Securities and Exchange Commission
Washington, D.C. 20549
Form 10-Q
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X Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Act of
- -
1934 for the quarterly period ended June 30, 2001.
- - Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File Number 000-23775
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Approved Financial Corp.
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(Exact Name of Registrant as Specified in its Charter)
Virginia 52-0792752
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
1716 Corporate Landing Parkway, Virginia Beach, Virginia 23454
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(Address of Principal Executive Office) (Zip Code)
757-430-1400
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(Registrant's Telephone Number, Including Area Code)
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 is
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No .
--- ----
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of August 1, 2001: 5,482,114 shares
APPROVED FINANCIAL CORP.
INDEX
PART I. FINANCIAL INFORMATION Page
Item 1. Financial Statements
Consolidated Balance Sheets as of
June 30, 2001 and December 31, 2000 4
Consolidated Statements of Income (Loss) and Comprehensive
Loss for the three months ended June 30, 2001
and 2000. 5
Consolidated Statements of Income (Loss) and Comprehensive
Loss for the six months ended June 30, 2001
and 2000. 6
Consolidated Statements of Cash Flows for
the six months ended June 30, 2001
and 2000. 7
Notes to Consolidated Financial Statements 9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 15
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 35
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 41
Item 2. Changes in Securities 41
Item 3. Defaults Upon Senior Securities 41
Item 4. Submission of Matters to a Vote of Security Holders 41
Item 5. Other Information 41
Item 6. Exhibits and Reports on Form 8-K 41
2
PART I . FINANCIAL INFORMATION
3
APPROVED FINANCIAL CORP.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share amounts)
ASSETS 2001 2000
--------- --------
Cash $12,813 $ 7,597
Mortgage loans held for sale, net 46,639 22,438
Mortgage loans held for yield, net 12,075 14,274
Real estate owned, net 775 1,151
Investments 1,056 2,847
Deferred tax asset, net 3,316 3,504
Income tax receivable 443 -
Premises and equipment, net 4,879 5,408
Goodwill, net 79 983
Loan Sale Receivable 1,258 -
Other assets 1,886 1,617
--------- --------
Total assets $85,219 $59,819
========= ========
LIABILITIES AND EQUITY
Liabilities:
Revolving warehouse loan $ 3,284 $ 1,694
FHLB bank advances and line of credit - 3,000
Mortgage notes payable 2,190 2,529
Notes payable-related parties 2,670 2,818
Certificate of indebtedness 2,187 2,043
Certificates of deposits 63,129 34,432
Money market account 2,799 3,926
Accrued and other liabilities 1,382 1,366
--------- --------
Total liabilities 77,641 51,808
--------- --------
Commitments and contingencies - -
Shareholders' equity:
Preferred stock series A, $10 par value; 1 1
Noncumulative, voting:
Authorized shares - 100
Issued and outstanding shares - 90
Common stock, par value - $1 5,482 5,482
Authorized shares - 40,000,000
Issued and outstanding shares - 5,482,114
Accumulated other comprehensive loss (3) (12)
Additional capital 552 552
Retained earnings 1,546 1,988
--------- --------
Total equity 7,578 8,011
--------- --------
Total liabilities and equity $85,219 $59,819
========= ========
The accompanying notes are an integral part of the consolidated financial
statements.
4
APPROVED FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS)
for the three months ended June 30, 2001 and 2000
(In thousands, except per share amounts)
2001 2000
Revenue:
Gain on sale of loans $5,179 $ 2,502
Interest income 1,618 1,317
Broker fee income 232 719
Other fees and income 710 478
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7,739 5,016
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Expenses:
Compensation and related 2,777 3,089
General and administrative 1,426 1,534
Write down of goodwill 845 -
Write down of fixed assets 106 -
Advertising expense 123 318
Loan production expense 690 274
Interest expense 1,122 959
Unrealized loss on loans held for sale 245 -
Provision for loan and foreclosed property losses 76 92
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7,410 6,266
------- --------
Income (loss) before income taxes 329 (1,250)
Provision for (benefit from) income taxes 124 (472)
------- --------
Net income (loss) 205 (778)
Other comprehensive income, net of tax:
Unrealized gain on securities:
Unrealized holding gain during period 2 (6)
------- --------
Comprehensive income (loss) $ 207 $ (784)
======= ========
Net income (loss) per share:
Basic and Diluted $ 0.04 $ (0.14)
======= ========
Weighted average shares outstanding:
Basic and Diluted 5,482 5,482
======= ========
The accompanying notes are an integral part of the consolidated financial
statements.
5
APPROVED FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF LOSS AND COMPREHENSIVE INCOME (LOSS)
for the six months ended June 30, 2001 and 2000
(In thousands, except per share amounts)
2001 2000
Revenue:
Gain on sale of loans $ 7,956 $ 6,428
Interest income 2,871 2,901
Broker fee income 431 1,356
Other fees and income 1,170 1,043
-------- --------
12,428 11,728
-------- --------
Expenses:
Compensation and related 5,469 6,222
General and administrative 2,830 3,326
Write down of goodwill 845 -
Write down of fixed assets 106 -
Advertising expense 405 655
Loan production expense 1,038 640
Interest expense 1,997 2,081
Unrealized loss on loans held for sale 245 -
Provision for loan and foreclosed property losses 188 147
-------- --------
13,123 13,071
-------- --------
Loss before income taxes (695) (1,343)
Benefit from income taxes (254) (505)
-------- --------
Net loss (441) (838)
Other comprehensive income, net of tax:
Unrealized gain on securities:
Unrealized holding gain during period 9 (6)
-------- --------
Comprehensive loss $ (432) $ (844)
======== ========
Net loss per share:
Basic and Diluted $ (0.08) $ (0.15)
======== ========
Weighted average shares outstanding:
Basic and Diluted 5,482 5,482
======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
6
APPROVED FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the six months ended June 30, 2001 and 2000
(In thousands)
2001 2000
---------- ----------
Operating activities
Net loss $ (441) $ (838)
Adjustments to reconcile net loss to net
cash (used in) provided by operating activities:
Depreciation of premises and equipment 330 382
Amortization of goodwill 58 69
Provision for loan losses 114 (44)
Provision for losses on real estate owned 73 191
Unrealized loss on loans held for sale 245 -
Deferred tax expense 188 (19)
Proceeds from sale and prepayments of loans 190,786 159,037
Originations of loans, net (205,455) (123,518)
Loss on sale/disposal of fixed assets 1 -
Loss on write down of goodwill 845 -
Loss on write down of fixed assets 106
Gain on sale of loans (7,956) (6,428)
Changes in assets and liabilities:
Loan sale receivable (1,254) 3
Income tax receivable (443)
Other assets (273) 328
Accrued and other liabilities 15 (753)
Income tax payable - 4,379
Loan proceeds payable - 0
---------- ----------
Net cash (used in) provided by operating activities (23,061) 32,789
Cash flows from investing activities:
Sales of securities - 115
Sales of ARM fund shares 2,311 -
Purchase of premises and equipment (72) (94)
Sales of premises and equipment 166 75
Sales of real estate owned 664 1,361
Real estate owned capital improvements (97) (93)
Purchases of ARM fund shares (46) (65)
Purchases of FHLB stock (467) (297)
---------- ----------
Net cash provided by investing activities 2,459 1,002
Continued on Next Page
7
APPROVED FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS, continued
for the six months ended June 30, 2001 and 2000
(In thousands)
2001 2000
-------- --------
Cash flows from financing activities:
Borrowings - warehouse $ 28,797 $ 29,111
Repayments of borrowings - warehouse (27,206) (46,454)
FHLB and LOC advances (repayments),net (3,000) (4,648)
Principal payments on mortgage notes payable (339) (43)
Net increase (decrease) in:
Notes payable (148) (96)
Certificates of indebtedness 143 (88)
Certificates of deposit 28,697 (14,805)
FDIC-insured money market account (1,126) 1,676
-------- --------
Net cash provided by (used in) financing activities 25,818 (35,347)
-------- --------
Net increase (decrease) in cash 5,216 (1,556)
Cash at beginning of period 7,597 10,656
-------- --------
Cash at end of period $ 12,813 $ 9,100
======== ========
Supplemental cash flow information:
Cash paid for interest $ 831 $ 1,964
Supplemental non-cash information:
Loan balances transferred to real estate $ 175 $ 838
owned
The accompanying notes are an integral part of the consolidated financial
statements.
8
APPROVED FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for the six months ended June 30, 2001 and 2000
Note 1. Organization and Summary of Significant Accounting Policies:
Organization: Approved Financial Corp., a Virginia corporation ("Approved" or
"AFC"), and its subsidiaries (collectively, the "Company") operate primarily in
the consumer finance business of originating, servicing and selling mortgage
loans secured primarily by first and second liens on one-to-four family
residential properties. The Company sources mortgage loans through two
origination channels; a network of mortgage brokers who refer mortgage customers
to the Company ("broker" or "wholesale") and an internal sales staff that
originate mortgages directly with borrowers ("retail" and "direct"). Approved
has two wholly owned subsidiaries through which it originates residential
mortgages: Approved Federal Savings Bank (the "Bank" or "AFSB") is a federally
chartered thrift institution with broker operations in fifteen states and three
retail offices as of June 30, 2001; and Approved Residential Mortgage, Inc.
("ARMI"). Approved has a third wholly owned subsidiary, Approved Financial
Solutions ("AFS"), through which it offers other financial products such as Debt
Free Solutions, Mortgage Acceleration Program and insurance products to its
mortgage customers. On April 1, 2000 the Company, as part of its expense
reduction initiatives, transferred all assets of Mortgage One Financial
Corporation ("MOFC") d/b/a ConsumerOne Financial ("ConsumerOne"), a wholly owned
subsidiary of Approved, to the Bank.
Principles of accounting and consolidation: The consolidated financial
statements of the Company include the accounts of Approved and its wholly-owned
subsidiaries. All significant inter-company accounts and transactions have been
eliminated.
Use of estimates: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Cash and cash equivalents: Cash and cash equivalents consist of cash on deposit
at financial institutions and short-term investments that are considered cash
equivalents if they were purchased with an original maturity of three months or
less.
Loans held for sale: Loans held for sale, that were originated less than 90 days
before the balance sheet date are carried at the lower of aggregate cost or
market value. Loans, which are held for sale, that were originated greater than
90 days before the balance sheet date are evaluated on a loan by loan basis and
carried at the lower of cost or market. The market value is determined by
current investor yield requirements.
