-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, WjTUaxD/6dIqnMdeQDqSv9XLec63Jwciz3LDXsKG4Es1q/xnlGqnftCDdxVFLeM8 jJvg6TR5hXENIBZ03eCQvg== 0000950144-98-006751.txt : 19980522 0000950144-98-006751.hdr.sgml : 19980522 ACCESSION NUMBER: 0000950144-98-006751 CONFORMED SUBMISSION TYPE: 10-Q/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19980228 FILED AS OF DATE: 19980521 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: MEGO MORTGAGE CORP CENTRAL INDEX KEY: 0001023334 STANDARD INDUSTRIAL CLASSIFICATION: MISCELLANEOUS BUSINESS CREDIT INSTITUTION [6159] IRS NUMBER: 880286042 STATE OF INCORPORATION: DE FISCAL YEAR END: 0831 FILING VALUES: FORM TYPE: 10-Q/A SEC ACT: SEC FILE NUMBER: 000-21689 FILM NUMBER: 98629348 BUSINESS ADDRESS: STREET 1: 1000 PARKWOOD CIRCLE STREET 2: SUITE 500 CITY: ATLANTA STATE: GA ZIP: 30339 BUSINESS PHONE: 7709526700 MAIL ADDRESS: STREET 1: 1000 PARKWOOD CIRCLE STREET 2: SUITE 500 CITY: ATLANTA STATE: GA ZIP: 30339 10-Q/A 1 MEGO FINANCIAL CORP 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q/A AMENDMENT NO. 1 (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED: FEBRUARY 28, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________TO _____________ COMMISSION FILE NUMBER: 0-21689 MEGO MORTGAGE CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 88-0286042 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 1000 PARKWOOD CIRCLE, SUITE 500, ATLANTA, GEORGIA 30339 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (770) 952-6700 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: As of May 19, 1998, there were 12,300,000 shares of Common Stock, $.01 par value per share, of the Registrant outstanding. ================================================================================ 2 The Registrant hereby amends the Registrant's Quarterly Report on Form 10-Q for the period ended February 28, 1998 in its entirety. In accordance with Rule 12b-15 promulgated under the Securities Exchange Act of 1934, as amended, the complete text of the Registrant's Amended Quarterly Report on Form 10-Q for the period ended February 28, 1998 follows. Subsequent to February 28, 1998, the Registrant reviewed its underlying assumptions with respect to the probability that the Registrant will be able to use any or all of the deferred tax asset created from the pre-tax losses during the previous six months within a reasonable amount of time. Upon this review, the Registrant determined that based on the weight of available evidence that it is more likely than not that the deferred tax asset relating to the net operating loss carryforwards will not be realized, and has elected to create an allowance (of 100%) of the deferred tax asset relating to the net operating loss carryforward portion of the deferred tax asset. Prior to this adjustment, the Registrant's net loss for the six month period ended February 28, 1998 was $20.2 million and after the adjustment, the Registrant's net loss for the six month period ended February 28, 1998 was $32.5 million. As discussed in Note 4 of the Notes to Condensed Financial Statements, the Registrant is not in compliance with certain covenants on its warehouse line of credit with outstanding balances in the amount of $8.5 million and $40.0 million at August 31, 1997 and February 28, 1998, respectively, and its revolving line of credit with outstanding balances in the amount of $25.0 million and $10.0 million at August 31, 1997 and February 28, 1998, and there is no assurance that the lines of credit will be renewed. As discussed in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations, certain mortgage servicing rights aggregating $3.1 million at February 28, 1998, are subject to termination due to loan default rates in excess of the permitted limit set forth in the related pooling and servicing agreements. Also, as discussed in Part II Other Information - Item 1. Legal Proceedings a class action suit was filed against the Registrant and the Registrant's Chief Executive Officer that alleges, among other things, that the Registrant violated the federal securities laws in connection with the preparation and issuance of the Registrant's financial statements. As discussed in Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations the Registrant is not in compliance with certain covenants in the subordinated notes indenture which prohibits the Registrant from obtaining additional financing. The Registrant has operated on a negative cash flow basis since inception and due to cash flow restrictions, the Registrant has curtailed loan originations and subsequently reduced its work force. During March and April 1998, the Registrant originated only $5.5 million of Conventional Loans, $0.5 million of Title I Loans and $3.3 million of First Mortgage Loans compared to $304.3 million, $18.1 million and $4.8 million, respectively, of Conventional, Title I and First Mortgage Loans for the six months ended February 28, 1998. These matters, among others, raise substantial doubt about the Registrant's ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. In order to return the Registrant to profitability and improve the Registrant's financial position, the Registrant is focusing on the following strategic initiatives: (i) consummation of the recapitalization transactions as described in Note 8 to Notes to Condensed Financial Statements; (ii) balancing whole loan sales on a servicing released or retained basis for cash premiums with the use of securitizations as a method of loan disposition; (iii) implementing cost saving measures; (iv) offering new complementary loan products such as non-conforming first mortgage loans; and (v) diversifying its production channels to include direct loan originations, including through one or more strategic acquisitions of retail lending institutions. If the Registrant is unable to obtain additional equity or financing as a result of the proposed recapitalization, the alternatives potentially available to the Registrant are limited and the Registrant may be forced to consider bankruptcy proceedings. 3 MEGO MORTGAGE CORPORATION INDEX -----
Page ---- PART I FINANCIAL INFORMATION Item 1. Condensed Financial Statements (unaudited) Condensed Statements of Financial Condition at August 31, 1997 and February 28, 1998...........................................1 Condensed Statements of Operations for the Three and Six Months Ended February 28, 1997 and 1998 ....................................................2 Condensed Statements of Cash Flows for the Six Months Ended February 28, 1997 and 1998 .....................................................3 Condensed Statements of Stockholders' Equity for the Six Months Ended February 28, 1998 ..............................................................4 Notes to Condensed Financial Statements.........................................5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations......................................................12 PART II OTHER INFORMATION Item 1. Legal Proceedings..............................................................32 Item 5. Other..........................................................................32 Item 6. Exhibits and Reports on Form 8-K...............................................32 SIGNATURE ................................................................................33
i 4 MEGO MORTGAGE CORPORATION CONDENSED STATEMENTS OF FINANCIAL CONDITION (unaudited)
AUGUST 31, FEBRUARY 28, 1997 1998 -------- -------- (thousands of dollars, except per share amounts) ASSETS Cash and cash equivalents $ 6,104 $ 3,152 Cash deposits, restricted 6,890 10,039 Loans held for sale, net of allowance for credit losses of $100 and $887 9,523 55,820 Mortgage related securities, at fair value 106,299 91,254 Mortgage servicing rights 9,507 8,714 Other receivables 7,945 4,835 Property and equipment, net of accumulated depreciation of $675 and $1,010 2,153 1,847 Organizational costs, net of amortization 289 193 Prepaid debt expenses 2,362 4,791 Prepaid commitment fee 2,333 3,869 Deferred income tax asset -- 2,152 Other assets 795 439 -------- -------- TOTAL ASSETS $154,200 $187,105 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Notes and contracts payable $ 35,572 $ 56,821 Accounts payable and accrued liabilities 17,858 13,387 Allowance for credit losses on loans sold with recourse 7,014 8,514 State income taxes payable 649 -- -------- -------- Total liabilities 61,093 78,722 -------- -------- Subordinated debt 40,000 80,367 -------- -------- Stockholders' equity: Preferred Stock, $.01 par value per share (Authorized--5,000,000 shares) -- -- Common Stock, $.01 par value per share (Authorized--50,000,000 shares; Issued and outstanding--12,300,000 at August 31, 1997 and February 28, 1998) 123 123 Additional paid-in capital 29,185 36,633 Retained earnings (accumulated deficit) 23,799 (8,740) -------- -------- Total stockholders' equity 53,107 28,016 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $154,200 $187,105 ======== ========
See notes to condensed financial statements. 1 5 MEGO MORTGAGE CORPORATION CONDENSED STATEMENTS OF OPERATIONS (unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED FEBRUARY 28, FEBRUARY 28, ----------------------------- ---------------------------- 1997 1998 1997 1998 ------------ ------------ ------------ ------------ (thousands of dollars, except per share amounts) REVENUES: Gain (loss) on sale of loans $ 5,823 $ (1,912) $ 15,424 $ 1,809 Net unrealized gain (loss) on mortgage related securities 3,143 (3,652) 2,908 (16,760) Loan servicing income, net 560 1,310 1,198 2,504 Interest income 2,029 4,879 3,029 9,175 Less: interest expense (1,503) (4,195) (2,148) (7,281) ------------ ------------ ------------ ------------ Net interest income 526 684 881 1,894 ------------ ------------ ------------ ------------ Net revenues (losses) 10,052 (3,570) 20,411 (10,553) ------------ ------------ ------------ ------------ COSTS AND EXPENSES: Net provision for credit losses (800) 706 911 2,296 Depreciation and amortization 156 298 296 506 Other interest 51 150 98 227 General and administrative: Payroll and benefits 2,497 4,624 4,313 9,831 Professional services 560 1,019 991 2,536 Commissions and selling 651 642 1,234 1,332 Sub-servicing fees 372 610 657 1,271 Other services 252 694 457 1,084 Rent and lease expenses 197 365 451 658 Travel 83 276 205 536 Credit reports 380 194 533 466 FHA insurance 75 37 278 143 Other 129 506 526 1,100 ------------ ------------ ------------ ------------ Total costs and expenses 4,603 10,121 10,950 21,986 ------------ ------------ ------------ ------------ INCOME (LOSS) BEFORE INCOME TAXES 5,449 (13,691) 9,461 (32,539) INCOME TAXES 2,078 7,153 3,611 -- ------------ ------------ ------------ ------------ NET INCOME (LOSS) $ 3,371 $ (20,844) $ 5,850 $ (32,539) ============ ============ ============ ============ EARNINGS (LOSS) PER COMMON SHARE: Basic: Net income (loss) $ 0.27 $ (1.69) $ 0.52 $ (2.65) ============ ============ ============ ============ Weighted-average number of common shares outstanding 12,300,000 12,300,000 11,296,133 12,300,000 ============ ============ ============ ============ Diluted: Net income (loss) $ 0.27 $ (1.69) $ 0.51 $ (2.65) ============ ============ ============ ============ Weighted-average number of common shares and assumed conversions 12,476,069 12,300,000 11,463,259 12,300,000 ============ ============ ============ ============
See notes to condensed financial statements. 2 6 MEGO MORTGAGE CORPORATION CONDENSED STATEMENTS OF CASH FLOWS (unaudited)
SIX MONTHS ENDED FEBRUARY 28, ------------------------- 1997 1998 --------- --------- (thousands of dollars) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ 5,850 $ (32,539) --------- --------- Adjustments to reconcile net income (loss) to net cash used in operating activities: Additions to mortgage servicing rights (3,086) (434) Net unrealized loss (gain) on mortgage related securities (2,908) 16,760 Additions to mortgage related securities (26,715) 1,532 Net provisions for estimated credit losses 911 2,296 Depreciation and amortization expense 296 506 Amortization of prepaid debt expense 177 656 Amortization of prepaid commitment fee 264 464 Amortization of mortgage servicing rights 1,108 1,227 Accretion of residual interest on mortgage related securities (1,306) (4,435) Payments on mortgage related securities 503 632 Amortization of mortgage related securities 956 556 Loans originated for sale (174,009) (335,510) Payments on loans held for sale 97 1,179 Proceeds from sale of loans 167,441 286,800 Changes in operating assets and liabilities: Increase in cash deposits, restricted (1,088) (3,149) Decrease (increase) in other assets, net (1,011) 2,755 Decrease in state income taxes payable (672) (649) Increase in deferred income tax asset -- (2,152) Increase (decrease) in other liabilities, net (6,447) 4,052 --------- --------- Total adjustments (45,489) (26,914) --------- --------- Net cash used in operating activities (39,639) (59,453) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (1,119) (30) Proceeds from sale of property and equipment 3 -- --------- --------- Net cash used in investing activities (1,116) (30) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings on notes and contracts payable 123,067 328,802 Payments on notes and contracts payable (126,278) (310,611) Amortization of premium on subordinated debt -- (33) Issuance of subordinated debt 37,750 38,373 Proceeds from sale of common stock 20,658 -- --------- --------- Net cash provided by financing activities 55,197 56,531 --------- --------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 14,442 (2,952) CASH AND CASH EQUIVALENTS--BEGINNING OF PERIOD 443 6,104 --------- --------- CASH AND CASH EQUIVALENTS--END OF PERIOD $ 14,885 $ 3,152 ========= ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 1,041 $ 4,602 ========= ========= State income taxes $ 1,241 $ 493 ========= ========= SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES: Addition to prepaid commitment fee and Due to Mego Financial Corp. in connection with loan sale commitment received $ 3,000 $ -- ========= ========= Increase in deferred federal income tax asset related to Spin-off $ -- $ 2,354 ========= =========
See notes to condensed financial statements. 3 7 MEGO MORTGAGE CORPORATION CONDENSED STATEMENTS OF STOCKHOLDERS' EQUITY (unaudited)
COMMON STOCK $.01 PAR VALUE ADDITIONAL -------------------------- PAID-IN RETAINED SHARES AMOUNT CAPITAL EARNINGS TOTAL ---------- ---------- ---------- ---------- ---------- (thousands of dollars, except per share amounts) Balance at August 31, 1997 12,300,000 $ 123 $ 29,185 $ 23,799 $ 53,107 Increase in additional paid-in capital due to adjustment of deferred federal income tax asset related to Spin-off -- -- 2,354 -- 2,354 Increase in additional paid-in capital due to settlement of amount payable to Mego Financial Corp. related to Spin-off (see Note 5 of Notes to Condensed Financial Statements) -- -- 5,094 -- 5,094 Net loss for the six months ended February 28, 1998 -- -- -- (32,539) (32,539) ---------- ---------- ---------- ---------- ---------- Balance at February 28, 1998 12,300,000 $ 123 $ 36,633 $ (8,740) $ 28,016 ========== ========== ========== ========== ==========
