ITEM 1. BUSINESS
BUSINESS OVERVIEW
Delta Financial Corporation (together with its subsidiaries "Delta" or "we") is a specialty consumer finance company that originates, securitizes and sells (and, prior to May 2001, serviced) non-conforming mortgage loans, which are primarily secured by first mortgages on one- to four-family residential properties. Throughout our 21-year operating history, we have focused on lending to individuals who generally do not satisfy the credit, documentation or other underwriting standards set by more traditional sources of mortgage credit, including those entities that make loans in compliance with conventional mortgage lending guidelines established by Fannie Mae and Freddie Mac. We make loans to these borrowers for such purposes as debt consolidation, refinancing, education and home improvement. Our corporate offices are located at 1000 Woodbury Road, Woodbury, NY 11797 and we can be contacted at (516) 364-8500 or through our internet web site at HTTP://WWW.DELTAFINANCIAL.COM. Our Exchange Act filings can be accessed on the Investor Relations page of our web site, through a link to EDGAR.
Our mortgage business has two principal components. First, we make mortgage loans to individual borrowers, which is a cash and expense outlay for us, because our cost to originate a loan exceeds the fees we collect at the time we originate that loan. At the time we originate a loan, and prior to the time we sell that loan, we finance that loan by borrowing under warehouse lines of credit. Second, we sell loans, either through securitization or on a whole loan basis, to generate cash and non-cash revenues, recording the premiums received as revenues. We use the proceeds from these sales to repay our warehouse lines of credit and for working capital.
ORIGINATION OF MORTGAGE LOANS. We make mortgage loans through two distribution channels - wholesale (or broker) and retail. We receive loan applications both directly from borrowers and from licensed independent third party mortgage brokers and other real estate professionals who submit applications on a borrower's behalf. While we generally collect points and fees from the borrower when a loan closes, our cost to originate a loan typically far outweighs any fees we may collect from the borrower.
In 2002, we originated approximately $872 million of loans, of which approximately $535 million were brokered loans and $337 million were retail loans, compared to 2001, when we originated approximately $622 million of loans, of which $346 million were brokered loans and $276 million were retail loans.
INDEPENDENT MORTGAGE BROKER (WHOLESALE) CHANNEL. Through our wholesale distribution channel, we originate mortgage loans indirectly through licensed mortgage brokers and other real estate professionals who submit loan applications on behalf of borrowers. We currently originate the majority of our wholesale loans in 26 states, through our network of approximately 1,500 brokers. The broker's role is to source the business, identify the applicant, assist in completing the loan application, gather necessary information and documents and serve as the liaison between us and the borrower through the entire origination process. We review, process and underwrite the applications submitted by the broker, approve or deny the application, set the interest rate and other terms of the loan and, upon acceptance by the borrower and satisfaction of all conditions imposed by us as the lender, lend the money to the borrower. Because brokers conduct their own marketing and employ their own personnel to complete loan applications (and hence charge a broker fee that is commensurate with their services) and maintain contact with borrowers, originating loans through our broker network allows us to increase our loan volume without incurring the higher marketing and employee costs associated with increased retail originations.
RETAIL LOAN CHANNEL. Through our retail distribution channel, we develop retail loan leads ("retail loans") primarily through our telemarketing system and our network of 7 retail offices and 4 origination centers (which are typically staffed with considerably more loan officers and cover a broader area than retail offices) located in eight states. In 2002, we converted our Charlotte, North Carolina retail office into an origination center and opened an additional origination center in Phoenix, Arizona. We continually monitor our retail operations and evaluate current and potential retail offices on the basis of selected demographic statistics, marketing analyses and other criteria developed by us. Typically, contact with the customer is initially handled through our telemarketing center. On the basis of an initial screening conducted at the time of the call, our telemarketer makes a preliminary determination of whether the customer and the property meet our lending criteria. If the customer does meet our criteria, the telemarketer will forward the customer to one of our local branches or origination centers. The mortgage analyst at the local branch or origination center may complete the application over the telephone, or schedule an appointment in the retail loan office most conveniently located to the customer or in the customer's home, depending on the customer's needs. The mortgage analyst assists the applicant in completing the loan application, ensures that an
appraisal has been ordered from an independent third party appraisal company, orders a credit report from an independent, nationally recognized credit reporting agency and performs various other tasks in connection with the completion of the loan package. Our mortgage analysts are trained to structure loans that meet the applicant's needs while satisfying our lending guidelines. The loan package is underwritten for loan approval on a centralized basis. If the loan package is approved, we will fund the loan.
POOLING OF LOANS PRIOR TO SALE. After we close or fund a loan, we typically pledge the loan as collateral under a warehouse line of credit to obtain financing against that loan. By doing so, we replenish our capital so we can make new loans. Typically, loans are financed through warehouse lines of credit for only a limited time - generally not more than three months - until such time as we can pool enough loans and sell the pool of loans either through securitization or on a whole loan basis. During this time, we earn interest paid by the borrower as income, but this income is offset in part by the interest we pay to the warehouse creditors for providing us with financing.
SALE OF LOANS. We derive the majority of our revenues and cash flows from selling mortgage loans through one of two outlets: (i) securitization, which involves the public offering by a securitization trust of asset-backed pass-through securities (and related interests including securitization servicing rights on newly-originated pools of mortgage loans); and (ii) whole loan sales, which includes the sale of pools of individual loans to institutional investors, banks, and consumer finance-related companies on a servicing released basis. We select the outlet depending on market conditions, relative profitability and cash flows. We generally realize higher gain on sale when we securitize than we do when we sell whole loans. We apply the proceeds from loan sales, whether through securitizations or whole loan basis, to repay our warehouse lines of credit - in order to make available capacity under these facilities for future funding of mortgage loans - and utilize any additional funds for working capital.
In 2002, securitizations and whole loan sales comprised approximately 89% and 11%, respectively, of our loan sales. Going forward, we expect to continue to use a combination of securitizations and whole loan sales, with the amounts of each dependent upon the marketplace and our goal of maximizing earnings and liquidity.
The following table sets forth certain information regarding the Company's securitizations and whole loan sales during the periods presented:
In 2002, we securitized the majority of our loans in four securitizations totaling $850 million, of which we delivered a total of $819 million of mortgage loans during 2002 (and delivered the remaining $31 million of mortgage loans in January 2003, pursuant to a pre-funding mechanism). We plan to continue to utilize a combination of securitization and whole loan sales for the foreseeable future.
SECURITIZATION. Securitizations are off balance sheet transactions that effectively provide us with a source of long-term financing.
In a securitization, we pool together loans, typically each quarter, and sell these loans to a securitization trust, which is a qualified special purpose entity or QSPE. The securitization trust raises money to purchase the mortgage loans from us by selling securities to the public - known as asset-backed pass-through securities that are secured by the pool of mortgage loans held by the securitization trust. These asset-backed securities or senior certificates, which are usually purchased for cash by insurance companies, mutual funds and/or other institutional investors, represent senior interests in the cash flows from the mortgage loans in the trust. We carry no contractual obligation related to these trusts or the loans sold to them, nor do we have any direct or contingent liability related to the trusts, except for the standard representations and warranties made in conjunction with each securitization trust. Furthermore, we provide no guarantees to investors with respect to cash flow or performance for these trusts. These entities represent qualified special purpose entities and are therefore not consolidated for financial reporting purposes in accordance with SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". Following the securitization, the securitization trust issues senior certificates, which entitles the holders of these senior certificates to receive the principal collected, including prepayments of principal, on the mortgage loans in the trust. In addition, holders receive a portion of the interest on the loans in the trust equal to the pass-through interest rate on the remaining principal balance. The securitization trust also issues a subordinate certificate
or a BIO certificate (referred to as an excess cashflow certificate), which entitles the holder to receive the excess cash flows after making all required payments to all other securities issued by the securitization trust, covering losses incurred by the trust and other costs and expenses of the trust. In addition, the securitization trust also issues a P certificate (representing the right to receive prepayment penalties from borrowers who payoff their loans early in their life). In each of our 2002 securitizations, we sold the excess cashflow certificate and P certificate (which entitles the holder to all prepayment penalties collected by the servicer of the underlying securitization trust) to a net interest margin trust, or NIM trust (QSPE), which in turn, issued interest-bearing NIM note(s) and a NIM owner trust certificate. We sell the excess cashflow certificate and P certificate without recourse except that we provide normal representations and warranties to the NIM trust. One or more investors purchase the NIM note(s) for a cash price and we receive the proceeds of the sale of the note(s), together with the NIM owner trust certificate in consideration of our selling the excess cashflow certificate and P certificates to the NIM Trust. The NIM note(s) entitles the holder(s) to receive all cash flows generated by the excess cashflow certificate and P certificate owned by the NIM trust, until the holder(s) are paid in full (all principal and interest). The NIM owner trust certificates entitle the holder to all cash flows generated by the excess cashflow certificate and P certificate after the NIM note(s) have been paid in full.
At the time we completed the 2002 securitizations, we recognized as revenue the following three economic interests:
o The cash purchase price from the sale of the NIM note(s) issued by a NIM Trust;
o The value of the excess cashflow certificates (initially, the NIM owner trust certificate) that we retained; and
o The cash premium we received from selling the right to service the loans being securitized.
These economic interests were recorded as net gain on sale of mortgage loans on our consolidated statement of operations.
WHOLE LOAN SALES WITHOUT RECOURSE. We also sell loans, without retaining the right to service the loans, in exchange for a cash premium. The premiums we receive from the loans sales are recorded as revenue under net gain on sale of mortgage loans at the time of sale. The cash premiums ranged between 2.0% to 5.5% of the principal amount of mortgage loans sold in 2002.
OTHER. In addition to the income and cash flows we earn from securitizations and whole loan sales, we also earn income and generate cash flows from:
o the net interest spread earned on mortgage loans while we hold the mortgage loans for sale (the difference between the interest rate on the mortgage loan paid by the underlying borrower less the financing costs we pay to our warehouse lenders to fund our loans);
o net loan origination fees on brokered loans and retail loans; and
o retained excess cashflow certificates and distributions from Delta Funding Residual Exchange Company LLC (the "LLC") (described below in "-Debt Modification and Debt Restructuring").
BUSINESS STRATEGY
Our core business strategy is to continue to increase profitability and generate cash revenues in excess of our cash expenses through an increase in our overall loan production and average loan size, such that we can continue to maintain our profitability and operate on a cash flow neutral to positive basis. We believe we have the infrastructure in place to expand loan production significantly (on a percentage basis) in both our wholesale and retail channels, without having to invest significantly in our infrastructure. We plan to increase loan production by:
o increasing the number of commissioned-based account executives responsible for generating new wholesale business;
o continuing to provide top quality service to our network of brokers and retail clients;
o maintaining our loan underwriting standards;
o penetrating further our established and recently-entered markets and expanding into new geographic markets;
o expanding our retail loan origination capabilities through larger call centers; and
o continuing to leverage off of our proprietary web-based and workflow technology platform.
CORPORATE RESTRUCTURING, DEBT MODIFICATION AND DEBT RESTRUCTURING
In 2000, we began a corporate restructuring - by reducing our workforce and modifying the terms of the indenture governing our senior notes due 2004 (the "senior notes") - as part of our continuing efforts to improve operating efficiencies and to address our negative cash flow from operations. Entering 2001, management still had several concerns, which we believed needed to be addressed for us to remain a viable company. Our principal concerns were:
o the cash drain created by our ongoing monthly delinquency and servicing advance requirements as servicer for securitization trusts (known as "securitization advances");
o the high cost of servicing a seasoned loan portfolio, including the capital charges associated with making securitization advances;
o our ability to make timely interest payments on our senior notes and senior secured notes due 2004 (the "senior secured notes"); and
o our ability to effectuate a successful business model given the overhang of corporate ratings of "Caa2" by Moody's and "CC" by Fitch.
Therefore in the first quarter of 2001, we embarked upon a business plan aimed at alleviating some of these concerns and issues.
CORPORATE RESTRUCTURING
In January 2001, we announced that we had entered into an agreement with Ocwen Financial Corporation ("Ocwen") to transfer our servicing portfolio to Ocwen. In May 2001, we physically transferred our entire servicing portfolio to Ocwen, and laid-off the majority of our servicing staff - a total of 128 employees. We recorded a $0.5 million pre-tax charge related to this restructuring, which is included in the line item called "restructuring and other special charges" on our consolidated statements of operations. This charge relates to employee severance associated with closing our servicing operations. We no longer service loans nor do we have a servicing operation.
DEBT MODIFICATION AND DEBT RESTRUCTURING
In August 2000, we announced an agreement to modify the terms of the indenture governing our senior notes (the "Debt Modification"). With the consent of the holders of greater than fifty percent of our senior notes, we modified a negative pledge covenant in the senior notes indenture, which had previously prevented us from selling or otherwise obtaining financing by using our excess cashflow certificates as collateral. In consideration for the senior noteholders' consent, we agreed, in an exchange offer (the "First Exchange Offer"), to offer then current holders the opportunity to exchange their then existing senior notes for (a) new senior secured notes and (b) ten-year warrants to buy approximately 1.6 million shares of common stock, at an initial exercise price of $9.10 per share, subject to upward or downward adjustment in certain circumstances. In December 2002, the exercise price for the warrants issued by us was adjusted downward to $0.01 per share in accordance with the agreement. The senior secured notes have the same coupon, face amount and maturity date as the senior notes and, up until the Second Debt Restructuring (see below) were secured by at least $165 million of our excess cashflow certificates. The First Exchange Offer was consummated in December 2000, with holders of greater than $148 million (of $150 million) of senior notes tendering in the exchange.
In February 2001, we entered into a letter of intent with the beneficial holders of over fifty percent of our senior secured notes to restructure, and ultimately extinguish, the senior secured notes (the "Second Debt Restructuring"). In March 2001, we obtained the formal consent of these beneficial holders of the senior secured notes through a consent solicitation that modified certain provisions of the senior secured notes indenture to, among other things, allow for the release of two excess cashflow certificates then securing the senior secured notes. We were able to first finance and ultimately sell the excess cashflow certificates underlying five securitizations (including two excess cashflow certificates that were released as part of the Second Debt Restructuring) for a $15 million cash purchase price to provide working capital.
In consideration for their consent, we agreed to offer the holders of the senior secured notes (and the senior notes, collectively, the "notes"), an opportunity to exchange their notes for new securities described immediately
below (the "Second Exchange Offer"). The Second Exchange Offer was consummated on August 29, 2001, pursuant to which holders of approximately $138.1 million (of $148.2 million) in principal amount of our senior secured notes and $1.1 million (of $1.8 million) in principal amount of our senior notes, exchanged their notes for commensurate interests in:
o voting membership interests in the LLC, a newly-formed limited liability company (unaffiliated with us), to which we transferred all of the mortgage-related securities previously securing the senior secured notes (primarily comprised of excess cashflow certificates);
o shares of common stock of a newly-formed management corporation that will manage the LLC's assets; and
o shares of our newly-issued Series A preferred stock having an aggregate preference amount of $13.9 million.
The LLC is controlled by the former noteholders that now hold all the voting membership interests in the LLC. As part of the transaction, we obtained a non-voting membership interest in the LLC, which entitles us to receive 15% of the net cash flows from the LLC for the first three years (through June 2004) and, thereafter, 10% of the net cash flows from the LLC. The net cash flows from the LLC are equal to the total cash flows generated by the assets held by the LLC for a particular period, less (a) all expenses of the LLC, (b) certain related income tax payments, and (c) the New York State Banking Department (the "NYSBD") subsidy payments (See "Regulations"). We began receiving distributions from the LLC in the first quarter of 2002 from a fourth quarter 2001 distribution.
As part of the Second Exchange Offer, all tendering noteholders waived their right to receive any future interest coupon payments on the tendered notes beginning with the August 2001 interest coupon payment. With the closing of the Second Exchange Offer, we recorded a charge of $19.3 million related to the extinguishment of debt and paid the August 2001 interest coupon payment on the approximately $10.8 million of notes that did not tender in the Second Exchange Offer. The notes bear interest at a rate of 9.5% per annum, payable semi-annually (on February 1st and August 1st) and a maturity date of August 1, 2004 when all outstanding principal is due.
By extinguishing substantially all of our long-term debt, the rating agencies that previously rated us and our long-term debt have withdrawn their corporate ratings.
HOME EQUITY LENDING OPERATIONS
OVERVIEW
Our consumer finance activities consist of originating, securitizing, selling (and, prior to May 2001, servicing) non-conforming mortgage loans. These loans are primarily secured by first mortgages on one- to four-family residences. Once loan applications have been received, the underwriting process completed and the loans funded or purchased, we typically package the loans in a portfolio and sell the loan portfolio through a securitization or on a whole loan, servicing released basis.
We provide our customers with an array of loan products designed to meet their needs, using a risk-based pricing strategy to develop products for various risk categories. Historically, we have offered fixed-rate loan products and, to date, the majority of our loan production is fixed-rate. As we have expanded geographically, we have expanded our product offerings to include hybrid mortgages, in which the interest rate remains fixed for the first two or three years and then adjusts thereafter.
We primarily conduct our broker lending operations out of our Woodbury, New York headquarters. Final underwriting approval for brokered loans is centralized and required from the Woodbury, New York headquarters. We conduct our retail operations out of 4 call centers, 7 retail offices and a telemarketing hub, located in eight states. Final underwriting approval for retail loans is required from either our retail underwriting office in Cincinnati, Ohio, which has full underwriting authority or from our Woodbury, New York headquarters.
We adhere to our Best Practice Lending Program aimed at ensuring the origination of quality loans and helping to better protect consumers. This Best Practice Lending Program includes:
o fair lending initiatives aimed at ensuring all borrowers are treated fairly and similarly regardless of race, color, creed, religion, national origin, sex, sexual orientation, marital status, age, disability, and the applicant's exercise, in good faith, of any right under the Consumer Credit Protection Act;
o increased oversight of mortgage brokers and closing agents;
o enhanced fraud detection and protection;
o enhanced plain English disclosures; and
o other originations and underwriting initiatives which we believe help protect consumers.
LOAN ORIGINATIONS AND PURCHASES
Our loan originations increased by 40% to $872 million in 2002 from $622 million in 2001. The following table shows certain data regarding our loans, presented by channel of loan originations, for the years shown:
- --------------- (1) We determine the weighted average initial loan-to-value ratio of a loan secured by a first mortgage by dividing the amount of the loan by the lesser of the purchase price or the appraised value of the mortgage property at origination. We determine the weighted average initial loan-to-value ratio of a loan secured by a second mortgage by taking the sum of the loan secured by the first and second mortgages and dividing by the lesser of the purchase price or the appraised value of the mortgage property at origination.
(2) We discontinued our correspondent operations in July 2000 to focus on our less cash intensive broker and retail channels.
The following table shows certain data regarding our loans, presented by channel of loan originations, on a quarterly basis for 2002:
- --------------- (1) We determine the weighted average initial loan-to-value ratio of a loan secured by a first mortgage by dividing the amount of the loan by the lesser of the purchase price or the appraised value of the mortgage property at origination. We determine the weighted average initial loan-to-value ratio of a loan secured by a second mortgage by taking the sum of the loan secured by the first and second mortgages and dividing by the lesser of the purchase price or the appraised value of the mortgage property at origination.
The following table shows lien position, weighted average interest rates and loan-to-value ratios for the years shown:
- --------------- (1) We determine the weighted average initial loan-to-value ratio of a loan secured by a first mortgage by dividing the amount of the loan by the lesser of the purchase price or the appraised value of the mortgage property at origination. We determine the weighted average initial loan-to-value ratio of a loan secured by a second mortgage by taking the sum of the loan secured by the first and second mortgages and dividing by the lesser of the purchase price or the appraised value of the mortgage property at origination.
The following table shows the geographic distribution of loan purchases and originations for the periods indicated:
- ------------ * Excluding New York (NY), New Jersey (NJ) and Pennsylvania (PA).
WHOLESALE MARKETING. Throughout our history, we have established and maintained relationships with brokers (and, prior to July 2000, correspondents) offering non-conforming mortgage products.
Typically, we initiate contact with a broker through our Business Development Department, supervised by a senior officer with over ten years of sales and marketing experience in the industry. We usually hire business development representatives, or account executives, who have contacts with brokers that originate non-conforming mortgage loans within their geographic territory. The account executives are responsible for developing and maintaining our broker network within their geographic territory by frequently visiting the broker, communicating our underwriting guidelines, disseminating new product information and pricing changes, and by demonstrating a continuing commitment to understanding the needs of the customer. The account executives attend industry trade shows and inform us about the products and pricing being offered by competitors and new market entrants. This information assists us in refining our programs and product offerings in order to remain competitive. Account executives are compensated with a base salary and commissions based on the volume of loans originated as a result of their efforts.
APPROVAL PROCESS. Before a broker becomes part of our network, it must go through an approval process. Once approved, brokers may begin submitting applications and/or loans to us.
To be approved, a broker must:
o demonstrate that it is properly licensed and registered in the state in which it seeks to transact business;
o submit to and pass a credit check; and
o sign a standard broker agreement with us that requires brokers to, among other things:
>> abide by our fair lending policy;
>> follow the National Association of Mortgage Brokers Best Practices Policies;
>> comply with all state and federal laws; and
>> submit only true and accurate documents and disclosures.
We also perform searches on all new brokers using a third party database that contains public and nonpublic information on individuals and companies that have incidents of potential fraud and misrepresentation. In addition, we regularly review the performance of loans originated through our brokers.
BROKERED LOANS. For the year ended December 31, 2002, our broker network accounted for $535.0 million, or 61%, of our loan originations, compared to $345.9 million, or 56%, of our loan originations for the year ended December 31, 2001 and $603.6 million, or 65%, of our loan purchases and originations for the year ended December 31, 2000. No single broker contributed more than 2.2%, 1.3% or 2.0% of our total loan production in the years ended December 31, 2002, 2001 and 2000, respectively.
Once approved, a broker may submit loan applications for prospective borrowers. To process broker submissions, our broker originations channel is organized by geographic regions and into teams, each consisting of account executives, account managers and processors, which are generally assigned to specific brokers. Because we
operate in a highly competitive environment where brokers often submit the same loan application to several prospective lenders simultaneously, we strive to provide brokers with a rapid and informed response. Account executives analyze the application and provide the broker with a preliminary approval, subject to final underwriting approval, or a denial, typically within one business day. The application is logged into our proprietary originations software program - called Click & Close - which automatically queues the loan over to an underwriter from the team covering that geographic area and/or broker. If the application is approved by our underwriter, a "conditional approval" will be issued to the broker with a list of specific conditions to be met and additional documents to be supplied prior to funding the loan. The file is then queued back to the account manager and processor, who work directly with the submitting broker to collect the requested information, meet all underwriting conditions and send out all appropriate documentation and disclosures. In most cases, we fund loans within 14 to 21 days after preliminary approval of the loan application. In the case of a denial, we will make all reasonable attempts to ensure that there is no missing information concerning the borrower or the application that might change the decision on the loan.
We compensate our account executives, who are the primary relationship contacts with the brokers, predominantly on a commission basis. We strive to have our account executives maintain the level of knowledge and experience integral to our commitment to providing the highest quality service for brokers. We believe that by maintaining an efficient, trained and experienced staff, we have addressed four central factors that determine where a broker sends its business:
o the service and support a lender provides;
o product offerings and pricing;
o the turn-around time, or speed with which a lender closes loans; and
o the lender's knowledge concerning the broker and his business.