Loans held for yield: Loans are stated at the amount of unpaid principal less
net deferred fees and an allowance for loan losses. Interest on loans is
accrued and credited to income based upon the principal amount outstanding.
Fees collected and costs incurred in connection with loan originations are
deferred and recognized over the term of the loan.
9
APPROVED FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for the six months ended June 30, 2001 and 2000
Note 1. Organization and Summary of Significant Accounting Policies, continued:
Allowance for loan losses: The allowance for loan losses is maintained at a
level believed adequate by management to absorb probable inherent losses in the
held for yield loan portfolio at the balance sheet date. Management's
determination of the adequacy of the allowance is based on an evaluation of the
current loan portfolio characteristics including criteria such as delinquency,
default and foreclosure rates and trends, age of the loans, credit grade of
borrowers, loan to value ratios, current economic and secondary market
conditions, current and anticipated levels of loan volume, and other relevant
factors. The allowance is increased by provisions for loan losses charged
against income. Loan losses are charged against the allowance when management
believes it is unlikely that the loan is collectible.
The loans held for sale are recorded at the lower of cost or market as of the
balance sheet date. The allowance for loan losses on the held for yield loans
are based upon the credit quality of the loans and prior history regarding
default and foreclosure rates.
Origination fees: Net origination fees are recognized over the life of the loan
or upon the sale of the loan, if earlier.
Real estate owned: Assets acquired through loan foreclosure are recorded as real
estate owned ("REO") at the lower of cost or fair market value, net of estimated
disposal costs. Cost includes loan principal and certain capitalized
improvements to the property. The estimated fair market value is reviewed
periodically by management, and any write-downs are charged against current
earnings using a valuation account, which has been netted against real estate
owned in the financial statements.
Premises and equipment: Premises, leasehold improvements and equipment are
stated at cost less accumulated depreciation and amortization. The buildings
are depreciated using the straight-line method over thirty and thirty-nine
years. Leasehold improvements are amortized over the lesser of the terms of the
lease or the estimated useful lives of the improvements. Depreciation of
equipment is computed using the straight-line method over the estimated useful
lives of three to five years. Expenditures for betterments and major renewals
are capitalized and ordinary maintenance and repairs are charged to operations
as incurred.
Investments: The Company's investment in the stock of the Federal Home Loan Bank
("FHLB") of Atlanta is stated at cost.
All other investment securities, except the FHLB stock, are classified as
available-for-sale and reported at fair value, with unrealized gains and losses
excluded from earnings and reported as other comprehensive income in
shareholders' equity. Realized gains and losses on sales of securities are
computed using the specific identification method.
10
APPROVED FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for the six months ended June 30, 2001 and 2000
Note 1. Organization and Summary of Significant Accounting Policies, continued:
Loan originations and income recognition: The Company applies a financial-
components approach that focuses on control when accounting and reporting for
transfers and servicing of financial assets and extinguishments of liabilities.
Under that approach, after a transfer of financial assets, an entity recognizes
the financial and servicing assets it controls and the liabilities it has
incurred, derecognizes financial assets when control has been surrendered, and
derecognizes liabilities when extinguished. This approach provides consistent
standards for distinguishing transfers of financial assets that are sales from
transfers that are secured borrowings. Gains on the sale of mortgage loans,
representing the difference between the sales proceeds and the net carrying
value of the loans, are recognized when mortgage loans are sold and delivered to
investors.
Interest on loans is credited to income based upon the principal amount
outstanding. Interest is accrued on loans until they become 31 days or more past
due.
Advertising costs: Advertising costs are expensed when incurred.
Income taxes: Taxes are provided on substantially all income and expense items
included in earnings, regardless of the period in which such items are
recognized for tax purposes. The Company uses an asset and liability approach
that requires the recognition of deferred tax assets and liabilities for the
estimated future tax consequences of events that have been recognized in the
Company's financial statements or tax returns. In estimating future tax
consequences, the Company generally considers all expected future events other
than enactments of changes in the tax laws or rates. The Company established a
$0.9 million valuation allowance for future unrealizable benefits for the
deferred tax asset. The valuation allowance is based upon an assessment by
management of future taxable income and its relationship to realizability of
deferred tax assets. The effect on deferred taxes of a change in tax rates is
recognized in income in the period that includes the enactment date.
Earnings per share: The Company computes "basic earnings per share" by dividing
income available to common shareholders by the weighted-average number of common
shares outstanding for the period. "Diluted earnings per share" reflects the
effect of all potentially dilutive potential common shares such as stock options
and warrants and convertible securities.
Comprehensive Income: The Company classifies items of other comprehensive
income/(loss) by their nature in a financial statement and displays the
accumulated balance of other comprehensive income/ (loss) separately from
retained earnings and additional capital in the equity section of the
consolidated balance sheets. The only item the Company has in comprehensive
income/(loss) for the six month periods ended June 30, 2001 and 2000, is an
unrealized holding gain (loss) on securities, net of deferred taxes.
11
APPROVED FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for the six months ended June 30, 2001 and 2000
Note 1. Organization and Summary of Significant Accounting Policies, continued:
Liquidity: The Company finances its operating cash requirements primarily
through certificates of deposit, warehouse credit facilities, and other
borrowings. Borrowings were 89.5% of total assets at June 30, 2001 compared to
84.3% at December 31, 2000.
Segments: A public business enterprise is required to report financial and
descriptive information about its reportable operating segments. Operating
segments are components of an enterprise about which separate financial
information is available that is evaluated regularly by the chief operating
decision-maker in deciding how to allocate and in assessing performance.
Generally, financial information is required to be reported on the basis that it
is used internally for evaluating segment performance and deciding how to
allocate resources to segments. The Company has evaluated this requirement and
determined it operates in one segment.
New accounting pronouncements:
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" as
amended by SFAS 137 and SFAS 138, is effective for fiscal years beginning after
June 15, 2000. This statement establishes accounting and reporting standards
for derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives), and for hedging
activities. It requires that entities recognize all derivatives as either
assets or liabilities in the financial statements and measure those instruments
at fair value. If certain conditions are met, a derivative may be specifically
designed as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or an unrecognized firm commitment, (b) a hedge of
the exposure to variable cash flows of a forecasted transaction, or (c) a hedge
of the foreign currency exposure of a net investment in a foreign operation, an
unrecognized firm commitment, an available-for-sale security, or a foreign-
currency-denominated forecasted transaction. This statement did not have any
material impact on the financial statements.
Securities and Exchange Commission Staff Accounting Bulletin 101 (SAB 101),
"Revenue Recognition in Financial Statements", as amended by SAB 101B, is
required to be adopted in the fourth calendar quarter of the year 2001. Adoption
of SAB 101 is not expected to have any material impact on the recognition,
presentation, and disclosure of revenue.
12
APPROVED FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for the six months ended June 30, 2001 and 2000
Note 1. Organization and Summary of Significant Accounting Policies, continued:
In September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, a replacement
of SFAS No. 125. It revises the standards for accounting for securitizations
and other transfers of financial assets and collateral and requires certain
disclosures, but it carries over most of the provisions of SFAS No. 125 without
reconsideration. The Statement requires a debtor to reclassify financial assets
pledged as collateral and report these assets separately in the statement of
financial position. It also requires a secured party to disclose information,
including fair value, about collateral that it has accepted and is permitted by
contract or custom to sell or repledge. The Statement includes specific
disclosure requirements for entities with securitized financial assets and
entities that securitize assets. This Statement is effective for transfers and
servicing of financial assets and extinguishments of liabilities occurring after
March 31, 2000 and is effective for recognition and reclassification of
collateral and for disclosures relating to securitization transactions and
collateral for fiscal years ending after December 15, 2000. The adoption of FAS
140 did not have a material effect on financial condition or results of
operation of the Company.
In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards Statement No. 141, Business Combinations.
Statement 141 requires that the purchase method of accounting be used for all
business combinations initiated after June 30, 2001; the use of the pooling-of-
interests method of accounting was prohibited after this time. Statement 141
also establishes specific criteria for the recognition of intangible assets
separately from goodwill, and it requires unallocated negative goodwill to be
written off immediately as an extraordinary gain (instead of being deferred and
amortized). This Statement is not expected to have a material impact on the
Company's financial statements.
In July 2001, the FASB issued Statement of Financial Accounting Standards
Statement No. 142, Goodwill and Other Intangible Assets. Statement 142
eliminates the amortization of goodwill and instead requires a periodic review
of any goodwill balance for possible impairment. The statement also requires
that goodwill be allocated at the reporting unit level. This Statement is
effective for years beginning after December 15, 2001. The Company will be
required to discontinue amortization of goodwill as of January 1, 2002, and
intends to complete an analysis of goodwill by reporting unit and an initial
impairment test by the end of 2001. Since this analysis has not been completed,
the Company cannot assess the impact on the financial statements at this time.
Statement 142 also contains provisions related to intangible assets other than
goodwill. However, the Company currently has no intangible assets other than
goodwill in its continuing operations.
Note 2. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three and six month periods ended June
30, 2001 are not necessarily indicative of the results that may be expected for
the year ending December 31, 2001. For further information, refer to the
consolidated financial statements and footnotes thereto included in the
Company's annual report on Form 10-K for the year ended December 31, 2000.
13
Note 3. Significant Second Quarter Events:
In the second quarter 2001, the Company recorded a charge of $0.8 million for
the write off of goodwill related to the 1998 acquisition of Mortgage One
Financial Corp. ("MOFC, Inc.") and the goodwill related to the only remaining
office of Armada Residential Mortgage, LLC which was liquidated and dissolved in
1997. These retail offices were closed in May 2001 and resulted in the write
off of the goodwill.
Also, in the second quarter of 2001, the Company recorded a charge of $0.1
million for the write down of the Company's old corporate headquarters building
to market value. The Company entered into a Purchase Agreement in July 2001 to
sell the building for a purchase price of $750,000. The transaction for the sale
of the building is tentatively scheduled to close in September of 2001.
14
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following financial review and analysis of the financial condition and
results of operations, for the six months ended June 30, 2001 and 2000 should be
read in conjunction with the consolidated financial statements and the
accompanying notes to the consolidated financial statements, and other detailed
information appearing in this document.
