1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
------------------------
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED JUNE 30, 1999
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 000-23725
BNC MORTGAGE, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 33-0661303
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1063 MCGAW AVENUE, IRVINE, CALIFORNIA 92614-5532
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES INCLUDING ZIP CODE)
(949) 260-6000
(REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
TITLE OF EACH CLASS
COMMON STOCK, PAR VALUE $0.001
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the voting stock held by non-affiliates of
Registrant, as of September 15, 1999, was $19,532,357, based upon the closing
price of Registrant's Common Stock on that date. For purposes of this
disclosure, shares of common stock held by directors and executive officers of
Registrant are assumed to be "held by affiliates"; this assumption is not to be
deemed to be an admission by such persons that they are affiliates of
Registrant.
As of September 15, 1999, Registrant had outstanding 5,042,350 shares of
Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III, Items 10, 11, 12 and 13 is
incorporated by reference to BNC Mortgage, Inc's. proxy statement which will be
filed with the Commission not more than 120 days after June 30, 1999.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
2
BNC MORTGAGE, INC.
TABLE OF CONTENTS
TO FORM 10-K
FOR THE YEAR ENDED JUNE 30, 1999
PAGE
----
PART I
Item 1. Business.................................................... 3
Item 2. Properties.................................................. 39
Item 3. Legal Proceedings........................................... 39
Item 4. Submission of Matters to a Vote of Security Holders......... 39
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters......................................... 40
Item 6. Selected Financial Data..................................... 42
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 43
Item 7A. Quantitative and Qualitative Disclosures about Market
Risk........................................................ 49
Item 8. Financial Statements and Supplementary Data................. 49
Item 9. Changes in and Disagreements With Accountants on Accounting
and Financial Disclosure.................................... 50
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 50
Item 11. Executive Compensation...................................... 50
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 50
Item 13. Certain Relationships and Related Transactions.............. 50
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 51
Signatures.................................................. 53
2
3
BNC MORTGAGE, INC.
PART I
ITEM 1. BUSINESS
This Report contains certain "forward-looking statements" which represent
the Company's expectations or beliefs, including, but not limited to, statements
concerning industry performance and the Company's operations, performance,
financial condition, prospects, growth and strategies. For this purpose, any
statements contained in this Report except for historical information may be
deemed to be forward-looking statements. Without limiting the generality of the
foregoing, words such as "may," "will," "expect," "believe," "anticipate,"
"intend," "could," "estimate," or "continue" or the negative or other variations
thereof or comparable terminology are intended to identify forward-looking
statements. These statements by their nature involve substantial risks and
uncertainties, certain of which are beyond the Company's control, and actual
results may differ materially depending on a variety of important factors,
including those described in the "Risk Factors" section and elsewhere in this
Report.
GENERAL
BNC Mortgage, Inc. ("BNC" or the "Company"), is a specialty finance company
engaged in the business of originating, purchasing and selling, on a whole loan
basis for cash, non-conforming and, to a lessor extent, conforming, residential
mortgage loans secured by one-to-four family residences. The term "non-
conforming loans" as used herein means (i) subprime loans, which are loans made
to borrowers who are unable or unwilling to obtain mortgage financing from
conventional mortgage sources, whether for reasons of credit impairment, income
qualification, credit history or a desire to receive funding on an expedited
basis and (ii) non-conforming loan products for primarily high credit borrowers
whose credit scores equal or exceed levels required for the sale or exchange of
their mortgage loans through the Federal National Mortgage Association ("FNMA")
and Federal Home Loan Mortgage Corporation ("FHLMC"), but where the loan itself
fails to meet conventional mortgage guidelines, such as the principal balance
exceeds the maximum loan limit of $240,000 or the loan structure documentation
does not conform to agency requirements. The Company's loans are made primarily
to refinance existing mortgages, consolidate other debt, finance home
improvements, education and other similar needs, and, to a lesser extent, to
purchase single family residences. The Company originates and purchases loans
through its: (i) wholesale subprime operations through which it has
relationships with approximately 5,050 approved independent loan brokers and
which to date has accounted for a majority of the Company's total loan
originations and (ii) wholesale prime operations through which it originates
conforming loans that meet FNMA, FHLMC and other conventional mortgage
guidelines and non-conforming loan products which are not subprime loans.
Since it commenced operations in August 1995, the Company has experienced
significant growth in loan originations, with approximately $1.3 billion of
originations in 41 states during fiscal year 1999 compared to $788.5 million of
originations in 42 states and $532.6 million in 33 states during years ended
June 30, 1998 and 1997, respectively. This growth in originations has produced
annual net earnings of $6.3 million in 1999 compared to annual net earnings of
$7.2 million and $7.5 million in 1998 and 1997, respectively.
The Company currently sells substantially all of its mortgage loans through
whole loan sales resulting in cash gain on sale of mortgage loans. For the years
ended June 30, 1999, 1998 and 1997, the Company had mortgage loans sales of $1.3
billion, $744.4 million and $519.9 million, respectively, with resulting cash
gain on sale of mortgage loans of $34.9 million, $30.5 million and $21.9
million, respectively.
For the year ended June 30, 1999, 73.0% of the loans originated by the
Company were subprime loans. Substantially all loans originated by the Company
are secured by a first priority mortgage on the subject property. During the
years ended June 30, 1999 and 1998, less than 1% the principal balance of the
loans originated were secured by second priority mortgages; none of such loans
were originated for the year ended June 30, 1997. The Company's core borrower
base consists of individuals who do not qualify for traditional "A" credit
because their credit history, income or other factors cause them not to conform
to standard agency lending criteria. During the years ended June 30, 1999, 1998
and 1997, approximately 65.0%, 62.2% and 57.5%
3
4
of the principal balance of the subprime loans originated by the Company,
respectively, were to borrowers with a Company risk classification of "A+" or
"A-" while the remainder were to borrowers with a Company risk classification of
"B," "C+," "C" or "C-," respectively, representing approximately 35.0%, 37.8%
and 42.5% of the total principal amount of loans originated by the Company.
Borrowers with a Company risk classification of "A+" or "A-" have a very good
credit history within the last 12 to 24 months with minor late payments allowed
on a limited basis. Borrowers with a "B" Company risk classification generally
have good credit within the last 12 months with some late payments. Borrowers
with a "C+" risk classification have some significant derogatory credit in the
past 12 months while those in the "C" category have frequent derogatory consumer
credit. Borrowers with a Company risk classification of "C-" have numerous
derogatory credit items up to and including a bankruptcy in the most recent 12
month period. During each of the years ended June 30, 1999, 1998 and 1997,
approximately 5.6%, 3.7% and 3.9% of the principal balance of the subprime loans
originated by the Company were to borrowers with a Company risk classification
of "C-." For a tabular presentation of the Company's loan production by borrower
risk classification, see "-- Loan Production by Borrower Risk Classification."
The Company believes that its primary strengths are (i) the experience of
its management, account executives and staff in the non-conforming lending
industry, which enhances the Company's ability to establish and maintain
long-term relationships with mortgage brokers, (ii) its service oriented sales
culture whereby the Company strives to respond quickly and efficiently to
customer needs and market demands, (iii) its operating philosophy to create
stable and deliberate loan origination growth by utilizing consistent and
prudent underwriting guidelines designed to produce mortgage products readily
saleable in the secondary market and (iv) its availability to manage and control
operating costs in order for it to remain a low cost originator. The Company
enters into a mortgage broker agreement with each of its independent mortgage
brokers. For a description of the contractual nature of the Company's
relationships with its independent mortgage brokers, see "-- Mortgage Loan
Originations -- Wholesale Subprime".
GROWTH & OPERATING STRATEGY
The Company's growth and operating strategy is based upon the following key
elements:
Whole Loan Sales for Cash. The Company sells substantially all of its
originated mortgage loans monthly for cash, historically at a premium over the
principal balance of the mortgage loans. The Company enhances earnings and cash
flows from whole loan sales by tailoring the composition of its whole loan pools
to meet the investment preferences of specific buyers. This strategy, as opposed
to securitizations, in which a residual interest in future payments on the loans
is retained, provides certain benefits. The Company receives cash revenue,
rather than recognizing non-cash revenue attributable to residual interests, as
is the case in securitizations, thereby avoiding the risk of having to adjust
revenue in future periods to reflect a lower realization on residual interests
because actual prepayments or defaults exceeded levels assumed at the time of
securitization. By selling its originated loans, the Company also reduces its
exposure to default risk (other than certain first payment defaults) and the
prepayment risk normally inherent in a mortgage lender's business. Management
believes that the cash received in loan sales provides the Company greater
flexibility and operating leverage than a traditional portfolio lender, which
holds the loans it originates, by allowing the Company to generate income
through interest on loans held for sale and gain on loans sold. This strategy of
frequent loan sales has been an important factor in generating the Company's
earnings, creating cash flow to fund operations, decreasing the need for other
forms of financing and reducing the level of interest rate and default risk
borne by the Company.
Continuing Growth of Subprime Wholesale Production. The Company intends to
continue the growth of its wholesale subprime operations through greater
penetration in existing markets and selective geographic expansion. Greater
market penetration is expected to be accomplished through additional sales
personnel to existing origination locations in order to provide continued high
levels of service to brokers to increase loan origination and further the basis
for repeat business, referral and other future lending opportunities. For each
of the years ended June 30, 1999, 1998 and 1997, the Company's loan originations
primarily were in California, Illinois, Florida, Hawaii, Washington, Oregon,
Massachusetts, Colorado, Maryland, Ohio, Wisconsin, Utah, Indiana, Michigan,
Missouri, Georgia, Virginia and Idaho. The Company will seek to improve and
4
5
enhance relationships with mortgage brokers by continuing to (i) improve
response times to loan applications, (ii) streamline wholesale origination and
funding activities and (iii) provide a broad selection of attractive product
offerings. The Company anticipates that short-term expansion will focus on those
geographic regions which it believes represent the most attractive markets for
the Company's products.
Continuing Growth of Wholesale Prime Production. The Company's wholesale
prime operations consists of its wholesale prime business which it established
in 1998 and MortgageLogic.com, Inc., its wholly owned subsidiary, which it
formed in February 1999. Through its wholesale prime operations, the Company
originates conforming mortgage loans that meet FNMA, FHLMC and other
conventional mortgage guidelines and non-conforming loans which are not subprime
loans. The Company's strategy focus is on originating loans using the same
marketing strategies as its wholesale subprime operations. The Company's
wholesale prime operations are coordinated at its executive offices, and to a
lesser extent, at its local sales offices, and at the executive offices of
MortgageLogic.com, Inc.
Expanding Product Offerings. The Company frequently reviews and tailors its
products and pricing for competitiveness, as well as introducing new products to
meet the needs of its borrowers and brokers, expand its customer base and
diversify its product mix. The Company utilizes long-term relationships with
mortgage loan brokers to quickly and efficiently tailor existing products or
introduce new products to satisfy its broker and consumer product needs. Also,
the Company attempts to anticipate changing demands and formulate new products
accordingly. Examples of recently introduced products include loans with higher
loan-to-value ratios for borrowers with good credit histories (see "-- Product
Types"). The Company believes that these mortgage products enable the Company to
increase loan production from brokers who have customers seeking such products.
Low Cost Originator of Mortgage Loans. The Company's success has been due
in part on its ability to manage and control operating costs. The Company has
established a low-cost origination network. For the years ended June 30, 1999,
1998 and 1997, the Company's cost to originate averaged 2.8%, 3.4% and 3.1% of
loan volume, respectively.
Wholesale Expansion Strategy. For its wholesale expansion strategy the
Company initially penetrates a market with a limited number of employees to
recruit brokers for the Company's wholesale network. The Company typically opens
an office in a market only after it achieves a minimum loan volume. By utilizing
this strategy, the Company believes it can maintain lower overhead expenses
compared with companies utilizing a more extensive branch office system. In
addition, the Company has the flexibility to expand or contract its operations
quickly in response to local demand.
Securitization Flexibility. While a substantial majority of the Company's
mortgage loan originations will continue to be sold through whole loan sales in
cash transactions, the Company may in the future sell a portion of its loans
through securitizations. The ability to conduct securitizations may provide the
Company with the flexibility to take advantage of favorable pricing
differentials between the securitization and whole loan sales markets that may
exist from time to time. The Company may seek to enhance earnings by
securitizing loans with characteristics which the securitization market
considers most favorable. The percentage of loans, if any, sold through
securitizations will be based on economic conditions, secondary market
conditions and available financial resources.
The Company intends to utilize its primary strengths and growth and
operating strategy to remain competitive in the mortgage industry. Increased
competition in the mortgage industry could have the effect of (i) lowering gains
that may be realized on loan sales, (ii) reducing an individual company's volume
of loan originations and sales, (iii) increasing demand for experienced
personnel increasing the likelihood such personnel will be recruited by
competitors and (iv) lowering the industry standard for underwriting guidelines
as competitors attempt to increase or maintain market share in the face of
increased competition. In the past, certain of these factors have caused the
revenues and net income of many participants in the mortgage industry, including
the Company, to fluctuate from quarter to quarter.
5
6
MORTGAGE LOAN ORIGINATIONS
The Company's wholesale operations originates loans through a network of
independent mortgage brokers. The Company discontinued its retail operations in
March 1999 and the origination of small commercial loans in April 1997.
Substantially all mortgage loans originated by the Company are secured by a
first priority mortgage on the subject property and for the years ended June 30,
1999 and 1998, less than 1% of the principal balance of the mortgage loans
originated were secured by second priority mortgages; none of such mortgage
loans were originated for the year ended June 30, 1997.
The following table sets forth selected information relating to total
mortgage loan originations during the periods shown:
YEAR ENDED JUNE 30,
----------------------------------
1999 1998 1997
---------- -------- --------
(DOLLARS IN THOUSANDS)
Mortgage loan originations:
Wholesale subprime principal balance............ $ 968,533 $750,406 $507,250
Wholesale prime principal balance............... 360,445 26,716 --
Retail principal balance........................ 6,597 11,357 7,451
Small commercial principal balance.............. -- -- 17,920
---------- -------- --------
$1,335,575 $788,479 $532,621
========== ======== ========
Number of mortgage loans.......................... 11,289 7,897 5,425
Average principal balance per loan................ $ 118 $ 100 $ 98
Weighted average initial loan-to-value ratio(1)... 73.6% 74.4% 69.3%
Weighted average fixed interest rate.............. 8.2% 10.2% 10.5%
Weighted average adjustable interest rate......... 8.7% 9.7% 9.2%
Weighted average fixed/adjustable interest rate... 9.8% 9.6% 9.5%
"A+" and "A-" loans as a percentage of total
subprime mortgage loans originated(2)........... 65.0% 66.1% 57.5%
- ---------------
(1) Determined by dividing the amount of the loan by the lesser of the purchase
price or the appraised value of the mortgaged property at origination.
(2) Based on initial principal balance, and excludes conforming loans, and
non-conforming loans which are not subprime loans originated by the
Company's wholesale prime operations.
WHOLESALE SUBPRIME
Historically, the Company's primary source of mortgage loans has been
through its wholesale subprime operations through which the Company maintains
relationships with approximately 5,050 independent mortgage brokers which,
during the year ended June 30, 1999, originated mortgage loans in 41 states.
During the years ended June 1998 and 1997, the Company had approximately 3,200
and 1,830 approved brokers and originated loans in 42 and 33 states,
respectively. At June 30, 1999, the Company's wholesale subprime operations had
49 origination locations and employed 93 account executives who service mortgage
brokers. The states in which the Company had origination locations at June 30,
1999 were California, Illinois, Florida, Hawaii, Utah, Wisconsin, Oregon,
Massachusetts, Maryland, Colorado, Indiana, Ohio, Washington, Idaho, Missouri,
Michigan, Georgia, South Carolina, Rhode Island, Pennsylvania, Tennessee, North
Carolina, Virginia, Arizona, New Mexico and Minnesota. Through its wholesale
subprime operations, the Company funded $968.5 million in loans, or 72.5%, of
the Company's total mortgage loan production during the year ended June 30,
1999. During the year ended June 30, 1999, the Company's 10 largest producing
brokers originated approximately 9.8% of the Company's mortgage loans, with the
largest broker accounting for approximately 2.3%.
Mortgage loan brokers act as intermediaries between property owners and the
Company in arranging mortgage loans. The Company enters into a mortgage broker
agreement with each of its independent
6
7
mortgage brokers. Pursuant to the agreement, the Company and the mortgage broker
establish a non-exclusive relationship whereby the mortgage broker will, from
time to time and at its option, submit completed mortgage loan application
packages from the general public to the Company for funding consideration and
facilitate the closing of mortgage loan application packages approved for
funding by the Company. The broker's role is to identify the applicant, assist
in completing the loan application form, gather necessary information and
documents and serve as the Company's liaison with the borrower through the
lending process. The Company reviews and underwrites the applications submitted
by the broker, approves or denies the application, sets the interest rate and
other terms of the loan and, upon acceptance by the borrower and satisfaction of
all conditions imposed by the Company, funds the loan. Because brokers conduct
their own marketing and employ their own personnel to obtain loan applications
and maintain contact with borrowers, originating loans through its wholesale
subprime operations allows the Company to increase its loan volume without
incurring the higher marketing, labor and other overhead costs associated with
increased retail originations. The Company has no obligation to pay a mortgage
broker any sum owed to the mortgage broker by a borrower, nor does the Company
have any obligation to pay a mortgage broker any sum with respect to accounts of
any mortgage loan application package which the Company does not fund and close.
Loan applications generally are submitted by mortgage brokers to an account
executive in one of the Company's sales offices. The loan is logged-in for
Federal Real Estate Procedures Settlement Act of 1974, as amended ("RESPA"), and
other regulatory compliance purposes, underwritten and, in most cases,
conditionally approved or denied within 24 hours of receipt. Because mortgage
brokers generally submit individual loan files to several prospective lenders
simultaneously, the Company attempts to respond to each application as quickly
as possible. If approved, a "conditional approval" will be issued to the broker
with a list of specific conditions to be met (for example, credit verifications
and independent third-party appraisals) and additional documents to be supplied
prior to the funding of the loan. The originating account executive and a
production assistant will work directly with the submitting mortgage broker to
collect the requested information and to meet the underwriting conditions and
other requirements. In most cases, the Company funds loans within 15 to 40 days
after approval of the loan application. All independent mortgage brokers who
submit loan applications to the Company must be registered or licensed as
required by the jurisdiction in which they operate and must be approved by the
Company. The Company audits 100% of its brokers on an annual basis in order to
confirm possession of a current license, updated financials on file and any
changes in broker staff or address.
The Company believes that an important element in developing, maintaining
and expanding its independent mortgage broker relationships is to provide a high
level of product knowledge and customer service to its brokers. Each account
executive receives training prior to being assigned to a territory which, in
most cases, includes experience in the loan production department so that the
account executive will be familiar with all phases of loan origination and
production. This training enables the account executive to quickly review a loan
application in order to identify the borrower's probable risk classification and
then assist the broker in identifying the appropriate product for the borrower,
thereby enhancing the likelihood that the loan will be approved at the rate and
on the terms anticipated by the borrower. After a loan package is submitted to
the Company, the account executive and a production assistant provide assistance
to the broker to complete the loan transaction. Account executives are
compensated based on the number and the dollar volume of loans funded.
7
8
The following table sets forth selected information relating to wholesale
subprime loan originations during the periods shown:
YEAR ENDED JUNE 30,
--------------------------------
1999 1998 1997
-------- -------- --------
(DOLLARS IN THOUSANDS)
Principal balance.................................. $968,533 $750,406 $507,250
Average principal balance per loan................. $ 105 $ 99 $ 96
Weighted average initial loan-to-value ratio....... 76.3% 74.4% 69.5%
Weighted average interest rate..................... 9.8% 9.7% 9.6%
Occupancy:
Owner occupied................................... 89.5% 87.7% 85.1%
Non-owner occupied............................... 10.5% 12.3% 14.9%
WHOLESALE PRIME
The Company's wholesale prime operations consist of its internal wholesale
prime business which it established in 1998 and MortgageLogic.com, Inc., its
wholly owned subsidiary, which it formed in February 1999. Through its wholesale
prime operations, the Company originates, purchases and sells mortgage loans
primarily made to high credit quality borrowers. The Company considers "high
credit quality borrowers" to be those whose credit scores equal or exceed levels
required for the sale or exchange of their mortgage loans through FNMA or FHLMC.
The wholesale prime operations originates a variety of mortgage loans including
(i) loans which qualify for inclusion in guarantee programs sponsored by FNMA or
FHLMC, (ii) non-conforming mortgage loans that do not meet agency guidelines,
such as the principal balance exceeds the maximum loan limit of $240,000, or the
loan structure or documentation does not conform to the agency's requirements,
or (iii) other niche loan products.
The Company believes that an important element in developing, and expanding
its service to independent mortgage brokers is the ability to offer conventional
mortgage loan products and non-conforming loans which are not subprime loans as
well as its subprime products.
At June 30, 1999, the Company employed four account executives who service
mortgage brokers located primarily in Southern California. During the year ended
June 30, 1999, through its wholesale prime operations, the Company originated
approximately $360.4 million in loans, or 27.0% of the Company's total mortgage
loan production.
The Company has sold its prime loans during the year on a serviced released
basis for cash to various investors, and originated substantially all of its
loans through independent mortgage loan brokers.
The following table sets forth selected information relating to a wholesale
prime loan originations during the periods shown:
YEAR ENDED JUNE 30,
-----------------------------
1999 1998 1997
-------- ------- ----
(DOLLARS IN THOUSANDS)
Principal balance..................................... $360,445 $26,716 --
Average principal balance per loan.................... $ 183 $ 142 --
Weighted average initial loan-to-value ratio.......... 68.8% 72.8% --
Weighted average interest rate........................ 7.2% 7.6% --
Occupancy:
Owner occupied...................................... 94.0% 90.4% --
Non-owner........................................... 6.0% 9.6% --
8
9
DISCONTINUED RETAIL OPERATIONS
The Company organized its retail operations to market mortgage loans
directly to homeowners in March 1996. The retail operations offered the same
products as those of the Company's wholesale subprime operations. The Company
discontinued its retail operations in March 1999. The Company originated through
its retail operations approximately $6.6 million, or 0.5%, and $11.3 million, or
1.4%, of the Company's total mortgage loan production during the years ended
June 30, 1999 and 1998, respectively.
The following table sets forth selected information relating to retail loan
originations during the periods shown:
YEAR ENDED JUNE 30,
---------------------------
1999 1998 1997
------ ------- ------
(DOLLARS IN THOUSANDS)
Principal balance....................................... $6,597 $11,357 $7,451
Average principal balance per loan...................... $ 114 $ 84 $ 83
Weighted average initial loan-to-value ratio............ 77.1% 73.3% 70.1%
Weighted average interest rate.......................... 8.8% 9.1% 9.6%
Occupancy:
Owner occupied........................................ 95.8% 93.1% 87.8%
Non-owner occupied.................................... 4.2% 6.9% 12.2%
PRODUCT TYPES
The Company primarily offers subprime loans and, to a lessor extent,
conforming mortgage products and non-conforming loans which are not subprime
loans.
Subprime Mortgages
The Company offers both fixed-rate and adjustable-rate subprime loans, as
well as subprime loans with an interest rate that is initially fixed for a
period of time and subsequently converts to an adjustable-rate. Most of the
adjustable-rate loans originated by the Company are offered at a low initial
rate, sometimes referred to as a "teaser" rate. At each interest rate adjustment
date, the Company adjusts the rate, subject to certain limitations on the amount
of any single adjustment, until the rate charged equals the fully indexed rate.
The Company's subprime borrowers fall into six subprime risk classifications and
products are available at different interest rates and with different
origination and application points and fees depending on the particular
borrower's risk classification. The Company offers a wide variety of interest
rate and points paid combinations on many of its products so that customers may
elect to pay higher points at closing to secure a lower rate over the life of
the loan or pay a higher interest rate and reduce or eliminate points payable at
closing. The interest rate on the Company's subprime adjustable rate mortgages
is typically tied to six-month LIBOR and the Company offers 1.0% or 1.5%
semi-annual interest rate caps and 6.5% or 7.0% life caps. The Company sets
subprime mortgage loan coupons and fees after considering several factors,
including the borrower's credit rating, the loan-to-value ratio of the property,
the state in which the loan was originated and competitive and market
conditions. The Company's maximum subprime loan amounts are generally $500,000
with a loan-to-value ratio of up to 90%. The Company does, however, offer larger
subprime loans with lower loan-to-value ratios on a case-by-case basis, and also
offers products that permit a loan-to-value ratio of up to 90% for selected
borrowers with a Company risk classification of "A+" or "A-". Subprime loans
originated by the Company for the year ended June 30, 1999, 1998 and 1997 had an
average principal balance per loan of $104,616, $99,845 and $98,179,
respectively, and a weighted average initial loan-to-value ratio of 76.3%, 74.3%
and 69.3%, respectively. Unless prohibited by state law or otherwise waived by
the Company upon the payment by the related borrower of higher origination fees
and a higher interest rate, the Company generally imposes a prepayment penalty
on the borrower. Approximately 75.4%, 58.0% and 58.1% of the subprime loans the
Company originated during the years ended June 30, 1999, 1998 and 1997,
respectively, provided for the
9
10
payment by the borrower of a prepayment charge in limited circumstances on
certain full or partial prepayments. The Company's current subprime products are
as follows:
Standard Products
2-Year, 3-Year, or 5-Year Fixed/Adjustable Rate Programs -- A 30-year fully
amortized program with the initial interest rate fixed for the first two, three,
or five years of the loan. Beginning with the 25th, 37th or 61st monthly
payment, the loan converts to an adjustable rate, LIBOR-indexed loan. There is
no rate cap on the first adjustment (at conversion). Thereafter, all interest
rate caps apply as described in the LIBOR loan product.
