ITEM 1.
BUSINESS
Overview
As used herein references to the “Company,” “FCMC,” “Franklin,” “we,” “our” and “us” refer to Franklin Credit Management Corporation, collectively with its subsidiaries.
We are a specialty consumer finance company that was, until December 28, 2007, primarily engaged in two related lines of business: (1) the acquisition, servicing and resolution of performing, reperforming and nonperforming residential mortgage loans and real estate assets; and (2) the origination of subprime mortgage loans, both for our portfolio and for sale into the secondary market. We specialized in acquiring and originating loans secured by 1-4 family residential real estate that generally fell outside the underwriting standards of Fannie Mae and Freddie Mac and involved elevated credit risk as a result of the nature or absence of income documentation, limited credit histories, higher levels of consumer debt or past credit difficulties. We typically purchased loan portfolios at a discount, and originated subprime loans with interest rates and fees calculated to provide us with a rate of return adjusted to reflect the elevated credit risk inherent in the types of loans we acquired and originated. Unlike many of our competitors, we generally held for investment the loans we acquired and a significant portion of the loans we originated.
On December 28, 2007, Franklin entered into a series of agreements (the “Forbearance Agreements”) with The Huntington National Bank, successor by merger in July 2007 to Sky Bank (Sky Bank, prior to the merger, and Huntington, thereafter, are referred to as the “bank”), whereby the bank agreed to restructure approximately $1.93 billion of the Company’s indebtedness to it and its participant banks, forgave $300 million of such indebtedness for a restructuring fee of $12 million paid to the bank, and waived certain existing defaults (the “Restructuring”). See “Management’s Discussion and Analysis - Borrowings.” In November 2007, Franklin ceased to acquire or originate loans and, under the terms of the Forbearance Agreements, the Company is expressly prohibited from acquiring or originating loans.
On March 31, 2008, the Company entered into amendments to the Forbearance Agreements whereby, among other things, (a) Tribeca’s indebtedness to BOS (USA) Inc. ($44.8 million as of December 31, 2007) was effectively rolled into the Forbearance Agreements, resulting in the payoff and retirement of Tribeca’s debt facilities with BOS (USA) Inc. and BOS acquiring a participation interest under the Forbearance Agreements; and (b) the interest rate and date of commencement of the accrual of PIK interest on approximately $125 million of the Company’s indebtedness was modified as of March 31, 2008. See “Management’s Discussion and Analysis - Borrowings - Forbearance Agreements with Lead Lending Bank - Recent Development - March 2008 Modifications to Forbearance Agreements and Refinancing of BOS Loan.”
From inception through December 31, 2007, we had purchased and originated in excess of $4.73 billion in mortgage loans. As of December 31, 2007, we had total assets of $1.69 billion, our portfolios of notes receivable and loans held for investment and sale, net totaled $1.53 billion, and our stockholders’ equity was $39.3 million.
The Company had a net loss of $8.6 million for the year ended December 31, 2007, compared with a net loss of $1.8 million for the year ended December 31, 2006. The net loss for the year ended December 31, 2007 was principally the result of a significant provision for loan losses, which was more than offset by a significant gain on debt forgiveness. Due principally to the rapid and substantial deterioration in the housing and subprime mortgage markets and deterioration in the performance of the Company’s portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, the Company reassessed its allowance for loan losses in the quarter ended September 30, 2007, which resulted in significantly increased estimates of inherent losses in its portfolios. As a result, the provision for loan losses increased to $262.7 million in the quarter ended September 30, 2007. For the year 2007, the provision for loan losses was $274.6 million, and the net gain on the debt forgiveness was $284.2 million. See “Management’s Discussion and Analysis - Year Ended December 31, 2007 Compared to Year Ended December 31, 2006.”
As a result of the Forbearance Agreements entered into on December 28, 2007 with the bank, the Company’s only business and principal operational activity as of December 31, 2007, is the servicing of its acquired and originated mortgage loans and real estate assets. Accordingly, discussions in this Form 10-K regarding loan acquisition and mortgage origination operations are of a historical nature, referring to those activities that the Company actively engaged in prior to entering into the Forbearance Agreements.
The Company is currently seeking to begin providing services for third parties, on a fee-paying basis, which are directly related to our servicing operations and our portfolio acquisition experience with residential mortgage loans. We are actively seeking to (a) expand our servicing operations to provide similar sub-servicing and collection services to third parties, and (b) capitalize on our experience to provide customized, comprehensive loan analysis and in-depth end-to-end transaction and portfolio management services to the residential mortgage markets. Some of these services include, in addition to servicing loans for others, performing 1-4 family residential portfolio stratification and analysis, pricing, due diligence, closing, and collateral transfer. In addition, we are actively seeking to broker new originated loans developed from internal leads from our existing portfolio or from externally developed leads. These new business activities will be subject to the consent of the bank, and we may not be successful in entering into or implementing any of these businesses.
All disclosures and explanations included in this Form 10-K must be read in light of the Forbearance Agreements and the changed nature of the Company’s business.
Loan Acquisitions
Since commencing operations in 1990, and until December 28, 2007, we had become a nationally recognized buyer of portfolios of residential mortgage loans, both first and second-lien loans, and real estate assets from a variety of financial institutions in the United States, including mortgage banks, commercial banks and thrifts, other traditional financial institutions and other specialty finance companies. These portfolios generally consisted of one or more of the following types of mortgage loans:
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performing loans - loans to borrowers who are contractually current, but may have been delinquent in the past and which may have deficiencies relating to credit history, loan-to-value ratios, income ratios or documentation;
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reperforming loans - loans to borrowers who are not contractually current, but have recently made regular payments and where there is a good possibility the loans will be repaid in full; and
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nonperforming loans - loans to borrowers who are delinquent, not expected to cure, and for which a primary avenue of recovery is through the sale of the property securing the loan.
We sometimes refer collectively to these types of loans as “scratch and dent” or “S&D” loans.
We refer to the S&D loans we acquired as “notes receivable.” In 2007, we purchased notes receivable with an aggregate unpaid principal balance of $528.7 million at an aggregate purchase price equal to 83% of the face amount of the notes. Approximately 49% of the unpaid principal balance of the loans purchased was secured by first liens on residential 1-4 family properties; the remaining 51% was secured by second liens on residential properties.
Loan Originations
We conducted our loan origination business through our wholly-owned subsidiary, Tribeca Lending Corp. (“Tribeca”), which we formed in 1997 in order to capitalize on our experience in evaluating and servicing scratch and dent residential mortgage loans. We originated primarily subprime residential mortgage loans to individuals with serious financial difficulties and whose documentation, credit histories, income and other factors caused them to be classified as subprime borrowers and to whom, as a result, conventional mortgage lenders often would not make loans (“Liberty Loans”). The loans we originated typically carried interest rates that were significantly higher than those of prime loans and we believe had fairly conservative loan-to-value ratios at origination. The principal factor in our underwriting guidelines has historically been our determination
of the borrower’s equity in his or her home and the related calculation of the loan-to-value ratio based on the appraised value of the property, and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan. In 2005, we began in an increasing number of cases to gather and analyze additional information that allowed us to assess to a reasonable degree the borrower’s ability and intent to repay the loan in connection with our credit decision. Throughout the first nine months of 2007, we made several credit tightening adjustments and/or modifications to our subprime loan origination programs, principally in response to the changing mortgage origination and housing markets. We chose to focus our marketing efforts on this segment of the 1-4 family residential real estate mortgage market in order to capitalize on our experience in acquiring and servicing loans with similar credit risk characteristics.
In 2007, we originated $291.6 million in subprime mortgage loans, 89% of which were adjustable-rate (fixed-rate for the first two years) loans. We originated approximately 32% of our mortgage loans on a retail basis, compared with 36% in 2006, and the remainder through our wholesale network of mortgage brokers. We hold the majority of mortgages we originated in our portfolio and have sold the remainder for cash in the whole-loan market, depending on market conditions and our own portfolio goals.
Loan Servicing
We have invested heavily to create a loan servicing capability that is focused on collections, loss mitigation and default management. In general, we seek to ensure that the loans we service are repaid in accordance with the original terms or according to amended repayment terms negotiated with the borrowers. Because we expect our loans will experience above average delinquencies, erratic payment patterns and defaults, our servicing operation is focused on maintaining close contact with our borrowers and as a result is more labor-intensive than traditional mortgage servicing operations. Through frequent communication we are able to encourage positive payment performance, quickly identify those borrowers who are likely to move into seriously delinquent status and promptly apply appropriate loss mitigation strategies. Our servicing staff employs a variety of collection strategies that we have developed to successfully manage serious delinquencies, bankruptcy and foreclosure. Additionally, we maintain a real estate department with experience in property management and the sale of residential properties.
Financing
We historically financed both our acquisitions of mortgage loan portfolios and our loan originations through various long and short-term borrowing arrangements with Sky Bank, with which we have had a strong relationship since the early 1990s.
In October 2004, we consolidated all of our arrangements with the bank relating to the term funding of loan acquisitions under a Master Credit and Security Agreement (“Master Credit Facility”). Under this Master Credit Facility, which had been extended to November 30, 2007, we requested loans to finance the purchase of pools of residential mortgage loans or refinance existing outstanding loans. In connection with our business expansion, the bank had arranged for additional financial institutions to participate under our Master Credit Facility. In August 2006, we entered into a $40 million revolving warehouse agreement (referred to as “Flow Warehouse”) with the bank and a participant to accumulate loans acquired on a flow basis prior to aggregating such loans into term debt under the Master Credit Facility. Prior to August 2006, loan acquisitions acquired on a flow basis were funded directly under the Master Credit Facility. Our borrowings under the Flow Warehouse and Master Credit Facility were secured by a first priority lien on the mortgage loans financed by the proceeds of our borrowings. This facility was renewed in August 2007 by the bank for $20 million and for a term of one year.
To finance the loans it originated, in October 2005, Tribeca entered into a Warehousing Credit and Security Agreement (referred to as “Tribeca Warehouse Facility” or “Tribeca Warehousing Agreement”) with Sky Bank and a participant in order to accumulate loans originated prior to aggregating such loans into term debt under a separate master credit and security agreement with the bank. This warehousing agreement was a revolving commitment for $60 million. The Tribeca Warehouse Facility was renewed in June 2007. In the first quarter of 2006, Tribeca and certain of its subsidiaries entered into a Master Credit and Security Agreement
(referred to as “Tribeca Master Credit Facility”) with the bank pursuant to which Tribeca could borrow term funds to finance originated loans temporarily financed under its Warehouse Facility. In the first quarter of 2006, Tribeca also entered into a $100 million Master Credit and Security Agreement with BOS (USA) Inc., an affiliate of the Bank of Scotland; $98 million under this facility was used to consolidate and refinance term loans previously made to Tribeca by the bank.
On December 28, 2007, Franklin entered into Forbearance Agreements with the bank, which substantially modified the borrowing arrangements summarized above and expressly terminated fundings for new acquisitions and originations under these credit facilities. See “Management’s Discussion and Analysis - Borrowings.”
Corporate History
We were formed in 1990 by, among others, Thomas J. Axon, our Chairman and President, and Frank B. Evans, Jr., one of our directors, for the purpose of acquiring consumer loan portfolios from the Resolution Trust Company, or RTC, and the Federal Deposit Insurance Corporation, or FDIC. We became a public company in December 1994, when we merged with Miramar Resources, Inc., a publicly traded oil and gas company that had emerged from bankruptcy proceedings in December 1993. The newly formed entity was renamed Franklin Credit Management Corporation. At the time of the merger, we divested substantially all of the remaining oil and gas assets directly owned by Miramar in order to focus primarily on the non-conforming sector of the residential mortgage industry. At that time, we decided to capitalize on our experience and expertise in acquiring and servicing loans from the RTC and the FDIC and began purchasing performing, reperforming and nonperforming residential mortgage loans from additional financial institutions. In 1997, we formed Tribeca to originate subprime residential mortgage loans.
In August 2005, we completed a public offering of 1,265,000 of shares of our common stock at a public offering price of $11.50 per share. This follow-on public offering resulted in net proceeds to the Company and the addition to equity of approximately $12.6 million. In conjunction with the public offering, the Company’s common stock ceased to be quoted on the Over-the-Counter Bulletin Board under the symbol “FCSC” and commenced trading on The Nasdaq National Market under the symbol “FCMC.” At December 31, 2007, the Company was not in compliance with certain requirements of the Nasdaq Stock Market. See Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Delisting Proceedings.”
Loan Acquisitions - Franklin
Most financial institutions generally sell or securitize the majority of the loans they originate in the secondary market. The vast majority of these loans are sold at a premium to the face value of the loan, creating a profit for the originator/seller. For a variety of reasons, however, a portion of their loan production either cannot be sold as intended or must be repurchased for any number of reasons including borrower credit, loan-to-value ratios, delinquencies, documentation deficiencies or changing demands by investors. Such loans typically must be sold at a discount to the face value of the note. Our acquisition business was focused on purchasing these S&D loans for which a highly liquid secondary market generally did not exist. We have had a variety of opportunities to purchase S&D loans, both shortly following origination and throughout the remainder of their lifecycle.
Newly originated loans. When a financial institution cannot sell a newly-originated mortgage loan through normal secondary market channels, it may sell that mortgage at a discounted price in order to free up cash or financing capacity. Newly originated loans may be sold multiple times before they are purchased by a long-term investor. A typical scenario is that a loan is originated by a local mortgage banker, sold to an intermediary mortgage banker, and finally either sold to a long-term investor or securitized. At any point in this process, we may have had an opportunity to purchase the loan for various reasons, including:
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Investor Fallout. Mortgages may not meet the requirements of the secondary market for a number of different reasons, including noncompliance with purchaser program requirements, documentation deficiencies and collateral valuation variances.
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Loan Repurchases. Once a mortgage is sold, it may be subject to a required repurchase by the seller for a number of different reasons, including a subsequent default by the borrower that occurs within a specified period of time after the sale.
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Facilitation. Occasionally, financial institutions will originate loans (frequently second liens) even though a liquid secondary market does not exist for those loans in order to facilitate the origination of mortgages that do have a liquid secondary market.
Seasoned loans. Seasoned loans may be sold in the secondary market for a number of reasons, including:
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Mergers and Acquisitions. The acquirer in a merger or acquisition may find that it has acquired mortgages that do not fit within its credit parameters.
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Credit or Performance Issues. A portfolio holder of mortgages may have accumulated mortgages that have credit or performance characteristics that do not meet its current needs.
