<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------------- -------------
Commission file number 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, including zip code)
Registrant's telephone number, including area code: (248) 488-7000
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No .
------- -------
As of May 15, 1998, the number of shares of the Registrant's Common Stock
outstanding was 3,211,881.
<PAGE> 2
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
<TABLE>
<S> <C>
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
ITEM 1. FINANCIAL STATEMENTS
Consolidated Statements of Condition
March 31, 1998 (Unaudited) and December 31, 1997 2
Consolidated Statements of Income (Unaudited),
Three Months Ended March 31, 1998 and 1997 3
Consolidated Statements of Comprehensive Income (Unaudited)
Three Months Ended March 31, 1998 and 1997 4
Consolidated Statements of Cash Flows (Unaudited),
Three Months Ended March 31, 1998 and 1997 5
Notes to Consolidated Financial Statements (Unaudited) 6-8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 9-14
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 15
SIGNATURES 16
</TABLE>
1
<PAGE> 3
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF CONDITION
(in thousands, except for share and per share amounts)
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------
March 31, December 31,
1998 1997
- ----------------------------------------------------------------------------------------------------
<S> <C> <C>
(Unaudited)
ASSETS
Cash $ 1,854 $ 3,134
Investments 111,806 86,239
Investment in unconsolidated affiliate (net) 222,613 192,137
Mortgage loans receivable 583,300 519,247
Pool loan purchases 195,107 149,791
Loans held for investment 5,781 5,191
Capitalized servicing (net) 160,327 181,025
Mortgage claims receivable and real estate acquired
(net of allowance for loan losses of $12,800) 40,925 41,199
Premises and equipment 22,091 22,171
Other assets 111,308 104,556
- ----------------------------------------------------------------------------------------------------
TOTAL ASSETS $1,455,112 $1,304,690
- ----------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Senior debt $ 784,825 $ 686,906
Subordinated debt 55,307 55,153
Accounts payable and other liabilities 154,712 107,582
- ----------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 994,844 849,641
- ----------------------------------------------------------------------------------------------------
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 $25 per share) issued and
outstanding as of March 31, 1998 and December 31, 1997 18 18
Common stock, $.01 par value, 8,000,000 shares authorized,
3,211,811 shares issued and outstanding 32 32
Paid-in capital 462,480 462,480
Accumulated other comprehensive income 59,128 41,102
Retained deficit (61,390) (48,583)
- ----------------------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY 460,268 455,049
- ----------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,455,112 $1,304,690
====================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.
2
<PAGE> 4
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except for per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------
Three Months Ended March 31, 1998 1997
- -----------------------------------------------------------------------------------------
<S> <C> <C>
REVENUE
Mortgage servicing revenue $ 22,511 $29,621
Amortization of capitalized servicing (14,685) (9,432)
Net gain (loss) on financial instruments 1,687 (6,096)
- -----------------------------------------------------------------------------------------
Net servicing revenue 9,513 14,093
- -----------------------------------------------------------------------------------------
Interest income 17,790 9,252
Interest expense (15,335) (8,059)
- -----------------------------------------------------------------------------------------
Net interest revenue 2,455 1,193
- -----------------------------------------------------------------------------------------
Net realized investment gain on exchange
of securities to affiliates 326
Net realized investment gain (loss) 2,016 (106)
Equity in earnings from unconsolidated affiliate 3,117 182
Net gain on sale of mortgages 16,695 7,919
Net gain (loss) on sale of servicing and assumption of subservicing 8,052 (3,195)
Other 6,149 4,340
- -----------------------------------------------------------------------------------------
TOTAL REVENUE 47,997 24,752
- -----------------------------------------------------------------------------------------
EXPENSES
Salaries and employee benefits 16,904 13,768
Office occupancy and equipment 2,822 3,193
Provision for loan losses 844 896
Other operating expenses 7,370 6,383
- -----------------------------------------------------------------------------------------
TOTAL EXPENSES 27,940 24,240
- -----------------------------------------------------------------------------------------
Income before income taxes 20,057 512
Income tax expense 6,937 325