6-Month LIBOR Adjustable -- An adjustable rate first mortgage program
indexed to six-month LIBOR, featuring a semi-annual interest rate cap of
1.0% - 1.5%, and a life cap of 6.5% - 7.0%. This product is fully amortized over
a 30-year life.
15- or 30-Year Fixed Rate Program -- A fixed rate first mortgage loan
program fully amortized over a 15- or 30-year period. All of the standard
mortgage products have prepayment penalties (where legally allowed) for a period
of one to five years.
Other Products
90% LTV First Mortgage Loan -- A 30-year fully amortized adjustable rate or
fixed rate program. The adjustable rate program is indexed to LIBOR featuring a
semi-annual interest rate cap of 1.0% and a life cap of 6.5%. This product is
limited to the A+ and A- credit risk categories.
Second Mortgage Program -- Fixed rate amortizing and fixed rate with
balloon payments are offered. This product is limited to the A+ through B credit
risk, with a maximum combined loan-to-value ratio equal to 100%. Underwriting
guidelines are similar to that of the Company's standard products.
125% LTV Program -- A fixed rate first or second mortgage with an initial
loan-to-value ratio of up to 125% with terms ranging from five to 25 years
limited to borrowers with good credit histories. The use of loan proceeds is
limited to debt consolidation, home improvements and/or asset purchases.
Underwriting guidelines are primarily credit score and mortgage history driven.
Prime Mortgages
The Company offers both fixed rate and adjustable rate conforming loan
programs that meet the guidelines for purchase by government sponsored entities,
such as FNMA and FHLMC, which guarantee mortgage backed securities and permanent
investors in mortgage backed securities secured by or representing an ownership
interest in such mortgage loans and loans that fail to satisfy the criteria to
be a conforming loan for one or more reasons.
These loan products can be categorized as follows:
Conforming Mortgage Loans -- These mortgage loans satisfy the underwriting
criteria for sale or exchange through one of the Agencies.
Non-conforming Mortgage Loans which are not Subprime Loans -- These
mortgage loans fail to satisfy the criteria to be an Agency mortgage loans for
one or more reasons. Certain of these mortgage loans ("Jumbos") generally meet
the Agency criteria but exceed the maximum loan size (currently $240,000 for
single family, one-unit mortgage loans in the continental United States). Jumbos
are generally eligible for sale to one of the national privately-sponsored
mortgage conduits.
Certain other non-conforming mortgage loans may fail to satisfy other
elements of the Agency underwriting criteria, such as those relating to
documentation, employment history, income verification, loan-to-value ratios,
qualifying ratios or borrower net worth. The Company refers to this category of
mortgage loans generally as Alternative A ("ALT A") mortgage loans. The Company
focuses on an applicant's credit score, in conjunction with other factors, in
underwriting its ALT A mortgage loans. While some ALT A mortgage
10
11
loans exceed the maximum loan size eligible for sale through one of the
Agencies, many have principal balances within the Agency limits.
Second Mortgage Loans -- Second mortgage loans are generally secured by
second liens on the related property. The mortgage loans can take the form of a
home equity line of credit ("HELOC") or a closed-end loan. Both types of home
equity mortgage loans are designed primarily for high credit quality borrowers
and are underwritten according to the Company's criteria for second-lien
mortgage loans. These mortgage loans are originated in some instances in
conjunction with the Company's origination of a first-lien mortgage loan on the
related property.
FHA/VA Mortgage Loans -- These mortgage loans satisfy the underwriting
criteria for sale or exchange through the Federal Housing Administration and
Veterans Administration loan programs.
The following tables set forth selected information relating to loan
originations by product type for the periods indicated:
YEAR ENDED JUNE 30, 1999
-----------------------------------------------------------------------------------------
WEIGHTED
AVERAGE WEIGHTED AVERAGE
PRINCIPAL NUMBER BALANCE AVERAGE WEIGHTED INITIAL
AMOUNT % OF TOTAL OF PER INTEREST AVERAGE LOAN-TO-VALUE
TYPE ORIGINATED ORIGINATIONS LOANS LOAN RATE MARGIN RATIO
---- ---------- ------------ ------ -------- -------- -------- -------------
(DOLLARS IN THOUSANDS, EXCEPT AVERAGE BALANCE)
Subprime Mortgages (1)(2):
2-Year Fixed............. $ 487,403 36.5% 4,467 $109,112 9.8% 6.2% 77.3%
3-Year Fixed............. 196,295 14.7 1,823 107,677 9.6% 6.1% 76.6%
6 Month Libor............ 78,729 5.9 601 130,997 9.4% 6.2% 77.3%
5-Year Fixed............. 17,307 1.3 170 101,806 9.3% 6.0% 74.6%
15-Year Fixed............ 18,869 1.4 321 58,782 9.8% -- 68.7%
30-Year Fixed............ 167,482 12.5 1,845 90,776 10.0% -- 73.8%
CLTV125/2nd TD........... 1,375 0.1 36 38,194 13.5% -- 32.0%
Other Mortgages.......... 7,670 0.6 58 132,245 -- -- --
---------- ----- ------
Subtotal........... 975,130 73.0 9,321 104,616 9.8% -- 76.3%
---------- ----- ------
Prime Mortgages(3):
Non-Conforming
Fixed.................. 126,728 9.5 420 301,733 7.2% -- 74.6%
ARM's.................. 24,762 1.9 59 419,695 6.8% 2.7% 73.0%
---------- ----- ------
151,490 11.4 479 316,263 7.1% -- 74.3%
Conforming
Fixed.................. 186,179 13.9 1,162 160,223 7.1% -- 69.5%
ARM's.................. 1,341 0.1 9 149,000 6.5% 2.9% 63.3%
---------- ----- ------
187,520 14.0 1,171 160,137 7.1% -- 69.5%
2nd TD..................... 9,663 0.7 231 41,831 9.2% -- 12.7%
FHA/VA..................... 11,772 0.9 87 135,310 7.3% -- 31.7%
---------- ----- ------
Subtotal........... 360,445 27.0 1,968 183,153 7.2% -- 68.8%
---------- ----- ------
$1,335,575 100.0% 11,289 118,308 9.8% 8.8% 73.6%
========== ===== ======
11
12
YEAR ENDED JUNE 30, 1998
-----------------------------------------------------------------------------------------
WEIGHTED
AVERAGE WEIGHTED AVERAGE
PRINCIPAL NUMBER BALANCE AVERAGE WEIGHTED INITIAL
AMOUNT % OF TOTAL OF PER INTEREST AVERAGE LOAN-TO-VALUE
TYPE ORIGINATED ORIGINATIONS LOANS LOAN RATE MARGIN RATIO
---- ---------- ------------ ------ -------- -------- -------- -------------
(DOLLARS IN THOUSANDS, EXCEPT AVERAGE BALANCE)
Subprime Mortgages:
2-Year Fixed.............. $539,934 68.5% 5,220 $103,436 9.7% 6.2% 75.4%
6-Month LIBOR
Adjustable.............. 100,601 12.8 816 123,286 9.7% 6.3% 74.8%
30-Year Fixed............. 83,079 10.5 1,136 73,133 10.2% -- 71.1%
5-Year Fixed.............. 22,537 2.9 211 106,810 9.3% 6.3% 71.8%
15-Year Fixed............. 11,825 1.5 231 51,191 10.2% -- 65.1%
CLTV125/2nd TD............ 3,787 0.4 95 39,863 13.5% -- 35.5%
-------- ----- -----
Subtotal.......... 761,763 96.6 7,709 98,815 9.7% -- 74.4%
-------- ----- -----
Prime Mortgages(3):
Non-Conforming............ 15,957 2.0 84 189,964 7.8% -- 74.6%
Conforming................ 10,119 1.3 85 119,047 7.1% -- 73.4%
2nd TD.................... 640 0.1 19 33,684 10.9% -- 16.8%
-------- ----- -----
Subtotal.......... 26,716 3.4 188 142,106 7.6% -- 72.8%
-------- ----- -----
$788,479 100.0% 7,897 99,845 9.7% 6.2% 74.4%
======== ===== =====
YEAR ENDED JUNE 30, 1997
-----------------------------------------------------------------------------------------
WEIGHTED
AVERAGE WEIGHTED AVERAGE
PRINCIPAL NUMBER BALANCE AVERAGE WEIGHTED INITIAL
AMOUNT % OF TOTAL OF PER INTEREST AVERAGE LOAN-TO-VALUE
TYPE ORIGINATED ORIGINATIONS LOANS LOAN RATE MARGIN RATIO
---- ---------- ------------ ------ -------- -------- -------- -------------
(DOLLARS IN THOUSANDS, EXCEPT AVERAGE BALANCE)
Subprime Mortgages:
2 Year Fixed.............. $289,549 54.4% 2,838 $102,027 9.5% 6.4% 70.5%
6-Month LIBOR
Adjustable.............. 110,870 20.8 1,066 104,005 9.2% 6.5% 70.2%
30-Year Fixed............. 74,162 13.9 1,011 73,355 10.5% -- 66.1%
5-Year Fixed.............. 30,379 5.7 286 106,221 9.2% 6.5% 67.4%
15-Year Fixed............. 9,741 1.8 198 49,198 10.6% -- 62.6%
Small Commercial(4)....... 17,920 3.4 26 689,231 9.8% -- 63.8%
-------- ----- ------
$532,621 100.0% 5,425 98,179 9.6% 6.4% 69.3%
======== ===== ======
- ---------------
(1) Each fixed rate loan bears interest at a fixed rate set on its date of
funding and lasting through the term of the loan. Loans bearing interest at
the adjustable rate adjust every six months to a new rate through the term
of the loan. The weighted average interest rate for loans bearing interest
at an adjustable rate is the weighted average of the rates of such loans
during the initial six month period. Loans bearing interest at the
fixed/adjustable rate bear interest at a fixed rate for an initial period
commencing on the date of funding (e.g., two years or five years) and
thereafter adjust to new rates every six months for the remaining term of
the loans. The weighted average interest rate for loans bearing interest at
a fixed/ adjustable rate is the weighted average of the rates of such loans
during the initial period.
(2) The margin for a loan is a fixed amount set for the life of the loan, which
when added to the index (as described below) determines the interest rate on
the loan (subject to interest rate floors, ceilings and caps). The index
used by the Company is the six-month LIBOR, as published each Monday in the
Wall Street Journal. Fixed rate loans have no margin because such loans are
not tied to an index.
(3) The Company's wholesale prime operations commenced operations in March 1998.
Through its wholesale prime operations the Company originates loan products
for primarily high credit quality borrowers whose credit scores equal or
exceed levels required for the sale or exchange of their mortgage loans
through FNMA or FHLMC.
(4) The Company discontinued the origination of small commercial loans in April
1997.
12
13
GEOGRAPHIC CONCENTRATION
The following table sets forth aggregate dollar amounts and the percentage
of all loans originated by the Company by state for the periods shown:
FOR THE YEAR ENDED JUNE 30,
--------------------------------------------------------------------------------------
1999 1998 1997
-------------------------- -------------------------- --------------------------
PRINCIPAL PRINCIPAL PRINCIPAL
AMOUNT % OF TOTAL AMOUNT % OF TOTAL AMOUNT % OF TOTAL
ORIGINATED ORIGINATIONS ORIGINATED ORIGINATIONS ORIGINATED ORIGINATIONS
---------- ------------ ---------- ------------ ---------- ------------
(DOLLARS IN THOUSANDS)
California........... $ 621,889 46.55% $236,735 30.0% $196,526 36.9%
Illinois............. 129,830 9.72 130,780 16.6 55,351 10.4
Florida.............. 74,417 5.57 70,758 9.0 28,597 5.4
Hawaii............... 59,579 4.46 46,740 5.9 63,868 12.0
Washington........... 45,497 3.41 23,079 2.9 9,495 1.8
Oregon............... 40,212 3.01 22,647 2.9 21,123 4.0
Massachusetts........ 32,119 2.40 25,904 3.3 6,277 1.2
Colorado............. 27,439 2.05 27,386 3.5 24,102 4.5
Maryland............. 26,934 2.02 24,701 3.1 5,010 0.9
Ohio................. 25,457 1.91 17,442 2.2 19,938 3.7
Wisconsin............ 24,665 1.85 29,176 3.7 22,174 4.2
Utah................. 20,971 1.57 30,459 3.9 20,486 3.8
Minnesota............ 20,918 1.57 9,691 1.2 1,839 0.3
Arizona.............. 17,997 1.35 2,537 0.3 1,823 0.3
Indiana.............. 16,835 1.26 17,180 2.2 12,757 2.4
Michigan............. 15,848 1.19 9,700 1.2 2,353 0.4
Missouri............. 13,930 1.04 14,669 1.9 10,712 2.0
Georgia.............. 12,225 0.92 -- -- -- --
Virginia............. 11,021 0.83 -- -- -- --
Other(1)............. 97,792 7.32 48,895 6.2 30,190 5.8
---------- ------ -------- ----- -------- -----
$1,335,575 100.0% $788,479 100.0% $532,621 100.0%
========== ====== ======== ===== ======== =====
- ---------------
(1) Except for Idaho which accounted for 1.6% for the year ended June 30, 1998,
no other state accounted for greater than 1.0% for the years ended June 30,
1999, 1998 and 1997.
QUALITY CONTROL AND UNDERWRITING
The Company has separate and distinct quality controls and underwriting for
each of its wholesale subprime and wholesale prime operations.
Wholesale Subprime Quality Control
The Company has implemented a subprime loan quality control process
designed to ensure sound lending practices and compliance with the Company's
policies and procedures. Prior to the funding of a subprime loan, the Company
performs a "pre-funding quality control audit" which consists of the
verification of a borrower's credit and employment, utilizing automated services
and verbal verifications.
Properties underlying the potential subprime mortgage loans are appraised
by an appraiser selected by the submitting broker. Every independent appraisal
is reviewed by the Company's chief subprime appraiser (the "Chief Subprime
Appraiser"), other Company appraisers or by another independent appraiser
approved by the Company's Chief Subprime Appraiser to confirm the adequacy of
the property as collateral prior to funding.
13
14
Subsequent to funding, the Company's quality assurance department audits
100% of all subprime closed loans. The department performs a review of
documentation for compliance with established underwriting guidelines and
lending procedures along with independent appraisal reviews and
recertifications. All funding documents are reviewed for accuracy, completeness
and adherence to corporate, state and federal requirements. As a part of this
audit process, deficiencies are reported to the Company's senior management to
determine trends and the need for additional training of Company personnel.
Underwriting The Company originates its subprime mortgage loans in
accordance with the underwriting criteria (the "Underwriting Guidelines")
described below. The subprime loans the Company originates generally do not
satisfy underwriting standards such as those utilized by FNMA and FHLMC;
therefore, the Company's subprime loans are likely to result in rates of
delinquencies and foreclosures that are higher, and may be substantially higher,
than those rates experienced by portfolios of mortgage loans underwritten in a
more traditional manner. The Subprime Underwriting Guidelines are intended to
evaluate the credit history of the potential borrower, the capacity of the
borrower to repay the subprime mortgage loan, the value of the real property and
the adequacy of such property as collateral for the proposed loan. Based upon
the underwriter's review of the subprime loan application and related data and
application of the Underwriting Guidelines, the loan terms, including interest
rate and maximum loan-to-value, are determined.
The Company employs experienced underwriters and the Company's chief
subprime underwriter (the "Chief Subprime Underwriter") must approve the hiring
of all underwriters, including those located in the regional offices and branch
locations. The Company's underwriters are required to have had either
substantial underwriting experience with a consumer finance company or other
subprime or non-conforming lender or substantial experience with the Company in
other aspects of the subprime or non-conforming mortgage finance industry before
becoming part of the Company's underwriting department. As of June 30, 1999, the
Company employed 36 underwriters with an average of approximately five years of
non-conforming mortgage lending experience. All underwriters participate in
ongoing training, including regular supervisory critiques of each underwriter's
work. The Company believes that its experienced underwriting personnel have the
ability to analyze the specific characteristics of each loan application and
make appropriate credit judgments.
The underwriting appraisal staff reviews the value of the underlying
collateral based on a full appraisal completed by pre-approved qualified
licensed independent appraisers. All appraisers are required to conform to the
Uniform Standards of Professional Appraisal Practice adopted by the Appraisal
Standards Board of the Appraisal Foundation. In addition, every independent
appraisal is reviewed by the Company's Chief Subprime Appraiser, other Company
appraisers or by another independent appraiser approved by the Company's Chief
Subprime Appraiser to confirm the adequacy of the property as collateral.
The Underwriting Guidelines include three levels of applicant documentation
requirements, referred to as the "Full Documentation," "Lite Documentation" and
"Stated Income Documentation" programs. Under each of the programs, the Company
reviews the applicant's source of income, calculates the amount of income from
sources indicated on the loan application or similar documentation, reviews the
credit history of the applicant, calculates the debt service-to-income ratio to
determine the applicant's ability to repay the loan, reviews the type and use of
the property being financed, and reviews the property. In determining the
ability of the applicant to repay the loan, the Company's underwriters use (i) a
qualifying rate that is equal to the stated interest rate on fixed-rate subprime
loans, (ii) the initial interest rate on subprime loans which provide for two,
three or five years of fixed payments before the initial interest rate
adjustment, or (iii) one percent above the initial interest rate on other
adjustable-rate subprime loans. The Underwriting Guidelines require that
subprime mortgage loans be underwritten in a standardized procedure which
complies with applicable federal and state laws and regulations and requires the
Company's underwriters to be satisfied that the value of the property being
financed, as indicated by an appraisal and the appraisal review. In general, the
maximum loan amount for subprime mortgage loans originated under the programs is
$500,000; however, larger subprime loans may be approved on a case-by-case
basis. The Underwriting Guidelines permit one-to-four family residential
property subprime loans to have loan-to-value ratios at origination of generally
up to 80%, or up to 90% for borrowers in the Company's highest credit grade
categories, depending on, among other things, the purpose of the mortgage loan,
a borrower's credit history, repayment ability and debt service-to-income ratio,
income documentation, as well as the type and use of the property.
14
15
Under the Full Documentation program, applicants are generally required to
submit two written forms of verification of stable income for at least 12
months. Under the Lite Documentation program, one such form of verification is
required for six months. Under the Stated Income Documentation program, an
applicant may be qualified based upon monthly income as stated on the subprime
mortgage loan application if the applicant meets certain criteria. All the
foregoing programs require that with respect to salaried employees there be a
telephone verification of the applicant's employment. Verification of the source
of funds required to be deposited by the applicant into escrow in the case of a
purchase money loan is generally required under the Full Documentation program
guidelines and on all purchase loans where the loan-to-value ratio is greater
than 80%. No such verification is required under any of the programs where the
loan-to-value ratio is less than 80%. The maximum loan-to-value ratio is reduced
by 5% to 10% for the Lite Documentation and Stated Income Documentation
programs. The level of documentation percentages of subprime loan originations
are as follows:
YEAR ENDED JUNE 30,
-----------------------
1999 1998 1997
----- ----- -----
Full................................................ 67.9% 56.2% 50.5%
Stated Income....................................... 31.6 43.1 48.8
Lite................................................ 0.5 0.7 0.7
----- ----- -----
100.0% 100.0% 100.0%
===== ===== =====
15
16
The Company's categories and criteria for grading the credit history of
potential borrowers is set forth in the table below. Generally, borrowers in
lower credit grades are less likely to satisfy the repayment obligations of a
subprime mortgage loan and, therefore, are subjected to lower loan-to-value
ratios and are charged higher interest rates and loan origination fees. Subprime
Loans made to lower credit grade borrowers, including credit-impaired borrowers,
entail a higher risk of delinquency and may result in higher losses than loans
made to borrowers who use conventional mortgage sources. The Company believes
that the amount of equity present in the collateral securing its subprime loans
generally mitigates these risks.
UNDERWRITING GUIDELINES(1)
A+ RISK A-- RISK B RISK C+ RISK
--------------------- --------------------- --------------------- ---------------------
Existing Mortgage.... One 30-day late Maximum of three Maximum of four No more than one
payment in the last 30-day late payments 30-day late payments 90-day late payment
12 months. in the last 12 within the last 12 in the last 12
months. months allowed if LTV months.
is greater than 80%.
Maximum four 30-day
late payments; or,
two 30-day late less.
payments and one
60-day late payment
in the last 12 months
if LTV is 80% or
less.
Other Credit......... Very good to Very good credit Generally good credit Some significant
excellent credit history within the within the last 12 derogatory credit in
within the last 24 last 12 months. Minor months. Some late the past 12 months.
months. Minor late late payments (not payments (not more Generally,
payments (not more more than 60 days) than 90 days) may be collections and
than 30 days) may be may be allowed on a allowed. chargeoffs not more
allowed on a limited limited basis. than $2,000 may
basis. remain open after
closing.
Bankruptcy filings... Generally, no Generally, no Generally, no Chapter 7 bankruptcy
bankruptcy filings in bankruptcy filings in bankruptcy filings in must have been
the last two years. the last two years. the last two years. discharged at least
12 months prior to
application. Chapter
13 Bankruptcy must
have been filed for
at least 18 months
and borrower must
have paid according
to the Chapter 13
Plan. Chapter 13
Bankruptcy must be
paid or discharged at
closing.
Debt service-to- 50% 50% 55% 55%
income ratio.......
Maximum LTV(2)....... 90% 90% 85% 80%
C RISK C-- RISK
--------------------- ---------------------
Existing Mortgage.... No more than one Unlimited 30- and
120-day late payment 60-day late payments
within the last 12 and a maximum of one
months. 150-day late payment
if LTV is greater
than 65%, maximum one
180-day late payment
if LTV is less than
65%. Delinquencies
more than 180 days
may be allowed if LTV
is less than 60%.
Other Credit......... Frequent derogatory Significant credit
consumer credit. defaults.
Bankruptcy filings... Chapter 7 Bankruptcy Current Bankruptcy.
must have been Bankruptcy allowed on
discharged at least a case by case basis;
six months prior to Bankruptcy must be
application. Chapter paid or discharged at
13 Bankruptcy must closing.
have been filed for
at least 12 months
and borrower must
have paid according
to the Chapter 13
Plan. Chapter 13
Bankruptcy must be
paid or discharged at
closing.
Debt service-to- 60% 60%
income ratio.......
Maximum LTV(2)....... 70% 70%
- ---------------
(1) The letter grade applied to each risk classification reflects the Company's
internal standards and does not necessarily correspond to the
classifications used by other mortgage lenders. "LTV" means loan-to-value.
(2) The maximum LTV set forth in the table is for borrowers providing Full
Documentation. The LTV is reduced for Lite Documentation and Stated Income
Documentation, if applicable.
16
17
The Company evaluates its Underwriting Guidelines on an ongoing basis and
periodically modifies the Underwriting Guidelines to reflect the Company's
current assessment of various issues related to an underwriting analysis. In
addition, the Company adopts underwriting guidelines appropriate to new loan
products.
Exceptions. As described above, the Company uses the foregoing categories
and characteristics as underwriting guidelines only. On a case-by-case basis,
the Company's underwriters may determine that the prospective borrower warrants
a risk category upgrade, a debt service-to-income ratio exception, a pricing
exception, a loan-to-value exception or an exception from certain requirements
of a particular risk category (collectively called an "upgrade" or an
"exception"). An upgrade or exception may generally be allowed if the
application reflects certain compensating factors, including among others: low
loan-to-value ratio; pride of ownership; stable employment; and the length or
residence in the subject property. Accordingly, the Company may classify certain
mortgage loan applications in a more favorable risk category than other mortgage
loan applications that, in the absence of such compensating factors, would only
satisfy the criteria of a less favorable risk category.
Wholesale Prime Division Quality Control
Underwriting. The Company originates its conforming and nonconforming loans
in accordance with the certain underwriting standards to achieve the quality of
mortgages required by either the Agencies or its secondary market investors.
The Company generally performs a pre-funding audit on each mortgage loan.
This audit includes a review for compliance with applicable underwriting program
guidelines and accuracy of the credit report and telephone verification of
employment. The Company performs a post-funding quality control review on a
minimum of 10% of the mortgage loans originated or acquired for complete
re-verification of employment, income and liquid assets used to qualify for such
mortgage loan. Such review also includes procedures intended to detect evidence
of fraudulent documentation and/or imprudent activity during the processing,
funding or selling of the mortgage loan. Verification of occupancy and
applicable information is made by regular mail, or by an independent inspection
company.
One- to-four-family residential properties are appraised by qualified
independent appraisers who are approved by the Company. All appraisals are
required to conform to the Uniform Standards of Professional Appraisal Practice
adopted by the Appraisal Standards Board of the Appraisal Foundation and must be
on forms acceptable to FNMA and FHLMC. As part of the Company's pre-funding
quality control procedures, either field or desk appraisal reviews are obtained
on 10% of all mortgage loans.
