SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------
FORM 10-K/A
(Mark one)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
for the Fiscal Year Ended June 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to __________
Commission file number 0-19604
AAMES FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 95-4340340
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
350 S. GRAND AVENUE, LOS ANGELES, CALIFORNIA 90071
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (323) 210-5000
Securities registered pursuant to Section 12(b) of the Act:
Title of each Class Name of each exchange on which registered
COMMON STOCK, PAR VALUE $0.001 NEW YORK STOCK EXCHANGE
PREFERRED STOCK PURCHASE RIGHTS NEW YORK STOCK EXCHANGE
10.50% SENIOR NOTES DUE 2002 NEW YORK STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
At July 30, 1999, there were outstanding 31,016,964 shares of the
Common Stock of Registrant, and the aggregate market value of the shares held on
that date by non-affiliates of the Registrant, based on the closing price
($1.6875 per share) of the Registrant's Common Stock on the New York Stock
Exchange was $49,158,906.75. For purposes of this computation, it has been
assumed that the shares beneficially held by directors and executive officers of
Registrant were "held by affiliates"; this assumption is not to be deemed to be
an admission by such persons that they are affiliates of Registrant.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrant's Proxy Statement dated October 29, 1998 to
Stockholders or an amendment to this Form 10-K are incorporated by
reference in Items 10, 11, 12 and 13 of Part III of this Annual Report.
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Aames Financial Corporation
Index to Form 10-K/A
Aames Financial Corporation (the "Company") hereby amends and restates in their
entirety each of the following items of the Company's Annual Report on Form 10-K
for the fiscal year ended June 30, 1998 filed with the Securities and Exchange
Commission on September 28, 1998.
ITEM NO. PAGE NO.
Part II
6 Selected Financial Data 3
7 Management's Discussion and Analysis of Financial Condition
And Results of Operations 6
7A Quantitative and Qualitative Disclosures About Market Risk 6
8 Financial Statements and Supplementary Data 32
Part IV
14 Exhibits and Reports on Form 8-K 26
Signatures 28
Index to Exhibits 29
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ITEM 6. SELECTED FINANCIAL DATA
As more fully discussed in "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Certain Accounting
Considerations," this Report has been restated to reflect the Company's change
in its practice of measuring and accounting for its interest-only strips to the
cash-out method.
The selected consolidated financial data set forth below with respect
to the Company for the five years ended June 30, 1998 have been derived from the
audited consolidated financial statements. The selected consolidated financial
data should be read in conjunction with the consolidated financial statements
and notes thereto and other financial information included herein. The selected
consolidated financial data gives effect to the acquisition of One Stop
Mortgage, Inc. ("One Stop") in August 1996.
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<PAGE>
<TABLE>
<CAPTION>
FISCAL YEAR ENDED JUNE 30,
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA)
STATEMENT OF INCOME DATA:
Revenue:
<S> <C> <C> <C> <C> <C>
Gain on sale of loans............... $ 120,828 135,421 71,255 15,870 8,705
Net gain or (loss) on valuation
of interest-only strips........... 19,495 (18,950) - - -
Commissions......................... 27,664 29,250 21,564 15,799 16,432
Loan service........................ 51,642 31,131 20,394 8,791 6,099
Fees and other...................... 46,860 37,679 15,215 7,940 5,595
------ ------ ------ ----- -----
Total revenue................... 266,489 214,531 128,428 48,400 36,831
Total expenses...................... 213,683 205,071 89,541 37,788 27,848
------- ------- ------ ------ ------
Income before income taxes.......... 52,806 9,460 38,887 10,612 8,983
Provision for income taxes.......... 25,243 7,982 17,814 4,828 3,684
------ ----- ------ ----- -----
Net income.......................... $ 27,563 1,478 21,073 5,784 5,299
====== ===== ====== ===== =====
Net income per share (diluted)...... $ 0.87 0.05 0.82 0.43 0.41
==== ==== ==== ==== ====
Weighted average number of shares
outstanding (in thousands) (diluted) 35,749 28,371 27,248 13,532 13,127
====== ====== ====== ====== ======
Cash dividends declared
per share $ .13 .13 .13 .13 .13
=== === === === ===
CASH FLOW DATA:
Used in operating activities........ $ (49,661) (280,073) (241,073) (43,375) 13,857)
Used in investing activities........ (5,163) (8,864) (5,885) (988) (870)
Provided by financing activities.... 40,244 291,898 250,540 48,209 22,855
Net increase (decrease) in cash and
cash equivalents.................. (14,580) 2,961 3,582 3,846 8,128
RATIOS AND OTHER DATA:
Return on average common equity(1)..
10.1% 18.6 21.5 10.8 18
Return on average managed receivables(2)
0.8% .1 2.1 1.2 1.6
Loans originated or purchased:
Broker network.................. $ 1,101,200 741,000 319,800 -- --
Retail loans.................... 636,100 436,900 220,900 148,200 30,200
Correspondent loans............. 646,300 1,170,000 628,200 206,800 19,700
------- --------- ------- ------- ------
Total......................... $ 2,383,600 2,347,900 1,168,900 355,000 49,900
========= ========= ========= ======= ======
Whole loans sold.................... $ 416,390 7,500 202,200 -- --
Loans pooled and sold in the secondary market
2,034,300 2,262,700 791,300 316,600 06,800
Loans serviced at period end......... 4,147,100 3,174,000 1,370,000 608,700 81,800
Weighted average commission rate on retail loan
originations(3)..................... 4.3% 4.9 7.7 9.4 12.0
Weighted average interest rate(3)... 10.1 10.6 11.3 11.6 10.3
Weighted average initial combined
loan-to-value ratio(3)(4):
Retail loans...................... 70 67 60 55 52
Broker network.................... 75 71 68 -- --
Correspondent loan................ 79 71 66 65 NM
At period end:
Number of retail loan offices....... 98 56 48 32 27
Number of One Stop branch offices... 52 37 25 -- --
Number of Retail Direct branch
offices............................. 5 -- -- -- -
</TABLE>
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<PAGE>
<TABLE>
<CAPTION>
AT JUNE 30,
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
BALANCE SHEET DATA:
<S> <C> <C> <C> <C> <C>
Cash and cash equivalents........... $ 12,322 26,902 23,941 20,359 16,513
Servicing assets(5)................. 522,632 360,892 167,740 50,421 18,780
Total assets........................ 815,187 717,595 401,524 108,084 53,344
------- ------- ------- ------- ------
10.5% Senior Notes due 2002......... 23,000 23,000 23,000 23,000 --
9.125% Senior Notes due 2003........ 150,000 150,000 -- -- --
5.5% Convertible Subordinated Debentures
due 2006........................... 113,990 113,990 115,000 -- --
Other long-term debt................ - -- 45 144 1,104
----------- --------- --------- -------- -------
Total long-term debt........... 286,990 286,990 138,045 23,144 1,104
Stockholders' equity................ $ 304,051 239,755 120,461 75,797 31,669
- --------------------
<FN>
(1) Excludes nonrecurring charges in the pre-tax amount of $32.0
million during the year ended June 30, 1997.
(2) Represents net income divided by the average servicing portfolio
during the fiscal year presented.
(3) Computed on loans originated or purchased during the fiscal year
presented.
(4) The weighted average initial combined loan-to-value ratio is
determined by dividing the sum of all loans secured by the junior or senior
mortgages on the property by the appraised value at origination.
(5) Represents the sum of interest-only strips and mortgage servicing
rights.
(6) As used throughout this document, interest-only strips includes
overcollateralization amounts.
</FN>
</TABLE>
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<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As more fully discussed below in "-- Certain Accounting
Considerations," this Report has been restated to reflect the Company's change
in its practice of measuring and accounting for its interest-only strips to the
cash-out method.
The following discussion should be read in conjunction with Item 6.
Selected Financial Data and Item 8. Financial Statements and Supplementary Data.
SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION
This Report contains statements that constitute "forward-looking
statements" within the meaning of Section 21E of the Securities Exchange Act of
1934 and Section 27A of the Securities Act of 1933. The words "expect,"
"estimate," "anticipate," "predict," "believe," and similar expressions and
variations thereof are intended to identify forward-looking statements. Such
statements appear in a number of places in this filing and include statements
regarding the intent, belief or current expectations of the Company, its
directors or officers with respect to, among other things (a) market conditions
in the securitization, capital, credit and whole loan markets and their future
impact on the Company's operations, (b) trends affecting the Company's liquidity
position, including, but not limited to, its access to warehouse and other
credit facilities and its ability to effect whole loan sales, (c) the impact of
the various cash savings plans and other restructuring strategies being
considered by the Company, (d) the Company's on-going efforts in improving its
equity position, (e) trends affecting the Company's financial condition and
results of operations, (f) the Company's plans to address the Year 2000 problem
and (g) the Company's business and liquidity strategies. The stockholders of the
Company are cautioned not to put undue reliance on such forward-looking
statements. Such forward-looking statements are not guarantees of future
performance and involve risks and uncertainties. Actual results may differ
materially from those projected in this Report, for the reasons, among others,
discussed under the caption "- Risk Factors." The Company undertakes no
obligation to publicly revise these forward-looking statements to reflect events
or circumstances that arise after the date hereof. Readers should carefully
review the factors referred to above and the other documents the Company files
from time to time with the Securities and Exchange Commission.
RECENT EVENTS
In its regular quarterly review of its interest-only strip, the Company
considered the historical performance of its securitized loan pools, the recent
prepayment experience of those pools, the credit performance of previously
securitized loans and other industry data and determined that it should adjust
each of its assumptions (rate of prepayment, discount rate and credit loss) to
reflect current market conditions. This change in estimate resulted in a
valuation adjustment of the Company's interest-only strips of $191.6 million
(the "Write-Down") in the quarter ended December 31, 1998. The components of the
valuation adjustment were as follows:
Rate of Prepayment. In its valuation analysis of prepayment speeds, the
Company considered the relationship between the rate paid on the certificates or
bonds issued in the securitizations and the weighted average coupons on the
mortgages outstanding in each securitization pool from time to time.
Additionally, For the quarters up to and including September 30, 1998,
prepayment rates used by the Company were held constant, e.g. flat, over the
life of the pool. The estimates used by the Company for the quarters up to and
including September 30, 1998 were flat prepayment rates ranging from 26% for
fixed to 30.5% for adjustable and hybrid loan products. These rates represented
a weighted average loan life of approximately 2.6 to 3.8 years. During the
quarter ended December 31, 1998, the Company finalized the development of an
enhanced analytical model which more precisely reflected the performance of the
securitized loans. This analytical model enabled the Company to refine its
estimate of the prepayment rates associated with the performance of its
securitized loans. Additionally, data and information received from market
participants (credit and capital providers) assisted the Company in its
assessment of current market conditions which resulted in the Company applying a
more precise valuation estimate to its prepayment assumptions. The Company
incorporated this new information in developing its improved judgment as to
prepayment speeds and changed its estimate of prepayment rates from a flat
constant prepayment rate to a vectored rate, which more closely approximates the
performance of the securitized loans. These revised prepayment rates resulted in
a weighted average life of 2.86 years. The impact of the change in prepayment
speeds amounted to approximately $62 million, which was included in the
Write-Down recorded for the quarter ended December 31, 1998.
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Discount Rate. For the quarters up to and including September 30, 1998,
the Company used the weighted average interest rates of the loans included in
the pool as the best estimate available as an appropriate discount rate to
determine fair value. As the market deteriorated in the quarter ended December
31, 1998, it became apparent that a change in discount rate would be required in
order for the estimate of fair value to be consistent with market conditions. To
determine the appropriate discount rate, the Company reviewed general market
conditions as reflected by market sales of senior tranche asset-backed
securities. Management believed that the pass-through rate on senior tranche
securities should be lower than the discount rate applied to the subordinate,
and higher risk, interest-only strips. However, the adversity of the market
during the quarter ended December 31, 1998 was so severe that, in some
instances, transactions of senior tranche asset-backed securities could not even
be completed. Accordingly, the Company incorporated this current market
information in developing its judgment as to the appropriate risk adjusted rate
of return in establishing its change in estimate of the discount rate to be used
in estimating the fair value of the interest-only strips. For the quarter ended
December 31, 1998, the Company increased its discount rate to 15% to reflect
current market conditions. The impact of this change in discount rate amounted
to approximately $65 million, which was included in the Write-Down recorded for
the quarter ended December 31, 1998.
Credit Losses. For the quarter up to and including September 30, 1998,
the Company used a prospective cumulative loan loss estimate of 1.4% of the
balance of the loans in the securitization pools as an appropriate estimate to
determine fair value. This estimate was developed through a review of the credit
performance of securitized loans in the aggregate. In conjunction with its
previous quarterly review of loss estimates, the Company considered the level of
delinquency of securitized loans and the percentage of annualized losses to
securitized loans in the aggregate. As market conditions deteriorated in the
quarter ended December 31, 1998, the Company refined its estimate of credit
losses by expanding the factors it considers in developing its credit loss
estimates to include loss and delinquency information by channel, credit grade
and product, and information available from other market participants such as
investment bankers, credit providers and credit agencies. For the quarter ended
December 31, 1998, the percentage of losses to average servicing portfolio
amounted to 1.08%, a significant increase from the previous quarter's level of
.80%. The Company had seen levels spike to .96% in the quarter ended June 30,
1998 but then subside to the .80% previously noted. This trend was in line with
the Company's assumption that losses were being realized as the servicing
portfolio was transferred in-house from sub-servicers. Management believes the
increase in losses in the December 1998 quarter reflected general market
conditions rather than the continuing effects of the transfer of servicing
in-house. Publicly available information from investment banking firms and
credit agencies began to indicate a market expectation that credit losses within
the sub-prime home equity sector would rise. Those indications, in part, arise
from the impact of the adverse market conditions on severely delinquent
borrowers who, in a more favorable market, would avoid default by refinancing
with other lenders. In the current market, with competition lessening and
underwriting guidelines tightening, these borrowers are much more likely to
default. Accordingly, the Company increased its prospective cumulative loan loss
estimate to 2.7% of the balance of the loans in the securitization pools at
December 31, 1998. This change in credit loss estimate resulted in a valuation
adjustment of $67 million, which was included in the Write-Down recorded for the
quarter ended December 31, 1998.
The Company recently announced that it modified each of its warehouse
and repurchase credit facilities to conform to the financial targets in those
facilities to its results for the quarter ended March 31, 1999 and the expected
results for the quarter ended June 30, 1999.
During the quarter ended March 31, 1999, the Company recorded a net
loss of $36.0 million. Contributing to the net loss was $15.1 million in pre-tax
operating losses and a $37.0 million one-time charge related to monthly and
servicing advances on loans included in securitization trusts for which it
acts as servicer. The Company records those advances as accounts receivable on
its consolidated balance sheet.
The operating loss during the quarter ended March 31, 1999 arose
primarily from the Company's reliance on the whole loan market rather than
securitizations for its loan disposition strategy and, to a lesser extent, on
reduced loan production. The whole loan market is generally less profitable than
the securitization market. Further, the gain on sale recorded for the Company's
whole loan sales during the quarter were less than its cost of production. There
is no assurance that market conditions will not change or other events will not
occur that would preclude or inhibit the Company's ability to complete
securitizations on a quarterly basis.
The one-time charge recorded in the quarter ended March 31, 1999
related to payments made by the Company in connection with securitization trusts
for which it acts as servicer. As servicer of the loans it securitizes, the
Company is obligated to advance, or "loan," to the trusts delinquent interest.
In addition, as servicer, the Company advances to the trusts foreclosure-related
expenses and certain tax and insurance remittances relating to loans in
securitized pools. The Company is then entitled to recover these advances from
regular monthly cash flows into the trusts, including monthly payments, pay-offs
and liquidation proceeds on the related loan. Until recovered, the Company
records the cumulative advances as accounts receivable on its consolidated
balance sheet. In addition, the Company, as servicer, is obligated to make
additional
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<PAGE>
payments into the trusts which are not recoverable from monthly cash flows and,
therefore, should not be included in accounts receivable. These payments, for
example, relate to compensating interest payments for loans that pay-off other
than at a month's end. As servicer, the Company is required to pay into the
trust that portion of a monthly interest payment that is not included in the
pay-off amount. At March 31, 1999, amounts included in accounts receivable that
were not recoverable from monthly principal and interest payments were
charged-off. However, payments into a trust that are not recovered from monthly
cash flows may be recovered from the trust's distributions to the Company as
residual certificate holder.
On December 23, 1998, as amended as of February 10, 1999, June 9, 1999
and July 16, 1999, the Company entered into a Preferred Stock Purchase Agreement
(the "Preferred Stock Purchase Agreement") with Capital Z Financial Services
Fund II, LP, a Bermuda limited partnership ("Capital Z"), pursuant to which
Capital Z agreed to make an equity investment in the Company of up to $126.5
million (the "Capital Z Investment"). The initial phase of the Capital Z
Investment occurred on February 10, 1999 when a partnership majority-owned by
Capital Z (the "Capital Z Partnership"), and other parties designated by Capital
Z, purchased 76,500 shares of Series B Convertible Preferred Stock and Series C
Convertible Preferred Stock for $1,000 per share, for an aggregate investment of
$76.5 million. In connection with this investment, the Company restructured its
Board of Directors. The Board was increased to nine directors, five of whom were
nominated by Capital Z pursuant to the terms of the Preferred Stock Purchase
Agreement. In the second phase which was added to the Preferred Stock Purchase
Agreement by the July 16, 1999 amendment, the Capital Z Partnership purchased
25,000 additional shares of Series C Convertible Preferred Stock for $1,000 per
share, for an aggregate additional investment of $25 million. Subject to the
approval of the amendments to the Company's Certificate of Incorporation by the
Company's stockholders, the third phase of the Capital Z Investment will include
an offering to holders of the Company's common stock of non-transferable rights
to purchase up to approximately $31 million of Series C Convertible Preferred
Stock at $1.00 per share (the "Rights Offering") and a sale to Capital Z or its
designees of up to $25 million of the Series C Convertible Preferred Stock but
only to the extent that the amount sold in the Rights Offering is less than
$25 million.
At the time the warehouse and repurchase facilities were entered into,
the Company and Capital Z had expected to complete the Rights Offering by June
30, 1999 and the original financial targets in the credit facilities reflected
that fact. Because of administrative delays involving the preparation of
documents and filings, the Company currently expects the Rights Offering to
occur in September 1999.
