- ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 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, 1998 OR [_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER: 0-23569 HEADLANDS MORTGAGE COMPANY (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) ---------------- CALIFORNIA 94-2851992 (I.R.S. EMPLOYER (STATE OR OTHER JURISDICTION IDENTIFICATION NO.) OF INCORPORATION OR ORGANIZATION) 1100 LARKSPUR LANDING CIRCLE, SUITE 101 LARKSPUR, CALIFORNIA 94939 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (415) 461-6790 (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 90 days. Yes [X] No [_] The number of shares of the Registrant's Common Stock outstanding on May 10, 1998 was 19,700,000. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- HEADLANDS MORTGAGE COMPANY FORM 10-Q TABLE OF CONTENTS PAGE ---- PART I -- FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS Consolidated Balance Sheets as of June 30, 1998 and December 31, 1997....................................................... 3 Consolidated Statements of Operations for the six and three months ended June 30, 1998 and 1997........................... 4 Consolidated Statements of Stockholders' Equity................ 5 Consolidated Statements of Cash Flows for the six months ended June 30, 1998 and 1997........................................ 6 Notes to Consolidated Financial Statements..................... 7 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.......................................... 11 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..... 17 PART II -- OTHER INFORMATION Item 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 17 Signatures.............................................................. 18 FORWARD-LOOKING STATEMENTS When used in this Form 10-Q or future filings by the Company with the Securities and Exchange Commission, in the Company's press releases or other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases "would be", "will allow", "intends to", "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project", or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including regional and national economic conditions, substantial changes in levels of market interest rates, credit and other risks of lending and investment activities and competitive and regulatory factors, could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from those anticipated or projected. For a discussion of such factors that could cause actual results to differ from those contained in forward-looking statements, see "Risk Factors" in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements. 2 PART I ITEM 1. FINANCIAL STATEMENTS HEADLANDS MORTGAGE COMPANY CONSOLIDATED BALANCE SHEETS JUNE 30, DECEMBER 31, 1998 1997 -------------- ------------ ASSETS Cash and cash equivalents.......................... $ 7,362,636 $ 4,322,701 Retained interests in securitizations.............. 40,742,193 32,552,277 Accounts receivable................................ 15,232,474 13,166,574 Accounts receivable from related parties........... 119,434 61,539 Mortgage loans held for sale, pledged.............. 899,536,421 651,080,189 Originated mortgage servicing rights, net.......... 27,930,460 26,127,391 Property, equipment and leasehold improvements, net............................................... 12,639,902 7,715,431 Mortgage loans held for investment, net............ 304,882 824,307 Real estate owned, net............................. 287,405 118,772 Other assets....................................... 2,390,917 1,836,021 -------------- ------------ TOTAL ASSETS................................... $1,006,546,724 $737,805,202 ============== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Notes payable...................................... $ 834,177,708 $641,960,679 Notes payable to stockholders...................... -- 9,670,000 Stockholder distributions payable.................. 13,748,975 -- Accounts payable................................... 35,916,783 12,014,212 Accrued liabilities................................ 9,760,533 7,629,072 -------------- ------------ Total liabilities.............................. 893,603,999 671,273,963 -------------- ------------ Commitments and contingencies Stockholders' equity: Common Stock (no par value; 50,000,000 shares authorized, 19,700,000 shares issued and outstanding).................................... 91,808,446 1,000 Additional paid-in-capital-stock options......... 830,095 118,585 Retained earnings................................ 20,304,184 66,411,654 -------------- ------------ Total stockholders' equity..................... 112,942,725 66,531,239 -------------- ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY..... $1,006,546,724 $737,805,202 ============== ============ See accompanying notes to consolidated financial statements. 3 HEADLANDS MORTGAGE COMPANY CONSOLIDATED STATEMENTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- --------------------------- 1998 1997 1998 1997 ------------- ------------- ------------- ------------ INCOME: Net gain from sales of mortgage loans....... $ 23,446,555 $ 10,040,343 $ 51,583,365 $ 17,931,283 Loan administration income............... 3,462,995 2,273,458 6,513,990 4,660,028 Gain from sale of mortgage servicing rights............... -- 243,904 130,622 9,038,359 Production income..... 4,472,168 2,169,712 8,661,390 3,817,460 Interest income, net of interest expense.. 6,053,643 3,028,952 10,967,327 5,370,245 Net unrealized gain in valuation of retained interests in securitizations...... 248,678 595,040 26,700 595,040 ------------- ------------- ------------- ------------ Total income ....... 37,684,039 18,351,409 77,883,394 41,412,415 EXPENSES: Personnel............. 13,221,961 6,493,834 24,561,506 12,458,045 General and adminis- trative.............. 6,155,063 3,625,577 12,064,443 6,744,354 Occupancy and rents... 912,661 549,603 1,715,701 1,069,752 Depreciation and amortization of property, equipment and leasehold improvements......... 1,283,933 593,301 2,283,888 1,222,227 Amortization and im- pairment of origi- nated mortgage ser- vicing rights........ 3,921,845 1,377,492 7,210,516 1,897,469 ------------- ------------- ------------- ------------ Total expenses...... 