See notes to condensed financial statements. 4 8 MEGO MORTGAGE CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS FOR THE THREE AND SIX MONTHS ENDED FEBRUARY 28, 1997 AND 1998 1. CONDENSED FINANCIAL STATEMENTS In the opinion of management, when read in conjunction with the audited Financial Statements for the years ended August 31, 1996 and 1997, contained in the Form 10-K of Mego Mortgage Corporation filed with the Securities and Exchange Commission for the year ended August 31, 1997, the accompanying unaudited Condensed Financial Statements contain all of the information necessary to present fairly the financial position of Mego Mortgage Corporation at February 28, 1998, the results of its operations for the three and six months ended February 28, 1997 and 1998, the change in stockholders' equity for the six months ended February 28, 1998 and the cash flows for the six months ended February 28, 1997 and 1998. Certain reclassifications have been made to conform prior periods with the current period presentation. The preparation of financial statements in conformity with generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. In the opinion of management, all material adjustments necessary for the fair presentation of these statements have been included herein which are normal and recurring in nature. The results of operations for the three and six months ended February 28, 1998 are not necessarily indicative of the results to be expected for the full year. 2. NATURE OF OPERATIONS Mego Mortgage Corporation (the "Company") was incorporated on June 12, 1992, in the state of Delaware. The Company, through its loan correspondents and home improvement contractors, is primarily engaged in the business of originating, selling, servicing and pooling home improvement and debt consolidation loans, certain of which qualify under the provisions of Title I of the National Housing Act which is administered by the U.S. Department of Housing and Urban Development ("HUD"). Pursuant to the Title I credit insurance program, 90% of the principal balances of the loans are U.S. government insured ("Title I Loans"), with cumulative maximum coverage equal to 10% of all Title I Loans originated by the Company. In May 1996, the Company commenced the origination of conventional home improvement loans, generally secured by residential real estate, and debt consolidation loans ("Conventional Loans") through its network of loan correspondents and dealers. In December 1997, the Company commenced the origination of subprime conventional residential first mortgage loans ("First Mortgage Loans") solely for sale at cash premiums in the secondary market, without recourse for credit losses or risk of prepayment. During the six months ended February 28, 1998, the Company's loan originations were comprised of 93.0% Conventional Loans, 5.5% Title I Loans and 1.5% First Mortgage Loans. The Company was formed as a wholly-owned subsidiary of Mego Financial Corp. ("Mego Financial") and remained so until November 1996, when the Company issued 2.3 million shares of its common stock, $.01 par value per share (the "Common Stock"), in an underwritten public offering (the "IPO") at $10.00 per share. As a result of this transaction, Mego Financial's ownership in the Company was reduced from 100% at August 31, 1996 to 81.3%. Concurrently with the Common Stock offering, the Company issued $40.0 million of 12.5% senior subordinated notes due in 2001 in an underwritten public offering. In October 1997, the Company issued an additional $40.0 million of 12.5% senior subordinated notes due in 2001 in a private placement (the "Private Placement"). The proceeds from the offerings received by the Company have been used to repay borrowings and provide funds for originations and securitizations of loans. See Note 8. On September 2, 1997, Mego Financial distributed all of its 10 million shares of the Company's Common Stock to Mego Financial shareholders in a tax-free spin-off (the "Spin-off"). 5 9 MEGO MORTGAGE CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued) FOR THE THREE AND SIX MONTHS ENDED FEBRUARY 28, 1997 AND 1998 3. RECENT DEVELOPMENTS In January 1998, in order to improve its cash position, the Company entered into the Excess Yield and Servicing Rights Purchase and Assumption Agreement (the "Excess Yield Agreement") with a financial institution with which the Company has a master loan purchase and servicing agreement providing for the purchase of up to $2.0 billion in loans over a five year period (the "Master Purchase Agreement"). Pursuant to the Excess Yield Agreement, the Company sold the excess yield and servicing rights pertaining to approximately $175.5 million of Conventional Loans which had previously been sold under the Master Purchase Agreement. In the aggregate, when combined with the original sales proceeds, the Company received a purchase price equivalent to 101% of the principal balance of the Conventional Loans. In February, March and April 1998, the First, Second and Third Amendments to the Excess Yield Agreement were executed pursuant to which an additional $19.5 million of Conventional Loans were sold. These transactions resulted in a loss of approximately $417,000 and generated approximately $4.5 million in cash proceeds to the Company. The Company is to receive additional compensation in the form of sales commissions upon the eventual disposition of certain of these Conventional Loans in the secondary market. The amount of the sales commissions will depend on the timing of those sales and the identities of the eventual purchasers. Approximately $99.0 million of these Conventional Loans had been resold in the secondary market by the end of March 1998. The remaining balance of these Conventional Loans of approximately $90.0 million are expected to be pooled with other Conventional Loans held by that financial institution with the intention of disposing of them in an asset-backed securitization in June 1998. The Company is to receive a two-thirds residual interest pertaining to the portion of Conventional Loans originated by the Company which are disposed of in that securitization. Prior to eventual disposition of the Conventional Loans, there is limited recourse to the Company for repurchase of those loans which become more than 60 days contractually delinquent. The amount of this recourse is limited to 2-1/2% of the principal balance of the loans as of the date they became subject to the Excess Yield Agreement. The servicing rights of these loans will transferred to a third party and a reversal of servicing rights of approximately $1.2 million was recorded pursuant to this transaction. In April 1998, an agreement was made to adjust by $5.3 million the federal income tax portion of a payable that the Company owed Mego Financial as a result of the Company filing a consolidated federal income tax return with Mego Financial's affiliated group prior to the Spin-off. See Note 5. 4. FINANCING ARRANGEMENTS The Company has four significant sources of financing: (i) a warehouse line of credit for up to $55.0 million decreasing in stages to $35.0 million at March 4, 1998 and subsequently to $16.0 million (the "Warehouse Line"), which matures on May 29, 1998 at which time the outstanding balance thereunder is payable in full; (ii) a revolving credit facility for up to $25.0 million, less amounts outstanding under repurchase agreements (the "First Revolving Credit Facility"); (iii) a second revolving credit facility for up to $5.0 million which may, under certain circumstances, be increased to $8.8 million (the "Second Revolving Credit Facility"); and (iv) $80.0 million of outstanding 12 1/2% Senior Subordinated Notes due 2001 (the "Notes"). In addition, the Company has the Master Purchase Agreement providing for the purchase of up to $2.0 billion in loans over a five year period. Pursuant to a letter agreement dated December 29, 1997, the Master Purchase Agreement may be amended to provide for the purchase of up to $3.0 billion in loans over the period ending September 2001. The Company is currently not in compliance with certain terms of the Warehouse Line, under which $14.5 million is presently outstanding, because the Company is not in compliance with the adjusted tangible net worth requirement and the amount outstanding exceeds the amount permitted to be borrowed thereunder. In addition, the Company does not have purchase commitments covering the pledged loans and has not delivered to the Warehouse Line lenders satisfactory takeout commitments. The Company is also not in compliance with the debt-to-net worth requirement contained in the agreement governing the First Revolving Credit Facility, under which $10.0 million is presently outstanding. In addition, under the terms of the Indenture governing the Notes (the "Indenture"), the Company cannot presently incur additional indebtedness other than Permitted Warehouse Indebtedness (as defined therein) and certain other types of indebtedness because the Company is not in compliance with the consolidated leverage ratio requirement contained in the Indenture. The agent has advised the Company that the Warehouse Line lenders do not intend to renew the Warehouse Line. In February 1998, in order to avoid non-compliance with the terms of the Warehouse Line, the Company entered into an amended and restated credit agreement (the "Amended Credit Agreement") which has been further amended modifying the existing Warehouse Line agreement to, among other things: (i) reduce the amount of the Warehouse Line from $65.0 million to $55.0 million and in stages to $35.0 million by March 4, 1998 and subsequently to $16.0 million (subject to increase with the approval of all of the parties to such agreement); (ii) change the expiration date of the Warehouse Line from June 15, 1998 to May 29, 1998; (iii) add the ability to borrow against First Mortgage Loans in an amount not to exceed 15% of the lenders' aggregate commitment; (iv) reduce the advance rate for certain loan categories; (v) prohibit the payment of dividends by the Company; (vi) limit the amount of "Funded Debt" (as defined therein to mean indebtedness for money borrowed, with certain exceptions) to the sum of (a) 100% of cash, (b) 95% of "loans held for sale, net" and (c) 80% of "Restricted Assets" which are restricted cash, mortgage related securities, mortgage servicing rights and excess servicing rights; and (vii) modify certain of the financial covenants 6 10 MEGO MORTGAGE CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued) FOR THE THREE AND SIX MONTHS ENDED FEBRUARY 28, 1997 AND 1998 to, among other things, require the maintenance of (a) an adjusted leverage ratio of total liabilities (which excludes subordinated debt up to $80.4 million) to adjusted tangible net worth not to exceed 1.75 to 1.0, (b) an adjusted tangible net worth (which includes subordinated debt) of at least $110.0 million plus 75% of positive net income after December 31, 1997 and 100% of any new equity or subordinated debt offering and (c) a tangible net worth (which excludes subordinated debt) of at least $30.0 million plus 75% of positive net income after December 31, 1997 and 100% of any new equity offering. At February 28, 1998, the Company's actual adjusted tangible net worth was $99.1 million, which was $10.9 million less than the required minimum. In addition, the Company agreed to provide satisfactory purchase commitments by March 3, 1998 to the Warehouse Line lenders, covering the then pledged loans in the Warehouse Line. An extension of this compliance date to March 13, 1998 was received and the Company was in compliance with this requirement at that date. As of the date hereof, the Company is not in compliance with the requirement to maintain purchase commitments. In April 1998, the Company entered in an amendment to the Amended Credit Agreement modifying such agreement to, among other things: (i) reduce the amount of the Warehouse Line to $20.0 million by April 17, 1998 and subsequently to $16.0 million; and (ii) change certain definitions relating to the eligibility of loans as collateral under the agreement. As of the date of this report, the Company is not in compliance with the terms of the Warehouse Line because, among other reasons, the amount outstanding under the line exceeds the amount permitted to be borrowed thereunder. The Company has received commitments for the sale of loans, the proceeds of which would be applied to reduce the amount outstanding under the line and would be sufficient to bring the Company in compliance with the terms thereof. However, there can be no assurance that such loan sales will be consummated. As a result of the losses the Company recognized during the six months ended February 28, 1998, the Company was not in compliance with certain provisions of the pledge and security agreement, as amended, governing the First Revolving Credit Facility and is not in compliance with certain provisions of the Indenture governing the Notes. Specifically, the pledge and security agreement governing the First Revolving Credit Facility requires the Company to maintain a debt-to-net worth ratio not to exceed 2.5:1 and at February 28, 1998, the ratio was 4.25:1. The financial institution providing the First Revolving Credit Facility has agreed to waive the non-compliance provided that the debt-to-net worth ratio shall not exceed 6:1 prior to May 31, 1998 after which the ratio may not exceed 2.5:1. Additionally, at February 28, 1998 the Company is required to maintain a minimum net worth of $42.5 million and the Company's actual net worth was $28.0 million. The Indenture governing the Notes includes material covenant restrictions which, among other things, limit the Company's ability to incur indebtedness other than warehouse loans, grant liens on its assets and enter into extraordinary corporate transactions. The Company may not incur indebtedness (other than Permitted Warehouse Indebtedness and certain other limited types of indebtedness) or issue capital stock containing certain terms. At February 28, 1998, the Consolidated Leverage Ratio was 5.52:1. Accordingly, while the Company is not in default under the terms of the Indenture, the Company cannot presently incur additional debt other than Permitted Warehouse Indebtedness and certain other types of indebtedness. The Company can give no assurance that it will be able to remain in compliance with financial covenants under the First Revolving Credit Facility, the Indenture or any of the Company's other credit facilities. Failure to remain in compliance is likely to result in material adverse consequences, including potential bankruptcy proceedings. 5. SETTLEMENT OF AMOUNT PAYABLE TO MEGO FINANCIAL CORP. In April 1998, an agreement was made to adjust by $5.3 million the income tax portion of a payable that the Company owed Mego Financial under a Tax Allocation and Indemnity Agreement dated November 19, 1996. The Company filed a consolidated federal income tax return with Mego Financial's affiliated group prior to the Spin-off under such Tax Allocation and Indemnity Agreement dated November 19, 1996. Following this transaction, the Company will owe Mego Financial $869,000 of which $215,000 is to be paid by conveyance to Mego Financial of certain loans with principal balances of approximately $404,000 with the balance payable in four annual installments. The settlement of the amount payable is recorded as an additional capital contribution on the Company's Statement of Financial Condition. 6. RECENT ACCOUNTING PRONOUNCEMENTS The Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 125") in June 1996. SFAS 125 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. This statement also provides consistent standards for 7 11 MEGO MORTGAGE CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued) FOR THE THREE AND SIX MONTHS ENDED FEBRUARY 28, 1997 AND 1998 distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. It requires that liabilities and derivatives incurred or obtained by transferors as part of a transfer of financial assets be initially measured at fair value. SFAS 125 also requires that servicing assets be measured by allocating the carrying amount between the assets sold and retained interests based on their relative fair values at the date of transfer. Additionally, this statement requires that the servicing assets and liabilities be subsequently measured by (a) amortization in proportion to and over the period of estimated net servicing income or loss and (b) assessment for asset impairment or increased obligation based on their fair values. SFAS 125 requires the Company's excess servicing rights be measured at fair market value and be reclassified as interest only receivables, carried as mortgage related securities, and accounted for in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." As required by SFAS 125, the Company adopted the new requirements effective January 1, 1997, and applied them prospectively. Implementation of SFAS 125 did not have any material impact on the financial statements of the Company, as the book value of the Company's mortgage related securities approximated fair value. The following table reflects the components of mortgage related securities as required by SFAS 125 at February 28, 1998 (thousands of dollars):
Interest only strip securities $ 4,916 Residual interest securities 78,709 Interest only receivables (formerly excess servicing rights) 7,629 ------- Total mortgage related securities $91,254 =======
All mortgage related securities are classified as trading securities and are recorded at their estimated fair values. Changes in the estimated fair values are recorded in current operations. See Note 7. SFAS No. 128, "Earnings per Share" ("SFAS 128") was issued by the FASB in February 1997, effective for financial statements issued after December 15, 1997. SFAS 128 provides simplified standards for the computation and presentation of earnings per share ("EPS"), making EPS comparable to international standards. SFAS 128 requires dual presentation of "Basic" and "Diluted" EPS, by entities with complex capital structures, replacing "Primary" and "Fully-diluted" EPS under Accounting Principles Board ("APB") Opinion No. 15. Basic EPS excludes dilution from common stock equivalents and is computed by dividing income (loss) available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution from common stock equivalents, similar to fully-diluted EPS, but uses only the average stock price during the period as part of the computation. 8 12 MEGO MORTGAGE CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued) FOR THE THREE AND SIX MONTHS ENDED FEBRUARY 28, 1997 AND 1998 Data utilized in calculating pro forma earnings per share under SFAS 128 is as follows:
THREE MONTHS ENDED SIX MONTHS ENDED FEBRUARY 28, FEBRUARY 28, ----------------------------- ------------------------------ 1997 1998 1997 1998 ----------- ----------- ----------- ------------ (thousands of dollars) Basic: Net income (loss) $ 3,371 $ (20,844) $ 5,850 $ (32,539) ============ ============ ============ ============ Weighted-average number of common shares outstanding 12,300,000 12,300,000 11,296,133 12,300,000 ============ ============ ============ ============ Diluted: Net income (loss) $ 3,371 $ (20,844) $ 5,850 $ (32,539) ============ ============ ============ ============ Weighted-average number of common shares and assumed conversions 12,476,069 12,300,000 11,463,259 12,300,000 ============ ============ ============ ============
