<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 September 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
------------- -------------
Commission file number 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 November 13, 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>
<CAPTION>
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO.
<S> <C>
ITEM 1. FINANCIAL STATEMENTS
Consolidated Statements of Condition
September 30, 1998 (Unaudited) and December 31, 1997.......................................................2
Consolidated Statements of Income (Unaudited),
Nine Months and Three Months Ended September 30, 1998 and 1997.............................................3
Consolidated Statements of Comprehensive Income (Unaudited),
Nine Months and Three Months Ended September 30, 1998 and 1997.............................................4
Consolidated Statements of Cash Flows (Unaudited),
Nine Months Ended September 30, 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...............................................................................9-20
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........................................21
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K..................................................................22
SIGNATURES................................................................................................23
</TABLE>
1
<PAGE> 3
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF CONDITION
(in thousands, except for share and per share amounts)
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------
September 30, December 31,
1998 1997
- -------------------------------------------------------------------------------------------------------------------
(Unaudited)
<S> <C> <C>
ASSETS
Cash $ 26,216 $ 3,134
Investments 83,366 86,239
Investment in unconsolidated affiliate (net) 204,693 192,137
Mortgage loans receivable 540,337 519,247
Pool loan purchases 205,823 149,791
Loans held for investment 592 5,191
Capitalized servicing (net) 183,254 181,025
Mortgage claims receivable and real estate acquired
(net of allowance for loan losses of $12,800) 38,900 41,199
Premises and equipment 22,604 22,171
Other assets 110,681 104,556
- ------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 1,416,466 $ 1,304,690
==================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Senior debt $ 792,714 $ 686,906
Subordinated debt 55,616 55,153
Accounts payable and other liabilities 181,619 107,582
- ------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 1,029,949 849,641
==================================================================================================================
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 September 30, 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 360,806 462,480
Accumulated other comprehensive income 43,434 41,102
Retained deficit (17,773) (48,583)
- ------------------------------------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY 386,517 455,049
==================================================================================================================
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,416,466 $ 1,304,690
==================================================================================================================
See accompanying notes to consolidated financial statements
</TABLE>
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>
- ---------------------------------------------------------------------------------------------------------------------
Nine Months Ended Three Months Ended
September 30, September 30,
- ---------------------------------------------------------------------------------------------------------------------
1998 1997 1998 1997
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
REVENUE
Mortgage servicing revenue $ 59,588 $ 69,380 $ 18,461 $ 20,741
Amortization of capitalized servicing (52,313) (46,450) (22,867) (20,648)
Net gain on financial instruments 22,359 4,286 16,836 6,026
- ------------------------------------------------------------------------------------------------------------------
Net servicing revenue 29,634 27,216 12,430 6,119
- ------------------------------------------------------------------------------------------------------------------
Interest income 61,887 32,020 21,197 12,032
Interest expense 51,335 25,067 17,859 8,791
- ------------------------------------------------------------------------------------------------------------------
Net interest revenue 10,552 6,953 3,338 3,241
- ------------------------------------------------------------------------------------------------------------------
Net realized investment gain on exchange
of securities with affiliates - 326 - -
Net realized investment gain (loss) 2,151 (706) 66 (300)
Equity in earnings from unconsolidated affiliate 10,103 6,312 3,691 3,071
Net gain on sale of mortgages 63,921 15,740 21,767 6,480
Net gain (loss) on sale of servicing and
assumption of subservicing 10,373 (4,296) 1,384 -
Other 21,922 13,771 8,200 4,774
- ------------------------------------------------------------------------------------------------------------------
TOTAL REVENUE 148,656 65,316 50,876 23,385
- ------------------------------------------------------------------------------------------------------------------
EXPENSES
Salaries and employee benefits 56,267 40,328 20,063 13,534
Office occupancy and equipment 9,068 9,351 3,216 2,760
Provision for loan losses 3,174 3,203 2,065 713
Restructuring charges - 1,728 - -
Other operating expenses 28,802 17,837 10,307 4,937
- ------------------------------------------------------------------------------------------------------------------
TOTAL EXPENSES 97,311 72,447 35,651 21,944
- ------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes and
extraordinary loss 51,345 (7,131) 15,225 1,441
Income tax expense (benefit) 17,755 (2,115) 5,247 353
- ------------------------------------------------------------------------------------------------------------------
Income (loss) before extraordinary loss 33,590 (5,016) 9,978 1,088
Extraordinary loss on early retirement of debt (net of
$3,217 income tax benefit) - (5,975) - -
- ------------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) $ 33,590 $ (10,991) $ 9,978 $ 1,088
Less dividends on preferred stock 2,780 2,780 927 927
- ------------------------------------------------------------------------------------------------------------------
Net income (loss) applicable to common stock $ 30,810 $ (13,771) $ 9,051 $ 161
- ------------------------------------------------------------------------------------------------------------------
BASIC NET INCOME (LOSS) PER COMMON SHARE:
Before extraordinary loss $ 9.59 $ (2.70) $ 2.82 $ .05
Extraordinary loss - (2.06) - -
- ------------------------------------------------------------------------------------------------------------------
Basic net income (loss) per common share $ 9.59 $ (4.76) $ 2.82 $ .05
- ------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
</TABLE>
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>
- --------------------------------------------------------------------------------------------------------------------
Nine Months Ended Three Months Ended
September 30, September 30,
- --------------------------------------------------------------------------------------------------------------------
1998 1997 1998 1997
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Net income (loss) $33,590 $(10,991) $ 9,978 $ 1,088
