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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the quarter ended March 31, 2004
|_| Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
MERIT SECURITIES CORPORATION
(Exact name of registrant as specified in its charter)
Commission file number 33-83524
Virginia 54-1736551
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060
(Address of principal executive offices) (Zip Code)
(804) 217-5800
(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 was
required to file such reports), and (2) has been subject to such filing
requirements for the past ninety days.
|X| Yes |_| No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). |_| Yes |X| No
As of May 10, 2004, there were 1,000 shares of Merit Securities Corporation
common stock outstanding.
The registrant meets the conditions set forth in General Instructions H (1)(a)
and (b) of Form 10-Q and is therefore filing this Form 10-Q with the reduced
disclosure format.
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i
MERIT SECURITIES CORPORATION
FORM 10-Q
INDEX
Page Number
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of March 31, 2004
and December 31, 2003 (unaudited)...................................................1
Condensed Consolidated Statements of Operations and Comprehensive (Loss)
Income for the three months ended March 31, 2004 and 2003 (unaudited)...............2
Condensed Consolidated Statements of Cash Flows for the three months ended
March 31, 2004 and 2003 (unaudited).................................................3
Notes to Unaudited Condensed Consolidated Financial Statements..........................4
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations...........................................7
Item 3. Quantitative and Qualitative Disclosures about Market Risk.............................12
Item 4. Controls and Procedures................................................................13
PART II. OTHER INFORMATION
Item 1. Legal Proceedings......................................................................14
Item 5. Other Information......................................................................14
Item 6. Exhibits and Reports on Form 8-K.......................................................14
SIGNATURES .......................................................................................15
i
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MERIT SECURITIES CORPORATION
Condensed Consolidated Balance Sheets, Unaudited
(amounts in thousands except share data)
March 31, December 31,
2004 2003
---------------- ------------------
ASSETS:
Securitized finance receivables:
Loans $ 744,191 $ 783,881
Debt securities, available-for-sale 240,413 251,554
Other loans 2,544 2,683
Asset-backed security, held-to-maturity 724 801
Due from affiliates, net 42,144 45,837
---------------- ------------------
$ 1,030,016 $ 1,084,756
================ ==================
LIABILITIES AND SHAREHOLDER'S EQUITY
LIABILITIES:
Non-recourse securitization financing $ 974,262 $ 1,018,899
---------------- ------------------
SHAREHOLDER'S EQUITY:
Common stock, no par value, 10,000 shares authorized, 1,000
shares issued and outstanding 10 10
Additional paid-in capital 68,674 68,674
Accumulated other comprehensive income (loss) 167 (82)
Accumulated deficit (13,097) (2,745)
---------------- ------------------
55,754 65,857
---------------- ------------------
$ 1,030,016 $ 1,084,756
================ ==================
See notes to unaudited condensed consolidated financial statements.
1
MERIT SECURITIES CORPORATION
Condensed Consolidated Statements of Operations and Comprehensive (Loss) Income,
Unaudited
(amounts in thousands)
Three Months Ended
March 31,
--------------------------------
2004 2003
------------- --------------
Interest income:
Securitized finance receivables $ 16,763 $ 22,354
Other loans 34 38
Asset-backed security, held-to-maturity 52 62
-------------- ------------------
16,849 22,454
-------------- ------------------
Interest and related expense:
Interest expense on non-recourse securitization financing 11,716 13,517
Other non-recourse securitization financing expense 400 238
-------------- ------------------
12,116 13,755
-------------- ------------------
Net interest margin before provision for loan losses 4,733 8,699
Provision for loan losses (3,625) (5,003)
-------------- ------------------
Net margin 1,108 3,696
Impairment charges (1,497) (1,454)
Other income 227 76
-------------- ------------------
Net (loss) income (162) 2,318
Change in net unrealized (loss) gain during period on:
Investments classified as available-for-sale (248) 464
-------------- ------------------
Comprehensive (loss) income $ (410) $ 2,782
============== ==================
See notes to unaudited condensed consolidated financial statements.
2
MERIT SECURITIES CORPORATION
Condensed Consolidated Statements of Cash Flows, Unaudited
(amounts in thousands)
-------------------------------------------
Three Months Ended
March 31,
-------------------------------------------
2004 2003
------------------- -------------------
Operating activities:
Net (loss) income $ (162) $ 2,318
Adjustments to reconcile net income to net cash provided by
operating activities:
Impairment charges 1,497 1,454
Provision for loan losses 3,625 5,003
Amortization, net 1,760 1,018
Other 176 837
------------------- -------------------
Net cash provided by operating activities 6,896 10,630
------------------- -------------------
Investing activities:
Principal payments on collateral 45,426 74,998
Net decrease in other loans 138 707
Payments received on securities 159 365
------------------- -------------------
Net cash provided by investing activities 45,723 76,070
------------------- -------------------
Financing activities:
Principal payments on non-recourse securitization financing (46,123) (79,666)
Decrease (increase) in due from affiliates 3,693 (7,034)
Dividends distribution (10,189) -
------------------- -------------------
Net cash used in financing activities (52,619) (86,700)
------------------- -------------------
Net decrease in cash - -
Cash, beginning of period - -
------------------- -------------------
Cash, end of period $ - $ -
------------------- -------------------
disclosure of cash flow information:
Cash paid for interest $ 10,460 $ 13,181
------------------- -------------------
See notes to unaudited condensed consolidated financial statements.