Underwriting. Mortgage loan applications must be approved by the Company's
underwriters in accordance with its underwriting criteria, including credit
scores, loan-to-value ratios, borrower income qualifications, investor
requirements, necessary mortgage insurance coverages and property appraisal
requirements. Mortgage loan applications are assigned to an underwriter at the
Company based upon the size and complexity of the mortgage loan and the
underwriter's experience level.
Conforming mortgage loans originated for sale to the Agencies must satisfy
the underwriting standards for one of the programs sponsored by such entities.
All other mortgage loans originated by the Company (including ALT A loans and
home equity loans) are underwritten by the Company according to its credit,
appraisal and underwriting standards. Such underwriting standards are applied to
evaluate the prospective borrower's credit standing and repayment ability and
the value and adequacy of the mortgaged property as collateral. These standards,
which are summarized below, are applied in accordance with applicable federal
and state laws and regulations. Exceptions to the underwriting standards are
permitted when compensating factors are present, and/or prior approval by its
secondary market investors.
The Company's underwriting standards for purchase money or rate/term
refinance mortgage loans secured by one- to two-family primary residences
generally allow loan-to-value ratios at origination of up to 95% for mortgage
loans with original principal balances of up to $400,000, up to 90% for mortgage
loans secured by one- to four-family primary residences with original principal
balances of up to $500,000 and up to 80% for mortgage loans with original
principal balances up to $1,000,000. The loan-to-value ratio for super
17
18
jumbos generally may not exceed 60%. For cash-out refinance mortgage loans, the
maximum loan-to-value ratio generally is 80%, and the maximum "cash out" amount
permitted is based in part on the original amount of the related mortgage loan.
The Company's underwriting standards for mortgage loans secured by
investment properties generally allow loan-to-value ratios at origination of up
to 90% for mortgage loans with original principal balances up to $400,000 on no
cash-out and purchase transactions. On a cash-out refinance mortgage loan, the
loan-to-value is reduced up to 80% with an original principal balance up to
$350,000 with a maximum cash-out of $150,000. The Company's underwriting
standards permit mortgage loans secured by investment properties to have higher
original principal balances if they have lower loan-to-value ratios at
origination.
For each mortgage loan secured by a first lien with a loan-to-value ratio
at origination exceeding 80%, the Company generally requires a private mortgage
insurance policy insuring a portion of the balance of the mortgage loan. In
certain circumstances, however, the Company does not require private mortgage
insurance on mortgage loans with principal balances up to $500,000 that have
loan to value ratios exceeding 80% but less than or equal to 90%. All
residences, except cooperative and certain high-rise condominium dwellings, are
eligible for this program. Each qualifying mortgage loan will be made at an
interest rate that is higher than the rate would be if the loan-to-value ratio
was 80% or less or if private mortgage insurance was obtained.
In determining whether a prospective borrower has sufficient monthly income
available (i) to meet the borrower's monthly obligation on the proposed mortgage
loan and (ii) to meet monthly housing expenses and other financial obligations,
including the borrower's monthly obligations on the proposed mortgage loan, the
Company generally considers, when required by the applicable documentation
program, the ratio of such amounts to the proposed borrower's acceptable monthly
gross income. Such ratios vary depending on a number of underwriting criteria,
including loan-to-value ratios, and are determined on a loan-by-loan basis.
The Company also examines a prospective borrower's credit report.
Generally, each credit report provides a credit score for the borrower. Credit
scores generally are available from three major credit bureaus: TRW, Equifax and
Trans Union. The Company attempts to obtain for each borrower a credit score
from each credit bureau. If three credit scores are obtained, the Company
applies the lowest middle score of all the borrowers. If two scores are
obtained, the Company applies the lower score of all the borrowers. These scores
estimate, on a relative basis, which mortgage loans are most likely to default
in the future. Lower scores imply higher default risk relative to a higher
score. Credit scores are empirically derived from historical credit bureau data
and represent a numerical weighing of a borrower's credit characteristics over a
two-year period. A credit score is generated through the statistical analysis of
a number of credit-related characteristics or variables. Common characteristics
include number of credit lines, payment history, past delinquencies, severity of
delinquencies, current levels of indebtedness, types of credit and length of
credit history. Attributes are the specific values of each characteristic. A
scorecard (the model) is created with weights or points assigned to each
attribute. An individual mortgage loan applicant's credit score is derived by
summing together the attribute weights for that applicant. Generally, the
wholesale prime operations do not originate mortgages where the borrower's
credit score is less than 620.
The Company originates and acquires mortgage loans under one of five
documentation programs: full documentation, alternative documentation, limited
documentation, no ratio loan documentation and no income/no asset verification.
Under the full documentation program, the prospective borrower's
employment, income and assets are verified through written and telephonic
communications. Alternative documentation provides for alternative methods of
employment verification generally using W-2 forms or pay stubs. Generally, under
a full documentation program, a prospective borrower is required to have a
minimum credit score of 620.
Under the limited documentation program, certain credit underwriting
documentation concerning income or income verification and/or employment
verification and assets or assets verification is waived. The limited
documentation program underwriting places more emphasis on the value of the
mortgaged property as collateral and other assets of the borrower than on credit
underwriting. Mortgage loans underwritten using the limited documentation
program are limited to borrowers with credit histories that demonstrate an
established
18
19
ability to repay indebtedness in a timely fashion. Under the limited
documentation program, a prospective borrower is required to have a minimum
credit score of 620. Mortgage loans originated and acquired with limited
documentation include cash-out refinance loans, super jumbos and mortgage loans
secured by investor-owned properties. Permitted maximum loan-to-value ratios
(including secondary financing) under the limited documentation program, which
range up to 80%, are more restrictive than mortgage loans originated with full
documentation or alternative documentation.
Under the no ratio loan documentation program, income ratios for the
prospective borrower are not calculated. Mortgage loans underwritten using the
no ratio loan documentation program have loan-to-value ratios less than or equal
to 80% and meet the standards for the limited documentation program. A minimum
credit score of 660 is required for this program.
Under the no income/no asset verification program, credit underwriting
documentation concerning income, employment verification and asset verification
is waived and income ratios are not calculated. Under the no income/no asset
verification program, emphasis is placed on the value and adequacy of the
mortgaged property as collateral and credit history rather than on verified
income and assets of the borrower. Mortgage loans underwritten under no
income/no asset verification are limited to borrowers with excellent credit
histories. Generally, a minimum credit score of 680 is required.
Exceptions. On a case-by-case basis, the Company's underwriters may
determine that the prospective borrower warrants an exception from its
underwriting guidelines. Such exceptions may include a debt service-to-income
ratio exception, a loan-to-value exception or an exception from certain
documentation requirements of a particular mortgage loan program. An exception
may generally be allowed if the application reflects certain compensating
factors, including among others: a high credit score; a low loan-to-value ratio;
cash reserves; stable employment; and the length of residence in the subject
property. Accordingly, the Company may classify certain mortgage loan
applications into a more extensive documentation program than other mortgage
loan applications that, in the absence of such compensating factors, would only
satisfy the criteria of a less extensive documentation program and may fund
mortgage loans that do not satisfy all of the criteria discussed above for any
particular documentation program.
19
20
LOAN PRODUCTION BY BORROWER RISK CLASSIFICATION
The following tables set forth information concerning the Company's loan
production by borrower risk classification for the years ended June 30, 1999,
1998 and 1997.
YEAR ENDED JUNE 30, 1999
-------------------------------------------------------------------------
WEIGHTED
WEIGHTED AVERAGE
PRINCIPAL % OF NUMBER AVERAGE WEIGHTED INITIAL
AMOUNT TOTAL OF INTEREST AVERAGE LOAN-TO-VALUE
CREDIT RATING ORIGINATED ORIGINATIONS LOANS RATE(1) MARGIN(2) RATIO
------------- ---------- ------------ ------ -------- --------- -------------
(DOLLARS IN THOUSANDS)
Subprime Loans:
Adjustable Rate (6-Month LIBOR):
A+............................... $ 37,468 47.6% 254 9.1% 6.1% 78.4%
A-............................... 19,888 25.3 142 9.3% 6.2% 80.3%
B................................ 13,825 17.6 119 9.4% 6.4% 75.6%
C+............................... 4,691 5.9 53 10.2% 6.9% 69.3%
C................................ 2,163 2.7 23 11.5% 7.4% 65.3%
C-............................... 694 0.9 10 11.1% 7.1% 62.9%
---------- ----- ------
$ 78,729 100.0% 601 9.4% 6.2% 77.3%
========== ===== ======
Fixed/Adjustable Rate
(2-Year, 3-Year, 5-Year)
A+............................... $ 275,041 39.2% 2,125 9.1% 5.9% 79.5%
A-............................... 165,103 23.6 1,395 9.7% 6.1% 79.7%
B................................ 165,102 23.5 1,658 10.0% 6.3% 75.4%
C+............................... 65,670 9.4 839 10.8% 6.8% 70.0%
C................................ 25,854 3.7 370 11.8% 7.3% 64.6%
C-............................... 4,236 0.6 73 12.9% 7.5% 60.8%
---------- ----- ------
$ 701,006 100.0% 6,460 9.8% 6.2% 77.0%
========== ===== ======
Fixed/Adjustable Rate
(15-Year, 30-Year)
A+............................... $ 86,156 46.2% 844 9.4% -- 74.2%
A-............................... 44,247 23.8 474 9.9% -- 75.4%
B................................ 38,475 20.6 519 10.5% -- 72.1%
C+............................... 12,847 6.9 227 11.6% -- 68.0%
C................................ 4,109 2.2 90 12.5% -- 62.0%
C-............................... 516 0.3 12 12.3% -- 64.6%
---------- ----- ------
$ 186,350 100.0% 2,166 10.0% -- 73.3%
========== ===== ======
Other:
Prime Mortgage Loans............. $ 360,445 97.6% 1,968 7.2% -- 68.8%
CLTV 125 Mortgage Loans.......... 1,375 0.4 36 13.5% -- 32.0%
Other Mortgage Loans............. 7,670 2.0 58 -- -- --
---------- ----- ------
$ 369,490 100.0% 2,062 7.2% -- 68.4%
---------- ===== ------
$1,335,575 11,289 8.8% -- 73.6%
========== ======
20
21
YEAR ENDED JUNE 30, 1998
-------------------------------------------------------------------------
WEIGHTED
WEIGHTED AVERAGE
PRINCIPAL % OF NUMBER AVERAGE WEIGHTED INITIAL
AMOUNT TOTAL OF INTEREST AVERAGE LOAN-TO-VALUE
CREDIT RATING ORIGINATED ORIGINATIONS LOANS RATE(1) MARGIN(2) RATIO
------------- ---------- ------------ ------ -------- --------- -------------
(DOLLARS IN THOUSANDS)
Subprime Loans:
Adjustable Rate (6-Month LIBOR):
A+................................ $ 42,320 42.1% 286 9.1% 5.6% 76.0%
A-................................ 22,249 22.1 169 9.5% 6.2% 78.3%
B................................. 20,170 20.0 179 9.8% 6.5% 75.0%
C+................................ 6,308 6.3 62 10.6% 6.9% 69.9%
C................................. 4,424 4.4 51 11.2% 7.5% 67.1%
C-................................ 5,130 5.1 69 12.5% 7.7% 62.1%
-------- ----- -----
$100,601 100.0% 816 9.7% 6.3% 74.8%
======== ===== =====
Fixed/Adjustable Rate
(2-Year, 5-Year)
A+................................ $239,460 42.6% 1,870 8.9% 5.9% 77.6%
A-................................ 123,913 22.0 1,133 9.6% 6.2% 77.3%
B................................. 126,007 22.4 1,348 9.9% 6.3% 73.9%
C+................................ 38,283 6.8 543 10.9% 6.9% 69.8%
C................................. 13,517 2.4 227 12.3% 7.4% 64.4%
C-................................ 21,211 3.8 309 12.8% 7.6% 61.3%
-------- ----- -----
$562,391 100.0% 5,430 9.6% 6.2% 75.3%
======== ===== =====
Fixed Rate
(15-Year, 30-Year)
A+................................ $ 41,513 43.7% 501 9.4% -- 71.5%
A-................................ 21,256 22.4 294 10.1% -- 71.5%
B................................. 20,195 21.3 313 10.7% -- 71.2%
C+................................ 7,137 7.5 152 11.5% -- 66.0%
C................................. 1,940 2.0 50 13.2% -- 59.4%
C-................................ 2,943 3.1 58 13.5% -- 59.4%
-------- ----- -----
$ 94,984 100.0% 1,368 10.2% -- 70.4%
======== ===== =====
Other
Prime Mortgage Loans(3)........... $ 26,716 87.6% 188 7.6% -- 72.8%
LTV125 Mortgage Loans............. 3,787 12.4 95 13.5% -- 35.5%
-------- ----- -----
$ 30,503 100.0% 283 8.3% -- 70.4%
======== ===== =====
$788,479 7,897 9.7% 6.2% 74.4%
======== =====
- ---------------
(1) Each fixed rate loan bears interest at a fixed rate set on its date of
funding and lasting through the term of the loan. Loans bearing interest at
the adjustable rate adjust every six months to a new rate through the term
of the loan. The weighted average interest rate for loans bearing interest
at an adjustable rate is the weighted average of the rates of such loans
during the initial six month period. Loans bearing interest at the
fixed/adjustable rate bear interest at a fixed rate for an initial period
commencing on the date of funding (e.g., two, three or five years) and
thereafter adjust to new rates every six months for the remaining term of
the loans. The weighted average interest rate for loans bearing interest at
a fixed/adjustable rate is the weighted average of the rates of such loans
during the initial period.
(2) The margin for a loan is a fixed amount set for the life of the loan, which
when added to the Index (as described below) determines the interest rate on
the loan (subject to interest rate floors, ceiling and
21
22
caps). The index used by the Company is the six-month LIBOR, as published each
Monday in The Wall Street Journal. Fixed rate loans have no margin because such
loans are not tied to an index.
(3) The Company's wholesale prime operations commenced in the quarter ended
March 1998 and also includes MortgageLogic.com, Inc., the Company's wholly
owned subsidiary which was acquired in February 1999. In general, the credit
guidelines for prime mortgage loans exceeds the credit ratings for the
Company's subprime mortgage loans, and the borrower's credit scores equal or
exceed levels required for the sale or exchange of their mortgage loans
through FNMA or FHLMC.
YEAR ENDED JUNE 30, 1997
-------------------------------------------------------------------------
WEIGHTED
WEIGHTED AVERAGE
PRINCIPAL % OF NUMBER AVERAGE WEIGHTED INITIAL
AMOUNT TOTAL OF INTEREST AVERAGE LOAN-TO-VALUE
CREDIT RATING ORIGINATED ORIGINATIONS LOANS RATE(1) MARGIN(2) RATIO
------------- ---------- ------------ ------ -------- --------- -------------
(DOLLARS IN THOUSANDS)
Subprime Loans:
Adjustable Rate (6-Month LIBOR):
A+................................ $ 21,238 19.1% 181 8.0% 6.0% 71.4%
A-................................ 32,913 29.7 280 8.5% 6.2% 72.6%
B................................. 24,915 22.5 236 9.0% 6.6% 72.4%
C+................................ 16,481 14.9 179 10.0% 6.7% 68.8%
C................................. 9,398 8.5 114 10.9% 7.3% 63.0%
C-................................ 5,925 5.3 76 12.7% 8.0% 59.3%
-------- ----- -----
$110,870 100.0% 1,066 9.2% 6.5% 70.2%
======== ===== =====
Fixed/Adjustable Rate
(2-Year, 5-Year)
A+................................ $116,138 36.4% 927 8.5% 6.1% 71.8%
A-................................ 82,402 25.8 708 9.2% 6.2% 71.9%
B................................. 60,570 18.9 613 9.7% 6.5% 71.0%
C+................................ 32,031 10.0 416 10.8% 6.9% 67.3%
C................................. 16,790 5.2 271 11.9% 7.2% 63.6%
C-................................ 11,997 3.7 189 12.4% 7.6% 57.7%
-------- ----- -----
$319,928 100.0% 3,124 9.5% 6.4% 70.2%
======== ===== =====
Fixed Rate
(15-Year, 30-Year)
A+................................ $ 26,249 31.2% 299 9.6% -- 64.2%
A-................................ 27,110 32.3 347 10.1% -- 66.4%
B................................. 14,980 17.9 225 10.9% -- 68.3%
C+................................ 8,529 10.2 177 11.8% -- 66.9%
C................................. 4,373 5.2 107 13.2% -- 63.5%
C-................................ 2,662 3.2 54 13.6% -- 57.9%
-------- ----- -----
$ 83,903 100.0% 1,209 10.5% -- 65.7%
======== ===== =====
Small Commercial(3)............... $ 17,920 26 9.8% -- 63.8%
======== =====
$532,621 5,425 9.6% 6.4% 69.3%
======== =====
- ---------------
(1) Each fixed rate loan bears interest at a fixed rate set on its date of
funding and lasting through the term of the loan. Loans bearing interest at
the adjustable rate adjust every six months to a new rate through the term
of the loan. The weighted average interest rate for loans bearing interest
at an adjustable rate is the weighted average of the rates of such loans
during the initial six month period. Loans bearing interest at the
fixed/adjustable rate bear interest at a fixed rate for an initial period
commencing on the date of funding (e.g., two, three or five years) and
thereafter adjust to new rates every six months for the remaining term of
the loans. The weighted average interest rate for loans bearing interest at
a fixed/adjustable rate is the weighted average of the rates of such loans
during the initial period.
22
23
(2) The margin for a loan is a fixed amount set for the life of the loan, which
when added to the index (as described below) determines the interest rate on
the loan (subject to interest rate floors, ceiling and caps). The index used
by the Company is the six-month LIBOR, as published each Monday in The Wall
Street Journal. Fixed rate loans have no margin because such loans are not
tied to an index.
(3) The Company discontinued the origination of small commercial loans in April
1997.
TECHNOLOGY
The Company utilizes computer technology to maximize its loan originations.
The Company has established a wide area network and is in the process of linking
most of the Company's account executives to the Company's computer systems.
Through this network, it is expected that an account executive will receive
daily status reports regarding pending loans so that he or she can direct
efforts to those cases that require attention to complete the processing.
Certain account executives, who are not on the network, receive the same data by
daily fax communication. The Company has established an Internet website through
which brokers and interested parties may access information about the Company's
prime wholesale operations and its products. In addition, the Company has
reserved the domain name for the Company's main website, which is currently
under development. The Company's website addresses are http://www.simpleusa.com,
http://www.bncloans.com, http://www.mortgagelogic.com. and
http://www.bncmortgage.com.
The Company makes extensive use of computer technology in its underwriting
process. Each loan application file is computerized so that it can be accessed
immediately by the appropriate persons, thereby eliminating delay that would be
caused by not having physical access to the file. See "-- Management Discussion
and Analysis of Financial Condition and Results of Operations -- Year 2000" for
a discussion of its Year 2000 plans.
FINANCING AND SALE OF LOANS
Warehouse Facilities
Since August 1995, the Company has funded its business primarily through a
warehouse line of credit with DLJ Mortgage Capital, Inc. ("DLJ") under which it
has borrowed money to finance the origination of loans. The current warehouse
line of credit with DLJ (the "DLJ Facility") provides a $150.0 million warehouse
line of credit to the Company. Borrowings under the DLJ Facility bear an
interest rate of the Federal Funds rate plus 100 basis points. The interest rate
is subject to increase based on the length of time loans are held by the
Company, and that DLJ receives a security interest on all loans, and other
rights in connection therewith, originated by the Company. Any loan not
purchased by DLJ is not allowed to remain on the warehouse line for more than
nine months. The term of the DLJ Facility is until March 2000.
The DLJ Facility further provides that DLJ does not have the exclusive
right to purchase loans from the Company. The Company has no obligation to sell
any loans to DLJ, and DLJ has no obligation to purchase any loans from the
Company.
In February 1999, the Company entered into a warehouse line of credit with
Bank United, which provides for borrowings up to $50.0 million with a floating
interest rate based on the LIBOR rate and a commitment fee of $125,000. This
line of credit matures and is subject to renewal on February 1, 2000.
In March 1999, the Company entered into a warehouse line of credit with
Residential Funding Corporation ("RFC"), which provides for borrowings up to
$50.0 million with a floating interest rate based on the LIBOR rate and a
commitment fee of $65,000. This line of credit matures and is subject to renewal
on March 1, 2000.
MortgageLogic.com, Inc. entered into an uncommitted master repurchase
credit agreement with PaineWebber Real Estate Securities ("PWRS"), which
provides for borrowings up to $50.0 million with a floating interest rate based
on the LIBOR rate. The Company is currently negotiating with other lenders to
obtain additional warehouse lines of credit at interest rates and terms that are
consistent with management's objectives.
23
24
Loan Sales
The Company follows a strategy of selling for cash substantially all of its
loan originations through loan sales in which the Company disposes of its entire
economic interest in the loans for a cash price that represents a premium over
the principal balance of the loans sold. The Company sold $1.3 billion, $744.4
million and $519.9 million of loans through loan sales during the years ended
June 30, 1999, 1998 and 1997, respectively. Loan sales are typically made
monthly. The Company did not sell any loans directly through securitizations
during these periods.
DLJ has purchased, and it is contemplated that it may continue to purchase,
loans under the Master Loan Purchase Agreement with a view towards
securitization or other resale transactions in the secondary mortgage market.
Since substantially all of the loans historically purchased by DLJ under the
master repurchase agreement have been resold by DLJ to institutional purchasers
generally within 48 hours of the initial purchase from the Company, DLJ has
agreed to allow the Company to assist it in the marketing of loans so resold by
DLJ. Prior to the purchase of the loans by DLJ under the Master Loan Purchase
Agreement, the Company undertakes a process to identify the institutional
purchasers who will immediately buy the subject loans from DLJ. This program
utilizes a competitive bidding process typically involving two to four potential
purchasers (including Wall Street firms, financial institutions and conduits,
along with other institutional purchasers) who in most cases have purchased
similar resold loans from DLJ in the past. The successful bidder is committed to
a minimum quantity of loans at a determined price, and is generally granted the
option to purchase more than the minimum quantity at a negotiated price. DLJ
then agrees to pay the Company the determined price, minus a certain number of
basis points, which represents DLJ's fees. Under the Master Loan Purchase
Agreement, DLJ will receive no fees in connection with any such purchases
through March 10, 1999 and may receive 12.5 basis points through March 10, 2000
if DLJ assists in the marketing of the loans. As a result of this agreement,
management is able to directly control the sales process of its loans in an
effort to obtain more favorable pricing and other terms. A successful bidder is
not obligated to purchase loans other than those to which its bid applies.
During the years ended June 30, 1999, 1998 and 1997, the Company sold loans to
DLJ having an aggregate principal balance of $612.3 million, $727.1 million and
$473.7 million, respectively. For the years ended June 30, 1998 and 1997, an
aggregate of $2.2 million and $2.1 million, was paid to DLJ as fees pursuant to
the Master Loan Purchase Agreement. There were no fees paid to DLJ for the year
ended June 30, 1999 pursuant to the Master Loan Purchase Agreement.
The Master Loan Purchase Agreement, along with the DLJ Facility, terminates
on March 10, 2000, or may be terminated earlier by DLJ upon an event of default
by the Company, including the occurrence of any proceeding adversely affecting
the Company's ability to perform its obligations to DLJ, a material breach by
the Company of any related agreement with DLJ or a material adverse change in
the Company's business. The Master Loan Purchase Agreement may also be
terminated by DLJ if the Company merges, sells substantially all of its assets
or fails to meet certain financial criteria as agreed to by DLJ and the Company.
Cash gain on sale of mortgage loans represented 65.9%,68.6% and 66.7% of
the Company's total revenues for the years ended June 30, 1999, 1998 and 1997,
respectively. The Company maximizes its cash gain on sale of mortgage loan
revenue by closely monitoring institutional purchasers' requirements and
focusing on originating the types of loans that meet those requirements and for
which institutional purchasers tend to pay higher rates.
Loan sales are made to various institutional purchasers on a non-recourse
basis pursuant to purchase and sales agreements containing customary
representations and warranties by the Company regarding the underwriting
criteria and the origination process. The Company, therefore, may be required to
repurchase or substitute loans in the event of a breach of its representations
and warranties. In addition, the Company sometimes commits to repurchase or
substitute a loan if a payment default occurs within the first month following
the date the loan is funded. The Company is also required in some cases to
repurchase or substitute a loan if the loan documentation is alleged to contain
fraudulent misrepresentations made by the borrower. Any claims asserted against
the Company in the future by its loan purchasers may result in liabilities or
legal expenses that could have a material adverse effect on the Company's
results of operations and financial condition. In addition, any material
repurchase or substitution may have an adverse effect on the market for
24
25
and pricing of the Company's loans. Since the Company commenced operations in
August 1995 through June 30, 1999, the Company has repurchased loans with an
aggregate principal balance of $2.5 million sold to various institutional
purchasers due to breaches of representations and warranties, fraudulent
misrepresentations or borrower default in the first month.
The Company has entered into a forward loan sale contract with an
investment bank under which it has committed to deliver $361.8 million in loans
originated during the period from February 1999 to July 1999. At June 30, 1999,
$284.9 million in loans had been delivered under this commitment and the balance
was delivered subsequent to year end. The price received under the commitment
includes adjustments for the actual weighted average coupons, weighted average
margins and prepayment terms of the loans sold.