Other comprehensive income (loss), net of tax
Unrealized gains on investments:
Unrealized holding gain (loss) arising during period
(net of income tax expense (benefit) of $1,255 and $19,245 for the
nine months ended September 30, 1998 and 1997, respectively and
$(14,903) and $12,070 for the three months ended September 30, 1998
and 1997,
respectively) 2,332 35,741 (27,677) 22,416
Less: reclassification adjustment for gains included in
net income (net of income tax expense of $114 for 1997) - (212) - -
- --------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss) 2,332 35,529 (27,677) 22,416
- --------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) 35,922 24,538 (17,699) 23,504
Less dividends on preferred stock 2,780 2,780 927 927
- --------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) applicable to common stock $33,142 $ 21,758 $(18,626) $22,577
- --------------------------------------------------------------------------------------------------------------------
Basic comprehensive income (loss) per common share $ 10.32 $ 7.52 $ (5.80) $ 7.03
- --------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
</TABLE>
4
<PAGE> 6
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Nine months ended September 30, 1998 1997
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
OPERATING ACTIVITIES:
Net income (loss) $ 33,590 $ (10,991)
Charges (credits) to reconcile net income (loss) to cash flows
from operations:
Amortization of capitalized servicing 52,313 46,450
Net unrealized gain on financial instruments (14,039) (4,697)
Provision for loan losses 3,174 3,203
Depreciation and amortization 2,646 4,588
Gain on sale of financial instruments (3,462) -
Write-down of loans held for investment - 3,000
Net realized (gain) loss on investments (2,151) 380
(Gain) loss on sale of servicing (10,373) 4,296
Gain on sale of permanent investments (849) -
Amortization of deferred gain on sale of servicing - (1,936)
Undistributed earnings from unconsolidated affiliate (8,969) (6,312)
Extraordinary loss on early retirement of debt - 5,975
Mortgage loan production (7,624,924) (2,716,901)
Mortgage loan sales and amortization 7,603,834 2,547,805
Net proceeds from sale of financial instruments 24,898 -
Additions to financial instruments (6,090) -
Net increase in accounts payable and other liabilities 53,752 25,622
Net decrease in other assets 18,181 47,679
Net change in current and deferred income taxes receivable and payable 16,950 (8,400)
- -----------------------------------------------------------------------------------------------------------------
Net cash provided (used) by operating activities 138,481 (60,239)
- -----------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES:
Collections on and sales of pool loan purchases, mortgage claims receivable
and real estate acquired 175,519 238,986
Additions to pool loan purchases, mortgage claims receivable and real estate
acquired (234,231) (251,327)
Additions to capitalized mortgage servicing rights (178,783) (111,140)
Net proceeds from sale of servicing 105,418 241,514
Net proceeds from sale of permanent investments 7,544 -
Additions to long-term investments (2,982) (53,924)
Collections on notes receivable 7,000 -
Principal payments received on long-term investments 3,785 852
Net decrease in short-term investments 3,157 24,756
Net (acquisition) disposition of premises and equipment (2,426) 1,553
Net (increase) decrease in loans held for investment (343) 8,188
- -----------------------------------------------------------------------------------------------------------------
Net cash (used) provided by investing activities (116,342) 99,458
- -----------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES:
Proceeds from issuance of commercial paper - 5,740,707
Repayments on commercial paper - (6,043,443)
Net increase in credit agreement borrowings 105,397 384,590
Retirement of debt - (129,872)
Proceeds from issuance of common stock - 12,675
Dividends paid (104,454) (2,780)
- -----------------------------------------------------------------------------------------------------------------
Net cash provided (used) by financing activities 943 (38,123)
- -----------------------------------------------------------------------------------------------------------------
Net increase in cash 23,082 1,096
Cash at beginning of period 3,134 923
- -----------------------------------------------------------------------------------------------------------------
Cash at end of period $ 26,216 $ 2,019
- -----------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
</TABLE>
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 adjustments (consisting of normal recurring
adjustments) considered necessary for a fair presentation have been included.
The operating results for the three month and nine month periods ended
September 30, 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 Statement of Financial Accounting
Standards ("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 in a separate statement. In addition, the Company has
provided a supplemental disclosure of comprehensive earnings per share.
Application of SFAS No. 130 did 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 ("FASB") 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. RECENTLY ISSUED ACCOUNTING STANDARD
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". SFAS No. 133 establishes accounting and
reporting standards for derivative instruments and for hedging activities. It
requires that companies record all derivatives as either assets or liabilities
in the statement of condition and measure those instruments at fair value. The
manner in which the companies are to record gains and losses resulting from
changes in the values of those derivatives depends on the use of the derivative
and whether it qualifies for hedge accounting. SFAS No. 133 is effective for all
fiscal quarters of fiscal years beginning after June 15, 1999 with earlier
adoption permitted. Upon initial application, hedging relationships must be
designated anew and documented pursuant to the provisions of the statement. The
Company has not yet evaluated the impact of the adoption of SFAS No. 133.
NOTE 4. FINANCIAL INSTRUMENTS
The Company invests in various financial instruments in an attempt 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"), interest rate
("I/R") swap agreements and principal-only ("P/O") swap agreements. These
financial instruments are carried at fair value as of the balance sheet date
with unrealized and realized gains and losses reported as net gain or loss on
financial instruments on the income statement.
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.
Some of the floor contracts cap the payments by specifying a second rate that is
less than the floor rate. If the prevailing interest rates fall below this rate,
payments will not increase. 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. During 1998, the Company sold
floors with a carrying value of $8.3 million and a notional value of $814.6
million for proceeds of $11.2 million and realized a net gain of $2.9 million.
During 1998, the Company entered into floor contracts with a notional value of
$1.2 billion for an initial investment of $6.1 million. As of September 30,
1998, the Company's open interest rate floor contracts with a total notional
principal amount of $1.1 billion had a carrying value of $9.8 million and an
original cost of $5.3 million. The floors have remaining terms ranging from
approximately 5 to 10 years with floor rates ranging from 3.54% to 5.05%.
