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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the quarter ended September 30, 2003
|_| Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
MERIT SECURITIES CORPORATION
(Exact name of registrant as specified in its charter)
Commission file number 33-83524
Virginia 54-1736551
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
4551 Cox Road, Suite 300, Glen Allen, Virginia 23060-6740
(Address of principal executive offices) (Zip Code)
(804) 217-5800 (Registrant's
telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past ninety days.
|X| Yes |_| No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). |_| Yes |X| No
As of October 31, 2003, the latest practicable date, there were 1,000 shares of
Merit Securities Corporation common stock outstanding.
The registrant meets the conditions set forth in General Instructions H (1)(a)
and (b) of Form 10-Q and is therefore filing this Form 10-Q with the reduced
disclosure format.
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MERIT SECURITIES CORPORATION
FORM 10-Q
INDEX
Page
Number
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at September 30, 2003
and December 31, 2002 (unaudited)....................................1
Condensed Consolidated Statements of Operations for the three months
and nine months ended September 30, 2003 and 2002 (unaudited)........2
Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2003 and 2002 (unaudited)........................3
Notes to Unaudited Condensed Consolidated Financial Statements.........4
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations..........................6
Item 3. Quantitative and Qualitative Disclosures about Market Risk.............9
Item 4. Controls and Procedures...............................................11
PART II.OTHER INFORMATION
Item 1. Legal Proceedings.....................................................11
Item 5. Other Information.....................................................11
Item 6. Exhibits and Reports on Form 8-K......................................11
SIGNATURES....................................................................14
i
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
MERIT SECURITIES CORPORATION
Condensed Consolidated Balance Sheets (Unaudited)
(amounts in thousands except share data)
--------------- --------------
September 30, December 31,
2003 2002
--------------- --------------
ASSETS:
Collateral for collateralized bonds:
Loans, net $ 825,220 $ 1,017,446
Debt securities, available-for-sale 270,287 323,791
Other loans 3,794 6,505
Asset-backed Securities, held-to-maturity 926 1,644
Due from affiliates, net 37,648 11,507
--------------- --------------
$ 1,137,875 $ 1,360,893
=============== ==============
LIABILITIES AND SHAREHOLDER'S EQUITY
LIABILITIES:
Collateralized bonds $ 1,081,423 $ 1,299,113
SHAREHOLDER'S EQUITY:
Common stock, no par value, 10,000 shares
authorized, 1,000 shares issued and outstanding 10 10
Additional paid-in capital 68,674 68,674
Accumulated other comprehensive income (loss) 367 (134)
Retained (deficit) earnings (12,599) (6,770)
--------------- --------------
56,452 61,780
--------------- --------------
$ 1,137,875 $ 1,360,893
=============== ==============
See notes to unaudited condensed consolidated financial statements.
1
MERIT SECURITIES CORPORATION
Condensed Consolidated Statements of Operations (Unaudited)
(amounts in thousands)
------------------------------------ -----------------------------------
Three Months Ended Nine Months Ended
September 30 September 30
------------------------------------ -----------------------------------
2003 2002 2003 2002
---------------- ---------------- --------------- ---------------
Interest income:
Collateral for collateralized bonds $ 19,176 $ 25,727 $ 61,701 $ 80,478
Other loans 26 17 101 44
Asset-backed securities, held-to-maturity 118 - 234 -
---------------- ---------------- --------------- ---------------
19,320 25,744 62,036 80,522
---------------- ---------------- --------------- ---------------
Interest and related expense:
Interest expense on collateralized bonds 11,945 15,648 38,111 49,002
Other collateralized bond expense 230 502 1,017 1,496
---------------- ---------------- --------------- ---------------
12,175 16,150 39,128 50,498
---------------- ---------------- --------------- ---------------
Net interest margin before provision for
loan losses 7,145 9,594 22,908 30,024
Provision for loan losses (5,003) (5,486) (27,298) (16,643)
---------------- ---------------- --------------- ---------------
Net interest margin 2,142 4,108 (4,390) 13,381
Impairment charges - (2,429) (1,454) (8,832)
Other (17) 164 15 (380)
---------------- ---------------- --------------- ---------------
Net income (loss) 2,125 1,843 (5,829) 4,169
Change in net unrealized loss during period on:
Investments classified as available-for-sale 1,943 (216) (501) 5,383
---------------- ---------------- --------------- ---------------
Comprehensive income (loss) $ 4,068 $ 1,627 $ (6,330) $ 9,552
================ ================ =============== ===============
See notes to unaudited condensed consolidated financial statements.
