1
Exhibit 99.2
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES
Page
ENHANCE FINANCIAL SERVICES GROUP INC
Independent Auditors' Report 2
Consolidated Balance Sheets as of December 31, 1999 and 1998 3
Consolidated Statements of Income for the Years Ended
December 31, 1999, 1998 and 1997 4
Consolidated Statements of Shareholders' Equity for the Years Ended
December 31, 1999, 1998 and 1997 5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1999, 1998 and 1997 6
Notes to Consolidated Financial Statements 7
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES, Combined
Financial Statements for the Years Ended December 31, 1999, 1998 and
1997 Schedule I
All schedules not included are omitted because they are either not applicable or
because the information required therein is included in Notes to Consolidated
Financial Statements.
2
INDEPENDENT AUDITORS' REPORT
To the Board of Directors
Enhance Financial Services Group Inc.
We have audited the accompanying consolidated balance sheets of Enhance
Financial Services Group Inc. and Subsidiaries as of December 31, 1999 and 1998
and the related consolidated statements of income, shareholders' equity and cash
flows for each of the three years in the period ended December 31, 1999. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Enhance Financial Services Group
Inc. and Subsidiaries as of December 31, 1999 and 1998 and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1999 in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
March 27, 2000
New York, New York
3
ENHANCE FINANCIAL SERVICES GROUP INC.
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands except share amounts)
December 31, December 31,
1999 1998
-------- --------
ASSETS
Investments:
Fixed maturities, held to maturity, at amortized cost $ 177,607 $ 196,768
(market value $181,474 and $205,792)
Fixed maturities available for sale, at market 745,963 694,374
(amortized cost $778,751 and $657,644)
Other invested assets 10,935 --
Common stock - at market (cost $498) 839 839
Short-term investments 34,657 50,794
-------- --------
Total Investments 970,001 942,775
Investment in affiliates 108,001 96,867
Cash and cash equivalents 2,558 5,542
Federal income taxes recoverable 7,859 9,717
Premiums and other receivables 22,959 35,950
Accrued interest and dividends receivable 18,977 15,241
Deferred policy acquisition costs 119,213 103,794
Furniture, fixtures and equipment 10,206 4,506
Prepaid reinsurance premiums 8,772 7,000
Reinsurance recoverable on unpaid losses 2,286 2,500
Receivable from affiliates 1,170 16,710
Receivable for securities -- 9,590
Prepaid federal income tax 24,797 29,267
Deferred income taxes-net 68,587 --
Goodwill 24,196 23,200
Other assets 64,350 38,025
-------- --------
Total Assets $1,453,932 $1,340,684
========== ==========
LIABILITIES, DEFERRED CREDIT AND SHAREHOLDERS' EQUITY
Liabilities
Losses and loss adjustment expenses $ 51,970 $ 36,239
Reinsurance payable on paid losses and loss
adjustment expenses 8,997 5,994
Deferred premium revenue 346,088 315,215
Accrued profit commissions 2,554 2,511
Deferred income taxes -- 108,836
Long-term debt 75,000 75,000
Short-term debt 113,941 54,290
Payable for securities -- 11,557
Accrued expenses and other liabilities 41,078 24,843
Payable to affiliates -- 43,553
-------- --------
Total Liabilities $639,628 $678,038
-------- --------
Deferred Credit 138,000 --
--------
Shareholders' Equity
Common stock - $.10 par value
Authorized - 100,000,000 shares
Issued - 40,007,404 and 39,812,937 shares $ 4,001 $ 3,981
Additional paid-in capital 253,109 249,851
Retained earnings 477,715 418,214
Accumulated other comprehensive income (25,935) 23,186
Treasury stock (32,586) (32,586)
-------- --------
Total Shareholders' Equity 676,304 662,646
-------- --------
Total Liabilities, Deferred Credit and
Shareholders' Equity $1,453,932 $1,340,684
========== ==========
See notes to consolidated financial statements
4
ENHANCE FINANCIAL SERVICES GROUP INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands except per share amounts)
Years ended December 31,
-------------------------------------------------
1999 1998 1997
--------------- --------------- ---------------
REVENUES
Net premiums written $132,953 $129,299 $100,506
Increase in deferred premium revenue (29,102) (26,962) (15,051)
--------------- --------------- -----------------
Premiums earned 103,851 102,337 85,455
Net investment income 58,053 53,423 50,618
Net realized (losses)gains on sale of investments (3,039) 2,434 657
Assignment sales 30,723 45,376 29,200
Other income 7,996 3,914 4,463
--------------- --------------- ---------------
Total revenues 197,584 207,484 170,393
--------------- --------------- ---------------
EXPENSES
Losses and loss adjustment expenses 26,156 10,324 9,755
Policy acquisition costs 39,959 35,007 30,020
Profit commissions 1,019 1,073 719
Other operating expenses - insurance 17,802 13,683 12,225
- non-insurance 52,320 39,873 25,141
--------------- --------------- ---------------
Total expenses 137,256 99,960 77,860
--------------- --------------- ---------------
Income from operations 60,328 107,524 92,533
Equity in income of affiliates 19,708 14,066 8,778
Minority interest 429 -- -
Foreign currency loss (32) (283) (38)
Interest expense (10,989) (8,500) (7,317)
--------------- --------------- ---------------
Income before income taxes 69,444 112,807 93,956
Income taxes 820 30,350 25,150
--------------- --------------- ---------------
NET INCOME $68,624 $82,457 $68,806
=============== =============== ===============
Earnings per share - Basic $1.81 $2.20 $1.86
----- ------ -----
- Diluted $1.76 $2.10 $1.78
----- ------ -----
Weighted average shares outstanding - Basic 38,000 37,520 37,069
------- ------- ------
- Diluted 39,024 39,275 38,627
------- ------- ------
See notes to consolidated financial statements
5
ENHANCE FINANCIAL SERVICES GROUP INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999
(In thousands except share amounts)
Common Stock Treasury Stock
------------------------- ------------------------
Additional
Shares Amount Shares Amount Paid-in Capital
----------- ----------- ----------- ----------- ---------------
Balance, December 31, 1996 37,066,650 $ 3,706 928,550 $ (7,758) $ 199,994
Comprehensive income:
Net income for the period -- -- -- -- --
Unearned compensation adjustment
(net of tax of $7) -- -- -- -- --
Unrealized gains during the period
(net of tax of $7,106) -- -- -- -- --
Reclassification adjustment for gains
included in net income (net of tax
of $87) -- -- -- -- --
Total comprehensive income: -- -- -- -- --
Dividends paid ($0.22 per share) -- -- -- -- --
Exercise of stock options 598,992 60 -- -- 7,281
Issuance of common stock 1,006,228 101 -- -- 21,232
Purchase of treasury stock -- -- 355,850 (7,021) --
----------- ----------- ----------- ----------- -----------
Balance, December 31, 1997 38,671,870 3,867 1,284,400 (14,779) 228,507
----------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income for the period -- -- -- -- --
Unearned compensation adjustment
(net of tax of $202) -- -- -- -- --
Unrealized foreign currency translation
adjustment (net of tax of $159) -- -- -- -- --
Unrealized gains during the period
(net of tax of $2,183) -- -- -- -- --
Reclassification adjustment for gains
included in net income (net of
tax of $718) -- -- -- -- --
Total comprehensive income: -- -- -- -- --
Dividends paid ($0.23 per share) -- -- -- -- --
Exercise of stock options 665,674 66 -- -- 9,854
Issuance of common stock 475,393 48 -- -- 11,490
Purchase of treasury stock -- -- 666,394 (17,807) --
----------- ----------- ----------- ----------- -----------
Balance, December 31, 1998 39,812,937 3,981 1,950,794 (32,586) 249,851
----------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income for the period -- -- -- -- --
Unrealized foreign currency translation
adjustment (net of tax of $1,573) -- -- -- -- --
Unrealized losses during the period
(net of tax of $25,582) -- -- -- -- --
Reclassification adjustment for losses
included in net income (net of tax
of $1,075) -- --
Total comprehensive income: -- -- -- -- --
Dividends paid ($0.24 per share) -- -- -- -- --
Exercise of stock options 192,349 19 -- -- 3,233
Issuance of common stock 2,118 1 -- -- 25
----------- ----------- ----------- ----------- -----------
Balance, December 31, 1999 40,007,404 $ 4,001 1,950,794 $ (32,586) $ 253,109
----------- ----------- ----------- ----------- -----------
Accumulated
Other Comprehensive Income
-----------------------------------------
Foreign
Currency Unrealized
Unearned Translation Holding Grant Retained
Compensation Adjustment (Losses) Earnings Total
------------ ----------- ------------ ---------- ---------
Balance, December 31, 1996 $ (20) $ -- $ 8,636 $ 283,791 $ 488,349
Comprehensive income:
Net income for the period -- -- -- 68,806 --
Unearned compensation adjustment
(net of tax of $7) 20 -- -- -- --
Unrealized gains during the period
(net of tax of $7,106) -- -- 10,894 -- --
Reclassification adjustment for gains
included in net income (net of tax
of $87) -- -- (134) -- --
Total comprehensive income: -- -- -- -- 79,586
Dividends paid ($0.22 per share) -- -- -- (8,195) (8,195)
Exercise of stock options -- -- -- -- 7,341
Issuance of common stock -- -- -- -- 21,333
Purchase of treasury stock -- -- -- -- (7,021)
----------- ----------- ----------- ----------- -----------
Balance, December 31, 1997 -- -- 19,396 344,402 581,393
----------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income for the period -- -- -- 82,457 --
Unearned compensation adjustment
(net of tax of $202) (493) -- -- --
Unrealized foreign currency translation
adjustment (net of tax of $159) -- 714 -- -- --
Unrealized gains during the period
(net of tax of $2,183) -- -- 5,318 -- --
Reclassification adjustment for gains
included in net income (net of
tax of $718) -- -- (1,749) -- --
Total comprehensive income: -- -- -- -- 86,247
Dividends paid ($0.23 per share) -- -- -- (8,645) (8,645)
Exercise of stock options -- -- -- -- 9,920
Issuance of common stock -- -- -- -- 11,538
Purchase of treasury stock -- -- -- -- (17,807)
----------- ----------- ----------- ----------- -----------
Balance, December 31, 1998 (493) 714 22,965 418,214 662,646
----------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income for the period -- -- -- 68,624 --
Unrealized foreign currency translation
adjustment (net of tax of $1,573) -- (2,942) -- -- --
Unrealized losses during the period
(net of tax of $25,582) -- -- (48,175) -- --
Reclassification adjustment for losses
included in net income (net of tax
of $1,075) -- 21 1,975 -- --
Total comprehensive income: -- -- -- -- 19,503
Dividends paid ($0.24 per share) -- -- -- (9,123) (9,123)
Exercise of stock options -- -- -- -- 3,252
Issuance of common stock -- -- -- -- 26
----------- ----------- ----------- ----------- -----------
Balance, December 31, 1999 $ (493) $ (2,207) $ (23,235) $ 477,715 $ 676,304
----------- ----------- ----------- ----------- -----------
See notes to consolidated financial statements
6
ENHANCE FINANCIAL SERVICES GROUP INC.
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Years ended December 31,
-----------------------------------------------------------
1999 1998 1997
----------------- ------------------ -------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $68,624 $82,457 $68,806
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization, net (6,272) (7,696) (8,869)
Gain (loss) on sale of investments, net 3,039 (2,434) (657)
Equity in income of affiliates (19,708) (14,066) (8,778)
Compensation, restricted stock award program -- -- 20
Change in assets and liabilities, net of effects
of purchase of Singer:
Premiums receivable 12,991 (5,992) (4,775)
Accrued interest and dividends receivable (3,736) (2,282) (1,525)
Accrued expenses and other liabilities 16,235 8,699 12,072
Deferred policy acquisition costs (15,419) (8,149) (8,320)
Deferred premium revenue, net 29,101 26,961 15,050
Accrued profit commissions 43 (1,257) 718
Losses and loss adjustment expenses, net 18,948 5,267 5,745
Payable to (receivable from) affiliates (28,013) 29,466 (5,671)
Payable (receivable) for securities (1,967) (2,649) 4,903
Other (28,814) (18,932) (15,700)
Income taxes, net (10,440) 6,281 14,789
------- -------- --------
Net cash provided by operating activities 34,612 95,674 67,808
------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (7,287) (2,616) (2,027)
Proceeds from sales and maturities of investments 362,863 309,582 412,892
Purchase of investments (459,900) (364,674) (444,793)
Purchase of other invested assets (9,531) -- --
Sales(purchases) of short-term investments, net 16,137 33 (16,211)
Investment in affiliates -- (32,401) (10,640)
Return of capital from affiliates 6,317 -- --
Cash of previously unconsolidated subsidiary -- -- 147
------- -------- --------
Net cash used in investing activities (91,401) (90,076) (60,632)
------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Capital stock 3,277 9,920 7,341
Short-term debt 59,651 10,790 1,000
Dividends paid (9,123) (8,645) (8,195)
Purchase of treasury stock -- (17,807) (7,021)
------- -------- --------
Net cash provided by (used in) financing activities 53,805 (5,742) (6,875)
------- -------- --------
Net change in cash and cash equivalents (2,984) (144) 301
Cash and cash equivalents, beginning of year 5,542 5,686 5,385
------- -------- --------
Cash and cash equivalents, end of year $2,558 $5,542 $5,686
======= ======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid during the year for income taxes $14,114 $3,000 $10,678
======= ======== ========
Cash paid during the year for interest $8,817 $8,591 $8,136
======= ======== ========
See notes to consolidated financial statements
7
ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
NOTE 1 - ORGANIZATION
Enhance Financial Services Group Inc. ("Enhance Financial," and together with
its consolidated subsidiaries, the "Company") is a holding company which was
incorporated in the State of New York in December 1985 and commenced operations
in November 1986. The Company principally engages, through its indirect
wholly-owned, New York-domiciled insurance subsidiaries Enhance Reinsurance
Company ("Enhance Re") and Asset Guaranty Insurance Company ("Asset Guaranty")
(together, the "Insurance Subsidiaries"), which are owned by a wholly-owned
subsidiary of Enhance Financial, Enhance Investment Corporation ("EIC"), in the
reinsurance of financial guaranties of municipal and asset backed debt
obligations issued by monoline financial guaranty insurers. EIC was dissolved in
March 2000 and its assets, which primarily consist of the capital stock of the
Insurance Subsidiaries, were transferred to Enhance Financial. In addition, the
Company is engaged in other insurance, reinsurance and non-insurance businesses
that utilize the Company's expertise in performing sophisticated analyses of
complex, credit-based risks.
The Company's other insurance businesses involve the issuance of direct
financial guaranties of smaller municipal debt obligations, trade credit
reinsurance, financial responsibility bonds and excess-SIPC/excess-ICS and
related type bonds. These other insurance businesses are conducted by the
Company's Insurance Subsidiaries, Van-American Companies, Inc. and subsidiaries
("Van-Am", See Note 5), and Enhance Reinsurance (Bermuda) Limited ("EnRe
Bermuda"), a Bermuda domiciled insurer.
The Company, through its consolidated subsidiaries, Singer Asset Finance
Company, L.L.C. ("Singer", See Note 5), Enhance Life Benefits LLC ("ELB") and
AGS Financial L.L.C. ("AGS Financial"), and partially-owned subsidiaries,
Credit-Based Asset Servicing and Securitization LLC ("C-BASS", See Note 5) and
Sherman Financial Group LLC ("Sherman" see Note 5), is also engaged in the
origination, purchase, servicing and/or securitization of special assets,
including lottery awards, structured settlement payments, viatical settlements,
sub-performing/non-performing residential mortgages and unsecured delinquent
consumer assets including credit cards receivables.
NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES
The accompanying consolidated financial statements have been prepared in
accordance with generally accepted accounting principles ("GAAP"), which, for
the Insurance Subsidiaries, differ in certain material respects from the
accounting practices prescribed or permitted by regulatory authorities (see Note
3). The preparation of the financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting periods. Actual results could differ from those
estimates. The significant accounting policies of Enhance Financial and its
subsidiaries are as follows:
CONSOLIDATION
The accompanying financial statements include the accounts of Enhance Financial,
Enhance Investment Corporation, the Insurance Subsidiaries, AGS Financial,
Singer, ELB, Van-Am and EnRe Bermuda (collectively the "Company"). Investments
in which the Company owns from 20% to 50% of those companies and where the
Company has a majority voting interest, but where the
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minority shareholders have substantive participating rights, are accounted for
in accordance with the equity method of accounting (See Note 5). All significant
intercompany accounts and transactions, and intercompany profits and losses,
including these transactions with equity method investee companies, have been
eliminated.
INVESTMENTS
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115
"Accounting for Certain Investments in Debt and Equity Securities," management
classifies all securities at the time of purchase as "held to maturity" or
"available for sale." Fixed maturity securities held to maturity are those
securities for which the Company has the intent and has the ability to hold
until maturity and are carried at amortized cost. There were no sales of or
transfers of securities classified as held-to-maturity for the years ended
December 31, 1999, 1998 and 1997. All other fixed maturity securities are
classified as available for sale and carried at fair value. Unrealized gains and
losses, net of taxes, on the available for sale portfolio are charged or
credited to accumulated other comprehensive income.
Common stocks are carried at fair value. Short-term investments are carried at
cost, which approximates market. Unrealized gains and losses, net of taxes, on
common stocks are reflected in accumulated other comprehensive income. Realized
gains or losses on sales of investments are determined on the basis of specific
identification.
Other invested assets consist of residential mortgage-backed securities (See
Note 6), which are classified as trading securities and are carried at fair
value, with changes in fair value recognized in income currently. At December
31, 1999, the carrying value approximates cost.
DERIVATIVES
The Company uses interest rate swaps and forward treasury lock agreements to
hedge interest rate risk associated with unsecuritized assets held and
anticipated acquisitions of assets by Singer. Gains and losses on such
instruments that qualify as accounting hedges are deferred until the underlying
hedged asset is sold, at which time the gain or loss on the related hedge is
recognized in income.
The Company uses forward currency contracts to hedge foreign currency exchange
risk associated with fixed maturity investments denominated in foreign
currencies. Gains and losses on open forward currency exchange contracts, which
qualify as accounting hedges are deferred and recognized as an adjustment of the
carrying amount of the hedged assets. Gains and losses on expired contracts are
recognized currently.
The counterparties to the Company's derivative agreements are substantial and
creditworthy multinational commercial banks or other financial institutions
which are recognized market makers.
PREMIUM REVENUE RECOGNITION
Premiums are earned in proportion to the level amortization of insured principal
over the contract period. Deferred premium revenue represents that portion of
premiums which will be earned over the remainder of the contract period, based
upon information reported by primary insurers and management's estimate of the
amortization of insured principal in those instances where information has not
been reported to the Company. When insured issues are refunded or called, the
remaining deferred premium revenue is generally earned at that time, since the
risk to the Company is considered to have been eliminated.
9
REINSURANCE
In the normal course of business, the Insurance Subsidiaries reinsure portions
of their direct and assumed exposures with other insurance companies through
contracts designed to limit losses from certain risks and to protect capital and
surplus.
The following summarizes the effect of reinsurance on premiums written and
earned (in 000s):
Years Ended December 31,
1999 1998 1997
---- ---- ----
Written Earned Written Earned Written Earned
------- ------ ------- ------ ------- ------
Direct $ 53,999 $ 23,710 $ 30,484 $19,704 $25,477 $13,950
Assumed 85,001 83,228 99,922 84,248 82,675 75,665
Ceded (6,047) (3,087) (1,107) (1,615) (7,646) (4,160)
------- ------- ---------- ------- ------- -------
Net premiums $132,953 $103,851 $129,299 $102,337 $100,506 $85,455
======== ======== ======== ======== ======== =======
The effect of reinsurance on losses and loss adjustments expenses for the years
ended December 31, 1999, 1998 and 1997 was a decrease of $1,369,000, $1,230,000
and $335,000, respectively.
In the event that any or all of the reinsurers were unable to meet their
obligations, the Insurance Subsidiaries would be liable for such defaulted
amounts.
The percentage of assumed premiums written as a part of net premiums written for
the years ended December 31, 1999, 1998 and 1997 was 63.9%, 77.3% and 82.3%
respectively.
ASSIGNMENT SALES
The Company acquires financial assets from individuals, including the rights to
receive lottery awards and structured settlement payments, and securitizes these
payment streams. The Company recognizes revenue from assignment sales in
accordance with the requirements of SFAS 125.
Through the securitization process, the Company transfers control over such
financial assets and recognizes income to the extent that net sale proceeds upon
such transfer of control exceeds amounts paid to individuals, after deducting
commissions and other fees paid to third parties.
DEFERRED POLICY ACQUISITION COSTS
Deferred policy acquisition costs comprise those expenses that vary with and are
primarily related to the production of insurance premiums, including:
commissions paid on reinsurance assumed, salaries and related costs of
underwriting and marketing personnel, rating agency fees, premium taxes and
certain other underwriting expenses, offset by ceding commission income on
premiums ceded to reinsurers. Acquisition costs are deferred and amortized over
the period in which the related premiums are earned. Deferred policy acquisition
costs are reviewed periodically to determine that they do not exceed or be less
than recoverable amounts, after considering investment income.
LOSSES AND LOSS ADJUSTMENT EXPENSES ("LAE")
Reserves for losses and LAE in the financial guaranty business are established
based on the Company's best estimate of specific and non-specific losses,
including expenses associated with settlement of such losses on its insured and
reinsured obligations. The Company's estimation of total reserves considers
known defaults, reports and individual loss estimates reported by primary
10
insurers and annual increases in the total net par amount outstanding of the
Company's insured obligations ($85.6 billion as of December 31, 1999). The
Company records a specific provision for losses and related LAE when reported by
primary insurers or when, in the Company's opinion, an insured risk is in
default or a default is probable and the amount of the loss is reasonably
estimable. In the case of obligations with fixed periodic payments, the
provision for losses and LAE represents the present value of the Company's
ultimate expected losses, adjusted for estimated recoveries under salvage or
subrogation rights. The non-specific reserves represent the Company's best
estimate of total reserves, less provisions for specific reserves. Generally,
when a case basis reserve is established or adjusted, a corresponding adjustment
is made to the non-specific reserve. The Company discounts certain financial
guaranty liabilities at annual rates which correspond to the Insurance
Subsidiaries investment yields ranging from 5.95% to 6.35%. These discounted
liabilities at December 31, 1999 and 1998 were $14.9 million and $17.5 million
respectively, net of discounts of $12.0 million and $11.0 million, respectively.
Reserves for losses and LAE for the Company's other lines of business, primarily
trade credit reinsurance, are based on reports and individual loss estimates
received from ceding companies, net of anticipated estimated recoveries under
salvage and subrogation rights. In addition, a liability is included for losses
and LAE incurred but not reported.
The Company periodically evaluates its estimates for losses and LAE and may
adjust such reserves based on the Company's actual loss experience, mix of
business and economic conditions. Changes in total estimates for losses and LAE
are reflected in current earnings. The Company believes that its total reserves
for losses and LAE are adequate to cover the ultimate cost of all claims net of
reinsurance recoveries. However, the reserves are based on estimates of losses
and LAE, and there can be no assurance that the ultimate liability of the
Company will not exceed such estimates.
FEDERAL INCOME TAXES
In accordance with SFAS No. 109, "Accounting for Income Taxes," deferred federal
income taxes are provided for temporary differences between the tax and
financial reporting basis of assets and liabilities that will result in
deductible or taxable amounts in future years when the reported amount of the
asset or liability is recovered or settled. In the case of the Company, such
temporary differences relate principally to premium revenue recognition and
deferred acquisition costs. See Note 6 for discussion relating to acquired
deferred tax assets.
The Internal Revenue Code permits municipal bond insurance companies to deduct
from taxable income, subject to certain limitations, the amounts added to the
statutory mandatory contingency reserve during the year. The deduction taken is
allowed only to the extent that U.S. Treasury non-interest-bearing tax and loss
bonds are purchased at their par value prior to the original due date of the
Company's consolidated federal tax return and held in an amount equal to the tax
benefit attributable to such deductions. The amounts deducted must be included
in taxable income when the contingency reserve is released, at which time the
Company may redeem the tax and loss bonds to satisfy the additional tax
liability. The purchases of tax and loss bonds are recorded as prepayments of
federal income taxes and are not reflected in the Company's current tax
provision.
POST-RETIREMENT AND POST-EMPLOYMENT BENEFITS
The Company provides various post-retirement and post-employment benefits,
including pension, health and life insurance benefits covering substantially all
employees who meet certain age and service criteria. The Company accounts for
these benefits under the accrual method of
11
accounting. Amounts related to anticipated obligations under the defined benefit
pension plan and post-retirement benefits are recorded based on actuarial
determinations.
STOCK COMPENSATION PLANS
The Company has in effect a stock option program for key employees and a
directors' stock option program for the benefit of directors who are not
employees of the Company. In March 1998, the board of directors adopted the
Director Stock Ownership Plan pursuant to which directors are entitled to elect
to receive all or a portion of their directors fees in the form of Enhance
Financial common stock. Under these programs, awards are granted to eligible
employees and directors of the Company in the form of Incentive Stock Options,
where they qualify under the Internal Revenue Code, or Non-Qualified Stock
Options. The Company follows the intrinsic value based method of accounting for
stock based compensation as prescribed by APB Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB 25"). In accordance with SFAS No. 123,
"Accounting for Stock-Based Compensation", the Company has provided pro forma
disclosures of net income and earnings per share as if the fair value based
method of accounting had been applied (See Note 12).
EARNINGS PER SHARE
In accordance with SFAS No. 128, "Earnings per Share," the Company reports
"basic" and "diluted" earnings per share ("EPS"). Basic EPS is determined by
dividing net income by the weighted average number of common shares outstanding
for the period. Diluted EPS reflects the potential dilution that would occur if
securities such as employee stock options were exercised. Diluted EPS is
computed using the treasury stock method to determine the weighted average
number of common stock equivalents outstanding during each year. For all periods
presented common stock equivalents comprise outstanding options pursuant to the
Company's stock option programs.
Following is a reconciliation of weighted average common shares outstanding to
weighted average common and common equivalent shares outstanding for the years
ended December 31, 1999, 1998 and 1997 (in 000s).
1999 1998 1997
---- ---- ----
Weighted average common shares outstanding 38,000 37,520 37,069
Dilutive effect of common stock options 1,024 1,755 1,558
------ ------ ------
Weighted average common and common equivalent
shares outstanding 39,024 39,275 38,627
====== ====== ======
NEW ACCOUNTING PRONOUNCEMENTS
During 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of
Enterprise and Related Information." This pronouncement requires a company to
present disaggregated information based on the internal segments used in
managing its business. The adoption of this statement did not impact the
Company's financial position or results of operations, but it did affect the
presentation of the Company's segment disclosures (See Note 17).
Effective in 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive
Income." This pronouncement established new rules for the reporting and display
of comprehensive income and its components in a full set of general purpose
financial statements. The adoption of this statement had no impact on the
Company's financial position or results of operations. SFAS No. 130 requires the
Company's unrealized gains and losses and changes in foreign currency
translation adjustment to be included in other comprehensive income.
12
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No.
133, "Accounting for Derivatives Instruments and Hedging Activities," which
becomes effective for the Company January 1, 2001. This pronouncement
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities. The Company will be required to recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. The accounting for a change in fair value of a
derivative in earnings or other comprehensive income will depend on the intended
use of the derivative and the resulting designation. Derivatives can be
designated as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or a firm commitment, (b) a hedge of the exposure
to variable cash flows of a forecast transaction. or (c) a hedge of foreign
currency exposure of a net investment in foreign operations, an unrecognized
firm commitment, an available-for-sale security, or a foreign currency
denominated forecasted transaction. The Company is currently reviewing the
impact of the implementation of SFAS No. 133 on its financial statements.
In March 1998, the National Association of Insurance Commissioners adopted the
Codification of Statutory Accounting Principles (the "Codification"). The
Codification is intended to standardize regulatory accounting and reporting for
the insurance industry and is proposed to be effective January 1, 2001. However,
statutory accounting principles will continue to be established by individual
state laws and permitted practices, and it is uncertain when or if, the State of
New York will require adoption of the Codification for the preparation of
statutory financial statements. The Company has not finalized the quantification
of the effects of Codification on its statutory financial statements.
GOODWILL
Goodwill represents the excess of cost of acquisitions over the tangible net
assets acquired. Goodwill, which is substantially attributable to the
acquisition of Singer, is amortized by the straight-line method over 20 years.
FURNITURE AND FIXTURES AND EQUIPMENT
Furniture, fixtures and equipment are carried at depreciated cost. Depreciation
is provided using the straight-line method over the estimated economic lives of
the assets, which range from 3 to 7 years. Leasehold improvements are amortized
over the lesser of 5 years or the lease term.
CASH AND CASH EQUIVALENTS
For purposes of the statements of cash flows, the Company considers all highly
liquid short-term investments with an original maturity of three months or less
to be cash equivalents.
STOCK SPLIT
All references to number of common shares and per-share information reflect the
two-for-one stock split which was effective on June 26, 1998.
RECLASSIFICATIONS
Certain of the prior years' amounts have been reclassified to conform to the
current year presentation.
NOTE 3 -INSURANCE REGULATORY MATTERS
The consolidated financial statements are prepared on the basis of GAAP which,
for the Insurance Subsidiaries, differ in certain material respects from
accounting practices prescribed or permitted by insurance regulatory
authorities. The significant differences result from statutory accounting
practices which treat premiums earned, policy acquisition costs, deferred income
taxes, investments in fixed maturities and loss reserves differently.
The statutory basis policyholders' surplus of Enhance Re and Asset Guaranty, as
reported to insurance regulatory authorities, was $214.8 million and $90.6
million, respectively at December 31, 1999 and $225.7 million and $98.5 million,
respectively, at December 31, 1998. Statutory net income of Enhance Re and Asset
Guaranty was $38.7 million and $8.4 million, respectively, for the year ended
December 31, 1999. Statutory net income of Enhance Re and
13
Asset Guaranty was $51.7 million and $11.0 million, respectively, for the year
ended December 31, 1998 and $40.7 million and $11.7 million, respectively, for
the year ended December 31, 1997.
The New York Insurance Law requires financial guaranty insurers to maintain a
minimum policyholders' surplus of $65 million. When added to the minimum
policyholders' surplus of $3.4 million separately required for the other lines
of insurance which it is licensed to write, each of the Insurance Subsidiaries
is required to have an aggregate minimum policyholders' surplus of $68.4
million.
Under the New York Insurance Law, the Insurance Subsidiaries may declare or
distribute dividends only out of earned surplus. The maximum amount of dividends
which may be paid by the Insurance Subsidiaries to Enhance Financial without
prior approval of the Superintendent of Insurance is subject to restrictions
relating to statutory surplus and net investment income as defined by statute.
Enhance Re declared and paid a dividend of $22 million and Asset Guaranty
declared and paid a dividend of $4 million for the year ended December 31, 1999.
At December 31, 1999, the Insurance Subsidiaries had an additional $11.0 million
available for dividend distribution.
The New York Insurance Law establishes single-risk limits applicable to all
obligations issued by a single entity and backed by a single revenue source.