In June 1998, the Company entered into a $50.0 million optional delivery
master commitment to sell certain nonconforming mortgage loans at current market
rates to "IFC". The forward sales commitment is for a 12 month period and
provides an option to increase the commitment to $100.0 million. The Company
paid a commitment fee of $63,000 which was recorded as an asset and will be
amortized as the loans are sold into the commitment. At June 30, 1999, $20.8
million loans had been sold under this commitment.
Securitization Capability
While the Company has not sold loans directly through securitizations, part
of the Company's loan sale strategy may include the sale of loans directly
through securitizations in the future if management determines that such sales
are more beneficial. Management has significant securitization experience in
that several members were involved in securitization prior to their employment
with the Company.
Typically in a securitization, the issuer aggregates mortgages into a real
estate mortgage investment conduit trust. The regular interests or the senior
tranches of the trust are investment grade. While the issuer generally retains
the residual interests in the trust, it immediately sells the regular interests
and generally uses the proceeds to repay borrowings that were used to fund or
purchase the loans in the securitized pool. The holders of the regular interests
are entitled to receive scheduled principal collected on the pool of securitized
loans and interest at the pass-through interest rate on the certificate balance
for such interests. The residual interests represent the subordinated right to
receive cash flows from the pool of securitized loans after payment of the
required amounts to the holders of the regular interests and the cost associated
with the securitization. The issuer recognizes non-cash revenue relating to the
residual interest at the time of the securitization.
SUB-SERVICING
While the Company currently sells substantially all of the mortgage loans
it originates servicing released (meaning the Company does not retain the
servicing rights to such loans), it is required to service the loans from the
date of funding through the date of sale. Since the Company conducts whole loan
sales monthly, the Company currently does not have a substantial servicing
portfolio. Nonetheless, the Company currently contracts for the sub-servicing of
all mortgage loans it originates through the date of sale and is subject to
risks associated with inadequate or untimely services. To the extent that the
Company decides to retain servicing rights in the future or conduct
securitizations, it currently intends to contract for the sub-servicing of such
mortgage loans, which would expose it to more substantial risks associated with
contracted sub-servicing. In such event, it is expected that many of the
Company's borrowers will require notices and reminders to keep their mortgage
loans current and to prevent delinquencies and foreclosures. A substantial
increase in the Company's delinquency rate or foreclosure rate could adversely
affect its ability to access profitably the capital market for its financing
needs, including any future securitizations.
Any of the Company's sub-servicing agreements with its third-party
sub-servicers are expected to provide that if the Company terminates the
agreement without cause (as defined in the agreement), the Company may be
required to pay the third-party sub-servicer a fee. Depending upon the size of
the Company's loan portfolio sub-serviced at any point in time, the termination
penalty that the Company would be obligated to pay upon termination without
cause, may be substantial.
25
26
INTEREST RATE RISK MANAGEMENT
The Company's profits depend, in part, on the difference, or "spread,"
between the effective rate of interest received by the Company on the loans it
originates or purchases and the interest rates payable by the Company under its
warehouse facilities or for securities issued in any future securitizations. The
spread can be adversely affected because of interest rate increases during the
period from the date the loans are originated until the closing of the sale or
securitization of such loans.
Since the Company historically has retained loans for a short period of
time pending sale, it has not engaged in hedging activities to date. However, in
the future the Company may hedge its variable-rate mortgage loans and any
interest-only and residual certificates retained in connection with any future
securitizations with hedging transactions which may include forward sales of
mortgage loans or mortgage-backed securities, interest rate caps and floors and
buying and selling of futures and options on futures. The nature and quantity of
hedging transactions will be determined by the Company's management based on
various factors, including market conditions and the expected volume of mortgage
loan originations and purchases. No assurance can be given that such hedging
transactions will offset the risks of changes in interest rates, and it is
possible that there will be periods during which the Company could incur losses
after accounting for its hedging activities.
COMPETITION
The Company faces intense competition in the business of originating and
selling mortgage loans. The Company's competitors in the industry include other
consumer finance companies, mortgage banking companies, commercial banks, credit
unions, thrift institutions, credit card issuers and insurance finance
companies. Many of these entities are substantially larger and have considerably
greater financial, technical and marketing resources than the Company. With
respect to other mortgage banking and specialty finance companies, there are
many larger companies that focus on the same types of mortgage loans with which
the Company directly competes for product. From time to time, one or more of
these companies may be dominant in the origination and sale of non-conforming
and conforming mortgage loans. In addition, many financial services
organizations that are much larger than the Company have formed national loan
origination networks offering loan products that are substantially similar to
the Company's loan programs. 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. In addition, the current level of gains
realized by the Company and its competitors on the sale of non-conforming loans
could attract additional competitors into this market. Additional competition
may lower the rates the Company can charge borrowers, thereby potentially
lowering gain on future loan sales and future securitizations. The Company may
in the future also face competition from, among others, government-sponsored
entities which may enter the non-conforming mortgage market. Existing or new
loan purchase programs may be expanded by FNMA, FHLMC, or Government National
Mortgage Association ("GNMA") to include non-conforming mortgages, particularly
those in the "Alt A" category, which constitute a significant portion of the
Company's loan production. For example, FHLMC has entered, on a limited basis,
the non-conforming mortgage market (not including subprime loans). Entries of
such government-sponsored entities into the non-conforming market may have an
adverse effect on loan yields on mortgage loans originated by the Company and
reduce or eliminate premiums on loan sales. To the extent any of these
competitors significantly expand their activities in the Company's market, the
Company could be materially adversely affected. Fluctuations in interest rates
and general economic conditions may also affect the Company's competition.
During periods of rising rates, competitors that have locked in low borrowing
costs may have a competitive advantage. During periods of declining rates,
competitors may solicit the Company's customers to refinance their loans.
REGULATION
The consumer financing industry is a highly regulated industry. The
Company's business is subject to extensive and complex rules and regulations of,
and examinations by, various federal, state and local government authorities.
These rules impose obligations and restrictions on the Company's loan
origination, credit activities and secured transactions. In addition, these
rules limit the interest rates, finance charges and
26
27
other fees the Company may assess, mandate extensive disclosure to the Company's
customers, prohibit discrimination and impose multiple qualification and
licensing obligations on the Company. Failure to comply with these requirements
may result in, among other things, loss of approved status, demands for
indemnification or mortgage loan repurchases, certain rights of rescission for
mortgage loans, class action lawsuits, administrative enforcement actions and
civil and criminal liability. Management believes that the Company is in
compliance with these rules and regulations in all material respects.
The Company's loan origination activities are subject to the laws and
regulations in each of the states in which those activities are conducted. For
example, state usury laws limit the interest rates the Company can charge on its
loans. The Company's lending activities are also subject to various federal
laws, including the Truth-in-Lending Act, Homeownership and Equity Protection
Act of 1994, the Equal Credit Opportunity Act, the Fair Credit Reporting Act,
the Real Estate Settlement Procedures Act and the Home Mortgage Disclosure Act.
The Company is subject to certain disclosure requirements under the
Truth-in-Lending Act ("TILA") and Regulation Z promulgated under TILA. TILA is
designed to provide consumers with uniform, understandable information with
respect to the terms and conditions of loan and credit transactions. TILA also
guarantees consumers a three-day right to cancel certain credit transactions,
including loans of the type originated by the Company. In addition, TILA gives
consumers, among other things, a right to rescind loan transactions in certain
circumstances if the lender fails to provide the requisite disclosure to the
consumer.
With respect to its conforming lending activities, lenders such as the
Company are required annually to submit to FNMA and FHLMC audited financial
statements, and each regulatory activity has its own financial requirements. The
Company's affairs are also subject to examination by FNMA and FHLMC at any time
to assure compliance with the applicable regulations, policies and procedures.
The Company is also subject to the Homeownership and Equity Protection Act
of 1994 (the "High Cost Mortgage Act"), which makes certain amendments to TILA.
The High Cost Mortgage Act generally applies to consumer credit transactions
secured by the consumer's principal residence, other than residential mortgage
transactions, reverse mortgage transactions or transactions under an open end
credit plan, in which the loan has either (i) total points and fees upon
origination in excess of the greater of eight percent of the loan amount or
$435, or (ii) an annual percentage rate of more than ten percent points higher
than United States Treasury securities of comparable maturity ("Covered Loans").
The High Cost Mortgage Act imposes additional disclosure requirements on lenders
originating Covered Loans. In addition, it prohibits lenders from, among other
things, originating Covered Loans that are underwritten solely on the basis of
the borrower's home equity without regard to the borrower's ability to repay the
loan and including prepayment fee clauses in Covered Loans to borrowers with a
debt-to-income ratio in excess of 50% or Covered Loans used to refinance
existing loans originated by the same lender. The High Cost Mortgage Act also
restricts, among other things, certain balloon payments and negative
amortization features.
The Company is also required to comply with the Equal Credit Opportunity
Act of 1974, as amended ("ECOA") and Regulation B promulgated thereunder, the
Fair Credit Reporting Act, as amended, the Real Estate Settlement Procedures Act
of 1975, as amended, and the Home Mortgage Disclosure Act of 1975, as amended.
ECOA prohibits creditors from discriminating against applicants on the basis of
race, color, sex, age, religion, national origin or marital status. Regulation B
restricts creditors from requesting certain types of information from loan
applicants. The Fair Credit Reporting Act, as amended, requires lenders, among
other things, to supply an applicant with certain information if the lender
denied the applicant credit. RESPA mandates certain disclosure concerning
settlement fees and charges, escrow account establishment and maintenance, and
mortgage servicing transfer practices. It also prohibits the payment or receipt
of kickbacks or referral fees in connection with the performance of settlement
services. In addition, beginning with loans originated in 1997, the Company must
file an annual report with the Department of Housing and Urban Development
("HUD") pursuant to the Home Mortgage Disclosure Act, which requires the
collection and reporting of statistical data concerning loan transactions.
In October 1997, HUD issued proposed regulations regarding the treatment
and disclosure of fees charged and collected by mortgage brokers providing
certain safe harbors for the payment of fees by lenders to
27
28
mortgage brokers and setting forth standards to determine whether payments to
mortgage brokers violate RESPA. In July 1998, HUD and the Board of Governors of
the Federal Reserve System delivered to Congress a joint report containing
legislative proposals to reform RESPA and TILA. This report proposed an
exemption from the fee restrictions of RESPA for mortgage brokers that offer a
package of settlement services for mortgage loans at a guaranteed price and
follow other requirements. In March 1999, HUD issued a policy statement setting
forth its position on lender-paid broker compensation under RESPA. In the policy
statement, HUD asserts that lender payments to mortgage brokers are not per se
illegal, but rather must be analyzed on a case-by-case basis. In determining
whether lender-paid compensation is permissible under RESPA, the policy
statement sets forth a two-part test: (i) whether the broker actually provided
compensable goods, facilities or services and (ii) whether the broker's total
compensation is reasonably related to the value of the goods, facilities or
services it provided. In the policy statement, HUD also stated that legislation
to improve RESPA is needed and that a reform package along the lines specified
in the HUD and Federal Reserve Board report remains the most effective way to
resolve the legal uncertainties under that statute. It is unknown at this time
whether HUD's October 1997 proposal or reform legislation will be adopted.
In the course of its business, the Company may acquire properties securing
loans that are in default. There is a risk that hazardous or toxic waste could
be found on such properties. In such event, the Company could be held
responsible for the cost of cleaning up or removing such waste, and such cost
could exceed the value of the underlying properties.
Because the Company's business is highly regulated, the laws, rules and
regulations applicable to the Company are subject to regular modification and
change. There are currently proposed various laws, rules and regulations which,
if adopted, could impact the Company. There can be no assurance that these
proposed laws, rules and regulations, or other such laws, rules or regulations,
will not be adopted in the future which could make compliance much more
difficult or expensive, restrict the Company's ability to originate, broker,
purchase or sell loans, further limit or restrict the amount of commissions,
interest and other charges earned on loans originated, brokered, purchased or
sold by the Company, or otherwise adversely affect the business or prospects of
the Company.
EMPLOYEES
At June 30, 1999, the Company employed 415 persons. None of the Company's
employees is subject to a collective bargaining agreement. The Company believes
that its relations with its employees are satisfactory.
RISK FACTORS
LIMITED HISTORY OF OPERATIONS LIMITS PRIOR PERFORMANCE AS AN INDICATOR OF FUTURE
PERFORMANCE
The Company commenced operations in August 1995 and began originating loans
in October 1995. Although the Company has been profitable for each fiscal period
presented herein and has experienced substantial growth in mortgage loan
originations and total revenues, there can be no assurance that the Company will
be profitable in the future or that these rates of growth will be sustainable or
indicative of future results. Furthermore, the Company has recently begun
originating conforming loans and non-conforming loans which are not subprime
loans. This is a new type of product and market in which the Company is
entering. There can be no assurance that the Company will be profitable and
there may be certain risks and uncertainties in which the Company is unfamiliar.
Any decline in future profitability or growth rates may adversely affect the
market for the Company's Common Stock which could result in volatility or a
decline in its market price.
Since it commenced operations in August 1995, the Company's growth in
originating loans has been significant. In light of this growth, the historical
financial performance of the Company may be of limited relevance in predicting
future performance. Since the Company historically has sold substantially all
loans originated on a whole loan basis, it has not tracked the performance of
its loans in the secondary market and thus is unable to determine the history of
loan losses associated with such loans. If a material portion of such
28
29
loans result in loan losses to the holders thereof, the market for and pricing
of the Company's loans could be adversely affected, which could materially lower
revenues for a subject reporting period.
NO ASSURANCE OF PLANNED GROWTH; INABILITY OF THE COMPANY TO GROW COULD ADVERSELY
AFFECT THE COMPANY'S OPERATING RESULTS
The Company's total revenues and net income have grown significantly since
inception, primarily due to increased mortgage loan origination and sales
activities. The Company intends to continue to pursue a growth strategy for the
foreseeable future. Since the Company expects recent higher levels of mortgage
broker compensation, which reduce the cash gain on sale of mortgage loans, to
continue for the year ending June 30, 2000 and possibly thereafter, the Company
believes that its future operating results will depend largely upon its ability
to expand its mortgage origination and sales activities, and, in particular,
increased penetration in existing markets. While the Company plans to continue
its growth of loan originations through the expansion of its wholesale
operations, these plans require additional personnel and assets. There can be no
assurance that the Company will be able to successfully expand and operate its
wholesale operations and programs profitably. It also is expected that such
expansion plans will result in a substantial increase in operating expenses in
the short-run. Furthermore, since management expects that there will be a time
lag between the expenditure of such monies and the receipt of any revenues from
such expansion efforts, the Company's results of operations may be adversely
affected in the short-run. There can be no assurance that the Company will
anticipate and respond effectively to all of the changing demands that its
expanding operations will have on the Company's management, information and
operating systems, and the failure to adapt its systems could have a material
adverse effect on the Company's results of operations and financial condition.
There can be no assurance that the Company will successfully achieve its planned
expansion or, if achieved, that the expansion will result in profitable
operations.
RISK OF VARIATIONS IN QUARTERLY OPERATING RESULTS
Several factors affecting the Company's business can cause significant
variations in its quarterly results of operations. In particular, variations in
the volume of the Company's loan originations, the differences between the
Company's costs of funds and the average interest rates of originated loans, the
inability of the Company to complete significant loan sales transactions in a
particular quarter, and problems generally affecting the mortgage loan industry
can result in significant increases or decreases in the Company's revenues from
quarter to quarter. A delay in closing a particular loan sale transaction during
a particular quarter would postpone recognition of cash gain on sale of loans.
In addition, delays in closing a particular loan sale transaction would also
increase the Company's exposure to interest rate fluctuations by lengthening the
period during which its variable rate borrowings under its warehouse facilities
are outstanding. If the Company were unable to sell a sufficient number of its
loans at a premium in a particular reporting period, the Company's revenues for
such period would decline, resulting in lower net income and possibly a net loss
for such period, which could have a material adverse effect on the Company's
results of operations and financial condition.
DISCONTINUANCE OF WAREHOUSE LINE OF CREDIT ARRANGEMENTS WITH DLJ COULD ADVERSELY
AFFECT THE COMPANY'S OPERATING RESULTS
The Company commenced operations in August 1995 and prior to its initial
public offering in March 1998 benefitted from its relationship with DLJ. Since
commencement of operations, DLJ has provided the Company with a warehouse line
of credit to fund loan production which was the only financing facility the
Company used prior to its initial public offering. The Company is substantially
dependent upon its access to warehouse lines of credit and other lending
facilities in order to fund loan originations.
The DLJ Facility provides the Company with a $150.0 million line of credit
which expires in March 2000. The interest rate of the DLJ Facility bore interest
at the federal funds rate plus 50 basis points until March 1999 and thereafter
the rate is the federal funds rate plus 100 basis points. It is expected that
the DLJ Facility will not be extended beyond the modified term. The Company has
obtained and continues to seek to obtain additional and alternative sources of
financing on favorable terms to decrease its reliance on DLJ. The Company
currently has a $50.0 million committed warehouse line of credit with Bank
United which is subject
29
30
to renewal on February 1, 2000 and a $50.0 million committed warehouse line of
credit with RFC which is subject to renewal on March 1, 2000. In addition,
MortgageLogic.com, Inc. has entered into an uncommitted master repurchase credit
agreement with PWRS, which provides for borrowings up to $50.0 million. The
Company is currently negotiating with other lenders to obtain additional
warehouse lines of credit, Any failure by it's lenders to continue to provide
financing or the Company's failure to obtain adequate funding under any
additional or alternative facilities, on favorable terms or otherwise, could
cause the Company to curtail loan origination activities, which would result in
a decline in revenues, the effect of which could have a material adverse effect
on the Company's operations.
SUBSTANTIAL DEPENDENCE ON INSTITUTIONAL PURCHASERS
Gain on sales of loans represents the primary source of the Company's
revenues and net income. The Company relies almost entirely on proceeds from
loan sales to generate cash for repayment of borrowings under the Company's
warehouse facilities. The Company has entered into a number of transactions with
three financial institutions which account for more than 10% of the Company's
loan sales. For the year ended June 30, 1999, the three institutions purchased
$612.3 million, $150.2 million and $134.3 million which accounted for 47.1%,
11.6% and 10.3% of the Company's loan sales. For the year ended June 30, 1998,
DLJ purchased substantially all of the Company's loan production. The Company
sells its loan production to institutional purchasers in the secondary market.
There can be no assurance that such institutional purchasers will continue to
purchase loans originated by the Company at previous levels or at all, or will
be willing to purchase such loans on terms under which they had historically
purchased the Company's loans. The loss of any of such investors may have a
material adverse effect on the Company operations. In addition, the failure by
the Company to timely sell its loans would expose the Company to interest rate
fluctuations and greater risks of borrower defaults and bankruptcies, fraud
losses and special hazard losses. The failure of the Company to negotiate
favorable terms for its loan sales would adversely affect the Company's
revenues.
SUBSTANTIAL DEPENDENCE ON WHOLESALE BROKERS
The Company depends largely on independent mortgage brokers, financial
institutions and mortgage bankers for its originations of mortgage loans.
Substantially all of the independent mortgage brokers with whom the Company does
business deal with multiple loan originators for each prospective borrower.
Mortgage loan originators, including the Company, compete for business based
upon pricing, service, loan fees and costs and other factors. The Company's
competitors also seek to establish relationships with such independent mortgage
brokers, financial institutions and mortgage bankers, none of whom is
contractually obligated to continue to do business with the Company. In
addition, the Company expects the volume of wholesale loans that it originates
to increase which will depend in large part on maintaining and expanding its
relationships with its independent mortgage brokers. The Company's future
results may become increasingly exposed to fluctuations in the volume and cost
of its wholesale loans resulting from competition from other originators and
purchasers of such loans, market conditions and other factors.
SUBSTANTIAL RISKS RELATED TO LENDING TO LOWER CREDIT GRADE BORROWERS
The Company's primary focus is lending in the subprime mortgage banking
industry, which means that the Company focuses the substantial portion of its
marketing efforts on borrowers who may be unable to obtain mortgage financing
from conventional mortgage sources. Approximately 5.6% of the total principal
amount of subprime loans originated by the Company during the year ended June
30, 1999 were to borrowers with a Company risk classification of "C--," which
includes borrowers with numerous derogatory credit items up to and including a
bankruptcy in the most recent 12-month period. In addition, for the year ended
June 30, 1999, approximately 31.6% of the Company's total subprime loan
originations were made under its "Stated Income Documentation" program pursuant
to which the Company does not require any income documentation. As a result, the
Company does not independently verify in writing the accuracy of the stated
income of such borrowers on their mortgage loan applications which may subject
the Company to a greater risk of borrower misrepresentations. Also, an
undeterminable percentage of the Company's subprime loans and non-conforming
loans are made based on exceptions to the Company's underwriting guidelines; any
exception may cause a borrower to be placed in a more favorable borrower risk
classification and thereby be provided loan
30
31
terms which such borrower may not have qualified for absent such exception.
Loans made to such borrowers generally entail a higher risk of delinquency and
higher losses than loans made to borrowers who utilize conventional mortgage
sources. Delinquencies, foreclosures and losses generally increase during
economic slowdowns or recessions. Further, any material decline in real estate
values increase the loan-to-value ratios of loans previously made by the
Company, thereby weakening collateral coverage and increasing the possibility of
a loss in the event of a borrower default. Any sustained period of increased
delinquencies, foreclosures or losses after the loans are sold could adversely
affect the pricing of the Company's future loan sales and the ability of the
Company to sell its loans in the future. In the past, certain of these factors
have caused revenues and net income of many participants in the mortgage
industry, including the Company, to fluctuate from quarter to quarter.
SUBSTANTIAL COMPETITION MAY ADVERSELY AFFECT THE COMPANY'S ABILITY TO ORIGINATE,
SELL OR FINANCE MORTGAGE LOANS
As an originator of mortgage loans, the Company faces intense competition,
primarily from mortgage banking companies, commercial banks, credit unions,
thrift institutions and finance companies. Many of these entities are
substantially larger and have more capital and other resources than the Company.
With respect to other mortgage banking and specialty finance companies, there
are many larger companies that focus on the same types of mortgage loans with
which the Company directly competes for product. From time to time, one or more
of these companies may be dominant in the origination and sale of mortgage
loans. In addition, many financial services organizations that are much larger
than the Company have formed national loan origination networks offering loan
products that are substantially similar to the Company's loan programs.
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.
If the Company is unable to remain competitive in these areas, the volume of the
Company's loan originations may be materially adversely affected as borrowers
seek out other lenders for their financing needs. Lower originations may have an
adverse effect on the Company's ability to negotiate and obtain sufficient
financing under warehouse lines of credit upon acceptable terms. Furthermore,
the current level of gains realized by the Company and its competitors on the
sale of the type of loans they originate and purchase is attracting and may
continue to attract additional competitors into this market with the possible
effect of lowering gains that may be realized on the Company's loan sales.
Establishing a broker-sourced loan business typically requires a substantially
smaller commitment of capital and personnel resources than a direct-sourced loan
business. This relatively low barrier to entry permits new competitors to enter
the broker-sourced loan market quickly, particularly existing direct-sourced
lenders which can draw upon existing branch networks and personnel in seeking to
sell products through independent brokers. Competition may be affected by
fluctuations in interest rates and general economic conditions. During periods
of rising rates, competitors which have locked in low borrowing costs may have a
competitive advantage.
Increased competition could have the possible effects of (i) lowering gains
that may be realized on the Company's loan sales, (ii) reducing the volume of
the Company's loan originations and loan sales, (iii) increasing the demand for
the Company's experienced personnel and the potential that such personnel will
be recruited by the Company's competitors, and (iv) lowering the industry
standard for non-conforming underwriting guidelines (i.e., providing for higher
loan-to-value ratios) as competitors attempt to increase or maintain market
share in the face of increased competition. In the past, certain of these
factors have caused revenues and net income of many participants in the mortgage
industry, including the Company, to fluctuate from quarter to quarter.
There can be no assurance that the Company will be able to continue to
compete successfully in the markets it serves. Inability to compete successfully
would have a material adverse effect on the Company's results of operations and
financial condition.
31
32
RISK OF COMPETITION IN NEW MARKETS
As the Company expands into new geographic markets, it may face competition
from lenders with established positions in these locations. There can be no
assurance that the Company will be able to successfully compete with such
established lenders, the effect of which may have a material adverse effect on
the Company's results of operations and financial condition.
RISK OF COMPETITION FROM GOVERNMENT-SPONSORED ENTITIES
In the future, the Company may also face competition from, among others,
government-sponsored entities which may enter the non-conforming mortgage
market. Existing or new loan purchase programs may be expanded by the FNMA,
FHLMC, or GNMA to include non-conforming mortgages, particularly those in the
"Alt A" category, which constitute a significant portion of the Company's loan
production. For example, FHLMC announced it has entered, on a limited basis, the
non-conforming mortgage market (not including subprime loans). Entries of such
government-sponsored entities into the non- conforming market may have an
adverse effect on loan yields on mortgage loans originated by the Company and
reduce or eliminate premiums on loan sales.