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Securitization Terminations. When mortgage loans are securitized, the securitization trust normally sells bonds with maturities that are shorter than the life of some of the mortgage loans that act as collateral. Optional call provisions may also provide certain interested parties with the ability to collapse the trust by selling or refinancing the remaining mortgage loans in the trust prior to maturity.
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Insolvency. When a financial institution becomes insolvent, a trustee may decide to liquidate a mortgage portfolio in order to satisfy the creditors of the insolvent institution.
It is often more efficient and economical (and sometimes imperative) for lenders in the situations described above to sell S&D loans at a discount to a third-party than to expend the resources necessary to rehabilitate these loans internally, as these lenders generally do not possess the financial capability, desire or specialized skills and infrastructure necessary to effectively value or service these types of assets. In contrast, we developed expertise and an economically-scaled organization that permitted us to effectively evaluate, bid, finance and service portfolios of these loans. In November 2007, Franklin ceased to acquire or originate loans, and under the terms of the Forbearance Agreements, the Company is prohibited from acquiring or originating loans.
Since commencing operations, we have purchased in excess of $3.45 billion in S&D loans, comprised of approximately 80,000 loans, primarily from financial institutions. During 2007, we purchased approximately $528.7 million of principally S&D loans (approximately 49% of which were first liens) at a weighted average price of 83%, compared with approximately $621.4 million during 2006 at a weighted average price of 92% and $505.7 million during 2005 at a weighted average price of 93%. In both 2005 and 2006, the loans we purchased consisted principally of second-lien mortgages on 1-4 family residential properties; and, the portfolio of second-lien mortgages on 1-4 family residential properties aggregated $920.8 million at December 31, 2007.
Our acquisition department sought and identified opportunities to purchase portfolios of S&D loans, performed due diligence on the loans included in a portfolio, prepared a bid for the portfolio in accordance with our price and yield guidelines based on the results of its due diligence investigation and assisted in the integration of the loans that we ultimately acquired for our existing portfolio.
“Bulk” and “Flow” Acquisitions
Some lenders sell their S&D loans in the secondary market in small amounts on a frequent basis, while other institutions tend to accumulate larger pools of mortgages before selling them. We established an acquisition group to focus on each of these two segments of the selling market. Our bulk purchase unit historically was responsible for acquisitions of portfolios with a face value of notes receivable in excess of $1.5 million, while our flow unit historically was responsible for acquisitions of portfolios or individual notes with a face value of up to $1.5 million. These amounts were increased to $2.0 million in 2006. We made the majority of our bulk pool purchases of S&D loans from large conventional lenders in connection with the various opportunities described above. In contrast, our flow purchases were generally made on a more regular
basis from smaller, regional mortgage banks that had a need to quickly dispose of one or more S&D loans. Bulk purchases constituted 81% of our overall purchases in 2007, 84% in 2006 and 79% in 2005, respectively.
Due Diligence
We established a due diligence review process over our years of experience with sellers of S&D loans that we used for all prospective purchases. In connection with our purchases of bulk portfolios, the due diligence process included an analysis of a majority of the loans in a prospective portfolio, except in the case of very large portfolios where, due to time constraints, we analyzed a representative sample of assets in the portfolio. Our team evaluated, among other things, lien position, the value of collateral and the borrower’s debt-to-income ratio, creditworthiness, employment stability, number of years of home ownership, FICO scores and mortgage payment history. Where appropriate, our acquisition department performed an on-site evaluation of the seller’s loan servicing department in addition to reviewing the loan files that comprised the portfolio. This process provided us with additional information as to the actual quality of the servicing of the loans in the portfolio, which we believed was critical to our ability to properly evaluate the portfolio. In the case of flow purchases, we typically performed due diligence at our office on each loan we acquired, which focused on the same matters described above. In all cases, we tailored our review as appropriate based on the level of our prior experience with the seller and other factors relevant to the specific portfolio.
Pricing
For both our bulk and flow purchases, we compared the information derived from our due diligence review to our historical statistical database and, coupled with our cumulative knowledge of the non-conforming segment of the mortgage industry, our acquisition department projected a collection strategy and estimated the collectibility, cost to service and timing of cash flows with respect to the loans in the portfolio. Using this information, the acquisition department prepared a bid based upon pricing and yield guidelines that reflected the returns we were then seeking on purchased assets.
We have accumulated proprietary databases, models and statistical data, over our years of experience with borrowers of S&D loans, based on our understanding of the entire credit cycle and our ability to resolve loans. We believe our intellectual property provided us with a competitive advantage in analyzing, pricing and bidding on S&D loans.
Competition
We faced increasingly intense competition in the market for the acquisition of S&D loans. Many of our competitors had financial resources, acquisition departments and servicing capacity considerably larger than our own. Among our largest competitors were Residential Funding Corporation, Bayview Financial Trading Group, Countrywide Financial Corporation, The Goldman Sachs Group, Lehman Brothers, Bear Stearns & Co., Inc. and C-Bass. Competition for acquisitions was generally based on price, reputation of the purchaser, funding capacity and ability to execute within timing parameters required by the seller.
Borrowers
Our business model focused for the most part on holding the mortgage assets that we acquired through resolution. The borrowers in our portfolio represent a broad and diverse group of individuals and no single borrower represents a significant portion of our S&D loans. Our borrowers from the loans we acquired are located in all 50 states.
Sellers
We acquired S&D loans through a variety of methods, including negotiated sales, existing purchase agreements, joint-bids with other institutions and private and public auctions. The supply of assets available for purchase by us was influenced by a number of factors, including knowledge by the seller of our interest in purchasing assets of the type it was seeking to sell, the general economic climate, financial industry regulation and new residential mortgage loan origination volume. During 2007, we purchased an aggregate of
portfolios from 212 sellers, compared with an aggregate of 425 portfolios from 204 sellers in 2006. Our sources of bulk loan acquisitions historically varied from year to year. In addition to acquiring loans directly from sellers, we also occasionally acquired loans indirectly through brokers.
Marketing
Members of the sales and marketing group of our acquisitions department continually sought to identify new opportunities for the purchase of bulk and flow mortgage assets. They focused on deepening relationships with sellers from whom we had made acquisitions in the past and on developing relationships with new sellers, as well as with brokers who had access to sellers of the types of portfolios that we were interested in purchasing.
Loan Originations - Tribeca
We formed Tribeca, our wholly-owned subsidiary, in 1997 as an origination platform for subprime residential mortgages. Tribeca’s mortgage origination platform provided us with an additional vehicle for growth and reduced our reliance on loan acquisitions from other financial institutions for growth. Since commencing operations in 1997, Tribeca originated approximately $1.55 billion in subprime residential mortgage loans for individuals in serious financial difficulties and with credit histories, income and/or other factors that caused them to be classified as subprime borrowers.
Through Tribeca, we originated principally first mortgage loans. While our strategy was to hold a majority of originated loans in our portfolio for investment, our strategy changed from time to time in the past based on market conditions and our own portfolio needs. During the third quarter of 2006, we began to sell a portion of our newly originated loans for cash on a whole-loan, servicing-released basis. We focused on developing and offering an array of proprietary niche products, including innovative purchase and refinance loans for 1-4 family residential real estate. We offered both fixed and adjustable rate mortgages. Our maximum loan amount was $2 million, and our maximum loan-to-value ratio generally was 75% for portfolio loans (100% for loans underwritten to specific investor guidelines), depending on the specific product and that product’s underwriting requirements. In 2007, our average loan amount was $238,000, compared with an average loan amount of $227,000 in 2006 and $228,000 in 2005. For loans originated in 2007, the weighted average loan-to-value ratio was 66%, compared with weighted average loan-to-value ratios of 65% and 67% for 2006 and 2005, respectively.
Wholesale and Retail Originations
Tribeca originated loans through both wholesale and retail channels. In 2007, approximately 32% of loans was originated through our retail channels, with the remainder originated through a wholesale network of mortgage brokers. Of retail loans originated in 2007, approximately 87% was Liberty Loans, which we generally have held for our portfolio, while the balance represented loans that we originated for sale to investors.
The focus of our retail operation had been direct-to-consumer loans. Our marketing efforts consisted primarily of pursuing internet-generated leads and to a lesser extent, referral-based business from attorneys, accountants, real estate agents and financial planners, as well as the retention of existing Franklin Credit Management Corporation borrowers. The focus of our wholesale account executives was on identifying qualified mortgage brokers and generating a consistent flow of business. Tribeca, at December 31, 2007, maintained two lending offices, located in New Jersey and Pennsylvania, but originated loans in 33 states.
Tribeca sought to minimize the inherent risk of using mortgage brokers to source a significant portion of its Liberty Loan originations through a mortgage broker review and approval process. Only approved mortgage brokers could submit mortgage loan request packages to Tribeca for processing and underwriting. Tribeca considered a number of factors for broker approval, including requiring experience in sourcing subprime mortgage loans, appropriate state licenses, and errors/omissions and fidelity insurance polices in force. Tribeca also reviewed broker tax returns, credit reports, and the broker’s history of lending experience and consumer complaints.
A complete mortgage loan request package included in many cases a completed borrower application in accordance with our particular program guidelines, credit report, appraisal and other required documentation supporting the application. Appraisals were only accepted from Tribeca-approved appraisers, and appraised values generally were compared with various other sources of property value estimates or opinions. When a mortgage loan request package was received from an approved broker, Tribeca personnel reviewed the package for all required documents and information. If the package was complete, Tribeca personnel underwrote the loan in accordance with its loan program requirements. After receipt of the broker loan package, Tribeca controlled the processing, underwriting, approval/denial, legal and regulatory documents, closing and funding of the approved loan.
Acquisition of Wholesale Mortgage Operation. In February 2007, Tribeca acquired a wholesale mortgage origination operation, which included the employment of 59 sales and processing personnel located in Bridgewater, New Jersey. The principal purpose of the acquisition was to add experienced origination personnel and senior management to Tribeca in order to further expand the origination of its Liberty Loan products.
Tribeca paid $485,000 for the associated fixed assets and assumed the lease obligation for the Bridgewater office facility. In addition, Tribeca took over the existing pipeline of “Alt-A” loans (loans on the credit scale between prime and subprime where the borrower possesses a strong credit history but is in need of non-traditional underwriting and processing) in various stages of processing as of the closing of the transaction, which included approximately $17 million of loans that were locked with the borrower out of a total pipeline of $27 million. Tribeca was required to pay 50 basis points to the seller of the wholesale mortgage origination operation for each loan in the acquired pipeline that was subsequently closed by Tribeca within 90 days of the acquisition. Tribeca did not purchase any closed loans or other assets, nor assume any liabilities other than those under the seller’s lease for the Bridgewater office space.
Tribeca closed a total of $6.5 million of the loans in the acquired pipeline and paid $33,000 in fees to the seller of the wholesale origination operation. Tribeca’s obligation to pay 50 basis points to the seller for closed loans from the acquired pipeline has been satisfied.
During the quarter ended September 30, 2007, we consolidated the processing, underwriting, closing and administrative operations of Tribeca into a single location, to take advantage of the synergies of this acquisition, and as origination volumes declined due to the tightening of our underwriting standards and the absence of the secondary market for “Alt-A” loan sales. As a result, the total number of Tribeca employees, including the Bridgewater employees, was reduced to 59 at September 30, 2007, from 144 at March 31, 2007. Additional staff reductions in Tribeca continued during the three months ended December 31, 2007 as we ceased to originate loans during the quarter. Tribeca had 37 employees at December 31, 2007.
Borrowers
As with loans we acquired, borrowers of loans we originated are a diverse population and no single borrower represents a significant portion of our loans. Our borrowers are located in 33 states, with approximately 55% and 62%, respectively, of the aggregate amount of loans originated in 2007 and 2006 being secured by property in New York and New Jersey. At December 31, 2007, approximately 59% of originated loans held for investment were secured by property in New York and New Jersey.
Secondary Marketing
In 2007, we sold $37.5 million of loans and realized a net loss on sale of $305,000, and in 2006, we sold $119.8 million of loans and realized a net gain on sale of $1.9 million. The percentage of originated loans sold varied from year to year, depending on market conditions and our portfolio needs.
From time to time, we sold a portion of the Tribeca loan originations for cash on a whole-loan, servicing-released basis. Certain whole-loan sale contracts included provisions requiring the Company to repurchase a loan if a borrower failed to make one or more of the first loan payments due on the loan after the date of sale.
In addition, the purchaser may require that the Company refund a portion of the premium paid on the sale of mortgage loans if a loan is prepaid in full within a certain amount of time from the date of sale.
In the years ended December 31, 2007 and 2006, the Company repurchased $25.4 million and $1.8 million, respectively, of Liberty Loans previously sold to investors. As of December 31, 2007, the Company was not subject to any claims by purchasers seeking to repurchase loans sold.
Licensing
Tribeca is currently licensed as a mortgage banker or exempt from licensing in 34 states. Tribeca is also a Department of Housing and Urban Development FHA Title I and Title II approved lender. Using its current mortgage banker licenses and exemptions, Tribeca has the ability to broker loans in 20 states. See “Risk Factors - Risks Related to Our Business.”
Products
We have varied our product offerings depending on market conditions. Our origination volume has focused on Liberty Loans, which we generally have held for investment in our own portfolio, and Gold and Platinum loans, which we originated for sale to investors as described above.
Liberty Loans. During 2006 and 2007, a majority of our loan originations were conducted through our Liberty Loan program. The Liberty Loan is oriented toward borrowers typically in severe financial difficulty who are undergoing a transition in their credit profile due to unforeseen life events such as divorce, business failure, loss of employment, health crises and similar events. A substantial portion of our Liberty Loan originations served as foreclosure bailouts for the borrowers. Our historical experience has been that Liberty Loan customers either pay off their loans in full by refinancing at a lower interest rate once they have re-established their credit record, or end up in the foreclosure process. Our experience prior to 2007 has been that a good portion of the loans in the foreclosure process pay off in full before actual foreclosure. However, due to the decline in home prices in the U.S. and related declines in borrowers’ equity in their homes during 2007, combined with the significant tightening of new credit throughout the mortgage lending industry, particularly in the subprime segment of the industry, borrowers with imperfect credit histories have encountered significant increased difficulty in refinancing their mortgages. Liberty Loans have been primarily adjustable-rate mortgages, or ARMs, with 30-year terms, with a fixed rate of interest for the first two years and a six-month adjustable rate of interest for the remaining term of the mortgage. The maximum Liberty Loan amount generally was $2 million, with a maximum loan-to-value ratio generally of 75%. Our average Liberty Loan amount in 2007 was $236,000, and in 2006 was $223,000.