Under the limit applicable to municipal bonds, the insured average annual debt
service for a single risk, net of reinsurance and collateral, may not exceed 10%
of the sum of the insurer's policyholders' surplus and contingency reserves. In
addition, insured principal of municipal bonds attributable to any single risk,
net of reinsurance and collateral, is limited to 75% of the insurer's
policyholders' surplus and contingency reserves. Additional single risk limits,
which generally are more restrictive than the municipal bond single risk limit,
are also specified for several other categories of insured obligations.
NOTE 4 - INVESTMENTS
The following is a summary of the Company's investments in fixed maturities at
December 31, 1999 and 1998 (in 000s):
Gross Gross
Amortized Unrealized Unrealized
1999 Cost Gains Losses Fair Value
- ---- ---- ----- ------ ----------
HELD TO MATURITY
Private placements $ 90,711 $ -- $ -- $ 90,711
Municipal obligations 77,231 3,767 -- 80,998
Corporate securities 3,593 102 -- 3,695
U.S. Government obligations 6,072 81 83 6,070
-------- -------- -------- --------
Total held to maturity $177,607 $ 3,950 $ 83 $181,474
======== ======== ======== ========
AVAILABLE FOR SALE
Municipal obligations $564,899 $ 3,259 $ 28,381 $539,777
Mortgage-backed securities 121,327 65 3,878 117,514
Corporate securities 56,213 82 1,490 54,805
Asset-backed securities 21,689 216 2,377 19,528
U.S. Government obligations 14,623 -- 284 14,339
-------- -------- -------- --------
Total available for sale $778,751 $ 3,622 $ 36,410 $745,963
======== ======== ======== ========
14
Gross Gross
Amortized Unrealized Unrealized
1998 Cost Gains Losses Fair Value
- ---- ---- ----- ------ ----------
HELD TO MATURITY
Private placements $ 96,289 $ -- $ -- $ 96,289
Municipal obligations 93,290 8,401 -- 101,691
Corporate securities 4,695 394 -- 5,089
U.S. Government obligations 2,494 229 2,723
-------- -------- -------- --------
Total held to maturity $196,768 $ 9,024 $ -- $205,792
-------- -------- -------- --------
AVAILABLE FOR SALE
Municipal obligations $489,477 $ 31,233 $ 35 $520,675
Mortgage-backed securities 95,956 2,644 3,640 94,960
Corporate securities 46,732 2,349 605 48,476
Foreign securities 22,203 4,497 3 26,697
U.S. Government obligations 3,276 290 -- 3,566
-------- -------- -------- --------
Total available for sale $657,644 $ 41,013 $ 4,283 $694,374
======== ======== ======== ========
The amortized cost and estimated fair value of fixed maturities at December 31,
1999 by contractual maturity are shown below (in 000s). Expected maturities will
differ from contractual maturities because borrowers may have the right to call
or prepay obligations with or without call or prepayment penalties.
Amortized Cost Fair Value
-------------- ----------
Fixed maturities, held to maturity
Due in one year or less $ 10,414 $ 10,500
Due after one year through five years 64,273 65,890
Due after five years through ten years 53,293 54,745
Due after ten years 49,627 50,339
--------- ---------
$ 177,607 $ 181,474
========= =========
Fixed maturities, available for sale
Due in one year or less $ -- $ --
Due after one year through five years 47,102 47,520
Due after five years through ten years 128,283 129,450
Due after ten years 603,366 568,993
------- -------
$ 788,751 $ 745,963
========= =========
Proceeds from sales of available for sale investments in fixed maturities during
1999, 1998 and 1997 were approximately $348 million, $301 million and $407
million, respectively. Gross gains of $5.5 million and gross losses of $3.3
million were realized in 1999. A write-down of book values for fixed income
securities, in the amount of $5.3 million, resulted in a net realized loss on
the sale of investments of $3.0 million in 1999. Gross gains of $5.0 million and
gross losses of $2.6 million were realized on those sales in 1998. Gross gains
of $4.8 million and gross losses of $4.2 million were realized on those sales in
1997.
Sources of the Company's consolidated net investment income are as follows (in
000s):
15
Years Ended December 31,
------------------------
1999 1998 1997
---- ---- ----
Fixed maturities $56,909 $53,312 $50,258
Short-term investments and cash equivalents 1,658 2,148 1,872
Other invested assets 1,405 - -
Other 436 416 572
------ ------ ------
Total investment income 60,408 55,876 52,702
Less investment expenses 2,355 2,453 2,084
------ ------ ------
Net investment income $58,053 $53,423 $50,618
======= ======= =======
The net unrealized appreciation (depreciation) of investments included as a
component of other accumulated comprehensive income at December 31, 1999 and
1998 is as follows (in 000s):
1999 1998
---- ----
Difference between market value and amortized cost of
available for sale portfolio
Fixed maturities $(32,788) $ 36,730
Equity securities 341 341
-------- --------
(32,447) 37,071
Deferred tax asset (liability) 9,212 (14,106)
-------- --------
Net unrealized appreciation of investments $ (23,235) $ 22,965
========= =======
Unrealized appreciation of investments in equity securities at December 31, 1999
and 1998 includes gross unrealized gains of $341,000.
Under agreements with its primaries and in accordance with statutory
requirements, the Insurance Subsidiaries maintain funds (fixed maturities and
cash equivalents) in trust accounts principally for the benefit of reinsured
companies and for the protection of policyholders in states in which the
Insurance Subsidiaries are not licensed. The Company maintains full control over
the management of assets held in trust accounts. The carrying amount of such
restricted balances amounted to approximately $437 million and $312 million at
December 31, 1999 and December 31, 1998, respectively.
See Note 6 for information relating to Other Invested Assets.
NOTE 5 - INVESTMENT IN AFFILIATES
The Company owns 360,000 shares of EIC Corporation Ltd. ("Exporters"), an
insurance holding company which, through its wholly-owned insurance subsidiary
licensed in Bermuda, insures foreign trade receivables. The Company's investment
represented an equity interest of approximately 41% at the date of acquisition
and approximately 36.5% (which represents 54% voting interest) at December 31,
1999. The Company accounts for its investment in Exporters in accordance with
the equity method of accounting as the control of Exporters does not rest with
the Company and since the minority shareholders have substantial participating
rights.
The Company owns a controlling equity interest in the outstanding stock of
Van-Am and accounts for its investment on a consolidated basis. Due to intense
pricing competition in Van-Am's core business and a poor strategic fit with the
Company's other operations, the Company
16
decided in 1998 to exit the financial responsibility bond line of business. The
Company sold a portion of Van Am business in 1999 and will either sell its
remaining interest in Van Am or wind-down Van Am's operations, thereby exiting
this line of business. A wind-down of Van Am's operation may take ten or more
years. An estimated $4.5 and $2.3 million of expenses associated with this
action have been recognized in 1999 and 1998, respectively.
In 1995, the Company acquired all of the outstanding shares of Litton Loan
Servicing, Inc. ("LLSI"), a Houston-based loss mitigation residential mortgage
servicer. The purchase price approximated the fair market value of the acquired
assets and liabilities at the date of acquisition.
In 1996, the Company and MGIC Investment Corporation formed C-BASS, with members
of management thereof. C-BASS evaluates, purchases, services and securitizes
sub-performing, non-performing, and seller financed residential mortgages and
real estate and subordinated residential mortgage-backed securities. At December
31,1999 the Company owned approximately a 48% interest in C-BASS, which is being
accounted for on the equity basis of accounting. Effective January 1, 2000, the
Company owns approximately a 46% interest in C-BASS. In 1998, the Company
contributed substantially all of the assets of in LLSI to C-BASS as part of its
initial capital commitment. At December 31, 1999, the Company had contributed
$55.5 million of capital to C-BASS. The following table sets forth combined
C-BASS financial data as of the date indicated and for the periods then ended
(in millions):
December 31,
------------
1999 1998 1997
---- ---- ----
Mortgage-related assets $773.0 $550.1 $189.6
Other assets 161.5 73.4 40.0
------ ------ ------
Total assets $934.5 $623.5 $229.6
====== ====== ======
Funding arrangements $617.2 $360.8 $121.9
Other liabilities 127.6 107.6 45.0
----- ----- ------
Total liabilities $744.8 $468.4 $166.9
====== ====== ======
For the year ended December 31,
-------------------------------
1999 1998 1997
---- ---- ----
Total revenues $114.1 $69.7 $36.2
Total expenses 73.7 43.7 21.0
------ ----- -----
Net income $ 40.4 $26.0 $15.2
====== ===== =====
In 1995, the Company acquired, for cash, a 50% joint venture interest in Singer,
which originates, securitizes and sells various types of special assets such as
lottery awards, structured settlement payments and similar obligations. In 1997,
the Company acquired the remaining 50% of Singer in a series of all-stock
transactions for an aggregate purchase price valued at $21.3 million. The excess
(approximately $20.4 million) of the Company's aggregate cost over the fair
value of the net assets of Singer represents goodwill.
Enhance Financial and Swiss Re, respectively, owns 45% equity interest in SBF
Participacoes Ltda ("SBF"), a Brazilian insurance holding company, which is the
parent holding company of UBF Garantias & Seguros SA, one of Brazil's largest
credit insurance and surety insurance companies ("UBF"). The remainder of SBF is
owned by UBF's management and private Brazilian investors. The Company
anticipates that the business of UBF will expand in the Latin American insurance
and other credit-related markets and opportunities. The Company's
17
investment in SBF as of December 31, 1999 and December 31, 1998 was
approximately $3.4 and $4.5 million, respectively, and is being accounted for on
the equity methods of accounting.
In November 1998, the Company acquired through merger all of the outstanding
shares of Alegis Group, Inc. ("Alegis"), the parent holding company of a
Houston-based servicer and collector of delinquent consumer assets, the purchase
price was approximately $11.7 million which approximated the fair market value
of Alegis (see Note 8).
In December 1998, the Company and MGIC formed a joint venture, Sherman, with
members of management thereof, to provide analytic and due diligence services to
purchasers of unsecured delinquent consumer assets; purchases, services and
securitizes unsecured delinquent consumer assets. The Company owns a 45.5%
interest in Sherman, which is being accounted for on the equity basis of
accounting. In December 1999 as part of its initial capital commitment, the
Company contributed substantially all the assets of one subsidiary of Alegis and
the capital stock of other subsidiaries to Sherman. At December 31, 1999, the
Company had committed to contribute an aggregate $20.0 million to the capital of
Sherman, approximately $9.1 million of which had been contributed as of December
31, 1999. At December 31, 1999 the Company has guaranteed $10.9 million of
Sherman's credit facility, which has an outstanding balance of $21.8 million.
Total assets of the Company's unconsolidated subsidiaries and affiliates
accounted for by the equity method of accounting at December 31, 1999 and 1998
were $1,275.5 and $707.2 million, respectively. Total liabilities at December
31, 1999 and 1998 were $868.4 and $507.3 million, respectively. Total net income
for the years' ended December 31, 1999 and 1998 was $40.3 and $30.5 million,
respectively.
NOTE 6 - INCOME TAXES
The Company files a consolidated federal income tax return with its includable
subsidiaries. Subject to the provisions of a tax sharing agreement, income tax
allocation is based upon separate return calculations.
On April 8, 1999, the Company completed a $13.7 million purchase of a portfolio
of approximately 500 residential mortgage-backed securities consisting of
residual interests in real estate mortgage investment conduits ("REMICs")
(classified as Investments - Other Invested Assets). Post-closing adjustments
subsequently reduced the net purchase price to $9.4 million. The transaction was
structured by C-BASS, which will also manage and service the portfolio for the
Company. The purchase price was financed by a short-term credit facility with an
initial principal balance of $10.3 million. As of December 31, 1999, the
outstanding balance of that credit facility was $3.9 million. The transaction is
expected to produce pre-tax economic profits over the life of the acquired
portfolio, which is anticipated to be eight to ten years and to provide tax
benefits that are expected to lower the Company's effective tax rate in 1999 and
beyond. The Company currently expects that it will continue to receive tax
benefits from the portfolio at a level comparable to the current year at least
through 2001 and will receive some additional tax benefits over a period of six
to eight years thereafter. However, the amount of pre-tax economic profits and
tax benefits recognized from year to year may vary significantly depending on a
variety of factors relating to the portfolio, some of which are outside the
control of the Company.
18
One of the prior owners of the portfolio has been audited by the Internal
Revenue Service ("IRS"). Upon completion of that audit, the IRS determined that
certain tax strategies adopted by the prior owner with respect to the portfolio
were improper and should be disallowed. The prior owner disputes the IRS's
determination and has filed suit in the United States Tax Court to overturn the
IRS's audit adjustments relating to the portfolio. The IRS has asserted a number
of theories in support of its audit position, one of which conceivably could
result in the loss of a material portion of the tax benefits that the Company
expects to receive from the portfolio. After reviewing the pleadings filed in
the pending litigation, Company counsel has reaffirmed its advice that the
Company should be able to realize the expected tax benefits associated with the
portfolio. Nonetheless, given the uncertainties involved in litigation, there
can be no complete assurance that the pending Tax Court litigation will not have
a material adverse effect on the tax benefits that the Company expects to
realize from the portfolio.
With respect to the acquired tax benefits, at December 31, 1999, the Company has
recorded a $138.0 million deferred tax assets and a related deferred credit. The
deferred tax asset is reduced and the deferred credit is amortized to income (as
a reduction of current tax expense) as the tax benefits are realized
(approximately $14.4 million for the year ended December 31, 1999). In addition,
for the period from the acquisition of the portfolio in April 1999 through
December 31, 1999, the Company has realized $1.4 million of investment income
from the portfolio. The tax benefits result from the fact that, under the
Internal Revenue Code (the "IRC"), the uniform yield to maturity method of
recognizing interest income and expense on debt instruments generally causes a
REMIC to recognize interest income with respect to its assets more rapidly than
it recognizes interest expense with respect to its regular interests. This
mismatching of interest income and expense generally results in the REMIC
producing significant taxable income for the holder of the residual interest in
its early years, followed by a corresponding amount of tax losses (which are
deductible by the holder of the residual interest) in later years. The Company's
tax benefits from the portfolio consists of the tax losses generated by the
REMICs, which offset taxable income of the REMICs which was previously allocated
to a prior owner of the portfolio.
At December 31, 1999, the Company did not record a deferred federal income tax
liability of $14.4 million for tax losses of $41.4 million associated with the
portfolio because the tax law provides a means, through the use of a particular
tax strategy which the Company intends to use, by which income tax benefits
associated with this portfolio will not result in future tax obligations. The
tax strategy involves numerous assumptions and requires that certain steps occur
in a specific order. Although the Company believes that the assumptions are
reasonable and that the Company can cause the required steps to occur in the
proper order, certain of the assumptions and steps are outside the control of
the Company and therefore there is no assurance that all the assumptions will be
satisfied or all of the steps will occur in the proper order. In addition, this
tax strategy is based on current law and there is no assurance that new laws,
regulations or court decisions will not be enacted or occur that render the tax
strategy ineffective. If (i) the Company were to dispose of the portfolio other
than in accordance with its currently anticipated tax strategy, (ii) the Company
were to determine that the Company would be unable or it would be unadvisable to
utilize the tax strategy, (iii) current tax law were to change, or (iv) there
were an unfavorable determination by the IRS regarding the Company's tax
strategy, the Company may be required to record a deferred federal income tax
liability for and/or recapture all or a significant portion of the tax losses
associated with the portfolio that the Company previously recognized ($14.4
million as of December 31, 1999).
The investment in the portfolio ($10.9 million at December 31, 1999) is carried
at estimated market value (which approximates cost) and is classified on the
consolidated balance sheet as Investment - Other Investment Assets.