GENERAL ECONOMIC CONDITIONS MAY ADVERSELY AFFECT COMPANY OPERATIONS
The Company's business may be adversely affected by periods of economic
slowdown or recession which 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
and increases the loan-to-value ratios of loans previously made by the Company,
thereby weakening collateral coverage and increasing the possibility of a loss
in the event of default. To the extent that the loan-to-value ratios of
prospective borrowers' home equity collateral do not meet the Company's
underwriting criteria, the volume of loans originated by the Company could
decline. Further, delinquencies, foreclosures and losses generally increase
during economic slowdowns or recessions. Because of the Company's focus on
borrowers who are unable or unwilling to obtain mortgage financing from
conventional mortgage sources, whether for reasons of credit impairment, income
qualification or credit history or a desire to receive funding on an expedited
basis, the actual rates of delinquencies, foreclosures and losses on such loans
could be higher under adverse economic conditions than those currently
experienced in the mortgage lending industry in general. Any sustained period of
such increased delinquencies, foreclosures or losses could adversely affect the
pricing of the Company's loan sales whether through whole loan sales or future
securitizations. A decline in loan origination volumes could have a material
adverse effect on the Company's operations and financial condition.
CHANGES IN INTEREST RATES MAY ADVERSELY AFFECT NET INCOME AND PROFITABILITY
Profitability may be directly affected by the level of and fluctuations in
interest rates which affect the Company's ability to earn a spread between
interest received on its loans held for sale and rates paid on warehouse lines.
The Company's profitability may be adversely affected during any period of
unexpected or rapid change in interest rates due to the fact that the Company
does not currently hedge its portfolio of mortgage loans held for sale. A
substantial and sustained increase in interest rates could adversely affect the
Company's ability to originate loans. Also, a significant decline in interest
rates could increase the level of loan prepayments and require the Company to
write down the value of the interest-only and residual certificates retained in
any future securitizations, thereby adversely impacting earnings.
Adjustable-rate subprime loans originated by the Company amounted to $78.7
million and $100.6 million in principal amount during the years ended June 30,
1999 and 1998, respectively. Substantially all such adjustable-rate mortgage
loans included a "teaser" rate, i.e., an initial interest rate significantly
below the fully indexed interest rate at origination. Although these loans are
underwritten at 1.0% above the initial or start rate at origination, borrowers
may encounter financial difficulties as a result of increases in the interest
rate over the life of the loan, which may adversely impact the performance of
the Company's loans in the secondary market. Any sustained period of increased
delinquencies, foreclosures or losses after the loans are
32
33
sold could adversely affect the pricing of the Company's future loan sales and
the ability of the Company to sell its loans in the future.
ELIMINATION OF LENDER PAYMENTS TO BROKERS COULD ADVERSELY AFFECT RESULTS OF
OPERATIONS
Lawsuits have been filed against several mortgage lenders, not including
the Company, alleging that such lenders have made certain payments to
independent mortgage brokers in violation of RESPA. These lawsuits have
generally been filed on behalf of a purported nationwide class of borrowers
alleging that payments made by a lender to a broker in addition to payments made
by the borrower to a broker are prohibited by RESPA and are therefore illegal.
If these cases are resolved against the lenders, it may cause an industry-wide
change in the way independent mortgage brokers are compensated. The Company's
broker compensation programs permit such payments. The Company makes such
payments in the ordinary course of business. Due to competitive conditions,
these payments have increased in recent periods, which adversely affected the
Company's cash gain on sale of mortgage loans for the year ended June 30, 1999.
Management expects this increased level of payments to continue for the year
ending June 30, 2000 and possibly thereafter. Although the Company believes that
its broker compensation programs comply with all applicable laws and are
consistent with long-standing industry practice and regulatory interpretations,
in the future new regulatory interpretations or judicial decisions may require
the Company to change its broker compensation practices. Such a change may have
a material adverse effect on the Company and the entire mortgage lending
industry.
POTENTIAL ADVERSE EFFECT OF REPRESENTATIONS AND WARRANTIES IN LOAN SALES
The Company typically makes whole loan sales to various institutional
purchasers on a non-recourse basis pursuant to Loan Purchase and Sales
Agreements containing customary representations and warranties by the Company
regarding the underwriting criteria and the origination process. The Company,
therefore, may be required to repurchase or substitute loans in the event of a
breach of it's representations or warranties to the institutional purchaser, any
misrepresentation during the mortgage loan origination process or, in some
cases, upon any fraud or first payment default on such mortgage loans. In an
environment of rapid whole loan sales, the Company may not have substitute loans
which are not previously committed for sale readily available in which case the
Company would be required to effect a repurchase. During the years ended June
30, 1999, 1998 and 1997, the Company repurchased $2.3 million, $75,000 and
$178,000 of loans, respectively. There can be no assurance that such repurchase
levels will not substantially increase in future periods. Any claims asserted
against the Company in the future by its loan purchasers may result in
liabilities or legal expenses that could have a material adverse effect on the
Company's results of operations and financial condition. In addition, any
material repurchase or substitution of loans may have an adverse effect on the
market for and pricing of the Company's loans.
DEPENDENCE ON A LIMITED NUMBER OF KEY PERSONNEL
The Company's growth and development to date have been largely dependent
upon the services of Evan R. Buckley, the Company's Chief Executive Officer, and
Kelly W. Monahan, the Company's President. The loss of Messrs. Buckley's or
Monahan's services for any reason could have a material adverse effect on the
Company. The Company does not maintain key person life insurance on the lives of
any of its employees. In addition, the Company's future success will require it
to recruit additional key personnel, including additional sales and marketing
personnel. The Company believes that its future success also substantially
depends on its ability to attract, retain and motivate highly skilled employees,
who are in great demand. There can be no assurance that the Company will be
successful in doing so.
33
34
SUBSTANTIAL RISKS ASSOCIATED WITH FUTURE SECURITIZATIONS
The Company may in the future sell loans through securitizations which
involve substantial risks, including the following:
Inability to Securitize Mortgage Loans
The Company anticipates that it may in the future acquire and accumulate
mortgage loans until a sufficient quantity has been acquired for securitization.
There can be no assurance that the Company will be successful in securitizing
mortgage loans. During the accumulation period, the Company will be subject to
risks of borrower defaults and bankruptcies, fraud losses and special hazard
losses. In the event of any default under mortgage loans held by the Company,
the Company will bear the risk of loss of principal to the extent of any
deficiency between the value of the mortgage collateral and the principal amount
of the mortgage loan. Also during the accumulation period, the costs of
financing the mortgage loans through warehouse lines of credit or reverse
repurchase agreements could exceed the interest income on the mortgage loans. It
may not be possible or economical for the Company to complete the securitization
of all mortgage loans that it acquires, in which case the Company will continue
to hold the mortgage loans and bear the risks of borrower defaults and special
hazard losses.
Potential Recourse Against Company in Securitizations
To the extent that the Company engages in securitizations, the Company
intends to transfer loans originated by the Company to a trust in exchange for
cash, "interest-only" and residual certificates issued by the trust. The trustee
will have recourse to the Company with respect to the breach of standard
representations or warranties made by the Company at the time such loans are
transferred, the effect of which may have a material adverse effect on the
Company's results of operations and financial condition.
Value of Interest-only, Principal-only, Residual Interest and Subordinated
Securities Subject to Fluctuation
To the extent that the Company engages in securitizations, the Company's
assets will likely include "interest-only," "principal-only," residual interest
and subordinated securities, which will be valued by the Company in accordance
with SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishment of Liabilities." The Company will record its retained
interest in securitizations (including "interest-only," "principal-only" and
subordinated securities) as investments classified as trading securities.
Realization of these "interest-only," "principal-only," residual interest and
subordinated securities in cash is subject to the timing and ultimate
realization of cash flows associated therewith, which is in turn effected by the
prepayment and loss characteristics of the underlying loans. The Company will
estimate future cash flows from these "interest-only," "principal-only,"
residual interest and subordinated securities and will value such securities
with assumptions that it believes to be consistent with those that would be
utilized by an unaffiliated third-party purchaser. If actual experience differs
from the assumptions used in the determination of the asset value, future cash
flows and earnings could be negatively impacted, and the Company could be
required to reduce the value of its "interest-only," "principal-only," residual
interest and subordinated securities in accordance with SFAS 125. The value of
such securities can fluctuate widely and may be extremely sensitive to changes
in discount rates, projected mortgage loan prepayments and loss assumptions.
Risks Regarding Hedging
In the future the Company may hedge its variable-rate mortgage loans and
any interest-only and residual certificates retained in connection with any
future securitizations with hedging transactions which may include forward sales
of mortgage loans or mortgage-backed securities, interest rate caps and floors
and buying and selling of futures and options on futures. Hedging techniques
involving the use of derivative financial investments are highly complex and may
prove volatile. The financial futures contracts and options thereon in which the
Company may invest are subject to periodic margin calls that would result in
additional costs to the Company. If a hedging instrument utilized by the Company
were found to be legally unenforceable, the Company's portfolio of loans held
for sale would be exposed to interest rate fluctuations which could
34
35
materially and adversely affect the Company's business and results of
operations. Additionally, hedging strategies have significant transaction costs.
The nature and quantity of hedging transactions will be determined by the
Company's management based on various factors, including market conditions and
the expected volume of mortgage loan originations and purchases. No assurance
can be given that such hedging transactions will offset the risks of changes in
interest rates, and it is possible that there will be periods during which the
Company could incur losses after accounting for its hedging activities.
COMPANY PERFORMANCE MAY BE AFFECTED BY CONTRACTED SUB-SERVICING
While the Company currently sells substantially all of the mortgage loans
it originates servicing released, it is required to service the loans from the
date of funding through the date of sale. Since the Company conducts whole loan
sales monthly, the Company currently does not have a substantial servicing
portfolio. Nonetheless, the Company currently contracts for the sub-servicing of
all mortgage loans it originates through the date of sale and is subject to
risks associated with inadequate or untimely services. To the extent that the
Company decides to retain servicing rights in the future or conduct
securitizations, it currently intends to contract for the sub-servicing of such
mortgage loans, which would expose it to more substantial risks associated with
contracted sub-servicing. In such event, it is expected that many of the
Company's borrowers will require notices and reminders to keep their mortgage
loans current and to prevent delinquencies and foreclosures. A substantial
increase in the Company's delinquency rate or foreclosure rate could adversely
affect its ability to access profitably the capital markets for its financing
needs, including any future securitizations.
Any of the Company's sub-servicing agreements with its third-party
sub-servicers are expected to provide that if the Company terminates the
agreement without cause (as defined in the agreement), the Company may be
required to pay the third-party sub-servicer a fee. Depending upon the size of
the Company's loan portfolio sub-serviced at any point in time, the termination
penalty that the Company would be obligated to pay upon termination without
cause, may be substantial.
The Company intends to subcontract with sub-servicers to service the
mortgage loans for any of its public securitizations. With respect to such
mortgage loans, the related pooling and servicing agreements would permit the
Company to be terminated as master servicer under specific conditions described
in such agreements, which generally include the failure to make payments,
including advances, within specific time periods. Such termination would
generally be at the option of the trustee but not at the option of the Company.
If, as a result of a sub-servicer's failure to perform adequately, the Company
were terminated as master servicer of a securitization, the value of any
servicing rights held by the Company would be adversely impacted. In addition,
if a new sub-servicer were selected with respect to any such securitization, the
change in sub-servicing may result in greater delinquencies and losses on the
related loans, which would adversely impact the value of any "interest-only,"
"principal-only," residual interest and subordinated securities held by the
Company in connection with such securitization.
CONCENTRATION OF OPERATIONS MAY ADVERSELY AFFECT COMPANY OPERATIONS
Approximately 46.55%, 30.0% and 36.9% of the dollar volume of loans
originated by the Company during the years ended June 30, 1999, 1998 and 1997,
respectively, were secured by properties located in California. No other state
contained properties securing more than 10% of the dollar volume of loans
originated by the Company during such periods, other than Illinois which
accounted for 16.6% and 10.4% for the years ended June 30, 1998 and 1997,
respectively, and Hawaii which accounted for 12.0% for the year ended June 30,
1997. Although the Company has a growing independent broker network outside of
California, the Company is likely to continue to have a significant amount of
its loan originations in California for the foreseeable future, primarily
because California represents a significant portion of the national mortgage
marketplace. Consequently, the Company's results of operations and financial
condition are dependent upon general trends in the California economy and its
residential real estate market. The California economy experienced a slowdown or
recession in recent years that has been accompanied by a sustained decline in
the California real estate market. Residential real estate market declines may
adversely affect the values of the properties securing loans such that the
principal balances of such loans will equal or exceed the value of the mortgaged
properties.
35
36
Reduced collateral value will adversely affect the volume of the Company's loans
as well as the pricing of the Company's mortgage loans and the Company's ability
to sell its 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 borrowers' ability to repay
mortgage loans made by the Company, any sustained period of increased
delinquencies or defaults could adversely affect the pricing of the Company's
future loan sales and the ability of the Company to sell its loans. The
existence of adverse economic conditions or the occurrence of such natural
disasters in California could have a material adverse effect on the Company's
results of operations and financial condition.
REAL PROPERTY WITH ENVIRONMENTAL PROBLEMS MAY CREATE LIABILITY FOR THE COMPANY
In the course of its business, the Company may acquire real property
securing loans that are in default. There is a risk that hazardous substances or
waste, contaminants, pollutants or sources thereof could be discovered on such
properties after acquisition by the Company. In such event, the Company might be
required to remove such substances from the affected properties at its sole cost
and expense. The cost of such removal may substantially exceed the value of the
affected properties or the loans secured by such properties. There can be no
assurance that the Company would have adequate remedies against the prior owners
or other responsible parties, or that the Company would not find it difficult or
impossible to sell the affected real properties either prior to or following any
such removal, the effect of which may have a material adverse effect on the
Company's results of operations and financial condition.
COMPANY SUBJECT TO EXTENSIVE LEGISLATIVE AND REGULATORY RISKS
The Company's business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and is subjected
to various laws and judicial and administrative decisions imposing requirements
and restrictions on a substantial portion of its operations. The Company's
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),
ECOA, the Fair Credit Reporting Act of 1970, as amended, Real Estate Settlement
Procedures Act and Regulation X, the Fair Housing Act, the Home Mortgage
Disclosure Act and the Federal Debt Collection Practices Act, as well as other
federal and state statutes and regulations affecting the Company's activities.
The Company is also subject to the rules and regulations of and examinations by
HUD and 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 the Company,
establish eligibility criteria for mortgage loans, prohibit discrimination,
provide for inspections and appraisals of properties, require 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, termination
or suspension of servicing contracts without compensation to the servicer,
demands for indemnifications or mortgage loan repurchases, certain rights of
rescission for mortgage loans, class action lawsuits and administrative
enforcement actions.
With respect to its conforming lending activities, lenders such as the
Company are required annually to submit to FNMA and FHLMC audited financial
statements, and each regulatory activity has its own financial requirements. The
Company's affairs are also subject to examination by FNMA and FHLMC at any time
to assure compliance with the applicable regulations, policies and procedures.
In October 1997, HUD issued proposed regulations regarding the treatment
and disclosure of fees charged and collected by mortgage brokers providing
certain safe harbors for the payment of fees by lenders to mortgage brokers and
setting forth standards to determine whether payments to mortgage brokers
violate RESPA. Whether such regulations will be adopted and the form and content
of any final regulations is unknown. In July 1998, HUD and the Board of
Governors of the Federal Reserve System delivered to Congress a joint report
containing legislative proposals to reform RESPA and TILA. This report proposed
an
36
37
exemption from the fee restrictions of RESPA for mortgage brokers that offer a
package of settlement services for mortgage loans at a guaranteed price and
follow other requirements. In March 1999, HUD issued a policy statement setting
forth its position on lender-paid broker compensation under RESPA. In the policy
statement, HUD asserts that lender payments to mortgage brokers are not per se
illegal, but rather must be analyzed on a case-by-case basis. In determining
whether lender-paid compensation is permissible under RESPA, the policy
statement sets forth a two-part test: (i) whether the broker actually provided
compensable goods, facilities or services and (ii) whether the broker's total
compensation is reasonably related to the value of the goods, facilities or
services it provided. In the policy statement, HUD also stated that legislation
to improve RESPA is needed and that a reform package along the lines specified
in the HUD and Federal Reserve Board report remains the most effective way to
resolve the legal uncertainties under that statute. It is unknown at this time
whether HUD's October 1997 proposal or reform legislation will be adopted.
The Company is subject to licensing by state authorities. In addition, any
person who acquires more than 10% of the Company's stock will become subject to
certain state licensing regulations requiring such person periodically to file
certain financial and other information. If any person holding more than 10% of
the Company's stock refuses to adhere to such filing requirements, the Company's
existing licensing arrangements could be jeopardized. The loss of required
licenses could have a material adverse effect on the Company's results of
operations and financial condition.
Although the Company believes that it has systems and procedures to
facilitate compliance with these requirements and believes that it is in
compliance in all material respects with applicable local, state and federal
laws, rules and regulations, there can be no assurance that more restrictive
laws, rules and regulations will not be adopted in the future that could make
compliance more difficult or expensive.
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 the Company's loans are made to borrowers
for the purpose of consolidating consumer debt or financing other consumer
needs, the competitive advantage 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 the Company.
POSSIBLE NEED FOR ADDITIONAL EQUITY FINANCING
The Company's primary operating cash requirements include the funding or
payment of (i) loan originations, (ii) interest expense incurred on borrowings
under warehouse lines of credit, (iii) income taxes, (iv) capital expenditures
and (v) other operating and administrative expenses. The Company funds these
cash requirements primarily through warehouse lines of credit and whole loan
sales. In addition, if the Company conducts securitizations, it would require
liquidity to fund its investments in "interest-only" and residual certificates
and for fees and expenses incurred with securitizations. The Company's ability
to implement its business strategy will depend upon its ability to establish
alternative long-term financing arrangements (such as the facilities with Bank
United, RFC and PWRS) with parties other than DLJ and obtain sufficient
financing under warehouse facilities upon acceptable terms. There can be no
assurance that such financing will be available to the Company on favorable
terms, if at all. If such financing were not available or the Company's capital
requirements exceed anticipated levels, then the Company would be required to
obtain additional equity financing which would dilute the interests of the
Company's stockholders. The Company cannot presently estimate the amount and
timing of additional equity financing requirements because such requirements are
tied to, among other things, the growth of the Company. If the Company were
unable to raise such additional capital, its results of operations and financial
condition would be adversely affected.
ANY FUTURE ACQUISITIONS OF OTHER SPECIALTY FINANCE COMPANIES, OTHER FINANCE OR
MORTGAGE COMPANIES OR ASSETS MAY HAVE ADVERSE EFFECTS ON THE COMPANY'S BUSINESS
The Company may, from time to time, engage in the acquisition of other
specialty finance companies, other finance or mortgage companies or portfolios
of loan assets. Any acquisition made by the Company may
37
38
result in potentially dilutive issuances of equity securities, the incurrence of
additional debt and the amortization of expenses related to goodwill and other
intangible assets, any of which could have a material adverse effect on the
Company's business and results of operations. The Company also may experience
difficulties in the assimilation of the operations, services, products and
personnel related to acquired companies or loan portfolios, an inability to
sustain or improve the historical revenue levels of acquired companies, the
diversion of management's attention from ongoing business operations and the
potential loss of key employees of such acquired companies. The Company
currently has no formal agreements with regard to any potential acquisition and
there can be no assurance that future acquisitions, if any, will be consummated.
SIGNIFICANT INFLUENCE OF CURRENT MANAGEMENT
The officers and directors of the Company beneficially own 36% of the
outstanding Common Stock of the Company. As a result, the Company's current
management through its stock ownership and otherwise is able to exert
significant influence over the business and affairs of the Company.
POSSIBLE VOLATILITY OF STOCK PRICE
The trading price of the Company's Common Stock has been in the past and
could be in the future subject to significant fluctuations in response to
variations in quarterly operating results, changes in analysts' estimates,
general conditions in the speciality finance industry and other factors. For
example, on July 20, 1998 the price per share was $10.875 and on March 16, 1999
it was $4.4375. In addition, for example, companies engaging in securitizations
record non-cash gain on sale of mortgage loans from the revenue expected to be
obtained from retained residual interests in future payments on the loans.
Realization of cash from these residual interests is subject to the timing and
ultimate realization of cash flows associated therewith, which in turn is
affected by the prepayment and loss characteristics of the underlying loans.
Several specialty finance companies recently have been required to "write-down"
the value of their retained interests, and therefore reduce or eliminate
reported earnings, largely as a result of a higher than anticipated level of
prepayments on the underlying loans which has materially adversely affected
their stock prices. Stock prices of other specialty finance companies that
utilize more conservative assumptions in recording non-cash gain on sale and
those, such as the Company, that sell whole loans for cash and do not engage in
material securitization activities, also have been adversely impacted by these
developments. There can be no assurance the future market price of the Company's
Common Stock will not be adversely impacted by the results of operation of, and
market reactions to, other specialty finance companies. Furthermore, in
September 1998, the Company initiated a stock repurchase program pursuant to
which it has, as of September 15, 1999, repurchased 833,629 shares of Common
Stock ranging from $4.50 to $7.125 per share at a total cost of approximately
$4.5 million.
The Company may increase its capital by making additional private or public
offerings of its Common Stock, securities convertible into its Common Stock or
debt securities. The actual or perceived effect of such offerings, the timing of
which cannot be predicted, may be the dilution of the book value or earnings per
share of the Common Stock outstanding, which may result in the reduction of the
market price of the Common Stock.
ANTI-TAKEOVER EFFECT OF DELAWARE LAW
The Company is a Delaware corporation and as such is subject to the
anti-takeover provisions of Section 203 of the Delaware General Corporation Law.
In general, Section 203 prevents an "interested stockholder" (defined generally
as a person owning more than 15% or more of the Company's outstanding voting
stock) from engaging in a "business combination" with the Company for three
years following the date that person became an interested stockholder unless the
business combination is approved in a prescribed manner. This statute could make
it more difficult for a third party to acquire control of the Company.
ISSUANCE OF PREFERRED STOCK MAY ADVERSELY AFFECT HOLDERS OF COMMON STOCK
The Board of Directors has the authority to issue up to 5,000,000 shares of
undesignated Preferred Stock, of which 570,000 has been designated Series A
Junior Participating Preferred Stock and to determine the
38
39
rights, preferences, privileges and restrictions of such shares without any
further vote or action by the stockholders. The terms and conditions of the
Series A Junior Preferred Stock could have the effect of delaying, deferring or
preventing a hostile changed in control of the Company. Although at present the
Company has no plans to issue any of the Preferred Stock, the Preferred Stock
could be issued with voting, liquidation, dividend and other rights superior to
the rights of the Common Stock. The issuance of Preferred Stock under certain
circumstances could have the effect of delaying or preventing a change in
control of the Company.
SHARES ELIGIBLE FOR FUTURE SALE MAY ADVERSELY AFFECT THE MARKET PRICE OF THE
COMPANY'S COMMON STOCK
The sales of substantial amounts of the Company's Common Stock in the
public market or the prospect of such sales could materially and adversely
affect the market price of the Common Stock. As of September 15, 1999, the
Company had outstanding 5,042,350 shares of Common Stock. Shares of Common Stock
held by affiliates are restricted in nature and are saleable to the extent
permitted pursuant to Rule 144 under the Securities Act. The Company's 1997
Stock Option, Deferred Stock and Restricted Stock Plan (the "Stock Option Plan")
authorizes the grant of options to purchase, and awards of, 800,000 shares; of
this amount, options to acquire 163,265 shares of Common Stock have been granted
at a per share exercise price of $6.10; options to acquire 447,402 shares of
Common Stock have been granted at a per share exercise of $9.50; options to
acquire 2,000 shares of Common Stock at per share exercise price of $10.50;
options to acquire 65,000 shares of Common Stock at a per share exercise price
of $5.75; options to acquire 15,000 shares of Common Stock at a per share
exercise price of $6.0625 and 12,500 options to acquire shares of Common Stock
have been granted at a per share exercise price of $11.00. The Company has to
registered under the Securities Act shares reserved for issuance pursuant to the
Stock Option Plan. In addition, in connection, with the Company's initial public
offering, the representatives of the underwriters were sold Representatives'
Warrants evidencing the right to purchase from the Company up to 317,319 shares
of Common Stock at an exercise price of $10.45 per share. The holders of the
Representatives' Warrants are entitled to certain registration rights.
ITEM 2. PROPERTIES
The Company's executive and administrative offices are located at 1063
McGaw Avenue, Irvine, California 92614, which consists of approximately 54,768
square feet. The lease on the premises expires on November 30, 2002 and the
current monthly rent is approximately $71,200.
The Company also leases space for its other offices. As of June 30, 1999,
these facilities aggregate approximately 66,990 square feet, with monthly
aggregate base rental of approximately $102,403. The terms of these leases vary
as to duration and rent escalation provisions. In general, the leases expire
between October 1999 and March 2003 and provide for rent escalations tied to
either increases in the lessor's operating expenses or fluctuations in the
consumer price index in the relevant geographical area.
ITEM 3. LEGAL PROCEEDINGS
The Company occasionally becomes involved in litigation arising from the
normal course of business. Management believes that any liability with respect
to pending legal actions, individually or in the aggregate, will not have a
material adverse effect on the Company's financial position or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's security holders
during the quarter ended June 30, 1999.
39
40
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In March 10, 1998 the Company's common stock began trading under the symbol
BNCM on the NASDAQ National Market. The initial public offering of 3,173,196
shares of common stock at $9.50 per share on March 10, 1998. On March 11, 1998,
the underwriters purchased an additional 475,979 shares of common stock at a
price of $9.50 per share following their exercise of the over allotment option,
resulting in a total of 3,649,175 shares sold in the initial public offering
(the "Offering"). The Company received net proceeds of $16,199,000 from the
Offering. As of June 30, 1999 of these proceeds, approximately $6.7 million was
used to fund loan originations, and the remaining balance has been invested in
short term investments.