The I/R swaps are derivative contracts which entitle the Company to receive
interest at a fixed rate and obligate it to pay interest at a variable rate
based on a contracted notional amount. The Company's exposure to losses on the
agreements is related to the differences, over the life of the contract, between
the contracted fixed interest rates and the variable interest rates. During
1998, the Company entered into I/R swap agreements with a total notional value
of $290.0 million. As of September 30, 1998, these I/R swap agreements had a
carrying value of $2.9 million. The I/R swaps have remaining terms of 5 to 10
years.
7
<PAGE> 9
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
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"). During 1998, the
Company sold P/O swaps with a carrying value of $13.1 million and an original
notional value of $98.1 million for proceeds of $13.7 million and realized a
net gain of $.6 million. During 1998, the Company entered into P/O swap
transactions with a total notional value of $50.0 million. As of September 30,
1998, the Company's open P/O swap agreements, with original notional value of
$50.0 million had a carrying value of $6.7 million. The P/O swaps have
remaining terms of approximately 5 years.
NOTE 5. BASIC NET INCOME AND COMPREHENSIVE INCOME PER SHARE
Basic net income and comprehensive income per share amounts were computed
based on 3,211,811 weighted average total number of common shares outstanding
for both the nine month and three month periods ended September 30, 1998. Basic
net income and comprehensive income per share amounts were computed based on
2,893,833 and 3,211,811 weighted average total number of common shares
outstanding for the nine month and three month periods ended September 30,
1997, respectively.
NOTE 6. 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>
- -----------------------------------------------------------------------------------------------------------------
Nine months ended September 30, (in thousands) 1998 1997
- -----------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Interest paid $ 56,709 $ 30,488
- -----------------------------------------------------------------------------------------------------------------
Income taxes paid $ 392 $ 5,980
- -----------------------------------------------------------------------------------------------------------------
Noncash investing and financing activities:
Exchange of common equity securities for shares of common stock from parent $ - $ 2,638
Sales of servicing rights 68,321 33,011
Capital contribution from parent in exchange for investment in unconsolidated
affiliate - 106,365
- -----------------------------------------------------------------------------------------------------------------
</TABLE>
NOTE 7. RECENT DEVELOPMENTS
In October of 1998, the Company paid return of capital dividends on its common
stock totaling $.5 million.
8
<PAGE> 10
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
ITEM 2. 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 (i) the
condensed consolidated financial statements and the notes thereto included
elsewhere in this report and (ii) the Company's Annual Report on Form 10-K for
the year ended December 31, 1997 (including the financial statements included
therein). 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. Management's Discussion and Analysis of Financial Condition and Results
of Operations.")
RESULTS OF OPERATIONS - NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
SUMMARY- Source One Mortgage Services Corporation (together with its
subsidiaries, the "Company") reported net income of $33.6 million for the nine
months ended September 30, 1998 compared to a net loss of $11.0 million for
1997. The Company's 1998 results include a $10.4 million pretax gain on sales of
servicing to third parties and adjustments to previous sales, $10.1 million
pretax equity in earnings of an unconsolidated affiliate and a $21.3 million
pretax charge for impairment of the Company's capitalized servicing asset, which
was offset by a $22.4 million net gain on financial instruments. The Company's
1997 results include the following one-time charges recorded by the Company in
the second quarter of 1997: a $9.2 million pretax extraordinary loss on the
early retirement of debt, a $3.0 million pretax charge related to mortgage loans
held for investment which were identified for sale and marked down from
amortized cost to current market value, $1.7 million pretax restructuring charge
related to a reduction in workforce and $.7 million pretax of other
miscellaneous charges. The Company's 1997 results also include a $4.3 million
pretax loss on the sale of servicing to a third party and the related assumption
of subservicing, $6.3 million pretax equity in earnings of an unconsolidated
affiliate and a $11.1 million pretax charge for impairment of the Company's
capitalized servicing asset, which was partially offset by a $4.3 million pretax
net gain on financial instruments.
The Company reported comprehensive income (which includes the net change in
after tax unrealized gains and losses) of $35.9 million for the nine months
ended September 30, 1998 compared to $24.5 million for 1997. The unrealized
gains and losses are primarily associated the Company's investment in Financial
Security Assurance Holdings Ltd. ("FSA"), which it acquired in the first half of
1997.
During the nine months ended September 30, 1998, the Company sold the rights
to service approximately $6.8 billion of its nonrecourse mortgage servicing
portfolio to third parties. During the comparable 1997 period, the Company sold
the rights to service $17.0 billion of its nonrecourse mortgage servicing
portfolio to a third party (the "1997 Servicing Sale") and continues to service
the loans pursuant to a subservicing agreement. In early November 1998, the
Company amended its subservicing agreement to extend its subservicing
responsibilities for two additional years. As a result, the Company will
continue to service these loans at least until March 2001, June 2001 and August
2001 for Federal Home Loan Mortgage Corporation ("FHLMC" or "Freddie Mac"),
Government National Mortgage Association ("GNMA" or "Ginnie Mae"), and Federal
National Mortgage Association ("FNMA" or "Fannie Mae") loans, respectively.
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)
The Company's mortgage loan production and mortgage servicing portfolio
activity for the first nine months of 1998 and 1997 are summarized in the
following tables:
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------
Nine Months Ended
September 30,
- ---------------------------------------------------------------------------------------------
MORTGAGE LOAN PRODUCTION: (in millions) 1998 1997
- ---------------------------------------------------------------------------------------------
BY TYPE:
<S> <C> <C>
FHA/VA Insured $ 5,403 $ 1,761
Conventional 2,222 956
- ---------------------------------------------------------------------------------------------
Total $ 7,625 2,717
- ---------------------------------------------------------------------------------------------
BY SOURCE:
Retail $ 2,072 1,013
Wholesale 5,553 1,704
- ---------------------------------------------------------------------------------------------
Total $ 7,625 $ 2,717
=============================================================================================
</TABLE>
In response to increased industry competition for producing and servicing
conforming mortgage loans, the Company decided in late 1997 to broaden its
product line by offering higher margin products. The Company began producing
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 4% of total production
in the nine months ended September 30, 1998.
