1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 0-26500 FIRSTCITY FINANCIAL CORPORATION (Exact Name of Registrant as Specified in Its Charter) DELAWARE 76-0243729 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 6400 IMPERIAL DRIVE, WACO, TX 76712 (Address of Principal Executive Offices) (Zip Code) (254) 751-1750 (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes [X] No [ ] The number of shares of common stock, par value $.01 per share, outstanding at November 1, 1998 was 8,273,832. 1 2 FORWARD LOOKING INFORMATION This Quarterly Report on Form 10-Q may contain forward-looking statements. The factors identified under Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations are important factors (but not necessarily all of the important factors) that could cause actual results to differ materially from those expressed in any forward-looking statement made by, or on behalf of, the Company. When any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, the Company cautions that, while such assumptions or bases are believed to be reasonable and are made in good faith, assumed facts or bases almost always vary from actual results, and the differences between assumed facts or bases and actual results can be material, depending upon the circumstances. When, in any forward-looking statement, the Company, or its management, expresses an expectation or belief as to future results, such expectation or belief is expressed in good faith and is believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will result or be achieved or accomplished. The words "believe," "expect," "estimate," "project," "anticipate" and similar expressions identify forward-looking statements. 2 3 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ ASSETS Cash and cash equivalents .................................................. $ 35,220 $ 31,605 Portfolio Assets, net ...................................................... 63,341 89,951 Loans receivable, net ...................................................... 78,687 90,115 Mortgage loans held for sale ............................................... 1,245,140 533,751 Investment securities ...................................................... 36,984 6,935 Equity investments in and advances to Acquisition Partnerships ............. 39,194 35,529 Mortgage servicing rights, net ............................................. 131,221 69,634 Receivable for servicing advances and accrued interest ..................... 41,819 21,410 Deferred tax benefit, net .................................................. 32,187 30,614 Other assets, net .......................................................... 26,881 30,575 ---------- ---------- Total Assets ........................................................ $1,730,674 $ 940,119 ========== ========== LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY Liabilities: Notes payable .......................................................... $1,512,499 $ 750,781 Other liabilities ...................................................... 59,000 34,672 ---------- ---------- Total Liabilities ................................................... 1,571,499 785,453 Commitments and contingencies .............................................. -- -- Redeemable preferred stock: Special preferred stock, including dividends of $669 in 1997 (nominal stated value of $21 per share; 2,500,000 shares authorized; 849,777 shares issued and outstanding in 1997) ......................... -- 18,515 Adjusting rate preferred stock, including dividends of $963 and $846, respectively (redemption value of $21 per share; 2,000,000 shares authorized; 1,222,701 and 1,073,704 shares, respectively, issued and outstanding) ................................................ 26,640 23,393 Shareholders' equity: Optional preferred stock (par value $.01 per share; 98,000,000 shares authorized; no shares issued or outstanding) ................. -- -- Common stock (par value $.01 per share; 100,000,000 authorized; issued and outstanding: 8,273,832 and 6,526,510 shares, respectively) ....................................................... 83 65 Paid in capital ........................................................ 78,274 29,509 Retained earnings ...................................................... 54,178 83,184 ---------- ---------- Total Shareholders' Equity .......................................... 132,535 112,758 Total Liabilities, Redeemable Preferred Stock and Shareholders' ---------- ---------- Equity ............................................................ $1,730,674 $ 940,119 ========== ========== See accompanying notes to consolidated financial statements. 3 4 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------ ------------------------ 1998 1997 1998 1997 --------- --------- --------- --------- Revenues: Gain on sale of mortgage and other loans .............. $ 26,749 $ 13,785 $ 75,321 $ 27,105 Gain on sale of automobile loans ...................... -- -- 2,434 -- Net mortgage warehouse income ......................... 2,796 702 6,913 1,994 Gain on sale of mortgage servicing rights ............. -- -- -- 4,529 Servicing fees: Mortgage ........................................... 7,410 3,726 17,692 10,711 Other .............................................. 1,534 1,711 3,906 11,233 Gain on resolution of Portfolio Assets ................ 1,947 3,957 7,883 14,149 Equity in earnings of Acquisition Partnerships ........ 3,061 1,798 7,798 6,111 Rental income on real estate Portfolios ............... -- 68 156 225 Interest income ....................................... 3,485 2,892 10,293 9,120 Other income .......................................... 2,176 1,064 8,452 4,634 Interest income on Class A Certificate ................ -- 330 -- 3,504 --------- --------- --------- --------- Total revenues ..................................... 49,158 30,033 140,848 93,315 Expenses: Interest on other notes payable ....................... 3,719 2,727 10,553 9,239 Salaries and benefits ................................. 22,148 11,873 58,612 31,157 Amortization: Mortgage servicing rights .......................... 5,638 1,993 12,940 5,136 Other .............................................. 1,953 98 2,758 1,863 Provision for loan losses and residual interests ...... 6,644 2,077 9,571 4,232 Provision for valuation of mortgage servicing rights .. 28,668 -- 29,168 -- Occupancy, data processing, communication and other .............................................. 19,136 10,904 43,956 27,089 --------- --------- --------- --------- Total expenses ..................................... 87,906 29,672 167,558 78,716 Earnings (loss) before minority interest, preferred dividends and income taxes ............................ (38,748) 361 (26,710) 14,599 Benefit (provision) for income taxes .................. (99) 16,078 1,297 15,496 --------- --------- --------- --------- Earnings (loss) before minority interest and preferred dividends ............................................. (38,847) 16,439 (25,413) 30,095 Minority interest ..................................... (347) (251) (333) (182) Preferred dividends ................................... 1,514 1,514 4,544 4,688 --------- --------- --------- --------- Net earnings (loss) to common shareholders ................ $ (40,014) $ 15,176 $ (29,624) $ 25,589 ========= ========= ========= ========= Net earnings (loss) per common share-- basic .............. $ (4.84) $ 2.33 $ (4.03) $ 3.93 Net earnings (loss) per common share-- diluted ............ $ (4.84) $ 2.30 $ (4.03) $ 3.89 Weighted average common shares outstanding-- basic ........ 8,261 6,519 7,351 6,517 Weighted average common shares outstanding-- diluted ............................................... 8,261 6,587 7,351 6,577 See accompanying notes to consolidated financial statements. 4 5 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DOLLARS IN THOUSANDS) NUMBER OF TOTAL COMMON COMMON PAID IN RETAINED SHAREHOLDERS' SHARES STOCK CAPITAL EARNINGS EQUITY --------- --------- --------- --------- ------------- BALANCES, JANUARY 1, 1997 ................. 6,513,346 $ 65 $ 29,783 $ 54,954 $ 84,802 Exercise of warrants, options and employee stock purchase plan ......... 13,164 -- 318 -- 318 Change in subsidiary year end ............. -- -- -- (1,195) (1,195) Net earnings for 1997 ..................... -- -- -- 35,628 35,628 Preferred dividends ....................... -- -- -- (6,203) (6,203) Other ..................................... -- -- (592) -- (592) --------- --------- --------- --------- --------- BALANCES, DECEMBER 31, 1997 ............... 6,526,510 65 29,509 83,184 112,758 Exercise of warrants, options and employee stock purchase plan ......... 505,172 5 12,493 -- 12,498 Issuance of common stock to acquire the minority interest of subsidiary .. 41,000 1 2,149 -- 2,150 Issuance of common stock in public offering ............................. 1,201,150 12 34,123 -- 34,135 Net loss for nine months ended September 30, 1998 ................... -- -- -- (25,080) (25,080) Foreign currency translation and other adjustments .......................... -- -- -- 618 618 Preferred dividends ....................... -- -- -- (4,544) (4,544) --------- --------- --------- --------- --------- BALANCES, SEPTEMBER 30, 1998 .............. 8,273,832 $ 83 $ 78,274 $ 54,178 $ 132,535 ========= ========= ========= ========= ========= See accompanying notes to consolidated financial statements. 5 6 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- 1998 1997 ------------ ------------- Cash flows from operating activities: Earnings (loss) before minority interest and preferred dividends ...................................................... $ (25,413) $ 30,095 Adjustments to reconcile net earnings (loss) to net cash used in operating activities, net of effect of acquisitions: proceeds from resolution of Portfolio Assets ........................... 37,551 43,822 Gain on resolution of Portfolio Assets ................................. (7,883) (14,149) Purchase of Portfolio Assets and loans receivable, net ................. (13,730) (26,770) Origination of automobile receivables .................................. (89,861) (64,640) Gain on sale of mortgage servicing rights .............................. -- (4,529) Increase in mortgage loans held for sale ............................... (752,197) (113,041) Increase in construction loans receivable .............................. (4,508) (10,400) Originated mortgage servicing rights ................................... (103,756) (27,044) Purchases of mortgage servicing rights ................................. (69) (4,813) Proceeds from sale of mortgage servicing rights ........................ -- 14,807 Provision for loan losses, residual interests and valuation of mortgage servicing rights .......................................... 38,739 4,232 Equity in earnings of Acquisition Partnerships ......................... (7,798) (6,111) Proceeds from performing Portfolio Assets and loans receivable, net ..................................................... 