<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------
FORM 10-Q/A-1
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarter ended September 30, 1998 Commission file number 0-20526
-----------
ARCADIA FINANCIAL LTD.
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1664848
(State or other jurisdiction (I.R.S. Employer Identification
Of incorporation or organization) Number)
7825 WASHINGTON AVENUE SOUTH, MINNEAPOLIS, MN 55439-2435
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (612) 942-9880
-----------
Indicate by checkmark 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
--- ---
The number of shares of the Common Stock of the registrant outstanding
as of October 30, 1998 was 39,166,813.
<PAGE>
The undersigned registrant hereby amends its Quarterly Report on From
10-Q for the quarter ended September 30, 1998 to amend Items 1 and 2 of Part
I in their entirety. Such amendments reflect a restatement of the Company's
consolidated balance sheets and related consolidated statements of operations
and comprehensive income, shareholders' equity and cash flows resulting from
a change in account policy with respect to the valuation and accounting for
the Company's finance income receivable. Refer to Note 2 to the Unaudited
Consolidated Financial Statements for additional information.
FORM 10-Q/A-1 INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements 3
Item 2. Results of Management's Discussion and Analysis of
Financial Condition and Operations 12
SIGNATURES 25
</TABLE>
The financial information for the interim periods presented herein is
unaudited. In the opinion of management, all adjustments necessary (which are
of a normal recurring nature) have been included for a fair presentation of
the results of operations. The results of operations for an interim period
are not necessarily indicative of the results that may be expected for a full
year or any other interim period.
SAFE HARBOR STATEMENT UNDER THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Certain statements under the caption "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and elsewhere in
this Form 10-Q constitute "forward-looking statements" within the meaning of
the Private Securities Litigation Reform Act of 1995. Such forward-looking
statements may be identified by the use of terminology such as "may," "will,"
"expect," "anticipate," "estimate," "should," or "continue" or the negative
thereof or other variations thereon or comparable terminology. Such
forward-looking statements are subject to certain risks and uncertainties
that could cause actual results to differ materially from historical results
or from those results presently anticipated or projected. Such factors
include, among other things, the following: delinquency and loan loss rates
which vary from assumptions; modifications to the Company's repossession
disposition program; accounting and regulatory changes; interest rate
fluctuations; difficulties or delays in the securitization of automobile
loans; availability of adequate short- and long-term financing; general
economic and business conditions; and other matters set forth under the
caption "Cautionary Statements" in exhibit 99.1 to the Company's June 30,
1998, Quarterly Report on Form 10-Q filed August 8, 1998.
2
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
(RESTATED)
(UNAUDITED) (RESTATED)
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) SEPTEMBER 30, 1998 DECEMBER 31, 1997
------------------ -----------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 6,328 $ 17,274
Due from securitization trust 98,384 107,207
Auto loans held for sale 20,045 49,133
Finance income receivable 592,951 602,454
Furniture, fixtures and equipment 17,140 17,371
Other assets 30,328 32,483
------------ ------------
Total assets $ 765,176 $ 825,922
------------ ------------
------------ ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Amounts due under warehouse facilities $ 57,843 $ 30,880
Senior notes 366,403 365,640
Subordinated notes 48,902 50,772
Capital lease obligations 3,735 5,368
Deferred income taxes - 11,506
Accounts payable and accrued liabilities 25,718 26,302
------------ ------------
Total liabilities 502,601 490,468
Commitments and contingencies
Shareholders' equity:
Capital stock, $.01 par value, 100,000,000 shares authorized:
Common stock 39,166,813 and 38,813,735 shares issued
and outstanding, respectively 392 388
Additional paid-in capital 325,143 322,819
Accumulated other comprehensive income 16,711 3,704
Retained earnings (deficit) (79,671) 8,543
------------ ------------
Total shareholders' equity 262,575 335,454
------------ ------------
Total liabilities and shareholders' equity $ 765,176 $ 825,922
------------ ------------
------------ ------------
</TABLE>
See notes to unaudited consolidated financial statements.
3
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(UNAUDITED)
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
REVENUES:
Net interest margin $ 22,675 $ 21,179 $ 63,593 $ 60,058
Gain (loss) on sale of loans 20,667 23,954 (39,631) (36,205)
Servicing fee income 21,236 17,748 61,086 47,761
------------ ------------ ------------ ------------
Total revenues 64,578 62,881 85,048 71,614
EXPENSES:
Salaries and benefits 15,658 16,230 48,778 45,823
General and administrative and other operating expenses 27,695 24,471 95,100 74,446
------------ ------------ ------------ ------------
Total operating expenses 43,353 40,701 143,878 120,269
Long-term debt and other interest expense 12,926 10,400 38,619 28,642
------------ ------------ ------------ ------------
Total expenses 56,279 51,101 182,497 148,911
------------ ------------ ------------ ------------
Operating income (loss) before income taxes and
extraordinary item 8,299 11,780 (97,449) (77,297)
Income tax expense (benefit) - 4,476 (9,235) (29,374)
------------ ------------ ------------ ------------
Income (loss) before extraordinary item 8,299 7,304 (88,214) (47,923)
Extraordinary item, net of tax - - - (15,828)
------------ ------------ ------------ ------------
Net income (loss) 8,299 7,304 (88,214) (63,751)
Other comprehensive income (loss):
Net unrealized gain (loss) on finance income receivables 7,631 2,565 10,736 4,322
Income tax provision (benefit) related to other - 974 (2,271) 1,643
comprehensive income
------------ ------------ ------------ ------------
7,631 1,591 13,007 2,679
------------ ------------ ------------ ------------
COMPREHENSIVE INCOME (LOSS) $ 15,930 $ 8,895 $ (75,207) $ (61,072)
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
BASIC EARNINGS PER SHARE:
Net income (loss) per share before extrordinary item $ 0.21 $ 0.19 $ (2.26) $ (1.24)
Extraordinary item per share - - - (0.41)
------------ ------------ ------------ ------------
Net income (loss) per share $ 0.21 $ 0.19 $ (2.26) $ (1.65)
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
DILUTED EARNINGS PER SHARE:
Net income (loss) per share before extraordinary item $ 0.21 $ 0.19 $ (2.26) $ (1.24)
Extraordinary item per share - - - (0.41)
------------ ------------ ------------ ------------
Net income (loss) per share $ 0.21 $ 0.19 $ (2.26) $ (1.65)
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
Weighted average shares outstanding:
Basic 39,142,050 38,740,078 39,031,668 38,615,060
Diluted 39,279,813 39,231,962 39,031,668 38,615,060
</TABLE>
See notes to unaudited consolidated financial statements.
