<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 December 31, 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) 210-5000
[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 February 6, 1998, Registrant had 27,812,400 shares of common stock
outstanding.
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TABLE OF CONTENTS
<TABLE>
<CAPTION>
ITEM NO. PAGE NO.
<S> <C>
PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements
Consolidated Balance Sheets at June 30, 1997 and December 31, 1997 3
Consolidated Statements of Income for the three and six months ended
December 31, 1996 and 1997 4
Consolidated Statements of Cash Flows for the six months ended
December 31, 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 7-25
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings 25
Item 2 - Changes in Securities 25
Item 3 - Defaults Upon Senior Securities 25
Item 4 - Submission of Matters to a Vote of Security Holders 25-26
Item 5 - Other Information 26
Item 6 - Exhibits and Reports on Form 8-K 26
Signature Page 27
</TABLE>
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AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1997 1997
------------ ------------
(Audited) (Unaudited)
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 26,902,000 $ 8,691,000
Loans held for sale, at lower of cost or market 242,987,000 215,861,000
Accounts receivable 59,180,000 41,418,000
Interest-only strips, estimated at fair market value 270,422,000 327,146,000
Mortgage servicing rights 21,641,000 28,218,000
Residual assets 112,827,000 154,208,000
Equipment and improvements, net 12,685,000 12,835,000
Prepaid and other 14,949,000 15,700,000
------------ ------------
Total assets $761,593,000 $804,077,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Borrowings $286,990,000 $286,990,000
Revolving warehouse facilities 137,500,000 129,500,000
Accounts payable and accrued expenses 29,297,000 38,305,000
Income taxes payable 39,452,000 56,094,000
Total liabilities 493,239,000 510,889,000
------------ ------------
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 27,812,000 shares outstanding 28,000 28,000
Additional paid-in capital 209,358,000 209,602,000
Retained earnings 58,968,000 83,558,000
------------ ------------
Total stockholders' equity 268,354,000 293,188,000
------------ ------------
Total liabilities and stockholders' equity $761,593,000 $804,077,000
============ ============
</TABLE>
The accompanying notes are an integral part of these financial statements
3
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AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------- ------------------------------
1996 1997 1996 1997
----------- ----------- ------------ ------------
<S> <C> <C> <C> <C>
Revenue:
Gain on sale of loans $56,960,000 $52,443,000 $113,160,000 $ 97,164,000
Net unrealized gain on valuation
of interest-only strips - 5,726,000 - 10,755,000
Commissions 7,841,000 7,161,000 15,587,000 13,016,000
Loan service 5,402,000 10,362,000 10,062,000 20,144,000
Fees and other 9,825,000 11,962,000 16,860,000 24,487,000
----------- ----------- ------------ ------------
Total revenue 80,028,000 87,654,000 155,669,000 165,566,000
----------- ----------- ------------ ------------
Expenses:
Compensation and related expenses 19,709,000 24,561,000 39,033,000 46,320,000
Production expenses 6,760,000 7,541,000 14,234,000 13,338,000
General and administrative expenses 7,156,000 9,580,000 14,718,000 17,665,000
Interest expense 7,743,000 10,819,000 15,187,000 20,917,000
Provision for loan losses 7,150,000 10,893,000 16,932,000 19,463,000
Nonrecurring charges - - 28,108,000 -
----------- ----------- ------------ ------------
Total expenses 48,518,000 63,394,000 128,212,000 117,703,000
----------- ----------- ------------ ------------
Income before income taxes 31,510,000 24,260,000 27,457,000 47,863,000
Provision for income taxes 13,236,000 10,917,000 13,807,000 21,439,000
----------- ----------- ------------ ------------
Net income $18,274,000 $13,343,000 $ 13,650,000 $ 26,424,000
=========== =========== ============ ============
Net income per share
Basic $ 0.67 $ 0.48 $ 0.53 $ 0.95
=========== =========== ============ ============
Diluted $ 0.53 $ 0.41 $ 0.45 $ 0.80
=========== =========== ============ ============
Dividends per share $ 0.03 $ 0.03 $ 0.07 $ 0.07
=========== =========== ============ ============
Weighted average number
of shares outstanding
Basic 27,397,000 27,799,000 25,577,000 27,784,000
=========== =========== ============ ============
Diluted 35,814,000 34,949,000 34,038,000 35,272,000
=========== =========== ============ ============
</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>
SIX MONTHS ENDED
DECEMBER, 31
-------------------------------------
1996 1997
--------------- ---------------
<S> <C> <C>
Operating activities:
Net income $ 13,650,000 $ 26,424,000
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Provision for loan losses 16,932,000 19,463,000
Net charge-offs for loans (1,764,000) (9,947,000)
Depreciation and amortization 1,223,000 1,845,000
Deferred income taxes 13,734,000 19,723,000
Gain on sale of loans (143,302,000) (103,290,000)
Net unrealized gain on valuation of interest-only strips - (10,755,000)
Amortization of interest-only strip 26,349,000 47,805,000
Mortgage servicing rights originated (7,828,000) (10,664,000)
Mortgage servicing rights amortization 2,283,000 4,087,000
Changes in assets and liabilities:
Loans originated or purchased (1,130,090,000) (1,138,802,000)
Proceeds from sale of loans 1,161,725,000 1,165,928,000
Decrease (Increase) in:
Accounts receivable (14,304,000) 17,762,000
Prepaid and other (5,065,000) (751,000)
Residual assets (25,852,000) (41,381,000)
Increase (decrease) in:
Accounts payable and accrued expenses 10,829,000 9,008,000
Income taxes payable (3,119,000) (3,081,000)
--------------- ---------------
Net cash (used in) operating activities (84,599,000) (6,626,000)
--------------- ---------------
Investing activities:
Purchases of property and equipment (3,815,000) (1,995,000)
--------------- ---------------
Net cash (used in) investing activities (3,815,000) (1,995,000)
--------------- ---------------
Financing activities:
Proceeds from sale of stock or exercise of options 117,565,000 244,000