56,845 55,527 Increase in net deferred tax asset ..................................... (1,573) (16,073) Depreciation and amortization .......................................... 17,499 8,740 Increase in other assets ............................................... (711) (33,427) Increase in other liabilities .......................................... 34,089 25,834 ------------ ------------ Net cash used in operating activities ................................ (822,776) (137,940) ------------ ------------ Cash flows from investing activities: Payments on advances to acquisition partnerships and affiliates .......................................................... -- 1,029 Acquisition of subsidiaries ................................................. -- 1,118 Principal payments on Class A Certificate ................................... -- 41,361 Property and equipment, net ................................................. (5,079) (2,061) Contributions to Acquisition Partnerships ................................... (15,369) (12,392) Distributions from Acquisition Partnerships ................................. 18,199 9,840 ------------ ------------ Net cash provided by (used in) investing activities .................. (2,249) 38,895 ------------ ------------ Cash flows from financing activities: borrowings under notes payable .............................................. 21,098,998 6,249,336 Payments of notes payable ................................................... (20,297,178) (6,114,844) Purchase or redemption of special preferred stock ........................... (14,716) (12,567) Proceeds from issuance of common stock ...................................... 46,633 154 Distributions to minority interest .......................................... -- (5,609) Preferred dividends paid .................................................... (5,097) (5,112) ------------ ------------ Net cash provided by financing activities ............................ 828,640 111,358 ------------ ------------ Net increase in cash .......................................................... $ 3,615 $ 12,313 Cash, beginning of period ..................................................... 31,605 16,995 ------------ ------------ Cash, end of period ........................................................... $ 35,220 $ 29,308 ============ ============ Supplemental disclosure of cash flow information: cash paid during the period for: interest .................................................................. $ 53,773 $ 20,982 Income taxes .............................................................. $ 407 $ 480 Non-cash investing activities: payment on Class A Certificate in form of performing loan ................... $ -- $ 15,340 See accompanying notes to consolidated financial statements. 6 7 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (1) BASIS OF PRESENTATION The unaudited consolidated financial statements of FirstCity Financial Corporation ("FirstCity" or the "Company") reflect, in the opinion of management, all adjustments, consisting only of normal and recurring adjustments, necessary to present fairly FirstCity's financial position at September 30, 1998, the results of operations and the cash flows for the three month and nine month periods ended September 30, 1998 and 1997. Additionally, the Company's merger with Harbor Financial Group, Inc. ("Mortgage Corp.") on July 1, 1997 has been accounted for as a pooling of interests. The accompanying consolidated financial statements have been retroactively restated to reflect the pooling of interests. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include the estimation of future collections on purchased portfolio assets used in the calculation of net gain on resolution of portfolio assets, interest rate environments, prepayment speeds of loans in servicing portfolios, collectibility on loans held in inventory and for investment. Actual results could differ materially from those estimates. Certain amounts in the financial statements for prior periods have been reclassified to conform with current financial statement presentation. (2) MERGERS AND ACQUISITIONS On July 1, 1997, the Company merged with Mortgage Corp. (the "Harbor Merger"). The Company issued 1,580,986 shares of its common stock in exchange for 100% of Mortgage Corp.'s outstanding capital stock in a transaction accounted for as a pooling of interests. Mortgage Corp. originates and services residential and commercial mortgage loans. Mortgage Corp. had approximately $12 million in equity, assets of over $300 million and 700 employees prior to the Harbor Merger. At year end 1997, an unrelated party exercised warrants to acquire a four percent minority interest in Mortgage Corp.'s subsidiary, Harbor Financial Mortgage Corporation. On March 31, 1998, the Company issued 41,000 shares of common stock in exchange for the four percent minority interest in this subsidiary. The Company's net revenues, net earnings to common shareholders and net earnings per common share, for the six months ended June 30, 1997, before and after the Harbor Merger are summarized as follows: SIX MONTHS ENDED JUNE 30, 1997 -------------- Net revenues (including equity earnings): Before 1997 pooling .................... $ 34,838 1997 pooling ........................... 28,444 After 1997 pooling ..................... 63,282 Net earnings to common shareholders: Before 1997 pooling .................... $ 8,966 1997 pooling ........................... 1,447 After 1997 pooling ..................... 10,413 Net earnings per common share - diluted: Before 1997 pooling .................... $ 1.79 1997 pooling ........................... (0.21) After 1997 pooling ..................... 1.58 In the first quarter of 1997, FirstCity received $6.8 million (recorded as servicing fees) from the FirstCity Liquidating Trust (the "Trust") for termination of the Investment Management Agreement. 7 8 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (3) PORTFOLIO ASSETS Portfolio Assets are summarized as follows: SEPTEMBER 30, DECEMBER 31, 1998 1997 --------- --------- Non-performing ............................................. $ 100,554 $ 130,657 Performing ................................................. 12,364 16,131 Real estate ................................................ 13,986 22,777 --------- --------- Total .................................................. 126,904 169,565 Discount required to reflect Portfolio Assets at carrying value .................................................. (63,563) (79,614) --------- --------- Portfolio Assets, net .................................. $ 63,341 $ 89,951 ========= ========= Portfolio Assets are pledged to secure non-recourse notes payable. (4) LOANS RECEIVABLE Loans receivable are summarized as follows: SEPTEMBER 30, DECEMBER 31, 1998 1997 -------- -------- Construction loans receivable ................... $ 24,102 $ 19,594 Residential mortgage and other loans held for investment .................................. 8,725 6,386 Automobile and consumer finance receivables ..... 57,291 73,417 Allowance for loan losses ....................... (11,431) (9,282) -------- -------- Loans receivable, net ....................... $ 78,687 $ 90,115 ======== ======== The activity in the allowance for loan losses is summarized as follows for the periods indicated: NINE MONTHS ENDED SEPTEMBER 30, ---------------------- 1998 1997 -------- -------- Balances, beginning of period .............. $ 9,282 $ 2,693 Provision for loan losses .............. 4,431 4,232 Discounts acquired ..................... 13,608 9,182 Reduction in contingent liabilities .... -- 458 Allocation of reserves to sold loans ... (7,602) -- Charge off activity: Principal balances charged off ...... (11,294) (12,158) Recoveries .......................... 3,006 1,992 -------- -------- Net charge offs ................. (8,288) (10,166) -------- -------- Balances, end of period .................... $ 11,431 $ 6,399 ======== ======== During 1997, a note recorded at the time of purchase of the initial automobile finance receivables pool and contingent on the ultimate performance of the pool was adjusted to reflect a reduction in anticipated payments due pursuant to the contingency. The reduction in the recorded contingent liability was recorded as an increase in the allowance for losses. 8 9 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (5) MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale include loans collateralized by first lien mortgages on one-to-four family residences as follows: SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ Residential mortgage loans .. $1,208,664 $ 522,970 Unamortized premiums,net .... 36,476 10,781 ---------- ---------- $1,245,140 $ 533,751 ========== ========== (6) INVESTMENT SECURITIES The Company has investment securities (investments) consisting of rated securities, retained interests and related interest only strips (collectively referred to as residual interests) which are all attributable to loans sold through securitization transactions by the Company. As of September 30, 1998, the Company had recorded an unrealized loss of $4.3 million on the investments. Investments are comprised of the following as of the dates indicated. SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ Rated securities ........... $ 2,413 $ -- Interest only strips ....... 19,115 3,396 Retained interests ......... 19,113 3,308 Other securities ........... 112 -- Accrued interest ........... 581 231 Allowance for losses ....... (4,350) -- -------- -------- Investment securities... $ 36,984 $ 6,935 ======== ======== The activity in investments for the nine months ended September 30, 1998 and the year ended December 31, 1997 is as follows: SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ Balance, beginning of period ......... $ 6,935 $ -- Cost allocated from securitizations .. 37,175 6,925 Interest accreted .................... 1,860 548 Increase in other securities, net .... 112 -- Cash received from trusts ............ (4,748) (538) Provision for losses ................. (4,350) -- -------- -------- Balance, end of period ............... $ 36,984 $ 6,935 ======== ======== The investments are valued using discounts rates ranging from 12% to 15% for both home equity and consumer residual interests. Estimated loss rates are 1.5% on home equity and range from 13%to 18% on consumer residual interests with prepayment assumptions ranging from 12% to 30% and 3% to 12% on home equity and consumer residual interests, respectively. (7) INVESTMENTS IN ACQUISITION PARTNERSHIPS The Company has investments in Acquisition Partnerships and their general partners that are accounted for on the equity method. The condensed combined financial position and results of operations of the Acquisition Partnerships, which include the domestic and foreign Acquisition Partnerships and their general partners, are summarized below: 9 10 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CONDENSED COMBINED BALANCE SHEETS SEPTEMBER 30, DECEMBER 31, 1998 1997 -------- -------- Assets ........................................ $269,793 $338,484 ======== ======== Liabilities ................................... $168,724 $250,477 Net equity .................................... 101,069 88,007 -------- -------- $269,793 $338,484 ======== ======== Company's equity in acquisition partnerships... $ 39,194 $ 35,529 ======== ======== CONDENSED COMBINED SUMMARY OF EARNINGS THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------- --------------------- 1998 1997 1998 1997 -------- -------- -------- -------- Proceeds from resolution of Portfolio Assets.... $ 33,575 $ 41,086 $121,203 $156,738 Gross margin ................................... 12,704 9,294 40,347 28,852 Interest income on performing portfolio assets 2,129 2,208 6,751 5,936 Net earnings ................................... $ 8,042 $ 5,679 $ 21,025 $ 16,694 ======== ======== ======== ======== Company's equity in earnings of Acquisition Partnerships .............................. $ 3,061 $ 1,798 $ 7,798 $ 6,111 ======== ======== ======== ======== (8) MORTGAGE SERVICING RIGHTS Volatility of the interest rate environment which produced a sharp drop in mortgage interest rates, caused a significant increase in the prepayment speed assumptions that are used to value mortgage servicing rights. This in turn resulted in a $29.2 million provision for losses on mortgage servicing rights in 1998. The reduction in value was particularly significant in the servicing originated over the last year during which the Company's strategy was to retain, rather than sell, servicing in what was thought to be an historically low rate environment. As of September 30, 1998, the allowance for future valuation impairments of mortgage servicing rights totaled $29.8 million, or 18.5% of servicing rights. (9) PREFERRED STOCK AND SHAREHOLDERS' EQUITY In May 1998, the Company closed the public offering of 1,542,150 shares of FirstCity common stock, of which 341,000 shares were sold by selling shareholders. Net proceeds (after expenses) of $34.1 million were used to retire debt. On May 11, 1998, the Company notified holders of its outstanding warrants to purchase shares of common stock that it was exercising its option to repurchase such warrants for $1.00 each. In June 1998, as a result of such notification, warrants representing 471,380 shares of common stock were exercised for an aggregate warrant purchase price of $11.8 million. In the first six months of 1997, the Company purchased 537,430 shares of special preferred stock. In the third quarter of 1998 and the third quarter of 1997, 148,997 and 1,073,704 shares, respectively, of special preferred stock were exchanged for a like number of shares of adjusting rate preferred stock. In September 1998, the remaining special preferred stock was redeemed for $14.7 million plus accrued dividends. At September 30, 1998, accrued dividends totaled $1.0 million for adjusting rate preferred stock, or $.7875 per share, and were paid on October 15, 1998. On July 17, 1998 the Company filed a shelf registration statement with the Securities and Exchange Commission which allows the Company to issue up to $250 million in debt and equity securities from time to time in the future. The registration statement became effective July 28, 1998. As of September 30, 1998 there have been no securities issued under this registration statement. 10 11 FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Earnings per share ("EPS") has been calculated in conformity with SFAS No. 128, Earnings Per Share, and all prior periods have been restated. A reconciliation between the weighted average shares outstanding used in the basic and diluted EPS computations is as follows: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------- ---------------------------- 1998 1997 1998 1997 ------------ ----------- ------------- ---------- Net earnings (loss) to common shareholders................ $ (40,014) $ 15,176 $ (29,624) $ 25,589 ============ =========== ============= ========== Weighted average common shares outstanding - basic........ 8,261 6,519 7,351 6,517 Effect of dilutive securities: Assumed exercise of stock options..................... - 47 - 45 Assumed exercise of warrants.......................... - 21 - 15 ------------ ----------- ------------- ---------- Weighted average common shares outstanding - diluted...... 8,261 6,587 7,351 6,577 ============ =========== ============= ========== Net earnings (loss) per common share - basic.............. $ (4.84) $ 2.33 $ (4.03) $ 3.93 Net earnings (loss) per common share - diluted............ $ (4.84) $ 2.30 $ (4.03) $ 3.89 The Company adopted Financial Accounting Standards Board Statement No. 130, Reporting Comprehensive Income ("SFAS 130") as of January 1, 1998. SFAS 130 establishes standards for reporting and displaying comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130 also requires the accumulated balance of other comprehensive income to be displayed separately in the equity section of the consolidated balance sheet. The accumulated balance of other comprehensive income at each of September 30, 1998 and December 31, 1997 was $364 and $44, respectively, and other comprehensive income for the nine months ended September 30, 1998 and 1997 was $320 and $34, respectively. The adoption of this statement had no material impact on net earnings or shareholders' equity. (10) INCOME TAXES Federal income taxes are provided at a 35% rate. Net operating loss carry forwards ("NOLs") are available to FirstCity and are recognized as an offset to the provision in the period during which the benefit is determined to be realizable. During the first nine months of 1998, FirstCity recognized a deferred tax benefit of $1.5 million (compared to $16.8 million in the first nine months of 1997). Realization of the resulting net deferred tax asset is dependent upon generating sufficient taxable income prior to expiration of the net operating loss carry forwards. Although realization is not assured, management believes it is more likely than not that all of the recorded deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be adjusted in the future if estimates of future taxable income during the carry forward period change. (11) COMMITMENTS AND CONTINGENCIES The Company is involved in various legal proceedings in the ordinary course of business. In the opinion of management, the resolution of such matters will not have a material adverse impact on the consolidated financial condition, results of operations or liquidity of the Company. The Company is a 50% owner in an entity that is obligated to advance up to $2.5 million toward the acquisition of Portfolio Assets from financial institutions in California. At September 30, 1998, advances of $.2 million had been made under the obligation. 11 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company is a diversified financial services company engaged in residential and commercial mortgage banking ("Mortgage Corp."), Portfolio Asset acquisition and resolution ("Commercial Corp.") and consumer lending ("Consumer Corp."). The mortgage banking business involves the origination, acquisition and servicing of residential and commercial mortgage loans and the subsequent warehousing, sale or securitization of such loans through various public and private secondary markets. The Portfolio Asset acquisition and resolution business involves acquiring Portfolio Assets at a discount to Face Value and servicing and resolving such Portfolios in an effort to maximize the present value of the ultimate cash recoveries. The Company also seeks opportunities to originate and retain high yield commercial loans to businesses and to finance real estate projects that are unable to access traditional lending sources. The consumer lending business involves the acquisition, origination, warehousing, securitization and servicing of consumer receivables. The Company's current consumer lending operations are focused on the acquisition of sub-prime automobile receivables. As discussed in the quarter to quarter comparison, the Company reported a loss before minority interest and preferred dividends of $38.8 million in the third quarter of 1998 compared to earnings of $16.4 million (including a deferred tax benefit of $16.2 million related to the Harbor merger) in the third quarter of 1997. The loss resulted primarily from a $28.7 million provision to reflect the reduction in the carrying value of the mortgage servicing rights of FirstCity's residential mortgage subsidiary. Loan loss and other asset provisions totaling $6.6 million, as well as narrowing interest margins on the mortgage loan warehouse also contributed to the quarterly loss. Net loss to common shareholders was $40.0 million for the third quarter of 1998 compared to net earnings of $15.2 million for the third quarter of 1997. On a per share basis, basic net loss attributable to common shareholders was $4.84 for the third quarter of 1998 compared to net earnings of $2.33 for the third quarter of 1997. Diluted net loss per common share was $4.84 for the third quarter of 1998 compared to net earnings of $2.30 ( a loss of $.16 excluding the deferred tax benefit) for the third quarter of 1997. The Company's financial results are affected by many factors including levels of and fluctuations in interest rates, fluctuations in the underlying values of real estate and other assets, and the availability and prices for loans and assets acquired in all of the Company's businesses. The Company's business and results of operations are also affected by the availability of financing with terms acceptable to the Company and the Company's access to capital markets, including the securitization markets. The Harbor Merger, which occurred in July 1997, was accounted for as a pooling of interests. The Company's historical financial statements have therefore been retroactively restated to include the financial position and results of operations of Mortgage Corp. for all periods presented. As a result of the significant period to period fluctuations in the revenues and earnings of the Company's Portfolio Asset acquisition and resolution business and the rapid growth in Mortgage Corp., period to period comparisons of the Company's results of operations may not be meaningful. ANALYSIS OF REVENUES AND EXPENSES The following table summarizes the revenues and expenses of each of the Company's businesses and presents the contribution that each business makes to the Company's operating margin. SUMMARY OF REVENUES AND EXPENSES (IN THOUSANDS, EXCEPT PER SHARE DATA) NINE MONTHS ENDED THIRD QUARTER SEPTEMBER 30, --------------------- --------------------- 1998 1997 1998 1997 -------- -------- -------- -------- MORTGAGE BANKING: Revenues: Net mortgage warehouse income ......................... $ 2,796 $ 702 $ 6,913 $ 1,994 Gain on sale of mortgage loans ........................ 26,749 13,785 75,321 27,105 Servicing fees ........................................ 7,410 3,726 17,692 10,711 Other ................................................. 1,729 609 5,285 7,457 -------- -------- -------- -------- Total ............................................... 