Our Liberty Loan application and approval process was streamlined, generally requiring little documentation. The principal factor in our underwriting guidelines was historically our determination of the borrower’s equity in his or her home and the related calculation of the loan-to-value ratio based on the appraised value of the property, and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan. The specific parameters of the Liberty Loan program continued to evolve. In 2005, we began in an increasing number of cases to gather and analyze additional information that allowed us to assess to a reasonable degree the borrower’s ability and intent to repay the loan in connection with our credit decision. We offered borrowers several variations of the Liberty Loan based on the amount of documentation provided by the borrower, with the loan-to-value ratio increasing to a maximum of 75% for the product variation requiring the most documentation supporting the ability and intent of the borrower to repay the loan and decreasing to a maximum of 65% for the product variation requiring the least of such documentation. Throughout 2006, loans were assessed to determine the borrower’s ability to make the required mortgage payments using debt-to-income ratio maximums, and taking into consideration compensating factors. However, the assessment of the borrower’s ability to pay was limited depending on the documentation requirements of the particular Liberty Loan product program. Prior to September 2006, we utilized third-party vendors to review the quality of the appraisals on all loans and we used broker price opinions only for loan amounts over $350,000. Effective in September 2006, broker price opinions were used for all loans to compare with appraisals in order to best assess the equity in the borrower’s home.
It was our policy not to originate loans subject to either HOEPA or the various state and local laws regarding “high-cost” loans. Consistent with what we believe were industry best practices, the Liberty Loan program, among other things, did not allow for negative amortization, interest-only payments, teaser rates, short-term balloon payments, the financing of single-premium credit life insurance, long-term prepayment penalties, interest rates that increase upon default, or mandatory arbitration clauses.
During 2007, in response to generally declining home prices in the U.S. and deteriorating mortgage origination conditions, Tribeca made a series of credit tightening changes to its loan programs, particularly its Liberty Loan programs. These underwriting and loan-to-value changes resulted in, as of mid-2007, a maximum loan-to-value of 70% for “full” documentation Liberty Loans with a maximum loan amount of $1 million, and a maximum-loan-to value of 65% for up to a maximum loan amount of $1 million for “stated” income Liberty Loans.
Platinum and Gold Loans. The balance of our loan originations in 2006 and 2007 were conducted through our Platinum and Gold programs, which were for loans to be sold to specific investors. Borrowers of our Platinum and Gold loans typically had higher credit ratings than borrowers under loans that we originated to hold for our portfolio, as they were underwritten to specific investor guidelines that required higher credit profiles.
Competition
The market for non-prime loan originations has been highly competitive. Up until the middle of the fourth quarter of 2007, Tribeca competed with a variety of lenders, including banks and mortgage bankers, for the origination of subprime and non-prime mortgages. Among the largest and most well-established of these competitors had been New Century Mortgage, Ameriquest Mortgage, Countrywide Financial Corporation, Household Financial Services, Quality Home Loan, Imperial Wholesale Lending and Emigrant Mortgage. Many of our competitors possessed greater financial resources, longer operating histories and lower costs of capital than we did. Competition for mortgage originations was based upon marketing efforts, loan processing capabilities, funding capacity, loan product desirability, interest rates and fees and, to a much lesser extent in our case, the ability to sell loans for a premium in the secondary market.
Mortgage Banking Segment Summary Information
The following table sets forth certain information regarding revenues, expenses and income before provision for income taxes for our mortgage banking segment:
Servicing
Except for a temporary period after acquiring a pool of loans when servicing may have been performed for us by the seller, we service substantially all of the loans in our portfolio, including both purchased and originated loans, until resolution. At December 31, 2007, our servicing department consisted of 106 employees who managed 31,077 loans. Our servicing operations are conducted in the following departments:
Loan Boarding and Administration. The primary objective of the loan boarding department is to ensure that newly acquired loans are properly transitioned from the prior servicer and that both newly acquired loans and originated loans are accurately boarded onto our servicing systems. In the bulk acquisition context, data generally is transmitted via an electronic file from the seller which is loaded directly onto our system, while data for originated loans and flow acquisitions is boarded directly by us onto our system. Our loan boarding department audits loan information for accuracy in approximately 10% of bulk purchased loans to ensure that the loans conform to the terms provided in the original note and mortgage. For the remaining bulk purchased loans, we perform verification of critical terms of the loans with information provided to us by the sellers. The information boarded onto our systems provides us with a file that we use to automatically generate introductory letters to borrowers summarizing the terms of their loan, among other standard industry procedures.
The loan administration department performs typical duties related to the administration of loans, including incorporating modifications to terms of loans as well as, in the case of acquisitions, completing and recording the assignment of collateral documents from the seller into our name, which it does in conjunction with our acquisition department. The loan administration department also ensures the proper maintenance and disbursement of funds from escrow accounts and monitors non-escrow accounts for delinquent taxes and insurance lapses. For purchased and originated loans with adjustable interest rates, the loan administration group ensures that adjustments are properly made and identified to the affected borrowers in a timely manner.
Customer Service. The primary objective of our customer service department is to obtain timely payments from borrowers, respond to borrower requests and resolve disputes with borrowers. Within ten days of boarding newly acquired loans onto our servicing system, our customer service representatives contact each new borrower to welcome them to Franklin Credit Management Corporation and to gather and/or verify any missing information, such as loan balance, interest rate, contact phone numbers, place of employment, insurance coverage and all other pertinent information required to properly service the loan. The customer service group responds to all inbound customer calls for information requests regarding payments, statement balances, escrow balances and taxes, payoff requests, returned checks and late payment and other fees. In addition, our customer service representatives process payoff requests and reconveyances.
Collections. The main objective of our collections department is to ensure loan performance through maintaining customer contact. Our collections group continuously reviews and monitors the status of collections and individual loan payments in order to proactively identify and solve potential collection problems. When a loan becomes seven days past due, our collections group begins making collection calls and generating past-due letters. Our collections group attempts to determine whether a past due payment is an aberration or indicative of a more serious delinquency. If the past due payment appears to be an aberration, we emphasize a cooperative approach and attempt to assist the borrower in becoming current or arriving at an alternative repayment arrangement. Upon a serious delinquency, by which we mean a delinquency of 61 days by a borrower, or the earlier determination by our collections group based on the evidence available that a serious delinquency is likely, the loan is typically transferred to our legal department where loss mitigation begins. We employ a range of strategies to modify repayment terms in order to enable the borrower to make payments and ultimately cure the delinquency, or focus on expediting the foreclosure process so that loss mitigation can begin as promptly as practicable.
Legal. Our legal department, which consists of non-lawyer administrative staff experienced in collection work, manages and monitors the progress of seriously delinquent loans and loans which we believe will develop into serious delinquencies. In addition to maintaining contact with borrowers through telephone calls and collection letters, this department utilizes various strategies in an effort to reinstate an account or revive cash flow on an account. The legal department analyzes each loan to determine a collection strategy to maximize the amount and speed of recovery and minimize costs. The particular strategy is based upon each individual borrower’s past payment history, current credit profile, current ability to pay, collateral lien position and current collateral value. We employ a range of strategies depending on the specific situation, including the following:
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Short-term repayment plans, or forbearance plans, when a delinquency can be cured within six months;
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Loan modifications, when a delinquency cannot be cured within three months but the borrower has the financial ability to abide by the terms of the loan modification;
•
Short sales, when the borrower does not have the ability to repay and the equity in the property is not sufficient to satisfy the total amount due under the loan, but we accept the sale price of the property in full satisfaction of the debt in order to expedite the process for all parties involved;
•
Deed-in-lieu, when the borrower does not have the ability to repay and the equity in the property is not sufficient to satisfy the total amount due, but we accept the deed in full satisfaction of the debt in order to expedite the process for all parties involved;
•
Assumption, when the borrower wishes to relinquish responsibility to a third party and the prospective borrower demonstrates the ability to repay the loan;
•
Subordination, when we have the second lien on a property and the first-lien holder wishes to refinance its loan, to which we will agree if the terms of the refinanced loan permit the borrower to repay our loan; and
•
Deferment agreements, when we forgo collection efforts for a period of time, typically as a result of a hardship incurred by the borrower, such as a natural disaster or a death or illness in the family, as a result of which the borrower is temporarily unable to repay.
Seriously delinquent accounts not resolved through the loss mitigation activities described above are foreclosed or a judgment is obtained against the related borrower in accordance with state and local laws, with the objective of maximizing asset recovery in the most expeditious manner possible. This is commonly referred to as loss management. Foreclosure timelines are managed through a timeline report built into the loan servicing system. The report schedules milestones applicable for each state throughout the foreclosure process, which enhances our ability to monitor and manage the process. Properties acquired through foreclosure are transferred to our real estate department to manage eviction and marketing or renting of the properties. However, until foreclosure is completed, efforts at loss mitigation are continued.
In addition, our legal department manages loans by borrowers who have declared bankruptcy. The primary objective of the bankruptcy group within our legal department, which utilizes outside counsel, is to proactively monitor bankruptcy assets and outside counsel to ensure compliance with individual plans and to ensure recovery in the event of non-compliance.
Real Estate. Our real estate department manages all properties acquired by us upon foreclosure of a delinquent loan or through purchase as part of a loan portfolio in order to preserve their value and ensure that maximum returns are realized upon sale. We own real estate, or OREO, in various states that we acquired through foreclosure, a deed-in-lieu or acquisition. These properties are 1-4 family residences, co-ops and condos. We acquire or foreclose on property primarily with the intent to sell it at a price to at least recover our cost. From time to time, OREO properties may be in need of repair or improvements in order to either increase the value of the property or reduce the time that the property is on the market. In those cases, the OREO property is evaluated independently and we make a determination of whether the additional investment would increase our return upon sale or rental of the property.
Quality Control. Our Quality Control department monitors all aspects of loan servicing from boarding through foreclosure. It is the department’s responsibility to ensure that the company’s policies and procedures are followed. Collection calls are monitored to ensure quality and to ensure that all Fair Debt Collection Act requirements are being met. Monthly meetings with staff to discuss individual quality control scores are held, and in certain cases, further training is recommended. Reviews of privacy and proper controls for document removal are done monthly.
Training. Our training department works with all departments of loan servicing to ensure that all employees of the department are fully informed of all the procedures necessary to completed their required tasks. The department ensures all loan servicing employees are trained in Fair Debt Collection Act practices as well as effective communication skills.
Portfolio Characteristics
Overall Portfolio
At December 31, 2007, our portfolio (excluding OREO) consisted of $1.42 billion of notes receivable (inclusive of purchase discount not reflected on the face of the balance sheet) and $505.7 million of loans held for investment. There were no loans held for sale at December 31, 2007. Our total loan portfolio grew 16% to $1.92 billion at December 31, 2007, from $1.66 billion at December 31, 2006. Not boarded loans represent
loans serviced by the seller on a temporary basis. The following table sets forth information regarding the types of properties securing our loans.
(1)
The loans included in this category are principally small balance (less than $10,000) second-lien loans acquired, and are collateralized by residential real estate.
(2)
The loans included in this category are principally second-lien loans where the residential real estate collateral has been foreclosed by the first-lien holder.
Geographic Dispersion. The following table sets forth information regarding the geographic location of properties securing the loans in our portfolio at December 31, 2007:
Amounts included in the tables above under the heading “Principal Balance” represent the aggregate unpaid principal balance outstanding of notes receivable, loans held for investment and loans held for sale.
Asset Quality
Delinquency. The following tables provide a breakdown of the delinquency status of our notes receivable, loans held for investment and loans held for sale portfolios as of the dates indicated, by principal balance. Because we specialized in acquiring and servicing loans with erratic payment patterns and an elevated level of credit risk, a portion of the loans we have acquired were in various stages of delinquency, foreclosure and bankruptcy when we acquired them. We monitor the payment status of our borrowers based on both contractual delinquency and recency delinquency. By contractual delinquency, we mean the delinquency of payments relative to the contractual obligations of the borrower. By recency delinquency, we mean the recency of the most recent full monthly payment received from the borrower. By way of illustration, on a recency delinquency basis, if the borrower has made the most recent full monthly payment within the past 30 days, the
loan is shown as current regardless of the number of contractually delinquent payments. In contrast, on a contractual delinquency basis, if the borrower has made the most recent full monthly payment, but has missed an earlier payment or payments, the loan is shown as contractually delinquent. We classify a loan as in foreclosure when we determine that the best course of action to maximize recovery of unpaid principal balance is to begin the foreclosure process. We classify a loan as in bankruptcy when we receive notice of a bankruptcy filing from the bankruptcy court.
(1)
Not boarded represents recently acquired loans serviced by the seller on a temporary basis. A portion of not boarded loans has been included in the appropriate delinquency categories based on information provided by the seller-servicer. The remaining portion of not boarded loans, for which information has not been entered into our servicing system, is shown in the not boarded category. Total not boarded loans amounted to $129,906,356 at December 31, 2006.
(2)
Excludes $17.2 million of loans sold to investors, which the Company committed to repurchase, that are included on the face of the balance sheet at December 31, 2006.
Notes Receivable Portfolio
As of December 31, 2007, our notes receivable portfolio, which consists of purchased loans, included approximately 28,865 loans with an aggregate unpaid principal balance (“UPB”) of $1.42 billion, compared with approximately 29,460 loans with an aggregate UPB of $1.25 billion as of December 31, 2006. Impaired loans comprise and will continue to comprise a significant portion of our portfolio. Many of the loans we have acquired were impaired loans at the time of purchase. We generally purchased such loans at discounts and have considered the payment status, underlying collateral value and expected cash flows when determining our purchase price. While interest income generally is not accrued on impaired loans, interest and fees are received on a portion of loans classified as impaired. The following table provides a breakdown of the notes receivable portfolio by year:
*
Represents purchase discount not reflected on the face of the balance sheet in accordance with SOP 03-3 for loans acquired after December 31, 2004. Accretable discount is the excess of the loan’s estimated cash flows over the purchase prices, which is accreted into income over the life of the loan. Nonaccretable discount is the excess of the undiscounted contractual cash flows over the undiscounted cash flows estimated at the time of acquisition.
The following table provides a breakdown of the balance of our portfolio of notes receivable between fixed-rate and adjustable-rate loans, net of allowance for loan losses and excluding loans purchased but not yet boarded onto our servicing operations system as of December 31, 2007, December 31, 2006 and December 31, 2005 of $0, $129,906,356, and $178,719,416, respectively:
Impaired loans comprise and will continue to comprise a significant portion of our portfolio. Many of the loans we acquired were impaired loans at the time of purchase. We generally purchased such loans at discounts and considered the payment status, underlying collateral value and expected cash flows when determining our purchase price. While interest income generally is not accrued on impaired loans, interest and fees are received on a portion of loans classified as impaired.