4
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
UNAUDITED)
<TABLE>
<CAPTION>
(RESTATED)
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------------
(DOLLARS IN THOUSANDS) 1998 1997
----------- -----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (88,214) $ (63,751)
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation and amortization 8,044 5,163
(Increase) decrease in assets:
Automobile loans held for sale:
Purchases of automobile loans (1,731,546) (2,323,464)
Sales of automobile loans 1,714,710 2,276,335
Repayments of automobile loans 45,925 27,784
Finance income receivable 22,510 (76,035)
Due from securitization trusts 8,823 27,646
Other assets 340 4,074
Increase (decrease) in liabilities:
Deferred income taxes (11,506) (37,430)
Accounts payable and accrued liabilities (584) 3,303
----------- -----------
Total cash used in operating activities (31,498) (156,375)
CASH FLOWS FROM INVESTING ACTIVITIES:
Net purchase of furniture, fixtures and equipment (4,704) (7,064)
Collections on subordinated certificates 758 1,187
----------- -----------
Total cash used in investing activities (3,946) (5,877)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of Common Stock 1,038 2,976
Proceeds from borrowings under warehouse facilities 2,067,182 2,559,245
Repayment of borrowings under warehouse facilities (2,040,219) (2,544,122)
Unsecured subordinated notes, net (1,870) (2,395)
Repayments of long-term debt - (145,000)
Proceeds from issuance of long term debt - 300,000
Deferred debt issuance cost - (4,870)
Reduction of capital lease obligations (1,633) (1,919)
----------- -----------
Total cash provided by financing activities 24,498 163,915
Net increase (decrease) in cash and cash equivalents (10,946) 1,663
Cash and cash equivalents at beginning of period 17,274 16,057
----------- -----------
Cash and cash equivalents at end of period $ 6,328 $ 17,720
----------- -----------
----------- -----------
Supplemental disclosures of cash flow information:
Non cash activities:
Additions to capital leases - $ 132
Cash paid for:
Interest $ 55,233 $ 36,669
</TABLE>
See notes to unaudited consolidated financial statements.
5
<PAGE>
ARCADIA FINANCIAL LTD.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(UNAUDITED)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
ACCUMULATED
NUMBER OF COMMON ADDITIONAL RETAINED OTHER
COMMON PAR PAID IN EARNINGS COMPREHENSIVE
SHARES VALUE CAPITAL (DEFICIT) INCOME TOTAL
---------- ---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1997, AS RESTATED 38,813,735 $ 388 $ 322,819 $ 8,543 $ 3,704 $ 335,454
Exercise of options and warrants 149,323 2 539 - - 541
Issuance of Common Stock:
Benefit plans 203,755 2 495 - - 497
Amortization of deferred compensation - - 1,290 - - 1,290
Unrealized gain on financed income receivable - - - - 13,007 13,007
Net loss, as restated - - - (88,214) - (88,214)
---------- ---------- ---------- ---------- ---------- ----------
BALANCE, SEPTEMBER 30, 1998, AS RESTATED 39,166,813 $ 392 $ 325,143 $ (79,671) $ 16,711 $ 262,575
---------- ---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ---------- ----------
</TABLE>
See notes to unaudited consolidated financial statements.
6
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION. The interim financial statements have been
prepared by the Company pursuant to the rules and regulations of the
Securities and Exchange Commission applicable to quarterly reports on Form
10-Q. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules
and regulations, although management believes that the disclosures present
fairly the financial position of the Company and its subsidiaries for the
periods presented. These financial statements should be read in conjunction
with the audited consolidated financial statements and related notes and
schedules included in the Company's 1997 Annual Report on Form 10-K/A filed
March 30, 1998.
The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated.
Certain reclassifications have been made to the September 30, 1997
balances to conform to current period presentation.
USE OF ESTIMATES
In conformity with generally accepted accounting principles, management
utilizes assumptions and estimates that affect the reported value of finance
income receivable and the gain on sale of automobile receivables. Such
assumptions include, but are not limited to, estimates of loan prepayments,
defaults, recovery rates and present value discount. The Company uses a
combination of its own historical experience, industry statistics and
expectation of future performance to determine such estimates. The Company's
estimation process is evaluated on a regular basis and modified when deemed
necessary. Modifications to the estimation process may result in changes in
estimates utilized to determine the carrying value of finance income
receivable. Actual results may differ from the Company's estimates due to
numerous factors both within and beyond the control of Company management.
Changes in these factors could require the Company to revise its assumptions
concerning the amount of voluntary prepayments, the frequency and/or severity
of defaults and the recovery rates associated with the disposition of
repossessed vehicles. The range of assumptions, as well as actual
performance, are reflective of the risk characteristics of the loans within
specific securitization pools.
The Company adopted Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income" ("SFAS 130"), effective January 1,
1998. SFAS 130 establishes standard for reporting comprehensive income and
its components in a full set of financial statements. The new standard
requires that all items that are required to be recognized under accounting
standards as components of comprehensive income, including an amount
representing total comprehensive income, be reported in a financial statement
that is displayed with the same prominence as other financial statements.
Pursuant to SFAS 130, the Company has reported comprehensive income in the
accompanying consolidated financial statements. Prior year financial
statements have been reclassified to conform to the requirements of SFAS 130.
7
<PAGE>
2. ACCOUNTING CHANGE
Pursuant to the FASB's Special Report, "A Guide to Implementation of
Statement 125 on Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities, Second Edition," dated December 1998, and
public comments from the Securities and Exchange Commission released on
December 8, 1998, during the fourth quarter of 1998 the Company changed its
accounting policy with respect to the valuation and accounting for its
finance income receivable to the "cash-out" method. Finance income receivable
represents the Company's retained interest in estimated future cash flows
from securitization transactions. Under the "cash-in" method previously used
by the Company, (i) the assumed discount period for measuring the present
value of future cash flows ended when these cash flows were deposited into
the securitization trust accounts and (ii) any initial deposits to spread
accounts were recorded at face value. Under the "cash-out" method, the
assumed discount period for measuring the present value of future cash flows
from the trusts ends when cash, including return of the initial deposits, its
distributed to the Company on an unrestricted basis. Prior period financial
statements have been restated to reflect this change on a retroactive basis.
The effects of the restatement on the consolidated balance sheet at December
31, 1997 and the consolidated statements of operations and comprehensive
income and shareholders' equity for the three months ended September 30, 1998
and 1997 are as follows:
<TABLE>
<CAPTION>
AT SEPTEMBER 30, 1998 AT DECEMBER 31, 1997
----------------------------- ------------------------------
ORIGINALLY AS ORIGINALLY AS
(IN MILLIONS, EXCEPT PER SHARE DATA) REPORTED RESTATED REPORTED RESTATED
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
BALANCE SHEET:
Finance income receivable $ 598,221 $ 592,951 $ 622,282 $ 602,454
Deferred income taxes - - 18,846 11,506
Shareholders' equity 267,845 262,575 347,942 335,454
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30,
---------------------------------------------------------------------
1998 1997
----------------------------- ------------------------------
ORIGINALLY AS ORIGINALLY AS
REPORTED RESTATED REPORTED RESTATED
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS:
Revenues $ 63,574 $ 64,578 $ 63,664 $ 62,881
Income tax expense (benefit) - - 4,774 4,476
Net Income (loss) 7,295 8,299 7,789 7,304
Basic earnings per share $ 0.19 $ 0.21 $ 0.20 $ 0.19
Diluted Earnings per share 0.19 0.21 0.20 0.19
</TABLE>
8
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
3. FINANCE INCOME RECEIVABLE
The following table sets forth the components of finance income receivable:
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
AT AT
SEPTEMBER 30, DECEMBER 31,
1998 1997
---------------- -----------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Estimated cash flows on loans sold, net of estimated prepayments $ 1,200,187 $ 1,009,800
Deferred servicing income (103,515) (88,282)
Reserve for loan losses (413,112) (235,599)
---------------- -----------------
Undiscounted cash flows on loans sold, net of estimated prepayments 683,560 685,919
Discount to present value (90,609) (83,465)
---------------- -----------------
$ 592,951 $ 602,454
---------------- -----------------
---------------- -----------------
Reserve for loan losses as a percentage of servicing portfolio 8.04% 4.75%
</TABLE>
The following represents the roll-forward of the finance income receivable
balance:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
<S> <C>
BALANCE, DECEMBER 31, 1997, AS RESTATED $ 602,454
Present value of estimated future cash flows from current period securitizations 175,669
Interest earned on spread accounts 10,695
Recognition of present value effect of discounted cash flows 36,493
Unrealized gain on retained assets 10,736
Less:
Spread account recourse reduction amount (1) (25,000)
Excess cash flows released to the Company (2) (103,596)
Change in estimates of charge-offs, recovery rates and prepayments (114,500)
----------------
BALANCE, SEPTEMBER 30, 1998, AS RESTATED $ 592,951
----------------
----------------
</TABLE>
- ------------------------
(1) In May 1998, the Company and its provider of asset-backed securities
insurance entered into an arrangement whereby the Company was allowed to
receive $25 million of cash from certain spread accounts sooner than it
would have absent such arrangement. The arrangement may be extended on an
annual basis upon mutual arrangement by and between the Company and its
provider of asset-backed securities insurance. The Company pays a monthly
fee to its provider of asset-backed securities insurance to maintain the
arrangement. The $25 million will be replenished in the relevant spread
accounts by means of a $3 million reduction in the level of monthly cash
releases from the spread accounts. The replishment period will begin in
May 1999, unless the terms of the arrangement are extended.
