<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 1997
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _____to _____
COMMISSION FILE NUMBER 0-19604
AAMES FINANCIAL CORPORATION
[Exact name of Registrant as specified in its charter]
DELAWARE 95-4340340
[State or other jurisdiction of [I.R.S. Employer
incorporation or organization] Identification No.]
350 SOUTH GRAND AVENUE, LOS ANGELES, CA 90071-3459
[Address of Registrant's principal executive offices including zip code]
(213) 640-5000
[Registrant's telephone number,
including area code]
NO CHANGES
[Former name, former address and former fiscal year,
if changed since last report]
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 [ ]
At November 7, 1997, Registrant had 27,804,417 shares of common stock
outstanding.
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TABLE OF CONTENTS
<TABLE>
<CAPTION>
ITEM NO. PAGE NO.
- -------- --------
<S> <C> <C>
PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements
Consolidated Balance Sheets at June 30, 1997 and September 30, 1997 3
Consolidated Statements of Income for the three months ended
September 30, 1996 and 1997 4
Consolidated Statements of Cash Flows for the three months ended
September 30, 1996 and 1997 5
Notes to Consolidated Financial Statements 6-7
Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of Operations 7-22
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings 22
Item 2 - Changes in Securities 22
Item 3 - Defaults Upon Senior Securities 22
Item 4 - Submission of Matters to a Vote of Security Holders 22
Item 5 - Other Information 22
Item 6 - Exhibits and Reports on Form 8-K 22
Signature Page 23
</TABLE>
2
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AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, September 30,
1997 1997
------------ ------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $26,902,000 $6,650,000
Loans held for sale, at lower of cost or market 242,987,000 203,716,000
Accounts receivable 59,180,000 61,486,000
Interest-only strips, estimated at fair market value 270,422,000 294,115,000
Mortgage servicing rights 21,641,000 24,588,000
Residual assets 112,827,000 131,324,000
Equipment and improvements, net 12,685,000 12,767,000
Prepaid and other 14,949,000 16,151,000
------------ ------------
Total assets $761,593,000 $750,797,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Borrowings $286,990,000 $286,990,000
Revolving warehouse facilities 137,500,000 104,500,000
Accounts payable and accrued expenses 29,297,000 29,931,000
Income taxes payable 39,452,000 48,795,000
------------ ------------
Total liabilities 493,239,000 470,216,000
------------ ------------
Stockholders' equity:
Preferred Stock, par value $.001 per
share, 1,000,000 shares authorized;
none outstanding
Common Stock, par value $.001 per share
50,000,000 shares authorized;
27,758,800, and 27,773,600 shares outstanding 28,000 28,000
Additional paid-in capital 209,358,000 209,420,000
Retained earnings 58,968,000 71,133,000
------------ ------------
Total stockholders' equity 268,354,000 280,581,000
------------ ------------
Total liabilities and stockholders' equity $761,593,000 $750,797,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
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AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
Three Months Ended
September 30,
----------------------------
1996 1997
------------ ------------
<S> <C> <C>
Revenue:
Gain on sale of loans $56,199,000 $44,721,000
Net unrealized gain on valuation
of interest-only strips -- 5,029,000
Commissions 7,747,000 5,855,000
Loan service 4,660,000 9,782,000
Fees and other 7,035,000 12,525,000
------------ ------------
Total revenue 75,641,000 77,912,000
------------ ------------
Expenses:
Compensation and related expenses 19,324,000 21,759,000
Production expenses 7,474,000 5,797,000
General and administrative expenses 7,562,000 8,085,000
Interest expense 7,444,000 10,098,000
Provision for loan losses 9,782,000 8,570,000
Nonrecurring charges 28,108,000 --
------------ ------------
Total expenses 79,694,000 54,309,000
------------ ------------
Income before income taxes (4,053,000) 23,603,000
Provision for income taxes 571,000 10,522,000
------------ ------------
Net income (loss) $ (4,624,000) $13,081,000
============ ============
Net income per share
Primary $ ( 0.17) $ 0.45
============ ============
Fully diluted $ (0.11) $ 0.40
============ ============
Dividends $ 0.03 $ 0.03
============ ============
Weighted average number
of shares outstanding
Primary 26,229,000 29,226,000
============ ============
Fully Diluted 32,389,500 35,333,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
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AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended
September 30,
------------------------------
1996 1997
------------- -------------
<S> <C> <C>
Operating activities:
Net (loss) income $ (4,624,000) $13,081,000
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Provision for loan losses 9,782,000 8,570,000
Depreciation and amortization 521,000 899,000
Deferred income taxes 7,356,000 5,233,000
Gain on sale of loans (69,933,000) (49,734,000)
Net unrealized gain on valuation of interest-only strips -- (5,029,000)
Amortization of interest-only strip 11,208,000 22,500,000
Mortgage servicing rights originated (3,387,000) (4,861,000)
Mortgage servicing rights amortization 728,000 1,914,000
Changes in assets and liabilities:
Loans originated or purchased (501,319,000) (523,139,000)
Proceeds from sale of loans 544,249,000 562,410,000
Decrease (Increase) in:
Accounts receivable 1,488,000 (2,306,000)
Prepaid and other 889,000 (1,202,000)
Residual assets (10,007,000) (18,497,000)
Increase (decrease) in:
Accounts payable and accrued expenses 7,865,000 634,000
Income taxes payable (9,295,000) 4,110,000
------------- -------------
Net cash (used in) provided by operating activities (14,479,000) 14,583,000
------------- -------------
Investing activities:
Purchases of property and equipment (1,734,000) (981,000)
------------- -------------
Net cash (used in) investing activities (1,734,000) (981,000)
------------- -------------
Financing activities:
Proceeds from sale of stock or exercise of options 94,000 62,000
Proceeds from borrowing 36,989,000 --
Amounts outstanding under warehouse facilities 57,929,000 (33,000,000)
Dividends paid (675,000) (916,000)
------------- -------------
Net cash provided by (used in ) financing activities 94,337,000 (33,854,000)
------------- -------------
Net increase (decrease) in cash and cash equivalents 78,124,000 (20,252,000)
Cash and cash equivalents at beginning of period 23,941,000 26,902,000
------------- -------------
Cash and cash equivalents at end of period $102,065,000 $6,650,000
============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
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AAMES FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: BASIS OF PRESENTATION
The consolidated financial statements of Aames Financial Corporation, a
Delaware corporation, and its subsidiaries (collectively, the "Company")
included herein have been prepared by the Company, without audit, pursuant to
the rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
omitted.
The consolidated financial statements include the accounts of the Company
and all of its subsidiaries after eliminating all significant intercompany
transactions and reflect all normal, recurring adjustments which are, in the
opinion of management, necessary to present a fair statement of the results of
operations of the Company for the interim periods reported. The results of
operations for the Company for the three months ended September 30, 1997 are not
necessarily indicative of the results expected for the full fiscal year.
NOTE 2: RECLASSIFICATIONS
Certain amounts related to fiscal year 1997 have been reclassified to
conform to the fiscal year 1998 presentation.