The following tables reconcile the net income (loss) applicable to common stockholders, basic and diluted shares, and EPS for the following periods:
THREE MONTHS ENDED FEBRUARY 28, 1997 THREE MONTHS ENDED FEBRUARY 28, 1998 ---------------------------------------------- ------------------------------------------------ PER-SHARE PER-SHARE INCOME SHARES AMOUNT INCOME SHARES AMOUNT ------------ ------------ ---------- ------------ ------------ ---------- (thousands of dollars, except per share amounts) Net income (loss) $ 3,371 $ (20,844) BASIC EPS Income (loss) applicable to common stockholders 3,371 12,300,000 $ 0.27 (20,844) 12,300,000 $ (1.69) ------------ ------------ ========== ------------ ------------ ========== Effect of dilutive securities: Warrants -- -- -- -- Stock options -- 176,069 -- -- ------------ ------------ ------------ ------------ DILUTED EPS Income (loss) applicable to common stockholders and assumed conversions $ 3,371 12,476,069 $ 0.27 $ (20,844) 12,300,000 $ (1.69) ============ ============ ========== ============ ============ ==========
9 13 MEGO MORTGAGE CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued) FOR THE THREE AND SIX MONTHS ENDED FEBRUARY 28, 1997 AND 1998
SIX MONTHS ENDED FEBRUARY 28, 1997 SIX MONTHS ENDED FEBRUARY 28, 1998 --------------------------------------------- --------------------------------------------- PER-SHARE PER-SHARE INCOME SHARES AMOUNT INCOME SHARES AMOUNT ------------ ------------ ======== ------------ ------------ ======== (thousands of dollars, except per share amounts) Net income (loss) $ 5,850 $ (32,539) BASIC EPS Income (loss) applicable to common stockholders 5,850 11,296,133 $ 0.52 (32,539) 12,300,000 $ (2.65) ------------ ------------ ======== ------------ ------------ ======== Effect of dilutive securities: Warrants -- -- -- -- Stock options -- 167,126 -- -- ------------ ------------ ------------ ------------ DILUTED EPS Income (loss) applicable to common stockholders and assumed conversions $ 5,850 11,463,259 $ 0.51 $ (32,539) 12,300,000 $ (2.65) ============ ============ ======== ============ ============ ========
In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive Income" ("SFAS No. 130") and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS No. 131 establishes standards of reporting by publicly-held business enterprise and disclosure of information about operating segments in annual financial statements and, to a lesser extent, in interim financial reports issued to shareholders. SFAS Nos. 130 and 131 are effective for fiscal years beginning after December 15, 1997. As both SFAS Nos. 130 and 131 deal with financial statements disclosure, the Company does not anticipate the adoption of these new standards will have a material impact on it financial position, results of operations or cash flows. The Company has not yet determined what its reporting segments will be under SFAS 131. 7. ADJUSTMENTS TO CARRYING VALUES OF MORTGAGE RELATED SECURITIES During the three months ended November 30, 1997, the Company experienced voluntary prepayment activity and delinquencies with respect to its securitized Conventional Loans which substantially exceeded the levels which had been assumed for this time frame. This acceleration in the speed of prepayment has caused management, after consultation with its financial advisors, to adjust as of November 30, 1997, the assumptions previously utilized in calculating the carrying value of its mortgage related securities. The revised prepayment assumptions reflect an annualized prepayment rate of 3% in the first month following a securitization, increasing by level monthly increments up to the 15th month at which time the annualized rate is at 17%. This annualized voluntary prepayment rate is maintained at that level through the 36th month at which time such rate is assumed to decline by 1/2% per month until the 42nd month, at which time the rate is presumed to be 14%. This rate is assumed to be maintained for the remaining life of the loan portfolio. The loss assumptions have also been modified to reflect losses commencing in the third month following a securitization increasing in level monthly increments until a 2% annualized loss rate is achieved in the 18th month. The annualized loss rate is projected to remain at that level throughout the remaining life of the portfolio. On a cumulative basis, this model assumes aggregate losses of approximately 9% of the original portfolio balance. Despite the moderate change in the acceleration of assumed losses, after applying the new voluntary prepayment rates, the cumulative loss assumption of 9% results in approximately the same level of loss as had been previously assumed. At November 30, 1997, the application of such revised prepayment and loss assumptions to the Company's portfolio of mortgage related securities required the Company to adjust the carrying value of such securities by approximately $14.1 million, of which $10.2 million related to Conventional Loans and $3.9 million related to Title I Loans. During the three months ended February 28, 1998, the Company experienced increased levels of over-collateralization and higher than anticipated prepayments on Title I Loans resulting in a downward adjustment to the portfolio of mortgage related securities. The Company also recognized the impairment of the carrying value of a security which had previously been recorded as a whole loan sale, sold servicing retained, whose underlying loans are anticipated to be repurchased and included in a future securitization. As a result of the foregoing, the Company adjusted the carrying value of mortgage related securities with negative adjustments of approximately $3.7 million and $17.7 million for the three and six months ended February 28, 1998, respectively. At February 28, 1998, 10 14 MEGO MORTGAGE CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (Continued) For the three and six months ended February 28, 1997 and 1998 mortgage related securities were $91.3 million compared to $94.3 million at November 30, 1997 and $106.3 million at August 31, 1997. The Company utilizes a 12% discount rate to calculate the present value of cash flow streams. Taken in conjunction with the above prepayment and loss assumptions, management believes these valuations reflect current market values. Because of the inherent uncertainty of the valuations these estimated market values may differ from values that would have been used had a ready market for the securities existed, and the difference could be material. The Company has not obtained an independent valuation of the assumptions utilized in calculating the carrying value of mortgage related securities for any period subsequent to August 31, 1997. 8. PRIVATE PLACEMENT In October 1997, the Company issued $40.0 million of 12.5% senior subordinated notes ("Additional Notes") due in 2001 in the Private Placement which increased the aggregate principal amount of outstanding 12.5% senior subordinated notes from $40.0 million to $80.0 million. The Company used the net proceeds of $38.4 million, after deducting expenses, of the Private Placement to repay $3.9 million of debt due to Mego Financial, $29.0 million to reduce the amounts outstanding under the Company's lines of credit and the balance to provide capital to originate and securitize loans and for working capital. These Additional Notes are subject to the indenture governing all of the Company's senior subordinated notes. In connection with the consent solicitation, the Company made consent payments totaling $392,000 ($10.00 cash per $1,000 principal amount of Exiting Notes) to holders thereof who properly furnished their consents to the amendments to the original indenture. The Company has entered into a registration rights agreement with Friedman, Billings, Ramsey & Co., Inc. ("Registration Rights Agreement") pursuant to which the Company agreed, for the benefit of the holders of the Additional Notes, at the Company's cost, (i) to file a registration statement (the "Exchange Offer Registration Statement") with respect to a registered offer to exchange the Additional Notes ("Exchange Offer") for notes of the Company with terms identical in all material respects to the Additional Notes ("Exchange Notes") (except that the Exchange Notes will not contain terms with respect to transfer restrictions or interest rate increases) with the Securities and Exchange Commission ("SEC") by November 28, 1997 and (ii) to use its best efforts to cause the Exchange Offer Registration Statement to be declared effective under the Securities Act on or before January 12, 1998. The Company did not meet the January 12, 1998 deadline and expects to pay additional interest of less than $20,000. Promptly after the Exchange Offer Registration Statement has been declared effective, the Company will offer the Exchange Notes in exchange for surrender of the Additional Notes. The Company will keep the Exchange Offer open for not less than 30 days (or longer if required by applicable law) after the date notice of the Exchange Offer is mailed to the holders of the Additional Notes. For each Additional Note validly tendered to the Company pursuant to the Exchange Offer and not withdrawn by the holder thereof, the holder of such Additional Note will receive Exchange Notes having a principal amount equal to that of the tendered Additional Note. Interest on each Exchange Note will accrue from the last interest payment date on which interest was paid on the tendered Additional Notes in exchange therefor or, if no interest has been paid on such Additional Notes, from the date of its original issue. The Company filed the Exchange Offer Registration statement with the SEC on November 28, 1997, however, such registration statement has not been declared effective by the SEC. 9. INCOME TAXES The Company has filed consolidated federal income tax returns with Mego Financial. Income taxes for the Company are provided for on a separate return basis. As part of a tax sharing arrangement, the Company has recorded a liability to Mego Financial for federal income taxes applied to the Company's financial statement income after giving consideration to applicable income tax law and statutory rates. The Company accounts for taxes under SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires an asset and liability approach. For periods after September 2, 1997 (after the Spin-off), the Company will file separate consolidated federal income tax returns. The provision for income taxes includes deferred income taxes, which result from reporting items of income and expense for financial statement purposes in different accounting periods than for income tax purposes. The Company also provides for state income taxes at the rate of 6% of income before income taxes. The Company provides a valuation allowance for deferred tax assets when management determines, based on the weight of available evidence, that it is more likely than not that some portion or all of the deferred tax asset will not be realized. Management determined that at February 28, 1998 a valuation allowance was required for the net operating loss deferred tax asset in the amount of $12.3 million which resulted in income tax expense for the three months ended February 28, 1998 in the amount of $7.2 million and a reversal of the income tax benefit of $7.2 million recorded for the three months ended November 30, 1997. Prior to the Spin-off, the Company recorded a liability to Mego Financial for federal income taxes at the statutory rate (currently 34%). State income taxes are computed at the appropriate state rate (6%) net of any available operating loss carryovers and are recorded as state income taxes payable. Income tax expense (benefit) has been computed as follows:
FOR THE THREE FOR THE SIX MONTHS ENDED MONTHS ENDED FEBRUARY 28, FEBRUARY 28, --------------------- --------------------------- 1997 1998 1997 1998 --------- --------- ------------ ------------ (THOUSANDS OF DOLLARS) Income (loss) before income taxes....................... $ 5,449 $ (13,691) $9,461 $(32,539) ======= ========= ====== ======== Federal income taxes (benefit) at 34% of income............ $ 1,853 $ (4,655) $3,217 $(11,063) State income taxes (benefit), net of federal income tax benefit..................... 218 (548) 571 (1,302) Increase in valuation allowance................... -- 12,349 -- 12,349 Other......................... 7 7 (177) 16 ------- --------- ------ -------- Income tax expense............ $ 2,078 $ 7,153 $3,611 $ -- ======= ========= ====== ======== Income tax expense is comprised of the following: Current..................... $ 2,078 $ 7,153 $3,037 $ -- Deferred.................... -- -- 574 -- ------- --------- ------ -------- Total............... $ 2,078 $ 7,153 $3,611 $ -- ======= ========= ====== ========
11 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS The following Management's Discussion and Analysis of Financial Condition and Results of Operations section contains certain forward-looking statements and information relating to Mego Mortgage Corporation (the "Company") that are based on the beliefs of management as well as assumptions made by and information currently available to management. Such forward-looking statements include, without limitation, the Company's expectation and estimates as to the Company's business operations, including the introduction of new loan programs and products and future financial performance, including growth in revenues and net income and cash flows. In addition, included herein the words "anticipates," "believes," "estimates," "expects," "plans," "intends" and similar expressions, as they relate to the Company or its management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company's management with respect to future events and are subject to certain risks, uncertainties and assumptions. Also, the Company specifically advises readers that the factors listed under the caption "Liquidity and Capital Resources" could cause actual results to differ materially from those expressed in any forward-looking statement. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated or expected. The following discussion and analysis should be read in conjunction with the Condensed Financial Statements, including the notes thereto, contained elsewhere herein and in the Financial Statements, including the notes thereto, in the Company's Form 10-K for the fiscal year ended August 31, 1997. GENERAL The Company is a specialized consumer finance company that originates, purchases, sells, securitizes and services consumer loans consisting primarily of conventional uninsured home improvement and debt consolidation loans which are generally secured by liens on residential property ("Conventional Loans"). The Company historically has originated loans through its network of independent correspondent lenders ("Correspondents") and home improvement construction contractors ("Dealers"). To both broaden its channels of origination and reduce its overall cost of loan acquisition, the Company commenced direct origination of Conventional Loans in the three months ended November 30, 1997. To facilitate these new origination channels, the Company has entered into contractual arrangements with third party financial institutions for the acquisition of qualified consumer loan referrals. These referrals do not conform to that institution's programs, but may be suitable for approval and funding under the Company's product lines that are not available at the referring institution. By making direct loans to consumers, the Company avoids the payment of premiums which it incurs with the acquisition of completed loans from its Correspondent network. It is anticipated that the origination fees charged to consumers on the direct loans will adequately cover the cost of the referrals and thereby place the Company on a positive cash flow basis with respect to these direct loan originations. Until May 1996, the Company originated only home improvement loans insured under the Title I credit insurance program ("Title I Loans") of the Federal Housing Administration (the "FHA"). Subject to certain limitations, the Title I program provides for insurance of 90% of the principal balance of the loan and certain other costs. The Company began offering Conventional Loans through its Correspondents in May 1996 and through its Dealers in September 1996. Since May 1996, Conventional Loans have accounted for an increasing portion of the Company's loan originations. For the three months ended February 28, 1997 and 1998, the Company originated $89.7 million and $116.5 million of Conventional Loans, respectively, which constituted 80.6% and 91.5%, respectively, of the Company's total loan originations during the periods. For the six months ended February 28, 1997 and 1998, the Company originated $120.8 million and $304.3 million of Conventional Loans, respectively, which constituted 69.6% and 93.0%, respectively, of the Company's total loan originations during the periods. In December 1997, the Company began