General
Approved Financial Corp. ("Approved" or "AFC") is a diversified financial
services company with subsidiaries operating throughout the United States. We
are a Virginia-chartered financial institution, principally involved in
originating, purchasing, servicing and selling loans secured primarily by first
and junior liens on owner-occupied, one- to four-family residential properties.
We offer through our subsidiaries both fixed-rate and adjustable-rate loans for
debt consolidation, home improvements and other purposes serving both conforming
and non-conforming borrowers.
Our specialty is mortgage lending to the "non-conforming" borrower who does not
meet traditional "conforming" or government agency credit qualification
guidelines, but who exhibits both the ability and willingness to repay the loan.
These borrowers include credit impaired borrowers, often resulting from personal
issues such as divorce, family illness or death and a temporary loss of
employment due to corporate downsizing as well as other factors, and other
borrowers who would qualify for loans from traditional sources but who are
attracted to our loan products due to our personalized service and timely
response to loan applications. Operating under current management for the past
sixteen years, we have helped non-conforming mortgage customers satisfy their
financial needs and in many cases have helped them improve their credit profile.
Through our retail division we also originate, service and sell traditional
conforming mortgage products and government mortgage products such as VA and
FHA.
We continue to explore a variety of opportunities to broaden product offerings,
increase revenues and reduce operating expenses. To achieve these goals, we may
consider various technologies and electronic commerce initiatives, strategic
relationships with other financial institutions or related companies, or
entering into new lines of business such as the origination and servicing of
loans insured by the Small Business Administration. We cannot assure you that we
will engage in any of the activities.
A recent focus by state and federal banking regulatory agencies, state attorneys
general offices, the Federal Trade Commission, the U.S. Department of Justice
and the U.S. Department of Housing and Urban Development relates to predatory
lending practices by companies in our industry. Sanctions have been imposed on
selected industry competitors for practices including but not limited to
charging borrowers excess fees, imposing higher interest rates than the
borrower's credit risk warrants and failing to disclose the material terms of
loans to the borrowers. We have reviewed our lending policies in light of these
actions against other lenders and we believe that we are in compliance with all
lending related guidelines. To date, no sanctions or recommendations from
governmental regulatory agencies regarding our practices related to predatory
lending have been imposed. We are unable to predict whether state or federal
regulatory authorities will require changes in our lending practices in the
future or the impact of those changes on our profitability.
Our business strategy is dependent upon our ability to identify and emphasize
lending related activities that will provide us with the most economic value.
The implementation of this strategy will depend in large part on a variety of
15
factors outside of our control, including, but not limited to, our ability to
obtain adequate financing on favorable terms, retain qualified employees to
implement our plans, profitably sell our loans on a regular basis and to expand
in the face of increasing competition. Our failure with respect to any of these
factors could impair our ability to successfully implement our strategy, which
could adversely affect our results of operations and financial condition.
Results of Operations
Results of Operations for the three and six months ended June 30, 2001 compared
to the three and six months ended June 30, 2000.
Net Income (Loss)
For the three months ended June 30, 2001 we reported net income of $0.2 million
compared to a loss of $0.8 million for the three months ended June 30, 2000.
For the six month period ended June 30, 2001 we reported a net loss of $0.4
million compared to a $0.8 million loss in 2000. On a per share basis, the net
income for the three months ended June 30, 2001 was $0.04 compared to a net loss
of $0.14 for the same period in 2000. On a per share basis the net loss for the
six months ended June 30, 2001 was $0.08 compared to $0.15 for 2000.
Origination of Mortgage Loans
The following table shows the loan originations in dollars and units for our
broker and retail divisions for the six months ended June 30, 2001 and 2000.
Additionally, the retail branches originate mortgages that are funded through
other lenders ("brokered loans"). Brokered loans consist primarily of non-
conforming mortgages that do not meet our underwriting criteria and conforming
loans.
Three Months Ended Six Months Ended
(dollars in millions) June 30, June 30,
2001 2000 2001 2000
-----------------------------------------------------
Dollar Volume of Loans Originated:
Broker $ 101.5 $ 29.8 $ 146.7 $ 70.0
Retail funded through other lenders 6.4 13.3 11.0 27.0
Retail funded in-house non-conforming 3.8 12.7 8.8 31.0
Retail funded in-house conforming and government 28.0 12.0 49.9 22.5
-----------------------------------------------------
Total $ 139.7 $ 67.8 $ 216.4 $ 150.5
=====================================================
Number of Loans Originated:
Broker 908 420 1,409 960
Retail funded through other lenders 49 208 108 386
Retail funded in-house non-conforming 62 199 136 459
Retail funded in-house conforming and government 211 123 383 215
-----------------------------------------------------
Total 1,230 950 2,036 2,020
=====================================================
The dollar volume of loans, originated in the three and six months ended June
30, 2001 (including retail loans brokered to other lenders) increased 106.0% and
43.8% when compared to the same period in 2000. The increase in loan
originations is primarily attributed to new products available in the secondary
market.
16
The dollar volume of loans funded in-house increased 144.6% and 66.3% in the
three and six months ended June 30, 2001 compared to the same period in 2000,
primarily due to our initiative to reduce the amount of retail loans brokered to
other lenders and the new products available in the secondary market. Brokered
loans generated by the retail division were $6.4 million and $11.0 million
during the three and six months ended June 30, 2001, which was a 51.9% and 59.3%
decrease for the three and six months ended June 30, 2001 compared to $13.3 and
$27.0 million during the same period in 2000.
The decrease in retail loan origination centers resulted in a 13.4% decrease in
our retail loan volume including retail loans brokered to other lenders for the
six months ended June 30, 2001 when compared to the same period in 2000.
The volume of loans originated through our wholesale division, which originates
loans through referrals from a network of mortgage brokers increased 240% and
110% to $101.5 million and $146.7 million for the three and six months ended
June 30, 2001, compared to $29.8 million and $70.0 million for the same period
in 2000. The increase was primarily the result of the addition of a wholesale
operation in the western portion of the United States, a decline in the number
of competitors in the non-conforming marketplace, and an expanded product line.
The western division, which was launched in the fourth quarter of 2000,
originated $34.2 million and $45.6 million in non-conforming loans for the three
and six month periods ended June 30, 2001. The Western division originated
loans in of CA, CO, UT, NV, WA and AZ during the six months ending June 30,
2001.
In July 2001, our largest investor during the year 2001 notified us of their
decision to exit the correspondent non-conforming mortgage business and
informed us that they would no longer purchase the Company's loans after July
25, 2001. The loss of this investor for loan sales may adversely affect loan
originations in subsequent quarters unless a new investor relationship is
secured to fill the mortgage product niche previously created by this exiting
investor. The Company sold 47.8% of our loan originations to this investor for
the six months ended June 30, 2001. However, we are actively seeking new
investors and currently have selling agreements with 22 different investors.
Average fees paid for services rendered on mortgage broker referral originations
for the three and six months ended June 30, 2001 was 64 and 65 basis points
compared to 43 basis points for the three and six months ended June 30, 2000.
Gain on Sale of Loans
The largest component of our net income is gain on sale of loans. There is an
active secondary market for most types of mortgage loans originated. The
majority of the loans originated are sold to other financial institutions. We
receive cash at the time loans are sold. The loans are sold service-released on
a non-recourse basis, except for normal representations and warranties, which is
consistent with industry practices. By selling loans in the secondary mortgage
market, we are able to obtain funds that may be used for additional lending and
investment purposes. Gain on sale of loans is comprised of several components,
as follows: (a) the difference between the sales price and the net carrying
value of the loan; plus (b) loan origination fee income collected at loan
closing and deferred until the loan is sold; less (c) loan sale recapture
premiums and loan selling costs.
Nonconforming loan sales totaled $92.3 and $136.2 million including loans owned
in excess of 180 days ("seasoned loans") for the three and six months ended June
30, 2001, compared to $42.4 and $126.6 million for the same period in 2000.
17
For the three and six month period ended June 30, 2001, we sold $0.7 and $1.2
million of seasoned loans, at a weighted average discount to par value of 5.3%
and 5.4%. The loss was fully reserved for in prior periods. For the three and
six months ended June 30, 2000, we did not sell any seasoned loans at a
discount.
Conforming and government loan sales were $26.2 and $44.5 million for the three
and six months ended June 30, 2001, compared to $12.8 and $23.5 million for the
three and six months ended June 30, 2000.
The combined gain on the sale of loans was $5.2 and $8.0 million for the three
and six months ended June 30, 2001, which compares with $2.5 and $6.4 million
for the same period in 2000. The increase in the combined gain on sale of loans
was primarily the result of an increase in the volume of loans sold Gain on the
sale of mortgage loans represented 66.9% and 64.0% of total revenue for the
three and six months ended June 30, 2001, compared to 49.9% and 54.8% of total
revenue for the same period in 2000. This was primarily a result of our
initiative to decrease brokered loans, revenues from which are reported in other
income, and to increase the percentage of retail loan originations funded in-
house, revenues from which are reported in gain on sale of loans.
The weighted-average premium, realized on non-conforming loan sales was 4.21%
and 4.15% (excluding seasoned loans), during the three and six months ended June
30, 2001, compared to 3.13% and 2.92% for the same periods in 2000. The
weighted-average premium realized on its conforming and government loans sales
was 1.40% and 1.55% during the three and six months ended June 30, 2001,
compared to 1.33% and 1.15% for the three and six months ended June 30, 2000.
We have never used securitization as a loan sale strategy. However, the whole-
loan sale marketplace for non-conforming mortgage loans was impacted by changes
that affected companies who previously used this loan sale strategy. Excessive
competition during 1998 and 1999 and a coinciding reduction in interest rates in
general caused an increase in the prepayment speeds for non-conforming loans.
The valuation method applied to interest-only and residual assets ("Assets"),
the capitalized assets created from securitization, include an assumption for
average prepayment speed in order to determine the average life of a loan pool
and an assumption for loan losses. The increased prepayment speeds as well as
the magnitude of loan losses experienced in the industry were greater than the
assumptions previously used by many securitization issuers and have resulted in
impairment or write down of Asset values for several companies in the industry.
Additionally, in September of 1998, due to the Russian crisis, and again in the
fourth quarter of 1999, due to Y2K concerns, a flight to quality among fixed
income investors negatively impacted the pricing spreads for mortgage-backed
securitizations compared to earlier periods and negatively impacted the
associated economics to the issuers. Consequently, many of these companies have
experienced terminal liquidity problems and others have diverted to whole loan
sale strategies in order to generate cash. This shift has materially decreased
the demand for and increased the supply of non-conforming mortgage loans in the
secondary marketplace, which resulted in significantly lower premiums on non-
conforming whole-loan mortgage sales beginning in the fourth quarter of 1998 and
continuing throughout the third quarter 2000 when compared to earlier periods.
