million, which
were used for general corporate purposes.
During 1995, the Company sold the rights to service a total of $11.0 billion
of mortgage loans to third parties for net proceeds of $199.1 million, which
were used to repurchase and retire debt, repurchase common stock and for
general corporate purposes.
During 1995, the Company transferred a total of $27.0 million of common
equity securities and $93.0 million in cash and money market investments to
White Mountains in exchange for 959,049 shares of the Company's common stock
held by White Mountains, which were retired by the Company.
The Company is currently considering further steps to restructure its debt
including (i) the issuance of approximately $50.0 million of additional
medium-term notes pursuant to an existing shelf registration and (ii)
entering into interest rate swaps whereby the Company's obligation to pay a
fixed rate of interest on a portion of its outstanding medium-term notes and
debentures will be swapped for an obligation to pay a floating rate of
interest. The Company believes that using floating rate debt to finance a
larger portion of its mortgage servicing assets is prudent, since the value
of such assets generally increases as interest rates increase, and declines
as interest rates decrease.
INFLATION
Inflation and changes in interest rates can have differing effects on various
aspects of the Company's business, particularly with respect to marketing
gains and losses from the sale of mortgage loans, mortgage loan production,
the value of the Company's servicing portfolio and net interest revenue.
Historically, the Company's loan originations and loan production income have
increased in response to falling interest rates and have decreased during
periods of rising interest rates. Periods of low inflation and falling
interest rates tend to reduce loan servicing income and the value of the
Company's mortgage loan servicing portfolio because prepayments of mortgages
increase and the average life of loan servicing rights is shortened.
Conversely, periods of increasing inflation and rising interest rates tend to
increase loan servicing income and the value of the Company's mortgage loan
servicing portfolio because prepayments of mortgages decline and the average
life of loan servicing rights is lengthened. In an attempt to mitigate the
Company's exposure to changes in market interest rates, the Company utilizes
various derivative financial instruments (refer to Note 11 to the
consolidated financial statements).
14
<PAGE> 15
REPORT OF INDEPENDENT AUDITORS
THE BOARD OF DIRECTORS
SOURCE ONE MORTGAGE SERVICES CORPORATION
We have audited the accompanying consolidated statement of condition of
Source One Mortgage Services Corporation and subsidiaries ("the Company") as
of December 31, 1997, and the related consolidated statements of income,
comprehensive income, stockholders' equity, and cash flows for the year then
ended. 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 audit. We did not audit the financial statements of
Financial Security Assurance Holdings Ltd. ("FSA") (a 12.1 percent owned
equity investee company). The Company's investment in FSA at December 31,
1997, was $104 million, and its equity in earnings of FSA was $9.5 million
for the year ended December 31, 1997. The financial statements of FSA were
audited by other auditors, Coopers & Lybrand L.L.P., whose report has been
furnished to us, and our opinion, insofar as it relates to the amounts
included for FSA, is based solely on the report of the other auditors. The
accompanying consolidated financial statements of the Company as of December
31, 1996, and for each of the years in the two-year period ended December 31,
1996, were audited by other auditors whose report thereon dated January 30,
1997, (except for Notes 7 and 22, as to which the date was March 21, 1997),
on those statements included an explanatory paragraph that described the
change in the Company's method of accounting for mortgage servicing rights
discussed in Notes 1 and 3 to the consolidated financial statements.
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 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 audit and the report of
the other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audit and the report of the other auditors, the
1997 consolidated financial statements referred to above present fairly, in
all material respects, the financial position of Source One Mortgage Services
Corporation and subsidiaries as of December 31, 1997, and the results of
their operations and their cash flows for the year then ended in conformity
with generally accepted accounting principles.
KPMG Peat Marwick LLP
Detroit, Michigan
January 29, 1998,
except for Note 23
as to which the date is
March 20, 1998
15
<PAGE> 16
CONSOLIDATED STATEMENTS OF CONDITION
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------
December 31, (in thousands, except for share and per share amounts) 1997 1996
- -------------------------------------------------------------------------------------------------------------------------
ASSETS
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Cash $ 3,134 $ 923
Investments 86,239 46,555
Investment in unconsolidated affiliate (net) 192,137 -
Mortgage loans receivable 519,247 314,937
Pool loan purchases 149,791 131,539
Loans held for investment 5,191 17,984
Capitalized servicing (net) 181,025 410,939
Receivable from sale of servicing 27,324 -
Common equity securities (net) - 2,312
Mortgage claims receivable and real estate acquired
(net of allowance for loan losses of $12,800 in 1997 and $15,400 in 1996) 41,199 57,119
Premises and equipment 22,171 28,054
Other assets 77,232 120,692
- -------------------------------------------------------------------------------------------------------------------------
Total assets $ 1,304,690 $ 1,131,054
=========================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
- -------------------------------------------------------------------------------------------------------------------------
Liabilities:
Senior debt $ 686,906 $ 643,262
Subordinated debt 55,153 54,535
Accounts payable and other liabilities 107,582 118,500
- -------------------------------------------------------------------------------------------------------------------------
Total liabilities 849,641 816,297
=========================================================================================================================
Stockholders' Equity:
Preferred stock, $.01 par value, 12,000,000 shares authorized,
1,760,939 shares of 8.42% cumulative Series A (aggregate
liquidation preference of $44,023) issued and
outstanding as of December 31, 1997 and 1996 18 18
Common stock, $.01 par value, 8,000,000 shares authorized,
3,211,881 and 2,247,000 shares issued and outstanding as of
December 31, 1997 and 1996, respectively 32 22
Paid-in capital 462,480 346,088
Accumulated other comprehensive income 41,102 -
Retained deficit (48,583) (31,371)
- -------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 455,049 314,757
- -------------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $ 1,304,690 $ 1,131,054
=========================================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.
16
<PAGE> 17
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands, except for per share amounts) 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
REVENUE
- -----------------------------------------------------------------------------------------------------------------------------
Mortgage servicing revenue $ 94,952 $ 139,578 $ 141,883
Amortization of capitalized servicing (64,150) (71,936) (81,385)
Net gain on financial instruments 11,271 9,904 840
- -----------------------------------------------------------------------------------------------------------------------------
Net servicing revenue 42,073 77,546 61,338
- -----------------------------------------------------------------------------------------------------------------------------
Interest income 45,754 40,826 37,669
Interest expense (35,362) (36,018) (27,348)
- -----------------------------------------------------------------------------------------------------------------------------
Net interest revenue 10,392 4,808 10,321
- -----------------------------------------------------------------------------------------------------------------------------
Net realized investment gain (loss) on sale and
exchange of securities with affiliates 326 (855) (2,159)
Net realized investment (loss) gain (1,048) 623 (544)
Equity in earnings of unconsolidated affiliate 9,507 - -
Net gain on sale of mortgages 21,497 38,346 24,015
Net (loss) gain on sale of servicing
and assumption of subservicing (8,032) 10,080 40,041
Other 19,159 18,132 15,583
- -----------------------------------------------------------------------------------------------------------------------------
Total revenue 93,874 148,680 148,595
=============================================================================================================================
EXPENSES
- -----------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits 54,794 56,294 51,257
Office occupancy and equipment 13,289 13,619 14,326
Provision for loan losses 8,610 10,260 6,956
Write-off of goodwill and other intangible assets - 29,128 -
Restructuring charges 1,727 - -
Other operating expenses 26,601 34,252 32,774
- -----------------------------------------------------------------------------------------------------------------------------
Total expenses 105,021 143,553 105,313
- -----------------------------------------------------------------------------------------------------------------------------
(Loss) income before income taxes and
extraordinary loss (11,147) 5,127 43,282
Income tax (benefit) expense (3,617) 9,453 16,132
- -----------------------------------------------------------------------------------------------------------------------------
(Loss) income before extraordinary loss (7,530) (4,326) 27,150
Extraordinary loss on repurchase of debt
(net of income tax benefit of $3,217
in 1997 and $486 in 1995) (5,975) - (902)
- -----------------------------------------------------------------------------------------------------------------------------
Net (loss) income (13,505) (4,326) 26,248
Less dividends on preferred stock 3,707 3,707 7,634
- -----------------------------------------------------------------------------------------------------------------------------
Net (loss) income applicable to common stock $ (17,212) $ (8,033) $ 18,614
=============================================================================================================================
Basic net (loss) income per common share:
Before extraordinary loss $ (3.78) $ (3.57) $ 7.55
Extraordinary loss (2.01) - (.35)
- -----------------------------------------------------------------------------------------------------------------------------
Basic net (loss) income per common share $ (5.79) $ (3.57) $ 7.20
=============================================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.
17
<PAGE> 18
CONSOLIDATED STATEMENTS
OF COMPREHENSIVE INCOME
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands, except for per share amounts) 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net (loss) income $ (13,505) $ (4,326) $ 26,248
Other comprehensive income, net of tax
Unrealized gains (losses) on investments:
Unrealized holding gain (loss) arising during year
(net of income tax expense (benefit) of $22,245, $(5) and
$914 for 1997, 1996 and 1995, respectively) 41,314 (10) 1,697
Less: reclassification adjustment for (gains) losses
included in net income (net of income tax (expense) benefit
of $(114), $299 and $981 for 1997, 1996 and 1995, respectively) (212) 556 1,822
- ------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income 41,102 546 3,519
- ------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) 27,597 (3,780) 29,767
Less dividends on preferred stock 3,707 3,707 7,634
- ------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) applicable to
common stock $ 23,890 $ (7,487) $ 22,133
==============================================================================================================================
Basic comprehensive income (loss) per common share $ 8.03 $ (3.33) $ 8.57
==============================================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.
18
<PAGE> 19
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------------------
Year ended December 31, 1997, 1996 and 1995
(in thousands, except for share and per share amounts)
- --------------------------------------------------------------------------------------------------------------------------------
Accumulated Total
Other Retained Stock-
Preferred Common Paid-in Comprehensive Earnings holders'
Stock Stock Capital Income (Deficit) Equity
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balances at January 1, 1995 $ 40 $ 32 $ 522,032 $ (4,065) $ (41,952) $ 476,087
Net income - - - - 26,248 26,248
Change in unrealized investment
gain (net) - - - 3,519 - 3,519
Repurchase of 959,049 shares of
common stock, $.01 par value,
from parent - (10) (119,990) - - (120,000)
Exchange of 2,239,061 shares of
8.42% cumulative Series A
preferred stock, $.01 par value
(aggregate liquidation preference
of $25 per share) for 9.375%
subordinated debentures (22) - (55,954) - - (55,976)
Preferred dividends declared
of $2.105 per share - - - - (7,634) (7,634)
================================================================================================================================
Balances at December 31, 1995 18 22 346,088 (546) (23,338) 322,244
Net loss - - - - (4,326) (4,326)
Change in unrealized investment
gain (net) - - - 546 - 546
Preferred dividends declared of
$2.105 per share - - - - (3,707) (3,707)
================================================================================================================================
Balances at December 31, 1996 18 22 346,088 - (31,371) 314,757
Net loss - - - - (13,505) (13,505)
Change in unrealized investment
gain (net) - - - 41,102 - 41,102
Repurchase of 21,239 shares of
common stock, $.01 par value,
from parent - - (2,638) - - (2,638)
Issuance of 105,000 shares of
common stock, $.01 par value,
to parent - 1 12,674 - - 12,675
Issuance of 230,293 shares of
common stock, $.01 par value,
to parent - 2 27,797 - - 27,799
Issuance of 650,827 shares of
common stock, $.01 par value,
to parent - 7 78,559 - - 78,566
Preferred dividends declared of
$2.105 per share - - - - (3,707) (3,707)
- --------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 $ 18 $ 32 $ 462,480 $ 41,102 $ (48,583) $ 455,049
================================================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.
19
<PAGE> 20
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
- ----------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
- ----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net (loss) income $ (13,505) $ (4,326) $ 26,248
Noncash items included in the determination of
net (loss) income:
Amortization of capitalized servicing 64,150 71,936 81,385
Write-off of goodwill and other intangible assets - 29,128 -
Net unrealized gain on financial instruments (13,323) (1,820) (840)
Provision for loan losses 8,610 10,260 6,956
Depreciation and amortization 6,586 8,825 7,347
Write down of loans held for investment identified
as held for sale 3,000 - -
Loss on sale of financial instruments 2,205 - -
Net realized loss on investments 722 232 2,703
Amortization of goodwill - 2,090 2,090
Loss (gain) on sale of servicing and assumption of
subservicing 8,032 (10,080) (40,041)
Amortization of deferred gain on sale of servicing (6,885) (6,139) (4,188)
Undistributed earnings from unconsolidated affiliate (8,668) - -
Mortgage loan production (4,403,281) (3,831,639) (2,852,017)
Mortgage loan sales and amortization 4,198,971 3,897,730 2,681,461
Net increase (decrease) in accounts payable and other
liabilities 15,950 (15,002) 18,749
Net decrease in other assets 31,154 5,433 3,985
Net change in current and deferred income taxes
receivable and payable (12,160) (10,158) 16,849
Extraordinary loss on repurchase of debt 5,975 - 902
- ----------------------------------------------------------------------------------------------------------------------------
Net cash (used) provided by operating activities (112,467) 146,470 (48,411)
- ----------------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
- ----------------------------------------------------------------------------------------------------------------------------
Collections on and sales of pool loan purchases,
mortgage claims receivable and real estate acquired 274,158 175,289 210,876
Additions to pool loan purchases, mortgage claims
receivable and real estate acquired (285,100) (205,745) (172,650)
Additions to capitalized mortgage servicing rights (139,500) (88,578) (120,786)
Net proceeds from sales of servicing 242,628 11,706 181,109
Additions to long-term investments (53,958) (6,188) (3,654)
Principal payments received on long-term investments 385 408 1,088
Net decrease (increase) in short-term investments 24,141 (14,354) 26,412
Proceeds from sale of common equity securities to affiliates - 514 -
Proceeds from sales of common equity securities - - 21,390
Net disposition (acquisition) of premises and equipment 914 (1,410) 185
Net decrease (increase) in loans held for investment 9,793 2,517 (726)
- ----------------------------------------------------------------------------------------------------------------------------
Net cash provided (used) by investing activities $ 73,461 $ (125,841) $ 143,244
- ----------------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
20
<PAGE> 21
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Proceeds from issuance of commercial paper $ 5,785,634 $ 5,140,110 $ 4,050,417
Repayments on commercial paper (6,147,814) (5,034,543) (3,819,904)
Net increase (decrease) in credit agreement
borrowings 524,470 (20,497) (133,978)
Retirement of debt (129,872) (104,350) (85,872)
Net proceeds from issuance of common stock 12,675 - -
Repurchase of common stock from parent - - (92,980)
Dividends paid on preferred stock (3,707) (3,707) (8,420)
Other (169) (865) (1,190)
- --------------------------------------------------------------------------------------------------------------
Net cash provided (used) by financing activities 41,217 (23,852) (91,927)
- --------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash 2,211 (3,223) 2,906
Cash at beginning of year 923 4,146 1,240
- --------------------------------------------------------------------------------------------------------------
Cash at end of year $ 3,134 $ 923 $ 4,146
- --------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
21
<PAGE> 22
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
ORGANIZATION
Source One Mortgage Services Corporation (together with its subsidiaries, the
"Company") was incorporated in 1972 and is the successor to Citizens Mortgage
Corporation which was organized in 1946. The Company is a wholly-owned
subsidiary of White Mountains Holdings, Inc. (formerly Fund American
Enterprises, Inc.) and its parent Fund American Enterprises Holdings, Inc.
("Fund American"), a Delaware corporation organized in 1980, which was
formerly known as The Fund American Companies, Inc. and Fireman's Fund
Corporation.
The Company is one of the largest mortgage banking companies in the United
States that is not affiliated with a commercial bank. As of December 31,
1997, the Company had a mortgage loan servicing portfolio totaling $26.5
billion, including $14.9 billion of loans subserviced for others, which is
serviced on behalf of approximately 234 institutional investors and numerous
other security holders. As of December 31, 1997, the Company had 129 retail
branch offices in 26 states and originated $4.4 billion in mortgage loans for
the year then ended.
As a mortgage banker, the Company primarily engages in the business of
producing and selling conforming and subprime residential mortgage loans,
servicing conforming residential mortgage loans and subservicing residential
mortgage loans for third parties. Its sources of revenue are net servicing
revenue, net interest revenue, net gain on sale of mortgages, net gain on
sale of servicing, earnings from unconsolidated affiliate and other revenue.
Through subsidiaries, the Company also provides credit-related insurance
products (such as life, disability, health, accidental death and property and
casualty insurance).
BASIS OF PRESENTATION
The accompanying consolidated financial statements of the Company include the
accounts of Central Pacific Mortgage Company, a wholly-owned subsidiary of
the Company, (together with its subsidiaries, "Central Pacific") and all
other subsidiaries, and have been prepared in accordance with generally
accepted accounting principles. Significant intercompany transactions have
been eliminated in consolidation. The financial statements include all
adjustments considered necessary by management to fairly present the
financial position, results of operations and cash flows of the Company. The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities 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.
Certain amounts in prior year financial statements have been reclassified to
conform with the current year presentation.
Fund American acquired the stock of the Company in 1986. The purchase price
paid for the Company in 1986 was in excess of historical book value of the
Company's net assets. The excess purchase price allocated to identifiable
assets was amortized primarily over 5 to 20 years depending on asset type and
prior to December 1996, the portion allocated to goodwill was amortized over
20 years. During 1996, the Company had been re-evaluating the recoverability
of goodwill and certain other intangible assets. The Company considered the
impact of the following factors on its forecast of future operations (i)
increased competition and industry consolidation which had adversely impacted
the value of the Company's mortgage loan production and servicing operation;
(ii) the attainment of a definitive agreement in the fourth quarter of 1996
to sell approximately $17.0 billion of the Company's mortgage servicing
portfolio at essentially book value and (iii) a reduction in interest rates
in the fourth quarter of 1996. Based on such valuation, the Company had
determined that its projected results would not support the future
amortization of the Company's remaining goodwill and certain other intangible
assets of $29.1 million at December 31, 1996 and, therefore, wrote-off such
assets.
ACCOUNTING STANDARDS RECENTLY ADOPTED
The Company adopted certain provisions of Statement of Financial Accounting
Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities" which supersedes SFAS
No. 122, "Accounting for Mortgage Servicing Rights" as of January 1, 1997.
SFAS No. 125 eliminates the distinction
22
<PAGE> 23
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
between "normal" servicing rights and excess servicing receivables and
changes the Company's method of measuring the value of its capitalized
servicing asset. SFAS No. 125 is effective for transfers and servicing of
financial assets beginning in fiscal year 1997. The effective date for certain
provisions of SFAS No. 125 has been deferred to fiscal year 1998. SFAS No. 125
prohibits retroactive application, therefore, the reported results for 1996
and 1995 are in accordance with prior accounting standards. The adoption of
SFAS No. 125 as it relates to the valuation of capitalized servicing is
discussed in Note 3 to the consolidated financial statements.
The Company adopted the provisions of SFAS No. 128, "Earning per Share" in
December 1997. SFAS No. 128 simplifies the calculation of earnings per share
and is intended to make the U.S. standard more comparable to the new
international standard. The adoption of SFAS No. 128 resulted in no change to
the method by which the Company calculates its earnings per share but
replaces the Company's historic presentation of "earnings per share" with a
presentation of "basic earnings per share". These provisions have been
applied retroactively, and therefore, the 1996 and 1995 earnings per share
amounts disclosed are directly comparable to the 1997 amounts.
The Company adopted the provisions of SFAS No. 130, "Reporting Comprehensive
Income" as of December 31, 1997. SFAS No. 130 establishes standards for the
reporting and display of comprehensive income and its components (such as
changes in net unrealized investment gains and losses) in a financial
statement that is displayed with the same prominence as other financial
statements. In accordance with the adoption of SFAS No. 130, the Company now
reports comprehensive income on a separate statement. Comprehensive income
includes net income and any changes in equity from non-owner sources that
bypass the income statement. The purpose of reporting comprehensive income is
to report a measure of all changes in equity of an enterprise that result
from recognized transactions and other economic events of the period other
than transactions with owners in their capacity as owners. Application of
SFAS No. 130 will not impact amounts previously reported for net income or
affect the comparability of previously issued financial statements.
The adoption of SFAS No. 128 and SFAS No. 130 resulted in a change in
financial statement disclosures only and had no effect on the Company's
financial position or results of operations.