38,684 18,822 105,211 47,267 Expenses: Salaries and benefits ................................. 19,029 9,095 49,180 22,668 Amortization of mortgage servicing rights ............. 5,638 1,993 12,940 5,136 Provision for valuation of mortgage servicing rights .. 28,668 -- 29,168 -- Provision for loan losses and residual interests ...... 2,064 -- 2,139 -- Interest on other notes payables ...................... 513 304 1,500 863 12 13 NINE MONTHS ENDED THIRD QUARTER SEPTEMBER 30, ------------------------ ------------------------ 1998 1997 1998 1997 --------- --------- --------- --------- Occupancy, data processing, communication and other ............................................ 16,295 6,068 33,734 14,914 --------- --------- --------- --------- Total ............................................ 72,207 17,460 128,661 43,581 --------- --------- --------- --------- Operating contribution before direct taxes ........... $ (33,523) $ 1,362 $ (23,450) $ 3,686 ========= ========= ========= ========= Operating contribution, net of direct taxes .......... $ (33,523) $ 1,362 $ (23,539) $ 3,686 ========= ========= ========= ========= PORTFOLIO ASSET ACQUISITION AND RESOLUTION: Revenues: Gain on resolution of Portfolio Assets ............. $ 1,947 $ 3,957 $ 7,883 $ 14,149 Equity in earnings of Acquisition Partnerships ..... 3,061 1,798 7,798 6,111 Servicing fees (1) ................................. 769 1,487 2,166 10,869 Other .............................................. 450 608 3,078 2,641 --------- --------- --------- --------- Total ............................................ 6,227 7,850 20,925 33,770 Expenses: Salaries and benefits .............................. 1,172 1,242 3,439 4,125 Interest on other notes payable .................... 1,573 1,979 4,502 5,193 Asset level expenses, occupancy, data processing and other ........................................ 1,859 2,274 5,960 8,306 --------- --------- --------- --------- Total ............................................ 4,604 5,495 13,901 17,624 --------- --------- --------- --------- Operating contribution before direct taxes ........... $ 1,623 $ 2,355 $ 7,024 $ 16,146 ========= ========= ========= ========= Operating contribution, net of direct taxes .......... $ 1,575 $ 2,271 $ 6,967 $ 15,957 ========= ========= ========= ========= CONSUMER LENDING: Revenues: Gain on sale of automobile loans .................. $ -- $ -- $ 2,434 $ -- Interest income ................................... 2,753 2,262 7,971 7,131 Servicing fees and other .......................... 1,079 183 2,129 417 --------- --------- --------- --------- Total ........................................... 3,832 2,445 12,534 7,548 Expenses: Salaries and benefits ............................. 1,149 784 3,553 1,881 Provision for loan losses and residual interests .. 4,580 2,077 7,432 4,232 Interest on other notes payable ................... 641 353 2,455 2,188 Occupancy, data processing and other .............. 1,648 858 4,418 2,452 --------- --------- --------- --------- Total ........................................... 8,018 4,072 17,858 10,753 --------- --------- --------- --------- Operating contribution before direct taxes .......... $ (4,186) $ (1,627) $ (5,324) $ (3,205) ========= ========= ========= ========= Operating contribution, net of direct taxes ......... $ (4,186) $ (1,627) $ (5,324) $ (3,208) ========= ========= ========= ========= Total operating contribution, net of direct taxes .. $ (36,134) $ 2,006 $ (21,896) $ 16,435 ========= ========= ========= ========= CORPORATE OVERHEAD: Interest income on Class A Certificate (2) ........... $ -- $ 330 $ -- $ 3,504 Salaries and benefits, occupancy, professional and other income and expenses, net ..................... (2,366) (1,878) (4,684) (6,494) Deferred tax benefit ................................. -- 16,232 1,500 16,832 --------- --------- --------- --------- Earnings (loss) before preferred dividends ........... (38,500) 16,690 (25,080) 30,277 Preferred dividends .................................. 1,514 1,514 4,544 4,688 --------- --------- --------- --------- Net earnings (loss) to common shareholders ....... $ (40,014) $ 15,176 $ (29,624) $ 25,589 ========= ========= ========= ========= SHARE DATA: Net earnings (loss) per common share--basic .......... $ (4.84) $ 2.33 $ (4.03) $ 3.93 Net earnings (loss) per common share--diluted ........ $ (4.84) $ 2.30 $ (4.03) $ 3.89 Weighted average common shares outstanding - basic ... 8,261 6,519 7,351 6,517 Weighted average common shares outstanding - diluted .............................................. 8,261 6,587 7,351 6,577 (1) Includes $6.8 million received as a result of terminating the Investment Management Agreement with FirstCity Liquidating Trust in first quarter 1997. (2) Prior to June 30, 1997, income was received from FirstCity Liquidating Trust equal to the Company's preferred stock dividend obligation. 13 14 NINE MONTHS ENDED THIRD QUARTER SEPTEMBER 30, ------------------------- ------------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- ORIGINATION AND OTHER FINANCIAL DATA: Mortgage Corp.: Origination of residential mortgage loans: Conventional ................................. $1,651,266 $ 684,474 $4,596,857 $1,560,824 Agency ....................................... 401,140 165,442 1,109,732 366,733 Home equity .................................. 135,171 59,373 282,456 118,895 Other ........................................ 39,979 18,765 93,168 42,903 ---------- ---------- ---------- ---------- Total ...................................... $2,227,556 $ 928,054 $6,082,213 $2,089,355 ========== ========== ========== ========== Origination of commercial mortgage loans: Correspondent ................................ $ 133,343 $ 177,305 $ 314,593 $ 219,780 Construction ................................. 21,195 18,049 55,112 44,430 ---------- ---------- ---------- ---------- Total ...................................... $ 154,538 $ 195,354 $ 369,705 $ 264,210 ========== ========== ========== ========== Acquisition of Home Equity Loans ............... $ 101,239 $ -- $ 206,967 $ -- Commercial Corp.: Aggregate purchase price of assets acquired .... $ 9,200 $ 9,441 $ 79,040 $ 67,628 Proceeds from resolution ....................... 41,095 54,785 158,754 200,560 Consumer Corp.: Aggregate acquisition of automobile and other consumer receivables.......................... $ 37,163 $ 19,653 $ 103,818 $ 72,758 MORTGAGE BANKING In the third quarter of 1998, Rick R. Hagelstein, Executive Vice President and Director of Subsidiary Operations, was named chairman and CEO of Mortgage Corp. Mr. Hagelstein replaced Richard J. Gillen who elected to retire. Mr. Gillen will continue to serve on the Company's board of directors. Volatility of the interest rate environment produced a sharp drop in mortgage rates, causing a significant increase in the prepayment speed assumptions that are used to value mortgage servicing rights. This in turn resulted in a $29.2 million reduction in the value of this asset in 1998. The reduction in value was particularly significant in the servicing originated over the last year during which the Company's strategy was to retain, rather than sell, servicing in what was thought to be a historically low rate environment. During this period, the volatility in rates precluded the Company from hedging the value of servicing assets with any degree of certainty. Narrowing spreads during the quarter negatively impacted mortgage margins on warehouse inventory, where borrowing costs have not declined as rapidly as rates on originated mortgage loan assets. The overall profitability of the mortgage unit was further impacted by the costs incurred as the Company undertook a previously announced review of the strategic direction of this business line. Following such review the Company announced it would reduce the level of capital commitment to this business line. In accordance with this strategy, the Company has accepted a contract on the sale of approximately $3.5 billion of servicing, at a price of $52 million. The sale, which is anticipated to close in November, along with the disposition of the approximately $280 million of GNMA buyout loans, will resize the servicing portfolio to a level which provides the appropriate level of liquidity and profitability while supporting Mortgage Corp.'s loan origination platform. In addition, consistent with its previously announced strategy, the Company intends to sell, on a quarterly basis, a substantial portion of its servicing rights related to future production. The following table presents selected information regarding the revenues and expenses of the Company's mortgage banking business. 14 15 ANALYSIS OF SELECTED REVENUES AND EXPENSES MORTGAGE BANKING (DOLLARS IN THOUSANDS) NINE MONTHS ENDED THIRD QUARTER SEPTEMBER 30, -------------------------- -------------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- WAREHOUSE INVENTORY: Average inventory balance ................... $1,196,205 $ 273,101 $1,011,400 $ 238,649 Net mortgage warehouse income: Dollar amount ............................. 2,796 702 6,913 1,994 Annualized percentage of average inventory balance ......................... 0.94% 1.03% 0.91% 1.11% GAIN ON SALE OF MORTGAGE LOANS: Gain on sale of mortgage loans as a Percentage of loans sold: Residential ............................... 1.18% 1.39% 1.23% 1.24% Home equity ............................... 4.30% 4.17% 4.49% 4.18% Securitized Home Equity ................... -- -- 1.24% -- OMSR income as a percentage of residential Mortgage loans sold ....................... 1.52% 1.40% 1.57% 1.39% SERVICING REVENUES: Average servicing portfolios: Residential ............................... $7,663,877 $3,623,143 $6,683,534 $3,923,691 Commercial ................................ 1,383,653 1,746,772 1,577,506 1,069,334 Sub-serviced .............................. 1,105,823 676,599 1,096,548 849,804 Servicing fees: Residential ............................... $ 6,897 $ 3,218 $ 16,304 $ 9,541 Commercial ................................ 247 275 732 528 Sub-serviced .............................. 266 233 656 642 ---------- ---------- ---------- ---------- Total .................................. $ 7,410 $ 3,726 $ 17,692 $ 10,711 Annualized servicing fee percentage: Residential ............................... 0.36% 0.36% 0.33% 0.32% Commercial ................................ 0.07% 0.06% 0.06% 0.07% Sub-serviced .............................. 0.10% 0.14% 0.08% 0.10% Gain on sale of servicing rights ............ -- -- -- $ 4,529 Amortization of servicing rights: Servicing rights amortization ............. $ 5,638 $ 1,993 $ 12,940 $ 5,136 Servicing rights amortization as a Percentage of average residential Servicing portfolio (annualized) ....... 0.29% 0.22% 0.26% 0.18% PERSONNEL: Personnel expenses .......................... $ 19,029 $ 9,095 $ 49,180 $ 22,668 Number of personnel (at period end): Production ................................ 529 305 Servicing ................................. 160 155 Other ..................................... 823 386 ---------- ---------- Total .................................. 