- -----------------------------------------------------------------------------------------
NET INCOME $ 13,120 $ 187
Less dividends on preferred stock 927 927
- -----------------------------------------------------------------------------------------
NET INCOME (LOSS) APPLICABLE TO COMMON STOCK $ 12,193 $ (740)
- -----------------------------------------------------------------------------------------
BASIC NET INCOME (LOSS) PER COMMON SHARE $ 3.80 $ (.33)
- -----------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
3
<PAGE> 5
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands, except for per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------
Three Months Ended March 31, 1998 1997
- --------------------------------------------------------------------------
<S> <C> <C>
Net income $13,120 $ 187
Other comprehensive income (loss), net of tax
Unrealized gains (losses) on investments:
Unrealized holding gain (loss) arising during period
(net of income tax expense (benefit) of $9,706 and
$(51) for 1998 and 1997, respectively) 18,026 (96)
Less: reclassification adjustment for gains
included in net income (net of income tax expense of
$114 for 1997) (212)
- --------------------------------------------------------------------------
Other comprehensive income (loss) 18,026 (308)
- --------------------------------------------------------------------------
Comprehensive income (loss) 31,146 (121)
Less dividends on preferred stock 927 927
- --------------------------------------------------------------------------
Comprehensive income (loss) applicable to common stock $30,219 $(1,048)
- --------------------------------------------------------------------------
Basic comprehensive income (loss) per common share $ 9.41 $ (.47)
- --------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
4
<PAGE> 6
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------
Three months ended March 31, 1998 1997
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net income $ 13,120 $ 187
Noncash items included in the determination of net income:
Amortization of capitalized servicing 14,685 9,432
Net unrealized loss on financial instruments 113 5,888
Provision for loan losses 844 896
Depreciation and amortization 807 1,271
Net realized gain on investments (2,016) (220)
(Gain) loss on sale of servicing (8,052) 3,195
Amortization of deferred gain on sale of servicing (645)
Undistributed earnings from unconsolidated affiliate (2,745) (182)
Mortgage loan production (2,374,745) (640,933)
Mortgage loan sales and amortization 2,310,692 706,204
Net decrease in accounts payable and other liabilities (37,403) (6,826)
Net decrease in other assets 12,086 37,821
Net change in current and deferred income taxes receivable and payable 6,667 (3,766)
- -------------------------------------------------------------------------------------------------------------------
Net cash (used) provided by operating activities (65,947) 112,322
- -------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES:
Collections on and sales of pool loan purchases, mortgage
claims receivable and real estate acquired 40,149 130,299
Additions to pool loan purchases, mortgage claims
receivable and real estate acquired (19,623) (186,718)
Additions to capitalized mortgage servicing rights (53,781) (35,570)
Net proceeds from sale of servicing 43,750 81,197
Additions to long-term investments (1,437) (1,776)
Collections on notes receivable 7,000
Principal payments received on long-term investments 3,785 378
Net (increase) decrease in short-term investments (26,005) 30,927
Net acquisition of premises and equipment (561) (501)
Net (increase) decrease in loans held for investment (590) 9,836
- -------------------------------------------------------------------------------------------------------------------
Net cash (used) provided by investing activities (7,313) 28,072
- -------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES:
Proceeds from issuance of commercial paper 2,114,700
Repayments on commercial paper (2,249,130)
Net increase (decrease) in credit agreement borrowings 98,037 (15,000)
Proceeds from issuance of common stock 12,675
Dividends paid (25,927) (927)
Other (130)
- -------------------------------------------------------------------------------------------------------------------
Net cash provided (used) by financing activities 71,980 (137,682)
- -------------------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash (1,280) 2,712
Cash at beginning of period 3,134 923
- -------------------------------------------------------------------------------------------------------------------
Cash at end of period $ 1,854 $ 3,635
- -------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
5
<PAGE> 7
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of Source One
Mortgage Services Corporation (together with its subsidiaries, the "Company")
have been prepared in conformity with generally accepted accounting principles
for interim financial information and with the instructions for Form 10-Q and
Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements.