RETAIL LOANS. We develop retail loan leads primarily through our automated telemarketing system and our network of 4 call centers and 7 retail offices located in eight states. For the year ended December 31, 2002, the retail channel accounted for $337.2 million, or 39%, of our loan originations, compared to $275.8 million, or 44%, of our loan originations for the year ended December 31, 2001 and $260.4 million, or 28%, of our loan purchases and originations for the year ended December 31, 2000. Through our marketing efforts, the retail loan channel is able to identify, locate and focus on individuals who, based on historic customer profiles, are likely customers for our products. Our telemarketing representatives identify interested customers and forward these potential borrowers to a branch manager through our Click & Close system. The branch managers, in turn, distribute these leads to mortgage analysts via Click & Close by queuing the loan to a mortgage analyst's to do list in Click & Close. The assigned mortgage analyst discusses the applicant's qualifications and available loan products, negotiates loan terms with the borrower and processes the loan through completion. Click & Close is utilized to queue the loan to underwriters at the appropriate times for approvals and help facilitate the loan application process through closing.
We compensate our mortgage analysts, who are the primary relationship contacts with our borrowers, predominantly on a commission basis.
CORRESPONDENT LOANS. We discontinued our correspondent operations in July 2000 to focus on our less cash intensive broker and retail channels. As such, we had no correspondent purchases in 2002 or 2001. For the year ended December 31, 2000, our correspondent network accounted for $69.4 million, or 7%, of our loan purchases and originations. No single correspondent contributed more than 1.5% of our total loan production in 2000.
LOAN UNDERWRITING
We maintain written underwriting guidelines that are utilized by all employees associated with the underwriting process. Throughout our 21 years in existence, these guidelines have been continually reviewed and updated by senior underwriters and the head of risk management. We provide our underwriting guidelines to all of the brokers from whom we accept loan applications. Loan applications received from brokers are classified according to particular characteristics including, but not limited to, the applicant's:
o ability to pay; o credit history (with emphasis on the applicant's existing mortgage payment history); o credit score; o income documentation type;
o lien position; o loan-to-value ratio; o property type; and o general stability, in terms of employment history, time in residence, occupancy and condition and location of the collateral.
We have established classifications with respect to the credit profile of the applicant, and each loan is placed into one of four letter ratings "A" through "D," with subratings within those categories. Terms of loans that we make, as well as maximum loan-to-value ratios and debt-to-income ratios, vary depending on the classification of the applicant and the borrower's credit score. Loan applicants with less favorable credit ratings and/or lower credit scores are generally offered loans with higher interest rates and lower loan-to-value ratios than applicants with more favorable credit ratings and/or higher credit scores. The general criteria our underwriting staff uses in classifying loan applicants are set forth in the following table.
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#100% LTV 2ND MORTGAGE REQUIREMENTS ARE AS FOLLOWS: (SEE GUIDELINES FOR ADDITIONAL REQUIREMENTS) [] Minimum 650 middle credit score. [] FIC only (24 month bank statements not allowed in this program). [] Min 4 yrs bankruptcy discharge or foreclosure. Consumer Credit Counseling not allowed in this program. [] 1 family detached only. No condos. [] REFINANCES only. No purchase money. [] Minimum loan amount $40,000 as a stand alone 2nd. As a simultaneous 1st and 2nd, minimum $20,000. [] Maximum loan amount $250,000. [] Minimum market value $100,000. [] 12 month mortgage history required. If 24 months reports to credit, 0x60 in months 13-24. - --------------------------------------------------------------------------------
We use these categories and characteristics as guidelines only. On a case-by-case basis, we may determine that the prospective borrower warrants an exception from the guidelines, if sufficient compensating factors exist. Examples of compensating factors we consider are:
o low debt ratio; o long-term stability of employment and/or residence; o excellent payment history on past mortgages; o a significant reduction in monthly expenses; or o low loan-to-value ratio.
The following table sets forth certain information with respect to our originations and purchases of first and second mortgage loans by borrower classification, along with weighted average coupons, for the periods shown and highlights the improved credit quality of our originations and purchases.
(DOLLARS IN THOUSANDS)
- ------------------ (1) Weighted Average Coupon ("WAC"). (2) Weighted Average Initial Loan-to-Value Ratio ("WLTV").
The mortgage loans we originate have amortization schedules ranging from 5 years to 30 years, generally bear interest at fixed rates and require equal monthly payments which are due as of a scheduled day of each month which is fixed at origination. Substantially all of our mortgage loans are fully amortizing loans. We primarily originate fixed rate loans, which amortize over a period not to exceed 30 years. The principal amounts of the loans we originate generally range from a minimum of $25,000 to a maximum of $600,000 and we will lend up to 100% of the combined loan-to-value ratio. Our loans are generally secured by one- to four-family residences, including condominiums and town-houses, and these properties are usually occupied by the owner. It is our policy not to accept commercial properties or unimproved land as collateral. However, we will accept mixed-use properties, such as a property where a portion of the property is used for residential purposes and the balance is used for commercial purposes, and will accept small multifamily properties of 5 to 8 units, both at reduced loan-to-value ratios. We do not originate loans where any senior mortgage contains open-end advance, negative amortization or shared appreciation provisions - all of which could have the effect of increasing the amount of the senior mortgage, thereby increasing the combined LTV, and making the loan more risky for us.
Our mortgage loan program includes:
o a full documentation program;
o a limited documentation program; o a no income verification program for self-employed borrowers; and o a stated income program.
Our borrowers' total monthly debt obligations - which include principal and interest on the new loan and all other mortgages, loans, charge accounts and scheduled indebtedness - generally are 50% or less of the borrower's monthly gross income, although some of our borrowers will qualify using our maximum debt-to-income ratio of 55%. For loans to borrowers who are salaried employees, we require current employment information in addition to employment history. We verify this information based on one or more of the following items: written confirmation from employers, recent pay-stubs, recent W-2 tax forms, recent tax returns, bank statements and telephone confirmation from the employer. For our limited documentation program, we require either 6 months of bank statements or a job letter to be submitted which contains substantially the same information one would find on a standard verification of employment form, including:
o job position; o length of time on job; o current salary; and o the job letter should appear on the employer's letterhead and include the telephone number and signature of the individual completing the letter on behalf of the employer.
For our no income verification program, we require proof of self-employment in the same business for 2 years. We only offer our stated income program, which represents a very small percentage of our loans, for better credit quality borrowers where a telephone verification is done by an underwriter to verify that the borrower is employed. We usually require lower combined loan-to-value ratios with respect to loans made under programs other than the full documentation program.
We assess a borrower's credit worthiness primarily based on his or her mortgage history and credit score, and generally adjust our pricing and loan to value ratios based on many other risk parameters. Our borrowers often have either (a) mortgage or other credit delinquencies, (b) problems providing documentation required by traditional lenders, and/or (c) collateral types that traditional lenders will not lend against. As such, we employ experienced non-conforming mortgage loan credit underwriters to review the applicant's credit profile and to evaluate whether an impaired credit history is a result of adverse circumstances or a continuing inability or unwillingness to meet credit obligations in a timely manner. An applicant's credit record will often be impaired by personal circumstances including divorce, family illnesses or deaths and temporary job loss due to layoffs and corporate downsizing.
As part of our settlement agreements with New York State regulators - I.E., the Remediation Agreement and Stipulated Order on Consent - we agreed to modify certain aspects of our underwriting guidelines. Even though these agreements terminated in September 2002, we have not eliminated the underwriting changes we agreed to and, in fact, intend to continue to originate loans in accordance with these agreements.
We have a staff of 43 underwriters with an average of 11 years of non-conforming lending experience. All underwriting functions for broker originations are centralized in our Woodbury, New York headquarters. All underwriting functions for retail originations are centralized in our retail underwriting "hub," located in Cincinnati, Ohio, and our Woodbury, New York headquarters. We do not delegate underwriting authority to any third party. Our underwriting department functions independently of our business development and sales departments and does not report to any individual directly involved in the sales origination process. None of our underwriters are compensated on an incentive or commission basis. Our underwriters are trained to review all components of the loan to determine its compliance with our underwriting guidelines.
We have instituted underwriting checks and balances that are designed to ensure that loans are generally reviewed and approved by a minimum of two underwriters. The Underwriting Department employs underwriters with different levels of experience and authority and loans generally must receive a secondary review by an underwriter of equal or higher rank. Although the most senior underwriters do not require a secondary review in certain circumstances, the vast majority of our loans are reviewed by at least two underwriters. Similarly, maximum loan amount and loan-to-value approval authorities are assigned to each level, ensuring that loans at the highest dollar or LTV-limits we offer are reviewed and approved only by the Department's most senior members.
We underwrite every loan submitted by not only thoroughly reviewing credit, but also by performing the following:
o a separate appraisal review conducted by our underwriter and/or appraisal review department; and
o a full compliance review, to ensure that all documents have been properly prepared, all applicable disclosures given in a timely fashion, and proper compliance with all federal and state regulations.
We require appraisals to be performed by third party, fee-based appraisers or by our approved appraisers and to conform generally to current Fannie Mae and Freddie Mac secondary market requirements for residential property appraisals. Each appraisal includes, among other things, an inspection of both the exterior and interior of the subject property and data from sales within the preceding 12 months of similar properties within the same general location as the subject property. We perform an appraisal review on each loan prior to closing. We do not believe that the general quality control practices of many conventional mortgage lenders, which is to perform only drive-by appraisals after closings, provides sufficient protection. As such, in addition to reviewing each appraisal for accuracy, we access alternate sources to validate sales used in the appraisal to determine market value. These sources include:
o Multiple Listing Services; o assessment and sales services, such as Comps, Inc., Pace, 1st American and Transamerica; o on-line internet services such as Realtor.com; and o other sources for verification, including broker price opinions and market analyses by local real estate agents.
We actively track and grade (based upon criteria that we have developed over time) all appraisers from which we accept appraisals for quality control purposes and do not accept work from appraisers who have not conformed to our review standards.
After completing the underwriting and processing of a brokered loan, we schedule the closing of the loan with an approved closing attorney or settlement agent. We hold the closing attorney or settlement agent responsible for completing the loan closing transaction in accordance with applicable law and our operating procedures. We also require title insurance that insures our interest as mortgagee and evidence of adequate homeowner's insurance naming us as an additional insured party on all loans.
We perform a post-funding quality control review to monitor and evaluate our loan origination policies and procedures. The quality control department is separate from the underwriting department and reports directly to a member of senior management.
We subject at least 10% of all loan originations to a full quality control re-underwriting and review, the results of which are reported to senior management on a quarterly basis. On a daily basis, should the need arise, the AVP in charge of QC Underwriting will e-mail senior management any critical loan findings. The sample of loans reviewed are selected in the following manner:
o All early default payments and customer complaints;
o At least 5% of the loans received are randomly sample; and
o Targets which may be based on sources of business (both internal branches/teams and external brokers, areas or other third parties) and products (perceived riskier products and newly offered products).
If any discrepancies are discovered during the review process, a senior quality control underwriter re-reviews the loan and proceeds with any necessary follow-up actions. Discrepancies noted by the review are analyzed and corrective actions are instituted. A typical quality control underwriting review currently includes:
o obtaining a new verification of value and/or photo for each property; o re-verifying the credit report; o reviewing loan applications for completeness, signatures, and for consistency with other processing documents; o obtaining new written and/or verbal verification of income and employment from employer; o obtaining new written and/or verbal verification of mortgage to re-verify any outstanding mortgages, if necessary; and o analyzing the underwriting and program selection decisions.
We update the quality control process from time to time as our policies and procedures change.
CLICK & CLOSE. Click & Close is a proprietary web-based system that we developed internally to streamline and integrate our origination's process. Click & Close, or C&C, opens an online channel of communications between us, brokers, borrowers and a wide range of other mortgage information sources. We already utilize C&C to automate and facilitate many of our origination processes, including but not limited to:
o logging in and tracking applications in our retail and wholesale channels; o increasing the amount of internal loan origination processes that can be handled electronically, thereby reducing paper flow between account managers, loan processors and underwriters and allowing us to become more paperless; o generating pre-approvals utilizing our risk-based pricing model; o generating stipulation sheets, preliminary disclosures and other documents; and o easy, real time supervisory oversight to ensure all applications are being worked on in a timely manner.
We are continuing to work to improve C&C to further streamline our processes and reduce the paper flow required throughout the mortgage origination process, with a goal of ultimately lowering our cost to originate.
LOAN SALES
We sell virtually all the loans we originate through one of two outlets: (i) securitizations, which involve the public offering by a securitization trust of asset-backed pass-through securities; and (ii) whole loan sales, which include the sale of pools of individual loans to institutional investors, banks, and consumer finance-related companies on a servicing released basis. In 2002, securitizations and whole loan sales comprised approximately 89% and 11%, respectively, of our loan sales. Going forward, we expect to continue to use a combination of securitizations and whole loan sales, with the amounts of each dependent upon the marketplace and our goal of maximizing earnings and liquidity.
SECURITIZATIONS. During 2002, we completed four securitizations totaling $850 million, of which we delivered a total of $819 million of mortgage loans during 2002 (and delivered the remaining $31 million of mortgage loans in January 2003, pursuant to a pre-funding mechanism). During 2001, we completed two securitizations totaling $345 million of mortgage loans. The following table sets forth certain information with respect to our 2002 securitizations (all of which contained ratings on various classes of securities ranging from AAA/Aaa to BBB/Baa2 by S&P, Fitch, and Moody's, respectively) by offering size, which includes pre-funded amounts, duration weighted average pass-through rate and type of credit enhancement.
* SENIOR/SUB STRUCTURE WITH A "AAA" RATED MONOLINE INSURER INSURING THE SENIOR OR "AAA" RATED PASS-THROUGH CERTIFICATES
When we securitize loans, we create trusts in the form of off-balance sheet qualified special purpose entities, or QSPEs. These trusts are established for the limited purpose of buying and reselling mortgage loans. Typically each quarter, we pool together loans, and sell these loans to these securitization trusts. We carry no contractual obligation related to these trusts or the loans sold to them, nor do we have any direct or contingent liability related to the trusts, except for the standard representations and warranties made in conjunction with each securitization trust. Furthermore, we provide no guarantees to investors with respect to cash flow or performance for these trusts. These entities represent qualified special purpose entities and are therefore not consolidated for financial reporting purposes in accordance with SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities".
The securitization trust raises money to purchase the mortgage loans from us by selling securities to the public - known as asset-backed pass-through securities that are secured by the pool of mortgage loans held by the securitization trust. These asset-backed securities or senior certificates, which are usually purchased for cash by
insurance companies, mutual funds and/or other institutional investors, represent senior interests in the cash flows from the mortgage loans in the trust.
The securitization trust issues senior certificates, which entitles the holders of these senior certificates to receive the principal collected, including prepayments of principal, on the mortgage loans in the trust. In addition, holders receive a portion of the interest on the loans in the trust equal to the pass-through interest rate on the remaining principal balance. The securitization trust also issues a subordinate certificate or BIO certificate (referred to as an excess cashflow certificate), and a P certificate (representing the right to receive prepayment penalties from borrowers who payoff their loans early in their life). Each month, the P certificate holder is entitled to receive prepayment penalties received from borrowers who payoff their loans early in their life.
For any monthly distribution, the holder of an excess cashflow certificate receives payments only after all required payments have been made on all the other securities issued by the securitization trust. In addition, before the holder of the excess cash flow certificate receives payments, cash flows from such excess cashflow certificates are applied in a "waterfall" manner. (See "- Management's Discussion & Analysis - Loan Securitizations" beginning on page 26 for a more complete discussion on the "waterfall" and securitizations in general.)
A summary of the gain on sale and cash flow we received from our aggregate securitizations in 2002 and 2001 is presented below. "Loans sold" represents the amount of loans actually transferred to the respective securitization trusts during each year:
- ---------- (1)The reduction in value of the excess cashflow certificates in 2002 compared to 2001 is primarily due to changes we made to our fair value assumptions of our excess cashflow certificates (see "- Excess Cashflow Certificate, Net"). (2)In 2001, the mortgage servicer purchased the P Certificate; in 2002, we transferred the P Certificate to the NIM Trust, which accounts for the reduced gain from the sale of mortgage servicing rights in 2002.
At the time we completed the 2002 securitizations, we recognized as revenue each the economic interests listed above, which was recorded as net gain on sale of mortgage loans on our consolidated statement of operations.
WHOLE LOAN SALES WITHOUT RECOURSE. We have found that, at times, we can receive better economic results by selling certain mortgage loans on a whole loan, without retaining servicing rights, generally in private transactions to financial institutions or consumer finance companies. We recognize a gain or loss when we sell loans on a whole loan basis equal to the difference between the cash proceeds received for the loans and our investment in the loans, including any unamortized loan origination fees and costs. We generally sell these loans without recourse, except that we provide normal representations and warranties to the purchasers of such loans.
In 2002 and 2001, we sold whole loans without recourse on a servicing-released basis of $102.9 million and $261.1 million, respectively.
LOAN SERVICING
Prior to May 2001, we serviced substantially all of the loans that we originated and purchased since our inception in 1982.
In January 2001, we announced that we had entered into an agreement with Ocwen to transfer our servicing portfolio to Ocwen. In May 2001, we physically transferred our entire servicing portfolio to Ocwen, and laid-off our servicing staff. We no longer service loans nor do we have a servicing operation. We do, however, maintain several employees to assist third parties with delinquent and defaulted loans, as well as portfolio retention.
COMPETITION
As an originator of mortgage loans, we face intense competition, primarily from diversified consumer financial companies and other diversified financial institutions, mortgage banking companies, commercial banks, credit unions, savings and loans, credit card issuers and finance companies. Many of these competitors in the financial services business are substantially larger and have more capital and other resources than we do. Competition can take many forms, including interest rates and costs of the loan, convenience in obtaining a loan, service, marketing and distribution channels. Furthermore, the level of gains realized by us and our competitors on the sale of the type of loans originated has attracted additional competitors into this market with the effect of lowering the gains that may be realized by us on future loan sales. In addition, efficiencies in the asset-backed market have generally created a desire for even larger transactions giving companies with greater volumes of originations a competitive advantage.
Competition may be affected by fluctuations in interest rates and general economic conditions. During periods of rising rates, competitors which have "locked in" low borrowing costs may have a competitive advantage. During periods of declining rates, competitors may solicit borrowers underlying our excess cashflow certificates to refinance their loans. During economic slowdowns or recessions, these borrowers may have new financial difficulties and may be receptive to offers by our competitors.
Over the past several years, many of the independent mortgage banking companies, which previously were among our most intense competitors, have either gone out of business or been acquired by larger, more diversified national financial institutions. At the same time, many larger finance companies, financial institutions and conforming mortgage originators have adapted their conforming origination programs and allocated resources to the origination of non-conforming loans and/or have otherwise begun to offer products similar to those offered by us, targeting customers similar to those we do. Fannie Mae and Freddie Mac also have expressed interest in adapting their programs to include products similar to those offered by us and have begun to expand their programs and presence into the non-conforming market. The entrance of these larger and better-capitalized competitors into our market may have a material adverse effect on our results of operations and financial condition.
REGULATION
Our business is subject to extensive regulation, supervision and licensing by federal, state and local governmental authorities and is subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. Our consumer lending activities are subject to, among other laws and regulations:
o the Federal Truth-in-Lending Act and Regulation Z (including the Home Ownership and Equity Protection Act of 1994);
o the Equal Credit Opportunity Act of 1974, as amended (ECOA);
o the Fair Credit Reporting Act of 1970, as amended;
o the Real Estate Settlement Procedures Act (RESPA), and Regulation X;
o the Home Mortgage Disclosure Act;
o the Federal Debt Collection Practices Act; and
o other federal, state and local statutes and regulations affecting our activities.
We also are subject to the rules and regulations of, and examinations by the Department of Housing and Urban Development ("HUD") and state regulatory authorities with respect to originating, processing and underwriting loans (and servicing loans prior to May 2001). These rules and regulations, among other things:
o impose licensing obligations on us;
o establish eligibility criteria for mortgage loans;
o prohibit discrimination;
o provide for inspections and appraisals of properties;
o require credit reports on loan applicants;
o regulate assessment, collection, foreclosure and claims handling, investment and interest payments on escrow balances and payment features;
o mandate certain disclosures and notices to borrowers; and
o in some cases, fix maximum interest rates, fees and mortgage loan amounts.
Failure to comply with these requirements can lead to, among other things, loss of approved status, demands for indemnification or mortgage loans repurchases, certain rights of rescission for mortgage loans, class action and other lawsuits, and administrative enforcement actions.
Several states and local municipalities have recently enacted so-called "high cost" mortgage laws and/or regulations. While many of these laws and regulations contain some provisions that are similar to one another, there are a variety of provisions that vary from state to state and municipality to municipality, which has significantly increased the costs of compliance. In addition, dozens of other state and local laws and regulations are currently under consideration, with even more likely to be proposed on the horizon, that are intended to further regulate our industry. Many of these laws and regulations seek to impose broad restrictions on certain commonly accepted lending practices, including some of our practices. There can be no assurance that these proposed laws, rules and regulations, or other similar laws, rules or regulations, will not be adopted in the future. Adoption of these laws, rules and regulations could have a material adverse impact on our business by:
o substantially increasing the costs of compliance with a variety of potentially inconsistent federal, state and local laws;
o substantially increasing the risk of litigation or administrative action associated with complying with these proposed federal, state and local laws, particularly those aspects of such proposed laws that contain subjective (as opposed to objective) requirements, among other things;
o restricting our ability to charge rates and fees adequate to compensate us for the risk associated with certain loans; or
o if the law, rule or regulation is too onerous, potentially limiting our ability or willingness to operate in a particular geographic area.
There are also several potential federal bills being proposed, at least one of which may provide for federal preemption over these myriad existing and proposed state and local laws and regulations. There can be no assurance that any federal law will be passed addressing this matter, or that, if passed, it will contain a provision that preempts these myriad state and local laws and regulations.
In September 1999, we settled allegations by the NYSBD and a lawsuit by the New York State Office of the Attorney General (the "NYOAG") alleging that we had violated various state and federal lending laws. The global settlement was evidenced by (a) a Remediation Agreement by and between Delta Funding and the NYSBD, dated as of September 17, 1999 and (b) a Stipulated Order on Consent by and among Delta Funding, Delta Financial and the NYOAG, dated as of September 17, 1999. As part of the Settlement, we, among other things, implemented agreed upon changes to our lending practices; are providing reduced loan payments aggregating $7.25 million to certain borrowers identified by the NYSBD; and have created a fund managed by the NYSBD and financed by the grant of 525,000 shares of Delta Financial's common stock.
Each month, on behalf of borrowers designated by the NYSBD, we make subsidy payments to the related securitization trusts. These subsidy payments fund the differential between the original loan payments and the reduced loan payments. As part of the Second Exchange Offer we completed in August 2001 (see Note 2 "Summary of Regulatory Settlement" and Note 3 "Corporate Restructuring, Debt Modification and Debt Restructuring" to Notes to the Consolidated Financial Statements), the LLC - an unaffiliated, newly-formed entity, the voting membership interests of which are owned by former holders of our notes - is obligated to satisfy these
payment subsidies out of the cash flows generated by the mortgage related securities (primarily from the excess cashflow certificates) it owns. If the LLC's cash flows are insufficient to pay this obligation, we remain responsible to satisfy our obligations under the Remediation Agreement.