3
MERIT SECURITIES CORPORATION
Notes to Unaudited Condensed Consolidated Financial Statements
March 31, 2004
(amounts in thousands)
NOTE 1 -- BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements have been prepared
in accordance with the instructions to Form 10-Q and do not include all of the
information and notes required by accounting principles generally accepted in
the United States of America, hereinafter referred to as "generally accepted
accounting principles" for complete financial statements. The financial
statements include the accounts of Merit Securities Corporation (the "Company")
and its wholly owned subsidiary, Financial Asset Securitization, Inc. ("FASI"),
which was purchased from Dynex Capital, Inc. ("Dynex"), its parent, on March 31,
2002. The Company is a wholly owned, limited-purpose finance subsidiary of
Issuer Holding Corporation ("IHC"). IHC was formed on September 4, 1996 to
acquire all of the outstanding stock of the Company and certain other affiliates
of Dynex. IHC is a wholly owned subsidiary of Dynex. Dynex has elected to be
treated as a real estate investment trust ("REIT") for federal income tax
purposes under the Internal Revenue Code of 1986. Accordingly, the Company is
not subject to federal income tax. The Company was organized to facilitate the
securitization of loans through the issuance and sale of collateralized bonds
(the "Bonds"). All inter company balances and transactions have been eliminated
in the consolidation of the Company.
In the opinion of management, all adjustments considered necessary for a fair
presentation of the financial statements have been included. The Condensed
Consolidated Balance Sheet at March 31, 2004 and December 31, 2003, the
Condensed Consolidated Statements of Operations and Comprehensive (Loss) Income
for the three months ended March 31, 2004 and 2003, the Condensed Consolidated
Statements of Cash Flows for the three months ended March 31, 2004 and 2003, and
the related notes to condensed consolidated financial statements are unaudited.
Operating results for the three months ended March 31, 2004 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2004. For further information, refer to the audited financial statements and
footnotes included in the Company's Form 10-K for the year ended December 31,
2003.
Certain reclassifications have been made to the financial statements for 2003 to
conform to the presentation for 2004. Certain basis adjustments were
reclassified from securitized finance receivables within assets to non-recourse
securitization financing within liabilities on the condensed consolidated
balance sheet and from interest income to interest expense on the income
statement. These remaining unamortized deferred hedging amounts were basis
adjustments recorded prior to 2001, which related to financing hedges and are
more appropriately recorded as part of the related debt.
NOTE 2 -- SECURITIZED FINANCE RECEIVABLES
Securitized finance receivables consists of loans and debt securities backed
primarily by adjustable-rate and fixed-rate mortgage loans secured by first
liens on single family residential housing and manufactured housing installment
loans secured by a Unified Commercial Code ("UCC") filing. All securitized
finance receivables are pledged to secure repayment of the related non-recourse
securitization financing. All principal and interest (less servicing-related
fees) on the collateral is remitted to a trustee and is available for payment on
the non-recourse securitization financing. The Company's exposure to loss on
securitized finance receivables is generally limited to the amount of collateral
pledged in excess of the related non-recourse securitization financing issued,
as the non-recourse securitization financing is non-recourse to the Company. The
securitized finance receivables can be sold by the Company, but only subject to
the lien of the non-recourse securitization financing indenture.
The following table summarizes the components of securitized finance receivables
at March 31, 2004 and December 31, 2003. Debt securities pledged as securitized
finance receivables are considered available-for-sale, and are therefore
recorded at fair value. Loans pledged as securitized finance receivables are
carried at amortized cost.