Lien Position. The following table sets forth information regarding the lien position of the properties securing our portfolio of notes receivable at December 31, 2007, December 31, 2006 and December 31, 2005:
Loan Acquisitions
We purchased over $528.7 million of single-family residential mortgage loans in 2007, compared with approximately $621.4 million of single-family residential mortgage loans and assets, principally secured by second liens, during 2006 and approximately $505.7 million of single-family residential mortgage loans during 2005. Approximately 49%, 8% and 36%, respectively, of the loans purchased in 2007, 2006 and 2005 were secured by first liens. During the twelve months ended December 31, 2007, we put back to sellers $16.4 million of loans previously acquired, and recovered substantially the total amount paid at the time of
purchase. The following table sets forth the amounts and purchase prices of our mortgage loan acquisitions during the previous three calendar years:
*
Represents $5.0 million of OREO that was acquired in the third quarter of 2006.
Notes Receivable Dispositions
In the ordinary course of our loan servicing process and through the periodic review of our portfolio of purchased loans, there are certain loans that, for various reasons, we determine to sell. We typically sell these loans on a whole-loan, servicing-released basis, for cash. The following table sets forth our dispositions of purchased loans during the previous three calendar years:
*
Sale of credit card portfolio. The carrying value of this portfolio was $1.2 million.
Tribeca’s Loan Originations
The following table sets forth Tribeca’s loan originations, as well as dispositions, during the previous three calendar years. During 2004, we began to originate loans, principally adjustable-rate loans with a fixed rate for the first two years, to be held in our portfolio. During 2006, we began to sell a portion of our newly originated adjustable-rate loans, which we refer to as our Liberty Loans, on a whole-loan, servicing-released basis, for cash.
(1)
Originated ARM loans are principally fixed-rate for the first two years and six-month adjustable-rate for the remaining term.
(2)
Included in loss on sale for 2007 are: net gain of $155,000 on the sale of Liberty Loans; a net gain of $286,000 on the sale of other loans originated for sale; a net loss of $828,000 on “Alt-A” loans both sold and transferred to portfolio at the lower of cost or market value; and a net recovery of $82,000 for previously established early payment default reserves for Liberty Loans sold in 2006.
(3)
At December 31, 2006, approximately $43 million of sold loans were anticipated to be repurchased. The gain on sale includes a reserve for the portion of the gain that relates to the gain recognized on the sold loans expected to be repurchased.
Property Types of Originated Loans Held for Investment. At December 31, 2007, Tribeca’s portfolio consisted of $505.7 million of loans originated and held for investment. Tribeca’s portfolio of loans held for investment increased by $79.6 million, or 19%, as of December 31, 2007, from $426.1 million at December 31, 2006. The following table sets forth information regarding the types of properties securing Tribeca’s portfolio of loans held for investment.
At December 31, 2007, Tribeca did not have any loans held for sale.
Geographic Dispersion of Originated Loans. The following table sets forth information regarding the geographic location of properties securing all loans originated by Tribeca during 2007 and the aggregate portfolio of loans originated and held for investment at December 31, 2007:
*
UPB before net deferred fees and allowance for loan losses.
Delinquency. The following tables provide a breakdown of the delinquency status of our loans held for investment and loans held for sale portfolios as of the dates indicated, by principal balance. Because we specialized in originating residential mortgage loans for individuals with credit histories, income and/or factors that caused them to be classified as subprime borrowers, a substantially greater portion of the loans we originated experience varying degrees of delinquency, foreclosure and bankruptcy than those of prime lenders. We monitor the payment status of our borrowers based on both contractual delinquency and recency delinquency. By contractual delinquency, we mean the delinquency of payments relative to the contractual obligations of the borrower. By recency delinquency, we mean the recency of the most recent full monthly payment received from the borrower. By way of illustration, on a recency delinquency basis, if the borrower has made the most recent full monthly payment within the past 30 days, the loan is shown as current regardless of the number of contractually delinquent payments. In contrast, on a contractual delinquency basis, if the borrower has made the most recent full monthly payment, but has missed an earlier payment or payments, the loan is shown as contractually delinquent. We classify a loan as in foreclosure when we determine that the best course of action to maximize recovery of unpaid principal balance is to begin the foreclosure process. We classify a loan as in bankruptcy when we receive notice of a bankruptcy filing from the bankruptcy court.
*
$181.7 million of loans were in various stages of the foreclosure process; our servicing practice for this portfolio is to move loans into our foreclosure collection process at an early stage of delinquency.
(1)
$103.6 million of loans were in various stages of the foreclosure process; our servicing practice for this portfolio is to move loans into our foreclosure collection process at an early stage of delinquency.
(2)
Excludes $17.2 million of loans sold to investors, which the Company committed to repurchase, that are included on the face of the balance sheet at December 31, 2006.
During 2007, our loans held for investment, principally Liberty Loans, became more seasoned and, as anticipated, a significant portion of our Liberty Loans were moved into the foreclosure process. At December 31, 2007, $180.8 million of Liberty Loans, or 36% of the portfolio of loans held for investment were in our foreclosure process, compared with $102.7 million, or 25%, at December 31, 2006. Our Servicing department personnel evaluates the collateral of each loan in the foreclosure process for its estimated realizable value, utilizing updated BPOs; the estimated losses on future disposition, which were included in the allowance for loan losses, aggregated approximately $5.8 million at December 31, 2007. In addition, our experience with Liberty Loans is that a percentage of the loans in the foreclosure process pay off in full, including approximately 90% of all unpaid interest due at the time of payoff, prior to actual foreclosure sale. However, during 2007, particularly during the second half of the year, due to declining housing prices in general and a rapid and severe credit tightening throughout the mortgage industry, total portfolio payoffs through borrower refinancing declined as it became more difficult for borrowers with any type of credit deficiency to refinance their loans. Portfolio payoffs declined approximately 36% in the third quarter ended September 30, 2007 from the second quarter ended June 30, 2007, and approximately 15% in the fourth quarter ended December 31, 2007 compared with the prior quarter.
Other Real Estate Owned
The following table sets forth our real estate owned, or OREO, portfolio and OREO sales during the previous three calendar years:
Government Regulation
The mortgage lending industry is highly regulated. Our business is regulated by federal, state and local government authorities and is subject to federal, state and local laws, rules and regulations, as well as judicial and administrative decisions that impose requirements and restrictions on our business. At the federal level, these laws, rules and regulations include:
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the Equal Credit Opportunity Act and Regulation B;
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the Federal Truth in Lending Act and Regulation Z;
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Home Ownership and Equity Protection Act, or HOEPA;
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the Real Estate Settlement Procedures Act, or RESPA, and Regulation X;
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the Fair Credit Reporting Act;
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the Fair Debt Collection Practices Act;
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the Home Mortgage Disclosure Act and Regulation C;
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the Fair Housing Act;
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the Telemarketing and Consumer Fraud and Abuse Prevention Act;
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the Telephone Consumer Protection Act;
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the Gramm-Leach-Bliley Act;
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the Soldiers and Sailors Civil Relief Act;
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the Fair and Accurate Credit Transactions Act; and
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the CAN-SPAM Act.
These laws, rules and regulations, among other things:
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impose licensing obligations and financial requirements on us;
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limit the interest rates, finance charges, and other fees that we may charge;
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prohibit discrimination both in the extension of credit and in the terms and conditions on which credit is extended;
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prohibit the payment of kickbacks for the referral of business incident to a real estate settlement service;
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impose underwriting requirements;
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mandate various disclosures and notices to consumers, as well as disclosures to governmental entities;
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mandate the collection and reporting of statistical data regarding our customers;
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require us to safeguard non-public information about our customers;
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regulate our collection practices;
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require us to combat money-laundering and avoid doing business with suspected terrorists;
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restrict the marketing practices we may use to find customers, including restrictions on outbound telemarketing; and
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in some cases, impose assignee liability on us as purchaser of mortgage loans as well as the entities that purchase our mortgage loans.
Our failure to comply with these laws can lead to:
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civil and criminal liability, including potential monetary penalties;
•
loss of lending licenses or approved status required for continued lending and servicing operations;
•
demands for indemnification or loan repurchases from purchasers of our loans;
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legal defenses causing delay and expense;
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adverse effects on our ability, as servicer, to enforce loans;
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the borrower having the right to rescind or cancel the loan transaction;
•
adverse publicity;
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individual and class action lawsuits;
•
administrative enforcement actions;
•
damage to our reputation in the industry;
•
inability to sell or securitize our loans; or
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inability to obtain credit to fund our operations.
Although we have systems and procedures directed to compliance with these legal requirements and believe that we are in material compliance with all applicable federal, state and local statutes, rules and regulations, we cannot provide assurance that more restrictive laws and regulations will not be adopted in the future, or that governmental bodies will not interpret existing laws or regulations in a more restrictive matter, which could render our current business practices non-compliant or which could make compliance more difficult or expensive. These applicable laws and regulations are subject to administrative or judicial interpretation, but some of these laws and regulations have been enacted only recently or may be interpreted infrequently or only recently and inconsistently. As a result of infrequent, sparse or conflicting interpretations, ambiguities in these laws and regulations may leave uncertainty with respect to permitted or restricted conduct under them. Any ambiguity under a law to which we are subject may lead to non-compliance with applicable regulatory laws and regulations. We actively analyze and monitor the laws, rules and regulations that apply to our business, as well as the changes to such laws, rules and regulations.
New Areas of Regulation
Regulatory and legal requirements are subject to change, making our compliance more difficult or expensive, or otherwise restricting our ability to conduct our business as it is now conducted. In particular, federal, state and local governments have become more active in the consumer protection area in recent years. For example, the federal Gramm-Leach-Bliley financial reform legislation imposes additional privacy obligations on us with respect to our applicants and borrowers. The Fair and Accurate Credit Transactions Act of 2003, enacted in December 2003, requires us to provide additional disclosures when we disapprove a loan application. Additional requirements will apply to our use of consumer reports and our furnishing of information to the consumer reporting agencies. Additionally, Congress and the Department of Housing and Urban Development have discussed an intent to reform RESPA. Several states are also considering adopting privacy legislation. For example, California has passed legislation known as the California Financial Information Privacy Act and the California On-Line Privacy Protection Act. Both pieces of legislation became effective July 1, 2004, and impose additional notification obligations on us that are not preempted by existing federal law. If other states choose to follow California and adopt a variety of inconsistent state privacy legislation, our compliance costs could substantially increase. Moreover, several federal, state and local laws, rules and regulations have been adopted, or are under consideration, that are intended to protect consumers from predatory lending. The impact of this legislation, should it be adopted in other states, may negatively affect the availability of credit to a broader segment of the borrowing population than the smaller group that the laws are aiming to protect.
Local, state and federal legislatures, state and federal banking regulatory agencies, state attorneys general offices, the FTC, the Department of Justice, the Department of Housing and Urban Development and state and local governmental authorities have increased their focus on lending practices by some companies, primarily
in the non-prime lending industry, sometimes referred to as “predatory lending” practices. Sanctions have been imposed by various agencies for practices such as charging excessive fees, imposing higher interest rates than the credit risk of some borrowers warrant, failing to disclose adequately the material terms of loans to borrowers and abrasive servicing and collections practices. The Office of the Comptroller of the Currency, the regulator of national banks, issued a final regulation in 2004 that prescribed an explicit anti-predatory lending standard without regard to a trigger test based on the cost of the loan, which prohibits a national bank from, among other restrictions, making a loan based predominately on the foreclosure value of the borrower’s home, rather than the borrower’s repayment ability, including current and expected income, current obligations, employment status and relevant financial resources. This restriction would prevent national banks and their operating subsidiaries from purchasing the variation of the Liberty Loan where no assessment is made of the borrower’s ability to repay the loan. In addition, if this standard were adopted more generally, it may impact the ability of Tribeca to originate the Liberty Loan.
On May 16, 2005, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration (the “Agencies”) jointly issued “Credit Risk Management Guidance for Home Equity Lending.” The guidance promotes sound credit risk management practices for institutions engaged in home equity lending (both home equity lines of credit and closed-end home equity loans). Among other risk factors, the Guidance cautions lenders to consider all relevant risk factors when establishing product offerings and underwriting guidelines, including a borrower’s income and debt levels, credit score (if obtained), and credit history, as well as the loan size, collateral value, lien position, and property type and location. It stresses that prudently underwritten home equity loans should include an evaluation of a borrower’s capacity to adequately service the debt, and that reliance on a credit score is insufficient because it relies on historical financial performance rather than present capacity to pay. While not specifically applicable to loans originated by Tribeca, the guidance is instructive of the regulatory climate covering low and no documentation loans, such as certain of Tribeca’s Liberty Loan products.
On June 29, 2007, the Agencies released their final statement on subprime mortgage lending to address certain concerns of the Agencies that subprime borrowers may not fully understand the risk and consequences of certain adjustable-rate mortgage products. The Agencies expressed particular concern with (1) marketing products to subprime borrowers offering low initial payments based on an introductory (“teaser”) rate that is considerably lower than the fully indexed rate; (2) approving borrowers without considering appropriate documentation of their income; (3) setting very high or no limits on payment or interest rate increases at reset periods; (4) loan product features likely to result in frequent refinancing to maintain an affordable monthly payment; (5) including substantial prepayment penalties and/or prepayment penalties that extend beyond the initial rate adjustment period; and (6) providing borrowers with inadequate information relative to product features, material loan terms and products risks.
The final statement identifies underwriting standards, consumer protection principles and control systems applicable to subprime mortgage loans that focus on the importance of evaluating the borrower’s ability to repay the debt by its final maturity at the fully indexed rate and providing information that enable consumers to understand material terms, costs, and risks. The Agencies caution their regulated institutions against making mortgage loans based predominately on the foreclosure or liquidation value of a borrower’s collateral rather than on the borrower’s ability to repay the mortgage according to its terms, inducing a borrower to repeatedly refinance a loan in order to charge high points and fees each time a loan is refinanced and engaging in fraud or deception to conceal the true nature of the mortgage loan obligation. The Agencies also advised their regulated institutions that when underwriting higher risk loans, stated income and reduced documentation should be accepted only if there are mitigating factors that clearly minimize the need for direct verification of repayment capacity. A higher interest rate is not considered a mitigating factor. While the final statement, in part, discusses subprime products not offered by Tribeca such as loans with “teaser” rates, the final statement appears to apply strict standards for all types of subprime loans and is instructive of the regulatory climate concerning subprime mortgage loans, such as Tribeca’s Liberty Loan, where the lending decision was or may have been based entirely or primarily on the borrower’s equity in his or her home and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan. In addition, as with the 2006 Interagency
Guidance on Nontraditional Mortgage Product Risks for mortgages where the borrower is able to defer repayment of principal for a period of time (interest only-loans and Pay Option ARMs), state regulators have adopted similar standards applicable to the institutions they regulate, which includes Tribeca. On July 17, 2007, the American Association of Residential Mortgage Regulators (AARMR), which is comprised of state officials with responsibility for regulating state licensed mortgage lenders and brokers, in conjunction with the Conference of State Bank Supervisors (CSBS) and the National Association of Consumer Credit Regulators (NACCA), issued a statement on subprime lending that is substantially similar to the Agencies’ final statement and which as of March 2008 has been adopted in 34 states plus the District of Columbia.