(2) Includes $0.6 million that has been restricted pursuant to an arrangement
between the Company and its provider of asset-backed securities insurance.
Such arrangement provides that, if any insured securitization trust
exceeds the specified portfolio performance test as defined within the
trust agreement, the Company may, in lieu of retaining excess cash from
that securitization trust in the related spread accounts, pledge an
equivalent amount of cash, which has the effect of preventing the
violation of the portfolio performance test. Such pledged amounts are
included in cash and cash equivalents. Restrictions on the pledged amounts
may be lifted if the portfolio performance tests are met and maintained
for the related securitization trusts as defined in the arrangement, the
violations are waived, or the loans within the securitization trust are
repurchased by the Company.
9
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
<TABLE>
<CAPTION>
4. OTHER ASSETS AT AT
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Advances due to servicer $ 5,464 $ 6,072
Deferred debt issuance costs 10,462 11,518
Investment in subordinated certificates 2,106 2,864
Servicing fee receivable 4,846 4,389
Prepaid expenses 1,532 1,078
Repossessed assets 132 1,181
Other assets 5,786 5,381
------------- -------------
$30,328 $32,483
------------- -------------
------------- -------------
<CAPTION>
5. SUBORDINATED NOTES AT AT
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Senior subordinated notes, Series 1996-A $30,000 $30,000
Junior subordinated notes 18,902 20,772
------------- -------------
$48,902 $50,772
------------- -------------
------------- -------------
</TABLE>
10
<PAGE>
ARCADIA FINANCIAL LTD.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
6. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings
per share for each of the three and nine month periods ended September 30:
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS) 1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Numerator:
Net income (loss ) before
extraordinary item $ 8,299 $ 7,304 $ (88,214) $ (63,751)
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
Denominator:
Denominator for basic earnings per
share - weighted average shares 39,142,050 38,740,078 39,031,668 38,615,060
Dilutive effect of options and warrants (1) 137,763 491,884 - -
------------ ------------ ------------ ------------
Denominator for diluted earnings per
share - adjusted weighted average
shares 39,279,813 39,231,962 39,031,668 38,615,060
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
Basic earnings (loss) per share before
extraordinary item $ 0.21 $ 0.19 $ (2.26) $ (1.24)
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
Diluted earnings (loss) per share before
extraordinary item $ 0.21 $ 0.19 $ (2.26) $ (1.24)
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
</TABLE>
- ------------------------
(1) For the nine months ended September 30, 1998 and 1997, the weighted average
shares under the diluted computation have an anti-dilutive effect; therefore
diluted earnings per share are shown equal to basic earnings per share.
11
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Substantially all of the Company's revenues are derived from the
purchase, securitization and servicing of consumer automobile loans
originated in 45 states primarily by car dealers affiliated with major
foreign and domestic manufacturers. Loans are purchased through 18 regional
buying centers (or "hubs") located in 15 states, supplemented by a network of
dealer development representatives ("DDRs") which develop and maintain
relationships with car dealers operating within each "hub's" immediate market
area or in surrounding market areas referred to as "spokes." Credit approval
and loan processing are generally performed at the "hub" or at the Company's
headquarters in Minneapolis, Minnesota. The Company acts as the servicer of
all loans originated and securitized by it in return for a monthly servicing
fee. To perform its servicing responsibilities the Company operates a
national customer service center in Minneapolis, Minnesota and four regional
collection centers located in Charlotte, North Carolina; Dallas, Texas;
Denver, Colorado; and Minneapolis, Minnesota.
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
RESULTS OF OPERATIONS
CHANGES IN ACCOUNTING ESTIMATES AND NON-RECURRING CHARGES
Included in the Company's financial results for the nine months ended
September 30, 1998, are two non-cash charges totaling $125 million. The
non-cash charges include a pre-tax $114.5 million charge to gain on sale of
loans associated with a change in accounting estimates to reflect (i) a
higher estimate of the frequency of defaulted receivables (ii) a reduction in
assumed loan loss recovery rates, (iii) a reduction in estimated voluntary
loan prepayments, and (iv) additions to general reserves applicable to
unanticipated changes in the future performance of the existing portfolio of
receivables. An additional $10.5 million pre-tax charge relates to the
elimination of the Company's retail remarketing program and other
organizational changes designed to improve future operating efficiencies.
Historically, management's estimate of the frequency of loan defaults
was based on actual credit performance incurred to date segregated by each
securitization transaction and loan product (Premier and Classic) as well as
comparisons to externally-generated industry information when available. In
response to a perception of increased risk within the consumer finance
industry and the Company's dependence on internal historical experience as an
indicator of future credit performance, management commenced a project to
identify what it hoped would be a more predictive alternative to estimating
future performance of its servicing portfolio to not only improve the
Company's assessment of its finance income receivable carrying amount but
also to enhance the Company's pricing of its loan products. This project
focused on identifying correlations between the credit performance of the
loans in the Company's servicing portfolio and the credit characteristics of
each contract at the time of origination, including externally-developed
credit score, loan-to-value ratio, debt-to-income ratio and payment-to-income
ratio. The Company's decision to obtain and utilize a credit score from a
nationally recognized independent credit scoring company rather than
utilizing its own internally-developed credit score was based on its desire
to reduce the subjectivity of the analysis. As a result of this project,
management determined that the combination of externally-developed credit
score and loan-to-value ratio was most predictive of future loan performance.
Using the information derived from this process, management was then able to
segregate the loans in its servicing portfolio into eight distinct tranches
of credit performance that management believes provide a higher level of
precision in estimating future default experience than its previous
methodology. As a result, management determined in June 1998 that it was
necessary to revise its estimate with respect to the frequency of future loan
defaults and reduce the carrying value of its finance income receivable by
approximately $67 million.
12
<PAGE>
In addition to the frequency of loan defaults, the valuation of the
Company's finance income receivable is based in part on an estimate of the
recovery upon the disposition of repossessed vehicles. Although the Company
was reserved for and realized recovery rates slightly above 50% on the sale
of repossessed vehicles during the first six months of 1998, management
believes that market pressure on used car prices will force future recovery
rates downward and therefore, believes that it was appropriate to lower the
estimated recovery rate to 45%. This decrease to the Company's estimated
recovery rate, taking into consideration the increase in the estimated
frequency of defaults discussed above, led to a further reduction in the
carrying value of finance income receivable at June 30, 1998, of
approximately $51 million.