NOTE 3: SUBSIDIARY GUARANTORS
In October 1996, the Company completed an offering of its 9.125% Senior
Notes due 2003 which were guaranteed by all of the Company's subsidiaries, all
of which are wholly-owned. The guarantees are joint and several, full, complete
and unconditional. There are no restrictions on the ability of such subsidiaries
to transfer funds to the Company in the form of cash dividends, loans or
advances. The Company is a holding company with limited assets or operations
other than its investments in its subsidiaries. Separate financial statements of
the guarantors are not presented because the aggregate total assets, net
earnings and net equity of such subsidiaries are substantially equivalent to the
total assets, net earnings and net equity of the Company on a consolidated
basis.
NOTE 4: NEW ACCOUNTING STANDARDS
The Company adopted Statement of Financial Accounting Standards No. 125
"Accounting for Transfers and Servicing of Financial Assets and Extinguishment
of Liabilities" ("SFAS 125") effective January 1, 1997. The adoption of SFAS 125
did not have a material effect on the Company's results of operations for the
quarter ended September 30, 1997. As a result of the adoption of SFAS 125, the
Company records amounts previously categorized as "Excess servicing
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gains" in the consolidated Statements of Income as "Gain on sale of loans."
Additionally, the Company now records the right to future interest income that
exceeds contractually specified servicing fees and previously recorded as
"Excess servicing receivable" as an investment security called "Interest-only
strips." The Company has classified this asset as a trading security and, for
the quarter ended September 30, 1997, recorded a mark-to-market unrealized gain
of $5.03 million on this security. SFAS 125 requires that this mark-to-market
unrealized adjustment be reported separately from "Gain on sale of loans" and
the adjustment has been labeled "Net unrealized gain on valuation of
interest-only strips" in the Consolidated Statements of Income.
In February 1997, the Financial Accounting Standards Board ("FASB"), issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS
128). SFAS 128 establishes standards for computing and presenting earnings per
share ("EPS") by replacing the presentation of primary EPS with a presentation
of basic EPS. Primary EPS included common stock equivalents while basic EPS
excludes them. This change simplifies the computation of EPS, while making the
United States computation more compatible to the standards of other countries.
It also requires dual presentation of basic and fully diluted EPS on the face of
the income statement for all entities with complex capital structures. The
Company will adopt SFAS 128 effective December 31, 1997, and does not expect the
adoption of SFAS 128 to have a material impact on its financial statements.
In February 1997, the FASB issued Statement of Financial Accounting
Standards No. 129, "Disclosure of Information about Capital Structure" ("SFAS
129"). SFAS 129 establishes disclosure requirements regarding pertinent rights
and privileges of outstanding securities. Examples of disclosure items regarding
securities include, though are not limited to, items such as dividend and
liquidation preferences, participation rights, call prices and dates, conversion
or exercise prices or rates. The number of shares issued upon conversion,
exercise or satisfaction of required conditions during at least the most recent
annual fiscal period and any subsequent interim period must also be disclosed.
Disclosure of liquidation preferences of preferred stock in the equity section
of the statement of financial condition is also required. SFAS 129 is effective
for fiscal periods beginning after December 15, 1997. The Company will adopt
SFAS 129 effective July 1, 1998.
In October 1995, the FASB released Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). This
statement establishes methods of accounting for stock-based compensation plans.
SFAS 123 is effective for fiscal years beginning after December 15, 1995. The
Company adopted SFAS 123 in fiscal year 1997. The adoption of SFAS 123 did not
have a material effect on the financial position or results of operations of the
Company.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis of the financial condition and results
of operations of the Company should be read in conjunction with the Company's
Consolidated Financial Statements included in Item 1 of this Form 10-Q.
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GENERAL
The Company is a consumer finance company primarily engaged, through its
subsidiaries, in the business of originating, purchasing, selling, and servicing
home equity mortgage loans secured by single family residences. The Company,
upon its formation in 1991, acquired Aames Home Loan, a home equity lender
founded in 1954. In August 1996, the Company acquired One Stop Mortgage, Inc.
("One Stop") which originates mortgage loans through a broker network. In late
fiscal 1997, the Company began offering small commercial loans on a limited
basis which it currently sells on a whole loan basis servicing released.
The Company's principal market is borrowers whose financing needs are not
being met by traditional mortgage lenders for a variety of reasons, including
the need for specialized loan products or credit histories that may limit such
borrowers' access to credit. The Company believes these borrowers continue to
represent an underserved niche of the home equity loan market and present an
opportunity to earn a superior return for the risk assumed. The mortgage loans
originated and purchased by the Company, which include fixed and adjustable rate
loans, are generally used by borrowers to consolidate indebtedness or to finance
other consumer needs rather than to purchase homes.
The Company originates and purchases loans on a nationwide basis through
three production channels--retail, broker and correspondent. The Company
underwrites and has each property appraised for every loan it originates and
generally re-underwrites and reviews appraisals on all loans it purchases. The
Company retains the servicing rights (collecting loan payments and managing
borrower defaults) to substantially all of the loans it originates or purchases.
Of the Company's $3.4 billion servicing portfolio at September 30, 1997, 45% was
subserviced by third parties. In fiscal 1997, the Company's servicing division
implemented systems and added personnel that will allow it to service directly
substantially all of its servicing portfolio by the end of fiscal 1998.
The Company's strategic plan calls for expanding its retail and broker
networks, the Company's core production units, and decreasing bulk loan
purchases resulting in lower production volume in the correspondent unit. The
Company plans continued national geographic expansion in its core production
units which is expected to enhance growth opportunities. The Company is also
considering expanding operations on an international basis, initially in the
United Kingdom through its broker subsidiary One Stop.
8
<PAGE> 9
The following table presents the volume of loans originated and purchased by
the Company through each of the three production channels and the portfolio
serviced by the Company during the periods presented:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
SEPTEMBER 30,
-------------
(IN THOUSANDS)
1996 1997
---------- ----------
<S> <C> <C>
Loans originated and purchased:
Broker Network ................ $140,916 $261,834
Retail(1) ..................... 101,390 133,546
Correspondent ................. 259,013 127,759
---------- ----------
Total ........................... $501,319 $523,139
========== ==========
Servicing portfolio at period end $1,773,000 $3,402,000
</TABLE>
(1) Includes loans brokered to institutional investors.
Despite the expected reduction in correspondent volume, total originations
increased 4.4% from $501 million for the quarter ended September 30, 1996 to
$523 million for the quarter ended September 30, 1997. The Company's core
operations, retail and broker, increased 63% from $242 million to $395 million
for the quarters ended September 30, 1996 and 1997, respectively. The growth in
core originations was due to the planned geographic expansion in the retail and
broker units. The Company's retail originations were $133 million for the
quarter ended September 30, 1997 compared to $101 million for the quarter ended
September 30, 1996. Origination volume for the broker network reached $262
million for the quarter ended September 30, 1997 compared to $141 million for
the quarter ended September 30, 1996. Correspondent purchases were $128 million
for the quarter ended September 30, 1997 compared to $259 million for the
quarter ended September 30, 1996. The pricing changes made in the last fiscal
year, with respect to bulk purchased loans, resulted in lower production volume
in the correspondent unit. The first fiscal quarter's production figures also
reflect the Company's strategic shift up the credit grade spectrum. Of the total
loans originated and purchased by the Company in the quarter ended September 30,
1997, 90% were A-, A, B and C credit grade loans and 10% were C- and D credit
grade loans, compared to 70% and 30% respectively in last year's comparable
quarter.