The proceeds of the stock fund will be used to pay borrowers and to finance a variety of consumer educational and counseling programs. We do not manage the fund created for this purpose. The number of shares of common stock deposited in the fund does not adjust to account for fluctuations in the market price of our common stock. Changes to the market price of these shares of common stock deposited in the fund do not have any impact on our financial statements. We did not make any additional financial commitments between the settlement date and March 2000. The Stipulated Order on Consent and the Remediation Agreement both terminated by their respective terms, in September 2002. We remain obligated as discussed above to continue to make subsidy payments on behalf of borrowers identified by the NYSBD for so long as such borrowers continue to make payments under the mortgage loans.
We believe we are in compliance in all material respects with applicable federal and state laws and regulations.
ENVIRONMENTAL MATTERS
To date, we have not been required to perform any investigation or clean up activities, nor have we been subject to any environmental claims. There can be no assurance, however, that this will remain the case in the future. Although we primarily lend to owners of residential properties, in the course of our business, we may acquire properties securing loans that are in default. There is a risk that we could be required to investigate and clean-up hazardous or toxic substances or chemical releases at such properties, and may be held liable to a governmental entity or to third parties for property damage, personal injury and investigation and cleanup costs incurred by such parties in connection with the contamination. In addition, the owner or former owners of a contaminated site may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from such property.
EMPLOYEES
As of December 31, 2002, we had a total of 693 employees (full-time and part-time). None of our employees are covered by a collective bargaining agreement. We consider our relations with our employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
Our executive and administrative offices are located at 1000 Woodbury Road, Woodbury, New York 11797, where we lease approximately 107,000 square feet of office space at an aggregate annual rent of approximately $2.0 million. The lease provides for certain scheduled rent increases and expires in 2008.
We also maintain business development offices in New Jersey, Ohio, Pennsylvania and Virginia. Our retail operation currently maintains four retail call centers in Woodbury, New York, Pittsburgh, Pennsylvania, Charlotte, North Carolina and Phoenix, Arizona, and seven retail mortgage origination offices in Illinois, Missouri, Ohio (3), Pennsylvania and Tennessee. We also maintain one telemarketing hub and one underwriting hub in Ohio. The terms of these leases vary as to duration and escalation provisions, with the latest expiring in 2008.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Because the nature of our business involves the collection of numerous accounts, the validity of liens and compliance with various state and federal lending laws, we are subject, in the normal course of business, to numerous claims and legal proceedings. Our lending practices have been the subject of several lawsuits styled as class actions and of investigations by various regulatory agencies including the NYSBD, the NYOAG and the United States Department of Justice (the "DOJ"). The current status of these actions is summarized below.
o In or about November 1998, we received notice that we had been named in a lawsuit filed in the United States District Court for the Eastern District of New York. In December 1998, plaintiffs filed an amended complaint alleging that we had violated the Home Ownership and Equity Protection Act ("HOEPA"), the Truth in Lending Act ("TILA") and New York State General Business Lawss.349. The complaint seeks (a) certification of a class of plaintiffs, (b) declaratory judgment permitting rescission, (c) unspecified actual, statutory, treble and punitive damages (including attorneys' fees), (d) certain injunctive relief, and (e)
declaratory judgment declaring the loan transactions as void and unconscionable. On December 7, 1998, plaintiff filed a motion seeking a temporary restraining order and preliminary injunction, enjoining us from conducting foreclosure sales on 11 properties. The District Court Judge ruled that in order to consider such a motion, plaintiff must move to intervene on behalf of these 11 borrowers. Thereafter, plaintiff moved to intervene on behalf of 3 of these 11 borrowers and sought injunctive relief on their behalf. We opposed the motions. On December 14, 1998, the District Court Judge granted the motion to intervene and on December 23, 1998, the District Court Judge issued a preliminary injunction that enjoined us from proceeding with the foreclosure sales of the three intervenors' properties. We filed a motion for reconsideration of the December 23, 1998 order. In January 1999, we filed an answer to plaintiffs' first amended complaint. In July 1999, plaintiffs were granted leave, on consent, to file a second amended complaint. In August 1999, plaintiffs filed a second amended complaint that, among other things, added additional parties but contained the same causes of action alleged in the first amended complaint. In September 1999, we filed a motion to dismiss the complaint, which was opposed by plaintiffs and, in June 2000, was denied in part and granted in part by the Court. In or about October 1999, plaintiffs filed a motion seeking an order preventing us, our attorneys and/or the NYSBD from issuing notices to certain of our borrowers, in accordance with a settlement agreement entered into by and between Delta and the NYSBD. In or about October 1999 and November 1999, respectively, we and the NYSBD submitted opposition to plaintiffs' motion. In March 2000, the Court issued an order that permitted us to issue an approved form of the notice. In September 1999, plaintiffs filed a motion for class certification, which we opposed in February 2000, and was ultimately withdrawn without prejudice by plaintiffs in January 2001. In February 2002, we executed a settlement agreement with plaintiffs, pursuant to which we denied all wrongdoing, but agreed to resolve the litigation on a class-wide basis. The Court preliminarily approved the settlement and a fairness hearing was held in May 2002. We are awaiting a decision from the Court on the fairness hearing. We believe that the Court will approve the settlement, but if it does not, we believe that we have meritorious defenses and intend to defend this suit, but cannot estimate with any certainty our ultimate legal or financial liability, if any, with respect to the alleged claims.
o In or about March 1999, we received notice that we had been named in a lawsuit filed in the Supreme Court of the State of New York, New York County, alleging that we had improperly charged certain borrowers processing fees. The complaint seeks (a) certification of a class of plaintiffs, (b) an accounting, and (c) unspecified compensatory and punitive damages (including attorneys' fees), based upon alleged (i) unjust enrichment, (ii) fraud, and (iii) deceptive trade practices. In April 1999, we filed an answer to the complaint. In September 1999, we filed a motion to dismiss the complaint, which was opposed by plaintiffs, and in February 2000, the Court denied the motion to dismiss. In April 1999, we filed a motion to change venue and plaintiffs opposed the motion. In July 1999, the Court denied the motion to change venue. We appealed and in March 2000, the Appellate Court granted our appeal to change venue from New York County to Nassau County. In August 1999, plaintiffs filed a motion for class certification, which we opposed in July 2000. In or about September 2000, the Court granted plaintiffs' motion for class certification, from which we appealed. The Appellate Court denied our appeal in December 2001. In or about June 2001, we filed a motion for summary judgment to dismiss the complaint, which was denied by the Court in October 2001. We appealed that decision, but the appellate court denied our appeal in November 2002. We filed a motion to reargue in December 2002, which was denied by the Court in January 2003. Discovery will now continue in the lower court. We believe that we have meritorious defenses and intend to defend this suit, but cannot estimate with any certainty our ultimate legal or financial liability, if any, with respect to the alleged claims.
o In November 1999, we received notice that we had been named in a lawsuit filed in the United States District Court for the Eastern District of New York, seeking certification as a class action and alleging violations of the federal securities laws in connection with our initial public offering in 1996 and our reports subsequently filed with the Securities and Exchange Commission. The complaint alleges that the scope of the violations alleged in the consumer lawsuits and regulatory actions brought in or around 1999 indicate a pervasive pattern of action and risk that should have been more thoroughly disclosed to investors in our common stock. In May 2000, the Court consolidated this case and several other lawsuits that purportedly contain the same or similar allegations against us and in August 2000 plaintiffs filed their Consolidated Amended Complaint. In October 2000, we filed a motion to dismiss the Complaint in its entirety, which was opposed by plaintiffs in November 2000, and denied by the Court in September 2001. We reached an agreement in principal with plaintiffs' counsel and our insurer to settle the action on a class-
wide basis in or about August 2002 and executed a settlement agreement in January 2003 (pursuant to which we denied all wrongdoing). The settlement has been preliminarily approved by the Court and a fairness hearing has been scheduled for April 2003, at which time we further anticipate that the Court will approve the settlement. In the event that the settlement is not approved, we believe that we have meritorious defenses and intend to defend this suit, but cannot estimate with any certainty our ultimate legal or financial liability, if any, with respect to the alleged claims.
o In or about April 2000, we received notice that we had been named in a lawsuit filed in the Supreme Court of the State of New York, Nassau County, alleging that we had improperly charged and collected from borrowers certain fees when they paid off their mortgage loans with us. The complaint seeks (a) certification of a class of plaintiffs, (b) declaratory relief finding that the payoff statements used include unauthorized charges and are deceptive and unfair, (c) injunctive relief, and (d) unspecified compensatory, statutory and punitive damages (including legal fees), based upon alleged violations of Real Property Law 274-a, unfair and deceptive practices, money had and received and unjust enrichment, and conversion. We answered the complaint in June 2000. In March 2001, we filed a motion for summary judgment, which was opposed by plaintiffs in March 2001, and we filed reply papers in April 2001. In June 2001, our motion for summary judgment dismissing the complaint was granted. In August 2001, plaintiffs appealed the decision. In September 2002, we executed a settlement agreement with plaintiffs pursuant to which we denied all wrongdoing, but agreed to resolve the litigation on a class-wide basis. We anticipate that a fairness hearing will be held in the upcoming months, at which point we further anticipate that the Court will approve the settlement. In the event that the settlement is not approved, we believe that we have meritorious defenses and intend to defend this suit, but cannot estimate with any certainty our ultimate legal or financial liability, if any, with respect to the alleged claims.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PRICE RANGE OF COMMON STOCK
Our common stock trades on the Over-The-Counter Bulletin Board ("OTCBB") under the symbol "DLTO". The following table sets forth for the periods indicated the range of the high and low closing sales prices for our common stock.
2002 HIGH LOW ---- ---- ---- First Quarter ......................... $ 1.54 $ 0.85 Second Quarter ........................ 2.76 0.91 Third Quarter.......................... 2.74 1.65 Fourth Quarter ........................ 1.50 0.95
2001 HIGH LOW ---- ---- ---- First Quarter ......................... $ 0.63 $ 0.36 Second Quarter ........................ 0.43 0.24 Third Quarter.......................... 0.51 0.28 Fourth Quarter ........................ 1.06 0.38
Our common stock previously was listed on the New York Stock Exchange (the "NYSE") under the symbol "DFC", but in May 2001, the NYSE de-listed our common stock. The NYSE stated that it took this action because we were unable to meet the NYSE's continued listing standards of maintaining a minimum of $15 million in market capitalization and a minimum share price of $1 over a 30-day trading period. When our common stock was de-listed in May 2001, it began trading on the OTCBB under the ticker symbol "DLTO".
On December 31, 2002, we had approximately 76 stockholders of record. This number does not include beneficial owners holding shares through nominee or "street" names. We believe the number of beneficial stockholders is approximately 1,200.
DIVIDEND POLICY
We did not pay any dividends in 2002 and, in accordance with our present general policy, we have no present intention to pay cash dividends on our common stock. Under the terms of our Certificate of Designations for our newly-issued preferred stock, we are obligated to commence paying dividends to holders of our Series A preferred stock in July 2003, and are limited in our ability to pay dividends to holders of our common stock.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR CONSOLIDATED FINANCIAL STATEMENTS AND ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SET FORTH THEREIN.
SUMMARY OF CRITICAL ACCOUNTING POLICIES
EXCESS CASHFLOW CERTIFICATES. Our excess cashflow certificates primarily consist of the right to receive the future excess cash flows from a pool of securitized mortgage loans. Our interest in these certificates generally consists of the following:
o The interest spread between the coupon on the underlying mortgage loans and the cost of financing (which, when we sell NIM notes, is only received after the NIM notes are paid in full);
o On our 2002 securitizations, prepayment penalties received from borrowers who payoff their loans early in their life (which, when we sell NIM notes, is only received after the NIM notes are paid in full); and
o Overcollateralization, which is designed to protect the securities sold to the securitization pass-through investors from credit loss on the underlying mortgage loans (and which we describe in greater detail below under "Loan Securitizations").
The excess cash flow we receive is highly dependent upon the interest rate environment to the extent basis risk exists between the securitization trust's assets and liabilities. For instance, in each of our securitizations in 2002, the cost of financing for the securitized loans is indexed against 1 month LIBOR meaning that each month the interest rate received by the pass through certificate holders may adjust (upwards or downwards) as 1 month LIBOR changes (liability), while the majority of the underlying mortgage loans in the securitization trust have a fixed note rate for at least 3 years (asset). As a result, as rates rise and fall, the amount of our excess cash flows will fall and rise, which in turn will increase or decrease the value of our excess cashflow certificates.
In each of our securitizations in which we sold NIM note(s), we purchased, on behalf of the NIM owner trust, an interest rate cap for the benefit of the NIM noteholder(s), which helps mitigate the basis risk for the approximate time that the NIM notes are outstanding.
We believe the accounting estimates related to the valuation of our excess cashflow certificates is a "critical accounting estimate" because it can materially affect net income and require us to forecast interest rates, mortgage principal payments, prepayments, and loan loss assumptions which are highly uncertain and require a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our excess cashflow certificates. Management uses internal, historical collateral performance data and published forward LIBOR curves when modeling future expected excess cashflows. We believe the value of our excess cashflows certificates is fair, but can provide no assurance that future prepayment and loss experience or changes in their required market discount rate will not require write-downs of the excess cashflow certificate asset. Write-downs would reduce income of future periods.
GENERAL
As discussed in more detail in the "Business Overview" in Part I, beginning on page 1, Delta Financial Corporation ("Delta" or "we"), through its wholly-owned subsidiaries, originates, securitizes and sells (and, prior to May 2001, serviced) non-conforming home equity loans, which are primarily secured by first mortgages on one- to four-family residential properties. Throughout our 21 years of operating history, we have focused on lending to individuals who generally have impaired or limited credit profiles or higher debt-to-income ratios for such purposes as debt consolidation, home improvement, mortgage refinancing or education. These borrowers generally do not satisfy the credit, documentation or other underwriting standards set by more traditional sources of mortgage credit, including those that make loans in compliance with conventional mortgage lending guidelines established by Fannie Mae and Freddie Mac.
Our mortgage business has two principal components. First, we make mortgage loans to individual borrowers, which is a cash and expense outlay for us, because our cost to originate a loan exceeds the fees we collect at the time we originate that loan. At the time we originate a loan, and prior to the time we sell that loan, we finance that loan by borrowing under warehouse lines of credit. Second, we sell loans, either through securitization or on a whole loan basis, to generate cash and non-cash revenues, recording the premiums we receive as revenues. We use the proceeds from these sales to repay our warehouse lines of credit and for working capital.
CORPORATE RESTRUCTURING, DEBT MODIFICATION AND DEBT RESTRUCTURING. As discussed in more detail in "Corporate Restructuring, Debt Modification and Debt Restructuring" in Part I, beginning on page 3, we engaged in a series of transactions beginning in 2000, and concluding in the third quarter of 2001, aimed at improving operating efficiencies and reducing our negative cash flow. We spent much of 2001 working on two transactions in particular, which we believe were of tantamount importance in this regard - selling our servicing portfolio and extinguishing most of our long term debt.
o In May 2001, we completed our transfer of servicing to Ocwen, which freed us from the significant cash drain associated with making securitization advances (and the capital costs associated with making such advances), and of servicing a highly seasoned portfolio following three successive quarters of selling the securitization servicing rights associated with newly originated mortgage loans.
o In August 2001, we completed our Second Exchange Offer, which extinguished substantially all of our long-term debt, leaving approximately $11 million out of $150 million of our notes still outstanding and resulted in us recording a $19.3 million charge to our statement of operations. This debt extinguishment helped us threefold. First, it eliminated nearly $139 million of principal which we otherwise would have had to repay in 2004. Second, it eliminated more than $14 million of yearly interest expense that we would have had to pay to the former noteholders had they still held their notes. Third, the ratings agencies that previously rated us and our notes have withdrawn their corporate ratings.
We believe that our transfer of servicing to Ocwen and the Second Exchange Offer were essential steps in our effort to restructure our operations and reduce our negative cash flow previously associated with our servicing operations and the notes.
LOAN SECURITIZATIONS
When we securitize loans, we create trusts in the form of off-balance sheet qualified special purpose entities, or QSPEs. These trusts are established for the limited purpose of buying and reselling mortgage loans. Typically each quarter, we pool together loans, and sell these loans to these securitization trusts. We carry no contractual obligation related to these trusts or the loans sold to them, nor do we have any direct or contingent liability related to the trusts, except for the standard representations and warranties made in conjunction with each securitization trust. Furthermore, we provide no guarantees to investors with respect to cash flow or performance for these trusts. These entities represent qualified special purpose entities and are therefore not consolidated for financial reporting purposes in accordance with SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities".
The securitization trust raises money to purchase the mortgage loans from us by selling securities to the public - known as asset-backed pass-through securities that are secured by the pool of mortgage loans held by the securitization trust. These asset-backed securities or senior certificates, which are usually purchased for cash by insurance companies, mutual funds and/or other institutional investors, represent senior interests in the cash flows from the mortgage loans in the trust.
The securitization trust issues senior certificates, which entitle the holders of these senior certificates to receive the principal collected, including prepayments of principal, on the mortgage loans in the trust. In addition, holders receive a portion of the interest on the loans in the trust equal to the pass-through interest rate on the remaining principal balance. The securitization trust also issues a subordinate certificate or BIO certificate (referred to as an excess cashflow certificate), and a P certificate (representing the right to receive prepayment penalties from borrowers who payoff their loans early in their life). Each month, the P certificate holder is entitled to receive prepayment penalties received from borrowers who payoff their loans early in their life.
For any monthly distribution, the holder of an excess cashflow certificate receives payments only after all required payments have been made on all the other securities issued by the securitization trust. In addition, before the holder of the excess cash flow certificate receives payments, cash flows from such excess cashflow certificates are applied in a "waterfall" manner as follows:
o first, to cover any losses on the mortgage loans in the related mortgage loan pool, because the excess cashflow certificates are subordinate in right of payment to all other securities issued by the securitization trust;
o second, to reimburse the bond insurer, if any, of the related series of pass-through certificates for amounts paid by or otherwise owing to that insurer;
o third, to build or maintain the overcollateralization provision (described in more detail immediately below) for that securitization trust at the required level by being applied as an accelerated payment of principal to the holders of the pass-through certificates of the related series;
o fourth, to reimburse holders of the subordinated certificates of the related series of pass-through certificates for unpaid interest and for any losses previously allocated to those certificates; and
o fifth, to pay interest on the related pass-through certificates which was not paid because of the imposition of a cap on their pass-through rates - these payments being called basis risk shortfall amounts.
The overcollateralization provision or "O/C" is a credit enhancement which is designed to protect the securities sold to the securitization pass-through investors from credit loss on the underlying mortgage loans. In short, overcollateralization is when the amount of collateral (I.E., mortgage loans) owned by a securitization trust exceeds the aggregate amount of senior pass-through certificates. The O/C is created to absorb losses that the securitization trust may suffer, as loans are liquidated at a loss. Historically, we built up the O/C typically over the first 18-24 months of a securitization (with the specific timing depending upon the structure, amount of excess spread, and performance of the securitization), by utilizing the cash flows from the excess cashflow certificates to make additional payments of principal to the holders of the pass-through certificates until the required O/C level was reached. Beginning with each of our 2002 securitizations, we created the O/C by initially selling pass-through securities totaling approximately 98.5% of the total amount of mortgage loans sold to the trust. In doing so, we create the full amount of the O/C required by the trust up front, at the time we complete the securitization, instead of over time. For example, if a securitization trust contains collateral of $100 million of mortgage loans, we sell approximately $98.5 million in senior pass-through certificates. Prior to our 2002 securitization transactions, we typically issued pass-through certificates for a par purchase price, or a slight discount to par - with par representing the aggregate principal balance of the mortgage loans backing the asset-backed securities. For example, if a securitization trust contains collateral of $100 million of mortgage loans, we typically received close to $100 million in proceeds from the sales of these certificates, depending upon the structure we utilize for the securitization.
The O/C is generally expressed as a percentage of the initial mortgage loan or collateral principal balance sold to the securitization trust. The required O/C is initially determined by either the rating agencies and/or the bond insurer, if any, using various factors including (1) characteristics of the mortgage loans sold to the trust (i.e., credit scores and loan to value ratios), (2) the amount of excess spread between the interest rate on the pool of mortgage loans sold to the securitization trust and the interest paid to the pass-through certificate holders, less the servicing fee, and other related expenses such as trustee fees and bond insurer fee, if any, and (3) the structure of the underlying securitization.
Our securitizations have typically required an O/C of between 1.25% and 3.0% of the initial mortgage loans sold to the securitization trust. The required O/C can increase or decrease throughout the life of the transaction depending upon subordination levels, delinquency and/or loss tests and is subject to minimums and maximums, as defined by the rating agencies and/or the bond insurer insuring the securitization. On our securitizations prior to 2002, after the O/C requirement is reached, the cash flows from the excess cashflow certificates are then distributed to us as the holder of the excess cashflow certificates, in accordance with the "waterfall" described above. Over time, if the cash collected during the periods exceeds the amount necessary to maintain the required O/C and all other required distributions have been met, and there is no shortfall in the related required O/C, the excess is then released to us as holder of the excess cashflow certificate.
We began utilizing a new securitization structure in 2002. In lieu of selling an interest-only certificate, we sold a net interest margin certificate or NIM. The NIM is generally structured where we sell the excess cashflow certificate and P certificate (which entitles the holder to all prepayment penalties collected by the securitization trust) to a QSPE or owner trust (the NIM trust) and the NIM trust in turn issues (1) interest-bearing NIM note(s) (backed by the excess cashflow certificate and P certificate), and (2) NIM owner trust certificate evidencing ownership in the NIM trust. We sell the excess cashflow certificate and P certificate without recourse except that we provide normal representations and warranties to the NIM trust. One or more investors purchase the NIM note(s) and the proceeds from the sale of the note(s), along with a owner trust certificate that is subordinate to the note(s), represent the consideration to us for the sale of the excess cashflow certificate.
The NIM note(s) entitles the holder to be paid a specified interest rate, and further provides for all cash flows generated by the excess cashflow certificate and P certificate to be used to pay all principal and interest on the NIM note(s) until paid in full. This typically occurs approximately 22-25 months from the date the NIM note(s) were issued. As part of the NIM transaction, we received the cash proceeds from the sale of the NIM note(s) and a
subordinate interest in the NIM owner trust, represented by the owner trust certificate. The owner trust certificate entitles us to all cash flows generated by the excess cashflow certificate and P certificate after the holder of the NIM note(s) has been paid in full. As such, we classify the NIM owner trust certificate on our balance sheet as an excess cashflow certificate and value the NIM owner trust certificate using the same assumptions that we utilize in valuing excess cashflow certificates.
As part of the NIM transaction, we were required to "fully fund" the O/C at closing - as opposed to having it build up over time as we had in past securitizations - which is why we sold senior pass-through certificates that were approximately 1.5% less than the collateral in the securitization trust. We use a portion of the proceeds we receive from selling NIM note(s) to make up for the difference between (1) the value of the mortgage loans sold and (2) the proceeds from selling the senior pass-through certificates.