25,495,463 12,639,807 47,836,054 23,391,847 ------------- ------------- ------------- ------------ Income before income taxes.............. 12,188,576 5,711,602 30,047,340 18,020,568 Income taxes related to earnings ....... 5,136,787 245,827 14,563,576 675,609 Income taxes related to S corporation conversion......... -- -- 18,487,965 -- ------------- ------------- ------------- ------------ Net income (loss)... $ 7,051,789 $ 5,465,775 $ (3,004,201) $ 17,344,959 ============= ============= ============= ============ PRO FORMA INFORMATION: Income before income taxes and pro forma data................. $ 12,188,576 $ 5,711,602 $ 30,047,340 $ 18,020,568 Provision for pro forma in- come taxes .......... 5,136,787 2,418,160 31,128,333 7,568,639 ------------- ------------- ------------- ------------ Pro forma net income (loss)............. $ 7,051,789 $ 3,293,442 $ (1,080,993) $ 10,451,929 ============= ============= ============= ============ Weighted average ba- sic shares outstanding........ 19,700,000 14,000,000 18,531,967 14,000,000 Pro forma loss per share--Basic ...... $ 0.36 $ 0.24 $ (0.06) $ 0.75 ============= ============= ============= ============ Weighted average di- luted shares outstanding........ 20,078,504 15,145,748 18,531,967 15,145,748 Pro forma loss per share--Diluted .... $ 0.35 $ 0.22 $ (0.06) $ 0.69 ============= ============= ============= ============ See accompanying notes to consolidated financial statements. 4 HEADLANDS MORTGAGE COMPANY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ADDITIONAL PAID-IN- TOTAL SIX MONTHS ENDED JUNE COMMON CAPITAL RETAINED STOCKHOLDERS' 30, 1997 STOCK STOCK OPTIONS EARNINGS EQUITY - --------------------- ----------- ------------- ------------ ------------- Balances at December 31, 1996................... $ 1,000 $ -- $ 29,143,241 $ 29,144,241 Net income.............. -- -- 17,344,959 17,344,959 ----------- -------- ------------ ------------ Balances at June 30, 1997................... $ 1,000 $ -- $ 46,488,200 $ 46,489,200 =========== ======== ============ ============ ADDITIONAL PAID-IN- TOTAL SIX MONTHS ENDED JUNE COMMON CAPITAL RETAINED STOCKHOLDERS' 30, 1998 STOCK STOCK OPTIONS EARNINGS EQUITY - --------------------- ----------- ------------- ------------ ------------- Balances at December 31, 1997................... $ 1,000 $118,585 $ 66,411,654 $ 66,531,239 Net loss as S corpora- tion, including loss related to establish- ment of C corporation deferred tax liabili- ty..................... -- -- (23,308,385) (23,308,385) Accrued distribution to S corporation stockholders........... -- -- (13,748,975) (13,748,975) Constructive recapitalization of S corporation undistributed earnings............... 29,354,294 -- (29,354,294) -- Net proceeds of initial public offering........ 62,453,152 -- -- 62,453,152 Stock option contribu- tion to capital........ -- 711,510 -- 711,510 Net income as C corpora- tion................... -- -- 20,304,184 20,304,184 ----------- -------- ------------ ------------ Balances at June 30, 1998................... $91,808,446 $830,095 $ 20,304,184 $112,942,725 =========== ======== ============ ============ See accompanying notes to consolidated financial statements. 5 HEADLANDS MORTGAGE COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, ---------------------------- 1998 1997 ------------- ------------- Cash flows from operating activities: Net (loss) income............................... $ (3,004,201) $ 17,344,959 Adjustments to reconcile net (loss) income to net cash used in operating activities: Depreciation and amortization of property, equipment and leasehold improvements......... 2,283,888 1,222,227 Amortization and impairment of originated mortgage servicing rights.................... 7,210,516 1,897,469 Compensation from stock options............... 711,510 -- Gain from sale of mortgage servicing rights... (130,622) (9,038,359) Net gain from sales of mortgage loans......... (51,583,365) (17,931,283) Net purchase of retained interests in securitizations.............................. (8,189,916) (743,601) Increase in accounts receivable............... (2,123,795) (3,210,711) Increase in mortgage loans held for sale, pledged...................................... (196,872,867) (119,789,735) Net (increase) decrease in originated mortgage servicing rights............................. (8,882,963) 5,220,565 Increase in other assets...................... (554,896) (241,921) Increase in accounts payable and accrued lia- bilities..................................... 26,034,032 2,962,002 ------------- ------------- Net cash used in operating activities....... (235,102,679) (122,308,388) Net cash used in investing activities: Purchase of property, equipment and leasehold improvements.................................. (7,208,359) (4,759,960) Net proceeds from mortgage loans held for in- vestment...................................... 519,425 (136,594) Net purchase of real estate owned.............. (168,633) 121,079 ------------- ------------- Net cash used in investing activities....... (6,857,567) (4,775,475) Net cash provided by financing activities: Net draws on notes payable..................... 192,217,029 125,706,738 Repayment of notes payable to stockholders..... (9,670,000) -- Proceeds from sale of common stock............. 62,453,152 -- ------------- ------------- Net cash provided by financing activities... 245,000,181 125,706,738 ------------- ------------- Net increase (decrease) in cash.................. 3,039,935 (1,377,125) Cash and cash equivalents beginning of period.... 4,322,701 2,701,333 ------------- ------------- Cash and cash equivalents end of period.......... $ 7,362,636 $ 1,324,208 ============= ============= Supplemental disclosures of cash flow informa- tion: Cash paid for interest......................... $ 22,568,506 $ 13,834,923 Cash paid for income taxes..................... 10,046,216 578,790 See accompanying notes to consolidated financial statements. 