originating subprime residential first mortgage loans ("First Mortgage Loans"). The Company originates First Mortgage Loans through the correspondent loan source network as well as through specifically approved brokers. The Company believes that there are several advantages to 12 16 originating First Mortgage Loans including (i) the existence of a more liquid secondary market for such loans, (ii) the average principal amount of such loans is typically two times greater than that of a Conventional Loan and (iii) such loans are originated by correspondents at lower premiums. For the six months ended February 28, 1998, the Company originated $4.8 million of First Mortgage Loans. The Company has historically sold substantially all the loans it originated either through securitizations at a yield below the stated interest rate on the loans, generally retaining the right to service the loans and to receive any amounts in excess of the yield to the purchasers, or through whole loan sales to third party institutional purchasers. In connection with whole loan sales, the Company either sells the loans on a servicing retained basis at a yield below the stated interest rate on the loans or on a servicing released basis. Currently, sales on a servicing released basis and some sales on a servicing retained basis are at a premium. In connection with securitizations, certain of the regular interests of the related securitizations were sold, with the interest only and residual class securities generally retained by the Company. The Company presently intends to dispose of a majority of its loan originations on an ongoing basis through whole loan sales on a servicing released basis, at a premium, as opposed to securitizations. The Company has operated since March 1994 on a negative cash flow basis. As a result of such negative cash flow of the Company's operations, the provisions under the indenture governing the Company's senior subordinated notes limiting the Company's ability to incur additional indebtedness and the reduction of the Company's warehouse line of credit ("Warehouse Line") from $55.0 million to $16.0 million, the Company has substantially curtailed the origination of loans during the quarter ended February 28, 1998. Loan originations for the three months ended February 28, 1998 totaled $127.3 million as compared to $199.9 million for the three months ended November 30, 1997. In conjunction with this curtailment, the Company restructured its workforce which resulted in a 32% reduction in the number of employees from its peak in early January 1998 through March 1998. The Company has refocused its operations on the origination of those loan products which are either cash flow positive at the time of their acquisition or substantially less expensive to acquire than the historical business previously generated by the Dealer and Correspondent divisions. In this regard, the Company is intensifying its efforts toward direct consumer loan origination which generates fees to the Company at the time of origination. Additional efforts are being made to expand the Company's First Mortgage Loan originations which have a lower cost of acquisition as well as a more liquid secondary market for loan dispositions. There can be no assurance, however, that the Company will be successful in its efforts to achieve a cash flow neutral or positive basis. The Company proposes to engage in a series of transactions to recapitalize the Company. While no definitive agreements have been executed and no terms have been determined, the Company proposes to raise $40.0 to $60.0 million through a private placement of equity securities at an anticipated price of between $1.50 and $2.00. The Company is also proposing to offer to exchange new subordinated notes and convertible preferred stock, subject to certain limitations, for all of the outstanding $80.0 million of 12 1/2% Senior Subordinated Notes due 2001 (the "Notes"). Consummation of the private placement is expected to be contingent upon holders of substantially all of the outstanding Notes accepting the exchange offer. The Company expects to commence the private placement and the exchange offer promptly. Offers will be made only by means of an offering memorandum. The securities proposed to be issued pursuant to the private placement and the exchange offer will not be registered under the Securities Act of 1933 and may not be offered or sold in the United States absent registration or an applicable exemption from such registration. The Company contemplates that following consummation of the private placement and the exchange offer it will issue to common stock holders of record on May 13, 1998, rights to purchase additional shares of common stock at the same price as common stock is sold in the private placement. Due to pressing cash requirements, the Company has curtailed its loan originations and proposes to use the net proceeds of the private placement and the rights offering to provide capital to originate loans and for general corporate purposes. The securities proposed to be issued pursuant to the rights offering will be registered under the Securities Act of 1933 and the offering will be made only by means of a prospectus. Management of the Company believes that if the Company is unable to complete the transactions to recapitalize the Company the alternatives potentially available to the Company are limited and that the Company may be forced to consider bankruptcy proceedings. The Company recognizes revenue from gain on sale of loans, unrealized gain on mortgage related securities, interest income and servicing income. Interest income, net, represents the interest received on loans in the Company's portfolio prior to their sale, plus accretion of interest related to mortgage related securities, net of interest paid under its credit agreements. The Company continues to service a substantial amount of loans sold through February 28, 1998. However, during the six months ended February 28, 1998, $113.1 million of loans were sold with servicing released. Net loan servicing income represents servicing fee income and other ancillary fees received for servicing loans less the amortization of capitalized mortgage servicing rights, and through January 1, 1997, the date of adoption of Statement of Financial Accounting Standards No. 125 ("SFAS 125"), the amortization of excess servicing rights. Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income. Excess servicing rights were amortized in proportion to and over the estimated lives of the related loans. Gain on sale of loans includes the gain on sale resulting from securitizations and whole loan sales. The gain on sale in securitization transactions is determined by an allocation of the cost of the securities based on the relative fair values of the interests sold and the interests retained. In a securitization, the Company retains a residual interest security and may retain an interest only strip security. The fair value of the residual interest and interest only strip security is the present value of the estimated net cash flows to be received after considering the effects of estimated prepayments and credit losses and, where applicable, net of estimated FHA insurance recoveries on Title I Loans. The net unrealized gain (loss) on mortgage related securities represents the difference between the allocated cost basis of the securities and the estimated fair value. 13 17 The Company carries interest only and residual securities at fair value. As such, the carrying value of these securities is affected by changes in market interest rates and prepayment and loss experiences of these and similar securities. The Company estimates the fair value of the interest only and residual securities utilizing prepayment and credit loss assumptions the Company believes to be appropriate for each particular securitization. To the Company's knowledge, there is no active market for the sale of these interest only and residual securities. Because of the inherent uncertainty of the valuations, those estimated market values may differ from values that would have been used had a ready market for the securities existed and the difference could be material. During the three months ended November 30, 1997, the Company experienced voluntary prepayment activity and delinquencies with respect to its securitized Conventional Loans which substantially exceeded the levels which had been assumed for this time frame. As a result of this increase, the Company adjusted the assumptions previously utilized in calculating the carrying value of its mortgage related securities. The revised prepayment assumptions presume an annualized prepayment rate of 3% in the first month following a securitization, increasing by level monthly increments up to the 15th month at which time the annualized rate is at 17%. This annualized voluntary prepayment rate is maintained at that level through the 36th month, at which time such rate is assumed to decline by 1/2% per month until the 42nd month, at which time the rate is presumed to be 14%. This rate is assumed to be maintained for the remaining life of the loan portfolio. The Company's loss assumptions have been further modified to reflect losses commencing in the third month following a securitization increasing in level monthly increments until a 2% annualized loss rate is achieved in the 18th month. This annualized loss rate is projected to remain at that level throughout the remaining life of the portfolio. On a cumulative basis, this loss model assumes aggregate losses of approximately 9% of the original portfolio balance. Despite the moderate change in the acceleration of assumed losses, after applying the new voluntary prepayment rates, the cumulative loss assumption of 9% results in approximately the same level of loss as had previously been assumed. The Company utilizes a 12% discount rate to calculate the present value of cash flow streams. Taken in conjunction with the above prepayment and loss assumptions, management believes these valuations reflect current market values. See Note 7 to Notes to Condensed Financial Statements. The application of such revised prepayment and loss assumptions to the Company's portfolio of mortgage related securities generated from its securitizations required the Company to adjust the carrying value of such securities by approximately $10.2 million at November 30, 1997. Additional negative adjustments of approximately $3.9 million to the carrying value of mortgage related securities pertaining to Title I loan securitizations and other sales were also recognized during the three months ended November 30, 1997 due to a higher level of defaults and prepayments than had been previously anticipated. Following a calculation of the effect of accretion of interest, amortization of cash flow residuals and increased prepayment penalty fees, the carrying value of the Company's mortgage related securities was reduced to $94.3 million as of November 30, 1997 from $106.3 million as of August 31, 1997. As a result of, among other things, the application of the revised prepayment and loss assumptions, the Company was required to take a $14.1 million charge to earnings during the three months ended November 30, 1997. During the three months ended February 28, 1998, negative adjustments of approximately $3.7 million were recognized due to increased required levels of over-collateralization and higher than anticipated prepayments on Title I Loans and the recognition of an impairment to the carrying value of a mortgage related security which had previously been recorded as a whole loan sale, sold servicing retained, whose underlying loans are anticipated to be repurchased and included in a future securitization. For the six months ended February 28, 1998, the Company incurred a net loss of $32.5 million as compared to net income of $5.9 million for the six months ended February 28, 1997. The rate of voluntary prepayments on the securitized Conventional Loans during December 1997, January 1998 and February 1998 was significantly lower than the new assumptions predicted. However, there can be no assurance that this decrease in prepayments is a trend or that, if it is a trend, the trend will continue. Although the Company believes that it has made reasonable estimates of the fair value of the mortgage related securities in formulating the revised prepayment and loss assumptions, the rate of prepayments and default rates utilized are estimates, and actual experience may vary from these estimates and the difference may be material. The Company has not obtained an independent valuation of the assumptions utilized in calculating the carrying value of the Company's mortgage related securities for any period subsequent to August 31, 1997. There can be no assurance that the revised prepayment and loss assumptions used to determine the fair value of the Company's mortgage related securities and mortgage servicing rights will remain appropriate for the life of the loans. If actual loan prepayments or credit losses exceed the Company's estimates, the carrying value of the Company's mortgage related securities and mortgage servicing rights may have to be further written down through a charge against earnings. 14 18 The Company has four significant sources of financing: (i) the Warehouse Line for up to $16.0 million; (ii) a revolving line of credit for up to $25.0 million, less amounts outstanding under repurchase agreements (the "First Revolving Credit Facility"); (iii) a second revolving credit facility for up to $5.0 million which, under certain circumstances, may be increased to $8.8 million (the "Second Revolving Credit Facility"); and (iv) $80.0 million of outstanding Notes. As a result of the losses the Company recognized during the six months ended February 28, 1998, the Company was not in compliance with certain provisions of the pledge and security agreement, as amended, governing the First Revolving Credit Facility and is not in compliance with certain provisions of the Indenture governing the Notes (the "Indenture") and the credit agreement governing the Warehouse Line. While the Company is not in default under the terms of the Indenture, the Company cannot presently incur additional debt other than Permitted Warehouse Indebtedness (as defined therein) and certain other types of indebtedness. The Company must maintain external sources of cash to fund its operations and therefore must maintain its sources of financing or identify other external sources of funds. See "Liquidity and Capital Resources." The Company is currently not in compliance with certain terms of the Warehouse Line, under which $14.5 million is presently outstanding, because the Company is not in compliance with the adjusted tangible net worth requirement and the amount outstanding exceeds the amount permitted to be borrowed thereunder. In addition, the Company does not have purchase commitments covering the pledged loans and has not delivered to the Warehouse Line lenders satisfactory takeout commitments. The Company is also not in compliance with the debt-to-net worth requirement contained in the agreement governing the First Revolving Credit Facility, under which $10.0 million is presently outstanding. In addition, under the terms of the Indenture, the Company cannot presently incur additional indebtedness other than Permitted Warehouse Indebtedness and certain other types of indebtedness because the Company is not in compliance with the consolidated leverage ratio requirement contained in the Indenture. The Company has operated since March 1994 on a negative cash flow basis. As a result of such negative cash flow, since December 31, 1997, the Company has significantly decreased the volume of its loan originations. In addition, partially as a result of such negative cash flow, and as part of the Company's cost saving measures, the Company completed an internal restructuring, resulting in a reduction of approximately 32% of its workforce from its peak in early January 1998, primarily as a result of a substantial reduction of the Dealer Division. The Dealer Division generated approximately 4.6% and 7.6% of Conventional and total loan originations, respectively, in the six months ended February 28, 1998, but accounted for a disproportionately higher amount of the Company's costs. The Company will continue to originate Title I Loans through its Correspondent Division, intended solely for sale to the Federal Home Loan Mortgage Association ("FNMA"). 15 19 RESULTS OF OPERATIONS The following table sets forth certain data regarding loans originated and serviced by the Company during the three and six months ended February 28, 1997 and 1998:
THREE MONTHS ENDED FEBRUARY 28, SIX MONTHS ENDED FEBRUARY 28, ---------------------------------------- --------------------------------------- 1997 1998 1997 1998 ------------------- ------------------- ------------------ ------------------- (thousands of dollars) PRINCIPAL BALANCE OF LOANS ORIGINATED: Correspondents: Title I $ 11,346 10.2% $ 2,014 1.6% $ 30,511 17.5% $ 6,916 2.1% Conventional 87,911 79.0 107,695 84.6 118,762 68.4 286,453 87.6 -------- ------- -------- ------- -------- ------- -------- ------- Total Correspondents 99,257 89.2 109,709 86.2 149,273 85.9 293,369 89.7 -------- ------- -------- ------- -------- ------- -------- ------- Dealers: Title I 10,186 9.2 4,014 3.2 22,425 12.9 11,214 3.4 Conventional 1,817 1.6 5,092 4.0 2,024 1.2 13,846 4.2 -------- ------- -------- ------- -------- ------- -------- ------- Total Dealers 12,003 10.8 9,106 7.2 24,449 14.1 25,060 7.6 -------- ------- -------- ------- -------- ------- -------- ------- Retail: Conventional -- -- 3,717 2.9 -- -- 3,964 1.2 First Mortgage -- -- 243 0.2 -- -- 243 0.1 -------- ------- -------- ------- -------- ------- -------- ------- Total Retail -- -- 3,960 3.1 -- -- 4,207 1.3 -------- ------- -------- ------- -------- ------- -------- ------- First Mortgage -- -- 4,509 3.5 -- -- 4,509 1.4 -------- ------- -------- ------- -------- ------- -------- ------- Total Principal Amount of Loans Originated $111,260 100.0% $127,284 100.0% $173,722 100.0% $327,145 100.0% ======== ======= ======== ======= ======== ======= ======== ======= NUMBER OF LOANS ORIGINATED: Correspondents: Title I 551 12.5% 95 2.3% 1,493 20.0% 320 2.9% Conventional 2,884 65.7 3,320 78.9 3,960 53.2 8,760 80.0 -------- ------- -------- ------- -------- ------- -------- ------- Total Correspondents 3,435 78.2 3,415 81.2 5,453 73.2 9,080 82.9 -------- ------- -------- ------- -------- ------- -------- ------- Dealers: Title I 873 19.9 357 8.5 1,907 25.6 944 8.6 Conventional 83 1.9 244 5.8 93 1.2 733 6.7 -------- ------- -------- ------- -------- ------- -------- ------- Total Dealers 956 21.8 601 14.3 2,000 26.8 1,677 15.3 -------- ------- -------- ------- -------- ------- -------- ------- Retail: Conventional -- -- 111 2.7 -- -- 119 1.1 First Mortgage -- -- 5 0.1 -- -- 5 -- -------- ------- -------- ------- -------- ------- -------- ------- Total Retail -- -- 116 2.8 -- -- 124 1.1 -------- ------- -------- ------- -------- ------- -------- ------- First Mortgage -- -- 73 1.7 -- -- 73 0.7 -------- ------- -------- ------- -------- ------- -------- ------- Total Number of Loans Originated 4,391 100.0% 4,205 100.0% 7,453 100.0% 10,954 100.0% ======== ======= ======== ======= ======== ======= ======== =======
FEBRUARY 28, ----------------------------------------------------------------- 1997 1998 ---------------------------- ---------------------------- LOANS SERVICED AT END OF PERIOD (INCLUDING LOANS SECURITIZED, SOLD TO INVESTORS AND HELD FOR SALE): Title I $237,633 64.5% $245,921 31.6% Conventional 130,736 35.5 529,887 68.1 First Mortgage -- -- 2,706 0.3 -------- ------- -------- ------- Total Loans Serviced at End of Period $368,369 100.0% $778,514 100.0% ======== ======= ======== =======
16 20 The following table sets forth the principal balance of loans sold or securitized and related gain on sale data for the three and six months ended February 28, 1997 and 1998:
THREE MONTHS ENDED SIX MONTHS ENDED FEBRUARY 28, FEBRUARY 28, ------------------------- ------------------------- 1997 1998 1997 1998 --------- --------- --------- --------- (thousands of dollars) WHOLE LOAN SALES SOLD WITH RECOURSE AND SECURITIZATIONS: Principal amount of loans sold: Title I $ 22,277 $ (7,952)(1) $ 55,666 $ (8,770)(1) Conventional 84,655 47,834 111,775 154,255 --------- --------- --------- --------- Total principal balances $ 106,932 $ 39,882 $ 167,441 $ 145,485 ========= ========= ========= ========= Gain (loss) on sale of loans $ 5,823 $ (3,519) $ 15,424 $ (730) ========= ========= ========= ========= Net unrealized gain (loss) on mortgage related securities $ 3,143 $ (3,661) $ 2,908 $ (16,768) ========= ========= ========= ========= Gain (loss) on sale of loans as a percentage of principal balance of loans sold 5.4% (8.8)% 9.2% (0.5)% Gain (loss) on sale of loans plus net unrealized gain (loss) on mortgage related securities as a percentage of principal balance of loans sold 8.4% (18.0)% 10.9% (12.0)% WHOLE LOAN SALES SOLD WITH SERVICING RELEASED TO FNMA AND OTHERS: Principal amount of loans sold: Title I $ -- $ 10,735 $ -- $ 22,627 Conventional -- 72,668 -- 111,029 First Mortgage -- 2,088 -- 2,088 --------- --------- --------- --------- Total principal balances $ -- $ 85,491 $ -- $ 135,744 ========= ========= ========= ========= Gain on sale of loans $ -- $ 1,607 $ -- $ 2,539 ========= ========= ========= ========= Net unrealized gain on mortgage related securities $ -- $ 9 $ -- $ 8 ========= ========= ========= ========= Gain on sale of loans as a percentage of principal balance of loans sold --% 1.9% --% 1.9% Gain on sale of loans plus net unrealized loss on mortgage related securities as a percentage of principal balance of loans sold --% 1.9% --% 1.9%
- --------- (1) Negative Title I Loan sales resulted from the repurchase of loans sold with recourse from a financial institution and the sale of certain of such loans to FNMA without recourse. The percentage of gain on sale of loans can vary for several reasons, including the relative amounts of Conventional and Title I Loans, each of which type of loan has different (i) estimated prepayment rates, (ii) weighted-average interest rates, (iii) weighted-average maturities, and (iv) estimated future default rates. Typically, the gain on sale of loans through securitizations is higher than on whole loan sales. 17 21 Delinquencies--The following table sets forth the Title I Loan and Conventional Loan delinquency and Title I insurance claims experience of loans serviced by the Company as of the dates indicated:
AUGUST 31, FEBRUARY 28, 1997 1998 -------------- -------------- (thousands of dollars) Delinquency period (1): 31-60 days past due 1.54% 1.53% 61-90 days past due 0.80 0.87 91 days and over past due 3.07 3.95 91 days and over past due, net of claims filed (2) 2.32 3.42 Outstanding claims filed with HUD (3) 0.75 0.53 Outstanding number of Title I insurance claims filed 269 244 Total servicing portfolio $ 628,068 $ 778,514 Title I Loans serviced 255,446 245,921 Conventional Loans serviced 372,622 529,887 First Mortgage Loans serviced -- 2,706 Amount of FHA insurance available for Title I Loans serviced 21,094 17,974(4) Amount of FHA insurance available as a percentage of Title I Loans serviced 8.26% 7.31%(4) Aggregate losses on liquidated loans (5) $ 201 $ 9
- --------------- (1) Represents the dollar amount of delinquent loans as a percentage of the total dollar amount of loans serviced by the Company (including loans owned by the Company) as of the dates indicated. Conventional Loan delinquencies represented 10.35% and 24.37%, respectively, of the Company's total delinquencies at August 31, 1997 and February 28, 1998. (2) Represents the dollar amount of delinquent loans net of delinquent Title I Loans for which claims have been filed with the U.S. Department of Housing and Urban Development ("HUD") and payment is pending as a percentage of the total dollar amount of total loans serviced by the Company (including loans owned by the Company) as of the dates indicated. (3) Represents the dollar amount of delinquent Title I Loans for which claims have been filed with HUD and payment is pending as a percentage of the total dollar amount of total loans serviced by the Company (including loans owned by the Company) as of the dates indicated. (4) If all claims filed with HUD had been processed as of February 28, 1998, the amount of FHA insurance available for all serviced Title I Loans would have been reduced to $14.0 million, which as a percentage of Title I Loans serviced would have been 5.80%. (5) On Title I Loans, a loss is recognized upon receipt of payment of a claim or final rejection thereof. Claims paid in a period may relate to a claim filed in an earlier period. Since the Company commenced its Title I lending operations in March 1994, there has been no final rejection of a claim by the FHA. Aggregate losses on liquidated Title I Loans related to 994 Title I insurance claims made by the Company, as servicer, since commencing operations through February 28, 1998. Losses on Title I Loans liquidated will increase as the balance of the claims are processed by HUD. The Company has received an average payment from HUD equal to 90% of the outstanding principal balance of such Title I Loans, plus appropriate interest and costs. The pooling and servicing agreements and sale and servicing agreements related to the Company's securitization transactions contain provisions with respect to the maximum permitted loan delinquency rates and loan default rates, which, if exceeded, would allow the termination of the Company's right to service the related loans. At February 28, 1998, the rolling three-month average annual default rates on the pools of loans sold in the March 1996, August 1996 and December 1996 securitization transactions exceeded 6.5%, the permitted limit set 18 22 forth in the related pooling and servicing agreements. Accordingly, this condition could result in the termination of the Company's servicing rights with respect to those pools of loans by the trustee, the master servicer or the insurance company providing credit enhancement for those transactions. No assurance can be given that the insurance company, trustee or master servicer will not exercise its right to terminate the Company's servicing rights. In the event of such termination, there would be an adverse effect on the valuation of the Company's mortgage servicing rights and results of operations in the amount of such mortgage servicing rights ($3.1 million before tax at February 28, 1998) on the date of termination. The Company has taken certain steps designed to reduce the default rates on these pools of loans as well as its other loans. These steps include the hiring of a new vice president in charge of collection of delinquent loans, the hiring of additional personnel to collect delinquent accounts, the assignment of additional personnel specifically assigned to the collection of these pools of loans and the renegotiation of the terms of certain delinquent accounts in these pools of loans within the guidelines promulgated by HUD. The pooling and servicing agreements and sale and servicing agreements also require that certain delinquency and default rates not exceed certain thresholds. If these thresholds are exceeded, higher levels of over-collateralization are required which can cause a delay in cash receipts to the Company as a holder of the residual interest, causing an adverse valuation adjustment to the carrying value of the residual security. Delinquencies of loans serviced by the Company have also decreased the amount of loan servicing income recorded during the six months ended February 28, 1998 as the Company's loan servicing income has been reduced by the amount of interest advanced to the owners of these loans, which advances the Company expects to recover. Delinquencies on loans serviced by the Company have increased to $49.5 million at February 28, 1998 from $34.0 million at August 31, 1997. Since the Company began originating Title I Loans in 1994, an increasing level of delinquencies has appeared as expected on such loans less than two years old. Conventional Loan delinquencies represented 10.35% and 24.37%, respectively, of the Company's total delinquencies at August 31, 1997 and February 28, 1998. Three Months Ended February 28, 1998 compared to Three Months Ended February 28, 1997 The Company originated $127.3 million of loans during the three months ended February 28, 1998 compared to $111.3 million of loans during the three months ended February 28, 1997, an increase of 14.4%. The increase is a result of the overall growth in the Company's business, including an increase in the number of active Correspondents. At February 28, 1998, the Company had 565 active Correspondents and 249 active Dealers, compared to 484 active Correspondents and 467 active Dealers at February 28, 1997. Of the $127.3 million of loans originated during the three months ended February 28, 1998, $116.5 million were Conventional Loans, $6.0 million were Title I Loans and $4.8 million were First Mortgage Loans compared to $89.7 million of Conventional Loans, $21.6 million of Title I Loans and no First Mortgage Loans during the three months ended February 28, 1997. Pursuant to its recent restructuring, the Company is de-emphasizing its reliance on the Dealer division, and to a lesser extent the Correspondent division, as a source of loan originations. Net revenues (losses) decreased to a loss of $3.6 million during the three months ended February 28, 1998 from revenues of $10.1 million during the three months ended February 28, 1997. The decrease was primarily the result of the downward valuation adjustment which is reflected in the net unrealized loss on mortgage related securities. See Note 7 of Notes to Condensed Financial Statements. The combined gain on sale of loans and net unrealized gain (loss) on sale of mortgage related securities decreased to a loss of $5.6 million during the three months ended February 28, 1998 from a gain of $9.0 million during the three months ended February 28, 1997. The decrease was primarily due to the change in business strategy whereby the Company is focusing on whole loan sales for cash premiums as opposed to securitizations and the downward valuation adjustment, causing the net unrealized loss on mortgage related securities. Loan servicing income, net, increased $750,000 to $1.3 million during the three months ended February 28, 1998 from $560,000 during the three months ended February 28, 1997. The increase was primarily the result of 19 23 the increase in the servicing portfolio to $778.5 million at February 28, 1998 from $368.4 million at February 28, 1997. Interest income on loans held for sale and mortgage related securities, net of interest expense, increased $158,000 to $684,000 during the three months ended February 28, 1998 from $526,000 during the three months ended February 28, 1997. The increase was primarily the result of the increase in the average size of the portfolio of loans held for sale and mortgage related securities, which was partially offset by interest accrued on the Additional Notes (as defined below) during the quarter ended February 28, 1998. The net provision for credit losses increased $1.5 million to $706,000 for the three months ended February 28, 1998 from $(800,000) for the three months ended February 28, 1997. The increase in the provision was directly related to the increase in the volume of loans originated and the increased ratio of Conventional Loans to Title I Loans originated during the three months ended February 28, 1998 compared to the three months ended February 28, 1997 and a shift away from securitizations to whole loan sales. No allowance for credit losses on loans sold with recourse is established on loans sold through securitizations or on whole loan sales on a servicing released basis, as the Company has no recourse obligation under those securitization agreements for credit losses and estimated credit losses on loans sold through securitizations are considered in the Company's valuation of its residual interest securities. The provision for credit losses is based upon periodic analysis of the portfolio, economic conditions and trends, historical credit loss experience, borrowers' ability to repay, collateral values and estimated FHA insurance recoveries on Title I Loans originated and sold. Total general and administrative expenses increased to $9.0 million during the three months ended February 28, 1998 compared to $5.2 million during the three months ended February 28, 1997. The increase was primarily a result of increased professional services due to increased legal and audit expenses associated with the creation of new debt, a private placement of $40.0 million of senior subordinated notes (the "Private Placement), additional Securities and Exchange Commission ("SEC") filings and amendments to existing debt agreements, increased loan servicing expenses due to an increase in loans serviced and increased payroll and benefits related to the hiring of additional underwriting, loan processing, administrative, loan quality control and other personnel as a result of the expansion of the Company's business. Payroll and benefits expense increased $2.1 million to $4.6 million during the three months ended February 28, 1998 from $2.5 million during the three months ended February 28, 1997 primarily due to an increased number of employees and severance expenses. The number of employees increased to 381 at February 28, 1998 from 277 at February 28, 1997 due to increased staff necessary to support the business expansion and maintain quality control. The Company has recently reduced its workforce by approximately 32% since its peak in early January 1998; however, the savings from the reduction will not be realized until subsequent accounting periods. Professional services increased $459,000 to $1.0 million during the three months ended February 28, 1998 from $560,000 for the three months ended February 28, 1997, due to increased legal and audit expenses and reclassification of certain consulting and management services expenses that were previously classified in different line items. Sub-servicing fees paid to Preferred Equities Corporation ("PEC") increased to $610,000 for the three months ended February 28, 1998 from $372,000 for the three months ended February 28, 1997 due primarily to a larger loan servicing portfolio, notwithstanding a lower sub-servicing fee rate. Other services increased $442,000 to $694,000 during the three months ended February 28, 1998 from $252,000 for the three months ended February 28, 1997 due to increased loan volume and documentation expenses associated with the sale of loans with servicing released during the current quarter. Rent and lease expenses increased $168,000 to $365,000 during the three months ended February 28, 1998 from $197,000 for the three months ended February 28, 1997 due to the prior year reflecting new tenant discounts for office space at Parkwood Circle. 