2
MERIT SECURITIES CORPORATION
Condensed Consolidated Statements of Cash Flows (Unaudited)
(amounts in thousands)
-----------------------
Nine Months Ended
September 30,
-----------------------
2003 2002
---------- ----------
Operating activities:
Net (loss) income ................................ $ (5,829) $ 4,169
Adjustments to reconcile net (loss) income to
net cash provided by operating activities:
Impairment charges ............................. 1,454 8,832
Provision for loan losses ...................... 27,298 16,643
Amortization, net .............................. 3,602 6,760
Other .......................................... 1,745 (1,806)
--------- ---------
Net cash provided by operating activities .... 28,270 34,598
--------- ---------
Investing activities:
Principal payments on collateral ............... 218,276 324,830
Purchase of loans .............................. -- (158,933)
Proceeds from sale of collateralized bonds ..... -- 605,272
--------- ---------
--------- ---------
Net cash provided by investing activities .... 218,276 771,169
--------- ---------
Financing activities:
Principal payments on collateralized bonds ..... (220,405) (775,649)
Payments to affiliates ......................... (26,141) (6,018)
Capital distributions .......................... -- (24,100)
--------- ---------
Net cash used for financing activities ....... (246,546) (805,767)
--------- ---------
Net change in cash ................................... -- --
Cash, beginning of period ............................ -- --
--------- ---------
Cash, end of period .................................. $ -- $ --
========= =========
Supplemental disclosure of cash flow information:
Cash paid for interest ........................... $ 36,124 $ 46,932
========= =========
See notes to unaudited condensed consolidated financial statements.
3
MERIT SECURITIES CORPORATION
NOTES TO UNAUDITED Condensed CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003
(amounts in thousands except share data)
NOTE 1 -- BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements have been
prepared in accordance with the instructions to Form 10-Q and do not include all
of the information and notes required by accounting principles generally
accepted in the United States of America, hereinafter referred to as "generally
accepted accounting principles" for complete financial statements. The financial
statements include the accounts of Merit Securities Corporation (the "Company")
and its wholly owned subsidiary, Financial Asset Securitization, Inc. ("FASI"),
which was purchased from Dynex Capital, Inc. ("Dynex"), its parent, on March 31,
2002. The Company is a wholly owned, limited-purpose finance subsidiary of
Issuer Holding Corporation ("IHC"). IHC was formed on September 4, 1996 to
acquire all of the outstanding stock of the Company and certain other affiliates
of Dynex. IHC is a wholly owned subsidiary of Dynex. Dynex has elected to be
treated as a real estate investment trust ("REIT") for federal income tax
purposes under the Internal Revenue Code of 1986. Accordingly, the Company is
not subject to federal income tax. The Company was organized to facilitate the
securitization of loans through the issuance and sale of collateralized bonds
(the "Bonds"). All significant inter-company balances and transactions have been
eliminated in the consolidation of the Company.
In the opinion of management, all material adjustments, consisting of
normal recurring adjustments, considered necessary for a fair presentation of
the condensed consolidated financial statements have been included. The
Condensed Consolidated Balance Sheet at September 30, 2003 and December 31,
2002, the Condensed Consolidated Statements of Operations for the three months
and nine months ended September 30, 2003 and 2002, the Condensed Consolidated
Statements of Cash Flows for the nine months ended September 30, 2003 and 2002,
and the related notes to condensed consolidated financial statements are
unaudited. Operating results for the nine months ended September 30, 2003 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 2003.
Certain reclassifications have been made to the financial statements for
2002 to conform to the presentation for 2003.
NOTE 2 -- COLLATERAL FOR COLLATERALIZED BONDS
Collateral for collateralized bonds consists of loans and debt securities
backed primarily by adjustable-rate and fixed-rate mortgage loans secured by
first liens on single family residential housing and manufactured housing
installment loans secured by a UCC filing. All collateral for collateralized
bonds is pledged to secure repayment of the related collateralized bonds. All
principal and interest (less servicing-related fees) on the collateral is
remitted to a trustee and is available for payment on the collateralized bonds.
The Company's exposure to loss on collateral for collateralized bonds is
generally limited to the amount of collateral pledged in excess of the related
collateralized bonds issued, as the collateralized bonds issued are non-recourse
to the Company. The collateral for collateralized bonds can be sold by the
Company, but only subject to the lien of the collateralized bond indenture.
The Company has classified all of its debt securities included within
collateral for collateralized bonds as available-for-sale. As such, debt
securities included within collateral for collateralized bonds at September 30,
2003 and December 31, 2002 are reported at fair value, with unrealized gains and
losses excluded from earnings and reported as accumulated other comprehensive
income. Loans included within collateral for collateralized bonds are reported
at amortized cost.