A third component in the valuation of finance income receivable is an
estimate of the amount and timing of voluntary prepayments of loans.
Historically, management has estimated the percentage of receivables it
expects to prepay on a monthly basis and has assumed that such monthly
prepayment speed would remain constant throughout the life of the
securitization trust. A detailed analysis of the Company's actual prepayment
data indicated, however, that for an extended period of time prepayment
speeds have performed slower than expected and have progressively declined as
a securitization trust ages. As a result, management determined that it was
appropriate to reduce its prepayment speed assumption, which resulted in an
increase to its finance income receivable carrying value at June 30, 1998, of
approximately $49 million.
Finally, to provide for current uncertainties related to the consumer
finance industry and the remaining subjectivity of the estimates used in
valuing the finance income receivable, management believes that it was
appropriate to increase its finance income receivable reserves at June 30,
1998, by an additional $45.5 million.
Also during the second quarter of 1998, the Company decided to
discontinue its retail remarketing operations and finalized plans aimed at
reducing infrastructure costs and improving operating efficiencies. After a
detailed review during 1997 and first half of 1998 the Company determined that
its retail remarketing operation which was responsible for the liquidation of
repossessed vehicles through retail consignment lots did not provide an adequate
risk-adjusted return commensurate with the attention necessary by management to
operate such strategy and therefore decided to cease such operations. Also
during this time period, the Company conducted an exhaustive study of
substantially all Company functions and developed a plan which includes further
consolidation of the Company's servicing and collection operations into its four
regional collection centers and streamlining of other operating procedures. As a
result, the Company recognized a $10.5 million pre-tax charge through other
operating expenses during the second quarter of 1998 associated with estimated
severance and benefit costs, termination or subleasing of certain lease
commitments, and legal expenses associated with the operational changes.
Included in the Company's financial results during the nine month period
ended June 30, 1997, are two special charges taken in March 1997. These charges
included a non-cash pre-tax charge of approximately $103 million, due primarily
to a change in accounting estimate related to the assumed recovery rates on
repossessed vehicles and modifications to the Company's retail disposition
strategy, and an extraordinary charge of approximately $15.8 million, net of
tax, due to the early extinguishment of the Company's 13% Senior Term Notes, due
2000 (the "13% Notes").
13
<PAGE>
NET INTEREST MARGIN. The components of net interest margin for each of
the three and nine months ended September 30 were:
<TABLE>
<CAPTION>
(RESTATED) (RESTATED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- ---------------------------
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Interest income on loans, net $ 7,947 $ 9,260 $ 20,979 $ 26,391
Interest income on short-term investments
and other cash accounts 2,538 3,267 8,485 8,438
Recognition of present value discount 12,885 9,699 36,493 27,110
Provision for credit losses on loans held for sale (695) (1,047) (2,364) (1,881)
------------ ------------ ------------ ------------
Net interest margin $ 22,675 $ 21,179 $ 63,593 $ 60,058
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
</TABLE>
Net interest margin increased 7% and 6% during the three and nine
months ended September 30, 1998, respectively, compared with the same periods
in 1997. The increase in net interest margin during the three and nine months
ended September 30, 1998, compared with the same periods in 1997, is
primarily due to an increase in the recognition of present value discount
reflecting the growth in the Company's finance income receivable and related
present value discount applied to the estimate of future cash flows. The
decrease in interest earned on loans during the three and nine months period
ended September 30, 1998 compared with the same periods of 1997 is primarily
due to a reduction in loan purchasing volume.
A decline in loan purchasing volume (see table below) of approximately
25% and the timing of securitization transactions during the three and nine
months ended September 30, 1998, respectively, resulted in a reduction in the
average monthly balance of loans held for sale, on which the Company earns
interest income until such loans are securitized, to $210.3 million and
$189.5 million, respectively, down from $258.1 million and $254.4 million in
the same periods of 1997, respectively. The decline in purchasing volume is
primarily due to the Company's emphasis on more selective loan purchases and
the time needed to market the Company's refined purchasing focus to its
dealer base. The impact of the lower average balance of loans held for sale
on interest income was partially offset by a rise in net interest rate
spreads. During the three and nine months ended September 30, 1998, the
weighted average net interest rate spread rose to 11.02% and 11.16%
respectively, compared with 10.43% and 10.08%, respectively, during the same
periods in 1997. The rise in net interest rate spread earned on loans held
for sale is principally due to higher average annual percentage rates
("APRs") on loans purchased during 1998 primarily resulting from a greater
proportion of loan volume consisting of higher rate Classic loans.
The Company's loan purchasing and securitization volume for each of the
three and nine months ended September 30 are set forth in the table below.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------------- ----------------------------------
1998 1997 1998 1997
--------------- --------------- -------------- ---------------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Premier $ 177,068 $ 326,087 $ 510,906 $ 1,087,825
Classic 392,953 434,230 1,215,968 1,192,865
--------------- --------------- -------------- ---------------
Total loans purchased $ 570,021 $ 760,317 $ 1,726,874 $ 2,280,690
--------------- --------------- -------------- ---------------
--------------- --------------- -------------- ---------------
Automobile loans securitized $ 554,734 $ 754,200 $ 1,714,710 $ 2,276,335
</TABLE>
14
<PAGE>
GAIN ON SALE OF LOANS. During the three months ended September 30, 1998,
gain on sale of loans declined 16% compared to the same period in 1997. During
the nine months ended September 30, 1998 and 1997, the Company recognized
non-recurring pre-tax charges to gain on sale of loans of $114.5 million and
$98.0 million, respectively, resulting in year to date losses on the sale of
loans of $39.6 million and $36.2 million, respectively. See "CHANGES IN
ACCOUNTING ESTIMATES AND NON-RECURRING CHARGES" for additional discussion.
Securitization volume decreased 26% and 25% during the three and nine months
ended September 30, 1998, respectively, compared with the same periods of 1997
due to lower origination growth. The impact of lower securitization volume on
revenues from gain on sale of loans was minimized during 1998, however, by the
widening of the gross interest rate spread earned. The following table
summarizes the Company's gross interest rate spreads for each of the three and
nine month periods ended September 30, 1998:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- --------------------------
1998 1997 1998 1997
--------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Weighted average APR of loans securitized 16.81 % 16.25 % 16.97 % 15.85 %
Weighted average securitization rate 5.64 6.37 5.87 6.46
--------- ---------- ---------- ----------
Gross interest rate spread (1) 11.17 % 9.88 % 11.10 % 9.39 %
--------- ---------- ---------- ----------
--------- ---------- ---------- ----------
</TABLE>
- -----------
(1) Before gains/losses on hedging transactions.
The rise in gross interest rate spread during the three and nine months
ended September 30, 1998 is primarily due to an increased proportion of loan
volume consisting of higher rate Classic loans and general rate increases on
the Company's Premier loans resulting from the Company's continued
refinements to its risk-based pricing strategy. Gross interest rate spreads
further benefited from a reduction in the securitization rate reflecting a
general decline in U.S. Treasury rates compared to the same periods of 1997.
During the third quarter of 1998, however, uncertainties in the bond market
caused investors in asset-backed securities to demand higher interest rates.
As a result, the spread over the two-year U.S. Treasury at which the Company
sells its loans increased by approximately 50 basis points compared to its
securitization transactions during 1997 and the first two quarters of 1998,
partially off-setting the favorable movement in the U.S. Treasury market and
its positive impact on the Company's gross interest rate spread.