Proceeds from borrowing 149,978,000 -
Amounts outstanding under warehouse facilities (12,363,000) (8,000,000)
Dividends paid (1,588,000) (1,834,000)
--------------- ---------------
Net cash provided by (used in ) financing activities 253,592,000 (9,590,000)
--------------- ---------------
Net increase (decrease) in cash and cash equivalents 165,178,000 (18,211,000)
Cash and cash equivalents at beginning of period 23,941,000 26,902,000
--------------- ---------------
Cash and cash equivalents at end of period $ 189,119,000 $ 8,691,000
=============== ===============
</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 and six months ended
December 31, 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 since
adoption. As a result of the adoption of SFAS 125, the Company records amounts
previously categorized as "Excess servicing 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
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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 December 31, 1997, recorded a mark-to-market unrealized gain
of $5.7 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 adopted SFAS 128 effective December 31, 1997. The
adoption of SFAS 128 did not have a material impact on the Company's 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.
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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.
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. Upon its
formation in 1991, the Company 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 bulk 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 has retained the servicing rights (collecting loan payments
and managing borrower defaults) to substantially all of the loans it has
originated or purchased and securitized. During the second fiscal quarter of
1998, the Company hired additional personnel to allow the Company to service
directly substantially all of its servicing portfolio. Of the Company's $3.8
billion servicing portfolio at December 31, 1997, only 25% was subserviced by
third parties compared to 48% at December 31, 1996. By the end of the third
fiscal quarter of 1998, the Company intends to be directly servicing
substantially all of its servicing portfolio. See "Expenses."
The Company's strategic plan calls for continued national expansion of
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. See "Recent Developments." The Company
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is also pursuing opportunities on an international basis, initially in the
United Kingdom through its broker subsidiary One Stop.
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 SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
1996 1997 1996 1997
---------- ---------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Loans originated and purchased:
Broker network .......................... $ 189,685 $ 273,756 $ 330,602 $ 535,590
Retail(1) ............................... 114,549 157,292 215,938 290,838
Correspondent ........................... 324,535 184,615 583,548 312,374
---------- ---------- ---------- ----------
Total ................................... $ 628,769 $ 615,663 $1,130,088 $1,138,802
========== ========== ========== ==========
Servicing portfolio at period end.......... $2,274,400 $3,750,750
</TABLE>
(1) Includes loans brokered to institutional investors.
Total loan production for the quarter decreased 2.1% from $629 million
for the quarter ended December 31, 1996 to $616 million for the quarter ended
December 31, 1997. The decline was primarily due to a reduction in correspondent
bulk loan purchases as a result of the previously announced pricing changes,
which was mostly offset by increased loan production in the retail and broker
production units. The growth in the Company's core production units reflects
continued geographic expansion through the opening of 15 retail branches and one
broker office in the second fiscal quarter. Included in that total are two new
retail offices in Texas which, along with One Stop's existing presence there,
positions the Company to benefit from this new home equity market. Effective
January 1, 1998, restrictions on home equity lending in Texas were significantly
reduced.
The Company's retail and broker units increased production 42% from $304
million to $431 million for the quarters ended December 31, 1996 and 1997,
respectively. The Company's retail originations were up 37% to $157 million for
the quarter ended December 31, 1997 compared to $115 million for the quarter
ended December 31, 1996. Origination volume for the broker network reached $274
million for the quarter ended December 31, 1997, up 44%, compared to $190
million for the quarter ended December 31, 1996. Correspondent purchases were
$185 million for the quarter ended December 31, 1997 down from $325 million for
the quarter ended December 31, 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 second fiscal quarter's production volume also
reflects the Company's strategic shift up the credit grade spectrum. Of the
total loans originated and purchased by the Company in the quarter ended
December 31, 1997, 93% were A-, A, B and C credit grade loans and 7% were C- and
D credit grade loans, compared to 80% and 20%, respectively, in last year's
comparable quarter.
Although total loan production for the six months ended December 31,
1996 and 1997 remained relatively flat, the Company's retail and broker units
increased loan production 51%
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from $547 million to $826 million for the six months ended December 31, 1996 and
1997, respectively. The Company's retail originations increased 35% to $291
million for the six months ended December 31, 1997 compared to $216 million for
the six months ended December 31, 1996. Origination volume for the broker
network reached $536 million for the six months ended December 31, 1997, up 62%
compared to $331 million for the six months ended December 31, 1996.
Correspondent volume decreased 46% from $584 million at December 31, 1996 to
$312 million at December 31, 1996.
At December 31, 1997, the Company operated 73 retail loan offices
serving 30 states compared to 53 offices serving 18 states at December 31, 1996.