4
The following table summarizes the types of collateral for collateralized
bonds as of September 30, 2003 and December 31, 2002:
- ------------------------------ -------------------------- ----------------------
September 30, 2003 December 31, 2002
- ------------------------------ -------------------------- ----------------------
Loans, at amortized cost $ 858,974 $ 1,038,146
Allowance for loan losses (33,754) (20,700)
- ------------------------------ -------------------------- ----------------------
825,220 1,017,446
Debt Securities, at fair value 270,287 323,791
- ------------------------------ -------------------------- ----------------------
$ 1,095,507 $ 1,341,237
- ------------------------------ -------------------------- ----------------------
The following table summarizes the amortized cost basis, gross unrealized
gains and losses, and estimated fair value of debt securities pledged as
collateral for collateralized bonds as of September 30, 2003 and December 31,
2002:
- ------------------------------------ ---------------------- --------------------
September 30, 2003 December 31, 2002
- ------------------------------------ ---------------------- --------------------
Debt securities, at amortized cost $ 269,822 $ 323,728
Gross unrealized gains 465 63
- ------------------------------------ ---------------------- --------------------
Estimated fair value $ 270,287 $ 323,791
- ------------------------------------ ---------------------- --------------------
NOTE 3 -- DUE FROM AFFILIATES, NET
Cash flows generated by operations are loaned by the Company to its parent
and interest is charged to the parent at the fed effective rate.
NOTE 4 -- FAIR VALUE
Securities classified as available-for-sale are carried in the accompanying
financial statements at estimated fair value. Estimates of fair value for
securities may be based on market prices provided by certain dealers. Estimates
of fair value for certain other securities are determined by calculating the
present value of the projected cash flows of the instruments using market-based
discount rates, prepayment rates and credit loss assumptions. The estimate of
fair value for securities pledged as collateral for collateralized bonds is
determined by calculating the present value of the projected cash flows of the
instruments using prepayment rate assumptions and credit loss assumptions based
on historical experience and estimated future activity, and using discount rates
commensurate with those believed would be used by third parties. Such discount
rate used in the determination of fair value of securities pledged as collateral
for collateralized bonds was 16% at September 30, 2003 and December 31, 2002.
Prepayment rate assumptions at September 30, 2003, and December 31, 2002, were
generally at a "constant prepayment rate," or CPR ranging from 35%-40% in 2003
and a range of 30%-45% in 2002, for collateral for collateralized bonds
consisting of securities backed by single-family mortgage loans, and a CPR
equivalent of 10% for 2003 and 11% for 2002 for collateral for collateralized
bonds consisting of securities backed by manufactured housing loans. CPR
assumptions for each year are based in part on the actual prepayment rates
experienced for the prior six-month period and in part on management's estimate
of future prepayment activity. The loss assumptions utilized vary depending on
the collateral pledged.
Estimates of fair value for other financial instruments are based primarily
on management's judgment. Since the fair value of the Company's financial
instruments are based on estimates, actual gains and losses recognized may
differ from those estimates recorded in the condensed consolidated financial
statements.
5
NOTE 5 -- ALLOWANCE FOR LOAN LOSSES
The following table summarizes the activity for the allowance for loan
losses on loans within collateral for collateralized bonds for the nine months
ended September 30, 2003 and September 30, 2002:
- --------------------------------- ----------------- ----------------------------
2003 2002
- --------------------------------- ----------------- ----------------------------
Beginning balance $ 20,700 $ 15,364
Provision for loan losses 27,298 16,643
Credit losses, net of recoveries (14,244) (17,080)
- --------------------------------- ----------------- ----------------------------
Ending balance $ 33,754 $ 14,927
- --------------------------------- ----------------- ----------------------------
The Company has limited exposure to credit risk retained on loans, which it
has securitized through the issuance of collateralized bonds. The aggregate loss
exposure is generally limited to the amount of collateral in excess of the
related investment-grade collateralized bonds issued (commonly referred to as
"over-collateralization"), excluding price premiums and discounts and hedge
gains and losses. The allowance for loan losses is included in collateral for
collateralized bonds in the accompanying balance sheets.
The Company continues to experience unfavorable results in its manufactured
housing loan portfolio in terms of elevated delinquencies and loss severity. For
the nine months ended September 30, 2003, the Company added $27,298 to provision
for loan losses. Included in this amount is $14,400 in provision for loan losses
recorded in June 2003 specifically for currently existing credit losses within
outstanding manufactured housing loans that are current as to payment but which
the Company has determined to be impaired. Previously, the Company had not
considered current loans to be impaired under generally accepted accounting
principles and therefore had not previously provided for the impairment of these
loans. Continued worsening trends in both the industry as a whole and the
Company's pools of manufactured housing loans prompted the Company to prepare
extensive analysis on these pools of loans. The Company has not originated any
new manufactured housing loans since 1999, and has extensive empirical data on
the historical performance of this static pool of loans. The Company analyzed
performance and default activity for loans that were current at various points
in time over the last 36 months, and based on that analysis, identified default
trends on these loans. The Company also considered current market conditions in
this analysis, with the expectation that these market conditions would continue
for the foreseeable future. Given this new observable data, the Company now
believes the inclusion of amounts in the provision for loan losses for loans
which are current as to payment is an appropriate application of the definition
of impairment within generally accepted accounting principles, and has accounted
for this provision as a change in accounting estimate and, accordingly, recorded
the amount as additional provision for loan losses.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The Company was organized to facilitate the securitization of loans through
the issuance and sale of collateralized bonds (the "Bonds"). The Bonds will be
secured primarily by: (i) mortgage loans secured by first or second liens on
residential property, (ii) Federal National Mortgage Association Mortgage-Backed
Certificates, (iii) Federal Home Loan Mortgage Corporation Mortgage-Backed
Certificates, (iv) Government National Mortgage Association Mortgage-Backed
Certificates, (v) other mortgage pass-through certificates or
mortgage-collateralized obligations. In the future, the Company may also
securitize other types of loans.