6 HEADLANDS MORTGAGE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1.ORGANIZATION Headlands Mortgage Company (the "Company") is a publicly held California corporation which was organized in 1981, and completed an initial public offering of common stock on February 4, 1998. The Company is a specialty mortgage banking company in the business of originating, selling, securitizing and servicing residential mortgage loans secured by one-to four-unit family residences, and purchasing and selling mortgage servicing rights. The Company is headquartered in Northern California, and has production branches in California, Washington, Oregon, Nevada, Florida, New Jersey, Virginia, Idaho, and Arizona. Loans are originated primarily through the Company's wholesale division, through a network of independent mortgage loan brokers approved by the Company, and also through its correspondent lending and retail lending divisions. The mortgage loans are acquired by the Company in one of the three following manners: (i) originated by an independent broker and purchased by the Company, (ii) originated by a broker and funded by the Company, or (iii) originated and funded by the Company in the ordinary course of business. The market for the Company's mortgage banking operations is predominantly California and the western United States. The consolidated financial statements include Headlands Mortgage Company ("HMC"), and its wholly-owned subsidiary Headlands Mortgage Securities Inc. ("HMSI"). The activity of the subsidiary is related to the Company's securitizations. All material intercompany balances and transactions have been eliminated. The Company diversified its residential mortgage loan sales activities in 1996 to include the securitization of such loans into Real Estate Mortgage Investment Conduits ("REMICs") and Asset-Backed Securities ("ABS"). The REMICs, which consist of pooled fixed-rate first-lien mortgages, were issued by the Company to the public through the registration statement of the related underwriter during 1996, and through the registration statement of HMSI during 1997 and 1998. The ABS, which consist of revolving home equity loans and closed-end second mortgages, were issued by the Company through Headlands Mortgage LLC (HMSI's predecessor) and the registration statement of the related underwriter in 1996, and through the registration statement of HMSI during 1997 and 1998. The Company's executive offices are located in Larkspur, California, and its loan servicing center is located in Santa Rosa, California. The Company's source of servicing is from mortgage loans it has originated and sold. 2.BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in conformity with generally accepted accounting principals and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 1998 are not necessarily indicative of the results that may be expected for the year ended December 31, 1998. The financial information presented herein should be read in conjunction with the consolidated financial statements and footnotes included in the Headlands Mortgage Company Annual Report on Form 10-K for the year ended December 31, 1997. Certain prior period amounts have been reclassified to conform to current period presentation. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods presented. Actual results could differ significantly from those estimates. 7 HEADLANDS MORTGAGE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 3.PRO FORMA INFORMATION (a) Pro Forma Income Taxes On January 31, 1998, the Company converted from an S corporation to a C corporation. As a C corporation, the Company bears the tax obligation relating to the net income earned for federal and state tax purposes. The accompanying consolidated statements of operations for the six months ended June 30, 1998 and 1997 reflect the income tax expense of the Company as if it had been subject to federal and state C corporation income taxes for the periods presented. The pro forma information also takes into consideration the one-time, non-cash charge relating to deferred income taxes on historical earnings resulting from termination of the Company's S corporation status. (b) Pro Forma Earnings Per Share Data The weighted average diluted shares for the six months ended June 30, 1998 did not include shares related to the Company's Stock Option Plan as they were anti-dilutive for the period presented. 4.CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with an original maturity of 90 days or less to be cash equivalents, including restricted cash and cash equivalents in the amount of $3,612,292 and $2,053,613 at June 30, 1998 and December 31, 1997, respectively. 5.RETAINED INTERESTS IN SECURITIZATIONS Retained interests in securitizations consist of assets generated by the Company's loan securitizations. These assets were as follows at: JUNE 30, DECEMBER 31, 1998 1997 ----------- ------------ REMIC subordinate certificates................... $ 5,886,610 $ 6,310,052 ABS Interest-only residual interest.............. 19,311,152 16,264,219 ABS principal interest........................... 15,544,431 9,978,006 ----------- ----------- $40,742,193 $32,552,277 =========== =========== 6.MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale included net deferred fees and costs, and consisted of the following at: JUNE 30, DECEMBER 31, 1998 1997 ------------ ------------ Mortgage loans................................. $845,669,268 $536,520,290 Home equity lines of credit.................... 44,577,187 107,800,278 Deferred costs, net of fees.................... 9,289,966 6,759,621 ------------ ------------ $899,536,421 $651,080,189 ============ ============ 8 HEADLANDS MORTGAGE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Company classifies REMIC and ABS securities as trading securities in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and carries them as current assets at market value. The Company is contractually bound by the Headlands Home Equity Loan (HHEL) ABS Trusts to retain its principal interest and overcollateralization. While the Company can sell these certificates, it would be considered a "Rapid Amortization Event" under the terms of the trust, and would trigger rapid amortization of the trust senior certificates. 7.PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS Property, equipment and leasehold improvements, net, consist of the following at: JUNE 30, DECEMBER 31, 1998 1997 ------------ ------------ Furniture and fixtures........................ $ 2,319,662 $ 1,483,317 Office equipment.............................. 23,834,470 17,940,908 Leasehold improvements........................ 