In the opinion of management, all necessary adjustments (consisting of
normal recurring adjustments) considered necessary for a fair presentation have
been included. The operating results for the three month period ended March 31,
1998 are not necessarily indicative of the results to be expected for the year
ending December 31, 1998.
For further information, refer to the consolidated financial statements and
notes thereto included in the Company's Annual Report on Form 10-K for the year
ended December 31, 1997 as filed with the Securities and Exchange Commission.
Certain reclassifications have been made to the financial statements to
achieve consistent presentation of the 1998 and 1997 results.
NOTE 2. ACCOUNTING STANDARDS RECENTLY ADOPTED
EARNINGS PER SHARE
The Company adopted the provisions of SFAS No. 128, "Earnings 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".
COMPREHENSIVE INCOME
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. In addition,
the Company has provided a supplemental disclosure of comprehensive earnings per
share. 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.
CERTAIN PROVISIONS OF SFAS NO. 125
In December 1996, the Financial Accounting Standards Board issued SFAS No.
127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125"
which deferred the adoption of certain transfer and collateral provisions of
SFAS No. 125 to periods beginning after December 31, 1997. The adoption of the
remaining provisions of SFAS No. 125 did not have a material effect on the
Company's current financial position or results of operations.
6
<PAGE> 8
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
NOTE 3. FINANCIAL INSTRUMENTS
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. The floor rates range
from 4.00% to 6.14% 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 of $4.7 million in
the floors. As of March 31, 1998, the carrying value of the Company's
open interest rate floor contracts totaled $7.5 million with a total
notional principal amount of $714.6 million. The floors have remaining
terms ranging from approximately 2.5 to 5 years.
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"). As of March 31, 1998, the carrying value of the
Company's P/O swap transactions totaled $13.1 million, with remaining
original notional value of $98.1 million. The P/O swaps have remaining
terms ranging from approximately 2.5 to 4 years.
Note 4. BASIC NET INCOME AND COMPREHENSIVE INCOME PER SHARE
Basic net income and comprehensive income per share amounts were
computed based on 3,211,811 and 2,247,136 weighted average total number of
common shares outstanding for the quarters ended March 31, 1998 and 1997,
respectively.
7
<PAGE> 9
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
NOTE 5. 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>
- --------------------------------------------------------------------------------
Three months ended March 31, (in thousands) 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
Interest paid $ 13,496 $ 5,101
- --------------------------------------------------------------------------------
Income taxes paid $ 125 $ 4,117
- --------------------------------------------------------------------------------
Noncash investing and financing activities:
Exchange of common equity securities for
shares of common stock from parent $ - $ 2,638
Sale of servicing rights 59,880 190,296
Capital contribution from parent in exchange for
investment in unconsolidated affiliate 27,800
- --------------------------------------------------------------------------------
</TABLE>
NOTE 6. RECENT DEVELOPMENTS
In the second quarter of 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. In April 1998, the Company sold approximately
$6.6 million of these loans (which is net of a $1.5 million reserve) for gross
proceeds of $7.5 million, which include $.1 million of accrued interest income,
and recognized a pretax gain of $.8 million on the sale. These loans were
included in loans held for investment and mortgage claims receivable and real
estate acquired in the consolidated statement of condition as of March 31, 1998.
In April and May of 1998, the Company paid dividends on its common stock
totaling $27.5 million and $10.0 million, respectively.
8
<PAGE> 10
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of the financial condition and
results of operations of the Company should be read in conjunction with
the condensed consolidated financial statements and the notes thereto
included elsewhere in this report and in the Company's Annual Report on
Form 10-K for the year ended December 31, 1997. The following discussion
and analysis contains certain forward-looking statements relating to
anticipated future financial conditions and operating results of the
Company and its current business plans. In the future, the financial
condition and operating results of the Company could differ materially
from those discussed herein and its current business plans could be
altered in response to market conditions and other factors beyond the
Company's control. Important factors that could cause or contribute to
such difference or changes include those discussed in the Company's Annual
Report on Form 10-K for the year ended December 31, 1997. (See the
disclosures under "Item 1. Business - Certain Business Conditions", "Item
1. Business - Forward Looking Statements" and under "Item 7. Managements's
Discussion and Analysis of Financial Condition and Results of
Operations.")