1,512 846 ========== ========== PORTFOLIO ASSET ACQUISITION AND RESOLUTION During the first quarter of 1997, the Trust terminated the Investment Management Agreement and paid Commercial Corp. a termination payment of $6.8 million representing the present value of servicing fees projected to have been earned by Commercial Corp. upon the liquidation of the assets of the Trust, which was expected to occur principally in 1997. The following table presents selected information regarding the revenues and expenses of the Company's Portfolio Asset acquisition and resolution business. 15 16 ANALYSIS OF SELECTED REVENUES AND EXPENSES PORTFOLIO ASSET ACQUISITION AND RESOLUTION (DOLLARS IN THOUSANDS) NINE MONTHS ENDED THIRD QUARTER SEPTEMBER 30, ---------------------- ---------------------- 1998 1997 1998 1997 -------- -------- -------- -------- GAIN ON RESOLUTION OF PORTFOLIO ASSETS: Average investment: Nonperforming Portfolios ............... $ 38,728 $ 78,047 $ 43,744 $ 59,405 Performing Portfolios .................. 13,546 10,685 13,819 8,979 Real estate Portfolios ................. 14,746 20,147 16,892 21,968 Gain on resolution of Portfolio Assets: Nonperforming Portfolios ............ $ 1,181 $ 3,388 $ 5,071 $ 11,418 Performing Portfolios .................. -- -- 299 -- Real estate Portfolios ................. 766 569 2,513 2,731 -------- -------- -------- -------- Total ............................... $ 1,947 $ 3,957 $ 7,883 $ 14,149 ======== ======== ======== ======== Interest income on performing Portfolios . $ 339 $ 312 $ 1,525 $ 1,373 Gross profit percentage on resolution of Portfolio Assets: Nonperforming Portfolios ............... 29.70% 29.12% 23.39% 32.69% Performing Portfolios .................. -- -- 7.99% -- Real estate Portfolios ................. 21.62% 27.49% 20.72% 30.70% Weighted average gross profit percentage 25.89% 28.89% 20.99% 32.29% Interest yield on performing Portfolios (annualized) ...................... 10.01% 11.68% 14.01% 20.39% SERVICING FEE REVENUES: Acquisition partnerships ............... $ 687 $ 1,211 $ 1,996 $ 3,594 Trust .................................. -- -- -- 6,800 Affiliates ............................. 82 276 170 475 -------- -------- -------- -------- Total ............................... $ 769 $ 1,487 $ 2,166 $ 10,869 ======== ======== ======== ======== PERSONNEL: Personnel expenses ....................... $ 1,172 $ 1,242 $ 3,439 $ 4,125 Number of personnel (at period end): Production ............................. 12 10 Servicing .............................. 70 95 -------- -------- Total ............................... 82 105 ======== ======== Interest expense: Average debt ........................ $ 74,301 $101,354 $ 73,826 $ 76,199 Interest expense .................... 1,571 1,979 4,380 4,945 Average yield (annualized) .......... 8.46% 7.81% 7.91% 8.65% The following chart presents selected information regarding the revenues and expenses of the Acquisition Partnerships. ANALYSIS OF SELECTED REVENUES AND EXPENSES ACQUISITION PARTNERSHIPS (DOLLARS IN THOUSANDS) NINE MONTHS ENDED THIRD QUARTER SEPTEMBER 30, -------------------- -------------------- 1998 1997 1998 1997 ------- ------- ------- ------- GAIN ON RESOLUTION OF PORTFOLIO ASSETS: Gain on resolution of Portfolio Assets ... $12,704 $ 9,294 $40,347 $28,852 Gross profit percentage on resolution of Portfolio Assets ....................... 37.84% 22.62% 33.29% 18.41% Interest income on performing Portfolios . 2,129 2,208 6,751 5,936 Other income ............................. 1,577 315 1,910 1,173 INTEREST EXPENSE: Interest expense .................... $ 3,250 $ 2,287 $10,207 $ 8,445 Average yield (annualized) .......... 7.99% 9.20% 7.28% 9.10% OTHER EXPENSES: Servicing fees ...................... $ 1,148 $ 1,511 $ 3,933 $ 4,178 Legal ............................... 711 667 1,696 1,891 Property protection ................. 1,679 1,056 3,673 3,322 Other ............................... 1,580 617 8,474 1,431 ------- ------- ------- ------- Total other expenses .............. 5,118 3,851 17,776 10,822 ------- ------- ------- ------- NET EARNINGS ........................ $ 8,042 $ 5,679 $21,025 $16,694 ======= ======= ======= ======= 16 17 CONSUMER LENDING The following chart presents selected information regarding the revenues and expenses of Consumer Corp.'s consumer lending business. ANALYSIS OF SELECTED REVENUES AND EXPENSES CONSUMER LENDING (DOLLARS IN THOUSANDS) NINE MONTHS ENDED THIRD QUARTER SEPTEMBER 30, -------------------- -------------------- 1998 1997 1998 1997 ------- ------- ------- ------- INTEREST INCOME: Average loans and investments: Auto ................................ $34,831 $41,576 $45,308 $48,007 Investments ......................... 31,586 6,917 23,219 3,460 Interest income: Auto ................................ $ 1,783 $ 1,838 $ 6,256 $ 6,367 Investments ......................... 833 239 1,522 316 Average yield (annualized): Auto ................................ 20.47% 17.68% 18.41% 17.68% Investments ......................... 10.55% 13.82% 8.74% 12.18% SERVICING FEE REVENUES: Affiliates .......................... $ 765 $ 224 $ 1,740 $ 364 PERSONNEL: Personnel expenses .................... $ 1,149 $ 784 $ 3,553 $ 1,881 Number of personnel (at period end): Production .......................... 99 21 Servicing ........................... 100 56 ------- ------- Total ............................ 199 77 ======= ======= INTEREST EXPENSE: Average debt ..................... $29,409 $16,016 $37,202 $33,230 Interest expense ................. 641 353 2,455 2,188 Average yield (annualized) ....... 8.72% 8.81% 8.80% 8.78% BENEFIT (PROVISION) FOR INCOME TAXES The Company has substantial federal NOLs, which can be used to offset the tax liability associated with the Company's pre-tax earnings until the earlier of the expiration or utilization of such NOLs. The Company accounts for the benefit of the NOLs by recording the benefit as an asset and then establishing an allowance to value the net deferred tax asset at a value commensurate with the Company's expectation of being able to utilize the recognized benefit in the next three to four year period. Such estimates are reevaluated on a quarterly basis with the adjustment to the allowance recorded as an adjustment to the income tax expense generated by the quarterly earnings. Significant events that change the Company's view of its currently estimated ability to utilize the tax benefits, such as the Harbor Merger in the third quarter of 1997, result in substantial changes to the estimated allowance required to value the deferred tax benefits recognized in the Company's periodic financial statements. Similar events could occur in the future, and would impact the quarterly recognition of the Company's estimate of the required valuation allowance associated with its NOLs. 17 18 RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements of the Company (including the Notes thereto) included elsewhere in this Quarterly Report on Form 10-Q. THIRD QUARTER 1998 COMPARED TO THIRD QUARTER 1997 The Company reported a loss before minority interest and preferred dividends of $38.8 million in the third quarter of 1998 compared to earnings of $16.4 million (including a deferred tax benefit of $16.2 million related to the Harbor merger) in the third quarter of 1997. The loss resulted primarily from a $28.7 million provision to reflect the reduction in the carrying value of the mortgage servicing rights of FirstCity's residential mortgage subsidiary. Loan loss and other asset provisions totaling $6.6 million, as well as narrowing interest margins on the mortgage loan warehouse also contributed to the quarterly loss. Net loss to common shareholders was $40.0 million for the third quarter of 1998 compared to earnings of $15.2 million for the third quarter of 1997. On a per share basis, basic net loss attributable to common shareholders was $4.84 for the third quarter of 1998 compared to net earnings of $2.33 for the third quarter of 1997. Diluted net loss per common share was $4.84 for the third quarter 1998 compared to net earnings of $2.30 ( a loss of $.16 excluding the deferred tax benefit) in 1997. Mortgage Banking Mortgage Corp. experienced significant revenue growth in the third quarter of 1998 relative to 1997 increasing to $38.7 million from $18.8 million. The direct retail group ("Direct Retail") and the broker retail group ("Broker Retail") origination networks experienced substantial growth in levels of origination volume reflecting, in part, the level of capital that has been contributed to Mortgage Corp. by the Company following the Harbor Merger and relatively lower market interest rates on mortgage loans in 1998 compared to 1997. Such revenue growth was partially offset by increases in operating expenses associated with the increased levels of origination volumes. The Company entered the mortgage conduit business in August 1997 with the formation of FirstCity Capital Corporation ("Capital Corp."). Capital Corp. has generated interest revenue from its acquired Home Equity Loans, has incurred interest expense to finance the acquisition of such loans and has incurred general and administrative expenses in its start-up phase. Gain on sale of mortgage loans. Gain on sale of mortgage loans increased by 94% to $26.7 million in 1998 from $13.8 million in 1997. This increase was the result of substantial growth in the levels of residential mortgage loan origination generated principally by the Broker Retail network of Mortgage Corp. and, to a lesser extent, the Direct Retail network of Mortgage Corp., and the resulting sales of such loans to government agencies and other investors. The change in the gain on sale percentage is the result of the sale of approximately $2.1 billion of mortgage loans in 1998 (compared to $.9 billion in 1997) and the overall mix and pricing of the loans sold. Net mortgage warehouse income. Net mortgage warehouse income increased by 298% to $2.8 million in 1998 from $.7 million in 1997. This is the result of a significant increase in the average balance of loans held in inventory during the year partially offset by a decrease in the spread earned between the interest rate on the underlying mortgages and the interest cost of the warehouse credit facility. Servicing fee revenues. Servicing fee revenues increased by 99% to $7.4 million in 1998 from $3.7 million in 1997 as a result of an increase in the size of the servicing portfolio. The average residential servicing portfolio increased $4.0 billion over third quarter 1997, to a level of $7.7 billion, accounting for the majority of the increase in the servicing fee revenue. Other revenues. Other revenues increased by 184% to $1.7 million in 1998 from $.6 million in 1997. This increase resulted from the volume driven fee revenue associated with increased originations. Operating expenses. Operating expenses of Mortgage Corp. increased to $72.2 million in 1998 from $17.5 million in 1997. The provision for valuation of mortgage servicing rights (discussed earlier), the expansion of the Broker Retail and Direct Retail operation and the commencement of Capital Corp.'s operations in late 1997 contributed to the period to period increases. Salaries and benefits increased by $9.9 million in 1998 reflecting the 666 additional staff required to support the increase in origination volumes derived principally from the Broker Retail network and, to a lesser extent, the Direct Retail network, and the increase in the size and number of loans in the residential and commercial servicing portfolios in 1998. Amortization of mortgage servicing rights increased in 1998 as a result of the substantially larger investment in mortgage servicing rights in 1998. During the quarter the Company added $28.7 million to the provision for valuation of mortgage servicing rights, resulting in a total allowance of $29.8 million, or 18.5% of total mortgage servicing rights. A provision for losses on approximately $280 million of GNMA buyout loans scheduled for disposition and for residual interests totaled $2.1 million. Interest on other notes payable (the portion not associated with Mortgage Corp.'s warehouse credit facility) increased due to higher working capital borrowing's during 1998. 