A key mortgage industry tool for finding new borrowers is under recent attack in class action litigation across the country. Those class actions have been filed by attorneys seeking to capitalize on a 2004 decision of the Seventh Circuit Court of Appeals, Cole v. U.S. Capital, Inc. (“Cole”) interpreting the meaning of “firm offers of credit” under the Fair Credit Reporting Act (“FCRA”). A prescreened or firm offer is any offer of credit to a consumer that will be honored if the consumer is determined, based on information in a consumer report on the consumer, to meet the specific criteria used to select the consumer for the offer. Cole was the first case in the nation to hold that an offer of nominal “value” to the consumer, which could arise from a combination of factors such as a low dollar amount of the offered credit, ambiguous or contradictory terms, or complex approval procedures, may not actually qualify as a “firm offer” under FCRA, even if the stated amount is guaranteed. Recent courts to address the issue have split on the issue. Some of the courts in these recent cases have concluded that the defendant’s violation of FCRA was “willful.” FCRA distinguishes negligent or inadvertent non-compliance from “willful” violations by the damages that are available. Specifically, FCRA provides for statutory damages of $100-1,000 per violation for “willful” violations and permits punitive damages as well. By contrast, FCRA provides that a defendant whose non-compliance was merely negligent will be liable only for “actual damages sustained by the consumer as a result of the failure.” This distinction is significant because FCRA does not have a cap for statutory damages in a class action, unlike other federal statutes regulating consumer lending which cap statutory damages in a class action at a maximum of $500,000 or one percent of the creditor’s net worth, whichever is less. If we are named as a defendant in a firm offer class action, and the court were to find that the violation was willful, we could face substantial liability that could have a material adverse affect on our financial condition and operations.
HOEPA identifies a category of mortgage loans and subjects such loans to restrictions not applicable to other mortgage loans. Loans subject to HOEPA consist of loans on which certain points and fees or the annual percentage rate, known as the APR, exceed specified levels. Liability for violations of applicable law with regard to loans subject to HOEPA would extend not only to us, but to the institutional purchasers of our loans as well. It was our policy to seek not to originate loans that are subject to HOEPA or state and local laws discussed in the following paragraph or purchase high cost loans that violate such laws. On October 1, 2002, the APR and points and fees thresholds for determining loans subject to HOEPA were lowered, thereby expanding the scope of loans subject to HOEPA. Non-compliance with HOEPA and other applicable laws may lead to demands for indemnification or loan repurchases from our warehouse lenders and institutional loan purchasers, class action lawsuits and administrative enforcement actions.
Laws, rules and regulations have been adopted, or are under consideration, at the state and local levels that are similar to HOEPA in that they impose certain restrictions on loans on which certain points and fees or the APR exceeds specified thresholds, which generally are lower than under federal law. These restrictions include prohibitions on steering borrowers into loans with high interest rates and away from more affordable products, selling unnecessary insurance to borrowers, flipping or repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans. If the numerical thresholds were miscalculated, certain variations of our Liberty Loan product, where the lending decision was or may have been based entirely or primarily on the borrower’s equity in his or her home and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan, would violate HOEPA and many of these state and local anti-predatory lending laws. In the past, we have sold a portion of our Liberty Loan production to third parties on a whole-loan, servicing-released basis. Going forward, however, our ability to sell the Liberty Loan product to third parties could be impaired if our sources of financing or mortgage investors are required or choose to incorporate prohibitions from certain anti-predatory lending practices into
their eligibility criteria, even if the laws themselves do not specifically apply to us. Compliance with some of these restrictions requires lenders to make subjective judgments, such as whether a loan will provide a “net tangible benefit” to the borrower. These restrictions expose a lender to risks of litigation and regulatory sanction no matter how carefully a loan is underwritten. The remedies for violations of these laws are not based on actual harm to the consumer and can result in damages that exceed the loan balance. In addition, an increasing number of these laws, rules and regulations seek to impose liability for violations on assignees, which may include our warehouse lenders and whole-loan buyers, regardless of whether the assignee knew of or participated in the violation.
RESPA prohibits the payment of fees for the mere referral of real estate settlement service business. This law does permit the payment of reasonable value for services actually performed and facilities actually provided unrelated to the referral. In the past, several lawsuits have been filed against mortgage lenders alleging that such lenders have made certain payments to independent mortgage brokers in violation of RESPA. These lawsuits generally have been filed on behalf of a purported nationwide class of borrowers alleging that payments made by a lender to a broker in addition to payments made by the borrower to a broker are prohibited by RESPA and are therefore illegal. On September 18, 2002, the Eleventh Circuit Court of Appeals issued a decision in Heimmermann v. First Union Mortgage Corp., which reversed the court’s earlier decision in Culpepper v. Irwin Mortgage Corp. in which the court found the yield spread premium payments received by a mortgage broker to be unlawful per se under RESPA. The Department of Housing and Urban Development responded to the Culpepper decision by issuing a policy statement (2001-1) taking the position that lender payments to mortgage brokers, including yield spread premiums, are not per se illegal. The Heimmermann decision eliminated a conflict that had arisen between the Eleventh Circuit and the Eighth and Ninth Circuit Courts of Appeals, with the result that all federal circuit courts that have considered the issue have aligned with the Department of Housing and Urban Development policy statement and found that yield spread premiums are not prohibited per se. If other circuit courts that have not yet reviewed this issue disagree with the Heimmermann decision, there could be a substantial increase in litigation regarding lender payments to brokers and in the potential costs of defending these types of claims and in paying any judgments that might result. In addition, proposed changes by the Federal Reserve Board to HOEPA in Regulation Z (Truth in Lending), would prohibit lenders from compensating mortgage brokers through yield spread premiums on all loans secured by a consumer’s principal dwelling, unless the broker previously entered into a written agreement with the consumer disclosing the broker’s total compensation and other facts.
Compliance, Quality Control and Quality Assurance
We maintain a variety of quality control procedures designed to detect compliance errors. We have a stated anti-predatory lending policy which is communicated to all employees at regular training sessions. In addition, Tribeca, from time to time, subjects a statistical sampling of our loans to post-funding quality assurance reviews and analysis. We track the results of the quality assurance reviews and report them back to the responsible origination units. Our loans and practices are reviewed regularly in connection with the due diligence that our loan buyers and lenders perform. State regulators also review our practices and loan files and report the results back to us.
Privacy
The federal Gramm-Leach-Bliley Act obligates us to safeguard the information we maintain on our borrowers. California has passed legislation known as the California Financial Information Privacy Act and the California On-Line Privacy Protection Act. Both pieces of legislation became effective on July 1, 2004, and impose additional notification obligations on us that are not pre-empted by existing federal law. Regulations have been proposed by several agencies and states that may affect our obligations to safeguard information. If other states or federal agencies adopt additional privacy legislation, our compliance costs could substantially increase.
Fair Credit Reporting Act
The Fair Credit Reporting Act provides federal preemption for lenders to share information with affiliates and certain third parties and to provide pre-approved offers of credit to consumers. Congress also amended the Fair Credit Reporting Act to place further restrictions on the use of information shared between affiliates, to provide new disclosures to consumers when risk based pricing is used in the credit decision, and to help protect consumers from identity theft. All of these new provisions impose additional regulatory and compliance costs on us and reduce the effectiveness of our marketing programs.
As discussed above under the heading “New Areas of Regulation,” there has been significant class action activity relating to prescreened offers of credit, which is a tool we and many other mortgage lenders use for finding new borrowers. We have not been named as a defendant in such a class action. However, if we were to be named in a class action alleging a violation of the Fair Credit Reporting Act’s prescreened offer provisions, and the court were to find that the violation was willful, we could face substantial liability that could have a material adverse affect on our financial condition and operations.
Home Mortgage Disclosure Act
In 2002, the Federal Reserve Board adopted changes to Regulation C promulgated under the Home Mortgage Disclosure Act. Among other things, the new regulations require lenders to report pricing data on loans that they originate with annual percentage rates that exceed the yield on treasury bills with comparable maturities by three percent. The expanded reporting took effect in 2004 for reports filed in 2005. A majority of our loans are subject to the expanded reporting requirements.
The expanded reporting does not provide for additional loan information such as credit risk, debt-to-income ratio, LTV ratio, documentation level or other salient loan features that might impact pricing on individual loans. As a result, the reported information may lead to increased litigation and government scrutiny to determine if any reported disparities between prices paid by minorities and majorities may have resulted from unlawful discrimination. For example, the Civil Rights Division of the New York State Attorney General’s office has requested that certain large lenders provide it with supplementary information to explain the disparities in their reported HMDA data.
Telephone Consumer Protection Act and Telemarketing Consumer Fraud and Abuse Prevention Act
The FCC and the FTC adopted “do-not-call” registry requirements, which, in part, mandate that companies such as us maintain and regularly update lists of consumers who have chosen not to be called. These requirements also mandate that we do not call consumers who have chosen to be on the list. Those prohibitions do not apply to calls made to a servicer’s existing customers. Several states have also adopted similar laws, with which we also seek to comply.
Environmental Matters
In the ordinary course of our business we have from time to time acquired, and we may continue to acquire in the future, properties securing loans that are in default. In addition, loans that we purchase that are initially not in default may subsequently be defaulted on by the borrower. In either case, it is possible that hazardous substances or waste, contamination, pollutants or sources thereof could be discovered on those properties after we acquire them. To date, we have not incurred any environmental liabilities in connection with our OREO, although there can be no guarantee that we will not incur any such liabilities in the future.
Employees
We recruit, hire, and retain individuals with the specific skills that complement our corporate growth and business strategies. As of December 31, 2007, we had 207 full time employees, of which 37 were employed by Tribeca, our origination subsidiary.
None of our employees are represented by a union or covered by a collective bargaining agreement. We believe our relations with our employees, under the Company’s current circumstances, are good. However,
under the Company’s current circumstances, retaining key employees and hiring for certain critical positions is more challenging.
ITEM 1A.
ITEM 1A. RISK FACTORS
Risks Related to Our Business
We may experience higher loan losses than we have reserved for in our financial statements.
Our loan losses could exceed the allowance for loan losses that we have reserved for in our financial statements. Reliance on historic loan loss experience may not be indicative of future loan losses. Regardless of the underwriting criteria we utilized at the time of purchase or origination, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of our loan collateral and problems affecting the credit and business of our borrowers. As a result of the rapid and substantial deterioration in the housing and credit markets, particularly the subprime mortgage market, and deterioration in the performance of our portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, we reassessed our allowance for loan losses in the quarter ended September 30, 2007, which resulted in significantly increased estimates of inherent losses in our portfolios. Should the housing and credit markets continue to deteriorate significantly in 2008, or the economy experience a severe or prolonged recession, we could experience additional allowances for loan losses and/or charge-offs.
A prolonged economic slowdown or a lengthy or severe recession could harm our operations, particularly if it results in a decline in the real estate market.
The risks associated with our business are more acute during periods of economic slowdown or recession because these periods may be accompanied by decreased real estate values, loss of jobs as well as an increased rate of delinquencies, defaults and foreclosures. In particular, any material decline in real estate values would increase the loan-to-value ratios on loans that we hold and, therefore, weaken our collateral coverage, increase the likelihood of a borrower with little or no equity in his or her home defaulting and increase the possibility of a loss if a borrower defaults. If the current economic slowdown continues to worsen, our business could experience even greater losses.
Our credit facilities require us to observe certain covenants, and our failure to satisfy such covenants could render us insolvent.
Our credit facilities with the bank, as modified by the Forbearance Agreements, require us to comply with affirmative and negative covenants customary for restricted indebtedness, including covenants requiring that we will: maintain a minimum consolidated net worth of at least $5 million, plus a certain percentage, to be mutually agreed upon, of any equity investment in the Company after the date of the Restructuring; maintain a minimum liquidity of $5 million; not enter into mergers, consolidations or sales of assets (subject to certain exceptions); and, will not, without the bank’s consent, enter into any material change in our capital structure that the bank or a nationally recognized independent public accounting firm determines could cause a consolidation of our assets with other persons under relevant accounting regulations. See “Management’s Discussion and Analysis - Borrowings.”
In addition, under our credit facilities, if our controlling shareholder ceasing to possess, directly or indirectly, the power to direct our management and policies through his ownership of our voting stock, this could constitute an event of default, which, without a waiver from our lender, would cause our indebtedness to become immediately payable.
Subject to notice and cure period requirements where they are provided for, any unwaived and uncured breach of the covenants applicable to our debt with either of our lenders could result in acceleration of the amounts owed to such lender and the cross-default and acceleration of the indebtedness owing to the other lender.
If our lenders fail to renew our loans for additional terms or provide us with refinancing opportunities, our indebtedness will become due and payable in 2009.
Our unpaid principal balances owed to the bank and BOS are generally based on amortization schedules, but mature in May and March 2009, respectively. The facilities do not include a commitment to refinance the remaining outstanding balance of the loans when they mature and there is no guarantee that our lenders will renew their loans at that time. Refusal to provide us with renewals or refinancing opportunities would cause our indebtedness to become immediately due and payable upon the contractual maturity of such indebtedness, which could result in our insolvency if we are unable to repay the debt.
If we do not comply with certain minimum servicing standards in the Forbearance Agreements with the bank, the bank can transfer our rights as servicer to a third party.
Under the terms of the Forbearance Agreements, we are entitled to continue to service the collateral we pledged under the Forbearance Agreements. However, the bank has the right to replace us as servicer in the event of a default or if the bank determines that we are not servicing the collateral in accordance with accepted servicing practices, as defined in the Forbearance Agreements. If the bank terminated us as servicer of the collateral our operations and financial condition would be adversely affected.
Our ability to fund operating expenses depends on our principal lender continuing to provide an adequate operating allowance.