RESULTS OF OPERATIONS - THREE MONTHS ENDED MARCH 31, 1998 AND 1997
SUMMARY- Source One Mortgage Services Corporation (together with its
subsidiaries, the "Company") reported net income of $13.1 million for the
first quarter of 1998 as compared to $.2 million for the first quarter of
1997. The 1998 net income includes an $8.1 million pretax gain on sales
of servicing to third parties and adjustments to previous sales, a $1.5
million pretax charge for impairment of the Company's capitalized
servicing asset, which was offset by a $1.7 million net gain on financial
instruments and $3.1 million pretax equity in earnings of an
unconsolidated affiliate. The 1997 results include a $3.2 million pretax
loss on the sale of servicing to a third party, a $6.5 million pretax
recovery of previously established valuation allowances related to the
Company's capitalized servicing asset, which was offset by a $6.1 million
pretax net loss on financial instruments and $.2 million pretax equity in
earnings of an unconsolidated affiliate.
The Company reported comprehensive income (which includes the net
change in after tax unrealized gains and losses) of $31.1 million for the
quarter ended March 31, 1998, compared to a comprehensive loss of $.1
million in 1997. The Company's unrealized gains and losses are primarily
associated with its investment in Financial Security Assurance Holdings
Ltd. ("FSA") which it acquired in the first and second quarters of 1997.
During the first quarter of 1998, the Company sold the rights to
service approximately $3.5 billion of its nonrecourse mortgage servicing
portfolio to third parties. In the first quarter of 1997, the Company
sold the rights to service $17.0 billion of its nonrecourse mortgage
servicing portfolio to a third party. The Company will continue to
service the loans sold in 1997 pursuant to a subservicing agreement at
least until March 1999, June 1999 and August 1999 for Federal Home Loan
Mortgage Corporation ("FHLMC"), Government National Mortgage Association
("GNMA"), 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.
The Company's mortgage loan production and mortgage servicing
portfolio activity for the first three months of 1998 and 1997 are
summarized in the following tables:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Three Months Ended
March 31,
MORTGAGE LOAN PRODUCTION: (in millions) 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
BY TYPE:
FHA/VA Insured $1,568 $ 370
Conventional 807 271
- --------------------------------------------------------------------------------
Total $2,375 $ 641
- --------------------------------------------------------------------------------
</TABLE>
9
<PAGE> 11
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Three Months Ended
March 31,
- --------------------------------------------------------------------------------------------------------------------
MORTGAGE LOAN PRODUCTION: (in millions) 1998 1997
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
BY SOURCE:
Retail $ 687 $ 268
Wholesale 1,688 373
- --------------------------------------------------------------------------------------------------------------------
Total $ 2,375 $ 641
- --------------------------------------------------------------------------------------------------------------------
- --------------------------------------------------------------------------------------------------------------------
Three Months Ended
March 31,
- --------------------------------------------------------------------------------------------------------------------
MORTGAGE SERVICING PORTFOLIO: (in millions) 1998 1997
- --------------------------------------------------------------------------------------------------------------------
Servicing portfolio owned at beginning of period $ 11,627 $ 26,410
Mortgage loan production 2,375 641
- --------------------------------------------------------------------------------------------------------------------
Total servicing in 2,375 641
- --------------------------------------------------------------------------------------------------------------------
Regular payoffs 489 424
Sale of servicing 3,534 17,026
Principal amortization, foreclosures and other 209 335
- --------------------------------------------------------------------------------------------------------------------
Total servicing out 4,232 17,785
- --------------------------------------------------------------------------------------------------------------------
Servicing portfolio owned at end of period 9,770 9,266
- --------------------------------------------------------------------------------------------------------------------
Subservicing portfolio 14,032 19,585
- --------------------------------------------------------------------------------------------------------------------
Total servicing portfolio at end of period $ 23,802 $ 28,851
- --------------------------------------------------------------------------------------------------------------------
</TABLE>
The significant increase in 1998 mortgage loan production and modest
increase in payoffs reflects lower market interest rates and a corresponding
increase in refinance activity throughout the first quarter of 1998 as compared
to the first quarter of 1997, as well as a smaller owned servicing portfolio.