INVESTMENTS
Investments primarily consist of the following: short-term investments stated
at cost; real estate investment conduit ("REMIC") residuals considered held
to maturity and carried at amortized cost using a method which approximates
the effective yield method of amortization on a prospective basis; investment
partnership interests reported using the cost method of accounting since the
Company's interests are minor (less than 5%) and a fixed maturity investment
considered available for sale and stated at fair value with unrealized gains
and losses, if any, reported net of tax, as a component of accumulated other
comprehensive income in stockholders' equity. The discount on the investment
is being amortized into income over the anticipated life of the investment.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company uses interest rate floor contracts and principal-only swaps in
order to manage the exposure to interest rate risk inherent in its servicing
asset (collectively "Financial Instruments"). Although SFAS No. 115 requires
that these Financial Instruments be classified as held for trading purposes,
the Company does not consider these investments to be speculative holdings.
The Financial Instruments are carried at fair value and are included in
investments in the consolidated statements of condition. Unrealized gains and
losses arising from changes in the value of these instruments are recorded in
net gain on financial instruments in the consolidated statements of income.
Gains and losses occurring from the termination, maturity, sale or
extinguishment of the Financial Instruments are recorded immediately in net
gain on financial instruments in the consolidated statements of income.
INVESTMENT IN UNCONSOLIDATED AFFILIATE
Investment in unconsolidated affiliate consists of the Company's investment
in common stock, redeemable preferred stock and options to acquire common
stock of Financial Security Assurance Ltd. ("FSA"). The Company accounts for
its investment in FSA common stock using the equity method. The Company
accounts for its investment in FSA preferred
23
<PAGE> 24
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
stock and options under the provisions of SFAS No. 115 whereby, the
investments are classified as available for sale and reported at fair value
as of the balance sheet date, with related unrealized investment gains and
losses excluded from earnings and reported, net of tax, as a component of
accumulated other comprehensive income in stockholders' equity.
MORTGAGE LOANS RECEIVABLE
Mortgage loans receivable are stated at the lower of aggregate cost or fair
value, including the fair value of commitments to originate and commitments
to sell mortgage loans. Conventional mortgage loans are placed on a
nonaccrual basis when delinquent ninety days or more as to interest or
principal. Interest on delinquent Federal Housing Administration ("FHA")
insured loans is accrued at the insured rate beginning on the sixty-first day
of delinquency. Interest on delinquent Veterans Administration ("VA")
guaranteed loans is accrued at the loan rate during the period of
delinquency.
RECOGNITION OF REVENUES RELATED TO MORTGAGE LOANS RECEIVABLE
Discounts from the origination of mortgage loans receivable are deferred and
recognized as adjustments to gain or loss on sale. Gains and losses from the
sale of mortgage loans are recognized when proceeds are received. Loan
origination fees, net of certain direct costs, have been deferred and are
recognized as income when the related mortgage loans are sold.
POOL LOAN PURCHASES
Pool loan purchases, which are carried at cost, represent FHA insured, VA
guaranteed and conventional loans which were either delinquent or in the
process of foreclosure at the time they were purchased from Government
National Mortgage Association ("GNMA"), Federal National Mortgage Association
("FNMA") or Federal Home Loan Mortgage Corporation ("FHLMC") mortgage-backed
security pools that the Company services. Following the purchase of these
loans, interest is accrued at a rate based on expected recoveries.
LOANS HELD FOR INVESTMENT
Loans held as permanent investments are stated at the lower of cost or market
value determined at the time the permanent investment decisions were made.
The amount of discount, if any, is amortized to income over the anticipated
life of the investment.
CAPITALIZED SERVICING
Capitalized servicing includes certain costs incurred in the origination and
acquisition of mortgage servicing rights ("originated and purchased
servicing") which are deferred and amortized over the expected life of the
loan. The total cost of acquiring mortgage loans either through origination
activities or purchase transactions, is allocated between the mortgage
servicing rights and the loans based on their relative fair values. The fair
values of mortgage servicing rights are estimated by calculating the present
value of the expected future net cash flows associated with such rights,
incorporating assumptions that market participants would use in their
estimates of future servicing income and expense. A current market rate is
used to discount estimated future net cash flows. Impairment of mortgage
servicing rights is measured on a disaggregated basis by stratifying the
mortgage servicing rights based on one or more predominant risk
characteristics of the underlying loans. Impairment is recognized through a
valuation allowance for each individual stratum. The valuation allowance for
the Company's principal recourse portfolio includes a reserve for estimated
losses on the corresponding loans.
Through 1996, capitalized servicing also included, as a separate component,
the present value of future servicing revenue in excess of normal servicing
revenue on loans sold with servicing retained ("excess servicing") which was
deferred and amortized using a method that relates the anticipated servicing
revenue to total projected servicing revenue to be received over the expected
life of the loan. Impairment tests for excess servicing were performed on a
disaggregated basis. The original discount rate was used to discount excess
servicing future cash flows (refer to Note 3 to the consolidated financial
statements for further discussion).
24
<PAGE> 25
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
RECOGNITION OF REVENUES RELATED TO SERVICING MORTGAGE LOANS
Mortgage servicing revenue represents fees earned for servicing real estate
mortgage loans owned by investors and late charge income. The servicing fees
are calculated based on the outstanding principal balances of the loans
serviced and are recognized together with late charge income when received.
COMMON EQUITY SECURITIES
Common equity securities are classified as available for sale and carried at
fair value. Unrealized gains and losses, net of tax, are recorded as a
separate component of stockholders' equity with no corresponding credit or
charge to net income. Realized gains and losses from sales of common equity
securities are based on the specific identification method.
MORTGAGE CLAIMS RECEIVABLE AND REAL ESTATE ACQUIRED
Mortgage claims receivable represent claims filed primarily with FHA and VA
and are carried at cost less an estimated allowance for amounts which are not
fully recoverable from claims filed with the underlying mortgage insuring
agencies.
Real estate acquired is stated at the lower of fair value less estimated
selling costs or the recorded balance satisfied at the date of acquisition
determined on an individual property basis. Costs relating to holding the
properties are charged to expense as incurred.
The allowance for loan losses is based upon an analysis of the mortgage loan
servicing portfolio and reflects an amount which, in management's judgment,
is adequate to provide for estimated losses.
PREMISES AND EQUIPMENT
Premises and equipment, including leasehold improvements and systems and
programming software, are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are computed on a straight-line
method over the estimated useful lives of the related assets or over the
lease terms, whichever period is shorter.
BASIC NET INCOME PER SHARE
Basic net income per share amounts were computed based on the weighted
average total number of common shares outstanding. There were 2,973,999,
2,247,000 and 2,584,450 weighted average common shares outstanding for the
years ended December 31, 1997, 1996 and 1995, respectively.
DIVIDENDS PER SHARE
Cash dividends per share were computed based on the total number of common
shares outstanding as of the dividend record dates.
NOTE 2. INVESTMENT IN UNCONSOLIDATED AFFILIATE
In March 1997, the Company issued 230,293 shares of its common stock to White
Mountains in exchange for 1.0 million shares of the common stock of FSA
valued at $27.8 million. The value of the Company's common stock represented
the book value of the stock as of December 31, 1996. The value of the FSA
common stock represented White Mountains' equity carrying value of such
assets at that time. Additionally, the Company agreed to issue shares of its
common stock to White Mountains in exchange for the remainder of its FSA
holdings, the value of which was determined at that time. Effective the
second quarter of 1997, upon receipt of insurance regulatory and lender
approvals, the Company received White Mountains' remaining FSA holdings. The
Company issued an additional 650,827 shares of its common stock to White
Mountains in exchange for 2.5 million shares of FSA common stock, 2.0 million
shares of FSA convertible redeemable preferred stock and options to acquire
2.6 million shares of FSA common stock valued at $78.5 million, net of
associated tax liabilities and other adjustments.
At December 31, 1997, the Company owned 3.5 million shares of FSA common
stock. This represented approximately 12.1% of the total shares of FSA
common stock outstanding at that time. In addition, Fund American had voting
rights
25
<PAGE> 26
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
to an additional 3.9 million shares of FSA common stock at December
31, 1997, raising the consolidated entity's voting control of FSA to
approximately 24.0%. At December 31, 1997, the Company also owned FSA
options and preferred stock which, in total, give the Company the right to
acquire up to 4.6 million additional shares of FSA common stock for
aggregate consideration of $125.7 million.
The Company accounts for its investment in FSA common stock using the equity
method. FSA is a leading Aaa/AAA writer of financial guaranty insurance
whose common stock is publicly traded on the New York Stock Exchange. The
market value of the FSA common stock as of December 31, 1997, as quoted on
the New York Stock Exchange, exceeded the Company's carrying value of the
FSA common stock on the equity method. The Company accounts for its
investments in FSA options and preferred stock under the provisions of SFAS
No. 115 whereby the investments are reported at fair value as of the balance
sheet date, with related unrealized investment gains and losses, net of tax,
excluded from earnings and reported as a component of accumulated other
comprehensive income in stockholders' equity.
The following table summarizes financial information for FSA, which was
derived from the audited financial statements of FSA as of and for the
period indicated:
<TABLE>
<CAPTION>
=====================================================================================
(in millions) 1997
- -------------------------------------------------------------------------------------
FSA balance sheet data
- -------------------------------------------------------------------------------------
<S> <C>
Total investments $ 1,432
Total assets 1,901
Deferred premium revenue 595
Loss and loss adjustment expense reserves 75
Preferred shareholder's equity 1
Common shareholders' equity 882
- -------------------------------------------------------------------------------------
FSA income statement data
- -------------------------------------------------------------------------------------
Gross premiums written $ 236
Net premiums written 173
Net premiums earned 110
Net investment income 72
Net income 101
=====================================================================================
</TABLE>
The following table summarizes the amounts recorded by the Company:
<TABLE>
<CAPTION>
=====================================================================================
(in millions) 1997
- -------------------------------------------------------------------------------------
<S> <C>
Investment in FSA common stock $ 104
Investment in FSA options and preferred stock 88
- -------------------------------------------------------------------------------------
Total investment in FSA 192
- -------------------------------------------------------------------------------------
Equity in earnings from FSA common stock (a) 10
Equity in net unrealized investment gains (losses)
from FSA's investment portfolio, before tax (b) 2
Unrealized investment gains on FSA options and
preferred stock, before tax (b) 61
=====================================================================================
</TABLE>
(a) Recorded net of related amortization of goodwill.
(b) Recorded directly to stockholders' equity as a component of accumulated
other comprehensive income.
26
<PAGE> 27
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. CAPITALIZED SERVICING
For the years ended December 31, 1997, 1996 and 1995, the Company estimated
the fair values of its mortgage servicing rights by calculating the present
value of the expected net future cash flows associated with such rights. In
making those estimates, the Company incorporated assumptions that market
participants would use in their estimates of future servicing income and
expense.
In 1997 and 1996, the Company evaluated the predominant risk characteristics
(prepayment, default and operational) on its owned servicing portfolio. The
Company stratified the portfolio by interest rate, loan type (investor),
original term to maturity and principal recourse. In 1996, as a result of
the pending sale of $17.0 billion of the Company's nonrecourse mortgage
servicing portfolio, the Company valued the $17.0 billion portfolio as one
stratum using the market price as determined by the third party purchaser.
The Company measured impairment of its owned servicing portfolio using
assumptions that market participants would use to value their estimates of
future net servicing revenue. In estimating fair value, the Company used
market consensus prepayment rates and discounted the net future cash flows
using discount rates that approximated the current market rates of 10.5% for
conventional loans, 12.0% for insured loans and 21.0% for recourse loans for
those years. The fair value of each stratum was computed and compared to its
recorded book value to determine if an impairment valuation allowance, or
recovery of a previously established allowance, was required.
In 1995, to measure impairment of its mortgage servicing rights, the Company
stratified the related mortgage loan servicing portfolio based on its
predominant risk characteristics which were determined to be prepayment,
default and operational risks. This resulted in stratification by interest
rate, loan type (investor) and original term to maturity. In estimating fair
value, the Company used market consensus prepayment rates and discounted the
net future cash flows using discount rates that approximated then current
market rates of 10.5% for conventional loans and 12.0% for insured loans.
The fair value of each stratum was computed and compared to its recorded
book value to determine if an impairment valuation allowance, or recovery of
a previously established valuation allowance, was required.
As a result of the 1997 sale of $17.0 billion of nonrecourse mortgage
servicing rights, the Company's principal recourse portfolio became a more
significant component of its total remaining owned servicing portfolio.
Included in the Company's calculation for measuring impairment of its
capitalized servicing asset is an $8.2 million and $7.3 million reserve for
estimated recourse losses on the corresponding loans in determining the fair
value of its principal recourse portfolio as of December 31, 1997 and 1996,
respectively.
The discount rate and prepayment assumptions are significant factors used in
estimating the fair value of the Company's mortgage servicing rights and
could be significantly impacted by changes in interest rates. Accordingly,
it is likely that management's estimate of the fair value of the mortgage
servicing rights could change in the near term due to changes in interest
rates.
In 1997, the Company adopted certain provisions of SFAS No. 125 which
eliminated the distinction between "normal" servicing rights and excess
servicing receivables. Therefore, in adopting SFAS No. 125, the Company
combined its "normal" mortgage servicing rights and its excess servicing
receivables. The Company estimated the fair value of the combined asset
based on the methodology described above, which did not materially effect
the Company's 1997 results.
Prior to the adoption of SFAS No. 125, the Company estimated the fair value
of its capitalized excess servicing asset by discounting the anticipated
future cash flows over the estimated life of the related loans. In making
these estimates, the Company used "interest only strip" interest rates as
quoted by market participants to determine the appropriate discount rates
and prepayment speed assumption rates that are based on interest rates, loan
types and original term of maturity. The discount rate used to capitalize
excess servicing ranged from 12.0% to 12.6% for 1996 and was 12.0% for 1995.
For the years ended December 31, 1996 and 1995, the weighted average
discount rates inherent in the carrying amount of the capitalized excess
servicing asset were 10.4% and 10.0%, respectively.
27
<PAGE> 28
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes the fair value of mortgage servicing rights
and certain characteristics of the Company's servicing portfolio related to
those mortgage servicing rights as of December 31, 1997:
<TABLE>
<CAPTION>
=========================================================================================================================
Fair Value Weighted
Mortgage Principal Average Weighted Weighted
Servicing Balance Interest Average Average
Rights Serviced Rate Maturity Service Fee
Loan Type (in thousands) (in millions) (in percent) (in months) (in percent)
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Rate:
Insured $ 102,200 $ 5,314 8.85% 291 .46%
Conventional 44,933 2,515 8.13 273 .39
Recourse 28,654 2,413 8.60 205 .49
Adjustable Rate 12,391 418 7.09 326 .53
- -------------------------------------------------------------------------------------------------------------------------
Total $ 188,178 $ 10,660 8.56% 269 .46%
=========================================================================================================================
</TABLE>
The above table excludes $773 million of principal balance of mortgage loans
serviced related to originations not capitalized prior to the adoption of
SFAS No. 122.
The following table summarizes changes in the Company's capitalized servicing
asset:
<TABLE>
<CAPTION>
Deferred
Gain on Total
Mortgage Valuation Sale of Capitalized
(in thousands) Servicing Allowance Subservicing Servicing Servicing
- --------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balances at January 1, 1995 $ 547,662 $ - $ - $ (17,212) $ 530,450
Additions 102,878 - - - 102,878
Scheduled amortization (52,853) - - - (52,853)
Impairment/unscheduled amortization (564) (27,968) - - (28,532)
Amortization of deferred gain - - - 4,188 4,188
Sales (159,060) - - - (159,060)
- --------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1995 438,063 (27,968) - (13,024) 397,071
Additions 125,514 - - - 125,514
Scheduled amortization (69,932) - - - (69,932)
Impairment/unscheduled amortization (1,076) (928) - - (2,004)
Amortization of deferred gain - - - 6,139 6,139
Sales (45,849) - - - (45,849)
- --------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996 446,720 (28,896) - (6,885) 410,939
Additions 90,412 (1,259) - - 89,153
Scheduled amortization (37,537) - (8,880) - (46,417)
Impairment/unscheduled amortization - (17,270) (463) - (17,733)
Amortization of deferred gain - - - 6,885 6,885
Sales (273,667) 2,285 9,580 - (261,802)
- --------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 $ 225,928 $ (45,140) $ 237 $ - $ 181,025
================================================================================================================================
</TABLE>
In connection with the February 1997 servicing sale and related subservicing
assumption, the Company recorded a subservicing asset of approximately $13.3
million. The value of the asset represents the net present value of
projected net cash flows over the subservicing period including a profit
margin. In December 1997, the subservicing agreement was amended to extend the
Company's subservicing responsibilities for one additional year at less
favorable terms than the original agreement provided. Accordingly, the net
carrying value of the subservicing asset reflects a reduction of approximately
$3.7 million which represents the net present value of projected net cash
flows over the extended subservicing period including a profit margin. The
asset is being amortized on a straight line basis over the subservicing period
and tested for impairment.
28
<PAGE> 29
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During 1994, the Company sold the rights to service $3.9 billion of mortgage
loans to a third party for net proceeds of $70.2 million and continued to
service these loans pursuant to a subservicing agreement. Accordingly, the
Company recorded a deferred gain on the sale which was being recognized as
income over the five-year life of the subservicing agreement. In the fourth
quarter of 1996, the third party sold the rights to service approximately
$1.0 billion of these mortgage loans, representing approximately 25% of the
total loans subserviced by the Company for this third party. Accordingly,
the Company recognized an additional $2.4 million of the deferred gain in
1996 as mortgage servicing revenue, representing approximately 25% of the
deferred balance at the time of the sale. In the fourth quarter of 1997, the
third party sold the remaining portfolio of loans. As a result, the Company
recognized the remaining balance of the $4.4 million deferred gain as
mortgage servicing revenue.
NOTE 4. COMMON EQUITY SECURITIES AND INVESTMENTS
In June 1997, the Company acquired an investment in U S WEST, Inc. ("U S
West") redeemable preferred stock from Fund American for cash proceeds of
$49.3 million. The investment, which is classified as available for sale, is
a fixed maturity investment which is redeemable in September 2004 and may be
redeemed at the option of U S West beginning in September 1999. The discount
on this investment is being amortized over the anticipated life of the
investment. The carrying value of this investment, which approximates fair
value, totaled $49.4 million as of December 31, 1997. The Company recognized
income from this investment of approximately $2.0 million in 1997, which is
included in interest income in the consolidated statement of income.
In December 1996, the Company received shares of certain common equity
securities with a market value of $2.3 million as a return of a partnership
investment. The resulting gain of $1.4 million is included in the
determination of income in 1996. In January 1997, the Company transferred
these shares to White Mountains in exchange for 21,239 shares of the
Company's common stock held by White Mountains, which were retired by the
Company. The Company realized a pretax gain of $.3 million on the transfer.
In January 1996, the Company sold its then remaining $1.4 million of common
equity securities to White Mountains for cash proceeds of $.5 million. The
Company realized a pretax loss of $.9 million on the sale. All of the equity
securities involved in such transactions were actively traded, readily
marketable, listed on a national exchange and, for purposes of such
transactions, valued at their reported closing prices on the day preceding
the date of each transaction.