1,373,718 1,063,892 Automobiles................................... 47,911 49,411 ------------ ------------ 27,575,761 20,537,528 Less accumulated depreciation and amortization................................. (14,935,859) (12,822,097) ------------ ------------ $ 12,639,902 $ 7,715,431 ============ ============ 8.MORTGAGE LOANS HELD FOR INVESTMENT During the normal course of business, the Company is required from time to time to repurchase certain loans from investors. Mortgage loans held for investment consisted of residential real estate mortgage loans at June 30, 1998 and December 31, 1997. All properties are located in the state of California. Interest rates on these mortgage loans are at variable and fixed rates which range from 7.88% to 12.00% at June 30, 1998, and from 7.25% to 12.00% at December 31, 1997. The maturities range from 5 months to 24 years at June 30, 1998, and from 11 months to 28 years at December 31, 1997. 9.REAL ESTATE OWNED Real estate owned, net, consists of the following at: JUNE 30, DECEMBER 31, 1998 1997 --------- ------------ Residential real estate at cost................... $ 443,985 $ 165,463 Less valuation allowance: Balance at beginning of year.................... (46,691) (52,255) Additions to allowance.......................... (216,121) (164,016) Deductions related to real estate sold.......... 106,232 169,580 --------- --------- Real estate owned, net............................ $ 287,405 $ 118,772 ========= ========= 9 HEADLANDS MORTGAGE COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 10.NOTES PAYABLE Notes payable consist of the following at: JUNE 30, DECEMBER 31, 1998 1997 ------------ ------------ Warehouse line of credit with banks, expiring on November 4, 1999, $275 million at June 30, 1998, and $215 million at December 31, 1997, bearing variable interest rates, including a rate adjusted for compensating balances............ $238,406,304 $195,688,752 Master repurchase agreement with an investment banker, secured by mortgage loans and expiring May 5, 1999, $250 million at June 30, 1998 and December 31, 1997, bearing variable interest rates ......... 28,887,298 174,542,715 Master repurchase agreement with an investment bank- er, secured by morgage loans, bearing a variable interest rate ..................................... 260,483,476 238,613,472 Master repurchase agreement with an investment banker, secured by mortgage loans and expiring December 11, 1998, bearing a variable interest rate based on the LIBOR................................. 296,417,063 21,312,832 Warehouse line of credit with a major corporation which was terminated on April 1, 1998, $15 million at December 31, 1997, bearing variable interest rates based on the LIBOR........................... -- 1,491,935 Master repurchase agreement with an investment bank- er, secured by marketable securities, bearing a variable interest rate based on the LIBOR.......... 2,711,545 2,949,223 Master repurchase agreement with an investment bank- er, secured by marketable securities, bearing a variable interest rate based on the LIBOR.......... 1,827,700 1,817,000 Master lease agreement with a leasing company, se- cured by fixed assets of the Company, bearing vari- ous interest rates based on the LIBOR.............. 5,444,322 5,544,750 ------------ ------------ $834,177,708 $641,960,679 ============ ============ 11.NOTES PAYABLE TO STOCKHOLDERS The Company issued notes during 1996 to two of its stockholders. The principal amount outstanding under the notes at December 31, 1997 was $9,670,000. On February 5, 1998, the Company commenced trading shares of its stock on the NASDAQ under the symbol HDLD. A portion of the proceeds received from the sale of its stock to the public was used to repay the balance due under the notes. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Headlands Mortgage Company (the "Company") is primarily engaged in the origination, purchase, sale, securitization and servicing of mortgage loans secured by one- to four-unit family residences. The Company's total income represents revenues derived from net gain from sales of mortgage loans, loan administration income, gain from sales of mortgage servicing rights, production income, net interest income and net unrealized gain in valuation of retained interests in securitizations. The net gain from sales of mortgage loans consists of two components: (i) gain on sale of mortgage loans sold through securitizations, which is recognized based on the sum of the selling price of the portion sold and the value of the portion retained less the carrying value of the mortgage loans sold; and (ii) net gain on mortgage loans sold through whole loan transactions, which is recognized based upon the difference between the selling price and the carrying value of the mortgage loans sold. If a whole loan is sold servicing released, the servicing release premium is included in the net gain on the sale of the mortgage loan. Loan administration income includes fees earned as servicer for mortgage loans owned by investors, net of fees paid to the subservicer. The Company recognizes gain on the sale of mortgage servicing rights which are sold separately from the mortgage loans, based upon the difference between the selling price, net of selling expenses, and the carrying value of the mortgage loan servicing rights. Production income includes fees paid to the Company by borrowers for the preparation, documentation and underwriting of mortgage loans. Net interest income consists of the net spread between interest received by the Company on its mortgage loans held for sale and interest paid by the Company under its credit facilities. It also includes interest earned on retained interests in securitizations net of interest expenses for the related investment financing. As of the date of this Report, the Company had 11 wholesale branches and a network of approximately 5,600 mortgage brokers. In addition, the Company initiated its correspondent and retail lending divisions in 1994 to access new mortgage loan origination markets. These strategies were designed to expand and diversify the Company's mortgage loan origination network and decrease the Company's reliance on the California real estate market. The Company has experienced significant