Any unamortized balance of participations paid to dealers is expensed
at the time the related loans are securitized and recorded as a reduction to
gain on sale. Due to the increased proportion of Classic loan purchases,
which generally require lower participation rates than Premier loans,
participations paid as a percentage of the principal balance of loans
purchased declined to 2.94% and 2.87% during the three and nine months ended
September 30, 1998, from 3.08% and 3.16%, respectively, in the same periods a
year ago.
The Company employs hedging strategies, including the use of derivative
financial instruments to manage the gross interest rate spread on
securitization transactions. The Company's securitization rate is indexed to
rates on U.S. Treasury Notes with maturities similar to the average
maturities of the assets being sold. To lock in the indexed rate for a
specific anticipated securitization transaction and protect against changes
in the treasury rate, the Company uses Forward U.S. Treasury Rate Lock
agreements that most closely parallel the average life of its loans held for
sale. Such hedging strategy includes certain risks created by the cash versus
non-cash relationship of the hedging instrument and the related
securitization. This relationship arises because the gain or loss realized
from Forward U.S. Treasury Rate Lock agreements is settled with current cash
payments and is subsequently recovered over time through a higher or lower
gross interest rate spread at the time of securitization. During the three
and nine months ended September 30, 1998, the Company had net realized losses
on hedging transactions of $8.4 million and $16.8 million, respectively,
compared with $4.0 million and $4.3 million, respectively, in the same
periods of 1997. These hedging losses have been charged against gain on sale
of loans. The increase in realized hedging losses during 1998 is primarily
due to significant downward movement of treasury rates during the third
quarter of 1998.
15
<PAGE>
SERVICING FEE INCOME. The components of servicing fee income for each
of the three and nine months ended September 30 were:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ -------------------------------
(RESTATED) (RESTATED)
1998 1997 1998 1997
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Contractual servicing fee income $14,577 $12,154 $42,756 $32,679
Other servicing income 6,659 5,594 18,330 15,082
------------ ------------ ------------ ------------
Total servicing fee income $21,236 $17,748 $61,086 $47,761
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
</TABLE>
The Company earns contractual servicing fee income for servicing loans
sold to investors through securitizations. The servicing fee is 1% per annum
of the outstanding principal balance of the loans for all securitizations
entered into prior to September 1997 and 1.25% per annum on loans included in
and subsequent to the third quarter 1997 securitization. The growth in
contractual servicing fee income is directly related to an increase in the
average servicing portfolio outstanding and the increase in the contractual
servicing rate in September 1997.
Other servicing income consists primarily of collection fees, such as
late payment fees and insufficient fund charges, and interest on collection
accounts earned by the Company as servicer of the loans. The rise in other
servicing income is principally due to increases in income from late fees and
insufficient fund charges reflecting the increase in delinquency rates and
growth in the Company's servicing portfolio compared to the same periods a
year ago and increased collection account interest attributable to the growth
in the average servicing portfolio outstanding.
The following table reflects the growth in the Company's servicing
portfolio from September 30, 1997 to September 30, 1998:
<TABLE>
<CAPTION>
AT SEPTEMBER 30,
----------------------------------
1998 1997
-------------- --------------
<S> <C> <C>
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED)
Principal balance of automobile loans held for sale $ 20,785 $ 57,023
Principal balance of loans serviced under securitizations 5,117,013 4,767,605
-------------- --------------
Servicing portfolio $ 5,137,798 $ 4,824,628
-------------- --------------
-------------- --------------
Average unpaid principal balance (actual dollars) $ 11,480 $ 12,248
Number of loans serviced 447,542 393,926
</TABLE>
The principal balance of the Company's servicing portfolio increased 6%
from September 30, 1997 to September 30, 1998. This increase reflects loan
purchases and subsequent securitizations, partially offset by defaults,
prepayments and scheduled repayments. The decline in average outstanding
balance of loans during the first nine months of 1998 reflects an increase in
the proportion of used to new cars financed by the Company and a reduction in
loan-to-value ratios on loan purchases resulting from the Company's more
selective buying practices.
The Company's servicing fee approximates adequate compensation as
defined by SFAS 125 and therefore, the Company has not recorded a servicing
asset or liability at September 30, 1998.
OPERATING EXPENSES. During the three months ended September 30, 1998,
salaries and benefits decreased approximately 4% from the same period in
1997. This reduction is primarily due to a decrease in the average number of
employees to 1,417 during the third quarter of 1998 compared with 1,545
during the same period of 1997 resulting primarily from efforts to centralize
the Company's collection operations. Beginning in the first quarter of 1998,
the Company began to move collection personnel out of buying centers into
centralized sites to better
16
<PAGE>
leverage collections resources and technology and to control collection
processes more tightly. The 6% increase in salaries and benefits during the
first nine months of 1998 is primarily due to increased overtime compensation
incurred during the first and second quarter of 1998 migration to the
centralized collection sites.
Other operating costs, including administrative, occupancy,
depreciation and amortization, origination, servicing and collection
expenses, increased 13% and 28% for the three and nine months ended September
30, 1998, respectively, compared with the same periods in 1997. Included in
operating costs during the nine months ended September 30, 1998 is a pre-tax
charge of approximately $10.5 million. This charge is related to the
elimination of the Company's retail remarketing program and other
organizational changes designed to improve operating efficiency. See "CHANGES
IN ACCOUNTING ESTIMATES AND NON-RECURRING CHARGES." Included in operating
costs during the first nine months of 1997 was a pre-tax charge of
approximately $5.0 million primarily related to legal costs and severance
expenses for certain former executives of the Company. Excluding these
charges, other operating costs increased 22% for the nine months ended
September 30, 1998, compared with the same period in 1997. The increase in
other operating costs during the three and nine months periods is primarily a
result of the higher percentage of Classic program loans in the portfolio,
since these loans generally require greater collection efforts and related
costs (including increased telephone, fax, postage and repossession expenses)
than Premier program loans.
LONG-TERM DEBT AND OTHER INTEREST EXPENSE. Long-term debt and other
interest expense increased 24% and 35% for the three and nine months ended
September 30, 1998, respectively, compared to the same periods in 1997. The
increases are primarily due to the issuance of $300.0 million and $75.0
million of 11.5% Senior Notes due 2007 (the "Senior Notes") in March 1997 and
October 1997, respectively, partially offset by the concurrent extinguishment
of $145.0 million of the 13% Notes in March 1997.
INCOME TAXES. The Company did not incur an income tax provision during
the three months ended September 30, 1998, due to the utilization of net
operating loss carryforwards resulting from the non-recurring non-cash charge
during the second quarter of 1998. See "CHANGES IN ACCOUNTING ESTIMATES AND
NON-RECURRING CHARGES" for additional discussion.
EXTRAORDINARY ITEM. In March 1997, the Company issued $300.0 million of
its Senior Notes and utilized approximately $173.5 million of the proceeds to
repurchase and covenant defease the Company's $145.0 million of 13% Notes,
including accrued interest of $7.9 million and a premium of approximately
$20.3 million. These charges and additional professional fees incurred to
retire such debt were treated as an extraordinary item, net of tax.
FINANCIAL CONDITION
FINANCE INCOME RECEIVABLE. Finance income receivable decreased to
$593.0 million at September 30, 1998 from $602.5 million at December 31,
1997. This 2% decrease reflects a non-recurring $114.5 million pre-tax charge
during the second quarter of 1998 (see "CHANGES IN ACCOUNTING ESTIMATES AND
NON-RECURRING CHARGES") partially offset by amounts capitalized upon
completion of the Company's securitization transactions related to the
present value of estimated cash flows.