At September 30, 1997, the Company operated 60 retail loan offices serving
26 states (including the District of Columbia), compared to 52 offices serving
18 states at September 30, 1996. At September 30, 1997, One Stop operated 40
branches serving 35 states (including the District of Columbia), compared to 29
branches serving 26 states at September 30, 1996.
CERTAIN ACCOUNTING CONSIDERATIONS AND RISK FACTORS
Accounting Considerations. As a fundamental part of its business and
financing strategy, the Company sells substantially all of its loans in
securitization transactions. In a securitization, the Company conveys loans that
it has originated or purchased to a separate entity (such as a trust or trust
estate) in exchange for cash proceeds and an interest in the loans securitized
represented by the gain on sale of loans. The cash proceeds are raised through
an offering of the pass-through
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certificates or bonds evidencing the right to receive principal payments on the
securitized loans and the interest rate on the certificate balance or on the
bonds. The gain on sale of loans (net of the unrealized gain or loss on
valuation of interest-only strips) represents, over the estimated life of the
loans, the present value of the excess of the weighted average coupon on each
pool of loans sold over the sum of the interest rate paid to investors, the
contractual servicing fee (currently .50%) and a monoline insurance fee, if any.
The gain on sale of loans provides the basis for the calculation of the
interest-only strips, which are recorded as an asset on the Company's
consolidated balance sheet. The interest-only strips represent the present value
of the Company's future cash flows from the securitized pools, adjusted for the
reserve for loan losses. The Company determines the present value of the cash
flows at the time each securitization transaction closes using certain estimates
made by management at the time the loans are sold. These estimates include the
following: (i) rate of prepayment; (ii) discount rate used to calculate present
value; and (iii) the provision for credit losses on loans sold. There can be no
assurance of the accuracy of management's estimates.
The estimated life of the securitized loans depends on the assumed annual
prepayment rate which is a function of estimated voluntary (full and partial)
and involuntary (liquidations) prepayments. The prepayment rate represents
management's expectations of future prepayment rates based on prior and expected
loan performance, the type of loans in the relevant pool (fixed or adjustable
rate) and industry data. The rate of prepayment may be affected by a variety of
economic and other factors, including the production channel which produced the
loan, prevailing interest rates, the presence of prepayment penalties, the
loan-to-value ratios and the credit grades of the loans included in the
securitization. Generally, a declining interest rate environment will encourage
prepayments. Lower credit grade loans tend to be more payment and less interest
rate sensitive than higher credit grade loans. There can be no assurance of the
accuracy of management's estimates. If actual prepayments occur more quickly
than was projected at the time loans were sold, the carrying value of the
interest-only strip may have to be written down through a charge to earnings in
the period of adjustment.
In order to determine the present value of the cash flow from the
interest-only strips, the Company discounts the cash flows based upon rates
prevalent in the market.
In determining the provision for credit losses on loans sold, the Company
uses assumptions that it believes are reasonable based on information from its
prior securitizations and the loan-to-value ratios of the loans included in the
current securitizations. At September 30, 1997, the Company had reserves of
$47.9 million related to these credit risks, or 1.5% of the outstanding balance
of loans securitized as of that date. Cumulative net losses to date from the
Company's securitization transactions since June 1992 have totaled $10.7
million. The weighted average loan-to-value ratio of the loans serviced by the
Company was 69% as of September 30, 1997.
The interest-only strips are amortized over the expected lives of the
related loans and a corresponding reduction in servicing fee income is recorded.
On a quarterly basis, the Company reviews the fair value of the interest-only
strips by analyzing its prepayment and other assumptions in relation to its
actual experience and current rates of prepayment prevalent in the industry. The
interest-only strips are marked-to-market through a charge to earnings.
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Additionally, upon sale or securitization of servicing retained mortgages,
the Company capitalizes the fair value of mortgage servicing rights assets
separate from the loan. The Company determines fair value based on the present
value of estimated net future cash flows related to servicing income. The cost
allocated to the servicing rights is amortized over the period of estimated net
future servicing fee income. The Company periodically reviews the valuation of
capitalized servicing fees receivable. This review is performed on a
disaggregated basis for the predominant risk characteristics of the underlying
loans which are loan type and origination date. The Company generally makes
loans to credit-impaired borrowers whose borrowing needs may not be met by
traditional financial institutions due to credit exceptions. The Company has
found that credit impaired borrowers are payment sensitive rather than interest
rate sensitive. As such, the Company does not consider interest rate a
predominant risk characteristic for purposes of valuation. As the Company
increases the amount of higher credit grade loans it originates and purchases,
it may find that interest rate sensitivity among its borrower base also
increases.
Prepayment, Credit and Basis Risk. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations-Risk Factors --
Prepayment and Credit Risk" in the Company's Form 10-K for the fiscal year ended
June 30, 1997. The value of the Company's interest-only strips created as a
result of the securitization of adjustable rate mortgage ("ARM") loans is
subject to so-called basis risk. Basis risk arises when the ARM loans in a
securitization trust bear interest based on an index or adjustment period that
is different from the mortgage-backed securities issued by the trust.
Accordingly, in the absence of effective hedging strategies, in a period of
increasing interest rates, the value of the interest-only strips would be
adversely affected because the interest rates on the mortgage-backed securities
issued by a securitization trust could adjust faster than the interest rates on
the Company's ARMs in the trust. Moreover, ARMs are typically subject to
periodic and lifetime interest rate caps, which limit the amount an ARM's
interest rate can change during any given period. Hence, in a period of rapidly
increasing interest rates, the value of the interest-only strips could be
adversely affected in the absence of effective hedging strategies because the
interest rates on the mortgage-backed securities issued by a securitization
trust could increase without limitation by caps, while the interest rates on the
Company's ARMs would be so limited. The Company pursues various securitization
strategies in an effort to reduce risk; however, there can be no assurances that
a securitization strategy will economically address this risk.
Losses in Securitization Trusts; Right to Terminate Mortgage Servicing. A
substantial majority of the Company's servicing portfolio consists of loans
securitized by the Company and sold to REMIC or owner trusts in securitization
transactions. Generally, the form of agreement entered into in connection with
these securitizations contains specified limits on losses that may be incurred
in each trust. Losses occur when the liquidation proceeds from disposal of
foreclosed properties, plus liquidation expenses, are less than the principal
balances of the loans previously secured by such properties. If, at any
measuring date, the losses with respect to any trust credit-enhanced by monoline
insurance were to exceed the limits applicable to such trust, provisions of the
agreements permit the monoline insurance company to terminate the Company's
servicing rights to the affected pool.