The amendments of the financial targets in the Company's credit
facilities also reflect the expected operational results for the quarter ended
June 30, 1999. The Company expects to incur an operating loss for the quarter
ended June 30, 1999, primarily due to its decision to delay its securitization
until the quarter ended September 30, 1999. During the quarter ended June 30,
1999, the Company relied on the less profitable whole loan market for its loan
disposition strategy.
The Company also recently announced that it had finalized a new
structure to monetize a substantial portion of its accounts receivables related
to the monthly and servicing advances, as well as substantially reduce the
burden of making future monthly and servicing advances on the loans in its
existing servicing portfolio. In connection with this structure, the Company
received approximately $50 million for certain of the monthly and servicing
advances carried on its consolidated balance sheet. Additionally, the Company
received the necessary approvals of the rating agencies, the trustee and the
monoline insurers on its securitization trusts to engage a third party to make a
significant portion of future servicing advances on those pools.
OVERVIEW
For the three years prior to fiscal 1998, the Company's significant
year over year growth was driven primarily by the increases in the volume of
loans purchased in the bulk correspondent business and the sale of the Company's
loan production in securitization transactions. The combination of these two
business strategies significantly contributed to the Company's operating on a
negative cash flow basis which was funded by the Company regularly accessing the
public equity and debt markets. In the fourth quarter of fiscal 1997, primarily
as a reaction to the uncertainties in those capital markets, the Company decided
to reduce its bulk loan purchases and focus on the less cash intensive core
retail and broker loan production units and its servicing division. The results
for the year ended June 30, 1998 reflect these strategic decisions in the record
levels of retail and broker loan production, increased expenses due to expedited
retail and broker loan office expansion and increased expenses to accommodate
the significant increase in the Company's in-house servicing portfolio. The
results for the year ended June 30, 1998 also reflect the Company's new loan
disposition strategy which relies on a
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combination of securitizations and whole loan sales for cash depending on market
conditions, profitability and cash flows.
CERTAIN ACCOUNTING CONSIDERATIONS
RESTATEMENT OF PRIOR PERIOD RESULTS. In December 1998, the Financial
Accounting Standards Board (the "FASB") issued, in question and answer format,
"A Guide to Implementation of Statement 125 on Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, Questions and
Answers, Second Edition" (the "Special Report"). The Special Report indicates
that two methods have arisen in practice for accounting for credit enhancements
relating to securitization. These methods are the cash-in method and the
cash-out method. The cash-in method treats credit enhancements (pledged loans or
cash) as belonging to the Company. As such, these assets are recorded at their
face value as of the time they are received by the trust. The cash-out method
treats credit enhancements as assets owned by the related securitization trust.
As such, these assets are treated as part of the interest-only strips and are
recorded at a discounted value for the period between when collected by the
trust and released to the Company. The Special Report indicates that if no true
market exists for credit enhancement assets, the cash-out method should be used
to measure the fair value of credit enhancements.
The Company has historically used the cash-in method to account for its
interest-only strips. However, during the three months ended December 31, 1998,
the Company retroactively changed its practice of measuring and accounting for
its interest-only strips to the cash-out method in response to the FASB's
Special Report and to public comments from the Securities and Exchange
Commission released on December 8, 1998.
Under the cash-in method previously used by the Company, the assumed
discount period for measuring the present value of the interest-only strips
ended when the cash flows were received by the securitization trust, and, the
initial deposits to overcollateralization accounts were recorded at face value.
Under the cash-out method now required by the FASB and Securities and Exchange
Commission, the assumed discount period for measuring the present value of the
interest-only strips ends when cash, including the return of any initial
deposits, is distributed to the Company on an unrestricted basis.
The change to the cash-out method results only in a difference in the
timing of revenue recognition from a securitization and has no effect on the
total cash flows of securitization transactions. While the total amount of
revenue recognized over the term of a securitization is the same under either
method, the cash-out method results in lower initial gains on the sale of loans
due to the longer discount period, and higher subsequent loan service revenue
resulting from the impact of discounting cash flows.
As a result, the Company's consolidated results of operations for
periods subsequent to June 30, 1994 have been restated. The aggregate pretax
amount of this change in accounting is $67.1 million.
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The restatement resulted in the following changes to prior financial
information (dollars in thousands, except per share amounts):
<TABLE>
<CAPTION>
YEAR ENDED JUNE 30,
--------------------------------------
1998 1997 1996 1995
------------- ------------- ------------- ---------
<S> <C> <C> <C> <C>
Revenue:
Previous $286,110 238,578 141,840 54,939
As restated 266,489 214,531 128,428 48,400
Net income:
Previous 40,317 17,109 29,791 10,034
As restated 27,563 1,478 21,073 5,784
Earnings per share:
Basic:
Previous 1.41 0.65 1.37 0.74
As restated 0.97 0.06 0.97 0.43
Diluted:
Previous 1.23 0.60 1.14 0.74
As restated 0.87 0.05 0.82 0.43
</TABLE>
Interest-only strips:
<TABLE>
<CAPTION>
YEAR ENDED JUNE 30,
--------------------------------------
1998 1997 1996 1995
------------- ------------- ------------- ---------
<S> <C> <C> <C> <C>
(end of period)
Previous 554,161 383,249 173,789 56,960
As restated 490,542 339,251 153,838 50,421
Stockholders' equity:
(end of period)
Previous 345,403 268,354 133,429 80,047
As restated 304,051 239,755 120,461 75,797
</TABLE>
The Company's loan disposition strategy relies on a combination of
securitization transactions and whole loan sales. 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 represents the difference between the proceeds
(including premiums) from the sale, net of related transaction costs, and the
allocated carrying amount of the loans sold. The allocated carrying amount is
determined by allocating the original amount of loans (including premiums paid
on loans purchased) between the portion sold and any retained interests
(interest-only strip), based on their relative fair values at the date of
transfer. The interest-only strip represents, over the estimated life of the
loans, the present value of the estimated cash flows. These cash flows are
determined by 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%), a monoline insurance fee, if any, a back-up
service fee, if any, and an estimate for loan losses. In quarters where the
Company engaged in a securitization transaction, net gains or losses in
valuation of interest-only strips includes the recognition of a gain or loss
which represents the initial difference between the allocated carrying amount
and the fair market value of the interest-only strip at the date of sale.
Additionally, increases or decreases in valuation of the interest-only strips
are also recognized as net gains or losses in valuation of interest-only strips.
Each agreement that the Company has entered into in connection with its
securitizations requires either the overcollateralization of the trust or the
establishment of a reserve account that may initially be funded by cash
deposited by the Company.
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: (i) future
rate of prepayment; (ii) discount rate used to calculate present value; and
(iii) credit losses on loans sold. There can be no assurance of the accuracy of
management's estimates.
RATE OF PREPAYMENT. 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), 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 and other industry data. The rate of prepayment may be affected
by a variety of economic and other factors.
Generally, a declining interest rate environment will result in
prepayments on higher credit grade loans. For fiscal 1998 and 1997, prepayment
rates held constant over the life of the pool used in the valuation of the
interest-only strips ranged from 26% to 30.5% and 23.5% to 38.3%, respectively.
These rates represent a weighted average loan life of approximately 2.6 to 3.8
years and 2.6 to 3.9 years for the years ended June 30, 1998 and 1997,
respectively. See "- Revenue" and "- Risk Factors -- Prepayment Risk."
DISCOUNT RATE. In order to determine the fair value of the cash flow
from the interest-only strips, the Company discounts the cash flows based upon
rates prevalent in the market. During the fiscal year ended June 30, 1998, the
Company used the weighted average interest rates of the loans included in the
pool as the best estimate available for an appropriate discount rate to
determine fair value.
CREDIT LOSSES. During the fiscal year ended June 30, 1998, in
determining the estimate for credit losses on loans securitized, the Company
used assumptions that it believed were reasonable based on information from its
prior securitizations, the loan-to-value ratios and credit grades of the loans
included in the current securitizations. During the three years ended June 30,
1998, the Company used a prospective cumulative loan loss estimate of 1.4% of
the balance of its loans in the securitization as an appropriate estimate to
determine
Page 10
<PAGE>
fair value. Losses ranged from 0.09% to .72% of the average servicing portfolio
for the fiscal years ended June 1996, 1997 and 1998. The weighted average
loan-to-value ratio of the loans serviced by the Company was 72% as of June 30,
1998.
The interest-only strips are recorded at estimated fair value and are
marked to market through a charge (or credit) to earnings. On a quarterly basis,
the Company reviews the fair value of the interest-only strips by analyzing its
prepayment, discount rate and loss assumptions in relation to its actual
experience and current rates of prepayment and loss prevalent in the industry
and may adjust or take a charge to earnings through an adjustment to net gain or
loss on valuation of interest-only strips.
In its regular quarterly review of its interest-only strip, the Company
considered the historical performance of its securitized loan pools, the recent
prepayment experience of those pools, the credit performance of previously
securitized loans and other industry data and determined that the pools were
performing in line with management's expectations and that no adjustment was
warranted at June 30, 1998.
(See "Recent Events," "- Risk Factors -- Credit Risk." See "- Revenue.")
Additionally, upon sale or securitization of servicing retained
mortgages, the Company capitalizes the fair value of mortgage servicing rights
("MSRs") 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.
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 ending after December 15, 1997. The Company adopted SFAS 129
in Fiscal 1998.
In June 1997, the FASB issued SFAS 130, "Reporting Comprehensive
Income" ("SFAS 130"). SFAS 130 establishes disclosure standards for reporting
comprehensive income in a full set of general purpose financial statements. SFAS
130 is effective for fiscal years beginning after December 15, 1997. The
adoption of this standard is not expected to have an impact on the Company's
financial position or results of operations.
In June 1997, the FASB issued SFAS 131, "Disclosures about Segments of
an Enterprise and Related Information" ("SFAS 131") which is effective for
periods beginning after December 15, 1997. SFAS 131 establishes standards for
the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to stockholders. It also establishes standards for related
disclosures about products and services, geographic areas and major customers.
The adoption of this standard is not expected to have an impact on the Company's
financial position or results of operations.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," effective for fiscal years beginning after
June 15, 2000. SFAS No. 133 requires companies to record derivatives on the
balance sheet as assets and liabilities, measured at fair value.
11
<PAGE>
RESULTS OF OPERATIONS -- FISCAL YEARS 1998, 1997 AND 1996
The following table sets forth information regarding the components of
the Company's revenue and expenses in fiscal 1998, 1997 and 1996:
<TABLE>
<CAPTION>
1998 1997 1996
--------------------- --------------------- ---------------------
DOLLARS Percentage Dollars Percentage Dollars Percentage
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Revenue:
Gain on sale of loans....... $ 120,828 45.3% $ 135,421 63.1% $ 71,255 55.5
Net gain (loss) on
valuation of interest-only
strips ................... 19,495 7.3 (18,950) (8.8) -- --
Commissions................. 27,664 10.4 29,250 13.6 21,564 16.8
Loan Service:
Servicing spread.......... 32,392 12.2 21,592 10.1 14,875 11.6
Prepayment fees........... 11,761 4.4 5,815 2.7 3,229 2.5
Late charges and
other servicing fees..... 7,489 2.8 3,724 1.7 2,290 1.8
Fees and other:
Closing................... 2,668 1.0 2,723 1.3 2,512 2.0
Appraisal................. 2,617 1.0 1,854 0.9 1,167 0.9
Underwriting.............. 1,085 0.4 1,382 0.6 1,600 1.2
Interest income........... 40,110 15.1 31,160 14.5 9,127 7.1
Other..................... 380 0.10 560 0.3 809 0.6
--------- ----- --------- ------ --------- --------
Total revenue......... $ 266,489 100.0% $ 214,531 100.00% $ 128,428 100.0
========= ===== ========= ====== ========= ========
Expenses:
Compensation.............. $ 94,820 35.6% $ 81,021 37.8% $ 40,758 31.7%
Production ............... 34,195 12.8 27,229 12.7 19,036 14.8
General and
administrative ......... 40,686 15.3 31,716 14.8 17,377 13.5
Interest ................. 43,982 16.5 33,105 15.4 12,370 9.6
Nonrecurring charges...... -- -- 32,000 14.9 -- --
--------- ----- --------- ----- --------- -----
Total expenses........ $ 213,683 80.2% $ 205,071 95.6% $ 89,541 69.6%
========= ===== ========= ===== ========= =====
Income before income taxes.... 52,806 19.8% $ 9,460 4.4% 38,887 30.4%
Income taxes.................. 25,243 9.5 7,982 3.7 17,814 13.9
---- ----- --------- ----- --------- -----
Net income............ $ 27,563 10.3% $ 1,478 0.7% $ 21,073 16.5%
========= ===== ========= ===== ========= =====
</TABLE>
REVENUE
Total revenue for fiscal 1998 increased $52.0 million, or 24.2%, from
total revenue for fiscal 1997, which, in turn, increased $86.1 million, or
67.0%, over total revenue in fiscal 1996. Total revenues include a $19.5 million
net gain and a $19.0 million net loss (see below) on valuation of the Company's
interest-only strips during the years ended June 30, 1998 and 1997,
respectively.
The increase in total revenue from the year ended June 30, 1997 to the
year ended June 30, 1998 was primarily due to an increase in net gain (loss) on
valuation of interest-only strips and the increase in loan service revenue,
offset by a decline in gain on sale of loans. The net loss on valuation of
interest-only strips during the year ended June 30, 1997 was due primarily to
the $28.0 million net unrealized loss on its interest-only strips recorded by
the Company in the fourth quarter of fiscal 1997. This unrealized loss was due
primarily to an increase in prepayment rates in certain of the Company's
adjustable rate loans in some of its earlier pools. Increased loan service
revenues during the year ended June 30, 1998 are a result of the continued
growth in the Company's servicing portfolio and the successful transfer in-house
of $1.47 billion of mortgage loans previously subserviced by others.
Increases in total revenue during the year ended June 30, 1997 compared
to the year ended June 30, 1996 were primarily the result of increased gain on
sale, offset by a net loss on valuation of interest-only strips, increased
interest income and increased loan service revenue. These increases resulted
from the significantly higher volumes of mortgage loans originated and purchased
by the Company and securitized and sold in fiscal 1997 which more than offset
the effects of the net loss on valuation of interest-only strips recorded in
that
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<PAGE>
year. The Company originated and purchased $2.35 billion of mortgage loans
during the year ended June 30, 1997 versus $1.17 billion of mortgage loans
during the year ended June 30, 1996. The substantial loan volume increase in
1997 over 1996 was due primarily to the increase in loans purchased through the
Company's correspondent loan division, loans originated through the independent
mortgage broker network and, to a lesser extent, the expansion of the retail
network.
Gain on sale, net of gain or loss on valuation of interest-only strips,
increased by $23.9 million, or 20.5% during the year ended June 30, 1998
compared to the year ended June 30, 1997 and $45.2 million, or 63.4%, during
1997 compared to the year ended June 30, 1996. The increase in 1998 over 1997
was primarily due to the net loss on valuation on interest-only strips recorded
in 1997. Fiscal 1998's gain on sale, net of gain or loss on valuation of
interest-only strips, as compared to fiscal 1997's, reflects gains recorded on
substantially the same total volumes of loan production but with a larger
percentage of the volume comprised of more profitable retail and broker loan
production as opposed to less profitable bulk correspondent loan production.
Premiums paid on the purchase of correspondent loans are recorded as an offset
to gain on sale. Total loan production for fiscal 1998 was $2.38 billion.
However, the fiscal 1998 gains reflect the lower premiums earned on whole loan
sales closed during the 1998 fiscal year. Generally, the gain recorded in a
whole loan sale is less than that recorded in a securitization. During fiscal
1998, the Company sold a total of $2.45 billion of loans, $2.03 billion of which
was sold in securitization transactions and $416 million of which was sold in
whole loan sales for cash. During fiscal 1997, the Company sold a total of $2.27
billion of loans, substantially all of which were sold in securitization
transactions. Further, gains recorded on loans securitized in fiscal 1998 were
negatively affected by reduced spreads and increased prepayment rate assumptions
established in the fourth fiscal quarter of 1997. The weighted average servicing
spread (the weighted average interest rate on the pool of loans sold over the
sum of the investor pass-through or bond rate and the monoline insurance fee, if
any) on loans securitized and sold during these periods was 3.91%, 4.16% and
4.93% for fiscal 1998, 1997 and 1996, respectively. The decreased weighted
average servicing spread reflects a decrease in weighted average interest rates
on pooled loans due primarily to the higher percentage of higher credit grade
loans included in the loans securitized during the year and the current interest
rate environment. The larger percentage of higher credit grade loans included in
the loans securitized during fiscal 1998 and 1997 reflects the Company's
previously announced diversification of its loan originations and purchases to
include more A, A-, B and C credit grade loans.
Commissions earned on loan originations continue to be an important
component of total revenue, although to a lesser degree than in prior years,
comprising 10.4%, 13.6% and 16.8% of total revenue in fiscal 1998, 1997 and
1996, respectively. Commissions decreased $1.59 million, or 5.4%, in fiscal year
1998 compared to fiscal 1997 and increased $7.69 million, or 36%, in fiscal 1997
compared to fiscal 1996. Commission revenue is primarily a function of the
volume of mortgage loans originated by the Company through its retail loan
office network, the credit grade of the loans originated and the weighted
average commission rate charged on such loans. The decrease in fiscal 1998
reflects the lower weighted average commission rate charged. The increase in
commissions in fiscal 1997 was a result of increased origination volume,
offsetting a decline in weighted average commission rate. The weighted average
commission rate was 4.3%, 4.9% and 7.7% during fiscal 1998, 1997 and 1996,
respectively. The lower weighted average commission rate in fiscal 1998 and
fiscal 1997 reflected the increase of higher credit grade loans originated
through the Company's retail loan office network, which generally carry lower
commission rates, and competitive factors. Commissions do not include $2.66
million and $1.18 million of commissions on loans which were held for sale as of
June 30, 1998 and 1997, respectively and deferred in accordance with GAAP.