growth in the last few years, particularly since April 1, 1995. Management believes that this growth is primarily attributable to (i) its changing mortgage loan product mix, (ii) the Company's geographic expansion, (iii) the Company's further penetration into its established markets, and (iv) the Company's increased access to additional funding sources which has enabled the Company to accumulate larger pools of mortgage loans for sales through securitizations. In connection with its growth, the Company has continued to focus its resources on developing mortgage loan production from borrowers, brokers and correspondents by designing mortgage loan products to meet the evolving needs of these customers. Any future growth will be limited by, among other things, the Company's need for continued funding sources, access to capital markets, sensitivity to economic slowdowns, ability to attract and retain qualified personnel, fluctuations in interest rates and competition from other mortgage lenders and from new market entrants. The Company's primary source of mortgage loan servicing rights is from mortgage loans originated or acquired and sold by the Company. Of the Company's $4.8 billion of mortgage loans serviced at June 30, 1998, $3.8 billion were serviced for others and $1.0 billion were either mortgage loans held for sale or other assets of the Company. Of the mortgage loans serviced for others, approximately $1.7 billion were mortgage loans serviced for Fannie Mae or Freddie Mac, $1.9 billion were mortgage loans included in securities created by the Company, and $0.2 billion were mortgage loans serviced for private investors. Of the total mortgage loans serviced for others at June 30, 1998 and 1997, respectively, 1.5% and 1.1% were 30 days or more delinquent. As of June 30, 1998 and 1997, the Company had not purchased mortgage loan servicing rights. 11 TERMINATION OF S CORPORATION STATUS AND INCOME TAXES On January 31, 1998, the Company's status as an S corporation terminated. In connection with the termination of the Company's S corporation status, the Company will distribute approximately $13.7 million, calculated as of January 31, 1998 to the stockholders of the Company prior to the S corporation termination. As an S corporation, the Company's income, whether or not distributed, was taxed at the stockholder level for federal and state tax purposes. Upon termination of its S corporation status, the Company became fully subject to federal and state income taxes and recorded a deferred tax liability on its consolidated balance sheets. The amount of the deferred tax liability recorded as of the date of termination of the S corporation status depends upon timing differences between tax and book accounting relating principally to recognition of gains on sale of mortgage loans. The deferred tax liability recognized was approximately $18.5 million (included in accounts payable), and was recorded as a current tax expense on January 31, 1998. The provision for pro forma income taxes on the consolidated statements of operations shows results as if the Company had always been fully subject to federal and state taxes at the tax rates effective for the periods presented, as well as the recording of the deferred tax liability relating to the conversion to a C corporation. RESULTS OF OPERATIONS Three and Six Months Ended June 30, 1998 Compared to Three and Six Months Ended June 30, 1997 Summary. The financial results for the three and six months ended June 30, 1998 reflect the Company's ability to successfully originate mortgage loans, and securitize and market them in the capital markets. Refinancing activity accounted for approximately 59% and 50% of the mortgage loans originated by the Company during the three months ended June 30, 1998 and 1997, respectively, compared to 61% and 55% of the mortgage loans originated by the Company during the six months ended June 30, 1998 and 1997, respectively. Net income for the three months ended June 30, 1998 increased $1.6 million, or 29%, to $7.1 million compared to net income of $5.5 million for the same period in the prior year. The percentage increase in net income was less than the percentage increase in revenue due to the Company's change in tax status from an S corporation to a C corporation. Income before income taxes for the three months ended June 30, 1998 increased $6.5 million, or 114%, to $12.2 million compared to income before income taxes of $5.7 million for the same period in the prior year. The percentage increase in income before income taxes was higher than the percentage increase in revenue due to a relatively lower increase in operating expenses during the three months ended June 30, 1998 compared to the three months ended June 30, 1997. Net loss for the six months ended June 30, 1998 decreased $20.3 million, or 117%, to $3.0 million compared to net income of $17.3 million for the same period in the prior year. The decrease in net income from the prior year was primarily due to the one-time non-cash deferred tax liability of $18.5 million recognized by the Company at the C corporation commencement as described in "Termination of S Corporation Status and Income Taxes" above. Additionally, the Company was taxed as a C corporation for five months during the six months ended June 30, 1998, compared to an S corporation tax status for the same period in the prior year. These increased tax expenses of $32.4 million were partially offset by an increase in income before income taxes. Income before income taxes for the six months ended June 30, 1998 increased $12.0 million, or 67%, to $30.0 million compared to income before income taxes of $18.0 million for the same period of the prior year. The percentage increase in income before income taxes was lower than the percentage increase in revenue due to a relatively higher increase in operating expenses during the six months ended June 30, 1998 compared to the six months ended June 30, 1997. Revenue. Revenue for the three months ended June 30, 1998 increased $19.3 million, or 105%, to $37.7 million as compared to $18.4 million for the three months ended June 30, 1997. Revenue for the six months ended June 30, 1998 increased $36.5 million, or 88%, to $77.9 million as compared to $41.4 million for the six months ended June 30, 1997. 