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------
Nine Months Ended
September 30,
- ---------------------------------------------------------------------------------------------
MORTGAGE SERVICING PORTFOLIO: (in millions) 1998 1997
- ---------------------------------------------------------------------------------------------
<S> <C> <C>
Servicing portfolio owned at beginning of period $ 11,627 $ 26,410
Mortgage loan production 7,625 2,717
- ---------------------------------------------------------------------------------------------
Total servicing in 7,625 2,717
- ---------------------------------------------------------------------------------------------
Regular payoffs 1,129 914
Sale of servicing 6,751 17,018
Principal amortization, foreclosures and other 851 767
- ---------------------------------------------------------------------------------------------
Total servicing out 8,731 18,699
- ---------------------------------------------------------------------------------------------
Servicing portfolio owned at end of period 10,521 10,428
- ---------------------------------------------------------------------------------------------
Subservicing portfolio 12,477 18,216
- ---------------------------------------------------------------------------------------------
Total servicing portfolio at end of period $ 22,998 $ 28,644
=============================================================================================
</TABLE>
The significant increase in 1998 mortgage loan production reflects lower
market interest rates and a corresponding increase in refinance activity
throughout the first nine months of 1998 compared to 1997. The modest increase
in payoffs also reflects lower market interest rates and a corresponding
increase in refinance activity, the effects of which were offset by a smaller
average owned servicing portfolio.
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)
Additional information regarding the Company's mortgage loan servicing
portfolio is shown below:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
September 30, December 31,
1998 1997
- --------------------------------------------------------------------------------------------------------------------
MORTGAGE SERVICING PORTFOLIO: Owned Total (a) Owned Total (a)
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Number of loans serviced 145,081 363,727 184,289 438,261
Weighted average net servicing fee
(at end of period) .418% (c) .420% (c)
Weighted average interest rate 7.83% 8.12% 8.52% 8.45%
Percent delinquent (b) 8.10% 7.75% 8.40% 7.53%
- --------------------------------------------------------------------------------------------------------------------
(a) Includes loans subserviced for others having a principal balance of $12,477 million and $14,919 million as of
September 30, 1998 and December 31, 1997, respectively.
(b) Includes loans in process of foreclosure.
(c) This amount is not meaningful, as it would be calculated as a combination of two different measurements: the
net servicing fee earned on the Company's owned servicing portfolio, which is calculated as a percentage of
the outstanding principal balance serviced; and the subservicing fee earned on the Company's subservicing
portfolio, which is calculated based upon the terms of the various subservicing agreements.
</TABLE>
REVENUE- Mortgage servicing revenue decreased to $59.6 million in the first
nine months of 1998 from $69.4 million in 1997. The decrease in mortgage
servicing revenue is primarily a result of the significant 1997 and 1998
servicing sales. Amortization of capitalized servicing was $52.3 million and
$46.5 million for the nine months ended September 30, 1998 and 1997,
respectively. Amortization includes a $21.3 million and a $11.1 million increase
to the valuation allowances for impairment of the Company's capitalized
servicing asset in 1998 and 1997, respectively. The 1998 and 1997 impairment
charges are the result of increased market consensus prepayment rates and a
corresponding decrease in the fair value of the Company's mortgage servicing
asset from year end 1997 and 1996, respectively. Excluding the effects of
impairment, amortization expense decreased to $31.0 million in the first nine
months of 1998 from $35.4 million in 1997. This decrease is primarily due to the
reduction in amortization of the Company's subservicing asset, related to the
1997 Servicing Sale, which coincided with the start of the second subservicing
period. 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 was reduced. The remaining balance is
being amortized on a straight line basis over the subservicing period and tested
for impairment.
The Company recorded a net gain on its financial instruments of $22.4 million
for the first nine months of 1998. The net gain includes a net realized gain of
$3.5 million on the sales of financial instruments during 1998, realized gains
of $4.9 million from net cash flows received and unrealized gains of $14.0
million due to a net increase in the fair market value of the remaining
financial instruments. The Company recorded a net gain on its financial
instruments of $4.3 million for the first nine months of 1997. The 1997 net gain
includes $4.7 million of unrealized gains due to a net increase in the fair
market value of the various instruments, slightly offset by realized losses of
$.4 million from net cash flows paid.
Interest income increased to $61.9 million in the first nine months of 1998
from $32.0 million in 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 $51.3 million and $25.1 million for the nine months ended September 30, 1998
and 1997, respectively. This increase is primarily the result of increased
short-term borrowings necessary to fund the increase in 1998 production and an
increase in the cost of borrowings due to the Company's inability to issue
commercial paper, slightly offset by the effect of the early retirement of
medium-term notes in the second 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)
The Company realized a net investment gain of $2.2 million for the nine months
ended September 30, 1998 compared to a net investment loss of $.1 million for
the comparable 1997 period. The 1998 gain is primarily the result of a realized
gain from the distribution received on a partnership investment. The 1997 loss
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 by White Mountains Holdings, Inc. ("White Mountains") of its
investment in FSA to the Company in exchange for shares of the Company's common
stock. The Company recognized $10.1 million and $6.3 million of equity in
earnings of FSA as a result of its investment for the nine months ended
September 30, 1998 and 1997, respectively.