We defer recognizing income from the loan origination fees we receive at the
time a loan is closed. These fees are recognized over the lives of the related
loans as an adjustment of the loan's yield using the level-yield method.
Deferred income pertaining to loans held for sale is taken into income at the
time of sale of the loan. Origination fee income is primarily derived from our
retail lending division. Origination fee income included in the gain on sale of
loans for the three and six months ended June 30, 2001 was $1.0 and $1.8
million, compared to $1.1 and $2.8 million for the three and six months ended
June 30, 2000. The decrease is the result of a decrease in the volume of loans
sold, which were generated by our retail division. Our non-conforming retail
loan sales for the three and six months ended June 30, 2001 comprised 9.3% and
18
12.2% of total non-conforming loan sales, with average loan origination fee
income earned of 4.8% and 4.5%. For the three and six months ended June 30,
2000, non-conforming retail loan sales were 35.3% and 33.9% of total non-
conforming loan sales with average origination fee income of 4.5% and 4.85%.
Average origination fee income from conforming and government loans was 2.25%
and 2.26% for the three and six months ended June 30, 2001 compared to 3.09% and
3.12% for the three and six months ended June 30, 2000. Miscellaneous investor
fees associated with loan sales were approximately 4 basis points for the three
and six months ended June 30, 2001 compared to 12 and 20 basis points for the
three and six months ended June 30, 2000.
We also defer recognition of the expense incurred, from the payment of fees to
mortgage brokers, for services rendered on loan originations. These costs are
deferred and recognized over the lives of the related loans as an adjustment of
the loan's yield using the level-yield method. The remaining balance of
expenses associated with fees paid to brokers is recognized when the loan is
sold.
Interest Income and Expense
Interest income for the three and six months ended June 30, 2001 was $1.6 and
$2.9 million compared with $1.3 and $2.9 million for the same periods ended in
2000. The increase in interest income for the three months ended June 30, 2001
was due to a higher average balance of loans held for sale.
Interest expense for the three and six months ended June 30, 2001 was $1.1 and
$2.0 million compared with $0.9 and $2.1 million for the three and six months
ended June 30, 2000. The increase in interest expense for the three months
ended June 30, 2001, was the direct result of an increase in the average balance
of interest bearing liabilities and the average yield on interest bearing
deposits.
Changes in the average yield received on the loan portfolio may not coincide
with changes in interest rates we must pay on revolving warehouse loans, the
Bank's FDIC-insured deposits, and other borrowings. As a result, in times of
rising interest rates, decreases in the difference between the yield received on
loans and other investments and the rate paid on borrowings and the Bank's
deposits usually occur.
19
The following tables reflect the average yields earned and rates paid during the
six months ended June 30, 2001 and 2000. In computing the average yields and
rates, the accretion of loan fees is considered an adjustment to yield.
Information is based on average month-end balances during the indicated periods.
(In thousands) June 30, 2001 June 30, 2000
-----------------------------------------------------------------------------
Average Average Average Average
Balance Interest Yield/Rate Balance Interest Yield/Rate
-----------------------------------------------------------------------------
Interest-earning assets:
Loan receivable (1) $53,506 $2,731 10.21% $46,820 $2,548 10.88%
Cash and other interest-
Earning assets 9,316 140 3.02 14,400 353 4.90
---------- ------ ------ ------- ------ ------
62,822 2,871 9.14% 61,220 2,901 9.48%
------ ------ ------ ------
Non-interest-earning assets:
Allowance for loan losses (1,445) (1,315)
Premises and equipment, net 5,227 5,934
Other 7,814 10,424
---------- -------
Total assets $74,418 $76,263
========== =======
Interest-bearing liabilities:
Revolving warehouse lines $ 4,169 157 7.50% $ 6,113 212 6.94%
FDIC - insured deposits 45,738 1,362 5.96 48,449 1,439 5.94
Other interest-bearing
liabilities 12,777 478 7.48 8,596 430 10.01
---------- ------ ------ ------- ------ ------
62,684 1,997 6.37% 63,158 2,081 6.59%
------ ------ ------ ------
Non-interest-bearing liabilities 4,344 2,160
---------- -------
Total liabilities 67,028 65,318
Shareholders' equity 7,390 10,945
---------- -------
Total liabilities and equity $74,418 $76,263
========== =======
Average dollar difference between
Interest-earning assets and
interest-
bearing liabilities $ 138 $(1,938)
========== =======
Net interest income $ 874 $ 820
====== ======
Interest rate spread (2) 2.77% 2.89%
====== ======
Net annualized yield on average
Interest-earning assets 2.78% 2.68%
====== ======
(1) Loans shown gross of allowance for loan losses, net of premiums/discounts.
(2) Average yield on total interest-earning assets less average rate paid on
total interest-bearing liabilities.
20
The following table shows the change in net interest income, which can be
attributed to rate (change in rate multiplied by old volume) and volume (change
in volume multiplied by old rate) for the six months ended June 30, 2001
compared to the six months ended June 30, 2000. The changes in net interest
income due to both volume and rate changes have been allocated to volume and
rate in proportion to the relationship of absolute dollar amounts of the change
of each. The table demonstrates that the increase of $0.05 million in net
interest income for the six months ended June 30, 2001 compared to the six
months ended June 30, 2000 was primarily the result of a decrease in the average
balance on interest-earning assets.
($ in thousands)
2001 Versus 2000
Increase (Decrease) due to:
Volume Rate Total
--------- ------ -------
Interest-earning assets:
Loans receivable $ 324 $(140) $ 184
Cash and other interest-
earning assets (102) (111) (213)
--------- ------ -------
222 (251) (29)
--------- ------ -------
Interest-bearing liabilities:
Revolving warehouse lines (43) (12) (55)
FDIC-insured deposits (81) 5 (76)
Other interest-
bearing liabilities 100 (52) 48
--------- ------ -------
(24) (59) (83)
--------- ------ -------
Net interest expense $ 246 $(192) $ 54
========= ====== =======
Broker Fee Income
In addition to net interest income (expense), and gain on sale of loans, we
derive income from origination fees earned on brokered loans generated by our
retail offices. For the three and six months ended June 30, 2001, broker fee
income totaled $0.2 and $0.4 million compared to $0.7 and $1.4 million for the
same period in 2000. The decrease was primarily the result of a decrease in
brokered loan volume.
Other Income
In addition to net interest income (expense), and gain on sale of loans, and
broker fee income we derive income from other fees earned on the loans funded
such as underwriting service fees, prepayment penalties, and late charge fees
for delinquent loan payments. Revenues associated with the financial products
marketed by Approved Financial Solutions are also recorded in other income. For
the three and six months ended June 30, 2001, other income totaled $0.7 and $1.2
million compared to $0.5 and $1.0 million for the same period in 2000. The
increase in other income was primarily the result of increases in underwriting
fee income due to the increase in loans originated.
21
Comprehensive Income/Loss
For the three and six months ended June 30, 2001 we had other comprehensive
income of $2,000 and $9,000 in the form of unrealized holding gains/losses on an
Asset Management Fund investment. For the three and six months ended June 30,
2000, we had other comprehensive losses of $6,000.
Compensation and Related Expenses
The largest component of expenses is compensation and related expenses, which
decreased by $0.3 and $0.8 million to $2.8 and $5.5 million for the three and
six months ended June 30, 2001 compared to the same period in 2000. The decrease
was directly attributable to a decrease in the number of employees. For the
three and six months ended June 30, 2001, salary expense decreased by $0.3 and
$1.0 million when compared to the same period in 2000. The decrease was caused
by a lower average number of employees related to our cost cutting initiative.
For the three and six months ended June 30, 2001, the average full time
equivalent employee count was 167 and 185 compared to 249 and 266 for the three
and six months ended June 30, 2000. The payroll and related benefits increased
$0.2 million for the six months ended June 30, 2001 when compared to the same
period in 2000. The increase was caused by an increase in the health insurance
claims paid of $0.2 million for the six months ended June 30, 2001 compared to
the six months ended June 30, 2000. We are self insured and claims paid can
vary from quarter to quarter based upon the medical needs of the employees.
General and Administrative Expenses
General and administrative expenses are comprised of various expenses such as
advertising, rent, postage, printing, general insurance, travel and
entertainment, telephone, utilities, depreciation, professional fees and other
miscellaneous expenses. General and administrative expenses for the three and
six months ended June 30, 2001 decreased by $0.1 and $0.5 million to $1.4 and
$2.8 million, compared to the three and six months ended June 30, 2000. The
decrease was the result of a reduction in retail loan origination offices, a
decline in our employee count, and our cost cutting initiative.
Loan Production Expense
Loan production expenses are comprised of expenses for appraisals, credit
reports, and payment of fees to mortgage brokers, for services rendered on loan
originations, and verification of mortgages. Loan production expenses for the
three and six months ended June 30, 2001 were $0.7 and $1.0 million compared to
$0.3 and $0.6 million for the three and six months ended June 30, 2000. The
increase was primarily the result of an increase in fees paid to brokers for
services rendered, which resulted from an increase in non- conforming loans sold
for the three and six months ended June 30, 2001.
Advertising Expense
Advertising expenses are comprised of newspaper advertising, yellow page
advertising, postage and printing associated with mailers, the purchase of
telemarketing lists, and marketing supplies for trade shows. Advertising
expenses for the three and six month periods ended June 30, 2001 were $0.1 and
$0.4 million compared to $0.3 and $0.7 million for the three and six month
periods ended June 30, 2001. The decrease was the result of the reduction in
retail loan origination offices.
22
Write Down of Goodwill
Goodwill related to the 1998 purchase of MOFC, Inc. d/b/a ConsumerOne Financial
and the remaining goodwill for Armada Residential Mortgage LLC was written off
due to the closure of the retail branches. The total write down for the three
and six month periods ended June 30, 2001 was $0.8 million. (See Note 3)
Write Down of Fixed Assets
In the second quarter 2001, we wrote down our old home office building to market
value based on a purchase agreement that was signed in July with a purchase
price of $750,000. The total charge taken in the second quarter was $0.1
million. (See Note 3)
Unrealized Loss on Loans Held for Sale
A valuation allowance on loans held for sale was created in the second quarter
2001, which resulted in a charge of $0.2 million. Loans originated greater than
90 days ago at June 30, 2001 were evaluated and written down to market value
based on current market conditions. Prior to the second quarter 2001 all loans
originated greater than 90 days prior to the balance sheet date were classified
as held for yield with a corresponding allowance for loan losses.