4
- --------------------------------- ---------------------- ---------------------
March 31, 2004 December 31, 2003
---------------------- ---------------------
Loans, at amortized cost $ 766,568 $ 804,871
Allowance for loan losses (22,377) (20,990)
- --------------------------------- ---------------------- ---------------------
744,191 783,881
Debt securities, at fair value 240,413 251,554
- --------------------------------- ---------------------- ---------------------
$ 984,604 $ 1,035,435
- --------------------------------- ---------------------- ---------------------
The following table summarizes the amortized cost basis, gross unrealized gains,
and estimated fair value of debt securities pledged as securitized finance
receivables at March 31, 2004 and December 31, 2003:
- -------------------------------------- -------------------- -------------------
March 31, 2004 December 31, 2003
- -------------------------------------- -------------------- -------------------
Debt securities, at amortized cost $ 240,246 $ 251,554
Gross unrealized gains 167 -
- -------------------------------------- -------------------- -------------------
Estimated fair value $ 240,413 $ 251,554
- -------------------------------------- -------------------- -------------------
The components of securitized finance receivables at March 31, 2004 and December
31, 2003 are as follows:
- ------------------------------- ------------------------------------------ ------------------------------------------
March 31, 2004 December 31, 2003
- ------------------------------- ------------------------------------------ ------------------------------------------
Loans, net Debt Total Loans, net Debt Total
Securities Securities
- ------------------------------- ------------- ------------- -------------- -------------- ----------- ---------------
Collateral:
Manufactured housing $ 455,796 $ 168,476 $ 624,272 $ 470,319 $ 172,847 $ 643,166
Single family 292,839 69,867 362,706 317,552 76,749 394,301
------------- ------------- -------------- -------------- ----------- ---------------
748,635 238,343 986,978 787,871 249,596 1,037,467
Funds held by trustees 1 - 1 1 - 1
Accrued interest receivable 4,600 1,502 6,102 4,847 1,565 6,412
Unamortized (discounts) and
premiums, net (9,045) 401 (8,644) (8,838) 393 (8,445)
Unrealized gain, net - 167 167 - - -
- ------------------------------- ------------- ------------- -------------- -------------- ----------- ---------------
$ 744,191 $ 240,413 $ 984,604 $ 783,881 $ 251,554 $ 1,035,435
- ------------------------------- ------------- ------------- -------------- -------------- ----------- ---------------
All of the securitized finance receivables are encumbered by non-recourse
securitized financing.
NOTE 3 -- ALLOWANCE FOR LOAN LOSSES
The following table summarizes the activity for the allowance for loan losses on
loans within securitized finance receivables for the three months ended March
31, 2004 and March 31, 2003:
- ----------------------------------------- ------------------ -------------------
March 31, 2004 March 31, 2003
- ----------------------------------------- ------------------ -------------------
Beginning balance $ 20,990 $ 20,700
Provision for loan losses 3,625 5,003
Losses charged-off, net of recoveries (2,238) (4,752)
- ----------------------------------------- ------------------ -------------------
Ending balance $ 22,377 $ 20,951
- ----------------------------------------- ------------------ -------------------
The Company continues to experience unfavorable results in its manufactured
housing loan portfolio in terms of elevated delinquencies and loss severity on
repossessed units. For the period ended March 31, 2004, the Company added $3,625
in provisions for loan losses related to the manufactured housing loan
portfolio.
The aggregate loss exposure is generally limited to the amount of collateral in
excess of the related investment-grade non-recourse securitization financing
issued (commonly referred to as "over-collateralization"), excluding price
premiums and discounts and hedge basis adjustments. Within each non-recourse
securitization financing, a group of loans are held within the securitization
structure as a credit reserve to provide additional cash flow to cover losses.
5
Once the cumulative level of losses have surpassed the cash flow available from
the credit reserve and losses has depleted the over-collateralization, future
losses are passed to the holders of the lowest classes of bonds within the
structure. In some cases, the aggregate loss exposure may be increased by the
use of surplus cash or cash reserve funds contained within the security
structure to cover losses. On one of the deal structures of the Company, total
cumulative losses have surpassed the cash flow available from the credit reserve
and have completely depleted the over-collateralization. During the three months
ended December 31, 2003, losses on this securitization began to pass to the
subordinate class bondholders. The reserves for loan losses on this
securitization decreased as these losses began to be borne by the subordinated
bondholders.
The allowance for loan losses on the over-collateralization totaled $22,377 at
March 31, 2004 and $20,951 at March 31, 2003, and are included in securitized
finance receivables in the accompanying condensed consolidated balance sheets.
Over-collateralization at March 31, 2004 and March 31, 2003 totaled $34,380 and
$53,442 respectively.
NOTE 4 -- DUE FROM AFFILIATES, NET
Cash flows generated by operations are loaned by the Company to its parent and
interest is charged to the parent at the Federal funds rate plus 100 basis
points. These inter-company loans are subject to a maximum outstanding of
balance of $50,000. Interest income on amounts due from affiliates was $245 and
$4 for the three months ended March 31, 2004 and March 31, 2003, respectively.
NOTE 5-- FAIR VALUE
Securities classified as available-for-sale are carried in the accompanying
financial statements at estimated fair value. The Company uses estimates in
establishing fair value for its available-for-sale securities. Estimates of fair
value for securities may be based on market prices provided by certain dealers.
Estimates of fair value for certain other securities are determined by
calculating the present value of the projected cash flows of the instruments
using market-based discount rates, prepayment rates and credit loss assumptions.
The estimate of fair value for securities pledged as securitized finance
receivables is determined by calculating the present value of the projected cash
flows of the instruments using prepayment rate assumptions and credit loss
assumptions based on historical experience and estimated future activity, and
using discount rates commensurate with those the Company believes would be used
by third parties. Such discount rate used in the determination of fair value of
securities pledged as securitized finance receivables was 16% at March 31, 2004
and December 31, 2003. Prepayment rate assumptions at March 31, 2004, and
December 31, 2003, were generally at a CPR ranging from 30%-35% at March 31,
2004 and 35%-40% at December 31, 2003, for securitized finance receivables
consisting of securities backed by single-family mortgage loans, and a CPR
equivalent of 8% for 2004 and 10% for 2003 for securitized finance receivables
consisting of securities backed by manufactured housing loans. CPR assumptions
for each year are based in part on the actual prepayment rates experienced for
the prior six-month period and in part on management's estimate of future
prepayment activity. The loss assumptions utilized vary depending on the
collateral pledged.