12 Net gain from sales of mortgage loans increased $13.4 million, or 134%, to $23.4 million for the three months ended June 30, 1998 compared to $10.0 million for the same period in the previous year. The increase was the result of an increase in mortgage loans sold through securitizations and on a whole loan basis. Mortgage loans either sold or securitized during the three months ended June 30, 1998 increased $1,167.1 million, or 160%, to $1,895.6 million from $728.5 million during the three months ended June 30, 1997, with a weighted average net gain on sale as a percentage of mortgage loans sold or securitized of 1.2% and 1.4%, respectively. The Company sold 72% of its loans with servicing rights released during the three months ended June 30, 1998, compared to 13% for the same period in the prior year. The Company retains 100% of the servicing rights on mortgage loans it sells through securitizations. Net gain from sales of mortgage loans increased $33.7 million, or 188%, to $51.6 million for the six months ended June 30, 1998 compared to $17.9 million for the same period in the previous year. The increase was the result of an increase in mortgage loans sold through securitizations and on a whole loan basis. Mortgage loans either sold or securitized during the six months ended June 30, 1998 increased $2,003.9 million, or 152%, to $3,321.4 million from $1,317.5 million during the six months ended June 30, 1997, with a weighted average net gain on sale as a percentage of mortgage loans sold or securitized of 1.6% and 1.4%, respectively. The Company sold 69% of its loans with servicing rights released during the six months ended June 30, 1998, compared to 17% for the same period in the prior year. The Company retains 100% of the servicing rights on mortgage loans it sells through securitizations. Loan administration income increased $1.2 million, or 52%, to $3.5 million for the three months ended June 30, 1998 from $2.3 million for the three months ended June 30, 1997. The increase was due primarily to a 19% increase in the average monthly balance of mortgage loans serviced for others to $3.8 billion from $3.2 billion in the prior year. Additionally, the weighted average service fee rate increased 0.04%, or 15%, to 0.31% at June 30, 1998 compared to 0.27% at June 30, 1997. Loan administration income increased $1.8 million, or 38%, to $6.5 million for the six months ended June 30, 1998 from $4.7 million for the six months ended June 30, 1997. The increase was due primarily to a 23% increase in the average monthly balance of mortgage loans serviced for others to $3.8 billion from $3.1 billion in the prior year, as well as an increase on the weighted average service fee rate noted in the previous paragraph. The Company sold mortgage servicing rights relating to $0.3 billion and $1.5 billion of mortgage loan principal balances during the six months ended June 30, 1998 and 1997, respectively, resulting in a pre-tax gain of $0.1 million and $9.0 million, respectively. These gains represent a 3 basis point and 60 basis point gain based on the outstanding principal balance of the underlying mortgage loans for the six months ended June 30, 1998 and 1997, respectively. Of the mortgage servicing rights sold during the six months ended June 30, 1998, 100% had capitalized values in accordance with SFAS 125, compared to 48% during the same period in the prior year. The remaining 52% in the prior year were mortgage servicing rights which were originated prior to 1995 and had no capitalized value. Thus, the decrease in gain is due to a lower book value related to the mortgage servicing rights sold during the six months ended June 30, 1997, partially offset by an increase in the weighted average sales price of 34 basis points, or 31%, to 142 basis points for the six months ended June 30, 1998 compared to 108 basis points in the prior year. The increase in weighted average sales price from the prior year is partially due to the type and characteristics of servicing rights sold. In general, the decision to sell, buy or retain mortgage servicing rights is based upon the market for and value of mortgage servicing rights, and the Company's current financial needs and objectives. The Company's ability to sell its mortgage servicing rights under its various mortgage loan servicing agreements with investors is generally subject to the consent of the investors. In addition, under the mortgage loan servicing provisions governing the Company's securitizations, the successor servicer is subject to prior approval of the rating agencies rating the subject securities. Production income increased $2.3 million, or 105%, to $4.5 million for the three months ended June 30, 1998 from $2.2 million for the three months ended June 30, 1997. The increase is due primarily to the growth in mortgage loan originations and purchases, partially offset by a 5% decrease in per loan fees collected during the three months ended June 30, 1998 over the same period in the prior year. During the three months ended June 30, 1998, mortgage 13 loan originations increased $1,227.1 million, or 149%, to $2,052.4 million compared to $825.3 million during the three months ended June 30, 1997. Production income increased $4.9 million, or 129%, to $8.7 million for the six months ended June 30, 1998 from $3.8 million for the six months ended June 30, 1997. The increase is due primarily to the growth in mortgage loan originations and purchases, partially offset by an 8% decrease in per loan fees collected during the six months ended June 30, 1998 over the same period in the prior year. During the six months ended June 30, 1998, mortgage loan originations increased $2,064.4 million, or 136%, to $3,581.8 million compared to $1,517.4 million during the six months ended June 30, 1997. Net interest income increased $3.1 million, or 103%, to $6.1 million during the three months ended June 30, 1998 from $3.0 million during the three months ended June 30, 1997. Net interest income increased $5.6 million, or 104%, to $11.0 million during the six months ended June 30, 1998 from $5.4 million during the six months ended June 30, 1997. The increase in net interest income was due to several factors: (i) a higher average balance