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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 quarterly period ended June 30, 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 23060-6740
(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 July 31, 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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MERIT SECURITIES CORPORATION
FORM 10-Q
Index
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at June 30, 2004
and December 31, 2003 (unaudited)...........................................................1
Condensed Consolidated Statements of Operations and Comprehensive
(Loss) Income for the three months and six months ended June 30, 2004
and 2003 (unaudited)........................................................................2
Condensed Consolidated Statements of Cash Flows for the six months
ended June 30, 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
EXHIBIT INDEX ...............................................................................................16
i
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MERIT SECURITIES CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(amounts in thousands except share data)
--------------------- ---------------------
June 30, 2004 December 31, 2003
--------------------- ---------------------
ASSETS:
Securitized finance receivables:
Loans $ 702,088 $ 783,881
Debt securities, available-for-sale 227,133 251,554
Other loans 1,425 2,683
Asset-backed security, held-to-maturity 579 801
Due from affiliates, net 56,440 45,837
--------------------- ---------------------
$ 987,665 $ 1,084,756
===================== =====================
LIABILITIES AND SHAREHOLDER'S EQUITY
LIABILITIES:
Non-recourse securitization financing $ 933,508 $ 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) 3,174 (82)
Accumulated deficit (17,701) (2,745)
54,157 65,857
--------------------- ---------------------
$ 987,665 $ 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 Six Months Ended
June 30, June 30,
------------------------------- ------------------------------
2004 2003 2004 2003
------------- ------------- ------------- ------------
Interest income:
Securitized finance receivables $ 15,899 $ 20,518 $ 32,662 $ 42,872
Other loans 34 38 68 76
Asset-backed security, held-to-maturity 40 54 92 115
------------- ------------- ------------- ------------
15,973 20,610 32,822 43,063
------------- ------------- ------------- ------------
Interest and related expense:
Interest expense on non-recourse securitization
financing 11,177 12,997 22,893 26,513
Other non-recourse securitization financing expense 356 616 756 854
------------- ------------- ------------- ------------
11,533 13,613 23,649 27,367
------------- ------------- ------------- ------------
Net interest margin before provision for loan losses 4,440 6,997 9,173 15,696
Provision for loan losses (3,985) (10,030) (7,610) (15,033)
------------- ------------- ------------- ------------
Net interest margin 455 (3,033) 1,563 663
Impairment charges (5,461) - (6,958) (1,454)
Other income 401 23 628 100
------------- ------------- ------------- ------------
Net loss (4,605) (3,010) (4,767) (691)
Change in net unrealized gain during period on:
Investments classified as available-for-sale 3,007 1,847 3,256 2,445
------------- ------------- ------------- ------------
Comprehensive (loss) income $ (1,598) $ (1,163) $ (1,511) $ 1,754
============= ============= ============= ============
See notes to unaudited condensed consolidated financial statements.
2
MERIT SECURITIES CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(amounts in thousands)
--------------------------------------
Six Months Ended
June 30,
--------------------------------------
2004 2003
----------------- -----------------
Operating activities:
Net loss $ (4,767) $ (691)
Adjustments to reconcile net loss to net cash provided by operating
activities:
Impairment charges 6,958 1,454
Provision for loan losses 7,610 15,033
Amortization, net 2,796 2,549
Other 504 997
----------------- -----------------
Net cash provided by operating activities 13,101 19,342
----------------- -----------------
Investing activities:
Principal payments on collateral 93,847 147,400
Net decrease in other loans 1,258 1,559
Payments received on securities 344 725
----------------- -----------------
Net cash provided by investing activities 95,449 149,684
----------------- -----------------
Financing activities:
Proceeds from issuance of non-recourse securitization financing 7,008 -
Principal payments on non-recourse securitization financing (94,766) (151,727)
Increase in due from affiliates (10,603) (17,299)
Dividends distribution (10,189) -
----------------- -----------------
Net cash used for financing activities (108,550) (169,026)
----------------- -----------------
Net change in cash - -
Cash, beginning of period - -
----------------- -----------------
Cash, end of period $ - $ -
================= =================
Supplemental disclosure of cash flow information:
Cash paid for interest $ 20,971 $ 24,835
================= =================
See notes to unaudited condensed consolidated financial statements.