Estimates of fair value for other financial instruments are based primarily on
management's judgment. Since the fair value of the Company's financial
instruments is based on estimates, actual gains and losses recognized may differ
from those estimates recorded in the condensed consolidated financial
statements.
NOTE 6-- RECENT ACCOUNTING PRONOUNCEMENTS
In December 2003, the Accounting Standards Executive Committee (AcSEC) of the
American Institute of Certified Professional Accountants (AICPA) issued
Statement of Position (SOP) No. 03-3, "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer." SOP No. 03-3 is effective for loans acquired
in fiscal years beginning after December 15, 2004, with early adoption
encouraged. A certain transition provision applies for certain aspects of loans
currently within the scope of Practice Bulletin 6, Amortization of Discounts on
Certain Acquired Loans. SOP No. 03-3 addresses accounting for differences
between contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities (loans) acquired in a
6
transfer if those differences are attributable, at least in part, to credit
quality. It includes loans acquired in business combinations and applies to all
non-governmental entities, including not-for-profit organizations. SOP No. 03-3
does not apply to loans originated by the entity. The Company is reviewing the
implications of SOP No. 03-3 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
In March 2004, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 105, "Application of Accounting Principles to Loan
Commitments." SAB No. 105 addresses the application of generally accepted
accounting practices which apply to loan commitments which are accounted for as
a derivative instrument and measured at fair value. The Company is reviewing the
implications of SAB No. 105 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The Company was organized to facilitate the securitization of loans through the
issuance and sale of non-recourse securitization financing (the "Bonds"). The
Bonds are secured by securities and loans backed primarily by: (i) mortgage
loans secured by first or second liens on residential property, and manufactured
housing installment loans secured by either a UCC filing or a motor vehicle
title, (ii) other mortgage pass-through certificates or mortgage-collateralized
obligations, and (iii) consumer installment loans (collectively, the
"Collateral"). In the future, the Company may also securitize other types of
loans or securities such as Federal National Mortgage Association
Mortgage-Backed Certificates, Federal Home Loan Mortgage Corporation
Mortgage-Backed Certificates, or Government National Mortgage Association
Mortgage-Backed Certificates.
After payment of the expenses of an offering and certain administrative
expenses, the net proceeds from an offering of Bonds is used to purchase
Collateral from IHC or various third parties. IHC can be expected to use the
proceeds to reduce indebtedness incurred to obtain such loans or to acquire
additional Collateral. After the issuance of a series of Bonds, the Company may
sell the Collateral securing that series of Bonds, subject to the lien of the
Bonds.
The Company is a financial services company, which invests in loans and
securities consisting of or secured by, principally single family mortgage loans
and manufactured housing installment loans. The loans and securities in which
the Company invests have generally been pooled and pledged (i.e. securitized) as
collateral for non-recourse bonds ("non-recourse securitization financing"),
which provides long-term financing for such loans while limiting credit,
interest rate and liquidity risk. The Company earns the net interest spread
between the interest income on the loans and securities in its investment
portfolio and the interest and other expenses associated with the non-recourse
securitization financing.
The Company owns the right to call securitization financing previously issued
and sold by the Company once the outstanding balance of such securities reaches
a call trigger, generally either 35% or less of the original amount issued or a
specified date. Generally interest rates on the bonds issued in the
securitization financing increase by 0.30%-2.00% if the bonds are not redeemed
by the Company. The Company will evaluate the benefit of calling such bonds at
the time they are redeemable. An estimated $200 million of securitization
financing were redeemable in March 2004 and an estimated $230 million will be
redeemable in August 2004. These non-recourse securitization financings are
collateralized by manufactured housing loans, and certain of the bonds may have
interest rates which exceed current market rates. The Company has the right to
call such bonds by class and is contemplating calling these bonds and reissuing
them at the lower current market rates. On April 26, 2004, the Company redeemed
the senior-most bond classes with an aggregate principal balance of $154.8
million in its Merit 12 securitization and reissued the bonds at a $7.4 million
premium to the Company. At March 31, 2004, the aggregate callable balance at the
time of the projected call of securitization financing which is expected to
reach respective call triggers during the remainder of 2004 is approximately
$230 million, relating to one securitization financing structure. The Company
may or may not elect to call all or part of this securitization, or other
securitizations, when eligible to call.
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of the Company's financial condition and results of
operations are based in large part upon its condensed consolidated financial
statements, which have been prepared in conformity with accounting principles
7
generally accepted in the United States of America ("generally accepted
accounting principles".) The preparation of the financial statements 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 revenue and
expenses during the reported period. Actual results could differ from those
estimates.