We are required to submit all payments we receive from obligors under pledged mortgage loans to a lockbox, from which we receive an operating allowance, which is subject to periodic review and approval by the bank, to sustain our business. Substantially all amounts submitted to the lockbox in excess of the agreed upon operating allowance are used to pay down amounts outstanding under our credit facilities with the bank and BOS. The operating allowance may not be sufficient to sustain our operations in the future, particularly for new business activities. If it is insufficient, there is no guarantee that the bank will increase our operating allowance, which could have a material adverse impact on our business.
Our business is sensitive to, and can be materially affected by, changes in interest rates.
Our business may be adversely affected by changes in interest rates, particularly changes that are unexpected in timing or size. The following are some of the risks we face related to an increase in interest rates:
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All of our borrowings bear interest at variable rates and we are only partially hedged through interest rate swaps and caps, while a significant majority of the loans in our portfolio have fixed rates. As a result, an increase in interest rates is likely to result in an increase in our interest expense without an offsetting increase in interest income. Further, our adjustable-rate loans typically provide for less frequent adjustments in response to rate increases than do our borrowings, and sometimes also include interest rate caps. To the extent this is the case, an increase in interest rates would result in a greater increase in our interest expense than in our interest income, which would adversely affect our profitability.
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An increase in interest rates would adversely affect the value that we would receive upon a sale of loans that bear interest at fixed rates, and our results of operations could be adversely affected.
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An increase in our borrowing costs without an offsetting increase in revenue would cause our cash flow to decrease, which in turn may have an adverse impact on our ability to meet our monthly debt service obligations. In the event we are unable to meet our monthly debt service obligations for this or for any other reason, we would be in default under the obligations of our credit facilities and our lenders would have the right to accelerate payments under these facilities.
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An increase in interest rates would result in a slowdown of borrower prepayments and a reduction of revenue as purchase discount accreted into income would decline. An increase in interest rates may also lead to an increase in our borrower defaults, if borrowers have difficulties making their adjustable-rate mortgage payments, and a corresponding increase in nonperforming assets, which could decrease our
revenues and our cash flows, increase our loan servicing costs and our provision for loan losses, and adversely affect our profitability.
We are also subject to risks from decreasing interest rates. For example, a significant decrease in interest rates could increase the rate at which loans are prepaid and reduce our interest income in subsequent periods.
The bank may prevent our pursuing future business opportunities.
The Forbearance Agreements prohibit our originating or acquiring mortgage loans or other assets, entering into new business activities such as providing mortgage servicing, due diligence or brokerage services to third parties, making certain material changes to our capital structure or participating in off-balance sheet joint ventures and special purpose vehicles, without the prior consent of the bank. The bank’s withholding such consent could preclude our pursuing future business opportunities.
We use estimates for recognizing revenue on a majority of our portfolio investments and our earnings would be reduced if actual results are less than our estimates.
We recognize income from the purchase discount on our portfolio of notes receivable using the interest method. We use this method only if we can reasonably estimate the expected amount and timing of cash to be collected based on historic experience and other factors. We reevaluate estimated future cash flows quarterly. If future cash collections are less than what we estimated they would be, we would recognize less than anticipated purchase discount, which would reduce our earnings.
When we acquired S&D loans, the price we paid was based on a number of assumptions. Material differences between the assumptions we used in determining the value of S&D loans we acquired and our actual experience could harm our financial position.
The purchase price and carrying value of the S&D loans we previously acquired was determined largely by estimating expected future cash flows from such loans based on the delinquency, loss, prepayment speed and discount rate assumptions we used. If the amount and timing of actual cash flows are materially different from our estimates, our cash flow and profitability would be materially adversely affected and we could be required to record further write-downs and/or increases to our reserves, which could adversely affect our financial condition.
If we do not obtain and maintain the appropriate state licenses, we will not be allowed to broker or service mortgage loans in some states, which would adversely affect our operations.
State mortgage finance licensing laws vary considerably. Most states and the District of Columbia impose a licensing obligation to broker or originate first and/or subordinate residential mortgage loans. In some of the states that impose a licensing obligation to broker or originate residential mortgage loans, the licensing obligation also arises to purchase closed mortgage loans. Many of those mortgage licensing laws impose a licensing obligation to service residential mortgage loans. Certain state collection agency licensing laws require entities collecting on delinquent or defaulted loans for others or to acquire such loans to be licensed. If we are unable to obtain the appropriate state licenses or do not qualify for an exemption, our operations may be adversely affected.
Additionally, if we do not meet certain requirements, such as minimum net worth or line of credit requirements, our licenses in certain states may be revoked or suspended and we may not be able to continue to broker or service loans, which could adversely affect our operations and financial condition and ability to attract new servicing clients. Our negative net worth as of September 30, 2007 may have resulted in our non-compliance with the licensure requirements of certain states as of that date. Although we subsequently restored our compliance with the net worth requirements as of December 31, 2007, certain states may determine to take action, including revocation of our licenses or assessment of fines, because of our temporary non-compliance, in which case our business could be adversely affected.
A significant amount of our mortgage loan originations are secured by property in New York and New Jersey, and our operations could be harmed by economic downturns or other adverse events in these states.
A significant portion of Tribeca’s mortgage loan origination activity was concentrated in the northeastern United States, particularly in New York and New Jersey. Of the loans originated by Tribeca and held for investment as of December 31, 2007, a majority of the aggregate principal was secured by property in these two states. An overall decline in the economy or the residential real estate market, a continuing decline in home prices, or the occurrence of events such as a natural disaster or an act of terrorism in the northeastern United States could decrease the value of residential properties in this region. This could result in an increase in the risk of delinquency, default or foreclosure on mortgage loans in our portfolio, which could reduce our revenues, increase our loan losses and/or charge-offs and reduce our profitability.
We may not be adequately protected against the risks inherent in subprime residential mortgage loans.
The vast majority of the loans we originated were underwritten generally in accordance with standards designed for subprime residential mortgages. Mortgage loans underwritten under these underwriting standards are likely to experience rates of delinquency, foreclosure and loss that are higher, and may be substantially higher, than prime residential mortgage loans. A majority of the loans previously originated by Tribeca were made under a “limited documentation” program, which generally placed the most significant emphasis on the loan-to-value ratio based on the appraised value of the property, and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan. Our past underwriting and loan servicing practices may not afford adequate protection against the higher risks associated with loans made to such borrowers particularly in a poor housing and credit market or an economic recession. If we are unable to mitigate these risks, our cash flows, results of operations, financial condition and liquidity could be materially harmed.
A number of our second lien mortgage loans are subordinated to ARM or interest-only mortgages that may be subject to monthly payment increases, which may result in delinquencies and increase our risk of loss on these loans.
A number of the second lien mortgage loans that we acquired are subordinated to an adjustable rate mortgage held by a third party that was originated in a period of unusually low interest rates or originated with a below market interest rate, or to an interest-only mortgage. A substantial majority of these ARMs bore a fixed rate for the first two or three years of the loan, followed by annual interest and payment rate resets. As short-term interest rates have generally risen since June 2004, holders of ARM loans may face monthly payment increases following their first interest rate adjustment date. Similarly, interest-only loans typically require principal payments to be made after the first one or two years from the date of the loan. The decreased availability of refinancing alternatives has impacted the run-off that typically occurs as an ARM nears its first rate reset or the interest-only loans begin to require the payment of principal. Interest rate adjustments or principal becoming payable on first lien mortgages may also have a direct impact on a borrower’s ability to repay any underlying second lien mortgage loan on a property. As a result, delinquencies on these loans may increase and our ability to recover the principal of these loans may be further adversely affected.
We are subject to losses due to fraudulent and negligent acts on the part of loan applicants, mortgage brokers, sellers of loans we acquired, vendors and our employees.
When we acquired and originated mortgage loans, we typically relied heavily upon information supplied by third parties, including the information contained in the loan application, property appraisal, title information and, employment and income stated on the loan application. If any of this information was intentionally or negligently misrepresented and such misrepresentation was not detected prior to the acquisition or funding of the loan, the value of the loan may end up being significantly lower than expected. Whether a misrepresentation was made by the loan applicant, the mortgage broker, another third party or one of our employees, we generally bear the risk of loss associated with the misrepresentation except when we purchased loans pursuant to contracts that include a right of return and the seller remains sufficiently creditworthy to render such right meaningful.
We may not be successful in entering into or implementing our planned business of providing servicing and other mortgage related services for other entities on a fee-paying basis.
The servicing and mortgage related services industries are highly competitive. The Company has not historically provided such services to unrelated third parties. Additionally, the absence of a rating by a statistical rating agency as a primary or special servicer of residential mortgage loans may make it difficult to compete or effectively market the Company’s ability to adequately service mortgage loans to entities that rely on such ratings as a factor in the selection of a servicer for their loans. If we do not succeed in entering the business of providing such services to third parties, or prove unable to provide such services on a profitable basis, such a failure could adversely affect our operations and financial condition.
The success and growth of our servicing business will depend on our ability to adapt to and implement technological changes, and any failure to do so could result in a material adverse effect on our business.
Our mortgage loan servicing business is dependent upon our ability to effectively adapt to technological advances, such as the ability to automate loan servicing, process borrower payments and provide customer information over the Internet, accept electronic signatures and provide instant status updates. The intense competition in our industry has led to rapid technological developments, evolving industry standards and frequent releases of new products and enhancements. The failure to acquire new technologies or technological solutions when necessary could limit our ability to remain competitive in our industry and our ability to increase the cost-efficiencies of our servicing operation, which would harm our business, results of operations and financial condition. Alternatively, adapting to technological changes in the industry to remain competitive may require us to make significant and costly changes to our loan servicing and information systems, which could in turn increase operating costs.
If we do not manage the changes in our businesses effectively, our financial performance could be harmed.
As we exit the acquisition and origination businesses and seek to engage in new businesses, our future growth could require capital resources beyond what we currently possess, which would place certain pressures on our infrastructure. Our future profitability will similarly depend on the proper management of our wind-down of the businesses we no longer operate. We will need to continue to upgrade and expand our financial, operational and managerial systems and controls, particularly our servicing systems and resources. If we do not manage the changes in our business effectively, our expenses could increase, our loan delinquencies and defaults could continue to accelerate and our business, liquidity and financial condition could be further significantly harmed.
The inability to attract and retain qualified employees could significantly harm our business.
We continually need to attract, hire and successfully integrate additional qualified personnel in an intensely competitive hiring environment in order to manage and operate our business. The market for skilled management, professional and loan servicing personnel is highly competitive. Competition for qualified personnel may lead to increased hiring and retention costs. If we are unable to attract, successfully integrate and retain a sufficient number of skilled personnel at manageable costs, we will be unable to continue to service mortgage loans, which would harm our business, results of operations and financial condition. As our business evolves and we wind-down our acquisition and origination operations and seek to provide servicing and other mortgage related services for other entities, retaining key employees and hiring for certain critical positions can become more challenging.
An interruption in or breach of our information systems may result in lost business and increased expenses.
We rely heavily upon communications and information systems to conduct our business. Any failure, interruption or breach in security of or damage to our information systems or the third-party information systems on which we rely could cause us to be noncompliant with significant federal and state regulations relating to the handling of customer information, particularly with respect to maintaining the confidentiality of such information. A failure, interruption or breach of our information systems could result in regulatory action
and litigation against us. We cannot assure you that such failures or interruptions will not occur or if they do occur that they will be adequately addressed by us or the third parties on which we rely.
We are exposed to the risk of environmental liabilities with respect to properties to which we take title.
In the course of our business, we may foreclose on defaulted mortgage loans and take title to the properties underlying those mortgages. If we do take title, we could be subject to environmental liabilities with respect to these properties. Hazardous substances or wastes, contaminants, pollutants or sources thereof may be discovered on these properties during our ownership or after a sale to a third party. Environmental defects can reduce the value of and make it more difficult to sell such properties, and we may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation, and cleanup costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. These costs could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operation could be materially and adversely affected. Although we have not to date incurred any environmental liabilities in connection with our real estate owned, there can be no guarantee that we will not incur any such liabilities in the future.
A loss of our Chairman may adversely affect our operations.
Thomas J. Axon, our Chairman and President, is responsible for making substantially all of the most significant policy and managerial decisions in our business operations. These decisions are paramount to the success and future growth of our business. Mr. Axon is also instrumental in maintaining our relationship with the bank and our operations under the terms of the Forbearance Agreements. A loss of the services of Mr. Axon could disrupt and adversely affect our operations.
Risks Related to Our Financial Statements
We may become subject to liability and incur increased expenditures as a result of the restatement of our financial statements.
The restatement of our previously issued financial statements in 2006 could expose us to government investigation or legal action. The defense of any such actions could cause the diversion of management’s attention and resources, and we could be required to pay damages to settle such actions or if any such actions are not resolved in our favor. Even if resolved in our favor, such actions could cause us to incur significant legal and other expenses. Moreover, we may be the subject of negative publicity focusing on any financial statement inaccuracies and resulting restatement and negative reactions from shareholders, creditors, or others with which we do business. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our securities to decline.
We may become subject to liability and incur increased expenditures as a result of our reassessment of our allowance for loan losses.
As a result of the rapid and substantial deterioration in the housing and credit markets, particularly the subprime mortgage sector, and deterioration in the performance of our portfolios of acquired and originated loans, we reassessed our allowance for loan losses in the quarter ended September 30, 2007, which resulted in significantly increased estimates of inherent losses in our portfolios of loans. The reassessment of our allowance for loan losses could expose us to legal action or government investigation. The defense of any such actions could cause the diversion of management’s attention and resources, and we could be required to pay damages to settle such actions or if any such actions are not resolved in our favor. Even if resolved in our favor, such actions could cause us to incur significant legal and other expenses. Moreover, we may be the subject of negative publicity focusing on the incurred allowance and negative reactions from shareholders, creditors, or others with which we do business. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our securities to decline.
Failures in our internal controls and disclosure controls and procedures could lead to material errors in our financial statements and cause us to fail to meet our reporting obligations.
Effective internal controls are necessary for us to provide reliable financial reports. Such controls are designed to provide reasonable, not absolute assurance that we are providing reliable financial reports. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there is only reasonable assurance that our controls will succeed in achieving their goals under all potential future conditions. If such controls fail to operate effectively, this may result in material errors in our financial statements. Deficiencies in our system of internal controls over financial reporting may require remediation, which could be costly. Failure to remediate such deficiencies or to implement required new or improved controls could lead to material errors in our financial statements, cause us to fail to meet our reporting obligations, and expose us to government investigation or legal action. Any of these results could cause investors to lose confidence in our reported financial information and could have a negative effect on the trading price of our common stock.