The fair value of the portfolio of common equity securities is as follows:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------
December 31, (in thousands) 1997 1996
- -----------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Common equity securities at adjusted cost $ - $ 2,312
Gross unrealized losses - -
- -----------------------------------------------------------------------------------------------------------------------
Common equity securities at fair value $ - $ 2,312
=======================================================================================================================
</TABLE>
The carrying value of debt securities, which is included in investments in
the consolidated statements of condition, approximates fair value and is as
follows:
<TABLE>
<CAPTION>
=======================================================================================================================
December 31, (in thousands) 1997 1996
- -----------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Debt securities at fair value which approximates amortized cost $ - $ 1,577
=======================================================================================================================
</TABLE>
The change in net unrealized investment loss on the portfolio of common
equity securities has been charged to stockholders' equity as follows:
<TABLE>
<CAPTION>
=======================================================================================================================
Year ended December 31, (in thousands) 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net unrealized investment loss at beginning of year $ - $ (546) $ (4,065)
Decrease in gross unrealized gains - - (1,068)
Decrease in gross unrealized losses - 840 6,481
Decrease in deferred income tax expense - (294) (1,894)
- -----------------------------------------------------------------------------------------------------------------------
Net unrealized investment loss at end of year $ - $ - $ (546)
=======================================================================================================================
</TABLE>
29
<PAGE> 30
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5. MORTGAGE LOANS RECEIVABLE
The following table summarizes mortgage loans receivable:
<TABLE>
<CAPTION>
=======================================================================================================================
December 31, (in thousands) 1997 1996
- -----------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Adjustable rate mortgage loans, weighted average interest rates of 6.36%
and 6.60% as of December 31, 1997 and 1996, respectively $ 51,589 $ 35,077
Fixed rate 5 year through 25 year mortgage loans, weighted average
interest rates of 7.68% and 7.73% as of December 31, 1997 and 1996,
respectively 60,382 51,160
Fixed rate 30 year mortgage loans, weighted average interest rates of
7.76% and 8.19% as of December 31, 1997 and 1996, respectively 404,996 228,067
- -----------------------------------------------------------------------------------------------------------------------
516,967 314,304
Net premiums 2,280 633
- -----------------------------------------------------------------------------------------------------------------------
Total mortgage loans receivable $ 519,247 $ 314,937
=======================================================================================================================
</TABLE>
NOTE 6. POOL LOAN PURCHASES
The following table summarizes pool loan purchases:
<TABLE>
<CAPTION>
============================================================================================================
Principal Balance
(in thousands) Number of Loans
- ------------------------------------------------------------------------------------------------------------
December 31, 1997 1996 1997 1996
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Loan Type:
FHA $ 103,067 $ 89,922 1,781 1,621
VA 43,349 35,341 669 592
Conventional 3,375 6,276 45 75
- ------------------------------------------------------------------------------------------------------------
Total pool loan purchases $ 149,791 $ 131,539 2,495 2,288
============================================================================================================
</TABLE>
NOTE 7. LOANS HELD FOR INVESTMENT
In the second quarter of 1997, the Company identified for sale a majority of
its mortgage loans held for investment and marked them down from amortized
cost to current market value. The Company recognized a $3.0 million pretax
charge to net gain on sale of mortgages as a result of establishing a
valuation allowance for these loans. As of December 31, 1997, these loans
totaled approximately $10.2 million, net of the valuation allowance, of
which $4.5 million are included in loans held for investment and $5.7
million are included in mortgage claims receivable and real estate acquired
in the consolidated statement of condition.
NOTE 8. OTHER ASSETS
The following table summarizes other assets:
<TABLE>
<CAPTION>
==============================================================================================
December 31, (in thousands) 1997 1996
- ----------------------------------------------------------------------------------------------
<S> <C> <C>
Escrow advances $ 11,825 $ 18,878
Interest receivable - pool loan purchases 10,225 11,900
Current income tax receivable (Note 16) 9,058 -
Notes receivable 8,000 7,000
Amount due from sale of servicing 354 46,823
Deferred income tax receivable (Note 16) - 18,210
Other 37,770 17,881
- ----------------------------------------------------------------------------------------------
Total other assets $ 77,232 $ 120,692
==============================================================================================
</TABLE>
30
<PAGE> 31
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9. SENIOR AND SUBORDINATED DEBT
Senior and Subordinated Debt consists of the following:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------
December 31, (in thousands) 1997 1996
- ---------------------------------------------------------------------------------------------------
<S> <C> <C>
Commercial paper, weighted average interest rate of 5.69%
as of December 31, 1996 $ - $ 362,180
Credit agreements, weighted average interest rates of 6.34%
and 6.19% as of December 31, 1997 and 1996, respectively 569,470 45,000
8.875% medium-term notes due October 15, 2001 18,723 138,355
9.0% debentures due June 1, 2012 100,000 100,000
9.375% subordinated debentures, due December 31, 2025 55,976 55,976
Less unamortized discount, premium and issuance costs (net) (2,110) (3,714)
- --------------------------------------------------------------------------------------------------
Total senior and subordinated debt $ 742,059 $ 697,797
===================================================================================================
</TABLE>
COMMERCIAL PAPER
The Company has a $650.0 million domestic commercial paper program backed by
its secured credit agreement. In November 1997, the Company's commercial paper
rating was downgraded by Moody's from Prime-3 to Not Prime. In addition, in
April 1997, the Company's commercial paper rating was downgraded by Standard &
Poors from A-2 to A-3. As a result of the rating downgrade in November,
the Company is not able to issue commercial paper and has replaced its
commercial paper borrowings with borrowings under its $600.0 million committed
bank facility. The weighted average number of days to maturity of commercial
paper outstanding as of December 31, 1996 was 22.8 days.
CREDIT AGREEMENTS
The Company amended and restated its secured revolving credit agreement in
July 1997, to reflect a reduction in its borrowing requirements resulting
from the cash proceeds received from the 1997 servicing sale. The provisions
of the amended agreement decreased the Company's revolving credit facility
from $750.0 million to $500.0 million, reduced borrowing costs by lowering
the facility fee and will allow the Company to use proceeds received from
the servicing sale to pay additional dividends on its common stock of up to
$75.0 million. The provisions also granted the Company the option to
increase the size of the facility up to $750.0 million, with bank
concurrence (refer to Note 23 to the consolidated financial statements). In
order to fund increased production volumes and replace commercial paper
financing no longer available as a result of the downgrade of the Company's
debt rating as described above, the Company exercised its right under the
agreement to request additional commitments in December 1997. With bank
concurrence, the Company obtained additional commitments of $100.0 million
which increased the available revolving facility to $600.0 million.
Borrowings under the facility are secured primarily by the Company's
mortgage loans receivable and pool loan purchases. The revolving credit
facility expires on July 24, 1998. As of December 31, 1997, the Company had
$559.0 million outstanding under this facility. As of December 31, 1996, the
Company had no outstanding borrowings under the previous facility.
The Company's $60.0 million unsecured revolving credit agreement was not
extended in July 1997. This agreement was designed to give the Company
benefit for escrow funds held in custodial banks. The Company continues to
receive this benefit by replacing borrowings under this facility with
borrowings under the bid loan provision of the Company's secured credit
agreement. The Company's total bank facility borrowing capacity was not
reduced by the termination of the unsecured agreement because borrowings
under this agreement reduced the Company's ability to borrow up to the
maximum amount under its secured credit facility. As of December 31, 1996,
there was $45.0 million outstanding under the Company's unsecured agreement.
The Company must comply with certain financial covenants provided in its
secured revolving credit facility, including restrictions relating to
tangible net worth and leverage. In addition, the Company's secured facility
contains certain
31
<PAGE> 32
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
covenants which limit its ability to pay dividends or make
distributions of its capital in excess of preferred stock dividend and
subordinated debt interest requirements each year. The Company is currently
in compliance with all such covenants.
Under the credit agreements described above, the Company receives interest
expense credits as a result of holding escrow and custodial funds in trust
accounts at non-affiliated banks.
The Company amended a short-term borrowing agreement in April 1997 which it
had entered into August 1996. The provisions of the amended agreement
increased the Company's facility from $25.0 million to $50.0 million. As a
result of the rating downgrade in November 1997, the Company is not able to
borrow under this agreement. As of December 31, 1996, there was $15.0
million outstanding under the original agreement.
Central Pacific entered into a new unsecured revolving credit agreement in
May 1997 under which it can borrow up to $15.0 million through June 1, 1998.
Central Pacific amended this agreement in December 1997 to change certain
reporting requirements and financial covenants. Borrowings under the
agreement are guaranteed by the Company. As of December 31, 1997, there was
$10.5 million outstanding under this agreement. As of December 31, 1996,
there were no borrowings outstanding under the previous agreement which
allowed for borrowings up to $10.0 million.
Central Pacific must comply with certain financial covenants provided in its
revolving credit agreement, including restrictions relating to tangible net
worth and leverage. As guarantor, these covenants apply to the Company.
Central Pacific is currently in compliance with all such covenants.
MEDIUM-TERM NOTES AND DEBENTURES
In June 1992, the Company issued $100.0 million of 9% debentures due June
2012 under terms of a $250.0 million shelf registration statement filed with
the Securities and Exchange Commission ("SEC") in April 1992. The debentures
may not be redeemed by the Company prior to maturity. The proceeds were used
for general corporate purposes.
In October 1991, the Company issued $160.0 million of 8.875% medium-term
notes due October 2001. In May 1997, the Company repurchased and retired
$119.6 million of these medium-term notes. As a result, the Company
recognized an extraordinary loss of approximately $6.0 million, net of
approximately $3.2 million of associated income tax benefit. In 1995, the
Company repurchased and retired $21.6 million of these medium-term notes.
SUBORDINATED DEBENTURES
Effective December 8, 1995, the Company exchanged and retired 2,239,061
shares of its 8.42% cumulative preferred stock, Series A, for $56.0 million
principal amount of 9.375% subordinated interest deferrable debentures
("subordinated debentures"), due December 31, 2025. Interest on the
subordinated debentures is paid quarterly in arrears at the annual rate of
9.375% on the last business day of each March, June, September and December.
The first interest payment was made on December 29, 1995 for the period from
November 1, 1995 (the last regular dividend payment date with respect to the
preferred stock) through December 8, 1995 at the annual rate of 8.42% and
from December 9, 1995 through December 31, 1995 at the annual rate of
9.375%.
The subordinated debentures are redeemable at the option of the Company, in
whole or in part, at any time on or after May 1, 1999. On or after such
date, the subordinated debentures may be redeemed at the option of the
Company at a price equal to 100% of the principal amount redeemed ($25 for
each $25 principal amount of subordinated debenture), plus accrued and
unpaid interest to the date fixed for redemption.
Aggregate maturities of medium-term notes, debentures and subordinated
debentures, excluding discount, premium and issuance costs, for the five
calendar years after December 31, 1997 are as follows:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------
(in thousands) 1998 1999 2000 2001 2002 Thereafter Total
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ - $ - $ - $18,723 $ - $155,976 $174,699
========================================================================================================
</TABLE>
32
<PAGE> 33
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10. STOCKHOLDERS' EQUITY
In March 1997, the Company issued 105,000 shares of its common stock to Fund
American for cash proceeds of $12.7 million. In addition, the Company issued
230,293 shares of its common stock to White Mountains in exchange for 1.0
million shares of the common stock of FSA valued at $27.8 million. The
Company issued an additional 650,827 shares of its common stock to White
Mountains effective in the second quarter of 1997 in exchange for 2.5
million shares of FSA common stock, 2.0 million shares of FSA convertible
redeemable preferred stock and options to acquire 2.6 million shares of FSA
common stock valued at $78.5 million, net of associated tax liabilities and
other adjustments. Stockholders' equity includes accumulated other
comprehensive income composed of unrealized gains and losses on the
investments in FSA convertible redeemable preferred stock and options to
acquire FSA common stock, net of tax.
In January 1997, the Company transferred its remaining common equity
securities with a market value of $2.6 million to White Mountains in
exchange for 21,239 shares of the Company's common stock held by White
Mountains, which were retired by the Company.
At December 31, 1997, the Company had 1,760,939 shares of 8.42% cumulative
preferred stock, Series A ("preferred stock") issued and outstanding. The
Company is authorized to issue 12,000,000 shares of preferred stock. In
December 1995, the Company exchanged and retired 2,239,061 shares of its
preferred stock for $56.0 million principal amount of 9.375% subordinated
debentures, due December 31, 2025.
The preferred stock is not redeemable prior to May 1, 1999. On or after such
date, the preferred stock may be redeemed at the option of the Company at a
price of $25 per share, plus accrued and unpaid dividends to the redemption
date. The preferred stock ranks senior to the common stock as to dividends
and upon the distribution of assets in the event of any liquidation,
dissolution, or winding up of the Company. Issued and outstanding shares of
the preferred stock are subordinate as to dividends and upon liquidation, to
the outstanding debt of the Company.
Quarterly cash dividends are paid on preferred stock at an annual rate of
8.42% or $2.105 per share, if declared by the Board of Directors, in arrears
on the first day of each February, May, August and November. Dividends on
the preferred stock accrue on a daily basis whether or not there are funds
legally available for the payment of such dividends and whether or not such
dividends are declared.
In connection with sales of rights to service a total of $11.0 billion of
mortgage loans to third parties during 1995, the Company transferred a total
of $27.0 million of common equity securities and $93.0 million in cash and
money market investments to White Mountains in exchange for 959,049 shares
of the Company's common stock held by White Mountains, which were retired by
the Company.
NOTE 11. FINANCIAL INSTRUMENTS
FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
The Company utilizes derivative financial instruments in the management of
interest rate risk. The Company's use of derivative financial instruments is
primarily limited to commitments to extend credit, mandatory forward
commitments, interest rate floor contracts ("floors") and principal-only
("P/O") swaps. Although SFAS No. 115 requires that these financial
instruments be classified as held for trading purposes, the Company does not
consider these investments to be speculative holdings.
The Company is a party to financial instruments with off-balance-sheet risk
in the normal course of business to meet the financing needs of its
customers and reduce its own exposure to fluctuations in interest rates.
These financial instruments primarily include commitments to extend credit
and mandatory forward commitments. Those instruments involve, to varying
degrees, elements of credit and market risk in excess of the amount
recognized in the consolidated statements of condition. The contract or
notional amounts of those instruments reflect the extent of risk the Company
has in the instruments.
33
<PAGE> 34
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company's exposure to credit loss in the event of nonperformance by the
counterparty to the financial instrument for commitments to extend credit
("mortgage loan pipeline") is represented by the contractual notional amount
of those instruments. The Company's locked mortgage loan pipeline that is
expected to close totaled $284.5 million and $175.7 million as of December
31, 1997 and 1996, respectively. Fixed rate commitments result in the
Company having market risk as well as credit risk. Variable rate commitments
result primarily in credit risk. The amount of collateral required upon
extension of credit is based on the Company's credit evaluation of the
mortgagor and consists of the mortgagor's residential property.
The Company obtains mandatory forward commitments of up to 120 days to sell
mortgage-backed securities to hedge the market risk associated with a
substantial portion of the mortgage loan pipeline that is expected to close
and all mortgage loans receivable. As of December 31, 1997 and 1996, the
Company had approximately $776.8 million and $454.6 million of mandatory
forward commitments outstanding, respectively. If secondary market interest
rates decline after the Company obtains a mandatory forward commitment for a
loan, the loan may not close and the Company may incur a loss from the cost
of covering its obligations under such commitment. If secondary market rates
increase before the Company obtains a mandatory forward commitment for a
loan and the loan closes, the Company may realize a loss when the loan is
subsequently sold.
The Company's risk management function closely monitors the mortgage loan
pipeline to determine appropriate forward commitment coverage on a daily
basis in order to manage the risk inherent in these off-balance-sheet
financial instruments. In addition, the risk management area seeks to reduce
counterparty risk by committing to sell mortgage loans only to its seventeen
approved dealers, with no dealer having in excess of 20% of current
commitments.
The Company sells loans either through mortgage-backed securities issued
pursuant to programs of GNMA, FNMA, FHLMC or through whole loan sales to
investors. Most loans are aggregated in pools of $1.0 million or more, which
are purchased by institutional investors after having been guaranteed by
GNMA, FNMA or FHLMC.
Substantially all GNMA securities are sold without recourse to the Company
for loss of principal in the event of a subsequent default by the mortgage
borrower due to underlying FHA or VA insurance. Prior to December 1992,
substantially all conventional securities were sold with recourse to the
Company to the extent of insufficient proceeds from private mortgage
insurance, foreclosure and other recoveries. Since December 1992,
conventional loans have been sold without recourse to the Company.
Servicing agreements relating to mortgage-backed securities issued pursuant
to the programs of GNMA, FNMA and FHLMC require the Company to advance funds
to make the required payments to investors in the event of a delinquency by
the borrower. The Company expects that it would recover most funds advanced
upon default by the borrower or at foreclosure. However, in connection with
VA partially guaranteed loans and certain conventional loans (which may be,
at most, partially insured by private mortgage insurers), funds advanced may
not cover losses due to potential declines in collateral value. The Company
is subject to limited amounts of principal risk with respect to these loans
since the insurer has the option to reimburse the servicer for the lower of
fair market value of the property or the mortgage loan outstanding, in
addition to the VA guarantee on the loan. In addition, most of the Company's
servicing agreements for mortgage-backed securities typically require the
payment to investors of a full month's interest on each loan although the
loan may be paid off (by optional prepayment or foreclosure) other than on a
month-end basis. In this instance, the Company is obligated to pay the
investor interest at the pass-thru rate from the date of the loan payoff
through the end of that calendar month without reimbursement.
As of December 31, 1997, 1996 and 1995, the Company serviced approximately
$5.4 billion, $13.5 billion and $10.7 billion of GNMA loans in its owned
servicing portfolio, respectively, and $2.5 billion, $2.9 billion and $3.5
billion of conventional loans with recourse, respectively.
In order to cover loan losses that may result from these servicing
arrangements and other losses, the Company has provided an allowance for
loan losses of $12.8 million, $15.4 million and $13.5 million as of December
31, 1997, 1996
34
<PAGE> 35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
and 1995, respectively. In addition, the valuation allowance
for the Company's capitalized servicing asset related to its principal
recourse portfolio includes an $8.2 million and $7.3 million reserve for
estimated losses on the corresponding loans at December 31, 1997 and 1996,
respectively. Management believes these amounts are adequate to cover
unreimbursed foreclosure advances and principal losses, including losses on
loans with recourse.
In order to offset changes in the value of its capitalized servicing asset
and to mitigate the effect on earnings of higher amortization and impairment
of the asset which results from increased prepayment activity, the Company
invests in various financial instruments. As interest rates decline,
prepayment activity generally increases, thereby reducing the value of the
capitalized servicing asset, while the value of the financial instruments
increases. Conversely, as interest rates increase, the value of the
capitalized servicing asset increases, while the value of such financial
instruments decreases. The financial instruments utilized by the Company
include interest rate floor contracts ("floors") and principal-only ("P/O")
swaps.
The floors derive their value from the 10 year constant maturity treasury
yield index. The floor strike rates range from 4.00% to 6.14%. To the extent
that market interest rates increase, the value of the floor declines.
However, the Company is not exposed to losses in excess of its initial
investment in the floors. The total notional principal amount of the floors
was $.7 billion and $1.0 billion as of December 31, 1997 and December 31,
1996, respectively. As of December 31, 1997 and 1996, the carrying value of
the Company's open floors was $8.2 million and $4.8 million, respectively.
The floors have remaining terms ranging from 3 to 5 years.
The value of the P/O swaps is determined by changes in the value of the
underlying P/O strip security. The payments received by the Company under
the P/O swaps relate to the cash flows of the referenced P/O security. The
payments made by the Company are based upon a notional amount tied to the
market price and the remaining balance of the underlying P/O security,
multiplied by a floating rate indexed to LIBOR. The Company's exposure to
loss in the P/O swaps is related to changes in the market value of the
underlying P/O security over the life of the contract. The remaining
original notional value of the P/O swaps was $98.1 million and $50.0 million
as of December 31, 1997 and 1996, respectively. The carrying value of the
P/O swaps was $12.5 million and $3.2 million as of December 31, 1997 and
1996, respectively. The P/O swaps have remaining terms ranging from 3 to 4
years.
The floors and P/O swaps are carried at market value and are included in
investments in the consolidated statements of condition. Realized and
unrealized gains and losses are recorded in net gain on financial
instruments in the consolidated statements of income.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company determines the estimated fair value of its financial instruments
using appropriate market information and valuation methodologies.
Considerable judgment is required to interpret the market information to
develop the estimates of fair value. As a result, the estimates provided
herein are not necessarily indicative of the amounts that could be realized
in a current market exchange.
The following methods and assumptions were used by the Company to estimate
the fair value of each class of financial instruments for which it is
practicable to estimate that value:
CASH AND INVESTMENTS
For cash, short-term investments and fixed maturity investments the carrying
value equals or approximates fair value.
For interest rate floor contracts and P/O swaps, fair value is estimated
based on quoted market prices for those or similar investments and is equal
to the carrying value.
For investments in REMIC residuals, for which there are no quoted market
prices, fair value is estimated based on discounted cash flow analyses,
using interest only strip interest rates, prepayment speed assumptions and
LIBOR rates, taking into consideration the characteristics of the related
collateral.
For investment partnership interests fair value is determined as the equity
method value calculated from the audited partnership financial statements.
35
<PAGE> 36
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MORTGAGE LOANS RECEIVABLE
For mortgage loans receivable, fair value is estimated using quoted market
prices for securities backed by similar loans.