Critical accounting policies are defined as those that are reflective of
significant judgements or uncertainties, and which may result in materially
different results under different assumptions and conditions, or the application
of which may have a material impact on the Company's financial statements. The
following are the Company's critical accounting policies.
Consolidation of Subsidiaries. The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries, after significant
inter-company transactions have been eliminated.
Impairments. The Company evaluates the debt and asset backed securities in its
investment portfolio for other-than-temporary impairments. A security is
generally defined to be other-than-temporarily impaired if, for a period of a
maximum of three consecutive quarters, the carrying value of such security
exceeds its estimated fair value and the Company estimates, based on projected
future cash flows or other fair value determinants, that the fair value is not
likely to exceed the carrying value in the foreseeable future. If an
other-than-temporary impairment is deemed to exist, the Company records an
impairment charge to adjust the carrying value of the security down to its
estimated fair value. In certain instances, as a result of the
other-than-temporary impairment analysis, the recognition or accrual of interest
will be discontinued and the security will be placed on non-accrual status.
Fair Value. Securities classified as available-for-sale are carried in the
accompanying consolidated financial statements at estimated fair value.
Estimates of fair value for securities may be based on market prices provided by
certain dealers. Estimates of fair value for certain other securities are
determined by calculating the present value of the projected cash flows of the
instruments using market-based discount rates, prepayment rates and credit loss
assumptions. The estimate of fair value for securities pledged as securitized
finance receivables is determined by calculating the present value of the
projected cash flows of the instruments using prepayment rate assumptions and
credit loss assumptions based on historical experience and estimated future
activity, and using discount rates commensurate with those believed would be
used by third parties. Such discount rate used in the determination of fair
value of securities pledged as securitized finance receivables was 16% at March
31, 2004 and December 31, 2003. Prepayment rate assumptions at March 31, 2004
and December 31, 2003 were generally at a "constant prepayment rate," or CPR,
ranging from 30%-35% in 2004 and 35%-40% in 2003, for securitized finance
receivables consisting of securities backed by single-family mortgage loans, and
a CPR equivalent ranging from 8% for 2004 and 10% for 2003 for securitized
finance receivables consisting of securities backed by manufactured housing
loans. CPR assumptions for each year are based in part on the actual prepayment
rates experienced for the prior six-month period and in part on management's
estimate of future prepayment activity. The loss assumptions utilized vary
depending on the collateral pledged.
Estimates of fair value for other financial instruments are based primarily on
management's judgment. Since the fair value of the Company's financial
instruments are based on estimates, actual gains and losses recognized may
differ from those estimates recorded in the consolidated financial statements.
Allowance for Loan Losses. The Company has limited exposure to credit risk
retained on loans, which it has securitized through the issuance of non-recourse
securitization financing. The aggregate loss exposure is generally limited to
the amount of collateral in excess of the related investment-grade non-recourse
securitization financing issued (commonly referred to as
"over-collateralization"), excluding price premiums and discounts and hedge
basis adjustments. The allowance for loan losses is included in securitized
finance receivables in the accompanying condensed consolidated balance sheets.
An allowance for loan losses has been estimated and established for currently
existing probable losses to the extent losses are borne by the Company under the
terms of the securitization transaction. Factors considered in establishing an
allowance include current loan delinquencies, historical cure rates of
delinquent loans, and historical and anticipated loss severity of the loans as
they are liquidated. The allowance for losses is evaluated and adjusted
periodically by management based on the actual and estimated timing and amount
8
of probable credit losses, using the above factors, as well as industry loss
experience. Where loans are considered homogeneous, the allowance for losses are
established and evaluated on a pool basis. Otherwise, the allowance for losses
is established and evaluated on a loan-specific basis. Provisions made to
increase the allowance are a current period expense to operations. Generally,
the Company considers manufactured housing loans to be impaired when they are 30
days past due. The Company also provides an allowance for currently existing
credit losses within outstanding manufactured housing loans that are current as
to payment but which the Company has determined to be impaired based on default
trends, current market conditions and empirical observable performance data on
the loans. Single-family loans are considered impaired when they are 60 days
past due. The Company's actual credit losses may differ from those estimates
used to establish the allowance.
FINANCIAL CONDITION
- ------------------------------------------------- -------------- ---------------
March 31, December 31,
(amounts in thousands except series outstanding) 2004 2003
- ------------------------------------------------- -------------- ---------------
Securitized finance receivables:
Loans, net $ 744,191 $ 783,881
Debt securities, available-for-sale 240,413 251,554
Other loans 2,544 2,683
Asset-backed security 724 801
Non-recourse securitization financing 974,262 1,018,899
Shareholder's equity 55,754 65,857
Securitization financing bond series outstanding 4 4
- ------------------------------------------------- -------------- ---------------
Securitized finance receivables
As of both March 31, 2004 and December 31, 2003, the Company had 4 series of
collateralized bonds outstanding. The securitized finance receivables decreased
to $984.6 million at March 31, 2004 compared to $1.0 billion at December 31,
2003. This decrease of $50.8 million is the result of $45.4 million in paydowns
on the collateral, $3.6 million of increased provisions for loan losses, a $1.5
million of impairment losses on securities, and a 0.3 million increase in
accrued interest receivable.