of mortgage loans held for sale during the three and six months ended June 30, 1998 compared to the same periods in 1997; (ii) earnings on subordinate certificates retained by the Company relating to securitizations; (iii) the Company's increase in available cash to invest in the warehouse lines of credit thereby increasing the margin between mortgage coupons and borrowing costs; and (iv) repayment of the $9.7 million notes to shareholders during the first quarter of 1998. Net unrealized gain in valuation of retained interests in securitizations decreased $0.4 million, or 67%, to $0.2 million for the three months ended June 30, 1998 from $0.6 million during the three months ended June 30, 1997. Net unrealized gain in valuation of retained interests in securitizations decreased $0.6 million, or 100%, for the six months ended June 30, 1998 compared to the same period in the prior year. Expenses. Operating expenses increased $12.9 million, or 102%, to $25.5 million during the three months ended June 30, 1998 from $12.6 million for the three months ended June 30, 1997. Operating expenses increased $24.4 million, or 104%, to $47.8 million during the six months ended June 30, 1998 from $23.4 million for the six months ended June 30, 1997. The increase in expense was primarily the result of additional personnel required for the greater volume of mortgage loan originations, higher general and administrative expenses related to the increase in mortgage loan originations and an increase in amortization and impairment of originated mortgage servicing rights relating to the increase in the capitalized asset during the three and six months ended June 30, 1998 as compared to the three and six months ended June 30, 1997. Personnel expense increased $6.7 million, or 103%, to $13.2 million during the three months ended June 30, 1998 from $6.5 million for the three months ended June 30, 1997. Personnel expense increased $12.1 million, or 97%, to $24.6 million during the six months ended June 30, 1998 from $12.5 million for the six months ended June 30, 1997. The increase in personnel expense was due primarily to increased staffing in the Company's mortgage loan originations area. As of June 30, 1998, the Company employed 936 people compared to 582 people at June 30, 1997, a 61% increase. Additionally, personnel expense includes volume-based compensation expenses which increased in direct proportion with mortgage loan originations. General and administrative expenses increased $2.6 million, or 72%, to $6.2 million during the three months ended June 30, 1998 from $3.6 million for the three months ended June 30, 1997. General and administrative expenses increased $5.4 million, or 81%, to $12.1 million during the six months ended June 30, 1998 from $6.7 million for the six months ended June 30, 1997. The increase in general and administrative expenses is due primarily to expenses incurred in connection with the increase in loan originations, and includes such items as office supplies, telephone, computers and postage. Amortization and impairment of originated mortgage loan servicing rights increased $2.5 million, or 179%, to $3.9 million for the three months ended June 30, 1998, from $1.4 million for the three months ended June 30, 1997. Amortization and impairment of originated mortgage loan servicing rights increased $5.3 million, or 279%, to $7.2 million for the six months ended June 30, 1998, from $1.9 million for the six months ended June 30, 14 1997. The increase in amortization and impairment of originated mortgage loan servicing rights was due to two factors: (1) an increase in the related asset of 26% from June 30, 1997, and (ii) additional impairment recognized by the Company relating to an increase in prepayment rates. FINANCIAL POSITION June 30, 1998 Compared to December 31, 1997 The balance of mortgage loans held for sale is affected by the timing of securitizations and whole loan sales. Mortgage loans held for sale increased $248.4 million, or 38%, to $899.5 million at June 30, 1998 from $651.1 million at December 31, 1997. The increase in mortgage loans held for sale resulted primarily from mortgage loan originations and purchases of $3,581.8 million and HELOC draws of $10.0 million during the six months ended June 30, 1998, partially offset by sales into securities of $298.6 million and whole loan sales of $3,022.8 million. Notes payable under warehouse lines of credit increased $192.2 million, or 30%, to $834.2 million at June 30, 1998 from $642.0 million at December 31, 1997, reflecting the mortgage loan origination, purchase and sale activity described above. The percentage increase in the borrowings under warehouse lines of credit was less than the percentage increase in the mortgage loans held for sale due to the Company's investment of available cash balances in the mortgage loans held for sale. Retained interests in securitizations increased $8.1 million, or 25%, to $40.7 million at June 30, 1998 from $32.6 million at December 31, 1997. The increase is due to interests retained by the Company in the securitization it effected during the six months ended June 30, 1998 with an estimated market value of $10.8 million and the increase in the Company's subordinate interest in a previously issued security with an estimated market value of $1.5 million, partially offset by a reclassification of security related liabilities of $4.1 million. Accounts payable increased $23.9 million, or 199%, to $35.9 million at June 30, 1998 from $12.0 million at December 31, 1997. The increase resulted primarily from the recognition of the C corporation deferred tax liability of $18.5 million and the additional tax liability relating to the five months the Company was taxed as a C corporation during the six months ended June 30, 1998. Notes payable to shareholders of $9.7 million at December 31, 1997 were repaid in full from proceeds of the initial public offering. Originated mortgage servicing rights increased $1.8 million, or 7%, to $27.9 million at June 30, 1998 from $26.1 million at December 31, 1997. The increase in originated mortgage servicing rights resulted from the sale of mortgage loans with servicing rights retained with a relative fair value of $11.7 million during the six months ended June 30, 