Risks Related to the Regulation of Our Industry
New legislation and regulations directed at curbing predatory lending practices could restrict our ability to price, sell, or finance non-prime residential mortgage loans, which could adversely impact our earnings.
The Federal Home Ownership and Equity Protection Act, or HOEPA, identifies a category of residential mortgage loans and subjects such loans to restrictions not applicable to other residential mortgage loans. Loans subject to HOEPA consist of loans on which certain points and fees or the annual percentage rate, which is based on the interest rate and certain finance charges, exceed specified levels. Laws, rules and regulations have been adopted, or are under consideration, at the state and local levels that are similar to HOEPA in that they impose certain restrictions on loans that exceed certain cost parameters. These state and local laws generally have lower thresholds and broader prohibitions than under the federal law. The restrictions include prohibitions on steering borrowers into loans with high interest rates and away from more affordable products, selling unnecessary insurance to borrowers, flipping or repeatedly refinancing loans and originating loans without a reasonable expectation that the borrowers will be able to repay the loans without regard to the value of the mortgaged property.
Compliance with some of these restrictions requires lenders to make subjective judgments, such as whether a loan will provide a “net tangible benefit” to the borrower. These restrictions expose a lender to risks of litigation and regulatory sanction no matter how carefully a loan is underwritten and impact the way in which a loan is underwritten. The remedies for violations of these laws are not based on actual harm to the consumer and can result in damages that exceed the loan balance. Liability for violations of HOEPA, as well as violations of many of the state and local equivalents, would extend not only to us, but to assignees, which may include our warehouse lenders and whole-loan buyers, regardless of whether such assignee knew of or participated in the violation.
It was our policy not to originate loans that are subject to either HOEPA or these state and local laws and not to purchase high cost loans that violate those laws. If we miscalculated the numerical thresholds described above, however, we may have mistakenly originated or purchased such loans and bear the related marketplace and legal risks and consequences. These thresholds below which we try to originate loans created artificial barriers to production and limited the price at which we offered loans to borrowers and our ability to underwrite, originate, sell and finance mortgage loans. In a number of states, for example, proposed and recently enacted state and local anti-predatory lending laws and regulations broaden the trigger test for loans subject to restrictions. If the numerical thresholds were miscalculated, certain variations of our Liberty Loan product, where the lending decision is or may have been based entirely or primarily on the borrower’s equity in his or her home and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan, would violate HOEPA and many of these state and local anti-predatory lending laws. In the past, we have sold a portion of our Liberty Loan production to third parties on a whole-loan, servicing-released basis. Going forward, however, our ability to sell the Liberty Loan product to third parties could be impaired if our investors are required or choose to incorporate prohibitions from certain anti-predatory lending practices into their eligibility criteria, even if the laws themselves do not specifically apply to us.
We purchased loans that are covered by one of these laws, rules or regulations only if, in our judgment, a loan was made in accordance with our strict legal compliance standards and without undue risk relative to litigation or to the enforcement of the loan according to its terms.
The 108th United States Congress considered legislation, such as the Ney-Lucas Responsible Lending Act introduced in 2003, which, among other provisions, would limit fees that a lender is permitted to charge, including prepayment fees, restrict the terms lenders are permitted to include in their loan agreements and increase the amount of disclosure required to be given to potential borrowers. Similar legislation was introduced in the 109th Congress. Certain Members of the 110th Congress, responding to increased foreclosures in the subprime mortgage sector, have indicated that they are considering introducing legislation to restrict risky, higher-interest home loans made to consumers with blemished credit records. On March 27, 2007, the subcommittee on Financial Institutions and Consumer Credit of the U.S. House Committee on Financial Services held a hearing on subprime and predatory lending. State Attorneys General have begun to investigate loan servicers and some State Attorneys General and state banking regulators have formed a foreclosure working group to prevent unnecessary foreclosures. The New York Attorney General has also recently stated that his office will investigate the practices of subprime lenders.
There are a number of proposed and recently enacted federal, state and local laws and regulations and guidance addressing mortgage lending and servicing practices. Congress is considering several bills to combat abuses in the mortgage lending market and to provide substantial new protections to mortgage consumers. Also, Congress is considering changes to federal bankruptcy laws that would, if passed, allow judges presiding in Chapter 13 bankruptcy cases to modify the terms of mortgages secured by a borrower’s principal residence, including but not limited to the interest rate, loan maturity and principal balance. At the state level, legislation building on the passage of mortgage lending restrictions in 2007 in states such as Minnesota, Maine, and North Carolina may appear in a number of jurisdictions. State bills attempting to establish new consumer protections governing loan servicing practices and foreclosure procedures are also expected in 2008. There are proposed laws providing greater protections to consumers, pertaining to such activities as maintenance of escrow funds, timely crediting of payments received, limitation on ancillary income, responding to customer inquiries and requirements to conduct loss mitigation. The Federal Reserve Board has proposed changes to HOEPA in Regulation Z (Truth in Lending), which the Federal Reserve Board maintains will protect consumers from unfair or deceptive home mortgage lending and advertising practices. The proposed amendment is not limited to the category of residential mortgage loans currently subject to HOEPA. The U.S. Department of Housing and Urban Development (HUD) has proposed a rule which it maintains will simplify and improve the disclosure requirements for mortgage settlement costs under the Real Estate Settlement Procedures Act of 1974 (RESPA) to protect consumers from unnecessarily high settlement costs.
We cannot predict whether or in what form Congress or the various state and local legislatures may enact legislation affecting our business. We are evaluating the potential impact of these initiatives, if enacted, on our lending practices and results of operations. As a result of these and other initiatives, we are unable to predict whether federal, state, or local authorities will require changes in our lending practices in the future, including reimbursement of fees charged to borrowers, or will impose fines. These changes, if required, could adversely affect our profitability, particularly if we make such changes in response to new or amended laws, regulations or ordinances in states where we originate a significant portion of our mortgage loans.
The broad scope of our operations exposes us to risks of noncompliance with an increasing and inconsistent body of complex laws and regulations at the federal, state and local levels.
Because we may service and may have purchased and originated mortgage loans in all 50 states, we must comply with the laws and regulations pertaining to licensing, disclosure and substantive practices, as well as judicial and administrative decisions, of all of these jurisdictions, as well as an extensive body of federal laws and regulations. The volume of new or modified laws and regulations has increased in recent years, and government agencies enforcing these laws, as well as the courts, sometimes interpret the same law in different ways. The laws and regulations of each of these jurisdictions are different, complex and, in some cases, in direct conflict with each other. As our operations grow, it may be more difficult to identify comprehensively and to interpret accurately applicable laws and regulations and to employ properly our policies, procedures
and systems and train our personnel effectively with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. State and local governmental authorities have focused on the lending practices of companies in the non-prime mortgage lending industry, sometimes seeking to impose sanctions for practices such as charging excessive fees, imposing interest rates higher than warranted by the credit risk of the borrower, imposing prepayment fees, failing to adequately disclose the material terms of loans and abusive servicing and collection practices.
Our failure to comply with this regulatory regimen can lead to:
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civil and criminal liability, including potential monetary penalties;
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loss of lending licenses or approved status required for continued servicing operations;
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demands for indemnification or loan repurchases from purchasers of our loans;
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legal defenses causing delay and expense;
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adverse effects on our ability, as servicer, to enforce loans;
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the borrower having the right to rescind or cancel the loan transaction;
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adverse publicity;
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individual and class action lawsuits;
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administrative enforcement actions;
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damage to our reputation in the industry;
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inability to sell our loans; or
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inability to obtain credit to fund our operations.
Although we have systems and procedures directed to compliance with these legal requirements and believe that we are in material compliance with all applicable federal, state and local statutes, rules and regulations, we cannot assure you that more restrictive laws and regulations will not be adopted in the future, or that governmental bodies or courts will not interpret existing laws or regulations in a more restrictive manner, which could render our current business practices non-compliant or which could make compliance more difficult or expensive. These applicable laws and regulations are subject to administrative or judicial interpretation, but some of these laws and regulations have been enacted only recently, or may be interpreted infrequently or only recently and inconsistently. As a result of infrequent, sparse or conflicting interpretations, ambiguities in these laws and regulations may leave uncertainty with respect to permitted or restricted conduct under them. Any ambiguity under a law to which we are subject may lead to regulatory investigations, governmental enforcement actions or private causes of action, such as class action lawsuits, with respect to our compliance with applicable laws and regulations.
If financial institutions face exposure stemming from legal violations committed by the companies to which they provide financing or underwriting services, this could negatively affect the market for whole-loans and mortgage-backed securities.
In June 2003, a California jury found a warehouse lender and securitization underwriter liable in part for fraud on consumers committed by a lender to whom it provided financing and underwriting services. The jury found that the investment bank was aware of the fraud and substantially assisted the lender in perpetrating the fraud by providing financing and underwriting services that allowed the lender to continue to operate, and held it liable for 10% of the plaintiff’s damages. In December 2006, the appeal court affirmed the jury verdict on liability and remanded the matter for further proceedings on the proper calculation of damages. This is the first case we know of in which an investment bank was held partly responsible for violations committed by a mortgage lender customer. Shortly after the announcement of the jury verdict in the California case, the Florida Attorney General filed suit against the same financial institution, seeking an injunction to prevent it from financing mortgage loans within Florida, as well as damages and civil penalties, based on theories of unfair and deceptive trade practices and fraud. The suit claims that this financial institution aided and abetted
the same lender involved in the California case in its commission of fraudulent representations in Florida. As of the date of this filing, there has been no ruling in this case. If other courts or regulators adopt this “aiding and abetting” theory, investment banks may face increased litigation as they are named as defendants in lawsuits and regulatory actions against the mortgage companies with which they do business. Some investment banks may exit the business, charge more for warehouse lending and reduce the prices they pay for whole-loans in order to build in the costs of this potential litigation. This could, in turn, have a material adverse effect on our results of operations, financial condition and business prospects.
We may be subject to fines or other penalties based upon the conduct of our independent brokers.
Mortgage brokers, from which we sourced some of our Tribeca loans, have parallel and separate legal obligations to which they are subject. While these laws may not explicitly hold the originating lenders responsible for the legal violations of mortgage brokers, increasingly federal and state agencies have sought to impose such assignee liability. For example, the FTC entered into a settlement agreement with a mortgage lender where the FTC characterized a broker that had placed all of its loan production with a single lender as the “agent” of the lender. The FTC imposed a fine on the lender in part because, as “principal,” the lender was legally responsible for the mortgage broker’s unfair and deceptive acts and practices. In the past, the United States Department of Justice has sought to hold a non- prime mortgage lender responsible for the pricing practices of its mortgage brokers, alleging that the mortgage lender was directly responsible for the total fees and charges paid by the borrower under the Fair Housing Act even if the lender neither dictated what the mortgage broker could charge nor kept the money for its own account. Accordingly, we may be subject to fines or other penalties based upon the conduct of our independent mortgage broker customers.
We are subject to reputational risks from negative publicity concerning the subprime mortgage industry.
The subprime mortgage industry in which we operate may be subject to periodic negative publicity, which could damage our reputation and adversely impact our earnings.
Reputation risk, or the risk to our business, earnings and capital from negative publicity, is inherent in our industry. There is a perception that the borrowers of subprime loans may be unsophisticated and in need of consumer protection. Accordingly, from time to time, consumer advocate groups or the media may focus attention on our services, thereby subjecting our industry to the possibility of periodic negative publicity.
We may also be negatively impacted if another company in the subprime mortgage industry or in a related industry engages in practices resulting in increased public attention to our industry. Negative publicity may also occur as a result of judicial inquiries and regulatory or governmental action with respect to the subprime mortgage industry. Negative publicity may result in increased regulation and legislative scrutiny of industry practices as well as increased litigation or enforcement actions by civil and criminal authorities. Additionally, negative publicity may increase our costs of doing business and adversely affect our profitability by impeding our ability to attract and retain customers and employees.
During the past several years, the press has widely reported certain industry related concerns, including rising delinquencies, the tightening of credit and more recently, increasing litigation. Some of the litigation instituted against subprime lenders is being brought in the form of purported class actions by individuals or by state or federal regulators or state attorneys general. The judicial climate in many states is such that the outcome of these cases is unpredictable. If we are subject to increased litigation due to such negative publicity, it could have a material adverse impact on our results of operations.
We are subject to significant legal and reputational risks and expenses under federal and state laws concerning privacy, use and security of customer information.
The federal Gramm-Leach-Bliley financial reform legislation imposes significant privacy obligations on us in connection with the collection, use and security of financial and other nonpublic information provided to us by applicants and borrowers. In addition, California has enacted, and several other states are considering enacting, even more stringent privacy or customer-information-security legislation, as permitted under federal law. Because laws and rules concerning the use and protection of customer information are continuing to
develop at the federal and state levels, we expect to incur increased costs in our effort to be and remain in full compliance with these requirements. Nevertheless, despite our efforts we will be subject to legal and reputational risks in connection with our collection and use of customer information, and we cannot assure you that we will not be subject to lawsuits or compliance actions under such state or federal privacy requirements. To the extent that a variety of inconsistent state privacy rules or requirements are enacted, our compliance costs could substantially increase.
If many of our borrowers become subject to the Servicemembers Civil Relief Act of 2003, our cash flows and interest income may be adversely affected.
Under the Servicemembers Civil Relief Act, which in 2003 re-enacted the Soldiers’ and Sailors’ Civil Relief Act of 1940, or the Civil Relief Act, members of the military services on active duty receive certain protections and benefits. Under the Civil Relief Act, a borrower who enters active military service after the origination of his or her mortgage loan generally may not be required to pay interest above an annual rate of 6%, and the lender is restricted from exercising certain enforcement remedies, including foreclosure, during the period of the borrower’s active duty status. The Civil Relief Act also applies to a borrower who was on reserve status and is called to active duty after origination of the mortgage loan. Considering the large number of U.S. Armed Forces personnel on active duty and likely to be on active duty in the future, compliance with the Civil Relief Act could reduce our cash flow and the interest payments collected from those borrowers, and in the event of default or delay, prevent us from exercising the remedies for default that otherwise would be available to us.
Legislative action to provide mortgage relief may negatively impact our business.
As delinquencies, defaults and foreclosures in and of residential mortgages have increased dramatically, there are several federal, state and local initiatives to restrict our ability to foreclose and resell the property of a customer in default. Any restriction on our ability to foreclose on a loan, any requirement that we forego a portion of the amount otherwise due on a loan or any requirement that we modify any original loan terms is likely to negatively impact our business, financial condition, liquidity and results of operations. These initiatives have come in the form of proposed legislation and regulations, including those pertaining to federal bankruptcy laws, government investigations and calls for voluntary standard setting.