POOL LOAN PURCHASES
For pool loan purchases, fair value is estimated based on discounted cash
flow analyses, using the Company's short-term incremental borrowing rate,
quoted market prices for securities backed by similar loans or actual prices
at which the loans were subsequently sold.
LOANS HELD FOR INVESTMENT
In 1997, the Company identified for sale the majority of its loans held for
investment and marked them down from amortized cost to current market value,
and therefore, the carrying amount for these loans equals fair value. Prior
to 1997, fair value was estimated using quoted market prices for securities
backed by similar loans.
CAPITALIZED EXCESS SERVICING
For capitalized excess servicing, fair value is estimated by computing the
anticipated revenue to be received over the life of the related loans based
on market consensus prepayment rates, discounted using quoted interest only
strip interest rates.
RECEIVABLE FROM SALE OF SERVICING
For receivable from sale of servicing, carrying value equals or approximates
fair value.
COMMON EQUITY SECURITIES
For common equity securities, fair value is based on quoted market prices
and is equal to the carrying value.
LOANS IN FORECLOSURE AND MORTGAGE CLAIMS RECEIVABLE
For these financial instruments, fair value is estimated by discounting
anticipated future cash flows using the Company's short-term incremental
borrowing rate.
DEBT
For commercial paper and credit agreements (short-term debt), the carrying
amount approximates fair value. For debentures and medium-term notes
(long-term debt), fair value is estimated by discounting future cash flows
using the Company's incremental borrowing rates for similar types of
borrowing arrangements. For subordinated debentures (long-term debt), fair
value is based on quoted market prices.
36
<PAGE> 37
NOTE TO CONSOLIDATED FINANCIAL STATEMENTS
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS
Fair value for commitments to sell mortgage loans is based on the current
settlement values of those commitments, net of the face amounts of the
commitments. Fair value for commitments to extend credit is based on current
quoted market prices for securities backed by similar loans, net of the
principal amounts of the commitments.
The estimated fair values of the Company's financial instruments are as
follows:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------
December 31, 1997 1996
- ---------------------------------------------------------------------------------------------------
Carrying Fair Carrying Fair
(in thousands) Amount Value Amount Value
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Financial Assets:
Cash $ 3,134 $ 3,134 $ 923 $ 923
Investments
Interest rate floor contracts 8,153 8,153 4,825 4,825
Principal-only swaps 12,508 12,508 3,185 3,185
Other 65,578 75,092 38,545 38,354
Mortgage loans receivable 519,247 529,260 314,937 315,895
Pool loan purchases 149,791 150,175 131,539 135,841
Loans held for investment 5,191 5,191 23,351 23,289
Capitalized excess servicing n/a(a) n/a(a) 38,672 39,617
Receivable from sale of servicing 27,324 27,324 - -
Common equity securities - - 2,312 2,312
Loans in foreclosure and mortgage
claims receivable (net) (b) 35,579 34,905 38,387 37,714
- ---------------------------------------------------------------------------------------------------
Financial Liabilities:
Short-term debt $ 569,399 $ 569,399 $406,205 $ 406,205
Long-term debt 172,660 186,978 291,592 322,715
Off-Balance-Sheet Financial Instruments:
Mandatory forward commitments n/a 1,642 n/a (160)
Commitments to extend credit
expected to close (pipeline) n/a 6,498 n/a 1,879
- ---------------------------------------------------------------------------------------------------
</TABLE>
(a) Information is not applicable as a result of the Company's adoption of
SFAS No. 125. Refer to notes 1 and 3 to the consolidated financial
statements.
(b) Excludes $5.6 million and $13.1 million of real estate owned in 1997 and
1996, respectively.
The Company's investments in FSA options and preferred stock are not
presented in the table above. These financial instruments are accounted
for under the provisions of SFAS No. 115 and are carried on the
consolidated statement of condition at fair value (refer to Note 2 to the
consolidated financial statements).
37
<PAGE> 38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12. MORTGAGE SERVICING
The Company's portfolio of mortgages serviced, including loans subserviced,
interim servicing contracts and those under contract to acquire and
excluding loans sold but not transferred, totaled $26.5 billion, $29.2
billion and $31.8 billion as of December 31, 1997, 1996 and 1995,
respectively. The Company's portfolio of mortgages serviced as of December
31, 1997 is summarized below:
<TABLE>
<CAPTION>
Weighted Average
----------------------------------------------------------
Net Remaining
Principal Loan Interest Servicing Contractual
Balance Serviced Balance Rate Fee Rate Life
Loan Type (in millions) (in thousands) (in percent) (in percent) (in months)
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Residential
Conventional $ 5,521 $ 68 8.37% .424% 240
FHA 3,916 57 8.80 .427 297
VA 2,124 62 8.42 .403 298
Commercial 66 889 7.45 .176 163
- --------------------------------------------------------------------------------------------------------------------
$ 11,627 $ 63 8.52% .420% 269
Subservicing 14,919
- --------------------------------------------------------------------------------------------------------------------
Total mortgage
servicing portfolio $ 26,546 $ 61 8.45% (a) 249
====================================================================================================================
</TABLE>
(a) This amount would be calculated as a combination of two different
measurements, the net servicing fee earned on the Company's owned
servicing portfolio and the subservicing fee earned on its subservicing
portfolio, which is not calculated as a percentage of the outstanding
principal balance serviced, and therefore, would not be meaningful.
The servicing fee rates in the table above are shown after deducting any
fees. Guarantee fees, when applicable, range from six basis points for
governmental loans up to approximately thirty basis points for certain
conventional loans. Certain loans sold to private investors have no
guarantee fees.
The following table summarizes the Company's owned mortgage servicing
portfolio by interest rate range:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------------
Weighted Weighted
Number Principal Average Number Principal Average
of Balance Interest Rate of Balance Interest Rate
Interest Rate Range Loans (in millions) (in percent) Loans (in millions) (in percent)
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
5.99% and lower 843 $ 66 5.41% 1,239 $ 87 5.50%
6.00%-6.49% 1,823 159 6.13 5,449 288 6.22
6.50%-6.99% 4,166 319 6.66 15,369 1,111 6.68
7.00%-7.49% 12,968 729 7.17 42,363 2,395 7.11
7.50%-7.99% 29,240 2,455 7.63 58,622 4,104 7.60
8.00%-8.49% 27,989 2,280 8.13 60,852 4,337 8.10
8.50%-8.99% 32,178 1,867 8.59 77,061 4,047 8.58
9.00%-9.49% 13,452 722 9.07 37,714 2,052 9.06
9.50%-9.99% 29,142 1,420 9.55 69,548 3,618 9.57
10.00% and above 32,488 1,610 10.49 83,585 4,371 10.49
- -----------------------------------------------------------------------------------------------------------------------------------
Total 184,289 $ 11,627 8.52% 451,802 $ 26,410 8.59%
====================================================================================================================================
</TABLE>
38
<PAGE> 39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes the Company's owned mortgage servicing
portfolio by location of property:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 1997 1996
- ------------------------------------------------------------------------------------------------------------------------------------
Percentage Percentage
of Principal of Principal
Number Principal Balance of Number Principal Balance of
of Balance Servicing of Balance Servicing
State Loans (in millions) Portfolio Loans (in millions) Portfolio
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
California 20,459 $ 1,889 16.3% 60,547 $ 4,955 18.7%
New York 22,118 1,162 10.0 42,195 2,441 9.2
Texas 15,655 736 6.3 29,851 1,513 5.7
Washington 7,889 690 5.9 23,048 1,692 6.4
Florida 12,894 663 5.7 28,361 1,408 5.3
Michigan 10,773 520 4.5 25,553 1,019 3.9
New Jersey 7,088 503 4.3 13,689 895 3.4
Illinois 6,335 420 3.6 16,704 1,036 3.9
Maryland 5,020 362 3.1 8,966 534 2.0
Ohio 6,658 357 3.1 15,772 656 2.5
Other* 69,400 4,325 37.2 187,116 10,261 39.0
- ------------------------------------------------------------------------------------------------------------------------------------
Total 184,289 $ 11,627 100.0% 451,802 $ 26,410 100.0%
====================================================================================================================================
</TABLE>
*No other state constitutes more than 3.1% of the Company's owned servicing
portfolio as of December 31, 1997.
The above tables exclude loans subserviced for others having a principal
balance of $14,919 million and $2,791 million as of December 31, 1997 and
1996, respectively.
Escrow funds of approximately $196.8 million, $207.8 million and $236.0
million as of December 31, 1997, 1996 and 1995, respectively, relating to
mortgages serviced and subserviced, are held in non-interest bearing
accounts at non-affiliated banks and are not included in the consolidated
financial statements.
The Company has in force an errors and omissions policy in the amount of $20
million. Primary fidelity coverage up to a limit of $35 million is provided
under a Fund American master policy, for which the Company pays a portion of
the premium.
NOTE 13. RESTRUCTURING CHARGES
In April 1997, the Company's management approved and implemented a
restructuring plan designed to reduce its operating costs in order to
improve its financial performance. As part of this plan, the Company reduced
its work force, primarily in overhead areas, by approximately 100 employees
during the second quarter of 1997 to bring its overhead costs in line with
its production and servicing operations. As a result, the Company recognized
restructuring charges totaling $1.7 million during the second quarter of
1997. The amount includes approximately $1.6 million of employee separation
costs, including severance payments, health care coverage and postemployment
education benefits and $.1 million of miscellaneous expenses. As of December
31, 1997, $.1 million of these charges remained accrued in the Company's
consolidated statements of condition.
In 1994, the Company implemented a restructuring plan to bring its mortgage
loan production network in line with anticipated levels of mortgage loan
production as a result of a contracting mortgage loan origination market. As
of December 31, 1997 and 1996, $.2 million and $.5 million, respectively,
remained accrued in the Company's consolidated statements of condition
relating to future lease expenses for closed facilities.
39
<PAGE> 40
NOTE TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14. LEASE COMMITMENTS
The Company has entered into a number of noncancelable operating lease
agreements with respect to premises and equipment. The minimum annual rental
commitments under these leases as of December 31, 1997 are as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------
(in thousands) 1998 1999 2000 2001 2002 Total
- --------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
$2,263 $1,057 $696 $359 $234 $4,609
====================================================================
</TABLE>
Leases for branches which were closed as a result of the Company's
restructuring plan implemented in 1994 are included in the table above. As
of December 31, 1997, $.2 million of future lease payments remained accrued
in the Company's consolidated statement of condition, and therefore, do not
represent future operating expenses.
Total rental expense for the years ended December 31, 1997, 1996 and 1995
was $3.9 million, $4.5 million and $4.6 million, respectively. Some leases
contain escalation clauses that correspond with increased real estate taxes,
other operating expenses and/or renewal options that call for increased
rents when the leases are renewed.
NOTE 15. OTHER OPERATING EXPENSES
The following table summarizes other operating expenses:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
- --------------------------------------------------------------------------------------
<S> <C> <C> <C>
Telephone $ 3,948 $ 4,316 $ 4,015
Professional services 3,587 3,376 1,649
Travel and entertainment 1,989 1,885 1,808
Office supplies and printing 1,903 2,063 1,768
Postage 1,812 2,119 1,985
Software systems 1,501 1,669 1,427
Bank charges 861 1,618 1,948
Amortization of goodwill - 2,090 2,090
Other 11,000 15,116 16,084
- --------------------------------------------------------------------------------------
Total other operating expenses $ 26,601 $ 34,252 $ 32,774
======================================================================================
</TABLE>
NOTE 16. INCOME TAXES
The Company files a consolidated federal income tax return with Fund
American. Federal income tax expense is provided substantially on a separate
return basis. As of December 31, 1997, the Company had recorded $39.1
million of deferred tax liability relating to accumulated unrealized gains
and equity in earnings of an investment in an unconsolidated affiliate, of
which $13.9 million was recorded as part of the initial exchange. As of
December 31, 1995, the Company had recorded $.3 million of deferred tax
assets relating to accumulated unrealized losses on the portfolio of common
equity securities. The Company files state income tax returns on a
stand-alone basis.
The following table summarizes federal income taxes due from or (to) Fund
American:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------
December 31, (in thousands) 1997 1996
- ---------------------------------------------------------------------------------------
<S> <C> <C>
Net current taxes $ 9,058 $ (5,746)
- ---------------------------------------------------------------------------------------
Net deferred taxes (17,219) 18,210
=======================================================================================
</TABLE>
40
<PAGE> 41
NOTE TO CONSOLIDATED FINANCIAL STATEMENTS
Total income tax (benefit) expense is as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
- --------------------------------------------------------------------------------------
<S> <C> <C> <C>
Current income taxes:
Federal $ (4,396) $ 17,280 $ 11,847
State and local 1,352 144 248
Deferred (benefit) expense (573) (7,971) 4,037
- --------------------------------------------------------------------------------------
Total income tax (benefit) expense $ (3,617) $ 9,453 $ 16,132
======================================================================================
</TABLE>
The current federal income tax (benefit) expense for the years ended
December 31, 1997 and 1995, as shown above, excludes a benefit of $3.2
million and $.5 million, respectively, which relates to the extraordinary
loss on the repurchase and retirement of debt which has been reported as a
net amount in the consolidated statements of income.
Deferred tax (benefit) expense for the years ended December 31, 1997, 1996
and 1995 represents the net change in the deferred tax asset or liability
during the year. Deferred income taxes arise from temporary differences
between the tax bases of assets and liabilities and their reported amounts
in the consolidated financial statements. The deferred tax (benefit) expense
for the years ended December 31, 1997, 1996 and 1995, shown above excludes
deferred tax expense of $22.1 million, $.3 million and $1.9 million,
respectively. The 1997 expense is associated with unrealized gains on the
Company's investment in an unconsolidated affiliate which were recorded
directly to stockholders' equity. The 1996 and 1995 expenses are associated
with unrealized gains and losses on the common equity securities portfolio
which were recorded directly to stockholders' equity.
The following table summarizes the types of temporary differences giving
rise to the net deferred tax assets and net deferred tax liabilities:
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
December 31, (in thousands) 1997 1996
- -------------------------------------------------------------------------------------------------------------------------------
Deferred Deferred Deferred Deferred
Tax Tax Tax Tax
Assets Liabilities Assets Liabilities
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Purchase accounting adjustments $ - $ 5,520 $ - $ 6,219
Unrealized gain on investment in
unconsolidated affiliate (net) - 36,002 - -
Equity in earnings of unconsolidated affiliate - 3,095 - -
Unrealized gain on financial instruments - 4,597 - 931
Capitalized servicing 26,163 - 18,384 -
Allowance for loan losses 4,803 - 4,838 -
Depreciation - 2,159 - 2,583
Deferred bi-weekly income 969 - 1,351 -
Accrued postretirement benefits 1,279 - 1,181 -
Other, net 7,921 6,981 6,739 4,550
- ----------------------------------------------------------------------------------------------------------------------------
Total $ 41,135 $ 58,354 $ 32,493 $ 14,283
============================================================================================================================
</TABLE>
In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred
tax assets will not be realized. The ultimate realization of deferred tax
assets is dependent upon the generation of future taxable income during the
periods in which those temporary differences become deductible. Based upon
the level of historical taxable income and projections for future taxable
income over the periods in which the deferred tax assets are deductible,
management believes it is more likely than not the Company will realize the
benefits of these deductible differences. Accordingly, no valuation
allowances have been provided as of December 31, 1997 and 1996.
41
<PAGE> 42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A reconciliation of taxes, calculated using the federal statutory rate of
35%, to income tax expense follows:
<TABLE>
<CAPTION>
------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
------------------------------------------------------------------------------
<S> <C> <C> <C>
Tax (benefit) expense at federal statutory rate $ (3,902) $ 1,795 $15,149
Write-off of goodwill and other intangible assets - 6,960 -
Purchase accounting adjustments - 732 732
Dividends received deduction (706) - (35)
State taxes 879 94 161
Other, net 112 (128) 125
------------------------------------------------------------------------------
Total income tax (benefit) expense $ (3,617) $ 9,453 $16,132
==============================================================================
</TABLE>
NOTE 17. PENSION PLAN
The Company has a defined benefit pension plan covering most of its
employees. Benefits under the plan are based on years of service and the
employees' highest average compensation over five consecutive years in their
last ten years of employment. The Company's policy is to fund the pension
plan in amounts which comply with the minimum funding requirements specified
by the Employee Retirement Income Security Act. Cash contributions made to
the plan for the years ended December 31, 1997, 1996 and 1995 totaled $.6
million, $1.3 million and $1.7 million, respectively. Plan assets primarily
consist of common stock and corporate bond mutual funds.
In the fourth quarter of 1997, the Company's Board of Directors approved
certain amendments to the Company's pension plan. The approved amendments
included the expansion of eligibility requirements for early retirement from
age 55 with ten years of service to the earlier of age 55 with ten years of
service or age 50 with fifteen years of service for retirements beginning on
or after January 1, 1997. In addition, the accrual rate for years of benefit
service was reduced from 1.6% to 1.2% for years of service credited on and
after January 1, 1998. The Company expects the net effect of these
amendments will be to reduce the future cost and funding requirements of the
plan.
The following table sets forth the plan's funded status and the related
amounts recognized in the Company's consolidated statements of condition:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
December 31, (in thousands) 1997 1996
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Actuarial present value of benefit obligation:
Accumulated benefit obligation, including vested benefits
of $19,269 and $16,627 in 1997 and 1996, respectively $ 20,960 $ 18,586
Effect of future projected salary increases 6,015 5,138
- --------------------------------------------------------------------------------------------------------------------
Projected benefit obligation 26,975 23,724
Plan assets at fair value (24,669) (20,942)
- --------------------------------------------------------------------------------------------------------------------
Projected benefit obligation in excess of plan assets 2,306 2,782
Unrecognized net gain (loss) 931 (1,111)
Unrecognized prior service cost 87 871
Unrecognized net obligation at transition - (11)
- --------------------------------------------------------------------------------------------------------------------
Accrued pension cost included in accounts payable
and other liabilities $ 3,324 $ 2,531
====================================================================================================================
</TABLE>
42
<PAGE> 43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the components of net periodic pension costs is as follows:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Service cost for benefits earned during the year $ 1,448 $ 1,578 $ 1,354
Interest cost on projected benefit obligation 1,718 1,633 1,388
Actual return on plan assets (3,752) (1,998) (3,801)
Net amortization and deferral 1,973 892 2,613
- -----------------------------------------------------------------------------------------------------------------
Net periodic pension cost $ 1,387 $ 2,105 $ 1,554
=================================================================================================================
</TABLE>
<TABLE>
<CAPTION>
Assumptions used in the determination of the projected benefit obligation were:
- -----------------------------------------------------------------------------------------------------------------
December 31, 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Discount rate 7.0% 7.25% 7.0%
Rate of increase in compensation levels 4.5% 5.0% 6.0%
Expected long-term rate of return on assets 8.0% 8.0% 8.0%
=================================================================================================================
</TABLE>
NOTE 18. POSTRETIREMENT BENEFITS
The Company has an unfunded postretirement benefit plan which provides for
postretirement health care and life insurance benefits. Postretirement life
insurance benefits are provided to substantially all employees.
Postretirement health care benefits are provided to substantially all
employees hired prior to January 1, 1991. The Company provides for term life
insurance coverage based on the employees' annual earnings and length of
service. Postretirement health care benefits are contributory, whereby the
Company provides for 87.5% of medical costs to retirees who retired prior to
January 1, 1993. Effective January 1, 1993, the plan was amended to provide
for a portion of monthly retiree medical costs, based on years of service,
to retirees who retire on or after January 1, 1993.
A summary of the components of net periodic postretirement benefit cost is
as follows:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Service cost $ 94 $ 110 $ 86
Interest cost 256 239 250
- --------------------------------------------------------------------------------------------------------
Net periodic postretirement benefit cost $ 350 $ 349 $ 336
========================================================================================================
</TABLE>
The following table sets forth the plan's funded status and the related amounts
recognized in the Company's consolidated statements of condition:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------
December 31, (in thousands) 1997 1996
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C>
Accumulated postretirement benefit obligation:
Retired participants $ 2,255 $ 1,868
Fully eligible active participants 739 533
Other active participants 801 1,009
- ----------------------------------------------------------------------------------------------------------
Total accumulated postretirement benefit obligation 3,795 3,410
Plan assets at fair value - -
- ----------------------------------------------------------------------------------------------------------
Accrued postretirement benefit obligation in excess of plan assets 3,795 3,410
Unrecognized prior service cost (157) -
Unrecognized net gain 15 67
- ----------------------------------------------------------------------------------------------------------
Accrued postretirement benefit cost included in accounts payable
and other liabilities $ 3,653 $ 3,477
=========================================================================================================
</TABLE>
43
<PAGE> 44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
An 8.6% annual rate of increase in the per capita costs of covered health
care benefits was assumed for 1998, gradually decreasing to 5.0% by the year
2007 and remaining at that level thereafter. Increasing the assumed health
care cost trend rate by one percentage point in each year would increase the
accumulated postretirement benefit obligation as of December 31, 1997 by
5.0% and increase the aggregate of the service cost and interest cost
components of net periodic postretirement benefit cost for 1997 by 4.1%. A
discount rate of 7.0% and 7.25% was used to determine the accumulated
postretirement benefit obligation as of December 31, 1997 and 1996,
respectively.