3
MERIT SECURITIES CORPORATION
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 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 non-recourse
securitization financing (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 June 30, 2004 and December 31, 2003, the Condensed
Consolidated Statements of Operations and Comprehensive (Loss) Income for the
three months and six months ended June 30, 2004 and 2003, the Condensed
Consolidated Statements of Cash Flows for the three months and six months ended
June 30, 2004 and 2003, and the related notes to condensed consolidated
financial statements are unaudited. Operating results for the six months ended
June 30, 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 Uniform 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 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 June 30, 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
- ---------------------------------- ------------------- -------------------------
June 30, 2004 December 31, 2003
- ---------------------------------- ------------------- -------------------------
Loans, at amortized cost $ 725,658 $ 804,871
Allowance for loan losses (23,570) (20,990)
- ---------------------------------- ------------------- -------------------------
702,088 783,881
Debt securities, at fair value 227,133 251,554
- ---------------------------------- ------------------- -------------------------
$ 929,221 $ 1,035,435
- ---------------------------------- ------------------- -------------------------
The following table summarizes the amortized cost basis, gross unrealized gains
and losses, and estimated fair value of debt securities pledged as securitized
finance receivables as of June 30, 2004 and December 31, 2003:
- --------------------------------------- --------------- ------------------------
June 30, 2004 December 31, 2003
- --------------------------------------- --------------- ------------------------
Debt securities, at amortized cost $ 223,959 $ 251,554
Gross unrealized gain 3,174 -
- --------------------------------------- --------------- ------------------------
Estimated fair value $ 227,133 $ 251,554
- --------------------------------------- --------------- ------------------------
The components of securitized finance receivables at June 30, 2004 and December
31, 2003 are as follows:
- ------------------------------- ------------------------------------------ ------------------------------------------
June 30, 2004 December 31, 2003
- ------------------------------- ------------------------------------------ ------------------------------------------
Loans, net Debt Total Loans, net Debt Total
Securities Securities
- ------------------------------- ------------- ------------- -------------- -------------- ----------- ---------------
Collateral:
Manufactured housing $ 439,705 $ 159,421 $ 599,126 $ 470,319 $ 172,847 $ 643,166
Single family 267,265 62,722 329,987 317,552 76,749 394,301
------------- ------------- -------------- -------------- ----------- ---------------
706,970 222,143 929,113 787,871 249,596 1,037,467
Funds held by trustees 1 - 1 1 - 1
Accrued interest receivable 4,389 1,434 5,823 4,847 1,565 6,412
Unamortized (discounts) and
premiums, net (9,272) 382 (8,890) (8,838) 393 (8,445)
Unrealized gain, net - 3,174 3,174 - - -
- ------------------------------- ------------- ------------- -------------- -------------- ----------- ---------------
$ 702,088 $ 227,133 $ 929,221 $ 783,881 $ 251,554 $ 1,035,435
- ------------------------------- ------------- ------------- -------------- -------------- ----------- ---------------
Non-recourse securitization financing encumbers all of the securitized finance
receivables.
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 six months ended June 30,
2004 and June 30, 2003:
- -------------------------------------- ------------------- ---------------------
June 30, 2004 June 30, 2003
- -------------------------------------- ------------------- ---------------------
Allowance, beginning of the period $ 20,990 $ 20,700
Provision for loan losses 7,610 15,033
Credit losses, net of recoveries (5,030) (9,695)
- -------------------------------------- ------------------- ---------------------
Allowance, end of the period $ 23,570 $ 26,038
- -------------------------------------- ------------------- ---------------------
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 six months ended June 30, 2004, the Company added
$7,610 in provisions for loan losses related to the manufactured housing loan
portfolio.