In each of the four securitizations that we issued in 2002, we derived the following economic interests:
o we received a cash purchase price from the sale of the NIM note(s) issued by a NIM trust, to which we sold the excess cashflow certificates;
o we retained a NIM owner trust certificate, which entitles us to receive cash flows generated by the excess cashflow certificates and the P certificate issued in connection with the securitization after the holder of the NIM note(s) has been paid in full. Although the cash flows generated by excess cashflow certificates are received over time, under existing accounting rules, we must report as income at the time of the securitization the present value of all projected cash flows we expect to receive in the future from these excess cashflow certificates based upon an assumed discount rate. Our valuation of these excess cashflow certificates is primarily based on (1) our estimate of the amount of expected losses or defaults that will take place on the underlying mortgage loans over the life of the mortgage loans, (2) the expected amount of prepayments on the mortgage loans due to the underlying borrowers of the mortgage loans paying off their mortgage loan prior to the loan's stated maturity, (3) the London Inter-Bank Offered Rate ("LIBOR") forward curve (using current LIBOR as the floor rate) and (4) a discount rate; and
o we received a cash premium from selling the right to service the loans being securitized. This right entitles the contractual servicer to service the loans on behalf of the securitization trust, and earn a contractual servicing fee, and ancillary servicing fees (which includes prepayment penalties for certain securitization servicing rights we previously sold) in such capacity.
At the time we completed the 2002 securitizations, we recognized as revenue each of the three economic interests described above, which was recorded as net gain on sale of mortgage loans on our consolidated statement of operations.
Our net investment in the pool of loans sold at the date of the securitization represents the amount originally paid to originate the loans, adjusted for the following:
o any direct loan origination costs incurred (an increase in the investment) and loan origination fees received (a decrease in the investment) in connection with the loans, which are treated as a component of the initial investment in loans;
o the principal payments received, and the amortization of the net loan fees or costs, during the period we held the loans prior to their securitization; and
o any gains (a decrease in the investment) or losses (an increase in the investment) we incur on any hedging instruments that we may have utilized to hedge against the effects of changes in interest rates during the period we hold the loans prior to their securitization. (See "-Hedging,").
We allocate our basis in the mortgage loans and excess cashflow certificates between the portion of the mortgage loans and excess cashflow certificates sold through securitization and the portion retained (the NIM owner trust certificate and prepayment penalty owner trust certificate, in 2002) based on the relative fair values of those portions on the date of sale. We may recognize gains or losses attributable to the changes in fair value of the excess cashflow certificates, which are recorded at estimated fair value and accounted for as "trading" securities. Since there is no active market for such excess cashflow certificates, we determine the estimated fair value of the excess cashflow certificates by discounting the future expected cash flows.
Each securitization trust has the benefit of either a financial guaranty insurance policy from a monoline insurance company or a senior-subordinated securitization structure, which insures the timely payment of interest
and the ultimate payment of principal of the credit-enhanced investor certificate, or both (known as a "hybrid"). In "senior-subordinated" structures, the senior certificate holders are protected from losses by subordinated certificates, which absorb any such losses first. In addition to such credit enhancement, the excess cash flows that would otherwise be paid to the holder of the excess cashflow certificate is used when if it subsequently becomes necessary to obtain or maintain required overcollateralization limits. Overcollateralization, which is created when the amount of collateral (I.E., mortgage loans) owned by a securitization trust exceeds the aggregate amount of senior pass-through certificates, is used to absorb losses prior to making a claim on the financial guaranty insurance policy or the subordinated certificates.
EXCESS CASHFLOW CERTIFICATES, NET
Our excess cashflow certificates primarily consist of the right to receive the future excess cash flows from a pool of securitized mortgage loans. Our interest in these certificates generally consists of the following:
o The interest spread between the coupon on the underlying mortgage loans and the cost of financing (which, when we sell NIM notes, is only received after the NIM Notes are paid in full);
o On our 2002 securitizations, prepayment penalties received from borrowers who payoff their loans early in their life (which, when we sell NIM notes, is only received after the NIM Notes are paid in full); and
o Overcollateralization, which is designed to protect the securities sold to the securitization pass-through investors from credit loss on the underlying mortgage loans (and which we describe in greater detail below under "Securitization").
The excess cash flow we receive is highly dependent upon the interest rate environment to the extent basis risk exists between the securitization trust's assets and liabilities. For instance, in the fourth quarter's securitization, the cost of financing for the securitized loans is indexed against 1 month LIBOR meaning that each month the interest rate received by the pass through certificate holders may adjust (upwards or downwards) as 1 month LIBOR changes (liability), while a significant amount of the underlying mortgage loans in the securitization trust have a fixed note rate for at least 3 years (asset). As a result, as rates rise and fall, the amount of our excess cash flows will fall and rise, which in turn will increase or decrease the value of our excess cashflow certificates.
In each of our securitizations in which we sold NIM note(s), we purchased, on behalf of the NIM owner trust, an interest rate cap for the benefit of the NIM noteholder(s), which helps mitigate the basis risk for the approximate time that the NIM notes are outstanding.
We believe the accounting estimates related to the valuation of our excess cashflow certificates is a "critical accounting estimate" because it can materially affect net income and require us to forecast interest rates, mortgage principal payments, prepayments, and loan loss assumptions which are highly uncertain and require a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our excess cashflow certificates. Management uses internal, historical collateral performance data and published forward LIBOR curves when modeling future expected excess cashflows. We believe the value of our excess cashflows certificates is fair, but can provide no assurance that future prepayment and loss experience, changes in the LIBOR rate, or changes in their required market discount rate will not require write-downs of the excess cashflow certificate asset. Write-downs would reduce income of future periods.
We classify excess cashflow certificates that we receive upon the securitization of a pool of loans as "trading securities." The amount initially allocated to the excess cashflow certificates at the date of a securitization reflects their fair value. The amount recorded for the excess cashflow certificates is reduced for distributions which we receive as the holder of these excess cashflow certificates, and is adjusted for subsequent changes in the fair value of the excess cashflow certificates we hold.
At the time each securitization transaction closes, we determine the present value of the related excess cashflow certificates (which, in our 2002 securitizations includes BIO certificates and NIM owner trust certificates), using certain assumptions we make regarding the underlying mortgage loans. The excess cashflow certificate is then recorded on our consolidated financial statements at an estimated fair value. Our estimates primarily include the following:
o future rate of prepayment of the mortgage loans - the expected amount of prepayments on the mortgage loans due to the underlying borrowers of the mortgage loans paying off their mortgage loan prior to the loan's expected maturity;
o credit losses on the mortgage loans - our estimate of the amount of expected losses or defaults that will take place on the underlying mortgage loans over the life of the mortgage loans because the excess cashflow certificates are subordinate in right of payment to all other securities issued by the securitization trust. Consequently, any losses sustained on mortgage loans comprising a particular securitization trust are first absorbed by the excess cashflow certificates;
o the LIBOR forward curve (using current LIBOR as the floor rate) - our estimate of future interest rates which affects both the rate paid to the floating rate pass-through security investors (primarily the 1 month LIBOR index) and the adjustable rate mortgage loans sold to the securitization trust (which provide for a fixed rate of interest for the first 24 or 36 months and a 6 month variable rate of interest thereafter using the 6 month LIBOR index); and
o a discount rate used to calculate present value.
The value of each excess cashflow certificate represents the cash flow we expect to receive in the future from such certificate based upon our best estimate. We monitor the performance of the loans underlying each excess cashflow certificate, and any changes in our estimates (and consequent changes in value of the excess cashflow certificates) are reflected in the line item called "interest income" in the quarter in which we make any such change in our estimate. Although we believe that the assumptions we use are reasonable, there can be no assurance as to the accuracy of the assumptions or estimates.
In determining the fair value of each of the excess cashflow certificates, we make the following underlying assumptions regarding mortgage loan prepayments, mortgage loan default rates, the LIBOR forward curve and discount rates:
(A) PREPAYMENTS. We base our prepayment rate assumptions upon our on-going analysis of the performance of mortgage pools we previously securitized, and the performance of similar pools of mortgage loans securitized by others in the industry. We apply different prepayment speed assumptions to different loan product types because it has been our experience that different loan product types exhibit different prepayment patterns. Generally, our loans can be grouped into two loan products - fixed rate loans and adjustable rate loans. With fixed rate loans, an underlying borrower's interest rate remains fixed throughout the life of the loan. Our adjustable rate loans are really a "hybrid" between fixed and adjustable rate loans, in that the rate generally remains fixed typically for the first three years of the loan, and then adjusts typically every six months thereafter. Within each product type, other factors can affect prepayment rate assumptions. Some of these factors, for instance, include:
o whether or not a loan contains a prepayment penalty - an amount that a borrower must pay to a lender if the borrower prepays the loan within a certain time after the loan was originated. Loans containing a prepayment penalty typically do not prepay as quickly as those without such a penalty;
o as is customary with adjustable rate mortgage loans, the introductory interest rate charged to the borrower is artificially lower, between one and two full percentage points, than the rate for which the borrower would have otherwise qualified. Generally, once the adjustable rate mortgage begins adjusting on the first adjustment date, the interest rate payable on that loan increases, at times fairly substantially. This interest rate increase can be exacerbated if there is an absolute increase in interest rates. As a result of these increases and the potential for future increases, adjustable rate mortgage loans typically are more susceptible to early prepayments.
There are several reasons why a loan will prepay prior to its maturity, including (but not limited to):
o a decrease in interest rates;
o improvement in the borrower's credit profile, which may allow the borrower to qualify for a lower interest rate loan;
o competition in the mortgage market, which may result in lower interest rates being offered;
o the borrower's sale of his or her home;
o the borrower's need for additional monies; and
o a default by the borrower, resulting in foreclosure by the lender.
It is unusual for a borrower to prepay a mortgage loan during the first few months because of the following:
o it typically takes at least several months after the mortgage loans are originated for any of the above events to occur;
o there are costs involved with refinancing a loan; and
o the borrower does not want to incur prepayment penalties.
The following table shows our most recent changes to the month one and peak speed components of our prepayment assumptions - in the third quarter of 2001 and, prior to that, in the third quarter 2000:
LOAN TYPE AT SEPTEMBER 30, 2001 AT SEPTEMBER 30, 2000 ------------------------------------------------------------------ Fixed Rate: At Month One 4.00% 4.00% Peak Speed 30.00% 23.00% Adjustable Rate: At Month One 4.00% 4.00% Peak Speed 75.00% 50.00%
A higher prepayment speed means that the mortgage loans prepay faster than anticipated and, as such, we will earn less income in connection with the mortgage loans and receive less excess cashflow in the future because the mortgage loans have paid off; conversely, if we have slower prepayment speeds, the mortgage loans remain outstanding for longer than anticipated and, as such, we earn more income and more excess cashflow in the future.
(B) DEFAULT RATE. At December 31, 2002 and December 31, 2001, on each newly issued securitization, we apply a default reserve for both fixed- and adjustable-rate loans sold to the securitization trusts totaling 5.00% of the amount initially securitized. We apply a default or loss rate to the excess cashflow certificate because it is the "first-loss" piece and is subordinated in right of payment to all other securities issued by the securitization trust. If defaults are higher than we anticipate, we will receive less income and less excess cash flow than expected in the future; conversely, if defaults are lower than we expected, we will receive more income and more excess cash flow than expected in the future.
(C) LIBOR FORWARD CURVE. The LIBOR forward curve is used to project future interest rates, which affects both the rate paid to the floating rate pass-through security investors (primarily the 1 month LIBOR index) and the adjustable rate mortgage loans sold to the securitization trust (a fixed rate of interest for either the first 24 or 36 months then a 6 month variable rate of interest thereafter using the 6 month LIBOR index). A significant portion of our loans are fixed rate mortgages and a significant amount of these fixed rate loans are backed by floating rate securities (I.E., 1 month LIBOR). As such, our excess cashflow certificates are subject to significant basis risk and a change in LIBOR will, therefore, impact our excess spread. If LIBOR is lower than anticipated we will receive more income and more excess cash flows than expected in the future; conversely, if LIBOR is higher than expected, we will receive less income and less excess cash flows than expected in the future. In each of our securitizations in which we sold NIM note(s), we purchased, on behalf of the NIM owner trust, an interest rate cap for the benefit of the NIM noteholder(s), which helps mitigate the basis risk for the approximate time that the NIM notes are outstanding.
(D) DISCOUNT RATE. We use a discount rate that we believe reflects the risks associated with our excess cashflow certificates. While quoted market prices on comparable excess cashflow certificates are not available, we compare our valuation assumptions and performance experience to our competitors in the non-conforming mortgage industry. Our discount rate takes into account the asset quality and the performance of our securitized mortgage loans compared to that of the industry and other characteristics of our securitized loans. We quantify the risks associated with our excess cashflow certificates by comparing the asset quality and payment and loss performance experience of the underlying securitized mortgage pools to comparable industry performance. The discount rate we use to determine the present value of cash flows from excess cashflow certificates reflects increased uncertainty surrounding current and future market conditions, including without limitation, uncertainty concerning inflation, recession, home prices, interest rates and equity markets.
We utilized a discount rate of 15% at December 31, 2002 and December 31, 2001 on all excess cashflow certificates. Prior to the quarter ended September 30, 2001, we used an 18% discount rate on a NIM transaction we consummated in November 2000. We increased the discount rate on these excess cashflow certificates during the period that the senior NIM securities remained outstanding, to account for the potentially higher risk associated with the residual cash flows expected to be received by the holder of the certificated interest in the NIM trust, which was subordinated to the multiple senior securities sold in the NIM transaction. As part of the Second Exchange Offer, all of the excess cashflow certificates that were subject to the November 2000 NIM transaction were transferred to the LLC. We did not increase the discount rate on the excess cashflow certificates from our latest securitizations despite issuing NIM securities because the NIM securities in the most recent transactions were:
o issued from a single securitization as compared to the November 2000 NIM transaction, which was backed by a combination of six securitizations issued between September 1997 and March 1999 resulting in more volatility or variability in determining the timing of cash flows to be received by the NIM; and
o issued from a new securitization as compared to the November 2000 NIM transaction, which was backed by several seasoned securitization trusts. The predictability in determining the timing of cash flows for the first two years on a newly issued securitization is typically higher than securitizations that have been outstanding for a greater period of time because defaults or losses to the trust within the first few years of issuance are typically lower and more predictable compared to a securitization that has been outstanding for a longer period of time (a more seasoned transaction). Additionally, prepayment speeds are more predictable compared to more seasoned transactions, which is aided by the presence of prepayment penalties, which typically expire within the first few years after a mortgage loan is originated. Therefore, there is a higher probability in determining the timing of cash flows to the NIM investor on a new issuance securitization as compared to a seasoned transaction.
At March 31, 2002, we recorded a charge to interest income to reflect a fair value adjustment to our excess cashflow certificates, totaling $2.1 million, relating to the timing of excess cash flows that are to be received by the excess cashflow certificate after the release or "step-down" of the overcollateralization account.
The following table summarizes the excess cashflow activity for the year ended December 31, 2002 and 2001:
Our valuation of retained excess cashflow certificates is highly dependent upon the reasonableness of our assumptions and the predictiveness of the relationships that drive the results of our valuation model. The assumptions we utilize, described above, are complex, as we must make judgment calls about the effect of matters that are inherently uncertain. As the number of variables and assumptions affecting the possible future resolution of the uncertainties increase, those judgments become even more complex.
In volatile markets, like those we have experienced in 2001 and in 2002, there is increased risk that our actual results may vary significantly from our assumed results. The greater the time period over which the uncertainty will exist, the greater the potential volatility for our valuation assumptions.
For example, assumptions regarding prepayment speeds, defaults, and LIBOR rates are used in estimating fair values of our excess cashflow certificates. If loans prepay faster than estimated, or loan loss levels are higher than anticipated, or LIBOR is higher than anticipated, we may be required to write down the value of such certificates.
While we believe that our assumptions are reasonable estimates using our historical loan performance and the performance of similar mortgage pools from other lenders - in addition to accessing other public information about market factors such as interest rates, inflation, recession, unemployment and real estate market values, among other things - these are just estimates and it is virtually impossible to predict the actual level of prepayments and losses, which are also driven by consumer behavior.
DEFERRED TAX ASSET
As of December 31, 2002, we carried a deferred tax asset, net of $5.6 million on our consolidated financial statements - comprised primarily of federal and state net operating losses or "NOLs" less the tax impact and a valuation allowance.
As of December 31, 2002, we have a gross deferred tax asset of $47.9 million (assuming a 40% effective tax rate) and a valuation allowance of $42.3 million. We established this valuation allowance in 2001, in the midst of two successive years of posting significant losses (2000 and 2001), and the modest amount of earnings we projected to earn over the ensuing several quarters. We believe it was appropriate to establish this valuation allowance in accordance with GAAP. Since then, we have now posted five consecutive quarters of profitability. If we are able to continue to record positive earnings over the next several quarters and demonstrate a reliable future earnings stream, we expect to:
o utilize a larger amount of the gross deferred tax asset to offset the tax that would otherwise be recorded on the majority of such earnings; and
o potentially reduce the amount of, and/or eliminate, the valuation allowance in accordance with GAAP (upon any reduction or elimination of the valuation allowance net earnings and retained earnings will increase; however, in subsequent quarters net earnings and retained earnings will be reduced by the amount of the tax provision).
As of December 31, 2002, federal and state NOL carryforwards totaled approximately $77.2 million, with $3.9 million expiring in 2020, and $73.3 million expiring in 2021.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2002, COMPARED TO THE YEAR ENDED DECEMBER 31, 2001
GENERAL
We recorded net income for the year ended December 31, 2002 of $17.6 million, or $1.11 per share basic and $1.04 per share diluted, compared to a net loss of $99.8 million, or $6.28 per share basic and diluted, for the year ended December 31, 2001. Our net income for 2002 included a special tax benefit of $2.2 million, or $0.14 per share basic and $0.13 diluted, which primarily relates to our obtaining favorable resolutions to tax issues for which we had previously reserved.
The majority of the net loss related to (1) a $25.4 million write down of excess cashflow certificates relating to a sale agreement we entered into in 2001; (2) a charge (loss) to interest income of $19.7 million reflecting a fair value adjustment to our excess cashflow certificates; (3) a charge of $19.3 million related to the extinguishment of debt; (4) a charge of $10.7 million relating to our disposition and transfer to Ocwen of our servicing platform in May 2001; (5) a charge of $3.6 million relating to a change in accounting estimates regarding the life expectancy of our computer-related equipment; (6) a charge of $1.4 million relating to professional fees incurred in connection with the Second Exchange Offer; and (7) a charge of $1.5 million for establishing a reserve for non-performing mortgage loans that were ultimately sold.
REVENUES
Total revenues increased $53.0 million, or 160%, to $86.1 million for the year ended December 31, 2002, from $33.1 million for the year ended December 31, 2001. The increase in revenues was primarily the result of two charges we incurred in 2001 that significantly reduced revenues in that year. First, we recorded a $25.4 million write-down of five excess cashflow certificates sold for a cash purchase price significantly below our carrying value of such excess cashflow certificates. Second, we recorded a fair value adjustment to our remaining excess cashflow certificates due to changes in our valuation assumptions totaling $19.7 million. The increase in revenues in 2002 was also attributable to higher net gain on sale due to us completing securitizations, net of pre-funding, of $819.0 million
in 2002, compared to $345.0 million in 2001. The increase in revenue was partially offset by (1) a decrease in interest income from our retained excess cashflow certificates, as we transferred the majority of these certificates in connection with our Second Exchange Offer in 2001 and (2) our not receiving any servicing fees following the transfer of our servicing portfolio to Ocwen in May 2001. (See "-Corporate Restructuring, Debt Modification and Debt Restructuring").
We originated $872.2 million of mortgage loans for the year ended December 31, 2002, representing a 40% increase from $621.7 million of mortgage loans originated for the year ended December 31, 2001. We securitized, net of pre-funding, $819.0 million of loans during the year ended December 31, 2002, representing a 137% increase from the $345.0 million of loans we securitized during 2001. Our whole loan sales amounted to $103.0 million during the year ended December 31, 2002, representing a 61% decrease from the $261.1 million of whole loans sold for the year ended December 31, 2001.
NET GAIN ON SALE OF MORTGAGE LOANS. Net gain on sale of mortgage loans is represented by the following:
(1) the sum of:
(a) the cash purchase price we receive in connection with selling one of the following securities in connection with our securitization(s) for a particular period: (i) a NIM note, net of overcollateralization amount and interest rate cap or (ii) an interest-only certificate;
(b) the fair value of the non-cash excess cashflow certificates we retain in a securitization for each period;
(c) the cash premium received from selling mortgage servicing rights in connection with each securitization; and
(d) the cash premium earned from selling whole loans on a servicing-released basis,
(2) less the (i) costs associated with securitizations, (ii) any hedge loss (gain) associated with a particular securitization, and (iii) any loss associated with loans sold at a discount.
Net gain on sale of mortgage loans increased $20.2 million, or 52%, to $58.8 million for the year ended December 31, 2002, from $38.6 million for the year ended December 31, 2001. This increase was primarily due to (a) higher loan production resulting in a greater amount of loans securitized and sold on a whole loan basis in 2002 as compared to 2001, (b) our securitizing a higher percentage of mortgage loans in 2002, instead of selling whole loans servicing-released, which typically results in a higher net gain on sale percentage than whole loan sales and (c) our selling approximately $60 million of mortgage loans we had held in inventory at December 31, 2001 in addition to the mortgage loans we originated during 2002. We securitized, net of pre-funding, $819.0 million in 2002 and sold $103.0 million of mortgage loans on a servicing-released basis in 2002, compared to $345.0 million of loans securitized and $261.1 million of mortgage loans sold in 2001.
INTEREST INCOME. Interest income primarily represents the sum of:
(1) the gross interest we earn on loans held for sale;
(2) the cash we receive from our excess cashflow certificates;
(3) the non-cash mark-to-market or non-cash valuation adjustments to our excess cashflow certificates to reflect changes in fair value;
(4) cash interest earned on bank accounts; and
(5) miscellaneous interest income including prepayment penalties received on certain of our securitizations prior to 2002.
Interest income increased $33.8 million, or 153%, to $11.7 million for the year ended December 31, 2002, from $(22.1) million for the year ended December 31, 2001. In 2001, we recorded a $25.4 million write-down of five excess cashflow certificates sold for a cash purchase price significantly below our carrying value of such excess cashflow certificates. In addition, we recorded a fair value adjustment to our remaining excess cashflow certificates due to changes in our valuation assumptions totaling $19.7 million. The increase was also attributed to higher average loan balance (and, consequently, more interest earned on loans held for sale) in 2002 compared to 2001. The increase was partially offset by a decrease in revenues from our excess cashflow certificates, as we transferred the majority of these certificates as part of our Second Exchange Offer in 2001. (See "-Corporate Restructuring, Debt
Modification and Debt Restructuring").
SERVICING FEES. Servicing fees represent all contractual and ancillary servicing revenue we receive, less the offsetting amortization of the capitalized mortgage servicing rights, and any adjustments recorded to reflect valuation allowances for the impairment in mortgage servicing rights.
We did not receive any servicing fees during 2002 as a result of us transferring our entire servicing portfolio to Ocwen in May of 2001. In 2001, servicing fees totaled $3.0 million.
NET ORIGINATION FEES AND OTHER INCOME. Origination fees represent (1) fees earned on broker and retail originated loans, (2) premiums paid to originate mortgage loans, (3) distributions from Delta Funding Residual Exchange Company, LLC (the "LLC"), and (4) other miscellaneous income, if any.