At December 31, 1997, One Stop operated 41 branches serving 39 states, compared
to 30 branches serving 26 states at December 31, 1996.
Recent Developments
The Company has historically securitized on a quarterly basis
substantially all of its loan production and recorded non-cash gain on sale in
accordance with generally accepted accounting principles. The Company operated
on a negative cash flow basis as the significant cash requirements necessitated
by its securitization program exceeded the cash generated by the Company's
operations. The Company recognized a gain on the sale of the loans securitized
upon the closing of the securitization, but actually received the net cash
proceeds over time. In determining the gain recognized at closing, the Company
uses certain estimates as to prepayment rates, discount rates and loan losses.
Since there can be no assurance as to the accuracy of management's estimates,
there is an inherent risk in non-cash gain on sale accounting. See "Certain
Accounting Considerations."
To provide positive cash flow and reduce the risks associated with
securitizations and non-cash gain on sale, the Company adopted a new business
strategy in January 1998. Beginning with the first calendar quarter of 1998, the
Company intends to focus on the sale of loans in the secondary market, either on
a servicing retained or servicing released basis ("whole loan sales"), to
generate cash earnings and reduce its reliance on securitizations. While the
Company intends to continue focusing on increasing its servicing portfolio,
whole loan market conditions may affect the Company's decision to sell loans on
a servicing retained or servicing released basis.
To implement this strategy, the Company is contemplating sponsoring a
real estate investment trust ("REIT") to purchase the Company's mortgage loan
production. It is anticipated that the REIT would operate a correspondent
division with substantially all of the Company's correspondent personnel. In
that event, although the Company would still purchase loans, its correspondent
loan production would materially decrease. The Company may also enter into
strategic alliances with existing mortgage REITs, depository institutions or
other third parties to which the Company would sell its loan production.
Further, depending on conditions in the whole loan market and other
circumstances, the Company may securitize a portion of its loan production in
the future.
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Since the prices paid for whole loans in the secondary market are
generally substantially less than the gains recorded in a securitization, the
Company expects that earnings will decrease. The Company expects, however, that
the quality of its earnings will improve since whole loan sales generate cash
earnings rather than non-cash gain on sale as in securitizations. As a result,
the Company anticipates that this new business strategy will eventually permit
it to operate on a positive cash flow basis.
Consistent with this strategy, the Company has signed a non-binding
letter of intent with Ocwen Financial Corporation ("Ocwen") and Ocwen Asset
Investment Corp. ("OAIC"), a REIT, pursuant to which the Company will sell up to
$600 million of whole loans to a third party on a servicing retained basis. It
is contemplated that the third party will securitize those loans and sell the
residual interest to OAIC. The letter of intent also provides that the Company
would service the loans underlying the residual until they become 60 days
delinquent and Ocwen would assume responsibility for the special servicing of
such loans once they become 60 or more days delinquent.
CERTAIN ACCOUNTING CONSIDERATIONS
As discussed under "Recent Developments," the Company has adopted a new
business strategy designed to provide positive cash flow and reduce the risks
associated with securitizations and non-cash gain on sale. The new strategy
focuses on whole loan sales in the secondary market to generate cash earnings.
The Company, however, will continue to include as an asset its interest-only
strips relating to its earlier securitizations.
Historically, the Company has sold 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 non-cash gain on sale of loans. The cash proceeds are raised
through an offering of the pass-through 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 non-cash 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 non-cash 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) future
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)
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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 on 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 strips 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 has historically used assumptions that it believes are reasonable based
on information from its prior securitizations and the loan-to-value ratios and
credit grade of the loans included in the current securitizations. At December
31, 1997, the Company had reserves of $51.8 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 $16.0 million. The weighted average loan-to-value
ratio of the loans included in the Company's servicing portfolio was 70% as of
December 31, 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.
Additionally, upon sale or securitization of servicing retained
mortgages, the Company capitalizes the fair value of originated mortgage
servicing rights ("OMSRs") 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. The Company also expects reduced levels of OMSRs
associated with whole loan sale transactions.
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RISK FACTORS
Delinquencies and 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 delinquencies
(i.e., loans past due 90 days or more) and losses that may be incurred in each
trust. Losses occur when the liquidation proceeds from disposal of foreclosed
properties, less liquidation expenses, are less than the principal balances of
the loans previously secured by such properties and related interest and
servicing advances (see below). If, at any measuring date, the delinquencies or
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 December 31, 1997, the dollar volume of loans delinquent more than 90
days in the Company's eight securitization trusts formed in November 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 required
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 leading to higher
loss levels also adversely influence the Company's assumptions underlying the
gain on sale in a securitization transaction. Additionally, the higher
delinquency rates permit the monoline insurance company to terminate the
Company's servicing rights with respect to the affected trusts. 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. However, management believes that the temporary disruption
of servicing associated with the recent transfer of servicing in-house from
third parties caused the one month delinquency rate to increase. The delinquency
rate for December 31, 1997 was 14.9% compared to 14.2% at December 31, 1996.