The components of the Company's consolidated provision for income taxes are as
follows (in 000s):
Year Ended December 31,
-------------------------------------------------
1999 1998 1997
---- ---- ----
Current income taxes $ 14,569 $10,815 $10,311
Deferred income taxes (13,749) 19,535 14,839
-------- ------- -------
Tax provision $ 820 $30,350 $25,150
======== ======= =======
A reconciliation from the tax provision calculated at the federal statutory rate
of 35% to the actual tax is as follows (in 000s):
Year Ended December 31,
-------------------------------------------------
1999 1998 1997
---- ---- ----
Tax provision at statutory rate $ 24,305 $ 39,482 $ 32,884
Tax exempt interest and dividends (10,283) (9,796) (7,878)
Residential mortgage backed securities (14,406) - -
Other, net 1,204 664 144
--------- -------- --------
Actual tax provision $ 820 $ 30,350 $ 25,150
========= ======== ========
The components of the net deferred income tax asset and liability as of December
31, 1999 and 1998 are as follows (in 000s):
19
December 31, 1999 December 31, 1998
----------------- -----------------
Assets Liabilities Assets Liabilities
------ ----------- ------ -----------
Contingency reserves $ - $ 34,242 $ - $ 49,129
Deferred policy acquisition costs - 41,816 - 36,327
Deferred premium revenue - 13,693 - 10,060
Unrealized capital gains - - - 14,106
Unrealized capital losses 9,212 - - -
Assignment sales income - 26,536 - 16,689
Alternative minimum tax
credit carry forward - - 8,545 -
Losses and LAE reserves 7,306 - 4,241 -
Deferred income 652 - 1,455 -
Impairment of investment asset 1,855 - - -
Accrued expenses 4,686 - 2,903 -
Net operating loss 22,689 - 1,781 -
Other - net 2,031 1,557 2,559 4,009
Residential mortgage-backed securities
acquired tax benefits 138,000 - - -
------- -------- ------- --------
$186,431 $117,844 $21,484 $130,320
======= ======== ======= ========
Prepaid federal income taxes includes Tax and Loss Bonds of $24.8 million and
$29.3 million as of December 31, 1999 and 1998, respectively.
At December 31, 1999, the Company has net operating loss carryforwards of $12
million which expire in 2019.
NOTE 7 - LONG-TERM DEBT AND CREDIT FACILITY
The carrying value of the Company's indebtedness is as follows (in 000s):
December 31,
-----------------------------------
1999 1998
---- ----
Debentures, due 2003 $ 75,000 $ 75,000
Short term debt 113,941 54,290
--------- ---------
Total $ 188,941 $ 129,290
========= =========
The debentures were issued at par and bear interest at 6.75% payable in March
and September each year. The debentures are non-callable obligations of Enhance
Financial.
Enhance Financial maintains an unsecured credit facility through a credit
agreement (the "Credit Agreement") with major commercial banks providing for
borrowing by Enhance Financial of up to $100 million due June 27, 2000, (which
was temporarily increased by $25 million from September 29, 1999 through March
31, 2000) to be used for general corporate purposes. Advances under the Credit
Agreement bear interest at variable LIBOR-based rates. The average interest rate
paid on such advances in 1999 was 6.02%. The Credit Agreement prohibits the
Company from incurring additional indebtedness to the extent the resulting total
would exceed 25% of the Company's total capitalization as defined or 50% of sum
of the Insurance Subsidiaries combined statutory surplus and contingency
reserves, and includes certain covenants, none of which significantly restricts
the Company's operating activities or dividend-paying ability. The total
outstanding under the Credit Agreement at December 31, 1999 was $110 million.
In 1995, the Company entered into a reverse interest-rate swap transaction based
on a notional amount of $50 million over the term equal to the remaining term of
Enhance Financial's 6.75% Debentures. On June 1, 1995, the Company terminated
the swap and realized a gain on
20
termination in the amount of $4.6 million. The gain ($1.8 million at December
31, 1999) has been deferred and is being amortized over the original term of the
swap.
See Note 6 for credit facility relating to Other Invested Assets.
NOTE 8 - SHAREHOLDERS' EQUITY AND DIVIDENDS
In December 1996, the board of directors terminated the then existing repurchase
program and authorized the repurchase of up to 1,500,000 shares of its common
stock from that date. Enhance Financial purchased 666,394 and 355,850 shares of
its common stock at an average price of $26.72 and $19.73 per share in 1998 and
1997 respectively. No shares were repurchased in 1999.
In connection with the repurchase program, Enhance Financial entered into a
forward purchase agreement during 1997 regarding 256,394 shares of its common
stock at a forward purchase price of $21.25 per share. The agreement settles
quarterly on a net basis in shares of Enhance Financial stock or in cash at
Enhance Financial's election. To the extent that the market price of Enhance
Financial common stock on a settlement date was higher (lower) than the forward
purchase price, the net differential was received (paid) by Enhance Financial.
During 1998, settlements resulted in Enhance Financial receiving 106,394 shares,
which were recorded as treasury shares. The agreement terminated in June 1998
after Enhance Financial repurchased the full amount under the program.
During 1998, Enhance Financial issued 454,473 shares of common stock in
connection with its acquisition of Alegis Group Inc. (See Note 5).
During 1997, Enhance Financial issued 1,006,228 shares of common stock in
connection with its acquisition of the remaining 50% ownership interest in
Singer (See Note 5).
In 1996, Swiss Reinsurance Company ("Swiss Re") acquired from Enhance Financial
and one of its shareholders, respectively 1,200,000 and 800,000 shares of
Enhance Financial common stock at a purchase price of $12.24 per share. In 1997,
Swiss Re acquired an additional 1,400,000 shares of Enhance Financial common
stock in the open market.
Under the terms of the Credit Agreement, the maximum amount of dividends which
may be paid by Enhance Financial as of December 31, 1999 was $9.6 million. In
connection with the Company's two-for-one stock split in June 1998, an
additional 40,000,000 shares of common stock were authorized.
NOTE 9 - FAIR VALUES OF FINANCIAL INSTRUMENTS
The following estimated fair value amounts have been determined by the Company
using available market information and appropriate valuation methodologies.
However, considerable judgment is necessarily required to interpret market data
to develop the estimates of fair value. Accordingly, the estimates presented
herein are not necessarily indicative of the amount the Company could realize in
a current market exchange. The use of different market assumptions and/or
estimation methodologies may have a material effect on the estimated fair value
amounts.
FIXED MATURITY SECURITIES - The fair values of fixed maturity securities are
based on quoted market prices or dealer quotes. For private placements, fair
value approximates amortized cost.
SHORT-TERM INVESTMENTS - Fair values of short-term investments are assumed to
equal cost.
OTHER INVESTED ASSETS - The fair value of the residential mortgage-backed
securities is based on the present value of the estimated net future cash flows,
including annual distributions of net cash proceeds from the exercise of call
rights using relevant market information.
21
DEFERRED PREMIUM REVENUE - The fair value of the Company's deferred premium
revenue, net of prepaid reinsurance premium, is based on the estimated cost of
entering into a cession of the entire portfolio with third-party reinsurers
under market conditions. This figure was determined by using the statutory basis
unearned premiums adjusted for ceding commission based on current market rates.
LOSS AND LOSS ADJUSTMENT RESERVES - The carrying amount, net of reinsurance
recoverable on unpaid losses, is composed of the present value of the expected
cash flows for specifically identified claims combined with a general estimate
for non-specific reserves. Therefore, the carrying amount is a reasonable
estimate of the fair value of the reserve.
LONG-TERM DEBT - The fair value is estimated based on the quoted market prices
for the same or similar issue or on the current rates offered to the Company for
debt of the same remaining maturities.
SHORT-TERM DEBT -The fair value of short-term debt, which bears interest at
variable rates, is assumed to equal the carrying value of the debt.
DERIVATIVE INSTRUMENTS - The fair values of foreign currency contracts are based
on the estimated termination values as of the balance sheet date. The fair
values of interest rate swaps and forward treasury lock agreements (notional
amounts of $65 million and $15 million, respectively, at December 31,1999) are
determined by the Company using relevant market information and appropriate
valuation methodologies.
The carrying amounts and estimated fair values of these financial instruments
are as follows (in 000s):
DECEMBER 31, 1999 DECEMBER 31, 1998
----------------- -----------------
Carrying Estimated Fair Carrying Estimated Fair
Amount Value Amount Value
------ ----- ------ -----
ASSETS:
Fixed maturity securities $923,570 $927,437 $891,142 $900,166
Common stock 839 839 839 839
Short-term investments 34,657 34,657 50,794 50,794
Other invested assets 10,935 10,935 - -
LIABILITIES:
Deferred premium revenue (net) 337,316 294,667 308,215 267,574
Loss and loss adjustment
expense reserve (net) 49,684 49,684 33,739 33,739
Long-term debt 75,000 74,010 75,000 78,083
Short-term debt 113,941 113,941 54,290 54,290
DERIVATIVE INSTRUMENTS:
Foreign currency contracts - - 256 256
Forward treasury lock
agreements 77 77 (664) (664)
Interest rate swap agreements 536 536 - -
NOTE 10 - INSURANCE IN FORCE
The Company principally insures and reinsures financial guaranties issued to
support public and private borrowing arrangements, including commercial paper,
bond financings, and similar
22
transactions. Financial guaranties are conditional commitments which guaranty
the performance of a customer to a third party.
The Company's potential liability in the event of nonperformance by the issuer
of the insured obligation is represented by its proportionate share of the
aggregate outstanding principal and interest payable ("insurance in force") on
such insured obligation. At December 31, 1999, the Company's aggregate insurance
in force was $85.6 billion. The Company's insured portfolio as of December 31,
1999 was broadly diversified by geographic and bond market sector with no single
credit representing more than 1.3% of the Company's net insurance in force.
The composition of the Company's insurance in force by type of issue and by
state of issue was as follows (in billions):
TYPE OF ISSUE December 31,
------------
1999 1998
---- ----
General obligation and other tax backed $22.9 $21.0
Non-municipal 12.2 15.3
Utilities 16.8 11.2
Health care 8.0 7.1
Airport/Transportation 9.2 7.7
Housing 1.5 1.5
Other municipal 5.3 5.1
Other insurance businesses 9.7 6.8
--- ---
Total $85.6 $75.7
===== =====
STATE OF ISSUE December 31,
------------
1999 1998
---- ----
California $ 9.4 $ 8.9
New York 9.7 8.1
Florida 5.4 4.7
Texas 5.0 4.3
Pennsylvania 4.2 3.7
Illinois 3.5 3.3
Other (each less than 3.5% for 1999 and
3.3% for 1998) 48.4 42.7
---- ----
Total $85.6 $75.7
===== =====
The Company manages its exposure to credit risk through a structured
underwriting process which includes detailed credit analysis, review of
primaries' underwriting guidelines, surveillance policies and procedures, and
the use of reinsurance.
NOTE 11 - EMPLOYEE BENEFITS
The Company maintains non-contributory defined benefit pension plans, including
a non-qualified restoration pension plan effective July 1, 1999, for the benefit
of all eligible employees. Employer contributions are based upon a fixed
percentage of employee salaries determined at the discretion of the Company.
Plan assets consist of domestic equity and high quality fixed income securities.
The actuarially computed net pension cost for 1999, 1998 and 1997, using the
projected unit credit actuarial method of attribution includes the following
components (in 000s):
23
Year Ended December 31,
-----------------------
1999 1998 1997
---- ---- ----
Service cost $1,707 $1,022 $900
Interest cost 726 485 494
Expected return on plan assets (394) (415) (377)
Amortization of transition obligation 1 2 2
Amortization of prior service cost 246 53 53
Recognized net actuarial gain (139) (129) (101)
----- ----- -----
Net periodic benefits cost $2,147 $1,018 $971
====== ====== ====
The following table sets forth the funding status of the plans and the accrued
pension cost recognized in the Company's consolidated balance sheets at December
31, 1999 and 1998 (in 000s):
December 31,
------------
1999 1998
---- ----
CHANGE IN BENEFIT OBLIGATION
Benefit obligation at beginning of year $13,241 $8,131
Service cost 1,707 1,022
Interest cost 726 485
Actuarial gains (2,018) (1,092)
Benefits paid (2,294) (1,463)
------- -------
Benefit obligation at year end 11,362 7,083
------- -------
CHANGE IN PLAN ASSETS
Fair value of plan assets at beginning of year 4,637 4,726
Actual return on plan assets 628 810
Employer contribution - 565
Benefits paid (2,294) (1,463)
------- -------
Fair value of plan assets at end of year 2,971 4,638
----- -------
Funded Status (8,391) (2,445)
Unrecognized transition obligation 11 13
Unrecognized prior service cost 6,820 907
Unrecognized net actuarial gain (4,057) (3,624)
------- -------
Accrued benefit cost $(5,617) $(5,149)
======== ========
Actuarial assumptions utilized to determine the projected benefit obligation and
estimated unrecognized net actuarial gain were as follows:
Year ended December 31,
-----------------------
1999 1998 1997
---- ---- ----
Discount rate 8.0% 7.0% 7.0%
Expected return on plan assets 8.5% 8.5% 8.5%
Rate of compensation increase 6.0% 6.0% 6.0%
In addition to pension benefits, the Company provides certain health care
benefits for retired employees. Substantially all employees of Enhance Financial
and the Insurance Subsidiaries may become eligible for these benefits if they
reach retirement age while working for the Company.
24
The net post-retirement benefit cost for 1999, 1998, and 1997 was $180,000,
$140,000, and $127,000, respectively, and includes service cost, interest cost
and amortization of the transition obligation and prior service cost.
At December 31, 1999 and 1998 the accumulated post-retirement benefit obligation
was $896,000 and $715,000, respectively, and was not funded. At December 31,
1999, the discount rate used in determining the accumulated post-retirement
benefit obligation was 8% and the health care trend was 10.5%, graded down to
5.5% after 12 years; at December 31, 1998, the discount rate used in determining
the accumulated post-retirement benefit obligation was 7% and the health care
trend was 12%, graded to 6% over 7 years. A one-percentage point change in
assumed healthcare cost trend rates would have the following effects (In
thousands):
1-Percentage Point 1-Percentage Point
Increase Decrease
-------- --------
Effect on total of service and interest cost components $ 35 ($ 27)
Effect on post-retirement benefit obligation 140 (113)
In January 1996, the Company implemented a 401(k) retirement savings plan
covering substantially all employees of the Company. Under this plan, the
Company provides a matching contribution of 50% on contributions up to 6% of
base salary made to the plan by eligible employees. The Company's matching
contributions were $275,000, $120,000, and $106,000 in 1999, 1998 and 1997,
respectively.
NOTE 12 - STOCK OPTION PROGRAMS
The Company maintains a stock option program for its key employees.
Substantially all options issued under the program vest in four equal annual
installments commencing one year after the date of grant. The Company also
maintains a directors' option program pursuant to which directors of Enhance
Financial and the Insurance Subsidiaries who are not employees of the Company
are granted non-qualified stock options. Options under this program vest in two
equal annual installments commencing on December 31 next following the date of
grant.
In March 1998, the board of directors adopted the Director Stock Ownership Plan,
which as amended, allows each outside director to elect to receive up to 100% of
his or her director fees in the form of shares of common stock valued at the
closing price of the common stock on the New York Stock Exchange on that date.
Each eligible director is entitled to make a new election annually for that
coming year's fee.