In connection with the Offering, warrants were issued to the
representatives of the underwriters to purchase up to 317,319 additional shares
of common stock at an exercise price of $10.45 per share, exercisable over a
period of four years, commencing one year from March 10, 1998. As of June 30,
1999, the Company had 5,092,350 shares of common stock outstanding.
As of April 6, 1999, the Company's Board of Directors authorized the
Company to repurchase up to $5 million of the Company's common stock, in open
market purchases from time to time at the discretion of the Company's
management; the timing and extent of the repurchases will depend on market
conditions. The Company intends to effect such repurchase in compliance with
rule 10b-18 under the Securities Exchange Act of 1934. As of September 15, 1999,
the Company had repurchased 833,629 shares of common stock at a cost of $4.5
million.
The follow table sets forth the range of high and low closing sale prices
of the Company's Common Stock for the periods indicated:
HIGH LOW
---- ---
YEAR ENDED JUNE 30, 1999
Quarter ended: September 30, 1998........................... $10 7/8 $ 6
Quarter ended: December 31, 1998............................ $ 6 $ 4 1/2
Quarter ended: March 31, 1999............................... $ 6 11/16 $ 4 7/16
Quarter ended: June 30, 1999................................ $ 8 5/8 $ 4 1/2
YEAR ENDED JUNE 30, 1998
Period from March 10, 1998 to March 31, 1998(1)............. $13 1/8 $11 5/8
Quarter ended: June 30, 1998................................ $14 1/8 $10 5/8
- ---------------
(1) The effective date of the Company's initial public offering was March 10,
1998.
No dividends have been paid on the Company's common stock. The Company does
not anticipate paying dividends in the near future. Any decision made by the
Company's Board of Directors to pay dividends in the future will depend upon the
Company's future earnings, capital requirements, financial condition and other
factors deemed relevant by the Company's Board of Directors.
Stockholder Rights Plan. On October 13, 1998, the Company's Board of
Directors adopted a Stockholder Rights Plan in which Preferred Stock Purchase
Rights were distributed as a dividend at the rate of one Right for each
outstanding share of Common Stock. The dividend distribution was made on October
26, 1998 payable to stockholders of record on that date. The Rights are attached
to the Company's Common Stock. The Rights will be exercisable and trade
separately only in the event that a person or group acquires or announces the
intent to acquire 15 percent or more of the Company's Common Stock. Each Right
will entitle stockholders to buy one-hundredth of a share of Series A Junior
Participating Preferred Stock at an exercise price of $25.00. If the Company is
acquired in a merger or other transaction after a person has acquired 15 percent
or more of Company outstanding Common Stock, each Right will entitle the
stockholder to purchase, at the Right's then-current exercise price, a number of
the acquiring Company's common shares having a market value of twice such price.
In addition, if a person or group acquires 15 percent or more of the
40
41
Company's Common Stock, each Right will entitle the stockholder (other than the
acquiring person) to purchase, at the Right's then-current exercise price, a
number of shares of the Company's Common Stock having a market value of twice
such price. Following the acquisition by a person of 15 percent or more of the
Company's Common Stock and before an acquisition of 50 percent or more of the
Common Stock, the Board of Directors may exchange the Rights (other than the
Rights owned by such person) at an exchange ratio of one share of Common Stock
per Right. Before a person or group acquires beneficial ownership of 15 percent
or more of the Company's Common Stock, the Rights are redeemable for $.0001 per
right at the option of the Board of Directors. The Rights will expire on October
26, 2008. The Rights distribution is not taxable to stockholders. The Rights are
intended to enable all the Company stockholders to realize the long-term value
of their investment in the Company.
On September 15, 1999, the Company had approximately 16 stockholders of
record, (including holders who are nominees for an undetermined number of
beneficial owners) of its Common Stock.
41
42
ITEM 6. SELECTED FINANCIAL DATA
The following selected statement of operations data and balance sheet data
are derived from consolidated financial statements of the Company. The data
should be read in conjunction with "Management's Discussion and Analysis of
Financial Condition and Results of Operations," the consolidated financial
statements and related notes and other financial information included herein.
The Company was formed on May 2, 1995 and began operations in August 1995. For
the period of May 2, 1995 through June 30, 1995, the Company did not have any
revenue and recorded start-up costs of $10,000. Selected statement of operations
data and balance sheet data are not presented for the period May 2, 1995 through
June 30, 1995, as the operations were not material.
YEAR ENDED JUNE 30,
--------------------------------------------------
1999 1998 1997 1996
----------- --------- --------- ---------
(IN THOUSANDS EXCEPT PER SHARE DATA AND RATIOS)
STATEMENT OF OPERATIONS DATA
Revenues:
Gain on sale of mortgage loans...... $ 34,860 $ 30,458 $ 21,855 $ 4,240
Loan origination income............. 8,412 5,399 5,473 1,978
Interest income..................... 8,167 7,860 5,182 1,960
Other Income........................ 1,473 676 250 52
---------- -------- -------- --------
Total revenues.............. 52,912 44,393 32,760 8,230
---------- -------- -------- --------
Expenses:
Employees' salaries and
commissions...................... 24,394 18,828 11,052 3,624
General and administrative
expenses......................... 12,493 8,028 5,543 2,400
Interest expense.................... 5,608 5,486 3,693 1,452
---------- -------- -------- --------
Total expenses.............. 42,495 32,342 20,288 7,476
---------- -------- -------- --------
Income before taxes................... 10,417 12,051 12,472 754
Income tax expense.................... 4,138 4,815 4,930 337
---------- -------- -------- --------
Net income............................ $ 6,279 $ 7,236 $ 7,542 $ 417
========== ======== ======== ========
Net income per share:
Basic............................... $ 1.14 $ 1.55 $ 1.80 $ 0.14
========== ======== ======== ========
Diluted............................. $ 1.14 $ 1.51 $ 1.80 $ 0.14
========== ======== ======== ========
Shares used in computing net income
per share:
Basic............................... 5,502 4,654 4,187 2,892
========== ======== ======== ========
Diluted............................. 5,502 4,796 4,187 2,892
========== ======== ======== ========
OPERATING STATISTICS
Loan originations:
Mortgage loan originations............ $1,335,575 $788,479 $532,621 $199,963
Whole loan sales...................... $1,274,335 $744,365 $519,909 $156,559
Average initial principal balance per
loan................................ $ 118 $ 100 $ 98 $ 101
Gain on sale as a percentage of whole
loan sales.......................... 2.7% 4.1% 4.2% 2.7%
42
43
AS OF JUNE 30,
-----------------------------------------
1999 1998 1997 1996
-------- -------- ------ -------
BALANCE SHEET DATA
Cash and cash equivalents.................. $ 29,867 $ 25,890 $8,268 $ 2,452
Restricted cash............................ 1,105 638 -- --
Mortgage loans held for sale............... 141,749 98,717 55,145 42,723
Total assets............................... 181,979 130,555 65,713 46,352
Warehouse line of credit................... 142,163 96,022 54,625 42,723
Total liabilities.......................... 149,063 99,704 56,509 44,506
Total stockholders' equity................. 32,916 30,851 9,204 1,846
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis of the financial condition, results
of operations and liquidity and capital resources should be read in conjunction
with the Company's consolidated financial statements and notes included in Item
14 of this 10-K.
GENERAL
BNC Mortgage, Inc., is a specialty finance company engaged in the business
of originating, purchasing and selling, on a whole loan basis for cash,
non-conforming and, to a lessor extent, conforming, residential mortgage loans
secured by one-to-four family residences. The term "non-conforming loans" as
used herein means (i) subprime loans, which are loans made to borrowers who are
unable or unwilling to obtain mortgage financing from conventional mortgage
sources, whether for reasons of credit impairment, income qualification, credit
history or a desire to receive funding on an expedited basis and (ii)
non-conforming loan products for primarily high credit borrowers whose credit
scores equal or exceed levels required for the sale or exchange of their
mortgage loans through the FNMA and FHLMC, but where the loan itself fails to
meet conventional mortgage guidelines, such as the principal balance exceeds the
maximum loan limit of $240,000 or the loan structure documentation does not
conform to agency requirements. The Company's loans are made primarily to
refinance existing mortgages, consolidate other debt, finance home improvements,
education and other similar needs, and, to a lesser extent, to purchase single
family residences. The Company originates and purchases loans through its: (i)
wholesale subprime operation through which it has relationships with
approximately 5,050 approved independent loan brokers and which to date has
accounted for majority of the Company's total loan originations and (ii)
wholesale prime operation through which it originates conforming loans that meet
FNMA, FHLMC and other conventional mortgage guidelines and non-conforming loan
products which are not subprime loans.
The following table shows the Company's mortgage loan originations,
mortgage loan sales, cash gain on sale of mortgage loans and origination
locations with account executives for the periods indicated:
YEAR ENDED JUNE 30,
----------------------------------
1999 1998 1997
---------- -------- --------
(DOLLARS IN THOUSANDS)
Mortgage loan originations........................ $1,335,575 $788,479 $532,621
Mortgage loan sales............................... $1,274,335 $744,365 $519,909
Gain on sale of mortgage loans.................... $ 34,860 $ 30,458 $ 21,855
Origination locations at end of period............ 51 53 38
Revenues are derived primarily from cash gain on sales of loans and
interest income from loans held for sale. The major components of the Company's
revenues are (i) the volume of loans originated, (ii) the premium over principal
amount received in loan sales, (iii) origination points received or paid, (iv)
origination fees received and (v) the differential between the interest rate on
borrowings under revolving warehouse credit facilities and the interest rate of
loans held for sale. Cash gain on sale of mortgage loans is affected by, among
other things, borrower credit risk classification, loan-to-value ratio, interest
rate and margin of the loans. Revenues increased 19% and 36% for the years ended
June 30 1999 and 1998, respectively.
43
44
The major components of expenses are employees' salaries and commissions,
general and administrative, and interest. Employees' salaries and commissions,
for the years ended June 30, 1999, 1998 and 1997 accounted for 57%, 58% and 54%
of total expenses, respectively. Employees' salaries and commissions are
primarily related to the loan origination volume because the Company's sales
force is compensated on a commission basis in addition to salaries. Total
expenses were $42.5 million, $32.3 million and $20.3 million for the years ended
June 30, 1999, 1998 and 1997, respectively.
The Company's net income decreased to $6.3 million for the year ended June
30, 1999 compared to $7.2 million and $7.5 million for years ended June 30, 1998
and 1997, respectively.
Increased competition in the mortgage industry could have the effect of (i)
lowering gains that may be realized on loan sales through lower cash premiums
paid for loans or an increase in demand for yield spread premium paid to the
mortgage brokers, (ii) reducing an individual company's volume of loan
originations and sales, (iii) increasing demand for experienced personnel
increasing the likelihood such personnel will be recruited by competitors and
(iv) lowering the industry standard for underwriting guidelines as competitors
attempt to increase or maintain market share in the face of increased
competition. In the past, certain of these factors have caused the revenues and
net income of many participants in the mortgage industry, including the Company,
to fluctuate from quarter to quarter.
RESULTS OF OPERATIONS
YEAR ENDED JUNE 30, 1999 COMPARED TO THE YEAR ENDED JUNE 30, 1998
Revenues. The following table sets forth the components of the Company's
revenues for the periods indicated:
YEAR ENDED JUNE 30,
----------------------
1999 1998
--------- ---------
(DOLLARS IN THOUSANDS)
Gain on sale of mortgage loans........................... $34,860 $30,458
Loan origination income.................................. 8,412 5,399
Interest income.......................................... 8,167 7,860
Other income............................................. 1,473 676
------- -------
$52,912 $44,393
======= =======
The increase in revenues was due primarily to increased mortgage loan
originations and cash gain on sales of mortgage loans. Mortgage loan
originations increased $547.1 million to $1,335.6 million for the year ended
June 30, 1999 from $788.5 million for the year ended June 30, 1998.
Cash gain on sale of mortgage loans increased $4.4 million to $34.9 million
for the year ended June 30, 1999 from $30.5 million for the year ended June 30,
1998. The increase was due primarily to a $529.9 million increase in mortgage
loan sales to $1.3 billion from $744.4 million for the years ended June 30, 1999
and 1998, respectively. The weighted average cash gain on sale was 3.6% for
wholesale subprime loans and .37% for prime loans for the year ended June 30,
1999 and 4.16% and .88% for the year ended June 30, 1998. There can be no
assurance that the Company will recognize comparable levels of cash gain on sale
of mortgage loans in future periods. The Company makes yield spread premium
payments to its mortgage broker customers in the ordinary course of business.
Due to competitive conditions, these payments have increased in recent periods,
which adversely affected the Company's cash gain on sale of mortgage loans for
the year ended June 30, 1999.
Loan origination income increased to $8.4 million for the year ended June
30, 1999 from $5.4 million for the year ended June 30, 1998. As a percentage of
total revenues, loan origination income for the year ended June 30, 1999
increased to 15.9% as compared to 12.2% for the year ended June 30, 1998. This
increase was primarily attributable to an increase in the amount of origination
fees charged on its loan products.
Interest income increased $300,000 to $8.2 million for the year ended June
30, 1999 from $7.9 million for the year ended June 30, 1998. This increase is
due to an increase in loan originations during the period.
44
45
Other income, which is composed of investment income, prepayment penalties
and late charges, increased to $1.5 million for the year ended June 30, 1999 as
compared to $676,000 for the year ended June 30, 1998 largely as a result of
interest received on the net proceeds from the Offering completed March 10,
1998.
Expenses. The following table sets forth the components of the Company's
expenses for the years indicated:
YEAR ENDED JUNE 30,
----------------------
1999 1998
--------- ---------
(DOLLARS IN THOUSANDS)
Employees' salaries and commissions...................... $24,394 $18,828
General and administrative expenses...................... 12,493 8,028
Interest expense......................................... 5,608 5,486
------- -------
$42,495 $32,342
======= =======
Total expenses increased to $42.5 million for the year ended June 30, 1999
from $32.3 for the year ended June 30, 1998. This increase is related to
geographical expansion and to an increase in mortgage loan originations.
Employee salaries and commissions increased $5.6 million to $24.4 million
during the year ended June 30, 1999 from $18.8 million for the year ended June
30, 1998. This increase is due primarily to an increase in geographical
expansion and the related increase in mortgage loan originations.
General and administrative expenses increased $4.5 million to $12.5 million
for the year ended June 30, 1999 from $8.0 million for the year ended June 30,
1998. This increase is due primarily to an increase in the number of origination
locations and the related increase in mortgage loan originations.
Interest expense increased $100,000 to $5.6 million for the year ended June
30, 1999 from $5.5 million for the year ended June 30, 1998 and is attributable
to the higher levels of warehouse borrowing as a result of the increase in
mortgage loan originations.
It is expected that the Company's expansion plans for its wholesale
operations will result in an increase in operating expenses in the short-term.
Furthermore, management expects that there will be a lag time between the
incurrence of such expense and the receipt of any revenues from such expansion
efforts, and the results of operations may be adversely affected in the
short-term.
YEAR ENDED JUNE 30, 1998 COMPARED TO THE YEAR ENDED JUNE 30, 1997
Revenues. The following table sets forth the components of the Company's
revenues for the periods indicated:
YEAR ENDED JUNE 30
----------------------
1998 1997
--------- ---------
(DOLLARS IN THOUSANDS)
Gain on sale of mortgage loans........................... $30,458 $21,855
Loan origination income.................................. 5,399 5,473
Interest income.......................................... 7,860 5,182
Other income............................................. 676 250
------- -------
$44,393 $32,760
======= =======
The increase in revenues was due primarily to increased mortgage loan
originations and cash gain on sales of mortgage loans. Mortgage loan
originations increased $255.9 million to $788.5 million for the year ended June
30, 1998 from $532.6 million for the year ended June 30, 1997.
Cash gain on sale of mortgage loans increased $8.6 million to $30.5 million
for the year ended June 30, 1998 from $21.9 million for the year ended June 30,
1997. The increase was due primarily to a $224.5 million
45
46
increase in mortgage loan sales to $744.4 from $519.9 million for the years
ended June 30, 1998 and 1997, respectively. The weighted average cash gain on
sale was 4.1% for the year ended June 30, 1998 and 4.2% for the year ended June
30, 1997. There can be no assurance that the Company will recognize comparable
levels of cash gain on sale of mortgage loans in future periods. The Company
makes yield spread premium payments to its mortgage broker customers in the
ordinary course of business. Due to competitive conditions, these payments have
increased in recent periods, which adversely affected the Company's cash gain on
sale of mortgage loans for the year ended June 30, 1998.
Loan origination income decreased to $5.4 million for the year ended June
30, 1998 from $5.5 million for the year ended June 30, 1997. As a percentage of
total revenues, loan origination income for the year ended June 30, 1998
decreased to 12.2% as compared to 16.7% for the year ended June 30, 1997. This
decrease was a result of competitive conditions as management was required to
lower the amount of origination points and fees charged on its loan products to
satisfy mortgage broker and consumer demands.
Interest income increased $2.7 million to $7.9 million for the year ended
June 30, 1998 from $5.2 million for the year ended June 30, 1997. This increase
is due to an increase in loan originations during the period.
Other income, which is composed of investment income, prepayment penalties
and late charges, increased to $676,000 for the year ended June 30, 1998 as
compared to $250,000 for the year ended June 30, 1997 largely as a result of
interest received on the net proceeds from the Offering completed March 10,
1998.
Expenses. The following table sets forth the components of the Company's
expenses for the period indicated:
YEAR ENDED JUNE 30,
----------------------
1998 1997
--------- ---------
(DOLLARS IN THOUSANDS)
Employees' salaries and commissions...................... $18,828 $11,052
General and administrative expenses...................... 8,028 5,543
Interest expense......................................... 5,486 3,693
------- -------
$32,342 $20,288
======= =======
Total expenses increased to $32.3 million for the year ended June 30, 1998
from $20.3 for the year ended June 30, 1997. This increase is related to
geographical expansion to 53 origination locations at June 30, 1998 from 38 at
June 30, 1997, and to an increase in mortgage loan originations.
Employee salaries and commissions increased $7.8 million to $18.8 million
during the year ended June 30, 1998 from $11.0 million for the year ended June
30, 1997. This increase is due primarily to an increase in the number of
origination locations, geographical expansion and the related increase in
mortgage loan originations.
General and administrative expenses increased $2.5 million to $8.0 million
for the year ended June 30, 1998 from $5.5 million for the year ended June 30,
1997. This increase is due primarily to an increase in the number of origination
locations and the related increase in mortgage loan originations.
Interest expense increased $1.8 million to $5.5 million for the year ended
June 30, 1998 from $3.7 million for the year ended June 30, 1997 and is
attributable to the higher levels of warehouse borrowing as a result of the
increase in mortgage loan originations.
It is expected that the Company's expansion plans will result in an
increase in operating expenses in the short-term. Furthermore, management
expects that there will be a lag time between the incurrence of such expense and
the receipt of any revenues from such expansion efforts, and the results of
operations may be adversely affected in the short-term.
DISCLOSURE ABOUT MARKET RISK
The Company's earnings can be affected significantly by the movement of
interest rates, which is the primary component of market risk to the Company.
The interest rate risk affects the value of the mortgage
46
47
loans held for sale, net interest income earned on its mortgage inventory,
interest income earned on idle cash, interest expense and cash gain on sale of
mortgage loans.
The Company currently sells its loan production monthly on a whole loan
basis for cash.
As it relates to lending activities, the Company originates mortgage loans,
which are generally presold through forward loan sales commitments. However,
between the time that the loan is originated and sold to the ultimate investor,
the Company earns interest income. The loans are funded through the use of the
warehouse line of credits and the interest charged by the lenders is generally
priced based upon short-term interest rates. Therefore, the net interest income
that is earned by the Company is generally dependent upon the spread between
long-term mortgage rates and short-term mortgage interest rates.
The Company currently does not maintain a trading portfolio. As a result,
the Company is not exposed to market risk as it relates to trading activities.
The majority of the Company's loan portfolio is held for sale which requires the
Company to perform quarterly market valuations of its portfolio in order to
properly record the portfolio at the lower of cost or market. Therefore, the
Company continually monitors the interest rates of its loan portfolio as
compared to prevalent interest rates in the market.
The Company currently does not enter into any hedging activities as it
currently sells its subprime loan production on a monthly basis and the
prohibitive cost versus the benefit of any hedging. The Company currently sells
its prime loan production on a best efforts delivery basis and generally matches
each prime loan into a takeout commitment from an investor.
Based on the information available and the interest environment as of June
30, 1999, the Company believes that a 100 basis point increase in long-term
interest rates over a twelve month period, with all else being constant, would
have an adverse effect on the pricing for the Company's whole loan sales.
Therefore, the Company believes that its net income could be adversely affected
in the range of $1.3 to $2.5 million. However, the Company believes that a 100
basis point decrease in long-term interest rates over a twelve-month period may
not result in a similar increase in the level of its net income. These estimates
are limited by the fact that they are performed at a particular point in time
and incorporate many other factors and thus should not be used as a forecast.
Therefore, there can be no assurance that the amount of such decrease would not
substantially vary from these estimates.
YEAR 2000
The Company has evaluated the internal information technology (IT) and
non-IT systems that could be affected by Year 2000 issues and also identified
the external systems that are critical to the Company's operations. An
assessment of the readiness of the Company's suppliers is ongoing. The Company's
plan for Year 2000 readiness has three phases. Phase one involves identifying
and remediating the internal systems and processes that must be Year 2000
compliant. Phase one has been completed. Phase two consists of testing both the
internal and external systems as a whole, and has been scheduled to be fully
implemented by January 1, 2000. The Company intends to test its systems
throughout 1999 to ensure that system and software upgrades are fully compliant.
Phase three consists of developing a contingency plan for those external systems
or suppliers that are critical for the Company to operate, but are not yet Year
2000 compliant. The Company will finalize these contingency plans before January
1, 2000.
The Company does not anticipate the cost of addressing all the issues
associated with becoming Year 2000 compliant will have a material impact on its
financial condition, results of operations or liquidity in any single year. The
Company's estimates are based upon the assumption that its major third party
suppliers are or become Year 2000 compliant within the time frame outlined
above. Efforts to modify the Company's IT systems have substantially been
performed internally, however, the Company does not separately track such costs.
These costs primarily relate to salaries and wages which are expensed as
incurred. The Company estimates its costs associated with becoming Y2K compliant
will be less than $100,000, exclusive of system upgrades incurred in the normal
course of business. The Company has requested that its major third party
suppliers provide details of their Year 2000 compliance program and schedule of
testing. In the event any of these vendors are unable to become compliant the
Company may incur additional costs.
47
48
Although the Company has taken steps to identify, evaluate and remediate
its Year 2000 compliance issues, it is possible that certain of its suppliers
and/or systems may not be Year 2000 compliant by January 1, 2000. These
suppliers provide the Company with computer processing systems, banking and
financial systems, and utility infrastructure. In the event that any of these
suppliers and/or systems are not Year 2000 compliant as of January 1, 2000, the
Company may be exposed to an impairment of its: (i) operations, (ii) business
processes, (iii) ability to meet its financial obligations. The impairment in
any of these areas could have a material adverse effect on the Company's
financial condition, results of operations and liquidity. The Company is
assessing these risks and is creating contingency plans intended to address such
risks, and expects to have such plans in place by January 1, 2000.
LIQUIDITY AND CAPITAL RESOURCES
The Company's sources of cash flow include cash gain on sale of mortgage
loans, origination income, net interest income and borrowings. The Company sells
its mortgage loans generally on a monthly basis to generate cash for operations.
The Company's uses of cash in the short-term include the funding of mortgage
loan originations, payment of interest, repayment of amounts borrowed under
warehouse lines of credit, operating and administrative expenses, start-up costs
for new origination locations, income taxes and capital expenditures. Long-term
uses of cash may also include the funding of securitization activities and
selective acquisitions of other specialty finance companies or portfolios of
loan assets. The Company currently has no formal agreements with regard to any
potential acquisition and there can be no assurance that future acquisitions, if
any, will be consummated. Capital expenditures totaled $1.3 million and $1.4 for
the years ended June 30, 1999 and 1998, respectively. Capital expenditures were
primarily comprised of furniture, fixtures and equipment, software and leasehold
improvements.
Cash and cash equivalents were $29.9 million and $25.9 million at June 30,
1999 and 1998, respectively. The Company invests its cash in short-term
investments maintaining flexibility for funding of loan originations and
strategic opportunities. In March, 1998 the Company concluded its initial public
offering and received net proceeds of $16.2 million from the Offering. As of
June 30, 1999, of these proceeds, approximately $6.7 million was used to fund
loan originations, and the remaining balance has been invested in short-term
investments.
As of April 6, 1999, the Company's Board of Directors had authorized the
Company to repurchase up to $5.0 million of the Company's common stock in open
market purchases from time to time at the discretion of the Company's
management. As of September 15, 1999, the Company had repurchased 833,629 shares
of Common Stock at a cost of $4.5 million.
The Company funds its operations through cash reserves, loan sales, net
earnings, revolving warehouse credit facilities and an uncommitted master loan
repurchase credit agreement, under which it borrows money to finance the
origination of mortgage loans. As of June 30, 1999, the Company had three
warehouse credit facilities, and one master repurchase credit agreement which
provides borrowings in the aggregate up to $300.0 million.