Six of the eight trusts referred to above plus two additional trusts
(representing 9.6% of the dollar volume of the Company's servicing portfolio)
exceeded one of two loss limits at December 31, 1997. The limit that has been
exceeded provides that losses may not exceed a certain threshold (which ranges
from .38% to 1.0% of the original pool balances in the relevant securitization
trusts) on a rolling 12 month basis. Current loss levels have increased due to
recent strategic moves to minimize the real estate owned ("REO") holding period
and reduce carrying costs. Losses are expected to continue to increase due to
the Company's accelerated efforts to sell properties. It is the Company's goal
to reduce the REO holding period to maximize the economics of liquidation
transactions. The other limit, which was not exceeded, provides that losses may
not exceed a certain cumulative threshold (which ranges from 1.3% to 2.0% of the
original pool balances in the relevant securitization trusts) since the
inception of the trust.
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 and the Company believes that the likelihood of such an event is
remote. There can be no assurance, however, that the
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<PAGE> 14
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.
Risk of Adverse Changes in the Secondary Market for Mortgage Loans. The
Company's most important capital resource is 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 or sell whole 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.
Historically, the Company has sold its loans primarily through
securitizations. With its new strategy of selling whole loans in the secondary
market, the Company will rely on institutional purchasers, such as REITs, banks
and other mortgage lenders, to purchase loans directly from the Company. There
can be no assurance that such purchasers will be willing to purchase loans on
terms satisfactory to the Company or that the market for such loans will
continue. To the extent the Company cannot successfully identify whole loan
purchasers or negotiate favorable terms for loan purchases, the Company's
results of operations and financial condition could be materially adversely
affected.
Year 2000 Compliance. The Company is aware of the issues associated with
the programming code in existing computer systems as the millennium (year 2000)
approaches. The "year 2000" problem is pervasive and complex as virtually every
computer operation will be affected in some way by the rollover of two digit
year value to 00. The issue is whether computer systems will properly recognize
date sensitive information when the year changes to 2000. Systems that do not
properly recognize such information could generate erroneous data or cause a
system to fail.
The Company is utilizing both internal and external resources to
identify, correct or reprogram, and test the systems for the year 2000
compliance. As part of the Company's overall systems enhancement program, the
Company has recently committed to purchase a loan origination system that is
year 2000 compliant. It is anticipated that all of the Company's year 2000
compliance efforts will be completed on time. There can be no assurance,
however, that the systems of other companies on which the Company's systems rely
will be timely reprogrammed for year 2000 compliance.
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
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<PAGE> 15
business include the following: negative cash flows and capital needs;
delinquencies, negative impact on cash flow, right to terminate mortgage
servicing; prepayment, basis and credit risk; losses in securitization trusts,
right to terminate mortgage servicing; risks of contracted servicing; 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; risks involved in commercial mortgage lending; competition;
concentration of operations in California; timing of loan sales; economic
conditions; contingent risks; and government regulation. For a more complete
discussion of these risks and uncertainties, see "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 and Form 10-Q for
the quarter ended September 30, 1997.
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<PAGE> 16
RESULTS OF OPERATIONS-THREE AND SIX MONTHS ENDED DECEMBER 31, 1996 AND 1997
The following table sets forth information regarding the components of
the Company's revenue and expenses for the three and six months ended December
31, 1996 and 1997:
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
DECEMBER 31, DECEMBER 31,
1996 1997 1996 1997
-------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Revenue:
Gain on sale of loans ............... $ 56,960 $ 52,443 $113,160 $ 97,164
Net unrealized gain on valuation
of interest-only strips ........... -- 5,726 -- 10,755
Commissions ......................... 7,841 7,161 15,587 13,016
Loan service:
Servicing spread .................... 3,540 5,251 6,547 11,421
Prepayment fees ..................... 1,186 3,263 2,220 5,618
Late charges and other servicing fees 676 1,848 1,295 3,105
Fees and other:
Closing ............................. 689 670 1,536 1,257
Appraisal ........................... 459 634 929 1,135
Underwriting ........................ 333 294 948 540
Interest income ..................... 8,151 10,078 13,044 21,109
Other ............................... 193 286 403 446
-------- -------- -------- --------
Total revenue ....................... $ 80,028 $ 87,654 $155,669 $165,566
-------- -------- -------- --------
Expenses:
Compensation and related expenses ... $ 19,709 $ 24,561 $ 39,033 $ 46,320
Production expenses ................. 6,760 7,541 14,234 13,338
General and administrative expenses . 7,156 9,580 14,718 17,665
Interest expense .................... 7,743 10,819 15,187 20,917
Provision for loan losses ........... 7,150 10,893 16,932 19,463
Nonrecurring charges ................ -- -- 28,108 --
-------- -------- -------- --------
Total expenses ...................... $ 48,518 $ 63,394 $128,212 $117,703
Income before income taxes .......... $ 31,510 $ 24,260 $ 27,457 $ 47,863
Provision for income taxes .......... 13,236 10,917 13,807 21,439
-------- -------- -------- --------
Net income .......................... $ 18,274 $ 13,343 $ 13,650 $ 26,424
======== ======== ======== ========
</TABLE>
REVENUE
Total revenue for the three and six months ended December 31, 1997 was
$87.7 million and $166 million, a 9.6% and 6.4% increase from $80.0 million and
$156 million for the three and six months ended December 31, 1996, respectively.
The increase in total revenue was primarily due to higher loan service income
resulting from the increased size of the Company's servicing portfolio and
higher interest income due to the greater amount of loans carried over as loans
held for sale.