At September 30, 1997, five of the Company's trusts formed during the
period from December 1994 through September 1995 and March 1996 (representing
7.9% of the dollar volume of the Company's servicing portfolio) exceeded one of
two loss limits. The limit that has been exceeded provides that losses may not
exceed a certain threshold (which ranges from .38% to .55% of the original pool
balances in the relevant securitization trusts) on a rolling 12 month basis (the
"Rolling Test"). The other limit, which was not exceeded, provides that losses
may not exceed a certain cumulative threshold (which ranges from 1.3% to 1.9% of
the original pool balances in the relevant securitization trusts) since the
inception of the trust. These trusts are included in the eight trusts with
respect to which the delinquency rates have also exceeded the applicable limits.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Capital Resources."
Although the monoline insurance company has the right to terminate
servicing with respect to the trusts referred to above, no servicing rights have
been terminated. There can be no assurance that the Company's servicing rights
with respect to the mortgage loans in such trusts, or any other trusts which
exceeds the specified delinquency or loss limits in future periods, will not be
terminated.
Risks Involved in Commercial Mortgage Lending. The Company offers
commercial mortgage loans on a limited basis in amounts ranging from $250,000 to
$2.0 million secured by commercial properties, such as multifamily residences,
retail establishments, office buildings, light industrial/warehouse facilities
and mobile home parks. In the September 1997 quarter, the Company sold $8.7
million of commercial loans to a third party, servicing released. Although the
Company intends to continue to sell these loans on a whole loan, servicing
released basis, the Company bears certain risks during the time it holds the
loans pending their sale. Commercial mortgage lending is generally viewed as
exposing the lender to a greater risk of loss than residential mortgage lending,
in part, because it typically involves larger loans to single borrowers or
groups of related borrowers than residential mortgage loans. Further, the
repayment of commercial mortgages secured by income-producing properties is
typically dependent upon the tenant's ability to meet its obligations under
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the lease relating to such property, which in turn depends upon profitable
operations of the related property. In the event of a default on any commercial
mortgage held by the Company, the Company bears the risk of loss of principal to
the extent of any deficiency between the value of the related mortgage property,
plus any payments from an insurer or guarantor, and the amount owed on the
commercial mortgage.
Commercial mortgages generally are non-recourse to the borrower. In the
event of foreclosure on a commercial mortgage, the value of the property and
other collateral securing the commercial mortgage may be less than the principal
amount outstanding on the commercial mortgage and the accrued but unpaid
interest. Also, there may be costs and delays involved in enforcing rights of a
property owner against tenants in default under the terms of leases with respect
to commercial properties, who may seek the protection of the bankruptcy laws
which can result in termination of lease contracts all of which may adversely
affect the timing and amount of payment received by the Company with respect to
such commercial mortgages.
Forward-Looking Statements. This Report contains forward looking statements
relating to such matters as anticipated financial performance, business
prospects and similar matters. The Private Securities Litigation Reform Act of
1995 provides a safe harbor for forward-looking statements. In order to comply
with the terms of the safe harbor, the Company notes that a variety of factors
could cause the Company's actual results and experience to differ materially
from the anticipated results or other expectations expressed in the Company's
forward-looking statements. The risks and uncertainties that may affect the
operations, performance and results of the Company's business include the
following: negative cash flows and capital needs, delinquencies, prepayment and
credit risk, basis risks, risks of contracted servicing, dependence on funding
sources, capitalized interest-only strips, recent acquisition of One Stop,
dependence on broker network, impact of increases in correspondent pricing,
risks associated with high loan-to-value loan products, competition,
concentration of operations, timing of loan sales, economic conditions,
contingent risks and government regulation. For a more complete discussion of
these risks and uncertainties, see "Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations-Risk Factors" in the Company's
Form 10-K for the fiscal year ended June 30, 1997.
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RESULTS OF OPERATIONS-THREE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997
The following table sets forth information regarding the components of the
Company's revenue and expenses for the three months ended September 30, 1996 and
1997:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
SEPTEMBER 30,
----------------------
(IN THOUSANDS)
1996 1997
-------- --------
<S> <C> <C>
Revenue:
Gain on sale of loans ........................... $56,199 $44,721
Net unrealized gain on valuation of interest-only
strips .......................................... -- 5,029
Commissions ..................................... 7,747 5,855
Loan service:
Servicing spread .............................. 3,007 6,170
Prepayment fees ............................... 1,034 2,355
Late charge and other servicing fees .......... 619 1,257
Fees and other:
Closing ....................................... 847 587
Appraisal ..................................... 470 501
Underwriting .................................. 615 246
Interest income ............................... 4,893 11,031
Other ......................................... 210 160
-------- --------
Total revenue ............................. $75,641 $77,912
-------- --------
Expenses:
Compensation and related expenses ............... $19,324 $21,759
Production expenses ............................. 7,474 5,797
General and administrative expenses ............. 7,562 8,085
Interest expense ................................ 7,444 10,098
Provision for loan losses ....................... 9,782 8,570
Nonrecurring charges ............................ 28,108 --
-------- --------
Total expenses ............................ $79,694 $54,309
Income (loss) before income taxes ............... $(4,053) $23,603
Provision for income taxes ...................... 571 10,522
-------- --------
Net income (loss) ......................... $(4,624) $13,081
======== ========
</TABLE>
REVENUE
Total revenue for the three months ended September 30, 1997 was $77.9
million, a 3.0% increase from $75.6 million for the three months ended September
30, 1996. The increase in total revenue was due to higher loan service income
resulting from the increased size of the servicing portfolio and higher interest
income due to the greater amount of loans carried over as loans held for sale.
Gain on sale, which included $5.03 million of an unrealized gain on
valuation of interest-only strips related to loans sold, for the three months
ended September 30, 1997 was $49.8 million, an 11.4% decrease from $56.2 million
for the corresponding period last year. This decrease was
13
<PAGE> 14
primarily the result of the lower gain on sale and the smaller mortgage loan
pool securitized and sold by the Company in the current quarter. Beginning in
the fourth quarter of fiscal 1997, the Company increased the prepayment rate
assumption used to record the gain on sale, thereby reducing the total amount
of gain recorded compared to prior periods. The Company securitized $504 million
for the period ended September 30, 1997 compared to $527 million for the period
ended September 30, 1996. However, the Company continues to carryover
significantly more loans held for sale than in previous years. Loans held for
sale at September 30, 1997 increased 43% to $204 million from $143 million at
September 30, 1996 and declined from $243 million at June 30, 1997. This decline
for the quarter ended September 30, 1997 from June 30, 1997 resulted from the
securitization of $504 million and whole loan sales totaling $39.0 million which
in the aggregate exceeded loan production for the quarter. Management believes
the increased carryover levels will provide the Company with additional cash
flows, efficiencies and flexibility in the future.
Commissions earned on loan originations continue to be an important
component of total revenue, although to a lesser degree than in prior years,
comprising 10% and 7.5% of total revenue for the three months ended September
30, 1996 and 1997, respectively. Commission revenue was $5.9 million for the
three months ended September 30, 1997, a 23% decrease from $7.7 million for the
three months ended September 30, 1996. The decrease in commissions for the three
months ended September 30, 1997 was the result of a decline in weighted average
commission rates for both the retail and broker network production units. The
lower weighted average commission rate in 1997 reflected competitive factors,
and the increase of higher credit grade loans originated which generally carry
lower commission rates.