NOTE 19. STOCK PLANS
In 1986, the Company established an Employee Stock Ownership Plan ("ESOP")
to enable employees to have an equity interest in the Company. The Company
redeemed all the shares of Class B common stock held by the ESOP in November
1993 for $4.6 million in cash. Management subsequently used that cash to
invest in Fund American common stock. The assets currently held by the ESOP
consist substantially of Fund American common stock. Effective in the fourth
quarter of 1993, the ESOP was amended to allow employees who terminate their
employment with the Company, and who are vested in the ESOP, to receive
their distribution in cash or shares of Fund American common stock.
Contributions to the ESOP are determined at the discretion of the Board of
Directors.
Effective October 1, 1996, the Company amended its ESOP to include employees
of White Mountains as eligible employees and to add an employee savings plan
feature under Section 401(k) of the Internal Revenue Code of 1986. Eligible
employees may contribute to the plan up to 14% of their salary not to exceed
the maximum allowable under Internal Revenue Service guidelines.
Contributions are invested at the direction of the employee in one or more
funds or can be directed to purchase common stock of Fund American at fair
market value.
In the fourth quarter of 1997, the Company's Board of Directors approved
certain amendments to the Company's ESOP to be effective as of January 1,
1998. The most significant of the amendments provided for the Company's ESOP
contribution to be changed to a 401(k) matching contribution. The matching
contribution is equal to a certain percentage of employee contributions, up
to a maximum of 5%, which is dependent on the Company's annual return on
equity. In addition, the amendment provided for the transfer of all of the
participant accounts in the ESOP portion of the plan to the 401(k) portion
of the plan. This will allow the participants to direct the investment of
the Company's contributions among the various investment options.
In connection with the exchange of Class B common stock, the Company
established a Stock Appreciation Rights ("SAR") plan under which certain
officers of the Company received stock appreciation rights in exchange for
their shares of Class B common stock. The SARs may be exercised any time at
the option of the holders thereof. The value of each SAR is equal to the
difference between $86.625 and the closing price of Fund American's common
stock on the date preceding the exercise of the SAR multiplied by a factor
of 1.223.
The Company has a long-term incentive plan which provides for the granting
of stock-based and cash incentive awards to key senior management employees
of the Company. Awards under the plan are payable upon the achievement of
specified financial goals covering four overlapping three-year periods
beginning January 1, 1994, 1995, 1996 and 1997.
NOTE 20. CONTINGENCIES
Various claims have been made against the Company in the ordinary course of
business. Management believes that any liabilities which could result would
not materially affect the Company's financial position or results of
operations.
44
<PAGE> 45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 21. RELATED-PARTY TRANSACTIONS
As discussed in Notes 4 and 10, the Company had various related-party
transactions with Fund American and White Mountains. The Company also has a
tax allocation agreement with Fund American.
The Company believes that all of the above transactions were on terms that
were reasonable and competitive. Additional transactions of this nature may
be expected to take place in the ordinary course of business in the future.
NOTE 22. SUPPLEMENTAL CASH FLOW INFORMATION
For purposes of reporting cash flows, cash includes cash on hand and amounts
on deposit at banks, excluding custodial bank accounts.
The following table provides additional cash and noncash information not
presented elsewhere in the consolidated financial statements:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------
Year ended December 31, (in thousands) 1997 1996 1995
- ----------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Interest paid $ 43,563 $ 57,172 $ 48,975
- ----------------------------------------------------------------------------------------------
Income taxes paid $ 8,268 $ 18,650 $ 345
- ----------------------------------------------------------------------------------------------
Noncash investing and financing activities:
Exchange of common equity securities for
shares of common stock from parent (Note 4) $ 2,638 $ - $ 27,020
Receivable from sale of servicing rights 27,324 - -
Capital contribution from parent in exchange for
investment in unconsolidated affiliate (Note 2) 106,365 - -
Acquisition of common equity securities as a return
of partnership investment, net (Note 4) - 2,312 -
Exchange of 2,239,061 shares of 8.42% cumulative
Series A preferred stock for 9.375% subordinated
debentures (Note 10) - - 55,976
==============================================================================================
</TABLE>
NOTE 23. SUBSEQUENT EVENTS
In March 1998, the Company paid dividends on its common stock totaling $25.0
million.
In March 1998, the Company increased and amended its $600.0 million secured
revolving credit agreement. The Company exercised its right under the
agreement to request additional commitments, with bank concurrence,
increasing its available revolving facility to $701.0 million to meet
increased borrowing requirements resulting from increased production
volumes. The provisions of the amendment allow the Company to more fully
utilize the facility by easing its restrictions with respect to the
Company's use of its subprime production as collateral and its repurchase of
delinquent loans out of mortgage pools.
45
<PAGE> 46
SELECTED QUARTERLY FINANCIAL DATA
(UNAUDITED)
Selected quarterly financial data for 1997 and 1996 is shown in the
following table. The quarterly financial data includes, in the opinion of
management, all necessary recurring adjustments for a fair presentation of
the results of operations for the interim periods.
<TABLE>
- ------------------------------------------------------------------------------------------------------
Quarters Ended March June September December
(in thousands, except for per share amounts) 31 30 30 31
- ------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
1997
Total revenue $25,561 $ 17,949 (b) $24,732 $25,632
Income (loss) before extraordinary loss 187 (6,291)(b) 1,088 (2,514) (c)
Extraordinary loss - (5,975) - -
Net income (loss) 187 (12,266)(b) 1,088 (2,514) (c)
Comprehensive (loss) income (120) 1,154 (b) 23,504 3,059 (c)
- ------------------------------------------------------------------------------------------------------
Basic net (loss) income per common share
before extraordinary loss (a) $ (.33) $(2.25) $ .05 $ (1.07)
Extraordinary loss per common share - (1.86) - -
Basic net (loss) income per common share (a) (.33) (4.11) .05 (1.07)
Basic comprehensive (loss) income per common share (a) (.47) .07 7.03 .66
- ------------------------------------------------------------------------------------------------------
1996
Total revenue $48,684 $39,762 $39,859 $20,375
Net income (loss) 13,294 5,922 8,258 (31,800) (d)
Comprehensive income (loss) 13,840 5,922 8,258 (31,800) (d)
- ------------------------------------------------------------------------------------------------------
Basic net income (loss) per common share (a) $5.50 $2.22 $3.26 $ (14.55)
Basic comprehensive income (loss) per common share (a) 5.75 2.22 3.26 (14.56)
- ------------------------------------------------------------------------------------------------------
</TABLE>
(a) After deducting dividends on preferred stock.
(b) Includes a $3.0 million pretax write-down of loans held for investment,
$1.7 million of pretax restructuring charges and a $1.1 million
pretax loss on the February 1997 servicing sale and related assumption of
subservicing.
(c) Includes a $3.7 million loss related to the February 1997 servicing
sale and related assumption of subservicing and $1.4 million pretax of
various one-time charges.
(d) Includes a $29.1 million pretax write-off of the Company's goodwill
and other intangible assets.
46
<PAGE> 47
BOARD AND SENIOR OFFICERS
BOARD OF DIRECTORS
Michael C. Allemang
Executive Vice President and Chief Financial Officer
Source One Mortgage Services Corporation
Raymond Barrette
Executive Vice President and Chief Financial Officer
Fund American Enterprises Holdings, Inc.
Terry L. Baxter*
President
White Mountains Holdings, Inc.
Robert R. Densmore
Executive Vice President
Source One Mortgage Services Corporation
Mark A. Janssen
Executive Vice President and Secretary
Source One Mortgage Services Corporation
Francis X. Mohan*
President and Chief Executive Officer
Source One Mortgage Services Corporation
James H. Ozanne*
Chairman
Source One Mortgage Services Corporation
Roger K. Taylor
President and Chief Operating Officer
Financial Security Assurance Holdings Ltd.
* Member of the Executive Committee of the Board
SENIOR OFFICERS
Francis X. Mohan
President and Chief Executive Officer
Michael C. Allemang
Executive Vice President and Chief Financial Officer
Robert R. Densmore
Executive Vice President
Servicing
Mark A. Janssen
Executive Vice President - Production & Capital Markets
and Secretary
Susan L. Bowen
Senior Vice President
Production Division
John J. Cleary
Senior Vice President
Loan Administration
Kathleen M. DeFrances
Senior Vice President
Residential Division
E. Roger Everett
Senior Vice President
Production Operations
Patrick D. Gillies
Senior Vice President
Delinquency Administration
John L. Jansen
Senior Vice President
Human Resources
William C. Manasco
Senior Vice President
Information Services
Pablo Sanchez, Jr.
Senior Vice President
Subprime Division
Phillip W. Shepard
Senior Vice President
Residential District
Charles D. Taylor
Senior Vice President
Information Services
Central Pacific Mortgage Company
John A. Courson
President and Chief Executive Officer
47
<PAGE> 48
CORPORATE ADDRESS
Source One Mortgage Services Corporation
27555 Farmington Road
Farmington Hills, Michigan 48334-3357
(248) 488-7000
48
<PAGE> 1
Exhibit 13(b)
REPORT OF INDEPENDENT AUDITORS
We have audited the consolidated statement of condition of Source One Mortgage
Services Corporation and subsidiaries ("the Company") as of December 31, 1996
and the related consolidated statements of income, comprehensive income,
stockholders' equity, and cash flows for each of the two 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 reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Source One
Mortgage Services Corporation and subsidiaries as of December 31, 1996 and the
consolidated results of their operations and their cash flows for each of the
two years in the period ended December 31, 1996, in conformity with generally
accepted accounting principles.
/s/ Ernst & Young LLP
Detroit, Michigan
January 30, 1997
<PAGE> 1
EXHIBIT 23(a)
CONSENT OF INDEPENDENT AUDITORS
The Board of Directors
Source One Mortgage Services Corporation
We consent to incorporation by reference in this Annual Report on Form 10-K of
Source One Mortgage Services Corporation of our report dated January 28, 1998,
except for Note 23, as to which the date is March 20, 1998, relating to the
consolidated statement of condition of Source One Mortgage Services Corporation
and subsidiaries as of December 31, 1997, and the related consolidated
statements of income, comprehensive income, stockholders' equity, and cash
flows for the year then ended, which report appears in the December 31, 1997
Annual Report to Shareholders of Source One Mortgage Services Corporation.
We consent to incorporation by reference in the registration statement (No.
33-47025) on Form S-3, the registration statement (No. 33-71924) on Form S-3
and the registration statement (No. 33-62765) on Form S-4 of Source One
Mortgage Services Corporation, and in the related Prospectuses, of our report
dated January 28, 1998, except for Note 23, as to which the date is March 20,
1998, relating to the consolidated statement of condition of Source One
Mortgage Services Corporation and subsidiaries as of December 31, 1997, and the
related consolidated statements of income, comprehensive income, stockholders'
equity, and cash flows for the year then ended, which report is incorporated by
reference in the December 31, 1997, Annual Report on Form 10-K of Source One
Mortgage Services Corporation.
/s/ KPMG Peat Marwick LLP
Detroit, Michigan
March 26, 1998
<PAGE> 1
Exhibit 23(b)
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation in this Annual Report (Form 10-K) of Source One
Mortgage Services Corporation and subsidiaries of our report dated January 30,
1997, with respect to the consolidated financial statements of Source One
Mortgage Services Corporation and subsidiaries incorporated by reference in
the Annual Report (Form 10-K) of Source One Mortgage Services Corporation and
subsidiaries for the year ended December 31, 1997.
/s/ Ernst & Young LLP
Detroit, Michigan
March 27, 1998
<PAGE> 1
EXHIBIT 23(c)
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference (from the 1997 Annual Report
on Form 10-K filed by Financial Security Assurance Holdings Ltd. ("FSA") - in
which filing our report was incorporated by reference from FSA's Annual Report
to Shareholders) in the Registration Statements, as amended, pertaining to
Medium-Term Notes Series B (Form S-3, No. 33-47025), Series A Preferred Stock
(Form S-3, No. 33-71924) and Quarterly Income Capital Securities ("QUICS")
(Form S-4, No. 33-62765) of Source One Mortgage Services Corporation of our
report dated January 26, 1998 with respect to the consolidated financial
statements of Financial Security Assurance Holdings Ltd. and Subsidiaries as of
December 31, 1997 and 1996 and for each of the three years in the period ended
December 31, 1997.
/s/ Coopers & Lybrand L.L.P.
New York, New York
March 27, 1998
<PAGE> 1
EXHIBIT 24
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that James H. Ozanne does hereby make,
constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert L.
Densmore, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
James H. Ozanne
<PAGE> 2
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that Robert R. Densmore does hereby
make, constitute and appoint Mark A. Janssen, Michael C. Allemang, and Francis
X. Mohan, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
Robert R. Densmore
<PAGE> 3
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that Raymond Barrette does hereby make,
constitute and appoint Mark A. Janssen, Michael C. Allemang and Robert R.
Densmore, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
Raymond Barrette
<PAGE> 4
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that Francis X. Mohan does hereby make,
constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert R.
Densmore, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
Francis X. Mohan
<PAGE> 5
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that Michael C. Allemang does hereby
make, constitute and appoint Mark A. Janssen, Robert R. Densmore, and Francis X.
Mohan, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
Michael C. Allemang
<PAGE> 6
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that Terry Baxter does hereby make,
constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert R.
Densmore, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
Terry Baxter
<PAGE> 7
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that Mark A. Janssen does hereby make,
constitute and appoint Michael C. Allemang, Robert L. Densmore and Francis X.
Mohan, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
Mark A. Janssen
<PAGE> 8
SOURCE ONE MORTGAGE SERVICES CORPORATION
KNOW ALL MEN by these presents that Roger K. Taylor does hereby make,
constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert R.
Densmore, and each of them, the true and lawful attorney-in-fact of the
undersigned, with full power of substitution and revocation, for and in the
name, place and stead of the undersigned, to execute and deliver the Annual
Report on Form 10-K of Source One Mortgage Services Corporation for the year
ended December 31, 1997, and any and all amendments thereto; such Form 10-K and
each such amendment to be in such form and to contain such terms and provisions
as said attorney or substitute shall deem necessary or desirable; giving and
granting unto said attorney, or to such person or persons as in any case may be
appointed pursuant to the power of substitution herein given, full power and
authority to do and perform any and every act and thing whatsoever requisite,
necessary or, in the opinion of said attorney or substitute, able to be done in
and about the premises as fully and to all intents and purposes as the
undersigned might or could do if personally present, hereby ratifying and
confirming all that said attorney for such substitute shall lawfully do or cause
to be done by virtue hereof.
IN WITNESS WHEREOF, the undersigned has duly executed this instrument
as of the 23rd day of March, 1998.
--------------------------
Roger K. Taylor
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 3,134
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 22,171
<DEPRECIATION> 0
<TOTAL-ASSETS> 1,304,690
<CURRENT-LIABILITIES> 0
<BONDS> 0
0
18
<COMMON> 32
<OTHER-SE> 454,999
<TOTAL-LIABILITY-AND-EQUITY> 1,304,690
<SALES> 0
<TOTAL-REVENUES> 93,874
<CGS> 0
<TOTAL-COSTS> 105,021
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 8,610
<INTEREST-EXPENSE> 35,362
<INCOME-PRETAX> (11,147)
<INCOME-TAX> (3,617)
<INCOME-CONTINUING> (7,530)
<DISCONTINUED> 0
<EXTRAORDINARY> (5,975)
<CHANGES> 0
<NET-INCOME> (13,505)
<EPS-PRIMARY> (5.79)
<EPS-DILUTED> 0
</TABLE>
<PAGE> 1
EXHIBIT 99
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors
of Financial Security Assurance Holdings Ltd.:
We have audited the accompanying consolidated balance sheets of Financial
Security Assurance Holdings Ltd. and Subsidiaries as of December 31, 1997 and
1996 and the related consolidated statements of income, changes in shareholders'
equity, and cash flows for each of the three years in the period ended December
31, 1997. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Financial Security
Assurance Holdings Ltd. and Subsidiaries as of December 31, 1997 and 1996, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles.
/s/ Coopers & Lybrand L.L.P.
New York, New York
January 26, 1998
<PAGE> 2
[Page 26 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
December 31, December 31,
ASSETS 1997 1996
------------ ------------
<S> <C> <C>
Bonds at market value (amortized cost of $1,230,479 and $1,058,417) $1,268,158 $1,072,439
Equity investments at market value (cost of $29,430 and $8,336) 30,539 8,336
Short-term investments 132,931 73,641
---------- ----------
Total investments 1,431,628 1,154,416
Cash 12,475 8,146
Deferred acquisition costs 171,098 146,233
Prepaid reinsurance premiums 173,123 151,224
Reinsurance recoverable on unpaid losses 30,618 29,875
Receivable for securities sold 20,623 --
Other assets 61,079 47,848
---------- ----------
TOTAL ASSETS $1,900,644 $1,537,742
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deferred premium revenue $ 595,196 $ 511,196
Losses and loss adjustment expenses 75,417 72,079
Deferred federal income taxes 56,872 41,167
Ceded reinsurance balances payable 11,199 12,599
Payable for securities purchased 72,979 14,390
Notes payable 130,000 30,000
Accrued expenses and other liabilities 76,621 55,051
---------- ----------
TOTAL LIABILITIES 1,018,284 736,482
---------- ----------
COMMITMENTS AND CONTINGENCIES
Preferred stock (3,000,000 shares authorized; 2,000,000
issued and outstanding; par value of $.01 per share) 20 20
Common stock (50,000,000 shares authorized; 32,276,301
issued; par value of $.01 per share) 323 323
Additional paid-in capital - preferred 680 680
Additional paid-in capital - common 693,851 695,118
Unrealized gain on investments (net of deferred income tax
provision of $13,575 and $4,908) 25,212 9,114
Accumulated earnings 231,124 142,721
Deferred equity compensation 26,181 12,069
Less treasury stock at cost (3,521,847 and 2,303,407 shares held) (95,031) (58,785)
---------- ----------
TOTAL SHAREHOLDERS' EQUITY 882,360 801,260
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,900,644 $1,537,742
========== ==========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are
an integral part of these statements.
2
<PAGE> 3
[Page 27 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
REVENUES:
Net premiums written (net of premiums ceded
of $63,513, $55,965 and $33,166,
of which $38,105, $35,299 and $20,582
were ceded to affiliates) $ 172,878 $ 121,000 $ 77,576
Increase in deferred premium revenue (63,367) (30,552) (8,229)
--------- --------- ---------
Premiums earned (net of premiums ceded of
$41,198, $38,723 and $38,013) 109,511 90,448 69,347
Net investment income 72,085 65,064 48,965
Net realized gains 11,522 3,189 5,120
Other income 9,303 297 3,841
--------- --------- ---------
TOTAL REVENUES 202,421 158,998 127,273
--------- --------- ---------
EXPENSES:
Losses and loss adjustment expenses:
Related to Merger -- -- 15,400
Other (net of reinsurance recoveries
of $3,605, ($2,249) and $9,101,
of which $3,199, ($3,084) and
$7,111 were ceded to affiliates) 9,156 6,874 6,258
Policy acquisition costs 27,962 23,829 16,888
Other operating expenses 26,804 18,524 13,685
--------- --------- ---------
TOTAL EXPENSES 63,922 49,227 52,231
--------- --------- ---------
INCOME BEFORE INCOME TAXES 138,499 109,771 75,042
--------- --------- ---------
Provision (benefit) for income taxes:
Current 30,960 27,227 23,187
Deferred 7,037 1,784 (3,183)
--------- --------- ---------
Total provision 37,997 29,011 20,004
--------- --------- ---------
NET INCOME $ 100,502 $ 80,760 $ 55,038
========= ========= =========
Basic earnings per common share $ 3.35 $ 2.64 $ 2.13
========= ========= =========
Diluted earnings per common share $ 3.25 $ 2.61 $ 2.13
========= ========= =========
</TABLE>
The accompanying Notes to Consolidated Financial Statements are
an integral part of these statements.