Other loans
Other loans decreased to $2.6 million at March 31, 2004 from $2.7 million at
December 31, 2003. Other loans is composed of non-performing loans not included
in the securitization completed in April 2002 which were reclassified to Other
loans from securitized finance receivables. This decrease resulted from paydowns
on the loans of $0.1 million.
Asset-backed security
Asset-backed security decreased to $0.7 million at March 31, 2004, compared to
$0.8 million at December 31, 2003, as a result of principal payments of $0.1
million during the year.
Non-recourse securitization financing
Non-recourse securitized financing decreased to $974.3 million at March 31, 2004
from $1.0 billion at December 31, 2003. This decrease of $44.6 million is the
result of $46.1 million in paydowns offset by $1.5 million of amortization of
premium and discounts during the three months ended March 31, 2004.
Shareholder's equity
Shareholder's equity decreased to $55.8 million at March 31, 2004 from $65.9
million at December 31, 2003. This decrease was the result of a net loss of $0.2
million during the three months ended March 31, 2004 and a dividend payment of
9
$10.2 million to its parent company, IHC offset by a $0.3 million unrealized
gain on investments classified as available-for-sale.
RESULTS OF OPERATIONS
- ----------------------------- --------------------------------------------------
Three Months Ended
March 31,
- ----------------------------- --------------------------------------------------
(amounts in thousands) 2004 2003
- ----------------------------- ----------------------- --------------------------
Interest income $ 16,849 $ 22,454
Interest expense 12,116 13,755
Provision for loan losses 3,625 5,003
Net interest margin 1,108 3,696
Impairment charges (1,497) (1,454)
Net (loss) income (162) 2,318
- ----------------------------- ----------------------- --------------------------
Interest income decreased to $16.8 million for the three months ended March 31,
2004 from $22.5 million for the three months ended March 31, 2003. This decrease
was primarily a result of the continued impact of prepayments on interest
income, as average securitized finance receivables declined from $1.3 billion at
March 31, 2003 to $1.0 billion at March 31, 2004, coupled with the overall
decline in one-month London InterBank Offered Rate ("LIBOR") from 1.30% at March
31, 2003 to 1.09% at March 31, 2004.
Interest and other expense decreased to $12.1 million for the three months ended
March 31, 2004 from $13.8 million for the three months ended March 31, 2003
primarily due to the decrease in one-month LIBOR from 1.30% at March 31, 2003 to
1.09% at March 31, 2004 and the decline in average securitization financing
bonds due to paydowns on the related securitized finance receivables. The
average securitization financing bonds decreased from $1.2 billion in 2003 to
$962 million in 2004.
Provision for loan losses decreased to $3.6 million for the three months ended
March 31, 2004 from $5.0 million for the same period in 2003 due largely to
losses on one securitization now being borne by the subordinated bondholders.
Net interest margin for the three months ended March 31, 2004 was $1.1 million
compared to $3.7 million for the same period in 2003. This decrease for the
three months ended March 31, 2004 was the result of a $1.4 million decrease in
provision for loan losses and a $1.6 million decrease in interest and other
expense, offset by a $5.6 million decrease in interest income, as discussed
above.
Impairment charges increased to $1.5 million for the three months ended March
31, 2004 from $1.4 million for the same period in 2003. This increase resulted
from the under-performance of the Company's manufactured housing loan portfolio
in debt securities.
Credit Exposures
With non-recourse securitization financing structures, the Company retains
credit risk relative to the amount of over-collateralization required in
conjunction with the bond insurance. Losses are generally first applied to the
over-collateralized amount, with any losses in excess of that amount borne by
the holders of the subordinated classes of the non-recourse securitization
financing. Generally, surplus cash that would otherwise be released to the
Company is retained within the securitization structure if losses exceed a
certain threshold. The Company only incurs credit losses to the extent that
losses are incurred in the repossession, foreclosure and sale of the underlying
collateral. Such losses generally equal the excess of the principal amount
outstanding, less any proceeds from mortgage or hazard insurance, over the
liquidation value of the collateral. To compensate the Company for retaining
this loss exposure, the Company generally receives an excess yield on the
collateralized loans relative to the yield on the non-recourse securitization
financing. At March 31, 2004, the Company retained $34.4 million in aggregate
principal amount of over-collateralization compared to $37.9 million at December
31, 2003. For certain other securitizations, since cumulative losses have
depleted the required level of over-collateralization provided as credit
enhancement, surplus cash in the amount of $1.0 million was retained to cover
losses. Other forms of credit enhancement that benefit the Company, based upon
10
the performance of the underlying loans, may provide additional protection
against losses. These additional protections include loss reimbursement
guarantees with a remaining balance of $27.5 million and a remaining deductible
aggregating $0.8 million on $47.0 million of securitized single family mortgage
loans, which are subject to such reimbursement agreements. In addition, $153.6
million of securitized single family mortgage loans are subject to various
mortgage pool insurance policies whereby losses would need to exceed the
remaining stop loss of at least 82% on such policies before the Company would
incur losses.