DEFERRED INCOME TAX. There were no deferred income taxes at September
30, 1998 compared with a net deferred tax liability of $11.5 million at
December 31, 1997. This decrease reflects the recognition of a portion of the
tax benefit from the 1998 second quarter loss from operations. In accordance
with SFAS No. 109, "Accounting for Income Taxes," the Company established a
valuation allowance during the quarter ended June 30, 1998. The valuation
allowance was established to offset the deferred tax asset associated with
the Company's net operating loss carryforward resulting in no net deferred
income taxes at September 30, 1998.
IMPACT OF YEAR 2000
The Company recognizes that the arrival of the Year 2000 poses a unique
worldwide challenge to the ability of all computer based applications to
recognize the date change from December 31, 1999 to January 1, 2000,
potentially causing miscalculations, system failures and other operational
problems.
17
<PAGE>
One of the Company's most critical operating systems is its loan
accounting system. In July 1997, an internal implementation team along with
outside consultants was assigned to evaluate, select, and implement a new
installment loan accounting system and various sub-systems (the "ILA system")
in connection with an initiative to replace and enhance the Company's key
operating systems. One of the requirements for consideration was that the new
ILA system be Year 2000 compliant. In late 1997, a contract was signed with a
nationally recognized vendor to provide the Company with such a system. The
contract warrants, among other things, that the core software system being
purchased would be fully Year 2000 compliant by mid 1998. The contract
further warrants that the software will be installed and in parallel testing
with the Company's current system in the first quarter of 1999. To date, the
terms of the contract have been met.
In addition, in early 1998 the Company formed a dedicated project team
to conduct an extensive analysis of the impact that the Year 2000 issue would
have on its automated information systems (exclusive of the ILA system),
business support systems and facility operating systems. The project team has
been responsible for the prioritization of Year 2000 tasks, development of
implementation plans, and the establishment of timetables for completion and
testing of all necessary modifications. As a result, the Company has
initiated the replacement, modification or reprogramming of Year 2000
non-compliant hardware and software and since 1997 has required that all new
hardware and software be certified as Year 2000 compliant prior to purchase.
To assist in this process, the Company has engaged an independent company to
aid in the remediation of non-compliant programs. The modification and
reprogramming of these programs is currently underway and scheduled to be
completed and tested by the end of 1998 with implementation completed during
the first quarter of 1999. All Year 2000 testing will be completed in an
isolated systems environment dedicated for Year 2000 issues. As a contingency
to the possibility of an unplanned delay in the implementation of the new ILA
system discussed above, the Company's current loan accounting system has been
included in the programs provided to the independent company for remediation.
This will provide a Year 2000 compliant installment loan accounting system
even if the implementation of the new ILA system should be delayed beyond the
end of 1999.
The Company currently expects to have all business critical hardware
and software Year 2000 compliant by the end of the first quarter of 1999 and
to complete a Year 2000 certification process by mid-1999. The Company
estimates that the cost of its Year 2000 project will aggregate approximately
$1.5 million, of which approximately $0.3 million has been expended through
September 30, 1998. These costs do not include amounts related to the
implementation of the ILA system or other hardware and software purchases
which the Company had planned to acquire and which are not directly related
to, or the purchase of which has not been accelerated because of, the Year
2000 issue. Consistent with the Company's capitalization policy, the cost of
such non-Year 2000 hardware and software purchases will be capitalized and
amortized over their expected useful lives.
Ultimately, the potential impact of the Year 2000 issue will depend not
only on the success of the corrective measures that the Company undertakes,
but also on the way in which the Year 2000 issue is addressed by its business
partners, service providers, utility providers, governmental agencies and
other entities with which the Company does business. The Company is
developing a plan to contact parties which provide services critical to the
successful operation of its business to heighten their awareness of the Year
2000 issue, to learn how they are addressing it and to evaluate any likely
impact on the Company. For example, the Company plans to begin a Year 2000
survey of its credit bureaus, investment bankers and warehouse providers
during the fourth quarter of 1998. The Year 2000 efforts of third parties are
not within the Company's control, however, and their failure to remediate
Year 2000 issues successfully could result in business disruption, increased
operating costs and increased credit risk for the Company. At the current
time, it is not possible to determine whether any such events are likely to
occur, or to quantify any potential negative impact they may have on the
Company's future results of operations and financial condition.
The Company believes that it has an effective plan in place to resolve the
Year 2000 issue in a timely manner. As noted above, the Company has not yet
completed all necessary processes of its Year 2000 plan. In the event that the
Company does not complete any additional phases of its plan, the Company may be
unable to perform its key operating activities such as the purchase of loans and
the invoicing, collecting and application of obligor repayments. In addition,
disruptions in the economy generally resulting for Year 2000 issues could also
materially adversely affect the Company. The Company could be subject to
litigation for computer systems failure,
18
<PAGE>
such as improper application of repayments and resulting incorrect credit
reporting to credit bureaus. The amount of potential liability and lost
revenue cannot reasonably be estimated at this time. The Company currently
has no contingency plans in place in the event it does not complete all
phases of its Year 2000 program. The Company plans to continuously monitor
the status of completion of its Year 2000 plan and, based on such
information, will develop contingency plans as necessary.
The foregoing discussion regarding Year 2000, including the discussion
of the timing and effectiveness of implementation and cost of the Company's
Year 2000 project, contains forward-looking statements, which are based on
management's best estimates derived using various assumptions. These
forward-looking statements involve inherent risks and uncertainties, and
actual results could differ materially from those contemplated by such
statements. Factors that might cause material difference include, but are not
limited to, the continued availability of key Year 2000 personnel, the
Company's ability to locate and correct all relevant computer codes, the
performance of contractors and companies retained to provide new software and
to remediate existing hardware and software, and the Company's ability to
respond to unforeseen Year 2000 complications. Such material differences
could result in, among other things, business disruption, operational
problems, financial loss, legal liability and similar risks.
DELINQUENCY, CREDIT LOSS AND REPOSSESSION EXPERIENCE
The following tables describe the Company's delinquency, credit loss
and repossession experience for the periods indicated. A delinquent loan may
result in the repossession and foreclosure of the collateral for the loan.
Losses resulting from repossession and foreclosure of the collateral are
charged against applicable allowances.
<TABLE>
<CAPTION>
DELINQUENCY EXPERIENCE (1):
SEPTEMBER 30, 1998 DECEMBER 31, 1997
---------------------------------- ----------------------------------
NUMBER OF NUMBER OF
LOANS BALANCE LOANS BALANCE
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Servicing portfolio at end of period 447,542 $5,137,798 411,429 $4,956,090
Delinquencies:
31-60 days 9,820 $ 114,398 8,297 $ 100,161
61-90 days 3,662 43,666 3,635 45,485
91 days or more 4,363 51,440 3,019 34,047
------------- ------------- ------------- -------------
Total loans delinquent 31 or more days 17,845 $ 209,504 14,951 $ 179,693
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Delinquencies as a percentage of
number of loans and amount
outstanding at end of period (2) 3.99% 4.08% 3.63% 3.63%
Amount in repossession 5,912 $ 35,739 6,083 $ 55,300
</TABLE>
(1) All amounts and percentages are based on the principal amount scheduled to
be paid on each loan. The information in the table includes previously sold
loans which the Company continues to service.
(2) Amounts shown do not include loans which are less than 31 days delinquent.