The Company has entered into a warehouse line of credit agreement with DLJ,
which provides for borrowings up to $150.0 million with interest payable monthly
at the Federal Funds rate plus 100 basis points. At June 30, 1999 and 1998,
borrowings under this line of $120.0 million and $96.0 million were
collateralized by mortgage loans held for sale. The interest rate is subject to
increase based on the length of time loans are held by the Company, and that DLJ
receives a security interest on all loans, and other rights in connection
therewith, originated by the Company. This line-of-credit matures and is subject
to renewal on March 16, 2000.
In February 1999, the Company entered into a warehouse line of credit with
Bank United, which provides for borrowings up to $50.0 million with a floating
interest rate based on the LIBOR rate and a commitment fee of $125,000. As of
June 30, 1999, borrowings under this line were $5.1 million and the interest
rate was 6.5%. The warehouse line of credit with Bank United contains certain
financial covenants including the requirement that the Company maintain a
minimum adjusted tangible net worth of not less than $25.0 million and a debt to
adjusted tangible worth ratio not to exceed 15:1, each computed as of the end of
each calendar quarter. The
48
49
Company was in compliance with these covenants as of June 30, 1999. The
warehouse line is secured by all mortgage loans used under the line and all
related rights thereto. This line of credit matures and is subject to renewal on
February 1, 2000.
In March 1999, the company entered into a warehouse line of credit with
RFC, which provides for borrowings up to $50.0 million with a floating interest
rate based on the LIBOR rate and a commitment fee of $65,000. As of June 1,
1999, borrowings under this line were $14.7 million and the interest rate was
6.7%. The warehouse line of credit with RFC contains certain financial covenants
including the requirement that the Company maintain a minimum adjusted tangible
net worth of not less than $25.0 million, liquidity of not less than $10.0
million, quarterly net income of not less than zero and a debt to adjusted
tangible worth ratio not to exceed 15:1. The Company was in compliance with
these covenants as of June 30, 1999. The warehouse line is secured by all
mortgage loans used under the line and all related rights thereto. This line of
credit matures and is subject to renewal on March 1, 2000.
The Company also entered into an uncommitted master repurchase credit
agreement with PWRS, which provides for borrowings up to $50.0 million with a
floating interest rate based on the LIBOR rate. As of June 30, 1999, borrowings
under this line were $2.4 million and the interest rate was 6.4%.
The Company is currently negotiating with other lenders to obtain
additional warehouse lines of credit with interest rates and terms that are
consistent with management's objectives. The Company repays borrowings with
proceeds of its loan sales.
During the years ended June 30, 1999 and 1998, the Company used cash of
$1.3 billion and $788.5 million, respectively, for new loan originations. During
the same periods, the Company received cash proceeds from the sale of loans of
$1.3 billion and $744.4 million, respectively, representing the principal
balance of loans sold. The Company received cash proceeds from the premiums on
such sale of loans of $34.9 million and $30.5 million respectively, for the
years ended June 30, 1999 and 1998, respectively.
The Company's ability to continue to originate loans is dependent upon a
number of factors, including the borrower credit risk classification,
loan-to-value ratios and interest rates, general economic conditions, warehouse
facility interest rates and governmental regulations.
Recently Issued Accounting Considerations.
In June 1998, the FASB issued SFAS 133, Accounting For Derivative
Instruments and Hedging Activities. This statement provides guidance for the way
public enterprises report information about derivatives and hedging in annual
financial statements and in interim financial reports. The derivatives and
hedging disclosure are required for financial statements for fiscal years
beginning after June 15, 2000. The Statement will require the Company to
recognize all derivatives on the balance sheet at fair value. Derivatives that
are not hedges must be adjusted to fair value through income. If the derivative
is a hedge, depending on the nature of the hedge, changes in fair value of
derivatives will either be offset against the change in fair value of the hedged
assets, liabilities or firm commitments through earnings or recognized in
earnings. The ineffective portion of a derivative's change in fair value will be
immediately recognized in earnings. The Company is in the process of evaluating
the effect of Statement 133, if any, on the earnings and financial position of
the Company.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is contained in Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Disclosure About Market Risk," incorporated herein by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Consolidated Financial Statements beginning on Page F-1 of this Annual
Report on Form 10-K.
49
50
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item is set forth in the Company's
definitive Proxy Statement (the "Proxy Statement"), which will be filed with the
Securities and Exchange Commission pursuant to Regulation 14A under the
Securities Exchange Act of 1934 and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is set forth in the Proxy Statement,
which will be filed with the Securities and Exchange Commission pursuant to
Regulation 14A under the Securities and Exchange Act of 1934 and is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is forth in the Proxy Statement,
which will be filed with the Securities and Exchange Commission pursuant to
Regulation 14A under the Securities Exchange Act of 1934 and is incorporated
herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is set forth in the Proxy Statement,
which will be filed with the Securities and Exchange Commission pursuant to
Regulation 14A under the to Regulation 14A under the Securities Exchange Act of
1934 and is incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
1.Consolidated Financial Statements -- See "Index to Consolidated
Financial Statements"
(a) Exhibits
EXHIBIT
NUMBER DESCRIPTION
- --------- -----------
2.1 (1) Agreement of Reorganization and Plan of Merger
3.1 (1) Certificate of Incorporation of BNC Mortgage, Inc., a
Delaware corporation
3.1 (a) Certificate of Designation of Series A Junior Participating
Preferred Stock
3.1 (b) Certificate of Correction
3.2 (1) Bylaws of BNC Mortgage, Inc., a Delaware corporation
4.1 (1) Specimen Stock Certificate
4.2 (3) Rights Agreement, dated October 13, 1998, between the
Registrant and U.S. Stock Transfer Corporation
4.2 (a)(4) Amendment No. 1 to Rights Agreement, dated December 16,
1998, between the Registrant and U.S. Stock Transfer
Corporation
10.1 (1) Office Lease, as amended, between the Registrant and Shuwa
Investments Corporation dated June 15, 1997
10.2 (1) 1997 Stock Option Plan and form of agreements
50
51
EXHIBIT
NUMBER DESCRIPTION
- --------- -----------
10.3 (1) Form of Indemnification Agreement
10.4 (1) Employment Agreement between the Registrant and Evan R.
Buckley
10.4 (a)(5) Amendment to Employment Agreement, dated January 13, 1999,
between Evan Buckley and the Registrant
10.5 (1) Employment Agreement between the Registrant and Kelly W.
Monahan
10.5 (a)(5) Amendment to Employment Agreement, dated January 13, 1999,
between Kelly Monahan and the Registrant
10.6 (a)(1) Letter Agreement, dated October 22, 1997, from DLJ Mortgage
Capital, Inc. to the Registrant
(b)(2) Commitment Letter, dated March 16, 1998, addressed to the
Registrant from DLJ Mortgage Capital, Inc.
(c)(2) Whole Loan Financing Facility, dated March 16, 1998, between
the Registrant and DLJ Mortgage, Inc.
(d)(2) Promissory Note, by the Registrant made in favor of DLJ
Mortgage Capital, Inc.
(f)(2) Whole Loan Financing Program Tri-Party Custody Agreement,
dated September 26, 1995, among Registrant and DLJ Mortgage
Capital, Inc. and Bankers Trust Company
(g)(2) Master Mortgage Loan Purchase Agreement, dated March 16,
1998, between the Registrant and DLJ Mortgage Capital, Inc.
(h)(2) Form of Subordinate Certificate Financing Agreement between
the Registrant and DLJ Mortgage Capital, Inc.
10.7 (2) Representative's Warrant, dated March 16, 1998, issued by
the Registrant to CIBC Oppenheimer Corp.
10.8 (2) Representative's Warrant, dated March 16, 1998, issued by
the Registrant to Piper Jaffray Inc.
10.9 (5) Warehouse Credit and Security Agreement, dated February 2,
1999, between the Registrant and Bank United, a federal
savings bank
10.10(5) Promissory Note, dated February 2, 1999, between the
Registrant and Bank United, a federal savings bank
10.11(5) Financing Statement, dated February 2, 1999, between the
Registrant and Bank United, a federal savings bank
10.12(6) Warehouse Credit and Security Agreement (Single Family
Mortgage Loans), dated March 1, 1999, between the Registrant
and Mortgage Logic.com, Inc., a California corporation and
Residential Funding Corporation, a Delaware corporation
10.13(6) Purchase Agreement, dated December 21, 1998, between the
Registrant, Mortgage Logic.com, Inc., America's Lender,
Inc., Keith Guy and SHL Holdings, Inc.
10.14(6) Non-Competition Agreement, dated February 26, 1999, between
the Registrant, Mortgage Logic.com, Inc., America's Lender,
Inc., Keith Guy and SHL Holdings, Inc.
10.15(6) Licensing and Web Site Hosting Agreement, dated February 26,
1999, between Mortgage Logic.com, Inc. and TrueLink, Inc.
10.16(6) Credit Bureau Services Agreement, dated February 26, 1999,
between the Registrant, Mortgage Logic.com, Inc. and
TrueLink, Inc.
11.1 Statement re: Computation of Per Share Earnings
21.1 (6) Subsidiaries
24.1 Power of Attorney (included on signature page)
27 Financial Data Schedule
- ---------------
(1) Incorporated by reference to, and all such exhibits have the corresponding
exhibit number filed as part of the Registration Statement on Form S-1, as
amended (File No. 333-38651) filed with the Securities and Exchange
Commission on October 24, 1997.
(2) Incorporated by reference to, and all such exhibits having the corresponding
exhibit number filed as part of, the Registrant's Form 10-K for the fiscal
year ended June 30, 1998.
51
52
(3) Incorporated by reference to, and all such exhibits having the corresponding
exhibit number filed as part of, the Registrant's Form 8-A filed with the
Securities and Exchange Commission on October 22, 1998.
(4) Incorporated by reference to, and all such exhibits having the corresponding
exhibit number filed as part of, the Registrant's Form 8-A/A filed with the
Securities and Exchange Commission January 6, 1999.
(5) Incorporated by reference to, and such exhibits having the corresponding
exhibit numbers 10.1, 10.2, 10.3, 10.4 and 10.5, respectively, filed as part
of, the Registrant's Form 10-Q for the quarter ended December 31, 1998.
(6) Incorporated by reference to, and such exhibits having the corresponding
exhibit numbers 10.1, 10.2, 10.3, 10.4, 10.5 and 21.1, respectively, filed
as part of, the Registrant's Form 10-Q for the quarter ended March 31, 1999.
2. Exhibits -- See "Exhibit Index"
(b) Reports on Form 8-K. No reports on Form 8-K were filed during the last
quarter of the fiscal year ended June 30, 1999.
52
53
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 in the City of Irvine,
State of California on September 28, 1999.
BNC MORTGAGE, INC.
By: /s/ EVAN R. BUCKLEY
------------------------------------
Evan R. Buckley
Chairman of the Board, Chief
Executive Officer,
Secretary and Director
POWER OF ATTORNEY
We, the undersigned Officers and Directors of BNC Mortgage, Inc. do hereby
constitute and appoint Evan R. Buckley and Kelly W. Monahan, or either of them,
our true and lawful attorneys and agents, to do any and all acts and things in
our names in the capacities indicated below, which said attorneys and agents, or
either of them may deem necessary or advisable to enable said corporation to
comply with the Securities Act of 1934, and as amended, and any rules,
regulations, and requirements of the Securities and Exchange Commission, in
connection with this Report, including specifically, but without limitation,
power and authority to sign for us or any of us in our names and in the
capacities indicated below, any and all amendments to this Report; and we do
hereby ratify and confirm all that the said attorneys and agents, or either of
them, shall do or cause to be done by virtue hereof.
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.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ EVAN R. BUCKLEY Chairman of the Board, Chief September 28, 1999
- ----------------------------------------------------- Executive Officer, Secretary
Evan R. Buckley and Director
/s/ KELLY W. MONAHAN President and Director September 28, 1999
- -----------------------------------------------------
Kelly W. Monahan
/s/ PETER R. EVANS Chief Financial Officer September 28, 1999
- -----------------------------------------------------
Peter R. Evans
/S/ Keith C. Honig Director September 28, 1999
- -----------------------------------------------------
Keith C. Honig
/s/ JOSEPH R. TOMKINSON Director September 28, 1999
- -----------------------------------------------------
Joseph R. Tomkinson
/s/ RICHARD B. WHITING Director September 28, 1999
- -----------------------------------------------------
Richard Whiting
53
54
BNC MORTGAGE, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Report of Independent Auditors.............................. F-2
Consolidated Balance Sheet as of June 30, 1999 and 1998..... F-3
Consolidated Statement of Income for the Years Ended June
30, 1999, 1998 and 1997................................... F-4
Consolidated Statement of Stockholders' Equity for the Years
Ended June 30, 1999, 1998 and 1997........................ F-5
Consolidated Statement of Cash Flows for Years Ended June
30, 1999, 1998 and 1997................................... F-6
Notes to Consolidated Financial Statements.................. F-7
F-1
55
REPORT OF INDEPENDENT AUDITORS
The Board of Directors BNC Mortgage, Inc.
We have audited the accompanying consolidated balance sheet of BNC
Mortgage, Inc. as of June 30, 1999 and 1998 and the related consolidated
statements of income, stockholders' equity and cash flows for each of the three
years in the period ended June 30, 1999. These consolidated 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 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 consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of BNC
Mortgage, Inc. at June 30, 1999 and 1998, and the results of its operations and
its cash flows for each of the three years in the period ended June 30, 1999, in
conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Orange County, California
August 6, 1999
F-2
56
BNC MORTGAGE, INC.
CONSOLIDATED BALANCE SHEET
ASSETS
JUNE 30,
----------------------------
1999 1998
------------ ------------
Cash and cash equivalents................................... $ 29,867,000 $ 25,890,000
Restricted cash............................................. 1,105,000 638,000
Mortgage loans held for sale................................ 141,749,000 98,717,000
Property and equipment, net................................. 1,882,000 1,533,000
Goodwill.................................................... 1,468,000 --
Deferred income taxes....................................... 2,424,000 2,131,000
Notes receivable from officers.............................. 100,000 100,000
Other assets................................................ 3,384,000 1,546,000
------------ ------------
Total assets...................................... $181,979,000 $130,555,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Warehouse line-of-credit.................................. $142,163,000 $ 96,022,000
Accounts payable and accrued liabilities.................. 4,955,000 2,880,000
Income taxes payable...................................... 1,945,000 802,000
------------ ------------
Total liabilities................................. 149,063,000 99,704,000
COMMITMENTS AND CONTINGENCIES (NOTE 9)
Stockholders' equity:
Preferred stock, $.001 par value:
Authorized shares -- 5,000,000
Issued and outstanding shares -- none in 1999 and 1998.... -- --
Common stock, voting $0.001 par value:
Authorized Shares -- 50,000,000
Issued and outstanding shares 5,092,350 in 1999 and
5,875,979 in 1998.................................... 5,000 6,000
Additional paid in capital................................ 11,980,000 16,193,000
Retained earnings......................................... 20,931,000 14,652,000
------------ ------------
Total stockholders' equity........................ 32,916,000 30,851,000
------------ ------------
Total liabilities and stockholders' equity........ $181,979,000 $130,555,000
============ ============
See accompanying notes.
F-3
57
BNC MORTGAGE, INC.
CONSOLIDATED STATEMENT OF INCOME
YEAR ENDED JUNE 30,
-----------------------------------------
1999 1998 1997
----------- ----------- -----------
Revenues:
Gain on sale of mortgage loans.................... $34,860,000 $30,458,000 $21,855,000
Loan origination income........................... 8,412,000 5,399,000 5,473,000
Interest income................................... 8,167,000 7,860,000 5,182,000
Other income...................................... 1,473,000 676,000 250,000
----------- ----------- -----------
Total revenues............................ 52,912,000 44,393,000 32,760,000
----------- ----------- -----------
Expenses:
Employees' salaries and commissions............... 24,394,000 18,828,000 11,052,000
General and administrative expenses............... 12,493,000 8,028,000 5,543,000
Interest expense.................................. 5,608,000 5,486,000 3,693,000
----------- ----------- -----------
Total expenses............................ 42,495,000 32,342,000 20,288,000
----------- ----------- -----------
Income before income taxes.......................... 10,417,000 12,051,000 12,472,000
Income tax expense.................................. 4,138,000 4,815,000 4,930,000
----------- ----------- -----------
Net income.......................................... $ 6,279,000 $ 7,236,000 $ 7,542,000
=========== =========== ===========
Basic earnings per share............................ $ 1.14 $ 1.55 $ 1.80
=========== =========== ===========
Diluted earnings per share.......................... $ 1.14 $ 1.51 $ 1.80
=========== =========== ===========
See accompanying notes.
F-4
58
BNC MORTGAGE INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
SERIES A SERIES A SERIES B
PREFERRED STOCK COMMON STOCK COMMON STOCK COMMON STOCK
------------------- -------------------- -------------------- -------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
------ ---------- ---------- ------- ---------- ------- --------- -------
Balance at June 30, 1996.......... 160 $1,575,000 2,886,598 $ -- 1,072,165 $ 2,000 -- $ --
Issuance of common stock........ -- -- -- -- 185,567 6,000 -- --
Repurchase of common shares..... -- -- -- -- (20,619) (1,000) -- --
Cash dividends on preferred
stock......................... -- -- -- -- -- -- -- --
Net Income...................... -- -- -- -- -- -- -- --
---- ---------- ---------- ------- ---------- ------- --------- -------
Balance at June 30, 1997.......... 160 1,575,000 2,886,598 -- 1,237,113 7,000 -- --
Issuance of common stock (less
cost of $455,599)............. -- -- -- -- -- -- 5,875,979 6,000
Repurchase of common shares..... -- -- -- -- (1,237,113) (7,000) -- --
Repurchase of preferred
shares........................ (160) (1,575,000) (2,886,598) -- -- -- -- --
Cash dividends on preferred
stock......................... -- -- -- -- -- -- -- --
Net income...................... -- -- -- -- -- -- -- --
---- ---------- ---------- ------- ---------- ------- --------- -------
Balance at June 30, 1998.......... -- -- -- -- -- -- 5,875,979 6,000
---- ---------- ---------- ------- ---------- ------- --------- -------
Repurchase of common shares..... -- -- -- -- -- -- (783,629) (1,000)
Net Income...................... -- -- -- -- -- -- -- --
---- ---------- ---------- ------- ---------- ------- --------- -------
Balance at June 30, 1999.......... -- $ -- -- $ -- -- $ -- 5,092,350 $ 5,000
==== ========== ========== ======= ========== ======= ========= =======
ADDITIONAL TOTAL
PAID IN RETAINED STOCKHOLDER'S
CAPITAL EARNINGS EQUITY
----------- ----------- -------------
Balance at June 30, 1996.......... $ -- $ 269,000 $ 1,846,000
Issuance of common stock........ -- -- 6,000
Repurchase of common shares..... -- -- (1,000)
Cash dividends on preferred
stock......................... -- (189,000) (189,000)
Net Income...................... -- 7,542,000 7,542,000
----------- ----------- -----------
Balance at June 30, 1997.......... -- 7,622,000 9,204,000
Issuance of common stock (less
cost of $455,599)............. 16,193,000 -- 16,199,000
Repurchase of common shares..... -- (131,000) (138,000)
Repurchase of preferred
shares........................ -- -- (1,575,000)
Cash dividends on preferred
stock......................... -- (75,000) (75,000)
Net income...................... -- 7,236,000 7,236,000
----------- ----------- -----------
Balance at June 30, 1998.......... 16,193,000 14,652,000 30,851,000
----------- ----------- -----------
Repurchase of common shares..... (4,213,000) -- (4,214,000)
Net Income...................... -- 6,279,000 6,279,000
----------- ----------- -----------
Balance at June 30, 1999.......... $11,980,000 $20,931,000 $32,916,000
=========== =========== ===========
See accompanying notes.
F-5
59
BNC MORTGAGE, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED JUNE 30,
-------------------------------------------------
1999 1998 1997
--------------- ------------- -------------
OPERATING ACTIVITIES
Net income.................................. $ 6,279,000 $ 7,236,000 $ 7,542,000
Adjustment to reconcile net income to net
cash used in operating activities:
Depreciation.............................. 914,000 486,000 250,000
Amortization of goodwill.................. 33,000 -- --
Origination of mortgage loans held for
sale................................... (1,335,575,000) (788,479,000) (532,621,000)
Sales and principal repayments of mortgage
loans held for sale.................... 1,293,062,000 745,275,000 520,600,000
Deferred loan origination fees............ (519,000) (368,000) (401,000)
Goodwill.................................. (1,501,000) -- --
Change in other assets.................... 162,000 (1,009,000) (338,000)
Change in accounts payable and accrued
liabilities............................ 2,075,000 1,522,000 479,000
Change in income taxes payable............ 1,143,000 276,000 (378,000)
Change in deferred income taxes........... (293,000) (977,000) (587,000)
--------------- ------------- -------------
Net cash used in operating activities....... (34,220,000) (36,038,000) (5,454,000)
--------------- ------------- -------------
INVESTING ACTIVITIES
Capital expenditures........................ (1,263,000) (1,410,000) (448,000)
Purchase of Simple Mortgage USA, Inc........ -- (100,000) --
Purchase of America's Lender, Inc........... (2,000,000) -- --
--------------- ------------- -------------
Net cash used in investing activities....... (3,263,000) (1,510,000) (448,000)
--------------- ------------- -------------
FINANCING ACTIVITIES
Payment of dividends on preferred stock..... -- (75,000) (189,000)
Repurchase of preferred shares.............. -- (1,575,000) --
Repurchase of common shares................. (4,214,000) (138,000) (1,000)
Proceeds from issuance of common stock...... -- 16,199,000 6,000
Increase in restricted cash................. (467,000) (638,000) --
Change in warehouse line of credit.......... 46,141,000 41,397,000 11,902,000
--------------- ------------- -------------
Net cash provided by financing activities... 41,460,000 55,170,000 11,718,000
--------------- ------------- -------------
Net increase in cash and cash equivalents... 3,977,000 17,622,000 5,816,000
Cash and cash equivalents at beginning of
the year.................................. 25,890,000 8,268,000 2,452,000
--------------- ------------- -------------
Cash and cash equivalents at end of the
year...................................... $ 29,867,000 $ 25,890,000 $ 8,268,000
=============== ============= =============
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid............................... $ 5,233,000 $ 5,468,000 $ 3,693,000
=============== ============= =============
Taxes paid.................................. $ 3,118,000 $ 5,515,000 $ 5,351,000
=============== ============= =============
See accompanying notes.
F-6
60
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS AND BASIS OF PRESENTATION
The Company is a specialty finance company engaged in the business of
originating, purchasing and selling non-conforming, and to a lesser extent,
conforming residential mortgage loans secured by one-to-four family residences.
The Company's loans are made to owners of single family residence who typically
use the loan proceeds for purposes such as refinancing existing mortgages, debt
consolidation, financing of home improvements, education and other similar
needs, and, to a lesser extent, to purchase residences. The Company originates
loans through its wholesale subprime operations and its wholesale prime
operations through, which it originates mortgage loans through approved
independent loan brokers. The Company currently sells all of its mortgage loans
to institutional purchasers such as investment banks, real estate investment
trusts and other large mortgage bankers for cash through whole loan sales.
In connection with the Company's March 10, 1998 initial public offering,
the Company reincorporated in Delaware. Further to the reincorporation, the
existing California corporation was merged into a newly formed Delaware
corporation pursuant to which each outstanding share of Class A and Class B
common stock of the existing California corporation was exchanged for
4,123.71134 shares of $.001 par value common stock of the new Delaware
corporation. The certificate of incorporation of the new Delaware corporation
authorized 50,000,000 shares of common stock and 5,000,000 shares of preferred
stock. In November 1997, the Company redeemed all shares of Series A Preferred
Stock for $1,575,000.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements of the Company include the accounts
of the Company and all of its wholly owned subsidiaries. All significant
intercompany transactions and balances are eliminated.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of the consolidated financial statements of the Company
requires management to make estimates and assumptions that affect reported
amounts. These estimates are based on information available as of the date of
the financial statements. Therefore, actual results could differ from those
estimates.
MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale are stated at the lower of cost or aggregate
market value. Market value is determined by purchase commitments from investors
and prevailing market prices.
LOAN ORIGINATION FEES
Loan origination fees and certain direct loan origination costs for
mortgage loans held for sale are deferred until the related loans are sold.
GAIN ON SALE OF MORTGAGE LOANS HELD FOR SALE
Gains or losses on the sale of mortgage loans held for sale are recognized
at the date of sale.
CASH AND CASH EQUIVALENTS
The Company accounts for all highly liquid investments with a maturity of
three months or less when purchased as cash equivalents.
F-7
61
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
PROPERTY AND EQUIPMENT
Property and equipment, consisting primarily of computer hardware and
software, is stated at cost, net of accumulated depreciation and amortization.
Depreciation is provided using the straight line method over their estimated
useful lives of three years.