After payment of the expenses of an offering and certain administrative
expenses, the net proceeds from an offering of Bonds will be used to purchase
Collateral from IHC or various third parties. IHC can be expected to use the
proceeds to reduce indebtedness incurred to obtain such loans or to acquire
additional Collateral. After the issuance of a series of Bonds, the Company may
sell the Collateral securing that series of Bonds, subject to the lien of the
Bonds.
6
FINANCIAL CONDITION
- ----------------------------------------------------- ------------- ------------
September 30, December 31,
(amounts in thousands except series outstanding) 2003 2002
- ----------------------------------------------------- ------------- ------------
Collateral for collateralized bonds ................. $1,095,507 $1,341,237
Other loans ......................................... 3,794 6,505
Asset-backed Securities, held-to-maturity ........... 926 1,644
Collateralized bonds ................................ 1,081,423 1,299,113
Shareholder's equity ................................ 56,452 61,780
Collateralized bond series outstanding .............. 4 4
- ----------------------------------------------------- ---------- ----------
Collateral for collateralized bonds
As of both September 30, 2003 and December 31, 2002, the Company had 4
series of collateralized bonds outstanding. The collateral for collateralized
bonds decreased to $1.1 billion at September 30, 2003 compared to $1.3 billion
at December 31, 2002. This decrease of $245.7 million is primarily the result of
$214.8 million in paydowns on the collateral, $27.3 million of additions to
allowance for loan losses, $1.5 million in loss on impairment, $1.9 million
decrease in accrued interest receivable, and $0.6 million of net premium
amortization offset by a $0.4 million decrease in unrealized loss on collateral
for collateralized bonds.
Other loans
Other loans decreased to $3.8 million at September 30, 2003 from $6.5
million at December 31, 2002. Other loans are composed of single family loans
not included in the securitization completed in April 2002 and retained by the
Company as individual loans. This decrease resulted from pay-downs on the loans
of $2.7 million.
Asset-backed Securities
Asset-backed securities decreased to $0.9 million at September 30, 2003,
compared to $1.6 million at December 31, 2002, as a result of principal payments
of $1.0 million during the year partially offset by $0.3 million in discount
amortization and accrued interest.
Collateralized bonds
Collateralized bonds decreased to $1.1 billion at September 30, 2003 from
$1.3 billion at December 31, 2002. This decrease of $217.7 million is the result
of $220.4 million in paydowns and a $0.3 million decrease in accrued interest
payable offset by $3.0 million of amortization of premium and discounts during
the nine months ended September 30, 2003. Additionally, for certain
securitizations, surplus cash in the amount of $3.3 million was retained within
the security structure and used to repay collateralized bonds outstanding,
instead of being released to the Company, as certain performance triggers were
not met in such securitizations.
Shareholder's Equity
Shareholder's equity decreased to $56.5 million at September 30, 2003 from
$61.8 million at December 31, 2002. This decrease was primarily the result of a
net loss of $5.8 million offset by a decrease of $0.5 million in net unrealized
loss on investments available-for-sale.
7
RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -------------------
(amounts in thousands) 2003 2002 2003 2002
- ----------------------------------------------------------------- -------------------
Interest income - collateral for ...... $ 19,176 $ 25,727 $ 61,701 $ 80,478
collateralized bonds
Interest expense - collateralized bonds 11,945 15,648 38,111 49,002
Provision for loan losses ............. 5,003 5,486 27,298 16,643
Net interest margin ................... 2,142 4,108 (4,390) 13,381
Impairment charges .................... -- (2,429) (1,454) (8,832)
Net income (loss) ..................... 2,125 1,843 (5,829) 4,169
- --------------------------------------------------------------------------------------
Interest income on the collateral for collateralized bonds decreased to
$19.2 million from $25.7 million for the three-month periods ended September 30,
2003 and 2002, respectively. Interest income on the collateral for
collateralized bonds decreased to $61.7 million for the nine months ended
September 30, 2003 from $80.5 million for the same period in 2002. This decrease
was primarily a result of the continued impact of prepayments on interest
income, as average collateral for collateralized bonds declined from $1.5
billion to $1.2 billion for the nine-month period ended September 30, 2002 and
2003, respectively, and $1.6 billion to $1.1 billion for the three-month period
ending September 30, 2002 and 2003, respectively, coupled with the overall
decline in interest rates during 2003.