19
<PAGE>
<TABLE>
<CAPTION>
CREDIT LOSS/REPOSSESSION EXPERIENCE (1):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------------ ------------------------------
1998 1997 1998 1997
-------------- --------------- ------------ -------------
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
Average servicing portfolio outstanding during the period $5,133,325 $4,661,818 $5,062,745 $4,318,830
Average number of loans outstanding during the period 444,285 379,681 431,694 349,480
Number of charge-offs 9,125 6,843 25,399 17,208
Gross charge-offs (2) $ 60,896 $ 38,681 $ 192,322 $ 118,352
Recoveries (3) 5,841 2,468 13,589 6,881
-------------- --------------- ------------ -------------
Net losses $ 55,055 $ 36,213 $ 178,733 $ 111,471
-------------- --------------- ------------ -------------
-------------- --------------- ------------ -------------
Annualized gross charge-offs as a percentage of average
servicing portfolio 4.75 % 3.32 % 5.07 % 3.65 %
Annualized net losses as a percentage of average
servicing portfolio 4.29 % 3.11 % 4.71 % 3.44 %
</TABLE>
- -------------------
(1) All amounts and percentages are based on the principal amount scheduled to
be paid on each loan. The information in the table includes previously sold
loans which the Company continues to service.
(2) Gross charge-offs represent principal amounts which management estimated to
be uncollectable after the consideration of anticipated proceeds from the
disposition of repossessed assets and selling expenses.
(3) Includes post-disposition collection amounts received on previously
charged-off loans.
The increase in delinquency rate at September 30, 1998, compared with
December 31, 1997, reflects the continued rise in the proportion of Classic
loans in the Company's servicing portfolio, which approximated 53% of loans
serviced at September 30, 1998, compared with 43% at December 31, 1997.
Repossessed inventory has decreased since December 31, 1997, primarily due to
the Company's decision to increase its use of wholesale disposition channels
to liquidate repossessed vehicles thereby shortening the average number of
days a vehicle is in inventory. During the first nine months of 1998 the
Company sold approximately 77% of its repossessed inventory through wholesale
channels compared with 48% in the same period a year ago, resulting in a
reduction in the average number of days vehicles are held in inventory to
approximately 64 days at September 30, 1998 compared with 105 days at
December 31, 1997.
The increase in gross charge-offs and net losses during the three and
nine months ended September 30, 1998, compared to the same periods a year ago
primarily reflects the continued rise in the proportion of Classic loans in
the Company's servicing portfolio and the increase in the utilization of
wholesale disposition channels. As previously discussed, the Company
announced that it is planning to discontinue the sale of repossessed vehicles
through retail disposition channels and anticipates that it will be
completely out of these operations by the end of 1998 (see "Changes in
Accounting Estimates and Non-Recurring Charges"). The Company believes that
its decision to discontinue its retail remarketing operations will enable it
to better manage its level of repossessed inventory and improve the timing of
excess cash flows released to the Company from securitization trusts as a
result of an increase in the speed at which repossessed vehicles can be
liquidated. Annualized gross charge-offs and net losses during the nine month
period ended September 30, 1998, include a charge of 0.57%, representing the
impact of a write-down of current inventory resulting from a revision to the
estimate of net realizable value (see "Changes in Accounting Estimates and
Non-Recurring Charges") and an additional provision primarily associated with
loans originated in connection with retail dispositions.
20
<PAGE>
LIQUIDITY
The Company's business requires substantial cash to support its
operating activities. The principal cash requirements include (i) amounts
necessary to purchase and finance automobile loans pending securitization,
(ii) payment of dealer participations, (iii) cash held from time to time in
restricted spread accounts to support securitizations and warehouse
facilities and other securitization expenses, (iv) interest advances to
securitization trusts, (v) repossessed inventory, and (vi) interest expense.
The Company also uses significant amounts of cash for operating expenses. The
Company receives cash principally from interest on loans held pending
securitization, from excess cash flow received from securitization trusts and
from fees earned through servicing of loans held by such trusts. The Company
has operated on a negative operating cash flow basis and expects to continue
to do so in the near future. The Company has historically funded these
negative operating cash flows principally through borrowings from financial
institutions, sales of equity securities and sales of senior and subordinated
notes. The Company may require additional capital in the future to fund
continued negative cash flows, although there can be no assurance that the
Company will have access to capital markets in the future or that financing
will be available to satisfy the Company's operating and debt service
requirements or to fund its future growth. See "Capital Resources."
PRINCIPAL USES OF CASH IN OPERATING ACTIVITIES
PURCHASE AND FINANCING OF AUTOMOBILE LOANS. Automobile loan purchases
represent the Company's most significant cash flow requirement. The Company
purchased $1.7 billion of loans during the first nine months of 1998 compared
to $2.3 billion during the same period in 1997. The Company funds the
purchase of loans primarily through the use of warehouse facilities prior to
securitization of such assets. However, because the warehouse facilities are
subject to advance rate restrictions and do not advance 100% of the loan
balances being purchased, the Company is required to fund the remainder of
all purchases with other available cash resources prior to securitization.
DEALER PARTICIPATIONS. Consistent with industry practice, the Company
pays dealers participations for selling loans to the Company. These
participations typically require the Company to advance an up-front amount to
dealers. Participations paid by the Company to dealers during the nine months
ended September 30, 1998 were $49.5 million, or approximately 2.87% of the
principal balance of loans purchased, compared with $72.1 million, or
approximately 3.16% of loans purchased, during the same period in 1997. The
decrease in dealer participations as an aggregate amount and as a percentage
of loans purchased reflects the growth in volume in Classic loans, which are
generally associated with lower dealer participations.
SECURITIZATION OF AUTOMOBILE LOANS. In connection with securitizations,
the Company is required to fund spread accounts related to each transaction.
The Company funds these spread accounts by foregoing receipt of excess cash
flow from the relevant securitization trust until these spread accounts
exceed predetermined levels. In addition, for certain securitizations prior
to the third quarter of 1997, the Company has been required to provide
initial cash deposits into the spread accounts. The Company had $252.9
million of restricted cash in spread accounts at September 30, 1998, compared
with $250.3 million at December 31, 1997. The increase in restricted cash in
spread accounts reflects the Company's continued securitization of loan
purchases and the related accumulation of excess cash flows to levels defined
within each securitization agreement, partially offset by the release of
excess cash flows. Restricted cash in spread accounts was further reduced by
$25.0 million during the second quarter of 1998 under an agreement between
the Company and its provider of asset-backed securities insurance which
allowed the Company to receive an early release from the spread accounts. See
"Liquidity - Other Capital Resources" for additional discussion.
The Company also incurs certain expenses in connection with
securitizations, including underwriting fees, credit enhancement fees,
trustee fees and other costs, which approximate 0.5% of the principal amount
of the asset-backed securities sold in the securitizations.
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<PAGE>
ADVANCES DUE TO SERVICER. As the servicer of loans sold in
securitizations, the Company periodically makes interest advances to the
securitization trusts to provide for temporary delays in the receipt of required
interest payments from borrowers. In accordance with the relevant servicing
agreements, the Company makes advances only in the event it expects to recover
such advances through payments from the obligor over the life of the loan.
REPOSSESSED INVENTORY. At September 30, 1998, repossessed inventory
managed or owned by the Company and held for resale was $35.7 million,
compared with $55.3 million at December 31, 1997. The rate of repossessed
inventory turnover impacts cash available for spread accounts under
securitization trusts and, consequently, the excess cash available for
distribution to the Company. At September 30, 1998, repossessed inventory was
0.7% of the total servicing portfolio compared with 1.1% at December 31,
1997. In June 1998, the Company decided to discontinue liquidating its
repossession inventory through retail disposition channels and began
disposing of its repossessed vehicles exclusively through wholesale auctions
(see "CHANGES IN ACCOUNTING ESTIMATES AND NON-RECURRING CHARGES"). Any
improvement in excess cash flows due to an increase in the inventory turnover
rate may be partially reduced by lower recoveries realized through the
exclusive use of wholesale auctions and generally lower wholesale used car
prices.