Net gain on sale of mortgages increased to $63.9 million in the first nine
months of 1998 from $15.7 million in the comparable 1997 period. This increase
is primarily the result of increased mortgage loan sales volumes and the
corresponding increase in capitalized originated mortgage servicing rights
("OMSR") income and net gains on mortgage sales. The 1997 net gain on sale of
mortgages also reflects a $3.0 million pretax charge in the second quarter of
1997 relating to the Company's mortgage loans held for investment which were
identified for sale and marked down from amortized cost to current market value.
The sharp spike in interest rates which occurred in early October of 1998 will
likely result in a reduction in gain on mortgage sales in the fourth quarter of
1998. However, management cannot predict the interest rate environment for the
remainder of 1998; therefore, there can be no assurance that this result will
occur.
The Company recorded a $10.4 million pretax gain on sales of servicing during
the first nine months of 1998, which reflects the sales of the rights to service
approximately $6.8 billion of the Company's nonrecourse mortgage servicing
portfolio to third parties and adjustments to previous servicing sales. The
Company recorded a $4.3 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 nine months of 1997.
Other revenue was $21.9 million and $13.8 million for the nine months ended
September 30, 1998 and 1997, respectively. The increase in other revenue
primarily reflects an increase in ancillary production income associated with
the increase in production volumes in 1998.
EXPENSES - Salaries and employee benefits expense was $56.3 million and $40.3
million for the nine months ended September 30, 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>
- ---------------------------------------------------------------------------------------------
Nine Months Ended
September 30,
- ---------------------------------------------------------------------------------------------
(in thousands) 1998 1997
- ---------------------------------------------------------------------------------------------
<S> <C> <C>
Unadjusted salaries and employee benefits expense $ 81,778 $ 53,851
GAAP net origination revenues (25,511) (13,523)
- ---------------------------------------------------------------------------------------------
GAAP salaries and employee benefits expense $ 56,267 $ 40,328
- ---------------------------------------------------------------------------------------------
</TABLE>
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)
An increase in loan origination revenues, reflecting the significant increase
in retail mortgage loan production during the first nine months of 1998 as
compared to the first nine months 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 52%. This
increase is primarily due to the increase in loan officer commissions associated
with the significant increase in 1998 mortgage loan production.
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
workforce, primarily in overhead areas, by approximately 100 employees during
the second quarter 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.
Other operating expenses were $28.8 million and $17.8 million for the nine
month periods ended September 30, 1998 and 1997, respectively. The increase in
1998 is primarily due to increased loan processing expense related to increased
production volumes and additional travel, advertising and promotional expenses
incurred in 1998 related to the Company's subprime and high loan-to-value
("LTV") business entered into during the third quarter of 1997.
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 1997.
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)
RESULTS OF OPERATIONS - THREE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
SUMMARY- Source One Mortgage Services Corporation (together with its
subsidiaries, the "Company") reported net income of $10.0 million and $1.1
million for the three months ended September 30, 1998 and 1997, respectively.
The 1998 results include a $1.4 million pretax gain on the sale of servicing to
third parties and adjustments to previous sales, $3.7 million pretax equity in
earnings of an unconsolidated affiliate and a $14.8 million pretax charge for
impairment of the Company's capitalized servicing asset, which was offset by a
$16.8 million net gain on financial instruments. The third quarter 1997 results
include $3.1 million pretax equity in earnings of an unconsolidated affiliate
and a $9.7 million pretax charge for impairment of the Company's capitalized
servicing asset, which was offset by a $6.0 million pretax net gain on financial
instruments.
The Company reported a comprehensive loss (which includes the net change in
after tax unrealized gains and losses) of $17.7 million for the quarter ended
September 30, 1998. The loss was primarily the result of the decline in market
value of the Company's investment in FSA preferred stock and options. For the
corresponding 1997 period, the Company reported comprehensive income of $23.5
million.
The Company's mortgage loan production and mortgage servicing portfolio
activity for the three months ended September 30, 1998 and 1997 are summarized
in the following tables:
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------
Three Months Ended
September 30,
- ------------------------------------------------------------------------------------------------
MORTGAGE LOAN PRODUCTION: (in millions) 1998 1997
- ------------------------------------------------------------------------------------------------
BY TYPE:
<S> <C> <C>
FHA/VA Insured $ 1,769 $ 873
Conventional 637 376
- ------------------------------------------------------------------------------------------------
Total $ 2,406 $ 1,249
- ------------------------------------------------------------------------------------------------
BY SOURCE:
Retail $ 634 $ 420
Wholesale 1,772 829
- ------------------------------------------------------------------------------------------------
Total $ 2,406 $ 1,249
- ------------------------------------------------------------------------------------------------
</TABLE>
The Company's higher margin products (203(k), manufactured housing, subprime
and 125% LTV loans) accounted for less than 5% of total production in the three
months ended September 30, 1998.
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------
Three Months Ended
September 30,
- -------------------------------------------------------------------------------------------------
MORTGAGE SERVICING PORTFOLIO: (in millions) 1998 1997
- -------------------------------------------------------------------------------------------------
<S> <C> <C>
Servicing portfolio owned at beginning of period $ 11,530 $ 9,651
Mortgage loan production 2,406 1,249
- ------------------------------------------------------------------------------------------------
Total servicing in 2,406 1,249
- ------------------------------------------------------------------------------------------------
Regular payoffs 320 271
Sale of servicing 2,781 --
Principal amortization, foreclosures and other 314 201
- ------------------------------------------------------------------------------------------------
Total servicing out 3,415 472
- ------------------------------------------------------------------------------------------------
Servicing portfolio owned at end of period 10,521 10,428
- ------------------------------------------------------------------------------------------------
Subservicing portfolio 12,477 18,216
- ------------------------------------------------------------------------------------------------
Total servicing portfolio at end of period $ 22,998 $ 28,644
- ------------------------------------------------------------------------------------------------
</TABLE>
14
<PAGE> 16
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
The increase in 1998 mortgage loan production and payoffs reflects lower
market interest rates and a corresponding increase in refinance activity
throughout the third quarter of 1998 compared to the third quarter of 1997.