Gain on sale of loans for the three and six months ended December 31,
1997, which included $5.7 million and $10.8 million of an unrealized gain on
valuation of interest-only strips related to loans sold, was $58.2 million and
$108 million, respectively, a 2.1% increase from $57.0
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<PAGE> 17
million and a 4.4% decrease from $113 million for the corresponding periods last
year. The decrease for the six month period was primarily the result of the
lower gain on sale and the smaller mortgage loan pool securitized and sold by
the Company in the first quarter as compared to last year's comparable quarter.
The lower gain on sale reflects the increased prepayment rate assumption used to
record the gain on sale on the Company's securitized ARM product, thereby
reducing the total amount of gain recorded compared to prior periods. During the
three months ended December 31, 1997, the impact of this change was offset by
the lower premiums paid on the quarter's correspondent production. Premiums paid
for loans purchased are netted against the gains recorded on the securitization
or sale of loans. The Company securitized $605 million and $1.11 billion of
loans for the three and six months ended December 31, 1997, respectively,
compared to $603 million and $1.13 billion of loans for the corresponding
periods in the prior year. However, the Company continues to carryover
significantly more loans held for sale than in previous years. Loans held for
sale at December 31, 1997 increased 39% to $216 million from $155 million at
December 31, 1996 and increased 5.9% from $204 million at September 30, 1997.
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 8.2% and 7.9% of total revenue for the three and six months ended
December 31, 1997 compared to 9.8% and 10.0% for the same periods last year.
Commission revenue for the three and six months ended December 31, 1997 was $7.2
million and $13.0 million, down 7.7% and 17%, respectively, when compared to
$7.8 million and $15.6 million for the corresponding periods in the prior year.
The decrease in commissions for the three and six months ended December 31, 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 for the three and six months ended December 31,
1997 increased to $10.4 million and $20.1 million, an increase of 93% and 99%,
respectively, from $5.4 million and $10.1 million for the corresponding periods
in the prior year. 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 OMSRs. The increase in loan service revenue for the
three and six months ended December 31, 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 OMSRs.
The Company's loan servicing portfolio at December 31, 1997 increased to
$3.8 billion, up 65% from $2.3 billion at December 31, 1996. 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-house
servicing grew to $2.8 billion, up 133% from $1.2 billion one year ago.
Additional personnel were added in the second fiscal quarter to allow the
Company to service directly substantially all of its servicing portfolio by the
end of the third fiscal quarter of 1998.
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<PAGE> 18
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.
The Company has historically experienced delinquency rates that are higher
than those prevailing in its industry. With the Company's focus on higher credit
grade loans, delinquencies in the Company's securitized pools have decreased
since September 30, 1996. Management, however, expects 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 some cases, the Company has determined that the proceeds from the
disposal of REO and foreclosed properties are maximized by accelerating
disposition of REO properties rather than holding such properties until market
conditions improve. During the six months ended December 31, 1997, losses
increased over the prior year period due to more aggressive disposition of REO
and foreclosed properties. Losses are expected to continue to increase due to
accelerated efforts to sell properties. It is the Company's goal to reduce the
REO holding period to maximize the economics of liquidation transactions. The
Company has increased its loan loss provision from an average of 1.5% of the
pool balances for the six months ended December 31, 1996 to an average of 1.8%
of the pool balances for the six months ended December 31, 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 Six Months Ended
June 30, December 31,
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% 3.8% 4.0%
Two months ........................................ 1.6 1.8 1.9 1.8 1.4
Three or more months:
Not foreclosed (4) ................................ 5.0 8.0 8.1 7.5 8.3
Foreclosed (5) .................................... 1.5 1.0 1.0 1.1 1.2
----------- ----------- ----------- ----------- -----------
Total ............................................. 12.0% 15.7% 15.3% 14.2% 14.9%
Percentage of dollar amount of loans foreclosed to
loans serviced (period end) (2) ............... 1.2% 1.1% 1.5% .78% 1.1%
Number of loans foreclosed ........................ 159 221(6) 560(6) 211(6) 519(6)
Principal amount of foreclosed loans .............. $ 6,675 $ 14,349 $ 48,029 $ 17,472 $ 41,975
Net losses on foreclosed loans included in pools(7) $ 127 $ 931 $ 5,470 $ 1,804 $ 9,947
Percentage of annualized losses to average
servicing portfolio ............................... .03% .09% .24% .20% .57%
Liquidation loss reserve (8) ...................... $ 3,371 $ 10,300 $ 43,586 $ 25,743 $ 51,833
Servicing portfolio (period end) .................. $ 608,700 $ 1,370,000 $ 3,174,000 $ 2,274,400 $ 3,750,750
</TABLE>
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<PAGE> 19
(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 of
loans originated by One Stop. The Company believes any such adjustment
would not be material.
(3) At December 31, 1997, the dollar volume of loans delinquent more than 90
days in the Company's eight REMIC trusts formed in November 1992 and
during the period from December 1994 to June 1996 exceeded the permitted
limit in the related pooling and servicing agreements. Six of those
trusts plus two additional trusts exceeded certain loss limits. See
"Risk Factors -Delinquencies and Losses in Securitization Trusts; Right
to Terminate Mortgage Servicing."
(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.