Loan service revenue increased $20.5 million, or 65.9% in fiscal 1998
compared to fiscal 1997 and $10.7 million, or 52.5%, in fiscal 1997 compared to
fiscal 1996. Loan service revenue consists of prepayment fees, late charges and
other fees retained by the Company in connection with the servicing of loans
reduced by amortization of the MSR and increased by accretion of the
interest-only strips. See "-- Certain Accounting Considerations." The increase
in loan service revenue in fiscal 1998 primarily reflects the successful
transfer of $1.47 billion of loans previously subserviced by third parties and,
to a lesser extent, interest-only strip accretion of $10.7 million offset by
$9.1 million in amortization of the Company's MSRs. During fiscal 1997, loan
service revenue was increased by $10.3 million in accretion of interest-only
strips and reduced by $5.5 million in amortization of MSRs. As of June 30, 1998,
of the Company's $4.15 billion servicing portfolio, 95% was serviced in-house.
At June 30, 1997, 47% of the Company's servicing portfolio was serviced
in-house. The Company's loan servicing portfolio increased to $4.15 billion at
June 30, 1998, up 31% from the June 30, 1997 balance of $3.17 billion which, in
turn, increased 131% from the June 30, 1996 balance of $1.37 billion. Management
believes that the business of loan servicing provides a more consistent revenue
stream and is less cyclical than the business of loan origination and
purchasing.
Fees and other revenue increased by $9.18 million, or 24%, in fiscal
1998 compared to fiscal 1997 and increased $22.5 million, or 148%, in fiscal
1997 compared to fiscal 1996. Fees and other revenue consist of fees received by
the Company through its retail loan office network in the form of closing,
appraisal, underwriting and other fees, plus interest income. The dollar amount
of these fees
13
<PAGE>
increased in each of the years presented due to the larger number of mortgage
loans originated through the Company's retail loan office network during the
respective periods. Interest income increased during the period 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 declining weighted average interest rates on loans held.
EXPENSES
Compensation expense increased $13.8 million, or 17.0%, in fiscal 1998
compared to fiscal 1997 and $40.3 million or 98.9% in fiscal 1997 compared to
fiscal 1996. The increases were primarily due to the continued effort to
accommodate increased origination volumes, core origination channel expansion
and increased in-house servicing. Compensation and related expenses as a
percentage of total loan originations and purchases were 4.0% for fiscal 1998
and 3.5% for fiscal 1996 and 1997.
Production expense increased $7.0 million, or 25.6%, in fiscal 1998
compared to fiscal 1997 and $8.2 million, or 43%, in fiscal 1997 compared to
fiscal 1996. These increases were primarily due to increased origination volume
and continued expansion into new geographical areas requiring concentrated
marketing efforts. Production costs as a percentage of total origination volume
were 1.4%, 1.2% and 1.6% for fiscal 1998, 1997 and 1996, respectively.
General and administrative expense increased $8.97 million, or 28%, in
fiscal 1998 compared to fiscal 1997 and $14.3 million, or 83%, in fiscal 1997
compared to fiscal 1996. These increases were primarily the result of increased
occupancy and communication costs related to the Company's core origination
channel expansion and increased origination volumes.
Interest expense increased to $44.0 million in fiscal 1998 from $33.1
million in fiscal 1997 and $12.4 million in fiscal 1996. These increases were
primarily the result of increased borrowings under various financing
arrangements used to fund the origination and purchase of mortgage loans prior
to their securitization or sale in the secondary market and as a result of the
Company's sale of $115 million of its 5.5% Convertible Subordinated Debentures
due 2006 in the third quarter of fiscal 1996 and $150 million of its 9.125%
Senior Notes due 2003 in the second quarter of fiscal 1997. Interest expense is
expected to increase in future periods due to the Company's continued reliance
on external financing to fund operations.
In fiscal 1997, the Company incurred $32.0 million of nonrecurring
charges. Approximately $25 million of these charges were recognized in August
1996 directly related to the acquisition of One Stop. The remaining amount
relates to an accrual for relocating corporate headquarters recorded in the
first fiscal quarter and to severance and other strategic decisions made in the
fourth fiscal quarter.
INCOME TAXES
The Company's provision for income taxes increased to $25.2 million in
1998 from $8.0 million in 1997 and $17.8 million in 1996, primarily as a result
of the fluctuation in pre-tax income after consideration of tax impact of
nonrecurring charges. The effective tax rate declined to 47.8% in fiscal 1998
from 84.4% in 1997 as a result of an adjustment in the Company's tax reserve to
more accurately reflect the risk of assessments on previously filed tax returns.
FINANCIAL CONDITION
LOANS HELD FOR SALE. The Company's portfolio of loans held for sale
decreased to $198.2 million at June 30, 1998 from $243.0 million at June 30,
1997. This decrease is directly related to production volume and the size of the
Company's securitizations and sales in the secondary market during the period.
ACCOUNTS RECEIVABLE. Accounts receivable representing servicing fees
and advances and other receivables, decreased to $51.1 million at June 30, 1998
from $59.2 million at June 30, 1997. This decrease reflects improved cash flows
related to the transfer in-house of mortgage loans previously serviced by third
parties offset by higher advances related to the delinquencies in the Company's
servicing portfolio. The level of servicing related advances, in any given
period, is dependent on delinquencies, the volume of real estate owned and loans
in the process of foreclosure in the servicing portfolio and the timing of cash
collections.
INTEREST-ONLY STRIPS. Interest-only strips increased to $490.5 million
at June 30, 1998 from $339.3 million at June 30, 1997 reflecting the non-cash
gain recognized on the Company's securitizations, net of $10.7 million of
accretion, during 1998. See "- Certain Accounting Considerations."
14
<PAGE>
MORTGAGE SERVICING RIGHTS. Mortgage servicing rights increased to $32.1
million at June 30, 1998 from $21.6 million at June 30, 1997 reflecting the
capitalization of mortgage servicing rights, offset by $9.1 million in
amortization, on the Company's securitizations during 1998. See "- Certain
Accounting Considerations."
EQUIPMENT AND IMPROVEMENTS, NET. Primarily as a result of the Company's
expansion and the associated investment in technology, equipment and
improvements, net, increased to $13.9 million at June 30, 1998 from $12.7
million at June 30, 1997.
PREPAID AND OTHER. Prepaid and other assets increased to $17.0 million
at June 30, 1998 from $14.9 million at June 30, 1997 primarily as a result of
the Company's growth.
BORROWINGS. Borrowings remained consistent at $287.0 million at June
30, 1998 and 1997.
REVOLVING WAREHOUSE FACILITIES. Amounts outstanding under revolving
warehouse facilities increased to $141.0 million at June 30, 1998 from $137.5
million at June 30, 1997. Although the Company's loans held for sale decreased
at June 30, 1998, outstanding amounts on warehouse facilities increased
slightly. This resulted from the negative cash flow from operations during the
year ended June 30, 1998 and the resulting decrease in working capital.
LIQUIDITY
The Company's operations require continued access to short-term and
long-term sources of cash. The Company's primary operating cash requirements
include the funding of: (i) mortgage loan originations and purchases prior to
their securitization or sale, (ii) fees, expenses and hedging costs, if any,
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 non-cash 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, (vii) advances in connection with the Company's servicing
portfolio, and (viii) costs associated with expanding the Company's core
production units.
The Company funds 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 operating and financing cash flow and reduce the need to access the
public equity and debt markets by selling a portion of its loan production in
the whole loan market for cash. In addition, the completion of the $38 million
capital infusion in April 1998 provided the Company with a significant source of
cash for expanding operations and additional flexibility in loan disposition
strategy.
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. Warehouse indebtedness is not
included in the indebtedness limitations. 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 and interest-only
strips allocable to post-September 1996 securitizations is limited to 75% of the
difference between such post-September 1996 residuals and interest-only strips
and $225 million.
The Company's loan disposition strategy consists of a combination of
securitizations and whole loan sales. During the years ended June 30, 1998, 1997
and 1996, the Company securitized $2.03 billion, $2.26 billion and $791.3
million of loans, 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.
Overcollateralization requirements increase up to approximately twice the level
otherwise required when the delinquency rates exceed the specified limit. As of
June 30, 1998, the Company was required to maintain an additional $89.9 million
in overcollateralization amounts as a result of the level of its delinquency
rates above that which would have been required to be maintained if the
applicable delinquency rates had been below the specified limit. Of this amount,
at June 30, 1998, $69.3 million remains to be added to the overcollateralization
amounts from future spread income on the loans held by these trusts.
15
<PAGE>
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.
The Company also incurs certain expenses in connection with
securitizations, including underwriting fees, credit enhancement fees, trustee
fees, hedging and other costs, which in fiscal 1998 approximated .60% of the
principal amount of the securitized mortgage loans.
CAPITAL RESOURCES
The Company has historically financed its operating cash requirements
primarily through (i) revolving warehouse facilities and working capital lines
of credit, (ii) the securitization or sale of mortgage loans, and (iii) the
issuance of debt and equity securities.
REVOLVING WAREHOUSE AND OTHER FACILITIES. At June 30, 1998, the Company
had three warehouse facilities in place with total borrowing capacity of $950
million with expirations ranging from September 1998 to April 1999. On Agust
19, 1998, the Company obtained a fourth warehouse facility from a financial
institution providing for a maximum borrowing capacity of $300 million which
expires on February 15, 1999. The Company will continue to require short term
warehouse facilities. The levels of short-term warehouse facilities required is
dependent on production volume levels and the timing of loan sales in the
secondary market. See "- Risk Factors -- Dependence on Funding Sources."
In September 1998, the Company entered into a revolving line of credit
with a maximum borrowing capacity of $50 million secured by certain of the
Company's interest-only strips. The collateral is subject to mark-to-market
valuation, or may otherwise be deemed unacceptable, in the sole discretion of
the lender. To the extent such provisions result in a shortfall, the line
provides for the term out of the loan or the delivery of additional collateral
to bring the line back into compliance. This line expires on September 3, 1999.
Additionally, in September 1998, the Company entered into a repurchase
facility secured by multifamily residential and commercial mortgage loans. The
repurchase facility provides for a maximum borrowing amount of $50 million. The
repurchase facility bears an interest rate for each transaction mutually agreed
upon by the Company and the financial institution at the time of the
transaction. The repurchase facility expires on September 9, 1999.
LOAN SALES. The Company's ability to sell loans originated and
purchased by it in the secondary market is necessary 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 -- Dependence on Funding Sources."
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, October 1996 and April 1998, the Company effected
offerings of its common stock with net proceeds to the Company aggregating $217
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 with various operating
and financial covenants including covenants which may restrict the Company's
ability to pay certain distributions, including dividends. At June 30, 1998, the
Company had available $52.5 million for the payment of such distributions under
the most restrictive of such covenants.
On April 27, 1998, the Company issued 2.78 million shares of its common
stock, or 9.9% of the Company's outstanding shares, to private entities
controlled by Ronald Perelman and Gerald Ford, at an aggregate purchase price of
approximately $38 million. The Company also issued warrants to these entities to
purchase an aggregate additional 9.9% of the Company's stock at an exercise
price of $17.2031 (125% of the purchase price of the stock), subject to
customary anti-dilution provisions. The warrants are exercisable only upon a
change in control of the Company and expire in three years. See "Item 1.
Business - Recent Events."
The Company had cash and cash equivalents of approximately $12.3
million (of which $1.6 million was restricted) at June 30, 1998. See "- Risk
Factors -- Negative Cash Flow and Capital Needs."
16
<PAGE>
YEAR 2000 COMPLIANCE AND TECHNOLOGICAL ENHANCEMENTS
The Company's year 2000 compliance program consists of four phases--
inventory, risk assessment process, corrective action and testing. The Company
has completed the inventory phase which included the identification of all
computer hardware and software, electronic data exchanges, operating systems,
communications systems and non-information items. As a corollary to the
inventory phase, the Company is making inquiries of its significant vendors as
to their year 2000 readiness.
The Company has also completed the risk assessment process of assigning
risk factors to each system used by the Company to determine the priority and
resource allocation of its year 2000 efforts. The Company expects to complete
the corrective action and testing phases with respect to mission critical
systems by September 1999. The Company will complete any remaining testing and
compliance by the end of 1999.
COSTS TO ADDRESS THE COMPANY'S YEAR 2000 ISSUES. The Company
anticipates that costs relating to year 2000 issues are not expected to be
material since the Company primarily relies on third party software for its
primary information technology systems and does not require significant internal
reprogramming resources to change program codes. The Company is in the process
of converting or is scheduled to convert its major computer systems, including
the loan origination system and the financial system from in-house to vendor-
supported systems. These conversions were planned to upgrade and improve
functionality rather than as a result of year 2000 issues.
RISKS OF THE COMPANY'S YEAR 2000 ISSUES. The most significant risk
associated with the Company's year 2000 compliance would result from the loss of
the Company's vendor supported servicing system and the inability to maintain
the ongoing loan service operations, including payment processing, collections
and investor remittance processing. The Company's servicing platform uses
software supplied by a subsidiary of Fiserv, Inc. To reduce the risk of
non-compliance, the Company intends to rely on the vendor's representations
regarding year 2000 compliance, the Company's testing efforts, as well as the
testing results of other companies that use the same software. The testing and
other costs relating to the Company's year 2000 compliance program are not
expected to be material.
Another year 2000 risk relates to the Company's vendor supported loan
origination system. In the event of year 2000 issues with respect to the
software used with such system (also supplied by a subsidiary of Fiserv, Inc.),
the Company's ability to originate loans would be diminished and may result in
reduced loan production until the problem is resolved. The Company intends to
rely on the vendor's assurances and Company testing to minimize the risk of
non-compliance of this system.
CONTINGENCY PLANS. The Company has no reason to believe that its most
significant systems will not be year 2000 compliant. If testing indicates any of
the systems are not compliant, the Company will develop appropriate contingency
plans.
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. At June 30, 1998, the Company hedged its fixed rate pipeline
and some LIBOR-based tranches in its fixed rate securitizations. The fixed rate
hedge products utilized at June 30, 1998 were 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 was an interest rate contract with a
specified LIBOR rate cap. The amount and timing of hedging transactions are
determined by members of the Company's senior management. During the first
quarter ending September 30, 1998, market conditions became extremely unsettled
resulting in a break down in the historical relationship between U.S. Treasury
securities and the pass-through rates on asset-backed securitizations.
Historically, the use of an interest rate hedge against Treasuries had been a
more conservative method of limiting interest rate risk. Changes in Treasury
rates were generally reflected in the pass-through rates of the fixed rate
portion of the Company's securitizations. However, during the first quarter
ending September 30, 1998, current market conditions resulted in a loss on the
Company's Treasury hedge without receiving an equivalent benefit from reductions
in the pass- through rates paid on the certificates sold on the fixed rate
portion of the Company's fiscal 1999 securitization. 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.
FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET ACTIVITIES
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SECURITIZATIONS - HEDGING INTEREST RATE RISK. The most significant
variable in the determination of gain on sale in a securitization is the spread
between the weighted average coupon on the securitized loans and the
pass-through interest rate. In the interim period between loan origination or
purchase and securitization of such loans, the Company is exposed to interest
rate risk. The majority of loans are securitized within 90 days of origination
or purchase. However, a portion of the loans are held for sale or securitization
for as long as 12 months (or longer, in very limited circumstances) prior to
securitization. If interest rates rise during the period that the mortgage loans
are held, the spread between the weighted average interest rate on the loans to
be securitized and the pass-through interest rates on the securities to be sold
(the latter having increased as a result of market rate movements) would narrow.
Upon securitization, this would result in a reduction of the Company's related
gain on sale. In the fiscal year ended June 30, 1998, the Company mitigated this
exposure through swap agreements with third parties that sell United States
Treasury securities not yet purchased and the purchase of Treasury Put Options.
Hedge gains or losses are initially deferred and subsequently included in gain
on sale upon completion of the securitization. With respect to the Company's
securitizations, gain on sale included hedge losses of $1.30 million and $3.04
million in fiscal 1998 and 1997, respectively. These hedging activities help
mitigate the risk of absolute movements in interest rates but they do not
mitigate the risk of a widening in the spreads between pass-through certificates
and U.S. Treasury securities with comparable maturities.
At June 30, 1998, the Company had outstanding notional balances of such
Treasury swap agreements in the amount of $250 million. This position expired on
September 30, 1998 and had a market value at June 30, 1998 of $248 million. The
Company had a similar position at June 30, 1997 in the notional amount of $135
million. This position expired on September 30, 1997 and had a market value at
June 30, 1997 of $135 million. These transactions are subject to Treasury
interest rate fluctuation and require cash settlement at expiration or voluntary
termination.
The Company also had LIBOR cap contracts outstanding at June 30, 1998
and 1997 in the notional amount of $17.5 million and $106 million, respectively.
These positions were valued at par at both fiscal year ends as their contractual
cap (strike price) exceeded the LIBOR market rate at June 30, 1998 and 1997. The
June 30, 1998 position expires December 23, 1998 and the June 30, 1997 position
had expiration dates from March 30, 1998 to December 23, 1998. These instruments
have no negative risk above the original premiums paid in cash. However, if the
LIBOR market rate exceeds the contractual cap, the Company will receive cash in
settlement.
The following table presents information about the Company's financial
instruments and derivative financial instruments that are sensitive to changes
in interest rate. For loans held for sale and for liabilities with contractual
maturities, the table presents principal cash flows and related weighted average
interest rates by contractual maturities as well as the Company's historical
prepayment experience. Derivative financial instruments include treasury put
options and LIBOR rate caps. Both derivative instruments are presented at their
notional balances and related weighted average rates. The rate disclosed for the
treasury contracts is the locked or purchased rate. The LIBOR cap rate is the
average strike price above which the contract would begin paying cash to the
Company.