Loan service revenue increased to $9.8 million in the quarter ended
September 30, 1997, an increase of 109% from $4.7 million in the comparable
quarter in 1996. The Company continues to focus its efforts on increasing its
loan servicing portfolio and achieving increasing economies of scale. Loan
service revenue consists of net servicing spread earned on the principal
balances of the loans in the Company's loan servicing portfolio, prepayment
fees, late charges and other fees retained by the Company in connection with the
servicing of loans reduced by the amortization of the interest-only strips and
originated mortgage servicing rights ("OMSR's"). The increase in loan service
revenues for the three months ended September 30, 1997 was due primarily to the
greater size of the portfolio of loans serviced in this period offset by
increased amortization of the interest-only strips and OMSR's.
The Company's loan servicing portfolio at September 30, 1997 increased to
$3.4 billion, up 89% from $1.8 billion for the same period last year. Consistent
with the Company's strategic plan, the Company's in-house serviced portfolio
increased by both the transfer of loans which had been subserviced by third
parties, and the direct servicing of the majority of new production during the
period. In fiscal 1997, the Company's servicing division implemented systems and
added personnel that will allow it to service directly substantially all of its
servicing portfolio by the end of fiscal 1998. Management believes the business
of loan servicing provides a more consistent revenue stream and is less cyclical
than the business of loan origination and purchasing.
14
<PAGE> 15
The Company has historically experienced delinquency rates that are higher
than those prevailing in its industry. However, management believes the
Company's historical loan losses are generally lower than those experienced by
most other lenders to credit-impaired borrowers because of the lower combined
loan-to-value ratios on the Company's servicing portfolio. Management does,
however, expect loss rates to increase as the Company originates and purchases a
larger portion of higher credit grade loans which generally carry higher
loan-to-value ratios. In addition, during the quarter ended September 30, 1997,
losses increased over the prior year period due to more aggressive efforts to
dispose of real estate owned properties. These efforts are expected to continue
which will likely result in higher levels of losses in future periods. The
Company has increased its loan loss provision from 1.3% of the pool balance at
December 31, 1996 to 1.7% of the pool balance at September 30, 1997. The
following table sets forth delinquency, foreclosure, loss and reserve
information of the Company's servicing portfolio for the periods indicated:
<TABLE>
<CAPTION>
Year Ended Three Months Ended
June 30, September 30,
------------------------------------------- ----------------------------
1995 1996 1997 1996 1997
----------- ----------- ----------- ----------- -----------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
Percentage of dollar amount of
delinquent loans
to loans serviced
(period end)(1)(2)(3)
One month ............................. 3.9% 4.9% 4.3% 5.0% 3.2%
Two months ............................ 1.6 1.8 1.9 1.9 1.3
Three or more months:
Not foreclosed (4) .................... 5.0 8.0 8.1 7.3 8.3
Foreclosed (5) ........................ 1.5 1.0 1.0 1.0 1.2
----------- ----------- ----------- ----------- -----------
Total ................................. 12.0% 15.7% 15.3% 15.2% 14.0%
Percentage of dollar amount of loans
foreclosed to loans serviced
(period end) (2) .................. 1.2% 1.1% 1.5% .42% .58%
Number of loans foreclosed ............ 159 221(6) 560(6) 86(6) 241(6)
Principal amount of foreclosed loans .. $ 6,675 $ 14,349 $ 48,029 $ 7,272 $ 19,744
Net losses on foreclosed loans included
in pools (3)(7) ................... $ 127 $ 931 $ 5,470 $ 932 $ 4,160
Percentage of annualized losses to
average servicing portfolio ........... .03% .09% .24% .24% .51%
Liquidation loss reserve (8) .......... $ 3,371 $ 10,300 $ 43,586 $ 19,410 $ 47,948
Servicing portfolio (period end) ...... $ 608,700 $ 1,370,000 $ 3,174,000 $ 1,773,000 $ 3,402,000
</TABLE>
(1) Delinquent loans are loans for which more than one payment is past due.
(2) The delinquency and foreclosure percentages are calculated on the basis
of the total dollar amount of mortgage loans originated or purchased by
the Company and, in each case, serviced by the Company, and any
subservicer as of the end of the periods indicated. Percentages for
fiscal year 1996 have not been restated to include delinquencies on
loans originated by One Stop. The Company believes any such adjustment
would not be material.
(3) At September 30, 1997, the dollar volume of loans delinquent more than
90 days in the Company's eight REMIC trusts, five of which also
exceeded certain loss limits, formed in December 1992 and during the
period from December 1994 to June 1996 exceeded the permitted limit in
the related pooling and servicing agreements. See "Certain Accounting
Considerations and Risk Factors -- Losses in Securitization Trusts;
Right to Terminate Mortgage Servicing" and "Capital Resources".
(4) Represents loans which are in foreclosure but as to which foreclosure
proceedings have not concluded.
(5) Represents properties acquired following a foreclosure sale and still
serviced by the Company.
15
<PAGE> 16
(6) The increase in the number of loans foreclosed and principal amount of
loans foreclosed in fiscal year 1997 and quarter ended September 30,
1997 relative to fiscal year 1996 and quarter ended September 30, 1996
is due to the larger, more seasoned servicing portfolio.
(7) Represents losses, net of gains, on foreclosed properties in pools sold
during the period indicated.
(8) Represents period end reserves for future liquidation losses.
Fees and other revenue increased 79% from $7.0 million for the three months
ended September 30, 1996, to $12.5 million for the three months ended September
30, 1997. Included in other revenue is interest income earned on loans in the
Company's portfolio. Interest income increased for the three months ended
September 30, 1997 due to interest earned on larger amounts of loans held by the
Company during the period from origination or purchase of the loans until the
date sold by the Company offset by the decline in the weighted average coupon
from 11.1% at September 30, 1996 to 10.3% at September 30, 1997. Fees and other
revenue also includes fees received by the Company through its retail loan
office network in the form of closing, appraisal, underwriting and other fees.
EXPENSES
Compensation and related expenses increased 13% from $19.3 million to $21.8
million for the quarters ended September 30, 1996 and 1997, respectively. This
increase was primarily due to the continued effort to accommodate increased
origination volumes and expansion of the Company's core production units.
Compensation and related expenses as a percentage of total loan originations and
purchases were 3.9% and 4.2%, and as a percentage of core loan originations were
8.0% and 5.5%, for the three months ended September 30, 1996 and 1997,
respectively.
Production expenses, primarily advertising, outside appraisal costs, travel
and entertainment and credit reporting fees, decreased 23% from $7.5 million to
$5.8 million for the quarters ended September 30, 1996 and 1997, respectively.