INTEREST EXPENSE. Although the Company records net interest margin as
earned, a significant portion of the interest income component is generally
received in cash from excess cash flow, while the interest expense component
(primarily warehousing interest) is paid prior to securitization. The Company
also incurs interest expense related to both short-term and long-term debt
obligations.
PRINCIPAL SOURCES OF CASH IN OPERATING ACTIVITIES
EXCESS CASH FLOW. The Company receives excess cash flow from
securitization trusts, including the realization of gain on sale, the
recovery of dealer participations, and the recovery of accrued interest
receivable earned, but not yet collected, on loans held for sale prior to
securitization. Recovery of dealer participations and accrued interest
receivable, which occur throughout the life of the securitization, result in
a reduction of the finance income receivable but, because they have been
considered in the original determination of the gain on sale of loans, have
no effect on the Company's results of operations in the year in which the
participations and interest are recovered from the securitization trust.
During the first nine months of 1998, the Company received $103.6 million of
excess cash flow (which amount does not include the $25 million released
sooner than would otherwise have been the case pursuant to an arrangement
with the Company's providers of asset-backed securities performance see
"Capital Resources - Other Capital Resources"), compared with $59.0 million
during the same nine months in 1997. Included in the 1998 cash released from
spread accounts is $0.6 million of cash which is restricted pursuant to an
arrangement between the Company and its asset-backed securities insurance
provider.
SERVICING FEES. The Company receives servicing fees for servicing
securitized loans included in various securitization trusts. The servicing
fee for loans in securitization trusts is equal to one percent per annum of
the outstanding principal balance of the loans for all securitizations
entered into prior to September 1997 and 1.25 percent per annum on loans
subsequently securitized. The Company also receives collection fees, such as
late payment fees and insufficient fund charges, and interest on collection
accounts earned by the Company as servicer of the loans. During the nine
months ended September 30, 1998 and 1997, the Company received cash for such
servicing in the amount of $61.1 million and $47.5 million, respectively.
Servicing fee income is reflected in the Company's revenues as earned.
CAPITAL RESOURCES
The Company finances the acquisition of automobile loans primarily
through (i) warehouse facilities, pursuant to which loans are sold or
financed generally on a temporary basis, and (ii) the securitization of
loans, pursuant to which loans are sold as asset-backed securities.
Additional financing is required to fund the Company's operations.
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<PAGE>
WAREHOUSE FACILITIES. Automobile loans held for sale are funded
primarily through warehouse facilities. At September 30, 1998, the Company
had three warehouse facilities in place with various financial institutions
and institutional lenders with an aggregate capacity of $700.0 million, of
which $642.2 million was available. The Company's current warehouse
facilities have expiration dates between July 1999 and October 1999, subject
to renewal or extension at the lenders' option. Proceeds from
securitizations, generally received within seven to ten days following the
cut-off date established for the securitization transaction, are applied to
repay amounts outstanding under warehouse facilities.
SECURITIZATION PROGRAM. An important capital resource for the Company
has been its ability to sell automobile loans in the secondary markets
through securitizations. The following table summarizes the Company's
securitization transactions for the nine months ended September 30, 1998,
all of which were publicly issued and rated "AAA/Aaa".
<TABLE>
<CAPTION>
REMAINING CURRENT
REMAINING BALANCE AS A CURRENT WEIGHTED GROSS
BALANCE AS OF PERCENTAGE WEIGHTED AVERAGE INTEREST
ORIGINAL SEPTEMBER 30, OF ORIGINAL AVERAGE SECURITIZATION RATE
Date BALANCE 1998 BALANCE APR RATE SPREAD
- ------------------------- ------------ ------------------ ----------------- ------------ ------------------ ------------
<S> <C> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS)
March 1998 $ 525,000 $ 455,230 86.71% 17.15% 5.93% 11.22%
June 1998 550,000 514,691 93.58% 17.16% 5.97% 11.19%
September 1998 (1) 600,000 536,722 89.45% 16.82% 5.63% 11.19%
------------ ------------------
$ 1,675,000 $ 1,506,643
------------ ------------------
------------ ------------------
</TABLE>
- ---------------------
(1) As of September 30, 1998, the Company had delivered $541.4 million of
automobile loans and $58.6 million of cash remained in the pre-funded portion of
the trust.
HEDGING STRATEGY
The Company enters into hedging transactions to manage its gross
interest rate spread on loans held for sale. The Company sells Forward U.S.
Treasury Locks that most closely parallel the average life of its portfolio
of loans held for sale. Hedging gains and losses are recognized as a
component of the gain on sale of loans on the date such loans are sold. To
the extent hedging gains or losses are significant, the resulting up-front
cash payments or receipts may impact the Company's liquidity. The Company
receives the up-front gains or losses back over time through a lower or
higher spread, respectively, at the time of securitization. During the first
nine months of 1998, the Company had net realized losses on hedging
transactions of $16.8 million. The Company had unrealized losses on hedge
contracts of $4.7 million that remained outstanding at September 30, 1998.
OTHER CAPITAL RESOURCES
Historically, the Company has utilized various debt and equity
financings to offset negative operating cash flows and support its operations.
The Company has a program to sell up to $100.0 million of unsecured
subordinated notes (the "Junior Subordinated Notes") to be offered to the
public from time to time (the "Note Program"). Issuance of Junior
Subordinated Notes under the Note Program is subject to restrictions under
the Company's Senior Note indenture. The Note Program includes Junior
Subordinated Notes extendible by the investor having maturities of 90 and 180
days and one year after the date of issue and fixed-term Junior Subordinated
Notes having maturities of one, two, three, four, five and 10 years after the
date of issue. Interest rates on any unsold Junior Subordinated Notes are
subject to change by the Company from time to time based on market
conditions. Interest rates on extendible Junior Subordinated Notes may be
adjusted at any roll-over date. During the first nine months of 1998, the
Company issued $6.2 million of Junior Subordinated Notes.
23
<PAGE>
In May 1998, the Company and its provider of asset-backed securities
insurance entered into an arrangement whereby the Company was allowed to
receive $25 million of cash from certain spread accounts sooner than it would
have absent such arrangement. The arrangement may be extended on an annual
basis upon mutual arrangement by and between the Company and its provider of
asset-backed securities insurance. The Company pays a monthly fee to its
provider of asset-backed securities insurance to maintain the arrangement.
The $25 million will be replenished in relevant spread accounts by means of a
$3 million reduction in the level of monthly cash releases from the spread
accounts beginning in May 1999, unless the terms of the arrangement are
extended.
24
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this amendment to its
Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned,
thereunto duly authorized.
ARCADIA FINANCIAL LTD.
<TABLE>
<CAPTION>
<S> <C>
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Richard A. Greenawalt President, Chief Executive Officer, and March 23, 1999
- ------------------------------- Director
Richard A. Greenawalt
/s/ John A. Witham Executive Vice President and Chief Financial Officer March 23, 1999
- ------------------------------- (Principal Financial Officer)
John A. Witham
/s/ Brian S. Anderson Senior Vice President, Corporate Controller and March 23, 1999
- ------------------------------- Assistant Secretary (Principal Accounting Officer)
Brian S. Anderson
</TABLE>
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