RECENTLY ISSUED ACCOUNTING STANDARD
In June 1998, the FASB issued SFAS 133, Accounting For Derivative
Instruments and Hedging Activities. This statement provides guidance for the way
public enterprises report information about derivatives and hedging in annual
financial statements and in interim financial reports. The derivatives and
hedging disclosure are required for financial statements for fiscal years
beginning after June 15, 2000. The Statement will require the Company to
recognize all derivatives on the balance sheet at fair value. Derivatives that
are not hedges must be adjusted to fair value through income. If the derivative
is a hedge, depending on the nature of the hedge, changes in fair value of
derivatives will either be offset against the change in fair value of the hedged
assets, liabilities or firm commitments through earnings or recognized in
earnings. The ineffective portion of a derivative's change in fair value will be
immediately recognized in earnings. The Company is in the process of evaluating
the effect of Statement 133, if any, on the earnings and financial position of
the Company.
INCOME TAXES
The Company accounts for income taxes using Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes (FAS 109). FAS 109
requires the use of the asset and liability method of accounting for taxes.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. Under FAS 109, the effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date.
NET INCOME PER SHARE
As of June 30, 1998, the Company adopted Statement No. 128, Earnings Per
Share, and restated all prior period earnings per share (EPS) data, as required.
Statement No. 128 replaced the presentation of primary and fully diluted EPS
pursuant to APB Opinion No. 15, Earnings Per Share, with the presentation of
basic and diluted EPS. Basic EPS excludes dilution and is computed by dividing
net income by the weighted average number of common shares outstanding for the
period. Diluted net income per share is computed by dividing net income by the
weighted average number of common shares outstanding for the period and the
dilutive effect, if any, of stock options and warrants outstanding for the
period.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair values presented in Note 7 are estimates of the fair values of the
financial instruments at a specific point in time using available market
information and appropriate valuation methodologies. These estimates are
subjective in nature and involve uncertainties and significant judgment in the
interpretation of current market data. Therefore, the fair values presented are
not necessary indicative of amounts the Company could realize or settle
currently.
F-8
62
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. BUSINESS ACQUISITION
On February 26, 1999, the Company acquired certain assets and the business
of America's Lender, Inc., a mortgage originator that utilizes an internet-based
wholesale mortgage lending operation that links independent mortgage brokers to
an automated underwriting and credit reporting system. The Company paid
$2,000,000 in cash and has agreed to pay up to an additional $1,000,000 based
upon net loan originations achieved during the first 12-month period. The
earn-out is $.001 for each dollar of net origination volume of the mortgage
business that equals or exceeds $500,000,000 during the 12-month period. The
Company deposited $500,000 into an interest-bearing escrow account to
collateralize the future obligation. Should the earn-out not be earned, the
$500,000 deposit will revert back to the Company. The transaction was accounted
for a purchase and the excess of cost over fair value of the net assets acquired
is being amortized on a straight-line basis over a 15-year period. America's
Lender, Inc. is operated as the Company's wholly owned subsidiary named Mortgage
Logic.com, Inc. The operations of America's Lender, Inc. are included in the
Company's consolidated statement of operations from the date of acquisition.
The pro forma unaudited results of operations for the years ended June 30,
1999 and 1998, assuming the purchase of America's Lender, Inc. had been
consummated as of July 1, 1997, follows:
1999 1998
----------- -----------
Revenue........................................... $59,488,000 $52,397,000
Net Income........................................ 6,425,000 7,105,000
Net Income per share:
Basic........................................... $1.17 $1.53
Diluted......................................... $1.17 $1.48
3. MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale are collateralized by first and second trust
deeds on underlying real properties and are used as collateral for the Company's
borrowings. Approximately 59% of these properties are located in California.
Mortgage loans held for sale include net deferred origination fees of $1,287,000
and $769,000 at June 30, 1999 and 1998, respectively.
4. PROPERTY AND EQUIPMENT
Property and equipment consists of the following at June 30:
1999 1998
----------- ----------
Leasehold improvements............................. $ 312,000 $ 251,000
Furniture and fixtures............................. 330,000 171,000
Office equipment................................... 2,661,000 1,685,000
Automobiles........................................ 14,000 --
Software........................................... 292,000 239,000
----------- ----------
3,609,000 2,346,000
Less accumulated depreciation...................... (1,727,000) (813,000)
----------- ----------
$ 1,882,000 $1,533,000
=========== ==========
F-9
63
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. INCOME TAXES
Income tax expense for the years ended June 30, 1999, 1998 and 1997 are
summarized as follows:
1999 1998 1997
---------- ----------- ----------
Current:
Federal............................. $3,295,000 $ 4,747,000 $4,119,000
State............................... 1,136,000 1,045,000 1,398,000
---------- ----------- ----------
4,431,000 5,792,000 5,517,000
Deferred:
Federal............................. (99,000) (1,020,000) (603,000)
State............................... (194,000) 43,000 16,000
---------- ----------- ----------
(293,000) (977,000) (587,000)
---------- ----------- ----------
$4,138,000 $ 4,815,000 $4,930,000
========== =========== ==========
The reconciliation of income tax expense at the U.S. federal statutory tax
rate to the income tax expense for the years ended June 30, 1999, 1998, and 1997
are as follows:
1999 1998 1997
---------- ----------- ----------
Tax computed at the statutory rate.... $3,646,000 $ 4,218,000 $4,365,000
State income tax, net of federal
income tax benefit.................. 612,000 708,000 665,000
Other................................. (120,000) (111,000) (100,000)
---------- ----------- ----------
Income tax expense.................... $4,138,000 $ 4,815,000 $4,930,000
========== =========== ==========
The components of the Company's deferred income tax assets and liabilities
as of June 30, 1999 and 1998 are as follows:
1999 1998
---------- ----------
Deferred tax assets (liabilities):
Depreciation...................................... $ 38,000 $ 21,000
State income taxes................................ 108,000 371,000
Reserve for loan repurchases...................... 938,000 234,000
Accrued vacation.................................. 222,000 195,000
Accrued compensation.............................. 263,000 183,000
Litigation reserve................................ 15,000 15,000
Mark-to-market adjustments........................ 1,392,000 1,786,000
Deferred loan fees................................ (548,000) (682,000)
Other accrued liabilities......................... (4,000) 8,000
---------- ----------
Total deferred tax assets................. $2,424,000 $2,131,000
========== ==========
6. WAREHOUSE LINE-OF-CREDIT
The Company has entered into a warehouse line of credit agreement with DLJ,
which provides for borrowings up to $150,000,000 with interest payable monthly
at the Federal Funds rate plus 50 basis points until March 16, 1999 and
thereafter at Federal Funds rate plus 100 basis points. At June 30, 1999 and
1998, borrowings under this line of $119,981,000 and $96,022,000 are
collateralized by mortgage loans held for sale. This line-of-credit matures and
is subject to renewal on March 16, 2000.
F-10
64
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In February 1999, the Company entered into a warehouse line of credit with
Bank United, which provides for borrowings up to $50,000,000 with a floating
interest rate based on the LIBOR rate and a commitment fee of $125,000. As of
June 30, 1999, borrowings under this line were $5,094,000 and are collateralized
by mortgage loans held for sale with an interest rate of 6.5%. This line of
credit matures and is subject to renewal on February 1, 2000.
In March 1999, the company entered into a warehouse line of credit with
Residential Funding Corporation ("RFC"), which provides for borrowings up to
$50,000,000 with a floating interest rate based on the LIBOR rate and a
commitment fee of $65,000. As of June 30, 1999, borrowings under this line were
$14,725,000 and are collateralized by mortgage loans held for sale with an
interest rate of 6.7%. This line of credit matures and is subject to renewal on
March 1, 2000.
MortgageLogic.com, Inc. entered into an uncommitted master repurchase
credit agreement with PaineWebber Real Estate Securities ("PWRS"), which
provides for borrowings up to $50,000,000 with a floating interest rate based on
the LIBOR rate. As of June 30, 1999, borrowings under this line were $2,363,000
and are collateralized by mortgage loans held for sale with an interest rate of
6.39%.
Under the Bank United and RFC credit agreements, the Company must comply
with certain financial and other covenants, including the maintenance of a
minimum tangible net worth of $25.0 million, a debt to tangible worth ratio not
to exceed 15:1, other financial ratios, and the maintenance of a quarterly net
income not less than zero. Further, absent the consent of Bank United, such
covenants prohibit the Company from declaring or paying any dividends on any
shares of the Company's common stock. At June 30, 1999, the Company was in
compliance with the aforementioned loan covenants.
The weighted average interest rates on line of credit borrowings for the
fiscal years ended June 30, 1999 and 1998 were 6.9% and 6.4%, respectively.
7. FINANCIAL INSTRUMENTS
The following describes the methods and assumptions used by the Company in
estimating fair value:
Mortgage loans held for sale -- Fair value is estimated using the quoted
market prices for securities backed by similar types of loans and investor
commitments to purchase loans on a service-released basis. Warehouse
line-of-credit -- Fair value is estimated using rates currently available to the
Company for debt with similar terms and remaining maturities.
The carrying values and the estimated fair values of the Company's
financial instruments for which it is practical to calculate a fair value are as
follows:
JUNE 30, 1999 JUNE 30, 1998
---------------------------- ---------------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
------------ ------------ ----------- ------------
Mortgage loans held for sale....... $141,749,000 $145,725,000 $98,717,000 $102,948,000
Warehouse line-of-credit........... 142,163,000 142,163,000 96,022,000 96,022,000
8. RELATED PARTY TRANSACTION
In July 1997, the Company loaned an aggregate of $250,000 to two officers
of the Company. The loans accrue interest monthly at the Federal Funds rate and
are due upon the sale of common stock. As of June 30, 1999, one loan remained
outstanding with a principal balance of $100,000. Interest income of $5,000 was
recorded related to this note for the year ended June 30, 1999.
For the year ended June 30, 1999, the Company sold $20.8 million of
mortgage loans to Impac Funding Corporation ("IFC"), a company of which Joseph
R. Tomkinson, a director of the Company, is the Chief
F-11
65
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Executive Officer, a director and a significant common shareholder. In addition,
the Company entered into a $50 million optional delivery master commitment to
sell non-conforming mortgage loans to IFC.
During the years ended June 30, 1999, 1998 and 1997 the Company sold loans
to DLJ having an aggregate principal balance of $612.3 million, $727.1 million
and $473.7 million, respectively, pursuant to a Master Loan Purchase Agreement.
In connection with such sales, the Company paid fees to DLJ of $2.2 million and
$2.1 million for the years ended June 30, 1998 and 1997, respectively.
On June 1, 1998, the Company acquired Simple Mortgage USA, Inc. ("Simple
USA") from Evan R. Buckley, Chairman and Chief Executive Officer of the Company.
The Company paid $258,000 for Simple USA, which had a book value of $245,000. At
the time of acquisition, Simple USA had $238,000 in cash and had no employees.
The purchase price included a cash payment of $100,000 and the forgiveness of a
note payable to the Company of $150,000 and accrued interest of $8,000. The
excess of the purchase price over the book value was charged to operations in
fiscal 1998.
9. COMMITMENTS AND CONTINGENCIES
Forward Loan Sales Commitments
The Company has entered into a forward loan sale contract with an
investment bank under which it has committed to deliver $361.8 million in loans
originated during the period from February 1999 to July 1999. At June 30, 1999,
$284.9 million in loans had been delivered under this commitment and the balance
was delivered subsequent to year end. The price received under the commitment
includes adjustments for the actual weighted average coupons, weighted average
margins and prepayment terms of the loans sold.
In June 1998, the Company entered into a $50 million optional delivery
master commitment to sell certain nonconforming mortgage loans at current market
rates to "IFC". The forward sales commitment is for a 12 month period and
provides an option to increase the commitment to $100 million. The Company paid
a commitment fee of $63,000 which was recorded as an asset and will be amortized
as the loans are sold into the commitment. At June 30, 1999, $20.8 million loans
had been sold under this commitment.
Repurchase Obligation
The Company engages in bulk loan sales pursuant to agreements that
generally require the Company to repurchase or substitute loans in the event of
a breach of a representation or warranty made by the Company to the loan
purchaser, any misrepresentation during the mortgage loan origination process
or, in some cases, upon any fraud or first payment default on such mortgage
loans. A reserve for potential repurchases of $1,352,000 and $500,000 at June
30, 1999 and 1998, respectively, is included in accounts payable and accrued
liabilities.
Leases
The Company's executive and administrative offices are occupied under a
noncancelable operating lease which expires in 2002 with aggregate monthly
payments of approximately $71,200. The lease agreement requires the Company to
maintain a refundable letter of credit to the lessor in the amount of $600,000.
Cash deposited into an escrow to secure the letter of credit and accrued
interest thereon is classified as restricted cash on the balance sheet.
The Company's loan offices are occupied under noncancelable operating
leases which expire between October 1999 and March 2003 and provide for rent
escalations tied to either increases in the lessor's operating
F-12
66
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
expenses or fluctuations in the consumer price index in the relevant
geographical area. The minimum annual rental payments under these operating
leases is as follows:
2000..................................................... $1,768,000
2001..................................................... 1,260,000
2002..................................................... 983,000
2003..................................................... 386,000
Thereafter............................................... --
----------
$4,397,000
==========
Rent expense for the years ended June 30, 1999, 1998 and 1997 was
$1,866,000, $1,293,000 and $597,000 respectively.
10. STOCKHOLDERS' EQUITY
PREFERRED STOCK
The Board of Directors has the authority, without further action by the
stockholders of the Company, to issue up to 5,000,000 shares of Preferred Stock
in one or more series, and to fix the designations, rights, preferences,
privileges, qualifications and restrictions thereof including dividend rights,
conversion rights, voting rights, rights and terms of redemption, liquidation
preferences and sinking fund terms, any or all of which may be greater than the
rights of the Common Stock. 570,000 shares has been designated Series A Junior
Participating Preferred Stock. The terms and conditions of the Series A Junior
Preferred Stock could have the effect of delaying, deferring or preventing a
hostile change in control of the Company.
WARRANTS
In connection with the initial public offering, the Company issued warrants
to purchase 317,319 shares of Common Stock at an exercise price per share equal
to $10.45. The warrants are exercisable over a period of four years, commencing
one year from March 10, 1998.
11. 401(K) PLAN
The Company adopted a 401(k) savings plan (the "401(k) Plan") effective on
July 1, 1996. Eligible employees may participate in the 401(k) Plan.
Participants in the 401(k) Plan may defer compensation in an amount not in
excess of the annual statutory limit ($10,000 in 1999). The Company may make
matching contributions in the amount determined annually by the Board of
Directors. Matching contributions if any, vest after three years. Contributions
made for the years ended June 30, 1999, 1998 and 1997 were $125,000, $74,000 and
$37,000, respectively.
12. STOCK OPTION PLAN
In October 1997, the Company adopted the 1997 Stock Option, Deferred Stock
and Restricted Stock Plan (the Stock Option Plan), which provides for a
committee of the Board of Directors (the Committee) to authorize the grant of
incentive stock options, nonqualified stock options, deferred stock, restricted
stock, stock appreciation rights and limited stock appreciation rights awards to
any officer or key employee of the Company. The Stock Option Plan authorizes the
grant of options to purchase, and awards of, an aggregate of 800,000 shares.
Incentive stock options are granted at a price not less than 100% (110% in the
case of incentive stock options granted to an employee who is deemed to own in
excess of 10% of the outstanding common stock) of the fair market value of the
shares of common stock at the time the option is granted. Incentive stock
options and nonqualified stock options become exercisable according to the terms
of the grant made by the Committee and remain exercisable until their specified
expiration date.
F-13
67
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company has issued nonqualified stock options to an employee for the
purchase of 163,265 shares of common stock at $6.10 per share. The options vest
ratably over a three year period beginning on October 1, 1997. The difference
between the fair market value of the common stock on the date of grant and the
exercise price of the options of $555,000 is being recorded as compensation
expense over the vesting period of the options. For the year ended June 30,
1999, compensation expense related to these options was $185,000.
The Company has issued nonqualified stock options to the non-employee board
members for the purchase of 69,000 shares of common stock at $5.75 - $9.50, the
fair value at the date of grant. The options vest ratably over a two year
period.
The Company has issued incentive stock options for the purchase of 472,902
shares of common stock at $5.75 - $11.00 per share. The options vest ratably
over a three year period.
The following summarizes stock option activity under the Company's stock
plan for the years ended June 30, 1999 and 1998:
1999 1998
-------------------------- --------------------------
WEIGHTED-AVERAGE WEIGHTED-AVERAGE
OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE
------- ---------------- ------- ----------------
Options outstanding at beginning of fiscal
year........................................ 621,893 $8.64 -- --
Option granted................................ 82,000 $5.92 623,167 $8.64
Options exercised............................. -- -- -- --
Options canceled.............................. (62,528) $9.56 (1,274) $9.50
------- -------
Options outstanding at end of fiscal year..... 641,365 $8.20 621,893 $8.64
======= =======
Exercise price:
Per share for options exercised during
fiscal year.............................. n/a n/a
OPTIONS OPTIONS
JUNE 30, 1999 JUNE 30, 1998
-------------- --------------
Per share for options outstanding at end of fiscal year..... $5.75 - $11.00 $6.10 - $11.00
Weighted average fair value of options granted Nonqualified
stock options............................................. $4.40 - $ 6.13 $5.32
Incentive stock options..................................... $4.40 - $ 7.29 $3.01
Weighted average contractual life of option outstanding (in
years).................................................... 8.62 9.58
As of June 30, 1999, there were 211,723 outstanding options exercisable.
There were no options exercisable at June 30, 1998. Options available for future
grants under the plans were 158,635 and 178,107 as of June 30, 1999 and 1998,
respectively.
The Company currently follows Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25) and related interpretations in
accounting for its stock options. Under APB 25, when the exercise price of the
Company's employee stock options are equal to the underlying stock on the date
of grant, no compensation expense is recognized. The Company intends to follow
the provisions of APB 25 for future years.
Pro forma information regarding net income and earnings per share is
required by FASB Statement No. 123, Accounting for Stock-Based Compensation (FAS
123), and has been determined as if the Company had accounted for its employee
stock options under the fair value method of that Statement. The fair value of
F-14
68
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
options at date of grant was estimated using the Black-Scholes model with the
following weighted average assumptions:
1999 1998
----------- ----
Expected life (years).................................... 6 6
Interest rate............................................ 6.10% 4.72%
Volatility............................................... 0.65 - 0.88 0.31
Dividend yield........................................... 0.00% 0.00%
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
The estimated stock-based compensation cost calculated using the
assumptions indicated totaled $534,000 and $151,000 for the years ended June 30,
1999 and 1998. The pro forma net income resulting from the increased
compensation cost was $5,745,000, ($1.04 per share) and $7,085,000 ($1.48 per
share) for the years ended June 30, 1999 and 1998, respectively.
13. SIGNIFICANT CUSTOMERS
The Company has entered into a number of transactions with various
financial companies which account for more than 10% of the Company's loan sales.
These transactions include whole loan purchase and sales agreements, under which
the financial companies agree to periodically purchase certain loans from the
Company. During the years ended June 30, 1999, 1998 and 1997, the Company sold a
total of $896.8 million, $744.4 million and $519.9 million, respectively, of
loans to these investors under these agreements and recognized gross cash gains
on sales of approximately $32.1 million, $30.5 million and $21.9 million,
respectively.
14. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings per share:
YEAR ENDED JUNE 30,
--------------------------------------
1999 1998 1997
---------- ---------- ----------
Numerator
Net income................................... $6,279,000 $7,236,000 $7,542,000
========== ========== ==========
Denominator
Shares used in computing basic earnings per
share..................................... 5,501,686 4,653,836 4,186,662
Effect of stock options treated as
equivalents under the treasury stock
method.................................... -- 142,392 --
---------- ---------- ----------
Denominator for diluted earnings per share... 5,501,686 4,796,228 4,186,662
========== ========== ==========
Basic earnings per share..................... $ 1.14 $ 1.55 $ 1.80
========== ========== ==========
Diluted earnings per share................... $ 1.14 $ 1.51 $ 1.80
========== ========== ==========
F-15
69
BNC MORTGAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. SUBSEQUENT EVENT
On August 20, 1999 the Company repurchased 50,000 shares of common stock at
a cost of $302,503 in accordance with the $5.0 million common stock repurchase
plan approved by the Board of Directors in fiscal year 1999. As of September 15,
1999, the Company had repurchased 833,629 shares of common stock at a cost of
$4.5 million.
F-16
70
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- --------- -----------
2.1 (1) Agreement of Reorganization and Plan of Merger
3.1 (1) Certificate of Incorporation of BNC Mortgage, Inc., a
Delaware corporation
3.1 (a) Certificate of Designation of Series A Junior Participating
Preferred Stock
3.1 (b) Certificate of Correction
3.2 (1) Bylaws of BNC Mortgage, Inc., a Delaware corporation
4.1 (1) Specimen Stock Certificate
4.2 (3) Rights Agreement, dated October 13, 1998, between the
Registrant and U.S. Stock Transfer Corporation
4.2 (a)(4) Amendment No. 1 to Rights Agreement, dated December 16,
1998, between the Registrant and U.S. Stock Transfer
Corporation
10.1 (1) Office Lease, as amended, between the Registrant and Shuwa
Investments Corporation dated June 15, 1997
10.2 (1) 1997 Stock Option Plan and form of agreements
10.3 (1) Form of Indemnification Agreement
10.4 (1) Employment Agreement between the Registrant and Evan R.
Buckley
10.4 (a)(5) Amendment to Employment Agreement, dated January 13, 1999,
between Evan Buckley and the Registrant
10.5 (1) Employment Agreement between the Registrant and Kelly W.
Monahan
10.5 (a)(5) Amendment to Employment Agreement, dated January 13, 1999,
between Kelly Monahan and the Registrant
10.6 (a)(1) Letter Agreement, dated October 22, 1997, from DLJ Mortgage
Capital, Inc. to the Registrant
(b)(2) Commitment Letter, dated March 16, 1998, addressed to the
Registrant from DLJ Mortgage Capital, Inc.
(c)(2) Whole Loan Financing Facility, dated March 16, 1998, between
the Registrant and DLJ Mortgage, Inc.
(d)(2) Promissory Note, by the Registrant made in favor of DLJ
Mortgage Capital, Inc.
(f)(2) Whole Loan Financing Program Tri-Party Custody Agreement,
dated September 26, 1995, among Registrant and DLJ Mortgage
Capital, Inc. and Bankers Trust Company
(g)(2) Master Mortgage Loan Purchase Agreement, dated March 16,
1998, between the Registrant and DLJ Mortgage Capital, Inc.
(h)(2) Form of Subordinate Certificate Financing Agreement between
the Registrant and DLJ Mortgage Capital, Inc.
10.7 (2) Representative's Warrant, dated March 16, 1998, issued by
the Registrant to CIBC Oppenheimer Corp.
10.8 (2) Representative's Warrant, dated March 16, 1998, issued by
the Registrant to Piper Jaffray Inc.
10.9 (5) Warehouse Credit and Security Agreement, dated February 2,
1999, between the Registrant and Bank United, a federal
savings bank
10.10(5) Promissory Note, dated February 2, 1999, between the
Registrant and Bank United, a federal savings bank
10.11(5) Financing Statement, dated February 2, 1999, between the
Registrant and Bank United, a federal savings bank
71
EXHIBIT
NUMBER DESCRIPTION
- --------- -----------
10.12(6) Warehouse Credit and Security Agreement (Single Family
Mortgage Loans), dated March 1, 1999, between the Registrant
and Mortgage Logic.com, Inc., a California corporation and
Residential Funding Corporation, a Delaware corporation
10.13(6) Purchase Agreement, dated December 21, 1998, between the
Registrant, Mortgage Logic.com, Inc., America's Lender,
Inc., Keith Guy and SHL Holdings, Inc.
10.14(6) Non-Competition Agreement, dated February 26, 1999, between
the Registrant, Mortgage Logic.com, Inc., America's Lender,
Inc., Keith Guy and SHL Holdings, Inc.
10.15(6) Licensing and Web Site Hosting Agreement, dated February 26,
1999, between Mortgage Logic.com, Inc. and TrueLink, Inc.
10.16(6) Credit Bureau Services Agreement, dated February 26, 1999,
between the Registrant, Mortgage Logic.com, Inc. and
TrueLink, Inc.
11.1 Statement re: Computation of Per Share Earnings
21.1 (6) Subsidiaries
24.1 Power of Attorney (included on signature page)
27 Financial Data Schedule
- ---------------
(1) Incorporated by reference to, and all such exhibits have the corresponding
exhibit number filed as part of the Registration Statement on Form S-1, as
amended (File No. 333-38651) filed with the Securities and Exchange
Commission on October 24, 1997.
(2) Incorporated by reference to, and all such exhibits having the corresponding
exhibit number filed as part of, the Registrant's Form 10-K for the fiscal
year ended June 30, 1998.
(3) Incorporated by reference to, and all such exhibits having the corresponding
exhibit number filed as part of, the Registrant's Form 8-A filed with the
Securities and Exchange Commission on October 22, 1998.
(4) Incorporated by reference to, and all such exhibits having the corresponding
exhibit number filed as part of, the Registrant's Form 8-A/A filed with the
Securities and Exchange Commission January 6, 1999.
(5) Incorporated by reference to, and such exhibits having the corresponding
exhibit numbers 10.1, 10.2, 10.3, 10.4 and 10.5, respectively, filed as part
of, the Registrant's Form 10-Q for the quarter ended December 31, 1998.
(6) Incorporated by reference to, and such exhibits having the corresponding
exhibit numbers 10.1, 10.2, 10.3, 10.4, 10.5 and 21.1, respectively, filed
as part of, the Registrant's Form 10-Q for the quarter ended March 31, 1999.