18 19 Occupancy expense increased by $2.3 million in 1998 as the result of the opening or acquisition of several new offices in the Broker Retail and Direct Retail networks. Increases in data processing, communication and other expenses in 1998 resulted from the substantial increases in production and servicing volumes. Portfolio Asset Acquisition and Resolution Commercial Corp. purchased $9.2 million of Portfolio Assets during the third quarter of 1998 for its own account and through the Acquisition Partnerships compared to $9.4 million of acquisitions in the third quarter of 1997. Commercial Corp.'s quarter end investment in Portfolio Assets decreased to $63.3 million in 1998 from $90.0 million in 1997. Commercial Corp. invested $2.7 million in equity in Portfolio Assets in 1998 compared to $5.3 million in 1997. Net gain on resolution of Portfolio Assets. Proceeds from the resolution of Portfolio Assets decreased by 45% to $ 7.5 million in 1998 from $13.7 million in 1997. The net gain on resolution of Portfolio Assets decreased by 51% to $1.9 million in 1998 from $4.0 million in 1997 as the result of reduced collections and lower gross profit percentage in 1998. The weighted average gross profit percentage on the resolution of Portfolio Assets in 1998 was 25.9% as compared to 28.9% in 1997. Equity in earnings of Acquisition Partnerships. Proceeds from the resolution of Portfolio Assets for the Acquisition Partnerships decreased by 18% to $33.6 million in 1998 from $41.1 million in 1997 while the gross profit percentage increased to 37.8% in 1998 from 22.6% in 1997. Other expenses of the Acquisition Partnerships increased by $1.3 million in 1998 generally reflecting costs associated with the resolution of Portfolio Assets in Europe which generated proceeds of $17.8 million. The net result was an overall increase in the net income of the Acquisition Partnerships of 42% to $8.0 million in 1998 from $5.7 million in 1997. As a result, Commercial Corp.'s equity earnings from Acquisition Partnerships increased by 70% to $3.1 million in 1998 from $1.8 million in 1997. Servicing fee revenues. Servicing fees decreased by 48% to $.8 million in 1998 from $1.5 million in 1997 as a result of lower domestic collection levels in the Acquisition Partnerships and affiliated entities. Operating expenses. Operating expenses declined to $4.6 million in 1998 from $5.5 million in 1997 primarily as a result of reduced interest expense and lower asset level expenses. Salaries and benefits declined in 1998 as a result of the closing of some of the servicing offices following the resolution of the portfolios serviced by such offices. Interest on other notes payable declined by $.4 million in 1998 due to a decrease in the average outstanding debt during the period. Asset level expenses incurred in connection with the servicing of Portfolio Assets decreased in 1998 as a result of lower investments in Portfolio Assets in 1998. Occupancy and other expenses decreased as a result of the consolidation of servicing offices in 1998. Consumer Lending Consumer Corp.'s revenues and expenses in 1997 were derived principally from its original sub-prime automobile financing program. Consumer Corp. terminated its obligations to the financial institutions participating in such program effective as of January 31, 1998. In late 1997 Consumer Corp., through its 80% owned subsidiary, Funding Corp., established a new sub-prime automobile financing program which originates automobile loans through direct relationships with franchised automobile dealerships. Substantially all of Consumer Corp.'s activities have been, and are expected to continue to be, conducted through Funding Corp. during 1998. Interest and other income. Interest income increased 22% in the third quarter of 1998 as compared to the third quarter of 1997 primarily due to the increased level of residual interest income on securitized assets. Other income increased by $.9 million due to an increase in service fee revenues from securitization trusts. Interest expense. Interest expense increased by 82% or $.3 million in 1998 from 1997 as a result of an increase in the average outstanding level of borrowing's secured by automobile receivables to $29.4 million in 1998 from $16.0 million in 1997. The average rate at which such borrowing's incurred interest decreased to 8.72% from 8.81% for the same period. Operating expenses. Salaries and benefits increased by 47% to $1.1 million in 1998 from $.8 million in 1997 as a result of the increased levels of operating activity in 1998. Other expenses increased $.8 million due to the growth of the origination and servicing operations. Provision for loan losses and residual interests. The provision for loan losses on automobile receivables decreased by 24% to $1.6 million in 1998 from $2.1 million in 1997. Consumer Corp. previously increased its rate of provision for loan losses based on its determination that the discount rate at which it acquired loans under its prior origination program did not properly provide for the losses expected to be realized on the acquired loans. The origination program currently operated by Funding Corp. generally allows for the 19 20 acquisition of loans from automobile dealerships at a larger discount from par than Consumer Corp.'s original financing program. The Company believes that such acquisition prices more closely approximate the expected loss per occurrence on the loans originated. To the extent that Funding Corp. cannot match such discount to expected losses, additional provisions might, in the future, be required to properly provide for the risk of loss on the loans originated. However, the provisions for loan losses recognized by the Company during 1998 are primarily attributable to loans acquired through its previous origination program. In addition, Consumer Corp. provided $3.0 million in 1998 for anticipated losses related to the retained interests in securitizations. This provision is primarily a result of Consumer Corps.'s review and increase of the underlying loss assumptions from a range of 13-14% to 16-18% based upon actual performance of the securitized assets. Other Items Affecting Net Earnings The following items affect the Company's overall results of operations and are not directly related to any one of the Company's businesses discussed above. Corporate overhead. Company level interest expense increased by $.9 million due to a higher level of corporate borrowings. Other corporate income decreased due to lower levels of interest earned on excess liquidity. Salary and benefits, occupancy and professional fees account for the majority of other overhead expenses, which remained relatively flat compared to 1997. Income taxes. Federal income taxes are provided at a 35% rate applied to taxable income and are offset by NOLs that the Company believes are available to it. The tax benefit of the NOLs is recorded in the period during which the benefit is realized. The Company recorded no deferred tax benefit in the third quarter of 1998 as compared to a benefit of $16.2 million (related to the Harbor merger) in the third quarter of 1997. NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 1997 The Company reported a loss before minority interest and preferred dividends of $25.4 million in the first nine months of 1998 (including a $1.5 million deferred tax benefit) compared to earnings of $30.1 million (including a $16.8 million deferred tax benefit) in the first nine months of 1997. Net loss to common shareholders was $29.6 million in the first nine months of 1998 compared to net earnings of $25.6 million in the first nine months of 1997. On a per share basis, basic net loss attributable to common shareholders was $4.03 in the first nine months of 1998 compared to net earnings of $3.93 in the first nine months of 1997. Diluted net loss per common share was $4.03 in the first nine months of 1998 compared to net earnings of $3.89 ($1.33 excluding the deferred tax benefit) in the first nine months of 1997. The 1997 results reflect the positive effect of the $6.8 million, or $1.03 per share, payment from the Trust in settlement of the Investment Management Agreement. Mortgage Banking Gain on sale of mortgage loans. Gain on sale of mortgage loans increased by 178% to $75.3 million in the first nine months of 1998 from $27.1 million in the first nine months of 1997. This increase was the result of substantial growth in the levels of residential mortgage loan origination generated principally by the Broker Retail network of Mortgage Corp. and, to a lesser extent, the Direct Retail network of Mortgage Corp., and the resulting sales of such loans to government agencies and other investors. The increase in the gain on sales recognized is the result of the sale of approximately $5.7 billion of mortgage loans in 1998 (compared to $1.9 billion in 1997) and the overall mix and pricing of the loans sold. Net mortgage warehouse income. Net mortgage warehouse income increased by 247% to $6.9 million in 1998 from $2.0 million in 1997. This is the result of a significant increase in the average balance of loans held in inventory during the year, offset by a decrease in the spread earned between the interest rate on the underlying mortgages and the interest cost of the warehouse credit facility as the overall levels of interest rates on residential mortgage loans reached their lowest levels in several years. Servicing fee revenues. Servicing fee revenues increased by 65% to $17.7 million in 1998 from $10.7 million in 1997 as a result of an increase in the size of the servicing portfolio. Mortgage Corp. substantially increased its commercial mortgage servicing portfolio and its ability to originate commercial mortgage loans for correspondents and conduit lenders with the purchase, in the second quarter of 1997, of MIG. Other revenues. Other revenues decreased by 29% to $5.3 million in 1998 from $7.5 million in 1997. This decrease resulted primarily from Mortgage Corp.'s decision to retain, rather than sell, servicing rights in 1998. The sale of servicing rights in 1997 resulted in a gain on sale of $4.5 million. Operating expenses. Operating expenses of Mortgage Corp. increased to $129 million in 1998 from $43.6 million in 1997. The provision for valuation of mortgage servicing rights, expansion of the Broker Retail and Direct Retail operation and the commencement of Capital Corp.'s operations in late 1997 contributed to the period to period increases. The acquisition of MIG in 1997, which was accounted for as a purchase by Mortgage Corp., produced higher relative totals for all components of Mortgage Corp.'s operating expenses in 1998. 