3
<PAGE> 4
[Page 28 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in thousands, except per share data)
<TABLE>
<CAPTION>
Additional Additional Unrealized
Paid-In Paid-In Gain Deferred
Preferred Common Capital - Capital - (Loss) on Accumulated Equity Treasury
Stock Stock Preferred Common Investment Earnings Compensation Stock Total
----- ----- --------- ------ ---------- -------- ------------ ----- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE, December 31, 1994 $ 20 $ 262 $ 680 $544,266 $(21,709) $ 25,647 $ -- $ (3,730) $545,436
Net income for the year
55,038 55,038
Net change in unrealized gain on
investments (net of deferred
income taxes of $22,421) 41,640 41,640
Issuance of common stock -
6,051,661 shares 61 151,987 152,048
Dividends paid on common
stock ($0.32 per share) (8,275) (8,275)
Deferred equity compensation 6,504 6,504
Purchase of 591,714 shares of
common stock (14,444) (14,444)
-------- -------- -------- -------- --------- -------- -------- ------- --------
BALANCE, December 31, 1995 20 323 680 696,253 19,931 72,410 6,504 (18,174) 777,947
Net income for the year 80,760 80,760
Net change in unrealized loss on
investments (net of deferred
income tax benefit of $5,823) (10,817) (10,817)
Dividends paid on common
stock ($0.35 per share) (10,536) (10,536)
Deferred equity compensation 5,565 5,565
Purchase of 1,529,131 shares of
common stock (40,611) (40,611)
Other common stock transactions (1,135) (1,135)
Adjustment to prior-year disposal
of subsidiary 87 87
-------- -------- -------- -------- -------- -------- -------- -------- --------
BALANCE, December 31, 1996 20 323 680 695,118 9,114 142,721 12,069 (58,785) 801,260
Net income for the year 100,502 100,502
Net change in unrealized gain on
investments (net of deferred
income taxes of $8,667) 16,098 16,098
Dividends paid on common stock
($0.405 per share) (12,099) (12,099)
Deferred equity compensation 17,781 17,781
Deferred equity payout 187 (3,287) 56 (3,044)
Purchase of 162,573 shares of
common stock (5,434) (5,434)
Issuance of 125,106 shares of
treasury stock for
options exercised 688 (382) 3,042 3,348
Forward share transactions:
Settlements with employees
and directors (2,142) (2,142)
Settlements with counterparties (33,910) (33,910)
-------- -------- -------- -------- -------- -------- -------- -------- --------
BALANCE, December 31, 1997 $ 20 $ 323 $ 680 $693,851 $ 25,212 $231,124 $ 26,181 $(95,031) $882,360
======== ======== ======== ======== ======== ======== ======== ======== ========
</TABLE>
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
4
<PAGE> 5
[Page 29 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Premiums received, net $ 171,145 $ 124,540 $ 85,481
Policy acquisition and other operating expenses
paid, net (43,279) (32,266) (36,067)
Recoverable advances received (paid) (7,629) 10,213 (9,419)
Losses and loss adjustment expenses paid (6,463) (15,473) (4,954)
Net investment income received 65,662 63,533 41,939
Federal income taxes paid (19,797) (34,595) (15,890)
Interest paid (5,158) (2,115) (95)
Other (2,017) (4,253) 9,872
----------- ----------- -----------
Net cash provided by operating activities 152,464 109,584 70,867
----------- ----------- -----------
Cash flows from investing activities:
Proceeds from sales of bonds 1,078,226 1,117,473 624,802
Proceeds from maturities of bonds 32,468 2,965 606
Purchases of bonds (1,254,274) (1,150,024) (713,799)
Net gain on sale of subsidiaries 7,986 -- --
Purchases of property and equipment (3,097) (2,188) (999)
Payment for purchase of subsidiary, net of cash
acquired -- -- (11,447)
Net decrease (increase) in short-term
investments (55,551) (18,586) 56,689
----------- ----------- -----------
Net cash used for investing activities (194,242) (50,360) (44,148)
----------- ----------- -----------
Cash flows from financing activities:
Issuance of notes payable, net 125,905 -- --
Repayment of notes payable (30,000) -- --
Dividends paid (12,099) (10,536) (8,275)
Treasury stock, net (36,246) (41,660) (14,444)
Payment of management notes -- -- (5,624)
Other (1,453) -- --
----------- ----------- -----------
Net cash provided by (used for) financing
activities 46,107 (52,196) (28,343)
----------- ----------- -----------
Net increase (decrease) in cash 4,329 7,028 (1,624)
Cash at beginning of year 8,146 1,118 2,742
----------- ----------- -----------
Cash at end of year $ 12,475 $ 8,146 $ 1,118
=========== =========== ===========
</TABLE>
Continued
The accompanying Notes to Consolidated Financial Statements
are an integral part of these statements.
5
<PAGE> 6
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
(Dollars in thousands)
<TABLE>
<CAPTION>
Year EndedDecember 31,
----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Reconciliation of net income to net cash flows
from operating activities:
Net income $ 100,502 $ 80,760 $ 55,038
Decrease (increase) in accrued investment income (2,504) (578) 124
Increase in deferred premium revenue and related
foreign exchange adjustment 62,101 29,622 8,141
Increase in deferred acquisition costs (24,865) (13,282) (10,305)
Increase (decrease) in current federal income
taxes payable 7,891 (7,368) 7,297
Increase (decrease) in unpaid losses and loss
adjustment expenses 2,596 (8,023) 14,587
Increase in amounts withheld for others 133 52 30
Provision (benefit) for deferred income taxes 10,309 1,784 (3,183)
Net realized gains on investments (11,522) (3,189) (5,120)
Deferred equity compensation 14,299 5,565 5,735
Depreciation and accretion of bond discount (2,802) (1,735) (5,735)
Net gain on sale of subsidiaries (7,986) -- --
Change in other assets and liabilities 4,312 25,976 4,258
----------- ----------- -----------
Cash provided by operating activities $ 152,464 $ 109,584 $ 70,867
=========== =========== ===========
</TABLE>
Additional common stock was issued in relation to the Merger in 1995.
The accompanying Notes to Consolidated Financial Statements are
an integral part of these statements.
6
<PAGE> 7
[Pages 30 - 44 of 1997 Annual Report to Shareholders]
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
1. ORGANIZATION AND OWNERSHIP
Financial Security Assurance Holdings Ltd. (the Company) is a holding
company incorporated in the State of New York. The Company is principally
engaged (through its insurance subsidiaries) in providing financial guaranty
insurance on asset-backed and municipal obligations. The Company's underwriting
policy is to insure asset-backed and municipal obligations that it determines
would be of investment-grade quality without the benefit of the Company's
insurance. The asset-backed obligations insured by the Company are generally
issued in structured transactions and are backed by pools of assets such as
residential mortgage loans, consumer or trade receivables, securities or other
assets having an ascertainable cash flow or market value. The municipal
obligations insured by the Company consist primarily of general obligation bonds
that are supported by the issuers' taxing power and of special revenue bonds and
other special obligations of states and local governments that are supported by
the issuers' ability to impose and collect fees and charges for public services
or specific projects. Financial guaranty insurance written by the Company
guarantees payment when due of scheduled payments on an issuer's obligation. In
the case of a payment default on an insured obligation, the Company is generally
required to pay the principal, interest or other amounts due in accordance with
the obligation's original payment schedule or, at its option, to pay such
amounts on an accelerated basis.
The Company expects to continue to emphasize a diversified insured
portfolio characterized by insurance of both asset-backed and municipal
obligations, with a broad geographic distribution and a variety of revenue
sources and transaction structures. The Company's insured portfolio consists
primarily of asset-backed and municipal obligations originated in the United
States, but the Company has also written and continues to pursue business in
Europe and the Pacific Rim.
On December 20, 1995, a subsidiary of the Company merged (the Merger) with
Capital Guaranty Corporation (CGC). The Merger provided for each CGC share to be
exchanged for 0.6716 share of the Company's common stock and cash of $5.69. The
Company issued in the aggregate 6,051,661 common shares and paid aggregate cash
consideration of $51,300,000. At December 31, 1995, the Company was owned 50.3%
by U S WEST, Inc. (U S WEST), 7.8% by Fund American Enterprises Holdings, Inc.
(Fund American), 6.1% by The Tokio Marine and Fire Insurance Co., Ltd. (Tokio
Marine) and 35.8% by the public and employees. At December 31, 1996, the Company
was owned 40.4% by U S WEST, 11.5% by Fund American, 6.4% by Tokio Marine and
41.7% by the public and employees. At December 31, 1997, the Company was owned
42.1% by U S WEST, 12.0% by Fund American, 6.7% by Tokio Marine and 39.2% by the
public and employees. These percentages are calculated based upon outstanding
shares, which are reduced by treasury shares as presented in these financial
statements.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying financial statements have been prepared in accordance
with generally accepted accounting principles (GAAP), which, for the insurance
company subsidiaries, differ in certain material respects from the accounting
practices prescribed or permitted by insurance regulatory authorities (see Note
6). The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities in the Company's consolidated
balance sheets at December 31, 1997 and 1996 and the reported amounts of
revenues and expenses in the consolidated statements of income during the years
ended December 31, 1997, 1996 and 1995. Such estimates and assumptions include,
but are not limited to, losses and loss adjustment expenses and the deferral and
amortization of deferred policy acquisition costs. Actual results may differ
from those estimates. Significant accounting policies under GAAP are as follows:
7
<PAGE> 8
Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its direct and indirect wholly owned subsidiaries, FSA Portfolio Management
Inc., CGC, Transaction Services Corporation, Financial Security Assurance Inc.
(FSA), FSA Insurance Company, Financial Security Assurance of Oklahoma, Inc. and
Financial Security Assurance (U.K.) Limited (collectively, the Subsidiaries).
All intercompany accounts and transactions have been eliminated. Certain
prior-year balances have been reclassified to conform to the 1997 presentation.
The Merger was accounted for on a purchase accounting basis. In view of the
short period between the date of the Merger, December 20, 1995, and the
year-end, the date of the Merger for accounting purposes is considered to be
December 31, 1995. As a result, the accounting for the Merger has no effect on
the Company's consolidated statement of income for the year ended December 31,
1995, except for the recording of $15,400,000 in losses and loss adjustment
expenses to increase FSA's general reserve to provide for the insured portfolio
assumed by FSA in the Merger (see Notes 17 and 19).
Investments
Investments in debt securities designated as available for sale are
carried at market value. Any resulting unrealized gain or loss is reflected as a
separate component of shareholders' equity, net of applicable deferred income
taxes. All of the Company's long-term investments are classified as available
for sale.
Bond discounts and premiums are amortized on the effective yield method
over the remaining terms of the securities acquired. For mortgage-backed
securities, and any other holdings for which prepayment risk may be significant,
assumptions regarding prepayments are evaluated periodically and revised as
necessary. Any adjustments required due to the resulting change in effective
yields are recognized in current income. Short-term investments, which are those
investments with a maturity of less than one year at time of purchase, are
carried at market value, which approximates cost. Realized gains or losses on
sale of investments are determined on the basis of specific identification.
Investment income is recorded as earned.
To manage adverse movements in interest rates, the Company uses exchange
traded futures and options. Primarily, these contracts are designated as hedges
of specific identified securities and any gains or losses on these hedges are
deferred and included as part of the Company's unrealized gains or losses in
stockholders' equity until the disposition of the hedged assets. The Company
will discontinue to account for these contracts as hedges if there ceases to be
a high correlation between the change in price of the hedged assets and the
hedge. Other derivative positions, also in exchange traded futures contracts,
that are not accounted for as hedges are marked-to-market on a daily basis, and
any gains or losses are included in capital gains or losses.
Premium Revenue Recognition
Gross and ceded premiums are earned in proportion to the amount of risk
outstanding over the expected period of coverage. Deferred premium revenue and
prepaid reinsurance premiums represent the portion of premium that is applicable
to coverage of risk to be provided in the future on policies in force. When an
insured issue is retired or defeased prior to the end of the expected period of
coverage, the remaining deferred premium revenue and prepaid reinsurance
premium, less any amount credited to a refunding issue insured by the Company,
are recognized.
Losses and Loss Adjustment Expenses
A case basis reserve for unpaid losses and loss adjustment expenses is
recorded at the present value of the estimated loss when, in management's
opinion, the likelihood of a future loss is probable and determinable at the
balance sheet date. The estimated loss on a transaction is discounted using
current risk-free rates.
The general reserve is calculated by applying a loss factor to the total
net par amount outstanding of the Company's insured obligations over the term of
such insured obligations and discounting the result at risk-free rates. The loss
factor used for this purpose has been determined based upon an independent
rating agency study of bond defaults and the Company's portfolio characteristics
and history. The general reserve is available to be applied against future
additions or accretions to existing case basis reserves or to new case basis
reserves to be established in the future.
Management of the Company periodically evaluates its estimates for losses
and loss adjustment expenses and establishes reserves that management believes
are adequate to cover the ultimate net cost of claims. The reserves are
necessarily based on estimates, and there can be no assurance that the ultimate
liability will not differ from such estimates. The Company will, on an
8
<PAGE> 9
ongoing basis, monitor these reserves and may periodically adjust such reserves
based on the Company's actual loss experience, its future mix of business, and
future economic conditions.
Deferred Acquisition Costs
Deferred acquisition costs comprise those expenses that vary with and are
primarily related to the production of business, including commissions paid on
reinsurance assumed, compensation and related costs of underwriting and
marketing personnel, certain rating agency fees, premium taxes and certain other
underwriting expenses, reduced by ceding commission income on premiums ceded to
reinsurers. Deferred acquisition costs and the cost of acquired business are
amortized over the period in which the related premiums are earned.
Recoverability of deferred acquisition costs is determined by considering
anticipated losses and loss adjustment expenses.
Federal Income Taxes
The provision for income taxes consists of an amount for taxes currently
payable and a provision for tax consequences deferred to future periods
reflected at current income tax rates.
Earnings per Common Share
In 1997, the Company adopted Statement of Financial Accounting Standards
(SFAS) No. 128, Earnings Per Share (EPS), specifying the computation,
presentation and disclosure requirements for EPS (see Note 20). The new standard
defines "basic" and "diluted" earnings per share. Basic earnings per share are
based on average basic shares outstanding, which is calculated by adding shares
earned but not issued under the Company's equity bonus and performance share
plans to the average common shares outstanding. Diluted earnings per share are
based on average diluted shares outstanding, which is calculated by adding
shares contingently issuable under stock options, the performance share plan and
the Company's convertible preferred stock to the average basic shares
outstanding. All earnings per share have been restated to reflect the adoption
of SFAS No. 128.
3. INVESTMENTS
Bonds at amortized cost of $11,025,000 and $17,669,000 at December 31,
1997 and 1996, respectively, were on deposit with state regulatory authorities
as required by insurance regulations.
Consolidated net investment income consisted of the following (in
thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Bonds $ 65,422 $ 61,740 $ 43,789
Equity investments 1,393 928 --
Short-term investments 7,206 3,966 6,070
Investment expenses (1,936) (1,570) (894)
-------- -------- --------
Net investment income $ 72,085 $ 65,064 $ 48,965
======== ======== ========
</TABLE>
The credit quality of the investment portfolio at December 31, 1997 was as
follows:
<TABLE>
<CAPTION>
Percent of
Rating Investment Portfolio
-------------------- ----------------------
<S> <C>
AAA 69.1%
AA 16.0
A 11.5
BBB 1.1
Other 2.3
</TABLE>
9
<PAGE> 10
The amortized cost and estimated market value of bonds were as follows (in
thousands):
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Estimated
December 31, 1997 Cost Gains Losses Market Value
- ----------------- ---- ----- ------ ------------
<S> <C> <C> <C> <C>
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies $ 122,817 $ 799 $ (454) $ 123,162
Obligations of states and political
subdivisions 777,042 40,187 (135) 817,094
Foreign securities 48,078 -- (6,126) 41,952
Mortgage-backed securities 195,567 2,213 (27) 197,753
Corporate securities 66,014 1,375 (501) 66,888
Asset-backed securities 20,961 349 (1) 21,309
---------- ---------- ---------- ----------
Total $1,230,479 $ 44,923 $ (7,244) $1,268,158
========== ========== ========== ==========
December 31, 1996
U.S. Treasury securities and obligations
of U.S. government corporations
and agencies $ 55,619 $ 1,103 $ (557) $ 56,165
Obligations of states and political
subdivisions 661,831 15,208 (2,870) 674,169
Foreign securities 15,019 197 (71) 15,145
Mortgage-backed securities 177,818 1,432 (906) 178,344
Corporate securities 76,760 381 (403) 76,738
Asset-backed securities 71,370 680 (172) 71,878
---------- ---------- ---------- ----------
Total $1,058,417 $ 19,001 $ (4,979) $1,072,439
========== ========== ========== ==========
</TABLE>
The change in net unrealized gains (losses) consisted of (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Bonds $ 23,657 $(16,640) $ 64,061
Equity investments 1,109 -- --
-------- -------- --------
Change in net unrealized gains (losses) $ 24,766 $(16,640) $ 64,061
======== ======== ========
</TABLE>
10
<PAGE> 11
The amortized cost and estimated market value of bonds at December 31,
1997 and 1996, by contractual maturity, are shown below (in thousands). Actual
maturities could differ from contractual maturities because borrowers have the
right to call or prepay certain obligations with or without call or prepayment
penalties.
<TABLE>
<CAPTION>
December 31, 1996 December 31, 1997
----------------- -----------------
Estimated Estimated
Amortized Market Amortized Market
Cost Value Cost Value
---- ----- ---- -----
<S> <C> <C> <C> <C>
Due in one year or less $ 4,009 $ 4,007 $ 38,305 $ 38,626
Due after one year through five years 70,283 70,007 57,531 57,712
Due after five years through ten years 208,986 208,170 105,495 105,848
Due after ten years 730,673 766,912 607,898 620,031
Mortgage-backed securities (stated
maturities of 4 to 39 years) 195,567 197,753 177,818 178,344
Asset-backed securities (stated
maturities of 2 to 30 years) 20,961 21,309 71,370 71,878
---------- ---------- ---------- ----------
Total $1,230,479 $1,268,158 $1,058,417 $1,072,439
========== ========== ========== ==========
</TABLE>
Proceeds from sales of bonds during 1997, 1996 and 1995 were
$1,131,317,000, $1,118,112,000 and $608,773,000, respectively. Gross gains of
$12,659,000, $15,335,000 and $12,434,000 and gross losses of $1,440,000,
$12,146,000 and $7,314,000 were realized on sales in 1997, 1996 and 1995,
respectively.
To hedge against changes in yields on certain one-year corporate
securities, the Company entered into a series of Eurodollar futures contracts,
which were marked-to-market on a daily basis. These contracts were accounted for
as hedges. At year-end 1996, the net unrealized loss on the contracts, included
in the Company's unrealized gains in the stockholders' equity section, was not
material. The aggregate notional amount of these contracts was $83,728,000 as of
December 31, 1996.
The Company held open positions in U.S. Treasury bond futures contracts
with an aggregate notional amount of $33,300,000 and $20,600,000 as of December
31, 1997 and 1996, respectively. Such positions are marked-to-market on a daily
basis, and for the years ended December 31, 1997 and 1996, the Company reported
net realized gains of $190,000 and $923,000, respectively, which are included in
gross realized capital gains, above.
4. DEFERRED ACQUISITION COSTS
Acquisition costs deferred for amortization against future income and the
related amortization charged to expenses are as follows (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Balance, beginning of period $ 146,233 $ 132,951 $ 91,839
--------- --------- ---------
Costs deferred during the period:
Ceding commission income (18,956) (15,956) (9,836)
Assumed commission expense 31 38 55
Premium taxes 5,554 3,718 2,537
Compensation and other acquisition costs 66,198 49,311 34,437
--------- --------- ---------
Total 52,827 37,111 27,193
--------- --------- ---------
Costs amortized during the period (27,962) (23,829) (16,888)
--------- --------- ---------
Balance of acquired subsidiary -- -- 30,807
--------- --------- ---------
Balance, end of period $ 171,098 $ 146,233 $ 132,951
========= ========= =========
</TABLE>
11
<PAGE> 12
5. OTHER OPERATING EXPENSES
Total salary expense and related benefits included in other operating
expenses were $19,796,000, $14,596,000 and $12,046,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.