1998, partially offset by amortization and impairment recorded of $7.2 million and capitalized servicing sold with a net book value of $2.7 million. Property, equipment and leasehold improvements, net, increased $4.9 million, or 64%, to $12.6 million at June 30, 1998 from $7.7 million at December 31, 1997. As a result of the Company's ongoing commitment to modern technology, this growth reflects the purchase of upgraded office equipment of $6.1 million, additional furniture and fixtures of $0.8 million and leasehold improvements of $0.3 million. These increases were partially offset by depreciation and amortization of $2.3 million. Accrued liabilities increased $2.2 million, or 29%, to $9.8 million at June 30, 1998 from $7.6 million at December 31, 1997. The increase was due to the general increase in operating expenses and the timing of payment of those expenses. Stockholders' equity increased $46.4 million, or 70%, to $112.9 million at June 30, 1998 from $66.5 million at December 31, 1997. This increase is due to net proceeds from the Company's initial public offering of $62.5 million, 15 additional paid in capital relating to stock options granted of $0.7 million, and earnings as a C corporation of $20.3 million, offset by the recognition of a stockholder distribution of $13.8 million, and the loss as an S corporation of $23.3 million (which includes the recognition of the deferred tax liability). LIQUIDITY AND CAPITAL RESOURCES The Company's principal liquidity requirements include the funding or payment of: (i) mortgage loan originations and purchases; (ii) investments and overcollateralization requirements in connection with its securitization program; (iii) fees and expenses incurred in connection with securitizations; (iv) advances of delinquent principal and interest payments and escrow balances required to be made as a mortgage loan servicer; and (v) ongoing administrative and other operating expenses. The Company must be able to sell mortgage loans and obtain adequate credit facilities and other sources of funding in order to continue to originate and purchase mortgage loans. As a result of increased loan originations and purchases, the Company used cash of $235.1 million for operating activities during the six months ended June 30, 1998. The Company used cash of $7.2 million for the purchase of property, equipment and leasehold improvements during the six months ended June 30, 1998. The increase during 1998 represents upgrades to office equipment, the purchase of additional furniture and fixtures, and leasehold improvements. The Company had cash flow from financing activities relating to the proceeds from the sale of Common Stock of $62.5 million and repayment of notes to shareholders of $9.7 million. Additionally, the Company utilizes short-term warehouse facilities and repurchase agreements to fund mortgage loan originations and purchases. Thus, the increase in loan production, combined with the other two financing activities, resulted in cash provided by financing activities of $245.0 million during the six months ended June 30, 1998. The Company increased its mortgage loan warehousing facility during the six months ended June 30, 1998 to $275.0 million from $230.0 million at December 31, 1997. The facility extends through November 4, 1999. At June 30, 1998, the outstanding balance under the Warehouse Facility was $238.4 million. In addition to the Warehouse Facility, the Company makes regular use of certain uncommitted lines of credit, short-term credit facilities and purchase and sale agreements (such as repurchase or "gestation" agreements) provided by major investment banks. Amounts outstanding under these various facilities at June 30, 1998 were $585.8 million. The Company terminated one of its warehouse lines of credit with a major corporation during the six months ended June 30, 1998. The Company decreased its servicing secured line of credit during the six months ended June 30, 1998 to $3.0 million from $15.0 million at December 31, 1997. This line of credit expires on November 4, 1998. At June 30, 1998, the Company had no outstanding balance under this line of credit. The Company has a master lease agreement with a leasing company for borrowing arrangements relating to fixed assets. At June 30, 1998, the Company had $5.4 million outstanding under this agreement. RECENT ACCOUNTING PRONOUNCEMENTS In June, 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which amends the disclosure requirements of Statement No. 52, "Foreign Currency Translations" and of Statement No. 107, "Disclosures about Fair Value of Financial Instruments." SFAS 133 supersedes Statements No. 80 "Accounting for Future Contracts", No. 105 "Disclosure of Information about Financial Instruments with Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk" and No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." Under the provisions of SFAS 133, the Company is required to recognize all derivatives as either assets or liabilities in the statement of financial 16 condition and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gain and losses) depends on the intended use of the derivative and the resulting operation. SFAS 133 is effective for all fiscal quarters of fiscal years beginning June 15, 1999, with early application encouraged, but it is permitted only as of the beginning of any fiscal quarter that begins after the issuance of the statement. SFAS 133 should not be applied retroactively to financial statements of prior periods. The Company does not expect that the adoption of SFAS 133 will have a material impact on its financial condition. ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not required. PART II ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K (a)Exhibits filed with this report are as follows: 27.1Financial data schedule (b)The Company filed the following report on Form 8-K during the quarter ended June 30, 1998: None 17 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. HEADLANDS MORTGAGE COMPANY Date: August 13, 1998 By: /s/ Gilbert J. MacQuarrie ------------------------- Gilbert J. MacQuarrie Executive Vice President and CFO (SIGNING IN THE CAPACITY OF (I) DULY AUTHORIZED OFFICER OF THE REGISTRANT AND (II) PRINCIPAL FINANCIAL OFFICER OF THE REGISTRANT) 18