20 24 Travel expenses increased $193,000 to $276,000 during the three months ended February 28, 1998 from $83,000 during the three months ended February 28, 1997 due to increased travel caused by higher staff levels necessary to support the business expansion. Other general and administrative expenses increased $377,000 to $506,000 during the three months ended February 28, 1998 from $129,000 during the three months ended February 28, 1997 due primarily to increased expenses related to the ongoing expansion of facilities. Income (loss) before income taxes decreased to a loss of $13.7 million for the three months ended February 28, 1998 from income of $5.4 million for the three months ended February 28, 1997. Due to the increase in the deferred income tax valuation adjustment of $7.2 million, the provision for income taxes increased to $7.2 million for the three months ended February 28, 1998 from an income tax expense of $2.1 million for the three months ended February 28, 1997. As a result of the foregoing, the Company incurred a net loss of $20.8 million for the three months ended February 28, 1998 compared to net income of $3.4 million for the three months ended February 28, 1997. Six Months Ended February 28, 1998 compared to Six Months Ended February 28, 1997 The Company originated $327.1 million of loans during the six months ended February 28, 1998 compared to $173.7 million of loans during the six months ended February 28, 1997, an increase of 88.3%. The increase is a result of the overall growth in the Company's business primarily during the quarter ended November 30, 1997, including an increase in the number of active Correspondents. At February 28, 1998, the Company had 565 active Correspondents and 249 active Dealers, compared to 484 active Correspondents and 467 active Dealers at February 28, 1997. Of the $327.1 million of loans originated during the six months ended February 28, 1998, $304.3 million were Conventional Loans, $18.1 million were Title I Loans and $4.7 million were First Mortgage Loans compared to $120.8 million of Conventional Loans, $52.9 million of Title I Loans and no First Mortgage Loans during the six months ended February 28, 1997. Net revenues (losses) decreased to a loss of $10.6 million during the six months ended February 28, 1998 from revenues of $20.4 million during the six months ended February 28, 1997. The decrease was primarily the result of the downward valuation adjustment which is reflected in the net unrealized loss on mortgage related securities and the change in business strategy with the focus on whole loan sales for cash premiums. See Note 7 of Notes to Condensed Financial Statements. The combined gain on sale of loans and net unrealized gain (loss) on sale of mortgage related securities decreased to a loss of $15.0 million during the six months ended February 28, 1998 from a gain of $18.3 million during the six months ended February 28, 1997. The decrease was primarily due to the downward valuation adjustment, causing the net unrealized loss on mortgage related securities. See Note 7 of Notes to Condensed Financial Statements. Loan servicing income, net, increased $1.3 million to $2.5 million during the six months ended February 28, 1998 from $1.2 million during the six months ended February 28, 1997. The increase was primarily the result of the increase in the servicing portfolio to $778.5 million at February 28, 1998 from $368.4 million at February 28, 1997. Interest income on loans held for sale and mortgage related securities, net of interest expense, increased $1.0 million to $1.9 million during the six months ended February 28, 1998 from $881,000 during the six months ended February 28, 1997. The increase was primarily the result of the increase in the average size of the portfolio of loans held for sale and mortgage related securities. The net provision for credit losses increased $1.4 million to $2.3 million for the six months ended February 28, 1998 from $911,000 for the six months ended February 28, 1997. The increase in the provision was directly related to the increase in the volume of loans originated and the increased ratio of Conventional Loans to Title I Loans originated during the six months ended February 28, 1998 compared to the six months ended 21 25 February 28, 1997 and a shift away from securitizations to whole loan sales. No allowance for credit losses on loans sold with recourse is established on loans sold through securitizations or on whole loan sales on a servicing released basis, as the Company has no recourse obligation under those securitization agreements for credit losses and estimated credit losses on loans sold through securitizations are considered in the Company's valuation of its residual interest securities. The provision for credit losses is based upon periodic analysis of the portfolio, economic conditions and trends, historical credit loss experience, borrowers' ability to repay, collateral values, and estimated FHA insurance recoveries on Title I Loans originated and sold. Total general and administrative expenses increased to $19.0 million during the six months ended February 28, 1998 from $9.6 million during the six months ended February 28, 1997. The increase was primarily a result of increased professional services due to increased legal and audit expenses associated with the creation of new debt, additional SEC filings and amendments to existing debt agreements, increased loan servicing expenses due to an increase in loans serviced and increased payroll and benefits related to the hiring of additional underwriting, loan processing, administrative, loan quality control and other personnel as a result of the expansion of the Company's business during the period prior to the reduction in the workforce. Payroll and benefits expense increased $5.5 million to $9.8 million during the six months ended February 28, 1998 from $4.3 million during the six months ended February 28, 1997 primarily due to an increased number of employees and severance expenses. The number of employees increased to 381 at February 28, 1998 from 277 at February 28, 1997 due to increased staff necessary to support the business expansion and maintain quality control. From its peak in early January 1998, the workforce has since been reduced by 32%, pursuant to the Company's restructuring. Professional services increased $1.5 million to $2.5 million during the six months ended February 28, 1998 from $991,000 for the six months ended February 28, 1997, due to increased legal and audit expenses associated with the creation of new debt, the Private Placement, additional SEC filings and amendments to existing debt agreements. Sub-servicing fees increased to $1.3 million for the six months ended February 28, 1998 from $657,000 for the six months ended February 28, 1997 due primarily to a larger loan servicing portfolio, notwithstanding a lower sub-servicing rate in the later part of the six months ended February 28 1998. Other services increased $627,000 to $1.1 million during the six months ended February 28, 1998 from $457,000 for the six months ended February 28, 1997 due to increased loan volume and documentation expenses for loans sold with servicing released during the current quarter. Rent and lease expenses increased $207,000 to $658,000 during the six months ended February 28, 1998 from $451,000 for the six months ended February 28, 1997 due to the prior year reflecting new tenant discounts for office space at Parkwood Circle. Travel expenses increased $331,000 to $536,000 during the six months ended February 28, 1998 from $205,000 during the six months ended February 28, 1997 due to increased travel necessary to support the then business expansion. Other general and administrative expenses increased $574,000 to $1.1 million during the six months ended February 28, 1998 from $526,000 during the six months ended February 28, 1997 due primarily to increased expenses related to the expansion of facilities. As a result of the foregoing, the Company incurred a net loss of $32.5 million for the six months ended February 28, 1998 compared to net income of $5.9 million for the six months ended February 28, 1997. 22 26 LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents were $3.2 million at February 28, 1998 compared to $6.1 million at August 31, 1997. The Company has operated since March 1994 on a negative cash flow basis. As a result of such negative cash flow, since December 1997, the Company has been required to significantly curtail the volume of its loan originations. In addition, as discussed below, the Company is not in compliance with certain of the financial requirements and covenants contained in certain of the Company's financing arrangements. In November 1996, the Company consummated an underwritten public offering (the "IPO") pursuant to which it issued 2.3 million shares of Common Stock at $10.00 per share. Concurrently with the IPO, the Company issued $40.0 million of senior subordinated notes (the "Existing Notes") in an underwritten public offering. The Company used approximately $13.9 million of the aggregate net proceeds from these offerings to repay intercompany debt due to Mego Financial and PEC and approximately $24.3 million to reduce the amounts outstanding under the Company's lines of credit. The balance of the net proceeds was used to originate loans. In October 1997, the Company consummated the Private Placement pursuant to which it issued $40.0 million in additional senior subordinated notes ("Additional Notes"), which increased the aggregate principal amount of the outstanding subordinated notes from $40.0 million to $80.0 million. The Company used approximately $3.9 million of the net proceeds from the Private Placement to repay debt due to Mego Financial and approximately $29.0 million to reduce the amounts outstanding under the Company's lines of credit. The balance of the net proceeds was used to originate loans and for working capital. Prior to the Private Placement, the Company obtained consents to certain amendments to the original indenture (as amended, the "Indenture") governing the Notes ("Indenture Amendments"), which among other things permitted the issuance of the Additional Notes, modified certain covenants applicable to the Company and will permit the issuance of an additional $70.0 million of principal amount of senior subordinated notes. In connection with the consent solicitation, the Company made consent payments totaling $392,000 ($10.00 cash per $1,000 principal amount of the Existing Notes) to holders thereof who properly furnished their consents to the amendments to the original indenture. See Note 8 of Notes to Condensed Financial Statements. The Company's cash requirements arise from loan originations, payments of operating and interest expenses, over-collateralization requirements related to securitization transactions and deposits to reserve accounts related to loan sale transactions. Loan originations are initially funded principally through the Company's Warehouse Line pending the sale of loans in the secondary market. In addition, the Company has an agreement providing for the purchase of up to $2.0 billion of loans over a five year period, of which $1.3 billion remained to be purchased at February 28, 1998. Substantially all of the loans originated by the Company are sold. Loans under the Warehouse Line are repaid primarily from the proceeds from the sale of loans in the secondary market. These proceeds totaled approximately $167.4 million and $281.2 million for the six months ended February 28, 1997 and 1998, respectively. The Company has operated since March 1994 on a negative cash flow basis, although the Company is implementing measures intended to place it on at least a cash flow neutral basis for the calendar year 1998. There can be no assurance that the Company will be successful in implementing these measures. In connection with securitizations and certain whole loan sales, the Company recognizes a gain on sale of the loans upon the closing of the transaction and the delivery of the loans, but does not receive the cash representing such gain until it receives the excess servicing spread, which is payable over the actual life of the loans sold. The Company is subject to over-collateralization requirements and incurs significant expenses in connection with securitizations and incurs tax liabilities as a result of the gain on sale. As a result of such negative cash flow, since November 30, 1997, the Company has curtailed the volume of its loan originations. The Company has reduced its dependence on securitizations during Fiscal 1998 due to the negative cash flow generated by this method of loan disposition. Alternatively, during Fiscal 1998 the Company has made whole loan sales on a servicing released basis, at a premium, in order to enhance its cash flow. 23 27 The pooling and servicing agreements and sale and servicing agreements related to the Company's securitizations require the Company to build over-collateralization levels through retention within each securitization trust of excess servicing distributions and application thereof to reduce the principal balances of the senior interests issued by the related trust or cover interest shortfalls. This retention causes the aggregate unpaid principal amount of the loans in the related pool to exceed the aggregate principal balance of the outstanding investor securities. Such over-collateralization amounts serve as credit enhancement for the related trust and therefore are available to absorb losses realized on loans held by such trust. The Company continues to be subject to the risks of default and foreclosure following the sale of loans through securitizations to the extent excess servicing distributions are required to be retained or applied to reduce principal or cover interest shortfalls from time to time. Such retained amounts are predetermined by the entity issuing any guarantee of the related interests as a condition to obtaining insurance or by the rating agencies as a condition to obtaining their applicable rating thereon. In addition, such retention delays cash distributions that otherwise would flow to the Company through its retained interest, thereby adversely affecting the flow of cash to the Company. Certain whole loan sale transactions require the subordination of certain cash flows payable to the Company to the payment of scheduled principal and interest due to the loan purchasers. In connection with certain of such sale transactions, a portion of amounts payable to the Company from the excess interest spread is required to be maintained in an account to the extent of the subordination requirements. The subordination requirements generally provide that the excess interest spread is payable to the account until a specified percentage of the principal balances of the sold loans is accumulated therein. Excess interest spread payable to the Company is subject to being utilized first to replenish cash paid from the account to fund shortfalls in collections of interest from borrowers who default on the payments on the loans until the Company's deposits into the account equal the specified percentage. The excess interest required to be deposited and maintained in the respective accounts is not available to support the cash flow requirements of the Company. At February 28, 1998, amounts on deposit in such accounts totaled $3.5 million. Adequate credit facilities and other sources of funding, including the ability of the Company to sell loans in the secondary market, are essential for the continuation of the Company's loan origination operations. Loan originations are initially funded principally through the Company's Warehouse Line. At February 28, 1998, $40.0 million was outstanding under this Warehouse Line. In excess of 95.2% of the aggregate loans originated by the Company since inception through February 28, 1998 had been sold. The Warehouse Line, which is secured by loans prior to sale, became effective in June 1997 and was increased from $40.0 million to $55.0 million in September 1997 and to $65.0 million in October 1997 and then reduced in stages to $35.0 million in March 1998 and to $16.0 million in May 1998. Under the original agreement, the Company had the option of borrowing funds under the Warehouse Line, subject to certain conditions, at an annual rate equal to (i) the higher of the corporate base rate of interest announced by The First National Bank of Chicago from time to time or the weighted-average of rates on overnight federal funds transactions, as published by the Federal Reserve Bank of New York, plus 0.5%, (ii) the Federal Funds Funding Rate plus 1.75% or (iii) the Eurodollar Base Rate. The original agreement required the Company to maintain minimum adjusted tangible net worth (defined as net worth less intangibles plus subordinated debt) of $65.0 million plus 50% of the Company's cumulative net income since November 30, 1996, plus all net proceeds received by the Company through the sale or issuance of stock or additional subordinated notes. Additionally, the following material covenant restrictions existed: i) the ratio of total liabilities (not including subordinated notes) divided by tangible net worth (including subordinated notes) cannot exceed 3:1, and ii) total liabilities must be less than the aggregate of 100% of cash plus 93% of loans held for sale plus 55% of restricted cash and mortgage related securities. At February 28, 1998, the ratio of total liabilities to tangible net worth was 0.79:1 and total liabilities were $78.1 million, which was $48.4 million under the maximum amount allowed. 