Interest expense on collateralized bonds decreased to $11.9 million from
$15.6 million for the three-month periods ended September 30, 2003 and 2002,
respectively. Interest expense on collateralized bonds decreased to $38.1
million for the nine months ended September 30, 2003 from $49.0 million for the
nine months ended September 30, 2002. This decrease resulted from the decline in
collateralized bonds due to prepayments and paydowns on the related assets and
normal scheduled bond paydowns, as well as a decrease in one-month London
InterBank Offered Rate ("LIBOR") during the three and nine month periods ended
September 30, 2003 and 2002. The one-month LIBOR rate at September 30, 2003 was
1.12% as compared to 1.81% at September 30, 2002.
Provision for loan losses decreased to $5.0 million from $5.5 million for
the three-month periods ended September 30, 2003 and 2002, respectively.
Provision for loan losses increased to $27.3 million for the nine-month period
ended September 30, 2003 from $16.6 million for the same period in 2002.
Included in provision for loan losses is $14,400 recorded in June 2003
specifically for currently existing credit losses within outstanding
manufactured housing loans that are current as to payment but which the Company
has determined to be impaired, as discussed in Note 5 of the notes to the
Financial Statements.
Net interest margin decreased to $2.1 million from $4.1 million for the
three-month periods ended September 30, 2003 and 2002, respectively. Net
interest margin decreased to $(4.4) million from $13.4 million for the
nine-month periods ended September 30, 2003 and 2002, respectively. These
decreases were primarily a result of an increase in provision for loan losses,
as discussed above, and a decline in interest earning assets partially offset by
reduced borrowing costs on collateralized bonds outstanding during these
periods.
No impairment charges were recorded in the three-month period ended
September 30, 2003 as compared to $2.4 million in the three-month period ended
September 30, 2002. Impairment charges decreased to $1.4 million from $8.8
million for the nine-month periods ended September 30, 2003 and 2002,
respectively. These decreases are primarily a result of a decrease in realized
losses on the debt securities portion of collateral for collateralized bonds and
an other than temporary impairment in 2002 on a group of loans retained by the
Company during the SASCO 9 securitization in 2002.
Net income increased to $2.1 million from $1.8 million for the three-month
periods ended September 30, 2003 and 2002, respectively. This increase is
primarily a result of a net decrease of $0.5 million in provision for loan
losses, a decrease of $3.9 million in interest expense, and a decrease of $2.4
million in impairment charges partially offset by a $6.5 million decrease in
interest income on collateral for collateralized bonds during the respective
periods. Net income decreased to a net loss of $5.8 million from net income of
$4.2 million for the nine-month periods ended September 30, 2003 and 2002,
8
respectively. This decrease is primarily a result of a net increase of $10.7
million in provision for loan losses and a $18.8 million decrease in interest
income on collateral for collateralized bonds partially offset by a decrease of
$11.4 million in interest expense on collateralized bonds, a $7.4 million
decrease in impairment charges, and a $0.4 million decrease in other expense
during the respective periods.
Credit Exposures
With collateralized bond structures, the Company retains credit risk
relative to the amount of over-collateralization required in conjunction with
the bond issuance. Losses are generally first applied to the over-collateralized
amount, or, in some instances, surplus cash and then the over-collateralized
amount, with any losses in excess of that amount borne by the bond insurer or
the holders of the collateralized bonds. The Company only incurs credit losses
to the extent that losses are incurred in the repossession, foreclosure and sale
of the underlying collateral. Such losses generally equal the excess of the
principal amount outstanding, less any proceeds from mortgage or hazard
insurance, over the liquidation value of the collateral. To compensate the
Company for retaining this loss exposure, the Company generally receives an
excess yield on the collateralized loans relative to the yield on the
collateralized bonds. At September 30, 2003, the Company retained $82.3 million
in aggregate principal amount of over-collateralization compared to $93.6
million at December 31, 2002. The Company had reserves, or otherwise had
provided coverage on $33.8 million at September 30, 2003. During the first nine
months of 2003, the Company provided for additional reserves of $27.3 million
and incurred credit losses of $14.2 million.
Other forms of credit enhancement that benefit the Company, based upon the
performance of the underlying loans, may provide additional protection against
losses. These additional protections include loss reimbursement guarantees with
a remaining balance of $27.5 million and a remaining deductible aggregating $0.9
million on $57.1 million of securitized single family mortgage loans which are
subject to such reimbursement agreements and $193.5 million of securitized
single family mortgage loans which are subject to various mortgage pool
insurance policies whereby losses would need to exceed the remaining stop loss
of at least 65% on such policies before the Company would incur losses.