All options are exercisable at the option price, being the fair value of the
stock at the date of grant. The board of directors has authorized a maximum of
11,631,050 shares of common stock to be awarded as options, of which 9,172,435
options for shares (net of expirations and cancellations) had been awarded as of
December 31, 1999. Information regarding activity in the option programs
follows:
25
Number of Weighted Average
1999 Options Shares Option Price Per Share Exercise Price
------------ ------ ---------------------- --------------
Outstanding at beginning of year 6,055,604 $7.25 - $34.281 $17.38
Granted - Employees 1,404,768 $16.438 - $29.375 17.82
- Directors 70,000 $16.25 16.25
Exercised (192,349) $7.25 - $28.21 11.10
Expired or canceled (141,526) $11.938 - $32.25 25.79
---------
Outstanding at year-end 7,196,497 $7.25 - $34.281 17.50
---------
Exercisable at year-end - Employees 3,969,601 $7.25 - $34.281 14.56
---------
- Directors 381,166 $8.563 - $29.75 18.35
Number of Weighted Average
1998 Options Shares Option Price Per Share Exercise Price
------------ ------ ---------------------- --------------
Outstanding at beginning of year 5,635,108 $7.25 - $29.75 $ 14.81
Granted - Employees 1,168,980 $24.937 - $34.281 25.49
- Directors 91,000 $30.00 30.00
Exercised (666,374) $7.25 - $20.75 9.89
Expired or canceled (173,110) $8.00 - $28.813 24.07
---------
Outstanding at year-end 6,055,604 $7.25 - $34.281 17.38
---------
Exercisable at year-end - Employees 3,234,202 $7.25 - $28.844 12.21
- Directors 306,166 $8.563 - $29.75 14.46
Number of Weighted Average
1997 Options Shares Option Price Per Share Exercise Price
------------ ------ ---------------------- --------------
Outstanding at beginning of year 5,106,220 $7.25 - $18.25 $ 10.91
Granted - Employees 1,220,374 $19.44 - $28.844 27.21
- Directors 91,000 $29.75 29.75
Exercised (598,792) $7.25 - $17.00 9.47
Expired or canceled (183,694) $8.00 - $19.44 13.36
---------
Outstanding at year-end 5,635,108 $7.25 - $29.75 14.81
---------
Exercisable at year-end - Employees 3,117,688 $7.25 - $19.44 10.27
- Directors 256,666 $8.563 - $18.25 11.07
Options Outstanding Options Exercisable
------------------- -------------------
Number Weighted Number
Outstanding Average Weighted Exercisable Weighted
Range of at December Remaining Average at December Average
Exercise Prices 31, 1999 Contract Life Exercise Price 31, 1999 Exercise Price
$ 7.25 - $10.99 2,026,390 3.1 $ 9.07 2,026,390 $ 9.07
$11.00 - $19.99 2,677,568 8.1 15.52 1,291,495 14.22
$20.00 - $34.281 2,492,539 8.5 26.47 1,032,882 27.17
--------- ---------
7,196,497 4,350,767
========= =========
The Company applies the provisions of APB Opinion No. 25 "Accounting for Stock
Issued to Employees" in accounting for its stock option program. Accordingly, no
compensation expense has been recognized for options granted under its stock
option program, and the Company has adopted the disclosure-only provisions of
SFAS No. 123, "Accounting for Stock-Based Compensation." Had compensation cost
for the Company's current and past stock option programs been determined based
upon the fair value at the grant date for awards under these plans consistent
with the methodology prescribed under SFAS No. 123, the Company's net
26
income and earnings per share would have been reduced to the pro forma amounts
indicated below:
1999 1998 1997
---- ---- ----
Net income - as reported $68,624 $82,457 $68,806
- pro forma 66,168 $80,906 $67,475
Basic earnings per share - as reported $ 1.81 $ 2.20 $ 1.86
- pro forma 1.74 $ 2.16 $ 1.82
Diluted earnings per share - as reported $ 1.76 $ 2.10 $ 1.78
- pro forma 1.70 $ 2.06 $ 1.75
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model. The weighted average grant date fair value
of option grants were $6.78, $16.62, and $12.01 in 1999, 1998 and 1997,
respectively. The following assumptions were used for option grants awarded in
1999, 1998 and 1997:
Options Granted
---------------
1999 1998 1997
---- ---- ----
Dividend yield 0.8% to 1.5% 0.6% to 1.0% 0.8% to 1.1%
Volatility 43.7% to 54.3% 24.1% to 75.1% 18.7% to 30.3%
Risk-free interest rate 4.7% to 6.3% 4.3% to 5.8% 5.8% to 6.7%
Assumed annual forfeiture rate 3.0% 3.0% 3.0%
Expected life 10 years 10 years 10 years
NOTE 13 - COMMITMENTS, CONTINGENCIES AND OTHER MATTERS
LEASE COMMITMENTS
The Company has committed to lease office space under non-cancelable leases
which expire at various dates through August 2015. The leases provided for
escalations resulting from increased assessments for taxes, utilities and
maintenance. Future minimum rental payments on all leases, before any deductions
for estimated sublease income, are as follows (in 000s):
YEAR ENDED DECEMBER 31, OPERATING LEASES
- ----------------------- ----------------
2000 $ 2,300
2001 5,400
2002 6,100
2003 6,300
2004 6,300
Thereafter 67,800
--------
$ 94,200
========
Rent expense, net of sublease income, was $3,228,000, $1,528,000, and
$1,699,000, for the years ended December 31, 1999, 1998 and 1997, respectively.
COMMITMENTS - OFFICE CAPITAL IMPROVEMENTS
The Company has committed to make capital improvements to its offices in New
York, New York and to purchase fixtures and furniture for such offices, in the
aggregate amount of $11.0 million, net of building owner's reimbursement.
27
REINSURANCE AGREEMENTS
The Company is a party to facultative agreements with all, and a party to treaty
agreements with all except one of, the four largest primary financial guaranty
insurance companies. The Company's facultative and treaty agreements are
generally subject to termination (i) upon written notice (ranging from 90 to 120
days) prior to the specified deadline for renewal, (ii) at the option of the
primary insurer if the Company fails to maintain certain financial, regulatory
and rating agency criteria which are equivalent to or more stringent than those
the Company is otherwise required to maintain for its own compliance with the
New York Insurance Law and to maintain a specified claims-paying ability or
financial strength rating for the particular Insurance Subsidiary or (iii) upon
certain changes of control of the Company. Upon termination under the conditions
set forth in (ii) and (iii) above, the Company may be required (under some of
its reinsurance agreements) to return to the primary insurer all unearned
premiums, less ceding commissions, attributable to reinsurance ceded pursuant to
such agreements. Upon the occurrence of the conditions set forth in (ii) above,
whether or not an agreement is terminated, the Company may be required to obtain
a letter of credit or alternative form of security to collateralize its
obligation to perform under such agreement.
OTHER
In August 1999, the senior long-term debt rating of Enhance Financial and the
insurance financial strength rating of Enhance Reinsurance were downgraded from
Aa3 to A2 and from Aaa to Aa2, respectively.
The Company does not believe that the downgrade of the senior long-term debt
rating of Enhance Financial from Aa3 to A2 has had or should have a material
adverse effect on Enhance Financial, except to the extent that it could have a
material adverse effect on Enhance Re. However, such downgrade could result in
an increase, which could be significant, in the costs to Enhance Financial of
borrowing funds or raising capital. Similarly, any additional downgrade of the
senior long-term debt rating of Enhance Financial could increase costs of
borrowing funds or raising capital, or could make certain types of borrowings or
capital unavailable to the Company, which could have a material adverse effect
on the Company.
On February 29, 2000, Moody's advised the Company that it had placed on review
for possible further downgrade both the above ratings. Moody's explained that
this review will focus on the uncertainty surrounding management's strategy with
respect to the Company's higher risk specialty finance businesses, the reliance
on these business lines to achieve publicly stated earnings targets, the
Company's future capital plans and the Company's financial flexibility. Moody's
indicated that the outcome of the review will depend on the Company's future
plans for achieving a balance between the financial guaranty insurance
operations and the Company's other lines of business. The Company does not
believe that a downgrade of Enhance Re's financial strength rating from Aa2 to
Aa3, should it occur, should have a material adverse effect on Enhance Re's
competitive position or Enhance Re's costs associated with cessions from primary
insurers under their treaties with Enhance Re. This is because many of Enhance
Re's reinsurance competitors do not have materially higher financial strength
ratings from Moody's than would Enhance Re and because of the terms of the
amendments of certain of its existing treaties and its new treaties with the
Company's primary insurers. In cases where a prior treaty with a primary insurer
remains in effect or a primary insurer had waived its rights with respect to the
1999 downgrade, any additional downgrade could result in those primary insurers
recapturing business previously ceded to Enhance Re. However, a downgrade in
Enhance Re's financial strength rating to (or below) A could have a material
adverse effect on Enhance Re's competitive position. Such a downgrade may so
diminish the value of Enhance Re's reinsurance to the
28
primary insurers that they could either materially increase the costs to Enhance
Re associated with cessions under their treaties with Enhance Re or recapture
business previously ceded to Enhance. In either case, the effect of such changes
could materially adversely affect the Company's ability to continue to engage in
the reinsurance of monoline financial guaranty insurers business. While the
Company believes that the recapture of business by the primaries would otherwise
be inconsistent with their long-standing risk-management practices, such action,
if it occurs and depending on its magnitude, could have a material adverse
effect on the Company.
NOTE 14 - PARENT COMPANY FINANCIAL INFORMATION
The following are the condensed balance sheets of Enhance Financial as of
December 31, 1999 and 1998 and its condensed statements of income and cash flows
for the years ended December 31, 1999, 1998 and 1997 (in 000s).
CONDENSED BALANCE SHEETS
December 31,
------------
1999 1998
---- ----
ASSETS
Cash $ 56 $ 2,715
Investments 19,497 7,095
Investment in affiliated companies 807,848 784,235
Other assets 59,025 4,865
-------- --------
$886,426 $798,910
-------- --------
LIABILITIES AND SHAREHOLDERS' EQUITY:
Long-term debt $ 75,000 $ 75,000
Other liabilities 135,122 61,264
Shareholders' equity 676,304 662,646
------- -------
$886,426 $798,910
======== ========
CONDENSED STATEMENTS OF INCOME
Year Ended December 31,
-----------------------
1999 1998 1997
---- ---- ----
Total revenues $ 690 $ 812 $ 510
Total expenses 21,545 17,514 14,652
------ ------ ------
(20,855) (16,702) (14,142)
Equity in income of affiliates 79,571 102,459 77,500
Minority interest 306 - -
-------- --------- --------
Income before income taxes 59,022 85,757 63,358
Income tax (expense) benefit 9,602 (3,300) 5,448
-------- --------- --------
Net income $ 68,624 $ 82,457 $68,806
======== ======== =======
29
CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31,
-----------------------
1999 1998 1997
---- ---- ----
Cash flows from operating activities:
Net income $ 68,624 $ 82,457 $ 68,806
Adjustments to reconcile net income to net cash from
operating activities
Equity in income of affiliates (79,571) (102,459) (77,500)
Other (40,273) 55,239 29,799
--------- --------- ---------
Net cash provided by
(used in) operating activities (51,220) 35,237 21,105
--------- --------- ---------
Cash flows from investing activities:
Investment in affiliates net of dividends received
6,317 (32,401) (7,186)
Investments activities (14,852) 741 (2,396)
Short-term investments, net 2,460 4,880 (4,648)
--------- --------- ---------
Net cash used in investing activities (6,075) (26,780) (14,230)
--------- --------- ---------
Cash flows from financing activities:
Capital stock 3,277 9,920 7,341
Short-term debt 60,482 10,790 1,000
Dividends paid (9,123) (8,645) (8,195)
Principal payment - senior notes -- --
Reissuance of treasury stock -- --
Purchase of treasury stock -- (17,807) (7,021)
--------- --------- ---------
Net cash provided by (used in)
financing activities 54,636 (5,742) (6,875)
--------- --------- ---------
Net increase (decrease) in cash (2,659) 2,715 --
Cash, beginning of year 2,715 -- --
--------- --------- ---------
Cash, end of year $ 56 $ 2,715 $ --
========= ========== =========
NOTE 15 - MAJOR CUSTOMERS
The Company derives a substantial portion of its premium writings from a small
number of primary insurers. The following table states the percentage of gross
premiums written for the years ended December 31, 1999, 1998 and 1997 for the
Company's four most significant primary insurers:
For year ended
December 31, Insurer #1 Insurer #2 Insurer #3 Insurer #4
------------ ---------- ---------- ---------- ----------
1999 20% 14% 9% 2%
1998 19% 19% 19% 5%
1997 25% 16% 9% 4%
This customer concentration results from the small number of primary insurance
companies which are licensed to write financial guaranty insurance. Prior years'
data has been restated to give retroactive effect to mergers between our primary
insurers.
30
NOTE 16- LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the liability for losses and loss adjustment expenses ("LAE") is
summarized as follows (in 000s):
In thousands Year Ended December 31,
- ------------ -----------------------
1999 1998 1997
---- ---- ----
Balance at January 1, $36,239 $33,675 $28,081
Less reinsurance recoverables 2,500 2,688 1,823
----- ----- -----
Net balance at January 1, 33,739 30,987 26,258
------ ------ ------
Net incurred related to:
Current year 16,645 6,000 6,002
Prior years 9,511 4,324 3,753
----- ----- -----
Net incurred 26,156 10,324 9,755
------ ------ -----
Net paid related to:
Current year 1,512 352 720
Prior years 8,699 7,220 4,306
----- ----- -----
Net paid 10,211 7,572 5,026
------ ----- -----
Net balance at December 31, 49,684 33,739 30,987
Plus reinsurance recoverables 2,286 2,500 2,688
----- ----- -----
Balance at December 31, $51,970 $36,239 $33,675
======= ======= =======
The incurred loss and paid loss information presented above is classified as
"current year" and "prior year" based upon the year in which the related
reinsurance contract or insurance policy was underwritten. Therefore, amounts
presented as "net incurred related to prior years" are not indicative of
redundancies or deficiencies in total reserves held as of prior year ends.
During the years ended December 31, 1999, 1998 and 1997, the actual adverse
(redundant) development of reserves held as of prior year ends was $2.3 million,
$(0.2) million, and $1.5 million, respectively.
NOTE 17 - SEGMENT REPORTING
The Company has two reportable segments: insurance and asset-based businesses.
The insurance segment provides credit-related insurance coverage to meet the
needs of customers in a wide variety of domestic and international markets. The
Company's largest insurance business is the provision of reinsurance to the
monoline primary financial guaranty insurers for both municipal bonds and
non-municipal obligations. The Company also provides trade credit reinsurance,
financial responsibility bonds, excess-SIPC insurance and direct financial
guaranty insurance. The asset-based businesses segment deals primarily with
credit-based servicing and securitization of assets in underserved markets, in
particular, the origination, purchase, servicing and securitization of special
assets, including lottery awards, viatical settlements, structured settlement
payments, sub-performing/non-performing and seller financed residential
mortgages and delinquent consumer assets. The Company's reportable segments are
strategic business units which are managed separately as each business requires
different marketing and sales expertise.
The accounting policies of the segments are the same as those described in the
summary of significant accounting policies. The Company evaluates performance
based on profit or loss from operating earnings, which it defines as net income
excluding the impact of capital and foreign
31
exchange gains and losses, and certain non-recurring items, net of taxes.