Additional information regarding the Company's mortgage loan servicing
portfolio is shown below:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------
March 31, December 31,
1998 1997
- --------------------------------------------------------------------------------------
MORTGAGE SERVICING PORTFOLIO: Owned Total (a) Owned Total (a)
- --------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Number of loans serviced 142,496 384,358 184,289 438,261
Weighted average net servicing fee
(at end of period) .401% (c) .420% (c)
Weighted average interest rate 8.12% 8.28% 8.52% 8.45%
Percent delinquent (b) 7.26% 6.44% 8.40% 7.53%
- --------------------------------------------------------------------------------------
</TABLE>
(a) Includes loans subserviced for others having a principal balance of $14,032
million and $14,919 million as of March 31, 1998 and December 31, 1997,
respectively.
(b) Includes loans in process of foreclosure.
(c) 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.
10
<PAGE> 12
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
REVENUE- Mortgage servicing revenue decreased to $22.5 million from $29.6
million in the first quarter of 1998 as compared to the first quarter of 1997.
The decrease in mortgage servicing revenue is primarily the result of the
February 1997 servicing sale, slightly offset by increased subservicing revenue
generated from 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 increased $5.3 million during
the first quarter of 1998 from the comparable 1997 period. Amortization
includes a $1.5 million increase to the valuation allowances for impairment of
the Company's capitalized servicing asset in 1998 and is net of a recovery of
$6.5 million of the valuation allowances in 1997. Excluding the effects of
these items, amortization expense decreased to $13.2 million from $15.9 million
for the quarters ended March 31, 1998 and 1997, respectively. This decrease in
amortization expense is primarily the result of a smaller average servicing
asset due to the February 1997 servicing sale partially offset by increased
amortization rates due to higher market consensus prepayment rates during the
first quarter of 1998 as compared to the first quarter of 1997.
The Company recorded a net gain on its financial instruments of $1.7
million for the first quarter of 1998 compared to a net loss of $6.1 million for
the same 1997 period. The 1998 net gain includes realized gains of $1.8 million
from cash flows received and unrealized losses of $.1 million due to a net
decrease in the fair market value of the various financial instruments. The
1997 net loss includes realized losses of $.2 million from cash flows paid and
$5.9 million of unrealized losses due to a net decrease in the fair market value
of the various instruments.
Interest income increased to $17.8 million in the first quarter of 1998
from $9.3 million in the first quarter of 1997. The increase in interest income
is primarily the result of the increase in mortgage loan production and the
corresponding increase in the average mortgage loans receivable inventory.
Interest expense was $15.3 million and $8.0 million for the quarters ended March
31, 1998 and 1997, respectively. This increase is primarily the result of
increased short-term borrowings necessary to fund the increase in 1998
production, slightly offset by the effects of the early retirement of
medium-term notes in the second quarter of 1997.
The Company realized a net investment gain of $2.0 million for the quarter
ended March 31, 1998 compared to a net investment loss of $.1 million for the
comparable 1997 period. The 1998 amount is primarily the result of a realized
gain from the distribution received on a partnership investment. The 1997
amount is primarily the result of the write-down of certain investments to
realizable value.
In mid-March 1997, the Board of Directors of Fund American Enterprises
Holdings, Inc. ("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 White Mountains Holdings,
Inc. ("White Mountains"). As a result, the Company recognized $3.1 million and
$.2 million of equity in earnings of FSA for the quarters ended March 31, 1998
and 1997, respectively.