Provision for Loan Losses
The following table presents the activity in the allowance for loan losses and
selected loan loss data for the six months ended June 30, 2001 and the year
ended December 31, 2000:
(In thousands)
2001 2000
------- -------
Balance at beginning of year $ 1,479 $ 1,382
Provision charged to expense 114 639
Loans charged off (238) (1,086)
Recoveries of loans previously charged off 31 544
------- --------
Balance at end of period $ 1,386 $ 1,479
======= ========
Loans receivable at the end of period, gross $60,649 $38,601
of allowance for losses and deferred fees
Ratio of allowance for loan losses to gross 2.29% 3.83%
loans receivable at the end of period
The provision for loan losses was $0.1 million for the six months ended June 30,
2001 compared to $0.04 million for the six months ended June 30, 2000. For the
six months ended June 30, 2001, there was a decrease in the allowance for loan
losses based upon management's assessment of credit risk of loans held for
yield. All losses ("charge offs" or "write downs") and recoveries realized on
loans previously charged off, are accounted for in the allowance for loan
losses.
The allowance is established at a level that we consider adequate to cover
future loan losses relative to the composition of the current portfolio of loans
held for yield. We consider characteristics of our current loan portfolio such
as credit quality, the weighted average coupon, the weighted average loan to
value ratio, the combined loan to value ratio, the age of the loan portfolio and
the portfolio's delinquency and loss history and current status in the
determination of an appropriate allowance. Other criteria such as covenants
associated with our credit facilities, trends in the demand for and pricing for
loans sold in the secondary market for similar mortgage loans and general
23
economic conditions, including interest rates, are also considered when
establishing the allowance. Adjustments to the reserve for loan losses may be
made in future periods due to changes in the factors mentioned above and any
additional factors that may effect anticipated loss levels in the future.
Provision for Foreclosed Property Losses
The provision for foreclosed property losses was $0.07 million for the six
months ended June 30, 2001 compared to $0.5 million for the year ended December
31, 2000. We increased our provision for foreclosed property losses by $73,000
for the six months ended June 30, 2001 compared to an increase of $191,000 for
the six months ended June 30, 2000.
Sales of real estate owned yielded net losses of $198,000 for the six months
ended June 30, 2001 versus $452,000 for the six months ended June 30, 2000.
The following table presents the activity in the allowance for foreclosed
property losses and selected real estate owned data for the six months ended
June 30, 2001 and the year ended December 31, 2000:
(in thousands)
2001 2000
------- --------
Balance at beginning of year $ 376 $ 717
Provision charged to expense 73 451
Loss on sale of foreclosures (198) (792)
------- --------
Balance at end of period $ 251 $ 376
======= ========
Real estate owned at the end of period, gross $1,027 $1,528
of allowance for losses
Ratio of allowance for foreclosed property losses 24.44% 24.67%
to gross real estate owned at the end of period
Assets acquired through loan foreclosure are recorded as real estate owned
("REO"). When a property is transferred to REO status a new appraisal is
ordered on the property. The property is written down to the value of the new
appraisal. An allowance for REO losses is then established on that property
based upon current market conditions and historical results with the sale of REO
properties. While we believe that our present allowance for foreclosed property
losses is adequate, future adjustments may be necessary.
Financial Condition at June 30, 2001 and December 31, 2000
Assets
The total assets were $85.2 million at June 30, 2001 compared to total assets of
$59.8 million at December 31, 2000.
Cash and cash equivalents increased by $5.2 million to $12.8 million at June 30,
2001, from $7.6 million at December 31, 2000. The principal reason for the
24
increase for the period ending June 30,2001 was the receipt of proceeds from
loan sales in the final week of June 2001. These proceeds are used to fund new
loans in July 2001.
Net mortgage loans receivable increased by $22.0 million to $58.7 million at
June 30, 2001. The 59.9% increase in the 2001 is primarily due to originating
more loans than were sold during the first six months of 2001. We generally
sell loans within sixty days of origination.
Real estate owned ("REO") decreased by $0.4 million to $0.8 million at June 30,
2001. The 32.7% decrease in REO resulted from the sale of $0.9 million in REO
properties compared to additions of $0.3 million to REO during the six months
ended June 30, 2001.
Investments decreased by $1.8 million to $1.1 million at June 30, 2001. The
62.9% decrease is primarily due to the sale of shares in the Asset Management
Fund, Inc. Adjustable Rate Mortgage Portfolio and was used to fund our increased
loan originations in the second quarter 2001. The investments consist of FHLB
stock owned by the Bank.
Premises and equipment decreased by $0.5 million to $4.9 million at June 30,
2001. The decrease is due to the $0.1 million write down of our previous home
office building to market value, the sale of the corporate condominium, the
disposal of furniture and equipment from retail loan offices closed in the six
months ending June 30, 2001 and depreciation of assets.
Goodwill (net) decreased by $0.9 million to $0.08 million at June 30, 2001. The
decrease is primarily due to the write down of goodwill related to retail loan
origination offices closed in the six month period ending June 30, 2001 and the
amortization of the intangible asset.
The deferred tax asset decreased by $0.2 million to $3.3 million at June 30,
2001. The decrease is primarily related to an increase in the timing difference
between book and tax income for the write off of Goodwill. Based upon
management's expectation of sufficient taxable income and the reversal of the
timing differences, management believes that it is more likely than not that the
Company will realize the net amount of the deferred tax asset. However, there
can be no assurances that the Company will generate taxable income in any future
period. The remainder of the decrease relates to changes in timing differences
of the deferred tax asset.
Income tax receivable increased by $0.4 million based on a refund due from the
federal government which resulted during an IRS audit of the Company's prior
year tax returns.
At June 30, 2001 we completed a loan sale with an investor, however the funds
were not received until July 2001. This created a loan sale receivable of $1.3
million at June 30, 2001.
Other assets increased by $0.3 million to $1.9 million at June 30, 2001. Other
assets consist of accrued interest receivable, prepaid assets, brokered loan
fees receivable, deposits, and various other assets. The primary reason for the
increase is due to an increase accrued interest receivable, which was due to
higher average loans held for sale at June 30, 2001.
Liabilities
Outstanding balances for our revolving warehouse loans increased by $1.6 million
to $3.3 million at June 30, 2001. The increase in 2001 was primarily
attributable to the $22.0 million increase in loans receivable.
25
The Bank's deposits totaled $63.1 million at June 30, 2001 compared to $34.4
million at December 31, 2000. The Savings Bank increased its deposits in the
second quarter in order to fund the increase in loan originations. Of the
certificate accounts on hand as of June 30, 2001, a total of $52.1 million was
scheduled to mature in the twelve-month period ending June 30, 2002.
During the six month period ended June 30, 2001, we received $2.8 million in
money market deposits through an arrangement with a local NYSE member
broker/dealer compared to $3.9 million at December 31, 2000.
As of June 30, 2001, the Bank had no outstanding balance on its Federal Home
Loan Bank (FHLB) line compared to $3.0 million at December 31, 2000.
Promissory notes and certificates of indebtedness totaled $4.9 million at June
30, 2001 compared to $4.9 million at December 31, 2000. During the six months
ended June 30, 2001 and the years of 2000 and 1999, we were not soliciting new
promissory notes or certificates of indebtedness. We have utilized promissory
notes and certificates of indebtedness, which are subordinated to our warehouse
lines of credit, to help fund operations since 1984. Promissory notes
outstanding carry terms of one to five years and interest rates between 8.00%
and 10.00%, with a weighted-average rate of 9.75% at June 30, 2001. Certificates
of indebtedness are uninsured deposits authorized for financial institutions,
which have Virginia industrial loan association charters. The certificates of
indebtedness carry terms of one to five years and interest rates between 6.75%
and 10.50%, with a weighted-average rate of 9.75% at June 30, 2001.
Mortgage loans payable totaled $2.2 million at June 30, 2001 compared to $2.5
million at December 31, 2000. The $0.3 million decrease is a combination of
payment of a $0.3 million first mortgage payable on one REO property as well as
a minimal decrease in mortgage loans payable due to the normal principal
reduction with payments made on the note payable.
Accrued and other liabilities increased by $0.02 million to $1.4 million at June
30, 2001. This category includes accounts payable, accrued interest payable,
deferred income, accrued bonuses, and other payables. The increase is the result
of an increase in investor loans payable, which are borrower payments due to the
investor who purchased loans in the last week of June 2001. These payments were
forwarded to the investor in the first week of July 2001.
26
Shareholders' Equity
Total shareholders' equity at June 30, 2001 was $7.6 million compared to $8.0
million at December 31, 2000. The $0.4 million decrease in 2001 was due to the
$0.4 million loss for the six months ended June 30, 2001.
Liquidity and Capital Resources
Our operations require access to short and long-term sources of cash. Our
primary sources of cash flow result from the sale of loans through whole loan
sales, loan origination fees, processing, underwriting and other fees associated
with loan origination and servicing, revenues generated by Approved Financial
Solutions and Global Title of Md., Inc., net interest income, and borrowings
under our warehouse facilities, certificates of indebtedness issued by Approved
Financial Corp. and certificates of deposit issued by the Bank to meet working
capital needs. Our primary operating cash requirements include the funding of
mortgage loan originations pending their sale, operating expenses, income taxes
and capital expenditures.
Adequate credit facilities and other sources of funding, including the ability
to sell loans in the secondary market, are essential to our ability to continue
to originate loans. We have historically operated, and expect to operate in the
future on a negative cash flow basis from operations based upon the timing of
proceeds used to fund loan originations and the subsequent receipt of cash from
the sale of the loan. Loan sales normally occur 30 to 45 days after proceeds are
used to fund the loan. For the six months ended June 30, 2001, we used cash
from operating activities of $23.1 million. For the six months ended June 30,
2000 we received cash from operating activities of $32.8 million.