(6) The increase in the number of loans foreclosed and principal amount of
loans foreclosed in fiscal year 1997 and six months ended December 31,
1997 relative to fiscal year 1996 and six months ended December 31, 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 for the three and six months ended December 31,
1997 increased 22% and 45% from $9.8 million and $16.9 million, for the three
and six months ended December 31, 1996, to $12.0 million and $24.5 million for
the three and six months ended December 31, 1997. Included in other revenue is
interest income earned on loans in the Company's portfolio held for sale.
Interest income increased for the three and six months ended December 31, 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 10.8% for the
three months ended December 31, 1996 to 10.1% for the three months ended
December 31, 1997. Fees and other revenue also includes fees received by the
Company through its retail loan office network in the form of appraisal,
underwriting and other fees.
EXPENSES
Compensation and related expenses for the three and six months ended
December 31, 1997 increased 25% and 19% from $19.7 million and $39.0 million for
the three and six months ended December 31, 1996, to $24.6 million and $46.3
million for the three and six months ended December 31, 1997. This increase was
primarily due to the continued effort to enhance the loan servicing
infrastructure for the final third party portfolio transfer expected in March
1998 and start up costs due to the expansion of the Company's core production
units. The record expansion in the branch system resulted in the opening of 15
new retail offices and one broker office during the quarter. Generally, new
offices become profitable within three to four months of opening. Compensation
and related expenses as a percentage of total loan originations and purchases
were 4.0% and 4.1% for the three and six months ended December 31, 1997 compared
to 3.1% and 3.5% for the corresponding periods last year.
Production expenses, primarily advertising, outside appraisal costs,
travel and entertainment, and credit reporting fees for the three and six months
ended December 31, 1997 increased 10% and decreased 6.3% from $6.8 million and
$14.2 million for the three and six months ended December 31, 1996, to $7.5
million and $13.3 million for the three and six months ended December 31, 1997.
This six month decrease was primarily due to the 18% reduction in advertising
costs from $10.1 million to $8.3 million for the six months ended December 31,
1996
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<PAGE> 20
and 1997 as the Company continued the use of direct mail over electronic media
and reduced advertising expenditures during the second quarter of 1997. 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 1.2% for both the three and six
months ended December 31, 1997 compared to 1.1% and 1.3% for the corresponding
periods last year.
General and administrative expenses for the three and six months ended
December 31, 1997 increased 33% and 20% from $7.2 million and $14.7 million for
the three and six months ended December 31, 1996, to $9.6 million and $17.7
million for the three and six months ended December 31, 1997. The increase was
primarily the result of increased occupancy and communication costs related to
the Company's retail expansion and increased loan service infrastructure in
connection with the in-house transfer of servicing. In connection with the
Company's implementation of its new loan origination system and other technology
enhancements, the Company expects general and administrative expenses to
increase.
Interest expense for the three and six months ended December 31, 1997
increased 40% and 38% from $7.7 million and $15.2 million for the three and six
months ended December 31, 1996, to $10.8 million and $20.9 million for the three
and six months ended December 31, 1997. The increase was the result of both the
sale in the second quarter of fiscal 1997 of $150 million of the Company's
9.125% Senior Notes due 2003 and the increased borrowings under various
financing arrangements used to fund the origination and purchase of mortgage
loans prior to their securitization and sale in the secondary market. Interest
expense relative to production volume is expected to decrease in future periods
due to reduced reliance on external sources resulting from the benefit of cash
flow related to whole loan sales.
The provision for loan losses for the three and six months ended
December 31, 1997 increased 51% and 15% from $7.2 million and $16.9 million for
the three and six months ended December 31, 1996, respectively, to $10.9 million
and $19.5 million for the three and six months ended December 31, 1997,
respectively. The increase was a result of increased loan loss provisions from
an average of 1.5% of the pool size for the six months ended December 31, 1996
to an average of 1.8% of pool size for the six months ended December 31, 1997.
The increase in loss provision was due to the expected higher loss levels
relating to the Company's strategic shift to higher credit quality loans which
generally have a higher loan-to-value ratio.
In the six months ended December 31, 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 $13.8 million
for the six months ended December 31, 1996 to $21.4 million for the six months
ended December 31, 1997. The effective tax rate increased from 42% for the
quarter ended June 30, 1997 to 45% for the six months
20
<PAGE> 21
ended December 31, 1997. This increase was due to the higher level of taxable
earnings and non-deductible compensation expense during the six month period
ended December 31, 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 $216 million at December 31,
1997. This decline from June 30, 1997 quarter carryover, resulted from the
Company's sale of mortgages exceeding production levels in the first two fiscal
quarters of 1998. 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, decreased from $59.2 million at June 30,
1997, to $41.4 million at December 31, 1997. This decrease was primarily the
result of more timely recovery of amounts previously advanced in pool related
receivables due to the transfer of servicing in-house and the immediate access
to related cash collections.
Interest-only strips. Interest-only strips increased from $270 million
at June 30, 1997 to $327 million at December 31, 1997 reflecting the Company's
non-cash gain on sale from the securitizations in the six months ended December
31, 1997, net of amortization.
Mortgage servicing rights. Mortgage servicing rights increased from
$21.6 million at June 30, 1997 to $28.2 million at December 31, 1997 reflecting
the Company's non-cash gain on sale relating to OMSRs from the securitization in
the six months ended December 31, 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 securitization trust. Residual assets increased from $113 million
at June 30, 1997, to $154 million at December 31, 1997.