Net gain on sale of mortgages increased to $16.7 million from $7.9 million
for the quarter ended March 31, 1998 as compared to the quarter ended March 31,
1997. This increase is primarily the result of increased capitalized originated
mortgage servicing rights ("OMSR") income resulting from the increase in
mortgage loan production and the corresponding increase in mortgage loan sales
volumes in the first quarter of 1998 as compared to the first quarter of 1997.
The Company recorded an $8.1 million pretax gain on sales of servicing
during the first quarter of 1998, which reflects the sales of the rights to
service approximately $3.5 billion of the Company's nonrecourse mortgage
servicing portfolio to third parties and adjustments to previous servicing
sales. The Company recorded a $3.2 million pretax loss from the sale of the
rights to service $17.0 billion of its nonrecourse mortgage servicing portfolio
and the related assumption of subservicing in the first quarter of 1997.
11
<PAGE> 13
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
EXPENSES - Salaries and employee benefits expense was $16.9 million and
$13.8 million for the quarters ended March 31, 1998 and 1997, 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>
- ------------------------------------------------------------------------------------------
Three Months Ended
March 31,
- ------------------------------------------------------------------------------------------
(in thousands) 1998 1997
- ------------------------------------------------------------------------------------------
<S> <C> <C>
Unadjusted salaries and employee benefits expense $24,992 $17,173
GAAP net origination revenues (8,088) (3,405)
- ------------------------------------------------------------------------------------------
GAAP salaries and employee benefits expense $16,904 $13,768
- ------------------------------------------------------------------------------------------
</TABLE>
An increase in loan origination revenues, reflecting increased retail
mortgage loan production during the first quarter of 1998 as compared to the
first quarter of 1997, partially offset the increase in unadjusted salaries and
benefits expense. Excluding the effects of loan origination revenue, salaries
and employee benefits expense increased 46%. This increase primarily reflects
the increase in loan officer commissions associated with the significant
increase in mortgage loan production for the three month period ended March 31,
1998 as compared to the same 1997 period.
The Company's income tax provision for the first quarter of 1997 includes
an additional provision for the effect of the February 1997 servicing sale.
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 the
second quarter of 1998. At that time, testing of the full system will begin and
is estimated to be completed 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 March 31, 1998 approximately
$1.1 million had been spent on the project, of which approximately $.1 million
was incurred during the first quarter of 1998.
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.
12
<PAGE> 14
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
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 and cash flow from operations. The
Company also generates cash from sales of mortgage servicing rights. 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.
Senior and subordinated debt consists of the following:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------
March 31, December 31,
(in thousands) 1998 1997
- --------------------------------------------------------------------------------------------------------
<S> <C> <C>
Credit agreements, weighted average interest rates
of 6.46% and 6.34% as of March 31, 1998 and
December 31, 1997, respectively $667,507 $569,470
8.875% medium-term notes due October 15, 2001 18,723 18,723
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) (2,074) (2,110)
- --------------------------------------------------------------------------------------------------------
Total senior and subordinated debt $840,132 $742,059
- --------------------------------------------------------------------------------------------------------
</TABLE>
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 higher 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.
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 March 31, 1998 and December 31, 1997, the Company had
$655.0 million and $559.0 million outstanding under this facility, respectively.
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.
In May 1998, the Company entered into a new secured credit agreement for
purposes of financing the origination or acquisition of subprime and high
loan-to-value ("LTV") loans. Under this agreement, the Company may borrow up to
$175.0 million through April 29, 1999. Borrowings under this facility are
secured by the underlying loans. The Company must comply with certain financial
covenants provided in the agreement, including restrictions relating to tangible
net worth and leverage.
In April 1998, Central Pacific Mortgage Company ("Central Pacific"), a
wholly-owned subsidiary of the Company, replaced its existing $15.0 million
unsecured revolving credit agreement with a new mortgage warehousing agreement
under which it can borrow up to $25.0 million through April 15, 1999.