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<TABLE>
<CAPTION>
1999 2000 2001 2002 2003 THEREAFTER TOTAL FAIR VALUE
----------- ---------- -------- ------- ------- ---------- ------ -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
RATE SENSITIVE ASSETS:
Loans held for sale:
Fixed rate mortgage loans $ 18,116 32,975 26,712 19,020 31,451 31,941 142,215 149,326
Weighted average rate 10.08% 10.08% 10.08% 10.08% 10.08% 10.08% 10.08% NA
Variable rate mortgage loans $ 9,034 17,989 12,522 4,048 3,058 9,336 55,987 58,786
Weighted average rate 10.45% 10.95% 11.45% 11.95% 11.95% 11.95% 9.95% NA
RATE SENSITIVE LIABILITIES:
Borrowings:
Fixed rate $ 5,750 5,750 5,750 5,750 - 263,990 286,990 246,938
Weighted average rate 7.74% 7.68% 7.62% 7.56% 7.56% 7.56% 7.80% NA
Variable rate $ 141,012 - - - - - 141,012 141,012
Weighted average rate 9.04% - - - - - 8.04% NA
RATE SENSITIVE DERIVATIVE
FINANCIAL INSTRUMENTS:
Treasury put options $ 250,000 - - - - - 250,000 248,455
Average locked rate 5.62% - - - - - 5.62% NA
LIBOR rate caps $ 17,514 - - - - - 17,514 9
Average strike price 7.00% - - - - - 7.00% NA
</TABLE>
INTEREST-ONLY STRIPS AND MSRS - The Company had interest-only strips of
$490.5 million and $339.3 million outstanding at June 30, 1998 and 1997,
respectively. The Company also had MSRs outstanding at June 30, 1998 and 1997 in
the amount of $32.1 million and $21.6 million, respectively. Both of these
instruments are valued at market at June 30, 1998 and 1997. The Company values
these assets based on the present value of future revenue streams net of
expenses using various assumptions. The discount rate used to calculate the
present value of the interest-only strips and MSRs was 10.8% and 11.4% at June
30, 1998 and 1997. The weighted average life used for valuation at June 30, 1998
was 2.6 to 3.8 years and at June 30, 1997 was 2.6 to 3.9 years.
These assets are subject to risk in accelerated mortgage prepayment or
losses in excess of assumptions used in valuation. Ultimate cash flows realized
from these assets would be reduced should prepayments or losses exceed
assumptions used in the valuation. Conversely, cash flows realized would be
greater should prepayments or losses be below expectations.
FAIR VALUE OF FINANCIAL INSTRUMENTS. The Company's financial
instruments are recorded at contractual amounts that approximate market or fair
value. As these amounts are short term in nature and/or generally bear market
rates of interest, the carrying amounts of these instruments are reasonable
estimates of their fair values. The carrying amount of the Company's long-term
debt approximates fair value when valued using available quoted market prices.
Off balance sheet financial instruments are based on quoted market prices.
CREDIT RISK. The Company is exposed to on-balance sheet credit risk
related to its loans held for sale and interest-only strips. The Company is
exposed to off-balance sheet credit risk related to loans which the Company has
committed to originate or purchase.
The Company is a party to financial instruments with off-balance sheet
credit risk in the normal course of business. These financial instruments
include commitments to extend credit to borrowers and commitments to purchase
loans from correspondents. The Company has a first or second lien position on
all of its loans, and the combined loan-to-value ratio ("CLTV") permitted by the
Company's mortgage underwriting guidelines generally may not exceed 90%. The
CLTV represents the combined first and second mortgage balances
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as a percentage of the appraised value of the mortgaged property, with the
appraised value determined by an appraiser with appropriate professional
designations. A title insurance policy is required for all loans.
WAREHOUSING EXPOSURE. The Company utilizes revolving warehouse
financing facilities to fund the holding of mortgage loans prior to
securitization. As of June 30, 1998 and 1997, the Company had total warehouse
facilities available in the amount of $950 million and $600 million,
respectively; the total outstanding related to these facilities was $141.0
million and $137.5 million at June 30, 1998 and 1997, respectively. Warehouse
facilities are typically for a term of one year or less and are designated to
fund mortgages originated within specified underwriting guidelines. The majority
of the assets generally remain in the facilities for a period of up to 90 days
at which point they are securitized or sold to institutional investors. As these
amounts are short term in nature and/or generally bear market rates of interest,
the contractual amounts of these instruments are reasonable estimates of their
fair values.
RISK FACTORS
NEGATIVE CASH FLOW AND CAPITAL NEEDS
We operate on a negative cash flow basis (our cash expenditures exceed
our cash earnings). Our negative cash flow arises mostly from our use of
securitization to sell our loans. Each time we enter into a securitization
transaction, we transfer a significant amount of loans that we recently
originated or purchased to a separate entity, usually a trust. In exchange for
the loans, we receive cash and an interest in the loans securitized. Our
interest in the loans securitized is evidenced by the non-cash gain on sale we
record at the closing of the securitization. The cash we receive from the trust
is raised through the trust's sale of certificates or bonds. These certificates
or bonds give the holders the right to receive principal payments on the
securitized loans and the interest rate on the certificate or bond. The interest
rate on the loans is higher than, usually substantially so, the interest rate on
the certificates or bonds. The amount of that excess spread provides the basis
for the non-cash gain we record at the closing. The actual amount of the gain is
reduced by fees paid to us as servicer of the loans (collecting interest and
managing delinquencies and foreclosures) and fees paid to an insurance company
for a credit-enhancement policy, if one is issued. The gain recorded also
reflects our estimate of the life of the loans (most of our loans prepay in
under 3 years even though substantially all have 30 year terms) and estimated
losses on the loans. A risk adjusted discount rate is then applied to the
estimated cash flows. The end result is our non-cash gain on sale. The amount of
the gain is added to the interest-only strips carried on our balance sheet. The
interest-only strips represents the aggregate amount of gain on sale recorded on
all of our securitizations. This amount is adjusted through amortization
(payments received by the trusts) and actual prepay or loss performance that is
different from our original estimates. In a securitization, we record as income
the non-cash gain on sale of the loans securitized upon the closing of the
securitization. We receive the cash representing the gain over the actual life
of the loans securitized.
Our primary uses of cash relate to our use of securitizations to sell
our loans. These uses include:
o mortgage loan originations and purchases before their securitization
and sale;
o fees, expenses and hedging costs, if any, incurred for the
securitization of loans;
o cash reserve accounts or overcollateralization required in the
securitization and sale of loans;
o tax payments generally due on recognition of non-cash gain on sale
recorded in the securitizations;
o ongoing administrative and other operating expenses;
o interest and principal payments under our credit facilities and other
existing indebtedness;
o cash advances made on delinquent loans included in our loan servicing
portfolio; and
o costs of expanding our loan production units.
We used net cash in operating activities for fiscal 1998, 1997 and 1996
of $49.7 million, $280.1 million and $241.1 million, respectively. Therefore, we
require continued access to short- and long-term external sources of cash to
fund our operations.
In the past, we have relied on the public equity and debt markets to
meet our cash needs. We adopted two business strategies during the fourth
quarter of 1977: reduce cash used for bulk loan purchases and selling larger
amounts of loans in whole loan sales for cash. These steps were designed to
reduce our reliance on the public equity and debt markets for cash.
Our primary sources of cash are expected to be cash from sales of
equity, warehouse (loan origination) facilities and working capital facilities.
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If available at all, the type, timing and terms of financing selected
by us will be dependent upon our cash needs, the availability of other financing
sources, limitations under debt covenants and the prevailing conditions in the
financial markets. However, we are not sure that these sources of cash will be
available when needed. Even if the sources of cash are available, the providers
of cash may impose terms that are not favorable to us. As a result of the
limitations described above, we may be restricted in the amount of loans that we
will be able to produce and sell.
DELINQUENCIES AND LOSSES IN SECURITIZATION TRUSTS; RIGHT TO TERMINATE MORTGAGE
SERVICING; NEGATIVE IMPACT ON CASH FLOW
A substantial majority of our servicing portfolio consists of loans
securitized by us and sold to real estate mortgage investment conduits or owner
trusts in securitization transactions. Generally, the agreement entered into in
connection with these securitizations contains specified limits on delinquencies
(i.e., loans past due 90, or in some cases 60, days or more) and losses that may
be incurred in each trust. Losses occur when the cash we receive from the sale
of foreclosed properties, less sales expenses, is less than the principal
balances of the loans previously secured by those properties and related
interest and servicing advances (see below).
A majority of our securitization transactions were credit-enhanced by
an insurance policy issued by a monoline insurance company. That insurance
policy protects the securitization investor against certain losses. If, at any
measuring date, the delinquencies or losses with respect to any trust
credit-enhanced by monoline insurance were to exceed the delinquency or loss
limits applicable to that trust, provisions of the agreements permit the
monoline insurance company to terminate our rights to service the loans in the
affected trust.
Higher delinquency rates hurt our cash flows. When delinquency rates
exceed the limit specified in the securitization agreement, our right to receive
cash from the trust is delayed. When delinquency rates exceed the specified
amount, we are required to use the cash flows from the trust to make accelerated
payments of principal on the certificates or bonds issued by the trust. These
accelerated payments increase the overcollateralization levels (the amount that
the principal balance of the loans in the trust exceeds the principal balance of
the certificates or bonds issued by the trust). We do not receive distributions
from the trust until after the required overcollateralization levels are met.
Generally, provisions in the securitization agreements have the effect of
requiring the overcollateralization amount to be increased up to approximately
twice the level otherwise required when the delinquency rates do not exceed the
specified limit. As of June 30, 1998, we were required to maintain an additional
$89.9 million in overcollateralization amounts as a result of the level of the
delinquency rates above that which would have been required to be maintained if
the applicable delinquency rates had been below the specified limit. Of this
amount, at June 30, 1998, $69.3 million remains to be added to the
overcollateralization amounts from future spread income on the loans held by
these trusts.
Higher delinquency rates also negatively affect our cash flows because
we act as servicer of the loans in the trust. As the servicer, we are required
to use our cash to pay (advance) to the trust past due interest.
Higher delinquency and loss levels may also affect our reported
earnings. We apply certain assumptions with respect to expected losses on loans
in a securitization trust to determine the amount of non-cash gain on sale that
we record at the closing of a securitization transaction. If actual losses
exceed those assumptions, we may be required to take a charge to earnings. The
charge to earnings would result in an adjustment to the carrying value of the
interest-only strips recorded on our balance sheet.
At June 30, 1998, the dollar volume of loans delinquent more than 90
days in our 12 securitization trusts formed in November 1992, December 1992 and
June 1993 and during the period from December 1994 to December 1996 exceeded the
permitted limit in the related securitization agreements.
We have implemented various plans to lower the delinquency rates in our
future trusts, including diversifying the loans we originate and purchase to
include higher credit grade loans. The delinquency rate at June 30, 1998 was
15.6% and at June 30, 1997 was 15.3%.
Seven of the twelve trusts referred to above (representing in the
aggregate 10.0% of the dollar volume of our servicing portfolio) exceeded one of
two loss limits at June 30, 1998. The limit that has been exceeded provides that
losses may not exceed a certain threshold (which ranges from .38% to .56% of the
original pool balances in the relevant securitization trusts) on a rolling 12
month basis.
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Although the monoline insurance company has the right to terminate
servicing with respect to the trusts that exceed the delinquency and loss
limits, no servicing rights have been terminated and we believe that it is
unlikely that we will be terminated as servicer. We cannot be sure, however,
that our servicing rights with respect to the mortgage loans in such trusts, or
any other trusts which exceed the specified delinquency or loss limits in future
periods, will not be terminated.
We believe that current loss levels have increased in part due to our
recently implemented strategy of minimizing the period of time foreclosed
properties are held before sale. In this way, we reduce carrying costs. The
implementation of this strategy accelerated the volume of foreclosed properties
sold. Current loss levels have also increased due to the aging of the lower
credit grade loans purchased in bulk and included in our earlier securitization
trusts. The losses incurred on those lower credit grade loans are higher than we
originally anticipated. We no longer purchase large volumes of lower credit
grade loans in bulk purchases. We expect the accelerated efforts to sell
properties to have a short-term impact on loss levels. We expect the aging of
the lower credit grade bulk portfolio and the current origination of higher
credit grade loans to contribute to an increase in losses over time.
RISK OF CHANGES IN INTEREST RATE ENVIRONMENT
A substantial and sustained increase in long-term interest rates could,
among other things:
o decrease the demand for consumer credit;
o adversely affect our ability to originate or purchase loans; and
o reduce the average size of loans we underwrite.
A significant decline in long-term interest rates could increase the
level of loan prepayments. An increase in prepayments would decrease the size
of, and servicing income from, our servicing portfolio. Our expectations as to
prepayment are used to determine the amount of non-cash gain on sale recorded at
the closing of a securitization transaction. An increase in prepayment rates
could result in a charge to earnings if the rate is faster than originally
expected. The charge to earnings would result in an adjustment to the carrying
value of the interest-only strips recorded on our balance sheet.
A substantial and sustained increase in short-term interest rates
could, among other things,
o increase our borrowing costs (most of which are tied to those rates);
and o reduce the gains recorded by us upon the securitization and sale
of loans.
YEAR 2000 COMPLIANCE AND TECHNOLOGY ENHANCEMENTS
As part of our overall systems enhancement program, we are using both
internal and external resources to identify, correct, reprogram or replace, and
test our systems for year 2000 compliance. It is anticipated that all of our
year 2000 compliance efforts will be completed on time. We cannot be sure,
however, that the systems of other companies on which our systems rely will be
timely reprogrammed for year 2000 compliance.
Certain state regulatory authorities have imposed early deadlines for
year 2000 compliance. We are unable to meet those deadlines. If we are unable to
satisfy those regulators that our year 2000 compliance effort is adequate, our
license to conduct business in a state could be revoked or not renewed.
We have recently installed and are testing a year 2000 compliant loan
origination system that is expected to add approximately $2.0 million per year
to our technology costs over the next three years. Other technology enhancements
are being reviewed but, to date, the costs for those enhancements have not been
determined.
PREPAYMENT RISK
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
adjusted through a charge to earnings in the period of adjustment. The rate of
prepayment of loans may be affected by a variety of economic and other factors.
We estimate prepayment rates based on our expectations of future prepayment
rates, which are based, in part, on the historic performance of our loans and
other considerations.
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CREDIT RISK
Loans made to borrowers in the lower credit grades have historically
resulted in a higher risk of delinquency and loss than loans made to borrowers
who use conventional mortgage sources. We believe that the underwriting criteria
and collection methods we use permit us to mitigate the higher risks inherent in
loans made to these borrowers. However, we cannot be sure that those criteria or
methods will protect us against those risks. In the event that loans we
originate and purchase experience higher delinquencies, foreclosures or losses
than anticipated, our results of operations or financial condition could be
adversely affected.
All of our loans are collateralized by residential property. The value
of the property collateralizing our loans may not be sufficient to cover the
principal amount of the loans in the event of liquidation. Losses not covered by
the underlying properties could have a material adverse effect on our results of
operations and financial condition. In addition, historical loss rates affect
the assumptions used by us in computing our non-cash gain on sale. If actual
losses exceed those assumptions, we may be required to take a charge to
earnings.
Adjustable rate loans account for a substantial portion of the mortgage
loans that we originate or purchase. Substantially all of the adjustable rate
mortgages include a "teaser" rate, i.e., an initial interest rate significantly
below the fully indexed interest rate at origination. Although these loans are
underwritten at the indexed rate as of the first adjustment date,
credit-impaired borrowers may encounter financial difficulties as a result of
increases in the interest rate over the life of the loan.
BASIS RISK
The value of our 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 (including fixed initial rate
mortgage) loans in a securitization trust bear interest based on an index or
adjustment period that is different from the certificates or bonds issued by the
trust. Accordingly, in the absence of effective hedging (loss mitigation)
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 certificates or bonds issued by a securitization trust could adjust faster
than the interest rates on our ARMs in the trust. 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. 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 certificates or bonds issued by a securitization trust
could increase without limitation by caps, while the interest rates on our ARMs
would be so limited.
DEPENDENCE ON FUNDING SOURCES.
We use cash draws under credit facilities, referred to as revolving
warehouse and repurchase facilities, to fund new originations and purchases of
mortgage loans before securitization or sale. At June 30, 1998, we had aggregate
borrowing capacity of approximately $950 million with financial institutions and
investment banks. To the extent that we are unable to maintain existing
facilities, arrange new warehouse, repurchase or other credit facilities or
obtain additional commitments to sell whole loans for cash, we may have to
curtail loan origination and purchasing activities. This would have a material
adverse effect on our financial position and results of operations and
jeopardize our ability to continue to operate as a going concern.
RISK OF ADVERSE CHANGES IN THE SECONDARY MARKET FOR MORTGAGE LOANS.
We must be able to sell loans we originate and purchase in the
securitization and whole loan market to generate cash proceeds to pay down our
warehouse and repurchase facilities and fund new originations and purchases. Our
ability to sell loans in the securitization and whole loan markets on acceptable
terms is essential for the continuation of our loan origination and purchase
operations. The value of and market for our loans are dependent upon a number of
factors, including general economic conditions, interest rates and governmental
regulations.
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We have in the past sold a substantial portion of our loans through
securitizations, and will again securitize a significant portion of our loans.
To facilitate the sale of certificates or bonds issued by the securitization
trust, we must obtain investment grade ratings for the certificates or bonds. To
obtain those credit ratings, we credit-enhance the securitization trust. The
overcollateralization amount (the amount by which the principal amount of the
loans in the securitization trust exceeds the principal amount of the
certificates or bonds issued by the trust) is one form of credit enhancement.
Additionally, we either obtain an insurance policy to protect holders of the
certificates or bonds against certain losses, or sell subordinated interests in
the securitization trusts.
Our financial position and results of operations would be materially
affected if investors were unwilling to purchase interests in our securitization
trusts or monoline insurance companies were unwilling to provide financial
guarantee insurance for the certificates or bonds sold. Other accounting, tax or
regulatory changes could also adversely affect our securitization program.
We rely on institutional purchasers, such as investment banks,
financial institutions and other mortgage lenders, to purchase our loans in the
whole loan market. We cannot be sure that the purchasers will be willing to
purchase loans on satisfactory terms or that the market for such loans will
continue. Our results of operations and financial condition could be materially
adversely affected if we could not successfully identify whole loan purchasers
or negotiate favorable terms for loan purchases.
DEPENDENCE ON BROKER NETWORK
We depend on independent mortgage brokers for the origination and
purchase of our broker loans, which constitute a significant portion of our loan
production. These independent mortgage brokers negotiate with multiple lenders
for each prospective borrower. We compete with these lenders for the independent
brokers' business on pricing, service, loan fees, costs and other factors. Our
competitors also seek to establish relationships with such brokers, who are not
obligated by contract or otherwise to do business with us. Our future results of
operations and financial condition may be vulnerable to changes in the volume
and cost of its broker loans resulting from, among other things, competition
from other lenders and purchasers of such loans.