Net origination fees and other income increased $1.9 million, or 14%, to $15.6 million for the year ended December 31, 2002, from $13.7 million for the year ended December 31, 2001. The increase in the net origination fees and other income during the twelve months ended December 31, 2002 is primarily due to us starting to receive distributions from the LLC (an unaffiliated entity to us) in the first quarter of 2002. In addition, our retail origination fees increased during the period due to higher production.
EXPENSES
Total expenses decreased by $40.5 million, or 37%, to $70.3 million for the year ended December 31, 2002, from $110.8 million for the year ended December 31, 2001. The decrease in revenues primarily resulted from expenses we incurred in 2001 that did not recur in 2002, including expenses associated primarily with: (1) our disposition and transfer of our servicing portfolio to Ocwen in May 2001, (2) capital charges associated with repurchasing our interest and servicing advance securitizations prior to the sale of the servicing portfolio, (3) a change in accounting estimates regarding the life expectancy of our computer-related equipment in 2001, (4) a charge for reserves primarily against a pool of non-performing loans, which we ultimately sold in July 2001, and (5) a charge related to professional fees incurred with the second exchange offer. The decrease also resulted from (a) a significantly lower interest expense in 2002 resulting from (1) our extinguishing approximately $139.2 million of Notes in the Second Exchange Offer (see "-Corporate Restructuring, Debt Modification and Debt Restructuring"), and (2) lower warehouse financing costs due to lower borrowing costs during 2002, as well as (b) a special tax benefit in 2002 related to a favorable resolution to tax issues for which we had previously reserved and do not expect to recur.
PAYROLL AND RELATED COSTS. Payroll and related costs include salaries, benefits and payroll taxes for all employees.
Payroll and related costs decreased by $1.6 million, or 4%, to $41.3 million for the year ended December 31, 2002, from $42.9 million for the year ended December 31, 2001. The decrease was primarily the result of a downsizing effectuated as part of our overall corporate restructuring, related to our transfer of our servicing operations in May 2001.
INTEREST EXPENSE. Interest expense includes the borrowing cost under our warehouse credit facility to finance loan originations, equipment financing and the notes.
Interest expense decreased by $10.8 million, or 67%, to $5.3 million for the year ended December 31, 2002 from $16.1 million for the year ended December 31, 2001. The decrease was primarily attributable to (i) our extinguishing $139.2 million of Senior notes in August 2001 and the corresponding interest related thereto, and (ii) lower warehouse financing costs due to lower borrowing costs. The average one-month LIBOR rate, which is the benchmark used to determine our cost of borrowed funds, decreased on average to 1.8% for the year ended December 31, 2002, compared to an average of 3.9% for the year ended December 31, 2001.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses consist primarily of office rent, insurance, telephone, depreciation, legal reserves and fees, license fees, accounting fees, travel and entertainment expenses, advertising and promotional expenses and the provision for loan losses on the inventory of loans held for sale and recourse loans.
General and administrative expenses decreased $25.4 million, or 52%, to $23.7 million for the year ended December 31, 2002, from $49.1 million for the year ended December 31, 2001. The year ended December 31, 2001 included expenses primarily associated with (1) our disposition and transfer of our servicing portfolio in May 2001
to Ocwen, (2) capital charges previously associated with our interest and servicing advance securitizations prior to the sale of the servicing portfolio, (3) a change in accounting estimates regarding the life expectancy of our computer-related equipment, and (4) a charge for reserves primarily against a pool of non-performing loans, which we ultimately sold in July 2001.
RESTRUCTURING AND OTHER SPECIAL CHARGES. In 2001, we recorded $2.7 million of restructuring and other special charges relating to professional fees incurred in connection with the Second Exchange Offer in 2001 (see "-Corporate Restructuring, Debt Modification and Debt Restructuring") and charges relating to the disposition of branches and severance costs associated with closing our servicing operation.
EXTINGUISHMENT OF DEBT. In 2001, we recorded a charge of $19.3 million, related to the extinguishment of debt associated with our notes. (see "-Corporate Restructuring, Debt Modification and Debt Restructuring")
INCOME TAXES. Deferred tax assets and liabilities are recognized on the income reported in the financial statements regardless of when such taxes are paid. These deferred taxes are measured by applying current enacted tax rates.
We recorded a tax benefit of $1.8 million for the year ended December 31, 2002 primarily due to us recording a special tax benefit of $2.2 million related to our obtaining a favorable resolution to tax issues for which we had previously reserved and do not expect to recur. This was offset by a tax provision of $0.4 million primarily related to excess inclusion income generated by our excess cashflow certificates. In 2001, we recorded a tax provision of $2.9 million which was primarily related to excess inclusion income.
We have less taxable excess inclusion income in 2002, as compared to 2001, due to our holding lower excess cashflow certificates during the period. Excess inclusion income cannot be offset by our NOLs under the REMIC tax laws. Going forward, we expect to continue to incur a modest amount of excess inclusion income, which we will be unable to offset using our NOLs.
YEAR ENDED DECEMBER 31, 2001, COMPARED TO THE YEAR ENDED DECEMBER 31, 2000
GENERAL
We reported a net loss for the year ended December 31, 2001 of $99.8 million, or $6.28 per share (basic and diluted), compared to a net loss of $49.4 million, or $3.11 per share (basic and diluted), for the year ended December 31, 2000. For the year ended December 31, 2001, the net loss included:
o a $25.4 million, or $1.60 per share (basic and diluted), write down of excess cashflow certificates relating to a sale agreement we entered into in the first quarter of 2001 (that closed in May 2001), for a cash purchase price of $15 million, which reflected a significant discount to our carrying value of such excess cashflow certificates;
o a charge (loss) to interest income of $19.7 million, or $1.24 per share (basic and diluted), in the third quarter, reflecting a fair value adjustment to our remaining excess cashflow certificates, due to our changing the valuation assumptions we use to estimate fair value (see Notes to the Consolidated Financial Statements - "Excess Cashflow Certificates, Net");
o a charge of $19.3 million, or $1.21 per share (basic and diluted) related to the extinguishment of debt associated with our notes;
o a charge of $10.7 million, or $0.67 per share (basic and diluted), relating to our disposition and transfer to Ocwen of our servicing platform in May 2001;
o a charge of $3.6 million, or $0.23 per share (basic and diluted), in the second quarter relating to a change in accounting estimates regarding the life expectancy of our computer-related equipment;
o a charge of $1.5 million, or $0.09 per share (basic and diluted), in the second quarter for establishing a reserve for non-performing mortgage loans; and
o a charge of $1.4 million, or $0.09 per share (basic and diluted) in the third quarter relating to professional fees incurred in connection with the Second Exchange Offer.
Results for the year ended December 31, 2001 were also negatively impacted by (a) our not executing a securitization in either the first or third quarters, which significantly reduced our revenues for the year ended December 31, 2001 and (b) a lower level of originations, compared to 2000.
For the year ended December 31, 2000, we reported a net loss of $49.4 million, or $3.11 per share (basic and diluted). The majority of the net loss incurred related to:
o the write-down of our capitalized mortgage servicing rights of $31.4 million;
o restructuring and debt modification charges of $7.7 million;
o a reduction in the carrying value of a portion of our excess cashflow certificates related to an increase in the discount rate of such certificates included in our NIM transaction, totaling $6.9 million;
o costs associated with our NIM transaction in November 2000 totaling $3.2 million; and
o the write-down of goodwill relating to our 1997 purchase of Fidelity Mortgage totaling $1.4 million.
This was partially offset by income associated with the sale of one of our domain names for $1.7 million.
REVENUES
Total revenues decreased $86.3 million, or 72%, to $33.1 million for the year ended December 31, 2001, from $119.4 million for the year ended December 31, 2000. The decrease in revenue was primarily attributable to:
o a decrease in interest income due to:
(1) a $25.4 million write-down in the first quarter of five excess cashflow certificates, and
(2) a $19.7 million charge in the third quarter reflecting a fair value adjustment to our remaining excess cashflow certificates, due to our changing the valuation assumptions we use to estimate fair value (See Notes to the Consolidated Financial Statements - "Excess Cashflow Certificates, Net");
o a lower net gain recognized on the sale of mortgage loans;
o lower origination fees and interest income due to a decrease in total loan production; and
o lower servicing fees due to our agreement in January 2001 to transfer our servicing portfolio to Ocwen, pursuant to which Ocwen immediately began receiving all servicing related fees and, in turn, paid us an interim servicing fee, until the servicing portfolio was physically transferred to Ocwen in May 2001.
We originated $621.7 million of mortgage loans for the year ended December 31, 2001, representing a 33% decrease from $933.4 million of mortgage loans originated and purchased for year ended December 31, 2000. The decrease in mortgage loans originated in 2001, was primarily due to senior management's attention being diverted to completing our necessary corporate and debt restructuring (See Notes to the Consolidated Financial Statements - "Corporate Restructuring, Debt Modification and Debt Restructuring"). We securitized $345.0 million of loans during the year ended December 31, 2001, representing a 61% decrease from the $880.0 million of loans we securitized during 2000. Our whole loan sales amounted to $261.1 million during the year ended December 31, 2001, representing a 348% increase from the $58.3 million of whole loans sold for the year ended December 31, 2000. This increase in whole loan sales reflects our present strategy to diversify our funding sources between securitizations and whole loan sales, in order to maximize cash flow and profitability.
Net gain on sale of mortgage loans decreased $14.0 million, or 27%, to $38.6 million for the year ended December 31, 2001, from $52.6 million for the year ended December 31, 2000. This decrease was primarily due to a 35% decrease in the amount of loans securitized or sold to $606.1 million in 2001, compared to $938.3 million of loans securitized or sold in 2000. The decrease in loans securitized or sold was due to an overall 33% decrease in total loan production in 2001, compared to 2000. The decrease in net gain on sale on a comparable basis was partially offset by (1) a higher gross profit margin recorded on our securitizations in 2001 versus 2000, and (2) no correspondent premiums (negative revenue) to acquire loans in 2001 - because we closed our correspondent channel in June 2000 - compared to the $1.6 million we paid during the first half of 2000. The weighted average net gain on sale ratio was 6.4% for the year ended December 31, 2001 compared to 5.6% for the year ended December 31, 2000.
Interest income decreased $54.4 million, or 168%, to $(22.1) million for the year ended December 31, 2001, from $32.3 million for the year ended December 31, 2000. The decrease in interest income was primarily due to:
o our $25.4 million write down of excess cashflow certificates that we sold for a cash purchase price of $15 million under a sale agreement we entered into in the first quarter of 2001;
o a charge to interest income of $19.7 million in the third quarter, reflecting a fair value adjustment to our remaining excess cashflow certificates, due to the changes we made to the valuation assumptions we use to estimate fair value (see "-Notes to Financial Statements - Note No. 8-Excess Cashflow Certificates, Net");
o a 33% decrease in loan production for the year ended December 31, 2001, compared to the year ended December 31, 2000, which resulted in a lower amount of mortgage loans generating interest income while held for sale;
o a lower average mortgage coupon rate charged to the borrower of 10.5% from 11.4% reflecting a lower economic interest rate environment; and
o a decrease in interest earned on interest bearing accounts that we received as servicer on our securitizations.
Servicing fees decreased $11.2 million, or 79%, to $3.0 million for the year ended December 31, 2001, from $14.2 million for the year ended December 31, 2000. This decrease was the result of our agreement to transfer our servicing portfolio to Ocwen in January 2001, pursuant to which Ocwen immediately began receiving all servicing related fees and, in turn, paid us an interim servicing fee, until the servicing portfolio was physically transferred to Ocwen in May 2001.
Net origination fees and other income decreased $6.7 million, or 33%, to $13.7 million for the year ended December 31, 2001, from $20.4 million for the year ended December 31, 2000. The decrease was primarily the result of a 33% decrease in loan originations and our sale of a domain name in July 2000.
EXPENSES
Total expenses decreased by $71.3 million, or 39%, to $110.8 million for the year ended December 31, 2001, from $182.1 million for the year ended December 31, 2000. The decrease was primarily due to a decrease in personnel costs due to our restructuring and our sale of our servicing portfolio and a decrease in interest expense. The decrease in expenses was also the result of our incurring higher expenses for the year ended 2000 relating to charges associated with a corporate restructuring and debt modification in the third quarter of 2000. The decrease in expenses was partially offset by charges principally incurred in connection with:
o our disposition and transfer of our servicing platform to Ocwen in May 2001;
o a change in our accounting estimates regarding the life expectancy of computer-related equipment in the second quarter of 2001; and
o our recording a reserve for non-performing mortgage loans in the second quarter of 2001.
Payroll and related costs decreased by $13.6 million, or 24%, to $42.9 million for the year ended December 31, 2001, from $56.5 million for the year ended December 31, 2000. The decrease was primarily the result of (1) the downsizing we effectuated as part of our overall corporate restructuring beginning in the second half of 2000 and culminating with the physical transfer of our servicing operation in May 2001; and (2) a lower amount of commissions paid due to the decrease in originations. We employed 609 full- and part-time employees as of December 31, 2001, compared to 851 full- and part-time employees as of December 2000.
Interest expense decreased by $14.3 million, or 47%, to $16.1 million for the year ended December 31, 2001 from $30.4 million for the year ended December 31, 2000. The decrease was primarily attributable to the $12.1 million of interest expense we saved in 2001 by extinguishing $139.2 million of notes in August 2001 and, to a lesser extent, to our lower loan production in 2001, which resulted in lower warehouse financing, and lower financing costs. The average one-month LIBOR rate, which is the benchmark used to determine our cost of borrowed funds, decreased on average to 3.9% for the year ended December 31, 2001, compared to an average of 6.4% for the year ended December 31, 2000.
General and administrative expenses increased $3.6 million, or 8%, to $49.1 million for the year ended December 31, 2001, from $45.5 million for the year ended December 31, 2000. The increase primarily resulted from:
o the cost of maintaining an unprofitable servicing platform until we physically transferred it to Ocwen in May 2001, plus the associated costs of transferring our servicing portfolio to Ocwen;
o a change in the useful life of computer-related equipment from five years to three years;
o a fair value adjustment to a pool of non-performing loans, which we ultimately sold in July 2001;
o partially offset by the cost savings related to our corporate restructuring, including the disposition of our servicing portfolio to Ocwen in May 2001 and elimination of capital charges associated with making securitization advances prior to the sale of the servicing portfolio.
We recorded the following restructuring and other special charges in 2001 and 2000:
o In 2001, $2.7 million of restructuring and other special charges relating to our disposition of branches and severance costs associated with closing our servicing operation.
o In the fourth quarter of 2000, a $1.6 million write-down of other servicing receivable assets.
o In the third quarter of 2000, $3.1 million of debt modification charges primarily related to legal fees and the noteholders' financial advisor fees associated with the Debt Modification and Exchange Offering. We also recorded $6.7 million of charges related to our restructuring of our operations, primarily related to employee severance associated with the layoffs, a reduction to goodwill and office equipment write-offs.
We recorded a charge to extinguishment of debt in 2001 of $19.3 million, related to the extinguishment of debt associated with our notes.
We recorded a tax provision of $2.9 million primarily related to excess inclusion income generated by our excess cashflow certificates and a tax benefit of $13.2 million for the year ended December 31, 2001 and 2000, respectively. Excess inclusion income cannot be offset by our NOLs under the REMIC tax laws. In 2001, excess inclusion income was primarily caused by the REMIC securitization trust utilizing cash, that otherwise would have been paid to us as holder of the excess cashflow certificate, to make payments to other security holders:
o to create and/or maintain overcollateralization by artificially paying down the principal balance of the asset-backed securities; and
o in connection with our NIM transaction, executed in November 2000, to pay down the debt collateralized by our excess cashflow certificates.
FINANCIAL CONDITION
DECEMBER 31, 2002 COMPARED TO DECEMBER 31, 2001
Cash and interest-bearing deposits decreased $3.0 million, or 47%, to $3.4 million at December 31, 2002, from $6.4 million at December 31, 2001. This decrease was primarily related to our utilizing operating cash to fund our production of mortgage loans rather than finance the mortgage loans through our warehouse facilities.
Accounts receivable decreased $2.4 million, or 59%, to $1.7 million at December 31, 2002, from $4.1 million at December 31, 2001. This decrease was primarily due to the settlement of cash surrender value of an officer's life insurance policies in December of 2002.
Loans held for sale, net, decreased $60.4 million, or 64%, to $34.0 million at December 31, 2002, from $94.4 million at December 31, 2001. This represents mortgage loans held in inventory awaiting either a whole loan sale or securitization. This decrease was primarily due to the net difference between loan originations and loans sold or securitized during 2002.
Excess cashflow certificates, net increased $7.8 million, or 46%, to $24.6 million at December 31, 2002, from $16.8 million at December 31, 2001. This increase was primarily due to us recording new excess cashflow certificates totaling $10.5 million from loans securitized in 2002. This increase was partially offset by a $2.1 million fair value mark-to-market adjustment of our excess cashflow certificates, reflecting the change in fair value of such excess cashflow certificates - which incorporates any change in value (accretion or reduction) in the carrying value of the excess cashflow certificates and the cash distributions we received from such excess cashflow certificates.
Equipment, net, decreased $2.4 million, or 48%, to $2.6 million at December 31, 2002, from $5.0 million at December 31, 2001. This decrease primarily reflects the periodic depreciation of fixed assets.
We have a deferred tax asset, net, of $5.6 million at December 31, 2002 and 2001, which was primarily attributable to the net operating losses we incurred in 2000 and 2001. Included in the deferred tax asset, net, is a valuation allowance established in 2000 (See Notes to Financial Statements - "Income Taxes").
Warehouse financing and other borrowings decreased $73.2 million, or 82%, to $16.4 million at December 31, 2002, from $89.6 at December 31, 2001. This decrease was primarily attributable to a lower amount of mortgage loans held for sale (mortgage loans held in inventory awaiting either a whole loan sale or securitization) to be financed under our warehouse credit facilities.
Senior notes totaled $10.8 million at December 31, 2002 and 2001. The senior notes accrue at a rate of 9.5% per annum, payable semi-annually on February 1, and August 1.
Accounts payable and accrued expenses decreased $2.7 million, or 18%, to $12.3 million at December 31, 2002 from $15.0 million at December 31, 2001. This decrease was primarily the result of the timing of various operating accruals and payables.
Income taxes payable decreased $2.0 million, or 38%, to $3.2 million at December 31, 2002 from $5.2 million at December 31, 2001. This decrease was primarily the result of us obtaining a favorable tax resolution to tax issues in the amount of $2.2 million, for which we had previously reserved and do not expect to recur.
Stockholders' equity increased $17.6 million, or 148%, to $29.5 million at December 31, 2002 from $11.9 million at December 31, 2001. This increase represents our positive earnings for the period.
LIQUIDITY AND CAPITAL RESOURCES
We require substantial amounts of cash to fund our loan originations, securitization activities and operations. In 2002, we operated on a positive cash flow basis. In the past, however, we have operated generally on a negative cash flow basis. Embedded in our current cost structure are many fixed costs, which are not likely to be significantly affected by a relatively substantial increase in loan originations. If we can increase our loan production to generate sufficient additional revenues from our securitizations and sales of such loans to offset our current cost structure and cash uses, we believe we can continue to generate positive cash flow in 2003. However, there can be no assurance we will be successful in this regard. To do so, we must generate sufficient cash from:
o the premiums we receive from selling NIM or interest-only certificates and mortgage servicing rights in connection with our securitizations;
o the premiums we receive from selling whole loans, servicing released;
o origination fees on newly closed loans;
o excess cashflow certificates we retain in connection with our securitizations;
o interest income we receive on our loans held for sale prior to securitization and/or whole loan sale; and
o distributions from the LLC.
There can be no assurance, however, that we will continue generating positive cash flow in 2003 or at all.
Currently, our primary cash requirements include the funding of:
o the equity in our mortgage loans held for sale, for which we receive financing on from our warehouse lenders up to only 98% of the total amount of the mortgage loan's principal balance (e.g., our warehouse lenders will provide financing to us equal to $98,000 on a mortgage loan with a principal balance of $100,000, leaving us with our $2,000 tied up in the equity of the mortgage loan);
o interest expense on warehouse lines of credit, the remaining notes and other financing;
o scheduled principal paydowns on other financing;
o expenses incurred in connection with our securitization program;
o tax payments on excess inclusion income generated from our excess cashflow certificates; and
o general ongoing administrative and operating expenses, including the cost to originate loans.
Historically, we have financed our operations utilizing various secured credit financing facilities, issuance of corporate debt (i.e., senior notes), issuance of equity, and the sale of interest-only certificates and/or NIM notes (sold
in conjunction with each of our securitizations) to offset our negative operating cash flow and support our originations, securitizations, servicing (prior to May 2001) and general operating expenses. Over the past few years, we have engaged in a series of transactions to further address our negative cash flow, including the following:
o in 2000, completing three securitizations of interest (delinquency) and servicing advances, in which we sold our rights to be reimbursed for our outstanding delinquency and servicing advances that we made as servicer for a cash purchase price. We used the proceeds from these securitizations to (1) repay a $25 million working capital sub-line of our former bank syndicate warehouse facility that expired in June 2000, which was secured by our delinquency and servicing advance receivables, and (2) for working capital to finance our operations, including the funding of new delinquency and servicing advances. We ultimately repurchased these securitizations in 2001, in connection with the sale of servicing to Ocwen, using the proceeds we received from selling the underlying delinquency and servicing advance receivables to Ocwen;
o modifying our senior notes in 2000 as part of the Debt Modification (see "-Corporate Restructuring, Debt Modification and Debt Restructuring"), which enabled us to monetize a portion of our excess cashflow certificates, first by obtaining $17 million in residual financing in August 2000, secured by some of our excess cashflow certificates. Shortly thereafter, in November 2000, we sold six excess cashflow certificates through a private placement NIM transaction to an owner trust that issued senior certificates to institutional investors for a cash purchase. The net proceeds of the NIM transaction, after expenses, was used entirely to repay the $17 million of residual financing we borrowed in August 2000 and to create a $7.125 million cash escrow account to be used to pay the semi-annual interest payment due on the notes in February 2001;
o as part of our Second Debt Restructuring, at the time of the signing of the Letter of Intent in February 2001, we obtained approximately $2.5 million of residual financing secured by several of our excess cashflow certificates. We received approximately $7.1 million of additional residual financing secured primarily by additional excess cashflow certificates following the consummation of the consent solicitation and the execution of the third supplemental indenture in March 2001. Also in March 2001, we entered into a sale agreement to sell five excess cashflow certificates for a $15 million cash purchase price. As customary with sales of similar assets, the cash settlement did not occur until the pools of mortgage loans underlying the five excess cashflow certificates were transferred to an agreed upon servicer to service the pool of mortgage loans for the benefit of the purchaser. The purchaser of these five excess cashflow certificates provided bridge financing, in the form of residual financing described above, until the transfer of servicing in May 2001. We used these proceeds to repay the residual financing and have been using the balance of the proceeds, together with the initial residual financing, for working capital. Because these excess cashflow certificates were sold at a significant discount to our book value for such excess cashflow certificates, we recorded $25.4 million pre-tax non-cash charge in the first quarter of 2001.
Currently, our primary sources of liquidity continue to be, subject to market conditions:
o on-balance sheet warehouse financing and other secured financing facilities (e.g., capital leasing);
o securitizations of mortgage loans and our corresponding sale of NIM Certificates (or interest-only certificates, depending upon the securitization structure) and mortgage servicing rights;
o sales of whole loans;
o cash flows from retained excess cashflow certificates;
o distributions from the LLC (an unaffiliated entity to us) (see "-Corporate Restructuring, Debt Modification and Debt Restructuring");
o origination fees, interest income and other cash revenues; and
o utilizing NIM securitizations and/or selling or financing our existing excess cashflow certificates.