Borrowings under this new facility are secured by the underlying loans, as each
advance under this facility will be used to finance the origination or
acquisition of mortgage loans and holding of such loans until they are sold,
delivered or pledged with the issuance of agency or other mortgage-backed
securities.
13
<PAGE> 15
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Central Pacific must comply with certain financial covenants provided in the
agreement, including restrictions relating to tangible net worth and leverage.
As of March 31, 1998 and December 31, 1997, there was $12.5 million and $10.5
million outstanding under the unsecured credit agreement, respectively.
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. In March 1998, the Company paid dividends on its common
stock totaling $25.0 million. The Company did not declare any dividends on its
common stock for the three months ended March 31, 1997.
In March 1998, the Company sold the rights to service approximately $3.5
billion of its nonrecourse mortgage servicing portfolio to third parties for net
proceeds of $76.1 million. The Company used the initial proceeds received from
the sales totaling $39.7 million for general corporate purposes. The remaining
balance of $36.4 million is included in other assets in the consolidated
statement of condition as of March 31, 1998.
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 $246.6 million received from the
sale through March 31, 1998 to reduce outstanding short-term debt and to retire
$119.6 million of its 8.875% medium-term notes. The remaining balance of $23.5
million, including accrued interest, is included in other assets in the
consolidated statement of condition as of March 31, 1998. The Company is
currently evaluating its 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.
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. See Note 4 to the consolidated financial statements for
further discussion.
14
<PAGE> 16
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits:
Exhibit
No. Description
-------- -----------------------
27 Financial Data Schedule
b. Form 8-K: The Company filed six current Reports on Form 8-K with the
Securities and Exchange Commission during the quarter ended March 31, 1998.
(i) January 26, 1998: Reported Distribution Date Statements for January 25,
February 1, February 1, and January 20, 1998 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.
(ii) January 26, 1998: Reported Report to the Trustee and Report to the
Certificate Holders for the month of January 1998 relating to the Source
One Mortgage Services Corporation 11-1/2% Mortgage Pass-Through
Certificates, Series A.
(iii) February 25, 1998: Reported Report to the Trustee and Report to the
Certificate Holders for the month of February 1998 relating to the Source
One Mortgage Services Corporation 11-1/2% Mortgage Pass-Through
Certificates, Series A.
(iv) February 27, 1998: Reported Distribution Date Statements for February
25, March 1, March 1,and February 20, 1998 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.
(v) March 24, 1998: Reported Distribution Date Statements for March 25,
March 25, April 1, April 1, and March 20, 1998 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.
(vi) March 25 1998: Reported Report to the Trustee and Report to the
Certificate Holders for the month of March 1998 relating to the Source
One Mortgage Services Corporation 11-1/2% Mortgage Pass-Through
Certificates, Series A.
15
<PAGE> 17
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SOURCE ONE MORTGAGE SERVICES CORPORATION
----------------------------------------
(Registrant)
<TABLE>
<S> <C>
DATE: MAY 15, 1998 /S/ MICHAEL C. ALLEMANG
- ------------------- ----------------------------------------
Michael C. Allemang
Executive Vice President and Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
</TABLE>
16
<PAGE> 18
INDEX TO EXHIBITS
EXHIBIT NO. DESCRIPTION
- ----------- -----------
27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<CASH> 1,854
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 22,091
<DEPRECIATION> 0
<TOTAL-ASSETS> 1,455,112
<CURRENT-LIABILITIES> 0
<BONDS> 0
0
18
<COMMON> 32
<OTHER-SE> 460,218
<TOTAL-LIABILITY-AND-EQUITY> 1,455,112
<SALES> 0
<TOTAL-REVENUES> 47,997
<CGS> 0
<TOTAL-COSTS> 27,940
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 844
<INTEREST-EXPENSE> 15,335
<INCOME-PRETAX> 20,057
<INCOME-TAX> 6,937
<INCOME-CONTINUING> 13,120
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 13,120
<EPS-PRIMARY> 3.80
<EPS-DILUTED> 0
</TABLE>