Equipment and improvements, net. Equipment and improvements, net,
remained relatively unchanged at approximately $13.0 million at both June 30,
1997 and December 31, 1997.
Prepaid and other assets. Prepaid and other assets increased from $14.9
million at June 30, 1997 to $15.7 million at December 31, 1997.
Borrowings. Borrowings remained unchanged at $287 million for both June
30, 1997 and December 31, 1997.
Revolving warehouse facilities. Amounts outstanding under warehouse
facilities decreased from $138 million at June 30, 1997, to $130 million at
December 31, 1997, primarily as a result
21
<PAGE> 22
of the reduction in mortgage loan carryover. Proceeds from the Company's loan
sales are used to pay down the Company's warehouse facilities.
LIQUIDITY
As discussed under "Recent Developments," the Company's primary
objective is to increase cash flows with the ultimate goal of becoming cash flow
positive. To accomplish these goals, the Company has adopted a strategy of
focusing on selling whole loans in the secondary market and reducing its
reliance on securitizations. Depending on prices in the secondary market, the
Company may continue to operate on a negative cash flow basis.
In addition, the Company's cash flow position will continue to be
impacted by the Company's historical operations. The securitizations completed
by the Company over the past six years have ongoing cash requirements in the
form of reserve accounts or overcollateralization requirements and servicing and
interest advances. To the extent the Company securitizes its loan production in
the future, the positive cash flow expected from whole loan sales would be
offset by the negative cash flow resulting from securitizations.
Both on an historical and continuing basis, the Company's operating
cash requirements include the funding of: (i) mortgage loan originations and
purchases prior to their securitization or 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's historical operations have required continued access to
short-term and long-term sources of cash. 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 improve cash flow
dramatically and reduce the need to access the capital markets with its new
whole loan sale strategy. During the short term, its negative operating cash
flows, subject to limitations under the Company's existing credit facilities,
will be funded principally from borrowings from financial institutions. 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 will be sufficient to fund the
Company's liquidity requirements for at least the next 12 months, if the Company
is able to execute whole loan sale transactions as planned. There can be no
assurance that the Company will be successful in executing whole loan sale
transactions 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 had placed certain
issues of the Company's debt under credit watch. At December 31, 1997, only one
rating agency maintains such
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<PAGE> 23
debt on credit watch. Agency ratings 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
approximately two times stockholders' 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 $605 million
and $1.11 billion of loans for the three and six months ended December 31, 1997,
compared to $603 million and $1.13 billion during the corresponding periods in
the prior year. 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 minimums. The
accumulated amounts of such over- collateralization and cash reserve accounts
are reflected on the Company's balance sheet as "residual assets." At December
31, 1997, the balance was $154 million compared to $70.5 million at December 31,
1996.
In addition, the historical use of securitization transactions as a
funding source by the Company has resulted in a significant amount of non-cash
gain on sale of loans recognized by the Company. During the three and six months
ended December 31, 1997, the Company recognized non-cash gain on sale of loans
in the amounts of $52.4 million and $97.2 million, respectively, compared to
$57.0 million and $113 million during the same periods of the prior year. In
addition, the Company recognized $5.7 million and $10.8 million for the three
and six months ended December 31, 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 non-cash 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. In addition, in the two quarters ended June 30, 1997 and
September 30, 1997 securitizations, the Company sold an interest-only strip
generating cash at the time of settlement in the amount of $2.7 million in the
23
<PAGE> 24
fourth quarter of fiscal 1997, and $5.5 million in the first quarter of fiscal
1998. The new strategy of whole loan cash sales will reduce the amount of gain
the Company can defer for tax purposes.
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 pools sold during the six months
ended December 31, 1997, approximated .62% of the principal amount of the
securitized mortgage loans sold.
CAPITAL RESOURCES
The Company has historically financed 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. The Company's new whole loan sale strategy is
expected to reduce reliance on external financing sources.
Warehouse Facilities. At December 31, 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. The warehouse line bears an interest rate of either 1.05% over the
federal funds rate or .80% over one-month LIBOR and the working capital line
bears an interest rate of either 1.60% over the federal funds rate or 1.35% over
the one month LIBOR. This line is currently scheduled to expire on April 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 March 31, 1998. Management expects, although
there can be no assurance, that the Company will be able to maintain these or
similar facilities in the future. Although external financing dependence is
expected to ease with the future implementation of the new whole loan sale
strategy, the Company will continue to require short term warehouse facilities.
The levels of short term warehouse facilities required is dependent on
production volume levels.
Loan Sales. 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 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. See "Risk Factors - Risk of
Adverse Changes in the Secondary Market for Mortgage Loans."
Other Capital Resources. The Company has historically 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.
24
<PAGE> 25
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. At December 31, 1997, the Company had cash and cash equivalents of
approximately $8.7 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. 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.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings - Not applicable.
Item 2. Changes in Securities - Not applicable.
Item 3. Defaults upon Senior Securities - Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
(a) The Company held its annual meeting of stockholders on
November 19, 1997.
(b) The following directors were elected at the annual meeting to
serve for a three-year term:
George W. Coombe, Jr.
Neil B. Kornswiet
Georges C. St. Laurent, Jr.