20 21 Salaries and benefits increased by $26.5 million in 1998 reflecting the additional staff required to support the increase in origination volumes derived principally from the Broker Retail network and, to a lesser extent, the Direct Retail network, and the increase in the size and number of loans in the residential and commercial servicing portfolios in 1998. Amortization of mortgage servicing rights increased in 1998 as a result of the substantially larger investment in mortgage servicing rights in 1998. The provision for valuation of mortgage servicing rights totaled $29.2 million. A provision for losses on approximately $280 million of GNMA buyout loans scheduled for disposition and for residual interests totaled $2.1 million. Interest on other notes payable (the portion not associated with Mortgage Corp.'s warehouse credit facility) increased due to higher working capital borrowings during 1998. Occupancy expense increased by $5.3 million in 1998 as the result of the opening or acquisition of several new offices in 1997 in the Broker Retail and Direct Retail networks. Increases in data processing, communication and other expenses in 1998 resulted from the substantial increases in production and servicing volumes. Portfolio Asset Acquisition and Resolution Commercial Corp. purchased $79.0 million of Portfolio Assets during the first nine months of 1998 for its own account and through the Acquisition Partnerships compared to $67.6 million of acquisitions in the first nine months of 1997. Commercial Corp.'s quarter end investment in Portfolio Assets decreased to $63 million in 1998 from $90 million in 1997. Commercial Corp. invested $19.6 million in equity in Portfolio Assets in 1998 compared to $17.6 million in 1997. Net gain on resolution of Portfolio Assets. Proceeds from the resolution of Portfolio Assets decreased 14% from 1997. The net gain on resolution of Portfolio Assets decreased by 44% to $7.9 million in 1998 from $14.1 million in 1997 as the result of a lower gross profit percentage in 1998. The weighted average gross profit percentage on the resolution of Portfolio Assets in 1998 was 21.0% as compared to 32.3% in 1997. Equity in earnings of Acquisition Partnerships. Proceeds from the resolution of Portfolio Assets for the Acquisition Partnerships decreased by 23% to $121 million in 1998 from $157 million in 1997 while the gross profit percentage increased to 33.3% in 1998 from 18.4% in 1997. Other expenses of the Acquisition Partnerships increased by $7.0 million in 1998 generally reflecting costs associated with the resolution of Portfolio Assets in Europe which generated proceeds of $76 million. The net result was an overall increase in the net income of the Acquisition Partnerships of 26% to $21.0 million in 1998 from $16.7 million in 1997. As a result, Commercial Corp.'s equity earnings from Acquisition Partnerships increased by 28% to $7.8 million in 1998 from $6.1 million in 1997. Servicing fee revenues. Servicing fees reported during 1997 included the receipt of a $6.8 million cash payment related to the early termination of a servicing agreement between the Company and the Trust, under which the Company serviced the assets of the Trust. The $6.8 million payment represents the present value of servicing fees projected to have been earned by Commercial Corp. upon liquidation of the Trust assets, which was expected to occur principally in 1997. Excluding fees related to Trust assets, servicing fees decreased by 47% to $2.2 million in 1998 from $4.1 million in 1997 as a result of lower domestic collection levels in the Acquisition Partnerships and affiliated entities. Other revenues. Other revenues were relatively flat period to period. Operating expenses. Operating expenses declined to $13.9 million in 1998 from $17.6 million in 1997 primarily as a result of reduced salaries and benefits, lower asset level expenses and reduced amortization expense. Salaries and benefits declined in 1998 as a result of the consolidation of some of the servicing offices (Portfolios being serviced in the closed offices reached final resolution). Interest on other notes payable declined by $.7 million in 1998. Asset level expenses incurred in connection with the servicing of Portfolio Assets decreased in 1998 as a result of lower investments in Portfolio Assets in 1998. Occupancy and other expenses decreased as a result of the consolidation of servicing offices in 1998. Consumer Lending Gain on sale of automobile loans. Year to date gains on the sale of automobile loans totaled $2.4 million. 21 22 Interest and other income. Interest income increased by 12% to $8.0 million in the first nine months of 1998 from $7.1 million in the first nine months of 1997, reflecting higher levels of loan origination activity in 1998 and an increase in the average balance of investments held by Consumer Corp. during 1998. Other income increased $1.7 million due to increased service fee revenue from securitization trusts. Interest expense. Interest expense was relatively flat period to period. Operating expenses. Salaries and benefits increased by 89% to $3.6 million in 1998 from $1.9 million in 1997 as a result of the increased levels of operating activity in 1998. Other expenses increased $2.0 million due to the growth in the origination and servicing operations. Provision for loan losses and residual interests. The provision for loan losses on automobile receivables was flat period to period. The provision for losses on residual interests totaled $3.0 million in 1998. This provision is primarily a result of Consumer Corp.'s review and increase of the underlying loss assumptions from a range of 13-14% to 16-18% based upon actual performance of the securitized assets. Other Items Affecting Net Earnings. The following items affect the Company's overall results of operations and are not directly related to any one of the Company's businesses discussed above. Corporate overhead. Interest income on the Class A Certificate during 1997 represents reimbursement to the Company from the Trust of dividends through June 30, 1997, of $3.2 million on special preferred stock and interest paid under a June 1997 agreement to retire the Class A Certificate. Company level interest expense increased to $2.1 million in the first nine months of 1998 from $1.0 million in the first nine months of 1997 as a result of higher volumes of debt associated with the equity required to purchase Portfolio Assets, equity interests in Acquisition Partnerships and capital support to operating subsidiaries. Other corporate income increased due to recognition of deferred premium related to the early redemption of special preferred stock. Salary and benefits, occupancy and professional fees account for the majority of other overhead expenses, which decreased in 1998 compared to 1997, as a result of lower executive and other officer bonuses granted in 1998. Income taxes. Federal income taxes are provided at a 35% rate applied to taxable income and are offset by NOLs that the Company believes are available to it. The tax benefit of the NOLs is recorded in the period during which the benefit is realized. The Company reported a deferred tax benefit of $1.5 million in the first nine months of 1998 as compared to a benefit of $16.8 million in 1997. LIQUIDITY AND CAPITAL RESOURCES Generally, the Company requires liquidity to fund its operations and for working capital, payment of debt, equity for acquisition of Portfolio Assets, investments in and advances to the Acquisition Partnerships, investments in expanding businesses to support their growth, retirement of and dividends on preferred stock, and other investments by the Company. The potential sources of liquidity are funds generated from operations, equity distributions from the Acquisition Partnerships, interest and principal payments on subordinated intercompany debt and dividends from the Company's subsidiaries, short-term borrowings from revolving lines of credit, proceeds from equity market transactions, securitization and other structured finance transactions and other special purpose short-term borrowings. In September 1998, the remaining special preferred stock was redeemed for $14.7 million plus accrued dividends. On July 17, 1998 the Company filed a shelf registration statement with the Securities and Exchange Commission which allows the Company to issue up to $250 million in debt and equity securities from time to time in the future. The registration statement became effective July 28, 1998. As of September 30, 1998 no securities have been issued under this registration statement. In May 1998, the Company closed the public offering of 1,542,150 shares of FirstCity common stock, of which 341,000 shares were sold by selling shareholders. Net proceeds (after expenses) of $34.1 million were used to retire debt. In June 1998, the Company received $11.8 million from the exercise of warrants. In the future, the Company anticipates being able to raise capital through a variety of sources including, but not limited to, public debt or equity offerings (subject to limitations related to the preservation of the Company's NOLs), thus enhancing the investment and growth opportunities of the Company. The Company believes that these and other sources of liquidity, including refinancing and expanding the Company's revolving credit facility to the extent necessary, securitizations, and funding from senior lenders for Acquisition Partnership investments and direct portfolio and business acquisitions, should prove adequate to continue to fund the Company's contemplated activities and meet its liquidity needs. The Company and each of its major operating subsidiaries have entered into one or more credit facilities to finance its respective operations. Each of the operating subsidiary credit facilities is nonrecourse to the Company and the other operating subsidiaries, except as discussed below. 