24 28 In February 1998, in order to avoid non-compliance with the terms of the Warehouse Line, the Company entered into an amended and restated credit agreement (the "Amended Credit Agreement") which has been further amended modifying the existing Warehouse Line agreement to, among other things: (i) reduce the amount of the Warehouse Line from $65.0 million to $55.0 million, and, thereafter, in stages to $35.0 million by March 4, 1998 and subsequently to $16.0 million with maturity on May 29, 1998 (subject to increase with the approval of all of the parties to such agreement); (ii) change the expiration date of the Warehouse Line from June 15, 1998 to May 29, 1998; (iii) add the ability to borrow against First Mortgage Loans in an amount not to exceed 15% of the lenders' aggregate commitment; (iv) reduce the advance rate for certain loan categories; (v) prohibit the payment of dividends by the Company; (vi) limit the amount of "Funded Debt" (as defined therein to mean indebtedness for money borrowed, with certain exceptions) to the sum of (a) 100% of cash, (b) 95% of "loans held for sale, net" and (c) 80% of "Restricted Assets" which are restricted cash, mortgage related securities, mortgage servicing rights and excess servicing rights; and (vii) modify certain of the financial covenants to, among other things, require the maintenance of (a) an adjusted leverage ratio of total liabilities (which excludes subordinated debt up to $80.4 million) to adjusted tangible net worth not to exceed 1.75 to 1.0, (b) an adjusted tangible net worth (which includes subordinated debt) of at least $110.0 million plus 75% of positive net income after December 31, 1997 and 100% of any new equity or debt offering and (c) a tangible net worth of at least $30.0 million plus 75% of positive net income after December 31, 1997 and 100% of any new equity. In addition, the Company agreed to provide satisfactory purchase commitments by March 3, 1998 to the Warehouse Line lenders, covering the then pledged loans in the Warehouse Line. An extension of this compliance date to March 13, 1998 was received and the Company was in compliance with this requirement at that date. All of the Company's funding under the Warehouse Line currently bears interest at an annual rate equal to the agent's corporate base rate plus 1.0%. The agent has advised the Company that the Warehouse Line lenders do not intend to renew the Warehouse Line. At February 28, 1998, the Company's actual adjusted tangible net worth calculated pursuant to the agreement was $99.1 million, which was $10.9 million less than the required minimum adjusted tangible net worth of $110.0 million. Additionally, the following material covenant restrictions exist: i) the ratio of total liabilities (not including subordinated notes) divided by tangible net worth (including subordinated notes) cannot exceed 1.75:1, and ii) total liabilities must be less than the aggregate of 100% of cash plus 95% of loans held for sale plus 80% of restricted cash and mortgage related securities. At February 28, 1998, the ratio of total liabilities to tangible net worth was 0.79:1 and total liabilities were $78.1 million, which was $48.4 million under the maximum amount allowed. As of the date of this report, the Company is not in compliance with the terms of the Warehouse Line because the amount outstanding under the line exceeds the amount permitted to be borrowed thereunder and the Company has not complied with the requirement to maintain purchase commitments from third parties. The Company has received commitments for the sale of loans, the proceeds of which would be applied to reduce the amount outstanding under the line and would be sufficient to bring the Company in compliance with the terms thereof. However, there can be no assurance that such loan sales will be consummated. In September 1996, the Company entered into a repurchase agreement with another financial institution pursuant to which the Company may pledge the interest only certificates from its securitizations in exchange for advances. In April 1997, the Company entered into a pledge and security agreement with the same financial institution which currently provides for a revolving credit facility, the First Revolving Credit Facility, of up to $25.0 million, less any amounts outstanding under the repurchase agreement, with respect to which credit facility $10.0 million was outstanding at February 28, 1998. The First Revolving Credit Facility is secured by a pledge of certain of the Company's interest only and residual class certificates relating to securitizations carried as mortgage related securities on the Company's Statements of Financial Condition, payable to the Company pursuant to its securitization agreements. A portion of the loans under the agreement bears interest at one-month LIBOR + 3.5%, is due and payable on December 31, 1998, and requires the Company to maintain a minimum net worth of the greater of $35.0 million, or following fiscal year end 1997, 80% of net worth as of August 31, 1997. The portion of the credit line agreement applicable to a repurchase agreement secured by insured interest only certificates bears interest at one-month LIBOR + 2.0%. At February 28, 1998, the required net worth was $42.5 million and the Company's actual net worth was $28.0 million. The agreement requires the Company to maintain a debt-to-net worth ratio to exceed 2.5:1, although at February 28, 1998, the ratio was 4.25:1. The financial institution has agreed to waive the noncompliance provided that the debt-to-net worth ratio shall not exceed 6:1 prior to May 31, 1998 after which the ratio may not exceed 2.5:1. 25 29 In October 1997, the Company entered into a revolving credit facility, the Second Revolving Credit Facility, with a financial institution providing for an initial advance of up to $5.0 million secured by certain residual interest and interest only securities. At February 28, 1998, $5.0 million was outstanding under the Second Revolving Credit Facility. The Second Revolving Credit Facility bears interest at an annual rate equal to the higher of (i) the prime rate as established by the Chase Manhattan Bank, N.A., plus 2.5% or (ii) 9.0%. The Second Revolving Credit Facility may be increased to an aggregate principal amount of up to $8.8 million with additional lender participations. The Second Revolving Credit Facility contains financial covenants similar to those contained in the original Warehouse Line. Certain material covenant restrictions also exist in the Indenture governing the Notes. These covenants include limitations on the Company's ability to incur indebtedness, grant liens on its assets and to enter into extraordinary corporate transactions. The Company may not incur indebtedness or issue capital stock having certain terms if, on the date of such incurrence or issuance and after giving effect thereto, the Consolidated Leverage Ratio would exceed 2:1, subject to certain exceptions. At February 28, 1998, the Consolidated Leverage Ratio was 5:52:1. Accordingly, while the Company is not in default under the terms of the Indenture, the Company cannot presently incur additional indebtedness other than Permitted Warehouse Indebtedness(as defined below) and certain other types of indebtedness, or issue capital stock having certain terms, not including the Common Stock offered in the proposed private placement, until such time as the required 2:1 ratio has been met. The Consolidated Leverage Ratio is the ratio of (i) all indebtedness of the Company, excluding the (A) Permitted Warehouse Indebtedness,guarantees thereof permitted under the Indenture, (B) Hedging Obligations permitted under the Indenture and (C) Junior Subordinated Obligations, to (ii) the consolidated net worth of the Company. The Permitted Warehouse Indebtedness generally is the outstanding amount under the Warehouse Line. In addition, an increasing amount of the Company's mortgage related securities are required to remain unpledged. At February 28, 1998, that requirement was $46.8 million, and at that date $43.7 million of mortgage related securities were pledged, and $47.6 million of mortgage related securities were unpledged. In addition, the Indenture Amendments provide, among other things, that the Company may not incur Unsecured Senior Indebtedness (as defined in the Indenture), if the Adjusted Consolidated Leverage Ratio, on the date of such incurrence after giving effect thereto, exceeds 1:1. The Adjusted Consolidated Leverage Ratio is the ratio of (i) the amount of all Unsecured Senior Indebtedness to (ii) the sum of (A) Consolidated Net Income (net income minus gain on sale of loans and net unrealized gain on mortgage related securities plus provision for credit losses, depreciation and amortization and amortization of excess servicing rights) from September 1, 1997 to the end of the most recent fiscal quarter and (B) the aggregate net proceeds received by the Company from the issuance or sale of stock or debt securities converted to stock, after September 1, 1997. Furthermore, the Indenture Amendments imposed a limit on the amount of mortgage related securities that must remain unpledged and removed the limitation on the amount of Permitted Warehouse Indebtedness. While the Company believes that following consummation of the proposed private placement and exchange offer it will be able to maintain its existing credit facilities and obtain replacement financing as its credit arrangements mature and additional financing, if necessary, there can be no assurance that such financing will be available on favorable terms, or at all. The lack of adequate capital may result in the further curtailment of loan originations and thereby impair the Company's revenue and income stream. At February 28, 1998, no commitments existed for material capital expenditures. In the absence of successful completion of the Company's proposed private placement and exchange offer, the Board of Directors of the Company believes that the strategic alternatives potentially available to the Company are limited and that the Company may be forced to consider bankruptcy proceedings. 26 30 In furtherance of the Company's earlier strategy to sell loans primarily through securitizations, beginning in March 1996 through August 1997, the Company completed its first seven securitizations pursuant to which it sold pools of loans aggregating $531.3 million. The Company previously reacquired an aggregate of $512.3 million of such loans. Pursuant to these securitizations, pass-through securities evidencing interests in the pools of loans were sold in public offerings. The Company continues to service the sold loans and is entitled to receive from payments in respect of interest on the sold loans, not in default, a servicing fee equal to 1.25% of the balance of each loan with respect to the March 1996 transaction and 1.0% with respect to the other transactions. In addition, from each securitization, the Company has received residual interest securities, contractual rights, and in certain of the transactions, also received interest only strip securities, all of which were recorded as mortgage related securities on the Statements of Financial Condition. The residual interest securities and the contractual rights represent the excess differential (after payment of any servicing, interest and other fees, and the contractual obligations payable to the note and certificate holders) between the interest paid by the obligors of the sold loans and the yield on the sold notes, certificates and interest only strip securities. Also, from the two securitizations completed during fiscal 1996 and the first two securitizations completed in fiscal 1997, the Company has also received interest only strip securities. These interest only securities yield annual rates between 0.45% and 1.00% calculated on the principal balance of the loans not in default. The Company may be required to repurchase loans that do not conform to the representations and warranties made by the Company in the securitization agreements and, as servicer, may be required to advance interest in connection with the securitizations. The values of and markets for the sale of Company's loans are dependent upon a number of factors, including general economic conditions, interest rates and government regulations. Adverse changes in those factors may affect the Company's ability to originate or sell loans in the secondary market for acceptable prices within reasonable time frames. The ability of the Company to sell loans in the secondary market is essential for continuation of the Company's loan origination activities. A reduction in size of the secondary market for home improvement or debt consolidation loans would adversely affect the Company's ability to sell its loans in the secondary market with a consequent adverse impact on the Company's profitability and future originations. The Company anticipates that a majority of its loan originations in 1998 will be disposed of through whole loan sales on a servicing released basis. This method of loan disposition is anticipated to generate cash sale premiums and further advance the Company's strategy to achieve at least a cash flow neutral basis from operations in 1998. Securitization transactions may be affected by a number of factors, some of which are beyond the Company's control, including, among other things, conditions in the securities markets in general, conditions in the asset-backed securitization market, the conformity of loan pools to rating agency requirements and, to the extent that monoline insurance is used, the requirements of such insurers. In April 1995, the Company entered into a continuing agreement with a financial institution pursuant to which an aggregate of approximately $884.9 million in principal amount of loans had been sold at February 28, 1998 for an amount approximately equal to their remaining principal balances. Pursuant to the agreement, as modified by the Excess Yield Sale Agreement the purchaser is entitled to receive interest at a variable rate equal to the sum of 200 basis points and the one-month LIBOR rate as in effect from time to time on loans not yet sold by the institution which amounted to $3.2 million at February 28, 1998. The Company retained the right to service the loans and the right to receive the excess interest. The Company is required to maintain a reserve account equal to 25% of the principal amount of Title 1 Loans which are more than 60 days delinquent plus 100% of the principal amount Conventional Loans which are more than 60 days delinquent. In the first quarter of fiscal 1997, the Company entered into the Master Purchase Agreement with the same financial institution, providing for the purchase of up to $2.0 billion of loans over a five-year period, of which $1.1 billion remained to be purchased at February 28, 1998. Pursuant to the agreement, Mego Financial issued to the financial institution four-year warrants to purchase 1.0 million shares of Mego Financial's common stock at an exercise price of $7.125 per share. The agreement also provides that so long as the aggregate principal balance of loans purchased by the financial institution and not resold to third parties exceeds $100.0 million (the "Facility Limit") and temporarily increased to $199.0 million in December 1997, the financial institution shall not be obligated to purchase, and the Company shall not be obligated to sell, loans under the agreement. The value of the warrants, estimated at $3.0 million (0.15% of the commitment amount) as of the commitment date, is being amortized as the commitment for the purchase of loans is utilized. 