REVENUE- Mortgage servicing revenue was $18.5 million and $20.7 million for
the three months ended September 30, 1998 and 1997, respectively. The decrease
in mortgage servicing revenue is primarily due to a decrease in subservicing
revenue resulting from a smaller average subservicing portfolio, coupled with a
lower net servicing fee earned on the subservicing portfolio. Amortization of
capitalized servicing was $22.9 million and $20.6 million for the third quarters
ended September 30, 1998 and 1997, respectively. Amortization includes a $14.8
million and a $9.7 million increase to the valuation allowances for impairment
of the Company's capitalized servicing asset in 1998 and 1997, respectively. The
impairment charges are a result of increased market consensus prepayment rates
and a corresponding decrease in the fair value of the Company's capitalized
servicing asset from the quarters ended June 30, 1998 and 1997. Excluding the
effects of impairment, amortization expense decreased to $8.1 million for the
quarter ended September 30, 1998 from $10.9 million in 1997. This decrease is
primarily due to the reduction in amortization of the Company's subservicing
asset, related to the 1997 Servicing Sale, which coincided with the start of the
second subservicing period. 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 was reduced. The remaining
balance is being amortized on a straight line basis over the subservicing period
and tested for impairment.
The Company recorded a net gain on its financial instruments of $16.8 million
and $6.0 million for the third quarters ended September 30, 1998 and 1997,
respectively. The 1998 net gain includes a net realized gain of $4.5 million
from the sales of financial instruments in the third quarter and realized gains
of $.5 million from net cash flows received. In addition, the Company recorded
unrealized gains totaling $11.8 million for the quarter due to a net increase in
the fair market value of the remaining financial instruments. The 1997 net gain
represents unrealized gains due to an increase in the fair market value of the
various instruments.
Interest income increased to $21.2 million in the third quarter of 1998 from
$12.0 million in 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 $17.9
million and $8.8 million for the three months ended September 30, 1998 and 1997,
respectively. This increase is primarily the result of increased short-term
borrowings necessary to fund the increase in 1998 production and an increase in
the cost of borrowings due to the Company's inability to issue commercial paper.
Net gain on sale of mortgages increased to $21.8 million for the third
quarter of 1998 from $6.5 million in the comparable 1997 period. This increase
is primarily the result of increased mortgage loan sales volumes and the
corresponding increase in capitalized originated mortgage servicing rights
("OMSR") income and net gains on mortgage sales.
15
<PAGE> 17
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
The Company recorded a $1.4 million pretax gain on sales of servicing during
the third quarter of 1998, which reflects the sale of the rights to service
approximately $2.8 billion of the Company's nonrecourse mortgage servicing
portfolio to third parties and adjustments to previous servicing sales.
Other revenue was $8.2 million and $4.8 million for the three months ended
September 30, 1998 and 1997, respectively. The increase in other revenue
primarily reflects an increase in ancillary production income associated with
the increase in production volumes in 1998.
EXPENSES - Salaries and employee benefits expense was $20.1 million and $13.5
million for the three months ended September 30, 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
September 30,
- --------------------------------------------------------------------------------
(in thousands) 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
Unadjusted salaries and employee benefits expense $ 28,565 $ 19,264
GAAP net origination revenues (8,502) (5,730)
- --------------------------------------------------------------------------------
GAAP salaries and employee benefits expense $ 20,063 $ 13,534
- --------------------------------------------------------------------------------
</TABLE>
An increase in loan origination revenues, reflecting increased retail mortgage
loan production during the third quarter of 1998 as compared to the third
quarter of 1997, partially offset the increase in unadjusted salaries and
benefits expense. The increase in salaries and employee benefits expense is
primarily due to the increase in loan officer commissions associated with the
significant increase in 1998 mortgage loan production.
The provision for loan losses was $2.1 million and $.7 million for the three
months ended September 30, 1998 and 1997, respectively. The increase in the
provision is primarily a result of reclassifications for nonrecourse loan losses
which were classified as impairment the first and second quarters of 1998 and
1997. Prior to 1998, the provision for loan losses included losses on the
Company's nonrecourse and recourse loans. In 1998, the Company began to charge
loan losses on its recourse loans against the reserve for such losses which is
included in the valuation allowance for the Company's capitalized servicing
asset. Therefore, the provision for these recourse losses is now included as a
component of impairment of the Company's capitalized servicing asset. The
Company has continued to refine its method for identifying these losses which
resulted in the reclassification of a certain amount of nonrecourse losses as
noted above and a corresponding increase in the provision for loan losses in the
third quarter of 1998, which did not have a material impact on the presentation
of the quarterly results.
Office occupancy and equipment expense increased to $3.2 million from $2.8
million during the three months ended September 30, 1998 and 1997, respectively.
This increase is primarily the result of additional rent expense related to the
Company's subprime branches opened in 1998.
Other operating expenses were $10.3 million and $4.9 million for the three
month periods ended September 30, 1998 and 1997, respectively. The increase in
1998 is primarily due to increased loan processing expense related to increased
production volumes and additional travel, advertising and promotional expenses
incurred in 1998 related to the Company's subprime and high LTV business entered
into during the third quarter of 1997.