5
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.
Once the cumulative level of losses have surpassed the cash flow available from
the credit reserve and losses have 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 $23,570 at
June 30, 2004 and $26,038 at June 30, 2003, and are included in securitized
finance receivables in the accompanying condensed consolidated balance sheets.
Over-collateralization at June 30, 2004 and June 30, 2003 totaled $31,441 and
$48,505 respectively.
NOTE 4 - DUE FROM AFFILIATES, NET
Due from affiliates, net, includes amounts loaned by the Company to its parent,
or to affiliates of its parent. Interest is charged on amounts due to or from
affiliates at the Federal Funds rate plus 100 basis points. Interest income was
$312 and $558 for the three and six-months ended June 30, 2004, respectively on
amounts due from affiliates. Interest income was $63 and $67 for the three and
six-months ended June 30, 2003, respectively on amounts due from affiliates.
NOTE 5 - FAIR VALUE
Securities classified as available-for-sale are carried in the accompanying
financial statements at estimated fair value. Securities are both fixed-rate and
adjustable-rate. Estimates of fair value for securities are based on market
prices provided by certain dealers, when available. Estimates of fair value for
certain other securities, including securities pledged as securitized finance
receivables, are determined by calculating the present value of the projected
cash flows of the instruments using market based assumptions such as the forward
yield based on the forward Eurodollar curve and estimated market spreads to
applicable indices for comparable securities, and using collateral based
assumptions such as prepayment rates and credit loss assumptions based on the
most recent performance and anticipated performance of the underlying
collateral.
NOTE 6 - RECENT ACCOUNTING PRONOUNCEMENTS
In March 2004, the Emerging Issues Task Force ("EITF") amended and ratified
previous consensus reached on EITF 03-01, "The Meaning of Other-Than-Temporary
Impairment", to introduce a three-step model to: 1) determine whether an
investment is impaired; 2) evaluate whether the impairment is
other-than-temporary; and 3) account for other-than-temporary impairments. In
part, this amendment requires companies to apply qualitative and quantitative
measures to determine whether a decline in the fair value of a security is
other-than-temporary. The amount of other-than-temporary impairments to be
recognized, if any, will be dependent on market conditions and management's
intentions and ability at the time of evaluation to hold underwater investments
until forecasted recovery in the fair value up to and beyond the adjusted cost.
This amendment is effective for financial periods beginning after June 15, 2004.
The Company has reviewed this statement but does not believe that its adoption
will have a significant impact on its financial position, results of operations
or cash flows.
6
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 Company does not redeem
the bonds. The Company will evaluate the benefit of calling such bonds at the
time they are redeemable. On April 26, 2004, the Company redeemed the
senior-most bond classes with an aggregate principal balance of $154.8 million
in its MERIT Series 12 securitization and reissued the bonds at a $7.0 million
premium to the Company. In addition, MERIT Series 13 reaches its optional
redemption date in August 2004, and the senior-most bond classes in this
securitization financing will have an estimated aggregate balance of
approximately $140.0 million. The Company estimates the value of these
senior-most bond classes to be approximately $4 million in excess of their
purchase price, and is currently attempting to structure a resecuritization of
these bonds where the company would retain a subordinate interest of as much as
$15 million in the new securitization which would have an estimated unleveraged
yield of approximately 15%. The Company's SASCO 2002-9 securitization financing
is projected to reach a call trigger during the first quarter of 2005 with an
aggregate callable balance of approximately $200 million at that time. 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
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.
7
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 all securities in its investment portfolio
for other-than-temporary impairments. A security is generally defined to be
other-than-temporarily impaired if, for a maximum period 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 carrying value is not likely to exceed fair value
in the foreseeable future. A security will be considered other-than-temporarily
impaired sooner than three consecutive quarters if the security is subject to
credit losses, and credit performance of such collateral has deteriorated and is
not anticipated to substantially recover for 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.