Summarized financial information concerning the Company's operating segments is
presented in the following tables (in 000s):
1999
----
Insurance Asset-based Totals
--------- ----------- ------
Revenues from external customers $ 103,557 $39,013 $142,570
Interest revenue 56,648 1,405 58,053
Interest expense 9,229 1,760 10,989
Equity in income of affiliates 2,103 17,605 19,708
Income tax expense (benefit) 10,417 (9,597) 820
Operating earnings 54,524 19,473 73,997
Investments in affiliates 8,029 99,972 108,001
Deferred policy acquisition cost 119,213 - 119,213
Identifiable assets 1,091,154 362,778 1,453,932
1998
----
Insurance Asset-based Totals
--------- ----------- ------
Revenues from external customers $ 104,820 $46,807 $ 151,627
Interest revenue 53,423 - 53,423
Interest expense 7,223 1,277 8,500
Equity in income of affiliates 2,054 12,012 14,066
Income tax expense 23,558 6,792 30,350
Operating earnings 66,500 16,021 82,521
Investments in affiliates 8,201 88,666 96,867
Deferred policy acquisition cost 103,794 - 103,794
Identifiable assets 1,143,293 197,391 1,340,684
1997
----
Insurance Asset-based Totals
--------- ----------- ------
Revenues from external customers $ 88,966 $30,152 $ 119,118
Interest revenue 50,618 0 50,618
Interest expense 5,881 1,436 7,317
Equity in income of affiliates 1,076 7,702 8,778
Income tax expense 19,486 5,664 25,150
Operating earnings 60,029 8,374 68,403
Investments in affiliates 6,086 32,776 38,862
Deferred policy acquisition cost 95,645 0 95,645
Identifiable assets 1,074,393 97,913 1,172,306
The following are reconciliations of reportable segment revenues and profit to
Enhance Financial's consolidated totals (in 000s):
32
1999 1998 1997
--------- --------- ---------
REVENUES
Total revenues from external customers for
reportable segments $ 142,570 $ 151,627 $ 119,118
Total interest revenue for reportable
segments 58,053 53,423 50,618
Realized (losses)/gains (3,039) 2,434 657
--------- --------- ---------
Total consolidated revenues $ 197,584 $ 207,484 $ 170,393
========= ========= =========
NET INCOME
Operating earnings for reportable segments $ 73,997 $ 82,521 $ 68,403
Capital and foreign exchange (losses)/gains
net of tax (2,463) 1,398 403
Non-recurring Van-Am and other non-recurring
expenses, net of tax (2,910) (1,462) --
--------- --------- ---------
Net income $ 68,624 $ 82,457 $ 68,806
========= ========= =========
The Company's revenues from external customers, by product line, are as follows
(in 000s):
1999 1998 1997
-------- -------- --------
INSURANCE:
Financial guaranty reinsurance $ 60,250 $ 66,264 $ 49,913
Financial guaranty direct 11,629 10,246 6,319
Trade credit reinsurance 20,234 15,973 19,165
Other 11,444 12,337 13,569
ASSET-BASED 39,013 46,807 30,152
-------- -------- --------
TOTAL REVENUES FROM EXTERNAL CUSTOMERS $142,570 $151,627 $119,118
======== ======== ========
NOTE 18- QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
In millions except per share amounts
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. Year
-------- -------- -------- -------- -------
1999
Net premiums written $ 29.5 $ 34.9 $ 28.9 $ 39.7 $ 133.0
Premiums earned 24.3 26.1 24.9 28.6 103.9
Investment and other income 11.9 17.5 13.9 19.7 63.0
Assignment sales 8.3 8.0 12.2 2.2 30.7
Losses and loss adjustment expenses 2.8 2.6 3.8 17.0 26.2
Equity in income of affiliates 4.7 7.9 4.5 2.6 19.7
Income before income taxes 19.6 25.4 20.6 3.8 69.4
Net income 18.2 23.5 22.4 4.5 68.6
Earnings per share - Basic $ 0.48 $ 0.62 $ 0.59 $ 0.12 $ 1.81
-------- -------- -------- -------- --------
- Diluted $ 0.46 $ 0.61 $ 0.57 $ 0.12 $ 1.76
-------- -------- -------- -------- --------
33
1998
Net premiums written $ 33.7 $ 27.3 $ 27.6 $ 40.7 $ 129.3
Premiums earned 23.7 24.4 29.0 25.2 102.3
Investment and other income 14.2 15.0 17.4 13.2 59.8
Assignment sales 10.4 12.1 12.7 10.2 45.4
Losses and loss adjustment expenses 2.3 1.6 4.6 1.8 10.3
Equity in income of affiliates 2.6 3.8 3.2 4.5 14.1
Income before income taxes 27.1 28.2 30.8 26.7 112.8
Net income 19.2 20.5 22.7 20.1 82.5
Earnings per share - Basic $ 0.51 $ 0.55 $ 0.61 $ 0.53 $ 2.20
------- ------- ------- ------- -------
- Diluted $ 0.49 $ 0.52 $ 0.58 $ 0.51 $ 2.10
------- ------- ------- ------- -------
NOTE 19- POST BALANCE SHEETS EVENTS
In February 2000, the Company announced that it had implemented cost control
initiatives and a reduction in staff. The Company estimates a first quarter
charge of approximately $1.9 million related to staff reductions.
The Company has begun a review of its strategic alternatives in order to
maximize shareholder value. In February 2000 Enhance Financial engaged Morgan
Stanley Dean Witter & Co. to advise the Company in connection with such review.
The Company's business strategy, including without limitation, its expectations
regarding sources of future growth may be changed materially following such
review of strategic alternatives.
34
SCHEDULE I
CREDIT-BASED ASSET
SERVICING AND SECURITIZATION
LLC AND AFFILIATES,
COMBINED FINANCIAL STATEMENTS FOR THE YEARS ENDED
DECEMBER 31, 1999, 1998 AND 1997
AND INDEPENDENT AUDITORS' REPORT
35
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC
AND AFFILIATES
TABLE OF CONTENTS
- --------------------------------------------------------------------------------
Page
INDEPENDENT AUDITORS' REPORT 36
FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997:
Combined Balance Sheets 37
Combined Statements of Operations 38
Combined Statements of Owners' Equity 39
Combined Statements of Cash Flows 40
Notes to Combined Financial Statements 41-53
COMBINED SCHEDULE OF MORTGAGE-RELATED ASSETS 54
36
INDEPENDENT AUDITORS' REPORT
To the Owners of
Credit-Based Asset Servicing and Securitization LLC and Affiliates
We have audited the accompanying combined balance sheets as of December 31, 1999
and 1998, including the combined schedule of mortgage-related assets as of
December 31, 1999, of Credit-Based Asset Servicing and Securitization LLC and
Affiliates (the "Company") and the related combined statements of operations,
owners' equity and cash flows for each of the three years in the period ended
December 31, 1999. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such combined financial statements present fairly, in all
material respects, the combined financial position of Credit-Based Asset
Servicing and Securitization LLC and Affiliates as of December 31, 1999 and
1998, and the combined results of their operations and their cash flows for each
of the three years in the period ended December 31, 1999 in conformity with
generally accepted accounting principles.
As explained in Note 1, at December 31, 1999 and 1998, the combined financial
statements include investments in mortgage-related assets valued at
approximately $773 million and $550 million, respectively (83% and 88% of
assets, respectively), whose values have been estimated by the Company's
management in the absence of readily ascertainable market values. We have
reviewed the procedures used by the Company's management in arriving at its
estimate of value of such investments and have inspected the underlying
documentation, and, in the circumstances, we believe the procedures are
reasonable and the documentation appropriate. However, those estimated values
may differ significantly from the values that would have been used had a ready
market for the mortgage-related assets existed, and the difference could be
material.
Deloitte & Touche LLP
January 6, 2000
New York, New York
37
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC
AND AFFILIATES
COMBINED BALANCE SHEETS
DECEMBER 31, 1999 AND 1998
- ---------------------------------------------------------------------------------------------
ASSETS 1999 1998
CASH AND CASH EQUIVALENTS $6,392,918 $4,115,708
MORTGAGE-RELATED ASSETS 772,979,564 550,125,141
RECEIVABLE FROM BROKERS 59,635,548 --
LEASEHOLD IMPROVEMENTS, FURNITURE AND
EQUIPMENT - Net 9,718,224 5,857,488
SERVICING RIGHTS, GOODWILL AND OTHER
INTANGIBLES - Net 38,356,757 32,078,103
SERVICING ADVANCES RECEIVABLE 20,920,484 12,531,238
ACCOUNTS RECEIVABLE AND OTHER ASSETS 26,548,507 18,822,227
------------ ------------
TOTAL ASSETS $934,552,002 $623,529,905
============ ============
LIABILITIES AND OWNERS' EQUITY
LIABILITIES:
Funding arrangements, including accrued interest $340,563,022 $159,552,484
Reverse repurchase agreements, including accrued interest 276,636,521 201,244,830
Subordinated debt, including accrued interest 52,850,625
Guaranteed term agreement, including accrued interest -- 50,300,000
Payable for open trades 62,239,826 50,275,185
Due to affiliates 2,029,024 334,675
Accrued expenses and other liabilities 10,433,819 6,656,016
------------ ------------
Total liabilities 744,752,837 468,363,190
COMMITMENTS AND CONTINGENCIES
OWNERS' EQUITY 189,799,165 155,166,715
------------ ------------
TOTAL LIABILITIES AND OWNERS' EQUITY $934,552,002 $623,529,905
============ ============
See notes to combined financial statements.
-2-
38
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC
AND AFFILIATES
COMBINED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
- -----------------------------------------------------------------------------------------------------------------------------------
1999 1998 1997
REVENUES:
Gain on liquidation or securitization
of mortgage-related assets $ 56,382,412 $ 30,047,452 $ 22,780,440
Unrealized (loss) gain on mortgage-
related assets (2,217,513) 5,000,000 --
Servicing and subservicing fees 28,770,067 18,856,183 4,723,886
Interest income $ 67,280,609 $ 33,713,981 $ 10,288,524
Interest expense (41,231,054) 26,049,555 (19,201,007) 14,512,974 (6,985,627) 3,302,897
------------ ------------ ------------
Other income, net 5,080,029 1,264,247 5,373,345
------------- ------------- -------------
Total revenues 114,064,550 69,680,856 36,180,568
------------- ------------- -------------
EXPENSES:
Compensation and benefits 38,385,922 21,982,160 13,053,808
Servicing costs 3,746,535 2,752,443 1,137,944
Transaction costs 6,170,696 3,358,550 1,646,143
Amortization of servicing rights,
goodwill and other intangibles 6,527,316 3,952,975 1,367,400
Other expenses 18,915,336 12,129,569 3,770,881
------------- ------------- -------------
Total expenses 73,745,805 44,175,697 20,976,176
------------- ------------- -------------
INCOME BEFORE TAXES 40,318,745 25,505,159 15,204,392
INCOME TAX BENEFIT 104,465 478,571 --
------------- ------------- -------------
NET INCOME $ 40,423,210 $ 25,983,730 $ 15,204,392
============= ============= =============
See notes to combined financial statements.
-3-
39
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC
AND AFFILIATES
COMBINED STATEMENTS OF OWNERS' EQUITY
YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
- ---------------------------------------------------------------------------------------------------------
C-BASS
ENHANCE MGIC HOLDING TOTAL
------------- ------------- ------------- -------------
BALANCE, JANUARY 1, 1997 $ 18,797,361 $ 15,823,337 $ 497,820 $ 35,118,518
Contributions 7,349,982 7,349,982 10,036 14,710,000
Distribution -- -- (535,825) (535,825)
Net income 7,352,844 7,352,844 498,704 15,204,392
------------- ------------- ------------- -------------
BALANCE, DECEMBER 31, 1997 33,500,187 30,526,163 470,735 64,497,085
Contributions 32,500,000 33,425,628 812,768 66,738,396
Distribution (2,048,396) -- (4,100) (2,052,496)
Net income 12,455,734 12,455,734 1,072,262 25,983,730
------------- ------------- ------------- -------------
BALANCE, DECEMBER 31, 1998 76,407,525 76,407,525 2,351,665 155,166,715
Distribution (2,500,000) (2,500,000) (790,760) (5,790,760)
Net income 19,377,128 19,377,128 1,668,954 40,423,210
------------- ------------- ------------- -------------
BALANCE, DECEMBER 31, 1999 $ 93,284,653 $ 93,284,653 $ 3,229,859 $ 189,799,165
============= ============= ============= =============
See notes to combined financial statements.
-4-
40
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC
AND AFFILIATES
COMBINED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
- ----------------------------------------------------------------------------------------------------------------
1999 1998 1997
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 40,423,210 $ 25,983,730 $ 15,204,392
Adjustments to reconcile net income to net cash used
in operating activities:
Unrealized loss (gain) on mortgage-related assets 2,217,513 (5,000,000) --
REMIC tax residual fee income -- -- (5,103,225)
Depreciation and amortization 9,333,189 5,543,864 2,041,901
Deferred income taxes (2,130) (461,314) --
Equity in earnings of unconsolidated subsidiaries (159,322) (353,953) --
Changes in operating assets and liabilities:
Increase in mortgage-related assets (225,071,936) (348,000,842) (106,374,849)
(Increase) decrease in receivable from brokers (59,635,548) 15,589,073 (13,514,815)
Increase in servicing rights (11,911,900) (9,333,988) (295,550)
Increase in accounts receivable and other assets (16,203,350) (17,294,505) (8,620,733)
Increase in payable for open trades 11,964,641 27,440,335 8,660,581
Increase (decrease) in due to affiliates 1,694,349 (136,615) (59,794)
Increase (decrease) in accrued expenses and
other liabilities 7,651,154 (2,179,771) 6,184,354
------------- ------------- -------------
Net cash used in operating activities (239,700,130) (308,203,986) (101,877,738)
------------- ------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in WSAT -- (17,317,638) --
Purchases of leasehold improvements, furniture
and equipment (6,666,609) (4,664,828) (1,536,562)
Purchase of intangible assets (894,070) (1,173,450) --
Distributions from unconsolidated subsidiaries 247,146 684,803 --
------------- ------------- -------------
Net cash used in investing activities (7,313,533) (22,471,113) (1,536,562)
------------- ------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings under reverse repurchase agreements
and other funding facilities 255,081,633 233,791,374 68,303,232
(Repayments) borrowings under guaranteed term
agreement (50,000,000) 30,000,000 20,000,000
Issuance of subordinated debt 50,000,000 -- --
Capital contributions from members -- 66,738,396 14,710,000
Distributions to members (5,790,760) (2,052,496) (535,825)
------------- ------------- -------------
Net cash provided by financing activities 249,290,873 328,477,274 102,477,407
------------- ------------- -------------
NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS 2,277,210 (2,197,825) (936,893)
CASH AND CASH EQUIVALENTS, BEGINNING
OF YEAR 4,115,708 6,313,533 7,250,426
------------- ------------- -------------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 6,392,918 $ 4,115,708 $ 6,313,533
============= ============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Interest and other financing costs $ 37,359,833 $ 18,231,531 $ 6,190,477
============= ============= =============
Cash paid during the year for income taxes $ 37,292 $ 57,217 $ 39,998
============= ============= =============
See notes to combined financial statements.
-5-
41
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC
AND AFFILIATES
NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
- --------------------------------------------------------------------------------
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BASIS OF PRESENTATION - The accompanying financial
statements present the financial position, results of operations and cash
flows of Credit-Based Asset Servicing and Securitization LLC and its
subsidiaries ("C-BASS") and of Litton Loan Servicing LP and its subsidiaries
("Litton") on a combined basis. All significant intercompany balances and
transactions have been eliminated. C-BASS and Litton combined are
hereinafter referred to as the "Company."
Prior to January 2000, both C-BASS and Litton were owned by Enhance
Financial Services Group, Inc. ("EFS") and a subsidiary of MGIC Investment
Corporation ("MGIC"), each owning approximately 48%, with the remainder
owned by C-BASS Holding LLC ("Holding") (collectively, the "Owners").
Holding is owned by certain members of C-BASS and Litton management.
Effective January 1, 2000, the Owners contributed their interests in Litton
and its general partner, Litton GP LLC, to C-BASS and Litton became an
indirect, wholly-owned subsidiary of C-BASS. Also, effective January 1,
2000, each of MGIC and EFS sold 2% of its interest in the Company to certain
members of senior management of C-BASS, which interests were contributed to
Holding in exchange for additional interests in Holding. As a result,
Holding's interest in C-BASS increased from approximately 4% to
approximately 8%. Profits and losses are allocated to the Owners in
accordance with their ownership percentages.