27 31 In December 1997, the Company entered into the December 1997 Letter Agreement with this financial institution, providing, among other things, for certain amendments to the Master Purchase Agreement. Pursuant to the December 1997 Letter Agreement, during the Interim Period, the Facility Limit was increased to $199.0 million from $150.0 million and the purchase price for loans was reduced. Upon expiration of the Interim Period, the Facility Limit will be reduced to $100.0 million and the purchase price for loans will be increased. In addition, upon the sale by the Company of equity securities for at least $15.0 million, the Facility Limit will be increased to $150.0 million. Pursuant to the December 1997 Letter Agreement, the Company paid a fee of $1.0 million to this financial institution and agreed to pay additional fees of $250,000 on each of March 31, June 30, September 30, and December 31, 1998. Under the most current agreement, although the financial institution has reached the Facility Limit, the institution has agreed to purchase additional loans, when the aggregate amount of loans now held by it has been reduced below $125.0 million by sales to third parties, in an amount which would not bring the total loans held by it above $125.0 million through March 31, 1998 and, thereafter, when the aggregate amount of loans held by it has been reduced below $100.0 million by sales to third parties, in an amount which would not bring the total amount of loans held by it above $100.0 million. In January 1998, in order to improve its cash position, the Company entered into the Excess Yield Sale Agreement with this financial institution pursuant to which it sold the excess spread and servicing rights with respect to $175.5 million of Conventional Loans and agreed to sell the excess spread and servicing rights with respect to $14.2 million of Title I Loans, in each case purchased by the financial institution under the Master Purchase Agreement and still held by the institution. Pursuant to the Excess Yield Sale Agreement, the Company is required to repurchase any Sold Loan that becomes more than 60 days delinquent, provided, that the Company's repurchase obligations will not exceed 2-1/2% of the aggregate principal balances of the Sold Loans as of December 31, 1997. In the aggregate, when combined with the original sales proceeds, the Company received a purchase price equivalent to 101% of the principal balance of the Conventional Loans. In February, March and April 1998, the First, Second and Third Amendments to the Excess Yield Sale Agreement were executed pursuant to which an additional $19.5 million of principal balance of Conventional Loans were sold under this agreement. These transactions resulted in a loss of approximately $417,000 and generated approximately $4.5 million in cash proceeds to the Company. The Company is to receive additional compensation in the form of sales commissions upon the eventual disposition of certain of these Conventional Loans in the secondary market. The amount of the sales commissions will depend on the timing of those sales and the identities of the eventual purchasers. Approximately $99.0 million of these Conventional Loans had been resold in the secondary market by the end of March 1998. The remaining balance of these Conventional Loans of approximately $96.0 million are expected to be pooled with other conventional loans held by that financial institution with the intention of disposing of them in an asset-backed securitization in June 1998. The Company is to receive a two-thirds residual interest pertaining to the portion of the Conventional Loans disposed of in that securitization which had been originated by the Company. Prior to eventual disposition of the Conventional Loans, there is limited recourse to the Company for repurchase of those loans which become more than 60 days contractually delinquent. The amount of this recourse is limited to 2 1/2% of the principal balance of the loans as of the date they became subject to the Excess Yield Agreement. The servicing rights of these loans will be transferred to a third party and a reversal of servicing rights of approximately $1.2 million was recorded in the three months ended February 28, 1998 pursuant to this transaction. In February, March and April 1998, the Company sold $19.5 million of Additional Sold Loans to the same institution, including the excess yield and servicing rights relating thereto, and the Excess Yield Sale Agreement was amended to include the Additional Sold Loans, with similar repurchase obligations. Upon the sale by the financial institution of the Sold Loans and the Additional Sold Loans, the Company will be entitled to receive a sales commission based upon a percentage of the Net Dispositions Proceeds (as defined in the Excess Yield Sale Agreement, as amended) received by the financial institution. Net cash used in the Company's operating activities for the six months ended February 28, 1997 and 1998 was $39.6 million and $59.5 million, respectively. During the six months ended February 28, 1997 and 1998, cash provided by financing activities amounted to $55.2 million and $56.5 million, respectively. Net cash used in investing activities for the six months ended February 28, 1997 and 1998 was $1.1 million and $30,000, respectively. Prior to the consummation of the Company's IPO in November 1996, the Company was dependent on Mego Financial to provide, among other things, (i) funds for operations without interest and (ii) guarantees of the Company's financing arrangements. Subsequent to the IPO, Mego Financial has advanced funds to the Company to pay servicing fees owed to PEC and amounts due others. Although it may do so, it is not anticipated that Mego Financial will advance funds to the Company or guarantee the Company's financing arrangements in the future. 28 32 In the absence of successful completion of the proposed private placement and exchange offer the Company's Board of Directors believes that the alternatives potentially available to the Company are limited and the Company may be forced to consider bankruptcy proceedings. FINANCIAL CONDITION February 28, 1998 compared to August 31, 1997 Cash and cash equivalents decreased 48.4% to $3.2 million at February 28, 1998 from $6.1 million at August 31, 1997 primarily as a result of higher levels of loans held for sale at February 28, 1998. Restricted cash deposits increased 45.7% to $10.0 million at February 28, 1998 from $6.9 million at August 31, 1997 primarily due to the number of loans sold and securitized in prior periods. Loans held for sale, net, increased to $55.8 million at February 28, 1998 from $9.5 million at August 31, 1997 primarily as a result of the Company's increased loan originations and the timing of loan sales, with no securitization transaction during the three and six months ended February 28, 1998. Changes in the allowance for credit losses and the allowance for credit losses on loans sold with recourse for the three and six months ended February 28, 1998 consist of the following (thousands of dollars):
Balance at November 30, 1997 $ 8,699 Provision for credit losses 817 Reductions to the provision due to securitizations or loans sold without (111) recourse Reductions due to charges to allowance for credit losses (4) ------------ Balance at February 28, 1998 $ 9,401 ============
Balance at August 31, 1997 $ 7,114 Provision for credit losses 2,519 Reductions to the provision due to securitizations or loans sold without (223) recourse Reductions due to charges to allowance for credit losses (9) ------------- Balance at February 28, 1998 $ 9,401 ============
The allowance for credit losses and the allowance for credit losses on loans sold with recourse consist of the following at these dates:
AUGUST 31, FEBRUARY 28, 1997 1998 ------------ ------------ (thousands of dollars) Allowance for credit losses $ 100 $ 887 Allowance for credit losses on loans sold with recourse 7,014 8,514 ------------ ------------ Total $ 7,114 $ 9,401 ============ ============
The increase in the allowance for credit losses and the allowance for credit losses on loans sold with recourse is primarily due to higher anticipated losses on Title I Loans. Although the Company believes it has made reasonable estimates of the losses on Title I Loans, there can be no assurance that the actual losses will not vary from these estimates. 29 33 Mortgage related securities decreased $15.0 million to $91.3 million at February 28, 1998 from $106.3 million at August 31, 1997 primarily due to the revaluation adjustments to the carrying value. See Note 7 of Notes to Condensed Financial Statements. Mortgage servicing rights decreased $793,000 to $8.7 million at February 28, 1998 from $9.5 million at August 31, 1997 due to a reversal of servicing rights of approximately $1.2 million as a result of the consummation of the transactions under the Excess Yield Agreement. See Note 3 to Notes to Condensed Financial Statements. Other receivables decreased $3.1 million to $4.8 million at February 28, 1998 from $7.9 million at August 31, 1997 primarily due to a payment of deferred charges due to the Company from whole loan sales prior to August 31, 1997. Prepaid debt expenses increased $2.4 million to $4.8 million at February 28, 1998 from $2.4 million at August 31, 1997 primarily due to the debt expense related to the additional $40.0 million of subordinated notes issued in October 1997. Prepaid commitment fees increased $1.5 million to $3.9 million at February 28, 1998 from $2.3 million at August 31, 1997 due to costs associated with the December 1997 letter agreement, providing, among other things,, for certain amendments to the Master Purchase Agreement. The deferred income tax asset was $2.2 million at February 28, 1998 while no such benefit was previously reported. Prior to the Spin-off, federal income taxes were included in the Due to Mego Financial caption since Mego Financial filed a consolidated tax return. Based on the Company's restructuring and the Company's past ability to create income, management believes that it may be able to utilize the tax benefits over the next several years. Other assets decreased 44.8% to $439,000 at February 28, 1998 from $795,000 at August 31, 1997 primarily due to a reclassification of accrued fees on securitizations to other receivables of $541,000. Notes and contracts payable increased $21.2 million to $56.8 million at February 28, 1998 from $35.6 million at August 31, 1997 due to the increased borrowings by the Company to fund loan originations as a result of the overall growth in the Company's business. Accounts payable and accrued liabilities decreased $4.5 million to $13.4 million at February 28, 1998 from $17.9 million at August 31, 1997 primarily due to the adjustment of the Company's payable to Mego Financial. See Note 5 of Notes to Condensed Financial Statements. Allowance for credit losses on loans sold with recourse increased $1.5 million to $8.5 million at February 28, 1998 from $7.0 million at August 31, 1997 primarily due to increased loan sales. Recourse to the Company on sales of loans is governed by the agreements between the purchasers and the Company. The allowance for credit losses on loans sold with recourse represents the Company's estimate of its probable future credit losses to be incurred over the lives of the loans considering estimated future FHA insurance recoveries on Title I Loans. No allowance for credit losses on loans sold with recourse is established on loans sold through securitizations, as the Company has no recourse obligation under those securitization agreements for credit losses and estimated credit losses on loans sold through securitizations are considered in the Company's valuation of its residual interest securities. Stockholders' equity decreased $25.1 million to $28.0 million at February 28, 1998 from $53.1 million at August 31, 1997 as a result of the net loss of $32.5 million during the six months ended February 28, 1998, partially offset by an increase in additional paid-in capital related to a federal income tax benefit which was a result of the Spin-off and the adjustment of the Company's payable to Mego Financial. See Note 5 of Notes to Condensed Financial Statements. 30 34 RECENT ACCOUNTING PRONOUNCEMENTS The FASB issued SFAS No. 128, "Earnings per Share," ("SFAS 128") in February 1997, effective for financial statements issued after December 15, 1997. The statement provides simplified standards for the computation and presentation of earnings per share ("EPS"), making EPS comparable to international standards. SFAS 128 requires dual presentation of "Basic" and "Diluted" EPS, by entities with complex capital structures, replacing "Primary" and "Fully-diluted" EPS under APB Opinion No. 15. See Note 6 of Notes to Condensed Financial Statements for further discussion and SFAS 128 pro forma calculations. In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"), and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS No. 131 establishes standards of reporting by publicly-held business enterprises and disclosure of information about operating segments in annual financial statements and, to a lesser extent, in interim financial reports issued to shareholders. SFAS Nos. 130 and 131 are effective for fiscal years beginning after December 15, 1997. As both SFAS Nos. 130 and 131 deal with financial statement disclosure, the Company does not anticipate the adoption of these new standards will have a material impact on its financial position, results of operations or cash flows. The Company has not yet determined what its reporting segments will be under SFAS 131. 31 35 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On February 23, 1998, an action was filed in the United States District Court for the Northern District of Georgia by Robert J. Feeney, as a purported class action against the Company and Jeffrey S. Moore, the Company's President and Chief Executive Officer. The complaint alleges, among other things, that the defendants violated the federal securities laws in connection with the preparation and issuance of certain of the Company's financial statements. The named plaintiff seeks to represent a class consisting of purchasers of the Common Stock between April 11, 1997 and December 18, 1997, and seeks damages in an unspecified amount, costs, attorney's fees and such other relief as the court my deem just and proper. The Company believes it has meritorious defenses to this lawsuit and that any resolution of this lawsuit will not have a material adverse effect on the business or financial condition of the Company. In the ordinary course of its business, the Company is, from time to time, named in lawsuits. The Company believes that it has meritorious defenses to these lawsuits and that resolution of these matters will not have a material adverse effect on the business or financial condition of the Company. ITEM 5. OTHER Jeremy Wiesen has been a Director of the Company since consummation of the IPO in November 1996 and subsequently resigned in March 1998. Christopher M. G. DeWinter resigned in March 1998 as Vice President--Corporate Development of the Company. Jack Elrod resigned in April 1998 as Vice President--Loan Administration of the Company. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K EXHIBIT NUMBER DESCRIPTION 10.70 Credit Agreement between the Company and Textron Financial Corporation dated October 22, 1997. 10.71 Excess Yield and Servicing Rights and Assumption Agreement between the Company and Greenwich Capital Markets, Inc. dated January 22, 1998 10.72 Amended and Restated Credit Agreement dated as of February 19, 1998 among the Company, the Lenders Party Thereto and The First National Bank of Chicago. 10.73 Amendment to Services and Consulting Agreement between the Company and Preferred Equities Corporation dated January 20, 1998. 10.74 Amendment to Loan Program Sub-Servicing Agreement between the Company and Preferred Equities Corporation dated January 20, 1998. 10.75 Agreement between the Company and Preferred Equities Corporation, dated February 9, 1998, regarding assignment of rights related to the Loan Program Sub-Servicing Agreement to Greenwich Capital Markets, Inc. 10.76 Amendment to Excess Yield and Servicing Rights and Assumption Agreement between the Company and Greenwich Capital Markets, Inc. dated February 10, 1998 10.77 Second Amendment to Excess Yield and Servicing Rights and Assumption Agreement between the Company and Greenwich Capital Markets, Inc. dated February, 1998 27.1 Financial Data Schedule (for SEC use only). No reports on Form 8-K were filed during the period. A report on Form 8-K dated March 30, 1998 was filed on March 31, 1998 to report that the Company's Board of Directors revoked and rescinded its actions previously taken changing the fiscal year end to December 31 and determined that the Company's fiscal year end shall revert back to August 31. A report on Form 8-K dated May 19, 1998 was filed on May 19, 1998 to report: (i) a press release announcing the Company's proposal to engage in a series of transactions to recapitalize the Company and (ii) that as a result of subsequent events, the Company's independent auditors, Deloitte & Touche LLP, have reissued their report with respect to the Company's financial statements as of August 31, 1996 and 1997 and the three years in the period ended August 31, 1997 to include an explanatory paragraph related to the Company's ability to continue as a going concern. 32 36 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Amendment No. 1 to be signed on its behalf by the undersigned thereunto duly authorized. MEGO MORTGAGE CORPORATION By: /s/ James L. Belter ------------------------------------- James L. Belter Executive Vice President Treasurer and Chief Financial Officer Date: May 20, 1998 33 -----END PRIVACY-ENHANCED MESSAGE-----