Other Matters
At September 30, 2003, the Company had securities of approximately $308.6
million remaining for issuance under a registration statement filed with the
Securities and Exchange Commission. The Company anticipates issuing additional
Bonds in the future.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument due to fluctuations in
interest and foreign exchange rates and in equity and commodity prices. Market
risk is inherent to both derivative and non-derivative financial instruments,
and accordingly, the scope of the Company's market risk management extends
beyond derivatives to include all market risk sensitive financial instruments.
As a financial services company, net interest margin comprises the primary
component of the Company's earnings. Additionally, cash flow from the investment
portfolio represents the primary component of the Company's incoming cash flow.
The Company is subject to risk resulting from interest rate fluctuations to the
extent that there is a gap between the amount of the Company's interest-earning
assets and the amount of interest-bearing liabilities that are prepaid, mature
or re-price within specified periods. The Company's strategy has been to
mitigate interest rate risk through the creation of a diversified investment
portfolio of high quality assets that, in the aggregate, preserves the Company's
capital base while generating stable income and cash flow in a variety of
interest rate and prepayment environments.
The Company and IHC monitor the aggregate cash flow, projected net yield
and market value of the collateral for collateralized bonds under various
interest rate and prepayment assumptions. While certain investments may perform
poorly in an increasing or decreasing interest rate environment, other
investments may perform well, and others may not be impacted at all.
The Company focuses on the sensitivity of its cash flow, and measures such
sensitivity to changes in interest rates. Changes in interest rates are defined
9
as interest rate movements in 100 basis point and 200 basis point ratable
increments, both up and down, over the ensuing twelve months from the
measurement date. The Company estimates its net interest margin cash flow for
the next twenty-four months assuming that interest rates over such time period
follow the forward LIBOR curve (based on the 90-day Eurodollar futures contract)
as of September 30, 2003. Once the base case has been estimated, cash flows are
projected for each of the defined interest rate scenarios. Those scenario
results are then compared against the base case to determine the estimated
change to cash flow.
The following table summarizes the Company's net interest margin cash flow
sensitivity analysis as of September 30, 2003. This analysis represents
management's estimate of the percentage change in net interest margin cash flow
given a shift in interest rates. The "Base" case represents the interest rate
environment as it existed as of September 30, 2003. As of September 30, 2003,
one-month LIBOR was 1.12% and six-month LIBOR was 1.18%. The analysis is heavily
dependent upon the assumptions used in the model. The effect of changes in
future interest rates, the shape of the yield curve or the mix of assets and
liabilities may cause actual results to differ from the modeled results. In
addition, certain financial instruments provide a degree of "optionality." The
most significant option affecting the Company's portfolio is the borrower's
option to prepay the loans. The model applies prepayment rate assumptions
representing management's estimate of prepayment activity on a projected basis
for each collateral pool in the investment portfolio. The model applies the same
prepayment rate assumptions for all five cases indicated below. Given the
current composition and performance of the investment portfolio, and the
limitation to estimating twenty-four months of net interest margin cash flows,
variations in prepayment rate assumptions are not expected to have a material
impact on the net interest margin cash flows. Projected results assume no
additions or subtractions to the Company's portfolio, and no change to the
Company's liability structure. Historically, there have been significant changes
in the Company's collateralized bonds, underlying collateral, and asset-backed
securities held-to-maturity and there are likely to be such changes in the
future.
- ------------------------------------- --- ----------------------------------
Basis Point % Change in Net
Increase (Decrease) Interest Margin
in Interest Rates From Base Case
+200 (19.9)%
+100 (10.4)%
Base -
-100 11.1%
-200 14.6%
- ------------------------------------- --- ----------------------------------
Approximately $390.5 million of the Company's collateral for collateralized
bonds as of September 30, 2003, are comprised of loans or securities that have
coupon rates which adjust over time (subject to certain periodic and lifetime
limitations) in conjunction with changes in short-term interest rates.
Approximately 73% and 14% of these ARM loans underlying the Company's collateral
for collateralized bonds are indexed to and reset based upon the level of
six-month LIBOR and one-year CMT, respectively. These ARM assets are financed
with adjustable-rate collateralized bond borrowings.
Generally, during a period of rising short-term interest rates, the
Company's net interest spread earned on its collateralized bonds will decrease.