25
<PAGE> 26
The following directors continued in office after the annual
meeting:
John C. Getzelman
Dennis F. Holt (resigned from Board on December 23, 1997)
Melvyn Kinder
Lee Masters
Cary H. Thompson
Gregory J. Witherspoon
(c) At the annual meeting, stockholders voted on (1) the election
of the Company's Class I directors; (2) the adoption of the
Company's 1997 Stock Option Plan; and (3) the ratification of
the appointment of Price Waterhouse LLP as the Company's
independent auditors for the fiscal year ending June 30, 1998.
The results of the voting were as follows:
<TABLE>
<CAPTION>
Votes Broker
Matter Votes For Against Withheld Abstentions Non-Votes
- ------ ---------- --------- -------- ----------- ---------
<S> <C> <C> <C> <C> <C>
Election of Directors
George C. Coombe, Jr. 23,422,840 -- 934,694 -- --
Neil B. Kornswiet 23,431,058 -- 926,476 -- --
Georges C. St. Laurent, Jr. 23,442,868 -- 914,666 -- --
- ------ ---------- --------- -------- ----------- ---------
1997 Stock 22,006,620 2,223,997 -- 126,917 --
Option Plan
Auditors 24,141,324 139,196 -- 77,014 --
</TABLE>
(d) Not applicable.
Item 5. Other Information - Not applicable.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
11 Computation of Per Share Earnings
27.1 Financial Data Schedule
(b) Reports on Form 8-K: Current reports on Form 8-K dated October 20,
1997 (reporting Board changes), and November 5, 1997 (reporting
earnings and cash dividend) were filed during the quarter ended
December 31, 1997.
26
<PAGE> 27
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
Dated: February 13, 1998 By: /s/ David A. Sklar
------------------------------------
David A. Sklar
Executive Vice President--Finance
and Chief Financial and Accounting
Officer
27
<PAGE> 28
EXHIBIT INDEX
Exhibit No. Description of Exhibit
- ----------- ----------------------
11 Computation of Per Share Earnings
27.1 Financial Data Schedule
<PAGE> 1
AAMES FINANCIAL CORPORATION
Earnings Per Share
For the three and six months ended December 31, 1996 and 1997
<TABLE>
<CAPTION>
Three months ended Six months ended
December 31, December 31,
---------------------------- -------------------------------
1996 1997 1996 1997
----------- ----------- -------------- -----------
<S> <C> <C> <C> <C>
BASIC EARNINGS PER COMMON SHARE:
Net Income for calculating basic earnings per
common share $18,274,000 $13,343,000 $13,650,000 $26,424,000
=========== =========== =========== ===========
Average common shares outstanding (1) 27,397,000 27,799,000 (1) 25,577,000 27,784,000
----------- ----------- ----------- -----------
BASIC EARNINGS PER COMMON SHARE $ 0.67 $ 0.48 $ 0.53 $ 0.95
=========== =========== =========== ===========
DILUTED EARNINGS PER COMMON SHARE:
Net Income $18,274,000 $13,343,000 $13,650,000 $26,424,000
=========== =========== =========== ===========
Adjust net income to add back the after-tax amount
of interest recognized in the period associated
with the convertible subordinated notes 917,000 862,000 1,875,000 1,760,000
----------- ----------- ----------- -----------
Adjusted net income $19,191,000 $14,205,000 $15,525,000 $28,184,000
=========== =========== =========== ===========
Average common shares outstanding (1) 27,397,000 27,799,000 (1) 25,577,000 27,784,000
Add exercise of options and warrants 2,255,500 1,043,000 2,300,702 1,381,000
Convertible subordinated notes 6,161,000 6,107,000 6,160,715 6,107,000
----------- ----------- ----------- -----------
Diluted shares outstanding 35,813,500 34,949,000 34,038,416 35,272,000
=========== =========== =========== ===========
DILUTED EARNINGS PER COMMON SHARE $ 0.53 $ 0.41 $ 0.45 $ 0.80
=========== =========== =========== ===========
</TABLE>
(1) Shares outstanding at December 31, 1996, adjusted for the three-for-two
stock split in the form of a stock dividend in February 1997.
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> JUN-30-1998
<PERIOD-START> JUL-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 8,691,000
<SECURITIES> 0
<RECEIVABLES> 567,354,000
<ALLOWANCES> 664,000
<INVENTORY> 215,861,000
<CURRENT-ASSETS> 791,242,000
<PP&E> 20,852,000
<DEPRECIATION> 8,017,000
<TOTAL-ASSETS> 804,077,000
<CURRENT-LIABILITIES> 223,899,000
<BONDS> 286,990,000
0
0
<COMMON> 28,000
<OTHER-SE> 293,160,000
<TOTAL-LIABILITY-AND-EQUITY> 804,077,000
<SALES> 165,566,000
<TOTAL-REVENUES> 165,566,000
<CGS> 13,338,000
<TOTAL-COSTS> 13,338,000
<OTHER-EXPENSES> 63,985,000
<LOSS-PROVISION> 19,463,000
<INTEREST-EXPENSE> 20,917,000
<INCOME-PRETAX> 47,863,000
<INCOME-TAX> 21,439,000
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 26,424,000
<EPS-PRIMARY> .95
<EPS-DILUTED> .80
</TABLE>