We finance our operating cash requirements primarily through warehouse and other
credit facilities, and the issuance of other debt. For the six months ended
June 30, 2001, we received cash from financing activities of $25.8 million, this
was primarily the result of proceeds from loan sales in excess of new borrowings
for funding loan originations. For the six months ended June 30, 2000, we paid
down debt from financing activities of $35.3 million.
Our borrowings (revolving warehouse loans, FDIC-insured deposits, mortgage loans
on our office buildings, FHLB advances, subordinated debt and loan proceeds
payable) were 89.4% of assets at June 30, 2001 compared to 84.3% at December 31,
2000.
27
Whole Loan Sale Program
The most important source of liquidity and capital resources is the ability to
profitably sell conforming and non-conforming loans in the secondary market.
The market value of the loans funded is dependent on a number of factors,
including but not limited to loan delinquency and default rates, the original
term and current age of the loan, the interest rate and loan to value ratio,
whether or not the loan has a prepayment penalty, the credit grade of the loan,
the credit score of the borrower, the geographic location of the real estate,
the type of property and lien position, the supply and demand for conforming and
non-conforming loans in the secondary market, general economic and market
conditions, market interest rates and governmental regulations. Adverse changes
in these conditions may affect our ability to sell mortgages in the secondary
market for acceptable prices, which is essential to the continuation of our
mortgage origination operations.
Bank Sources of Capital
The Bank's deposits totaled $63.1 million at June 30, 2001 compared to $34.4
million at December 31, 2000. The Bank currently utilizes funds from deposits
and a $15 million line of credit with the FHLB of Atlanta to fund first lien and
junior lien mortgage loans. We plan to increase the use of credit facilities and
funding opportunities available to the Bank.
Effective June 1, 2001 and until further notice the Federal Home Loan Bank
("FHLB") reduced the advance rate on the Savings Bank's warehouse line of credit
from 95% of the collateral value to 50% and suspended all advances under the
Savings Banks Daily Rate Credit Line due to the Savings Banks first quarter 2001
financial condition and results of operations.
Warehouse and Other Credit Facilities
On July 21, 2000, we obtained a $40.0 million line of credit from Bank United.
However, effective December 29, 2000, we obtained an amendment to the credit
line, which reduced the size of the warehouse facility to $20.0 million, since
the utilization of the credit line has been very low in 2000. The credit line
can be used for prime and sub-prime mortgage loans and is secured by loans
originated. The line bears interest at a rate of 2.25% and 3.00% over the one-
month LIBOR rate for prime and sub-prime loans respectively. We may receive
warehouse credit advances of 98%, 97%, and 90% for prime, sub-prime, and high
LTV loans (loans with LTV's greater than 90%), respectively, of the collateral
value amount on pledged mortgage loans for a period of 90 days after advance of
funds on each loan. If an investor has not purchased a loan within 90 days of
such advance, the interest rate on the loan increases to 4.00% over the one-
month LIBOR and we have an additional 30 days to sell the loan or purchase the
loan back from the warehouse. All interest rates reflect a 25 basis point
increase from the original interest rates, which was the result of the December
29th amendment. The aged loan sub limit is $2.0 million. As of June 30, 2001,
$3.3 million was outstanding under this facility. The line of credit is
scheduled to expire on July 21, 2001 and we have sent notice to Bank United that
we are terminating this warehouse line of credit agreement. The agreement was
amended to provide for all outstanding advances on the line to be settled by
September 15, 2001. The line of credit is subject to financial covenants for a
current ratio, tangible net worth and a leverage ratio. As of June 30, 2001 we
are in compliance with all financial covenants. We are actively seeking new
funding sources at this time.
On November 10, 1999, we obtained a $20.0 million sub-prime line of credit from
Regions Bank. The line is secured by loans originated and bears interest at a
rate of 3.25% over the one-month LIBOR rate. We may receive warehouse credit
advances of 100% of the net loan value amount on pledged mortgage loans for a
28
period of 90 days after origination. As of June 30, 2001 there were no
borrowings outstanding under this facility. The line of credit is scheduled to
expire on November 10, 2001. The line of credit is subject to financial
covenants for a current ratio, tangible net worth and a leverage ratio. As of
June 30, 2001 we are in compliance with all financial covenants. However, this
line of credit is administratively and operationally unusable. This line of
credit was structured for brokers and not lenders. Regions Bank must underwrite
each loan and make a determination as to whether they will fund the loan. Due
to the volume of loans generated by the Company, this procedure makes the line
unusable. The line of credit will not be renewed.
On November 10, 1999, we obtained a $20.0 million conforming loan line of credit
from Regions Bank. The line is secured by loans originated and bears interest
ranging from 2.25% to 2.75% over the one-month LIBOR rate based upon the monthly
advance levels. We may receive warehouse credit advances of 100% of the net
loan value amount on pledged mortgage loans for a period of 90 days after
origination. As of June 30, 2001 there were no borrowings outstanding under
this facility. The line of credit is scheduled to expire on November 10, 2001.
The line of credit is subject to financial covenants for a current ratio,
tangible net worth and a leverage ratio. As of June 30, 2001 we are in
compliance with all financial covenants. This line of credit was structured for
brokers and not lenders. Regions Bank must underwrite each loan and make a
determination as to whether they will fund the loan. Due to the volume of loans
generated by the Company, this procedure makes the line unusable. The line of
credit will not be renewed.
Other Capital Resources
Promissory notes and certificates of indebtedness have been a source of capital
since 1984 and are issued primarily according to an intrastate exemption from
security registration. Promissory notes and certificates of indebtedness totaled
$4.9 million at June 30, 2001 compared to $4.9 million at December 31, 2000.
These borrowings are subordinated to our warehouse lines of credit. We cannot
issue subordinated debt to new investors under the exemption since the state of
Virginia is no longer our primary state of operation.
We had cash and cash equivalents of $12.8 million at June 30, 2001. We have
sufficient resources to fund our current operations. Alternative sources for
future liquidity and capital resource needs may include the issuance of debt or
equity securities, increase in Saving Bank deposits and new lines of credit.
Each alternative source of liquidity and capital resources will be evaluated
with consideration for maximizing shareholder value, regulatory requirements,
the terms and covenants associated with the alternative capital source. We
expect that we will continue to be challenged by a limited availability of
capital, a reduction in premiums received on non-conforming mortgage loans sold
in the secondary market compared to premiums realized in recent years, new
competition and a rise in loan delinquency and the associated loss rates.
Bank Regulatory Liquidity
Liquidity is the ability to meet present and future financial obligations,
either through the acquisition of additional liabilities or from the sale or
maturity of existing assets, with minimal loss. Regulations of the OTS require
thrift associations and/or banks to maintain liquid assets at certain levels.
At present, the minimum required ratio of liquid assets to borrowings, which can
be withdrawn and are due in one year or less is 4.0%. Penalties are assessed
for noncompliance. In 2000 and the six months ended June 30, 2001, the Bank
maintained liquidity in excess of the required minimum amount, and we anticipate
that we will continue to do so.
29
Bank Regulatory Capital
At June 30, 2001, the Bank's book value under generally accepted accounting
principles ("GAAP") was $8.4 million. OTS Regulations require that institutions
maintain the following capital levels: (1) tangible capital of at least 1.5% of
total adjusted assets, (2) core capital of 4.0% of total adjusted assets, and
(3) overall risk-based capital of 8.0% of total risk-weighted assets. As of
June 30, 2001, the Bank satisfied all of the regulatory capital requirements, as
shown in the following table reconciling the Bank's GAAP capital to regulatory
capital:
Tangible Core Risk-Based
(In thousands) Capital Capital Capital
GAAP capital $ 8,362 $ 8,362 $ 8,362
Add: unrealized loss on securities - - -
Nonallowable asset: goodwill (79) (79) (79)
Nonallowable asset: deferred taxes (1,012) (1,012) (1,012)
Additional capital item: general allowance - - 665
------- ------- --------
Regulatory capital - computed 7,271 7,271 7,936
Minimum capital requirement 1,143 3,048 4,246
------- ------- --------
Excess regulatory capital $ 6,128 $ 4,223 $ 3,690
======= ======= ========
Ratios:
Regulatory capital - computed 9.54% 9.54% 14.95%
Minimum capital requirement 1.50% 4.00% 8.00%
------- ------- --------
Excess regulatory capital 8.04% 5.54% 6.95%
======= ======= ========
Recently an FDIC discussion draft proposal has been made public regarding
requirements for subprime lenders. Under the proposal, regulatory capital
required to be held for certain loan classes included in the institution's
portfolio could be increased. The ultimate resolution of this proposal is
uncertain at this time. However, we currently believe that the Bank can remain
in compliance with its capital requirements.
We are not aware of any other trends, events or uncertainties other than those
discussed in this document, which are expected to have a material effect on our
or the Bank's liquidity, capital resources or operations.
Bank Regulatory Directive
As disclosed in the 10Q filing for March 31, 2001, the Office of Thrift
Supervision (the "OTS") issued a written directive to Approved Financial Corp.
(the "AFC") and Approved Federal Savings Bank (the "AFSB") dated April 20, 2001
stating that as a result of the AFSB's practice of assigning loans to AFC, its
holding company, it was declaring AFSB a "problem association" and was declaring
the AFC in "troubled condition" as set forth in applicable laws and regulations.
The practice of inter-company loan assignments has been standard operating
procedure between the AFSB and AFC for several years. This operating procedure
was disclosed during audits, including audits by the Company's independent
public accountants and has no effect on previously audited consolidated
financial statements. The Board of Directors of AFSB and the AFC acknowledge
and respect the authority and power of the OTS and acted promptly to implement
corrective actions requested by the OTS and continue to develop, refine and
implement inter-company operating procedures and formalize a Business Plan
acceptable to the OTS.
The regulatory and supervisory restrictions and requirements contained in the
April 2001 letters and comments as to the corrective action related to such are
as follows:
30
1. Restriction or Requirement: Immediate cessation of assignments of loans from
the AFSB to the AFC.
Corrective Action: AFSB ceased assignment of loans to AFC on April 19,
2001. However, as of June 27, 2001, the OTS permitted the AFSB to assign
loans to AFC with the AFSB receiving the full principal amount of the loan
at time of assignment, which provided for use of AFC warehouse credit
facilities to fund loans.
2. Restriction or Requirement. Reassignment to the AFSB of loans previously
assigned to the AFC which have not been pledged, sold or encumbered,
reimbursement to the AFSB for full book value of loans assigned which have
been sold or pledged by the AFC (and to the extent this cannot be
accomplished to develop a detailed plan to accomplish this for approval by
the Regional Director of the OTS).