The decrease of the net interest spread results from (i) the lag in resets of
the ARM loans underlying the collateral for collateralized bonds relative to the
rate resets on the collateralized bonds and (ii) rate resets on the ARM loans
which are generally limited to 1% every six months or 2% every twelve months and
subject to lifetime caps, while the associated borrowings have no such
limitation. As short-term interest rates stabilize and the ARM loans reset, the
net interest margin may be restored to its former level as the yields on the ARM
loans adjust to market conditions. Conversely, net interest margin may increase
following a fall in short-term interest rates. This increase may be temporary as
the yields on the ARM loans adjust to the new market conditions after a lag
period. In each case, however, the Company expects that the increase or decrease
in the net interest spread due to changes in the short-term interest rates to be
temporary. The net interest spread may also be increased or decreased by the
proceeds or costs of interest rate swap and cap agreements, to the extent that
the Company has entered into such agreements.
The remaining portion of the Company's collateral for collateralized bonds
as of September 30, 2003, approximately $749.6 million, is comprised of loans
that have coupon rates that are fixed. The Company has limited its interest rate
10
risk on such collateral primarily through the issuance of fixed-rate
collateralized bonds. Overall, the Company's interest rate risk is primarily
related to the rate of change in short-term interest rates and to the level of
short-term interest rates.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures.
As required by Rule 13a-15 under the Exchange Act, as of the
end of the period covered by this quarterly report (the
"Evaluation Date"), the Company carried out an evaluation of
the effectiveness of the design and operation of the Company's
disclosure controls and procedures. This evaluation was
carried out under the supervision and with the participation
of the Company's management. Based upon that evaluation, the
Company's management concluded that the Company's disclosure
controls and procedures are effective. Disclosure controls and
procedures are controls and other procedures that are designed
to ensure that information required to be disclosed in the
Company's reports filed or submitted under the Exchange Act is
recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms. Disclosure
controls and procedures include, without limitation, controls
and procedures designed to ensure that information required to
be disclosed in the Company's reports filed under the Exchange
Act is accumulated and communicated to management, including
the Company's management, as appropriate, to allow timely
decisions regarding required disclosures.
(b) Changes in internal controls.
There were no significant changes in the Company's internal
controls or in other factors that could materially affect, or
are reasonably likely to materially affect the Company's
internal controls subsequent to the Evaluation Date, nor any
significant deficiencies or material weaknesses in such
internal controls requiring corrective actions.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings:
None
Item 5. Other Information:
None
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits
3.1 Articles of Incorporation of the Registrant
(Incorporated herein by reference to the Exhibits to
Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
3.2 Bylaws of the Registrant (Incorporated herein by
reference to the Exhibits to Registrants Registration
Statement No. 33-83524 on Form S-3 filed August 31,
1994).
3.3 Amended and Restated Articles of Incorporation of the
Registrant, effective April 19, 1995 (Incorporated
herein by reference to Exhibit to the Registrant's
Current Report on Form 8-K, filed April 21, 1995).
11
4.1 Indenture between Registrant and Trustee, dated as of
August 1, 1994 (Incorporated herein by reference to
the Exhibits to Registrant's Registration Statement
No. 33-83524 on Form S-3 filed August 31, 1994).
4.2 Form of Supplement Indenture between Registrant and
Trustee (Incorporated herein by reference to the
Exhibits to Registrant's Registration Statement No.
33-83524 on Form S-3 filed August 31, 1994).
4.3 Copy of the Indenture, dated as of November 1, 1994,
by and between the Registrant and Texas Commerce Bank
National Association, as Trustee (Incorporated herein
by reference to Exhibit to the Registrant's Current
Report on Form 8-K, filed December 19, 1994).
4.4 Copy of the Series 11 Indenture Supplement, dated as
of March 1, 1998, by and between the Registrant and
Texas Commerce Bank National Association, as Trustee
(related schedules and exhibits available upon
request of the Trustee). (Incorporated herein by
reference to Exhibit of Registrant's Current Report
on Form 8-K, filed June 12, 1998).
4.5 Copy of the Series 12 Indenture Supplement, dated as
of March 1, 1999, by and between the Registrant and
Texas Commerce Bank National Association, as Trustee
(related schedules and exhibits available upon
request of the Trustee). (Incorporated herein by
reference to Exhibit of Registrant's Current Report
on Form 8-K, filed April 12, 1999).
4.6 Copy of the Series 13 Indenture Supplement, dated as
of August 1, 1999, by and between the Registrant and
Texas Commerce Bank National Association, as Trustee
(related schedules and exhibits available upon
request of the Trustee). (Incorporated herein by
reference to Exhibit of Registrant's Current Report
on Form 8-K, filed September 13, 1999).
4.7 Copy of the Structure Asset Securitization
Corporation Series 2002-9 Indenture Supplement, dated
as of April 1, 2002, by and between Structured Asset
Securitization Corporation and J. P. Morgan Chase, as
Trustee (related schedules and exhibits available
upon request of the Trustee). (Incorporated herein by
reference to Exhibit of Structured Asset
Securitization Corporation's Current Report on Form
8-K, filed April 25, 2002).