22 23 Excluding the term acquisition facilities of the unconsolidated Acquisition Partnerships, as of September 30, 1998 the Company and its subsidiaries had credit facilities providing for borrowings in an aggregate principal amount of $2.2 billion and outstanding borrowings of $1.5 billion. The following table summarizes the material terms of the credit facilities to which the Company, its major operating subsidiaries and the Acquisition Partnerships were parties and the outstanding borrowings under such facilities as of September 30, 1998. CREDIT FACILITIES OUTSTANDING PRINCIPAL BORROWINGS AS OF AMOUNT SEPTEMBER 30, 1998 INTEREST RATE OTHER TERMS AND CONDITIONS ------ ------------------ ------------- -------------------------- (DOLLARS IN MILLIONS) FIRSTCITY Company Credit Prime or Secured by the assets of the Facility.............. $90 $81 LIBOR + 2.625% Company, expires April 30, 1999 Term fixed asset facility.............. .8 .8 Fixed 9.25% Secured by certain fixed assets, expires January 1, 2001 MORTGAGE CORP. Warehouse facility...... 851 813 LIBOR + 0.5% TO 2.5% Revolving line to warehouse residential mortgage loans, expires March 31, 1999 Supplemental warehouse facility.............. 36 33 LIBOR + 0.5% TO 2.25% Revolving line to warehouse residential mortgage loans and related receivables, expires March 31, 1999 FNMA warehouse facility.............. 700 254 Fed Funds + 0.5% TO 1.0% Open facility to fund committed loans to FNMA and other Operating line.......... 48 45 LIBOR + 2.25% Revolving operating line secured by the unencumbered assets of Harbor, expires December 15, 2002 CAPITAL CORP. Warehouse facility...... 200 135 LIBOR + 0.75% Repurchase agreement to facilitate the acquisition of Home Equity Loans, expires March 30, 1999 Warehouse facility........ 48 37 LIBOR +0.85%TO 3.00% Repurchase agreement to facilitate the acquisition of Home Equity Loans, renewable monthly COMMERCIAL CORP. Portfolio acquisition Acquisition facility to acquire facility.............. 100 24 LIBOR + 2.5% Portfolio Assets, expires February 28, 1999 (includes $14 million advanced to unconsolidated Acquisition Partnerships) 23 24 OUTSTANDING PRINCIPAL BORROWINGS AS OF AMOUNT SEPTEMBER 30, 1998 INTEREST RATE OTHER TERMS AND CONDITIONS ------ ------------------ ------------- -------------------------- (DOLLARS IN MILLIONS) French acquisition facility.............. 15 10 French franc LIBOR + 3.5% Acquisition facility to fund equity investments in French Portfolio Assets, expires March 31, 1999. Guaranteed by Commercial Corp. and the Company. Term facility .......... 14 14 Prime + 7% Term facility to finance the purchase of mortgage servicing rights from Mortgage Corp., expires October 30, 1998. Guaranteed by the Company (facility was repaid at expiration date) Term acquisition facilities............ 35 35 Fixed AT 7.66% Acquisition facilities for existing Portfolio Assets. Secured by portfolio assets. Expires June 5, 2002 CONSUMER CORP. Warehouse facility...... 70 41 LIBOR + 3% Revolving line secured by automobile receivables, expires May 31, 1999 UNCONSOLIDATED ACQUISITION PARTNERSHIPS Senior and subordinated loans Term acquisition Fixed at 7.51% TO 10.17%, secured by Portfolio Assets, facilities.............. LIBOR + 3% TO 6.5% and various maturities 123 123 Prime + 2% TO 7% - - -------------------------- YEAR 2000 COMPLIANCE The Year 2000 could have a broad impact on the business environment in which the Company operates due to the possibility that many computerized systems across all industries will be unable to process information containing dates beginning in the Year 2000. The Company has established an enterprise-wide program to prepare its computer systems and applications for the Year 2000 and is utilizing both internal and external resources to identify, correct and test the systems for Year 2000 compliance. The Company has completed the majority of its reprogramming, and testing efforts will be substantially concluded by December 31, 1998. Further validation through testing will be conducted throughout 1999. The Company relies on in-house data processing, computer programming and third party vendors for all business lines. Mortgage Corp.'s primary data processing vendor, Alltel, Inc., has a history of producing high quality banking applications and has assured the Company that its core applications will be capable of handling the Year 2000. Because third party failures could have a material impact on the Company's ability to conduct business, questionnaires have been sent to substantially all of the Company's vendors to certify that plans are being developed to address the Year 2000 issue. The returned questionnaires are currently being assessed by the Company, and are being categorized based upon readiness for the Year 2000 issues and prioritized in order of significance to the business of the Company. To the extent that business-critical vendors do not provide the Company with satisfactory evidence of their readiness to handle Year 2000 issues, contingency plans will be developed. The Company intends to make every reasonable effort to assess the Year 2000 readiness of these critical business partners and to create action plans to address the identified risks. The Company has completed an assessment of the Year 2000 compliance status of all information technology and noninformation technology equipment and will address the Year 2000 compliance of such equipment By December 31, 1998. 24 25 Testing and remediation of all of the Company's systems and applications are expected to cost in the aggregate approximately $400,000, $150,000 of which had been incurred as of September 30, 1998. All estimated costs have been budgeted and are expected to be funded by cash flows from operations. The Company does not believe the costs and efforts related to the Year 2000 compliance project will be material to its financial position or results of operations. However, the cost of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. Unanticipated failures by critical vendors, as well as the failure by the Company to execute its own remediation efforts, could have a material adverse effect on the cost of the project and its completion date. As a result, there can be no assurance that these forward-looking estimates will be achieved and the actual cost and vendor compliance could differ materially from those plans, resulting in material financial risk. 25 26 PART II - OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 2.1 Joint Plan of Reorganization by First City Bancorporation of Texas, Inc., Official Committee of Equity Security Holders and J-Hawk Corporation, with the Participation of Cargill Financial Services Corporation, Under Chapter 11 of the United States Bankruptcy Code, Case No. 392-39474-HCA-11 (incorporated by reference herein to Exhibit 2.1 of the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 2.2 Agreement and Plan of Merger, dated as of July 3, 1995, by and between First City Bancorporation of Texas, Inc. and J-Hawk Corporation (incorporated herein by reference to Exhibit 2.2 of the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 4.1 Amended and Restated Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 4.2 Certificate of Designations of the New Preferred Stock ($0.01 par value) of the Company (incorporated herein by reference to Exhibit 4.1 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997) 4.3 Bylaws of the Company (incorporated herein by reference to Exhibit 3.2 of the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 4.4 Registration Rights Agreement, dated July 1, 1997, among the Company, Richard J. Gillen, Bernice J. Gillen, Harbor Financial Mortgage Company Employees Pension Plan, Lindsey Capital Corporation, Ed Smith and Thomas E. Smith (incorporated herein by reference to Exhibit 4.3 of the Company's Annual Report on Form 10- K for the fiscal year ended December 31, 1997) 27.1 Financial Data Schedule. (Exhibit 27.1 is being submitted as an exhibit only in the electronic format of this Quarterly Report on Form 10-Q being submitted to the Securities and Exchange Commission. Exhibit 27.1 shall not be deemed filed for purposes of Section 11 of the Securities Act of 1933, Section 18 of the Securities Act of 1934, as amended, or Section 323 of the Trust Indenture Act of 1939, as amended, or otherwise be subject to the liabilities of such sections, nor shall it be deemed a part of any registration statement to which it relates.) (b) Reports on Form 8-K. The Company filed the following Current Reports on Form 8-K, with the Commission during the third quarter of 1998: 1. Form 8-K dated July 6, 1998: Items reported: Item 5 (Other Events) 2. Form 8-K dated July 30, 1998: Items reported: Item 5 (Other Events) 3. Form 8-K dated August 24, 1998: Items reported: Item 5 (Other Events) 4. Form 8-K dated August 28, 1998: Items reported: Item 5 (Other Events) 5. Form 8-K dated September 11, 1998: Items reported: Item 5 (Other Events) 26 27 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRSTCITY FINANCIAL CORPORATION By /s/ Matt A. Landry, Jr. -------------------------------------- Name: Matt A. Landry, Jr. Title: Executive Vice President and Chief Administrative Officer (Duly authorized officer and principal financial officer of the Registrant) By /s/Gary H. Miller -------------------------------------- Name: Gary H. Miller Title: Senior Vice President and Chief Financial Officer (Duly authorized officer and principal accounting officer of the Registrant) Dated: November 16, 1998 27 28 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.1 Joint Plan of Reorganization by First City Bancorporation of Texas, Inc., Official Committee of Equity Security Holders and J-Hawk Corporation, with the Participation of Cargill Financial Services Corporation, Under Chapter 11 of the United States Bankruptcy Code, Case No. 392-39474-HCA-11 (incorporated by reference herein to Exhibit 2.1 of the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 2.2 Agreement and Plan of Merger, dated as of July 3, 1995, by and between First City Bancorporation of Texas, Inc. and J-Hawk Corporation (incorporated herein by reference to Exhibit 2.2 of the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 4.1 Amended and Restated Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 4.2 Certificate of Designations of the New Preferred Stock ($0.01 par value) of the Company (incorporated herein by reference to Exhibit 4.1 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1997) 4.3 Bylaws of the Company (incorporated herein by reference to Exhibit 3.2 of the Company's Current Report on Form 8-K dated July 3, 1995 filed with the Commission on July 18, 1995) 4.4 Registration Rights Agreement, dated July 1, 1997, among the Company, Richard J. Gillen, Bernice J. Gillen, Harbor Financial Mortgage Company Employees Pension Plan, Lindsey Capital Corporation, Ed Smith and Thomas E. Smith (incorporated herein by reference to Exhibit 4.3 of the Company's Annual Report on Form 10- K for the fiscal year ended December 31, 1997) 27.1 Financial Data Schedule. (Exhibit 27.1 is being submitted as an exhibit only in the electronic format of this Quarterly Report on Form 10-Q being submitted to the Securities and Exchange Commission. Exhibit 27.1 shall not be deemed filed for purposes of Section 11 of the Securities Act of 1933, Section 18 of the Securities Act of 1934, as amended, or Section 323 of the Trust Indenture Act of 1939, as amended, or otherwise be subject to the liabilities of such sections, nor shall it be deemed a part of any registration statement to which it relates.)