6. STATUTORY ACCOUNTING PRACTICES
GAAP for the Subsidiaries differs in certain significant respects from
accounting practices prescribed or permitted by insurance regulatory
authorities. The principal differences result from the following statutory
accounting practices:
- Upfront premiums on municipal business are recognized as earned when
related principal and interest have expired rather than over the expected
coverage period;
- Acquisition costs are charged to operations as incurred rather than as
related premiums are earned;
- A contingency reserve (rather than a general loss reserve) is computed
based on the following statutory requirements:
(i) For all policies written prior to July 1, 1989, an amount equal
to 50% of cumulative earned premiums less permitted reductions, plus;
(ii) For all policies written on or after July 1, 1989, an amount
equal to the greater of 50% of premiums written for each category of
insured obligation or a designated percentage of principal guaranteed for
that category. These amounts are provided each quarter as either 1/60th or
1/80th of the total required for each category, less permitted reductions;
- Certain assets designated as "non-admitted assets" are charged
directly to statutory surplus but are reflected as assets under
GAAP;
- Federal income taxes are provided only on taxable income for which
income taxes are currently payable;
- Accruals for deferred compensation are not recognized;
- Purchase accounting adjustments are not recognized;
- Bonds are carried at amortized cost;
- Surplus notes are recognized as surplus rather than a liability.
A reconciliation of net income for the calendar years 1997, 1996 and 1995
and shareholders' equity at December 31, 1997, 1996 and 1995, reported by the
Company on a GAAP basis, to the amounts reported by the Subsidiaries on a
statutory basis, is as follows (in thousands):
<TABLE>
<CAPTION>
Net Income: 1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
GAAP BASIS $ 100,502 $ 80,760 $ 55,038
Non-insurance companies net loss (gain) (243) 95 (50)
Premium revenue recognition (23,130) (5,518) (4,805)
Losses and loss adjustment expenses incurred 4,653 (2,138) 10,871
Deferred acquisition costs (24,865) (12,482) (10,305)
Deferred income tax provision (benefit) 8,025 911 (3,055)
Amortization of bonds 56 566 1,195
Accrual of deferred compensation, net 26,681 12,737 5,663
Other (61) 1,404 (1,580)
--------- --------- --------
STATUTORY BASIS $ 91,618 $ 76,335 $ 52,972
========= ========= ========
</TABLE>
12
<PAGE> 13
<TABLE>
<CAPTION>
December 31,
------------------------------
Shareholders' Equity: 1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
GAAP BASIS $ 882,360 $ 801,260 $ 777,947
Non-insurance companies liabilities, net 15,500 14,072 12,039
Premium revenue recognition (74,863) (51,760) (46,248)
Loss and loss adjustment expense reserves 34,313 29,660 31,798
Deferred acquisition costs (171,098) (146,233) (132,951)
Contingency reserve (287,694) (227,139) (183,967)
Unrealized gain on investments, net of tax (43,027) (14,084) (30,298)
Deferred income taxes 59,867 41,682 43,205
Accrual of deferred compensation 41,451 18,390 5,653
Surplus notes 50,000 -- --
Other (12,841) (17,043) (16,492)
--------- --------- ---------
STATUTORY BASIS (SURPLUS) $ 493,968 $ 448,805 $ 460,686
========= ========= =========
SURPLUS PLUS CONTINGENCY RESERVE $ 781,661 $ 675,944 $ 644,653
========= ========= =========
</TABLE>
7. FEDERAL INCOME TAXES
For periods prior to May 13, 1994, the date of the initial public offering
when the Company became less than 80% owned by U S WEST, the Company and its
Subsidiaries joined with U S WEST and its subsidiaries in filing a consolidated
federal income tax return. Under a U S WEST practice, an income tax benefit or
liability was allocated to the Company to the extent that benefits were usable
or additional liabilities were incurred by U S WEST due to the Company's
inclusion in the U S WEST tax returns. For each year since the Company's
acquisition by U S WEST, the Company's resulting income tax provision has been
the same as if the allocation of taxes were based on a separate return
calculation. For the Subsidiaries, under a separate tax sharing agreement with U
S WEST, the allocation of income taxes was based upon separate return
calculations, which provided that benefits or liabilities created by the
Subsidiaries were allocated to the Subsidiaries regardless of whether the
benefits were usable or additional liabilities were incurred in the U S WEST tax
returns. For periods subsequent to May 12, 1994, the Company and all members of
its group elected to file consolidated federal income tax returns. The
calculation of each member's tax benefit or liability was controlled by a tax
sharing agreement that based the allocation of such benefit or liability upon a
separate return calculation.
The cumulative balance sheet effects of deferred tax consequences are (in
thousands):
<TABLE>
<CAPTION>
December 31,
------------
1997 1996
---- ----
<S> <C> <C>
Deferred acquisition costs $ 59,884 $ 51,182
Deferred premium revenue adjustments 8,424 3,520
Unrealized capital gains 15,618 7,952
Contingency reserves 38,037 30,893
Market discounts 2,016 1,950
--------- ---------
Total deferred tax liabilities 123,979 95,497
--------- ---------
Loss and loss adjustment expense reserves (12,009) (10,381)
Deferred compensation (21,503) (10,730)
Tax credits (1,807) (7,861)
Tax and loss bonds (30,520) (22,526)
Other, net (1,268) (2,832)
--------- ---------
Total deferred tax assets (67,107) (54,330)
--------- ---------
Total deferred income taxes $ 56,872 $ 41,167
========= =========
</TABLE>
No valuation allowance was necessary at December 31, 1997 or 1996.
13
<PAGE> 14
A reconciliation of the effective tax rate with the federal statutory rate
follows:
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Tax at statutory rate 35.0% 35.0% 35.0%
Tax-exempt interest (7.9) (8.9) (8.5)
Other 0.3 0.3 0.2
---- ---- ----
Provision for income taxes 27.4% 26.4% 26.7%
==== ==== ====
</TABLE>
8. SHAREHOLDERS' EQUITY
On September 2, 1994, the Company issued to Fund American 2,000,000 shares
of Series A, non-dividend paying, voting, convertible preferred stock having an
aggregate liquidation preference of $700,000. The preferred stock is
convertible, at the option of the holder upon payment of the conversion price
therefor, into an equal number of shares of common stock (subject to
anti-dilutive adjustment). The conversion price per share (subject to
anti-dilutive adjustment) is $29.65. The preferred stock will be redeemed (if
then outstanding) on May 13, 2004 at a redemption price of $0.35 per share. Fund
American is entitled to one vote per share of preferred stock, voting together
as a single class with the holders of common stock on all matters upon which
holders of common stock are entitled to vote. As the holder of the preferred
stock, Fund American is not entitled to receive dividends or other distributions
of any kind payable to shareholders of the Company, except that, in the event of
the liquidation, dissolution or winding up of the Company, it is entitled to
receive out of the assets of the Company available therefor, before any
distribution or payment is made to the holders of common stock or to any other
class of capital stock of the Company ranking junior to the Company's preferred
stock, liquidation payments in the amount of $0.35 per share. Fund American may
not transfer the preferred stock, except to one of its majority-owned
subsidiaries.
On December 20, 1995, CGC merged with a subsidiary of the Company. The
Merger provided for each CGC share to be exchanged for 0.6716 share of the
Company's common stock and cash of $5.69. The Company issued in the aggregate
6,051,661 common shares and paid aggregate cash consideration of $51,300,000.
In May 1996, the Company repurchased 1,000,000 shares of its common stock
from U S WEST for a purchase price of $26.50 per share. At the same time, the
Company also entered into forward agreements with National Westminster Bank Plc
and Canadian Imperial Bank of Commerce (the Counterparties) in respect of
1,750,000 shares (the Forward Shares) of the Company's common stock. Under the
forward agreements, the Company has the obligation either: (i) to purchase the
Forward Shares from the Counterparties for a price equal to $26.50 per share
plus carrying costs or (ii) to direct the Counterparties to sell the Forward
Shares, with the Company receiving any excess or making up any shortfall between
the sale proceeds and $26.50 per share plus carrying costs in cash or additional
shares, at its option. Simultaneous with the Company entering into the forward
agreements, the Company made the economic benefit and risk of 750,000 of these
shares available for subscription by certain of the Company's employees and
directors. When an individual participant exercises Forward Shares under the
subscription program, the Company settles with the participant but does not
necessarily close out the corresponding forward share position with the
Counterparties. The cost of these settlements during 1997 was $2,142,000 and was
charged to additional paid-in capital. By the fourth quarter of 1997, such
exercises by participants had increased the number of shares allocated to the
Company from 1,000,000 shares to 1,187,800 shares. During the fourth quarter of
1997, the Company purchased 1,187,800 Forward Shares for $33,910,000 by
exercising rights under the forward agreements. At December 31, 1997, as a
result of the Company's exercise, the repurchased shares are held as treasury
stock, and the remaining 562,200 Forward Shares were allocated to the
subscription program.
14
<PAGE> 15
9. DIVIDENDS AND CAPITAL REQUIREMENTS
Under New York Insurance Law, FSA may pay a dividend to the Company
without the prior approval of the Superintendent of the New York State Insurance
Department only from earned surplus subject to the maintenance of a minimum
capital requirement. In addition, the dividend, together with all dividends
declared or distributed by FSA during the preceding twelve months, may not
exceed the lesser of 10% of its policyholders' surplus shown on FSA's last filed
statement, or adjusted net investment income, as defined, for such twelve-month
period. As of December 31, 1997, FSA had $49,846,000 available for the payment
of dividends over the next twelve months. In addition, the New York
Superintendent has approved the repurchase by FSA of up to $75,000,000 of its
shares from the Company through December 31, 1998, pursuant to which FSA has
repurchased $66,500,000 of its shares through December 31, 1997.
10. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES
The Company has a credit arrangement aggregating $150,000,000 at December
31, 1997, which is provided by commercial banks and intended for general
application to transactions insured by the Subsidiaries. At December 31, 1997,
there were no borrowings under this arrangement, which expires on November 23,
1999. In addition, there are credit arrangements assigned to specific insured
transactions. In August 1994, FSA entered into a facility agreement with
Canadian Global Funding Corporation and Hambros Bank Limited. Under the
agreement, FSA can arrange financing for transactions subject to certain
conditions. The amount of this facility was $186,911,000, of which $100,911,000
was unutilized at December 31, 1997.
FSA has a standby line of credit commitment in the amount of $240,000,000
with a group of international Aaa/AAA-rated banks to provide loans to FSA after
it has incurred, during the term of the facility, cumulative municipal losses
(net of any recoveries) in excess of the greater of $230,000,000 or 5.75% of
average annual debt service of the covered portfolio. The obligation to repay
loans made under this agreement is a limited recourse obligation payable solely
from, and collateralized by, a pledge of recoveries realized on defaulted
insured obligations including certain installment premiums and other collateral.
This commitment has a term beginning on April 30, 1997 and expiring on April 30,
2004 and contains an annual renewal provision subject to approval by the banks.
No amounts have been utilized under this commitment as of December 31, 1997.
In connection with the Merger, the Company assumed $30,000,000 of CGC's
senior notes. Interest on these notes was paid semiannually at the rate of 7.05%
per annum. These notes were repaid in September 1997.
On September 18, 1997, the Company issued $130,000,000 of 7.375% Senior
Quarterly Income Debt Securities (Senior QUIDS) due September 30, 2097 and
callable without premium or penalty on or after September 18, 2002. Interest on
these notes is paid quarterly beginning on December 31, 1997. Debt issuance
costs of $4,300,000 are being amortized over the life of the debt. The Company
used the proceeds to repay the CGC senior notes described above, to augment
capital in the Subsidiaries, to repurchase Forward Shares (see Note 8) and for
general corporate purposes.
11. EMPLOYEE BENEFIT PLANS
The Subsidiaries maintain both a qualified and a non-qualified
non-contributory defined contribution pension plan for the benefit of all
eligible employees. The Subsidiaries' contributions are based upon a fixed
percentage of employee compensation. Pension expense, which is funded as
accrued, amounted to $2,535,000, $2,215,000 and $1,898,000 for the years ended
December 31, 1997, 1996 and 1995, respectively.
The Subsidiaries have an employee retirement savings plan for the benefit
of all eligible employees. The plan permits employees to contribute a percentage
of their salaries up to limits prescribed by the Internal Revenue Service (IRS
Code, Section 401(k)). The Subsidiaries' contributions are discretionary, and
none have been made.
15
<PAGE> 16
During 1991, the Subsidiaries established the Profit Participation Plan as
a long-term incentive compensation plan for the benefit of certain of its
employees. Prior to the Company's initial public offering in 1994, the Company
adopted a Supplemental Restricted Stock Plan. Pursuant to this plan, awards of
outstanding units to existing employees under the Profit Participation Plan were
valued at $0.20 per dollar of award ($0.70 per dollar of award in the case of
1994 regular units granted thereunder) and, at the election of each outstanding
employee, were exchanged for restricted shares of common stock valued at the
initial public offering price of $20.00 per share. All employees of the Company,
including all senior executives, exchanged their outstanding interests in the
Profit Participation Plan for restricted shares of common stock at the public
offering price under the Supplemental Restricted Stock Plan. In exchange for an
accrued balance of $7,126,000 in such Profit Participation Plan, the Company
issued 356,345 shares of restricted stock. This transaction was treated as a
non-cash financing transaction for cash flow purposes. The stock was restricted
because ownership of the shares by employees required continued employment. The
shares vested ratably over a three-year period on July 1, 1994, 1995 and 1996.
Pursuant to the 1993 Equity Participation Plan, 1,810,780 shares of common
stock, subject to anti-dilutive adjustment, were reserved for awards of options,
restricted shares of common stock, and performance shares to employees for the
purpose of providing, through the grant of long-term incentives, a means to
attract and retain key personnel and to provide to participating officers and
other key employees long-term incentives for sustained high levels of
performance. Shares available under the 1993 Equity Participation Plan were
increased from 1,810,780 to 2,110,780 in May 1995. The 1993 Equity Participation
Plan also contains provisions that permit the Human Resources Committee to pay
all or a portion of an employee's bonuses in the form of shares of common stock
credited to the employees at a 15% discount from current market value and paid
to employees five years from the date of award. Up to an aggregate of 10,000,000
shares may be allocated to such equity bonuses. Common stock to pay performance
shares, stock options and equity bonus awards is acquired by the Company through
open-market purchases by a trust established for such purpose.
During 1994, under the Company's 1993 Equity Participation Plan, the
Company granted to officers and employees, in respect of future performance,
non-qualified options to purchase an aggregate of 1,099,000 shares of common
stock, of which 39,000 were forfeited and 1,060,000 were still outstanding at
December 31, 1994, substantially all of which have an exercise price of $20.00
per share. (As described below, 1,025,500 of these options were converted to
performance shares.) The foregoing options vest, subject to continuation of
employment and other terms of the option grants, at the rate of 20% per year,
for five one-year periods, with the first period ending on July 1, 1994. Such
options expire ten years after the effective dates of their grant. In the fourth
quarter of 1994, holders of outstanding stock options under the 1993 Equity
Participation Plan were offered the right to exchange such stock options for an
equal number of performance shares under such Plan. Also, as a result of the
Merger, the Company granted stock options to acquire an aggregate of 169,956
shares of common stock with strike prices ranging from $18.63 to $23.53 per
share to employees of CGC in exchange for outstanding stock options of CGC.
During 1997, employees acquired 125,106 shares subject to options at an average
strike price of $22.32 per share and with an average market price of $41.47 per
share. In addition, options to purchase 20,194 shares were forfeited during
1997. Giving effect to such exchange and subsequent awards, at December 31,
1997, there were outstanding 1,366,375 performance shares and options to
purchase 56,656 shares of common stock.
Performance shares granted under the 1993 Equity Participation Plan were
as follows:
<TABLE>
<CAPTION>
Outstanding Granted Earned Forfeited Outstanding Market
at Beginning During During During at End Price at
of Year the Year the Year the Year of Year Grant Date
------- -------- -------- -------- ------- ----------
<S> <C> <C> <C> <C> <C> <C>
1995 1,025,500 83,650 -- -- 1,109,150 $19.250
1996 1,109,150 282,490 -- 17,300 1,374,340 25.250
1997 1,374,340 253,057 201,769 59,253 1,366,375 35.500
</TABLE>
The Company applies APB Opinion 25 and related Interpretations in
accounting for its performance shares. The Company estimates the final cost of
these performance shares and accrues for this expense over the performance
period. The accrued expense for the performance shares was $29,500,000,
$13,741,000 and $5,744,000 for the years ended December 31, 1997, 1996 and 1995,
respectively. In tandem with this accrued expense, the Company estimates those
performance shares that it expects to settle in stock and records this amount in
stockholders' equity as deferred compensation. The remainder of the accrual,
which represents the amount of performance shares that the Company estimates it
will settle in cash, is recorded in accrued expenses and other liabilities. In
1996, the Company adopted disclosure provisions of SFAS No. 123. Had the
compensation cost for the Company's performance shares been determined based
upon the provisions of SFAS No. 123, there would have been no effect on the
Company's reported net income and earnings per share.
16
<PAGE> 17
In November 1994, the Company appointed an independent trustee authorized
to purchase shares of the Company's common stock in open market transactions, at
times and prices determined by the trustee. These purchases are intended to fund
future obligations relating to equity bonuses, performance shares and stock
options under the 1993 Equity Participation Plan and are presented as treasury
stock in these financial statements. During 1997, 1996 and 1995, the total
number of shares purchased by the trust was 162,573, 529,131 and 591,714,
respectively, at a cost of $5,434,000, $14,111,000 and $14,444,000,
respectively. In 1996 and 1995, the Company also repurchased stock from its
employees in satisfaction of withholding taxes on shares distributed under its
restricted stock plan.
The Company does not currently provide post-retirement benefits, other
than under its defined contribution plans, to its employees, nor does it provide
post-employment benefits to former employees.
12. COMMITMENTS AND CONTINGENCIES
The Company and its Subsidiaries lease office space and equipment under
non-cancelable operating leases, which expire at various dates through 2005.
Future minimum rental payments are as follows (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
<S> <C>
1998 $ 2,477
1999 2,440
2000 2,301
2001 2,014
2002 1,739
Thereafter 5,071
-------
Total $16,042
=======
</TABLE>
Rent expense for the years ended December 31, 1997, 1996 and 1995 was
$4,067,000, $3,816,000 and $3,712,000, respectively.
During the ordinary course of business, the Subsidiaries have become
parties to certain litigation. Management believes that these matters will be
resolved with no material financial impact on the Company.
13. REINSURANCE
The Subsidiaries reinsure portions of their risks with affiliated (see
Note 15) and unaffiliated reinsurers under quota share treaties and on a
facultative basis. The Subsidiaries' principal ceded reinsurance program
consisted in 1997 of two quota share treaties and three automatic facultative
facilities. One treaty covered all of the Subsidiaries' approved regular lines
of business, except U.S. municipal obligation insurance. Under this treaty in
1997, the Subsidiaries ceded 9.75% of each covered policy, up to a maximum of
$19,500,000 insured principal per policy. At their sole option, the Subsidiaries
could have increased, and in certain instances did increase, the ceding
percentage to 19.5% up to $39,000,000 of each covered policy. A second treaty
covered the Subsidiaries' U.S. municipal obligation insurance business. Under
this treaty in 1997, the Subsidiaries ceded 9% of each covered policy that is
classified by the Subsidiaries as providing U.S. municipal bond insurance as
defined by Article 69 of the New York Insurance Law up to a limit of $24,000,000
per single risk, which is defined by revenue source. At their sole option, the
Subsidiaries could have increased, and in certain instances did increase, the
ceding percentage to 35% up to $93,333,000 per single risk. These cession
percentages under both treaties were reduced on smaller-sized transactions.
Under the three automatic facultative facilities in 1997, the Subsidiaries at
their option could allocate up to a specified amount for each reinsurer (ranging
from $4,000,000 to $50,000,000 depending on the reinsurer) for each transaction,
subject to limits and exclusions, in exchange for which the Subsidiaries agreed
to cede in the aggregate a specified percentage of gross par insured by the
Subsidiaries. Each of the treaties and automatic facultative facilities allowed
the Subsidiaries to withhold a ceding commission to defray their expenses. The
Subsidiaries also employed non-treaty, quota share facultative reinsurance on
various transactions in 1997 in keeping with prior practices. In 1997, the
Subsidiaries also implemented facultative first-loss reinsurance on selected
asset-backed transactions.