This decrease was mainly due to the 31% reduction in advertising costs from $5.2
million to $3.6 million for the quarters ended September 30, 1996 and 1997 as
the Company emphasized direct mail over electronic media advertising. The
Company continually monitors the sources of its loan applications to determine
the most effective methods of advertising. Production costs as a percentage of
total loan originations and purchases were 1.5% and 1.1%, and as a percentage of
core loan originations were 3.1% and 1.5%, for the three months ended September
30, 1996, and 1997 respectively.
General and administrative expenses increased 6.6% from $7.6 million to
$8.1 million for the quarters ended September 30, 1996 and 1997, respectively.
The increase was primarily the result of increased occupancy and communication
costs related to the Company's expansion and increased origination volumes.
Interest expense increased 36% from $7.4 million to $10.1 million for the
quarters ended September 30, 1996 and 1997, respectively. The increase was
primarily the result of the sale in the second quarter of fiscal 1997 of $150
million of its 9.125% Senior Notes due 2003. Interest expense is expected to
increase in future periods due to the Company's continued reliance on
warehousing arrangements to fund increased originations and purchases of loans
pending their securitization.
The provision for loan losses decreased 12% from $9.8 million to $8.6
million for the quarters ended September 30, 1996 and 1997, respectively. The
decrease was primarily related to the smaller size of the Company's
securitization in the first quarter of 1997 compared to the first quarter of
1996 and the reduction in provisions from 1.86% of the pool size for the quarter
ended September 30, 1996 to 1.70% of pool size for
16
<PAGE> 17
the quarter ended September 30, 1997. Higher provision estimates were used in
the first quarter of fiscal 1996 due to the Company's uncertainty as to expected
loss experience with One Stop's products. The Company has evaluated its actual
loss performance over the last year and believes that the 1.70% loss provision
is adequate; however, there can be no assurance that the Company's actual losses
will not exceed this estimate.
In the three months ended September 30, 1996, the Company incurred $28.1
million of nonrecurring charges. Approximately $25.0 million was directly
related to the acquisition of One Stop. The remaining amount related primarily
to a reserve for vacating corporate headquarters.
INCOME TAXES
The Company's provision for income taxes increased from $571,000 for the
three months ended September 30, 1996 to $10.5 million for the three months
ended September 30, 1997. Despite the net loss reported in the three months
ended September 30, 1996, a provision for income taxes was required as a result
of the impact of $5.4 million of nonrecurring charges that were not tax
deductible. The effective tax rate increased from 42% for the quarter ended June
30, 1997 to 45% for the quarter ended September 30, 1997. This increase was due
to the higher level of taxable earnings and non-deductible compensation expense
during the quarter ended September 30, 1997.
FINANCIAL CONDITION
Loans held for sale. The Company's portfolio of loans held for sale
decreased from $243 million at June 30, 1997, to $204 million at September 30,
1997. The decline from the prior quarter carryover resulted from the Company's
sale of mortgages exceeding production levels in the current quarters. However,
the Company continues to carryover significantly more loans than in previous
years. Management believes the increase in the carryover amount will provide the
Company with additional cash flows, efficiencies and flexibility in the future.
There can be no assurance that the Company can maintain this level of carryover
in future periods.
Accounts receivable. Accounts receivable, representing servicing fees and
advances and other receivables, increased from $59.2 million at June 30, 1997,
to $61.5 million at September 30, 1997. This increase was primarily the result
of larger pools serviced and increases in related advances and receivables.
Interest-only-strips. Interest-only-strips increased from $270 million at
June 30, 1997 to $294 million at September 30, 1997 reflecting the Company's
gain on sale from the securitization in the quarter ended September 30, 1997,
net of amortization.
Mortgage servicing rights. Mortgage servicing rights increased from $21.6
million at June 30, 1997 to $24.6 million at September 30, 1997 reflecting the
Company's gain on sale from the securitization in the quarter ended September
30, 1997, net of amortization.
Residual assets. Residual assets represent the reserve accounts and
overcollateralization amounts required to be maintained in connection with the
securitization of loans. Residual assets include cash and mortgage loans in
excess of the principal amounts of the senior and subordinated certificates or
bonds of the
17
<PAGE> 18
securitization trust. Residual assets increased from $113 million at June 30,
1997, to $131 million at September 30, 1997.
Equipment and improvements, net. Equipment and improvements, net, increased
from $12.7 million at June 30, 1997, to $12.8 million at September 30, 1997.
Prepaid and other assets. Prepaid and other assets increased from $14.9
million at June 30, 1997 to $16.2 million at September 30, 1997.
Borrowings. Borrowings remained unchanged at $287 million for both June 30,
1997 and September 30, 1997.
Revolving warehouse facilities. Amounts outstanding under warehouse
facilities decreased from $138 million at June 30, 1997, to $105 million at
September 30, 1997, primarily as a result of the reduction in mortgage loan
carryover. Proceeds from the Company's securitizations are used to pay down the
Company's warehouse facilities.
LIQUIDITY
The Company's operations require continued access to short-term and
long-term sources of cash. The Company's operating cash requirements include the
funding of: (i) mortgage loan originations and purchases prior to their
securitization and sale, (ii) fees and expenses incurred in connection with the
securitization and sale of loans, (iii) cash reserve accounts or
overcollateralization requirements in connection with the securitization and
sale of mortgage loans, (iv) tax payments due on recognition of gain on sale
other than in a debt-for-tax securitization structure, (v) ongoing
administrative and other operating expenses, (vi) interest and principal
payments under the Company's warehouse credit facilities and other existing
indebtedness and (vii) advances in connection with the Company's servicing
portfolio.
The Company has operated on a negative cash flow basis and expects to
continue to do so for as long as growth causes the Company's cash requirements
to exceed cash generated by the Company from its operations, including its
servicing activities. To increase the cash generated from operations, the
Company may increase the volume of whole loans sold in bulk to other mortgage
lenders. Unlike a securitization, a whole loan sale generates cash at the
closing of the sale; however, such sales may generate less profit than a
securitization.
The Company is continuing efforts to enhance cash flow with the ultimate
goal of reducing dependence on external sources. Historically, the Company
funded its negative operating cash flow principally through borrowings from
financial institutions, sales of equity securities and sales of senior and
subordinated notes, among other sources. The Company expects to continue to fund
its negative operating cash flows, subject to limitations under the Company's
existing credit facilities, principally from borrowings from financial
institutions and, to a lesser extent, sales of equity securities and public
debt. There can be no assurance that the Company will have access to the 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.
The Company anticipates that its sources of liquidity, assuming access to
residual financing, will be sufficient to fund the Company's liquidity
requirements for the next 12 months, if the Company's future operations are
consistent with
18
<PAGE> 19
management's current growth expectations. There can be no assurance that the
Company will be successful in consummating any such financing transaction in the
future on terms the Company would consider to be favorable. Further, principally
as a result of the events described under "Item 1, Business--Recent Events," in
the Company's Annual Report on Form 10-K for the fiscal year ended June 30,
1997, certain rating agencies have placed certain issues of the Company's debt
under credit watch and one credit rating agency has downgraded certain issues of
the Company's debt. This may affect the ability of the Company to secure credit
facilities on favorable terms.