Corrective Action: Loans previously assigned to AFC by AFSB and other
assets owned by AFC including mortgage loans, the home office building and
land were transferred from AFC to AFSB during the second quarter of 2001.
In the March Thrift Financial Report filed with the OTS, AFSB recorded a
charge to income as a provision to an Allowance established for an
estimated loss on the net inter-company receivable due to AFSB after the
transfer of these assets. This first quarter expense related to the inter-
company Allowance was estimated and recorded on the AFSB income statement
as an expense and recorded as an Allowance on the AFSB balance sheet in the
first quarter of 2001. The Allowance was then charged against the inter-
company receivable on AFSB balance sheet in the second quarter of 2001
after adjusting for the final valuation of all assets transferred during
the second quarter.
3. Restriction or Requirement Restrictions on asset growth requiring that AFSB
only originate loans that meet criteria for sale to investors and requiring
that there be no increase in the dollar amount or number of loans in its
held for yield portfolio
Corrective Action: The AFSB and AFC were underwriting all loans to the
guidelines of investor's prior to the April 2001 letter and continue to do
so.
4. Restriction or Requirement: Resignation of the Chairman of the Board and the
President of the AFSB and immediate efforts to obtain new independent senior
management for the AFSB. AFSB must obtain get prior OTS approval for new
directors and officers and third-party contracts
Corrective Actions: The Chairman of the Board and the President of AFSB as
of April 20, 2001 resigned their positions.
New Management. By means of a letter dated May 25, 2001, the Regional
Director of the OTS approved the proposed slate of AFSB officers and their
compensation arrangements. The slate of officers consist of qualified
individuals who were employed by the AFSB or AFC prior to April 20, 2001
thus eliminating the expense and time involved in making a transition to
outside independent management as initially directed by the OTS. The
following officers were elected by the Board of Directors for the following
positions with Approved Federal Savings AFSB and approved by the letter
from the OTS dated May 25, 2001:
31
. Jean S. Schwindt, President & COO of AFSB. Ms. Schwindt has served as
Director of AFC since 1992, Director of AFSB since 1996 and as an
officer of AFC since 1998. Ms. Schwindt has over twenty years of
financial services experience working primarily in highly regulated
environments.
. Phil Gray, Senior Vice President and Controller of AFSB. Mr. Gray has
served as Controller of AFC since 1997 and as controller of AFSB since
2000. Mr. Gray is a Certified Public Accountant and has over eighteen
years of experience with various companies where he served in the
capacity of Chief Financial Officer or Controller.
. Lynn-LaVigne-Fiamingo, Vice President of AFSB. Ms. LaVigne-Fiamingo has
served as a member of AFSB management since 1998 and as Vice President
of AFSB since 2000. Ms. LaVigne-Fiamingo has over twenty years of
experience in the financial services industry.
A letter dated July 25, 2001 was sent to the OTS requesting approval for
the transfer of three additional officers from AFC to AFSB in order to
realign staff reporting and solidify the "wall" between AFC and AFSB.
New Outside Directors. Upon OTS approval of our Director nominee request,
the Board of Directors of AFSB will consist of four outside Directors and
four Directors that are employed by either AFC or AFSB.
. The Board of Directors nominated Dennis J. Pitocco as a new outside
Director of AFSB at a meeting held on April 25, 2001. This nomination
became effective upon receipt of a letter dated May 25, 2001, from the
OTS approving Mr. Pitocco as a Director. Mr. Pitocco's experience
includes 27 years in the financial services industry having served in
management positions for regulated banking institutions and non-bank
lending institutions.
. Eric Yeakel, who has been a Director of AFSB since 1996 and the Chief
Financial Officer of AFC since 1994, resigned his position as Chief
Financial Officer in July of 2001. Mr. Yeakel remains as an outside
Director of AFSB.
. A letter dated July 25, 2001 was submitted to the OTS requesting
approval of another individual approved by the Board of Directors on
July 23,2001 to serve as an AFSB Director.
5. Restriction or Requirement. Development of a fee schedule for future charges
to AFSB for services rendered by the AFC subject to OTS approval and a
restriction that no cash or assets be transferred from AFSB to AFC without
OTS approval until the fee schedule is approved by the OTS.
Corrective Action: New Operational Business Plan ("Plan"). The Plan, which
is in the final stages of development, which reflects a revised
organizational structure and financial model for AFC and AFSB that
establishes a "wall" between AFSB and AFC . Under the Plan all AFC staff
will report to a manager or officer of AFC and all AFSB staff will report
to a manager or officer of AFSB. Management of both entities are currently
working with the OTS to finalize this Plan, which requires OTS approval
prior to full implementation. An internal financial projection model is
used as the primary development tool for the Plan and the revised inter-
company procedures and fee schedules. Stress testing has been conducted to
evaluate the financial position of AFC and AFSB under various business
conditions and applying various assumptions for loan volume and whole loan
sale revenue. During the Plan development stage, all transfers and
assignments of assets from AFSB to AFC have been approved by the OTS.
32
6. Restriction or Requirement. Loss of expedited status for AFSB applications
and notices, and payment of higher exams assessments and application fees.
Loss of expedited status for AFC applications and notices, prior
notification of change of any director or senior executive for AFC and
payment of higher exams assessment and application fees.
Corrective Action. AFC and AFSB acknowledge and will comply with
requirements for additional fees, applications and notices.
Interest Rate Risk Management
We originate mortgage loans for sale as whole loans. We mitigate our interest
rate exposure, and the related need for hedging activity, by selling most of the
loans within sixty days of origination. However, we may choose to hold certain
loans for a longer period prior to sale in order to increase net interest
income. Currently loans held for investment by the Bank are primarily composed
of adjustable rate mortgages in order to minimize the Bank's interest rate risk
exposure. However, excluding the Bank's loans held for investment the majority
of loans held beyond the normal sixty-day holding period are fixed rate
instruments. Since most of our borrowings have variable interest rates, we have
exposure to interest rate risk. For example, if market interest rates were to
rise between the time we originate the loans and the time the loans are sold,
the original interest rate spread on the loans narrows, resulting in a loss in
value of the loans. To offset the effects of interest rate fluctuations on the
value of our fixed rate mortgage loans held for sale, we in certain cases, may
enter into Treasury security lock contracts, which function similar to short
sales of U.S. Treasury securities. If the value of an interest rate hedge
position decreases, offsetting an increase in the value of the hedged loans,
upon settlement with the counter-party, will pay the hedge loss in cash and
realize the corresponding increase in the value of the loans. Conversely, if the
value of a hedge position increases, offsetting a decrease in the value of the
hedged loans, we will receive the hedge gain in cash at settlement. We believe
that our current hedging strategy using Treasury rate lock contracts is an
effective way to manage interest rate risk on fixed rate loans prior to sale. We
may in the future enter into similar transactions with government and quasi-
government agency securities in relation to our origination and sale of
conforming mortgage loans or similar forward loan sale commitments concerning
non-conforming mortgages. Prior to entering into any type of hedge transaction
or forward loan sale commitment, we perform an analysis of the loan associated
with the transaction or commitment taking into account such factors as credit
quality of the loans, interest rate and term of the loans, as well as current
economic market trends, in order to determine the appropriate structure and/or
size of a hedge transaction or loan sale commitment that will limit our exposure
to interest rate risk. We had no hedge contracts or forward commitments
outstanding at June 30, 2001. We have not entered into any hedge contracts since
the fourth quarter of 1997. That commitment expired during the first quarter of
1998.
Impact of Inflation and Changing Prices
The consolidated financial statements and related data presented in this
document have been prepared in accordance with generally accepted accounting
principles, which require the measurement of the financial position and
operating results in terms of historical dollars, without considering changes in
the relative purchasing power of money over time due to inflation.
The majority of the assets are monetary in nature. As a result, interest rates
have a more significant impact on our performance than the effects of general
levels of inflation. Inflation affects us most significantly in the area of
residential real estate values and inflation's effect on interest rates. Real
estate values generally increase during periods of high inflation and are
stagnant during periods of low inflation. While, interest rates do not
33
necessarily move in the same direction or with the same magnitude as the prices
of goods and services, normally interest rates increase during periods of high
inflation and decrease during periods of low inflation.
Loan origination volume generally increases as residential real estate values
increase because homeowners have new home equity values against which they can
borrow. A large portion of our loan volume is related to refinancing and debt
consolidation mortgages, therefore, an increase in real estate values enhances
the marketplace for this type of loan origination. Conversely, as residential
real estate values decrease, the market for home equity and debt consolidation
loan origination decreases. Additionally, an increase or decrease in residential
real estate values may have a positive or negative effect, respectively, on the
liquidation of foreclosed property.
Because we sell a significant portion of the loans we originate, the effect that
inflation has on interest rates has a diminished effect on the results of
operations. However, we hold a portfolio of loans held for investment, the size
of which varies from time to time and this portfolio will be more sensitive to
the effects of inflation and changes in interest rates. Profitability may be
directly affected by the level and fluctuation of interest rates, which affect
our ability to earn a spread between interest received on loans and the costs of
borrowings. Our profitability is likely to be adversely affected during any
period of unexpected or rapid changes in interest rates. (See also: "Interest
Rate Risk Management").
A substantial and sustained increase in interest rates could adversely affect
our ability to originate and purchase loans and affect the mix of first and
junior lien mortgage loan products. Generally, first mortgage production
increases relative to junior lien mortgage production in response to low
interest rates and junior lien mortgage loan production increases relative to
first mortgage loan production during periods of high interest rates.
While we have no plans to adopt a Securitization loan sale strategy at this
time, if we were to do so in the future, then to the extent servicing rights and
interest-only and residual classes of certificates are capitalized on the books
from future loan sales through securitization, higher than anticipated rates of
loan prepayments or losses could require us to write down the value of such
servicing rights and interest-only and residual certificates, adversely
affecting earnings. A significant decline in interest rates could increase the
level of loan prepayments. Conversely, lower than anticipated rates of loan
prepayments or lower losses could allow us to increase the value of interest-
only and residual certificates, which could have a favorable effect on our
results of operations and financial condition.
34
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk Management - Asset/Liability Management
Our primary market risk exposure is interest rate risk. Fluctuations in
interest rates will impact both the level of interest income and interest
expense and the market value of our interest-earning assets and interest-bearing
liabilities.
We strive to manage the maturity or repricing match between assets and
liabilities. The degree to which we are "mismatched" in our maturities is a
primary measure of interest rate risk. In periods of stable interest rates,
financing higher yielding long-term mortgage loan assets with lower cost short-
term Bank deposits and borrowings can increase net interest income. Although
such a strategy may increase profits in the short run, it increases the risk of
exposure to rising interest rates and can result in funding costs rising faster
than asset yields. We attempt to limit our interest rate risk by selling a
majority of the fixed rate mortgage loans that we originate.
Contractual principal repayments of loans do not necessarily reflect the actual
term of our loan portfolio. The average lives of mortgage loans are
substantially less than their contractual terms because of loan prepayments and
because of enforcement of due-on-sale clauses, which gives us the right to
declare a loan immediately due and payable in the event, among other things, the
borrower sells the real property subject to the mortgage and the loan is not
repaid. In addition, certain borrowers increase their equity in the security
property by making payments in excess of those required under the terms of the
mortgage.
The majority of the loans originated are sold through loan sale strategies in an
attempt to limit exposure to interest rate risk in addition to generating cash
revenues. We sold, during 2000 and the first six months of 2001 approximately
97.9% of the total loans originated and funded in-house during the year ended
December 31, 2000. Also, we sold, during the first six months in 2001
approximately 86.49% of loans originated and funded in-house during the five
month period January to May 2001. We expect to sell the majority of our loan
originations, other than loans specifically originated to hold for investment
and yield, during the same twelve-month period in which they are funded in
future periods. As a result, loans are held on average for less than 12 months
in our portfolio of Loans Held for Sale. The "gap position", defined as the
difference between interest-earning assets and interest-bearing liabilities
maturing or repricing in one year or less, was negative at June 30, 2001, as
anticipated, and is expected to remain negative in future periods. We have no
quantitative target range for past gap positions, nor any anticipated ranges for
future periods due to the fact that we sell the majority of our loans within a
twelve month period while the gap position is a static illustration of the
contractual repayment schedule for loans.
35
Our one-year gap was a negative 21.54% of total assets at June 30, 2001, as
illustrated in the following table:
One Year Two Three to More Than Four
Description Total Or Less Years Four Years Years
Interest earning assets:
Loans held for sale (1) $46,278 $ 21,586 $ 1,036 $ 2,376 $21,280
Loans held for yield (1) 13,823 6,447 309 710 6,357
Cash and other 12,813 12,813
interest-earning assets
---------------------------------------------------------------
72,914 $ 40,846 $ 1,345 $ 3,086 $27,637
====================================================
Allowance for loan losses (1,386)
Premises and equipment, net 4,879
Other 8,812
----------
Total assets $85,219
==========
Interest-bearing liabilities:
Revolving warehouse lines $ 3,284 3,284
FDIC - insured deposits 63,129 52,145 7,516 3,468 0
FDIC - insured money market account 2,799 2,799
Other interest-bearing 7,094 976 1,624 2,542 1,952
liabilities
--------------------------------------------------------------
76,306 $ 59,204 $ 9,140 $ 6,010 $ 1,952
====================================================
Non-interest-bearing liabilities 1,335
----------
Total liabilities 77,641
Shareholders' equity 7,578
----------
Total liabilities and equity $85,219
==========
Maturity/repricing gap $(18,358) $ (7,795) $ (2,924) $25,685
====================================================
Cumulative gap $(18,358) $(26,153) $(29,077) $(3,392)
====================================================
As percent of total assets (21.54)% (30.69)% (34.12)% (3.98)%
Ratio of cumulative interest earning 0.69 0.62 0.61 0.96
Assets to cumulative interest bearing
liabilities
========================================================================================================
(1) Loans shown gross of allowance for loan losses, net of premiums/discounts.
36
Interest Rate Risk
The principal quantitative disclosure of our market risks is the above gap
table. The gap table shows that the one-year gap was a negative 21.54% of total
assets at June 30, 2001. We originate fixed-rate, fixed-term mortgage loans for
sale in the secondary market. While most of these loans are sold within a month
or two of origination, for purposes of the gap table the loans are shown based
on their contractual scheduled maturities. As of June 30, 2001, receipt of
46.0% of the principal due on loan outstanding was expected more than four years
from that date. However, our activities are financed with short-term loans and
credit lines, 77.6% of which re-price within one year of June 30, 2001. We
attempt to limit our interest rate risk by selling a majority of the fixed rate
loans that we originate. If our ability to sell such fixed-rate, fixed-term
mortgage loans on a timely basis were to be limited, we could be subject to
substantial interest rate risk.
Profitability may be directly affected by the level of, and fluctuations in
interest rates, which affect our ability to earn a spread between interest
received on our loans and the cost of borrowing. Our profitability is likely to
be adversely affected during any period of unexpected or rapid changes in
interest rates. For example, a substantial or sustained increase in interest
rates could adversely affect our ability to purchase and originate loans and
would reduce the value of loans held for sale. A significant decline in
interest rates could decrease the size of our loan servicing portfolio by
increasing the level of loan prepayments. Additionally, to the extent mortgage
loan servicing rights in future periods have been capitalized on our books,
higher than anticipated rates of loan prepayments or losses could require us to
write down the value of these assets, adversely affecting earnings.
In an environment of stable interest rates, our gains on the sale of mortgage
loans would generally be limited to those gains resulting from the yield
differential between mortgage loan interest rates and rates required by
secondary market purchasers. A loss from the sale of a loan may occur if
interest rates increase between the time we establish the interest rate on a
loan and the time the loan is sold. Fluctuating interest rates also may affect
the net interest income earned, resulting from the difference between the yield
to us on loans held pending sale and the interest paid for funds borrowed,
including our warehouse facilities, subordinated debt, and the Bank's FHLB
advances and FDIC-insured customer deposits. Because of the uncertainty of
future loan origination volume and the future level of interest rates, there can
be no assurance that we will realize gains on the sale of financial assets in
future periods.
37
Asset Quality
The following table summarizes all of our delinquent loans at June 30,2001 and
December 31, 2000:
(in thousands)
2001 2000
-------- ---------
Delinquent 31 to 60 days $ 550 $ 362
Delinquent 61 to 90 days 667 164
Delinquent 91 to 120 days 509 354
Delinquent 121 days or more 963 955
-------- ---------
Total delinquent loans (1) $ 2,689 $ 1,835
======== =========
Total loans receivable outstanding, gross $60,649 $38,602
======== =========
Delinquent loans as a percentage of
total loans outstanding:
Delinquent 31 to 60 days .91% .94%
Delinquent 61 to 90 days 1.10 0.42
Delinquent 91 to 120 days .84 0.92
Delinquent 121 days or more 1.58 2.47
-------- ---------
Total delinquent loans as a percentage
of total loans outstanding 4.43% 4.75%
-------- ---------
Reserve as a % of delinquent loans 51.6% 80.6%
======== =========
- ---------------
(1) Includes loans in foreclosure proceedings and delinquent loans to borrowers
in bankruptcy proceedings, but excludes real estate owned.
The decrease in "Reserve as a % of delinquent loans" is related to a change in
the accounting for loan loss estimates related to loans held for sale, which
results in a reduced "Reserve" amount for certain loan categories. Potential
loan losses are now "charged off" rather than creating a reserve carried in the
allowance for loan losses. As discussed under "Unrealized Loss on Loans held for
Sale", beginning with the three month period ended June 30, 2001, loans held for
sale are accounted for at the lower of cost or market and a charge to income is
recorded related to a valuation allowance on loans held for sale. For the period
ended December 30, 2000, all loans originated greater than 90 days prior to the
balance sheet date were classified as held for yield with a corresponding
allowance for loan losses. The Company now classifies these loans as held for
sale.
The valuation allowance related to loans held for sale is not included in the
allowance for loan losses and therefore is not reflected above in the "Reserve
as a % of delinquent loans" for June 30, 2001. This valuation allowance was
approximately $245,000 at June 30, 2001. In prior periods, a charge to income
was recorded through the loan loss provision, which was reflected in an
allowance for loan losses in lieu of a valuation provision reflecting the lower
of cost or market value for loans held for sale on the balance sheet.
Additionally, the decrease in the "Reserve as a % of delinquent loans" from
December 31, 2000 to June 30, 2001, can be attributed to a lower percentage of
loans delinquent over 90 days at June 30, 2001 compared to December 31, 2000. In
most cases, a larger allowance for loan losses or valuation allowance is
recorded for loans delinquent over 90 days than for those between 31 days and 90
days delinquent.
Interest on most loans is accrued until they become 31 days or more past due.
Interest on loans held for investment by the Bank is accrued until the loans
become 90 days or more past due. Non-accrual loans were $2.1 million and $1.5
million at June 30, 2001 and December 31, 2000 respectively. The amount of
additional interest that would have been recorded had the loans not been placed
38
on non-accrual status was approximately $98,000 and $148,000 for the six months
ended June 30, 2001 and the year ended December 31, 2000, respectively. The
amount of interest income on the non-accrual loans, that was included in net
income for the six months ended June 30, 2001 and the year ended December 31,
2000 was $48,000 and $95,000, respectively.
Loans delinquent 31 days or more as a percentage of total loans outstanding
decreased to 4.43% at June 30, 2001 from 4.75% at December 31, 2000.
At June 30, 2001 and December 31, 2000 the recorded investment in loans for
which impairment has been determined, which includes loans delinquent in excess
of 90 days, totaled $1.5 million and $1.3 million, respectively. The average
recorded investment in impaired loans for the six months ended June 30, 2001 and
the year ended December 31, 2000 was approximately $1.1 million and $1.9
million, respectively.
39
PART II. OTHER INFORMATION
40
Item 1. Legal Proceedings - The Company is party to various legal proceedings
arising out of the ordinary course of its business. Management believes that
none of these actions, individual or in the aggregate will have a material
adverse effect on our results of operations or financial condition
Item 2. Changes in Securities - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
Item 5. Other Information - None
Item 6. Exhibits and Reports on Form 8-K - None
Pursuant to the requirements 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.
Date: August 14, 2001 APPROVED FINANCIAL CORP.
---------------
By: /s/ Allen D. Wykle
---------------------------------
Allen D. Wykle,
Chairman, President, and Chief
Executive Officer
By: /s/ Cheri D. Spencer
---------------------------------
Cheri D. Spencer
Its Vice President Finance
41