COMPETITION
We face intense competition in the business of originating, purchasing
and selling mortgage loans. Competition among industry participants can take
many forms, including convenience in obtaining a loan, customer service,
marketing and distribution channels, amount and term of the loan, loan
origination fees and interest rates. Many of our competitors are substantially
larger and have considerably greater financial, technical and marketing
resources than we do. Our competitors in the industry include other consumer
finance companies, mortgage banking companies, commercial banks, investment
banks, credit unions, thrift institutions, credit card issuers and insurance
companies. In the future, we may also face competition from government-sponsored
entities, such as FNMA and FHLMC. These government-sponsored entities may enter
the subprime mortgage market and target potential customers in our highest
credit grades, who constitute a significant portion of our customer base.
The historical level of gains realized on the sale of subprime mortgage
loans could attract additional competitors into this market. Certain large
finance companies and conforming mortgage originators have announced their
intention to originate, or have purchased companies that originate and purchase,
subprime mortgage loans, and some of these large mortgage companies, thrifts and
commercial banks have begun offering subprime loan products to customers similar
to our targeted borrowers. In addition, establishing a broker-sourced loan
business requires a substantially smaller commitment of capital and human
resources than a direct- sourced loan business. This relatively low barrier to
entry permits new competitors to enter this market quickly and compete with our
broker lending business.
Additional competition may lower the rates we can charge borrowers and
increase the cost to purchase loans, which could potentially lower the gain on
future loan sales or securitizations. Increased competition may also reduce the
volume of our loan origination and loan sales and increase the demand for our
experienced personnel and the potential that such personnel will leave for
competitors.
Competitors with lower costs of capital have a competitive advantage
over us. During periods of declining rates, competitors may solicit our
customers to refinance their loans. In addition, during periods of economic
slowdown or recession, our borrowers may face financial difficulties and be more
receptive to the offers of our competitors to refinance their loans.
Our correspondent and broker programs depend largely on independent
mortgage bankers and brokers and other financial
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institutions for the purchases of new loans. Our competitors also seek to
establish relationships with the same sources.
CONCENTRATION OF OPERATIONS IN CALIFORNIA
At June 30, 1998, 24.4% of the loans we serviced were collateralized by
residential properties located in California. Because of this concentration in
California, our financial position and results of operations have been and are
expected to continue to be influenced by general trends in the California
economy and its residential real estate market. Residential real estate market
declines may adversely affect the values of the properties collateralizing
loans. If the principal balances of our loans, together with any primary
financing on the mortgaged properties, equal or exceed the value of the
mortgaged properties, we could incur higher losses on sales of properties
collateralizing foreclosed loans. In addition, California historically has been
vulnerable to certain natural disaster risks, such as earthquakes and
erosion-caused mudslides, which are not typically covered by the standard hazard
insurance policies maintained by borrowers. Uninsured disasters may adversely
impact our ability to recover losses on properties affected by such disasters
and adversely impact our results of operations.
TIMING OF LOAN SALES
Our loan disposition strategy calls for substantially all of our
production to be sold in the secondary market each quarter. However, market and
other considerations, including the conformity of loan pools to monoline
insurance company and rating agency requirements, could affect the timing of the
sale transactions. Any delay in the sale of a significant portion of our loan
production beyond a quarter-end would postpone the recognition of gain on sale
related to such loans until their sale and would likely result in losses for the
quarter.
ECONOMIC CONDITIONS
The risks associated with our business become more acute in any
economic slowdown or recession. Periods of economic slowdown or recession may be
accompanied by decreased demand for consumer credit and declining real estate
values. Any material decline in real estate values reduces the ability of
borrowers to use home equity to support borrowings. Material declines in real
estate values also weakens collateral coverage and increases the possibility of
a loss in the event of liquidation. Further, delinquencies, foreclosures and
losses generally increase during economic slowdowns or recessions. Because of
our focus on credit-impaired borrowers, the actual rates of delinquencies,
foreclosures and losses on such loans could be higher than those generally
experienced in the mortgage lending industry. In addition, in an economic
slowdown or recession, our servicing costs may increase. Any sustained period of
increased delinquencies, foreclosure, losses or increased costs could adversely
affect our ability to securitize or sell loans in the secondary market and could
increase the cost of these transactions. See "-- Credit Risk" and "-- Risk of
Adverse Changes in the Secondary Market for Mortgage Loans."
CONTINGENT RISKS
Although we sell substantially all the mortgage loans which we
originate or purchase, we retain some degree of credit risk on substantially all
loans sold where we continue to service (collect loan payments and manage late
payments and defaults). During the period of time that loans are held before
sale, we are subject to the various business risks associated with the lending
business including the risk of borrower default, the risk of foreclosure and the
risk that a rapid increase in interest rates would result in a decline in the
value of loans to potential purchasers. Cash flows from the securitization trust
are represented by the interest rate earned on the loans in the trust over the
amount of interest paid by the trust to the holders of the certificates or bonds
issued by the trust, plus certain monoline and servicing fees. The agreements
governing our securitization program require us to credit-enhance the
securitization trust by either establishing deposit accounts or building
overcollateralization levels. Deposit accounts are established by maintaining a
portion of the excess cash flows in a trust deposit account.
Overcollateralization levels are built up by applying these excess cash flows to
reduce the principal balances of the certificates or bonds issued by the trust.
Those amounts are available to fund losses realized on loans held by such trust.
We continue to be subject to the risks of default and foreclosure following
securitization and the sale of loans to the extent excess cash flows are
required to be maintained in the deposit account or applied to build up
overcollateralization, as opposed to being distributed to us. In addition,
agreements governing our securitization program and whole loan sales require us
to commit to repurchase or replace loans which do not conform to our
representations and warranties at the time of sale.
When borrowers are delinquent in making monthly payments on loans
included in a securitization trust, as servicer of the
25
<PAGE>
loans in the trust, we are required to advance interest payments with respect to
such delinquent loans. These advances require funding from our capital
resources, but have priority of repayment from collections or recoveries on the
loans in the related pool in the succeeding month.
In the ordinary course of our business, we are subject to claims made
against us by borrowers and private investors arising from, among other things,
losses that are claimed to have been incurred as a result of alleged breaches of
fiduciary obligations, misrepresentations, errors and omissions of our employees
and officers, incomplete documentation and failures to comply with various laws
and regulations applicable to our business. We believe that liability with
respect to any currently asserted claims or legal actions is not likely to be
material to our financial position or results of operations. However, any claims
asserted in the future may result in legal expenses or liabilities which could
have a material adverse effect on our financial position and results of
operations.
GOVERNMENT REGULATION
Our operations are subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and are subject
to various laws and judicial and administrative decisions imposing requirements
and restrictions on part or all of our operations. Our consumer lending
activities are subject to the Federal Truth-in-Lending Act and Regulation Z
(including the Home Ownership and Equity Protection Act of 1994), the Federal
Equal Credit Opportunity Act, as amended, and Regulation B, the Fair Credit
Reporting Act of 1970, as amended, the Federal Real Estate Settlement Procedures
Act and Regulation X, the Home Mortgage Disclosure Act, the Federal Debt
Collection Practices Act and the National Housing Act of 1934, as well as other
federal and state statutes and regulations affecting our activities. We are also
subject to the rules and regulations of, and examinations by, state regulatory
authorities with respect to originating, processing, underwriting, selling,
securitizing and servicing loans. These rules and regulations, among other
things, impose licensing obligations on us, establish eligibility criteria for
mortgage loans, prohibit discrimination, govern inspections and appraisals of
properties and credit reports on loan applicants, regulate assessment,
collection, foreclosure and claims handling, investment and interest payments on
escrow balances and payment features, mandate certain disclosures and notices to
borrowers and, in some cases, fix maximum interest rates, fees and mortgage loan
amounts. Failure to comply with these requirements can lead to loss of approved
status, certain rights of rescission for mortgage loans, class action lawsuits
and administrative enforcement action.
Members of Congress and government officials have from time-to-time
suggested the elimination of the mortgage interest deduction for federal income
tax purposes, either entirely or in part, based on borrower income, type of loan
or principal amount. Because many of our loans are made to borrowers for the
purpose of consolidating consumer debt or financing other consumer needs, the
competitive advantages of tax deductible interest, when compared with
alternative sources of financing, could be eliminated or seriously impaired by
such government action. Accordingly, the reduction or elimination of these tax
benefits could have a material adverse effect on the demand for loans of the
kind offered by us.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are attached to this report:
Reports of Independent Accountants
Consolidated Balance Sheet at June 30, 1998 and 1997
Consolidated Statement of Income for Fiscal Years Ended June
30, 1998, 1997 and 1996 Consolidated Statement of
Stockholders' Equity for Fiscal Years Ended June 30, 1998,
1997 and 1996 Consolidated Statement of Cash Flows for Fiscal
Years Ended June 30, 1998, 1997 and 1996 Notes to Consolidated
Financial Statements
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES and REPORTS ON FORM 8-K
(a) Financial Statements:
See Financial Statements listed as part of Item 8. Financial
Statements and Supplementary Data
(b) The exhibits filed in response to Item 601 of Regulation S-K
are listed in the Index to Exhibits
26
<PAGE>
(c) Reports on Form 8-K:
During the last quarter of the fiscal year ending June 30,
1998, the Company filed (i) a Current Report on form 8-K dated
April 24, 1998 (earliest event reported in April 10, 1998),
reporting information under Item 5 with respect to the
execution of the Second Amended and Restated Mortgage Loan
Warehousing Agreement by and among the Company, ACC,
NationsBank of Texas, N.A. and the lenders from time to time
party thereto; and (ii) a Current Report on Form 8-K dated
April 27, 1998 (earliest event reported April 27, 1998),
reporting information under Item 5 with respect to the
acquisition of shares of the Company's common stock and
warrants to purchase the common stock by Thirty-Five East
Investments LLC and Turtle Creek Revocable Trust.
27
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
AAMES FINANCIAL CORPORATION
(Registrant)
Dated: August 6, 1999 By: /s/ MANI A. SADEGHI
------------------------------
Mani A. Sadeghi
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
<S> <C> <C>
/s/ GEORGE S. COOMBE, JR. Director August 6, 1999
- ----------------------------
George S. Coombe, Jr.
/s/ STEVEN M. GLUCKSTERN Chairman of the Board August 6, 1999
- ----------------------------
Steven M. Gluckstern
/s/ NEIL B. KORNSWIET President, Director August 6, 1999
- ----------------------------
Neil B. Kornswiet
/s/ ADAM M. MIZEL Director August 6, 1999
- ----------------------------
Adam M. Mizel
/s/ ERIC RAHE Director August 6, 1999
- ----------------------------
Eric Rahe
/s/ MANI A. SADEGHI Chief Executive Officer, August 6, 1999
- ---------------------------- Director
Mani A. Sadeghi
/s/ DAVID A. SKLAR Executive Vice President-Finance August 6, 1999
- ----------------------------- and Chief Financial Officer
David A. Sklar (Principal Financial
and Accounting Officer)
/s/ CARY H. THOMPSON Director August 6, 1999
- ----------------------------
Cary H. Thompson
/s/ GEORGES S. ST. LAURENT, JR. Director August 6, 1999
- ------------------------------
Georges S. St. Laurent, Jr.
/s/ DAVID A. SPURIA Director August 6, 1999
- ------------------------------
David A. Spuria
</TABLE>
28
<PAGE>
<TABLE>
INDEX TO EXHIBITS
<CAPTION>
Exhibit Number
<S> <C>
11 Statement Re Computation of Earnings Per Share
23.1 Consent of PricewaterhouseCoopers, LLP
27.1 Financial Data Schedule - 1998
27.2 Financial Data Schedule - 1997
27.3 Financial Data Schedule - 1996
27.4 Financial Data Schedule - 1995
</TABLE>
29
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
One Stop Mortgage, Inc.
We have audited the statements of operations, changes in stockholders' equity
and cash flows of One Stop Mortgage, Inc. (the "Company") for the period January
1, 1996 through June 30, 1996 and the period August 24, 1995 (inception) through
December 31, 1995. These financial statements, which are not separately
presented herein, are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the results of operations of One Stop Mortgage, Inc. and
its cash flows for the period January 1, 1996 through June 30, 1996 and the
period August 24, 1995 (inception) through December 31, 1995 in conformity with
generally accepted accounting principles.
/s/ KPMG PEAT MARWICK LLP
Orange County, California
August 16, 1996
30
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
and Stockholders of
Aames Financial Corporation
In our opinion, based upon our audits and the report of other auditors, the
accompanying consolidated balance sheets and the related consolidated statements
of income, of stockholders' equity and of cash flows present fairly, in all
material respects, the financial position of Aames Financial Corporation and its
subsidiaries (the "Company") at June 30, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
June 30, 1998, in conformity with generally accepted accounting principles.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We did not audit the financial statements of One Stop Mortgage,
Inc., a wholly-owned subsidiary, which statements reflect total revenues of $7
million for the period from August 24, 1995 (inception) through June 30, 1996.
Those statements were audited by other auditors whose report thereon has been
furnished to us, and our opinion expressed herein, insofar as it relates to the
amounts included for One Stop Mortgage, Inc. is based solely on the report of
the other auditors. We conducted our audits of these statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for the opinion expressed above.
As discussed in Note 1, the Company adopted accounting standards that changed
its method of accounting for transfers and servicing of financial assets during
the year ended June 30, 1997 and its method of accounting for mortgage servicing
rights for the year ended June 30, 1996.
As discussed in Note 2, the consolidated financial statements have been restated
to reflect a change in the method of measuring and accounting for credit
enhancement assets.
/s/ PricewaterhouseCoopers LLP
Los Angeles, California
August 6, 1998, except as to the information presented in Note 2 for which the
date is August 5, 1999.
31
<PAGE>
<TABLE>
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
<CAPTION>
June 30, June 30,
1998 1997
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 12,322,000 26,902,000
Loans held for sale, at lower of cost or market 198,202,000 242,987,000
Accounts receivable 51,072,000 59,180,000
Interest-only strips, at estimated fair market value 490,542,000 339,251,000
Mortgage servicing rights, net 32,090,000 21,641,000
Equipment and improvements, net 13,939,000 12,685,000
Prepaid and other 17,020,000 14,949,000
------------- -------------
Total assets $ 815,187,000 717,595,000
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Borrowings $ 286,990,000 286,990,000
Revolving warehouse facilities 141,012,000 137,500,000
Accounts payable and accrued expenses 49,964,000 29,297,000
Income taxes payable 33,170,000 24,053,000
-------------- ------------
Total liabilities 511,136,000 477,840,000
-------------- ------------
Commitments and contingencies (Note 8)
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;
30,962,600, and 27,758,800 shares
outstanding (Note 10) 31,000 28,000
Additional paid-in capital 249,851,000 209,358,000
Retained earnings 54,169,000 30,369,000
------------- -----------
Total stockholders' equity 304,051,000 239,755,000
------------- -----------
Total liabilities and stockholders' equity $ 815,187,000 717,595,000
============= ===========
</TABLE>
See accompanying notes to consolidated financial statements
32
<PAGE>
<TABLE>
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME
<CAPTION>
TWELVE MONTHS ENDED
JUNE 30
-------------------------------------------------------
1998 1997 1996
-------------- ----------- ------------
<S> <C> <C> <C>
Revenue:
Gain on sale of loans $ 120,828,000 135,421,000 71,255,000
Net gain or (loss)
on valuation of
interest-only strips 19,495,000 (18,950,000) --
Commissions 27,664,000 29,250,000 21,564,000
Loan service 51,642,000 31,131,000 20,394,000
Fees and other 46,860,000 37,679,000 15,215,000
----------- ----------- ------------
Total revenue 266,489,000 214,531,000 128,428,000
----------- ----------- -----------
Expenses:
Compensation 94,820,000 81,021,000 40,758,000
Production 34,195,000 27,229,000 19,036,000
General and administrative 40,686,000 31,716,000 17,377,000
Interest 43,982,000 33,105,000 12,370,000
Nonrecurring charges -- 32,000,000 --
----------- ----------- -----------
Total expenses 213,683,000 205,071,000 89,541,000
----------- ----------- -----------
Income before income taxes 52,806,000 9,460,000 38,887,000
Provision for income taxes 25,243,000 7,982,000 17,814,000
------------ ----------- -----------
Net income $ 27,563,000 1,478,000 21,073,000
============== =========== ===========
Net income per share:
Basic $ 0.97 0.06 0.97
============== ============ ============
Diluted $ 0.87 0.05 0.82
============== ========== ============
Dividends per share $ 0.13 0.13 0.13
============== =========== ============
Weighted average number
of shares outstanding:
Basic 28,548,000 26,400,000 21,681,000
=========== =========== ===========
Diluted 35,749,000 28,371,000 27,248,000
=========== =========== ===========
</TABLE>
See accompanying notes to consolidated financial statements
33
<PAGE>
<TABLE>
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
<CAPTION>
TWELVE MONTHS ENDED
JUNE 30
------------------------------------------------------------
1998 1997 1996
------------- ------------- -------------
<S> <C> <C> <C>
Operating activities:
Net income $ 27,563,000 1,478,000 21,073,000
Adjustments to reconcile net income to net cash
used in operating activities:
Depreciation and amortization 3,909,000 2,853,000 1,275,000
Gain on sale of loans (121,098,000) (194,026,000) (87,424,000)
Net (gain) loss on valuation
of interest-only strips (19,495,000) 18,950,000 --
Accretion of interest-only strips (10,698,000) (10,337,000) (15,993,000)
Mortgage servicing rights originated (19,513,000) (16,251,000) (11,759,000)
Mortgage servicing rights amortized 9,064,000 5,512,000 857,000
Changes in assets and liabilities:
Loans originated or purchased (2,383,638,000) (2,347,938,000) (1,168,945,000)
Proceeds from sale of loans 2,428,423,000 2,291,140,000 1,006,887,000
Decrease (increase) in:
Accounts receivable 8,108,000 (49,495,000) (3,595,000)
Prepaid and other (2,071,000) (4,654,000) (5,276,000)
Increase (decrease) in:
Accounts payable and accrued expenses 20,667,000 13,490,000 8,278,000
Income taxes payable 9,118,000 9,205,000 13,549,000
------------- ------------- -------------
Net cash used in operating activities (49,661,000) (280,073,000) (241,073,000)
------------- ------------- -------------
Investing activities:
Purchases of equipment and improvements (5,163,000) (8,864,000) (5,885,000)
------------- ------------- -------------
Net cash used in investing activities (5,163,000) (8,864,000) (5,885,000)
------------- ------------- -------------
Financing activities:
Proceeds from sale of stock or exercise of options 40,505,000 121,228,000 26,280,000
Proceeds from borrowings -- 148,945,000 114,901,000
Proceeds from revolving warehouse facilities 3,512,000 25,137,000 112,048,000
Dividends paid (3,773,000) (3,412,000) (2,689,000)
------------- ------------- -------------
Net cash provided by financing activities 40,244,000 291,898,000 250,540,000
------------- ------------- -------------
Net increase (decrease) in cash and cash equivalents (14,580,000) 2,961,000 3,582,000
Cash and cash equivalents at beginning of period 26,902,000 23,941,000 20,359,000
------------- ------------- -------------
Cash and cash equivalents at end of period $ 12,322,000 26,902,000 23,941,000
============= ============= =============
Supplemental disclosures:
Interest paid $ 44,501,000 30,207,000 6,633,000
Taxes paid (refunded) 16,125,000 (1,197,000) 4,354,000
</TABLE>
See accompanying notes to consolidated financial statements.