31.1 Certification of Principal Executive Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer and
Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
99.1 Standard Provisions to Servicing Agreement
(Incorporated herein by reference to the Exhibits to
Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
99.2 Form of Servicing Agreement (Incorporated herein by
reference to the Exhibits to Registrant's
Registration Statement No. 33-83524 on Form S-3 filed
August 31, 1994).
99.3 Standard Terms to Master Servicing Agreement
(Incorporated herein by reference to the Exhibits to
Registrant's Registration Statement No. 33-83524 on
Form S-3 filed August 31, 1994).
12
99.4 Form of Master Servicing Agreement (Incorporated
herein by reference to the Exhibits to Registrant's
Registration Statement No. 33-83524 on Form S-3 filed
August 31, 1994).
99.5 Form of Prospectus Supplement of Bonds secured by
adjustable-rate mortgage loans (Incorporated herein
by reference to Exhibits to Registrant's Pre-
Effective Amendment No. 4 to Registration Statement
No. 33-83524 on Form S-3 filed December 5, 1994).
99.6 Form of Financial Guaranty Assurance Policy
(Incorporated herein by reference to the Exhibits
to Registrant's Registration Statement No. 33-83524
on Form S-3 filed August 31, 1994).
99.7 Form of GEMICO Mortgage Pool Insurance Policy
(Incorporated herein by reference to the Exhibits
to Registrant's Registration Statement No. 33-83524
on Form S-3 filed August 31, 1994).
99.8 Form of PMI Mortgage Insurance Co. Pool Insurance
Policy (Incorporated herein by reference to the
Exhibits to Registrant's Registration Statement No.
33-83524 on Form S-3 filed August 31, 1994).
99.9 Form of Prospectus Supplement of Bonds secured by
fixed-rate mortgage loans (Incorporated herein by
reference to Exhibits to Registrant's Pre-Effective
Amendment No. 4 to Registration Statement No.33-83524
on Form S-3 filed December 5, 1994).
99.10 Copy of the Saxon Mortgage Funding Corporation
Servicing Guide for Credit Sensitive Loans, February
1, 1995 Edition (Incorporated herein by reference to
Exhibit to the Registrant's Current Report on Form
8-K, filed March 8, 1995).
99.11 Copy of the Standard Terms to Master Servicing
Agreement, June 1, 1995 Edition (Incorporated herein
by reference to Exhibit to the Registrant's Current
Report on Form 8-K, filed July 10, 1995).
(b) Reports on Form 8-K
None
13
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MERIT SECURITIES CORPORATION
Dated: November 13, 2003 By: /s/ Stephen J. Benedetti
-------------------------------
Stephen J. Benedetti
President
(Principal Executive Officer,
Principal Financial Officer)
/s/ Kevin J. Sciuk
-------------------------------
Kevin J. Sciuk
Controller
(Principal Accounting Officer)
14
Exhibit 31.1
CERTIFICATION
PURSUANT TO 17 CFR 240.13a-14
PROMULGATED UNDER
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Stephen J. Benedetti, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Merit Securities
Corporation;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the
registrant and have:
(a) Designed such disclosure controls and procedures or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls and
procedures, as of the end of the period covered by this report
based on such evaluation; and
(c) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has
materially affected, or is reasonable likely to materially affect,
the registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
function):
(a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which
are reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial information;
and
(b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Dated: November 13, 2003 By: /s/ Stephen J. Benedetti
--------------------------
Stephen J. Benedetti
Principal Executive Officer
15
Exhibit 31.2
CERTIFICATION
PURSUANT TO 17 CFR 240.13a-14
PROMULGATED UNDER
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Kevin J. Sciuk, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Merit Securities
Corporation;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the
registrant and have:
(a) Designed such disclosure controls and procedures or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls and
procedures, as of the end of the period covered by this report
based on such evaluation; and
(c) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has
materially affected, or is reasonable likely to materially affect,
the registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
function):
(a) All significant deficiencies and material weaknesses in the design
or operation of internal control over financial reporting which
are reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial information;
and
(b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Dated: November 13, 2003 By: /s/ Kevin J. Sciuk
---------------------------
Kevin J. Sciuk
Principal Financial Officer
16
Exhibit 32.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Merit Securities Corporation (the
"Company") on Form 10-Q for the quarter ending September 30, 2003, as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Stephen J. Benedetti, the Principal Executive Officer of the Company, certify,
pursuant to and for purposes of 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge:
(1) The Report fully complies with the requirements of Section
13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in
all material respects, the financial condition and results of
operations of the Company.
Dated: November 13, 2003 By: /s/ Stephen J. Benedetti
---------------------------
Stephen J. Benedetti
Principal Executive Officer
By: /s/ Kevin J. Sciuk
---------------------------
Kevin J. Sciuk
Principal Financial Officer
17