If we are not able to obtain financing, we will not be able to originate new loans and our business and results of operations will be materially and adversely affected.
To accumulate loans for securitization or sale, we borrow money on a short-term basis through warehouse lines of credit. We have relied upon a few lenders to provide the primary credit facilities for our loan originations and currently have two warehouse facilities as of December 31, 2002 for this purpose. We have two $200 million credit
facilities that have a variable rate of interest and expire in May 2003. There can be no assurance that we will be able either to renew or replace these warehouse facilities at their maturities at terms satisfactory to us or at all.
In addition to our common stock, we currently have the following securities outstanding:
o Series A preferred stock having an aggregate preference of $13.9 million, for which we are required to pay 10% annual dividends, payable semi-annually, commencing in July 2003;
o Ten-year warrants to purchase approximately 1.6 million shares of our common stock, currently at an exercise price of $0.01 per share; and
o Approximately $10.8 million of senior notes due 2004, paying 9.5% annual interest, payable semi-annually.
We are required to comply with various operating and financial covenants as provided in our warehouse agreements, which are customary for agreements of their type. The continued availability of funds provided to us under these agreements is subject to, among other conditions, our continued compliance with these covenants. Additionally, we are required to comply with restrictive covenants in connection with our Series A preferred stock and our warrants. We believe we are in compliance with such covenants as of December 31, 2002.
We have repurchase agreements with certain of the institutions that have purchased mortgages loans from us. Currently, some of the agreements provide for the repurchase by us of any of the mortgage loans that go to foreclosure sale. At the foreclosure sale, we will repurchase the mortgage, if necessary, and make the institution whole. The dollar amount of loans that were sold with recourse and still outstanding totaled $2.6 million at December 31, 2002 and $3.5 million at December 31, 2001. Included in accounts payable is an allowance for recourse losses of $1.2 million at December 31, 2002 and $1.4 million at December 31, 2001, respectively.
We may, from time to time, if opportunities arise that we deem to be appropriate, repurchase in the open market some of our outstanding preferred stock and senior notes. The funds for any such repurchases would be expected to come from our existing cash. There is no assurance that we will effectuate any such repurchases or the terms thereof.
Subject to our ability to execute our business strategy and the various uncertainties described above (and described in more detail in "-Forward Looking Statements and Risk Factors" below), we anticipate that we will have sufficient cash flows, short-term funding and capital resources to meet our liquidity obligations for the foreseeable future.
INTEREST RATE RISK
Our primary market risk exposure is interest rate risk. Profitability may be directly affected by the level of, and fluctuation in, interest rates, which affect our ability to earn a spread between interest received on our loans and the costs of our borrowings, which are tied to various interest rate swap maturities, commercial paper rates and LIBOR. Our profitability is likely to be adversely affected during any period of unexpected or rapid changes in interest rates. A substantial and sustained increase in interest rates could adversely affect our ability to originate loans. A significant decline in interest rates could increase the level of loan prepayments thereby decreasing the size of the loan servicing portfolio underlying our securitizations. To the extent excess cashflow certificates have been capitalized on our financial statements, higher than anticipated rates of loan prepayments or losses could require us to write down the value of such excess cashflow certificates, adversely impacting our earnings. In an effort to mitigate the effect of interest rate risk, we periodically review our various mortgage products and identify and modify those that have proven historically more susceptible to prepayments. However, there can be no assurance that these modifications to our product line will mitigate effectively interest rate risk in the future.
Periods of unexpected or rapid changes in interest rates, and/or other volatility or uncertainty regarding interest rates, also can affect adversely us by increasing the likelihood that asset-backed investors will demand higher spreads than normal to offset the volatility and/or uncertainty, which decreases the value of the excess cashflow certificates we receive in connection with a securitization.
Fluctuating interest rates also may affect the net interest income we earn, resulting from the difference between the yield we receive on loans held pending sales and the interest paid by us for funds borrowed under our warehouse facility. We may, however, undertake to hedge our exposure to this risk by using various hedging strategies, including Fannie Mae mortgage securities, treasury rate lock contracts and/or interest rate swaps. (See "--
Hedging"). Fluctuating interest rates also may significantly affect net interest income (the excess cash flows from our excess cashflow certificates) as certain of our asset-backed securities are priced based on one-month LIBOR, but the collateral underlying such securities are comprised of mortgage loans with either fixed interest rates or "hybrid" interest rates - fixed for the initial two or three years of the mortgage loan, and adjusting thereafter every six months - which creates basis risk (See Notes to the Consolidated Financial Statements - "Excess Cashflow Certificates, Net").
HEDGING
We adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as of January 1, 2001. The Standard requires that all derivative instruments be recorded in the balance sheet at fair value. However, the accounting for changes in fair value of the derivative instrument depends on whether the derivative instrument qualifies as a hedge. If the derivative instrument does not qualify as a hedge, changes in fair value are reported in earnings when they occur. If the derivative instrument qualifies as a hedge, the accounting treatment varies based on the type of risk being hedged. There was no impact on our financial condition or results of operations upon the adoption of SFAS No. 133, as amended.
We originate mortgage loans and then sell them through a combination of whole loan sales and securitizations. Between the time we originate the mortgage and sell it in the secondary market, we may hedge the risk of fluctuations in interest rates. Our risk begins subsequent to originating mortgage loans and prior to selling or securitizing such mortgage loans. Since we have a closed (and funded) mortgage loan at a specified interest rate with an expected gain at time of sale, our exposure is to a higher interest rate environment due to market conditions. A higher interest rate market implies that we will have a higher cost of funds, which decreases the net spread we would earn between the mortgage interest rate on each mortgage loan less the cost of funds. As a result, we may experience a lower gain on sale.
The cost of funds is generally composed of two components - the benchmark interest rate (I.E., the treasury rate or interest rate swap with a similar duration and average life) and the spread or profit margin required by the investors. We had previously used a "Treasury Rate Lock" and 15-year Fannie Mae mortgage securities ("FNMA Securities") to hedge our cost of funds exposure. However recently, the securitizations are priced to the investor using the interest rate swaps curve. As such, our cost of funds is more closely tied to interest rate swaps and, to the extent we hedge, we will likely use interest rate swaps to hedge our mortgage loans in inventory pending securitization pricing. While none of the above are perfect hedges, we believe interest rate swaps will demonstrate the highest correlation to our cost of funds on a go-forward basis.
We make decisions concerning the nature of our hedging transactions based upon various factors including, without limitation, market conditions and the expected volume of mortgage originations. We may enter into these hedging strategies through one of our warehouse lenders and/or an investment bank that underwrites our securitizations. These strategies are designated as hedges on our financial statements and are closed out when we sell the associated loans. We will review continually the frequency and effectiveness of our hedging strategy to mitigate risk pending a securitization or loan sale.
If the value of the hedges decrease, offsetting an increase in the value of the loans, upon settlement with our hedge counterparty, we will pay the hedge loss in cash and then realize the corresponding increase in the value of the loans as part of our net gain on sale of mortgage loans through either the excess cashflow certificates we retain from securitization or from whole loan premiums. Conversely, if the value of the hedges increase, offsetting a decrease in the value of the loans, upon settlement with our hedge counterparty, we will receive the hedge gain in cash and realize the corresponding decrease in the value of the loans through a reduction in either the value of the corresponding excess cashflow certificates or whole loan premiums.
We believe our hedging strategy has historically largely been an effective tool to manage our interest rate risk on loans prior to securitization, by providing us with a cash gain (or loss) to largely offset the reduced (increased) excess spread and resultant lower (or higher) net gain on sale from an increase (decrease) in interest rates. A hedge may not, however, perform its intended purpose of offsetting changes in net gain on sale.
If a hedging transaction is deemed to be appropriate, and can be properly documented and mathematically shown to meet the appropriate effectiveness criteria, we will account for these hedges as fair value hedges in accordance with SFAS No. 133, as amended.
We did not hedge during the year ended December 31, 2002 nor during the year ended December 31, 2001, primarily due to the tremendous uncertainty in the United States economy resulting from an overall weakened economy, depressed stock market, threat of war and terrorism, among other things, that has caused U.S. interest rates to remain at or near 40 year historical lows. For the year ended December 31, 2000, we recorded a hedge loss of $2.1 million, which largely offset a change in the value of mortgage loans being hedged, as part of our net gain on sale of loans.
We will continue to review our hedging strategy in order to best mitigate risk pending securitization or loan sales.
INFLATION
Inflation most significantly affects our loan originations and values of our excess cashflow certificates, because of the substantial effect inflation can have on interest rates. Interest rates normally increase during periods of high inflation and decrease during periods of low inflation. (See "--Interest Rate Risk.").
IMPACT OF NEW ACCOUNTING STANDARDS
For discussion regarding the impact of new accounting standards, refer to Note No. 1 of Notes to the Consolidated Financial Statements.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
Except for historical information contained herein, certain matters discussed in this Form 10-K are "forward-looking statements" as defined in the Private Securities Litigation Reform Act ("PSLRA") of 1995, which involve risk and uncertainties that exist in our operations and business environment, and are subject to change on various important factors. We wish to take advantage of the "safe harbor" provisions of the PSLRA by cautioning readers that numerous important factors discussed below, among others, in some cases have caused, and in the future could cause our actual results to differ materially from those expressed in any forward-looking statements made by us, or on our behalf. The following include some, but not all, of the factors or uncertainties that could cause actual results to differ from projections:
o Our ability or inability to increase our loan originations to specified levels (and subsequent sale or securitization of such loans) to offset our current cost structure and cash uses;
o Our ability or inability to continue our practice of securitizing mortgage loans held for sale, as well as our ability to utilize optimal securitization structures (including the sale of NIM or interest-only certificates, and the sale of servicing rights, at the time of securitization) at terms favorable to us;
o Our ability or inability to continue to access lines of credit at favorable terms and conditions, including without limitation, warehouse and other credit facilities used to finance newly-originated mortgage loans held for sale;
o The potential effect that a possible war with Iraq, or other similar conflicts or terrorist acts and/or threats, may have on the capital markets, and in particular the asset-backed market;
o The effect that the adoption of new, or changes in, federal, state or local lending laws and regulations and the application of such laws and regulations may have on our ability to originate loans within a particular area. Many states and local municipalities have adopted and/or are considering adopting laws that are intended to further regulate our industry. Many of these laws and regulations seek to impose broad restrictions on certain commonly accepted lending practices, including some of our practices. In some cases, the restrictions and/or costs and risks associated with complying with the laws have been so onerous that we have decided to not lend in a state (I.E., Georgia) or municipality (I.E., Oakland). In those cases where we continue to do business, our costs of complying with a variety of potentially inconsistent federal, state and local laws has increased our compliance costs, as well as the risk of litigation or administrative action associated with complying with these proposed and enacted federal, state and local laws, particularly those aspects of such proposed and enacted laws that contain subjective (as opposed to objective) requirements, among other things.
o Costs associated with litigation and rapid or unforeseen escalation of the cost of regulatory compliance, generally including but not limited to, adoption of new, or changes in, federal, state or local lending laws and regulations and the application of such laws and regulations, licenses, environmental compliance, adoption of new, or changes in accounting policies and practices and the application of such polices and practices. Failure to comply with various federal, state and local regulations, accounting policies and/or environmental compliance
can lead to loss of approved status, certain rights of rescission for mortgage loans, class action lawsuits and administrative enforcement action against us;
o Our ability or inability to continue monetizing our existing excess cashflow certificates, including without limitation, selling, financing or securitizing (through NIM transactions) such assets;
o A general economic slowdown. Periods of economic slowdown or recession may be accompanied by decreased demand for consumer credit and declining real estate values. Because of our focus on credit-impaired borrowers, the actual rate of delinquencies, foreclosures and losses on loans affected by the borrowers reduced ability to use home equity to support borrowings could be higher than those generally experienced in the mortgage lending industry. Any sustained period of increased delinquencies, foreclosure, losses or increased costs could adversely affect our ability to securitize or sell loans in the secondary market;
o The effects of interest rate fluctuations and our ability or inability to hedge effectively against such fluctuations in interest rates, the effect of changes in monetary and fiscal policies, laws and regulations, other activities of governments, agencies, and similar organizations, social and economic conditions, unforeseen inflationary pressures and monetary fluctuation;
o Increased competition within our markets has taken on many forms, such as convenience in obtaining a loan, customer service, marketing and distribution channels, loan origination fees and interest rates. We are currently competing with large finance companies and conforming mortgage originators many of whom have greater financial, technological and marketing resources;
o Unpredictable delays or difficulties in development of new product programs;
o The unanticipated expenses of assimilating newly-acquired businesses into our structure, as well as the impact of unusual expenses from ongoing evaluations of business strategies, asset valuations, acquisitions, divestitures and organizational structures; and
o Regulatory actions which may have an adverse impact on our lending.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We originate mortgage loans and then sell the mortgage loans through a combination of whole loan sales and securitizations. As a result, our primary market risk is interest rate risk. In turn, interest rates are highly sensitive to many factors, including:
o governmental monetary and tax policies;
o domestic and international economic and political considerations; and
o other factors beyond our control.
Changes in the general interest rate levels between the time we originate mortgage loans and the time when we sell such mortgage loans in securitization transactions can affect the value of our mortgage loans held for sale and, consequently, our net gain on sale revenue by affecting the "excess spread" between the interest rate on the mortgage loans and the interest rate paid to asset-backed investors who purchase pass-through certificates issued by the securitization trusts. If interest rates rise between the time we originate the loans and the time we sell the loans in a securitization transaction, the excess spread generally narrows, resulting in a loss in value of the loans and a lower net gain on sale for us. Since we close and fund mortgage loans at a specified interest rate with an expected gain on sale to be booked at the time of their sale, our exposure to decreases in the fair value of the mortgage loans arises when moving from a lower to a higher interest rate environment. A higher interest rate environment results in our having higher cost of funds. This decreases both the fair value of the mortgage loans, and the net spread we earn between the mortgage interest rate on each mortgage loan and our cost of funds under available warehouse lines of credit used to finance the loans prior to their sale in a securitization transaction. As a result, we may experience a lower gain on sale.
The following table illustrates the impact on our earnings resulting from a hypothetical 10 basis point change in interest rates. Historically, such a basis point increase has resulted in an approximately 10 basis point change in the excess spread or "yield." The product of 10 basis points in yield (0.10%) and the duration of 2.5 years equals a 25.0 basis point or 0.25% change in the net gain on sale as shown below.
The table below demonstrates the sensitivity, at December 31, 2002, of the estimated fair value of our excess cashflow certificates caused by an immediate 10% and 20%, respectively, adverse change in the key assumptions we use to estimate fair value:
These sensitivities are hypothetical and are presented for illustrative purposes only. Changes in the fair value resulting from a change in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the resulting change in fair value may not be linear. Each change in assumptions presented above was calculated independently without changing any other assumption. However, in reality, changes in one assumption may result in changes in another assumption, which may magnify or counteract the sensitivities. For example, a change in market interest rates may simultaneously impact prepayment speeds, credit losses and the discount rate. It is impossible to predict how one change in a particular assumption may impact other assumptions.
To reduce our financial exposure to changes in interest rates, we may hedge our mortgage loans held for sale through hedging products that are correlated to the pass-though certificates issued in connection with the securitization of our mortgage loans (I.E., interest rate swaps) (See "-Hedging"). Changes in interest rates also could adversely affect our ability to originate loans and/or could affect the level of loan prepayments thereby impacting the size of the loan portfolio underlying our excess cashflow certificates and, consequently, the value of our excess cashflow certificates. (See "-Interest Rate Risk" and "-Risk Factors - Interest Rate Risk").
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
INDEPENDENT AUDITORS' REPORT
To The Board of Directors and Stockholders of Delta Financial Corporation:
We have audited the accompanying consolidated balance sheets of Delta Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Delta Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company adopted FASB Statement No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections" as of December 31, 2002.
/s/ KPMG LLP
Melville, New York February 3, 2003
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
DELTA FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2002, 2001, AND 2000
(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) ORGANIZATION Delta Financial Corporation ("Delta" or "we") is a Delaware corporation, which was organized in August 1996. On October 31, 1996, we acquired all of the outstanding common stock of Delta Funding Corporation ("Delta Funding"), a New York corporation which had been organized on January 8, 1982 for the purpose of originating, selling, servicing and investing in residential first and second mortgages. On November 1, 1996, we completed an initial public offering of 4,600,000 shares of common stock, $.01 par value.
(B) PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements are prepared on the accrual basis of accounting and include our accounts and those of our wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated.
Certain prior period amounts in the consolidated financial statements and notes have been reclassified to conform with the current year presentation.
(C) USE OF ESTIMATES The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant items subject to such estimates and assumptions include the carrying amount of excess cashflow certificates and a valuation allowance on deferred tax assets. Actual results could differ from those estimates and assumptions.
(D) LOAN ORIGINATION FEES AND COSTS Loan origination fees received, net of direct costs of originating or acquiring mortgage loans, are recorded as adjustments to the initial investment in the loan. Such fees are deferred until the loans are securitized or sold.
(E) LOANS HELD FOR SALE, NET Loans held for sale are accounted for at the lower of cost or estimated fair value, determined on a net aggregate basis. Cost includes unamortized loan origination fees and costs. Net unrealized losses are provided for in a valuation allowance created through a charge to operations. Losses are recognized when the fair value is less than cost.
(F) SECURITIZATION AND SALE OF MORTGAGE LOANS Securitizations effectively provide us with a source of long-term financing. In conjunction with securitization transactions, trusts are created in the form of off-balance sheet qualified special purpose entities, or QSPEs. These trusts are established for the limited purpose of buying and reselling mortgage loans. Typically each quarter, we pool together loans, and sell these loans to a securitization trust. We carry no contractual obligation related to these trusts or the loans sold to them, nor do we have any direct or contingent liability related to the trusts, except for the standard representations and warranties made in conjunction with each securitization trust. Furthermore, we provide no guarantees to investors with respect to cash flow or performance for these trusts. These entities represent qualified special purpose entities and are therefore not consolidated for financial reporting purposes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities".
The securitization trust raises money to purchase the mortgage loans from us by selling securities to the public - known as asset-backed pass-through securities that are secured by the pool of mortgage loans held by the securitization trust. These asset-backed securities or senior certificates, which are usually purchased for cash by insurance companies, mutual funds and/or other institutional investors, represent senior interests in the cash flow from the mortgage loans in the trust.
The securitization trust issues senior certificates, which entitle the holders of these senior certificates to receive the principal collected, including prepayments of principal, on the mortgage loans in the trust. In addition, holders
receive a portion of the interest on the loans in the trust equal to the pass-through interest rate on the remaining principal balance. The securitization trust also issues a subordinate certificate or BIO certificate (referred to as an excess cashflow certificate), and a P certificate (representing the right to receive prepayment penalties from borrowers who payoff their loans early in their life). Each month, the P certificate holder is entitled to receive prepayment penalties received from borrowers who payoff their loans early in their life.
For any monthly distribution, the holder of an excess cashflow certificate receives payments only after all required payments have been made on all the other securities issued by the securitization trust. In addition, before the holder of the excess cash flow certificate receives payments, cash flows from such excess cashflow certificates are applied in a "waterfall" manner (see Note 6 "Securitization Transaction").
We have found that, at times, we can receive better economic results by selling certain mortgage loans on a whole loan, non-recourse basis, without retaining servicing rights, generally in private transactions to financial institutions or consumer finance companies. We recognize a gain or loss when we sell loans on a whole loan basis equal to the difference between the cash proceeds received for the loans and our investment in the loans, including any unamortized loan origination fees and costs.
(G) EXCESS CASHFLOW CERTIFICATES, NET We classify excess cashflow certificates that we receive upon the securitization of a pool of loans as "trading securities." The excess cashflow certificates represent an ownership interest in a securitization trust. The assets of each securitization trust consist primarily of two groups of mortgage loans: a group of fixed rate mortgage loans and a group of hybrid/adjustable rate mortgage loans. The mortgage loans in each mortgage pool underlying each excess cashflow certificate consist of fully amortizing and balloon mortgage loans secured by first or second liens primarily on one- to four-family residential real properties having original terms to stated maturity of not greater than 30 years.
The amount initially allocated to the excess cashflow certificates at the date of a securitization reflects their fair value. At the time each securitization transaction closes, we determine the present value of the related excess cashflow certificates using certain assumptions we make regarding the underlying mortgage loans. The excess cashflow certificate is then recorded on our consolidated financial statements at an estimated fair value. Our estimates primarily include the following:
o future rate of prepayment of the mortgage loans - the expected amount of prepayments on the mortgage loans due to the underlying borrowers of the mortgage loans paying off their mortgage loan prior to the loan's expected maturity;
o credit losses on the mortgage loans - our estimate of the amount of expected losses or defaults that will take place on the underlying mortgage loans over the life of the mortgage loans because the excess cashflow certificates are subordinate in right of payment to all other securities issued by the securitization trust. Consequently, any losses sustained on mortgage loans comprising a particular securitization trust are first absorbed by the excess cashflow certificates;
o the LIBOR forward curve (using current LIBOR as the floor rate) - our estimate of future interest rates which affects both the rate paid to the floating rate pass-through security investors (primarily the 1 month LIBOR index) and the adjustable rate mortgage loans sold to the securitization trust (which provide for a fixed rate of interest for the first 24 or 36 months and a 6 month variable rate of interest thereafter using the 6 month LIBOR index); and
o a discount rate used to calculate present value.
The amount recorded for the excess cashflow certificates is reduced for distributions which we receive as the holder of these excess cashflow certificates, and is adjusted for subsequent changes in the fair value of the excess cashflow certificates we hold. The value of each excess cashflow certificate represents the cash flow we expect to receive in the future from such certificate based upon our best estimate. We monitor the performance of the loans underlying each excess cashflow certificate, and any changes in our estimates (and consequent changes in value of the excess cashflow certificates) is reflected in the line item called "interest income" in the quarter in which we make any such change in our estimate. Although we believe that the assumptions we use are reasonable, there can be no assurance as to the accuracy of the assumptions or estimates. (see Note 8 "Excess Cashflow Certificates, Net").
(H) FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards (SFAS) No. 107, "Disclosure About Fair Value of Financial Instruments," requires us to disclose the fair value of financial instruments for which it is practicable to estimate fair value. Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation, and is best evidenced by a quoted market price. Other than excess cashflow certificates which are reported at fair value, substantially all our assets and liabilities deemed to be financial instruments are carried at cost, which approximates their fair value.
(I) CASH AND INTEREST-BEARING DEPOSITS The fair value of cash and interest-bearing deposits consist of money market accounts which approximates the carrying value reported in our consolidated balance sheet.
(J) EQUIPMENT, NET Equipment, including leasehold improvements, is stated at cost, less accumulated depreciation and amortization. Depreciation of equipment is computed using the straight-line method over the estimated useful lives of three to seven years. Leasehold improvements are amortized over the lesser of the terms of the lease or the estimated useful lives of the improvements. Expenditures for betterments and major renewals are capitalized and ordinary maintenance and repairs are charged to operations as incurred.