16
<PAGE> 18
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>
- -------------------------------------------------------------------------------------------------
September 30, December 31,
(in thousands) 1998 1997
- -------------------------------------------------------------------------------------------------
<S> <C> <C>
Credit agreements, weighted average interest rates
of 6.43% and 6.34% as of September 30, 1998 and
December 31, 1997, respectively $ 675,492 $ 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) (1,861) (2,110)
- -------------------------------------------------------------------------------------------------
Total senior and subordinated debt $ 848,330 $ 742,059
- -------------------------------------------------------------------------------------------------
</TABLE>
In July 1998, the Company amended and restated its $701.0 million secured
revolving credit agreement to increase its borrowing capacity and flexibility.
The provisions of the amended agreement increased its borrowing capacity from
$701.0 million to $800.0 million, which allows the Company to meet higher
borrowing requirements resulting from increased production volumes. The
provisions also allow the Company to more fully utilize the facility by easing
its restrictions with respect to the Company's use of its high LTV mortgage
loans and non-conforming second mortgage loans as collateral and increasing the
collateral value of the Company's mortgage-backed-security ("MBS") pools. The
revolving credit facility expires on July 9, 1999. Borrowings under the facility
are secured primarily by the Company's mortgage loans receivable and pool loan
purchases. As of September 30, 1998 the Company had $580.0 million outstanding
under this facility. As of December 31, 1997 the Company had $559.0 million
outstanding under the previous facility.
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 to holders of its common stock. The limits do not
apply to preferred stock dividend and subordinated debt interest requirements
each year. The Company is currently in compliance with all such covenants.
17
<PAGE> 19
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
In July 1998, the Company entered into an additional secured credit agreement
to be used for working capital and general corporate purposes, including the
funding of mortgage loans. Under this agreement, the Company may borrow up to
$35.0 million through July 9, 1999. Borrowings under this facility are secured
by the Company's investment in FSA common stock. As of September 30, 1998, the
Company had $35.0 million outstanding under this facility. The Company must
comply with certain financial convenants provided in the agreement, including
restrictions relating to tangible net worth and leverage. 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 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. As of September 30, 1998, the Company had $35.7 million outstanding under
this facility. The Company must comply with certain financial covenants provided
in the agreement, including restrictions relating to tangible net worth and
leverage. The Company is currently in compliance with all such covenants.
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. In July
1998, Central Pacific amended this new agreement to increase its borrowing
capacity to $40.0 million. As of September 30, 1998 and December 31, 1997, there
was $24.8 million and $10.5 million outstanding under these credit agreements,
respectively. Central Pacific must comply with certain financial covenants
provided in the agreement, including restrictions relating to tangible net worth
and leverage. Central Pacific is currently in compliance with all such
covenants.
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 paid cash dividends on its common stock totaling $101.7
million for the nine months ended September 30, 1998 which have been reflected
as reductions in paid-in capital. The Company did not declare any dividends on
its common stock for the nine months ended September 30, 1997.
During the first nine months of 1998, the Company sold the rights to service
approximately $6.8 billion of its nonrecourse mortgage servicing portfolio to
third parties for net proceeds of $146.5 million. The Company used the initial
proceeds received from the sales totaling $100.7 million for general corporate
purposes. The remaining balance of $45.8 million is included in other assets in
the consolidated statement of condition as of September 30, 1998. Under
circumstances deemed appropriate by management, additional sales transactions
may occur in the future. However, there can be no assurance that such additional
sales will occur.
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.
18
<PAGE> 20
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
YEAR 2000 COMPLIANCE
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 that the Company currently believes are
necessary to achieve a year 2000 date conversion with no material adverse
effects to its 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. The Company expects to complete the testing phase of
the project by year end 1998. The total pretax cost of achieving Year 2000
compliance is approximately $1.2 million of which the majority of this amount
has been expensed as of September 30, 1998. The estimate does not include the
cost of hardware and software replacements and upgrades made in the normal
course of business.
The Company has also been closely monitoring the Year 2000 issues of its
third party constituents that it voluntarily interacts with (e.g. customers,
suppliers, reinsures, creditors, borrowers). These third party constituents have
been requested to demonstrate their ability to become Year 2000 compliant by
year-end 1998. For those constituents who either fail to respond to this inquiry
or are deemed to be unlikely to remedy their own Year 2000 issues in a timely
manner, the Company is in the process of either replacing that constituent or
establishing similar relationships with new parties that expect to be Year 2000
compliant.
The failure to identify or correct significant Year 2000 issues could result
in an interruption in, or a failure of, certain normal business activities or
operation concerning the Company. Such failures could adversely affect the
Company's results of operations, liquidity and financial condition. Due to the
general uncertainty inherent in the Year 2000 problem, resulting in part from
the uncertainty of potential business interruptions caused by third party
constituents in which the Company must interact (including but not limited to
suppliers of electrical power, various private and public markets for equity and
debt securities, certain agencies of the Federal government and the states in
which the Company conducts business), the Company is unable to determine at this
time whether the consequences of any Year 2000 failures will have a material
impact on its results of operation, liquidity or financial condition. However,
the Company currently believes that, with the implementation of its Year 2000
plan (which is in the final stages of completion), the possibility of
significant interruptions of normal business activities due to the Year 2000
issue should be reduced.
19
<PAGE> 21
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
OTHER MATTERS
ACCOUNTING FOR FSA OPTIONS AND CONVERTIBLE PREFERRED STOCK. The Company
currently owns 3,460,200 shares of the common stock of FSA ("FSA Shares") and
various fixed price options and shares of convertible preferred stock of FSA
(the "FSA Options and FSA Preferred Stock") which, in total, gives the Company
the right to acquire up to 4,560,607 additional FSA Shares. The Company's
investment in FSA Shares is accounted for using the equity method of accounting
pursuant to which the investment is reported at FSA's equity value ($33.96 per
FSA Share at September 30, 1998). The Company's investments in FSA Options and
FSA Preferred Stock are currently accounted for under the provisions of SFAS No.