34
<PAGE>
<TABLE>
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<CAPTION>
ADDITIONAL
COMMON PAID-IN RETAINED
STOCK CAPITAL EARNINGS TOTAL
------------ -------------- ------------ -----------
<S> <C> <C> <C> <C>
As of June 30, 1995 ....... $ 21,000 61,857,000 13,919,000 75,797,000
Issuance of common stock 2,064,000 2,064,000
Shares issued in merger
transaction ......... 3,000 (3,000) --
Dividends .............. (2,689,000) (2,689,000)
Issuance of common stock
warrants ............. 24,216,000 24,216,000
Net income ............. 21,073,000 21,073,000
------------ ------------ ------------
As of June 30, 1996 ....... 24,000 88,134,000 32,303,000 120,461,000
Issuance of common stock 4,000 121,224,000 121,228,000
Dividends .............. (3,412,000) (3,412,000)
Net income ............. 1,478,000 1,478,000
------------ ------------ ------------
As of June 30, 1997 ....... 28,000 209,358,000 30,369,000 239,755,000
Issuance of common stock 3,000 40,493,000 10,000 40,506,000
Dividends .............. (3,773,000) (3,773,000)
Net income ............. 27,563,000 27,563,000
------------ ------------ ------------
As of June 30, 1998 ....... $ 31,000 249,851,000 54,169,000 304,051,000
============ ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
35
<PAGE>
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
OPERATIONS
Aames Financial Corporation (the "Company" or "Aames") is a consumer
finance company primarily engaged, through its subsidiaries, in the business of
originating, purchasing, selling, and servicing home equity mortgages secured by
single family residences. At June 30, 1998, Aames operated 98 retail loan
offices serving 32 states. At June 30, 1998, 12 of the 98 branches were located
in California. Its wholly-owned subsidiary, One Stop Mortgage, Inc. ("One Stop")
operated 46 offices located in 45 states and one international office located in
England. At June 30, 1998, 4 of the 46 domestic branches were located in
California. The Company originates and purchases loans on a nationwide basis
through three production channels--retail, broker and correspondent. For the
years ended June 30, 1998 and 1997, the Company originated and purchased $2.38
billion and $2.35 billion of mortgage loans, respectively. 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. Loans originated by the Company are extended on the basis of
the equity in the borrower's property and the creditworthiness of the borrower.
The aggregate outstanding balance of loans serviced by the Company was $4.15
billion and $3.17 billion at June 30, 1998 and June 30, 1997, respectively
(which include $206 million and $1.67 billion of loans at June 30, 1998 and June
30, 1997, respectively, serviced for the Company by unaffiliated subservicers
under subservicing agreements).
LOAN SALES
The Company's ability to sell loans originated and purchased by it in
the secondary market is necessary 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.
ACQUISITION OF ONE STOP
On August 28, 1996, the Company acquired One Stop, through the merger
of a wholly-owned subsidiary of the Company into One Stop, in a tax-free
exchange accounted for as a pooling of interests, in which the Company issued
approximately 3.49 million shares (adjusted for the three-for-two stock split in
the form of a stock dividend in February 1997) of its common stock, par value
$.001 per share ("common stock"), and assumed options granted to key employees
to purchase approximately 563,000 shares (adjusted for the three-for-two stock
split in the form of a stock dividend in February 1997) of common stock. Under
the pooling rules, the costs incurred by the Company and One Stop in
consummating the merger were expensed in the first quarter of fiscal 1997.
All prior years financial statements have been restated to include One Stop.
The following table shows the effect of the merger:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FISCAL YEAR ENDED JUNE 30, 1996
-------------------------------
<S> <C>
Net income by entity:
Aames, as previously reported $ 22,330
One Stop (1,257)
--------
Restated June 30, 1996 net income $ 21,073
--------
Net income per fully diluted share:
Previously reported (2/97 stock split) $ 1.02
Restated $ 0.82
</TABLE>
One Stop's operations, from the period July 1, 1996 through August 28,
1996, were immaterial for purposes of separate restatement.
PRINCIPLES OF ACCOUNTING AND CONSOLIDATION
The consolidated financial statements of the Company include the
accounts of Aames and its wholly-owned subsidiaries. All significant
intercompany balances and transactions have been eliminated in consolidation.
36
<PAGE>
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH IN TRUST
The Company services loans on behalf of customers. In such capacity,
certain funds are collected and placed in segregated trust accounts which
totaled $57.8 million and $28.3 million at June 30, 1998 and June 30, 1997,
respectively. These accounts and corresponding liabilities are not included in
the accompanying consolidated balance sheet.
EQUIPMENT AND IMPROVEMENTS, NET
Equipment and improvements, net are stated at cost less accumulated
depreciation and amortization. Depreciation and amortization are being recorded
utilizing straight-line and accelerated methods over the following estimated
useful lives:
Data Processing Equipment Five years
Furniture Five to seven years
Date Processing Software Three years
Leasehold Improvement Lower of life of lease or asset
Automobiles Five years
REVENUE RECOGNITION
The Company adopted Statement of Financial Accounting Standards
("SFAS") 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("SFAS 125") effective January 1, 1997. As a
result of the adoption of SFAS 125, the Company records amounts previously
categorized as "Excess servicing gains" in the consolidated statement 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 asset called
interest-only strips. The Company has classified this asset as a trading
security and during the year ended June 30, 1998, recorded a net unrealized gain
of $19.5 million on the valuation of this security. SFAS 125 requires that this
mark-to-market adjustment be reported separately from gain on sale of loans.
In fiscal year 1996, the Company adopted SFAS 122. Under SFAS 122, the
Company recognized originated mortgage servicing rights ("MSRs") as assets
separate from the mortgage loans to which the MSRs relate based on their
respective fair values. Prior to SFAS 122, the Company allocated the entire cost
of originating or purchasing mortgage loans to the carrying value of such
mortgage loans. The effect of adopting SFAS 122 was to increase the net income
of the Company for the fiscal year ended June 30,1996, by $5.7 million, or $0.21
per fully diluted weighted average share.
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 gain on sale of loans represents the
difference between the proceeds (including premiums) from the sale, net of
related transaction costs, and the allocated carrying amount of the loans sold.
The allocated carrying amount is determined by allocating the original amount of
the loan (including premiums paid on loans purchased) between the portion sold
and any retained interests (interest-only strip), based on their relative fair
values at the date of transfer. The interest-only strip 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, adjusted for the reserve for loan losses. Unrealized
gains or losses include the recognition of an unrealized gain or loss which
represents the initial difference between the allocated carrying amount and the
fair market value of the interest-only strip at the date of sale. Each agreement
that the Company has entered into in connection with its securitizations
requires either the overcollateralization of the trust or the establishment of a
reserve account that may initially be funded by cash deposited by the Company.
The Company's interest in each overcollateralization amount and reserve account
is reflected on the Company's Consolidated Financial Statements as
"interest-only strips" and is recorded as of the time such amounts are received
by the trust.
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: (i) a future
rate of prepayment; (ii) a discount rate used to calculate present value; and
(iii) a prospective cumulative loan loss estimate on loans sold. There can be no
assurance of the accuracy of management's estimates.
Additionally, upon sale or securitization of servicing retained
mortgages, the Company capitalizes mortgage servicing rights
37
<PAGE>
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 in proportion to and over the
period of estimated net future servicing fee income. The Company periodically
reviews capitalized servicing rights for valuation impairment. This review is
performed on a disaggregated basis for the predominant risk characteristics of
the underlying loans which are loan type and origination date. At June 30, 1998
and 1997, there were no valuation allowances on mortgage servicing rights.
INCOME TAXES
Taxes are provided on substantially all income and expense items
included in earnings, regardless of the period in which such items are
recognized for tax purposes. The Company uses an asset and liability approach
that requires the recognition of deferred tax assets and liabilities for the
expected future tax consequences of events that have been recognized in the
Company's financial statements or tax returns. In estimating future tax
consequences, the Company generally considers all expected future events other
than the enactment of changes in the tax law or rates.
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 some
LIBOR-based tranches 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
contract with a specified LIBOR rate cap. The amount and timing of hedging
transactions are determined by members of the Company's senior management. The
Company is currently reevaluating its current hedging policy.
CASH AND CASH EQUIVALENTS
At June 30, 1998, the Company had $12.3 million in cash, of which $1.6
million was held in a restricted account in connection with the securitization
which closed in June 1998. These funds were released to the Company in July
1998.
LOANS HELD FOR SALE
Loans held for sale are carried at the lower of aggregate cost or
market value. Market value is determined by current investor yield requirements.
ACCOUNTS RECEIVABLE
Accounts receivable primarily consisted of pool related advances,
accrued interest receivable and various servicing advances.
DEBT ISSUANCE COSTS
At June 30, 1998 and 1997, the Company had an unamortized balance of
debt issuance costs of $7.2 million and $8.4 million, respectively, related to
the issuance of $23.0 million of 10.5% Senior Notes due 2002, the issuance of
$115.0 million of 5.5% Convertible Subordinated Debentures due 2006 and the
issuance of $150.0 million of 9.125% Senior Notes due 2003. This balance is
included in prepaid and other on the consolidated balance sheet and is amortized
to expense over the life of the related debt issuance.
EARNINGS PER SHARE
Basic earnings per share of common stock is computed using the weighted
average number of shares of common stock outstanding during each period. Fully
diluted earnings per share includes the effects of the conversion of shares
related to the Company's 5.5% Convertible Subordinated Debentures due 2006 as
well as the average number of stock options outstanding.
All references in the accompanying consolidated balance sheet,
consolidated statement of income and notes to consolidated financial statements
to the number of common shares and share amounts have been restated to reflect
the three-for-two stock splits in the form of stock dividends effected on
February 21, 1997 and May 17, 1996, and the Company's presentation of basic
earnings per share ("EPS") under the adoption of FAS 128 during the year ended
June 30, 1998.
RECLASSIFICATIONS
Certain amounts related to 1997 and 1996 have been reclassified to
conform to the 1998 presentation.
38
<PAGE>
ADOPTION OF RECENT ACCOUNTING STANDARDS
In October 1995, the FASB released SFAS 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 of the Company.
In February 1997, the FASB issued SFAS 128, "Earnings Per Share" ("SFAS
128") which 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 includes common stock equivalents while basic EPS
excludes them. This change simplifies the computation of EPS. 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.
In February 1997, the FASB issued SFAS 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 Balance Sheet is
also required. The Company adopted SFAS 129 for the fiscal year 1998.
In June 1997, the FASB issued SFAS 130, "Reporting Comprehensive
Income" ("SFAS 130"). SFAS 130 establishes disclosure standards for reporting
comprehensive income in a full set of general purpose financial statements. SFAS
130 is effective for fiscal years beginning after December 15, 1997. The
adoption of this standard is not expected to have an impact on the Company's
financial position or results of operations.
In June 1997, the FASB issued SFAS 131, "Disclosures about Segments of
an Enterprise and Related Information" ("SFAS 131") which is effective for
periods beginning after December 15, 1997. SFAS 131 establishes standards for
the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to stockholders. It also establishes standards for related
disclosures about products and services, geographic areas and major customers.
The adoption of this standard is not expected to have an impact on the Company's
financial position or results of operations.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS is effective for fiscal years
beginning after June 15, 2000. SFAS No. 133 requires companies to record
derivatives on the balance sheet as assets and liabilities, measured at fair
value. Gains and losses resulting from changes in the values of those
derivatives would be accounted for as components of comprehensive income
depending on the use of the derivative and whether it qualifies for hedge
accounting. The Company has not determined the impact that adoption of this
standard will have on its future consolidated financial statements.
NOTE 2 RESTATEMENT
RESTATEMENT OF PRIOR PERIOD RESULTS. In December 1998, the Financial
Accounting Standards Board (the "FASB") issued, in question and answer format,
"A Guide to Implementation of Statement 125 on Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, Questions and
Answers, Second Edition" (the "Special Report"). The Special Report indicates
that two methods have arisen in practice for accounting for credit enhancements
relating to securitization. These methods are the cash-in method and the
cash-out method. The cash-in method treats credit enhancements (pledged loans or
cash) as belonging to the Company. As such, these assets are recorded at their
face value as of the time they are received by the trust. The cash-out method
treats credit enhancements as assets owned by the related securitization trust.
As such, these assets are treated as part of the interest-only strips and are
recorded at a discounted value for the period between when collected by the
trust and released to the Company. The Special Report indicates that if no true
market exists for credit enhancement assets, the cash-out method should be used
to measure the fair value of credit enhancements.
The Company has historically used the cash-in method to account for its
interest-only strips. However, during the three months ended December 31, 1998,
the Company retroactively changed its practice of measuring and accounting for
its interest-only strips to the cash-out method in response to the FASB's
Special Report and to public comments from the Securities and Exchange
Commission released on December 8, 1998.
Under the cash-in method previously used by the Company, the assumed
discount period for measuring the present value of the interest-only strips
ended when the cash flows were received by the securitization trust; and, the
initial deposits to overcollateralization accounts were recorded at face value.
Under the cash-out method now required by the FASB and Securities and Exchange
Commission, the assumed discount period for measuring the present value of the
interest-only strips ends when cash, including the return of any initial
deposits, is distributed to the Company on an unrestricted basis.
39
<PAGE>
The change to the cash-out method results only in a difference in the
timing of revenue recognition from a securitization and has no effect on the
total cash flows of securitization transactions. While the total amount of
revenue recognized over the term of a securitization is the same under either
method, the cash-out method results in lower initial gains on the sale of loans
due to the longer discount period, and higher subsequent loan service revenue
resulting from the impact of discounting cash flows.
As a result, the Company's consolidated results of operations for
periods subsequent to June 30, 1994 have been restated. The aggregate pretax
amount of this change in accounting is $67.1 million.
The restatement resulted in the following changes to prior financial
information (Dollars in thousands, except per share amounts):
<TABLE>
YEAR ENDED JUNE 30,
<CAPTION>
--------------------------------------------------------
1998 1997 1996 1995
------------- ------------- --------- ------------
<S> <C> <C> <C> <C>
Revenue:
Previous $286,110 238,578 141,840 54,939
As restated 266,489 214,531 128,428 48,400
Net income:
Previous 40,317 17,109 29,791 10,034
As restated 27,563 1,478 21,073 5,784
Earnings per share:
Basic:
Previous 1.41 0.65 1.37 0.74
As restated 0.97 0.06 0.97 0.43
Diluted:
Previous 1.23 0.60 1.14 0.74
As restated 0.87 0.05 0.82 0.43
Interest-only strips:
(end of period)
Previous 554,161 383,249 173,789 56,960
As restated 490,542 339,251 153,838 50,421
Stockholders' equity:
(end of period)
Previous 345,403 268,354 133,429 80,047
As restated 304,051 239,755 120,461 75,797
</TABLE>
NOTE 3 NONRECURRING CHARGES
In fiscal 1997, the Company incurred $32.0 million of nonrecurring
charges. Approximately $25.0 million of these charges were recognized in August
1996 directly related to the acquisition of One Stop. The remaining amount
relates to a reserve for relocating corporate headquarters recorded in the first
fiscal quarter of 1998and to severance and other strategic decisions made in the
fourth fiscal quarter of 1998.
NOTE 4 INTEREST-ONLY STRIPS AND MORTGAGE SERVICING RIGHTS
The activity in the interest-only strips during the years ended June
30, 1998 and 1997 is summarized as follows:
40
<PAGE>
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
---- ----
<S> <C> <C>
Balance, beginning of year $339,251,000 $ 153,838,000
Gain on sale of loans 121,098,000 194,026,000
Accretion 10,698,000 10,337.000
Net gain (loss) on valuation
of interest-only strips 19,495,000 (18,950,000)
---------- -----------
Balance, end of year $490,542,000 $339,251,000
============ ============
</TABLE>
The activity in mortgage servicing rights during the years ended June
30, 19989 and 1997 is summarized as follows:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
---- ----
<S> <C> <C>
Balance, beginning of year $21,641,000 $10,902,000
Mortgage servicing rights originated 19,513,000 16,251,000
Mortgage servicing rights amortized (9,064,000) (5,512,000)
----------- -----------
Balance, end of year $32,090,000 $21,641,000
=========== ===========
</TABLE>
The interest-only strips and the mortgage servicing rights are
amortized over the estimated lives of the loans to which they relate.