17
<PAGE> 18
In the event (which management considers to be highly unlikely) that any
or all of the reinsuring companies were unable to meet their obligations to the
Subsidiaries, the Subsidiaries would be liable for such defaulted amounts. The
Subsidiaries have also assumed reinsurance of municipal obligations from
unaffiliated insurers.
Amounts reinsured were as follows (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Written premiums ceded $ 63,513 $ 55,965 $33,166
Written premiums assumed 1,352 1,873 1,684
Earned premiums ceded 41,713 38,723 38,013
Earned premiums assumed 5,121 6,020 2,759
Loss and loss adjustment expense payments
ceded 2,862 29,408 3,060
Loss and loss adjustment expense payments
assumed 2 3 3
Incurred losses and loss adjustment expenses ceded 3,605 (2,249) 9,101
Incurred losses and loss adjustment expenses
assumed 161 38 81
<CAPTION>
December 31,
------------
1997 1996
---- ----
<S> <C> <C>
Principal outstanding ceded $24,547,361 $20,292,615
Principal outstanding assumed 1,670,468 1,995,752
Deferred premium revenue ceded 173,123 151,224
Deferred premium revenue assumed 14,128 18,929
Loss and loss adjustment expense reserves ceded 30,618 29,875
Loss and loss adjustment expense reserves assumed 865 705
</TABLE>
14. OUTSTANDING EXPOSURE AND COLLATERAL
The Company's policies insure the scheduled payments of principal and
interest on asset-backed and municipal obligations. The principal amount insured
(in millions) as of December 31, 1997 and 1996 (net of amounts ceded to other
insurers of $10,129 and $9,601 of asset-backed and $14,418 and $10,691 of
municipal, respectively) and the terms to maturity are as follows:
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
<S> <C> <C> <C> <C>
0 to 5 Years $ 7,553 $ 2,230 $ 7,424 $ 1,571
5 to 10 Years 5,637 5,683 3,920 3,841
10 to 15 Years 2,858 8,257 1,461 6,272
15 to 20 Years 524 14,340 714 11,433
20 Years and Above 11,917 16,479 9,681 12,877
------- ------- ------- -------
Total $28,489 $46,989 $23,200 $35,994
======= ======= ======= =======
</TABLE>
18
<PAGE> 19
The principal amount ceded as of December 31, 1997 and 1996 and the terms
to maturity are as follows (in millions):
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal
- ----------------- ------------ --------- ------------ ---------
<S> <C> <C> <C> <C>
0 to 5 Years $ 3,828 $ 965 $ 3,695 $ 769
5 to 10 Years 2,118 1,693 2,413 1,192
10 to 15 Years 553 2,078 452 1,479
15 to 20 Years 257 3,005 302 2,345
20 Years and Above 3,373 6,677 2,739 4,906
------- ------- ------- -------
Total $10,129 $14,418 $ 9,601 $10,691
======= ======= ======= =======
</TABLE>
The Company limits its exposure to losses from writing financial
guarantees by underwriting investment-grade obligations, by diversifying its
portfolio and by maintaining rigorous collateral requirements on asset-backed
obligations. The gross principal amounts of insured obligations in the
asset-backed insured portfolio are backed by the following types of collateral
(in millions):
<TABLE>
<CAPTION>
Net of Amounts Ceded Ceded
December 31, December 31,
------------ ------------
Types of Collateral 1997 1996 1997 1996
- ------------------- ---- ---- ---- ----
<S> <C> <C> <C> <C>
Residential mortgages $12,928 $10,987 $ 3,665 $ 3,077
Consumer receivables 10,659 7,548 4,601 3,735
Government securities 787 1,477 120 449
Pooled corporate obligations 3,004 1,663 540 852
Commercial mortgage portfolio:
Commercial real estate 98 113 418 463
Corporate secured 55 66 481 619
Investor-owned utility obligations 643 791 229 266
Other asset-backed obligations 315 555 75 140
------- ------- ------- -------
Total asset-backed obligations $28,489 $23,200 $10,129 $ 9,601
======= ======= ======= =======
</TABLE>
The asset-backed insured portfolio, which aggregated $38,618,244,000
principal before reinsurance at December 31, 1997, was collateralized by assets
with an estimated fair value of $44,382,716,000. At December 31, 1996, it
aggregated $32,792,722,000 principal before reinsurance and was collateralized
by assets with an estimated fair value of $38,323,180,000. Such estimates of
fair value are calculated at the inception of each insurance policy and are
changed only in proportion to changes in exposure. At December 31, 1997, the
estimated fair value of collateral and reserves over the principal insured
averaged from 100% for commercial real estate to 172% for corporate secured
obligations. At December 31, 1996, the estimated fair value of collateral and
reserves over the principal insured averaged from 100% for commercial real
estate to 168% for corporate secured obligations. Collateral for specific
transactions is generally not available to pay claims related to other
transactions. The amounts of losses ceded to reinsurers are determined net of
collateral.
The gross principal amount of insured obligations in the municipal insured
portfolio includes the following types of issues (in millions):
<TABLE>
<CAPTION>
Net of Amounts Ceded Ceded
December 31, December 31,
------------ ------------
Types of Issues 1997 1996 1997 1996
- --------------- ---- ---- ---- ----
<S> <C> <C> <C> <C>
General obligation bonds $17,101 $12,523 $ 3,182 $2,423
Housing revenue bonds 1,770 1,794 955 1,033
Municipal utility revenue bonds 5,892 4,671 2,294 1,472
Health care revenue bonds 3,924 2,854 2,175 2,049
Tax-supported bonds (non-general obligation) 11,210 8,805 3,526 2,152
Transportation revenue bonds 1,972 1,479 1,041 436
Other municipal bonds 5,120 3,868 1,245 1,126
------- ------- ------- -------
Total municipal obligations $46,989 $35,994 $14,418 $10,691
======= ======= ======= =======
</TABLE>
19
<PAGE> 20
In its asset-backed business, the Company considers geographic
concentration as a factor in underwriting insurance covering securitizations of
pools of such assets as residential mortgages or consumer receivables. However,
after the initial issuance of an insurance policy relating to such
securitization, the geographic concentration of the underlying assets may not
remain fixed over the life of the policy. In addition, in writing insurance for
other types of asset-backed obligations, such as securities primarily backed by
government or corporate debt, geographic concentration is not deemed by the
Company to be significant given other more relevant measures of diversification
such as issuer or industry.
The Company seeks to maintain a diversified portfolio of insured municipal
obligations designed to spread its risk across a number of geographic areas. The
following table sets forth, by state, those states in which municipalities
located therein issued an aggregate of 2% or more of the Company's net par
amount outstanding of insured municipal securities as of December 31, 1997:
<TABLE>
<CAPTION>
Net Par Percent of Total Ceded Par
Number Amount Municipal Net Par Amount
State of Issues Outstanding Amount Outstanding Outstanding
----- --------- ----------- ------------------ -----------
(in millions) (in millions)
<S> <C> <C> <C> <C>
California 403 $ 7,832 16.7% $ 1,929
New York 281 4,307 9.2 2,163
Pennsylvania 231 3,125 6.6 650
New Jersey 207 2,730 5.8 1,260
Florida 103 2,669 5.7 817
Texas 294 2,472 5.3 669
Illinois 274 1,851 3.9 254
Massachusetts 101 1,460 3.1 553
Michigan 147 1,417 3.0 409
Minnesota 129 1,152 2.5 111
Wisconsin 179 1,138 2.4 206
All Other States 1,190 15,575 33.1 4,528
Non-U.S 29 1,261 2.7 869
------- ------- ----- -------
Total 3,568 $46,989 100.0% $14,418
======= ======= ===== =======
</TABLE>
15. RELATED PARTY TRANSACTIONS
The Subsidiaries ceded premiums of $21,216,000, $19,890,000 and
$13,061,000 to Tokio Marine for the years ended December 31, 1997, 1996 and
1995, respectively. The amounts included in prepaid reinsurance premiums at
December 31, 1997 and 1996 for reinsurance ceded to Tokio Marine were
$53,603,000 and $44,634,000, respectively. Reinsurance recoverable on unpaid
losses ceded to Tokio Marine was $613,000 and $477,000 at December 31, 1997 and
1996, respectively.
The Subsidiaries ceded premiums of $16,890,000, $15,409,000 and $7,522,000
on a quota share basis to affiliates of U S WEST for the years ended December
31, 1997, 1996 and 1995, respectively, of which $351,000, $372,000 and $629,000,
respectively, were ceded to Commercial Reinsurance Company (Commercial Re). The
amounts included in prepaid reinsurance premiums for reinsurance ceded to these
affiliates were $51,980,000 and $49,649,000 at December 31, 1997 and 1996,
respectively, of which $5,554,000 and $8,728,000, respectively, were ceded to
Commercial Re. The amounts of reinsurance recoverable on unpaid losses ceded to
these affiliates at December 31, 1997 and 1996 were $24,195,000 and $23,473,000,
respectively, of which $20,335,000 and $19,170,000, respectively, were ceded to
Commercial Re. The Commercial Re reinsurance agreement was subject to, and
received, the non-disapproval of the State of New York Insurance Department due
to its nature as an affiliate transaction. FSA has taken credit for the
reinsurance ceded to Commercial Re.
20
<PAGE> 21
16. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair values have been determined by the Company
using available market information and appropriate valuation methodologies.
However, considerable judgment is necessary to interpret the data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amount the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
Bonds -- The carrying amount of bonds represents fair value. The fair
value of bonds is based upon quoted market price.
Short-term investments -- The carrying amount is fair value, which
approximates cost due to the short maturity of these instruments.
Cash, receivable for investments sold and payable for investments
purchased -- The carrying amount approximates fair value because of the short
maturity of these instruments.
Deferred premium revenue, net of prepaid reinsurance premiums -- The
carrying amount of deferred premium revenue, net of prepaid reinsurance
premiums, represents the Company's future premium revenue, net of reinsurance,
on policies where the premium was received at the inception of the insurance
contract. The fair value of deferred premium revenue, net of prepaid reinsurance
premiums, is an estimate of the premiums that would be paid under a reinsurance
agreement with a third party to transfer the Company's financial guaranty risk,
net of that portion of the premiums retained by the Company to compensate it for
originating and servicing the insurance contracts.
Installment premiums -- Consistent with industry practice, there is no
carrying amount for installment premiums since the Company will receive premiums
on an installment basis over the term of the insurance contract. Similar to
deferred premium revenue, the fair value of installment premiums is the
estimated present value of the future contractual premium revenues that would be
paid under a reinsurance agreement with a third party to transfer the Company's
financial guaranty risk, net of that portion of the premium retained by the
Company to compensate it for originating and servicing the insurance contract.
Losses and loss adjustment expenses, net of reinsurance recoverable on
unpaid losses -- The carrying amount is fair value, which is the present value
of the expected cash flows for specifically identified claims and potential
losses in the Company's insured portfolio.
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
(In thousands) Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------ ---------- ------ ----------
<S> <C> <C> <C> <C>
Assets:
Bonds $1,268,158 $1,268,158 $1,072,439 $1,072,439
Short-term investments 132,931 132,931 73,641 73,641
Cash 12,475 12,475 8,146 8,146
Receivable for securities sold 20,623 20,623 -- --
Liabilities:
Deferred premium revenue, net of
prepaid reinsurance premiums 422,073 295,451 359,972 251,980
Losses and loss adjustment expenses,
net of reinsurance recoverable on
unpaid losses 44,799 44,799 42,204 42,204
Notes payable 130,000 131,612 30,000 30,000
Payable for investments purchased 72,979 72,979 14,390 14,390
Off-balance-sheet instruments:
Installment premiums -- 116,888 -- 102,988
</TABLE>
21
<PAGE> 22
17. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company's liability for losses and loss adjustment expenses consists
of the case basis and general reserves. Activity in the liability for losses and
loss adjustment expenses is summarized as follows (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Balance at January 1 $ 72,079 $ 111,759 $ 91,130
Less reinsurance recoverable 29,875 61,532 55,491
--------- --------- ---------
Net balance at January 1 42,204 50,227 35,639
Incurred losses and loss adjustment expenses:
Current year 5,400 5,300 3,000
Prior years 3,756 1,574 3,258
Related to Merger -- -- 15,400
Paid losses and loss adjustment expenses:
Current year (2,850) -- --
Prior years (3,711) (14,897) (7,070)
--------- --------- ---------
Net balance December 31 44,799 42,204 50,227
Plus reinsurance recoverable 30,618 29,875 61,532
--------- --------- ---------
Balance at December 31 $ 75,417 $ 72,079 $ 111,759
========= ========= =========
</TABLE>
During 1995, the Company increased its general reserve by $6,258,000, of
which $3,000,000 was for originations of new business and $3,258,000 was to
reestablish the general reserve for transfers from general reserves to case
basis reserves. During 1995, the Company transferred $10,788,000 from its
general reserve to case basis reserves associated predominantly with certain
residential mortgage and timeshare receivables transactions. Also in December
1995, FSA recognized a one-time increase of $15,400,000 to the general reserve
to provide for the insured portfolio it had assumed in the Merger with CGC in a
manner consistent with the Company's reserving methodology. Prior to the Merger,
CGC did not maintain a general reserve. Giving effect to all the 1995 events,
the general reserve totaled $31,798,000 at December 31, 1995.
During 1996, the Company increased its general reserve by $6,874,000, of
which $5,300,000 was for originations of new business and $1,574,000 was to
reestablish a portion of the general reserve that had previously been
transferred to case basis reserves. During 1996, the Company transferred
$9,012,000 from its general reserve to case basis reserves associated
predominantly with certain residential mortgage and timeshare receivables
transactions. Giving effect to these transfers, the general reserve totaled
$29,660,000 at December 31, 1996.
During 1997, the Company increased its general reserve by $9,156,000, of
which $5,400,000 was for originations of new business and $3,756,000 was to
reestablish a portion of the general reserve that had previously been
transferred to case basis reserves. During 1997, the Company transferred
$4,503,000 from its general reserve to case basis reserves associated
predominantly with certain residential mortgage transactions. Giving effect to
these transfers, the general reserve totaled $34,313,000 at December 31, 1997.
Reserves for losses and loss adjustment expenses are discounted at
risk-free rates. The amount of discount taken was approximately $19,779,000,
$17,944,000 and $15,276,000 at December 31, 1997, 1996 and 1995, respectively.
22
<PAGE> 23
18. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
<TABLE>
<CAPTION>
(In thousands, except share data) First Second Third Fourth Full Year
----- ------ ----- ------ ---------
<S> <C> <C> <C> <C> <C>
1997
Gross premiums written $41,111 $90,995 $42,470 $61,815 $236,391
Net premiums written 27,184 67,495 28,911 49,288 172,878
Net premiums earned 24,774 27,561 27,204 29,972 109,511
Net investment income 16,361 17,121 17,920 20,683 72,085
Losses and loss adjustment expenses 2,285 2,156 2,426 2,289 9,156
Income before taxes 27,266 35,058 37,896 38,279 138,499
Net income 20,250 25,233 27,225 27,794 100,502
Basic earnings per common share 0.67 0.84 0.91 0.93 3.35
Diluted earnings per common share 0.66 0.82 0.88 0.90 3.25
1996
Gross premiums written $52,580 $44,762 $38,994 $40,630 $176,966
Net premiums written 34,139 30,726 28,449 27,686 121,000
Net premiums earned 22,734 19,750 21,637 26,327 90,448
Net investment income 15,682 15,986 16,467 16,929 65,064
Losses and loss adjustment expenses 1,625 1,530 1,482 2,237 6,874
Income before taxes 26,234 25,211 22,948 35,378 109,771
Net income 19,544 18,748 17,210 25,258 80,760
Basic earnings per common share 0.62 0.61 0.57 0.84 2.64
Diluted earnings per common share 0.62 0.60 0.57 0.83 2.61
</TABLE>
19. PRO FORMA RESULTS OF ACQUISITION (UNAUDITED)
The unaudited consolidated results of operations (in thousands, except per
share data) on a pro forma basis as though the Merger had been consummated on
January 1, 1995, excluding the effect of the one-time general reserve charge in
1995 of $15,400, were as follows:
<TABLE>
<CAPTION>
December 31,
1995
----
<S> <C>
Total revenues $157,150
Total expenses 44,239
Earnings per common share 2.53
</TABLE>
The pro forma information is presented for informational purposes only and
is not necessarily indicative of the operating results that would have occurred
had the Merger been consummated as of January 1, 1995, nor is it necessarily
indicative of future operating results.
23
<PAGE> 24
20. EARNINGS PER SHARE
In 1997, the Company adopted SFAS No. 128 specifying the computation,
presentation and disclosure requirements for EPS. The new standard defines
"basic" and "diluted" earnings per share. Basic earnings per share are based on
average basic shares outstanding, which is calculated by adding shares earned
but not issued under the Company's equity bonus and performance share plans to
the average common shares outstanding. Diluted earnings per share are based on
average diluted shares outstanding, which is calculated by adding shares
contingently issuable under stock options, the performance share plan and the
Company's convertible preferred stock to the average basic shares outstanding.
The calculations of average basic and diluted common shares outstanding are as
follows (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
<S> <C> <C> <C>
Average common shares outstanding 29,858 30,547 25,797
Shares earned but unissued under stock-based
compensation plans 170 80 59
------ ------ ------
Average basic common shares outstanding 30,028 30,627 25,856
Shares contingently issuable under:
Stock-based compensation plans 395 268 43
Convertible preferred stock 490 -- --
------ ------ ------
Average diluted common shares outstanding 30,913 30,895 25,899
</TABLE>
21. RECENTLY ISSUED ACCOUNTING STANDARDS
In February 1997, the Securities and Exchange Commission (SEC) issued
Financial Reporting Release No. 48, Disclosure of Accounting Policies for
Derivative Financial Instruments and Derivative Commodity Instruments and
Disclosure of Quantitative and Qualitative Information about Market Risk
Inherent in Derivative Financial Instruments, Other Financial Instruments, and
Derivative Commodity Instruments (FRR No. 48).
FRR No. 48 amends rules and forms for registrants and requires
clarification and expansion of existing disclosures for derivative financial
instruments, other financial instruments and derivative commodity instruments,
as defined therein. The amendments require enhanced disclosure with respect to
these derivative instruments in the footnotes to the financial statements.
Additionally, the amendments expand existing disclosure requirements to include
quantitative and qualitative discussions with respect to market risk inherent in
market-risk-sensitive instruments such as equity and fixed-maturity securities,
as well as derivative instruments.
In June 1997, the Financial Accounting Standards Board issued SFAS No.
130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. Comprehensive income is defined as the change in stockholders'
equity during a period from transactions and other events and circumstances from
non-owner sources and includes net income and all changes in stockholders'
equity except those resulting from investments by owners and distributions to
owners.
SFAS No. 130 requires that an enterprise (i) classify items of other
comprehensive income by their nature in a financial statement and (ii) display
the accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in capital in the equity section of a statement of
financial position.
SFAS No. 130 is effective for fiscal years beginning after December 15,
1997. Reclassification of financial statements for earlier periods provided for
comparative purposes is required.
Also in June 1997, the Financial Accounting Standards Board issued SFAS
No. 131, Disclosure about Segments of an Enterprise and Related Information.
SFAS No. 131 establishes standards for the way that public business enterprises
report information about operating segments in annual and interim financial
statements and requires presentation of a measure of profit or loss, certain
specific revenue and expense items and segment assets. It also establishes
standards for related disclosures about products and services, geographic areas
and major customers, superseding most of SFAS No. 14, Financial Reporting for
Segments of a Business Enterprise.
24
<PAGE> 25
SFAS No. 131 requires that a public business enterprise report financial
and descriptive information about its reportable operating segments. Generally,
financial information is required to be reported on the basis that is used
internally for evaluating segment performance and deciding how to allocate
resources to segments. The enterprise must report information about revenues
derived, major customers, and countries in which it earns revenues and holds
assets, regardless of whether that information is used in making operating
decisions. However, SFAS No. 131 does not require an enterprise to report
information that is not prepared for internal use if reporting would be
impracticable.
SFAS No. 131 is effective for financial statements for periods beginning
after December 15, 1997. SFAS No. 131 need not be applied to interim financial
statements in the initial year of its application, but comparative information
for interim periods in the initial year of application is to be reported in
financial statements of the interim periods in the third year of application.
The Company is in the process of determining the effect of these standards
on its financial statements.
25