Recent Accounting Pronouncements
In December 2003, the Accounting Standards Executive Committee (AcSEC) of the
American Institute of Certified Professional Accountants (AICPA) issued
Statement of Position (SOP) No. 03-3, "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer." SOP No. 03-3 is effective for loans acquired
in fiscal years beginning after December 15, 2004, with early adoption
encouraged. A certain transition provision applies for certain aspects of loans
currently within the scope of Practice Bulletin 6, Amortization of Discounts on
Certain Acquired Loans. SOP No. 03-3 addresses accounting for differences
between contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities (loans) acquired in a
transfer if those differences are attributable, at least in part, to credit
quality. It includes loans acquired in business combinations and applies to all
non-governmental entities, including not-for-profit organizations. SOP No. 03-3
does not apply to loans originated by the entity. The Company is reviewing the
implications of SOP No. 03-3 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
In March 2004, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin (SAB) No. 105, "Application of Accounting Principles to Loan
Commitments." SAB No. 105 addresses the application of generally accepted
accounting practices which apply to loan commitments which are accounted for as
a derivative instrument and measured at fair value. The Company is reviewing the
implications of SAB No. 105 but does not believe that its adoption will have a
significant impact on its financial position, results of operations or cash
flows.
Other Matters
At March 31, 2004, the Company had securities of approximately $308.6 million
remaining for issuance under a registration statement filed with the Securities
and Exchange Commission. The Company anticipates issuing additional Bonds in the
future.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument due to fluctuations in
interest and in equity and commodity prices. Market risk is inherent to both
derivative and non-derivative financial instruments, and accordingly, the scope
of the Company's market risk management extends beyond derivatives to include
all market risk sensitive financial instruments. As a financial services
company, net interest margin comprises the primary component of the Company's
earnings and cash flows. The Company is subject to risk resulting from interest
rate fluctuations to the extent that there is a gap between the amount of the
Company's interest-earning assets and the amount of interest-bearing liabilities
that are prepaid, mature or re-price within specified periods. The Company's
strategy has been to mitigate interest rate risk through the creation of a
diversified investment portfolio that generates stable income and cash flow in a
variety of interest rate and prepayment environments.
The Company and IHC monitor the aggregate cash flow, projected net yield and
estimated market value of the securitized finance receivables under various
interest rate and prepayment assumptions. While certain investments may perform
poorly in an increasing or decreasing interest rate environment, other
investments may perform well, and others may not be impacted at all.
The Company focuses on the sensitivity of its investment portfolio cash flow,
and measures such sensitivity to changes in interest rates. Changes in interest
rates are defined as interest rate movements in 100 basis point and 200 basis
point ratable increments, both up and down, over the ensuing twelve months from
the measurement date. The Company estimates its net interest margin cash flow
11
for the next twenty-four months assuming that interest rates over such time
period follow the forward LIBOR curve (based on the 90-day Eurodollar futures
contract) as of March 31, 2004. Once the base case has been estimated, cash
flows are projected for each of the defined interest rate scenarios. Those
scenario results are then compared against the base case to determine the
estimated change to cash flow.
The following table summarizes the Company's net interest margin cash flow and
market value sensitivity analysis as of March 31, 2004. This analysis represents
management's estimate of the percentage change in net interest margin cash flow
and value expressed as a percentage change in shareholders' equity given a
parallel shift in interest rates, as discussed above. The "Base" case represents
the interest rate environment as it existed as of March 31, 2004. As of March
31, 2004, one-month LIBOR was 1.09% and six-month LIBOR was 1.16%. The analysis
is heavily dependent upon the assumptions used in the model. The effect of
changes in future interest rates, the shape of the yield curve or the mix of
assets and liabilities may cause actual results to differ from the modeled
results. In addition, certain financial instruments provide a degree of
"optionality." The most significant option affecting the Company's portfolio is
the borrower's option to prepay the loans. The model applies prepayment rate
assumptions representing management's estimate of prepayment activity on a
projected basis for each collateral pool in the investment portfolio. The model
applies the same prepayment rate assumptions for all five cases indicated below.
Given the current composition and performance of the investment portfolio, and
the limitation to estimating twenty-four months of net interest margin cash
flows, variations in prepayment rate assumptions are not expected to have a
material impact on the net interest margin cash flows. Projected results assume
no additions or subtractions to the Company's portfolio, and no change to the
Company's liability structure. Historically, there have been significant changes
in the Company's non-recourse securitization financing, underlying collateral,
and asset-backed securities held-to-maturity and there are likely to be such
changes in the future.