NOTE 5 EQUIPMENT AND IMPROVEMENTS, net
Equipment and improvements, net consisted of the following at June 30,
1998 and 1997:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
---- ----
<S> <C> <C>
Data processing equipment $ 10,421,000 8,239,000
Furniture and fixtures 7,958,000 5,892,000
Data processing software 3,213,000 1,756,000
Leasehold improvements 2,032,000 1,666,000
Equipment under capital leases -- 806,000
Automobiles 395,000 497,000
------------- -----------
Total 24,019,000 18,856,000
Accumulated depreciation and amortization (10,080,000) (6,171,000)
------------- ------------
Equipment and improvements, net $ 13,939,000 12,685,000
============== ============
</TABLE>
NOTE 6 BORROWINGS AND REVOLVING WAREHOUSE FACILITIES
Borrowings consisted of the following at June 30, 1998 and 1997:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
---- ----
<S> <C> <C>
9.125% Senior Notes due 2003, guaranteed by each of the
Restricted Subsidiaries of the Company. $150,000,000 150,000,000
5.5% Convertible Subordinated Debentures due 2006, convertible to
6.2 million shares of the common stock at $19 per share. The
Convertible Subordinated Debentures are subordinated to all
existing and future senior indebtedness of the Company
(as defined in the Indenture). 113,990,000 113,990,000
10.5% Senior Notes due 2002, collateralized by certain residual
certificates. Principal payments of $5,750,000 in each of
calendar years 1999 through 2002. 23,000,000 23,000,000
------------- ------------
Total borrowings $286,990,000 286,990,000
============ ===========
</TABLE>
41
<PAGE>
Maturities on borrowings are as follows:
<TABLE>
<CAPTION>
FISCAL YEARS ENDED JUNE 30,
- ---------------------------
<S> <C>
1999 $ 5,750,000
2000 5,750,000
2001 5,750,000
2002 5,750,000
2003 --
2004 150,000,000
Thereafter 113,990,000
--------------
Total Borrowings $ 286,990,000
=============
</TABLE>
Amounts outstanding under revolving warehouse facilities consisted of the
following at June 30, 1998 and 1997:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
------ ------
<S> <C> <C>
Warehouse facility with a syndicate of ten commercial banks
collateralized by loans originated and purchased by the Company
as well as certain servicing receivables; expires April 9, 1999
with interest at the option of the Company of either 1.05% over
Fed Funds rate, or .80% over one-month LIBOR rate. Total credit
available $400 million. Fed Funds rate was 7.1% and one-month
LIBOR was 5.7% at June 30, 1998 $ 135,500,000 137,500,000
Warehouse facility from an investment bank collateralized by
loans originated and purchased by the Company. This line of $300
million bears interest at a rate of .65% over one-month LIBOR and
expires on September 11, 1998 One-month LIBOR rate was 5.7% at
June 30, 1998 5,512,000 --
------------- -------------
Total amounts outstanding under warehouse facilities $ 141,012,000 137,500,000
============= =============
</TABLE>
NOTE 7 INCOME TAXES
The provision for income taxes consisted of the following for the years
ended June 30, 1998, 1997 and 1996:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Current:
Federal $10,060,000 203,000 6,344,000
State 3,249,000 262,000 2,212,000
-----------
13,309,000 465,000 8,556,000
----------- ----------- -----------
Deferred:
Federal 6,814,000 4,665,000 5,518,000
State 5,120,000 2,852,000 3,740,000
-----------
11,934,000 7,517,000 9,258,000
----------- -----------
Total $25,243,000 7,982,000 17,814,000
=========== ===========
</TABLE>
Current and deferred taxes payable were comprised of the following at June 30,
1998 and 1997:
42
<PAGE>
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
---- ----
<S> <C> <C>
Current taxes payable (receivable):
Federal $ 3,190,000 4,431,000
State (967,000) (1,350,000)
----------- -----------
2,223,000 3,081,000
Deferred taxes payable:
Federal 17,129,000 11,531,000
State 13,818,000 9,441,000
----------- -----------
30,947,000 20,972,000
Total $33,170,000 24,053,000
=========== ===========
</TABLE>
The tax effects of temporary differences that give rise to significant portions
of deferred tax assets and deferred tax liabilities consist of the following at
June 30, 1998 and 1997:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
---- ----
<S> <C> <C>
Deferred tax liabilities:
Interest-only strips $ 18,908,000 23,187,000
Depreciation -- 440,000
Deferred loan fees 578,000 1,346,000
Mortgage servicing rights 16,770,000 9,116,000
Bad debts 6,579,000 --
------------ ------------
Total gross deferred tax
liabilities 42,835,000 34,089,000
------------ ------------
Deferred tax assets:
Sec. 475 mark-to-market -- (2,870,000)
State taxes (4,836,000) (3,396,000)
Vacation accrual (801,000) (701,000)
Allowance for doubtful -- (435,000)
accounts
Lease cancellation accrual (920,000) (920,000)
Excess inclusion income (1,539,000) --
Depreciation (98,000) --
Other accruals (1,471,000) (1,714,000)
------------ ------------
Total gross deferred tax assets (9,665,000) (10,036,000)
------------ ------------
Net deferred tax liabilities $ 33,170,000 24,053,000
============ ============
</TABLE>
The estimated effective tax rates for the years ended June 30, 1998 and 1997
were as follows:
<TABLE>
<CAPTION>
1998
-------------------------------------------
Tax Affected Effective
Permanent Permanent Tax Rate
DIFFERENCES DIFFERENCES CALCULATION
------------ ------------ ------------
<S> <C> <C> <C>
Tax provision $25,243,000
Income before income taxes 52,806,000
Effective tax rate 47.8%
Federal statutory rate 35.0%
State pre-tax after permanent
difference $ 8,369,000 5,439,000 10.3
Disallowed compensation 3,398,000 1,189,300 2.3
Other, net 253,940 132,250 0.2
----------
47.8%
==========
</TABLE>
43
<PAGE>
<TABLE>
<CAPTION>
1997
TAX AFFECTED EFFECTIVE
PERMANENT PERMANENT TAX RATE
DIFFERENCES DIFFERENCES CALCULATION
----------- ----------- -----------
<S> <C> <C> <C>
Tax provision $ 7,982,000
Income before income taxes 9,460,000
Effective tax rate 84.4%
Federal statutory rate 35.0%
State pre-tax after
permanent difference 36,558,000 2,654,000 28.1
Pooling of interests 5,156,000 1,805,000 19.0
Stock options (2,227,000) (779,000) (8.2)
Other, net 2,872,000 1,005,000 10.5
---------------
84.4%
</TABLE>
The Company's effective tax rate for the year ended June 30, 1996 was computed
using the appropriate statutory rates with no significant differences.
NOTE 8 COMMITMENTS AND CONTINGENCIES
The Company leases office space under operating leases expiring at various dates
through February 2012. In addition, in February 1996, the Company entered into
an operating lease for an airplane, which expires February 2006. Total rent
expense related to operating leases amounted to $9.1 million, $5.3 million and
$3.2 million, for the years ended June 30, 1998, 1997 and 1996, respectively.
Certain leases have provisions for renewal options and/or rental increases at
specified increments or in relation to increases in the Consumer Price Index (as
defined). At June 30, 1998, future minimum rental payments required under
non-cancelable operating leases that have initial or remaining terms in excess
of one year are as follows:
<TABLE>
<CAPTION>
COMMITMENTS
-----------
<S> <C>
1999 $ 7,695,000
2000 8,370,000
2001 6,696,000
2002 5,662,000
2003 4,871,000
Thereafter 32,211,000
------------
$ 65,505,000
============
</TABLE>
LITIGATION
In the ordinary course of its business, the Company is subject to claims made
against it by borrowers and private investors arising from, among other things,
losses that are claimed to have been incurred as a result of alleged breaches of
fiduciary obligations, misrepresentations, errors and omissions of employees and
officers of the Company, incomplete documentation and failures by the Company to
comply with various laws and regulations applicable to its business. The Company
believes that liability with respect to any currently asserted claims or legal
action is not likely to be material to the Company's financial position or
results of operations; however, any claims asserted in the future may result in
legal expenses which could have a material adverse effect on the Company's
financial position and results of operations.
EMPLOYMENT AND SEVERANCE AGREEMENTS
At June 30, 1998, the Chief Executive Officer of the Company had an employment
agreement with the Company expiring on June 30, 2001, which provided for a base
salary and a performance bonus measured against a target return on equity. In
addition, certain options were granted thereunder. The agreement also provided
that, in the event of a termination without cause or in the event of certain
changes in control, the Company would pay two years' base salary plus an amount
equal to his performance bonus over the previous eight quarters.
At June 30, 1998, the President of the Company had an employment agreement with
the Company expiring on August 26, 2003, which provided for a base salary and
quarterly performance bonuses of between $1.35 million and $1.65 million
depending on broker
44
<PAGE>
and retail loan production. The agreement also provided that, in the event of a
termination without cause, the Company would pay an amount equal to the base
salary for the remaining term of the agreement, plus $30 million minus the
performance bonuses paid prior to termination ("performance payment"). In the
event of a change in control, the Company would pay the performance payment.
Certain other members of management had employment or severance agreements which
provided for enhanced severance and other benefits upon a change in control, as
defined in the agreements.
NOTE 9 FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosures of the estimated fair value of financial instruments
as of June 30, 1998 and 1997 are made by the Company using available market
information, historical data, and appropriate valuation methodologies. However,
considerable judgment is required to interpret market and historical data to
develop the estimates of fair value. Accordingly, the estimates presented herein
are not necessarily indicative of the amounts the Company could realize in a
current market exchange.
The use of different market assumptions and/or estimation methodologies may have
a material effect on the estimated fair value amounts.
<TABLE>
<CAPTION>
JUNE 30, 1998 JUNE 30, 1997
------------------------------ ----------------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
BALANCE SHEET:
<S> <C> <C> <C> <C>
Cash and cash equivalents $ 12,322,000 $ 12,322,000 $ 26,902,000 $ 26,902,000
Loans held for sale 198,202,000 208,112,000 242,987,000 255,136,000
Interest-only strips, at estimated fair
market value 490,542,000 490,542,000 339,251,000 339,251,000
Mortgage servicing rights 32,090,000 32,090,000 21,641,000 21,641,000
Amounts outstanding under
revolving warehouse facilities 141,012,000 141,012,000 137,500,000 137,500,000
Borrowings 286,990,000 246,938,000 286,990,000 284,735,000
OFF BALANCE SHEET:
Hedge position notional
amount outstanding 250,000,000 248,455,000 135,000,000 135,246,000
</TABLE>
The fair value estimates as of June 30, 1998 and 1997 are based on
pertinent information available to management as of the respective dates.
Although management is not aware of any factors that would significantly affect
the estimated fair value amounts, such amounts have not been revalued for
purposes of these financial statements since those dates and, therefore, current
estimates of fair value may differ significantly from the amounts presented
herein.
The following describes the methods and assumptions used by the Company
in estimating fair values:
Cash and cash equivalents are based on the carrying amount which is a reasonable
estimate of the fair value.
Loans held for sale are based on current investor yield requirements.
Interest-only strips and mortgage servicing rights are based on the
expected future cash flows using assumptions based on Company-specific
and industry information as well as the Company's historical
experience.
Amounts outstanding under revolving warehouse facilities are short term
in nature and generally bear market rates of interest and therefore,
are based on the carrying amount which is a reasonable estimate of fair
value.
Borrowings are based on the quoted market prices for the same or
similar issues or on the current rates offered to the Company for debt
of the same remaining maturities.
Hedge positions are based on quoted market prices.
45
<PAGE>
NOTE 10 EMPLOYEE BENEFIT PLANS
401(K) RETIREMENT SAVINGS PLAN
The Company sponsors a 401(k) Retirement Savings Plan, a defined
contribution plan. Substantially all employees are eligible to participate in
the plan after reaching the age of 21 and completion of six months of service.
Contributions are made from employees' elected salary deferrals. Employer
contributions are determined at the beginning of the plan year at the option of
the employer. During the years ended June 30, 1998, 1997 and 1996, the Company's
contribution to the plan aggregated $549,000, $432,000 and $252,000,
respectively.
DEFERRED COMPENSATION PLAN
In April 1997, the Company implemented a Deferred Compensation Plan for
highly compensated employees and directors of the Company. The plan is unfunded
and non-qualified. Eligible participants may defer a portion of their
compensation and receive a Company matching amount up to 4% of their annual base
salary. The Company may also make discretionary contributions to the plan.
During the year ended June 30, 1998, the Company made $203,700 of discretionary
contributions to the plan.
STOCK BASED COMPENSATION
At June 30, 1998, the Company has reserved 5,450,000 shares of the
common stock for issuance under its 1991 Stock Incentive Plan, 1995 Stock
Incentive Plan, 1996 Stock Incentive Plan, 1997 Stock Option Plan and 1997
Non-Qualified Stock Option Plan. Under these plans, the Company may grant
incentive and non-qualified options to eligible participants that may vest
immediately on the date of grant or in accordance with a vesting schedule, as
determined in the sole discretion of the Compensation Committee of the Company's
Board of Directors. The exercise price is based on the closing price of the
common stock on the day before the date of grant. Each option plan provides for
a term of 10 years. The Company has also granted options outside of these plans,
on terms established by the Compensation Committee. A summary of the Company's
stock option plans and arrangements as of June 30, 1998, 1997 and 1996 and
changes during the years then ended are as follows:
<TABLE>
<CAPTION>
OPTION OPTION
SHARES PRICE RANGE
------ -----------
1998
<S> <C> <C>
Outstanding at beginning of year 4,182,491 $ 0.19 - 29.70
Granted 1,084,091 11.81 - 19.94
Exercised (419,414) 3.33 - 13.63
Forfeited (276,499) 0.20 - 28,92
--------- --------------
Outstanding at end of year 4,570,669 $ 0.19 - 29.70
========= ==============
1997
Outstanding at beginning of year 2,940,722 $ 0.19 - 18.61
Granted 1,647,733 12.0 - 29.70
Exercised (325,049) 3.33 - 11.50
Forfeited (80,915) 3.89 - 28.92
--------- --------------
Outstanding at end of year 4,182,491 $ 0.19 - 29.70
========= ==============
1996
Outstanding at beginning of year 712,996 $ 3.33 - 5.11
Granted 2,464,049 0.19 -18.61(1)
Exercised (223,148) 3.33 - 7.95
Forfeited (13,175) 3.33 - 7.95
--------- --------------
Outstanding at end of year 2,940,722 $ 0.19 - 18.61
========= ==============
<FN>
(1) Includes options assumed in One Stop acquisition.
</FN>
</TABLE>
The number of options exercisable at June 30, 1998 and 1997, was
2,324,755 and 1,563,722, respectively. The weighted-average fair value of
options granted during 1998 and 1997 was $18.56 and $13.83, respectively.
The Company applies APB Opinion 25 and related interpretations in
accounting for its stock-based compensation plans and arrangements. No
compensation cost has been recognized for its stock option plan. If compensation
cost for the stock option
46
<PAGE>
plan and arrangements had been determined based on the fair value at the grant
dates for awards under this plan consistent with the method prescribed by SFAS
123, the Company's net income and earnings per share would have been reduced to
the pro forma amounts indicated below:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
------------ ------------
Net income:
<S> <C> <C>
As reported $ 27,563,000 1,478,000
Pro forma 26,511,000 (2,437,000)
Basic earnings per share:
As reported 0.97 0.06
Pro forma 0.93 (0.09)
Diluted earnings per share:
As reported 0.87 0.05
Pro forma 0.84 (0.09)
</TABLE>
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted-average
assumptions:
<TABLE>
<CAPTION>
JUNE 30,
--------
1998 1997
---- ----
<S> <C> <C>
Dividend yield 1.20% .54%
Expected volatility 54.56 47.98
Risk-free interest rate 5.78 6.30
Expected life of option 5 years 6 years
</TABLE>
NOTE 11 STOCKHOLDERS' EQUITY
The Company issued a three-for-two stock split in the form of a stock
dividend on February 21, 1997 to stockholders of record on February 10, 1997.
The split was effected as a dividend of one share of common stock for every two
shares of common stock outstanding. After giving effect to this stock split, the
Company had 27.8 million shares outstanding at June 30, 1997.
The Company issued a three-for-two stock split in the form of a stock
dividend on May 17, 1996 to stockholders of record on May 6, 1996. The split was
effected as a dividend of one share of common stock on every two shares of
common stock outstanding. After giving effect to this stock split, the Company
had 23.8 million shares outstanding at June 30, 1996.
On October 10, 1996, the Company completed the sale of 3.6 million
shares of common stock in a public offering. The proceeds to the Company from
the offering, net of expenses, were $118 million.
The Company's bank agreements generally limit the Company's ability to
pay dividends to an amount equal to 85% of its net income. In addition, the
Company's indentures relating to its 10.5% Senior Notes due 2002 and 9.125%
Senior Notes due 2003 place certain restrictions on the payment of dividends and
the encumbrance of additional indebtedness based on the Company's net worth.
In June 1996, the Board of Directors of the Company declared a dividend
distribution of one preferred stock purchase right ("Right") on each share of
the Company's common stock outstanding on July 12, 1996. Each Right, when
exercisable, entitles the holder to purchase from the Company one one-hundredth
of a share of Preferred Stock, par value $0.001 per share, of the Company at a
price of $100.00, subject to adjustments in certain cases to prevent dilution.
The Rights will become exercisable (with certain limited exceptions
provided in the Rights agreement) following the 10th day after (a) a person or
group announces acquisition of 15 percent or more of the common stock, (b) a
person or group announces commencement of a tender offer, the consummation of
which would result in ownership by the person or group of 15 percent or more of
the common stock, (c) the filing of a registration statement for an exchange
offer of 15 percent or more of the common stock under the Securities Act of
1933, as amended, or (d) the Company's board of continuing directors determines
that a person is an "adverse person," as defined in the Rights agreement.
47
<PAGE>
On April 27, 1998, the Company issued 2.78 million shares of its common
stock, or 9.9% of the Company's outstanding shares, to private entities
controlled by Ronald Perelman and Gerald Ford, at a purchase price of $13.7625
per share, or approximately $38 million. The purchase price represented the
average of the closing sales prices of the Company's common stock on the New
York Stock Exchange during the 15-day period preceding the signing of the
agreement (March 19, 1998). As part of the agreement, the Company also issued
warrants to these entities to purchase an aggregate additional 9.9% of the
Company's stock at an exercise price of $17.2031 (125% of the purchase price of
the stock), subject to customary anti-dilution provisions. The warrants are
exercisable only upon a change in control of the Company and expire in three
years.