(K) INCOME TAXES Deferred tax assets and liabilities are recognized for the future tax effects of differences between the financial reporting and tax bases of assets and liabilities. These deferred taxes are measured by applying current enacted tax rates.
(L) EARNINGS PER SHARE Basic Earnings Per Share ("EPS") excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
(M) STOCK OPTION PLANS The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations including FASB Interpretation No. 44, ACCOUNTING FOR CERTAIN TRANSACTIONS INVOLVING STOCK COMPENSATION, AN INTERPRETATION OF APB OPINION NO. 25, issued in March 2000, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net income if the fair-value-based method had been applied to all outstanding and unvested awards in each period.
(Dollars in thousands, except share data) 2002 2001 2000 -------- -------- -------- Net income (loss), as reported $ 17,637 (99,790) (49,417)
Deduct total stock-based employee compensation expense determined under fair-value-based method for all rewards, net of tax (997) (2,000) (4) -------- -------- -------- Pro forma net income(loss) $ 16,640 (101,790) (49,421) ======== ======== ========
Earnings (loss) per share:
Basic - as reported $ 1.11 (6.28) (3.11) ======== ======== ======== Basic - pro forma $ 1.05 (6.41) (3.11) ======== ======== ======== Diluted - as reported $ 1.04 (6.28) (3.11) ======== ======== ======== Diluted - pro forma $ 0.98 (6.41) (3.11) ======== ======== ========
(N) SEGMENT REPORTING We operate as one reporting segment, as such, the segment disclosure requirements, are not applicable to us.
(O) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46 ("FIN No. 46"), "Consolidation of Variable Interest Entities," which is an interpretation of ARB No. 51. This Interpretation addresses consolidation by business enterprises of variable interest entities. The Interpretation applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to various interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. Management does not expect that the provisions of FIN No. 46 will impact our results of operations or financial condition.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based compensation - Transition and Disclosure, which amends FASB No. 123, Accounting for Stock-Based compensation." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No.148 amends the disclosure requirements of SFAS No. 123 to require more permanent disclosure in both interim and annual financial statements. Certain of the disclosure modifications are required for December 31,2002 and are included in the notes in the financial statements.. Management does not expect that the provisions of SFAS No. 148 will impact our results of operations or financial condition.
In July 2002, FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses financial accounting and reporting for costs associated with exit or disposal activities. It nullifies EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires that a liability be recognized for those costs only when the liability is incurred, that is, when it meets the definition of a liability in the FASB's conceptual framework. There was no impact on the Company's consolidated balance sheet or consolidated statement of operations upon the adoption of SFAS No. 146 on January 1, 2003.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." Among other things, the standard changes the income statement classification of gains and losses from early extinguishments of debts. The provisions of SFAS No. 145 are effective for fiscal years beginning after May 15, 2002. There was no material impact on our financial condition or results of operations upon the adoption of SFAS No. 145.
In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which replaced SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." SFAS No. 144 established a single accounting model, based on the framework established in SFAS No. 121, for long-lived assets to be disposed of by sale. SFAS No. 144 also resolved significant implementation issues related to SFAS No. 121. The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001. There was no impact on the Company's consolidated balance sheet or consolidated statements of operations upon adoption of SFAS No. 144 on January 1, 2002.
In June 2001, FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations," which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The provisions of SFAS No. 143 are effective for fiscal years beginning after June 15, 2002. The adoption of SFAS No. 143 did not have an impact on the financial position, results of operations, or cash flows of the Company.
(2) SUMMARY OF REGULATORY SETTLEMENTS
In September 1999, we settled allegations by the New York State Banking Department (the "NYSBD") and a lawsuit by the New York State Office of the Attorney General (the "NYOAG") alleging that we had violated various state and federal lending laws. The global settlement was evidenced by (a) a Remediation Agreement by and between Delta Funding and the NYSBD, dated as of September 17, 1999 and (b) a Stipulated Order on Consent by and among Delta Funding, Delta Financial and the NYOAG, dated as of September 17, 1999. As part of the Settlement, we, among other things, implemented agreed upon changes to our lending practices; are providing reduced loan payments aggregating $7.25 million to certain borrowers identified by the NYSBD; and have created a fund managed by the NYSBD and financed by the grant of 525,000 shares of Delta Financial's common stock.
Each month, on behalf of borrowers designated by the NYSBD, we make subsidy payments to the related securitization trusts. These subsidy payments fund the differential between the original loan payments and the reduced loan payments. As part of the second exchange offer we completed in August 2001 (see Note No. 3 "-Corporate Restructuring, Debt Modification, and Debt Restructuring"), Delta Funding Residual Exchange Company, LLC (the "LLC") (an unaffiliated entity to us) - a newly-formed entity, the voting membership interests of which are owned by former holders of our senior secured notes and senior notes due 2004 (the "Notes") who tendered their Notes for such membership interests and other securities - is obligated to satisfy these payment subsidies out of the cash flows generated by the mortgage related securities (primarily from the excess cashflow certificates) it owns. If the LLC's cash flows are insufficient to pay this obligation (which we believe is unlikely), we remain responsible to satisfy our obligations under the Remediation Agreement.
The proceeds of the stock fund will be used to pay borrowers and to finance a variety of consumer educational and counseling programs. We do not manage the fund created for this purpose. The number of shares of common stock deposited in the fund does not adjust to account for fluctuations in the market price of our common stock. Changes to the market price of these shares of common stock deposited in the fund do not have any impact on our financial statements. We did not make any additional financial commitments between the settlement date and March 2000. The Stipulated Order on Consent and the Remediation Agreement both terminated by their respective terms, in September 2002. We remain obligated as discussed above to continue to make subsidy payments on behalf of borrowers identified by the NYSBD for so long as such borrowers continue to make payments under the mortgage loans.
In March 2000, we finalized an agreement with the U.S. Department of Justice, the Federal Trade Commission and the Department of Housing and Urban Development, to complete the global settlement we had reached with the NYSBD and NYOAG. The federal agreement mandates some additional compliance efforts for us, but it does not require any additional financial commitment by us.
We believe we are in compliance in all material respects with applicable federal and state laws and regulations.
(3) CORPORATE RESTRUCTURING, DEBT MODIFICATION, AND DEBT RESTRUCTURING
In 2000, we began a corporate restructuring - by reducing our workforce and modifying the terms of the indenture governing our senior notes due 2004 (the "senior notes") - as part of our continuing efforts to improve operating efficiencies and to address our negative cash flow from operations. Entering 2001, management still had several concerns, which we believed needed to be addressed for us to remain a viable company. Our principal concerns were:
o the cash drain created by our ongoing monthly delinquency and servicing advance requirements as servicer for securitization trust (known as "securitization advances");
o the high cost of servicing a seasoned loan portfolio, including the capital charges associated with making securitization advances;
o our ability to make timely interest payments on our senior notes and senior secured notes due 2004 (the "senior secured notes"); and
o our ability to effectuate a successful business model given the overhang of corporate ratings of "Caa2" by Moody's and "CC" by Fitch.
Therefore in the first quarter of 2001, we embarked upon a business plan aimed at alleviating some of these concerns and issues.
CORPORATE RESTRUCTURING
In January 2001, we announced that we had entered into an agreement with Ocwen Financial Corporation ("Ocwen") to transfer our servicing portfolio to Ocwen. In May 2001, we physically transferred our entire servicing portfolio to Ocwen, and laid-off the majority of our servicing staff - a total of 128 employees. We recorded a $0.5 million pre-tax charge relating to this restructuring which is included in the line item call "restructuring and other special charges" on our consolidated statements of operations. This charge relates to employee severance associated with closing our servicing operations. We no longer service loans nor do we have a servicing operation.
We have accrued restructuring charges related to the write down of lease obligations of $0.1 million and $0.6 million at December 31, 2002 and December 31, 2001. The unpaid accrued restructuring charge was initially recorded under the exit plan. No charges under this exit plan are associated with or benefit from activities that will be continued at the commitment date.
DEBT MODIFICATION AND DEBT RESTRUCTURING
In August 2000, we announced an agreement to modify the terms of the indenture governing our senior notes (the "Debt Modification"). With the consent of the holders of greater than fifty percent of our senior notes, we modified a negative pledge covenant in the senior notes indenture, which had previously prevented us from selling or otherwise obtaining financing by using our excess cashflow certificates as collateral. In consideration for the senior noteholders' consent, we agreed, in an exchange offer (the "First Exchange Offer"), to offer then current holders the opportunity to exchange their then existing senior notes for (a) new senior secured notes due 2004 (the "senior secured notes") and (b) ten-year warrants to buy approximately 1.6 million shares of common stock, at an initial exercise price of $9.10 per share, subject to upward or downward adjustment in certain circumstances. In December 2002, the exercise price for the warrants issued by us was adjusted downward to $0.01 per share in accordance with our agreement. The senior secured notes have the same coupon, face amount and maturity date as the senior notes and, up until the Second Debt Restructuring (see below) were secured by at least $165 million of the our excess cashflow certificates. The First Exchange Offer was consummated in December 2000, with holders of greater than $148 million (of $150 million) of senior notes tendering in the exchange.
In February 2001, we entered into a letter of intent with the beneficial holders of over fifty percent of our senior secured notes to restructure, and ultimately extinguish, the senior secured notes (the "Second Debt Restructuring"). In March 2001, we obtained the formal consent of these beneficial holders of the senior secured notes through a consent solicitation that modified certain provisions of the senior secured notes indenture to, among other things, allow for the release of two excess cashflow certificates then securing the senior secured notes. We were first able to finance and then ultimately sell the excess cashflow certificates underlying five securitizations (including two excess cashflow certificates that were released as part of the Second Debt Restructuring) for a $15 million cash purchase price to provide working capital.
In consideration for their consent, we agreed to offer the holders of the senior secured notes (and the senior notes, collectively, the "notes"), an opportunity to exchange their notes for new securities described immediately below (the "Second Exchange Offer"). The Second Exchange Offer was consummated on August 29, 2001, pursuant to which holders of approximately $138.1 million (of $148.2 million) in principal amount of our senior secured notes and $1.1 million (of $1.8 million) in principal amount of our senior notes, exchanged their notes for commensurate interests in:
o voting membership interests in Delta Funding Residual Exchange Company LLC (the "LLC"), a newly-formed limited liability company (unaffiliated with us), to which we transferred all of the mortgage-related securities previously securing the senior secured notes (primarily comprised of excess cashflow certificates);
o shares of common stock of a newly-formed management corporation that will manage the LLC's assets; and
o shares of our newly-issued Series A preferred stock having an aggregate preference amount of $13.9 million.
The LLC is controlled by the former noteholders that now hold all the voting membership interest in the LLC. As part of the transaction, we obtained a non-voting membership interest in the LLC, which entitles us to receive 15% of the net cash flows from the LLC for the first three years (through June 2004) and, thereafter, 10% of the net
cash flows from the LLC. The net cash flows from the LLC are equal to the total cash flows generated by the assets held by the LLC for a particular period, less (a) all expenses of the LLC, (b) certain related income tax payments, and (c) the NYSBD subsidy payments (see "- Note No. 2 Summary of Regulatory Settlement"). We began receiving distributions from the LLC in the first quarter of 2002 from a fourth quarter 2001 distribution.
As part of the Second Exchange Offer, all tendering noteholders waived their right to receive any future interest coupon payments on the tendered notes beginning with the August 2001 interest coupon payment. With the closing of the Second Exchange Offer, we recorded a charge of $19.3 million related to the extinguishment of debt and paid the August 2001 interest coupon payment on the approximately $10.8 million of notes that did not tender in the Second Exchange Offer. The notes bear interest at a rate of 9.5% per annum, payable semi-annually (on February 1st and August 1st) and a maturity date of August 1, 2004 when all outstanding principal is due.
By extinguishing substantially all of our long-term debt, the rating agencies that previously rated us and our long-term debt withdrew their corporate ratings in 2001.
(4) LOANS HELD FOR SALE, NET
Our inventory consists of first and second mortgages, which had a weighted average interest rate of 8.45% at December 31, 2002 and 10.11% at December 31, 2001. These mortgages are being held, at the lower of cost or estimated fair value, for future sale. Certain of these mortgages are pledged as collateral for a portion of the warehouse financing and other borrowings.
Included in loans held for sale are deferred origination fees and purchase premiums in the amount of $0.2 million and $0.8 million at December 31, 2002 and 2001, respectively, and a valuation allowance of approximately $0.4 million at December 31, 2002 and $0.7 million as of December 31, 2001. Mortgages are payable in monthly installments of principal and interest and have terms varying from five to thirty years.
(5) ACCOUNTS RECEIVABLE
Accounts receivable as of December 31, consist of the following:
(DOLLARS IN THOUSANDS) 2002 2001 - -------------------------------------------------------------------------------- Prepaid insurance premiums $ -- 2,227 Advances on loans sold with recourse 1,335 1,550 Other 365 285 - -------------------------------------------------------------------------------- Total accounts receivable $ 1,700 4,062 - --------------------------------------------------------------------------------
Funds due to us for accounts receivable are tracked through various asset accounts. These accounts are reconciled monthly, at which time we perform research and resolution on the receivables. All aged items are identified and reported to management and management decides whether to write-off any aged items. We evaluate accounts receivable items on an individual basis and an item is not written off until all options for payment have been exhausted.
Activity in Accounts Receivable for the years ended December 31, is as follows (dollars in thousands):
6) SECURITIZATION TRANSACTION
During 2002, we completed four securitizations totaling $850 million, of which we delivered a total of $819 million of mortgage loans during 2002 (and delivered the remaining $31 million of mortgage loans in January 2003, pursuant to a pre-funding mechanism). During 2001, we completed two securitizations totaling $345 million of mortgage loans. The following table sets forth certain information with respect to our 2002 securitizations (all of which contained ratings on various classes of securities ranging from AAA/Aaa to BBB/Baa2 by S&P, Fitch, and Moody's, respectively) by offering size, which includes pre-funded amounts, duration weighted average pass-through rate and type of credit enhancement.
* SENIOR/SUB STRUCTURE WITH A "AAA" RATED MONOLINE INSURER INSURING THE SENIOR OR "AAA" RATED PASS-THROUGH CERTIFICATES.
When we securitize loans, we create trusts in the form of off-balance sheet qualified special purpose entities, or QSPEs. These trusts are established for the limited purpose of buying and reselling mortgage loans.
For any monthly distribution, the holder of an excess cashflow certificate receives payments only after all required payments have been made on all the other securities issued by the securitization trust. In addition, before the holder of the excess cash flow certificate receives payments, cash flows from such excess cashflow certificates are applied in a "waterfall" manner as follows:
o first, to cover any losses on the mortgage loans in the related mortgage loan pool, because the excess cashflow certificates are subordinate in right of payment to all other securities issued by the securitization trust;
o second, to reimburse the bond insurer, if any, of the related series of pass-through certificates for amounts paid by or otherwise owing to that insurer;
o third, to build or maintain the overcollateralization provision (described in more detail immediately below) for that securitization trust at the required level by being applied as an accelerated payment of principal to the holders of the pass-through certificates of the related series;
o fourth, to reimburse holders of the subordinated certificates of the related series of pass-through certificates for unpaid interest and for any losses previously allocated to those certificates; and
o fifth, to pay interest on the related pass-through certificates which was not paid because of the imposition of a cap on their pass-through rates - these payments being called basis risk shortfall amounts.
The overcollateralization provision or "O/C" is a credit enhancement which is designed to protect the securities sold to the securitization pass-through investors from credit loss on the underlying mortgage loans. In short, overcollateralization is when the amount of collateral (I.E., mortgage loans) owned by a securitization trust exceeds the aggregate amount of senior pass-through certificates. The O/C is created to absorb losses that the securitization trust may suffer, as loans are liquidated at a loss. Historically, we built up the O/C typically over the first 18-24 months of a securitization (with the specific timing depending upon the structure, amount of excess spread, and performance of the securitization), by utilizing the cash flows from the excess cashflow certificates to make additional payments of principal to the holders of the pass-through certificates until the required O/C level was reached. Beginning with each of our 2002 securitizations, we created the O/C by initially selling pass-through securities totaling approximately 98.5% of the total amount of mortgage loans sold to the trust. In doing so, we create the full amount of the O/C required by the trust up front, at the time we complete the securitization, instead of
over time. For example, if a securitization trust contains collateral of $100 million of mortgage loans, we sell approximately $98.5 million in senior pass-through certificates. Prior to our 2002 securitization transactions, we typically issued pass-through certificates for a par purchase price, or a slight discount to par - with par representing the aggregate principal balance of the mortgage loans backing the asset-backed securities. For example, if a securitization trust contains collateral of $100 million of mortgage loans, we typically received close to $100 million in proceeds from the sales of these certificates, depending upon the structure we utilize for the securitization.
Our securitizations have typically required an O/C of between 1.5% and 3.0% of the initial mortgage loans sold to the securitization trust. The required O/C can increase or decrease throughout the life of the transaction depending upon subordination levels, delinquency and/or loss tests and is subject to minimums and maximums, as defined by the rating agencies and/or the bond insurer insuring the securitization. On our securitizations prior to 2002, after the O/C requirement is reached, the cash flows from the excess cashflow certificates are then distributed to us as the holder of the excess cashflow certificates, in accordance with the "waterfall" described above. Over time, if the cash collected during the periods exceeds the amount necessary to maintain the required O/C and all other required distributions have been met, and there is no shortfall in the related required O/C, the excess is then released to us as holder of the excess cashflow certificate.
We began utilizing a new securitization structure in 2002. In lieu of selling an interest-only certificate, we sold a net interest margin certificate or NIM. The NIM is generally structured where we sell the excess cashflow certificate and P certificate (which entitles the holder to all prepayment penalties collected by the trust) to a QSPE or owner trust (the NIM trust) and the NIM trust in turn issues (1) interest-bearing NIM note(s) (backed by the excess cashflow certificate), and (2) a NIM owner trust certificate evidencing ownership in the NIM trust. We sell the excess cashflow certificate and P certificate without recourse except that we provide normal representations and warranties to the NIM trust. One or more investors purchase the NIM note(s) and the proceeds from the sale of the note(s), along with a owner trust certificate that is subordinate to the note(s), represent the consideration to us for the sale of the excess cashflow certificate and P certificate.
The NIM note(s) entitles the holder to be paid a specified interest rate, and further provides for all cash flows generated by the excess cashflow certificate and P certificate to be used to pay all principal and interest on the NIM note(s) until paid in full. This is estimated to occur approximately 22-25 months from the date the NIM note(s) were issued. As part of the NIM transaction, we received the cash proceeds from the sale of the NIM note(s) and a subordinate interest in the NIM owner trust, represented by the owner trust certificate. The owner trust certificate entitles us to all cash flows generated by the excess cashflow certificate and P certificate after the holder of the NIM note(s) has been paid in full. As such, we classify the NIM owner trust certificate on our balance sheet as an excess cashflow certificate and value the NIM owner trust certificate using the same assumptions that we utilize in valuing excess cashflow certificates.
As part of the NIM transaction, we were required to "fully fund" the O/C at closing - as opposed to having it build up over time as we had in past securitizations - which is why we sold senior pass-through certificates that were approximately 1.25% less than the collateral in the securitization trust. We use a portion of the proceeds we receive from selling NIM note(s) to make up for the difference between (1) the value of the mortgage loans sold and (2) the proceeds from selling the senior pass-through certificates.
In each of the four securitizations that we issued in 2002, we derived the following economic interests:
o we received a cash purchase price from the sale of the NIM note(s) issued by a NIM trust, to which we sold the excess cashflow certificates;
o we retained a NIM owner trust certificate, which entitles us to receive cash flows generated by the excess cashflow certificates and the P certificate issued in connection with the securitization after the holder of the NIM note(s) has been paid in full. Although the cash flows generated by excess cashflow certificates are received over time, under existing accounting rules, we must report as income at the time of the securitization the present value of all projected cash flows we expect to receive in the future from these excess cashflow certificates based upon an assumed discount rate. Our valuation of these excess cashflow certificates is primarily based on (1) our estimate of the amount of expected losses or defaults that will take place on the underlying mortgage loans over the life of the mortgage loans, (2) the expected amount of prepayments on the mortgage loans due to the underlying borrowers of the mortgage loans paying off their mortgage loan prior to the loan's stated maturity, (3) the London Inter-Bank Offered Rate ("LIBOR") forward curve (using current LIBOR as the floor rate), and (4) a discount rate; and
o we received a cash premium from selling the right to service the loans being securitized. This right entitles the contractual servicer to service the loans on behalf of the securitization trust, and earn a contractual servicing fee, and ancillary servicing fees (which includes prepayment penalties for certain securitization servicing rights we previously sold) in such capacity.
At the time we completed the 2002 securitizations, we recognized as revenue each of the three economic interests described above, which was recorded as net gain on sale of mortgage loans on our consolidated statement of operations.
A summary of the gain on sale and cash flow we received from our aggregate securitizations in 2002 and 2001 is presented below. "Loans sold" represents the amount of loans actually transferred to the respective securitization trust or trusts during each year:
- ---------- (1) The reduction in value of the excess cashflow certificates in 2002 compared to 2001 is primarily due to changes we made to our fair value assumptions of our excess cashflow certificates (see Note 8 "Excess Cashflow Certificate, Net"). (2) In 2001, the mortgage servicer purchased the P Certificate; in 2002, we transferred the P Certificate to the NIM Trust, which accounts for the reduced gain from the sale of mortgage servicing rights in 2002.
Our net investment in the pool of loans sold at the date of the securitization represents the amount originally paid to originate the loans, adjusted for the following:
o any direct loan origination costs incurred (an increase in the investment) and loan origination fees received (a decrease in the investment) in connection with the loans, which are treated as a component of the initial investment in loans;
o the principal payments received, and the amortization of the net loan fees or costs, during the period we held the loans prior to their securitization; and
o any gains (a decrease in the investment) or losses (an increase in the investment) we incur on any hedging instruments that we may have utilized to hedge against the effects of changes in interest rates during the period we hold the loans prior to their securitization. (See "Note 9").
We allocate our basis in the mortgage loans and excess cashflow certificates between the portion of the mortgage loans and excess cashflow certificates sold through securitization and the portion retained (the NIM owner trust certificates in 2002) based on the relative fair values of those portions on the date of sale. We may recognize gains or losses attributable to the changes in fair value of the excess cashflow certificates, which are recorded at estimated fair value and accounted for as "trading" securities. Since there is no active market for such excess cashflow certificates, we determine the estimated fair value of the excess cashflow certificates by discounting the future expected cash flows.
Each securitization trust has the benefit of either a financial guaranty insurance policy from a monoline insurance company or a senior-subordinated securitization structure, which insures the timely payment of interest
and the ultimate payment of principal of the credit-enhanced investor certificate, or both (known as a "hybrid"). In "senior-subordinated" structures, the senior certificate holders are protected from losses by subordinated certificates, which absorb any such losses first. In addition to such credit enhancement, the excess cash flows that would otherwise be paid to the holder of the excess cashflow certificate is used when it subsequently becomes necessary to obtain or maintain required overcollateralization limits. Overcollateralization is intended to create an additional source of credit enhancement to absorb losses prior to making a claim on the financial guaranty insurance policy or the subordinated certificates.
(7) CAPITALIZED MORTGAGE SERVICING RIGHTS
Prior to 2001, we recognized rights to service mortgage loans as separate assets. Subsequent to 2001, we do not recognize rights to service mortgage loans because we sell our servicing rights in connection with our whole loan sales or securitizations.