Projected in Net
Basis Point Interest Margin Cash Projected Change in Value,
Increase (Decrease) in Flow From expressed as a percentage of
Interest Rates Base Case Shareholders'Equity
- ------------------------- ------------------------- ----------------------------
+200 (18.4)% (14.4)%
+100 (11.4)% (7.2)%
Base
-100 13.0% 10.1%
-200 19.1% 18.5%
Approximately $326.8 million of the Company's investment portfolio as of March
31, 2004 is comprised of loans or securities that have coupon rates which adjust
over time (subject to certain periodic and lifetime limitations) in conjunction
with changes in short-term interest rates. Approximately 71% and 14% of the ARM
loans or securities underlying the Company's securitized finance receivables are
indexed to and reset based upon the level of six-month LIBOR and one-year CMT,
respectively. These ARM assets are financed with adjustable-rate non-recourse
securitization financing borrowings.
Generally, during a period of rising short-term interest rates, the Company's
net interest spread earned on its investment portfolio will decrease. The
decrease of the net interest spread results from (i) the lag in resets of the
ARM loans underlying the ARM securities and securitized finance receivables
relative to the rate resets on the associated borrowings and (ii) rate resets on
the ARM loans which are generally limited to 1% every six months or 2% every
twelve months and subject to lifetime caps, while the associated borrowings have
no such limitation. As short-term interest rates stabilize and the ARM loans
reset, the net interest margin may be restored to its former level as the yields
on the ARM loans adjust to market conditions. Conversely, net interest margin
may increase following a fall in short-term interest rates. This increase may be
temporary as the yields on the ARM loans adjust to the new market conditions
after a lag period. In each case, however, the Company expects that the increase
or decrease in the net interest spread due to changes in the short-term interest
rates to be temporary. The net interest spread may also be increased or
decreased by the proceeds or costs of interest rate swap, cap or floor
agreements, to the extent that the Company has entered into such agreements.
12
The remaining portion of the Company's securitized finance receivables as of
March 31, 2004, approximately $695.6 million, is comprised of loans that have
coupon rates that are fixed. The Company has limited its interest rate risk on
such collateral primarily through (i) the issuance of fixed-rate non-recourse
securitization financing which approximated $436.7 million as of March 31, 2004,
and (ii) equity, which was $55.8 million. Overall, the Company's interest rate
risk is primarily related to the rate of change in short-term interest rates,
not the level of short-term interest rates.
Item 4. Controls And Procedures
(a) Evaluation of disclosure controls and procedures.
Disclosure controls and procedures are controls and other
procedures that are designed to ensure that information
required to be disclosed in the Company's reports filed or
submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in
the SEC's rules and forms. Disclosure controls and procedures
include, without limitation, controls and procedures designed
to ensure that information required to be disclosed in the
Company's reports filed under the Exchange Act is accumulated
and communicated to management, including the Company's
management, as appropriate, to allow timely decisions
regarding required disclosures.
As of the end of the period covered by this report, the
Company carried out an evaluation of the effectiveness of the
design and operation of the Company's disclosure controls and
procedures pursuant to Rule 13a-15 under the Exchange Act.
This evaluation was carried out under the supervision and with
the participation of the Company's management. Based upon that
evaluation, the Company's management concluded that the
Company's disclosure controls and procedures are effective.
In conducting its review of disclosure controls, management
concluded that sufficient disclosure controls and procedures
did exist to ensure that information required to be disclosed
in the Company's reports filed or submitted under the Exchange
Act is recorded, processed, summarized and reported within the
time periods specified in the SEC's rules and forms.
(b) Changes in internal controls.
The Company's management is also responsible for establishing
and maintaining adequate internal control over financial
reporting. During the Company's last fiscal quarter, processes
were implemented to monitor overcollateralization on
non-recourse securitization financing to more accurately
predict when losses will begin to be borne by subordinated
bond classes. There were no other changes in the Company's
internal control over financial reporting identified in
connection with the evaluation that occurred during the
Company's last fiscal quarter that materially affected, or are
reasonably likely to materially affect internal control over
financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings:
None.
13
Item 5. Other Information:
None.
Item 6. Exhibits and Reports on Form 8-K:
a) Exhibits
31.1 Certification of Principal Executive Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Financial Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
b) Reports on Form 8-K
None.
14
I
SIGNATURES
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.
MERIT SECURITIES CORPORATION
Dated: May 21, 2004 By: /s/ Stephen J. Benedetti
-------------------------------------
Stephen J. Benedetti
President
Pursuant to the requirements of the Securities and Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Capacity Date
/s/ Stephen J. Benedetti Principal Executive Officer/Director May 21, 2004
- --------------------------------------------
Stephen J. Benedetti
/s/ Kevin J. Sciuk Principal Financial Officer/Controller May 21, 2004
- --------------------------------------------
Kevin J. Sciuk
15
EXHIBIT INDEX
Sequentially
Exhibit Numbered Page
31.1 Certification of Principal Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002. I
31.2 Certification of Principal Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002. II
32.1 Certification of Principal Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 III
32.2 Certification of Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002. IV
16