The following table reconciles basic earnings per share to fully
diluted earnings per share for the years ended June 30, 1998, 1997 and 1996
(dollars and share data in thousands, except earnings per share):
<TABLE>
<CAPTION>
YEAR ENDED JUNE 30,
-------------------
1998 1997 1996
---------- ------------ ----------
<S> <C> <C> <C>
Basic weighted average number of 28,548 26,400 21,681
shares
Add: options 1,094 1,971 3,513
Add: convertible shares 6,107 -- 2,054
------- ------- -------
Diluted shares 35,749 28,371 27,248
======= ======= =======
Basic net income $27,563 1,478 21,073
Convert interest 3,645 -- 1,223
------- ------- -------
Diluted net income $31,208 $ 1,478 $22,296
======= ======= =======
Earnings per share:
Basic $ 0.97 0.06 0.97
Diluted $ 0.87 0.05 0.82
</TABLE>
NOTE 12 SUBSIDIARY GUARANTORS
In October 1996, the Company completed an offering of its 9.125% Senior
Notes due 2003 which are 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 income and
net equity of such subsidiaries are substantially equivalent to the total
assets, net income and net equity of the Company on a consolidated basis.
NOTE 13 QUARTERLY FINANCIAL DATA (UNAUDITED)
A summary of unaudited quarterly operating results for the years ended
June 30, 1998 and 1997 follows (in thousands, except per share amounts):
<TABLE>
<CAPTION>
THREE MONTHS ENDED
---------------------------------------------
SEPT 30 DEC 31 MAR 31 JUNE 30
------------ --------- ---------- ---------
1998
- ----
<S> <C> <C> <C> <C>
Revenue $ 64,499 70,341 59,538 72,111
Income before income taxes 18,760 17,840 3,937 12,269
Net income 9,933 9,170 2,018 6,442
Earnings per share - diluted 0.31 0.29 0.07 0.20
1997
- ----
Revenue $ 59,092 64,992 67,113 23,334
Income (loss) before income
taxes (10,820) 23,624 21,851 (25,195)
Net income (loss) (9,023) 13,148 12,078 (14,725)
Earnings (loss) per share -
diluted (0.38) 0.39 0.36 (0.53)
</TABLE>
NOTE 14 FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET ACTIVITIES
Securitizations - Hedging Interest Rate Risk
48
<PAGE>
The most significant variable in the determination of gain on sale in a
securitization is the spread between the weighted average coupon on the
securitized loans and the pass-through interest rate. In the interim period
between loan origination or purchase and securitization of such loans, the
Company is exposed to interest rate risk. The majority of loans are securitized
within 90 days of origination or purchase. However, a portion of the loans are
held for sale or securitization for as long as twelve months (or longer, in very
limited circumstances) prior to securitization. If interest rates rise during
the period that the mortgage loans are held, the spread between the weighted
average interest rate on the loans to be securitized and the pass-through
interest rates on the securities to be sold (the latter having increased as a
result of market interest rate movements) would narrow. Upon securitization,
this would result in a reduction of the Company's related gain on sale. The
Company mitigates this exposure through swap agreements with third parties that
sell United States Treasury securities not yet purchased and the purchase of
Treasury Put Options. Hedge gains or losses are initially deferred and
subsequently included in gain on sale upon completion of the securitization.
With respect to the Company's securitizations, gain on sale included hedge
losses of $1.30 million and $3.04 million in fiscal 1998 and 1997, respectively.
These hedging activities help mitigate the risk of absolute movements in
interest rates but they do not mitigate the risk of a widening in the spreads
between pass-through certificates and U.S. Treasury securities with comparable
maturities.
Credit Risk
The Company is exposed to on-balance sheet credit risk related to its
receivables and interest-only strips. The Company is exposed to off-balance
sheet credit risk related to loans which the Company has committed to originate
or purchase.
The Company is a party to financial instruments with off-balance sheet
credit risk in the normal course of business. These financial instruments
include commitments to extend credit to borrowers and commitments to purchase
loans from correspondents. The Company has a first or second lien position on
all of its loans, and the combined loan-to-value ratio ("CLTV") permitted by the
Company's mortgage underwriting guidelines generally may not exceed 90%. The
CLTV represents the combined first and second mortgage balances as a percentage
of the appraised value of the mortgaged property, with the appraised value
determined by an appraiser with appropriate professional designations. A title
insurance policy is required for all loans.
Warehousing Exposure
The Company utilizes revolving warehouse financing facilities to
finance the holding of mortgage loans prior to sale or securitization. As of
June 30, 1998 and 1997, the Company had total revolving warehouse facilities
available in the amount of $950 million and $600 million, respectively. The
total amount outstanding related to these facilities was $141.0 million and
$137.5 million at June 30, 1998 and 1997, respectively. Warehouse facilities
typically have a term of one year or less and are designated to fund mortgage
loans originated within specified underwriting guidelines. The majority of the
mortgage loans remain in the facilities for a period generally of up to 90 days
at which point they are securitized or sold to institutional investors. As these
amounts outstanding under these facilities are short term in nature and/or
generally bear market rates of interest, the contractual balances of these
instruments are reasonable estimates of their fair values.
NOTE 15. SUBSEQUENT EVENTS (UNAUDITED)
In its regular quarterly review of its interest-only strip, the Company
considered the historical performance of its securitized loan pools, the recent
prepayment experience of those pools, the credit performance of previously
securitized loans and other industry data and determined that it should adjust
each of its assumptions (rate of prepayment, discount rate and credit loss) to
reflect current market conditions. This change in estimate resulted in a
valuation adjustment of the Company's interest-only strips of $191.6 million
(the "Write-Down") in the quarter ended December 31, 1998. The components of the
valuation adjustment were as follows:
Rate of Prepayment. In its valuation analysis of prepayment speeds, the
Company considered the relationship between the rate paid on the certificates or
bonds issued in the securitizations and the weighted average coupons on the
mortgages outstanding in each securitization pool from time to time.
Additionally, For the quarters up to and including September 30, 1998,
prepayment rates used by the Company were held constant, e.g. flat, over the
life of the pool. The estimates used by the Company for the quarters up to and
including September 30, 1998 were flat prepayment rates ranging from 26% for
fixed to 30.5% for adjustable and hybrid loan products. These rates represented
a weighted average loan life of approximately 2.6 to 3.8 years. During the
quarter ended December 31, 1998, the Company finalized the development of an
enhanced analytical model which more precisely reflected the performance of the
securitized loans. This analytical model enabled the Company to refine its
estimate of the prepayment rates associated with the performance of its
securitized loans. Additionally, data and information received from market
participants (credit
49
<PAGE>
and capital providers) assisted the Company in its assessment of current market
conditions which resulted in the Company applying a more precise valuation
estimate to its prepayment assumptions. The Company incorporated this new
information in developing its improved judgment as to prepayment speeds and
changed its estimate of prepayment rates from a flat constant prepayment rate to
a vectored rate, which more closely approximates the performance of the
securitized loans. These revised prepayment rates resulted in a weighted average
life of 2.86 years. The impact of the change in prepayment speeds amounted to
approximately $62 million, which was included in the Write-Down recorded for the
quarter ended December 31, 1998.
Discount Rate. For the quarters up to and including September 30, 1998,
the Company used the weighted average interest rates of the loans included in
the pool as the best estimate available as an appropriate discount rate to
determine fair value. As the market deteriorated in the quarter ended December
31, 1998, it became apparent that a change in discount rate would be required in
order for the estimate of fair value to be consistent with market conditions. To
determine the appropriate discount rate, the Company reviewed general market
conditions as reflected by market sales of senior tranche asset-backed
securities. Management believed that the pass-through rate on senior tranche
securities should be lower than the discount rate applied to the subordinate,
and higher risk, interest-only strips. However, the adversity of the market
during the quarter ended December 31, 1998 was so severe that, in some
instances, transactions of senior tranche asset-backed securities could not even
be completed. Accordingly, the Company incorporated this current market
information in developing its judgment as to the appropriate risk adjusted rate
of return in establishing its change in estimate of the discount rate to be used
in estimating the fair value of the interest-only strips. For the quarter ended
December 31, 1998, the Company increased its discount rate to 15% to reflect
current market conditions. The impact of this change in discount rate amounted
to approximately $65 million, which was included in the Write-Down recorded for
the quarter ended December 31, 1998.
Credit Losses. For the quarter up to and including September 30, 1998,
the Company used a prospective cumulative loan loss estimate of 1.4% of the
balance of the loans in the securitization pools as an appropriate estimate to
determine fair value. This estimate was developed through a review of the credit
performance of securitized loans in the aggregate. In conjunction with its
previous quarterly review of loss estimates, the Company considered the level of
delinquency of securitized loans and the percentage of annualized losses to
securitized loans in the aggregate. As market conditions deteriorated in the
quarter ended December 31, 1998, the Company refined its estimate of credit
losses by expanding the factors it considers in developing its credit loss
estimates to include loss and delinquency information by channel, credit grade
and product, and information available from other market participants such as
investment bankers, credit providers and credit agencies. For the quarter ended
December 31, 1998, the percentage of losses to average servicing portfolio
amounted to 1.08%, a significant increase from the previous quarter's level of
.80%. The Company had seen levels spike to .96% in the quarter ended June 30,
1998 but then subside to the .80% previously noted. This trend was in line with
the Company's assumption that losses were being realized as the servicing
portfolio was transferred in-house from sub-servicers. Management believes the
increase in losses in the December 1998 quarter reflected general market
conditions rather than the continuing effects of the transfer of servicing
in-house. Publicly available information from investment banking firms and
credit agencies began to indicate a market expectation that credit losses within
the sub-prime home equity sector would rise. Those indications, in part, arise
from the impact of the adverse market conditions on severely delinquent
borrowers who, in a more favorable market, would avoid default by refinancing
with other lenders. In the current market, with competition lessening and
underwriting guidelines tightening, these borrowers are much more likely to
default. Accordingly, the Company increased its prospective cumulative loan loss
estimate to 2.7% of the balance of the loans in the securitization pools at
December 31, 1998. This change in credit loss estimate resulted in a valuation
adjustment of $67 million, which was included in the Write-Down recorded for the
quarter ended December 31, 1998.
The Company recently announced that it modified each of its warehouse
and repurchase credit facilities to conform to the financial targets in those
facilities to its results for the quarter ended March 31, 1999 and the expected
results for the quarter ended June 30, 1999.
During the quarter ended March 31, 1999, the Company recorded a net
loss of $36.0 million. Contributing to the net loss was $15.1 million in pre-tax
operating losses and a $37.0 million one-time charge related to monthly and
servicing advances on loans included in securitization trusts for which it acts
as servicer. The Company records those advances as accounts receivable on its
consolidated balance sheet.
The operating loss during the quarter ended March 31, 1999 arose
primarily from the Company's reliance on the whole loan market rather than
securitizations for its loan disposition strategy and, to a lesser extent, on
reduced loan production. The whole loan market is generally less profitable than
the securitization market. Further, the gain on sale recorded for the Company's
whole loan sales during the quarter were less
50
<PAGE>
than its cost of production. There is no assurance that market conditions will
not change or other events will not occur that would preclude or inhibit the
Company's ability to complete securitizations on a quarterly basis.
The one-time charge recorded in the quarter ended March 31, 1999
related to payments made by the Company in connection with other securitization
trusts for which it acts as servicer. As servicer of the loans it securitizes,
the Company is obligated to advance, or "loan," to the trusts delinquent
interest. In addition, as servicer, the Company advances to the trusts
foreclosure-related expenses and certain tax and insurance remittances relating
to loans in securitized pools. The Company is then entitled to recover these
advances from regular monthly cash flows into the trusts, including monthly
payments, pay-offs and liquidation proceeds on the related loan. Until
recovered, the Company records the cumulative advances as accounts receivable on
its consolidated balance sheet. In addition, the Company, as servicer, is
obligated to make additional payments into the trusts which are not recoverable
from monthly cash flows and, therefore, should not be included in accounts
receivable. These payments, for example, relate to compensating interest
payments for loans that pay-off other than at a month's end. As servicer, the
Company is required to pay into the trust that portion of a monthly interest
payment that is not included in the pay-off amount. At March 31, 1999, amounts
included in accounts receivable that were not recoverable from monthly principal
and interest payments were charged-off. However, payments into a trust that are
not recovered from monthly cash flows may be recovered from the trust's
distributions to the Company as residual certificate holder.
On December 23, 1998, as amended as of February 10, 1999, June 9, 1999
and July 16, 1999, the Company entered into a Preferred Stock Purchase Agreement
(the "Preferred Stock Purchase Agreement") with Capital Z Financial Services
Fund II, LP, a Bermuda limited partnership ("Capital Z"), pursuant to which
Capital Z agreed to make an equity investment in the Company of up to $126.5
million (the "Capital Z Investment"). The initial phase of the Capital Z
Investment occurred on February 10, 1999 when a partnership majority-owned by
Capital Z (the "Capital Z Partnership"), and other parties designated by Capital
Z, purchased 76,500 shares of Series B Convertible Preferred Stock and Series C
Convertible Preferred Stock for $1,000 per share, for an aggregate investment of
$76.5 million. In connection with this investment, the Company restructured its
Board of Directors. The Board was increased to nine directors, five of whom were
nominated by Capital Z pursuant to the terms of the Preferred Stock Purchase
Agreement. In the second phase which was added to the Preferred Stock Purchase
Agreement by the July 16, 1999 amendment, the Capital Z Partnership purchased
25,000 additional shares of Series C Convertible Preferred Stock for $1,000 per
share, for an aggregate additional investment of $25 million. Subject to the
approval of the amendments to the Company's Certificate of Incorporation by the
Company's stockholders, the third phase of the Capital Z Investment will include
an offering to holders of the Company's common stock of non-transferable rights
to purchase up to approximately $31 million of Series C Convertible Preferred
Stock at $1.00 per share (the "Rights Offering") and a sale to Capital Z or its
designees of up to $25 million of the Series C Convertible Preferred Stock but
only to the extent that the amount sold in the Rights Offering is less than $25
million.
At the time the warehouse and repurchase facilities were entered into,
the Company and Capital Z had expected to complete the Rights Offering by June
30, 1999 and the original financial targets in the credit facilities reflected
that fact. Because of administrative delays involving the preparation of
documents and filings, the Company currently expects the Rights Offering to
occur in September 1999.
The amendments of the financial targets in the Company's credit
facilities also reflect the expected operational results for the quarter ended
June 30, 1999. The Company expects to incur an operating loss for the quarter
ended June 30, 1999, primarily due to its decision to delay its securitization
until the quarter ended September 30, 1999. During the quarter ended June 30,
1999, the Company relied on the less profitable whole loan market for its loan
disposition strategy.
The Company also recently announced that it had finalized a new
structure to monetize a substantial portion of its accounts receivables related
to the monthly and servicing advances, as well as substantially reduce the
burden of making future monthly and servicing advances on the loans in its
existing servicing portfolio. In connection with this structure, the Company
received approximately $50 million for certain of the monthly and servicing
advances carried on its consolidated balance sheet. Additionally, the Company
received the necessary approvals of the rating agencies, the trustee and the
monoline insurers on its securitization trusts to engage a third party to make a
significant portion of future servicing advances on those pools.
51
<TABLE>
AAMES FINANCIAL CORPORATION
EARNINGS PER SHARE
For the years ended June 30, 1998,1997, 1996 and 1995
<CAPTION>
------------- ----------- ------------ ------------
1998 1997 1996 1995
------------- ----------- ------------ ------------
<S> <C> <C> <C> <C>
BASIC EARNINGS PER COMMON SHARE:
Net income for calculating basic
earnings per common share $ 27,563,000 1,478,000 21,073,000 5,784,000
Average common shares outstanding 28,548,000 26,400,000 21,681,000 13,532,000
--------------- ----------- ------------ ------------
Basic earnings per common share $ 0.97 0.06 0.97 0.43
=============== =========== ============ ============
DILUTED EARNINGS PER COMMON SHARE:
Net income for calculating diluted
earnings per per common share $ 27,563,000 1,478,000 21,073,000 5,784,000
Adjust net income to add back the
after-tax amount of interest recognized
in the period associated with the
convertible subordinated notes 3,645,000 - 1,223,000 -
--------------- ----------- ------------ ------------
Adjusted net income $ 31,208,000 1,478,000 22,296,000 5,784,000
--------------- ----------- ------------ ------------
Average common shares outstanding 28,548,000 26,400,000 21,681,000 13,532,000
Add exercise of options and warrants 1,094,000 1,971,000 3,513,000 -
Convertible subordinated notes 6,107,000 - 2,054,000 -
--------------- ----------- ------------ ------------
Diluted shares outstanding 35,749,000 28,371,000 27,248,000 13,532,000
--------------- ----------- ------------ ------------
Diluted earnings per common share $ 0.87 0.05 0.82 0.43
=============== =========== ============ ============
</TABLE>
Exhibit 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Prospectuses
constituting part of the Registration Statements on Forms S-3 (Nos. 33-95120,
33-93826, 333-15777 and 333-27537) and S-8 (Nos. 33-44606, 333-01512, 333-12063
and 333- 19675) of Aames Financial Corporation of our report dated August 6,
1998, except as to the information presented in Note 2 for which the date is
July 30, 1999, appearing on page 31 of this Form 10-K/A.
PricewaterhouseCoopers LLP
Los Angeles, California
August 5, 1999
52
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
(Replace this text with the legend)
</LEGEND>
<CIK> 0000879957
<NAME> Aames Financial Corporation
<MULTIPLIER> 1
<CURRENCY> U.S. Dollars
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> JUN-30-1998
<PERIOD-START> JUL-1-1997
<PERIOD-END> JUN-30-1998
<EXCHANGE-RATE> 1
<CASH> 12,322,000
<SECURITIES> 0
<RECEIVABLES> 591,388,000
<ALLOWANCES> 664,000
<INVENTORY> 198,202,000
<CURRENT-ASSETS> 801,248,000
<PP&E> 24,019,000
<DEPRECIATION> 10,080,000
<TOTAL-ASSETS> 815,187,000
<CURRENT-LIABILITIES> 224,146,000
<BONDS> 286,990,000
0
0
<COMMON> 31,000
<OTHER-SE> 304,020,000
<TOTAL-LIABILITY-AND-EQUITY> 815,187,000
<SALES> 266,489,000
<TOTAL-REVENUES> 266,489,000
<CGS> 34,195,000
<TOTAL-COSTS> 34,195,000
<OTHER-EXPENSES> 135,506,000
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 43,982,000
<INCOME-PRETAX> 52,806,000
<INCOME-TAX> 25,243,000
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 27,563,000
<EPS-BASIC> 0.97
<EPS-DILUTED> 0.87
</TABLE>