C-BASS is a Delaware limited liability company that commenced operations on
July 9, 1996. In connection with the formation of C-BASS, the Owners entered
into a Transaction Agreement whereby Litton Loan Servicing, Inc. ("LLSI") (a
wholly-owned subsidiary of EFS) would be transferred into a separate entity
owned by the Owners in the same proportion as they owned C-BASS. To effect
this transfer of ownership, a new entity, Litton, a Delaware limited
partnership, was funded and capitalized by the Owners at approximately $1.0
million.
Pursuant to the Transaction Agreement, during 1998, EFS contributed the
assets and liabilities of LLSI to Litton for approximately $2.9 million. At
the time of this transaction, MGIC and Holding contributed capital to Litton
of approximately $925,000 and $112,000, respectively, and EFS was
distributed approximately $2.0 million in cash. Because of common ownership
and a continuity of operations and management, the accompanying financial
statements include the operations of LLSI prior to its transfer to Litton as
described above.
The Company engages in the acquisition and resolution of delinquent
single-family residential mortgage loans ("Mortgage Loans"). The Company
also purchases and sells seller-financed notes ("Notes") and real estate
owned ("REO"), invests in mortgage-backed securities ("Mortgage Securities")
and interests in real estate mortgage investment conduit ("REMIC")
residuals, and performs mortgage loan servicing and mortgage and contract
collections. In addition, the Company issues mortgage-backed securities
collateralized by Mortgage Loans, Mortgage Securities and/or Notes. The
Company maintains several subsidiaries to perform certain activities and to
hold specific assets.
-6-
42
USE OF ESTIMATES - The preparation of financial statements in conformity
with generally accepted accounting principles ("GAAP") requires management
to make estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosures of contingent assets and liabilities at the
date of the combined financial statements and the reported amount of
revenues and expenses during the reporting period. Actual results could
differ from those estimates. Significant estimates in the combined financial
statements include the valuation of mortgage-related assets, goodwill,
servicing rights and solicitation rights and the amortization thereof.
MORTGAGE-RELATED ASSETS - C-BASS considers itself a nonregistered investment
company for financial reporting purposes. GAAP for investment companies
requires that the Mortgage Loans, Mortgage Securities, Notes and REO
(collectively, "Mortgage-Related Assets") owned by C-BASS be carried at
their estimated fair values, with the resulting net unrealized gains and
losses reflected in earnings. Litton does not own significant
Mortgage-Related Assets. Mortgage-Related Assets are generally recorded as
of the date of purchase or sale (trade date), unless the Company anticipates
an extended period between the trade date and the settlement date, in which
case the settlement date is used.
In January 2000, Litton became an indirect subsidiary of C-BASS, and C-BASS
therefore no longer met the requirement to be considered a nonregistered
investment company for financial reporting purposes. Beginning in 2000,
Mortgage Securities will be classified as trading securities, with
unrealized gains and losses reflected in earnings. Mortgage Loans and Notes
will be carried at the lower of cost or fair value, and REO will be carried
at cost, subject to an impairment test. Implementation of this change in
accounting will not have a significant impact on the Company's financial
position or results of operations.
a. Mortgage Securities - Securities listed or traded on any United States
national exchange are valued at the last sales price of the close of the
principal securities exchange on which such securities are traded or, if
there are no sales, at the mean of the last bid and asked prices.
Many of the Mortgage Securities purchased by the Company or retained in
the Company's securitizations consist of below-investment grade and
nonrated subordinated interests ("B-Pieces"). The timing and amount of
cash flows on these securities are significantly influenced by
prepayments on the underlying loans and foreclosure losses. There is
generally not an active public market for such securities, and market
quotations are not readily available. The fair value of these securities
is estimated by management by discounting future cash flows using
discount rates and credit loss and prepayment estimates that approximate
current market rates, and by comparison to values used by institutions
providing financing to the Company on such securities. Given the complex
nature of these securities and the market for them, the values estimated
by management do not necessarily represent the amounts that would be
received by the Company if it sold all or a portion of its portfolio.
-7-
43
The following table sets forth the geographic distribution of the
mortgage loans underlying the Company's Mortgage Securities as of
December 31, 1999:
PERCENTAGE OF
STATE PRINCIPAL BALANCE
California 42%
New York 4
Texas 4
Florida 4
All Other(1) 46
----
100%
====
(1) No other state contains more than 5% of the properties securing
loans in the Company's Mortgage Securities portfolio.
As of December 31, 1999, the Company used discount rates for
below-investment grade and nonrated B-Pieces of 11.5% to 20% and 20% to
30%, respectively; annual prepayment estimates of 10% to 35% CPR for
prime loans, 10% to 18% for FHA/VA loans, and 7.5% to 80% for sub-prime
loans, and lifetime credit loss estimates of 0.15% to 15% of the
original principal balances for prime loans, 0.1% to 1.5% for FHA/VA
loans, and 2.5% to 6.0% for sub-prime loans.
b. MORTGAGE LOANS AND NOTES - Mortgage Loans and Notes purchased by C-BASS
are carried at estimated fair value. Fair value is generally determined
based upon price quotations, broker price opinions regarding the value
of the underlying collateral, and the Company's valuation model that
considers the yields, maturities and characteristics of such assets and
third-party indications of value under borrowing arrangements. The
acquisition cost for a pool of loans is allocated to each loan in the
pool based upon the Company's valuation model. Interest is accrued on
mortgage loans that are less than 90 days in arrears or are
reperforming. The Company also accrues interest on loans guaranteed by
the Federal government, up to the amount that the Company estimates is
guaranteed by the Federal government. In situations where the collateral
is foreclosed on, the loans are transferred to REO upon receipt of title
to the property.
c. REAL ESTATE OWNED - Properties acquired directly are initially recorded
at cost. Properties acquired through foreclosure are recorded at
estimated fair value, less projected costs of disposal. Management
periodically reviews each REO property's carrying value and adjusts it
to fair value if changes in local real estate markets or the property's
condition or situation warrant. Fair value is determined primarily on
the basis of collateral value estimates obtained from real estate
specialists. Sales proceeds and related costs are recognized when title
has passed to the buyer.
Interest income is recorded as earned, with purchase discounts or premiums
amortized into income using the effective yield method. The gain on sale of
mortgage-backed securities issued by the Company through securitization
transactions is computed based on the price of the securities sold and the
estimated fair value of any securities retained in accordance with Statement
of Financial Accounting Standards ("SFAS") No. 125, ACCOUNTING FOR TRANSFERS
AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENT OF LIABILITIES.
-8-
44
Mortgage Loans, Notes, and Mortgage Securities are primarily collateralized
by residential single-family properties. These assets expose the Company to
the risk that the borrowers may be unable to repay principal of and interest
on the amount borrowed. At the time of purchase of Mortgage Loans and
Mortgage Securities, the Company evaluates the performance of the underlying
collateral and, where appropriate, the ability and willingness of the
borrower to repay principal of and interest on the amount of the loan
outstanding.
CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash held by
depository institutions and short-term investments with remaining maturities
at acquisition of less than three months.
INTEREST RATE SWAPS - During 1999, the Company utilized interest rate swaps
in a strategy intended to reduce the impact of changes in interest rates on
the value of a portion of its Mortgage-Related Assets. At December 31, 1999,
the Company had outstanding an aggregate notional amount of $510.0 million.
During 1999, the Company had outstanding an average of $265.4 million. With
respect to all such transactions, the notional amount represents the stated
principal balance used as a basis for calculating payments. On the swaps
outstanding at December 31, 1999, the Company receives a floating rate
ranging from 5.404% to 5.608% based on various floating rate indices and
pays fixed rates ranging from 4.755% to 6.140%. The swaps expire at various
periods during 2000 and 2001. The Company incurred a net expense during the
year ended December 31, 1999 of approximately $804,000 which is included in
interest expense. The interest rate swaps are carried at their estimated
fair values, determined using quotes obtained from dealers who make a market
in such securities. The unrealized gain or loss on the swaps is included in
earnings with the unrealized gain or loss on Mortgage-Related Assets. The
fair value of the swaps was approximately $5.0 million at December 31, 1999,
and is included in Mortgage-Related Assets at December 31, 1999. The Company
had no interest rate swap contracts open at December 31, 1998. The interest
rate swaps expose the Company to interest rate risk, as well as to credit
loss in the event of non-performance by the counterparty to the swap. The
Company does not anticipate non-performance by any counterparties.
SHORT SALES - From time to time, the Company enters into contracts to sell
securities it does not own ("short sales"), in a strategy intended to reduce
the impact of changes in interest rates on the value of a portion of its
Mortgage-Related Assets. Under these contracts, the Company sells
securities, generally mortgage-backed securities or U.S. Treasury
securities, borrowed from a broker. The proceeds from the sale are retained
by the broker as collateral for the Company's obligation to deliver the
borrowed securities at a specified date. The Company's obligation to deliver
the borrowed securities is carried at fair value in the combined balance
sheet as part of "payable for open trades," with changes in such fair value
included in earnings with the unrealized gain or loss on Mortgage-Related
Assets. The sales proceeds retained by the broker of $54.7 million, are
included in "receivable from brokers" in the combined balance sheet. At
December 31, 1999, the Company had an open obligation to deliver a FNMA TBA
security on January 19, 2000 with a face amount of $55.0 million and a fair
value of $54.4 million. The Company is exposed to credit risk in the event
of nonperformance by a broker holding the sales proceeds as collateral for
the securities borrowed. The Company does not anticipate nonperformance by
any broker.
LEASEHOLD IMPROVEMENTS, FURNITURE AND EQUIPMENT - Computer hardware and
software, furniture and fixtures, and leasehold improvements are stated at
cost. Depreciation and amortization is provided using the straight-line
method over the estimated useful lives of the assets, which range from three
to seven years. Leasehold improvements are amortized over the shorter of
their useful lives or the lease term.
-9-
45
CAPITALIZATION OF SOFTWARE COSTS - Costs related to the implementation of
new software for internal use and costs related to development of software
for external and internal use have been capitalized in accordance with
Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use, and Statement of Financial
Accounting Standards No. 86, Accounting for the Costs of Computer Software
to Be Sold, Leased, or Otherwise Marketed, respectively. Amortization is
provided using the straight-line method over three years.
ACCOUNTS RECEIVABLE - Accounts receivable consists of investor receivables,
servicing receivables, advances and other receivables.
Investor receivables consist primarily of amounts due from various companies
which own the servicing rights on loans that the Company services under
subservicing agreements. The balances in these accounts consist of
subservicing fees, foreclosure advances and other miscellaneous charges
incurred by the Company on behalf of the investors.
Servicing receivables consist primarily of escrow advances and principal and
interest advances.
Escrow advances are Company payments made to escrow custodial accounts to
avoid overdrafts in these accounts when tax or insurance payments are made
for loans. The advances are recovered from future mortgage payments or from
sale of the property or from investors if the mortgagee defaults.
Principal and interest ("P&I") advances are Company payments to the P&I
custodial accounts so that sufficient funds are available for the monthly
remittance to security holders. These advances are recovered from future
mortgage payments as they are received, or from sale of the property or from
investors if the mortgagee defaults.
Foreclosure advances represent foreclosure costs which are advanced by the
Company as part of the mortgage loan foreclosure process and are recovered
primarily from sale of the property, from investors or by filing claims with
the various agencies or companies that insure the loans.
SERVICING RIGHTS - Servicing rights ("SRs") are reported at the lower of
amortized cost or fair value and are periodically evaluated for impairment
based on the fair values of those rights determined by discounting estimated
future net cash flows using a discount rate commensurate with the risks
involved. This method of valuation incorporates assumptions that market
participants would use in their estimates of future servicing income and
expense, including assumptions about prepayment, default and interest rates.
The fair value of SRs at December 31, 1999 was determined using discount
rates ranging from approximately 10% to 15% and prepayment rates ranging
from approximately 11% to 40%. For purposes of measuring impairment, the
loans underlying the SRs are stratified on the basis of type (agency or
nonagency). The amount of impairment, if any, is the amount by which the
amortized cost of SRs by strata exceeds the fair value of that strata. SRs
are amortized in proportion to, and over the period of, estimated net
servicing revenues.
-10-
46
REMIC RESIDUALS - The Company has acquired residual interests in REMICs
which, at acquisition, are anticipated to generate substantial amounts of
taxable income, with little, if any, cash flow, in the first several years
after acquisition, and approximately equal amounts of taxable losses
thereafter (REMIC residuals). Generally, issuers of REMICs do not retain
such residuals, instead paying investors an inducement fee to take ownership
of the residual and assume the tax liability. During 1999, 1998 and 1997,
the Company sold REMIC residual interests, which resulted in a gain, after
payment of inducement fees to the buyers, of $2.0 million, $0.2 million and
$5.1 million, respectively. C-BASS no longer acquires REMIC residual
securities for its own account.
GOODWILL AND OTHER INTANGIBLES - Goodwill and other intangibles consist of
goodwill and solicitation rights. Goodwill is stated at amortized cost and
is being amortized over 12 years.
The Company owns, through acquisitions, databases of names of
seller-financed noteholders. These databases ("solicitation rights") are
used to solicit, via direct mail, the purchase of the note from the
noteholder. Solicitation rights are being amortized over the estimated life
of the databases, which range from five to nine years.
These assets are evaluated periodically to determine whether events and
circumstances have developed that warrant revision of the estimated lives of
the related assets or their write-off.
LOAN SERVICING - The fees received for loan servicing or subservicing are
generally based on either a monthly fee, payable on all loans serviced, or
on a percentage of the outstanding principal balance of such loans, payable
from interest collected from mortgagors. Such loan servicing fees are
generally credited to income monthly or when the related mortgagor payments
are collected. Late charges and other fees collected from mortgagors are
credited to income when collected. Loan servicing costs are charged to
expense as incurred.
INCOME TAXES - Litton is a partnership. C-BASS is a limited liability
company, and as such is generally treated as a partnership for Federal
income tax purposes. Thus, the taxable income or loss of C-BASS and Litton
is included in the tax returns of the Owners, and no provision or liability
for income taxes has been recorded related to such companies' operations in
the accompanying financial statements. Litton and C-BASS may be subject to
state taxes in certain jurisdictions in which they operate.
Income taxes applicable to the Company's C-corporation subsidiaries are
accounted for under the liability method. Deferred income tax assets and
liabilities are computed for differences between the financial statement and
income tax basis of assets and liabilities that will result in taxable or
deductible amounts in the future.
The primary differences between taxable income and income under GAAP include
those arising from REMIC residuals and the amortization of SRs, solicitation
rights and goodwill.
In 1997, LLSI was included in the consolidated Federal income tax return of
its parent, EFS. Income taxes for 1997 were computed on a separate company
basis, with any current tax liability or refund settled through intercompany
accounts.
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47
REVERSE REPURCHASE AGREEMENTS - Transactions involving sales of securities
under agreements to repurchase ("reverse repurchase agreements") are treated
as collateralized financing transactions and are recorded at their
contracted repurchase amounts plus accrued interest. The Company is
generally required to deliver the securities that collateralize the reverse
repurchase agreements to the counterparties. The Company is required to
maintain agreed-upon amounts of collateral with these counterparties during
the term of the reverse repurchase agreements.
RECENT ACCOUNTING PRONOUNCEMENTS - The Company adopted SFAS No. 130,
Reporting Comprehensive Income, in 1998. This statement established
standards for reporting and display of comprehensive income and its
components (revenue, expenses, gains and losses). SFAS No. 130 requires that
all items that are required to be recognized under accounting standards as
components of comprehensive income be reported in a financial statement that
is displayed with the same prominence as other financial statements. The
Company had no items of comprehensive income during 1999, 1998 and 1997.
SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES,
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts and for
hedging activities. SFAS No. 133 requires that an entity recognize all
derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. This statement is
effective for the Company beginning January 1, 2001. The Company is
currently reviewing the impact of the implementation of SFAS No. 133 on its
financial statements.
INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES - Investments in unconsolidated
subsidiaries are accounted for under the equity method.
RECLASSIFICATIONS - Certain prior year amounts have been reclassified to
conform with the current year presentation.
2. ACQUISITIONS
In February 1998, the Company established Wynwood Servicing and Technology
LLC ("WSAT") with an initial capitalization of $18 million. In separate
transactions, WSAT then acquired all of the shares of Wynwood, Inc.
("Wynwood") for approximately $15.0 million and all of the operations of
South Plains Mortgage Company ("South Plains") for approximately $3 million.
Wynwood and its subsidiaries are engaged primarily in the business of
mortgage and contract collections. South Plains is engaged in the business
of acquiring Notes for resale to investors.
WYNWOOD ACQUISITION - The Wynwood purchase agreement provides for additional
earn-out payments of a maximum of approximately $7.8 million to the sellers
and certain members of management, if contract servicing, solicitation
rights, and note or mortgage purchase thresholds specified in the agreement
are met during the four-year period following the acquisition date. C-BASS
has provided the sellers a guarantee of the earn-out payments required to be
made. No payment has been made under such earn-out agreements. At December
31, 1999, no liability has been recorded under the earn-out provisions.
SOUTH PLAINS ACQUISITION - The South Plains purchase agreement provides for
additional earn-out payments of a maximum of approximately $1.0 million to
the sellers if certain note purchase thresholds are met during the two-year
period following the acquisition date. Through December 31, 1999, the
Company has paid $750,000 in earn-out payments.
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3. FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS,
requires the Company to report the estimated fair value of its financial
instruments, as defined. At December 31, 1999 and 1998, substantially all of
the Company's assets and liabilities are carried at estimated fair value or
contracted amounts which approximate fair value.
Mortgage Loans, Notes, Mortgage Securities and REO are carried at estimated
fair value. Assets that are recorded at contracted amounts approximating
fair value consist of receivables from affiliates and certain other
receivables. Similarly, the Company's short-term liabilities consist
primarily of reverse repurchase agreements, amounts payable to affiliates
and certain other payables. Such amounts are recorded at contracted amounts
approximating fair value. These instruments generally have variable interest
rates and short-term maturities, or are payable upon demand, and accordingly
are not materially affected by changes in interest rates. The carrying value
of the Company's Senior Subordinated Notes approximates its fair value.
4. INCENTIVE COMPENSATION
The Company paid "sign-on" bonuses totaling approximately $1.4 million to
its officers at the inception of their employment. The amounts paid were
capitalized and were amortized to compensation expense over the vesting
periods, which ranged from 12 to 18 months. Amortization was approximately
$891,000 in 1997. The capitalized amounts were fully amortized at December
31, 1997.
The Company has established incentive bonus programs, which set forth the
guidelines for computation of incentive bonus pools based on the Company's
pretax, preincentive bonus return on equity for the twelve-month periods
ending June 30, net of certain unrealized gains and losses, if any, and on
the performance of certain managed portfolios (see Note 9). The allocation
of the bonus pool is subject to review by the Company's Board of Managers.
For each of the twelve-month periods ended June 30, 1999, 1998 and 1997, the
Company paid incentive compensation of approximately $9.8 million, $8.0
million and $3.4 million as payable under the incentive bonus pool in July
of 1999, 1998 and 1997, respectively. The Company has accrued approximately
$5.3 million at December 31, 1999 based on results of operations and
estimated portfolio performance for the six months ended December 31, 1999.
5. SERVICING RIGHTS
The activity in the Company's SRs during 1999 and 1998 was as follows:
CONTRACT MORTGAGE
SERVICING SERVICING
RIGHTS RIGHTS TOTAL
Balance, January 1, 1998 $ -- $ 4,768,472 $ 4,768,472
Acquisition of Wynwood 4,323,789 -- 4,323,789
Additions 326,446 9,007,542 9,333,988
Amortization (686,314) (1,785,200) (2,471,514)
------------ ------------ ------------
Balance, December 31, 1998 3,963,921 11,990,814 15,954,735
Additions 688,323 11,223,577 11,911,900
Amortization (784,347) (3,875,713) (4,660,060)
------------ ------------ ------------
Balance, December 31, 1999 $ 3,867,897 $ 19,338,678 $ 23,206,575
============ ============ ============
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In addition, the Company also accrued approximately $2.1 million at December
31, 1999 as incentive to manage an asset portfolio for EFS and MGIC, for
which C-BASS receive an incentive fee (see Note 9).
Cost approximates fair value at December 31, 1999 and 1998.
During 1997, additions to mortgage servicing rights totaled approximately
$295,000 and accumulated amortization was approximately $1.6 million at
December 31, 1997.
The unpaid principal balance of mortgage loans serviced for others is not
included in the accompanying combined financial statements. These balances
were approximately $3.4 billion at December 31, 1999 and $3.0 billion at
December 31, 1998.
The following table sets forth the geographic distribution of the mortgage
loans underlying the mortgage servicing rights portfolio as of December 31,
1999:
PERCENTAGE OF
PRINCIPAL BALANCE
STATE SERVICED
California 22%
Texas 10%
New York 10%
Florida 5%
All other(1) 53%
----
100%
====
(1) No other state contains more than 5% of the properties securing
loans in the Company's mortgage servicing rights portfolio.
At December 31, 1999, the Company had errors and omissions insurance
coverage of $5.0 million and fidelity insurance coverage of $5.0 million.
Custodial escrow balances maintained in connection with the foregoing loan
servicing were a net deficit of approximately $8.3 million and $3.1 million
at December 31, 1999 and 1998, respectively. The Company has made advances
to cover the deficit escrow balances. Included in accounts receivable at
December 31, 1999 are $10.1 million of escrow advances due from borrowers
and from investors. Escrow funds are held in trust for mortgagors at various
financial institutions and are not included in the accompanying combined
balance sheets.
6. GOODWILL AND OTHER INTANGIBLES
As of December 31, 1999, goodwill and other intangible assets were comprised
of the following:
1999 1998
Goodwill and other intangibles $ 14,867,355 $ 14,765,408
Accumulated amortization - goodwill and other
intangibles (2,418,143) (1,101,252)
Solicitation rights 3,631,544 2,839,421
Accumulated amortization - solicitation rights (930,574) (380,209)
------------ ------------
Total $ 15,150,182 $ 16,123,368
============ ============
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7. DEBT OBLIGATIONS
Debt obligations are summarized as follows:
DECEMBER 31,
1999 1998
Warehouse Line of Credit with variable
rates of interest. At December 31,
1999 and 1998, such rates were 5.44%
and 5.50%, respectively. The weighted
average interest rate during 1999
and 1998 was 6.38% and 7.21%,
respectively. Borrowings are secured
by Mortgage Loans, Notes, Mortgage
Securities, mortgage servicing advances
and SRs. $303,376,222 $146,051,893
Guaranteed Term Agreement with interest
at the weekly Federal Funds rate plus
0.1%, payable monthly. At
December 31, 1998, such rates was 5.67%.
The weighted average interest rate
during 1998 was 5.86%. -- 50,000,000
Senior Subordinated Notes due
September 1, 2004, with interest at
15.91% payable semi-annually. 50,000,000 --
Reverse repurchase agreements with
various counterparties. Such agreements
accrue interest at variable rates based
on one-month LIBOR plus a range of 0.5%
to 2.25%. At December 31, 1999 and 1998,
such rates ranged from 6.45% to 8.48%
and 5.80% to 9.25%, respectively. The
weighted average interest rate during
1999 and 1998 was 6.15% and 6.82%,
respectively. Borrowings under such
agreements are secured by Mortgage
Securities and Mortgage Loans. 275,341,535 200,939,930
Revolving Credit Agreement with variable
rate of interest based on LIBOR plus
2.50%. At December 31, 1999, such rate
was 8.98%, and at December 31, 1998,
such rate was 7.50%. During the years
ended December 31, 1999 and 1998, the
weighted average interest rate was 8.59%
and 9.12%, respectively. The borrowings
are secured by Mortgage Loans, Notes
and REO. 34,301,788 10,511,152
Other notes and contracts payable with
interest at rates ranging from 0% to 1,699,523 2,134,460
18% per annum.
The Company has a $400 million Warehouse Line of Credit Agreement (the
"Warehouse Agreement") with a group of financial institutions, with a
maturity date of June 19, 2000. The Warehouse Agreement provides for
interest rates based on various indices, mainly Federal Funds and LIBOR, as
selected by the Company. The Warehouse Agreement contains restrictive
financial covenants that require the Company to meet, among other things,
certain capital requirements and debt to adjusted equity ratios (as
defined). The Warehouse Agreement also restricts the Company's ability to
pay distributions.
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In 1997, the Company entered into a Guaranteed Term Agreement (the "Term
Agreement") for a fixed amount of $20 million, later increased to $50
million. The Term Agreement was guaranteed by EFS and MG1C. The Term
Agreement was repaid on July 30, 1999.
On August 23, 1999, the Company issued $50 million of 15.91% Senior
Subordinated Notes due September 1, 2004. Net proceeds, after purchasers'
discount and offering expenses, was $47.4 million, resulting in a yield of
approximately 17%. The Senior Subordinated Notes indenture contains
restrictive financial covenants, including minimum net worth, maximum total
debt to net worth, and maximum subordinated debt to net worth (as defined).
The indenture also restricts the Company's ability to pay distributions. The
notes may be redeemed at par plus a "make-whole" amount determined with
respect to the discounted value of remaining scheduled payments.
Included in reverse repurchase agreements are $85.6 million with Bank of
America, $81.9 million with Merrill Lynch, $39.2 million with Greenwich
Capital and $27.0 million with Bear Stearns. Most repurchase agreements have
stated maturities of less than one year.
In October 1998, the Company entered into a Revolving Credit Agreement with
a bank (the "Credit Agreement") with a one-year term and borrowing limit of
$40 million; the Credit Agreement has been extended to December, 2000.
Substantially all of the Company's Mortgage-Related Assets, servicing rights
and servicing advances are pledged as collateral under its debt obligations.
The aggregate amount of minimum payments required on debt obligations for
periods after December 31, 1999 are as follows:
2000 $ 607,020,704
2001 6,449,972
2002 184,860
2003 253,459
2004 50,258,924
Thereafter 551,149
-------------
$ 664,719,068
=============
8. INCOME TAXES
The Company has several C-Corporation subsidiaries, subject to income tax. The
components of the benefit for income taxes are as follows:
1999 1998 1997
---------- ---------- ---------
Current expense (benefit) $ (102,335) $ (17,257) $ 228,083
Deferred benefit (2,130) (461,314) (228,083)
---------- ---------- ---------
Total benefit $ (104,465) $ (478,571) $ --
========== ========== =========
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At December 31, 1999 and 1998, the net deferred tax liability was comprised
of the following temporary differences:
1999 1998
Deferred tax assets:
Net operating losses $ 173,950 $ 447,425
----------- -----------
Total 173,950 447,425
----------- -----------
Deferred tax liabilities:
Servicing rights and other intangibles (772,729) (1,012,010)
Other (154,419) (190,743)
----------- -----------
Total (927,148) (1,202,753)
----------- -----------
Net deferred tax liability $ (753,198) $ (755,328)
=========== ===========
The differences between the income tax benefit and the amount determined by
applying the statutory Federal income tax rate of 34% to the pretax loss of
taxable C-corporation subsidiaries at December 31, 1999 and 1998 are as follows:
1999 1998
Income tax benefit calculated at the
statutory rate $ (448,062) $ (780,095)
Goodwill amortization (GAAP-nondeductible) 327,540 298,485
Other 16,057 3,039
----------- -----------
Income tax benefit $ (104,465) $ (478,571)
=========== ===========
There was no significant difference between the 1997 tax provision and the
provision determined by applying the statutory Federal income tax rate to
pretax loss of taxable subsidiaries.
9. RELATED PARTY TRANSACTIONS
EFS - The Company occupies certain office facilities leased by EFS and
reimburses EFS for its occupancy costs. The Company incurred costs totaling
approximately $435,000, $288,000 and $180,000 in 1999, 1998 and 1997,
respectively. The Company had an outstanding borrowing from EFS at December
31, 1999 of approximately $786,000. These borrowings do not bear interest
and are repayable upon demand.
EFS acquired partnerships (the "EFS partnerships") holding interests in
Mortgage Securities in the second quarter of 1999, and engaged C-BASS to
manage the portfolio. C-BASS receives an annual base management fee and an
incentive fee based on portfolio performance. The annual incentive fee is
paid out over 4 years. The total management fee is estimated to be
approximately $1.5 million for 1999.
C-BASS, as manager for the EFS Partnerships, acquired and disposed of
certain mortgage securities during 1999, resulting in net proceeds payable
to the EFS Partnerships of approximately $1.1 million at December 31, 1999.
MGIC - Affiliates of MGIC provide the Company with various services,
including referral of investment opportunities. During 1999, 1998 and 1997,
the Company paid MGIC approximately $7,000, $16,000 and $257,000 for such
services, respectively.
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MGIC acquired partnerships (the "MGIC Partnerships") holding interests in
Mortgage Securities in the second quarter of 1999, and engaged C-BASS to
manage the portfolio. C-BASS receives an annual base management fee and an
incentive fee based on portfolio performance. The annual incentive fee is
paid out over 4 years. The total management fee is estimated to be
approximately $0.9 million for 1999.
C-BASS, as manager for the MGIC Partnerships, acquired and disposed of
certain mortgage securities during 1999, resulting in net proceeds payable
to the MGIC Partnerships of approximately $2.0 million.
10. COMMITMENTS AND CONTINGENCIES
The Company and its subsidiaries are obligated under leases for office space
through 2005. Minimum future lease commitments at December 31, 1999 are:
2000 $ 2,700,490
2001 2,645,536
2002 2,350,106
2003 2,262,461
2004 1,908,471
Thereafter 10,165,782
------------
$ 22,032,846
============
WSAT leases its office space in Tacoma, Washington from WTE, L.L.C., which is
17% owned by officers and the former owners of Wynwood.
The Company is involved in various legal proceedings and pending claims arising
in the ordinary course of business. The final outcome is uncertain. However,
management does not expect the resolution of these matters to have a significant
effect on the financial statements as of December 31, 1999.
11. DEFINED CONTRIBUTION PLANS
The Company maintains 401(k) plans, which were established in 1997, that
cover substantially all of its eligible employees. The permitted employee
contributions vary among the entities comprising the Company, as do the
employer matching contribution percentages. The employer matching
percentages are at the Company's discretion and are subject to change. The
Company's matching contributions totaled approximately $408,000 in 1999,
$255,000 in 1998 and $155,000 in 1997.
******
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54
CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC
AND AFFILIATES
COMBINED SCHEDULE OF MORTGAGE-RELATED ASSETS
DECEMBER 31, 1999
- --------------------------------------------------------------------------------
NOTIONAL AMOUNT ISSUER VALUE
MORTGAGE SECURITIES
$ 157,907,451 C-BASS $ 109,412,894
114,961,248 PNC 52,155,866
48,222,491 Merrill Lynch 44,727,925
323,213,936 Other 158,946,641
510,000,000 Interest rate swaps 4,980,614
-------------
Total Mortgage Securities 370,223,940
MORTGAGE LOANS $448,380,000 unpaid principal balance 388,575,903
REAL ESTATE OWNED 195 Properties 14,179,721
-------------
TOTAL MORTGAGE-RELATED ASSETS $ 772,979,564
=============
See notes to combined financial statements.
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