Under the terms of the Company's Indenture, dated October 21, 1996 with
respect to its 9.125% Senior Notes due 2003, the Company's ability to incur
certain additional indebtedness, including residual financing, is limited to two
times stockholder equity. Further, until the Company receives investment grade
ratings for the notes issued under the Indenture, the amount of residual
financing the Company may incur on its residuals (interest-only strips)
allocable to post-September 1996 securitizations is limited to 75% of the
difference between such post-September 1996 residuals and $225 million.
Warehouse indebtedness is not included in the indebtedness limitations.
The Company securitized and sold in the secondary market $527 million and
$504 million of loans for the three months ended September 30, 1996 and 1997,
respectively. In connection with securitization transactions completed during
these periods, the Company was required to provide credit enhancements in the
form of overcollateralization amounts or reserve accounts. In addition, during
the life of the related securitization trusts, the Company subordinates a
portion of the excess cash flow otherwise due it to the rights of holders of
senior interests as a credit enhancement to support the sale of the senior
interests. The terms of the securitization trusts generally require that all
excess cash flow otherwise payable to the Company during the early months of the
trusts be used to increase the cash reserve accounts, or to repay the senior
interests in order to increase overcollateralization to specified maximums. The
accumulated amounts of such overcollateralization and cash reserve accounts are
reflected on the Company's balance sheet as "residual assets." At September 30,
1997, the balance was $131 million compared to $113 million at September 30,
1996.
In addition, the use of securitization transactions as a funding source by
the Company has resulted in a significant amount of gains on sale of loans
recognized by the Company. During the three months ended September 30, 1996 and
1997, the Company recognized gain on sale of loans in the amounts of $56.2
million and $44.7 million, respectively. In addition, the Company recognized
$5.03 million for the quarter ended September 30, 1997 in net unrealized gain on
valuation of interest-only strips in accordance with SFAS 125 implemented in the
quarter ended March 31, 1997. In the Company's securitizations structured as a
REMIC, the recognition of gain on sale has a negative impact on the cash flow of
the Company since the Company is required to pay federal and state taxes on a
portion of these amounts in the period recognized although it does not receive
the cash representing the gain until later periods as the related service fees
are collected and applicable reserve or overcollateralization requirements are
met. In its operations, the Company employs various tax planning strategies,
including the debt-for-tax securitization structure which allows the Company to
defer the payment of taxes until income is distributed or received by the trust.
In March 1997, the Company completed its first securitization using the
debt-for-tax structure. This had a positive effect on the Company's cash flows.
In addition, in the two most recent securitizations, the Company sold an
interest-only strip
19
<PAGE> 20
generating cash at the time of settlement in the amount of $2.7 million in the
fourth quarter of fiscal 1997, and $5.5 million in the first quarter of fiscal
1998.
The Company also incurs certain expenses in connection with
securitizations, including underwriting fees, credit enhancement fees, trustee
fees, hedging and other costs which, for the three months ended September 30,
1997, approximated .66% of the principal amount of the securitized mortgage
loans sold.
CAPITAL RESOURCES
The Company finances its operational cash requirements primarily through
(i) warehouse facilities and working capital lines of credit, (ii) the
securitization and sale of mortgage loans, and (iii) the issuance of debt and
equity securities.
Warehouse Facilities. At September 30, 1997, the Company had two warehouse
facilities in place. One facility is a warehouse line and working capital line
of credit with a syndicate of eight commercial banks. This facility provides for
a maximum borrowing amount of $350 million, is secured by loans originated and
purchased by the Company as well as certain servicing receivables, and bears an
interest rate of either 1.05% over the federal funds rate or .80% over one-month
LIBOR. This line is currently scheduled to expire on January 13, 1998 and is
subject to renewal. There is an additional warehouse line of credit from an
investment bank that is secured by loans originated and purchased by the
Company. This line of $250 million bears interest at a rate of 0.70% over
one-month LIBOR and expires on December 30, 1997. The Company has a commitment
from an investment bank for a warehouse facility with a maximum borrowing amount
of $400 million. Management expects, although there can be no assurance, that
the Company will be able to maintain these or similar facilities in the future.
Securitization Program. The Company's most important capital resource has
been its ability to sell loans originated and purchased by it in the secondary
market in order to generate cash proceeds to pay down its warehouse facilities
and fund new originations and purchases. The value of and market for the
Company's loans are dependent upon a number of factors, including general
economic conditions, interest rates and governmental regulations. Adverse
changes in such factors may affect the Company's ability to securitize and sell
loans for acceptable prices within a reasonable period of time. The ability of
the Company to sell loans in the secondary market on acceptable terms is
essential for the continuation of the Company's loan origination and purchase
operations. A reduction in the size of the secondary market for loans of the
types originated or purchased by the Company may adversely affect the Company's
ability to sell loans in the secondary market with a consequent adverse impact
on the Company's profitability and ability to fund future originations and
purchases.
In addition, in order to gain access to the secondary market, the Company
has principally utilized monoline insurance companies to provide financial
guarantee insurance on senior interests in the securitization trusts established
by the Company. Although, the Company recently completed two securitizations
utilizing a senior/subordinated structure, which relied on the internal credit
enhancements of the pool rather than monoline insurance, the Company expects to
utilize monoline insurance companies for at least a portion of its future
securitizations. Any substantial reduction in the size or availability of the
secondary market for the Company's loans or the unwillingness of monoline
insurance companies to provide financial guarantee insurance for the
20
<PAGE> 21
senior interests in the securitization trusts could have a material adverse
effect on the Company's financial position and results of operations. At
September 30, 1997, the dollar volume of loans delinquent more than 90 days in
the Company's eight securitization trusts, five of which also exceeded certain
loss limits, formed in December 1992 and during the period from December 1994 to
June 1996 exceeded the permitted limit in the related pooling and servicing
agreements. The higher delinquency rates negatively affect the Company's cash
flows by increasing the overcollateralization levels, thereby deferring the
Company's receipt of cash, and, in certain instances, by obligating the Company,
as servicer, to advance past due interest. See "Liquidity". Higher delinquency
levels also adversely influence the Company's assumptions underlying the gain on
sale. Additionally, the higher delinquency and loss rates permit the monoline
insurance company to terminate the Company's servicing rights with respect to
the affected trusts. To date, no servicing rights have been terminated, and the
Company believes that the likelihood of such an event is remote. The Company has
implemented various plans to lower the delinquency rates in its future trusts,
including diversifying the loans it originates and purchases to include higher
credit grade loans. The delinquency rate for September 30, 1997 was 14.0%
compared to 15.2% at September 30, 1996. Further, the monoline insurance
companies agreed to higher permitted delinquency limits than in the older pools
mentioned above in the six most recent securitizations. See "Certain Accounting
Considerations and Risk Factors -- Losses in Securitization Trusts; Right to
Terminate Mortgage Servicing."
Other Capital Resources. The Company has funded negative cash flow
primarily from the sale of its equity and debt securities. In December 1991,
July 1993, June 1995 and October 1996, the Company effected offerings of its
Common Stock with net proceeds to the Company aggregating $179 million. In March
1995, the Company completed an offering of its 10.5% Senior Notes due 2002 with
net proceeds to the Company of $22.2 million. In February 1996, the Company
completed an offering of its 5.5% Convertible Subordinated Debentures due 2006
with net proceeds to the Company of $112 million. In October 1996, the Company
completed an offering of its 9.125% Senior Notes due 2003 with net proceeds to
the Company of $145 million. Under the agreements relating to these debt
issuances, the Company is required to comply to with various operating and
financial covenants including covenants which may restrict the Company's ability
to pay certain distributions, including dividends. The Company had cash and cash
equivalents of approximately $6.65 million.
RISK MANAGEMENT
The Company's earnings may be directly affected by the level of and
fluctuation in interest rates and the level of prepayment in the Company's
securitizations. The Company currently hedges its fixed rate pipeline and any
LIBOR-based tranche, in its fixed rate securitizations, and continues to explore
other avenues of risk mitigation, although none have been employed to date. The
current fixed rate hedge products utilized are swap agreements with third
parties that sell United States Treasury securities not yet purchased and the
purchase of Treasury put options. The hedge instrument used on the existing
LIBOR-based tranches secured by fixed rate mortgages is an interest rate swap
with a specified LIBOR rate cap. See "Certain Accounting Considerations and Risk
Factors -- Prepayment, Credit and Basis Risk." The amount and timing of hedging
transactions are determined by members of the Company's senior management. While
the Company monitors the interest rate environment and employs fixed rate
hedging strategies, there can be no assurance that the earnings of the Company
would not be adversely affected during any period of unexpected changes in
interest rates or prepayment rates.
The Company may also mitigate its exposure to interest rate risk through a
pre-funding strategy in which it agrees to sell loans to the securitization
trust in the future at an agreed-upon price. The pre-funding locks in the price
agreed upon with investors on the pricing date typically five business days
prior to the closing date of the securitizations for a period of generally 30
days. In a pre-funding arrangement, the Company typically
21
<PAGE> 22
delivers approximately 75% of the loans sold at the closing and the remainder
generally within 30 days after the closing. Due to the expected benefit of
increased mortgage loan carryover at June 30, 1997, there was no restricted cash
related to the settlement of the Company's securitization in September 1997.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Changes in Securities - None
Item 3. Defaults upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
Item 5. Other Information - None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
11 Computation of Per Share Earnings
27.1 Financial Disclosure Schedule
99 Press release dated November 11, 1997
(b) Reports on Form 8-K: Current reports on Form 8-K dated August 29, 1997
(reporting the Company's earnings and cash dividend) and July 31, 1997
(reporting the appointment of two new directors) were filed during the
quarter ended September 30, 1997.
22
<PAGE> 23
AAMES FINANCIAL CORPORATION
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this Report on Form 10-Q to be signed on
its behalf by the undersigned, thereunto duly authorized.
AAMES FINANCIAL CORPORATION
Date: November 13, 1997 By:/s/ David A. Sklar
-----------------------------------
David A. Sklar
Executive Vice President-Finance
and Chief Financial and Accounting
Officer
23
<PAGE> 1
EXHIBIT 11
AAMES FINANCIAL CORPORATION
Earnings Per Share
For the three months ended September 30, 1996 and 1997
<TABLE>
<CAPTION>
Three Months ended
September 30,
---------------------------
1996 1997
------------ -----------
<S> <C> <C>
Average shares outstanding 23,845,000 27,767,000
Common equivalent shares:
Options and warrants 2,383,500 1,459,000
Convertible subordinated notes 6,161,000 6,107,000
------------ -----------
Fully diluted shares outstanding 32,389,500 35,333,000
============ ===========
Net Income $ (4,624,000) $13,081,000
Adjustment to add back interest on
Convertible subordinated notes 958,000 898,000
------------ -----------
Adjusted Net Income $ (3,666,000) $13,979,000
============ ===========
------------ -----------
Fully diluted earnings per share $ (.11) 0.40
============ ===========
</TABLE>
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<FISCAL-YEAR-END> JUN-30-1998
<PERIOD-START> JUL-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 6,650,000
<SECURITIES> 0
<RECEIVABLES> 528,328,000
<ALLOWANCES> 664,000
<INVENTORY> 203,716,000
<CURRENT-ASSETS> 738,030,000
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0
0
<COMMON> 28,000
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<PAGE> 1
FOR IMMEDIATE RELEASE
Contact: Toni Guzman Jeff Lloyd/Steve Hawkins
Aames Financial Corporation Sitrick And Company
(213) 210-5311 (310) 788-2850
AAMES FINANCIAL CORPORATION ANNOUNCES MANAGEMENT CHANGES
DAVID SKLAR NAMED CFO; GREGORY WITHERSPOON NAMED EVP, STRATEGIC PLANNING
LOS ANGELES, CALIF. -- NOV. 11, 1997 -- AAMES FINANCIAL CORPORATION
(NYSE: AAM) today announced that David A. Sklar has been appointed chief
financial officer, succeeding Gregory J. Witherspoon who has been named
executive vice president for strategic planning.
Mr. Sklar, 44, joined Aames in May 1997 as chief financial officer of
the company's retail and correspondent divisions. He has more than 20 years
experience in executive management. A former executive vice president and chief
financial officer of Imperial Bancorp, he has also held management positions at
West Coast Bancorp and Lloyds Bank of California and was a certified public
accountant with KPMG PeatMarwick LLP.
Mr. Witherspoon, 51, assumes the newly-created position of executive
vice president for strategic planning. "Greg has contributed significantly to
Aames' success over the past decade," said Cary H. Thompson, chief executive
officer. "In his new position he will assist management in exploring and
implementing new financing and securitization structures." A certified public
accountant, he joined Aames in 1987 as controller and was later named chief
financial officer in 1987, a director in 1991 and executive vice president in
1994.
Aames Financial Corporation is a leading home equity lender and
currently operates 59 Aames Home Loan offices in 23 states throughout the United
States. Its wholly owned subsidiary, One Stop Mortgage, Inc. operates in 41
offices in 35 states.
From time to time the company may publish forward-looking statements
relating to such matters as anticipated financial performance, business
prospects and similar matters. The Private Securities Litigation Reform Act of
1995 provides a safe harbor for forward-looking statements. In order to comply
with the terms of the safe harbor, the company notes that a variety of factors
could cause the company's actual results and experience to differ materially
from the anticipated results or other expectations expressed in the company's
forward-looking statements. The risks and uncertainties that may affect the
operations, performance and results of the company's business include the
following: negative cash flows and capital needs, delinquencies; negative impact
on cash flow; right to terminate mortgage servicing, risks of contracted
servicing, prepayment and credit risk, dependence on funding sources,
capitalized interest-only strips; mortgage servicing rights, recent acquisition
of One-Stop, dependence on broker network, impact of increases in correspondent
pricing, risks associated with high loan-to-value loan products, competition,
concentration of operations, timing of loan sales, economic conditions,
contingent risks and government regulation. For a more complete discussion of
these risks and uncertainties, see "Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Risk Factors" in the
company's form 10-K for the fiscal year ended June 30, 1997.
###