115 pursuant to which the investments are reported at fair value ($47.29 per FSA
Share at September 30, 1998).
The Company currently expects to exercise the FSA Options during 1999 and
convert the FSA Preferred Stock during 2004. Assuming that equity accounting
continues to be the proper accounting method for valuing the Company's
investment in FSA Shares, upon exercise of the FSA Options and conversion of the
FSA Preferred Stock, the Company expects that it would be required to restate
its historic balance sheets to account for its investments in FSA Options and
FSA Preferred Stock from fair value to their original cost. Upon exercise, the
Company's original cost basis in the FSA Shares acquired will be increased by
the exercise price paid. Because the new cost basis of the Company's investment
in FSA Shares is expected to be considerably less than its portion of the fair
value of FSA's net identifiable assets at the date of exercise, the Company
would be required to record a deferred credit that would be amortized to income
over an anticipated five year period. Assuming the FSA Options were exercised
and the FSA Preferred Stock converted as of September 30, 1998, the Company
would be required to reduce its stockholder's equity by $46.8 million and would
record a deferred credit of $11.2 million. This net difference in carrying value
of $35.6 million (which represents the effective write-down of the FSA Options
and FSA Preferred Stock from fair value to FSA's equity value) would
continue to exist until such time as equity accounting is no longer appropriate
for the Company's investment in FSA Shares.
This analysis is based solely on the Company's current circumstances
concerning its investments in FSA Options and FSA Preferred Stock. The Company's
actual accounting valuation will be determined at the point of exercise for the
FSA Options and upon the conversion of the FSA Preferred Stock and will be based
on the circumstances concerning such investments existing at that time.
20
<PAGE> 22
FORM 10-Q
Source One Mortgage Services Corporation and Subsidiaries
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
By virtue of General Instruction 1 to Item 305 of Regulation S-K, and because
it is neither a bank nor a thrift and its market capitalization on January 28,
1997 did not exceed $2.5 billion, the Company is not required at this time to
provide disclosures under this Item 3.
21
<PAGE> 23
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:
<TABLE>
<CAPTION>
Exhibit
No. Description
------- -----------------------
<S> <C>
27 Financial Data Schedule
</TABLE>
b. Form 8-K: The Company filed eight current Reports on Form 8-K with the
Securities and Exchange Commission during the quarter ended September 30,
1998.
(i) July 10, 1998: Mortgage Warehousing Loan Agreement dated as of April 18,
1998 by and between Central Pacific Mortgage and PNC Bank National
Association.
(ii) July 23, 1998: Reported Distribution Date Statements for July 25, August
1, August 1, and July 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.
(iii) July 27, 1998: Reported Report to the Trustee and Report to the
Certificate Holders for the month of July 1998 relating to the Source One
Mortgage Services Corporation 11-1/2% Mortgage Pass-Through Certificates,
Series A.
(iv) August 25, 1998: Reported Report to the Trustee and Report to the
Certificate Holders for the month of August 1998 relating to the Source
One Mortgage Services Corporation 11-1/2% Mortgage Pass-Through
Certificates, Series A.
(v) August 27, 1998: Reported Distribution Date Statements for August 25,
September 1, September 1, and August 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.
(vi) September 2, 1998: Under Item 7 as exhibits:
Fourth Amended and Restated Revolving Credit Agreement dated as of July
10, 1998 by and among Source One Mortgage Services Corporation and the
First National Bank of Chicago, individually and as Administrative Agent
and Certain Other Lenders.
Revolving Credit Agreement dated as of July 10, 1998 by and among Source
One Mortgage Services Corporation and the First National Bank of Chicago,
individually and as Administrative Agent and Certain Other Lenders.
Pledge and Security Agreement dated as of July 10, 1998 between Source One
Mortgage Services Corporation and the First National Bank of Chicago, as
Collateral Agent for the Lenders.
Fourth Amended and Restated Security and Collateral Agency Agreement dated
as of July 10, 1998 by and among Source One Mortgage Services Corporation
and The First National Bank of Chicago (in its capacity as Administrative
Agent for the lenders) and National City Bank, Kentucky, as Collateral
Agent.
(vii) September 22, 1998: Reported Distribution Date Statements for September
25, September 25, October 1, October 1, and September 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.
(viii)September 25, 1998: Reported Report to the Trustee and Report to the
Certificate Holders for the month of September 1998 relating to the Source
One Mortgage Services Corporation 11-1/2% Mortgage Pass-Through
Certificates, Series A.
22
<PAGE> 24
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)
DATE: NOVEMBER 13, 1998 /S/ MICHAEL C. ALLEMANG
- ------------------------ ------------------------
Michael C. Allemang
Executive Vice President and Chief Financial Officer
(Principal Financial Officer and Principal
Accounting Officer)
23
<PAGE> 25
Exhibit Index
-------------
<TABLE>
<CAPTION>
Exhibit No. Description
- ----------- -----------
<S> <C>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 26,216
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 22,604
<DEPRECIATION> 0
<TOTAL-ASSETS> 1,416,466
<CURRENT-LIABILITIES> 0
<BONDS> 0
0
18
<COMMON> 32
<OTHER-SE> 386,467
<TOTAL-LIABILITY-AND-EQUITY> 1,416,466
<SALES> 0
<TOTAL-REVENUES> 148,656
<CGS> 0
<TOTAL-COSTS> 97,311
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 3,174
<INTEREST-EXPENSE> 51,335
<INCOME-PRETAX> 51,345
<INCOME-TAX> 17,755
<INCOME-CONTINUING> 33,590
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 33,590
<EPS-PRIMARY> 9.59
<EPS-DILUTED> 0
</TABLE>