We recognized a $38.2 million write-down, which represented the entire carrying value of our MSR at December 31, 2000. In December 2000, we entered into discussions with three third-party non-conforming servicers to either purchase or sub-service our entire $3.31 billion servicing portfolio. Management felt this write-down was necessary to reflect the current market price we would have received at December 31, 2000 for our servicing portfolio. We sold all of our mortgage servicing rights for the years ended December 31, 2002 and 2001 and as such had no activity or carrying values for those assets during the periods. The activity related to our capitalized mortgage servicing rights for the year ended December 31, 2000 is as follows:
(8) EXCESS CASHFLOW CERTIFICATES, NET
Our excess cashflow certificates primarily consist of the right to receive the future excess cash flows from a pool of securitized mortgage loans. Our interest in these certificates generally consists of the following:
o The interest spread between the coupon on the underlying mortgage loans and the cost of financing (which, when we sell NIM notes, is only received after the NIM Notes are paid in full);
o On our 2002 securitizations, prepayment penalties received from borrowers who payoff their loans early in their life (which, when we sell NIM notes, is only received after the NIM Notes are paid in full ); and
o Overcollateralization, which is designed to protect the securities sold to the securitization pass-through investors from credit loss on the underlying mortgage loans (and which we describe in greater detail in Note 6).
The excess cash flow we receive is highly dependent upon the interest rate environment to the extent basis risk exists between the securitization trust's assets and liabilities.
In each of our securitizations in which we sold NIM note(s), we purchased, on behalf of the NIM owner trust, an interest rate cap for the benefit of the NIM noteholder(s), which helps mitigate the basis risk for the approximate time that the NIM notes are outstanding.
The value of each excess cashflow certificate represents the cash flow we expect to receive in the future from such certificate based upon our best estimate. We monitor the performance of the loans underlying each excess cashflow certificate, and any changes in our estimates (and consequent changes in value of the excess cashflow certificates) are reflected in the line item called "interest income" in the quarter in which we make any such change in our estimate. Although we believe that the assumptions we use are reasonable, there can be no assurance as to the accuracy of the assumptions or estimates.
In determining the fair value of each of the excess cashflow certificates, we make the following underlying assumptions regarding mortgage loan prepayments, mortgage loan default rates, the LIBOR forward curve and discount rates:
(A) PREPAYMENTS. We base our prepayment rate assumptions upon our ongoing analysis of the performance of mortgage pools we previously securitized, and the performance of similar pools of mortgage loans securitized by others in the industry. We apply different prepayment speed assumptions to different loan product types because it has been our experience that different loan product types exhibit different prepayment patterns. Generally, our loans can be grouped into two loan products - fixed rate loans and adjustable rate loans. With fixed rate loans, an underlying borrower's interest rate remains fixed throughout the life of the loan. Our adjustable rate loans are really a "hybrid" between fixed and adjustable rate loans, in that the rate generally remains fixed for typically the first three years of the loan, and then adjusts typically every six months thereafter. Within each product type, other factors can affect prepayment rate assumptions.
The following table shows our most recent changes to month one and peak speed components of our prepayment assumptions - in the third quarter of 2001 and, prior to that, in the third quarter 2000:
LOAN TYPE AT SEPTEMBER 30, 2001 AT SEPTEMBER 30, 2000 --------------------------------------------------------------------- Fixed Rate: At Month 4.00% 4.00% Peak Speed 30.00% 23.00% Adjustable Rate: At Month 4.00% 4.00% Peak Speed 75.00% 50.00%
A higher prepayment speed means that the mortgage loans prepay faster than anticipated and, as such, we will earn less income in connection with the mortgage loans and receive less excess cashflow in the future because the mortgage loans have paid off; conversely, if we have slower prepayment speeds, the mortgage loans remain outstanding for longer than anticipated and, as such, we earn more income and more excess cashflow in the future.
(B) DEFAULT RATE. At December 31, 2002 and December 31, 2001, on each newly issued securitization, we apply a default reserve for both fixed- and adjustable-rate loans sold to the securitization trusts totaling 5.00% of the amount initially securitized. We apply a default or loss rate to the excess cashflow certificate because it is the "first-loss" piece and is subordinated in right of payment to all other securities issued by the securitization trust. If defaults are higher than we anticipate, we will receive less income and less excess cashflow than expected in the future; conversely, if defaults are lower than we expected, we will receive more income and more excess cashflow than expected in the future.
(C) LIBOR FORWARD CURVE. The LIBOR forward curve is used to project future interest rates, which affects both the rate paid to the floating rate pass-through security investors (primarily the 1 month LIBOR index) and the adjustable rate mortgage loans sold to the securitization trust (a fixed rate of interest for either the first 24 or 36 months then a 6 month variable rate of interest thereafter using the 6 month LIBOR index). A significant portion of our loans are fixed rate mortgages and a significant amount of these fixed rate loans are backed by floating rate securities (I.E., 1 month LIBOR). As such, our excess cashflow certificates are subject to significant basis risk and a change in LIBOR will, therefore, impact our excess spread. If LIBOR is lower than anticipated, we will receive more income and more excess cash flows than expected in the future; conversely, if LIBOR is higher than anticipated, we will less income and less excess cash flows than expected in the future. In each of our securitizations in which we sold NIM note(s), we purchased, on behalf of the NIM owner trust, an interest rate cap for the benefit of the NIM noteholder(s), which helps mitigate the basis risk for the approximate time that the NIM notes are outstanding.
(D) DISCOUNT RATE. We use a discount rate that we believe reflects the risks associated with our excess cashflow certificates. While quoted market prices on comparable excess cashflow certificates are not available, we compare our valuation assumptions and performance experience to our competitors in the non-conforming mortgage industry. Our discount rate takes into account the asset quality and the performance of our securitized mortgage loans compared to that of the industry and other characteristics of our securitized loans. We quantify the risks associated with our excess cashflow certificates by comparing
the asset quality and payment and loss performance experience of the underlying securitized mortgage pools to comparable industry performance. The discount rate we use to determine the present value of cash flows from excess cashflow certificates reflects increased uncertainty surrounding current and future market conditions, including without limitation, uncertainty concerning inflation, recession, home prices, interest rates and equity markets.
We utilized a discount rate of 15% at December 31, 2002 and December 31, 2001 on all excess cashflow certificates. Prior to the quarter ended September 30, 2001, we used an 18% discount rate on a NIM transaction we consummated in November 2000.
In the third quarter of 2000, we had increased the discount rate we used on those excess cashflow certificates included in the NIM transaction to 18% (from 12%) and recorded an $8.8 million valuation adjustment. The adjustment reflected a reduction in the present value of those excess cashflow certificates sold in connection with our NIM transaction completed in the fourth quarter of 2000. We increased the discount rate on these excess cashflow certificates during the period that the senior NIM securities remain outstanding, to account for the potentially higher risk associated with the residual cash flows expected to be received by the holder of the certificated interest in the NIM trust, which is subordinated to the multiple senior securities sold in the NIM transaction.
In the fourth quarter of 2000, we had increased the discount rate we used in determining the present value of our "senior" excess cashflow certificates to 13% from 12%, and recorded a $7.1 million valuation adjustment. The adjustment reflected an increase in volatility concerning the other underlying assumptions used in estimating expected future cash flows due to greater uncertainty surrounding current and future market conditions, including without limitation, inflation, recession, home prices, interest rates and equity markets.
For 2000, we recorded a non-cash increase of $9.6 million to interest income for a fair value adjustment to our excess cashflow certificates, due to the decrease in one-month LIBOR. Some of the our excess cashflow certificates are backed by floating rate securities, which are susceptible to interest rate risk (positive or negative) associated with a movement in short-term interest rates.
At September 30, 2001, we recorded a charge to interest income to reflect a fair value adjustment to our remaining excess cashflow certificates totaling $19.7 million. Our change in assumptions at September 30, 2001, primarily reflect recent unforeseen market events relating to the terrorist attacks on September 11, 2001, that further accelerated an economic downturn in the U.S. economy, and which we believe may have a significant adverse impact on the economy for the foreseeable future.
At March 31, 2002, we recorded a charge to interest income to reflect a fair value adjustment to our excess cashflow certificates, totaling $2.1 million, relating to the timing of excess cashflows that are to be received by the excess cashflow certificate after the release or "step-down" of the overcollateralization account.
The activity related to our excess cashflow certificates for the years ended December 31, is as follows:
Our valuation of retained excess cashflow certificates is highly dependent upon the reasonableness of our assumptions and the predictiveness of the relationships that drive the results of our valuation model. The assumptions we utilize, described above, are complex, as we must make judgment calls about the effect of matters that are inherently uncertain. As the number of variables and assumptions affecting the possible future resolution of the uncertainties increase, those judgments become even more complex.
In volatile markets, like those we have experienced in 2002 and in 2001, there is increased risk that our actual results may vary significantly from our assumed results. The greater the time period over which the uncertainty will exist, the greater the potential volatility for our valuation assumptions.
At December 31, 2002, key economic assumptions and the sensitivity of the current estimated fair value of retained interests caused by immediate 10% and 20% adverse changes in those assumptions are as follows:
Fair value of excess Impact to (Dollars in thousands) cashflow certificates earnings - ---------------------------------------------------------------------------- Fair value as of 12/31/02: $ 24,565 10% increase in prepayment speed 19,011 $5,554 20% increase in prepayment speed 15,476 9,089
10% increase in credit losses 19,012 5,553 20% increase in credit losses 14,448 10,117
10% increase in discount rates 23,032 1,533 20% increase in discount rates 21,676 2,889
10% increase in one- & six-month LIBOR 21,809 2,756 20% increase in one- & six-month LIBOR 19,227 5,338
These sensitivities are hypothetical and are presented for illustrative purposes only. Changes in carrying amount based on a change in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in carrying amount may not be linear. The changes in assumptions presented in the above table were calculated without changing any other assumption; in reality, changes in one assumption may result in changes in another, which may magnify or counteract the sensitivities. For example, changes in market interest rates may simultaneously impact repayment speed, credit losses and the discount rate.
(9) HEDGING TRANSACTIONS
We did not hedge during the years ended December 31, 2002 and December 31, 2001. For the year ended December 31, 2000, we recorded a hedge loss of $2.1 million, which largely offset a change in the value of mortgage loans being hedged, as part of our net gain on sale of loans.
(10) WAREHOUSE FINANCING AND OTHER BORROWINGS
We have two warehouse credit facilities for a combined amount of $400.0 million as of December 31, 2002. At December 31, 2001 we had one warehouse credit facility in the amount of $200.0 million. The lines are collateralized by specific mortgage receivables, which are equal to or greater than the outstanding balances under the line at any point in time.
The following table summarizes certain information regarding warehouse financing and other borrowings at December 31:
(DOLLARS IN MILLIONS)
We are required to comply with various operating and financial covenants as provided in our warehouse agreements, which are customary for agreements of their type. The continued availability of funds provided to us under these agreements is subject to, among other conditions, our continued compliance with these covenants. We believe we are in compliance with such covenants as of December 31, 2002.
Future contractual obligations related to principal balances for capital leases as of December 31, 2002 and 2001 are as follows:
(Dollars in thousands)
(11) SENIOR NOTES
In July 1997, we issued $150 million in the aggregate of 9 1/2% senior notes due 2004. These notes were the subject of two exchange offers (as described in more detail in Note 3), which modified the terms of the indenture governing then notes - the second of which resulted in the extinguishment of approximately $139.2 million of the notes in 2001.
The outstanding balance of the notes totaled $10.8 million as of December 31, 2002 and 2001. The outstanding balance as of December 31, 2000, prior to the restructuring (as described in Note 3), totaled $149.6 million, net of unamortized bond discount. During 2001, in connection with the restructuring, we wrote off the unamortized issuance cost related to the Senior Note of approximately $2.5 million.
(12) BANK PAYABLE
In order to maximize our cash management practices, we have instituted a procedure whereby checks written against our operating account are covered as they are presented to the bank for payment, either by drawing down our lines of credit or from subsequent deposits of operating cash. Bank payable represents the checks outstanding at December 31, 2002 and 2001, to be paid in this manner.
(13) EMPLOYEE BENEFIT PLANS
We sponsor a 401(k) Retirement Savings Plan. Substantially all our employees who are at least 21 years old are eligible to participate in the plan after completing one year of service. Contributions are made from employees' elected salary deferrals. We elected to make discretionary contributions to the Plan of $0.3 million, $0.5 million and $0.7 million for 2002, 2001 and 2000, respectively.
(14) COMMITMENTS AND CONTINGENCIES
We have repurchase agreements with certain of the institutions that have purchased mortgages. Some of the agreements provide for the repurchase by us of any of the mortgage loans that go to foreclosure sale. At the foreclosure sale, we will repurchase the mortgage, if necessary, and make the institution whole. The dollar amount of loans that were sold with recourse and are still outstanding totaled $2.6 million at December 31, 2002 and $3.5 million at December 31, 2001.
Included in accounts payable is an allowance for recourse losses of $1.2 million at December 31, 2002 and $1.4 million at December 31, 2001, respectively. We recognized, as a charge to operations, a provision for recourse losses of approximately $73,500, $311,000 and $11,600 for the years 2002, 2001 and 2000, respectively. Additions to the allowance for loan losses are provided by charges to income based upon various factors, which, in management's judgment, deserve current recognition in estimating probable losses. The loss factors are determined by management based upon an evaluation of historical loss experience, delinquency trends, loan volume and the impact of economic conditions in our market area.
Our rental expense, net of sublease income, for the years ended December 31, 2002, 2001 and 2000 amounted to $4.5 million, $5.0 million and $7.0 million, respectively.
Minimum future rentals under non-cancelable operating leases as of December 31, 2002 are as follows:
Because the nature of our business involves the collection of numerous accounts, the validity of liens and compliance with various state and federal lending laws, we are subject, in the normal course of business, to numerous legal proceedings and claims, including several class action lawsuits. The resolution of these lawsuits, in management's opinion, will not have a material adverse effect on our financial position or results of operations.
(15) STOCK OPTION PLAN
The 1996 Stock Option Plan (the "1996 Plan") authorized the reserve of 2,200,000 shares of unissued common stock for issuance pursuant to the 1996 Plan. The 2001 Stock Option Plan (the "2001 Plan," collectively with the 1996 Plan, the "Plans") authorized the reserve of 1,500,000 shares of unissued common stock for issuance pursuant to the 2001 Plan. Substantially all of the options issued vest over a five-year period at 20% per year and expire seven years from the grant date.
The following table summarizes certain information regarding the Plans at December 31:
The weighted-average fair value of options granted during 2002, 2001 and 2000 was $1.25, $1.21 and $0.34, respectively. For purposes of the pro forma calculation under SFAS No. 123, the fair value of the options granted is estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions used for the 2002, 2001 and 2000 grants:
2002 2001 2000 - -------------------------------------------------------------------------------- Dividend yield 0% 0% 0% Expected volatility 103% 164% 145% Risk-free interest rate 2.87% 4.22% 6.14% Expected life 5 years 5 years 5 years Average remaining contractual life 5.37 years 5.28 years 3.70 years
(16) INCOME TAXES
The provision (benefit) for income taxes for the years ended December 31, 2002, 2001 and 2000 is as follows:
Significant components (temporary differences and carryforwards) that give rise to our net deferred tax asset as of December 31, 2002 and 2001 were as follows:
(DOLLARS IN THOUSANDS)
We are required to recognize all or a portion of our gross deferred tax assets if we believe that it is more likely than not, given the weight of all available evidence, that all or a portion of the benefits of the carryforward losses and other deferred tax assets will be realized. Management believes that, based on the available evidence, it is more likely than not that we will realize the benefit from our gross deferred tax assets, net of the valuation allowance.
A valuation allowance was initially established in 2000 and increased in 2001 because, it was unclear whether we would have sufficient earnings in the then immediate future to ensure realization of our entire gross deferred tax assets, following two consecutive years of significant losses. We are constantly evaluating the anticipated amount and recoverability of the gross deferred tax asset in light of our historical operations and susceptibility to changes in market conditions.
As of December 31, 2002, Federal and State net operating loss carryforwards ("NOLs") totaled approximately $77.2 million, with $3.9 million expiring in 2020, and $73.3 million expiring in 2021.
A reconciliation of the statutory income tax rate to the effective income tax rate, as applied to income (loss) for the years ended December 31, 2002, 2001 and 2000 is as follows:
(17) EARNINGS PER SHARE
The following is a reconciliation of the denominators used in the computations of basic and diluted EPS. The numerator for calculating both basic and diluted EPS is net income.
For the years ended December 31:
For 2001 and 2000 Stock Options of approximately 23,000 and 37,000, respectively, are excluded from the calculation of diluted EPS because their effect is antidiluted in periods where losses are reported.
(18) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table is a summary of financial data by quarter for the years ended December 31, 2002 and 2001:
For the quarters ended
(c) The quarter ended March 31, 2001 includes: (1) a $25.4 million write-down of excess cashflow certificates relating to a sale agreement entered into by us, (2) a $0.8 million charge related to disposition of branches, and (3) a $0.5 million related to restructuring charges. (d) The quarter ended June 30, 2001 includes non-recurring charges principally incurred in connection with the recognition of cost attributable to the disposition and transfer of our servicing platform of $10.7 million and a change in accounting estimate regarding the life expectancy of our equipment of $3.6 million. In addition, we recorded a $1.5 million charge related to a fair value adjustment to a pool of non-performing loans. (e) The quarter ended September 30, 2001 includes a charge of $19.7 million, which represents a fair value adjustment to our remaining excess cashflow certificates. We changed the valuation assumptions we use to estimate fair value. The quarter also includes a charge of $19.3 million related to the extingushment of debt .The quarter also includes a non-recurring charge of $1.4 million relating to professional fees incurred in connection with the Second Exchange Offer.
ITEM 9.
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10.
We incorporate by reference information in our proxy statement that complies with the information called for by Item 10 of Form 10-K. The proxy will be filed at a later date with the Commission.
ITEM 11.
ITEM 11.
We incorporate by reference information in our proxy statement that complies with the information called for by Item 11 of Form 10-K. The proxy will be filed at a later date with the Commission.
ITEM 12.
ITEM 12.
We incorporate by reference information in our proxy statement that complies with the information called for by Item 12 of Form 10-K. The proxy will be filed at a later date with the Commission.
The following securities to be issued under our equity compensation plans at December 31, 2002 have been approved by security holders:
(1) Excluding securities reflected in the first column.
ITEMS 13.
We incorporate by reference information in our proxy statement that complies with the information called for by Item 13
ITEM 14. CONTROLS AND PROCEDURES
Our chief executive officer and chief financial officer, based on their evaluation of our disclosure controls and procedures within the past 90 days, have concluded that such disclosure controls and procedures were effective to ensure that material information relating to the Company and required to be disclosed by us has been made known to them and has been recorded, processed, summarized and reported timely. There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of evaluation.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(A)(1) FINANCIAL STATEMENTS
(A)(3) EXHIBITS:
- --------------- (a) Incorporated by reference from our Registration Statement on Form S-1 (No. 333-11289), filed with the Commission on October 9, 1996. (b) Incorporated by reference from our Current Report on Form 8-K (No. 001-12109), filed with the Commission on July 30, 1997. (c) Incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 1997 (File No. 1-12109), filed with the Commission on March 31, 1998. (d) Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended March 31, 1998 (File No. 1-12109), filed with the Commission on May 12, 1998. (e) Incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 1998 (File No. 1-12109), filed with the Commission on March 31, 1999. (f) Incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 1999 (File No. 1-12109), filed with the Commission on March 31, 2000. (g) Incorporated by reference from our Current Report on Form 8-K (File No. 1-12109), filed with the Commission on August 4, 2000. (h) Incorporated by reference from our Current Report on Form 8-K (File No. 1-12109), filed with the Commission on January 10, 2001. (i) Incorporated by reference from our Current Report on Form 8-K (File No. 1-12109), filed with the Commission on March 2, 2001. (j) Incorporated by reference from our Current Report on Form 8-K (File No. 1-12109), filed with the Commission on March 22, 2001. (k) Incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 2000 (File No. 1-12109), filed with the Commission on April 2, 2001. (l) Incorporated by reference from our Current Report on Form 8-K (File No. 1-12109), filed with the Commission on August 3, 2001. (m) Incorporated by reference from our Annual Report on Form 10-K for the year ended December 31, 2001 (File No. 1-12109), filed with the Commission on April 1, 2002. (n) Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 (File No. 1-12109), filed with the Commission on November 13, 2002. (o) Filed herewith
(B) REPORTS ON FORM 8-K.
On December 23, 2002, we filed a Current Report on Form 8-K under Item 5, in which we announced that, effective December 21, 2002, the exercise price for warrants issued by us under a Warrant Agreement, dated December 21, 2000, by and between the Company and Mellon Investor Services LLP, as warrant agent, was adjusted from $9.10 per share to $0.01 per share in accordance with Section 6 of the Warrant Agreement.
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, thereto duly authorized.
DELTA FINANCIAL CORPORATION (Registrant)
Dated: March 27, 2003 By: /S/ HUGH MILLER -------------------------- Hugh Miller President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
I, Hugh Miller, Chief Executive Officer of Delta Financial Corporation (the "Company"), certify that:
1. I have reviewed this annual report on Form 10-K of the Company;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this annual report;
4. The Company's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Company and we have:
o designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
o evaluated the effectiveness of the Company's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
o presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The Company's other certifying officers and I have disclosed, based on our most recent evaluation, to the Company's auditors and the audit committee of the Company's board of directors (or persons performing the equivalent function):
(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Company's ability to record, process, summarize and report financial data and have identified for the Company's auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal controls; and
6. The Company's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 27, 2003
By:/S/ HUGH MILLER ----------------------------------- Hugh Miller PRESIDENT AND CHIEF EXECUTIVE OFFICER
CERTIFICATION
I, Richard Blass, Chief Financial Officer of Delta Financial Corporation (the "Company"), certify that:
1. I have reviewed this annual report on Form 10-K of the Company;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this annual report;
4. The Company's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Company and we have:
o designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
o evaluated the effectiveness of the Company's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
o presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The Company's other certifying officers and I have disclosed, based on our most recent evaluation, to the Company's auditors and the audit committee of the Company's board of directors (or persons performing the equivalent function):
(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Company's ability to record, process, summarize and report financial data and have identified for the Company's auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal controls; and
6. The Company's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 27, 2003
By: /S/ RICHARD BLASS ------------------------------ Richard Blass EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER
CERTIFICATION OF PRESIDENT AND CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
I, Hugh Miller, President and Chief Executive Officer of Delta Financial Corporation (the "Company"), pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, do hereby certify as follows:
1. The annual report on Form 10-K of the Company for the year ended December 31, 2002 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 such Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Company.
IN WITNESS WHEREOF, I have executed this Certification this 27th day of March, 2003.
/s/HUGH MILLER ------------------------------------- Hugh Miller PRESIDENT AND CHIEF EXECUTIVE OFFICER
CERTIFICATION OF EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
I, Richard Blass, Executive Vice President and Chief Financial Officer of Delta Financial Corporation (the "Company"), pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, do hereby certify as follows:
1. The annual report on Form 10-K of the Company for the year ended December 31, 2002 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 such Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Company.
IN WITNESS WHEREOF, I have executed this Certification this 27th day of March, 2003.
/s/RICHARD BLASS ------------------------------------- Richard Blass EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER