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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 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 0-26500
FIRSTCITY FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
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DELAWARE 76-0243729
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
6400 IMPERIAL DRIVE, WACO, TX 76712
(Address of Principal Executive Offices) (Zip Code)
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(254) 751-1750
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
TITLE OF EACH CLASS
Common Stock, par value $.01
Adjusting Rate Preferred Stock, par value $.01
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13, or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No [ ]
The number of shares of common stock outstanding at February 1, 1999 was
8,287,959. As of such date, the aggregate market value of the voting and
non-voting common equity held by non-affiliates, based upon the closing price of
the common stock on the NASDAQ National Market System, was approximately
$80,646,913.
DOCUMENTS INCORPORATED BY REFERENCE
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PART OF FORM 10-K
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Notice of Annual Meeting and Proxy Statement for the
1999 Annual Meeting of Shareholders............... III
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FIRSTCITY FINANCIAL CORPORATION
TABLE OF CONTENTS
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PART I
Item 1. Business.................................................... 3
Item 2. Properties.................................................. 30
Item 3. Legal Proceedings........................................... 30
Item 4. Submission of Matters to a Vote of Security Holders......... 31
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters....................................... 31
Item 6. Selected Financial Data..................................... 32
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 32
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 64
Item 8. Financial Statements and Supplementary Data................. 66
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 104
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 104
Item 11. Executive Compensation...................................... 104
Item 12. Security Ownership of Certain Beneficial Owners and
Management................................................ 104
Item 13. Certain Relationships and Related Transactions.............. 104
Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K....................................................... 104
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FORWARD LOOKING INFORMATION
This Annual Report on Form 10-K may contain forward-looking statements. The
factors identified under "Risk Factors" are important factors (but not
necessarily all of the important factors) that could cause actual results to
differ materially from those expressed in any forward-looking statement made by,
or on behalf of, the Company.
When any such forward-looking statement includes a statement of the
assumptions or bases underlying such forward-looking statement, the Company
cautions that, while such assumptions or bases are believed to be reasonable and
are made in good faith, assumed facts or bases almost always vary from actual
results, and the differences between assumed facts or bases and actual results
can be material, depending upon the circumstances. When, in any forward-looking
statement, the Company, or its management, expresses an expectation or belief as
to future results, such expectation or belief is expressed in good faith and is
believed to have a reasonable basis, but there can be no assurance that the
statement of expectation or belief will result or be achieved or accomplished.
The words "believe," "expect," "estimate," "project," "anticipate" and similar
expressions identify forward-looking statements.
PART I
ITEM 1. BUSINESS.
GENERAL
The Company is a diversified financial services company headquartered in
Waco, Texas with over 100 offices throughout the United States and a presence in
France, Mexico, and Japan. The Company began operating in 1986 as a specialty
financial services company focused on acquiring and resolving distressed loans
and other assets purchased at a discount relative to the aggregate unpaid
principal balance of the loans or the appraised value of the other assets ("Face
Value"). To date the Company has acquired, for its own account and through
various affiliated partnerships, pools of assets of single assets (collectively
referred to as "Portfolio Assets" or "Portfolios") with a Face Value of
approximately $3.5 billion. In 1996, the Company adopted a growth strategy to
diversify and expand its financial services business. To implement its growth
strategy, the Company has acquired or established several businesses in the
financial services industry, building upon its core strength and expertise as
one of the earliest participants in the business of acquiring and resolving
distressed financial assets and other assets. The Company's servicing expertise,
which it has developed largely through the resolution of distressed assets, is a
cornerstone of its growth strategy. Today the Company is engaged in three
principal businesses: (i) residential and commercial mortgage banking; (ii)
Portfolio Asset acquisition and resolution; and (iii) consumer lending.
BUSINESS STRATEGY
The Company's business strategy is to continue to broaden and expand its
business within the financial services industry while building on its core
servicing strengths and credit expertise. The following principles are key
elements to the execution of the Company's business strategy:
- Expand the financial products and services offered by existing
businesses.
- Broaden its sources of revenue and operating earnings by developing or
acquiring additional businesses that leverage its core strengths and
management expertise.
- Cross-sell between the Company's businesses.
- Invest in fragmented or underdeveloped markets in which the Company has
the investment and servicing expertise to achieve attractive risk
adjusted rates of return.
- Pursue new business opportunities through joint ventures, thereby
capitalizing on the expertise of partners whose skills complement those
of the Company.
- Maximize growth in earnings, thereby permitting the utilization of the
Company's net operating loss carryforwards ("NOLs").
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BACKGROUND
The Company began operating in the financial service business in 1986 as a
purchaser of distressed assets from the Federal Deposit Insurance Corporation
("FDIC"). From its original office in Waco, Texas, with a staff of four
professionals, the Company's asset acquisition and resolution business grew to
become a significant participant in an industry fueled by the problems
experienced by banks and thrifts throughout the United States. In the late
1980s, the Company also began acquiring assets from healthy financial
institutions interested in eliminating nonperforming assets from their
portfolios. The Company began its relationship with Cargill Financial Services
Corporation ("Cargill Financial") in 1991. Since that time, the Company and
Cargill Financial have formed a series of Acquisition Partnerships through which
they have jointly acquired over $2.7 billion in Face Value of distressed assets.
By the end of 1994, the Company had grown to nine offices with over 180
professionals and had acquired portfolios with assets in virtually every state.
In July 1995, the Company acquired by merger (the "Merger") First City
Bancorporation of Texas, Inc. ("FCBOT"), a former bank holding company that had
been engaged in a proceeding under Chapter 11 of the Bankruptcy Code since
November 1992. As a result of the Merger, the Common Stock of the Company became
publicly held and the Company received $20 million of additional equity capital
and entered into an incentive-based servicing agreement to manage approximately
$300 million in assets for the benefit of the former equity holders of FCBOT. In
addition, as a result of the Merger, the Company retained FCBOT's rights to
approximately $596 million in NOLs, which the Company believes it can use to
offset taxable income generated by the Company and its consolidated
subsidiaries.
Following the Merger, the Company adopted a growth and diversification
strategy designed to capitalize on its servicing and credit expertise to expand
into additional financial service businesses with management partners that have
distinguished themselves among competitors. To that end, in July 1997 the
Company acquired Harbor Financial Group, Inc., a company engaged in the
residential and commercial mortgage banking business since 1983. The Company has
also expanded into related niche financial services markets, such as consumer
finance and mortgage conduit banking.
MORTGAGE BANKING
General
The Company engages in the mortgage banking business through two principal
subsidiaries, FirstCity Financial Mortgage Corporation ("Mortgage Corp.") and FC
Capital Corp. ("Capital Corp."). Mortgage Corp. is a direct retail and broker
retail mortgage bank, which originates, purchases, sells and services
residential and commercial mortgage loans through more than 70 offices
throughout the United States. The Company acquired Mortgage Corp. (then named
Harbor Financial Group, Inc.) by merger in July 1997 (the "Harbor Merger").
Mortgage Corp. which was formed as a subsidiary of a savings and loan
association in 1983, completed a management led buy-out of the ownership of
Mortgage Corp. in 1987 and continued to expand through acquisitions and internal
growth. Many of Mortgage Corp.'s acquisitions represented opportunistic
situations whereby it was able to acquire origination capability or servicing
portfolios from the FDIC, the Resolution Trust Corporation ("RTC") or other
sellers of distressed assets. Mortgage Corp. conducts its residential and
commercial mortgage banking and servicing business primarily through its
subsidiaries Harbor Financial Mortgage Corporation ("Harbor") and New America
Financial, Inc. ("New America"). Mortgage Corp. ranks among the 50 largest
mortgage banks in the United States.
Capital Corp. was formed in 1997 to acquire, originate, warehouse,
securitize and service residential mortgage loans to borrowers who have
significant equity in their homes and who generally do not satisfy the more
rigid underwriting standards of the traditional residential mortgage lending
market (referred to herein as "Home Equity Loans"). These loans are extended to
borrowers who demonstrate an ability and willingness to repay credit, but who
might have experienced an adverse event, such as job loss, illness or divorce,
or have had past credit problems such as delinquency, bankruptcy, repossession
or charge-offs. Such an event normally will temporarily impair a borrower's
credit rating such that the borrower will not qualify as a prime borrower from a
traditional mortgage lender that concentrates on prime credit quality
conventional conforming loans. Capital
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Corp. has acquired $366 million such loans from formation through December 31,
1998 and has securitized approximately $321 million of such product through two
securitizations in 1998.
The Company owns 80% of the outstanding stock of Capital Corp. with Capital
Corp.'s senior management owning the remaining 20%. This ownership structure
aligns the interests of the key management team of Capital Corp. with those of
the Company. The Company became acquainted with Capital Corp.'s management team
during their tenure as senior management for a Wall Street firm's mortgage
conduit and structured finance division. This team has demonstrated to the
Company a disciplined approach to growing a business where the emphasis is on
credit quality and sound operating standards. The Company and the management
shareholders of Capital Corp. entered into a shareholders' agreement in
connection with the formation of Capital Corp. in August 1997. Commencing on the
fifth anniversary of such agreement, the Company and the management shareholders
have put and call options with respect to the stock of Capital Corp. held by the
other party at a mutually agreed upon fair market value.
Residential Mortgage Banking
Products and Services
Mortgage Corp. originates and purchases both fixed rate and adjustable rate
mortgage loans, primarily secured by first liens on single family residences.
The majority of the residential loans originated by Mortgage Corp. are
conventional conforming loans that qualify for sale to Federal National Mortgage
Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC").
Additionally, Mortgage Corp. originates loans insured by the Federal Housing
Administration ("FHA") and the Farmers Home Administration ("FMHA") and loans
guaranteed by the Veterans Administration ("VA"). These loans qualify for
inclusion in guarantee programs sponsored by the Government National Mortgage
Association ("GNMA"). Substantially all the conventional conforming loans are
originated with loan-to-value ratios at or below 80% unless the borrower obtains
private mortgage insurance. The Company also originates a number of other
mortgage loan products to respond to a variety of customer needs. These products
include:
- First lien residential mortgage loans that meet the specific underwriting
standards of private investors, issuers of mortgage backed securities,
and other conduits seeking to purchase loans originated by Mortgage Corp.
These loans do not meet the established standards of FNMA or FHLMC and
are generally referred to as non-conforming mortgage loans. The loans may
be non-conforming because, among other reasons, they exceed the dollar
limitations established by FNMA or FHLMC, are originated with an original
loan-to-value ratio in excess of 80%, or are made to a borrower who is
self-employed.
- First and second lien residential mortgage Home Equity Loans to borrowers
who have some level of impaired credit.
- First and second lien residential home improvement loans.
- First and second lien residential home equity lines of credit.
Mortgage Corp. offers its customers a range of choices with respect to
repayment plans and interest rates on the loans that it originates. Most loans
originated by Mortgage Corp. have either 15 or 30 year terms and accrue interest
at fixed or variable rates. Quoted interest rates are a function of the current
interest rate environment and generally may be reduced at the option of the
customer by paying additional discount points at the time the loan is
originated. The adjustable rate mortgage ("ARM") products offered by Mortgage
Corp. reflect the current offerings of its agency or private investors. A basic
ARM loan could have an interest rate that adjusts on an annual basis throughout
its term with limits on the amount of the annual and aggregate lifetime
adjustments. A more complicated ARM loan could have a fixed rate of interest for
a stipulated period of time (for example, five years) with the annual adjustment
rate option commencing on an annual basis after the expiration of the initial
fixed term. Mortgage Corp. continuously monitors and adjusts its product
offerings and pricing so that it is able to sell the loans that it originates in
the secondary markets. To that end, price quotes and product descriptions are
distributed throughout its origination network on a daily basis.
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In 1996, Mortgage Corp. implemented a program to supplement its
conventional conforming loans by offering Home Equity Loans. Mortgage Corp.'s
customers use the proceeds of Home Equity Loans to finance home purchases and
improvements, debt consolidation, education and other consumer needs.
Approximately 93.5% of the Home Equity Loans originated by Mortgage Corp. in
1998 were secured by first mortgages. In addition to originating Home Equity
Loans, the Company also operates a mortgage conduit business through its
subsidiary Capital Corp., which acquires Home Equity Loans individually and in
bulk from several independent loan origination sources.
The Home Equity Loans originated and acquired by Mortgage Corp. and Capital
Corp. are similar in nature. Home Equity Loans have repayment options and
interest rate options that are similar to the options available for conventional
conforming loans. The primary difference between Home Equity Loans and
conventional conforming loans is the underwriting guidelines that govern the two
types of loans. Various underwriting criteria are evaluated to establish
guidelines as to the amount and type of credit for which the prospective
borrower is eligible. These factors also determine the interest rate and
repayment terms to be offered to the borrower. Interest rates on Home Equity
Loans are generally in excess of rates of interest charged on agency or
conforming residential loans. The underwriting guidelines and interest rates
charged for Home Equity Loans are revised as necessary to address market
conditions, the interest rate environment, general economic conditions and other
factors. See "-- Underwriting."
Home equity line of credit ("HELOC") products are secured loans that
provide the borrower with the flexibility to access funds up to the approved
limit over the life of the loan. Both the balance and the interest rate, which
is typically tied to the bank prime rate, are variable. The balance can revolve
over a predetermined period (10-15 years). At the end of this revolving period,
the balance is frozen and becomes due and payable in the form of a balloon
payment or begins to amortize over a fixed period of time. Interest is computed
on a daily accrual basis.
Historically, through various other subsidiaries and affiliates, Mortgage
Corp. conducted business in a number of areas related to its principal mortgage
business. These businesses included property management, property appraisal and
inspections, and financial advisory services. Under management contracts, an
affiliate of Mortgage Corp. provided management and administrative services to
an insurance agency, which offers complete lines of personal, commercial and
property insurance products, and a company providing outside services for title
escrow and insurance services. None of these businesses historically contributed
a significant portion of the Company's earnings, and have been discontinued.
Loan Origination
General. Mortgage Corp. originates and acquires mortgage loans through a
direct retail group ("Direct Retail") that operates principally within Harbor,
and a broker retail group ("Broker Retail") whose activities are conducted
through New America. Mortgage Corp. believes that the Direct Retail and Broker
Retail origination channels offer distinct advantages and seeks to expand the
operations of both channels. In the Broker Retail business, customers conduct a
substantial portion of their business with an independent broker who will
present a relatively complete loan application to the Broker Retail account
executives for consideration. Broker Retail mortgage loan origination is cost
effective because it involves reduced fixed overhead costs for items such as
offices, furniture, computer equipment and telephones, or additional personnel
costs, such as loan officers and loan processors. By limiting the number of
offices and personnel needed to generate production, Mortgage Corp.'s Broker
Retail business transfers a portion of the overhead burden of mortgage
origination to the independent mortgage loan brokers. As a result, through its
Broker Retail network, Mortgage Corp. is able to match its loan origination
costs more closely with loan origination volume so that a substantial portion of
its loan origination costs are variable rather than fixed. In addition, Broker
Retail affords management the flexibility to expand or contract production
capacity as market conditions warrant. As of December 31, 1998, Broker Retail
employed 170 account executives working in 34 offices and operating in 17
states. Broker Retail account executives work with and through a group of
approximately 9,700 independent mortgage loan brokers, approximately 5,800 of
whom closed loans through the Broker Retail network in 1998.
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A customer of the Direct Retail business works with an employee of Mortgage
Corp. throughout the entire loan origination process. Direct Retail loan
origination offers the advantage of greater fee retention to compensate for
higher fixed operating costs. It also facilitates the formation of direct
relationships with customers, which tends to create a more sustainable loan
origination franchise and results in increased control over the lending process
and the refinance activity that is becoming more prevalent in the mortgage
industry. As of December 31, 1998, Direct Retail employed 150 loan officers, who
were supported by 87 loan processing staff and 185 loan underwriting staff, all
of whom are employees of Mortgage Corp. The Direct Retail group operates through
36 branches located in 11 states.
As a complement to its Direct Retail and Broker Retail businesses, the
Company operates a mortgage conduit business through Capital Corp. Capital Corp.
acquires Home Equity Loans from third-party origination sources for
securitization. Capital Corp. was formed in August 1997 and, as of December 31,
1998, had 42 employees.
Broker Retail. Mortgage Corp. entered into the Broker Retail business
through the acquisition of New America in July 1994. At the time of the
acquisition, New America had offices in Dallas, Texas and Fort Lauderdale,
Florida. Since becoming a part of Mortgage Corp., New America has expanded to
its present complement of 36 offices. Broker Retail account executives work with
and through independent mortgage loan brokers to identify lending opportunities
for the various loan products offered by Mortgage Corp.
In arranging mortgage loans, independent mortgage loan brokers act as
intermediaries between prospective borrowers and Mortgage Corp. Mortgage Corp.
is an approved FHMA, FHLMC and GNMA seller/ servicer and has access to private
investors as well, which provides brokers access to the secondary market for the
sale of mortgage loans that they otherwise could not access because they do not
meet the applicable seller/ servicer net worth requirements. Mortgage Corp.
attracts and maintains relationships with mortgage brokers by offering a variety
of competitive and responsive services as well as a variety of mortgage loan
products at competitive prices. Mortgage Corp.'s relationship with these
independent mortgage brokers differs from traditional wholesale purchases in
that Mortgage Corp. underwrites and funds substantially all of the loans funded
through the Broker Retail channel in its own name.
Separately, the Broker Retail channel conducts a whole loan pool
acquisition business. In most cases, the loans purchased in bulk are
underwritten by the seller-originator to FHA, FMHA, VA, FNMA or FHLMC
underwriting standards, with the seller warranting that such loans comply with
such standards. Mortgage Corp. employs quality review procedures prior to
purchase in an effort to ensure that the loans acquired in bulk purchases meet
such standards. See "-- Underwriting." During 1998, bulk acquisitions of loans
constituted less than 1% of Broker Retail production.
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The following table presents the number and dollar amount of Broker Retail
production, including bulk acquisitions, for the periods indicated.
BROKER RETAIL RESIDENTIAL MORTGAGE LOAN PRODUCTION
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FISCAL YEAR(1)
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1998 1997 1996
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(DOLLARS IN THOUSANDS)
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Conventional Loans:
Volume of loans........................................ $5,836,697 $2,222,232 $1,270,497
Number of loans........................................ 44,015 18,332 11,665
FHA/VA/FMHA Loans:
Volume of loans........................................ $1,093,774 $ 273,336 $ 55,917
Number of loans........................................ 9,583 2,741 632
Home Equity Loans:
Volume of loans........................................ $ 387,828 $ 178,492 $ 6,583
Number of loans........................................ 5,241 2,423 183
Total Production:
Volume of loans........................................ $7,318,299 $2,674,060 $1,332,997
Number of loans........................................ 58,839 23,496 12,480
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(1) 1996 data is for the 12 months ended September 30, the fiscal year end for
Mortgage Corp. prior to the Harbor Merger; data for all other years is for
the 12 months ended December 31.
Direct Retail. The Direct Retail group originates mortgage loans using
direct contact with consumers and operates through a network of 36 branches
located in Texas, Oklahoma, Pennsylvania, Virginia, West Virginia, Maryland,
Florida, Washington, Arizona, Colorado and Illinois. The marketing efforts of
the Direct Retail group are focused on the loan origination activities of retail
loan officers located in the branch offices. These loan officers identify
prospective customers through contacts within their local markets by developing
relationships with real estate agents, large employers, home builders,
commercial bankers, accountants, attorneys and others who would have contact
with prospective home owners seeking financing or refinancing. Over time,
successful loan officers develop a reputation for being able to provide quick
and accurate service to the customer and often generate new customers through
referrals from existing customers. The marketing efforts of the loan officers
are supported by print media advertising in selected local markets to target
prospects with featured product types or to highlight Mortgage Corp.'s broad
range of service capabilities. Mortgage Corp. has expanded its Direct Retail
network of loan officers by hiring experienced lenders in targeted markets and
by acquiring successful retail mortgage origination businesses.
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The following table presents the number and dollar amount of loan
originations through Direct Retail for the periods indicated.
DIRECT RETAIL RESIDENTIAL MORTGAGE LOAN ORIGINATIONS
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FISCAL YEAR(1)
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1998 1997 1996
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(DOLLARS IN THOUSANDS)
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Conventional Loans:
Volume of loans........................................... $ 611,437 $182,640 $162,117
Number of loans........................................... 4,903 1,425 1,374
FHA/VA/FMHA Loans:
Volume of loans........................................... $ 534,123 $319,667 $184,098
Number of loans........................................... 5,393 3,300 2,073
Home Improvement Loans:(2)
Volume of loans........................................... $ -- $ 631 $ 211
Number of loans........................................... -- 14 12
Brokered Loans:(3)
Volume of loans........................................... $ 128,622 $ 62,524 $ 19,851
Number of loans........................................... 1,042 532 99
Total Originations:
Volume of loans........................................... $1,274,182 $565,462 $366,277
Number of loans........................................... 11,338 5,271 3,558
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(1) 1996 data is for the 12 months ended September 30, the fiscal year end for
Mortgage Corp. prior to the Harbor Merger; data for all other years is for
the 12 months ended December 31.
(2) Home Improvement Loans are loans that are used by borrowers to finance
various home improvement projects and are generally secured by second liens.
(3) Brokered Loans are originated through the Direct Retail process, but are
closed and funded by a third-party correspondent.
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Characteristics of Retail Loan Production. As a result of Mortgage Corp.'s
extensive Direct Retail and Broker Retail origination networks, the portfolio of
retail mortgage loans originated by Mortgage Corp. on an annual basis is
comprised of loans with a variety of characteristics that are offered to
borrowers who are geographically dispersed. Based upon production data
maintained by Mortgage Corp., the following table sets forth, as a percentage of
aggregate principal balance, the geographic distribution and other data for the
loans originated through the retail network of Mortgage Corp. for the 12 month
periods ended December 31, 1998 and 1997.
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DECEMBER 31, DECEMBER 31,
1998 1997
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Production by State:
California................................................ 36% 23%
Texas..................................................... 8 13
Florida................................................... 7 7
Oregon.................................................... 6 7
Washington................................................ 5 7
Georgia................................................... 3 6
Arizona................................................... 4 5
All others................................................ 31 32
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Total............................................. 100% 100%
Interest rate characteristics:
Fixed rate loans.......................................... 97% 93%
Variable rate loans....................................... 3 7
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Total............................................. 100% 100%
Loan purpose:
Purchase transactions..................................... 39% 61%
Refinance transactions.................................... 61 39
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Total............................................. 100% 100%
</TABLE>
Substantially all of the retail mortgage production of Mortgage Corp. represents
loans secured by first liens on the underlying collateral.
Mortgage Conduit. The Company organized Capital Corp. in August 1997 to
acquire Home Equity Loans from third-party origination sources for
securitization. Capital Corp. acquires existing pools of Home Equity Loans in
individually negotiated transactions from approximately thirty-five approved
correspondents. From January 1 through December 31, 1998, Capital Corp. acquired
3,539 Home Equity Loans in 129 pools with principal balances totaling $312
million.
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Characteristics of Mortgage Conduit Production. The loans acquired by
Capital Corp. have been acquired from Home Equity Loan originators who originate
loans primarily on the East Coast of the United States. The following table sets
forth, as a percentage of aggregate principal balance, the geographic
distribution and other data for the portfolio of loans acquired by Capital Corp.
for 1998 and 1997.
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1998 1997(1)
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Production by state:
New York.................................................. 31% 22%
New Jersey................................................ 11 2
Pennsylvania.............................................. 7 3
Florida................................................... 7 15
Illinois.................................................. 7 11
All others (38 states).................................... 37 47
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Total............................................. 100% 100%
Interest rate characteristics:
Fixed rate loans.......................................... 71% 43%
Variable rate loans....................................... 29 57
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Total............................................. 100% 100%
Lien status:
First liens............................................... 93% 96%
Subordinate liens......................................... 7 4
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Total............................................. 100% 100%
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(1) 1997 data includes loans acquired from October, 1997 through December 31,
1997.
Underwriting
Direct Retail and Broker Retail. Loan underwriting in both the Broker
Retail and Direct Retail groups is performed on a regional basis in larger
branch locations. Substantially all Broker Retail and Direct Retail loans are
processed and individually underwritten by Mortgage Corp. personnel and are
directly funded by Mortgage Corp. Mortgage Corp. believes that having
underwriters in each market area enables these personnel to remain abreast of
changing conditions in property values, employment conditions and various other
conditions in each market. Furthermore, in order to ensure compliance with
Mortgage Corp.'s underwriting guidelines, the underwriters operate independently
of origination personnel.
Mortgage Corp.'s guidelines for underwriting conventional conforming loans
comply with the criteria employed by FHLMC and FNMA, as applicable. Mortgage
Corp.'s guidelines for underwriting FHA and FMHA insured loans and VA guaranteed
loans comply with the criteria established by these agencies. Mortgage Corp.'s
guidelines for underwriting conventional non-conforming loans are based on the
underwriting standards employed by private mortgage insurers and private
investors that purchase such loans. Mortgage Corp.'s guidelines for underwriting
Home Equity Loans are based on the underwriting standards employed by the
private and conduit investors that purchase such loans and are similar to the
underwriting standards employed by Capital Corp. for acquired Home Equity Loans.
Such private investors (i) have given Mortgage Corp. delegated underwriting
authority for approval to close and sell such loans based on policy and
guidelines established by the investor, (ii) require that the loan be
underwritten on a contract basis for the closing and sale of such loans by an
independent third party approved by the investor, typically a mortgage insurance
company, or (iii) are approved directly by the investor before closing and sale
of such loans.
Home Equity Loans are extended to borrowers who, for some reason, do not
qualify for an agency or conventional mortgage loan. In most cases, borrowers
seeking Home Equity Loans have experienced some level of historical credit
difficulty. Through a tiered underwriting system, Mortgage Corp. subjects
borrowers seeking Home Equity Loans to limits based, among other things, on the
loan-to-value ratio applicable to the particular transaction. The maximum
allowed loan-to-value ratio varies depending upon whether the collateral is
classified as a primary, secondary or investor residence. Maximum loan amounts
established for each
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classification of collateral generally do not exceed $500,000 for a primary
residence with a loan-to-value ratio of less than 80%. At the low end of the
credit spectrum for qualified Home Equity Loan borrowers, the maximum
loan-to-value ratios cannot exceed 65%, with security limited to a primary
residence and the loan amount limited to $100,000. Sub-limits within the
underwriting guidelines also place loan-to-value and borrowing amount
limitations on the Home Equity Loan based upon whether the loan is used to
acquire a home or refinance an existing loan. Through December 31, 1998,
Mortgage Corp. has sold, on a servicing released basis, substantially all of its
Home Equity Loan production.
Mortgage Conduit. Capital Corp. acquires existing Home Equity Loans from
several loan origination sources under a tiered underwriting system. Capital
Corp. acquires each loan pool in an individually negotiated transaction from the
seller after a full underwriting review of each individual loan by Capital Corp.
prior to the offer to purchase. The underwriting review is performed to
determine that the borrower on each underlying loan has a demonstrated ability
to repay the loan, to determine the quality and value of the collateral securing
the loan and to determine that the loans to be acquired meet the various
underwriting criteria for each credit grade. Generally, the underwriting grade
is a function of the prospective borrower's credit history, which, in turn, will
drive the loan-to-value relationship, the debt to income ratio, and other credit
criteria to be applied by Capital Corp. in evaluating a loan.
The following table presents, for each of Capital Corp.'s underwriting
grades, for the twelve months ended December 31, 1998, the aggregate principal
balance of loans acquired, the aggregate number of loans acquired, the weighted
average coupon rate of loans acquired, and the weighted average loan to value
for each grade.
CAPITAL CORP.'S LOAN PRODUCTION
<TABLE>
<CAPTION>
WEIGHTED AVERAGE
AGGREGATE LOAN NUMBER OF WEIGHTED AVERAGE LOAN-TO-VALUE
CAPITAL CORP.'S GRADE BALANCE LOANS COUPON RATIO
--------------------- -------------- --------- ---------------- ----------------
(DOLLARS IN
THOUSANDS)
<S> <C> <C> <C> <C>
A1..................................... $ 62,919 653 9.9% 77.5%
A2..................................... 106,026 1,103 10.2 79.2
B...................................... 74,244 888 10.7 76.3
C...................................... 47,688 638 11.3 71.0
D...................................... 21,016 257 12.4 63.1
-------- ----- ---- ----
Total or Weighted Average.... $311,893 3,539 10.6% 75.8%
======== ===== ==== ====
</TABLE>
Financing Strategy
Direct Retail and Broker Retail. Mortgage Corp. finances originated
mortgage loans primarily through its warehouse credit facilities provided by a
group of commercial bank lenders. Loans are generally held in inventory by
Mortgage Corp. pending their sale to investors or agencies. From the stage of
initial application by the borrower through the final sale of the loan, Mortgage
Corp. bears interest rate risk.
In order to offset the risk that a change in interest rates will result in
a decrease in the value of Mortgage Corp.'s current mortgage loan inventory or
its commitments to purchase or originate mortgage loans ("Committed Pipeline"),
Mortgage Corp. enters into hedging transactions. Mortgage Corp.'s hedging
policies generally require that substantially all of its inventory of
conventional conforming and agency loans and the anticipated portion of the
Committed Pipeline that Mortgage Corp. believes may close, be hedged with
forward contracts for the delivery of mortgage-backed securities ("MBS") or
options on MBS. The inventory is then used to form the MBS that will fill the
forward delivery contracts and options. Mortgage Corp. hedges its inventory and
Committed Pipeline of jumbo (generally loans in excess of $227,200) and other
non-conforming mortgage loans, by using whole-loan sale commitments to ultimate
buyers or, because such loans are ultimately sold based on a market spread to
MBS, by selling a like amount of MBS. Because the market value of the loan and
the MBS are both subject to interest rate fluctuations, Mortgage Corp. is not
exposed to
12
<PAGE> 13
significant risk and will not derive any significant benefit from changes in
interest rates on the price of the inventory net of gains or losses in
associated hedge positions.
The correlation between price performance of the hedging instruments and
the inventory being hedged is very high as a result of the similarity of the
asset and the related hedge instrument. Mortgage Corp. is exposed to
interest-rate risk to the extent that the portion of loans from the Committed
Pipeline that actually closes at the committed price is different from the
portion expected to close and hedged in the manner described. Mortgage Corp.
determines the portion of its Committed Pipeline that it will hedge based on
numerous assumptions, including composition of the Committed Pipeline, the
portion of such Committed Pipeline likely to close, the timing of such closings
and anticipated changes in interest rates. See Notes 16 and 20 to the Company's
Consolidated Financial Statements.
Mortgage Corp. customarily sells all loans that it originates or purchases.
Conventional conforming and agency loans are generally sold with the right to
service the loan retained and non-conforming loans are generally sold without
retaining the right to service the loan. Mortgage Corp. packages substantially
all of its FHA- and FMHA-insured and VA-guaranteed mortgage loans into pools of
loans. It sells these pools to national or regional broker-dealers in the form
of MBS guaranteed by GNMA. With respect to loans securitized through GNMA
programs, Mortgage Corp. is insured against foreclosure loss by the FHA or FMHA
or partially guaranteed against foreclosure loss by the VA (at present,
generally 25% to 50% of the loan, depending upon the amount of the loan).
Conventional conforming loans are also pooled by Mortgage Corp. and exchanged
for securities guaranteed by FNMA or FHLMC, which securities are then sold to
national or regional broker-dealers. Loans securitized through FNMA or FHLMC are
sold on a nonrecourse basis whereby foreclosure losses are generally the
responsibility of FNMA and FHLMC, and not Mortgage Corp. Alternatively, Mortgage
Corp. may sell FHA- and FMHA-insured and VA-guaranteed mortgage loans and
conventional conforming loans, and consistently sells its jumbo loan production
to large buyers in the secondary market (which can include national or regional
broker-dealers) on a nonrecourse basis. These loans can be sold either on a
whole-loan basis or in the form of pools backing securities which are not
guaranteed by any governmental instrumentality but which generally have the
benefit of some form of external credit enhancement, such as insurance, letter
of credit, payment guarantees or senior/subordinated structures. Substantially
all loans sold by Mortgage Corp. are sold without recourse, subject, in the case
of VA loans, to the limits of the VA guaranty described above. To date, losses
on VA loans in excess of the VA guaranty have not been material to Mortgage
Corp.
Mortgage Conduit. Capital Corp. currently finances the purchase of Home
Equity Loans utilizing a secured warehouse credit facility provided by a large
investment bank. Under this credit facility, Capital Corp. is only permitted to
finance a portion of the purchase price of loans, which are generally purchased
at a premium. The amount of purchase price in excess of that financed is paid by
cash flow from Capital Corp. or the Company. Capital Corp. is in the process of
negotiating additional warehouse credit facilities. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources."
Capital Corp. has completed two private securitizations in 1998 and will
continue to securitize substantially all of the Home Equity Loans it acquires or
originates. The predominant structure will provide for the issuance of senior
certificates to be sold to third-party investors and the issuance of R
certificates. The R certificates (or subordinated interests) evidence ownership
of all cash flows generated by the assets which comprise the security after
payments to senior certificate holders and payments to achieve certain
predetermined credit enhancement levels. To date, Capital Corp. has retained and
anticipates that it will continue to retain the R certificates.
Upon the sale of Home Equity Loans in securitization transactions, the sum
of the cash proceeds received, and the estimated present values of the
subordinated interests less the costs of securitization and the basis in the
Home Equity Loans (including origination costs) sold results in the gain
recognized at the time of the securitization transaction. The present values of
the subordinated interests to be recognized by Capital Corp. are estimated based
upon prepayment, loss and discount rate assumptions that are determined in
13
<PAGE> 14
accordance with the unique underlying characteristics of the Home Equity Loans
comprising each securitization.
Servicing
Direct Retail and Broker Retail. Historically, it is Mortgage Corp.'s
strategy to build and retain its servicing portfolio. With the exception of Home
Equity Loans, Mortgage Corp. has serviced substantially all of the mortgage
loans that it originates. Historically, Mortgage Corp. has, from time to time,
purchased bulk servicing contracts for servicing of single family residential
mortgage loans originated by other lenders. Following Mortgage Corp.'s
acquisition by the Company in July 1997, it had been the practice to retain
substantially all of the newly originated mortgage servicing rights when the
option to retain such rights existed. However, in the third quarter of 1998,
Mortgage Corp. made the strategic decision to sell its existing residential
servicing portfolio and begin selling its current production either servicing
released or on a flow basis to other mortgage servicers. This change in strategy
was based on the volatility of the servicing rights and the capital intensive
nature of the assets which requires Mortgage Corp. to finance such servicing
rights. To date the Company has sold $5.0 billion of retained servicing rights
and delivered $2.8 billion of production into flow contracts. In the future
Mortgage Corp. expects to produce and deliver all of its residential mortgage
servicing rights into flow contracts or sell such rights in a mini-bulk
environment.
To facilitate the sale and delivery of servicing rights on flow and
mini-bulk basis, Mortgage Corp. expects to maintain a servicing portfolio equal
to approximately two months of loan production. Since these servicing rights
will be sold under existing flow contracts, the age of the production will
remain relatively new and the amount in portfolio will be relatively small as
compared to historical levels. Accordingly, the risk exposure based on rate and
prepayment speed volatility should be minimized.
The following table presents certain information regarding Mortgage Corp.'s
residential servicing portfolio, including loans held for sale, as of the dates
indicated.
RESIDENTIAL SERVICING PORTFOLIO BALANCES
<TABLE>
<CAPTION>
FISCAL YEAR(1)
-------------------------------------
1998 1997 1996
----------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
FHA-insured mortgage loans...................... $ 1,482,270 $ 429,216 $ 342,694
VA-guaranteed mortgage loans.................... 873,255 266,294 178,943
Conventional mortgage loans..................... 8,188,724 4,280,315 3,234,197
Other........................................... 19,386 20,688 66,815
----------- ---------- ----------
Total residential servicing
portfolio........................... $10,563,635 $4,996,513 $3,822,649
</TABLE>
- ---------------
(1) 1996 data is as of September 30, the fiscal year end for Mortgage Corp.
prior to the Harbor Merger; data for all other years is as of December 31.
Mortgage Corp.'s contractual right to subservice approximately $4.2 billion
of residential mortgages at December 31, 1998 is included in the data presented
in the preceding table. Of the total subservicing portfolio, approximately $1.5
billion, or 36%, represents subservicing for loans in California. No other state
accounts for more than 9% of Mortgage Corp.'s subservicing portfolio. These
subservicing rights represent Mortgage Corp.'s right to service loans for which
third parties own the servicing rights. Such parties have contracted with
Mortgage Corp. to service the portfolio of loans under short-term contracts
(generally for original terms of less than five years) for a fixed dollar amount
of servicing fee per year (generally approximately $75.00 per loan per year).
14
<PAGE> 15
Mortgage Corp.'s residential servicing portfolio (excluding subserviced
loans and loans held for sale), stratified by interest rate, was as follows as
of the dates indicated:
RESIDENTIAL SERVICING PORTFOLIO
INTEREST RATE STRATIFICATION
<TABLE>
<CAPTION>
PERCENTAGE OF
PRINCIPAL
BALANCE SERVICED
------------------
AS OF FISCAL YEAR
------------------
1998 1997
------- -------
<S> <C> <C>
Under 7.0%.................................................. 19.7% 7.9%
7.0 to 7.49................................................. 22.3 15.2
7.5 to 7.99................................................. 27.4 28.1
8.0 to 8.49................................................. 15.4 22.4
8.5 to 8.99................................................. 8.4 15.0
9.0 to 9.49................................................. 1.9 3.4
9.5 to 9.99................................................. 2.4 4.0
10% and over................................................ 2.5 4.0
----- -----
Total residential servicing portfolio............. 100.0% 100.0%
===== =====
</TABLE>
At December 31, 1998 and 1997, 96% and 92% of the principal balance of
loans in the servicing portfolio bore interest at fixed rates and 4% and 8%,
respectively, bore interest at adjustable rates. The weighted average servicing
fee of the portfolio was 0.36% and 0.34% of the principal balance of serviced
loans at December 31, 1998 and 1997, respectively.
The following table presents the geographic distribution of Mortgage
Corp.'s residential servicing portfolio (excluding subserviced loans), as of the
dates indicated.
RESIDENTIAL SERVICING PORTFOLIO GEOGRAPHIC DISTRIBUTION
<TABLE>
<CAPTION>
PERCENTAGE OF
PRINCIPAL
BALANCE SERVICED
----------------
FISCAL YEAR
----------------
1998 1997
------ ------
<S> <C> <C>
California.................................................. 28.2% 27.8%
Texas....................................................... 15.5 17.3
Florida..................................................... 7.4 7.1
Maryland.................................................... 7.2 5.2
Washington.................................................. 4.5 6.7
Other states (none more than 5%)............................ 37.2 35.9
----- -----
Total residential servicing portfolio............. 100.0% 100.0%
===== =====
</TABLE>
15
<PAGE> 16
The following table presents, as a percentage of aggregate principal
balance, the delinquency statistics of Mortgage Corp.'s residential servicing
portfolio (excluding subserviced loans) as of the dates indicated.
RESIDENTIAL SERVICING PORTFOLIO DELINQUENCY STATISTICS
<TABLE>
<CAPTION>
FISCAL YEAR
---------------
1998 1997
------ ------
(DOLLARS IN
MILLIONS)
<S> <C> <C>
Delinquencies at period end:
30 days................................................... 3.8% 2.4%
60 days................................................... 1.1 0.5
90 days or more........................................... 1.3 0.2
------ ------
Total delinquencies......................................... 6.2% 3.1%
====== ======
Foreclosures pending........................................ 2.2% 0.7%
====== ======
Distressed portfolios only:
Total delinquencies....................................... 12.4% 7.1%
====== ======
Foreclosures pending...................................... 37.1% 4.9%
====== ======
Unpaid principal balance.................................. $222.5 $172.3
====== ======
</TABLE>
The delinquency data included in the preceding table include the results of
three distressed servicing portfolios acquired by Mortgage Corp. At December 31,
1998 and 1997, the distressed portfolios totaled approximately $222.5 and $172.3
million, respectively, of servicing, of which approximately 12.4% and 7.1%,
respectively, represented delinquent principal balances. In addition,
approximately 37.1% and 4.9% of the principal balance of these distressed
portfolios was in foreclosure at year end 1998 and 1997, respectively.
In late 1997, Mortgage Corp. initiated a trial program whereby it acquired
delinquent FHA and VA loans from other mortgage bankers' GNMA securitizations.
Mortgage Corp. has discontinued this initiative and intends to liquidate the
remaining $86 million of these assets outstanding as of December 31, 1998. These
loans are represented in the distressed portfolio statistics in the previous
table.
In order to track information on its mortgage servicing portfolio, Mortgage
Corp. utilizes a data processing system provided by Alltel Information Systems,
Inc. ("Alltel"). Alltel is one of the largest mortgage banking service bureaus
in the United States. Management believes that this system gives Mortgage Corp.
sufficient capacity to support the anticipated expansion of its residential
mortgage loan servicing portfolio. See "Risk Factors -- Reliance on Systems;
Year 2000 Issues."
Mortgage Conduit. The loans acquired by Capital Corp. to date are being
subserviced by Advanta Mortgage Corp. USA. Capital Corp. owns the servicing
rights to its loans as master servicer and assigns collection and resolution
responsibilities to a subsidiary of the Company as special servicer when its
loans reach certain stages of delinquency, thus placing the final decisions as
to collection management under the control of the Company. The Company is
exploring the viability of creating a servicing unit to bring the servicing of
Capital Corp.'s loans in-house. Such action would enable Capital Corp. and the
Company to be able to control the intensity and quality of servicing, thus
minimizing the third-party servicer risk.
Strategy
Direct Retail and Broker Retail. Mortgage Corp. intends to pursue the
following strategies in an effort to continue growth in earnings in all aspects
of its residential mortgage business:
- Reduce the servicing portfolio to that necessary to facilitate a "flow"
or "mini-bulk" sales delivery.
- Refocus efforts on production capabilities.
- Explore offering new products in the higher margin, home equity arena.
16
<PAGE> 17
- Decrease the level of capital commitment required for Mortgage Corp.
Mortgage Conduit. Capital Corp. intends to implement the following
strategies as it continues to develop and grow its mortgage conduit business:
- Form strategic relationships with selected small originators of Home
Equity Loans by extending secured warehouse lines of credit or mezzanine
loans to, or making equity investments in, such entities.
- Capitalize on the distressed asset collection experience of Commercial
Corp. to address the collection and resolution challenges inherent in
Home Equity Loan servicing.
- Expand the internal servicing platform to include all aspects of
servicing of the Home Equity Loans originated or acquired by Capital
Corp.
Commercial Mortgage Banking
Mortgage Corp.'s commercial mortgage banking business consists of
commercial loans secured by commercial real estate properties and single family
residential construction loans. The following table presents the number and
dollar amount of Mortgage Corp.'s commercial loan production for the periods
indicated.
COMMERCIAL MORTGAGE LOAN ORIGINATIONS
<TABLE>
<CAPTION>
FISCAL YEAR(1)
-----------------------------
1998 1997 1996
-------- -------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Correspondent Loans:
Volume of loans........................................... $413,692 $348,060 $35,600
Number of loans........................................... 120 86 3
Construction Loans:
Volume of loans........................................... $ 73,606 $ 65,740 $28,780
Number of loans........................................... 494 466 263
Total Loans:
Volume of loans........................................... $487,298 $413,800 $64,380
======== ======== =======
Number of loans........................................... 614 552 266
======== ======== =======
</TABLE>
- ---------------
(1) 1996 data is for the 12 months ended September 30, the fiscal year end for
Mortgage Corp. prior to the Harbor Merger; data for all other years is for
the 12 months ended December 31.
Correspondent Loan Business
Through eight offices located in California, Texas and Colorado, Mortgage
Corp. originates commercial loans that are funded by third parties for which
Mortgage Corp. serves as the correspondent. The loans are secured by
multi-family residential projects, office buildings, shopping centers and other
income producing properties. Revenues derived from Mortgage Corp.'s commercial
lending business are principally origination fees based on a percentage of the
loan amount and, in certain instances, application fees assessed at the time a
loan application is processed by Mortgage Corp. During 1998, Mortgage Corp.
generated $3.2 million in origination fees from its commercial mortgage
origination business. Mortgage Corp.'s commercial lending offices are staffed by
31 loan officers and ten servicing personnel.
Mortgage Corp. originates commercial loans in accordance with the
underwriting guidelines of its investors. These investors include life insurance
companies, commercial mortgage conduits, real estate investment trusts and
others. Commercial loans are funded by investors at closing. Mortgage Corp.
originated a substantial portion of its 1998 commercial production for a single
large insurance company. In addition, a substantial portion of its commercial
servicing portfolio consists of servicing for such company.
17
<PAGE> 18
At December 31, 1998, Mortgage Corp. serviced a portfolio of commercial
loans for 36 investors totaling approximately $1.4 billion representing 467
loans. At December 31, 1998, the commercial servicing portfolio represented
loans in 15 states with California (70%), Texas (12%), Colorado (8%) and Arizona
(3%) representing the largest concentrations of the principal balance of loans
serviced.
Commercial loans are serviced in a servicing center located in Walnut
Creek, California. Mortgage Corp. owns the rights to service its correspondent's
loans, with termination rights by the correspondent on a 30-day notice basis.
Servicing fees for such loans range from five to eight basis points per annum of
the principal balance of the loans.
Construction Loans
In 1995, Mortgage Corp. began originating for its own account and servicing
single-family residential construction loans through a construction loan
department headquartered in Houston, Texas. Mortgage Corp. is currently
evaluating the continued viability of this product. As of December 31, 1998,
there are no unfunded construction loan commitments outstanding.
Strategy
In its commercial mortgage banking business, Mortgage Corp. intends to
continue to serve its correspondent clients by sourcing opportunities through
its retail offices and its home builder clients. It is the Company's intention
to explore and develop cross-selling opportunities between the commercial
mortgage capability of Mortgage Corp. and the commercial lending business of
FirstCity Commercial Corp.
PORTFOLIO ASSET ACQUISITION AND RESOLUTION
The Company engages in the Portfolio Asset acquisition and resolution
business through its wholly owned subsidiary, FirstCity Commercial Corporation,
and its subsidiaries and affiliates ("Commercial Corp."). In the Portfolio Asset
acquisition and resolution business, Commercial Corp. acquires and resolves
portfolios of performing and nonperforming commercial and consumer loans and
other assets, which are generally acquired at a discount to Face Value.
Purchases may be in the form of pools of assets or single assets. Performing
assets are those as to which debt service payments are being made in accordance
with the original or restructured terms of such assets. Nonperforming assets are
those as to which debt service payments are not being made in accordance with
the original or restructured terms of such assets, or as to which no debt
service payments are being made. Portfolios are designated as nonperforming
unless substantially all of the assets comprising the Portfolio are performing.
Once a Portfolio has been designated as either performing or nonperforming, such
designation is not changed regardless of the performance of the assets
comprising the Portfolio. Portfolios are either acquired for Commercial Corp.'s
own account or through investment entities formed with Cargill Financial or one
or more other co-investors (each such entity, an "Acquisition Partnership"). See
"-- Portfolio Asset Acquisition and Resolution Business -- Relationship with
Cargill Financial." To date, Commercial Corp. and the Acquisition Partnerships
have acquired over $3.5 billion in Face Value of assets.
Portfolio Asset Acquisition and Resolution Business
Background
In the early 1990s large quantities of nonperforming assets were available
for acquisition from the RTC and the FDIC. Since 1993, most sellers of
nonperforming assets have been private sellers, rather than government agencies.
These private sellers include financial institutions and other institutional
lenders, both in the United States and in various foreign countries, and, to a
lesser extent, insurance companies in the United States. As a result of mergers,
acquisitions and corporate downsizing efforts, other business entities
frequently access the market served by the Company to dispose of excess real
estate property or other financial assets not meeting the strategic needs of a
seller. Sales of such assets improve the seller's balance sheet, reduce overhead
costs, reduce staffing requirements and avoid management and personnel
distractions associated with the intensive and time-consuming task of resolving
loans and disposing of real estate. Consolidations within a broad range of
industries, especially banking, have augmented the trend of financial
institutions and other
18
<PAGE> 19
sellers packaging and selling asset portfolios to investors as a means of
disposing of nonperforming loans or other surplus assets.
Portfolio Assets
Commercial Corp. acquires and manages Portfolio Assets, which are generally
purchased at a discount to Face Value by Commercial Corp. or through Acquisition
Partnerships. The Portfolio Assets are generally nonhomogeneous assets,
including loans of varying qualities that are secured by diverse collateral
types and foreclosed properties. Some Portfolio Assets are loans for which
resolution is tied primarily to the real estate securing the loan, while others
may be collateralized business loans, the resolution of which may be based
either on business or real estate or other collateral cash flow. Consumer loans
may be secured (by real or personal property) or unsecured. Portfolio Assets may
be designated as performing, nonperforming or real estate. Commercial Corp.
generally expects to resolve Portfolio Assets within three to five years after
purchase.
To date, a substantial majority of the Portfolio Assets acquired by
Commercial Corp. have been designated as nonperforming. Commercial Corp. seeks
to resolve nonperforming Portfolio Assets through (i) a negotiated settlement
with the borrower in which the borrower pays all or a discounted amount of the
loan, (ii) conversion of the loan into a performing asset through extensive
servicing efforts followed by either a sale of the loan to a third party or
retention of the loan by Commercial Corp. or (iii) foreclosure of the loan and
sale of the collateral securing the loan. Commercial Corp. generally retains
Portfolio Assets that are designated as performing for the life of the loans
comprising the Portfolio.
Commercial Corp. has substantial experience acquiring, managing and
resolving a wide variety of asset types and classes. As a result, it does not
limit itself as to the types of Portfolios it will evaluate and purchase. The
main factors determining Commercial Corp.'s willingness to acquire Portfolio
Assets include the information that is available regarding the assets in a
portfolio, the price at which such portfolio can be acquired and the expected
net cash flows from the resolution of such assets. Commercial Corp. has acquired
Portfolio Assets in virtually all 50 states, the Virgin Islands, Puerto Rico,
France, Japan and Mexico. Commercial Corp. believes that its willingness to
acquire nonhomogeneous Portfolio Assets without regard to geographical location
provides it with an advantage over certain competitors that limit their
activities to either a specific asset type or geographical location. Although
Commercial Corp. imposes no constraints on geographic locations of Portfolio
Assets, the majority of assets acquired to date have been in the Northeastern
and Southern areas of the United States.
Commercial Corp. also seeks to capitalize on emerging opportunities in
foreign markets where the market for nonperforming loans of the type generally
purchased by Commercial Corp. is less efficient than the market for such assets
in the United States. Through December 31, 1998, Commercial Corp. has acquired,
with Cargill Financial and a local French partner, five Portfolios in France,
consisting of approximately 8,000 assets, for an aggregate purchase price of
approximately $153 million. Such assets had a Face Value of approximately $649
million. Commercial Corp.'s share of the equity interest in the Portfolios
acquired in France ranges from 10% to 33 1/3% and Commercial Corp. has made a
total equity investment therein of approximately $13 million. The underlying
assets and debt are denominated in French francs and Commercial Corp.'s equity
investments are funded with a French franc line of credit, thereby mitigating
against foreign currency translation risks. Commercial Corp. does not otherwise
attempt to hedge any profits that might be derived from its equity investments.
Commercial Corp. has an established presence in Paris, France and is actively
pursuing opportunities to purchase additional pools of distressed assets in
France and other areas of Western Europe. In addition, Commercial Corp. has
established an office in a Guadalajara, Mexico and Tokyo, Japan. Commercial
Corp. has acquired a portfolio of residential mortgages in Mexico consisting of
approximately 3,000 assets for a purchase price of approximately $11 million and
a Face Value of approximately $134 million. Additionally, Commercial Corp. has
acquired a 45% interest in a group of 30 loans in Japan with a purchase price of
$2.7 million and a Face Value of approximately $110 million.
19
<PAGE> 20
The following table presents, for each of the years in the three-year
period ended December 31, 1998, selected data for the Portfolio Assets acquired
by Commercial Corp.
PORTFOLIO ASSETS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------
1998 1997 1996
-------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Face Value.................................................. $537,356 $504,891 $413,844
Total purchase price........................................ 139,691 183,229 205,524
Total equity invested....................................... 55,533 54,764 92,937
Commercial Corp. equity invested............................ $ 27,377 $ 37,109 $ 35,973
Total number of Portfolio Assets............................ 4,966 5,503 5,921
</TABLE>
Sources of Portfolio Assets
Commercial Corp. develops its Portfolio Asset opportunities through a
variety of sources. The activities or contemplated activities of expected
sellers are publicized in industry publications and through other similar
sources. Commercial Corp. also maintains relationships with a variety of parties
involved as sellers, brokers or agents for sellers. Many of the brokers and
agents concentrate by asset type and have become familiar with Commercial
Corp.'s acquisition criteria and periodically approach Commercial Corp. with
identified opportunities. In addition, repeat business referrals from Cargill
Financial or other co-investors in Acquisition Partnerships, repeat business
from previous sellers, focused marketing by Commercial Corp. and the nationwide
presence of Commercial Corp. and the Company are important sources of business.
Commercial Corp. has identified and seeks to continue to identify foreign
partners that have contacts within each foreign market and can bring Commercial
Corp. Portfolio Asset opportunities. Commercial Corp. expects that it will only
pursue acquisitions in foreign markets in conjunction with a local foreign
partner. Commercial Corp. has in the past pursued, and expects in the
foreseeable future to pursue, foreign acquisition opportunities in markets where
Cargill Financial has a presence.
Asset Analysis and Underwriting
Prior to making an offer to acquire any Portfolio, Commercial Corp.
performs an extensive evaluation of the assets that comprise the Portfolio. If,
as is often the case, the Portfolio Assets are nonhomogeneous, Commercial Corp.
will evaluate all individual assets determined to be significant to the total of
the proposed purchase. If the Portfolio Assets are homogenous in nature, a
sample of the assets comprising the Portfolio is selected for evaluation. The
evaluation of an individual asset generally includes analyzing the credit and
collateral file or other due diligence information supplied by the seller. Based
upon such seller-provided information, Commercial Corp. will undertake
additional evaluations of the asset which, to the extent permitted by the
seller, will include site visits to and environmental reviews of the property
securing the loan or the asset proposed to be purchased. Commercial Corp. will
also analyze relevant local economic and market conditions based on information
obtained from its prior experience in the market or from other sources, such as
local appraisers, real estate principals, realtors and brokers.
The evaluation further includes an analysis of an asset's projected cash
flow and sources of repayment, including the availability of third party
guarantees. Commercial Corp. values loans (and other assets included in a
portfolio) on the basis of its estimate of the present value of estimated cash
flow to be derived in the resolution process. Once the cash flow estimates for a
proposed purchase and the financing and partnership structure, if any, are
finalized, Commercial Corp. can complete the determination of its proposed
purchase price for the targeted Portfolio Assets. Purchases are subject to
purchase and sale agreements between the seller and the purchasing affiliate of
Commercial Corp.
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Servicing
After a Portfolio is acquired, Commercial Corp. assigns it to an account
servicing officer who is independent of the officer that performed the due
diligence evaluation in connection with the purchase of the Portfolio. Portfolio
Assets are serviced either at the Company's headquarters or in one of Commercial
Corp.'s other offices. Commercial Corp. generally establishes servicing
operations in locations in close proximity to significant concentrations of
Portfolio Assets. Most of such offices are considered temporary and are reviewed
for closing after the assets in the geographic region surrounding the office are
substantially resolved. The assigned account servicing officer develops a
business plan and budget for each asset based upon an independent review of the
cash flow projections developed during the investment evaluation, a physical
inspection of each asset or the collateral underlying the related loan, local
market conditions and discussions with the relevant borrower. Budgets are
periodically reviewed and revised as necessary. Commercial Corp. employs loan
tracking software and other operational systems that are generally similar to
systems used by commercial banks, but which have been enhanced to track both the
collected and the projected cash flows from Portfolio Assets.
To date, the net present value of Commercial Corp.'s cash flows from
serviced assets has exceeded initial projections. Because of this success,
Commercial Corp. has been able to structure securitization and structured
financing transactions based upon cash flow projections expected to be derived
from Portfolio Assets. The basis for such transactions differs from traditional
securitization structures in which the execution levels are predicated upon the
existence of an underlying contractual stream of cash flows from periodic
payments on underlying loans. Transactions completed by Commercial Corp. to date
have been based not only on the cash flow from performing assets but also the
projected cash flows from nonperforming assets such as unoccupied real estate
and raw land parcels. Commercial Corp. believes that its success in predicting
cash flows from Portfolio Assets has permitted it to access the securitization
markets on attractive terms.
Commercial Corp. services all of the Portfolio Assets owned for its own
account, all of the Portfolio Assets owned by the Acquisition Partnerships and,
to a very limited extent, Portfolio Assets owned by related third parties. In
connection with the Acquisition Partnerships, Commercial Corp. earns a servicing
fee of between 3% and 8% of gross cash collections generated in the Acquisition
Partnerships rather than a periodic management fee based on the Face Value of
the asset being serviced. In some cases a portion of the servicing fee may be
deferred until certain thresholds have been met. The rate of servicing fee
charged is a function of the average Face Value of the assets within each pool
being serviced (the larger the average Face Value of the assets in a Portfolio,
the lower the fee percentage within the prescribed range).
Structure and Financing of Portfolio Asset Purchases
Portfolio Assets are acquired for the account of a subsidiary of Commercial
Corp. and through the Acquisition Partnerships. Portfolio Assets owned directly
by a subsidiary of Commercial Corp. are financed with cash contributed by
Commercial Corp. and secured senior debt that is recourse only to such
subsidiary.
Each Acquisition Partnership is a separate legal entity, generally formed
as a limited partnership. Commercial Corp. and an investor typically form a
corporation to serve as the corporate general partner of each Acquisition
Partnership. Generally, Commercial Corp. and the investor each own 50% of the
general partner and a 49% limited partnership interest in the Acquisition
Partnership (the general partner owns the other 2% interest). Cargill Financial
or its affiliates are the investor in the vast majority of the Acquisition
Partnerships currently in existence. See "-- Relationship with Cargill
Financial." Certain institutional investors have also held limited partnership
interests in the Acquisition Partnerships and may hold interests in the related
corporate general partners. Acquisition Partnerships may also be formed as a
trust, corporation or other type of entity.
The Acquisition Partnerships generally are financed by debt secured only by
the assets of the individual entity and are nonrecourse to the Company,
Commercial Corp., its co-investors and the other Acquisition Partnerships.
Commercial Corp. believes that such legal structure insulates it, the Company
and the other Acquisition Partnerships from certain potential risks, while
permitting Commercial Corp. to share in the economic benefits of each
Acquisition Partnership. Prior to the Merger, a significant portion of the
funding for
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each Acquisition Partnership was provided in the form of subordinated debt
provided by Cargill Financial. Because the Merger increased the capital
available to Commercial Corp., the need for subordinated debt has been
substantially eliminated, enabling Commercial Corp. to commit a larger portion
of its own funds to the Acquisition Partnerships. In addition, the Merger has
enhanced Commercial Corp.'s capacity to invest in Portfolios without the
participation of an investment partner.
Senior secured acquisition financing currently provides the majority of the
funding for the purchase of Portfolios. Commercial Corp. and the Acquisition
Partnerships have relationships with a number of senior lenders. Senior
acquisition financing is obtained at variable interest rates ranging from LIBOR
to prime based pricing with negotiated spreads to the base rates. The final
maturity of the senior secured acquisition debt is normally two years from the
date of funding of each advance under the facility. The terms of the senior
acquisition debt of the Acquisition Partnerships generally allow, under certain
conditions, distributions to equity partners before the debt is repaid in full.
Prior to maturity of the senior acquisition debt, the Acquisition
Partnerships typically refinance the senior acquisition debt with long-term debt
secured by the assets of partnerships or transfer assets from the Portfolios to
special purpose entities to effect structured financings or securitization
transactions. Such long-term debt generally accrues interest at a lower rate
than the senior acquisition debt, has collateral terms similar to the senior
acquisition debt, and permits distributions of excess cash flow generated by the
partnership to the equity partners so long as the partnership is in compliance
with applicable financial covenants.
Relationship with Cargill Financial
Cargill Financial, a diversified financial services company, is a wholly
owned subsidiary of Cargill, Incorporated, which is generally regarded as one of
the world's largest privately-held corporations and has offices worldwide.
Cargill Financial and its affiliates provide significant debt and equity
financing to the Acquisition Partnerships. In addition, Commercial Corp.
believes its relationship with Cargill Financial significantly enhances
Commercial Corp.'s credibility as a purchaser of Portfolio Assets and
facilitates its ability to expand into other businesses and foreign markets.
Under a Right of First Refusal Agreement and Due Diligence Reimbursement
Agreement effective as of January 1, 1998 (the "Right of First Refusal
Agreement") among the Company, FirstCity Servicing Corporation, Cargill
Financial and its wholly owned subsidiary CFSC Capital Corp. II ("CFSC"), if the
Company receives an invitation to bid on or otherwise obtains an opportunity to
acquire interests in domestic loans, receivables, real estate or other assets in
which the aggregate amount to be bid exceeds $4 million, the Company is required
to follow a prescribed notice procedure pursuant to which CFSC has the option to
participate in the proposed purchase by requiring that such purchase or
acquisition be effected through an Acquisition Partnership formed by the Company
and Cargill Financial (or an affiliate). The Right of First Refusal Agreement
does not prohibit the Company from holding discussions with entities other than
CFSC regarding potential joint purchases of interests in loans, receivables,
real estate or other assets, provided that any such purchase is subject to
CFSC's right to participate in the Company's share of the investment. The Right
of First Refusal Agreement further provides that, subject to certain conditions,
CFSC will bear 50% of the due diligence expenses incurred by the Company in
connection with proposed asset purchases. The Right of First Refusal Agreement
terminates on January 1, 2001.
Business Strategy
Historically, Commercial Corp. has leveraged its expertise in asset
resolution and servicing by investing in a wide variety of asset types across a
broad geographic scope. Commercial Corp. continues to follow this investment
strategy and seeks expansion opportunities into new asset classes and geographic
areas when it believes it can achieve attractive risk adjusted returns. The
following are the key elements of Commercial Corp.'s business strategy in the
portfolio acquisition and resolution business:
- Niche markets. Commercial Corp. will continue to pursue profitable
private market niches in which to invest. The niche investment
opportunities that Commercial Corp. has pursued to date include (i) the
acquisition of improved or unimproved real estate, including excess
retail sites and, (ii) periodic
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purchases of single financial or real estate assets from banks and other
financial institutions with which Commercial Corp. has established
relationships, and from a variety of other sellers that are familiar with
the Company's reputation for acting quickly and efficiently.
- Emphasis on smaller Portfolios. Generally, Commercial Corp. seeks
purchases of Portfolio Assets with a purchase price of less than $100
million in order to avoid large portfolio offerings that attract larger
institutional purchasers and hedge funds, which have lower threshold
return requirements and lower funding costs than Commercial Corp.
- Foreign markets. Commercial Corp. believes that the foreign markets for
distressed assets are less developed than the U.S. market, and therefore
provide a greater opportunity to achieve attractive risk adjusted
returns. Commercial Corp. has purchased Portfolio Assets in France, Japan
and Mexico expects to continue to seek purchase opportunities outside of
the United States.
Commercial Lending Opportunities
Commercial Corp.'s extensive experience in the asset acquisition and
resolution business has led to numerous opportunities to originate commercial
loans. In most cases, the prospective borrower was unwilling or unable to meet a
traditional lenders' requirements or found that a traditional lender could not
or would not be responsive within a short time frame. In some cases, the
prospective borrower was already aware of Commercial Corp.'s familiarity and
comfort with a particular type of collateral, such as lodging properties, small
commercial real estate developments, franchisee properties or small multi-family
projects. In Commercial Corp.'s view, its extensive experience in servicing
difficult distressed asset credits qualifies it to originate, and service
commercial loans.
Commercial Corp. expects that it will continue to analyze commercial
lending opportunities as they arise. In some cases, the opportunity might be a
unique and defined lending opportunity. In others, an attractive opportunity
would be characterized by a flow of lending opportunities, such as in the
factoring business. Commercial Corp. will also entertain the opportunity to
joint venture with businesses already in the targeted business activity but
which need additional capital or funding and the servicing expertise of
Commercial Corp.
CONSUMER LENDING
The Company conducts all of its consumer receivable origination activities
through FirstCity Consumer Lending Corporation and its subsidiaries ("Consumer
Corp."). Consumer Corp.'s current focus is on the origination and servicing of
sub-prime consumer loans. Such loans are extended to borrowers who evidence an
ability and willingness to repay credit, but have experienced an adverse event,
such as a job loss, illness or divorce, or have had past credit problems, such
as delinquency, bankruptcy, repossession or charge-offs. The significant
majority of Consumer Corp.'s current business is focused on the sub-prime
automobile sector, with each loan funded after individual underwriting and
pricing of each proposed extension of credit.
Market Background
The sub-prime automobile finance business has been characterized by several
factors that the Company believes increase its likelihood of being able to build
a successful sub-prime automobile finance business. Within the past several
years, significant amounts of new capital have become available, thereby
allowing a large number of new market participants to originate loans to
sub-prime automobile borrowers. This increase in competition led to reduced
credit underwriting standards and lower dealer discounts as lenders sought to
maintain earnings by increasing loan origination levels. In the Company's view,
too little attention was paid to both the importance of matching the discount to
the expected loss per occurrence and the special effort required to service a
sub-prime automobile loan. Because of many notable failures, especially among
undiversified automobile finance businesses, the Company believes that the
opportunity now exists to increase market share by providing a fully
underwritten loan product that utilizes risk-adjusted pricing to franchised
automobile dealerships that seek a steady source of funding supported by
meaningful and responsive service.
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Consumer Corp. Background
Through its Portfolio Asset acquisition and resolution business, the
Company has acquired approximately $718 million in Face Value of distressed
consumer loans. In addition, through its wholly owned subsidiary, FirstCity
Servicing Corporation of California ("Consumer Servicing") the Company has
extensive experience in the servicing of distressed sub-prime automobile loans.
The Company's initial venture into the sub-prime automobile market involved
the acquisition of a distressed sub-prime automobile loan portfolio from a
secured lender. In addition to acquiring the distressed loans, the Company
acquired the equity of the company that operated the program through which the
loans had been originated. This program involved the indirect acquisition of
automobile loans from financial intermediaries that had direct contact with
automobile dealerships. The Company was required to purchase loans that
satisfied minimum contractual underwriting standards and was not permitted to
negotiate purchase discounts for a loan based on the individual risk profile of
the loan and the borrower. After operating this program for approximately 15
months, the Company concluded that the contractual underwriting standards and
purchase discounts on which the program was based were insufficient to generate
sub-prime automobile loans of acceptable quality to the Company. As a result,
the Company terminated its obligations with the financial institutions
participating in such origination program effective as of January 31, 1998.
With the benefit of the experience gained by the Company through its
initial attempt at originating acceptable sub-prime automobile loans, the
Company began, in early 1997, to explore other business models that it felt
would be successful in the current market environment. This investigation and
research resulted in the formation, during the third quarter of 1997, of
FirstCity Funding Corporation ("Funding Corp."), 80% of which is owned by the
Company and 20% of which is owned by Funding Corp.'s management team. Funding
Corp.'s management team is experienced in the automobile finance business, with
significant prior experience in the sales and finance activities of franchised
dealerships. Funding Corp.'s business model is predicated upon the acquisition
of newly originated sub-prime automobile finance contracts at a price that is
adjusted to reflect the expected loss per occurrence on defaulted contracts. The
approach emphasizes service to the dealership and a steady source of funding for
contracts that meet Funding Corp.'s underwriting and pricing criteria. In
addition, all loans are serviced by Consumer Servicing, which is dedicated
exclusively to the servicing of consumer loans originated or acquired by
Consumer Corp.
Consumer Corp. and the management shareholders of Funding Corp. entered
into a shareholders' agreement in connection with the formation of Funding Corp.
in September 1997. Commencing on the fifth anniversary of such agreement,
Consumer Corp. and the management shareholders have put and call options with
respect to the stock of Funding Corp. held by the other party, which will be
priced at a mutually agreed upon fair market value.
Product Description
Consumer Corp. currently acquires and originates loans, secured by
automobiles, to borrowers who have had past credit problems or have little or no
credit experience. Such loans are individually underwritten to Consumer Corp.'s
underwriting and credit guidelines. See "-- Loan Acquisition and Underwriting."
The collateral for the loan generally is a used automobile purchased from a
franchised automobile dealership. The loans generally have a term of no more
than 60 months and generally accrue interest at the maximum rate allowed by
applicable state law.
Origination Channels
Through a sales staff managed by professionals with an extensive automobile
dealership background, Funding Corp. markets its loan products and dealership
services directly to participating franchised automobile dealerships. Funding
Corp. currently maintains approximately 704 automobile dealership relationships
in California, Georgia, Kansas, Missouri, North Carolina, Oklahoma, South
Carolina and Texas. Near term plans call for expansion into other states as
staffing levels, licensing and training permit. Funding Corp. is targeting
expansion into states that offer attractive opportunities due to population
growth, attractive consumer
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lending rate environments and lender-friendly repossession and collection
remedies with respect to defaulting borrowers.
The dealership servicing and marketing staff of Funding Corp. consists of
ten marketing representatives who work with dealers that submit funding
applications to Funding Corp. These marketing representatives call upon new
dealership prospects within the current marketing territories and work with
existing dealerships to solicit additional loan acquisition opportunities. All
of the marketing staff are full time employees of Funding Corp. and have
completed an extensive training program. In addition to the initial training,
weekly updates with the marketing representatives and monthly meetings for the
entire staff are held to maintain current knowledge of the dealership programs
and product offerings.
Participating dealerships submit funding applications for each prospective
loan to Funding Corp.'s home office in Dallas, Texas. Applications are reviewed
and checked for completeness and all complete applications are forwarded to a
credit analyst for review. Within two hours after receipt of an application, a
representative of Funding Corp. will notify the dealership of the terms on which
it would acquire the loan, subject to confirmation of the application data. See
"-- Loan Acquisition and Underwriting." The geographic dispersion of loans
acquired by Funding Corp. during 1998, is displayed in the following table:
<TABLE>
<CAPTION>
FISCAL YEAR 1998
----------------
<S> <C>
</TABLE>
<TABLE>
Texas. % 62
<S> <C>
California.................................................. 16
Oklahoma.................................................... 9
North Carolina.............................................. 6
Other states................................................ 7
---
Total loan production............................. 100%
===
</TABLE>
In addition to Funding Corp.'s operations, FirstCity Consumer Finance
Corporation ("Consumer Finance"), a wholly owned subsidiary of Consumer Corp.,
originates loans with borrowers who have established payment records on recently
originated automobile receivables through direct marketing to the consumer.
Through contractual relationships with third parties, Consumer Finance
identifies loan prospects for underwriting, documentation and funding upon final
approval of a request for credit. The activities of Consumer Finance are not
significant to date, with 50 loans having an aggregate principal balance of
approximately $900,000 outstanding at December 31, 1998.
Loan Acquisition and Underwriting
Funding Corp. acquires sub-prime automobile loans originated by franchised
dealerships under a tiered pricing system. Under its pricing and underwriting
guidelines, each loan is purchased in an individually negotiated transaction
from the selling dealership only after it has been fully underwritten and
independently verified by Funding Corp. A staff of 49 credit and compliance
personnel in Funding Corp.'s home office completes the underwriting and due
diligence for each funding application. During the compliance phase of the
underwriting review, Funding Corp. verifies all pertinent information on a
borrower's credit application, including verification of landlord information
for borrowers without a mortgage. As an additional check on the quality of the
prospective loan, each borrower is personally contacted by Funding Corp. prior
to the acquisition of the loan. At such time, all of the details of the proposed
transaction are confirmed with the borrower, including the borrower's level of
satisfaction with the purchased vehicle.
Each transaction is individually priced to achieve a risk-adjusted target
purchase price, which is expressed as a percentage of the unpaid principal
balance of the loan. The tiered pricing structure of Funding Corp. is designed
as a guideline for establishing minimum underwriting and pricing standards for
the loans to be acquired. The minimum amount of the discount from par for the
four tiers ranges from no discount for Tier 1 loans to a 10% discount for Tier 4
loans. Funding Corp.'s underwriting standards do not permit the purchase of a
loan for more than its unpaid principal balance. Other factors impacting the
tier level of a loan include, but
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are not limited to, prior credit history, repossession and bankruptcy history,
open credit account status, income minimums, down payment requirements, payment
ratio tests and the contract advance amount as a percentage of the wholesale
value of the collateral vehicle. The purpose of the tiered underwriting and
pricing structure is to acquire loans that are priced in accordance with risk
characteristics and the underlying value of the collateral. The process is
designed to approve loan applications for borrowers who are likely to pay as
agreed, and to minimize the risk of loss on the disposition of the underlying
collateral in the event that a default occurs.
The following table depicts the 1998 loan characteristics by tier:
<TABLE>
<CAPTION>
TIER
------------------------------------------------
1 2 3 4 TOTAL
------- ------- ------- ------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Amount funded....................... $17,499 $26,795 $27,129 $46,771 $118,194
Number of loans..................... 1,158 1,917 2,050 3,778 8,903
Loan to Value....................... 100.8% 100.2% 99.2% 99.6% 99.8%
Purchase discount................... 10.7% 13.1% 14.9% 15.8% 14.2%
Weighted average coupon............. 19.0% 19.1% 19.2% 19.2% 19.2%
Term of loan (in months)............ 53.5 52.2 51.3 50.3 51.4
Total down payment percentage....... 18.8% 18.5% 19.4% 20.6% 19.6%
</TABLE>
Funding Corp. seeks to acquire loans that have the following
characteristics:
- Loans originated by a franchised dealership of new automobiles
- Loans secured by automobiles that have established resale values and a
targeted age of approximately two years
- The borrower has made a substantial down payment on the automobile, which
evidences a significant equity commitment
- The loan is underwritten to provide a debt to income ratio permitting the
borrower to comfortably afford the monthly payments
- The borrower evidences a tendency toward repairing impaired credit
- Funding Corp.'s purchase price of the contract from the dealership is
less than the published wholesale value of the automobile
The average automobile financed by Funding Corp. through December 31, 1998
was two years old with approximately 29,000 miles. The average contractual
repayment term for the loans acquired by Funding Corp. was 51 months. The ratio
of the borrower's monthly debt service amount to the borrower's monthly gross
income was, on average, equal to 11.3%.
Financing Strategy
Funding Corp. financed its operations with a warehouse credit facility
provided by ContiTrade Services L.L.C. ("ContiTrade"), in connection with which
ContiFinancial Services Corporation, an affiliate of ContiTrade, had the right
to provide advisory and placement services to Funding Corp. for the
securitization of acquired loans. Funding Corp. has negotiated a new $100
million facility with Enterprise Funding Corporation, an affiliate of
NationsBank, N.A., to replace the ContiTrade warehouse facility. This new
facility is insured by Mortgage Bankers Insurance Association and will be
effective April 1, 1999. Funding Corp. plans to provide permanent financing for
its acquired consumer loans through securitizations of pools of loans totaling
between $40 and $100 million pursuant to an investment management agreement with
NationsBank Montgomery Securities.
The securitization transactions are expected to be consummated through the
creation of special purpose trusts. The loans will be transferred to a trust in
exchange for certificates representing the senior interest in the
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securitized loans held by the trust and, if applicable, a subordinated interest
in the securitized loans. The subordinated interests generally consist of the
excess spread between the interest and principal paid by the borrowers on the
loans pooled in the securitization and the interest and principal of the senior
interests issued in the securitization, and other unrated interests issued in
the securitization. The senior interests are subsequently sold to investors for
cash. Consumer Corp. may elect to retain the subordinated interests or may sell
all or some portion of the subordinated interests to investors for cash.
Consumer Corp. anticipates that it will retain the rights to the excess spreads.
Upon the sale of loans in securitization transactions, the sum of the cash
proceeds received and the estimated present values of the subordinated interests
less the costs of origination and securitization and the basis in the loans sold
results in the gain recognized at the time of the securitization transaction.
The present values of the subordinated interests to be recognized by Consumer
Corp. are to be estimated based upon prepayment, loss and discount rate
assumptions that will be determined in accordance with the unique underlying
characteristics of the loans comprising each securitization.
Servicing
Consumer Servicing, an indirect wholly owned subsidiary of the Company, is
responsible for the loan accounting, collection, payment processing, locating
past due borrowers and recovery activities associated with the Company's
consumer lending activities. Consumer Servicing has extensive experience in
servicing automobile loans and the Company believes that Consumer Servicing is a
critical element to the Company's ultimate success in the consumer loan
business. Consumer Servicing's activities are closely integrated with the
activities of Consumer Corp. This enables Consumer Servicing to take advantage
of the information regarding the quality of originated credit that is available
from a servicer in order to assist in the evaluation and modification of product
design and underwriting criteria.
The staffing of Consumer Servicing consists of 106 personnel, including 69
assigned to customer service and collections and 23 assigned to the special
recovery activities associated with assignments for repossession through the
liquidation of the collateral (in addition to three individuals at Funding Corp.
who work in asset liquidation). This group also coordinates any contract
reinstatements, notices of intent to dispose of collateral and recovery of any
insurance, warranty or other premium payments subject to recovery in the event
of cancellation. An additional staff of seven personnel is dedicated to asset
recovery, which includes tracing of individuals who cannot be located, seeking
to collect on deficiencies, managing the storage of repossessed vehicles prior
to their disposition and physical damage claims on collateral vehicles. An
administrative staff handles the special issues associated with borrowers in
bankruptcy and the more complicated issues associated with contracts involved in
other legal disputes.
The servicing practices associated with sub-prime loans are extensive. For
example, Consumer Servicing personnel contact each borrower three days prior to
the payment due date during each of the first three months of the contract. This
process assists in avoiding first payment defaults and confirms that the
customer can be located. If a borrower is delinquent in payment, an attempt to
contact the borrower is made on the first day of delinquency. Continual contact
is attempted until the borrower is located and payment is made, or a commitment
is made to bring the contract current. If the borrower cannot be contacted, the
account may be assigned to Consumer Servicing's asset recovery staff.
If the borrower does not meet a payment commitment and has not indicated a
verifiable and reasonable intention to bring the loan current, the account is
assigned to outside agents for repossession at the thirty-third day of
delinquency. At such time, the borrower has missed two payments and has not
indicated a willingness to enter into a repayment plan. After the collateral is
repossessed, the borrower has a limited opportunity to reinstate the obligation
under applicable state law by bringing the payment current and reimbursing
Consumer Servicing for its repossession expenses. If the loan is not reinstated
within the reinstatement period, the collateral is sold by the asset liquidation
group. Funding Corp. disposes of repossessed automobiles at auction after a
thorough inspection and detailing. A representative of Funding Corp. generally
will attend the auction to represent Funding Corp. and ensure that the
automobile is properly represented by the auction firm.
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Strategy
The Company continues to evaluate a number of business opportunities in the
consumer sector, which have the capability of generating or acquiring consumer
loans that represent identifiable and predictable credit quality and whose
return thresholds match or exceed those targeted by the Company. These include
secured consumer loan products and certain aspects of direct and indirect
unsecured consumer lending. Through contacts with investment banks, business
brokers and others in the consumer lending field, the Company seeks acquisition
or merger candidates or qualified management teams with which to associate in
start-up ventures. As with other aspects of its business, the Company seeks to
be opportunistic in targeting additional consumer lending opportunities.
GOVERNMENT REGULATION
Many aspects of the Company's business are subject to regulation,
examination and licensing under various federal, state and local statutes and
regulations that impose requirements and restrictions affecting, among other
things, the Company's loan originations, credit activities, maximum interest
rates, finance and other charges, disclosures to customers, the terms of secured
transactions, collection repossession and claims handling procedures, multiple
qualification and licensing requirements for doing business in various
jurisdictions, and other trade practices.
Mortgage Banking. The Company's mortgage banking business is subject to
extensive and complex rules and regulations of, and examinations by, various
federal, state and local government authorities. These rules and regulations
impose obligations and restrictions on loan originations, credit activities and
secured transactions. In addition, these rules limit the interest rates, finance
charges and other fees that Mortgage Corp. and Capital Corp. may assess, mandate
extensive disclosure to their customers, prohibit discrimination and impose
multiple qualification and licensing obligations. Failure to comply with these
requirements may result in, among other things, demands for indemnification or
mortgage loan repurchases, certain rights of rescission for mortgage loans,
class action lawsuits, administrative enforcement actions and civil and criminal
liability. The Company believes that its mortgage banking business is in
compliance with these rules and regulations in all material respects.
Loan origination activities are subject to the laws and regulations in each
of the states in which those activities are conducted. For example, state usury
laws limit the interest rates that can be charged on loans. Lending activities
are also subject to various federal laws, including those described below.
Mortgage Corp. and Capital Corp. are subject to certain disclosure requirements
under the Federal Truth-In-Lending Act ("TILA") and the Federal Reserve Board's
Regulation Z promulgated thereunder. TILA is designed to provide consumers with
uniform, understandable information with respect to the terms and conditions of
loan and credit transactions. TILA also guarantees consumers a three day right
to cancel certain credit transactions, including loans of the type originated by
Mortgage Corp. and Capital Corp. Such three day right to rescind may remain
unexpired for up to three years if the lender fails to provide the requisite
disclosures to the consumer.
Mortgage Corp. and Capital Corp. are also subject to the High Cost Mortgage
Act ("HCMA"), which amends TILA. The HCMA generally applies to consumer credit
transactions secured by the consumer's principal residence, other than
residential mortgage transactions, reverse mortgage transactions or transactions
under an open-end credit plan, in which the loan has either (i) total points and
fees upon origination in excess of the greater of eight percent of the loan
amount or $400 or (ii) an annual percentage rate of more than ten percentage
points higher than United States Treasury securities of comparable maturity
("Covered Loans"). The HCMA imposes additional disclosure requirements on
lenders originating Covered Loans. In addition, it prohibits lenders from, among
other things, (i) originating Covered Loans that are underwritten solely on the
basis of the borrower's home equity without regard to the borrower's ability to
repay the loan and (ii) including prepayment fee clauses in Covered Loans to
borrowers with a debt-to-income ratio in excess of 50% or Covered Loans used to
refinance existing loans originated by the same lender. The HCMA also restricts,
among other things, certain balloon payments and negative amortization features.
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Mortgage Corp. and Capital Corp. are also required to comply with the Equal
Credit Opportunity Act ("ECOA") and the Federal Reserve Board's Regulation B
promulgated thereunder, the Fair Credit Reporting Act ("FCRA"), the Real Estate
Settlement Procedures Act of 1974 ("RESPA"), the Home Mortgage Disclosure Act
("HMDA") and the Federal Fair Debt Collection Procedures Act. Regulation B
restricts creditors from requesting certain types of information from loan
applicants. FCRA requires lenders, among other things, to supply an applicant
with certain disclosures concerning settlement fees and charges and mortgage
servicing transfer practices. It also prohibits the payment or receipt of
kickbacks or referral fees in connection with the performance of settlement
services. In addition, beginning with loans originated in 1994, an annual report
must be filed with the Department of Housing and Urban Development pursuant to
HMDA, which requires the collection and reporting of statistical data concerning
loan transactions.
Regulation of Sub-prime Automobile Lending. Consumer Corp.'s automobile
lending activities are subject to various federal and state consumer protection
laws, including TILA, ECOA, FCRA, the Federal Fair Debt Collection Practices
Act, the Federal Trade Commission Act, the Federal Reserve Board's Regulations B
and Z, and state motor vehicle retail installment sales acts and other similar
laws that regulate the origination and collection of consumer receivables and
impact Consumer Corp.'s business. These laws, among other things, (i) require
Consumer Corp. to obtain and maintain certain licenses and qualifications, (ii)
limit the finance charges, fees and other charges on the contracts purchased,
(iii) require Consumer Corp. to provide specific disclosures to consumers, (iv)
limit the terms of the contracts, (v) regulate the credit application and
evaluation process, (vi) regulate certain servicing and collection practices,
and (vii) regulate the repossession and sale of collateral. These laws impose
specific statutory liabilities upon creditors who fail to comply with their
provisions and may give rise to defenses to the payment of the consumer's
obligation. In addition, certain of the laws make the assignee of a consumer
installment contract liable for the violations of the assignor.
Each dealer agreement contains representations and warranties by the dealer
that, as of the date of assignment, the dealer has complied with all applicable
laws and regulations with respect to each contract. The dealer is obligated to
indemnify Consumer Corp. for any breach of any of the representations and
warranties and to repurchase any non-conforming contracts. Consumer Corp.
generally verifies dealer compliance with usury laws, but does not audit a
dealer's full compliance with applicable laws. There can be no assurance that
Consumer Corp. will detect all dealer violations or that individual dealers will
have the financial ability and resources either to repurchase contracts or
indemnify Consumer Corp. against losses. Accordingly, failure by dealers to
comply with applicable laws, or with their representations and warranties under
the dealer agreement, could have a material adverse effect on Consumer Corp.
If a borrower defaults on a contract, Consumer Corp., as the servicer of
the contract, is entitled to exercise the remedies of a secured party under the
Uniform Commercial Code (the "UCC"), which typically includes the right to
repossession by self-help unless such means would constitute a breach of peace.
The UCC and other state laws regulate repossession and sales of collateral by
requiring reasonable notice to the borrower of the date, time and place of any
public sale of collateral, the date after which any private sale of the
collateral may be held and the borrower's right to redeem the financed vehicle
prior to any such sale, and by providing that any such sale must be conducted in
a commercially reasonable manner.
The Company believes that it is in compliance with applicable government
regulations, relating to all aspects of the Company's lending activities,
including its loan origination activities, consumer credit transactions and
subprime automobile lending.
COMPETITION
All of the business lines in which the Company operates are highly
competitive. Some of the Company's principal competitors in certain of its
businesses are substantially larger and better capitalized than the Company.
Because of these resources, these companies may be better able than the Company
to obtain new customers for mortgage or other loan production, to acquire
Portfolio Assets, to pursue new business opportunities or to survive periods of
industry consolidation.
29
<PAGE> 30
The Company encounters significant competition in its mortgage banking
business. Mortgage Corp. competes with other mortgage banking companies,
mortgage and servicing brokers, commercial banks, savings associations, credit
unions, other financial institutions and various other lenders. A number of
these competitors have substantially greater financial resources and greater
operating efficiencies. Customers distinguish between product and service
providers in the industries in which Mortgage Corp. operates for various
reasons, including convenience in obtaining the product or service, overall
customer service, marketing and distribution channels and pricing (primarily in
the form of prevailing interest rates). Competition for Mortgage Corp. is
particularly affected by fluctuations in interest rates. During periods of
rising interest rates, competitors of Mortgage Corp. who have locked into lower
borrowing costs may have a competitive advantage. During periods of declining
rates, competitors may solicit Mortgage Corp.'s customers to refinance their
loans.
The Company believes that it is one of the largest, independent,
full-service companies in the distressed asset business. There are, however, no
published rankings available, because many of the transactions that would be
used for ranking purposes are with private parties. Generally, there are three
aspects of the distressed asset business: due diligence, principal acquisition
activities, and servicing. The Company is a major participant in all three
areas, whereas certain of its competitors (including certain securities and
banking firms) have historically competed primarily as portfolio purchasers, as
they have customarily engaged other parties to conduct due diligence on
potential portfolio purchases and to service acquired assets, and certain other
competitors (including certain banking and other firms) have historically
competed primarily as servicing companies.
The Company believes that its ability to acquire Portfolios for its own
account and through Acquisition Partnerships will be an important aspect of the
Company's overall future growth. Acquisitions of Portfolios are often based on
competitive bidding, which involves the danger of bidding too low (which
generates no business), or bidding too high (which could win the Portfolio at an
economically unattractive price).
The sub-prime automobile finance market is highly fragmented and very
competitive. There are numerous financial services companies serving, or capable
of serving, this market, including traditional financial institutions such as
banks, savings and loans, credit unions, and captive finance companies owned by
automobile manufacturers, and other non-traditional consumer finance companies,
many of which have significantly greater financial and other resources than the
Company.
The Company also encounters significant competition in its other
businesses. Within the Home Equity Loan securitization businesses, access to and
the cost of capital are critical to the Company's ability to compete. Many of
the Company's competitors have superior access to capital sources and can
arrange or obtain lower cost of capital for customers.
EMPLOYEES
The Company had 1,918 employees as of December 31, 1998. No employee is a
member of a labor union or party to a collective bargaining agreement. The
Company believes that its employee relations are good.
ITEM 2. PROPERTIES.
FirstCity leases all its office locations. FirstCity leases its current
headquarters building from a related party under a noncancellable operating
lease which calls for monthly payments of $7,500 through its expiration in
December 2001. All leases of the other offices of FirstCity and its subsidiaries
expire prior to 2006.
ITEM 3. LEGAL PROCEEDINGS.
Periodically, FirstCity, its subsidiaries, its affiliates and the
Acquisition Partnerships are parties to or otherwise involved in legal
proceedings arising in the normal course of business. FirstCity does not believe
that there is any proceeding threatened or pending against it, its subsidiaries,
its affiliates or the Acquisition Partnerships which, if determined adversely,
would have a material adverse effect on the consolidated financial
30
<PAGE> 31
position, results of operations or liquidity of FirstCity, its subsidiaries, its
affiliates or the Acquisition Partnerships.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth
quarter ended December 31, 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
COMMON AND PREFERRED STOCK DATA
FirstCity's common stock, $.01 par value per share (the "Common Stock")
(FCFC), and adjusting rate preferred (FCFCO) stock are listed on the Nasdaq
National Market System. Its special preferred (FCFCP) stock was redeemed on
September 30, 1998. The number of common stockholders of record on March 24,
1999 was approximately 521. High and low stock prices and dividends for the
Common Stock, special preferred stock and adjusting rate preferred stock in 1998
and 1997 are displayed in the following table:
<TABLE>
<CAPTION>
1998 1997
--------------------------- ---------------------------
MARKET PRICE CASH MARKET PRICE CASH
--------------- DIVIDENDS --------------- DIVIDENDS
QUARTER ENDED HIGH LOW PAID HIGH LOW PAID
- ------------- ------ ------ --------- ------ ------ ---------
<S> <C> <C> <C> <C> <C> <C>
Common Stock:
March 31..................... $31.50 $27.00 $ -- $29.50 $23.00 $ --
June 30...................... 33.38 27.38 -- 27.75 20.00 --
September 30................. 29.50 12.06 -- 29.00 23.88 --
December 31.................. 15.50 10.38 -- 30.75 25.25 --
Special Preferred Stock:
March 31..................... $22.88 $21.88 $.7875 $23.88 $22.88 $.7875
June 30...................... 22.38 21.13 .7875 24.38 22.88 .7875
September 30(1).............. 22.38 20.13 1.575 24.00 21.88 .7875
December 31.................. -- -- -- 23.00 21.88 .7875
Adjusting Rate Preferred Stock:
March 31..................... $23.25 $21.75 $.7875 $ -- $ -- $ --
June 30...................... 23.88 21.50 .7875 -- -- --
September 30(2).............. 22.75 18.25 .7875 23.50 22.00 --
December 31.................. 19.00 14.69 .7875 23.00 21.00 .7875
</TABLE>
- ---------------
(1) Redeemed on September 30, 1998.
(2) Beginning August 13, 1997.
The Company has never declared or paid a dividend on the Common Stock. The
Company currently intends to retain future earnings to finance its growth and
development and therefore does not anticipate that it will declare or pay any
dividends on the Common Stock in the foreseeable future. Any future
determination as to payment of dividends will be made at the discretion of the
Board of Directors of the Company and will depend upon the Company's operating
results, financial condition, capital requirements, general business conditions
and such other factors that the Board of Directors deems relevant. The Company
Credit Facility and substantially all of the credit facilities to which the
Company's subsidiaries and the Acquisition Partnerships are parties contain
restrictions relating to the payment of dividends and other distributions.
31
<PAGE> 32
ITEM 6. SELECTED FINANCIAL DATA.
The Harbor Merger, which occurred in July 1997, was accounted for as a
pooling of interests. The Company's historical financial statements have
therefore been retroactively restated to include the financial position and
results of operations of Mortgage Corp. for all periods presented. Earnings per
share has been calculated in conformity with SFAS No. 128, Earnings Per Share,
and all prior periods have been restated.
The Selected Financial Data presented below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" under Item 7 of this Report and with the related Consolidated
Financial Statements and Notes thereto under Item 8 of this Report.
SELECTED FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
1998 1997 1996 1995 1994
---------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Income................................. $ 199,544 $129,622 $ 99,089 $ 59,965 $ 40,865
Expenses(2)............................ 220,649 109,322 73,709 43,521 32,649
Earnings (loss) before minority
interest, preferred dividends and
income taxes......................... (21,105) 20,300 25,380 16,444 8,216
Net earnings (loss).................... (20,192) 35,628 39,129 15,244 5,445
Redeemable preferred dividends......... 5,186 6,203 7,709 3,876 --
Net earnings (loss) to common
shareholders(1)...................... (25,378) 29,425 31,420 11,368 5,445
Net earnings (loss) per common share --
Basic(1)............................. (3.35) 4.51 4.83 2.18 1.32
Net earnings (loss) per common share --
Diluted(1)........................... (3.35) 4.46 4.79 2.18 1.32
Dividends per common share............. -- -- -- -- --
At year end:
Total assets......................... 1,663,977 940,119 425,189 439,051 105,812
Total notes payable.................. 1,462,231 750,781 266,166 317,189 72,843
Preferred stock...................... 26,319 41,908 53,617 55,555 --
Total common equity.................... 136,955 112,758 84,802 52,788 27,122
</TABLE>
- ---------------
(1) Includes $1.2 million, $13.6 million and $16.2 million, respectively, of
deferred tax benefits related to the recognition of benefits to be realized
from net operating loss carryforwards (NOLs) in 1998, 1997 and 1996
(2) Includes $29.3 million provision for valuation of mortgage servicing rights
in 1998
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company is a diversified financial services company engaged in
residential and commercial mortgage banking, Portfolio Asset acquisition and
resolution and consumer lending. The mortgage banking business involves the
origination, acquisition and servicing of residential and commercial mortgage
loans and the subsequent warehousing, sale or securitization of such loans
through various public and private secondary markets. The Portfolio Asset
acquisition and resolution business involves acquiring Portfolio Assets at a
discount to Face Value and servicing and resolving such Portfolios in an effort
to maximize the present value of the ultimate cash recoveries. The Company also
seeks opportunities to originate and retain high yield commercial loans to
businesses and to finance real estate projects that are unable to access
traditional lending sources. The consumer lending business involves the
acquisition, origination, warehousing, securitization and servicing of consumer
receivables. The Company's current consumer lending operations are focused on
the acquisition of sub-prime automobile receivables.
32
<PAGE> 33
As discussed in the year to year comparison, the Company reported a loss
before minority interest and preferred dividends of $20.1 million in 1998
(including a $1.2 million deferred tax benefit from recognition of NOLs)
compared to earnings of $35.8 million (including a $13.6 million deferred tax
benefit from recognition of NOLs) in 1997. Net loss to common shareholders was
$25.4 million in 1998 compared to net earnings of $29.4 million in 1997. On a
per share basis, basic net loss attributable to common shareholders was $3.35 in
1998 compared to net earnings of $4.51 in 1997. Diluted net loss per common
share was $3.35 in 1998 compared to net earnings of $4.46 ($2.40 excluding the
deferred tax benefit from recognition of NOLs) in 1997. The 1997 results reflect
the positive effect of the $6.8 million, or $1.03 per share, payment from the
Trust in settlement of the Investment Management Agreement.
The Company's financial results are affected by many factors including
levels of and fluctuations in interest rates, fluctuations in the underlying
values of real estate and other assets, and the availability and prices for
loans and assets acquired in all of the Company's businesses. The Company's
business and results of operations are also affected by the availability of
financing with terms acceptable to the Company and the Company's access to
capital markets, including the securitization markets.
The Harbor Merger, which occurred in July 1997, was accounted for as a
pooling of interests. The Company's historical financial statements have
therefore been retroactively restated to include the financial position and
results of operations of Mortgage Corp. for all periods presented. As a result
of the significant period to period fluctuations in the revenues and earnings of
the Company's Portfolio Asset acquisition and resolution business, and the rapid
growth in Mortgage Corp., period to period comparisons of the Company's results
of operations may not be meaningful.
ANALYSIS OF REVENUES AND EXPENSES
The following table summarizes the revenues and expenses of each of the
Company's business lines and presents the contribution that each business makes
to the Company's operating margin.
ANALYSIS OF REVENUES AND EXPENSES
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
----------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
MORTGAGE BANKING:
Revenues:
Net mortgage warehouse income............................. $ 7,782 $ 3,499 $ 3,224
Gain on sale of mortgage loans............................ 109,383 36,496 19,298
Servicing fees............................................ 25,537 14,732 10,079
Other..................................................... 5,298 10,999 5,019
-------- ------- -------
Total............................................. 148,000 65,726 37,620
Expenses:
Salaries and benefits..................................... 68,955 30,398 16,105
Amortization of mortgage servicing rights................. 19,110 7,550 4,091
Provision for valuation of mortgage servicing rights...... 29,305 -- --
Provision for loan losses and residual interests.......... 1,973 -- --
Interest on other notes payables.......................... 2,800 1,187 423
Occupancy, data processing, communication and other....... 46,745 20,675 11,013
-------- ------- -------
Total............................................. 168,888 59,810 31,632
-------- ------- -------
Operating contribution (loss), before direct taxes.......... $(20,888) $ 5,916 $ 5,988
======== ======= =======
Operating contribution (loss), net of direct taxes.......... $(20,977) $ 8,005 $ 3,724
======== ======= =======
</TABLE>
33
<PAGE> 34
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
----------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
PORTFOLIO ASSET ACQUISITION AND RESOLUTION:
Revenues:
Gain on resolution of Portfolio Assets.................... $ 9,208 $24,183 $19,510
Equity in earnings of Acquisition Partnerships............ 12,827 7,605 6,125
Servicing fees(1)......................................... 3,062 11,513 12,440
Other..................................................... 4,185 4,402 6,592
-------- ------- -------
Total............................................. 29,282 47,703 44,667
Expenses:
Salaries and benefits..................................... 4,619 5,353 6,002
Interest on other notes payable........................... 5,118 7,084 6,447
Asset level expenses, occupancy, data processing and
other.................................................. 7,204 12,103 10,862
-------- ------- -------
Total............................................. 16,941 24,540 23,311
-------- ------- -------
Operating contribution before direct taxes.................. $ 12,341 $23,163 $21,356
======== ======= =======
Operating contribution, net of direct taxes................. $ 12,284 $22,970 $21,210
======== ======= =======
CONSUMER LENDING:
Revenues:
Gain on sale of automobile loans.......................... $ 7,214 $ -- $ --
Interest income........................................... 10,035 10,182 3,604
Servicing fees and other.................................. 2,811 99 46
-------- ------- -------
Total............................................. 20,060 10,281 3,650
Expenses:
Salaries and benefits..................................... 5,602 2,959 698
Provision for loan losses and residual interests.......... 9,201 6,613 2,029
Interest on other notes payable........................... 3,196 3,033 1,284
Occupancy, data processing and other...................... 5,819 3,272 1,469
-------- ------- -------
Total............................................. 23,818 15,877 5,480
-------- ------- -------
Operating loss before direct taxes.......................... $ (3,758) $(5,596) $(1,830)
======== ======= =======
Operating loss, net of direct taxes......................... $ (3,758) $(5,599) $(1,830)
======== ======= =======
Total operating contribution (loss), net of direct
taxes........................................... $(12,451) $25,376 $23,104
======== ======= =======
CORPORATE OVERHEAD:
Interest income on Class A Certificate(2)................... $ -- $ 3,553 $11,601
Interest expense on senior subordinated notes............... -- -- (3,892)
Salaries and benefits, occupancy, professional and other
income and expenses, net.................................. (8,930) (5,275) (7,843)
Deferred tax benefit from NOLs.............................. 1,189 13,592 16,159
Harbor Merger related expenses.............................. -- (1,618) --
-------- ------- -------
Net earnings (loss)......................................... (20,192) 35,628 39,129
Preferred dividends......................................... (5,186) (6,203) (7,709)
-------- ------- -------
Net earnings (loss) to common shareholders.................. $(25,378) $29,425 $31,420
======== ======= =======
SHARE DATA:
Net earnings (loss) per common share -- basic............... $ (3.35) $ 4.51 $ 4.83
Net earnings (loss) per common share -- diluted............. $ (3.35) $ 4.46 $ 4.79
Weighted average common shares outstanding -- basic......... 7,584 6,518 6,504
Weighted average common shares outstanding -- diluted....... 7,584 6,591 6,556
</TABLE>
- ---------------
(1) Includes $6.8 million in 1997 as a result of terminating the Investment
Management Agreement with FirstCity Liquidating Trust.
(2) Represents dividends on preferred stock accrued or paid prior to June 30,
1997 and interest paid on outstanding senior subordinated notes.
34
<PAGE> 35
MORTGAGE BANKING
In the third quarter of 1998, Rick R. Hagelstein, Executive Vice President
and Director of Subsidiary Operations, was named Chairman and CEO of Mortgage
Corp. Mr. Hagelstein replaced Richard J. Gillen who elected to retire.
During 1998, volatility of the interest rate environment produced a sharp
drop in mortgage rates, causing a significant increase in the prepayment speed
assumptions that are used to value mortgage servicing rights which resulted in a
$29.3 million reduction in the value of this asset. The reduction in value was
particularly significant in the servicing originated over the last year during
which the Company's strategy was to retain, rather than sell servicing in what
was thought to be a historically low rate environment. During this period, the
volatility in rates precluded the Company from hedging the value of servicing
assets with any degree of certainty. Narrowing spreads negatively impacted
mortgage margins on warehouse inventory, where borrowing costs have not declined
as rapidly as rates on originated mortgage loan assets. The overall
profitability of the mortgage unit was further impacted by the costs incurred as
the Company undertook a previously announced review of the strategic direction
of this business line. Following such review the Company announced it would
reduce the level of capital commitment to this business line. In accordance with
this strategy, the Company sold approximately $4.1 billion of servicing, at a
price of $66 million. The sale began the resizing of the servicing portfolio to
a level which provides the appropriate level of liquidity and profitability
while supporting Mortgage Corp.'s loan origination platform. In addition,
consistent with its previously announced strategy, the Company intends to sell,
on a quarterly basis, a substantial portion of its servicing rights related to
future production.
The primary components of revenues derived by Mortgage Corp. and Capital
Corp. are net mortgage warehouse income, gain on sale of mortgage loans,
servicing fees earned for loan servicing activities, and other miscellaneous
sources of revenues associated with the origination and servicing of residential
and commercial mortgages. The principal components of expenses of Mortgage Corp.
and Capital Corp. are salaries and employee benefits, amortization of originated
and acquired mortgage servicing rights, provision for valuation of mortgage
servicing rights, interest expense and other general and administrative
expenses. The following paragraphs describe the principal factors affecting each
of the significant components of revenues of Mortgage Corp. and Capital Corp.
The following table presents selected information regarding the revenues and
expenses of the Company's mortgage banking business.
ANALYSIS OF SELECTED REVENUES AND EXPENSES
MORTGAGE BANKING
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------
1998 1997 1996
---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
WAREHOUSE INVENTORY:
Average inventory balance................................ $1,087,554 $ 329,112 $ 138,035
Net mortgage warehouse income:
Dollar amount.......................................... 7,782 3,499 3,224
Percentage of average inventory balance................ 0.72% 1.06% 2.34%
GAIN ON SALE OF MORTGAGE LOANS:
Gain on sale of mortgage loans as a percentage of loans
sold:
Residential............................................ 1.27% 0.98% 1.16%
Home Equity............................................ 3.38% 3.55% --
Securitized Home Equity................................ 1.24% -- --
OMSR income as a percentage of residential mortgage loans
sold................................................... 1.71% 1.75% 1.79%
</TABLE>
35
<PAGE> 36
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------
1998 1997 1996
---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
SERVICING REVENUES:
Average servicing portfolios:
Residential............................................ $6,664,481 $3,661,031 $2,144,298
Commercial............................................. 1,413,962 1,134,348 109,581
Sub-serviced........................................... 1,076,684 741,174 305,149
Servicing fees:
Residential............................................ $ 23,611 $ 13,091 $ 9,625
Commercial............................................. 964 809 126
Sub-serviced........................................... 962 832 328
---------- ---------- ----------
Total.......................................... 25,537 14,732 10,079
Annualized servicing fee percentage:
Residential............................................ 0.35% 0.36% 0.45%
Commercial............................................. 0.07% 0.07% 0.11%
Sub-serviced........................................... 0.09% 0.11% 0.11%
Gain (loss) on sale of servicing rights.................. $ (2,075) $ 4,246 $ 2,641
Provision for valuation of mortgage servicing rights..... $ 29,305 -- --
Amortization of servicing rights:
Servicing rights amortization.......................... $ 19,110 $ 7,550 $ 4,091
Servicing rights amortization as a percentage of
average residential servicing portfolio............. 0.29% 0.21% 0.19%
PERSONNEL:
Personnel expenses....................................... $ 68,955 $ 30,398 $ 16,105
Number of personnel (at year end):
Production............................................. 517 586 319
Servicing.............................................. 263 118 93
Other.................................................. 815 255 155
---------- ---------- ----------
Total.......................................... 1,595 959 567
Salaried............................................... 90% 87% 84%
Commission............................................. 10% 13% 16%
</TABLE>
Net Mortgage Warehouse Income
Mortgage Corp. originates or acquires residential mortgage loans, which are
recorded as mortgage loans held for sale and financed under warehouse credit
facilities pending sale. The difference between interest income on the
originated or acquired loans and the cost of warehouse borrowings is recorded as
net mortgage warehouse income. The amount of recorded net mortgage warehouse
income varies with the average volume of loans in the warehouse and the spread
between the coupon rate of interest on the loans and the interest cost of the
warehouse credit facility.
Gain on Sale of Mortgage Loans
Residential mortgage loans originated or acquired by Mortgage Corp.
currently are accumulated in inventory and held for sale. The disposition of the
loans generally produces a gain. Such gains result from the cash sale of the
mortgage loans and the additional recognition of the value of mortgage servicing
rights as proceeds, less the basis of the mortgage loans sold.
The portion of the Company's mortgage banking business conducted through
Capital Corp. is devoted to the acquisition of Home Equity Loans that are pooled
and sold in public or private securitization transactions. Gains on the
securitization and sale of Home Equity Loans represent the amount by which the
proceeds received (including the estimated value of retained subordinated
interests) exceed the basis of the Home Equity Loans and the costs associated
with the securitization process. The retained interests are valued at the
36
<PAGE> 37
discounted present value of the cash flows expected to be realized over the
anticipated average life of the assets sold after deducting future estimated
credit losses, estimated prepayments, servicing fees and other securitization
fees related to the Home Equity Loans sold. The recorded value of retained
interests are computed using Capital Corp.'s assumptions of market discount
rates, prepayment speeds, default rates, credit losses and other costs based
upon the unique underlying characteristics of the Home Equity Loans comprising
each securitization.
Capital Corp. expects that the assumptions it will use in its
securitization transactions will include discount rates ranging from 12% to 15%
and prepayment speeds at annualized rates starting at approximately 7% per year
and, depending upon the mix of fixed and variable rate and prepayment penalty
provisions of the underlying loans, increasing to 40% per year. Loss assumptions
are expected to vary depending upon the mix of the credit quality and loan to
value characteristics of the underlying loans that are securitized. The actual
assumptions used by Capital Corp. in its securitization transactions will vary
based on numerous factors, including those listed above, and there can be no
assurance that actual assumptions will correspond to Capital Corp.'s current
expectations.
Servicing Fees, Amortization and Provision for Valuation of Mortgage Servicing
Rights
A significant component of Mortgage Corp.'s residential mortgage banking
business is attributable to the future right to service the residential mortgage
loans it originates or acquires. Mortgage Corp. generally retains the servicing
right upon the sale of the originated loan (and expects to retain such rights
upon securitization) and records the value of such right as mortgage servicing
rights on its balance sheet. Subsequently, Mortgage Corp. earns revenues as
compensation for the servicing activities it performs. Mortgage Corp. amortizes
the mortgage servicing right asset as a periodic expense to allocate the cost of
the servicing right to the income generated on a periodic basis.
The recorded values of mortgage servicing rights are reviewed on a
quarterly basis by comparing the fair market value of these rights as determined
by a third party to their recorded values. Based on this review, Mortgage Corp.
either adjusts amortization rates of such mortgage servicing rights or, if there
is any impairment in value, records a charge to earnings in the period during
which such impairment is deemed to have occurred (provision for valuation of
mortgage servicing rights). The fair market value of mortgage servicing rights
is heavily impacted by the relative levels of residential mortgage interest
rates. When interest rates decline, underlying loan prepayment speeds generally
increase. Prepayments in excess of anticipated levels will cause actual fair
market values of mortgage servicing rights to be less than recorded values
thereby resulting in increases in the rates of amortization, or a revaluation of
recorded mortgage servicing rights as described above.
A decline in interest rates generally contributes to higher levels of
mortgage loan origination (particularly refinancings) and the related
recognition of increased levels of gain on sale of mortgage loans. The ability
of Mortgage Corp. to originate loans and its ability to regenerate the recorded
value of its servicing portfolio on an annualized basis also provides Mortgage
Corp. with the ability to approximately replace the recorded value of its
residential servicing portfolio in a one-year time frame, based upon current
origination levels. Loans originated during periods of relatively low interest
rates generate servicing rights with a higher overall value due to the decreased
probability of future prepayment by the borrower. Accordingly, Mortgage Corp.
believes that it has an inherent hedge against a significant and swift decline
in the value of its recorded mortgage servicing rights. There can be no
assurance that, in the long term, Mortgage Corp. will be able to continue to
maintain an even balance between the production capacity of its origination
network and the principal value of its servicing portfolio.
In an environment of increasing interest rates, the rate of current and
projected future prepayments decreases, resulting in increases in fair market
values of mortgage servicing rights. Although the Company does not recognize
gain as a result of such increases in fair market values, it may decrease the
rate of amortization of the mortgage servicing rights. In addition, in periods
of rising interest rates, mortgage loan origination rates generally decline.
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Other
In its commercial mortgage business, Mortgage Corp. generates loan
origination fees paid by commercial borrowers for underwriting and application
activities performed by Mortgage Corp. as a correspondent of various insurance
company and conduit lenders. In addition, Mortgage Corp. generates other fees
and revenues from various activities associated with originating and servicing
residential and commercial mortgage loans and in its construction lending
activities. Mortgage Corp. has in the past sold, and may in the future sell, a
portion of its rights to service residential mortgage loans. The results of such
sales are recorded as gains on sales of mortgage servicing rights and reflected
as a component of other revenue.
PORTFOLIO ASSET ACQUISITION AND RESOLUTION
Revenues at Commercial Corp. consist primarily of cash proceeds on
disposition of assets acquired in Portfolio Asset acquisitions for Commercial
Corp.'s own account and its equity in the earnings of affiliated Acquisition
Partnerships. In addition, Commercial Corp. derives servicing fees from
Acquisition Partnerships for the servicing activities performed related to the
assets held in the Acquisition Partnerships. Following the Merger, Commercial
Corp. serviced assets held in an affiliated liquidating trust created for the
benefit of former FCBOT shareholders (the "Trust") and derived servicing fees
for its activities under a servicing agreement between the Trust and Commercial
Corp. During the first quarter of 1997, the Trust terminated the servicing
agreement and paid Commercial Corp. a termination payment of $6.8 million
representing the present value of servicing fees projected to have been earned
by Commercial Corp. upon the liquidation of the assets of the Trust, which was
expected to occur principally in 1997.
In its Portfolio Asset acquisition and resolution business, Commercial
Corp. acquires Portfolio Assets that are designated as nonperforming, performing
or real estate. Each Portfolio is accounted for as a whole and not on an
individual asset basis. To date, a substantial majority of the Portfolio Assets
acquired by Commercial Corp. have been designated as nonperforming. Once a
Portfolio has been designated as either nonperforming or performing, such
designation is not changed regardless of the performance of the assets
comprising the Portfolio. The Company recognizes revenue from Portfolio Assets
and Acquisition Partnerships based on proceeds realized from the resolution of
Portfolio Assets, which proceeds have historically varied significantly and
likely will continue to vary significantly from period to period. The following
table presents selected information regarding the revenues and expenses of the
Company's Portfolio Asset acquisition and resolution business.
ANALYSIS OF SELECTED REVENUES AND EXPENSES
PORTFOLIO ASSET ACQUISITION AND RESOLUTION
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------
1998 1997 1996
------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
GAIN ON RESOLUTION OF PORTFOLIO ASSETS:
Average investment:
Nonperforming Portfolios.................................. $41,873 $61,764 $42,123
Performing Portfolios..................................... 14,629 9,759 10,280
Real estate Portfolios.................................... 15,919 21,602 30,224
Gain on resolution of Portfolio Assets:
Nonperforming Portfolios.................................. $ 6,112 $20,288 $11,635
Performing Portfolios..................................... 299 -- --
Real estate Portfolios.................................... 2,797 3,895 7,875
------- ------- -------
Total............................................. 9,208 24,183 19,510
</TABLE>
38
<PAGE> 39
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------
1998 1997 1996
------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Interest income on performing Portfolios.................... $ 2,140 $ 2,052 $ 2,603
Gross profit percentage on resolution of Portfolio Assets:
Nonperforming Portfolios.................................. 23.6% 27.8% 38.5%
Performing Portfolios..................................... 8.0% -- --
Real estate Portfolios.................................... 20.9% 27.9% 19.3%
Weighted average gross profit percentage.................. 21.4% 27.8% 27.5%
Interest yield on performing Portfolios..................... 14.1% 21.0% 25.3%
SERVICING FEE REVENUES:
Acquisition Partnerships.................................... $ 2,843 $ 4,363 $ 6,468
Trust....................................................... -- 6,800 4,241
Affiliates.................................................. 219 350 1,731
------- ------- -------
Total............................................. 3,062 11,513 12,440
PERSONNEL:
Personnel expenses.......................................... $ 4,619 $ 5,353 $ 6,002
Number of personnel (at period end):
Production.................................................. 12 9 12
Servicing................................................... 64 68 107
INTEREST EXPENSE:
Average debt................................................ $71,091 $85,262 $64,343
Interest expense............................................ 5,111 7,084 6,447
Average yield............................................... 7.2% 8.3% 10.0%
</TABLE>
Nonperforming Portfolio Assets
Nonperforming Portfolio Assets consist primarily of distressed loans and
loan related assets, such as foreclosed-upon collateral. Portfolio Assets are
designated as nonperforming unless substantially all of the assets comprising
the Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. Commercial Corp. acquires such assets on the basis
of an evaluation of the timing and amount of cash flow expected to be derived
from borrower payments or disposition of the underlying asset securing the loan.
On a monthly basis, the amortized cost of each nonperforming Portfolio is
evaluated for impairment. A valuation allowance is established for any
impairment identified with provisions to establish such allowance charged to
earnings in the period identified.
All nonperforming Portfolio Assets are purchased at substantial discounts
from their Face Value. Net gain on the resolution of nonperforming Portfolio
Assets is recognized to the extent that proceeds collected on the Portfolio
exceed a pro rata portion of allocated costs of the resolved Portfolio Assets.
Proceeds from the resolution of Portfolio Assets that are nonperforming are
recognized as cash is realized from the collection, disposition and other
resolution activities associated with the Portfolio Assets. No interest income
or any other yield component of revenue is recognized separately on
nonperforming Portfolio Assets.
Performing Portfolio Assets
Performing Portfolio Assets consist of consumer and commercial loans
acquired at a discount from the aggregate amount of Face Value. Portfolio Assets
are classified as performing if substantially all of the loans comprising the
Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. On a monthly basis, the amortized cost of each
performing Portfolio is evaluated for impairment. A valuation allowance is
established for any identified impairment with provisions to establish such
allowance charged to earnings in the period identified.
Interest income is recognized when accrued in accordance with the
contractual terms of the loans. The accrual of interest is discontinued once a
loan becomes past due 90 days or more. Acquisition discounts for the Portfolio
Assets as a whole are accreted as an adjustment to yield over the estimated life
of the Portfolio.
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<PAGE> 40
Real Estate Portfolios
Commercial Corp. also acquires Portfolios comprised solely of real estate.
Real estate Portfolios are recorded at the lower of cost or fair value less
estimated costs to sell. Costs relating to the development or improvement are
capitalized and costs relating to holding assets are charged to expense as
incurred. Rental income, net of expenses, is recognized as revenue when
received. Gains and losses are recognized based on the allocated cost of each
specific real estate asset.
Equity in Earnings of Acquisition Partnerships
Commercial Corp. accounts for its less than 50% owned investments in
Acquisition Partnerships using the equity method of accounting. This accounting
method generally results in the pass-through of its pro rata share of earnings
from the Acquisition Partnerships' activities as if it had a direct investment
in the underlying Portfolio Assets held by the Acquisition Partnerships. The
revenues and earnings of the Acquisition Partnerships are determined on a basis
consistent with the accounting methodology applied to nonperforming, performing
and real estate Portfolios described in the preceding paragraphs.
Distributions of cash flow from the Acquisition Partnerships are a function
of the terms and covenants of the loan agreements related to the secured
borrowings of the Acquisition Partnerships. Generally, the terms of the
underlying loan agreements permit some distribution of cash flow to the equity
partners so long as loan to cost and loan to value relationships are in
compliance with the terms and covenants of the applicable loan agreement. Once
the secured borrowings of the Acquisition Partnerships are fully paid, all cash
flow in excess of operating expenses is available for distribution to the equity
partners. The following chart presents selected information regarding the
revenues and expenses of the Acquisition Partnerships. Such selected information
includes the combined activity of Commercial Corp.'s 100% owned Acquisition
Partnerships and the Acquisition Partnerships in which the Company has less than
50% ownership interest.
ANALYSIS OF SELECTED REVENUES AND EXPENSES
ACQUISITION PARTNERSHIPS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------
1998 1997 1996
-------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
GAIN ON RESOLUTION OF PORTFOLIO ASSETS:
Gain on resolution of Portfolio Assets...................... $ 57,628 $ 33,398 $ 39,505
Gross profit percentage on resolution of Portfolio Assets... 33.9% 18.7% 22.7%
Interest income on performing Portfolios.................... $ 9,714 $ 8,432 $ 7,870
Other interest income....................................... 3,127 1,053 862
INTEREST EXPENSE:
Interest expense............................................ 13,081 10,294 22,065
Average debt................................................ 159,145 111,422 188,231
Average yield............................................... 8.2% 9.2% 11.7%
OTHER EXPENSES:
Servicing fees.............................................. $ 5,360 $ 4,984 $ 6,809
Legal....................................................... 2,557 1,957 2,266
Property protection......................................... 5,898 3,956 5,712
Other....................................................... 9,867 1,575 693
-------- -------- --------
Total other expenses.............................. 23,682 12,472 15,480
-------- -------- --------
NET EARNINGS................................................ $ 33,706 $ 20,117 $ 10,692
======== ======== ========
</TABLE>
Servicing Fee Revenues
Commercial Corp. derives fee income for its servicing activities performed
on behalf of the Acquisition Partnerships. Prior to the second quarter of 1997,
Commercial Corp. also derived servicing fees from the
40
<PAGE> 41
servicing of assets held in the Trust. In connection with the Acquisition
Partnerships, Commercial Corp. earns a servicing fee of between 3% and 8% of
gross cash collections generated by the Acquisition Partnerships, rather than a
periodic management fee based on the Face Value of the assets being serviced.
The rate of servicing fee charged is a function of the average Face Value of the
assets within each Portfolio being serviced (the larger the average Face Value
of the assets in a Portfolio, the lower the fee percentage within the prescribed
range).
CONSUMER LENDING
The primary components of revenue derived by Consumer Corp. are interest
income and gain on sale of loans. The primary expenses of Consumer Corp. are
salaries and benefits, provision for loan losses and interest expense. The
following chart presents selected information regarding the revenues and
expenses of Consumer Corp.'s consumer lending business.
ANALYSIS OF SELECTED REVENUES AND EXPENSES
CONSUMER LENDING
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------
1998 1997 1996
------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
INTEREST INCOME:
Average loans and investments:
Auto...................................................... $35,880 $48,682 $19,740
Investments............................................... 26,720 4,278 --
Other..................................................... 6,195 3,571 144
Interest income
Auto...................................................... 7,542 9,067 3,546
Investments............................................... 2,181 548 --
Other..................................................... 179 567 30
Average yield
Auto...................................................... 21.0% 18.6% 18.0%
Investments............................................... 8.2% 12.8% --
Other..................................................... 2.9% 15.9% 20.8%
SERVICING FEE REVENUES:
Affiliates.................................................. $ 2,705 $ 553 $ 16
PERSONNEL:
Personnel expenses.......................................... $ 5,602 $ 2,959 $ 698
Number of personnel (at period end):
Production................................................ 93 53 15
Servicing................................................. 110 53 26
INTEREST EXPENSE:
Average debt................................................ $36,302 $34,129 $14,885
Interest expense............................................ 3,109 3,016 1,258
Average yield............................................... 8.6% 8.8% 8.5%
</TABLE>
Interest Income
Interest income is accrued on originated and acquired loans at the
contractual rate of interest of the underlying loan. The accrual of interest
income is discontinued once a loan becomes 90 days past due.
Gain on Sale of Loans
Funding Corp. accumulates and pools automobile loans acquired from
franchised dealerships for sales in public and private securitization
transactions. Such transactions result in the recognition of gains to the extent
that the proceeds received (including the estimated value of the retained
subordinated interests) exceed the
41
<PAGE> 42
basis of the automobile loans and the costs associated with the securitization
process. When the automobile loans are securitized and sold, the retained
interests are valued at the discounted present value of the cash flows expected
to be realized over the anticipated average life of the assets sold after future
estimated credit losses, estimated prepayments, servicing fees and other
securitization fees related to the loans sold. The discounted present value of
such interests is computed using Consumer Corp.'s assumptions of market discount
rates, prepayment speeds, default rates, credit losses and other costs based
upon the unique underlying characteristics of the automobile loans comprising
each securitization.
In its securitization transactions completed to date NAF 1997-1, NAF
1998-1, FAR 1998-2 and FAR 1998-3, Consumer Corp. assumed that losses would
approximate an aggregate of 18.0%, 16.5%, 12.0% and 10.5%, respectively, of the
outstanding principal balance of the underlying loans. Consumer Corp. calculated
the present value of future cash flows from the securitizations using discount
rates ranging from 7.3% to 15% per year. All of the completed securitization
transactions were sold in private transactions.
Provision for Loan Losses
The carrying value of consumer loans is evaluated on a monthly basis for
impairment. A valuation allowance is established for any impairment identified
with provisions to augment the allowance charged to earnings in the period
identified. The evaluation of the need for an allowance is determined on a pool
basis, with each pool being the loans originated or acquired during a quarterly
period of production or acquisition. Loans generally are acquired at a discount
from the Face Value of the loan with the acquisition discount established as an
allowance for losses at the acquisition date of the loan. If the initially
established allowance is deemed to be insufficient, additional allowances are
established through provisions charged to earnings.
The operating margin of Consumer Corp. was significantly impacted by 1998
and 1997 provisions for losses in the amount of approximately $9.2 million and
$6.6 million, respectively, the majority of which was related to the loans
originated and retained interests in securitizations in Consumer Corp.'s initial
sub-prime auto receivable business. The Company's initial venture into the
sub-prime automobile market involved the acquisition of a distressed sub-prime
portfolio from a secured lender. Following the acquisition of the portfolio, the
Company began the acquisition of additional loans on an indirect basis from
financial institutions who originated loans pursuant to contractual agreements.
The Company concluded that the contractual underwriting standards and the
purchase discounts on which the initial program was based were insufficient to
generate automobile loans of acceptable quality to the Company. As a result, the
Company terminated its obligations with the financial institutions participating
in the original origination program effective January 31, 1998. The continued
flow of production into 1998 required that the Company provide for the losses
anticipated on such loans and related retained residual interests in
securitizations in 1998 in the amount of $8.4 million. The remaining $.8 million
provision was comprised of $.5 million related to the discontinued student loan
origination initiative and $.3 million related to the inventory of Funding
Corp..
Based upon the experience gained with its initial consumer origination
program, the Company undertook to develop an origination and underwriting
approach that would give Consumer Corp. significantly greater control over the
origination and pricing standards governing its consumer lending activities. The
formation of Funding Corp. resulted from these development activities. The
underwriting process and purchase discount methodology employed by Funding Corp.
has significantly changed the underwriting criteria and purchase standards of
Consumer Corp. from the methodology employed during the majority of 1996 and
1997. In Funding Corp.'s case, the objectives established for purchasing loans
from originating dealers are designed to result in the purchase discount
approximating the expected loss for all loans acquired.
BENEFIT (PROVISION) FOR INCOME TAXES
As a result of the Merger, the Company has substantial federal NOLs, which
can be used to offset the tax liability associated with the Company's pre-tax
earnings until the earlier of the expiration or utilization of such NOLs. The
Company accounts for the benefit of the NOLs by recording the benefit as an
asset and then establishing an allowance to value the net deferred tax asset at
a value commensurate with the Company's expectation of being able to utilize the
recognized benefit in the next three to four year period. Such estimates
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<PAGE> 43
are reevaluated on a quarterly basis with the adjustment to the allowance
recorded as an adjustment to the income tax expense generated by the quarterly
earnings. Significant events that change the Company's view of its currently
estimated ability to utilize the tax benefits, such as the Harbor Merger in the
third quarter of 1997, result in substantial changes to the estimated allowance
required to value the deferred tax benefits recognized in the Company's periodic
financial statements. Similar events could occur in the future, and would impact
the quarterly recognition of the Company's estimate of the required valuation
allowance associated with its NOLs.
Earnings for 1997 and 1996 were significantly increased by the recognition
of tax benefits resulting from the Company's reassessment of the valuation
allowance related to its NOL asset. Realization of the asset is dependent upon
generating sufficient taxable earnings to utilize the NOL. Prior to 1996, the
deferred tax asset resulting from the Company's NOL was entirely offset by its
valuation reserve. In 1997 and 1996, the valuation reserve was adjusted based on
the Company's estimate of its future pre-tax income. The amount of tax benefits
recognized will be adjusted in future periods should the estimates of future
taxable income change. If there are changes in the estimated level of the
required reserve, net earnings will be affected accordingly. Results of
operations for 1998 were nominally impacted by the effect of recording a
deferred tax benefit of $1.2 million to recognize the benefit related to NOLs.
FIRSTCITY LIQUIDATING TRUST AND EXCHANGE OF PREFERRED STOCK
In connection with the Merger, the Company received the Class A Certificate
of the Trust (the "Class A Certificate"). Distributions from the Trust in
respect of the Class A Certificate were used to retire the senior subordinated
notes of the Company and to pay dividends on, and repurchase some of, the
special preferred stock of the Company (the "Special Preferred"). Pursuant to a
June 1997 settlement agreement with the Company, the Trust's obligation to the
Company under the Class A Certificate was terminated (other than the Trust's
obligation to reimburse the Company for certain expenses) in exchange for the
Trust's agreement to pay the Company an amount equal to $22.75 per share for the
1,923,481 shares of Special Preferred outstanding at June 30, 1997, the 1997
second quarter dividend of $0.7875 per share, and 15% interest from June 30,
1997 on any unpaid portion of the settlement agreement. Under such agreement,
the Company assumed the obligation for the payment of the liquidation preference
amount and the future dividends on the Special Preferred. The Trust distributed
$44.1 million to the Company under the settlement agreement.
In June 1997, the Company began an offer to exchange one share of newly
issued adjusting rate preferred stock ("Adjusting Rate Preferred") for each
outstanding share of Special Preferred. The Company completed such exchange
offer in the third quarter of 1997 pursuant to which 1,073,704 shares of Special
Preferred were tendered for a like number of shares of Adjusting Rate Preferred.
An additional 148,997 shares were exchanged in 1998. The remaining Special
Preferred was redeemed on September 30, 1998 for $14.7 million plus accrued
dividends. The Adjusting Rate Preferred has a redemption value of $21.00 per
share and a 15% annual dividend rate through September 30, 1998, at which time
the dividend rate was reduced to 10% per annum. The Adjusting Rate Preferred is
redeemable by the Company on or after September 30, 2003, with a mandatory
maturity date of September 30, 2005.
The redemption by the Trust of its obligation on the Class A Certificate
represented a premium over the redemption value of the Special Preferred, which
is reflected as a deferred credit in the Company's financial statements. The
deferred credit is being accreted to income over the weighted average life of
the Special Preferred and the Adjusting Rate Preferred.
RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with
the Consolidated Financial Statements of the Company (including the Notes
thereto) included elsewhere in this Annual Report on Form 10-K.
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<PAGE> 44
1998 Compared to 1997
The Company reported a net loss of $20.2 million in 1998 (including a $1.2
million deferred tax benefit related to the benefit of NOLs) compared to
earnings of $35.6 million (including a $13.6 million deferred tax benefit
related to the benefit of NOLs) in 1997. Net loss to common shareholders was
$25.4 million in 1998 compared to net earnings of $29.4 million in 1997. On a
per share basis, basic net loss attributable to common shareholders was $3.35 in
1998 compared to net earnings of $4.51 in 1997. Diluted net loss per common
share was $3.35 in 1998 compared to net earnings of $4.46 ($2.40 excluding the
deferred tax benefit related to the benefit of NOLs) in 1997. The 1997 results
reflect the positive effect of the $6.8 million, or $1.03 per share, payment
from the Trust in settlement of the Investment Management Agreement.
Mortgage Banking
Gain on sale of mortgage loans. Gain on sale of mortgage loans increased by
200% to $109.4 million in 1998 from $36.5 million in 1997. This increase was the
result of substantial growth in the levels of residential mortgage loan
origination generated principally by the Broker Retail network of Mortgage Corp.
and, to a lesser extent, the Direct Retail network of Mortgage Corp., and the
resulting sales of such loans to government agencies and other investors. This
is evidenced by the sale of approximately $8.1 billion of mortgage loans in 1998
(compared to $3.0 billion in 1997) and the overall mix and pricing of the loans
sold.
Net mortgage warehouse income. Net mortgage warehouse income increased by
122% to $7.8 million in 1998 from $3.5 million in 1997. This is the result of a
significant increase in the average balance of loans held in inventory during
the year, offset by a decrease in the spread earned between the interest rate on
the underlying mortgages and the interest cost of the warehouse credit facility
as the overall levels of interest rates on residential mortgage loans reached
their lowest levels in several years.
Servicing fee revenues. Servicing fee revenues increased by 73% to $25.5
million in 1998 from $14.7 million in 1997 as a result of an increase in the
size of the servicing portfolio. Mortgage Corp. substantially increased its
commercial mortgage servicing portfolio and its ability to originate commercial
mortgage loans for correspondents and conduit lenders with the purchase, in the
second quarter of 1997, of MIG Financial Corporation ("MIG"), a commercial loan
origination and servicing company based in California with a $1.6 billion
commercial mortgage servicing portfolio at the time of acquisition.
Other revenues. Other revenues decreased by 52% to $5.3 million in 1998
from $11.0 million in 1997. This decrease resulted primarily from Mortgage
Corp.'s decision to retain, rather than sell, servicing rights for most of 1998.
The sale of servicing rights in 1997 resulted in a gain on sale of $4.2 million,
while a loss of $2.1 million was realized in late 1998.
Operating expenses. Operating expenses of Mortgage Corp. increased to
$168.9 million in 1998 from $59.8 million in 1997. The provision for valuation
of mortgage servicing rights, expansion of the Broker Retail and Direct Retail
operation and the full year of Capital Corp.'s operations contributed to the
period to period increases. The acquisition of MIG in 1997, which was accounted
for as a purchase by Mortgage Corp., produced higher relative totals for all
components of Mortgage Corp.'s operating expenses in 1998.
Salaries and benefits increased by $38.6 million in 1998 reflecting the
additional staff required to support the increase in origination volumes derived
principally from the Broker Retail network and, to a lesser extent, the Direct
Retail network, and the increase in the size and number of loans in the
residential and commercial servicing portfolios in 1998.
Amortization of mortgage servicing rights increased as a result of the
substantially larger investment in mortgage servicing rights in 1998. As
discussed earlier, the provision for valuation of mortgage servicing rights
totaled $29.3 million. A provision for losses on loans held for sale totaled
$2.0 million. Interest on other notes payable (the portion not associated with
Mortgage Corp.'s warehouse credit facility) increased due to higher working
capital borrowings during 1998.
Occupancy expense increased by $7.3 million in 1998 as the result of the
opening or acquisition of several new offices in 1997 in the Broker Retail and
Direct Retail networks. Increases in data processing,
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<PAGE> 45
communication and other expenses in 1998 resulted from the substantial increases
in production and servicing volumes.
Portfolio Asset Acquisition and Resolution
Commercial Corp. purchased $139.7 million of Portfolio Assets during 1998
for its own account and through the Acquisition Partnerships compared to $183.2
million of acquisitions in 1997. Commercial Corp.'s year end investment in
Portfolio Assets decreased to $70 million in 1998 from $90 million in 1997.
Commercial Corp. invested $27.4 million in equity in Portfolio Assets in 1998
compared to $37.1 million in 1997.
Net gain on resolution of Portfolio Assets. Proceeds from the resolution of
Portfolio Assets decreased 51% from 1997. The net gain on resolution of
Portfolio Assets decreased by 62% to $9.2 million in 1998 from $24.2 million in
1997 as the result of reduced collections and a lower gross profit percentage in
1998. The weighted average gross profit percentage on the resolution of
Portfolio Assets in 1998 was 21.4% as compared to 27.8% in 1997.
Equity in earnings of Acquisition Partnerships. Proceeds from the
resolution of Portfolio Assets for the Acquisition Partnerships decreased by
4.5% to $170 million in 1998 from $178 million in 1997 while the gross profit
percentage increased to 33.9% in 1998 from 18.7% in 1997. Other expenses of the
Acquisition Partnerships increased by $11.2 million in 1998 generally reflecting
costs associated with the resolution of Portfolio Assets in Europe which
generated proceeds of $98.7 million. The net result was an overall increase in
the net income of the Acquisition Partnerships of 68% to $33.7 million in 1998
from $20.1 million in 1997. As a result, Commercial Corp.'s equity earnings from
Acquisition Partnerships increased by 69% to $12.8 million in 1998 from $7.6
million in 1997.
Servicing fee revenues. Servicing fees reported during 1997 included the
receipt of a $6.8 million cash payment related to the early termination of a
servicing agreement between the Company and the Trust, under which the Company
serviced the assets of the Trust. The $6.8 million payment represents the
present value of servicing fees projected to have been earned by Commercial
Corp. upon liquidation of the Trust assets, which was expected to occur
principally in 1997. Excluding fees related to Trust assets, servicing fees
decreased by 35% to $3.1 million in 1998 from $4.7 million in 1997 as a result
of lower domestic collection levels in the Acquisition Partnerships and
affiliated entities.
Other revenues. Other revenues were relatively flat year to year.
Operating expenses. Operating expenses declined to $16.9 million in 1998
from $24.5 million in 1997 primarily as a result of reduced salaries and
benefits, lower asset level expenses and reduced amortization expense.
Salaries and benefits declined in 1998 as a result of the consolidation of
some of the servicing offices (Portfolios being serviced in the closed offices
reached final resolution).
Interest on other notes payable declined by $2.0 million in 1998 due to
lower outstanding average balances of portfolio debt.
Asset level expenses incurred in connection with the servicing of Portfolio
Assets decreased in 1998 as a result of lower investments in Portfolio Assets in
1998. Occupancy and other expenses decreased as a result of the consolidation of
servicing offices in 1998.
Consumer Lending
Gain on sale of automobile loans. The Company realized gains of $7.2
million on the sale of approximately $172 million of automobile loans in 1998.
Interest and other income. Interest income was relatively flat year to
year. Other income increased $2.7 million due to increased service fee revenue
from securitization trusts.
Interest expense. Interest expense was relatively flat year to year.
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<PAGE> 46
Operating expenses. Salaries and benefits increased by 89% to $5.6 million
in 1998 from $3.0 million in 1997 as a result of the increased levels of
operating activity in 1998. Other expenses increased $2.5 million due to the
growth in the origination and servicing operations.
Provision for loan losses and residual interests. The provision for loan
losses on automobile receivables and residual interests increased to $9.2
million from $6.6 million in 1997. The provision for losses on residual
interests totaled $4.5 million while the provision for loan losses totaled $4.7
million in 1998. This provision is primarily a result of Consumer Corp.'s review
and increase of the underlying loss assumptions from a range of 13-14% to 16-18%
based upon actual performance of the securitized assets and anticipated losses
on the loans originated under the discontinued initial venture into the subprime
automobile market.
Other Items Affecting Net Earnings.
The following items affect the Company's overall results of operations and
are not directly related to any one of the Company's businesses discussed above.
Corporate overhead. Interest income on the Class A Certificate during 1997
represents reimbursement to the Company from the Trust of dividends through June
30, 1997, of $3.6 million on special preferred stock and interest paid under a
June 1997 agreement to retire the Class A Certificate. Company level interest
expense increased to $3.8 million in 1998 from $1.1 million in 1997 as a result
of higher volumes of debt associated with the equity required to purchase
Portfolio Assets, equity interests in Acquisition Partnerships and capital
support to operating subsidiaries. Other corporate income increased due to
recognition of deferred premium related to the early redemption of special
preferred stock. Salaries and benefits, occupancy and professional fees account
for the majority of other overhead expenses, which increased in 1998 compared to
1997, as a result of increased levels of borrowings during the year and
professional fees.
Income taxes. Federal income taxes are provided at a 35% rate applied to
taxable income and are offset by NOLs that the Company believes are available.
The tax benefit of the NOLs is recorded in the period during which the benefit
is realized. The Company reported a deferred tax benefit of $1.2 million in 1998
as compared to a benefit of $13.6 million in 1997 related to the benefits of
NOLs.
1997 Compared to 1996
The Company reported net earnings of $35.6 million in 1997 (including a
$13.6 million deferred tax benefit related to the benefits of NOLs) compared to
$39.1 million in 1996 (including a $16.2 million deferred tax benefit related to
the benefits of NOLs). Net earnings to common shareholders were $29.4 million in
1997 compared to $31.4 million in 1996. On a per share basis, basic net earnings
attributable to common shareholders were $4.51 in 1997 compared to $4.83 in
1996. Diluted net earnings per common share were $4.46 in 1997 compared to $4.79
in 1996.
Mortgage Banking
Mortgage Corp. experienced significant revenue growth in 1997 relative to
1996. The Direct Retail and Broker Retail origination networks experienced
substantial growth in levels of origination volume reflecting, in part, the
level of capital that has been contributed to Mortgage Corp. by the Company
following the Harbor Merger and relatively lower interest rates in 1997 compared
to 1996. Such revenue growth was partially offset by increases in operating
expenses associated with the increased levels of origination volume.
The Company entered the mortgage conduit business in August 1997 with the
formation of Capital Corp. Capital Corp. generated nominal interest revenue from
its acquired Home Equity Loans, incurred interest expense to finance the
acquisition of such loans and incurred general and administrative expenses in
its start-up phase.
Gain on sale of mortgage loans. Gain on sale of mortgage loans increased by
89% to $36.5 million in 1997 from $19.3 million in 1996. This increase was the
result of substantial increases in the levels of residential mortgage loan
origination generated principally by the Broker Retail network of Mortgage Corp.
and, to a lesser extent, the Direct Retail network of Mortgage Corp., and the
resulting sales of such loans to government
46
<PAGE> 47
agencies and other investors. The change in the gain on sale percentage
recognized in 1997 compared to 1996 is the result of the sale, on a servicing
released basis, of approximately $120 million of Home Equity Loans in 1997.
Net mortgage warehouse income. Net mortgage warehouse income increased by
8.5% to $3.5 million in 1997 from $3.2 million in 1996. This increase is the
result of a significant increase in the average balance of loans held in
inventory during the year offset by a decrease in the spread earned between the
interest rate on the underlying mortgages and the interest cost of the warehouse
credit facility as the overall levels of interest rates on residential mortgage
loans reached their lowest levels in several years.
Servicing fee revenues. Servicing fee revenues increased by 46.2% to $14.7
million in 1997 from $10.1 million in 1996 as a result of an increase in the
size of the servicing portfolio. Mortgage Corp. increased its servicing
portfolio with the purchase, in the second quarter of 1996, of Hamilton
Financial Services Corporation ("Hamilton") and its right to service
approximately $1.7 billion in mortgage loans, and by retaining the servicing
rights to a substantial portion of the residential mortgage loans originated
since the Harbor Merger. In addition, Mortgage Corp. substantially increased its
commercial mortgage servicing portfolio and its ability to originate commercial
mortgage loans for correspondents and conduit lenders with the purchase, in the
second quarter of 1997, of MIG.
Other revenues. Other revenues increased by 119% to $11.0 million in 1997
from $5.0 million in 1996. This increase resulted from an increase in the gain
on sale of mortgage servicing rights of $1.6 million to $4.2 million in 1997
from $2.6 million in 1996 and an increase of $2.2 million in fee income
associated with residential and commercial mortgage origination activity.
Operating expenses. Operating expenses of Mortgage Corp. increased by 89%
to $59.8 million in 1997 from $31.6 million in 1996. The acquisition of Hamilton
in 1996 and MIG in 1997, both of which were accounted for as purchases by
Mortgage Corp., produced higher relative totals for all components of Mortgage
Corp.'s operating expenses in 1997 compared to 1996. The commencement of Capital
Corp.'s operations in late 1997 also contributed to the year over year
increases.
Salaries and benefits increased by $14.3 million in 1997 compared to 1996
reflecting the additional staff required to support the increase in origination
volumes derived principally from the Broker Retail network and, to a lesser
extent, the Direct Retail network, and the increase in the size and number of
loans in the residential and commercial servicing portfolios in 1997 compared to
1996.
Amortization of mortgage servicing rights increased in 1997 compared to
1996 as a result of the substantially larger investment in mortgage servicing
rights in 1997 compared to 1996. Interest on other notes payable (the portion
not associated with Mortgage Corp.'s warehouse credit facility) increased due to
increased working capital borrowings during 1997 as compared to 1996.
Occupancy expense increased by $3.6 million in 1997 compared to 1996 as the
result of the opening or acquisition of several new offices in 1997 in the
Broker Retail and Direct Retail networks. Increases in data processing,
communication and other expenses in 1997 compared to 1996 resulted from the
substantial increases in the production and servicing volumes experienced during
1997.
Portfolio Asset Acquisition and Resolution
Commercial Corp. purchased $183.2 million of Portfolio Assets during 1997
for its own account and through the Acquisition Partnerships compared to $205.5
million in acquisitions in 1996. Commercial Corp.'s year end investment in
Portfolio Assets increased to $90.0 million in 1997 from $76.2 million in 1996.
Commercial Corp. invested $37.1 million in equity in Portfolio Assets in 1997
compared to $36.0 million in 1996.
Net gain on resolution of Portfolio Assets. Proceeds from the resolution of
Portfolio Assets increased by 22.8% to $87.1 million in 1997 from $70.9 million
in 1996. The net gain on resolution of Portfolio Assets increased by 24.0% to
$24.2 million in 1997 from $19.5 million in 1996 as the result of increased cash
proceeds
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<PAGE> 48
and a higher gross profit percentage in 1997 compared to 1996. The gross profit
percentage on the proceeds from the resolution of Portfolio Assets in 1997 was
27.8% as compared to 27.5% in 1996.
Equity in earnings of Acquisition Partnerships. Proceeds from the
resolution of Portfolio Assets for the Acquisition Partnerships increased by
2.4% to $178 million in 1997 from $174 million in 1996 while the gross profit
percentage on proceeds decreased to 18.7% in 1997 from 22.7% in 1996. More than
offsetting the decline in gross profit was the reduction in interest and other
expenses incurred by the Acquisition Partnerships in 1997 compared to 1996.
Interest income in the Acquisition Partnerships increased nominally while
interest expense decreased by $11.8 million in 1997 compared to 1996. The year
to year comparisons result from the relative levels of interest earning assets
and interest bearing liabilities carried by the Acquisition Partnerships in each
of the two periods. In addition, the effect of refinancing Acquisition
Partnership Portfolio Assets reduced average interest rates incurred on
borrowings in 1997 to 9.2% from 11.7% in 1996. Other expenses of the Acquisition
Partnerships decreased by $3.0 million in 1997 generally reflecting the
relatively lower costs associated with the resolution of Portfolio Assets in
somewhat mature partnerships as compared to the property protection and
improvement expenses normally associated with new Portfolio Asset acquisitions.
The net result was an overall increase in the net income of the Acquisition
Partnerships of 88% to $20.1 million in 1997 from $10.7 million in 1996. As a
result, Commercial Corp.'s equity earnings from Acquisition Partnerships
increased by 24.2% to $7.6 million in 1997 from $6.1 million in 1996.
Servicing fee revenues. Servicing fee revenues decreased by 7.5% to $11.5
million in 1997 from $12.4 million in 1996. Servicing fees reported during 1997
included the receipt of a $6.8 million cash payment related to the early
termination of a servicing agreement between the Company and the Trust, under
which the Company serviced the assets of the Trust. The $6.8 million payment
represents the present value of servicing fees projected to have been earned by
Commercial Corp. upon liquidation of the Trust assets, which was expected to
occur principally in 1997. Servicing fees earned from the Trust in 1996 were
$4.2 million. Excluding fees related to Trust assets, servicing fees decreased
by 42.5% to $4.7 million in 1997 from $8.2 million in 1996 as a result of
decreased collection levels in the Acquisition Partnerships and affiliated
entities.
Other revenues. Other revenues declined to $4.4 million in 1997 compared to
$6.6 million in 1996 as a result of reduced levels of rental income derived from
lower average investments in real estate Portfolios in 1997 as compared to 1996.
Operating expenses. Operating expenses increased to $24.5 million in 1997
from $23.3 million in 1996. The relatively stable levels of operating expenses
incurred by Commercial Corp. in 1997 compared to 1996 reflect the relatively
consistent levels of investment and servicing activities associated with
Commercial Corp.'s operations during such periods.
Salaries and benefits declined in 1997 as a result of the consolidation of
some of the servicing offices as the Portfolios being serviced in the closed
offices reached final resolution.
Interest on other notes payable increased as a result of increased average
borrowing levels in 1997 as compared to 1996 partially offset by lower average
costs of borrowings.
Asset level expenses incurred in connection with the servicing of Portfolio
Assets increased in 1997 compared to 1996 as a result of the increase in
investments in Portfolio Assets in 1997 compared to 1996. Occupancy and other
expenses decreased as a result of the consolidation of servicing offices in
1997.
Consumer Lending
Consumer Corp.'s revenues and expenses in 1997 were derived principally
from its original sub-prime automobile financing program, which was established
during the first quarter of 1996. Consumer Corp. terminated its obligations to
the financial institutions participating in such program effective as of January
31, 1998. In late 1997 Consumer Corp., through its 80% owned subsidiary, Funding
Corp., established a new sub-prime automobile financing program through which it
originates automobile loans through direct relationships with franchised
automobile dealerships.
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<PAGE> 49
Interest income. Interest income on consumer loans increased by 183% to
$10.2 million in 1997 from $3.6 million in 1996 reflecting increased levels of
loan origination activity in 1997 as compared to 1996 and an increase in the
average balance of aggregate loans held by Consumer Corp. during 1997.
Interest expense. Interest expense increased by 136% to $3.0 million in
1997 from $1.3 million in 1996 as a result of an increase in the average
outstanding level of borrowings secured by automobile receivables to $34.1
million in 1997 from $14.9 million in 1996. The average rate at which such
borrowings incurred interest increased to 8.8% from 8.5% for the same period.
Operating expenses. Salaries and benefits increased by 324% to $3.0 million
in 1997 from $0.7 million in 1996 as a result of the increased levels of
operating activity in 1997 as compared to 1996. In addition, during the later
portion of 1997, Consumer Corp.'s operating expenses reflected the duplicative
effects of the start up of Funding Corp. while still operating the indirect
origination program.
Provision for loan losses. The provision for loan losses on automobile
receivables increased by 226% to $6.6 million in 1997 from $2.0 million in 1996.
The increase is attributable to loan originations of $89.8 million in 1997
compared to loan originations of $17.6 million in 1996. Consumer Corp. increased
its rate of provision for loan losses based on its determination that the
discount rate at which it acquired loans under its original origination program
did not properly provide for the losses expected to be realized on the acquired
loans. The origination program currently operated by Funding Corp. generally
allows for the acquisition of loans from automobile dealerships at a larger
discount from par than Consumer Corp.'s original financing program. The Company
believes that such acquisition prices more closely approximate the expected loss
per occurrence on the loans originated.
Securitization of automobile loans. During the second quarter of 1997,
Consumer Corp. completed its first sale and securitization of automobile loans.
Consumer Corp. has retained subordinated interests in the form of nonrated
tranches and excess spreads resulting from the securitization transaction and
reflected an aggregate of $6.7 million in such interests at December 31, 1997.
Other Items Affecting Net Earnings
The following items affect the Company's overall results of operations and
are not directly related to any one of the Company's businesses discussed above.
Corporate overhead. Interest income on the Class A Certificate during 1997
represents reimbursement to the Company from the Trust of accrual of dividends
of $3.6 million on special preferred stock through June 30, 1997 and interest
paid under a June 1997 agreement to retire the Class A Certificate. Company
level interest expense declined by 49.8% to $1.1 million in 1997 from $2.2
million in 1996 as a result of lower volumes of debt associated with the equity
required to purchase Portfolio Assets, equity interests in Acquisition
Partnerships and capital support to operating subsidiaries. The Company incurred
less indebtedness in 1997 because a substantial portion of the Company's funding
needs in 1997 were met by the Trust's redemption of its obligation under the
Class A Certificate. Other corporate income increased due to interest earned on
the excess liquidity derived from the Trust's redemption of the Class A
Certificate. Salary and benefits, occupancy and professional fees account for
the majority of other overhead expenses decreased in 1997 compared to 1996 as a
result of the decrease in the amount of executive and other officer bonuses
granted in 1997 compared to 1996.
Income taxes. Federal income taxes are provided at a 35% rate applied to
taxable income and are offset by NOLs that the Company believes are available to
it as a result of the Merger. The tax benefit of the NOLs is recorded in the
period during which the benefit is realized. The Company reported a deferred tax
benefit of $13.6 million in 1997 as compared to a benefit of $16.2 million in
1996 related to the benefits of NOLs.
Harbor Merger related expenses. In 1997 the Company incurred Harbor Merger
related expenses of $1.6 million for legal, other professional and financial
advisory costs associated with the Harbor Merger.
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<PAGE> 50
LIQUIDITY AND CAPITAL RESOURCES
Generally, the Company requires liquidity to fund its operations, working
capital, payment of debt, equity for acquisition of Portfolio Assets,
investments in and advances to the Acquisition Partnerships, investments in
expanding businesses to support their growth, retirement of and dividends on
preferred stock, and other investments by the Company. The potential sources of
liquidity are funds generated from operations, equity distributions from the
Acquisition Partnerships, interest and principal payments on subordinated
intercompany debt and dividends from the Company's subsidiaries, short-term
borrowings from revolving lines of credit, proceeds from equity market
transactions, securitization and other structured finance transactions and other
special purpose short-term borrowings.
In September 1998, the remaining special preferred stock was redeemed for
$14.7 million plus accrued dividends. On July 17, 1998 the Company filed a shelf
registration statement with the Securities and Exchange Commission which allows
the Company to issue up to $250 million in debt and equity securities from time
to time in the future. The registration statement became effective July 28,
1998. As of December 31, 1998 no securities have been issued under this
registration statement. In May 1998, the Company closed the public offering of
1,542,150 shares of FirstCity common stock, of which 341,000 shares were sold by
selling shareholders. Net proceeds (after expenses) of $34.1 million were used
to retire debt. In June 1998, the Company received $11.8 million from the
exercise of warrants.
In the future, the Company anticipates being able to raise capital through
a variety of sources including, but not limited to, public debt or equity
offerings (subject to limitations related to the preservation of the Company's
NOLs), thus enhancing the investment and growth opportunities of the Company.
The Company believes that these and other sources of liquidity, including
refinancing and expanding the Company's revolving credit facility to the extent
necessary, securitizations, and funding from senior lenders for Acquisition
Partnership investments and direct portfolio and business acquisitions, should
prove adequate to continue to fund the Company's contemplated activities and
meet its liquidity needs.
The Company and each of its major operating subsidiaries have entered into
one or more credit facilities to finance its respective operations. Each of the
operating subsidiary credit facilities is nonrecourse to the Company and the
other operating subsidiaries, except as discussed below.
Excluding the term acquisition facilities of the unconsolidated Acquisition
Partnerships, as of December 31, 1998, the Company and its subsidiaries had
credit facilities providing for borrowings in an aggregate principal amount of
$2.3 billion and outstanding borrowings of $1.5 billion. The following table
summarizes the material terms of the credit facilities to which the Company, its
major operating subsidiaries and the Acquisition Partnerships were parties as of
March 22, 1999 and the outstanding borrowings under such facilities as of
December 31, 1998.
CREDIT FACILITIES
<TABLE>
<CAPTION>
OUTSTANDING
PRINCIPAL BORROWINGS AS OF
AMOUNT DECEMBER 31, 1998 INTEREST RATE OTHER TERMS AND CONDITIONS
--------- ----------------- ------------- --------------------------
(DOLLARS IN MILLIONS)
<S> <C> <C> <C> <C>
FIRSTCITY
Company Credit Facility... $ 90 $ 85 Prime + 1.0% to Secured by the assets of the
Prime + 4% or LIBOR + Company, expires April 30, 1999
2.625%
Term fixed asset
facility................ 0.8 0.8 Prime + 1.0% Secured by certain fixed assets,
expires January 1, 2001
MORTGAGE CORP.
Warehouse facilities...... 546 528 LIBOR + 1.375% to 2.5% Revolving lines to warehouse
residential mortgage loans,
expires March 31, 1999
</TABLE>
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<PAGE> 51
<TABLE>
<CAPTION>
OUTSTANDING
PRINCIPAL BORROWINGS AS OF
AMOUNT DECEMBER 31, 1998 INTEREST RATE OTHER TERMS AND CONDITIONS
--------- ----------------- ------------- --------------------------
(DOLLARS IN MILLIONS)
<S> <C> <C> <C> <C>
Supplemental warehouse
facilities.............. 134 125 LIBOR + 1.75% to 2.75% Revolving line to warehouse
residential mortgage loans and
related receivables, expires March
31, 1999
Gestation facilities...... 873 574 Fed Funds + 0.8% to Open facilities to fund committed
1.05% and LIBOR + 0.5% loans to FNMA and others
to 0.8%
Servicing sale receivable
facility................ 15 15 Prime + 10.0% Mortgage Servicing line secured by
mortgage servicing rights, expired
February 18, 1999
CAPITAL CORP.
Warehouse facility........ 200 6 LIBOR + 0.85% to 3.0% Repurchase agreement to facilitate
the acquisition of Home Equity
Loans, expired January 31, 1999
Warehouse facility........ 200 42 LIBOR + 0.75% to 0.90% Repurchase agreement to facilitate
the acquisition of Home Equity
Loans, renewable monthly
Repurchase agreement...... 7 7 LIBOR + 2.75% Repurchase agreement secured by
residual interests in Home Equity
securitized loans, expires June
30, 1999
COMMERCIAL CORP.
Portfolio acquisition
facility................ 100 69 LIBOR + 2.25% Acquisition facility to acquire
Portfolio Assets, expires April
30, 1999 (includes $50 million
advanced to unconsolidated
Acquisition Partnerships)
French and Japanese
acquisition facility.... 15 10 French franc Acquisition facility to fund
LIBOR + 3.5% equity investments in French and
Japanese Yen Japanese Portfolio Assets, expires
LIBOR + 3.5% April 15, 1999. Guaranteed by
Commercial Corp. and the Company
Term acquisition
facilities.............. 36 36 Fixed at 7.00% to 7.66% Acquisition facilities for
existing Portfolio Assets. Secured
by Portfolio Assets. Expires
February 25, 2003 and June 5, 2002
CONSUMER CORP.
Warehouse facility........ 70 7 LIBOR + 3% Revolving line secured by
automobile receivables, expires
April 2, 1999
Repurchase Agreement...... 9 9 LIBOR + 3% Repurchase agreement secured by
residual interests in automobile
securitized loans, expires June
30, 1999
</TABLE>
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<PAGE> 52
<TABLE>
<CAPTION>
OUTSTANDING
PRINCIPAL BORROWINGS AS OF
AMOUNT DECEMBER 31, 1998 INTEREST RATE OTHER TERMS AND CONDITIONS
--------- ----------------- ------------- --------------------------
(DOLLARS IN MILLIONS)
<S> <C> <C> <C> <C>
Term facility............. 4 -- Prime + 1% Term facility secured by residual
interests in automobile
securitized loans, expires March
15, 2000
UNCONSOLIDATED ACQUISITION
PARTNERSHIPS
Term acquisition
facilities.............. 105 105 Fixed at 4.5% to Senior and subordinated loans
10.17%%, LIBOR + 2.25% secured by Portfolio Assets,
to 6.5% and Prime + .5% various maturities
to 7%
</TABLE>
FirstCity. The Company Credit Facility is a $90 million revolving credit
facility secured by the assets of the Company, including a pledge of the stock
of substantially all of its operating subsidiaries and its equity interests in
the Acquisition Partnerships. At December 31, 1998, the amount outstanding under
the facility totaled approximately $85 million. The Company Credit Facility
matures on April 30, 1999. The Company is in the process of negotiating an
extension and renewal of the Company Credit Facility.
Mortgage Corp. Currently, Mortgage Corp. has a primary warehouse facility
of $490 million with a group of banks led by Chase Bank, Houston. The facility,
which matures in March 1999, is used to finance mortgage warehouse operations as
well as other activities. Mortgage Corp. is in the process of negotiating an
extension and renewal of the primary warehouse facility for an additional year.
The $490 million facility is priced at LIBOR plus a different margin to LIBOR
for each of the sub-limits within the facility. The primary warehouse components
of the facility are priced at LIBOR plus from 1.37% to 2.5%, depending upon the
status of the warehouse collateral securing the loan. In addition to its primary
warehouse facility, Mortgage Corp. maintains supplemental facilities priced at
LIBOR plus 1.75% to 2.75%. Mortgage Corp. had a servicing sale receivable line
with Cargill in the amount $15 million, which bore interest at a rate of Prime +
10%. This line of credit was repaid in February 1999. The banks are obligated to
fund loans under such line through March 31, 1999, although final maturity of
any then outstanding loans may be extended, at Mortgage Corp.'s election, to
December 15, 2002. Mortgage Corp. considers these facilities adequate for its
current and anticipated levels of activity in its mortgage operations.
The Company has executed a performance guarantee in favor of the lending
bank group in the event of overdrafts arising in Mortgage Corp.'s funding
accounts. An overdraft could occur in the event of the presentment of a loan
closing draft to the drawee bank prior to receipt of full closed loan
documentation from the closing agent. The receipt of documents by the lending
bank would release funds under the warehouse facility to cover the closing draft
prior to the presentment of the draft, in normal circumstances. The possibility
exists, therefore, for an overdraft in Mortgage Corp.'s funding account. The
performance guarantee by the Company in favor of the lending bank group is to
cover such overdrafts that are not cleared in a specified period of time. In
addition, Mortgage Corp. has $873 million of gestation lines for loans to be
resold to FNMA and others.
Capital Corp. Currently Capital Corp. finances the purchase of Home Equity
Loans utilizing a secured warehouse credit facility provided by a large
investment bank. Under this credit facility, Capital Corp. is only permitted to
finance a portion of the purchase price of loans, which are generally purchased
at a premium. The amount of purchase price in excess of that financed is paid by
cash flow from Capital Corp. or the Company. Capital Corp. is in the process of
negotiating additional warehouse credit facilities.
Commercial Corp. Commercial Corp. funds its activities with equity
investments and subordinated debt from the Company and nonrecourse financing
provided by a variety of bank and institutional lenders. Such lenders provide
funds to the special purpose entities formed for the purpose of acquiring
Portfolio Assets or to Acquisition Partnerships formed for the purpose of
co-investing in asset pools with other investors, principally Cargill Financial.
Commercial Corp. has outstanding debt with Nomura of approximately $50 million,
priced at LIBOR plus 2.25%, the proceeds of which were used to fund up to 85% of
the purchase price of Portfolio
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<PAGE> 53
Assets acquired by Commercial Corp. or the Acquisition Partnerships. This
facility matures on April 30, 1999. Commercial Corp. is in the process of
negotiating additional credit facilities which, when combined with the cash flow
from its existing Portfolio Assets and its investment in equities of Acquisition
Partnerships, are expected to be adequate to meet its current and anticipated
liquidity needs. A Commercial Corp. subsidiary has a $15 million dollar
equivalent French franc and Japanese yen facility for use in Portfolio purchases
in France and Japan, which facility accrues interest at LIBOR plus 3.5%, matures
on April 15, 1999 and is guaranteed by Commercial Corp. and the Company.
Consumer Corp. Consumer Corp. conducts most of its activities through
Funding Corp. and funds its activities with equity investments and subordinated
debt from the Company and a limited recourse $70 million warehouse credit
facility with ContiTrade Services L.L.C. ("ContiTrade"). Funds are advanced
under the facility in accordance with an eligible loan borrowing base priced at
LIBOR plus 3.0%. Loans are eligible for inclusion in the borrowing base if they
meet documented underwriting standards as approved by ContiTrade and are not
delinquent beyond terms established in the loan agreement. Under the terms of
the credit facility, the Company guarantees 25% of the amount outstanding under
the facility from time to time in addition to an undertaking by the Company to
support the liquidity requirements of securitization transactions. The
ContiTrade facility matures on April 2, 1999. Funding Corp. has negotiated a new
$100 million facility with Enterprise Funding Corporation, an affiliate of
NationsBank, N.A., to replace the ContiTrade facility. This new facility is
insured by Mortgage Bankers Insurance Association and will be effective April 1,
1999. Funding Corp. plans to provide permanent financing for its acquired
consumer loans through securitizations of pools of loans totaling between $40
and $100 million pursuant to an investment management agreement with NationsBank
Montgomery Securities.
RELIANCE ON SYSTEMS; YEAR 2000 ISSUES
The Year 2000 Issue consists of shortcomings of many electronic data
processing systems that make them unable to process year-date data accurately
beyond the year 1999. The primary shortcoming arises because computer
programmers have abbreviated dates by eliminating the first two digits of the
year under the assumption that these digits would always be 19. Another
shortcoming is caused by the routine used by some computers for calculating leap
year does not detect that the year 2000 is a leap year. This inability to
process dates could potentially result in a system failure or miscalculation
causing disruptions in the Company's operations or performance.
The potential problems posed by this issue effect the Company's internal
business-critical systems ("internal systems") upon which the Company depends.
This includes information technology systems and applications ("IT"), as well as
non-IT systems and equipment with embedded technology, such as fax machines and
telephone systems. Examples of internal IT systems includes accounting systems
such as general ledger, loan servicing systems, cash management systems and loan
origination systems. In addition to the internal systems, the Company may be at
risk from Year 2000 failures caused by or occurring to third parties. Some third
parties have significant direct business relationships with the Company. These
parties include borrowers, lenders, investors who buy the Company's loan
products and outside system vendors such as Alltel, Inc., the primary data
processing provider for the servicing of Mortgage Corp's loans.
The Company's Year 2000 Initiative
The Company, with the assistance of a consulting firm that specializes in
Year 2000 readiness, is conducting an enterprise-wide Year 2000 initiative that
encompasses both the internal systems and exposure to third parties. For the
Company's internal systems, the initiative is being approached in three phases
comprised of assessment, remediation and testing. While there is considerable
overlap in the timing of the three phases, the assessment phase is the first
step in the initiative. In this phase, the objective is to identify the
components (i.e., hardware and software) of all internal systems and to assess
the readiness of each component. This information is then used to prepare a
comprehensive plan for remediation and testing. The information gathered during
this phase is also used to develop a more precise estimate of the costs of
remediation and testing.
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<PAGE> 54
Third party exposures are addressed by obtaining written representations of
Year 2000 readiness from the third parties and through cooperative testing
between the Company and certain of its significant third parties. The third
party initiative includes contingency planning which is based on the responses
to requests for representations of readiness and the results of cooperative
testing. Contingency plans also involve a comprehensive risk assessment in order
to maintain focus on critical business relationships. A contingency plan could
include replacement of a third party with a comparable firm believed to be
compliant.
The Company is in the process of completing the assessment phase for all of
its internal systems. Remediation and testing have already begun and complete
Year 2000 readiness for internal systems is scheduled to be achieved by July
1999. The Company does not anticipate any material difficulties in achieving
Year 2000 readiness within this time frame. The Company has not yet developed a
most reasonably likely worst case scenario with respect to Year 2000 issues, but
instead has focused its efforts on reducing uncertainties through the review
described above. The Company has not developed Year 2000 contingency plans other
than as described above, and does not expect to do so unless merited by the
results of its continuing review.
With respect to third party exposure, the process of obtaining written
representation from third parties is still ongoing. Therefore, the Company has
not completed its contingency plan. Based on responses received and testing to
date, it is not anticipated that the Company will be materially affected by any
third party Year 2000 readiness issue. The Company expects to have a
comprehensive contingency plan in place by the end of 1999. In general, any
significant third party service providers that have not completed their Year
2000 initiative by the third quarter of 1999 and certified their readiness to
the Company will be replaced with comparable firms that are believed to be
compliant. Contingency planning with respect to third parties and the potential
effects on internal systems will continue throughout the remainder of 1999.
In addition to the being included in the Company's initiative described
above, Mortgage Corp. is currently participating in the Year 2000 Inter-Industry
Test sponsored by the Mortgage Bankers Association ("MBA Test"). Other
participants in the MBA Test are from a cross section of the top industry
participants including originators, servicers, mortgage insurers, service
bureaus, investors and software vendors. Mortgage Corp.'s primary data
processing vendor, Alltel, Inc., and FNMA, Mortgage Corp.'s primary investor,
are also participants. The objective of the test is to prove that the
interaction with common mortgage industry trading partners is acceptable in a
year 2000+ environment. The test covers 17 types of transactions that fall under
the three primary mortgage processes: origination, secondary marketing, and
servicing. The test is scheduled to conclude no later than June 30, 1999. While
this test will not replace internal testing, it does provide additional
assurance to Mortgage Corp. and the other participants that the readiness of
their systems, many of which are directly interfaced, are subjected to
independent verification.
The Company has increased its estimate of the cost of its Year 2000
initiative and now believes that it will be approximately $1,500,000, a majority
of which will be incurred during 1999. Of these costs, approximately $150,000 is
for computer systems that must be replaced and the remainder is personnel costs
(employees and external consultants). The increase is due to the cost of
participation in the MBA Test and higher then anticipated costs for outside
consultants. All estimated costs have been budgeted and are expected to be
funded by cash flows from operations.
The cost of the initiative and the date on which the Company plans to
complete the Year 2000 modifications are based on management's best estimates,
which are derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors. Unanticipated failures by critical third parties, as well as the
failure by the Company to execute its own remediation efforts, could have a
material adverse effect on the cost of the initiative and its completion date.
As a result, there can be no assurance that these forward-looking estimates will
be achieved and the actual cost and third party compliance could differ
materially from those plans, resulting in material financial risk.
Potential Risks
Currently, there is uncertainty as to the ultimate success of global
remediation efforts, including the efforts of entities that provide services to
large segments of society such as airlines, utilities and securities
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exchanges. There could be short term or longer-term disruptions in segments of
the economy that could impact the Company. Due to the uncertainty with respect
to how the Year 2000 issue will affect business and government, it is not
possible to list all potential problems or risks to the Company.
The Company believes that the most reasonably likely worst case scenarios
that could have adverse effects on the Company are the failures of third
parties, particularly residential mortgage loan borrowers, its lenders and the
investors who purchase its mortgage and consumer loan products. The Company's
residential mortgage and consumer loan borrowers could be affected by any
adverse impact on the general economy that could cause a rise in delinquencies.
Lenders, who provide funds used by the Company to acquire assets, might be
adversely affected, disrupting the flow of funds, which could have an adverse
impact on the Company's ability to make new loans. Likewise, a disruption in
services by investors such as FNMA could have an adverse impact on the Company's
ability to sell loans, which would result in significant reductions in operating
activities.
Any Year 2000 factors that might impact borrowers' abilities to repay their
obligations relate to the failure of global remediation efforts over which the
Company has no influence. The Company's lenders and investors, most of which
operate in highly regulated industries, are among the largest such institutions
in the world. These institutions are under government regulatory mandates to
achieve full readiness prior to the end of 1999. The Company believes that it is
unlikely that these institutions will fail to achieve readiness within a
reasonable time frame; however, the Company will continue to monitor their
readiness and building an adequate ongoing contingency plan.
FOURTH QUARTER
Net earnings for the fourth quarter of 1998 were $4.9 million, including a
$.3 million deferred tax benefit. After deducting preferred dividends, net
earnings attributable to common equity were $4.2 million, or $.51 per diluted
share. Net earnings for the fourth quarter of 1997 were $5.4 million, including
a $.3 million deferred tax benefit. After deducting preferred dividends, net
earnings attributable to common equity were $3.8 million in 1997, or $.58 per
diluted share. The following table presents a summary of operations for the
fourth quarters of 1998 and 1997.
CONDENSED CONSOLIDATED SUMMARY OF OPERATIONS
<TABLE>
<CAPTION>
FOURTH QUARTER
-----------------------
1998 1997
---------- ----------
(DOLLARS IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Revenues.................................................... $58,696 $36,307
Expenses.................................................... 53,091 30,606
------- -------
Earnings before minority interest, preferred dividends and
income taxes.............................................. 5,605 5,701
Provision for income taxes.................................. (254) (11)
Minority interest........................................... (463) (339)
------- -------
Net earnings................................................ 4,888 5,351
======= =======
Preferred dividends......................................... 642 1,515
Net earnings to common shareholders......................... $ 4,246 $ 3,836
======= =======
Net earnings per common share -- basic...................... $ 0.51 $ 0.59
Net earnings per common share -- diluted.................... $ 0.51 $ 0.58
</TABLE>
EFFECT OF NEW ACCOUNTING STANDARDS
Statement of Position 98-5 ("SOP 98-5") issued by the American Institute of
Certified Public Accountants -- Reporting on the Costs of Start-up Activities
requires that previously capitalized start-up costs including organization costs
be written off and future costs related to start up entities be charged to
expense as incurred. The effective date of the SOP 98-5 is for financial
statements for fiscal years beginning after
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December 15, 1998. The Company adopted SOP 98-5 effective January 1, 1999 at
which time the Company had unamortized start up costs of $.8 million which will
affect the earnings of the Company in the first quarter of 1999.
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities,
establishes accounting and reporting standards for derivative instruments and
for hedging activities and is effective for all fiscal quarters of fiscal years
beginning after June 15, 1999. This statement is not anticipated to have a
material impact on the Company's financial position or results of operations.
RISK FACTORS
RISKS ASSOCIATED WITH RAPID GROWTH AND ENTRY INTO NEW BUSINESSES
Following the Merger, the Company embarked upon a strategic diversification
of its business. Previously, the Company had been engaged primarily in the
Portfolio Asset acquisition and resolution business. The Company entered the
residential and commercial mortgage banking business and the consumer lending
business through a combination of acquisitions and the start-up of new business
ventures. The entry of the Company into these new businesses has resulted in
increased demands on the Company's personnel and systems. The development and
integration of the new businesses requires the investment of additional capital
and the continuous involvement of senior management. The Company also must
manage a variety of businesses with differing markets, customer bases, financial
products, systems and managements. An inability to develop, integrate and manage
its businesses could have a material adverse effect on the Company's financial
condition, results of operations and business prospects. The Company's ability
to support and manage continued growth is dependent upon, among other things,
its ability to attract and retain senior management for each of its businesses,
to hire, train, and manage its workforce and to continue to develop the skills
necessary for the Company to compete successfully in its existing and new
business lines. There can be no assurance that the Company will successfully
meet all of these challenges.
CONTINUING NEED FOR FINANCING
General. The successful execution of the Company's business strategy
depends on its continued access to financing for each of its major operating
subsidiaries. In addition to the need for such financing, the Company must have
access to liquidity to invest as equity or subordinated debt to meet the capital
needs of its subsidiaries. Liquidity is generated by the cash flow to the
Company from subsidiaries, access to the public debt and equity markets and
borrowings incurred by the Company. The Company's access to the capital markets
is affected by such factors as changes in interest rates, general economic
conditions, and the perception in the capital markets of the Company's business,
results of operations, leverage, financial condition and business prospects. In
addition, the Company's ability to issue and sell common equity (including
securities convertible into, or exercisable or exchangeable for, common equity)
is limited as a result of the tax laws relating to the preservation of the NOLs
available to the Company as a result of the Merger. There can be no assurance
that the Company's funding relationships with commercial banks, investment banks
and financial services companies (including Cargill Financial) that have
previously provided financing for the Company and its subsidiaries will continue
past their respective current maturity dates. The majority of the credit
facilities to which the Company and its subsidiaries are parties have short-term
maturities. Negotiations are underway to extend certain of such credit
facilities that are approaching maturity and the Company expects that it will be
necessary to extend the maturities of other such credit facilities in the near
future. There can be no assurance that such negotiations will be successful. If
such negotiations do not result in the extension of the maturities of such
credit facilities and the Company or its subsidiaries cannot find alternative
funding sources on satisfactory terms, or at all, the Company's financial
condition, results of operations and business prospects would be materially
adversely affected. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."
Each of the Company and its major operating subsidiaries has its own source
of debt financing. In certain circumstances, a default by the Company or any of
its major operating subsidiaries in respect of indebtedness
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owed to a third party constitutes a default under the Company Credit Facility.
Certain of the credit facilities to which the Company's major operating
subsidiaries are a party do not contain similar cross-default or cross-
acceleration provisions. Although the Company intends to continue to segregate
the debt obligations of each such subsidiary, there can be no assurance that its
existing financing sources will continue to agree to such arrangements or that
alternative financing sources that would accept such arrangements would be
available. In those instances where a subsidiaries credit facility has
cross-default or cross-acceleration provisions or in the event other of the
Company's major operating subsidiaries are compelled to accept cross-guarantees,
or cross-default or cross-acceleration provisions in connection with their
respective credit facilities, financial difficulties experienced by one of the
Company's subsidiaries could adversely impact the Company's other subsidiaries.
Dependence on Warehouse Financing. As is customary in the mortgage banking
and consumer lending businesses, the Company's subsidiaries depend upon
warehouse credit facilities with financial institutions or institutional lenders
to finance the origination and purchase of loans on a short-term basis pending
sale or securitization. Implementation of the Company's business strategy
requires the continued availability of warehouse credit facilities, and may
require increases in the permitted borrowing levels under such facilities. There
can be no assurance that such financing will be available on terms satisfactory
to the Company. The inability of the Company to arrange additional warehouse
credit facilities, to extend or replace existing facilities when they expire or
to increase the capacity of such facilities may have a material adverse effect
on the Company's financial condition, results of operations and business
prospects.
RISKS OF SECURITIZATION
Significance of Securitization. The Company believes that it will become
increasingly dependent upon its ability to securitize Home Equity Loans,
sub-prime automobile loans and other loans to efficiently finance the volume of
assets expected to be generated. Accordingly, adverse changes in the secondary
market for such loans could impair the Company's ability to originate, purchase
and sell loans on a favorable or timely basis. Any such impairment could have a
material adverse effect upon the Company's financial condition, results of
operations and business prospects. Proceeds from the securitization of
originated and acquired loans are required to be used to repay borrowings under
warehouse credit facilities, thereby making such facilities available to finance
the origination and purchase of additional loan assets. There can be no
assurance that, as the Company's volume of loans originated or purchased
increases and other new products available for securitization increases, the
Company will be able to securitize its loan production efficiently. An inability
to efficiently securitize its loan production could have a material adverse
effect on the Company's financial condition, results of operations and business
prospects.
Securitization transactions may be affected by a number of factors, some of
which are beyond the Company's control, including, among other things, the
adverse financial condition of, or developments related to, some of the
Company's competitors, conditions in the securities markets in general, and
conditions in the asset-backed securitization market. The Company's
securitizations typically utilize credit enhancements in the form of financial
guaranty insurance policies in order to achieve enhanced credit ratings. Failure
to obtain insurance company credit enhancement could adversely affect the timing
of, or ability of the Company to effect, securitizations. In addition, the
failure to satisfy rating agency requirements with respect to loan pools would
adversely impact the Company's ability to effect securitizations.
Contingent Risks. Although the Company intends to sell substantially all of
the Home Equity Loans, sub-prime automobile loans and other consumer loans that
it originates or purchases, the Company retains some degree of credit risk on
substantially all loans sold. During the period in which loans are held pending
sale, the Company is subject to various business risks associated with the
lending business, including the risk of borrower default, the risk of
foreclosure and the risk that a rapid increase in interest rates would result in
a decline in the value of loans to potential purchasers. The Company expects
that the terms of its securitizations will require it to establish deposit
accounts or build over-collateralization levels through retention of
distributions otherwise payable to the holders of subordinated interests in the
securitization. The Company also expects to be required to commit to repurchase
or replace loans that do not conform to the representations and warranties made
by the Company at the time of sale.
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Retained Risks of Securitized Loans. The Company makes various
representations with respect to the loans that it securitizes. With respect to
acquired loans, the Company's representations rely in part on similar
representations made by the originators of such loans when they were purchased
by the Company. In the event of a breach of its representations, the Company may
be required to repurchase or replace the related loan using its own funds. While
the Company may have a claim against the originator in the event of a breach of
any of these representations made by the originators, the Company's ability to
recover on any such claim will be dependent on the financial condition of the
originator. There can be no assurance that the Company will not experience a
material loss in respect of any of these contingencies.
Performance Assumptions. Capital Corp. and Funding Corp.'s future net
income will be highly dependent on realizing securitization gains on the sale of
loans. Such gains will be dependent largely upon the estimated present values of
the subordinated interests expected to be derived from the transactions and
retained by the Company. Management makes a number of assumptions in determining
the estimated present values for the subordinated interests. These assumptions
include, but are not limited to, prepayment speeds, default rates and subsequent
losses on the underlying loans, and the discount rates used to present value the
future cash flows. All of the assumptions are subjective. Varying the
assumptions can have a material effect on the present value determination in one
securitization as compared to any other. Subsequent events will cause the actual
occurrences of prepayments, losses and interest rates to be different from the
assumptions used for such factors at the time of the recognition of the sale of
the loans. The effect of the subsequently occurring events could cause a
re-evaluation of the carrying values of the previously estimated values of the
subordinated interests and excess spreads and such adjustment could be material.
Because the subordinated interests to be retained by Capital Corp. and
Funding Corp. represent claims to future cash flow that are subordinated to
holders of senior interests, Capital Corp. and Funding Corp. retain a
significant portion of the risk of whether the full value of the underlying
loans may be realized. In addition, holders of the senior interests may have the
right to receive certain additional payments on account of principal in order to
reduce the balance of the senior interests in proportion to the credit
enhancement requirements of any particular transaction. Such payments for the
benefit of the senior interest holders will delay the payment, if any, of excess
cash flow to Capital Corp. and Funding Corp. as the holder of the subordinated
interests.
IMPACT OF CHANGING INTEREST RATES
Because most of the Company's borrowings are at variable rates of interest,
the Company will be impacted by fluctuations in interest rates. The Company
monitors the interest rate environment and employs hedging strategies designed
to mitigate certain effects of changes in interest rates when the Company deems
such strategies appropriate. However, certain effects of changes in interest
rates, such as increased prepayments of outstanding loans, cannot be mitigated.
Fluctuations in interest rates could have a material adverse effect on the
Company's financial condition, results of operations and business prospects.
Among other things, a decline in interest rates could result in increased
prepayments of outstanding loans, particularly on loans in the servicing
portfolio of Mortgage Corp. The value of servicing rights is a significant asset
of Mortgage Corp. As prepayments of serviced mortgages increase, the value of
such servicing rights (as reflected on the Company's balance sheet) declines,
with a corresponding reduction in income as a result of the impairment of the
value of mortgage servicing rights. Absent a level of new mortgage production
sufficient to mitigate the effect of mortgage loan prepayments, the future
revenue and earnings of the Company will be adversely affected. In addition to
prepayment risks, during periods of declining interest rates, Mortgage Corp.
experiences higher levels of borrowers who elect not to close on loans for which
they have applied because they tend to find loans at lower interest rates. If
Mortgage Corp. has entered into commitments to sell such a loan on a forward
basis and the prospective borrower fails to close, Mortgage Corp. must
nevertheless meet its commitment to deliver the contracted loans at the promised
yields. Mortgage Corp. will incur a loss if it is required to deliver loans to
an investor at a committed yield higher than current market rates. A substantial
and sustained decline in interest rates also may adversely impact the amount of
distressed assets available for purchase by Commercial Corp. The value of the
Company's interest-earning assets and liabilities may be directly affected by
the level of and fluctuations in interest rates, including the valuation of any
residual
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interests in securitizations that would be severely impacted by increased loan
prepayments resulting from declining interest rates.
Conversely, a substantial and sustained increase in interest rates could
adversely affect the ability of the Company to originate loans and could reduce
the gains recognized by the Company upon their securitization and sale.
Fluctuating interest rates also may affect the net interest income earned by the
Company resulting from the difference between the yield to the Company on
mortgage and other loans held pending sale and the interest paid by the Company
for funds borrowed under the Company's warehouse credit facilities or otherwise.
CREDIT IMPAIRED BORROWERS
The Company's sub-prime borrowers generally are unable to obtain credit
from traditional financial institutions due to factors such as an impaired or
poor credit history, low income or another adverse credit event. The Company is
subject to various risks associated with these borrowers, including, but not
limited to, the risk that the borrowers will not satisfy their debt service
obligations and that the realizable value of the assets securing their loans
will not be sufficient to repay the borrowers' debt. While the Company believes
that the underwriting criteria and collection methods it employs enable it to
identify and control the higher risks inherent in loans made to such borrowers,
and that the interest rates charged compensate the Company for the risks
inherent in such loans, no assurance can be given that such criteria or methods,
or such interest rates, will afford adequate protection against, or compensation
for, higher than anticipated delinquencies, foreclosures or losses. The actual
rate of delinquencies, foreclosures or losses could be significantly accelerated
by an economic downturn or recession. Consequently, the Company's financial
condition, results of operations and business prospects could be materially
adversely affected. The Company has established an allowance for loan losses
through periodic earnings charges and purchase discounts on acquired receivables
to cover anticipated loan losses on the loans currently in its portfolio. No
assurance can be given, however, that loan losses in excess of the allowance
will not occur in the future or that additional provisions will not be required
to provide for adequate allowances in the future.
AVAILABILITY OF PORTFOLIO ASSETS
The Portfolio Asset acquisition and resolution business is affected by
long-term cycles in the general economy. In addition, the volume of domestic
Portfolio Assets available for purchase by investors such as the Company has
generally declined since 1993 as large pools of distressed assets acquired by
governmental agencies in the 1980s and early 1990s have been resolved or sold.
The Company cannot predict its future annual acquisition volume of Portfolio
Assets. Moreover, future Portfolio Asset purchases will depend on the
availability of Portfolios offered for sale, the availability of capital and the
Company's ability to submit successful bids to purchase Portfolio Assets. The
acquisition of Portfolio Assets has become highly competitive in the United
States. This may require the Company to acquire Portfolio Assets at higher
prices thereby lowering profit margins on the resolution of such Portfolios.
Under certain circumstances, the Company may choose not to bid for Portfolio
Assets that it believes cannot be acquired at attractive prices. As a result of
all the above factors, Portfolio Asset purchases, and the revenue derived from
the resolution of Portfolio Assets, may vary significantly from quarter to
quarter.
AVAILABILITY OF NET OPERATING LOSS CARRYFORWARDS
The Company believes that, as a result of the Merger, approximately $596
million of NOLs were available to the Company to offset future taxable income as
of December 31, 1995. Since December 31, 1995, the Company has generated an
additional $47 million in tax operating losses. Accordingly, as of December 31,
1998, the Company believes that it has approximately $643 million of NOLs
available to offset future taxable income. In accordance with the terms of
Financial Accounting Standards Board Statement Number 109 (relating to
accounting for income taxes), the Company has established a future utilization
equivalent to approximately $91.9 million of the total $643 million of NOLs,
which equates to a $32.2 million deferred tax asset on the Company's books and
records. However, because the Company's position in respect of its NOLs is based
upon factual determinations and upon legal issues with respect to which there is
uncertainty and
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because no ruling has been obtained from the Internal Revenue Service (the
"IRS") regarding the availability of the NOLs to the Company, there can be no
assurance that the IRS will not challenge the availability of the Company's NOLs
and, if challenged, that the IRS will not be successful in disallowing the
entire amount of the Company's NOLs, with the result that the Company's $32.2
million deferred tax asset would be reduced or eliminated.
Assuming that the $643 million in NOLs is available to the Company, the
entire amount of such NOLs may be carried forward to offset future taxable
income of the Company until the tax year 2005. Thereafter, the NOLs begin to
expire. The ability of the Company to utilize such NOLs will be severely limited
if there is a more than 50% ownership change of the Company during a three-year
testing period within the meaning of section 382 of the Internal Revenue Code of
1986, as amended (the "Tax Code").
If the Company were unable to utilize its NOLs to offset future taxable
income, it would lose significant competitive advantages that it now enjoys.
Such advantages include, but are not limited to, the Company's ability to offset
non-cash income recognized by the Company in connection with certain
securitizations, to generate capital to support its expansion plans on a
tax-advantaged basis, to offset its and its consolidated subsidiaries' pretax
income, and to have access to the cash flow that would otherwise be represented
by payments of federal tax liabilities.
ASSUMPTIONS UNDERLYING PORTFOLIO ASSET PERFORMANCE
The purchase price and carrying value of Portfolio Assets acquired by
Commercial Corp. are determined largely by estimating expected future cash flows
from such assets. Commercial Corp. develops and revises such estimates based on
its historical experience and current market conditions, and based on the
discount rates that the Company believes are appropriate for the assets
comprising the Portfolios. In addition, many obligors on Portfolio Assets have
impaired credit, with risks associated with such obligors similar to the risks
described in respect of borrowers under " -- Credit Impaired Borrowers." If the
amount and timing of actual cash flows is materially different from estimates,
the Company's financial condition, results of operations and business prospects
could be materially adversely affected.
GENERAL ECONOMIC CONDITIONS
Periods of economic slowdown or recession, or declining demand for
residential or commercial real estate, automobile loans or other commercial or
consumer loans may adversely affect the Company's business. Economic downturns
may reduce the number of loan originations by the Company's mortgage banking,
consumer and commercial finance businesses and negatively impact its
securitization activity and generally reduce the value of the Company's assets.
In addition, periods of economic slowdown or recession, whether general,
regional or industry-related, may increase the risk of default on mortgage loans
and other loans and could have a material adverse effect on the Company's
financial condition, results of operations and business prospects. Such periods
also may be accompanied by declining values of homes, automobiles and other
property securing outstanding loans, thereby weakening collateral coverage and
increasing the possibility of losses in the event of default. Significant
increases in homes or automobiles for sale during recessionary economic periods
may depress the prices at which such collateral may be sold or delay the timing
of such sales. There can be no assurance that there will be adequate markets for
the sale of foreclosed homes or repossessed automobiles. Any material
deterioration of such markets could reduce recoveries from the sale of
collateral.
Such economic conditions could also adversely affect the resolution of
Portfolio Assets, lead to a decline in prices or demand for collateral
underlying Portfolio Assets, or increase the cost of capital invested by the
Company and the length of time that capital is invested in a particular
Portfolio. All or any one of these events could decrease the rate of return and
profits to be realized from such Portfolio and materially adversely affect the
Company's financial condition, results of operations and business prospects.
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RISK OF DECLINING VALUE OF COLLATERAL
The value of the collateral securing mortgage loans, automobile and other
consumer loans and loans acquired for resolution, as well as real estate or
other acquired distressed assets, is subject to various risks, including
uninsured damage, change in location or decline in value caused by use, age or
market conditions. Any material decline in the value of such collateral could
adversely affect the financial condition, results of operations and business
prospects of the Company.
GOVERNMENT REGULATION
Many aspects of the Company's business are subject to regulation,
examination and licensing under various federal, state and local statutes and
regulations that impose requirements and restrictions affecting, among other
things, the Company's loan originations, credit activities, maximum interest
rates, finance and other charges, disclosures to customers, the terms of secured
transactions, collection, repossession and claims handling procedures, multiple
qualification and licensing requirements for doing business in various
jurisdictions, and other trade practices. The Company believes it is currently
in compliance in all material respects with applicable regulations, but there
can be no assurance that the Company will be able to maintain such compliance.
Failure to comply with, or changes in, these laws or regulations, or the
expansion of the Company's business into jurisdictions that have adopted more
stringent regulatory requirements than those in which the Company currently
conducts business, could have an adverse effect on the Company by, among other
things, limiting the interest and fee income the Company may generate on
existing and additional loans, limiting the states in which the Company may
operate or restricting the Company's ability to realize on the collateral
securing its loans. See "Business -- Government Regulation."
The mortgage banking industry in particular is highly regulated. Failure to
comply with any of the various state and federal laws affecting the industry,
all of which are subject to regular modification, may result in, among other
things, demands for indemnification or mortgage loan repurchases, certain rights
of rescission for mortgage loans, class action lawsuits, administrative
enforcement actions and civil and criminal liability. Furthermore, currently
there are proposed various laws, rules and regulations which, if adopted, could
materially affect the Company's business. There can be no assurance that these
proposed laws, rules and regulations, or other such laws, rules or regulations
will not be adopted in the future that will make compliance more difficult or
expensive, restrict the Company's ability to originate, purchase, service or
sell loans, further limit or restrict the amount of commissions, interest and
other charges earned on loans originated, purchased, serviced or sold by the
Company, or otherwise have a material adverse effect on the Company's financial
condition, results of operations and business prospects. See
"Business -- Government Regulation."
Members of Congress and government officials have from time to time
suggested the elimination of the mortgage interest deduction for federal income
tax purposes, either entirely or in part, based on borrower income, type of loan
or principal amount. The reduction or elimination of these tax benefits may
lessen the demand for residential mortgage loans and Home Equity Loans, and
could have a material adverse effect on the Company's financial condition,
results of operations and business prospects.
ENVIRONMENTAL LIABILITIES
The Company, through its subsidiaries and affiliates, acquires real
property in its Portfolio Asset acquisition and resolution business, and
periodically acquires real property through foreclosure of mortgage loans that
are in default. There is a risk that properties acquired by the Company could
contain hazardous substances or waste, contaminants or pollutants. The Company
may be required to remove such substances from the affected properties at its
expense, and the cost of such removal may substantially exceed the value of the
affected properties or the loans secured by such properties. Furthermore, the
Company may not have adequate remedies against the prior owners or other
responsible parties to recover its costs, either as a matter of law or
regulation, or as a result of such prior owners' financial inability to pay such
costs. The Company may find it difficult or impossible to sell the affected
properties either prior to or following any such removal.
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COMPETITION
All of the businesses in which the Company operates are highly competitive.
Some of the Company's principal competitors are substantially larger and better
capitalized than the Company. Because of their resources, these companies may be
better able than the Company to obtain new customers for mortgage or other loan
production, to acquire Portfolio Assets, to pursue new business opportunities or
to survive periods of industry consolidation. Access to and the cost of capital
are critical to the Company's ability to compete. Many of the Company's
competitors have superior access to capital sources and can arrange or obtain
lower cost of capital, resulting in a competitive disadvantage to the Company
with respect to such competitors.
In addition, certain of the Company's competitors may have higher risk
tolerances or different risk assessments, which could allow these competitors to
establish lower margin requirements and pricing levels than those established by
the Company. In the event a significant number of competitors establish pricing
levels below those established by the Company, the Company's ability to compete
would be adversely affected.
RISK ASSOCIATED WITH FOREIGN OPERATIONS
Commercial Corp. has acquired, and manages and resolves, Portfolio Assets
located in France, Mexico and Japan and is actively pursuing opportunities to
purchase additional pools of distressed assets in these locations as well as
other areas of Western Europe. Foreign operations are subject to various special
risks, including currency translation risks, currency exchange rate
fluctuations, exchange controls and different political, social and legal
environments within such foreign markets. To the extent future financing in
foreign currencies is unavailable at reasonable rates, the Company would be
further exposed to currency translation risks, currency exchange rate
fluctuations and exchange controls. In addition, earnings of foreign operations
may be subject to foreign income taxes that reduce cash flow available to meet
debt service requirements and other obligations of the Company, which may be
payable even if the Company has no earnings on a consolidated basis. Any or all
of the foregoing could have a material adverse effect on the Company's financial
condition, results of operations and business prospects.
DEPENDENCE ON INDEPENDENT MORTGAGE BROKERS
The Company depends in large part on independent mortgage brokers for the
origination and purchase of mortgage loans. In 1998 and 1997, a substantial
portion of the loans originated by Mortgage Corp., and all of the loans
originated by Capital Corp., were originated by independent mortgage brokers or
otherwise acquired from third parties. These independent mortgage brokers deal
with multiple lenders for each prospective borrower. The Company competes with
these lenders for the independent brokers' business based on a number of
factors, including price, service, loan fees and costs. The Company's financial
condition, results of operations and business prospects could be adversely
affected by changes in the volume and profitability of mortgage loans resulting
from, among other things, competition with other lenders and purchasers of such
loans.
Class action lawsuits have been filed against a number of mortgage lenders,
including Mortgage Corp., alleging that such lenders have violated the federal
Real Estate Settlement Procedures Act of 1974 by making certain payments to
independent mortgage brokers. If these cases are resolved against the lenders,
it may cause an industry-wide change in the way independent mortgage brokers are
compensated. Such changes may have a material adverse effect on the Company's
results of operations, financial condition and business prospects.
DEPENDENCE ON AUTOMOBILE DEALERSHIP RELATIONSHIPS
The ability of the Company to expand into new geographic markets and to
maintain or increase its volume of automobile loans is dependent upon
maintaining and expanding the network of franchised automobile dealerships from
which it purchases contracts. Increased competition, including competition from
captive finance affiliates of automobile manufacturers, could have a material
adverse effect on the Company's ability to maintain or expand its dealership
network.
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<PAGE> 63
LITIGATION
Industry participants in the mortgage and consumer lending businesses from
time to time are named as defendants in litigation involving alleged violations
of federal and state consumer protection or other similar laws and regulations.
A judgment against the Company in connection with any such litigation could have
a material adverse effect on the Company's consolidated financial condition,
results of operations and business prospects.
RELATIONSHIP WITH AND DEPENDENCE UPON CARGILL
The Company's relationship with Cargill Financial is significant in a
number of respects. Cargill Financial, a subsidiary of Cargill, Incorporated, a
privately held, multi-national agricultural and financial services company,
provides equity and debt financings for many of the Acquisition Partnerships.
Cargill Financial owns approximately 2.7% of the Company's outstanding Common
Stock, and a Cargill Financial designee, David W. MacLennan, serves as a
director of the Company. The Company believes its relationship with Cargill
Financial significantly enhances the Company's credibility as a purchaser of
Portfolio Assets and facilitates its ability to expand into other businesses and
foreign markets. Although management believes that the Company's relationship
with Cargill Financial is excellent, there can be no assurance that such
relationship will continue in the future. Absent such relationship, the Company
and the Acquisition Partnerships would be required to find alternative sources
for the financing that Cargill Financial has historically provided. There can be
no assurance that such alternative financing would be available. Any termination
of such relationship could have a material adverse effect on the Company's
financial condition, results of operations and business prospects.
DEPENDENCE ON KEY PERSONNEL
The Company is dependent on the efforts of its senior executive officers,
particularly James R. Hawkins (Chairman and Chief Executive Officer), James T.
Sartain (President and Chief Operating Officer) and Rick R. Hagelstein
(Executive Vice President of the Company and Chairman and Chief Executive
Officer of Mortgage Corp.). The Company is also dependent on several of the key
members of management of each of its operating subsidiaries, many of whom were
instrumental in developing and implementing the business strategy for such
subsidiaries. The inability or unwillingness of one or more of these individuals
to continue in his present role could have a material adverse effect on the
Company's financial condition, results of operations and business prospects.
None of the senior executive officers has entered into an employment agreement
with the Company. There can be no assurance that any of the foregoing
individuals will continue to serve in his current capacity or for what time
period such service might continue. The Company does not maintain key person
life insurance for any of its senior executive officers.
INFLUENCE OF CERTAIN SHAREHOLDERS
The directors and executive officers of the Company collectively
beneficially own 23.5% of the Common Stock. Although there are no agreements or
arrangements with respect to voting such Common Stock among such persons except
as described below, such persons, if acting together, may effectively be able to
control any vote of shareholders of the Company and thereby exert considerable
influence over the affairs of the Company. James R. Hawkins, the Chairman of the
Board and Chief Executive Officer of the Company, is the beneficial owner of
11.5% of the Common Stock. James T. Sartain, President and Chief Operating
Officer of the Company, and ATARA I, Ltd. ("ATARA"), an entity associated with
Rick R. Hagelstein, Executive Vice President of the Company and Chairman and
Chief Executive Officer of Mortgage Corp. each beneficially own 4.3% of the
outstanding Common Stock. In addition, Cargill Financial owns approximately 2.7%
of the Common Stock. Mr. Hawkins, Mr. Sartain, Cargill Financial and ATARA are
parties to a shareholder voting agreement (the "Shareholder Voting Agreement").
Under the Shareholder Voting Agreement, Mr. Hawkins, Mr. Sartain and ATARA are
required to vote their shares in favor of Cargill Financial's designee for
director of the Company, and Cargill Financial is required to vote its shares in
favor of one or more of the designees of Messrs. Hawkins and Sartain and ATARA.
Richard J. Gillen and Ed Smith are the beneficial owners of 7.7% and 7.2%,
respectively, of the Common Stock. As a result, Messrs. Gillen and Smith may be
able to exert
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<PAGE> 64
influence over the affairs of the Company and if their shares are combined with
the holdings of Messrs. Hawkins and Sartain and the shares held by ATARA, will
have effective control of the Company. There can be no assurance that the
interests of management or the other entities and individuals named above will
be aligned with the Company's other shareholders.
SHARES ELIGIBLE FOR FUTURE SALE
The utilization of the Company's NOLs may be limited or prohibited under
the Tax Code in the event of certain ownership changes. The Company's Amended
and Restated Certificate of Incorporation (the "Certificate of Incorporation")
contains provisions restricting the transfer of its securities that are designed
to avoid the possibility of such changes. Such restrictions may prevent certain
holders of common stock of the Company from transferring such stock even if such
holders are permitted to sell such stock without restriction under the
Securities Act, and may limit the Company's ability to sell common stock to
certain existing holders of common stock at an advantageous time or at a time
when capital may be required but unavailable from any other source.
RELIANCE ON SYSTEMS; YEAR 2000 ISSUES
The Year 2000 Issue as fully described in management's discussion and
analysis of financial condition and results of operations, consists of
shortcomings of many electronic data processing systems that make them unable to
process year-date data accurately beyond the year 1999. The primary shortcoming
arises because computer programmers have abbreviated dates by eliminating the
first two digits of the year under the assumption that these digits would always
be 19. Another shortcoming is caused by the routine used by some computers for
calculating leap year does not detect that the year 2000 is a leap year. This
inability to process dates could potentially result in a system failure or
miscalculation causing disruptions in the Company's operations or performance.
The potential problems posed by this issue effect the Company's internal
business-critical systems ("internal systems") upon which the Company depends.
This includes information technology systems and applications ("IT"), as well as
non-IT systems and equipment with embedded technology, such as fax machines and
telephone systems. Examples of internal IT systems includes accounting systems
such as general ledger, loan servicing systems, cash management systems and loan
origination systems. In addition to the internal systems, the Company may be at
risk from Year 2000 failures caused by or occurring to third parties. Some third
parties have significant direct business relationships with the Company. These
parties include borrowers, lenders, investors who buy the Company's loan
products and outside system vendors such as Alltel, Inc., the primary data
processing provider for the servicing of Mortgage Corp's loans.
Potential Risks
Currently, there is uncertainty as to the ultimate success of global
remediation efforts, including the efforts of entities that provide services to
large segments of society such as airlines, utilities and securities exchanges.
There could be short term or longer-term disruptions in segments of the economy
that could impact the Company. Due to the uncertainty with respect to how the
Year 2000 issue will affect business and government, it is not possible to list
all potential problems or risks to the Company.
The Company has not yet developed a most reasonably likely worst case
scenario with respect to Year 2000 issues, but instead has focused its efforts
on reducing uncertainties through the review described above. However, the
Company believes that the most reasonably likely worst case scenarios that could
have adverse effects on the Company are the failures of third parties,
particularly residential mortgage loan borrowers, its lenders and the investors
who purchase its mortgage and consumer loan products. The Company's residential
mortgage and consumer loan borrowers could be affected by any adverse impact on
the general economy that could cause a rise in delinquencies. Lenders, who
provide funds used by the Company to acquire assets, might be adversely
affected, disrupting the flow of funds, which could have an adverse impact on
the Company's ability to make new loans. Likewise, a disruption in services by
investors such as FNMA
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<PAGE> 65
could have an adverse impact on the Company's ability to sell loans, which would
result in significant reductions in operating activities.
Any Year 2000 factors that might impact borrowers' abilities to repay their
obligations relate to the failure of global remediation efforts over which the
Company has no influence.
ANTI-TAKEOVER CONSIDERATIONS
The Company's Certificate of Incorporation and by-laws contain a number of
provisions relating to corporate governance and the rights of shareholders.
Certain of these provisions may be deemed to have a potential "anti-takeover"
effect to the extent they are utilized to delay, defer or prevent a change of
control of the Company by deterring unsolicited tender offers or other
unilateral takeover proposals and compelling negotiations with the Company's
Board of Directors rather than non-negotiated takeover attempts even if such
events may be in the best interests of the Company's shareholders. The
Certificate of Incorporation also contains certain provisions restricting the
transfer of its securities that are designed to prevent ownership changes that
might limit or eliminate the ability of the Company to use its NOLs.
PERIOD TO PERIOD VARIANCES
The Company Portfolio Assets and Acquisition Partnerships based proceeds
realized from the resolution of the Portfolio Assets, which proceeds have
historically varied significantly and likely will continue to vary significantly
from period to period. Consequently, the Company's period to period revenue and
net income have historically varied, and are likely to continue to vary,
correspondingly. Such variances, alone or with other factors, such as conditions
in the economy or the financial services industries or other developments
affecting the Company, may result in significant fluctuations in the reported
earnings of the Company and in the trading prices of the Company's securities,
particularly the Common Stock.
TAX, MONETARY AND FISCAL POLICY CHANGES
The Company originates and acquires financial assets, the value and income
potential of which are subject to influence by various state and federal tax,
monetary and fiscal policies in effect from time to time. The nature and
direction of such policies are entirely outside the control of the Company, and
the Company cannot predict the timing or effect of changes in such policies.
Changes in such policies could have a material adverse effect on the Company's
consolidated financial condition, results of operations and business prospects.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risk is the risk of loss from adverse changes in market prices and
interest rates. The Company's earnings are materially impacted by net gains on
sales of loans and net interest margins. The level of gains from loan sales the
Company achieves is dependent on demand for the products originated. Net
interest margins are dependent on the Company to maintain the spread or interest
differential between the interest it charges the customer for loans and the
interest the Company is charged for the financing of those loans. The following
describes each component of interest bearing assets held by the Company and how
each could be affected by changes in interest rates.
Portfolio assets consist of investments in pools of non-homogenous assets
that predominantly consist of loan and real estate assets. Earnings from these
assets are based on the estimated future cash flows from such assets and
recorded when those cash flows occur. The underlying loans within these pools
bear both fixed and variable rates. Due to the non-performing nature and history
of these loans, changes in prevailing bench-mark rates (such as the prime rate
or LIBOR) generally have a nominal effect on the ultimate future cash flow to be
realized from the loan assets. Furthermore, these pools of assets are held for
sale, not for investment; therefore, the disposition strategy is to liquidate
these assets as quickly as possible.
The sub-prime loans the Company sells generally are included in asset
backed securities the investor or purchaser issues. These securities are priced
at spreads over LIBOR or an equivalent term treasury security. These spreads are
determined by demand for the security. Demand is affected by the perception of
credit quality and prepayment risk associated with the loans the Company
originates and sells. Interest rates offered to customers also affect prices
paid for loans. These rates are determined by review of competitors rate
65
<PAGE> 66
offerings to the public and current prices being paid to the Company for the
products. The Company does not hedge these price risks.
Prices paid for prime loans, primarily mortgage loans held for sale, are
impacted by movements in interest rates. The Company mitigates this risk by
locking in prices with its investors as the customer locks in the price with the
Company, thus allowing the Company to maintain its margin. Generally, if
interest rates rise significantly, home sales and refinancing will decline
adversely affecting the Company's prime mortgage loan production.
The Company's residual interests in securitizations represent the present
value of the excess cash flows the Company expects to receive over the life of
the underlying sub-prime mortgage or automobile loans. The value of the
sub-prime mortgage residual interest is adversely affected by prepayment, losses
and delinquencies due to the longer term of the underlying assets and the value
would be negatively impacted by an increase in short-term rates, as a portion of
the cash flows fluctuate monthly based upon the one-month LIBOR. The sub-prime
automobile residual interests is affected less by prepayment speeds due to the
shorter term of the underlying assets and the fact that the loans are fixed
rate, generally at the highest rate allowable by law.
The Company's investment in mortgage servicing rights is based on weighted
average service fee rates and assumed prepayment speeds. Changes in prevailing
mortgage interest rates contribute to changes in the prepayment assumption of
servicing rights, thus causing increases to the value of the servicing rights
when mortgage rates increase and decreases in value when mortgage rates
decrease.
In summary, the Company would be negatively impacted by rising interest
rates and declining prices for its sub-prime loans. Rising interest rates would
negatively impact prime mortgage production and the value of the residual
interests in securitizations and declining prices for the Company's sub-prime
loans would adversely effect the levels of gains achieved upon the sale of those
loans.
The following table is a summary of the fair value of interest earning
assets and interest bearing liabilities, segregated by asset type and various as
described in the previous paragraphs, with expected maturity or sales dates as
indicated:
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1998 WEIGHTED GREATER
- ----------------------- AVERAGE 0-3 3-6 6-9 9-12 THAN
INTEREST BEARING ASSETS RATE MONTHS MONTHS MONTHS MONTHS 12 MONTHS TOTAL
- ----------------------- -------- --------- ------ ------ ------ --------- ---------
<S> <C> <C> <C> <C> <C> <C> <C>
Portfolio assets(1).............................. N/A 22,396 11,117 6,947 2,477 26,780 69,717
Mortgage loans(2)................................ 7.35% 1,218,559 -- -- -- -- 1,218,559
Construction loans(2)............................ 8.75% 24,590 -- -- -- -- 24,590
Automobile loans and student finance
receivables(2)................................. 18.75% 8,651 76 79 83 1,386 10,275
Residual interests in securitizations............ 14.00% 1,649 1,119 2,330 2,499 57,645 65,242
--------- ------ ----- ----- ------ ---------
1,275,845 12,312 9,356 5,059 85,811 1,388,383
========= ====== ===== ===== ====== =========
INTEREST BEARING LIABILITIES
- -------------------------------------------------
Lines of credit:(3)
Portfolio assets............................... 7.60% 28,230 -- -- -- 32,656 60,886
Mortgage loans................................. 6.74% 1,213,189 -- -- -- -- 1,213,189
Construction loans............................. 8.05% 22,629 -- -- -- -- 22,629
Automobile loans and student finance
receivables.................................. 8.33% 7,017 -- -- -- -- 7,017
Residual interests in securitizations.......... 8.44% 1,649 14,620 -- -- -- 16,269
--------- ------ ----- ----- ------ ---------
1,272,714 14,620 -- -- 32,656 1,319,990
========= ====== ===== ===== ====== =========
Company credit facility.......................... 7.75% -- 84,807 -- -- -- 84,807
========= ====== ===== ===== ====== =========
</TABLE>
- ---------------
(1) Portfolio assets are shown based on estimated proceeds from disposition,
which could occur much faster or slower than anticipated or as directed.
(2) Mortgage loans, Construction loans, Automobile loans and consumer loans are
shown in the table based upon the expected date of sale.
(3) Lines of credit mature in the periods indicated. This does not necessarily
indicate when the outstanding balances would be paid. The lines of credit
fund up to 100% of the corresponding asset class. If the asset balance
declines whether through a sale or a payment from the borrower, the
corresponding liability must be paid.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1998 1997
----------- ---------
(DOLLARS IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Cash and cash equivalents................................... $ 13,677 $ 31,605
Portfolio Assets, net....................................... 69,717 89,951
Loans receivable, net....................................... 45,881 90,115
Mortgage loans held for sale................................ 1,207,543 533,751
Investment securities, net.................................. 65,242 6,935
Equity investments in and advances to Acquisition
Partnerships.............................................. 41,466 35,529
Mortgage servicing rights, net.............................. 91,440 69,634
Receivable for servicing advances and accrued interest...... 58,977 21,410
Deferred tax benefit, net................................... 32,162 30,614
Other assets, net........................................... 37,872 30,575
---------- --------
Total Assets...................................... $1,663,977 $940,119
========== ========
LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY
Liabilities:
Notes payable............................................. $1,462,231 $750,781
Other liabilities......................................... 38,472 34,672
---------- --------
Total Liabilities................................. 1,500,703 785,453
Commitments and contingencies............................... -- --
Redeemable preferred stock:
Special preferred stock, including dividends of $669 in
1997 (nominal stated value of $21 per share; 2,500,000
shares authorized; 849,777 shares issued and
outstanding in 1997)................................... -- 18,515
Adjusting rate preferred stock, including dividends of
$642 and $846, respectively (redemption value of $21
per share; 2,000,000 shares authorized; 1,222,701 and
1,073,704 shares, respectively, issued and
outstanding)........................................... 26,319 23,393
Shareholders' equity:
Optional preferred stock (par value $.01 per share;
98,000,000 shares authorized; no shares issued or
outstanding)........................................... -- --
Common stock (par value $.01 per share; 100,000,000 shares
authorized; issued and outstanding: 8,287,959 and
6,526,510 shares, respectively)........................ 83 65
Paid in capital........................................... 78,456 29,509
Retained earnings......................................... 58,073 83,140
Accumulated other comprehensive income.................... 343 44
---------- --------
Total Shareholders' Equity........................ 136,955 112,758
---------- --------
Total Liabilities, Redeemable Preferred Stock and
Shareholders' Equity............................ $1,663,977 $940,119
========== ========
</TABLE>
See accompanying notes to consolidated financial statements.
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<PAGE> 68
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------
1998 1997 1996
----------- ----------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
Revenues:
Gain on sale of mortgage and other loans.................. $109,383 $ 36,496 $19,298
Gain on sale of automobile loans.......................... 7,214 -- --
Net mortgage warehouse income............................. 7,782 3,499 3,224
Gain (loss) on sale of mortgage servicing rights.......... (2,075) 4,246 2,641
Servicing fees:
Mortgage............................................... 25,537 14,732 10,079
Other.................................................. 5,767 12,066 12,456
Gain on resolution of Portfolio Assets.................... 9,208 24,183 19,510
Equity in earnings of Acquisition Partnerships............ 12,827 7,605 6,125
Rental income on real estate Portfolios................... 156 332 3,033
Interest income........................................... 13,495 13,448 7,707
Other income.............................................. 10,250 9,462 3,415
Interest income on Class A Certificate.................... -- 3,553 11,601
-------- -------- -------
Total revenues.................................... 199,544 129,622 99,089
======== ======== =======
Expenses:
Interest on other notes payable........................... 14,888 12,433 10,403
Salaries and benefits..................................... 82,710 42,191 26,927
Amortization of mortgage servicing rights................. 19,110 7,550 4,091
Provision for loan losses and impairment on residual
interests.............................................. 11,174 6,613 2,029
Provision for valuation of mortgage servicing rights...... 29,305 -- --
Harbor Merger related expenses............................ -- 1,618 --
Occupancy, data processing, communication and other....... 63,462 38,917 26,367
Interest on senior subordinated notes..................... -- -- 3,892
-------- -------- -------
Total expenses.................................... 220,649 109,322 73,709
-------- -------- -------
Earnings (loss) before minority interest and income taxes... (21,105) 20,300 25,380
Benefit for income taxes.................................. 1,043 15,485 13,749
-------- -------- -------
Earnings (loss) before minority interest.................... (20,062) 35,785 39,129
Minority interest......................................... 130 157 --
-------- -------- -------
Net earnings (loss)......................................... (20,192) 35,628 39,129
Preferred dividends....................................... (5,186) (6,203) (7,709)
-------- -------- -------
Net earnings (loss) to common shareholders.................. $(25,378) $ 29,425 $31,420
======== ======== =======
Net earnings (loss) per common share -- basic............... $ (3.35) $ 4.51 $ 4.83
Net earnings (loss) per common share -- diluted............. $ (3.35) $ 4.46 $ 4.79
Weighted average common shares outstanding -- basic......... 7,584 6,518 6,504
Weighted average common shares outstanding -- diluted....... 7,584 6,591 6,556
</TABLE>
See accompanying notes to consolidated financial statements.
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<PAGE> 69
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
<TABLE>
<CAPTION>
ACCUMULATED
NUMBER OF OTHER TOTAL
COMMON COMMON PAID IN COMPREHENSIVE RETAINED SHAREHOLDERS'
SHARES STOCK CAPITAL INCOME EARNINGS EQUITY
--------- ------ ------- ------------- -------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
BALANCES, JANUARY 1, 1996... 6,502,408 $65 $29,189 $ -- $ 23,534 $ 52,788
Exercise of warrants,
options and employee stock
purchase plan............. 10,938 -- 266 -- -- 266
Net earnings for 1996....... -- -- -- -- 39,129 39,129
Preferred dividends......... -- -- -- -- (7,709) (7,709)
Other....................... -- -- 328 -- -- 328
--------- --- ------- ---- -------- --------
BALANCES, DECEMBER 31,
1996...................... 6,513,346 65 29,783 -- 54,954 84,802
--------- --- ------- ---- -------- --------
Exercise of warrants,
options and employee stock
purchase plan............. 13,164 -- 318 -- -- 318
Change in subsidiary year
end....................... -- -- -- -- (1,239) (1,239)
Comprehensive income:
Net earnings for 1997..... -- -- -- -- 35,628 35,628
Foreign currency items.... -- -- -- 44 -- 44
--------
Total comprehensive
income.................... 35,672
--------
Preferred dividends......... -- -- -- -- (6,203) (6,203)
Other....................... -- -- (592) -- -- (592)
--------- --- ------- ---- -------- --------
BALANCES, DECEMBER 31,
1997...................... 6,526,510 65 29,509 44 83,140 112,758
--------- --- ------- ---- -------- --------
Exercise of warrants,
options and employee stock
purchase plan............. 519,299 5 12,675 -- -- 12,680
Issuance of common stock to
acquire the minority
interest of subsidiary.... 41,000 1 2,149 -- -- 2,150
Issuance of common stock in
public offering........... 1,201,150 12 34,123 -- -- 34,135
Comprehensive loss:
Net loss for 1998......... -- -- -- -- (20,192) (20,192)
Foreign currency items.... -- -- -- 299 -- 299
--------
Total comprehensive loss.... (19,893)
--------
Other....................... -- -- -- -- 311 311
Preferred dividends......... -- -- -- -- (5,186) (5,186)
--------- --- ------- ---- -------- --------
BALANCES, DECEMBER 31,
1998...................... 8,287,959 $83 $78,456 $343 $ 58,073 $136,955
========= === ======= ==== ======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
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<PAGE> 70
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------
1998 1997 1996
------------ ----------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Cash flows from operating activities:
Net earnings (loss)....................................... $ (20,192) $ 35,628 $ 39,129
Adjustments to reconcile net earnings (loss) to net cash
used in operating activities, net of effect of
acquisitions:
Proceeds from resolution of Portfolio Assets............ 42,976 87,138 70,940
Gain on resolution of Portfolio Assets.................. (9,208) (24,183) (19,510)
Purchase of Portfolio Assets and loans receivable,
net................................................... (28,644) (44,350) (61,525)
Origination of automobile receivables................... (119,096) (89,845) (17,635)
(Gain) loss on sale of mortgage servicing rights........ 2,075 (4,246) (2,641)
Increase in mortgage loans held for sale................ (673,792) (396,599) (30,418)
Increase in construction loans receivable............... (4,998) (10,414) (7,370)
Originated mortgage servicing rights.................... (152,802) (40,734) (18,128)
Purchases of mortgage servicing rights.................. (69) (5,798) (3,075)
Proceeds from sale of mortgage servicing rights......... 65,581 14,598 9,048
Provision for loan losses, residual interests and
valuation of
mortgage servicing rights............................. 40,479 6,613 2,029
Equity in earnings of Acquisition Partnerships.......... (12,827) (7,605) (6,125)
Proceeds from performing Portfolio Assets and loans
receivable, net....................................... 144,627 72,388 11,768
Increase in net deferred tax asset...................... (1,548) (14,200) (14,235)
Depreciation and amortization........................... 24,585 11,791 8,791
(Increase) decrease in other assets..................... (63,175) (18,288) (18,554)
Increase (decrease) in other liabilities................ 12,744 17,264 (344)
Adjustment to equity from change in subsidiary year
end................................................... -- (1,239) --
------------ ----------- -----------
Net cash used in operating activities.............. (753,284) (412,081) (57,855)
------------ ----------- -----------
Cash flows from investing activities, net of effect of
acquisitions:
Advances to Acquisition Partnerships and affiliates....... -- (50) (1,256)
Payments on advances to Acquisition Partnerships and
affiliates.............................................. -- 1,029 9,821
Acquisition of subsidiaries............................... -- 1,118 (3,936)
Principal payments on Class A Certificate................. -- 46,477 115,337
Property and equipment, net............................... (6,613) (2,919) (2,530)
Contributions to Acquisition Partnerships................. (22,534) (25,282) (30,704)
Distributions from Acquisition Partnerships............... 28,050 11,833 31,279
------------ ----------- -----------
Net cash provided by (used in) investing
activities....................................... (1,097) 32,206 118,011
------------ ----------- -----------
Cash flows from financing activities, net of effect of
acquisitions:
Borrowings under notes payable............................ 12,068,980 9,196,377 4,105,451
Payments of notes payable................................. (11,358,567) (8,777,337) (4,048,369)
Payment of senior subordinated notes...................... -- -- (105,690)
Purchase or redemption of special preferred stock......... (14,716) (12,567) --
Proceeds from issuance of common stock.................... 46,815 318 266
Distributions to minority interest........................ -- (5,129) --
Preferred dividends paid.................................. (6,059) (6,627) (9,647)
Other increases in paid in capital........................ -- -- 64
------------ ----------- -----------
Net cash provided by (used in) financing
activities....................................... 736,453 395,035 (57,925)
------------ ----------- -----------
Net (decrease) increase in cash............................. $ (17,928) $ 15,160 $ 2,231
Cash, beginning of year..................................... 31,605 16,445 14,214
------------ ----------- -----------
Cash, end of year........................................... $ 13,677 $ 31,605 $ 16,445
============ =========== ===========
Supplemental disclosure of cash flow information:
------------ ----------- -----------
Cash paid during the year for:
Interest........................................... $ 78,175 $ 37,284 $ 21,420
============ =========== ===========
Income taxes....................................... $ 629 $ 852 $ 116
============ =========== ===========
</TABLE>
NON CASH INVESTING ACTIVITY:
During 1998 and 1997, the Company received investment securities as a
result of sales of loans through securitizations totaling $66,962 and $6,925,
respectively.
See accompanying notes to consolidated financial statements.
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<PAGE> 71
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Basis of Presentation
On July 3, 1995, FirstCity Financial Corporation (the "Company" or
"FirstCity") was formed by the merger of J-Hawk Corporation and First City
Bancorporation of Texas, Inc. (the "Merger"). The Company's merger with Harbor
Financial Group, Inc. ("Mortgage Corp.") on July 1, 1997 was accounted for as a
pooling of interests. The accompanying consolidated financial statements were
retroactively restated to reflect the pooling of interests.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Significant estimates include the estimation of future
collections on purchased portfolio assets used in the calculation of net gain on
resolution of portfolio assets, interest rate environments, prepayment speeds of
loans in servicing portfolios, collectibility on loans held in inventory and for
investment. Actual results could differ materially from those estimates.
(b) Description of Business
The Company is a diversified financial services company with offices
throughout the United States, and a presence in France, Japan and Mexico. The
Company is engaged in three principal reportable segments: (i) residential and
commercial mortgage banking; (ii) portfolio asset acquisition and resolution;
and (iii) consumer lending. Refer to Note (10) for operational information
related to each of these principal segments.
The Company engages in the mortgage banking business through direct retail
and broker retail mortgage banking activities through which it originates,
purchases, sells and services residential and commercial mortgage loans
throughout the United States. Additionally the Company acquires, originates,
warehouses and securitizes mortgage loans to borrowers who have significant
equity in their homes and who generally do not satisfy the more rigid
underwriting standards of the traditional residential mortgage lending market
(referred to herein as "Home Equity Loans"). In addition to mortgage banking
activities, the Company performs other ancillary services such as residential
property management, property appraisal and inspection, portfolio/ corporate
evaluations, risk management and hedging advisory services, marketing of loan
servicing portfolios, and mergers and acquisitions advisory services.
In the portfolio asset acquisition and resolution business the Company
acquires and resolves portfolios of performing and nonperforming commercial and
consumer loans and other assets (collectively, "Portfolio Assets" or
"Portfolios"), which are generally acquired at a discount to their legal
principal balance. Purchases may be in the form of pools of assets or single
assets. The Portfolio Assets are generally nonhomogeneous assets, including
loans of varying qualities that are secured by diverse collateral types and
foreclosed properties. Some Portfolio Assets are loans for which resolution is
tied primarily to the real estate securing the loan, while others may be
collateralized business loans, the resolution of which may be based either on
business or real estate or other collateral cash flow. Portfolio Assets are
acquired on behalf of the Company or its wholly-owned subsidiaries, and on
behalf of legally independent domestic and foreign partnerships and other
entities ("Acquisition Partnerships") in which a partially owned affiliate of
the Company is the general partner and the Company and other investors are
limited partners.
The Company's consumer lending activities include the origination,
acquisition and servicing of sub-prime consumer loans principally secured by
automobiles with the intention of selling the acquired loans in securitization
transactions.
71
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company services, manages and ultimately resolves or otherwise disposes
of substantially all of the assets it, its Acquisition Partnerships, or other
related entities acquire. The Company services all such assets until they are
collected or sold and normally does not manage assets for non-affiliated third
parties.
(c) Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
all of the majority owned subsidiaries of the Company. Investments in 20 percent
to 50 percent owned affiliates are accounted for on the equity method. All
significant intercompany transactions and balances have been eliminated in
consolidation.
(d) Cash Equivalents
For purposes of the consolidated statements of cash flows, the Company
considers all highly liquid debt instruments with original maturities of three
months or less to be cash equivalents. The Company has maintained balances in
various operating and money market accounts in excess of federally insured
limits.
(e) Portfolio Assets
Portfolio Assets are classified as either non-performing Portfolio Assets,
performing Portfolio Assets or real estate Portfolios. The following is a
description of each classification and the related accounting policy accorded to
each Portfolio type:
Non-Performing Portfolio Assets
Non-performing Portfolio Assets consist primarily of distressed loans and
loan related assets, such as foreclosed upon collateral. Portfolio Assets are
designated as non-performing unless substantially all of the loans in the
Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. Such Portfolios are acquired on the basis of an
evaluation by the Company of the timing and amount of cash flow expected to be
derived from borrower payments or other resolution of the underlying collateral
securing the loan.
All non-performing Portfolio Assets are purchased at substantial discounts
from their outstanding legal principal amount, the total of the aggregate of
expected future sales prices and the total payments to be received from
obligors. Subsequent to acquisition, the amortized cost of non-performing
Portfolio Assets is evaluated for impairment on a quarterly basis. A valuation
allowance is established for any impairment identified through provisions
charged to earnings in the period the impairment is identified. No valuation
allowance was required as of December 31, 1998 or 1997.
Net gain on resolution of non-performing Portfolio Assets is recognized as
income to the extent that proceeds collected exceed a pro rata portion of
allocated cost from the Portfolio. Cost allocation is based on a proration of
actual proceeds divided by total estimated proceeds of the pool. No interest
income is recognized separately on non-performing Portfolio Assets. All
proceeds, of whatever type, are included in proceeds from resolution of
Portfolio Assets in determining the gain on resolution of such assets.
Accounting for Portfolios is on a pool basis as opposed to an individual
asset-by-asset basis.
Performing Portfolio Assets
Performing Portfolio Assets consist primarily of Portfolios of consumer and
commercial loans acquired at a discount from the aggregate amount of the
borrowers' obligation. Portfolios are classified as performing if substantially
all of the loans in the Portfolio are being repaid in accordance with the
contractual terms of the underlying loan agreements.
72
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Performing Portfolio Assets are carried at the unpaid principal balance of
the underlying loans, net of acquisition discounts. Interest is accrued when
earned in accordance with the contractual terms of the loans. The accrual of
interest is discontinued once a loan becomes past due 90 days or more.
Acquisition discounts for the Portfolio as a whole are accreted as an adjustment
to yield over the estimated life of the Portfolio. Accounting for these
Portfolios is on a pool basis as opposed to an individual asset-by-asset basis.
The Company accounts for its performing Portfolio Assets by evaluating the
collectibility of both contractual interest and principal of loans when
assessing the need for a loss accrual. Impairment is measured based on the
present value of the expected future cash flows discounted at the loans'
effective interest rates, or the fair value of the collateral, less estimated
selling costs, if any loans are collateral dependent and foreclosure is
probable.
Real Estate Portfolios
Real estate Portfolios consist of real estate assets acquired from a
variety of sellers. Such Portfolios are carried at the lower of cost or fair
value less estimated costs to sell. Costs relating to the development and
improvement of real estate are capitalized, whereas those relating to holding
assets are charged to expense. Income or loss is recognized upon the disposal of
the real estate. Rental income, net of expenses, on real estate Portfolios is
recognized when received.
(f) Loans receivable
Construction loans receivable consist of single-family residential
construction loans originated by the Company and are carried at the lower of
cost or market.
Loans held for investment include originated residential mortgage loans and
other loans made to third parties. Mortgage loans held for investment are
transferred to the investment category at the lower of cost or market on the
date of transfer. The mortgage loans consist principally of loans originated by
the Company which do not meet investor purchase criteria and loans repurchased
from mortgage-backed securities pools.
Automobile and consumer finance receivables consist of sub-prime automobile
finance receivables and student loan receivables, which are originated and
acquired from third party dealers and other originators, purchased at a
non-refundable discount from the contractual principal amount. This discount is
allocated between discount available for loan losses and discount available for
accretion to interest income. Discounts allocated to discounts available for
accretion are deferred and accreted to income using the interest method. To date
all acquired discounts have been allocated as discounts available for loan
losses. To the extent the discount is considered insufficient to absorb
anticipated losses on the loans receivable, additions to the allowance are made
through a periodic provision for loan losses (see Note 4). The evaluation of the
allowance considers loan portfolio performance, historical losses, delinquency
statistics, collateral valuations and current economic conditions. Such
evaluation is made on an individual loan basis using static pool analyses.
Interest is accrued when earned in accordance with the contractual terms of
the loans. The accrual of interest is discontinued once a loan becomes past due
90 days or more.
(g) Mortgage Loans Held for Sale
Mortgage loans held for sale include the market value of related hedge
contracts and are stated at the lower of cost or market value, as determined by
outstanding commitments from investors on an aggregate portfolio basis. Any
differences between the carrying amounts and the proceeds from sales are
credited or charged to operations at the time the sale proceeds are collected.
Loan origination fees and certain direct loan origination costs are
deferred until the related loan is sold. Discounts from origination of mortgage
loans held for sale are deferred and recognized as adjustments to gain
73
<PAGE> 74
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
or loss upon sale. Loan servicing income represents fees earned for servicing
loans owned by investors. The fees generally are based on a contractual
percentage of the outstanding principal balance. Fees are recorded as income
when cash payments are received. Loan servicing costs are charged to expense as
incurred.
(h) Investment Securities
The Company has investment securities (investments) consisting of rated
securities, retained interests and related interest only strips (collectively
referred to as residual interests) which are all attributable to loans sold
through securitization transactions by the Company. The investments are
classified as available for sale. Accordingly, the Company records these
investments at estimated fair value. The increases or decreases in estimated
fair value are recorded as unrealized gains or losses in the accompanying
consolidated statements of shareholders' equity. The determination of fair value
is based on the present value of the anticipated excess cash flows using
valuation assumptions unique to each securitization. Impairment in the fair
value of investment securities that is deemed to be other than temporary is
reflected in a valuation allowance with provisions charged to earnings in the
period in which the impairment is identified.
(i) Mortgage Servicing Rights
In 1997 the Company adopted the provisions of SFAS No. 125, ("SFAS. No.
125") Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities. This statement establishes the criteria for
distinguishing transfers of financial assets that are sales from transfers that
are secured borrowings. It superseded several accounting standards including
SFAS No. 122, Accounting for Mortgage Servicing Rights, and is effective for all
transactions that occurred after December 31, 1996. The adoption of this
statement had no material impact on the Company's consolidated financial
statements.
The Company capitalizes all mortgage servicing rights (MSRs), whether
acquired by purchase or origination, when there is a definitive plan to sell the
underlying loans with servicing rights retained. Subsequent to capitalization,
MSRs are carried at the lower of cost or fair value and amortized in proportion
to the estimated net servicing income over the estimated life of the servicing
portfolio.
The Company determines fair value of capitalized MSRs using assumptions
regarding economic factors as they relate to the servicing portfolio. These
assumptions are obtained from an independent servicing consultant and agreed to
by management. The Company evaluates the servicing rights by stratifying the
portfolio based on predominant risk characteristics of the underlying loans
including loan type and coupon rate ranges. Impairment in each strata is
recognized through a valuation allowance with a charge to earnings.
(j) Property and Equipment
Property and equipment are carried at cost, less accumulated depreciation
and are included in other assets. Depreciation is provided using accelerated
methods over the estimated useful lives of the assets.
(k) Receivable for Servicing Advances
Funds advanced for escrow, foreclosure and other investor requirements are
recorded as receivables and a loss provision is recorded for estimated
uncollectible amounts. An allowance for losses is provided for potential losses
on loans serviced for others that are in the process of foreclosure or may be
reasonably expected to be foreclosed in the future.
(l) Prepaid Commitment Fees
Prepaid commitment fees are included in other assets and represent fees
paid primarily to permanent investors for the right to deliver mortgage loans in
the future at a specified yield. These fees are recognized as
74
<PAGE> 75
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
expense when the loans are sold to permanent investors, when the commitment
expires, or when it is determined that loans will not be delivered under the
commitment. Deferred gains or losses are included in the carrying amount of the
loans being hedged, which are valued at the lower of aggregate cost or market
value.
(m) Intangibles
Intangible assets represent the excess of cost over fair value of assets
acquired in connection with purchase transactions (goodwill) as well as the
purchase price of future service fee revenues and are included in other assets.
These intangible assets are amortized over periods estimated to coincide with
the expected life of the underlying asset pool owned or serviced by the acquired
subsidiary. The Company periodically evaluates the existence of intangible asset
impairment on the basis of whether such intangibles are fully recoverable from
the projected, undiscounted net cash flows of the related assets acquired.
(n) Comprehensive Income
The Company adopted SFAS No. 130 ("SFAS 130"), Reporting Comprehensive
Income as of January 1, 1998. SFAS 130 establishes standards for reporting and
displaying comprehensive income and its components in a financial statement that
is displayed with the same prominence as other financial statements. SFAS 130
also requires the accumulated balance of other comprehensive income to be
displayed separately in the equity section of the consolidated balance sheet.
The adoption of this statement had no material impact on net earnings or
shareholders' equity. The Company's other comprehensive income consists of
foreign currency transactions only and had an accumulated balance of $343 and
$44 at December 31, 1998 and 1997, respectively.
(o) Taxes
The Company files a consolidated federal income tax return with its 80% or
greater owned subsidiaries. The Company records all of the allocated federal
income tax provision of the consolidated group in the parent corporation.
Deferred tax assets and liabilities are recognized for future tax
consequences attributable to differences between the financial statement
carrying amounts and the tax basis of existing assets and liabilities and
operating loss and tax credit carry forwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effects of future changes in tax laws or rates are not
anticipated. The measurement of deferred tax assets, if any, is reduced by the
amount of any tax benefits that, based on available evidence, are not expected
to be realized.
(p) Net Earnings (Loss) Per Common Share
The Company adopted the provisions of SFAS No. 128, Earnings Per Share,
which revised the previous calculation methods and presentation of earnings per
share in the fourth quarter of 1997. Basic net earnings (loss) per common share
calculations are based upon the weighted average number of common shares
outstanding restated to reflect the equivalent number of shares of the Company's
common stock that were issued in connection with the Harbor Merger discussed in
Note 2. Earnings (loss) included in the earnings (loss) per common share
calculation are reduced by or, in the case of loss, increased by preferred stock
dividends. Potentially dilutive common share equivalents include warrants and
stock options in the diluted earnings per common share calculations.
75
<PAGE> 76
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(q) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of
The Company assesses the impairment of long-lived assets and certain
identifiable intangibles whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to future net cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell.
(r) Reclassifications
Certain amounts in the financial statements for prior periods have been
reclassified to conform with current financial statement presentation.
(2) MERGERS AND ACQUISITIONS
On July 1, 1997, the Company merged with Mortgage Corp. (the "Harbor
Merger"). The Company issued 1,580,986 shares of its common stock in exchange
for 100% of Mortgage Corp.'s outstanding capital stock in a transaction
accounted for as a pooling of interests. Mortgage Corp. originates and services
residential and commercial mortgage loans. Mortgage Corp. had approximately $12
million in equity, assets of over $300 million and 700 employees prior to the
Harbor Merger. The consolidated financial statements of the Company have been
restated to reflect the Harbor Merger as if it occurred at the beginning of the
earliest period presented.
At year end 1997, an unrelated party exercised warrants to acquire a four
percent minority interest in Mortgage Corp.'s subsidiary, Harbor Financial
Mortgage Corporation. On March 31, 1998, the Company issued 41,000 shares of
common stock in exchange for the four percent minority interest in this
subsidiary.
On May 15, 1997, Mortgage Corp. acquired substantially all of the assets of
MIG Financial Corporation ("MIG"), MIG's $1.7 billion commercial mortgage
servicing portfolio, and MIG's commercial mortgage operations headquartered in
Walnut Creek, California for an aggregate purchase price of $4 million plus the
assumption of certain liabilities in a transaction accounted for as a purchase.
The assets purchased consisted of servicing rights, fixed assets and the
business relationships of MIG. MIG's assets, revenues and historical earnings
are insignificant to the total assets and results of operations of the Company.
The transaction was funded by $1.3 million of senior debt and $2.6 million of
subordinated debt. The Company provided the $2.6 million subordinated loan in
connection with such transaction. The terms of the loan reflected market terms
for comparable loans made on an arms'-length basis.
(3) PORTFOLIO ASSETS
Portfolio Assets are summarized as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
-------- --------
<S> <C> <C>
Non-performing Portfolio Assets............................. $ 93,716 $130,657
Performing Portfolio Assets................................. 24,759 16,131
Real estate Portfolios...................................... 12,561 22,777
-------- --------
Total Portfolio Assets............................ 131,036 169,565
Discount required to reflect Portfolio Assets at carrying
value..................................................... (61,319) (79,614)
-------- --------
Portfolio Assets, net............................. $ 69,717 $ 89,951
======== ========
</TABLE>
76
<PAGE> 77
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Portfolio Assets are pledged to secure non-recourse notes payable.
(4) LOANS RECEIVABLE
Loans receivable are summarized as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1998 1997
------- -------
<S> <C> <C>
Construction loans receivable............................... $24,590 $19,594
Residential mortgage and other loans held for investment.... 11,016 6,386
Automobile and consumer finance receivables................. 16,147 73,417
Allowance for loan losses................................... (5,872) (9,282)
------- -------
Loans receivable, net............................. $45,881 $90,115
======= =======
</TABLE>
The activity in the allowance for loan losses is summarized as follows for
the periods indicated:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Balances, beginning of year......................... $ 9,282 $ 2,693 $ --
Provision for loan losses......................... 4,750 6,613 2,029
Discounts acquired................................ 18,335 13,152 5,989
Reduction in contingent liabilities............... -- 458 1,415
Allocation of reserves to sold loans.............. (17,133) (1,363) --
Charge off activity:
Principal balances charged off................. (12,980) (15,126) (7,390)
Recoveries..................................... 3,618 2,855 650
-------- -------- -------
Net charge offs........................... (9,362) (12,271) (6,740)
-------- -------- -------
Balances, end of year............................... $ 5,872 $ 9,282 $ 2,693
======== ======== =======
</TABLE>
During 1997 and 1996, a note recorded at the time of purchase of the
initial automobile finance receivables pool and contingent on the ultimate
performance of the pool was adjusted to reflect a reduction in anticipated
payments due pursuant to the contingency. The reductions in the recorded
contingent liability were recorded as increases in the allowance for losses.
(5) MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale include loans collateralized by first lien
mortgages on one-to-four family residences as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1998 1997
---------- --------
<S> <C> <C>
Residential mortgage loans.................................. $1,190,585 $522,970
Unamortized premiums and discounts, net..................... 16,958 10,781
---------- --------
$1,207,543 $533,751
========== ========
</TABLE>
(6) INVESTMENT SECURITIES
The Company has investment securities (investments) consisting of rated
securities, retained interests and related interest only strips (collectively
referred to as residual interests) which are all attributable to loans
77
<PAGE> 78
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
sold through securitization transactions by the Company. Investments are
comprised of the following as of the dates indicated.
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------
1998 1997
------- ------
<S> <C> <C>
Rated securities............................................ $ 2,073 $ --
Interest only strips........................................ 37,977 3,396
Retained interests.......................................... 28,496 3,308
Accrued interest............................................ 1,146 231
Allowance for losses........................................ (4,450) --
------- ------
Investment securities............................. $65,242 $6,935
======= ======
</TABLE>
The activity in investments for 1998 and 1997 is as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------
1998 1997
--------- --------
<S> <C> <C>
Balance, beginning of year.................................. $ 6,935 $ --
Cost allocated from securitizations......................... 66,962 6,925
Interest accreted........................................... 3,041 548
Cash received from trusts................................... (7,246) (538)
Provision for permanent impairment of value................. (4,450) --
------- ------
Balance, end of year........................................ $65,242 $6,935
======= ======
</TABLE>
The investments are valued using discounts rates ranging from 12% to 15%
for both home equity and consumer residual interests. Estimated loss rates range
from 1.5% to 2% on home equity and range from 13% to 18% on consumer residual
interests with prepayment assumptions ranging from 12% to 30% and 3% to 54% on
home equity and consumer residual interests, respectively. During 1998, the
Company recorded a provision for permanent impairment of value of approximately
$4.5 million on the investments.
(7) INVESTMENTS IN ACQUISITION PARTNERSHIPS
The Company has investments in Acquisition Partnerships and their general
partners that are accounted for on the equity method. Acquisition Partnerships
invest in Portfolio Assets in a manner similar to the Company, as described in
Note 1. The condensed combined financial position and results of operations of
the
78
<PAGE> 79
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Acquisition Partnerships, which include the domestic and foreign Acquisition
Partnerships and their general partners, are summarized below:
CONDENSED COMBINED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
-------- --------
<S> <C> <C>
Assets...................................................... $295,114 $338,484
======== ========
Liabilities................................................. $190,590 $250,477
Net equity.................................................. 104,524 88,007
-------- --------
$295,114 $338,484
======== ========
Company's equity in Acquisition Partnerships................ $ 41,466 $ 35,529
======== ========
</TABLE>
CONDENSED COMBINED SUMMARY OF EARNINGS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Proceeds from resolution of Portfolio Assets......... $170,187 $178,222 $174,012
Gross margin......................................... 57,628 33,398 39,505
Interest income on performing Portfolio Assets....... 9,714 8,432 7,870
Net earnings......................................... $ 33,706 $ 20,117 $ 10,692
======== ======== ========
Company's equity in earnings of Acquisition
Partnerships....................................... $ 12,827 $ 7,605 $ 6,125
======== ======== ========
</TABLE>
(8) MORTGAGE SERVICING RIGHTS
Mortgage servicing rights consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1998 1997
-------- --------
<S> <C> <C>
Mortgage servicing rights................................... $129,404 $ 87,742
Deferred excess servicing fees.............................. 22,077 5,929
-------- --------
151,481 93,671
Accumulated amortization.................................... (42,666) (23,489)
-------- --------
108,815 70,182
Valuation allowance......................................... (17,375) (548)
-------- --------
$ 91,440 $ 69,634
======== ========
</TABLE>
The following summarizes the activity in the Company's valuation allowance:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
1998 1997 1996
--------- ----- -----
<S> <C> <C> <C>
Beginning balance........................................... $ 548 $448 $ --
Provision for impairment.................................... 29,305 100 448
Realized loss on mortgage servicing rights sold............. (12,478) -- --
-------- ---- ----
Ending balance.............................................. $ 17,375 $548 $448
======== ==== ====
</TABLE>
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(9) NOTES PAYABLE
Notes payable consisted of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------
1998 1997
---------- --------
<S> <C> <C>
Collateralized loans, secured by Portfolio Assets:
Fixed rate (7.66% at December 31, 1998), due 2002......... $ 32,656 $ 79,206
French franc LIBOR (3.50% at December 31, 1998) plus
3.50%, due 1999........................................ 8,865 8,301
LIBOR (5.5466% at December 31, 1998) plus 2.50%, due
1999................................................... 18,105 3,259
Japanese yen LIBOR (0.3125% at December 31, 1998) plus
3.50%, due 1999........................................ 1,260 --
Collateralized loans, secured by automobile finance
receivables:
LIBOR (5.5466% at December 31, 1998) plus 1.00% to 3.00%,
due 1999............................................... 7,017 50,006
Repurchase agreements, secured by investment securities:
LIBOR (5.5466% at December 31, 1998) plus 2.75% to 3.00%,
due 1999............................................... 16,269 --
Residential mortgage warehouse lines of credit, secured by
individual notes:
LIBOR (5.17% at December 31, 1998) plus .50% to 2.50%, due
1999................................................... 563,157 337,598
Fed Funds (4.07% at December 31, 1998) plus .80 to 1.05%,
due 1999............................................... 506,253 187,141
Repurchase agreements (5.17% at December 31, 1998) plus
0.75% to 3.0%, due 1999................................ 47,898 35,826
Other notes payable, secured by substantially all the assets
of Mortgage Corp.:
LIBOR (5.17% at December 31, 1998) plus 2.25%, due 2002... 157,210 38,000
Other notes payable, secured by mortgage servicing rights:
Prime(7.75% at December 31, 1998) plus 10%, due 1999...... 15,000 --
Borrowings under revolving line of credit, secured and with
recourse to the Company................................... 84,807 6,994
Other borrowings, secured by fixed assets................... 780 849
---------- --------
Notes payable, secured...................................... 1,459,277 747,180
Notes payable to others (Diversified shareholder debt) 7%,
due 2003.................................................. 2,954 3,601
---------- --------
$1,462,231 $750,781
========== ========
</TABLE>
The Company has a $90 million revolving line of credit with a foreign bank
and a United States national bank. The line bears interest at Wall Street prime
and expires on April 30, 1999. The line is secured by substantially all of the
Company's unencumbered assets.
Under terms of certain borrowings, the Company and its subsidiaries are
required to maintain certain tangible net worth levels and debt to equity and
debt service coverage ratios. The terms also restrict future levels of debt. The
Company was in compliance with all covenants at December 31, 1998. The aggregate
maturities of notes payable for the five years ending December 31, 2003 are as
follows: $1,394,538 in 1999, $11,321 in 2000, $11,888 in 2001, $43,791 in 2002
and $693 in 2003.
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(10) SEGMENT REPORTING
As previously described in Note 1, the Company is engaged in three
reportable segments i) residential and commercial mortgage banking; ii)
portfolio asset acquisition; and iii) consumer lending. These segments have been
segregated based on products and services offered by each. The following is a
summary of results of operations for each of the segments and a reconciliation
to net earnings (loss) for 1998, 1997 and 1996.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
----------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
MORTGAGE BANKING:
Revenues:
Net mortgage warehouse income............................. $ 7,782 $ 3,499 $ 3,224
Gain on sale of mortgage loans............................ 109,383 36,496 19,298
Servicing fees............................................ 25,537 14,732 10,079
Other..................................................... 5,298 10,999 5,019
-------- ------- -------
Total............................................. 148,000 65,726 37,620
Expenses:
Salaries and benefits..................................... 68,955 30,398 16,105
Amortization of mortgage servicing rights................. 19,110 7,550 4,091
Provision for valuation of mortgage servicing rights...... 29,305 -- --
Provision for loan losses and residual interests.......... 1,973 -- --
Interest on other notes payables.......................... 2,800 1,187 423
Occupancy, data processing, communication and other....... 46,745 20,675 11,013
-------- ------- -------
Total............................................. 168,888 59,810 31,632
-------- ------- -------
Operating contribution (loss), before direct taxes.......... $(20,888) $ 5,916 $ 5,988
======== ======= =======
Operating contribution (loss), net of direct taxes.......... $(20,977) $ 8,005 $ 3,724
======== ======= =======
PORTFOLIO ASSET ACQUISITION AND RESOLUTION:
Revenues:
Gain on resolution of Portfolio Assets.................... $ 9,208 $24,183 $19,510
Equity in earnings of Acquisition Partnerships............ 12,827 7,605 6,125
Servicing fees............................................ 3,062 11,513 12,440
Other..................................................... 4,185 4,402 6,592
-------- ------- -------
Total............................................. 29,282 47,703 44,667
Expenses:
Salaries and benefits..................................... 4,619 5,353 6,002
Interest on other notes payable........................... 5,118 7,084 6,447
Asset level expenses, occupancy, data processing and
other.................................................. 7,204 12,103 10,862
-------- ------- -------
Total............................................. 16,941 24,540 23,311
-------- ------- -------
Operating contribution before direct taxes.................. $ 12,341 $23,163 $21,356
======== ======= =======
Operating contribution, net of direct taxes................. $ 12,284 $22,970 $21,210
======== ======= =======
</TABLE>
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1998 1997 1996
----------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
CONSUMER LENDING:
Revenues:
Gain on sale of automobile loans.......................... $ 7,214 $ -- $ --
Interest income........................................... 10,035 10,182 3,604
Servicing fees and other.................................. 2,811 99 46
-------- ------- -------
Total............................................. 20,060 10,281 3,650
Expenses:
Salaries and benefits..................................... 5,602 2,959 698
Provision for loan losses and residual interests.......... 9,201 6,613 2,029
Interest on other notes payable........................... 3,196 3,033 1,284
Occupancy, data processing and other...................... 5,819 3,272 1,469
-------- ------- -------
Total............................................. 23,818 15,877 5,480
-------- ------- -------
Operating loss before direct taxes.......................... $ (3,758) $(5,596) $(1,830)
======== ======= =======
Operating loss, net of direct taxes......................... $ (3,758) $(5,599) $(1,830)
======== ======= =======
Total operating contribution (loss), net of direct taxes.... $(12,451) $25,376 $23,104
======== ======= =======
CORPORATE OVERHEAD:
Revenues:
Interest income on Class A Certificate.................... $ -- $ 3,553 $11,601
Other..................................................... 2,202 2,359 4,551
-------- ------- -------
Total............................................. 2,202 5,912 16,152
Interest expense on senior subordinated notes............. -- -- (3,892)
Salaries and benefits, occupancy, professional and
expenses, net.......................................... (11,132) (7,634) (12,394)
Deferred tax benefit...................................... 1,189 13,592 16,159
Harbor Merger related expenses............................ -- (1,618) --
-------- ------- -------
Net earnings (loss)......................................... $(20,192) $35,628 $39,129
======== ======= =======
</TABLE>
Total assets for each of the segments and a reconciliation to total assets
is as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------
1998 1997
---------- --------
<S> <C> <C>
Mortgage assets............................................. $1,413,663 $650,775
Portfolio acquisition and resolution assets................. 114,596 125,480
Consumer assets............................................. 51,722 61,135
Deferred tax asset.......................................... 32,162 30,614
Other assets................................................ 51,834 72,115
---------- --------
Total assets...................................... $1,663,977 $940,119
========== ========
</TABLE>
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(11) MORTGAGE SERVICING PORTFOLIO AND RELATED OFF-BALANCE SHEET CREDIT RISK, AND
INSURANCE COVERAGE
At December 31, 1998 and 1997, a substantial portion of the Company's loan
production activity and collateral for loans serviced is concentrated within the
states of Texas, California and Florida. The Company's mortgage servicing
portfolio is comprised of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1998 1997
----------- ----------
<S> <C> <C>
Number of loans............................................. 108 62
Aggregate principal balance................................. $11,964,451 $6,688,452
Related escrow funds........................................ $ 55,340 $ 32,708
</TABLE>
The above table includes subserviced mortgage loans of approximately $4.2
billion and $707 million at December 31, 1998 and 1997, respectively.
The Company is required to advance, from corporate funds, escrow and
foreclosure costs for loans which it services. A portion of these advances for
loans serviced for GNMA are not recoverable. As of December 31, 1998 and 1997,
reserves for unrecoverable advances of approximately $378 and $357,
respectively, were established for GNMA loans in default.
Upon foreclosure, an FHA/VA property is typically conveyed to HUD or the
VA. However, the VA has the authority to deny conveyance of the foreclosed
property to the VA (a "VA no-bid"). The VA, instead, reimburses the Company
based on a percentage of the loan's outstanding principal balance ("guarantee"
amount). For GNMA VA no-bids, the foreclosed property is conveyed to the Company
and the Company then assumes the market risk of disposing of the property. The
related allowance for GNMA VA loans in default for potential no-bid losses as of
December 31, 1998 and 1997, is included in the allowance for unrecoverable
advances described above.
The Company is servicing approximately $11 million in loans with recourse
to Mortgage Corp. on behalf of FNMA and other investors. The recourse obligation
is the result of servicing purchases by Mortgage Corp. pursuant to which
Mortgage Corp. assumed the recourse obligation. As a result, Mortgage Corp. is
obligated to repurchase those loans that ultimately foreclose.
In addition, Mortgage Corp. has issued various representations and
warranties associated with whole loan and bulk servicing sales. The
representations and warranties may require Mortgage Corp. to repurchase
defective loans as defined by the applicable servicing and sales agreements.
Mortgage Corp. and its subsidiaries originated and purchased mortgage loans
with principal balances totaling approximately $9.4 billion and $3.7 billion in
1998 and 1997, respectively. Errors and omissions and fidelity bond insurance
coverage under a mortgage banker's bond was $10.1 million and $6.5 million at
December 31, 1998 and 1997, respectively.
(12) PREFERRED STOCK AND SHAREHOLDERS' EQUITY
In May 1998, the Company closed the public offering of 1,542,150 shares of
FirstCity common stock, of which 341,000 shares were sold by selling
shareholders. Net proceeds (after expenses) of $34.1 million were used to retire
debt. On May 11, 1998, the Company notified holders of its outstanding warrants
to purchase shares of common stock that it was exercising its option to
repurchase such warrants for $1.00 each. In June 1998, as a result of such
notification, warrants representing 471,380 shares of common stock were
exercised for an aggregate warrant purchase price of $11.8 million. No warrants
were outstanding as of December 31, 1998. On July 17, 1998, the Company filed a
shelf registration statement with the Securities and Exchange Commission which
allows the Company to issue up to $250 million in debt and equity securities
from time to
83
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
time in the future. The registration statement became effective July 28, 1998.
As of December 31, 1998, there have been no securities issued under this
registration statement.
The holders of shares of common stock are entitled to one vote for each
share on all matters submitted to a vote of common shareholders. In order to
preserve certain tax benefits available to the Company, transactions involving
shareholders holding or proposing to acquire more than 4.75% of outstanding
common shares are prohibited unless the prior approval of the Board of Directors
is obtained.
In 1997, the Company purchased 537,430 shares (representing $11.3 million
in liquidation preference) of special preferred stock with a distribution from
the Trust. The special preferred stock was redeemed for $14.7 million plus
accrued dividends in 1998. Dividends of $2.7 million and $5.8 million,
respectively, or $3.15 per share, were paid in 1998 and 1997.
In June 1997, the Company initiated an offer to exchange one share of
special preferred stock for one share of the newly designated adjusting rate
preferred stock. The adjusting rate preferred stock has a redemption value of
$21.00 per share and cumulative quarterly cash dividends at the annual rate of
$3.15 per share through September 30, 1998, adjusting to $2.10 per share through
the redemption date of September 30, 2005. The Company may redeem the adjusting
rate preferred stock after September 30, 2003 for $21 per share plus accrued
dividends. The adjusting rate preferred stock carries no voting rights except in
the event of non-payment of dividends. Pursuant to the exchange offer, 1,073,704
shares in 1997 and 148,997 shares in 1998 of special preferred stock were
exchanged for a like number of shares of adjusting rate preferred stock.
Dividends of $3.4 million and $.8 million, respectively, or $3.15 and $.7875 per
share, were paid in 1998 and 1997, and additional dividends of $.6 million, or
$.525 per share, were accrued at December 31, 1998 (paid on January 15, 1999).
The Board of Directors of the Company may designate the relative rights and
preferences of the optional preferred stock when and if issued. Such rights and
preferences can include liquidation preferences, redemption rights, voting
rights and dividends and shares can be issued in multiple series with different
rights and preferences. The Company has no current plans for the issuance of an
additional series of optional preferred stock.
The Company has stock option and award plans for the benefit of key
individuals, including its directors, officers and key employees. The plans are
administered by a committee of the Board of Directors and provide for the grant
of up to a total of 730,000 shares of common stock.
The per share weighted-average fair value of stock options granted during
1998 and 1997 was $23.49 and $19.14, respectively, on the grant date using the
Black-Scholes option pricing model with the following assumptions: $0 expected
dividend yield, risk-free interest rate of 5.75%, expected volatility of 30%,
and an expected life of 10 years.
The Company applies Accounting Principles Board Opinion No. 25 in
accounting for its stock option and award plans and, accordingly, no
compensation cost has been recognized for its stock options in the financial
statements. Had the Company determined compensation cost based on the fair value
at the grant date for its stock options under SFAS No. 123, Accounting for
Stock-Based Compensation, the Company's net earnings
84
<PAGE> 85
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(loss) to common shareholders and net earnings (loss) per common share would
have been charged to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
1998 1997
-------- -------
<S> <C> <C>
Net earnings (loss) to common shareholders:
As reported............................................... $(25,378) $29,425
Pro forma................................................. (26,659) 28,263
Net earnings (loss) per common share -- diluted:
As reported............................................... $ (3.35) $ 4.46
Pro forma................................................. (3.52) 4.29
</TABLE>
Stock option activity during the periods indicated is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------------------ ------------------ ------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------- -------- ------- -------- ------- --------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning of
year........................... 314,300 $22.64 223,100 $21.07 229,600 $20.20
Granted.......................... 15,000 29.69 125,200 26.47 18,000 30.75
Exercised........................ (12,350) 22.04 (4,750) 20.00 (4,500) 20.00
Forfeited........................ (32,000) 22.50 (29,250) 25.91 (20,000) 20.00
------- ------- -------
Outstanding at end of year....... 284,950 $23.06 314,300 $22.64 223,100 $21.07
======= ======= =======
</TABLE>
At December 31, 1998, the range of exercise prices and weighted-average
remaining contractual life of outstanding options was $20.00 to $30.75 and 7.12
years, respectively. In addition, 138,897 options were exercisable with a
weighted-average exercise price of $21.83.
The Company has an employee stock purchase plan which allows employees to
acquire an aggregate of 100,000 shares of common stock of the Company at 85% of
the fair value at the end of each quarterly plan period. The value of the shares
purchased under the plan is limited to the lesser of 10% of compensation or
$25,000 per year. Under the plan, 35,220 shares were issued in 1998 and 8,308
shares were issued during 1997. At December 31, 1998, an additional 52,659
shares of common stock are available for issuance pursuant to the plan.
A reconciliation between the weighted average shares outstanding used in
the basic and diluted EPS computations is as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Net earnings (loss) to common shareholders......... $ (25,378) $ 29,425 $ 31,420
========== ========== ==========
Weighted average common shares
outstanding -- basic............................. 7,583,831 6,517,716 6,504,065
Effect of dilutive securities:
Assumed exercise of stock options................ -- 48,824 45,467
Assumed exercise of warrants..................... -- 24,672 6,392
---------- ---------- ----------
Weighted average common shares
outstanding -- diluted........................... 7,583,831 6,591,212 6,555,924
========== ========== ==========
Net earnings (loss) per common share -- basic...... $ (3.35) $ 4.51 $ 4.83
Net earnings (loss) per common share -- diluted.... $ (3.35) $ 4.46 $ 4.79
</TABLE>
85
<PAGE> 86
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
No effect was given to dilutive securities in the 1998 EPS calculation as
such had an anti-dilutive effect. However during the year an average of 299,625
options were outstanding that could have a potentially dilutive basic EPS effect
in the future.
(13) INCOME TAXES
Income tax benefit (expense) consists of:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1998 1997 1996
------ ------- -------
<S> <C> <C> <C>
Federal and state current expense........................ $ (505) $(1,231) $(2,751)
Federal deferred benefit................................. 1,548 16,716 16,500
------ ------- -------
Total.......................................... $1,043 $15,485 $13,749
====== ======= =======
</TABLE>
The actual income tax expense (benefit) attributable to earnings (loss)
from operations differs from the expected tax expense (computed by applying the
federal corporate tax rate of 35% to earnings (loss) from operations before
income taxes) as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------- -------- --------
<S> <C> <C> <C>
Computed expected tax expense (benefit)............... $(7,387) $ 7,105 $ 8,883
Increase (reduction) in income taxes resulting from:
Tax effect of Class A Certificate................... -- (1,243) (4,060)
Change in valuation allowance....................... 5,549 (23,388) (18,616)
Alternative minimum tax and state income tax.......... 505 1,646 --
REMIC excess inclusion income......................... -- 268 --
Other................................................. 290 127 44
------- -------- --------
$(1,043) $(15,485) $(13,749)
======= ======== ========
</TABLE>
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets at December 31, 1998 and 1997, are as
follows:
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
Deferred tax assets:
Investments in Acquisition Partnerships, principally due
to differences in basis for tax and financial reporting
purposes............................................... $ 2,521 $ 1,453
Intangibles, principally due to differences in
amortization........................................... 1,613 1,317
Book loss reserve greater than (less than) tax loss
reserve................................................ 76 (1,200)
Tax basis in fixed assets greater than book............... 42 255
Federal net operating loss carryforward................... 225,118 213,028
Valuation allowance....................................... (174,520) (168,971)
--------- ---------
Total deferred tax assets......................... 54,850 45,882
Deferred tax liabilities:
Book basis in servicing rights greater than tax basis..... (22,036) (15,231)
Other, net................................................ (652) (37)
--------- ---------
Total deferred tax liabilities.................... (22,688) (15,268)
--------- ---------
Net deferred tax asset...................................... $ 32,162 $ 30,614
========= =========
</TABLE>
86
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As a result of the Merger, the Company has net operating loss carryforwards
for federal income tax purposes of approximately $643 million at December 31,
1998, available to offset future federal taxable income, if any, through the
year 2018. A valuation allowance is provided to reduce the deferred tax assets
to a level which, more likely than not, will be realized. During 1998, 1997 and
1996, the Company adjusted the previously established valuation allowance to
recognize deferred tax expense (benefit) of $5.5 million, ($23.4) million and
($18.6) million, respectively. The ultimate realization of the resulting net
deferred tax asset is dependent upon generating sufficient taxable income prior
to expiration of the net operating loss carryforwards. Although realization is
not assured, management believes it is more likely than not that all of the
recorded deferred tax asset, net of the allowance, will be realized. The amount
of the deferred tax asset considered realizable, however, could be adjusted in
the future if estimates of future taxable income during the carryforward period
change. The change in valuation allowance primarily represents an increase in
the estimate of the future taxable income during the carryforward period since
the prior year end and the utilization of or addition to net operating loss
carryforwards since the Merger. The ability of the Company to realize the
deferred tax asset is periodically reviewed and the valuation allowance is
adjusted accordingly.
(14) EMPLOYEE BENEFIT PLAN
The Company has a defined contribution 401(k) employee profit sharing plan
pursuant to which the Company matches employee contributions at a stated
percentage of employee contributions to a defined maximum. The Company's
contributions to the 401(k) plan were $980 in 1998, $603 in 1997 and $407 in
1996.
(15) LEASES
The Company leases its current headquarters from a related party under a
noncancelable operating lease. The lease calls for monthly payments of $7.5
through its expiration in December 2001 and includes an option to renew for two
additional five-year periods. Rental expense for 1998, 1997 and 1996 under this
lease was $90 each year.
The Company also leases office space and equipment from unrelated parties
under operating leases expiring in various years through 2006. Rental expense
under these leases for 1998, 1997 and 1996 was $6.9 million, $4.1 million and
$2.3 million, respectively. As of December 31, 1998, the future minimum lease
payments under all noncancelable operating leases are: $7,238 in 1999, $5,256 in
2000, $3,768 in 2001, $2,993 in 2002 and $3,765 in 2003 and beyond.
The Company has subleased various office space. These sublease agreements
primarily relate to leases assumed in the acquisition of Hamilton. Future
minimum rentals to be received under noncancelable operating leases are $421 in
1999, $137 in 2000, $86 in 2001, $89 in 2002, and $37 in 2003.
(16) MORTGAGE LOAN PIPELINE, HEDGES, AND RELATED OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk
in the normal course of business through the origination and selling of mortgage
loans. The risks are associated with fluctuations in interest rates. The
financial instruments include commitments to extend credit, mandatory forward
contracts, and various hedging instruments. The instruments involve, to varying
degrees, interest rate risk in excess of the amount recognized in the
consolidated financial statements.
The Company's mortgage loan pipeline as of December 31, 1998, totaled
approximately $1.8 billion. The Company's exposure to loss in the event of
nonperformance by the party committed to purchase the mortgage loan is
represented by the amount of loss in value due to increases in interest rates on
its fixed rate commitments. The pipeline consists of approximately $565 million
of fixed rate commitments and $1.2 billion of floating rate obligations. The
floating rate commitments are not subject to significant interest rate risk.
87
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Management believes that the Company had adequate lines of credit at December
31, 1998 to fund its projected loan closings from its mortgage loan pipeline.
The Company uses a variety of methods to hedge the interest rate risk of
the mortgage loans in the pipeline that are expected to close and the mortgage
loans held for sale. Mandatory forward commitments to sell whole loans and
mortgage-backed securities are the Company's primary hedge instruments. At
December 31, 1998, the Company had approximately $975 million of mandatory
forward commitments to sell. To the extent mortgage loans at the appropriate
rates are not available to fill these commitments, the Company has interest rate
risk due primarily to the impact of interest rate fluctuations on its
obligations to fill forward commitments.
The Company's mortgage loan pipeline and mandatory forward commitments are
included in the lower of cost or market value calculation of mortgage loans held
for sale.
(17) OTHER RELATED PARTY TRANSACTIONS
The Company has contracted with FirstCity Liquidating Trust (the "Trust"),
the Acquisition Partnerships and related parties as a third party loan servicer.
Servicing fees totaling $5.8 million, $12.1 million (including $6.8 million from
the termination of a management agreement with the Trust) and $12.5 million for
1998, 1997 and 1996, respectively, and due diligence fees (included in other
income) were derived from such affiliates.
During 1997, the Company, along with selected Acquisition Partnerships,
sold certain assets to an entity 80% owned by the Company. The gain on the sale
of the assets was deferred and is being recognized as the assets are ultimately
resolved.
(18) COMMITMENTS AND CONTINGENCIES
The Company is involved in various legal proceedings in the ordinary course
of business. In the opinion of management, the resolution of such matters will
not have a material adverse impact on the consolidated financial condition,
results of operations or liquidity of the Company.
The Company is a 50% owner in an entity that is obligated to advance up to
$2.5 million toward the acquisition of Portfolio Assets from financial
institutions in California. At December 31, 1998, advances of $.7 million had
been made under the obligation.
(19) YEAR 2000 INITIATIVES
The Year 2000 issue consists of shortcomings of many electronic data
processing systems that make them unable to process year-date data accurately
beyond the year 1999. The primary shortcoming arises because computer
programmers have abbreviated dates by eliminating the first two digits of the
year under the assumption that these digits would always be 19. Another
shortcoming is caused by the routine used by some computers for calculating leap
year that does not detect the year 2000 as a leap year. This inability to
process dates could potentially result in a system failure or miscalculation
causing disruptions in the Company's operations or performance.
The Company, with the assistance of a consulting firm that specializes in
Year 2000 readiness, is conducting an enterprise-wide Year 2000 initiative that
encompasses both the internal systems and exposure to third parties. For the
Company's internal systems, the initiative is being approached in three phases
comprised of assessment, remediation and testing. While there is considerable
overlap in the timing of the three phases, the assessment phase is the first
step in the initiative. In this phase, the objective is to identify the
components (i.e., hardware and software) of all internal systems and to assess
the readiness of each component. This information is then used to prepare a
comprehensive plan for remediation and testing. The
88
<PAGE> 89
FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
information gathered during this phase is also used to develop a more precise
estimate of the costs of remediation and testing.
The Company is in the process of completing the assessment phase for all of
its internal systems. Remediation and testing have already begun and complete
Year 2000 readiness for internal systems is scheduled to be achieved by July
1999. The Company does not anticipate any material difficulties in achieving
Year 2000 readiness within this time frame. The Company has not yet developed a
most reasonably likely worst case scenario with respect to Year 2000 issues, but
instead has focused its efforts on reducing uncertainties through the review
described above. The Company has not developed Year 2000 contingency plans other
than as described above, and does not expect to do so unless merited by the
results of its continuing review.
The Company believes that the costs associated with its Year 2000
initiative will be approximately $1,500,000, a majority of which will be
incurred during 1999. Of these costs, approximately $150,000 is for computer
systems that must be replaced and the remainder is personnel costs (employees
and external consultants). All estimated costs have been budgeted and are
expected to be funded by cash flows from operations.
The cost of the initiative and the date on which the Company plans to
complete the Year 2000 modifications are based on management's best estimates,
which are derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors. Unanticipated failures by critical third parties, as well as the
failure by the Company to execute its own remediation efforts, could have a
material adverse effect on the cost of the initiative and its completion date.
As a result, there can be no assurance that these estimates will be achieved and
the actual cost and third party compliance could differ materially from those
plans, resulting in material financial risk.
(20) FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosures about Fair Value of Financial Instruments,
requires that the Company disclose estimated fair values of its financial
instruments. Fair value estimates, methods and assumptions are set forth below.
(a) Cash and Cash Equivalents
The carrying amount of cash and cash equivalents approximated fair value at
December 31, 1998 and 1997.
(b) Portfolio Assets and Loans Receivable
The Portfolio Assets and loans receivable are carried at the lower of cost
or estimated fair value. The estimated fair value is calculated by discounting
projected cash flows on an asset-by-asset basis using estimated market discount
rates that reflect the credit and interest rate risks inherent in the assets.
The carrying value of the Portfolio Assets and loans receivable was $116 million
and $180 million, respectively, at December 31, 1998 and 1997. The estimated
fair value of the Portfolio Assets and loans receivable was approximately $123
million and $199 million, respectively, at December 31, 1998 and 1997.
(c) Mortgage Loans Held For Sale
Market values of loans held for sale are generally based on quoted market
prices or dealer quotes. The carrying value of mortgage loans held for sale was
$1.2 billion and $534 million, respectively, at December 31, 1998 and 1997. The
estimated fair value of mortgage loans held for sale approximated their carrying
value at December 31, 1998 and 1997.
89
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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(d) Investment Securities
Investment securities are carried at the lower of cost or market. Carrying
values which are believed to approximate fair value were $65,242 and $6,935 at
December 31, 1998 and 1997, respectively. The investments are valued using
various discount rates, loss and prepayment assumptions, as described in Note 6.
(e) Notes Payable
Management believes that the repayment terms for similar rate financial
instruments with similar credit risks and the stated interest rates at December
31, 1998 and 1997 approximate the market terms for similar credit instruments.
Accordingly, the carrying amount of notes payable is believed to approximate
fair value.
(f) Redeemable Preferred Stock
Redeemable preferred stock is carried at redemption value plus accrued but
unpaid dividends. Carrying values were $26,319 and $41,908 at December 31, 1998
and 1997, respectively. Fair market values based on quoted market rates were
$22,803 and $42,048 at December 31, 1998 and 1997, respectively.
90
<PAGE> 91
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
FirstCity Financial Corporation:
We have audited the accompanying consolidated balance sheets of FirstCity
Financial Corporation and subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations, shareholders' equity, and cash
flows for each of the years in the three-year period ended December 31, 1998.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of FirstCity
Financial Corporation and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998, in conformity with generally accepted
accounting principles.
KPMG LLP
Fort Worth, Texas
February 12, 1999
91
<PAGE> 92
FIRSTCITY FINANCIAL CORPORATION
The Harbor Merger, which occurred in July 1997, was accounted for as a
pooling of interests. The Company's historical financial statements have
therefore been retroactively restated to include the financial position and
results of operations of Mortgage Corp. for all periods presented. Earnings per
share has been calculated in conformity with SFAS No. 128, Earnings Per Share,
and all prior periods have been restated.
SELECTED QUARTERLY FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
1998 1997
-------------------------------------- -------------------------------------
FIRST SECOND THIRD FOURTH FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
------- ------- -------- ------- ------- ------- ------- -------
(UNAUDITED)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Income................. $42,026 $49,544 $ 49,278 $58,696 $32,297 $30,985 $30,033 $36,307
Expenses(1)............ 37,086 42,446 88,026 53,091 22,728 26,316 29,672 30,606
Net earnings
(loss)(2)............ 5,796 7,624 (38,500) 4,888 9,217 4,370 16,690 5,351
Preferred dividends.... 1,515 1,515 1,514 642 1,659 1,515 1,514 1,515
Net earnings (loss) to
common
shareholders(2)...... 4,281 6,109 (40,014) 4,246 7,558 2,855 15,176 3,836
Net earnings (loss) per
common share --
Basic(2)............. 0.66 0.84 (4.84) 0.51 1.16 0.44 2.33 0.59
Net earnings (loss) per
common share --
Diluted(2)........... 0.64 0.83 (4.84) 0.51 1.14 0.44 2.30 0.58
</TABLE>
- ---------------
(1) Includes provision for valuation of mortgage servicing rights of $28.7
million in the third quarter of 1998
(2) Includes $16.2 million of deferred tax benefits in third quarter of 1997
related to the benefit of NOLs.
92
<PAGE> 93
WAMCO PARTNERSHIPS
COMBINED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
(DOLLARS IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
1998 1997
-------- --------
<S> <C> <C>
Cash........................................................ $ 12,109 $ 11,702
Portfolio Assets, net....................................... 148,142 104,189
Investments in partnerships................................. 591 185
Investments in trust certificates........................... 6,097 5,816
Receivable from affiliates.................................. 54 892
Deferred profit sharing..................................... 5,307 --
Other assets, net........................................... 2,261 2,958
-------- --------
$174,561 $125,742
======== ========
LIABILITIES AND PARTNERS' CAPITAL
Accounts payable (including $37 and $330 to affiliates in
1998 and 1997, respectively).............................. $ 1,086 $ 441
Accrued liabilities......................................... 2,010 1,081
Deferred compensation....................................... 9,420 --
Long-term debt (including $49,849 and $58,923 to affiliates
in 1998 and 1997, respectively)........................... 105,989 68,950
-------- --------
Total liabilities................................. 118,505 70,472
Commitments and contingencies............................... -- --
Partners' capital........................................... 56,056 55,270
-------- --------
$174,561 $125,742
======== ========
</TABLE>
See accompanying notes to combined financial statements.
93
<PAGE> 94
WAMCO PARTNERSHIPS
COMBINED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
1998 1997 1996
-------- --------- ---------
<S> <C> <C> <C>
Proceeds from resolution of Portfolio Assets............... $ 71,473 $ 159,159 $ 174,012
Cost of Portfolio Assets resolved.......................... (49,855) (132,626) (134,507)
-------- --------- ---------
Gain on resolution of Portfolio Assets..................... 21,618 26,533 39,505
Interest income on performing Portfolio Assets............. 8,341 8,432 7,870
Interest expense (including $4,494, $8,187 and $14,571 to
affiliates in 1998, 1997 and 1996, respectively)......... (7,483) (10,659) (22,065)
General, administrative and operating expenses............. (10,033) (10,338) (14,777)
Other income, net.......................................... 1,772 1,008 210
-------- --------- ---------
Net earnings..................................... $ 14,215 $ 14,976 $ 10,743
======== ========= =========
</TABLE>
See accompanying notes to combined financial statements.
94
<PAGE> 95
WAMCO PARTNERSHIPS
COMBINED STATEMENTS OF CHANGES IN PARTNERS' CAPITAL
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
CLASS B
CLASS A EQUITY EQUITY
------------------- --------
GENERAL LIMITED LIMITED GENERAL LIMITED
PARTNERS PARTNERS PARTNERS PARTNERS PARTNERS TOTAL
-------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995..... $ 573 $ 28,086 $ 21,232 $ 91 $ 4,437 $ 54,419
Contributions.................. 54 2,621 -- 986 48,303 51,964
Distributions.................. (400) (19,598) (3,082) (860) (42,068) (66,008)
Net earnings................... 47 2,301 556 156 7,683 10,743
----- -------- -------- ----- -------- --------
Balance at December 31, 1996..... $ 274 $ 13,410 $ 18,706 $ 373 $ 18,355 $ 51,118
Contributions.................. -- -- -- 522 29,592 30,114
Distributions.................. (113) (5,522) (16,533) (375) (18,395) (40,938)
Net earnings................... 111 5,432 1,173 162 8,098 14,976
----- -------- -------- ----- -------- --------
Balance at December 31, 1997..... $ 272 $ 13,320 $ 3,346 $ 682 $ 37,650 $ 55,270
Contributions.................. 10 488 -- 503 34,077 35,078
Distributions.................. (111) (5,461) (1,111) (699) (41,125) (48,507)
Net earnings(loss)............. (5) (224) (290) 201 14,533 14,215
----- -------- -------- ----- -------- --------
Balance at December 31, 1998..... $ 166 $ 8,123 $ 1,945 $ 687 $ 45,135 $ 56,056
===== ======== ======== ===== ======== ========
</TABLE>
See accompanying notes to combined financial statements.
95
<PAGE> 96
WAMCO PARTNERSHIPS
COMBINED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
1998 1997 1996
-------- --------- ---------
<S> <C> <C> <C>
Cash flows from operating activities:
Net earnings............................................. $ 14,215 $ 14,976 $ 10,743
Adjustments to reconcile net earnings to net cash (used
in) provided by operating activities:
Amortization of loan origination and commitment
fees................................................ 678 1,707 1,483
Provision (credit) for losses......................... -- (587) 585
Net gain on Portfolio Assets.......................... (21,618) (26,533) (39,505)
Purchase of Portfolio Assets.......................... (91,713) (73,734) (102,695)
Capitalized costs on Portfolio Assets................. (2,095) (1,143) (3,330)
Proceeds from resolution of Portfolio Assets.......... 71,473 159,159 188,002
Increase in investment in Partnership................. (406) -- --
Decrease (increase) in receivable from affiliates..... 838 (660) (126)
Increase in deferred profit sharing................... (5,307) -- --
Decrease (increase) in other assets................... 19 (1,556) (2,191)
Increase (decrease) in accounts payable............... 645 (1,304) 1,032
Increase (decrease) in accrued liabilities............ 929 (601) (6,812)
Increase in deferred compensation..................... 9,420 -- --
-------- --------- ---------
Net cash (used in) provided by operating
activities..................................... (22,922) 69,724 47,186
-------- --------- ---------
Cash flows from investing activities:
Contribution to subsidiaries............................. -- (185) --
Purchase of trust certificates........................... (281) (225) (4,224)
Payments received from trust certificates -- 191 --
-------- --------- ---------
Net cash used in operating activities............ (281) (219) (4,224)
-------- --------- ---------
Cash flows from financing activities:
Borrowing on acquisition debt............................ -- -- --
Repayment of acquisition debt............................ -- -- (28,967)
Borrowing on long-term debt.............................. 93,308 34,489 263,614
Repayment of long-term debt.............................. (56,269) (106,593) (265,041)
Capital contributions.................................... 35,078 30,114 38,180
Capital distributions.................................... (48,507) (25,420) (52,224)
-------- --------- ---------
Net cash provided by (used in) financing
activities..................................... 23,610 (67,410) (44,438)
-------- --------- ---------
Net increase (decrease) in cash............................ 407 2,095 (1,476)
Cash at beginning of year.................................. 11,702 9,607 11,083
-------- --------- ---------
Cash at end of year........................................ $ 12,109 $ 11,702 $ 9,607
======== ========= =========
</TABLE>
Supplemental disclosure of cash flow information (note 5):
Cash paid for interest was approximately $6,889, $11,091 and $27,652 for
1998, 1997 and 1996, respectively.
WAMCO V and WAMCO XVII contributed $1,243 and $324 of portfolio assets,
respectively, in exchange for an investment in trust certificates in 1996.
WAMCO IX, WAMCO XXI and WAMCO XXII contributed $1,542 of portfolio assets
in exchange for an equity interest in a related party in 1997. This equity
interest was subsequently distributed to the partners of the partnerships.
In January, 1997 a partner purchased the other 50% interest in the
Whitewater partnership, thus removing $14,043 in Portfolio and other assets and
$14,043 of other liabilities and partners' capital from the accounts of the
combined WAMCO partnerships.
See accompanying notes to combined financial statements.
96
<PAGE> 97
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997 AND 1996
(DOLLARS IN THOUSANDS)
(1) ORGANIZATION AND PARTNERSHIP AGREEMENTS
The combined financial statements include the accounts of WAMCO III, Ltd.;
WAMCO V, Ltd.; WAMCO IX, Ltd.; WAMCO XVII, Ltd.; WAMCO XXI, Ltd.; WAMCO XXII,
Ltd.; WAMCO XXIII, Ltd.; WAMCO XXIV, Ltd.; WAMCO XXV, Ltd.; WAMCO XXVI, Ltd.;
Calibat Fund, LLC; DAP City Partners, L.P.; FC Properties, Ltd., First B Realty,
L.P.; First Paradee, L.P.; GLS Properties, Ltd.; Imperial Fund I, L.P.; VOJ
Partners, L.P. and Whitewater Acquisition Co. One L.P., all of which are Texas
limited partnerships (Acquisition Partnerships or Partnerships). FirstCity
Financial Corporation ("FirstCity") or its wholly owned subsidiary, FirstCity
Commercial Corporation, owns limited partnership interests in all of the
Partnerships. All significant intercompany balances have been eliminated. The
combined financial statements do not include any accounts of Acquisition
Partnerships which are wholly owned by FirstCity or Acquisition Partnerships
located in foreign countries.
The Partnerships were formed to acquire, hold and dispose of Portfolio
Assets acquired from the Federal Deposit Insurance Corporation, Resolution Trust
Corporation and other nongovernmental agency sellers, pursuant to certain
purchase agreements or assignments of such purchase agreements. In accordance
with the purchase agreements, the Partnerships retain certain rights of return
regarding the assets related to defective title, past due real estate taxes,
environmental contamination, structural damage and other limited legal
representations and warranties.
Generally, the partnership agreements of the Partnerships provide for
certain preferences as to the distribution of cash flows. Proceeds from
disposition of and payments received on the Portfolio Assets are allocated based
on the partnership and other agreements which ordinarily provide for the payment
of interest and mandatory principal installments on outstanding debt before
payment of intercompany servicing fees and return of capital and restricted
distributions to partners.
Additionally, WAMCO III, Ltd., WAMCO V, Ltd., WAMCO XVII, Ltd., WAMCO XXI,
Ltd. and Whitewater Acquisition Co. One L.P. provide for Class A and Class B
Equity partners in their individual partnership agreements. The Class B Equity
limited partners are allocated 20 percent of cumulative net income recognized by
the respective partnerships prior to allocation to the Class A Equity limited
partners and the general partners.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Portfolio Assets
The Partnerships acquire and resolve portfolios of performing and
nonperforming commercial and consumer loans and other assets (collectively,
"Portfolio Assets" or "Portfolios"), which are generally acquired at a discount
to their legal principal balance. Purchases may be in the form of pools of
assets or single assets. The Portfolio Assets are generally nonhomogeneous
assets, including loans of varying qualities that are secured by diverse
collateral types and foreclosed properties. Some Portfolio Assets are loans for
which resolution is tied primarily to the real estate securing the loan, while
others may be collateralized business loans, the resolution of which may be
based either on business or real estate or other collateral cash flow. Portfolio
Assets are acquired on behalf of legally independent Acquisition Partnerships in
which a corporate general partner, FirstCity and other investors are limited
partners.
97
<PAGE> 98
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Portfolio Assets are classified as either non-performing Portfolio Assets,
performing Portfolio Assets or real estate Portfolios. The following is a
description of each classification and the related accounting policy accorded to
each Portfolio type:
Non-Performing Portfolio Assets
Non-performing Portfolio Assets consist primarily of distressed loans and
loan related assets, such as foreclosed upon collateral. Portfolio Assets are
designated as non-performing unless substantially all of the loans in the
Portfolio are being repaid in accordance with the contractual terms of the
underlying loan agreements. Such Portfolios are acquired on the basis of an
evaluation by the Partnerships of the timing and amount of cash flow expected to
be derived from borrower payments or other resolution of the underlying
collateral securing the loan.
All non-performing Portfolio Assets are purchased at substantial discounts
from their outstanding legal principal amount, the total of the aggregate of
expected future sales prices and the total payments to be received from
obligors. Subsequent to acquisition, the amortized cost of non-performing
Portfolio Assets is evaluated for impairment on a quarterly basis. A valuation
allowance is established for any impairment identified through provisions
charged to earnings in the period the impairment is identified. No valuation
allowance was required at December 31, 1998 or 1997.
Net gain on resolution of non-performing Portfolio Assets is recognized as
income to the extent that proceeds collected exceed a pro rata portion of
allocated cost from the Portfolio. Cost allocation is based on a proration of
actual proceeds divided by total estimated proceeds of the Portfolio. No
interest income is recognized separately on non-performing Portfolio Assets. All
proceeds, of whatever type, are included in proceeds from resolution of
Portfolio Assets in determining the gain on resolution of such assets.
Accounting for Portfolios is on a pool basis as opposed to an individual
asset-by-asset basis.
Performing Portfolio Assets
Performing Portfolio Assets consist primarily of Portfolios of consumer and
commercial loans acquired at a discount from the aggregate amount of the
borrowers' obligation. Portfolios are classified as performing if substantially
all of the loans in the Portfolio are being repaid in accordance with the
contractual terms of the underlying loan agreements.
Performing Portfolio Assets are carried at the unpaid principal balance of
the underlying loans, net of acquisition discounts. Interest is accrued when
earned in accordance with the contractual terms of the loans. The accrual of
interest is discontinued once a loan becomes past due 90 days or more.
Acquisition discounts for the Portfolio as a whole are accreted as an adjustment
to yield over the estimated life of the Portfolio. Accounting for these
Portfolios is on a pool basis as opposed to an individual asset-by-asset basis.
The Partnerships account for performing Portfolio Assets by evaluating the
collectibility of both contractual interest and principal of loans when
assessing the need for a loss accrual. Impairment is measured based on the
present value of the expected future cash flows discounted at the loans'
effective interest rates, or the fair value of the collateral, less estimated
selling costs, if any loans are collateral dependent and foreclosure is
probable.
Real Estate Portfolios
Real estate Portfolios consist of real estate assets acquired from a
variety of sellers. Such Portfolios are carried at the lower of cost or fair
value less estimated costs to sell. Costs relating to the development and
improvement of real estate are capitalized, whereas those relating to holding
assets are charged to expense. Income or loss is recognized upon the disposal of
the real estate. Rental income, net of expenses, on real estate Portfolios is
recognized when received.
98
<PAGE> 99
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Assets are foreclosed when necessary through an arrangement with an
affiliated entity whereby title to the foreclosed asset is held by the
affiliated entity and a note receivable from the affiliate is held by the
Partnerships. For financial statement presentation, the affiliated entity note
receivable created by the arrangement is included in Portfolio Assets and is
recorded at the lower of allocated cost or fair value less estimated cost to
sell the underlying asset.
Costs relating to the development and improvement of foreclosed assets are
capitalized by the Partnerships. Costs relating to holding foreclosed assets are
charged to operating expense by the Partnerships.
(b) Investment in Trust Certificates
The Partnerships hold an investment in trust certificates, representing an
interest in a REMIC created by the sale of certain Partnership assets. This
interest is subordinate to the senior tranches of the certificate. The
investment is carried at the unpaid balance of the certificate, net of
acquisition discounts. Interest is accrued in accordance with the contractual
terms of the agreement. Acquisition discounts are accreted as an adjustment to
yield over the estimated life of the investment.
(c) Income Taxes
Under current Federal laws, partnerships are not subject to income taxes;
therefore, no provision has been made for such taxes in the accompanying
combined financial statements. For tax purposes, income or loss is included in
the individual tax returns of the partners.
(d) Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
(3) PORTFOLIO ASSETS
Portfolio Assets are summarized as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1998 1997
-------- --------
<S> <C> <C>
Non-performing Portfolio Assets............................. $ 83,530 $106,377
Performing Portfolio Assets................................. 94,271 77,794
Real estate Portfolios...................................... 48,212 6,696
-------- --------
Total Portfolio Assets............................ 226,013 190,867
Discount required to reflect Portfolio Assets at carrying
value..................................................... (77,871) (86,678)
-------- --------
Portfolio Assets, net............................. $148,142 $104,189
======== ========
</TABLE>
Portfolio Assets are pledged to secure non-recourse notes payable.
(4) DEFERRED PROFIT SHARING
In connection with the formation of FC Properties, Ltd., an agreement was
entered into which provided for potential payments to the project manager based
on a percentage of total estimated sales. The deferred amount is amortized into
expense in proportion to actual sales realized. No profit participation will be
paid out until the FC Properties, Ltd.'s long-term debt is extinguished,
totaling $12,230 at December 31, 1998 and the
99
<PAGE> 100
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
limited partners have recognized a 20% return on their investment. At December
31, 1998, the estimated liability for this profit participation was $8,429 and
is included in deferred compensation in the accompanying balance sheet.
Additionally, amortization of $3,122, was recognized during the period and has
been included in general, administrative and operating expense in the
accompanying statement of operations in 1998.
(5) LONG-TERM DEBT
Long-term debt at December 31, 1998 and 1997 consist of the following:
<TABLE>
<CAPTION>
1998 1997
-------- -------
<S> <C> <C>
Senior collateralized loans, secured by Portfolio Assets:
Prime (7.5% at December 31, 1998) plus 0.5% to 7%......... $ 1,123 $ --
LIBOR (5.5% at December 31, 1998) plus 2.25% to 4.0%...... 85,452 43,198
Fixed rate -- 8.48% to 10.17%............................. 18,690 24,681
Subordinated collateralized loans, secured by Portfolio
Assets:
Prime (7.5% at December 31, 1998) plus 7%................. 724 1,071
-------- -------
$105,989 $68,950
======== =======
</TABLE>
Collateralized loans are typically payable based on proceeds from
disposition of and payments received on the Portfolio Assets.
Contractual maturities (excluding principal and interest payments payable
from proceeds from dispositions of and payments received on the Portfolio
Assets) of long-term debt are as follows:
Year ending December 31:
<TABLE>
<S> <C>
1999...................................................... $ 70,414
2000...................................................... 7,932
2001...................................................... 15,059
2002...................................................... 7,461
2003...................................................... 1,123
Thereafter................................................ 4,000
--------
$105,989
========
</TABLE>
The loan agreements and master note purchase agreements, under which notes
payable were incurred, contain various covenants including limitations on other
indebtedness, maintenance of service agreements and restrictions on use of
proceeds from disposition of and payments received on the Portfolio Assets. As
of December 31, 1998, the Partnerships were in compliance with the
aforementioned covenants.
In connection with the long-term debt, the Partnerships incurred
origination and commitment fees. These fees are being amortized proportionate to
the principal reductions on the related notes and are included in general,
administrative and operating expenses. At December 31, 1998 and 1997,
approximately $1,139 and $1,298, respectively, of origination and commitment
fees were included in other assets, net.
(6) TRANSACTIONS WITH AFFILIATES
Under the terms of the various servicing agreements between the
Partnerships and FirstCity Servicing Corp., an affiliated company. FirstCity
Servicing Corp. receives a servicing fee based on proceeds from resolution of
the Portfolio Assets for processing transactions on the Portfolio Assets and for
conducting settlement, collection and other resolution activities. Included in
general, administrative and operating
100
<PAGE> 101
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
expenses in the accompanying combined statements of operations are approximately
$2,752, $4,353, and $6,468 in servicing fees incurred by the Partnerships in
1998, 1997 and 1996, respectively.
Under the terms of a Master Note Purchase Agreement, Varde, Varde II-A and
OPCO, limited partners of VOJ Partners L.P. ("VOJ"), are to receive 5 percent, 5
percent and 10 percent, respectively, of cumulative income before profit
participation expense recognized by VOJ. Due to continued net losses, in 1997,
VOJ wrote off $103 of receivables from affiliates related to this profit
participation agreement. No amounts were accrued under this agreement during
1997 or 1998. VOJ accrued $103 in 1996 included in the receivables from
affiliates and recognized $18 and $68 in 1997 and 1996, respectively, included
in other income (expenses), net, in the accompanying combined financial
statements.
Under the terms of a Master Note Purchase Agreement, each of two limited
partners of Imperial Fund I, L.P. ("Imperial") are to receive 10 percent of
cumulative income before profit participation expense recognized by Imperial.
Imperial has recorded accounts payable of $23 at December 31, 1997, and expensed
$92 and $40 in the years ended December 31, 1997 and 1996, respectively, in the
accompanying combined financial statements under this profit participation
agreement. The profit participation will be paid to the limited partners upon
final disposition of the Portfolio Assets in accordance with the Master Note
Purchase Agreement.
On January 1, 1997, FirstCity purchased the other limited partner's
interest in Whitewater for $4,165.
During 1997, Wamco XXI, Ltd. and Whitewater merged into WAMCO XXII, Ltd.
After the merger, Wamco XXII, Ltd. transferred $47,517 in assets and $516 in
liabilities to Bosque Asset Corporation (Bosque) in exchange for cash and an
investment in Bosque. Subsequent to the transaction, Wamco XXII, Ltd.
distributed its investment in Bosque to its partners and dissolved. During 1997,
Wamco IX, Ltd. contributed $3,316 in notes to Bosque in exchange for cash and an
investment in Bosque. Subsequent to the transfer, WAMCO IX, Ltd. distributed its
investment in Bosque to its partners.
(7) FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures about
Fair Value of Financial Instruments," requires that the Partnerships disclose
estimated fair values of their financial instruments. Fair value estimates,
methods and assumptions are set forth below.
(a) Cash, Receivable from Affiliates, Accounts Payable and Accrued Liabilities
The carrying amount of cash, receivable from affiliates, accounts payable
and accrued liabilities approximates fair value at December 31, 1998 and 1997
due to the short-term nature of such accounts.
(b) Portfolio Assets
Portfolio Assets are carried at the lower of cost or estimated fair value.
The estimated fair value is calculated by discounting projected cash flows on an
asset-by-asset basis using estimated market discount rates that reflect the
credit and interest rate risk inherent in the assets. The carrying value of
Portfolio Assets was $148,142 and $104,189 at December 31, 1998 and 1997,
respectively. The estimated fair value of the Portfolio Assets was approximately
$174,776 and $122,515 at December 31, 1998 and 1997, respectively.
(c) Investment in Trust Certificates
Investments in trust certificates are carried at the lower of cost or
estimated fair value. Management estimates that the cost of the investments
approximates fair value at December 31, 1998 and 1997.
101
<PAGE> 102
WAMCO PARTNERSHIPS
NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
(d) Long-term Debt
Management believes that for similar financial instruments with comparable
credit risks, the stated interest rates at December 31, 1998 and 1997
approximate market rates. Accordingly, the carrying amount of long-term debt is
believed to approximate fair value.
(8) COMMITMENTS AND CONTINGENCIES
Calibat Fund, LLC has committed to make additional investments in
partnerships up to $1.8 million at December 31, 1998.
The Partnerships are involved in various legal proceedings in the ordinary
course of business. In the opinion of management, the resolution of such matters
will not have a material adverse impact on the combined financial condition,
results of operations or liquidity of the Partnerships.
102
<PAGE> 103
INDEPENDENT AUDITORS' REPORT
The Partners
WAMCO Partnerships:
We have audited the accompanying combined balance sheets of the WAMCO
Partnerships as of December 31, 1998 and 1997, and the related combined
statements of operations, changes in partners' capital, and cash flows for each
of the years in the three-year period ended December 31, 1998. These combined
financial statements are the responsibility of the Partnerships' management. Our
responsibility is to express an opinion on these combined financial statements
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the combined financial statements referred to above present
fairly, in all material respects, the financial position of the WAMCO
Partnerships as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1998, in conformity with generally accepted accounting
principles.
KPMG LLP
Fort Worth, Texas
January 29, 1999
103
<PAGE> 104
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information called for by this item with respect to the Company's
directors and executive officers is incorporated by reference from the Company's
definitive proxy statement pertaining to the 1999 Annual Meeting of Stockholders
to be filed pursuant to Regulation 14A.
ITEM 11. EXECUTIVE COMPENSATION.
The information called for by this item is incorporated by reference from
the Company's definitive proxy statement pertaining to the 1999 Annual Meeting
of Stockholders to be filed pursuant to Regulation 14A.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information called for by this item is incorporated by reference from
the Company's definitive proxy statement pertaining to the 1999 Annual Meeting
of Stockholders to be filed pursuant to Regulation 14A.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information called for by this item is incorporated by reference from
the Company's definitive proxy statement pertaining to the 1999 Annual Meeting
of Stockholders to be filed pursuant to Regulation 14A.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) 1. Financial Statements
The consolidated financial statements of FirstCity and combined
financial statements of Acquisition Partnerships are incorporated herein by
reference to Item 8, "Financial Statements and Supplementary Data," of this
Report.
2. Financial Statement Schedules
Financial statement schedules have been omitted because the
information is either not required, not applicable, or is included in Item
8, "Financial Statements and Supplementary Data."
3. Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
2.1 -- Joint Plan of Reorganization by First City Bancorporation
of Texas, Inc., Official Committee of Equity Security
Holders and J-Hawk Corporation, with the Participation of
Cargill Financial Services Corporation, Under Chapter 11
of the United States Bankruptcy Code, Case No.
392-39474-HCA-11 (incorporated herein by reference to
Exhibit 2.1 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995)
2.2 -- Agreement and Plan of Merger, dated as of July 3, 1995,
by and between First City Bancorporation of Texas, Inc.
and J-Hawk Corporation (incorporated herein by reference
to Exhibit 2.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995)
</TABLE>
104
<PAGE> 105
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
3.1 -- Amended and Restated Certificate of Incorporation of the
Company (incorporated herein by reference to Exhibit 3.1
of the Company's Current Report on Form 8-K dated July 3,
1995 filed with the Commission on July 18, 1995).
3.2 -- Bylaws of the Company (incorporated herein by reference
to Exhibit 3.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995).
4.1 -- Certificate of Designations of the New Preferred Stock
($0.01 par value) of the Company.
4.2 -- Warrant Agreement, dated July 3, 1995, by and between the
Company and American Stock Transfer & Trust Company, as
Warrant Agent (incorporated herein by reference to
Exhibit 4.2 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995).
4.3 -- Registration Rights Agreement, dated July 1, 1997, among
the Company, Richard J. Gillen, Bernice J. Gillen, Harbor
Financial Mortgage Company Employees Pension Plan,
Lindsey Capital Corporation, Ed Smith and Thomas E.
Smith.
4.4 -- Stock Purchase Agreement, dated March 24, 1998, between
the Company and Texas Commerce Shareholders Company.
4.5 -- Registration Rights Agreement, dated March 24, 1998,
between the Company and Texas Commerce Shareholders
Company.
9.1 -- Shareholder Voting Agreement, dated as of June 29, 1995,
among ATARA I Ltd., James R. Hawkins, James T. Sartain
and Cargill Financial Services Corporation.
10.1 -- Trust Agreement of FirstCity Liquidating Trust, dated
July 3, 1995 (incorporated herein by reference to Exhibit
10.1 of the Company's Current Report on Form 8-K dated
July 3, 1995 filed with the Commission on July 18, 1995).
10.2 -- Investment Management Agreement, dated July 3, 1995,
between the Company and FirstCity Liquidating Trust
(incorporated herein by reference to Exhibit 10.2 of the
Company's Current Report on Form 8-K dated July 3, 1995
filed with the Commission on July 18, 1995).
10.3 -- Lock-Box Agreement, dated July 11, 1995, among the
Company, NationsBank of Texas, N.A., as lock-box agent,
FirstCity Liquidating Trust, FCLT Loans, L.P., and the
other Trust-Owned Affiliates signatory thereto, and each
of NationsBank of Texas, N.A. and Fleet National Bank, as
co-lenders (incorporated herein by reference to Exhibit
10.3 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
10.4 -- Custodial Agreement, dated July 11, 1995, among Fleet
National Bank, as custodian, Fleet National Bank, as
agent, FCLT Loans, L.P., FirstCity Liquidating Trust, and
the Company (incorporated herein by reference to Exhibit
10.4 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
10.5 -- Tier 3 Custodial Agreement, dated July 11, 1995, among
the Company, as custodian, Fleet National Bank, as agent,
FCLT Loans, L.P., FirstCity Liquidating Trust, and the
Company, as servicer (incorporated herein by reference to
Exhibit 10.5 of the Company's Form 8-A/A dated August 25,
1995 filed with the Commission on August 25, 1995).
</TABLE>
105
<PAGE> 106
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.6 -- 12/97 Amended and Restated Facilities Agreement, dated
effective as of December 3, 1997, among Harbor Financial
Mortgage Corporation, New America Financial, Inc., Texas
Commerce Bank National Association and the other
warehouse lenders party thereto. (incorporated herein by
reference to Exhibit 10.6 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
10.7 -- Modification Agreement, dated January 26, 1998, to the
Amended and Restated Facilities Agreement, dated as of
December 3, 1997, among Harbor Financial Mortgage
Corporation, New America Financial, Inc. and Chase Bank
of Texas, National Association (formerly known as Texas
Commerce Bank National Association). (incorporated herein
by reference to Exhibit 10.7 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
10.8 -- $50,000,000 3/98 Chase Texas Temporary Additional
Warehouse Note, dated March 17, 1998, by Harbor Financial
Mortgage Corporation and New America Financial, Inc., in
favor of Chase Bank of Texas, National Association.
(incorporated herein by reference to Exhibit 10.8 of the
Company's Form 10-K dated March 24, 1998 filed with the
Commission March 26, 1998).
10.9 -- Employment Agreement, dated as of July 1, 1997, by and
between Harbor Financial Mortgage Corporation and Richard
J. Gillen. (incorporated herein by reference to Exhibit
10.9 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998).
10.10 -- Employment Agreement, dated as of September 8, 1997, by
and between FirstCity Funding Corporation and Thomas R.
Brower, with similar agreements between FC Capital Corp.
and each of James H. Aronoff and Christopher J.
Morrissey. (incorporated herein by reference to Exhibit
10.10 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998).
10.11 -- Shareholder Agreement, dated as of September 8, 1997,
among FirstCity Funding Corporation, FirstCity Consumer
Lending Corporation, Thomas R. Brower, Scot A. Foith,
Thomas G. Dundon, R. Tyler Whann, Bradley C. Reeves,
Stephen H. Trent and Blake P. Bozman. (incorporated
herein by reference to Exhibit 10.11 of the Company's
Form 10-K dated March 24, 1998 filed with the Commission
March 26, 1998).
10.12 -- Revolving Credit Loan Agreement, dated as of March 20,
1998, by and between FC Properties, Ltd. and Nomura Asset
Capital Corporation. (incorporated herein by reference to
Exhibit 10.12 of the Company's Form 10-K dated March 24,
1998 filed with the Commission March 26, 1998).
10.13 -- Revolving Credit Loan Agreement, dated as of February 27,
1998, by and between FH Partners, L.P. and Nomura Asset
Capital Corporation. (incorporated herein by reference to
Exhibit 10.13 of the Company's Form 10-K dated March 24,
1998 filed with the Commission March 26, 1998).
10.14 -- Note Agreement, dated as of June 6, 1997, among Bosque
Asset Corp., SVD Realty, L.P., SOWAMCO XXII, LTD., Bosque
Investment Realty Partners, L.P. and Bankers Trust
Company of California, N.A. (incorporated herein by
reference to Exhibit 10.14 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
</TABLE>
106
<PAGE> 107
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.15 -- 60,000,000 French Franc Revolving Promissory Note, dated
September 25, 1997, by J-Hawk International Corporation
in favor of the Bank of Scotland. (incorporated herein by
reference to Exhibit 10.15 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
10.16 -- Loan Agreement, dated as of September 25, 1997, by and
between Bank of Scotland and J-Hawk International
Corporation. (incorporated herein by reference to Exhibit
10.16 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998).
10.17 -- Guaranty Agreement, dated as of September 25, 1997, by
J-Hawk Corporation (now known as FirstCity Commercial
Corporation) in favor of Bank of Scotland. (incorporated
herein by reference to Exhibit 10.17 of the Company's
Form 10-K dated March 24, 1998 filed with the Commission
March 26, 1998).
10.18 -- Guaranty Agreement, dated as of September 25, 1997, by
FirstCity Financial Corporation in favor of Bank of
Scotland. (incorporated herein by reference to Exhibit
10.18 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998).
10.19 -- Warehouse Credit Agreement, dated as of May 17, 1996,
among ContiTrade Services L.L.C., N.A.F. Auto Loan Trust
and National Auto Funding Corporation. (incorporated
herein by reference to Exhibit 10.19 of the Company's
Form 10-K dated March 24, 1998 filed with the Commission
March 26, 1998).
10.20 -- Funding Commitment, dated as of May 17, 1996, by and
between ContiTrade Services L.L.C. and the Company.
(incorporated herein by reference to Exhibit 10.20 of the
Company's Form 10-K dated March 24, 1998 filed with the
Commission March 26, 1998).
10.21 -- Revolving Credit Agreement, dated as of December 29,
1995, by and between the Company and Cargill Financial
Services Corporation, as amended by the Eighth Amendment
to Revolving Credit Agreement dated February 1998.
(incorporated herein by reference to Exhibit 10.21 of the
Company's Form 10-K dated March 24, 1998 filed with the
Commission March 26, 1998).
10.22 -- Master Repurchase Agreement Governing Purchases and Sales
of Mortgage Loans, dated as of July 1998, between Lehman
Commercial Paper Inc. and FHB Funding Corp. (incorporated
herein by reference to Exhibit 10.1 of the Company's Form
10-Q dated August 14, 1998, filed with the Commission on
August 18, 1998).
10.23 -- Warehouse Credit Agreement, dated as of April 30, 1998,
among ContiTrade Services, L.L.C., FirstCity Consumer
Lending Corporation, FirstCity Auto Receivables L.L.C.
and FirstCity Financial Corporation (incorporated herein
by reference to Exhibit 10.1 of the Company's Form 10-Q
dated August 14, 1998, filed with the Commissions on
August 18, 1998).
10.24 -- Servicing Agreement, dated as of April 30, 1998, among
FirstCity Auto Receivables L.L.C., FirstCity Servicing
Corporation of California, FirstCity Consumer Lending
Corporation and ContiTrade Services L.L.C. (incorporated
herein by reference to Exhibit 10.1 of the Company's Form
10-Q dated August 14, 1998, filed with the Commission on
August 18, 1998).
10.25 -- Security and Collateral Agent Agreement, dated as of
April 30, 1998, among FirstCity Auto Receivables L.L.C.,
ContiTrade Services L.L.C. and Chase Bank of Texas,
National Association (incorporated herein by reference to
Exhibit 10.1 of the Company's Form 10-Q dated August 14,
1998, filed with the Commission on August 18, 1998).
</TABLE>
107
<PAGE> 108
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.26 -- Loan Agreement, dated as of July 24, 1998, between
FirstCity Commercial Corporation and CFSC Capital Corp.
XXX (incorporated herein by reference to Exhibit 10.1 of
the Company's Form 10-Q dated August 14, 1998, filed with
the Commission on August 18, 1998).
10.27 -- Loan Agreement, dated April 8, 1998, between Bank of
Scotland and the Company (incorporated herein by
reference to Exhibit 10.1 of the Company's Form 10-Q
dated August 14, 1998, filed with the Commission on
August 18, 1998).
10.28 -- First Amendment to Loan Agreement, dated July 20, 1998,
between Bank of Scotland and the Company (incorporated
herein by reference to Exhibit 10.1 of the Company's Form
10-Q dated August 14, 1998, filed with the Commission on
August 18, 1998).
23.1 -- Consent of KPMG LLP.
23.2 -- Consent of KPMG LLP.
27.1 -- Financial Data Schedule. (Exhibit 27.1 is being submitted
as an exhibit only in the electronic format of this
Annual Report on Form 10-K being submitted to the
Securities and Exchange Commission. Exhibit 27.1 shall
not be deemed filed for purposes of Section 11 of the
Securities Act of 1933, Section 18 of the Securities Act
of 1934, as amended, or Section 323 of the Trust
Indenture Act of 1939, as amended, or otherwise be
subject to the liabilities of such sections, nor shall it
be deemed a part of any registration statement to which
it relates.)
</TABLE>
(b) The Company did not file a Report on Form 8-K during, or dated during,
the fourth quarter of 1998.
108
<PAGE> 109
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
FIRSTCITY FINANCIAL CORPORATION
By /s/ JAMES R. HAWKINS
-----------------------------------
James R. Hawkins
Chairman of the Board
March 24, 1998
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <S> <C>
/s/ JAMES R. HAWKINS Chairman of the Board, Chief March 31, 1999
- ----------------------------------------------------- Executive Officer and
James R. Hawkins Director (Principal
Executive Officer)
/s/ JAMES T. SARTAIN President, Chief Operating March 31, 1999
- ----------------------------------------------------- Officer and Director
James T. Sartain
/s/ RICK R. HAGELSTEIN Executive Vice President, March 31, 1999
- ----------------------------------------------------- Managing Director and
Rick R. Hagelstein Director
/s/ GARY H. MILLER Senior Vice President, and March 31, 1999
- ----------------------------------------------------- Chief Financial
Gary H. Miller Officer(Principal financial
and accounting officer)
/s/ MATT A. LANDRY, JR Director March 31, 1999
- -----------------------------------------------------
Matt A. Landry, Jr.
/s/ RICHARD E. BEAN Director March 31, 1999
- -----------------------------------------------------
Richard E. Bean
/s/ BART A. BROWN, JR Director March 31, 1999
- -----------------------------------------------------
Bart A. Brown, Jr.
</TABLE>
109
<PAGE> 110
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
2.1 -- Joint Plan of Reorganization by First City Bancorporation
of Texas, Inc., Official Committee of Equity Security
Holders and J-Hawk Corporation, with the Participation of
Cargill Financial Services Corporation, Under Chapter 11
of the United States Bankruptcy Code, Case No.
392-39474-HCA-11 (incorporated herein by reference to
Exhibit 2.1 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995).
2.2 -- Agreement and Plan of Merger, dated as of July 3, 1995,
by and between First City Bancorporation of Texas, Inc.
and J-Hawk Corporation (incorporated herein by reference
to Exhibit 2.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995).
3.1 -- Amended and Restated Certificate of Incorporation of the
Company (incorporated herein by reference to Exhibit 3.1
of the Company's Current Report on Form 8-K dated July 3,
1995 filed with the Commission on July 18, 1995).
3.2 -- Bylaws of the Company (incorporated herein by reference
to Exhibit 3.2 of the Company's Current Report on Form
8-K dated July 3, 1995 filed with the Commission on July
18, 1995).
4.1 -- Certificate of Designations of the New Preferred Stock
($0.01 par value) of the Company.
4.2 -- Warrant Agreement, dated July 3, 1995, by and between the
Company and American Stock Transfer & Trust Company, as
Warrant Agent (incorporated herein by reference to
Exhibit 4.2 of the Company's Current Report on Form 8-K
dated July 3, 1995 filed with the Commission on July 18,
1995).
4.3 -- Registration Rights Agreement, dated July 1, 1997, among
the Company, Richard J. Gillen, Bernice J. Gillen, Harbor
Financial Mortgage Company Employees Pension Plan,
Lindsey Capital Corporation, Ed Smith and Thomas E.
Smith.
4.4 -- Stock Purchase Agreement, dated March 24, 1998, between
the Company and Texas Commerce Shareholders Company.
4.5 -- Registration Rights Agreement, dated March 24, 1998,
between the Company and Texas Commerce Shareholders
Company.
9.1 -- Shareholder Voting Agreement, dated as of June 29, 1995,
among ATARA I Ltd., James R. Hawkins, James T. Sartain
and Cargill Financial Services Corporation.
10.1 -- Trust Agreement of FirstCity Liquidating Trust, dated
July 3, 1995 (incorporated herein by reference to Exhibit
10.1 of the Company's Current Report on Form 8-K dated
July 3, 1995 filed with the Commission on July 18, 1995).
10.2 -- Investment Management Agreement, dated July 3, 1995,
between the Company and FirstCity Liquidating Trust
(incorporated herein by reference to Exhibit 10.2 of the
Company's Current Report on Form 8-K dated July 3, 1995
filed with the Commission on July 18, 1995).
10.3 -- Lock-Box Agreement, dated July 11, 1995, among the
Company, NationsBank of Texas, N.A., as lock-box agent,
FirstCity Liquidating Trust, FCLT Loans, L.P., and the
other Trust-Owned Affiliates signatory thereto, and each
of NationsBank of Texas, N.A. and Fleet National Bank, as
co-lenders (incorporated herein by reference to Exhibit
10.3 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
</TABLE>
<PAGE> 111
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.4 -- Custodial Agreement, dated July 11, 1995, among Fleet
National Bank, as custodian, Fleet National Bank, as
agent, FCLT Loans, L.P., FirstCity Liquidating Trust, and
the Company (incorporated herein by reference to Exhibit
10.4 of the Company's Form 8-A/A dated August 25, 1995
filed with the Commission on August 25, 1995).
10.5 -- Tier 3 Custodial Agreement, dated July 11, 1995, among
the Company, as custodian, Fleet National Bank, as agent,
FCLT Loans, L.P., FirstCity Liquidating Trust, and the
Company, as servicer (incorporated herein by reference to
Exhibit 10.5 of the Company's Form 8-A/A dated August 25,
1995 filed with the Commission on August 25, 1995).
10.6 -- 12/97 Amended and Restated Facilities Agreement, dated
effective as of December 3, 1997, among Harbor Financial
Mortgage Corporation, New America Financial, Inc., Texas
Commerce Bank National Association and the other
warehouse lenders party thereto. (incorporated herein by
reference to Exhibit 10.6 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
10.7 -- Modification Agreement, dated January 26, 1998, to the
Amended and Restated Facilities Agreement, dated as of
December 3, 1997, among Harbor Financial Mortgage
Corporation, New America Financial, Inc. and Chase Bank
of Texas, National Association (formerly known as Texas
Commerce Bank National Association). (incorporated herein
by reference to Exhibit 10.7 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
10.8 -- $50,000,000 3/98 Chase Texas Temporary Additional
Warehouse Note, dated March 17, 1998, by Harbor Financial
Mortgage Corporation and New America Financial, Inc., in
favor of Chase Bank of Texas, National Association.
(incorporated herein by reference to Exhibit 10.8 of the
Company's Form 10-K dated March 24, 1998 filed with the
Commission March 26, 1998).
10.9 -- Employment Agreement, dated as of July 1, 1997, by and
between Harbor Financial Mortgage Corporation and Richard
J. Gillen. (incorporated herein by reference to Exhibit
10.9 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998).
10.10 -- Employment Agreement, dated as of September 8, 1997, by
and between FirstCity Funding Corporation and Thomas R.
Brower, with similar agreements between FC Capital Corp.
and each of James H. Aronoff and Christopher J.
Morrissey. (incorporated herein by reference to Exhibit
10.10 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998).
10.11 -- Shareholder Agreement, dated as of September 8, 1997,
among FirstCity Funding Corporation, FirstCity Consumer
Lending Corporation, Thomas R. Brower, Scot A. Foith,
Thomas G. Dundon, R. Tyler Whann, Bradley C. Reeves,
Stephen H. Trent and Blake P. Bozman. (incorporated
herein by reference to Exhibit 10.11 of the Company's
Form 10-K dated March 24, 1998 filed with the Commission
March 26, 1998).
10.12 -- Revolving Credit Loan Agreement, dated as of March 20,
1998, by and between FC Properties, Ltd. and Nomura Asset
Capital Corporation. (incorporated herein by reference to
Exhibit 10.12 of the Company's Form 10-K dated March 24,
1998 filed with the Commission March 26, 1998).
10.13 -- Revolving Credit Loan Agreement, dated as of February 27,
1998, by and between FH Partners, L.P. and Nomura Asset
Capital Corporation. (incorporated herein by reference to
Exhibit 10.13 of the Company's Form 10-K dated March 24,
1998 filed with the Commission March 26, 1998).
</TABLE>
<PAGE> 112
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.14 -- Note Agreement, dated as of June 6, 1997, among Bosque
Asset Corp., SVD Realty, L.P., SOWAMCO XXII, LTD., Bosque
Investment Realty Partners, L.P. and Bankers Trust
Company of California, N.A. (incorporated herein by
reference to Exhibit 10.14 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
10.15 -- 60,000,000 French Franc Revolving Promissory Note, dated
September 25, 1997, by J-Hawk International Corporation
in favor of the Bank of Scotland. (incorporated herein by
reference to Exhibit 10.15 of the Company's Form 10-K
dated March 24, 1998 filed with the Commission March 26,
1998).
10.16 -- Loan Agreement, dated as of September 25, 1997, by and
between Bank of Scotland and J-Hawk International
Corporation. (incorporated herein by reference to Exhibit
10.16 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998)
10.17 -- Guaranty Agreement, dated as of September 25, 1997, by
J-Hawk Corporation (now known as FirstCity Commercial
Corporation) in favor of Bank of Scotland. (incorporated
herein by reference to Exhibit 10.17 of the Company's
Form 10-K dated March 24, 1998 filed with the Commission
March 26, 1998).
10.18 -- Guaranty Agreement, dated as of September 25, 1997, by
FirstCity Financial Corporation in favor of Bank of
Scotland. (incorporated herein by reference to Exhibit
10.18 of the Company's Form 10-K dated March 24, 1998
filed with the Commission March 26, 1998).
10.19 -- Warehouse Credit Agreement, dated as of May 17, 1996,
among ContiTrade Services L.L.C., N.A.F. Auto Loan Trust
and National Auto Funding Corporation. (incorporated
herein by reference to Exhibit 10.19 of the Company's
Form 10-K dated March 24, 1998 filed with the Commission
March 26, 1998).
10.20 -- Funding Commitment, dated as of May 17, 1996, by and
between ContiTrade Services L.L.C. and the Company.
(incorporated herein by reference to Exhibit 10.20 of the
Company's Form 10-K dated March 24, 1998 filed with the
Commission March 26, 1998).
10.21 -- Revolving Credit Agreement, dated as of December 29,
1995, by and between the Company and Cargill Financial
Services Corporation, as amended by the Eighth Amendment
to Revolving Credit Agreement dated February 1998.
(incorporated herein by reference to Exhibit 10.21 of the
Company's Form 10-K dated March 24, 1998 filed with the
Commission March 26, 1998)
10.22 -- Master Repurchase Agreement Governing Purchases and Sales
of Mortgage Loans, dated as of July 1998, between Lehman
Commercial Paper Inc. and FHB Funding Corp. (incorporated
herein by reference to Exhibit 10.1 of the Company's Form
10-Q dated August 14, 1998, filed with the Commission on
August 18, 1998).
10.23 -- Warehouse Credit Agreement, dated as of April 30, 1998,
among ContiTrade Services, L.L.C., FirstCity Consumer
Lending Corporation, FirstCity Auto Receivables L.L.C.
and FirstCity Financial Corporation (incorporated herein
by reference to Exhibit 10.1 of the Company's Form 10-Q
dated August 14, 1998, filed with the Commissions on
August 18, 1998).
10.24 -- Servicing Agreement, dated as of April 30, 1998, among
FirstCity Auto Receivables L.L.C., FirstCity Servicing
Corporation of California, FirstCity Consumer Lending
Corporation and ContiTrade Services L.L.C. (incorporated
herein by reference to Exhibit 10.1 of the Company's Form
10-Q dated August 14, 1998, filed with the Commission on
August 18, 1998).
</TABLE>
<PAGE> 1
INDEPENDENT AUDITORS' CONSENT
The Board of Directors
FirstCity Financial Corporation:
We consent to incorporation by reference in the registration statements
(Numbers 333-10345, 333-48671, 333-59333, 333-00623 and 333-09485) on Forms S-3
and S-8 of FirstCity Financial Corporation, of our report dated February 12,
1999, relating to the consolidated balance sheets of FirstCity Financial
Corporation and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of operations, shareholders' equity, and cash flows for
each of the years in the three-year period ended December 31, 1998, which report
appears in the December 31, 1998, annual report on Form 10-K of FirstCity
Financial Corporation.
KPMG LLP
Fort Worth, Texas
March 31, 1999
<PAGE> 1
INDEPENDENT AUDITORS' CONSENT
The Partners
WAMCO Partnerships:
We consent to incorporation by reference in the registration statements
(Numbers 333-10345, 333-48671, 333-59333, 333-00623 and 333-09485) on Forms S-3
and S-8 of FirstCity Financial Corporation, of our report dated January 29,
1999, relating to the combined balance sheets of WAMCO Partnerships as of
December 31, 1998 and 1997, and the related combined statements of operations,
partners' capital, and cash flows for each of the years in the three-year period
ended December 31, 1998, which report appears in the December 31, 1998, annual
report on Form 10-K of FirstCity Financial Corporation.
KPMG LLP
Fort Worth, Texas
March 31, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 13,677
<SECURITIES> 65,242
<RECEIVABLES> 1,207,543
<ALLOWANCES> 0
<INVENTORY> 115,598
<CURRENT-ASSETS> 0
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 1,663,997
<CURRENT-LIABILITIES> 0
<BONDS> 1,462,231
26,319
0
<COMMON> 83
<OTHER-SE> 136,872
<TOTAL-LIABILITY-AND-EQUITY> 1,663,977
<SALES> 42,976
<TOTAL-REVENUES> 233,312
<CGS> 33,768
<TOTAL-COSTS> 33,768
<OTHER-EXPENSES> 165,282
<LOSS-PROVISION> 40,479
<INTEREST-EXPENSE> 14,888
<INCOME-PRETAX> (21,105)
<INCOME-TAX> (1,043)
<INCOME-CONTINUING> (20,062)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (25,378)
<EPS-PRIMARY> (3.35)
<EPS-DILUTED> (3.35)
</TABLE>