The Company considers an investment to be impaired if the fair value of the
investment is less than its recorded cost basis. Impairments of other
investments are considered other-than-temporary when the Company determines that
the collection trends indicate the investment is not recoverable. The impairment
recognized on other investments is the difference between the book value of the
investment and the expected collections less collection costs.
Fair Value. Securities classified as available-for-sale are carried in the
accompanying financial statements at estimated fair value. Securities are both
fixed-rate and adjustable-rate. Estimates of fair value for securities are based
on market prices provided by certain dealers, when available. Estimates of fair
value for certain other securities, including securities pledged as securitized
finance receivables, are determined by calculating the present value of the
projected cash flows of the instruments using market based assumptions such as
the forward yield based on the forward Eurodollar curve and estimated market
spreads to applicable indices for comparable securities, and using collateral
based assumptions such as prepayment rates and credit loss assumptions based on
the most recent performance and anticipated performance of the underlying
collateral.
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
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
thirty (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 sixty (60) days past due. The Company's actual credit losses may differ
from those estimates used to establish the allowance.
8
FINANCIAL CONDITION
- -------------------------------------------------- ------------ ----------------
June 30, December 31,
(amounts in thousands except series outstanding) 2004 2003
- -------------------------------------------------- ------------ ----------------
Securitized finance receivables:
Loans, net $ 702,088 $ 783,881
Debt securities, available-for-sale 227,133 251,554
Other loans 1,425 2,683
Asset-backed security 579 801
Non-recourse securitization financing 933,508 1,018,899
Shareholder's equity 54,157 65,857
Securitization financing bond series outstanding 4 4
- -------------------------------------------------- ------------ ----------------
Securitized finance receivables - loans, net
As of both June 30, 2004 and December 31, 2003, the Company had 4 series of
securitization financing bond series outstanding. The loans portion of
securitized finance receivables decreased to $702.1 million at June 30, 2004
compared to $783.9 million at December 31, 2003. This decrease of $81.8 million
is primarily the result of $73.3 million in paydowns on the collateral, $7.6
million of additions to allowance for loan losses, and $0.9 million of net
premium amortizations and decrease in accrued interest receivable.
Securitized finance receivables - debt securities
The debt securities portion of securitized finance receivables decreased to
$227.1 million at June 30, 2004 compared to $251.6 million at December 31, 2003.
This decrease of $24.4 million is primarily the result of $20.5 million in
paydowns on the collateral, $6.9 million of impairment losses, and $0.2 million
of net premium amortizations and decrease in accrued interest receivable offset
by a $3.2 million increase in unrealized gain on debt securities.
Other loans
Other loans decreased to $1.4 million at June 30, 2004 from $2.7 million at
December 31, 2003. Other loans is composed of single family loans not included
in the securitization completed in April 2002 and retained by the Company as
individual loans. This decrease resulted from pay-downs on the loans of $1.3
million.
Asset-backed security
The asset-backed security decreased to $0.6 million at June 30, 2004, compared
to $0.8 million at December 31, 2003, as a result of principal payments of $0.2
million during the year.
Non-recourse securitization financing
Non-recourse securitization financing decreased to $933.5 million at June 30,
2004 from $1.0 billion at December 31, 2003. This decrease of $85.4 million is
the result of $94.8 million in paydowns offset by $7.0 million of additional
premium on the call and re-issuance of non-recourse securitization financing and
$2.4 million of amortization of premium and discounts during the six months
ended June 30, 2004.
Shareholder's equity
Shareholder's equity decreased to $54.2 million at June 30, 2004 from $65.9
million at December 31, 2003. This decrease was the result of a dividend payment
of $10.2 million to its parent company, IHC and a net loss of $4.7 million
9
offset by a $3.2 million unrealized gain on investments classified as
available-for-sale during the six months ended June 30, 2004.
RESULTS OF OPERATIONS
- -------------------------------------------------------------------------------------------------
(amounts in thousands) Three Months Ended Six Months Ended
June 30, June 30,
--------------------------------- ------------------------------------
2004 2003 2004 2003
- ----------------------------------------------------------- ------------------------------------
Interest income $ 15,973 $ 20,610 $ 32,822 $ 43,063
Interest expense 11,533 13,613 23,649 27,367
Provision for loan losses (3,985) (10,030) (7,610) (15,033)
Net interest margin 455 (3,033) 1,563 663
Impairment charges (5,461) - (6,958) (1,454)
Net loss (4,605) (3,010) (4,767) (691)
- -------------------------------------------------------------------------------------------------
Interest income decreased to $16.0 million from $20.6 million for the three
months ended June 30, 2004 and 2003, respectively. Interest income decreased to
$32.8 million for the six months ended June 30, 2004 from $43.1 million for the
same period in 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 to $1.0 billion for the six-months ended
June 30, 2003 and 2004 respectively and $1.2 billion to $1.0 billion for the
three-months ending June 30, 2003 and 2004, respectively, offset by an increase
in one-month London InterBank Offered Rate ("LIBOR") during the three and six
months ended June 30, 2004 and 2003. The one-month LIBOR rate at June 30, 2004
was 1.37% as compared to 1.12% at June 30, 2003.
Interest expense decreased to $11.5 million from $13.6 million for the three
months ended June 30, 2004 and 2003, respectively. Interest expense decreased to
$23.6 million for the six months ended June 30, 2004 from $27.4 million for the
six months ended June 30, 2003. This decrease resulted from a decline in average
non-recourse securitization financing due to prepayments and paydowns on the
related securitized finance receivables and normal scheduled bond paydowns,
offset by an increase in one-month LIBOR during the three and six months ended
June 30, 2004 and 2003. The average securitization financing bonds declined from
$1.2 billion to $937.5 million for the six months ended June 30, 2003 and 2004
respectively and from $1.1 billion to $914.8 million for the three months ending
June 30, 2003 and 2004 respectively. The one-month LIBOR rate at June 30, 2004
was 1.37% as compared to 1.12% at June 30, 2003.
Provision for loan losses decreased to $4.0 million from $10.0 million for the
three months ended June 30, 2004 and 2003, respectively. Provision for loan
losses decreased to $7.6 million for the six months ended June 30, 2004 from
$15.0 million for the same period in 2003. Provision for loan losses has
declined due largely to losses on one securitization being borne by the
subordinated bondholders. Within each non-recourse securitization financing
series, a group of loans are held within the securitization structure as
additional support for potential credit losses and to provide additional cash
flow to cover such credit losses. Once the cumulative level of losses surpassed
the cash flow available from the credit reserve and losses have depleted the
over-collateralization, future losses are passed to the holders of the lowest
classes of bonds within the structure. On one of the Company's securitizations,
total cumulative losses have surpassed the level of the cash flow available from
the credit reserve and have completely depleted the over-collateralization. As
the over-collateralization has been depleted, the Company's provision for loan
losses correspondingly declined.
Net interest margin increased to $0.5 million from a negative $3.0 million for
the three months ended June 30, 2004 and 2003, respectively. This increase was a
result of a decrease of $1.9 million in interest expense and a decrease of $6.0
million in provision for loan losses offset by a decrease of $4.4 million in
interest income, as discussed above. Net interest margin increased to $1.6
million from $0.7 million for the six months ended June 30, 2004 and 2003,
respectively. This increase was a result of a decrease of $7.4 million in
provision for loan losses, as discussed above, and a $3.3 million decrease in
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interest expense offset by a $9.9 million decrease in interest income during the
respective periods.
Impairment charges increased by $5.5 million for the three months ended June 30,
2004 from the same period last year on debt securities pledged as securitized
finance receivables and comprised largely of manufactured housing loans.
Impairment charges increased to $6.9 million from $1.4 million for the six
months ended June 30, 2004 and 2003, respectively. This increase was primarily a
result of losses on debt securities pledged as securitized finance receivables
and comprised largely of manufactured housing loans. Impairment of these debt
securities is determined as the difference between the fair value of the
security, as measured by discounting the cash flows of the security certificates
utilizing prepayment and loan loss rate assumptions, at discount rates that a
market participant would use, and the book value of those securities. The fair
value of these debt securities has declined during the second quarter 2004 as
the result of an increase in losses during the quarter which is not anticipated
to improve for the foreseeable future. The Company believes that market
participants will use the higher loss rate assumptions in evaluating the fair
value of these 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 June 30, 2004, the Company retained $31.4 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 $1.5 million was retained to cover
losses. Other forms of credit enhancement that benefit the Company, based upon
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 $0.2 million on $41.0 million of securitized single family mortgage
loans, which are subject to such reimbursement agreements. In addition, $138.6
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 62% on such policies before the Company would
incur losses.
Recent Accounting Pronouncements
In March 2004, the Emerging Issues Task Force ("EITF") amended and ratified
previous consensus reached on EITF 03-01, "The Meaning of Other-Than-Temporary
Impairment", to introduce a three-step model to: 1) determine whether an
investment is impaired; 2) evaluate whether the impairment is
other-than-temporary; and 3) account for other-than-temporary impairments. In
part, this amendment requires companies to apply qualitative and quantitative
measures to determine whether a decline in the fair value of a security is
other-than-temporary. The amount of other-than-temporary impairments to be
recognized, if any, will be dependent on market conditions and management's
intentions and ability at the time of evaluation to hold underwater investments
until forecasted recovery in the fair value up to and beyond the adjusted cost.
This amendment is effective for financial periods beginning after June 15, 2004.
The Company has reviewed this statement but does not believe that its adoption
will have a significant impact on its financial position, results of operations
or cash flows.
11
Other Matters
At June 30, 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
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 June 30, 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 June 30, 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 June 30, 2004. As of June 30,
2004, one-month LIBOR was 1.37% and six-month LIBOR was 1.94%. 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.
12
Projected in Net Projected Change in Value,
Basis Point Interest Margin Cash expressed as a percentage
Increase (Decrease) in Flow From of Shareholders'
Interest Rates Base Case Equity
- ------------------------ ---------------------- --------------------------------
+200 (18.6)% (9.8)%
+100 (5.2)% (4.7)%
Base
-100 11.9% 5.0%
-200 25.8% 9.7%
Approximately $298.5 million of the Company's investment portfolio as of June
30, 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 to item (i), the Company has substantially limited its
interest rate risk on such investments through (a) the issuance of fixed-rate
non-recourse securitization financing which approximated $439.7 million as of
June 30, 2004, and (b) equity, which was $54.2 million. 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. The remaining portion of the Company's securitized finance
receivables as of June 30, 2004, approximately $670.4 million, is comprised of
loans that have coupon rates that are fixed.
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, including the
Company's Principal Executive Officer and Principal Financial
Officer. Based upon that evaluation, the Company's management
concluded that the Company's disclosure controls and
procedures are effective.
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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. There were no changes in the Company's internal
controls or in other factors that could materially affect, or
are reasonably likely to materially affect the Company's
internal controls subsequent to the Evaluation Date, nor any
significant deficiencies or material weaknesses in such
internal controls requiring corrective actions.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings:
None.
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 and Principal Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
None.
14
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: August 20, 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 August 20, 2004
- --------------------------------------------
Stephen J. Benedetti
/s/ Kevin J. Sciuk Principal Financial Officer/Controller August 20, 2004
- --------------------------------------------
Kevin J. Sciuk
15
EXHIBIT INDEX
Exhibit
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 and Principal
Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
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