While perhaps not common over the last 20 years, there is a long history of legislative proposals providing for foreclosure moratoriums during periods of economic distress. One approach is to delay the ability of a lender to foreclose and resell the property of a customer in default. These bills could be procedural in nature, such as requiring the foreclosing lender to provide various types of notices to the mortgagor as a condition to consummating the foreclosure, or they could be more substantive, such as requiring the lender to forbear for a specified period of time or obligating the servicer to engage in various forms of loss mitigation as an alternative to foreclosure. Depending on an individual customer’s qualifications, such alternatives may include: (i) special forbearance or a temporary repayment plan; (ii) modification to reduce the monthly payment or extend the term of the loan; (iii) a pre-foreclosure sale; or (iv) a deed-in-lieu of foreclosure. The goal is to prevent a servicer from foreclosing on a customer’s house if there are viable alternatives. If such proposals are enacted, the cost to service and the time to foreclose on a customer in default could materially increase.
Also, Congress is considering changes to federal bankruptcy laws that would, if passed, allow judges presiding in Chapter 13 bankruptcy cases to modify the terms of mortgages secured by a borrower’s principal residence, including but not limited to, the interest rate, loan maturity and principal balance.
Regardless of whether a specific law is proposed or enacted, there are several federal and state government initiatives that seek to obtain the voluntary agreement of servicers to subscribe to a code of conduct or statement of principles or methodologies when working with borrowers facing foreclosure on their homes. Generally speaking, the principles call for servicers to reach out to borrowers before their loans “reset” with higher monthly payments that might result in a default by a borrower and seek to modify loans prior to the reset. Applicable servicing agreements, federal tax law and accounting standards limit the ability of a servicer to modify a loan before the borrower has defaulted on the loan or the servicer has determined that a
default by the borrower is reasonably likely to occur. Servicing agreements generally require the servicer to act in the best interests of the note holders or at least not to take actions that are materially adverse to the interests of the note holders. Compliance with the code or principles must conform to these other contractual, tax and accounting standards. As a result, servicers have to confront competing demands from consumers and those advocating on their behalf to make home retention the overarching priority when dealing with borrowers in default, on the one hand, and the requirements of note holders to maximize returns on the loans, on the other.
Risks Related to Our Securities
Thomas J. Axon effectively controls our company, substantially reducing the influence of our other stockholders.
Thomas J. Axon, our Chairman and President, beneficially owns more than 43% of our outstanding common stock. As a result, Mr. Axon will be able to influence significantly the actions that require stockholder approval, including:
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the election of our directors; and
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the approval of mergers, sales of assets or other corporate transactions or matters submitted for stockholder approval.
Furthermore, the members of the board of directors as a group (including Mr. Axon) beneficially own a substantial majority of our outstanding common stock. As a result, our other stockholders may have little or no influence over matters submitted for stockholder approval. In addition, Mr. Axon’s influence and/or that of our current board members could preclude any unsolicited acquisition of us and consequently materially adversely affect the price of our common stock.
We may be delisted from The Nasdaq Stock Market, in which case the price and liquidity of our common stock and our ability to access the capital markets would be adversely affected.
Our common stock is currently listed on The Nasdaq Global Market. On January 2, 2008, we were notified by The Nasdaq Stock Market that our common stock had failed to maintain a minimum market value of publicly held shares of $5 million, as required for continued inclusion on the Nasdaq Global Market, and that if compliance with the minimum was not restored for at least ten consecutive trading days before April 1, 2008, our common stock would be delisted from The Nasdaq Global Market. We have not regained compliance with this requirement and expect to submit on April 1, 2008 our application for transfer of our listing to The Nasdaq Capital Market, which requires that we maintain only $1 million in minimum market value of publicly held shares. Our application for transfer will stay the delisting of our common stock from The Nasdaq Global Market while it is pending. If we regain compliance with the minimum market value of publicly held shares requirement during this period, we will petition to retain our position on The Nasdaq Global Market. In the event that we transfer our listing from The Nasdaq Global Market to The Nasdaq Capital Market, our common stock could become less liquid, which would adversely affect its value. If our application for transfer to The Nasdaq Capital Market is not approved, because we have failed to maintain a bid price of $1.00 or for any other reason, our common stock will be delisted.
In addition, on February 20, 2008, we were notified by The Nasdaq Stock Market that for the last 30 consecutive business days, the bid price of our common stock closed below the minimum $1.00 per share required for continued inclusion on the Nasdaq Global Market. If we do not restore compliance with the minimum bid price requirement for at least 10 consecutive trading days before August 18, 2008, our common stock will be delisted from The Nasdaq Global Market.
The delisting of our common stock would significantly affect the ability of investors to trade our securities and would negatively affect the value and liquidity of our common stock. If delisted from The Nasdaq Stock Market, our common stock will likely be quoted in the over-the-counter market in the so-called “pink sheets” or quoted in the OTC Bulletin Board. In addition, our common stock would be subject to the rules promulgated under the Securities Exchange Act of 1934 relating to “penny stocks.” These rules require brokers who sell securities that are subject to the rules, and who sell to persons other than established
customers and institutional accredited investors, to complete required documentation, make suitability inquiries of investors and provide investors with information concerning the risks of trading in the security. These requirements could make it more difficult to buy or sell our common stock in the open market. In addition, the delisting of our common stock could materially adversely affect our ability to raise capital on terms acceptable to us or at all. Delisting could also have other negative results, including the potential loss of confidence by employees, the loss of institutional investor interest and fewer business development opportunities.
Our organizational documents, Delaware law and our credit facilities may make it harder for us to be acquired without the consent and cooperation of our board of directors, management and lender.
Several provisions of our organizational documents, Delaware law, and our credit facilities may deter or prevent a takeover attempt, including a takeover attempt in which the potential purchaser offers to pay a per share price greater than the current market price of our common stock.
Our classified board of directors will make it more difficult for a person seeking to obtain control of us to do so. Also, our supermajority voting requirements may discourage or deter a person from attempting to obtain control of us by making it more difficult to amend the provisions of our certificate of incorporation to eliminate an anti-takeover effect or the protections they afford minority stockholders, and will make it more difficult for a stockholder or stockholder group to put pressure on our board of directors to amend our certificate of incorporation to facilitate a takeover attempt. In addition, under the terms of our certificate of incorporation, our board of directors has the authority, without further action by the stockholders, to issue shares of preferred stock in one or more series and to fix the rights, preferences, privileges and restrictions thereof. The ability to issue shares of preferred stock could tend to discourage takeover or acquisition proposals not supported by our current board of directors.
Section 203 of the Delaware General Corporation Law, subject to certain exceptions, prohibits a Delaware corporation from engaging in any business combination with any interested stockholder (such as the owner of 15% or more of our outstanding common stock) for a period of three years following the date that the stockholder became an interested stockholder. The preceding provisions of our organizational documents, as well as Section 203 of the Delaware General Corporation Law, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management, even if such events would be in the best interests of our stockholders.
Under the terms of the Forbearance Agreements, we cannot enter into mergers, consolidations or sales of assets (subject to certain exceptions). In addition, we cannot, without the bank’s consent, enter into any material change in our capital structure that the bank or a nationally recognized independent public accounting firm determine could cause a consolidation of our assets with other persons under relevant accounting regulations.
In addition, if our controlling shareholder ceasing to possess, directly or indirectly, the power to direct our management and policies through his ownership of our voting stock constitutes an event of default under our credit facilities, which, without a waiver from our lender, would cause our indebtedness to become immediately payable and could result in our insolvency if we are unable to repay our debt.
Our quarterly operating results may fluctuate and cause our stock price to decline.
Because of the nature of our business, our quarterly operating results may fluctuate, or we may incur additional operating losses. Our results may fluctuate as a result of any of the following:
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the timing and amount of collections on loans in our portfolio;
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the rate of delinquency, default, foreclosure and prepayment on the loans we hold and service;
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changes in interest rates;
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deviations in the amount or timing of collections on loans from our expectations when we purchased or originated such loans;
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our inability to purchase and originate new mortgage loans for portfolio or for sale in the secondary mortgage market;
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our inability to successfully enter the new business of servicing loans for third parties;
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further declines in the estimated value of real property securing mortgage loans;
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increases in operating expenses associated with the changes in our business;
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general economic and market conditions; and
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the effects of state and federal tax, monetary and fiscal policies.
Many of these factors are beyond our control, and we cannot predict their potential effects on the price of our common stock. We cannot assure you that the market price of our common stock will not fluctuate or further significantly decline in the future.
Various factors unrelated to our performance may cause the market price of our common stock to become volatile, which could harm our ability to access the capital markets in the future.
The market price of our common stock may experience fluctuations that are unrelated to our operating performance. In particular, our stock price may be affected by general market movements as well as developments specifically related to the consumer finance industry, changes in home values, the financial services sector, the mortgage origination industry and the subprime origination sector. These could include, among other things, interest rate movements, quarterly variations or changes in financial estimates by securities analysts, governmental or regulatory actions or investigations of us or our lenders, or a significant reduction in the price of publicly traded securities of another participant in the consumer finance industry. This volatility may make it difficult for us to access the capital markets in the future through additional secondary offerings of our common stock, regardless of our financial performance, and such difficulty may preclude us from being able to take advantage of certain business opportunities or meet our obligations.
Future sales of our common stock may depress our stock price.
Sales of a substantial number of shares of our common stock in the public market could cause a decrease in the market price of our common stock. In addition to the portion of our outstanding common stock that is freely tradable, we may issue additional shares in connection with our business and may grant equity-based awards to our employees, officers, directors and consultants. If a significant portion of these shares were sold in the public market, the market value of our common stock could be adversely affected.
Compliance with the rules of the market in which our common stock trades and proposed and recently enacted changes in securities laws and regulations are likely to increase our costs.
The Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by the Securities and Exchange Commission and the national securities exchanges have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices for public companies, including ourselves. These rules and regulations could also make it more difficult for us to attract and retain qualified executive officers and members of our board of directors, particularly to serve on our audit committee. Our common stock was listed on The Nasdaq Global Market, formerly known as The Nasdaq National Market, on July 19, 2005. Accordingly, we must comply with Nasdaq’s qualitative and quantitative requirements, which will require additional cost and effort on our part.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2.
PROPERTIES
On March 4, 2005, we entered into a sublease agreement with Lehman Brothers Holdings Inc. to sublease approximately 33,866 square feet of space on the 25th floor at 101 Hudson Street, Jersey City, New Jersey for
use as executive and administrative offices. Pursuant to the sublease, in 2007 we paid Lehman Brothers Holdings Inc. rent of approximately $68,697 per month. The term of the sublease is through December 30, 2010.
On July 27, 2005, we entered into a lease agreement with 101 Hudson Leasing Associates to lease approximately 6,856 square feet of space on the 37th floor at 101 Hudson Street, Jersey City, New Jersey for use as administrative offices. Pursuant to the lease, in 2007 we paid 101 Hudson Leasing Associates rent of approximately $15,569 per month. The term of the lease is through December 30, 2010. After December 30, 2010, we will lease both the 25th floor space and the 37th floor space directly from 101 Hudson Leasing Associates. The term of this combined lease will be through December 30, 2013 for approximately $114,808 per month. In addition, we lease approximately 228 square feet of office space in Trevose, Pennsylvania under a lease agreement that was extended in March 2008 on a month-to-month basis. The monthly lease payment is not significant.
Our Tribeca subsidiary currently maintains its corporate headquarters on the 37th floor at 101 Hudson Street, Jersey City, New Jersey. We have also leased two offices for Tribeca, one of which is in Trevose, Pennsylvania (approximately 1,000 square feet) under a lease agreement that was extended in December 2007 on a month-to-month basis, and the other of which is in Marlton, New Jersey (approximately 2,426 square feet) under a lease agreement with a term that was extended to July 31, 2009. The monthly lease payment for the Trevose office is not significant. The monthly lease payment for the Marlton office was approximately $6,025 in 2007. At December 31, 2007, the Marlton office space was not being utilized by Tribeca, and it is being marketed for sublease.
On February 13, 2006, Tribeca entered into a lease agreement with 18 Harrison Development Associates, an entity controlled by Thomas J. Axon, to lease approximately 950 square feet on the 5th floor at 18 Harrison Street, New York, New York for use as additional office space. The term of the lease was through February 12, 2007, at approximately $4,880 per month, and the option to extend the lease for an additional period of one year at a rate of approximately $5,124 per month was exercised. The lease was extended in February 2007, and expired unrenewed in February 2008.
As part of its acquisition of the wholesale mortgage origination unit in February 2007, Tribeca assumed the lease obligation for office space located in Bridgewater, New Jersey, for approximately 14,070 square feet. The term of the lease is through January 31, 2011 at approximately $20,621 per month. At December 31, 2007, the space was not being utilized by Tribeca, and it is being marketed for sublease.
On March 30, 2007, we entered into a lease agreement with 101 Hudson Leasing Associates to lease approximately 6,269 square feet of space on the 37th floor at 101 Hudson Street, Jersey City, New Jersey for use as administrative offices. Pursuant to the lease, in 2007 we paid 101 Hudson Leasing Associates rent of approximately $16,717 per month. The term of the lease is through December 31, 2013.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
We are involved in routine litigation matters incidental to our business related to the enforcement of our rights under mortgage loans we hold, none of which is individually material. In addition, because we originated and service mortgage loans throughout the country, we must comply with various state and federal lending laws and we are routinely subject to investigation and inquiry by regulatory agencies, some of which arise from complaints filed by borrowers, none of which is individually material.
On February 6, 2008, the Company commenced an action in the Supreme Court of the State of New York, County of New York styled: Franklin Credit Management Corp. v. WMC Mortgage LLC, successor to WMC Mortgage Corp. (the “WMC Litigation”). The WMC Litigation arises from the Company’s purchase of approximately $170 million of second mortgages during 2006 from WMC Mortgage Corp. (“WMC”), an affiliate of General Electric Corporation. Through the WMC Litigation, the Company seeks damages in an amount not less than $35.5 million resulting from breaches of the representations and warranties contained in the loan purchase agreements entered into between the Company and WMC. The Defendant has not yet filed an Answer in the WMC Litigation.
In connection with the WMC Litigation, the Company is in the process of conducting a review of the second mortgages purchased from WMC during 2006. In connection with the review, the Company has identified approximately $31 million of additional loans which do not conform to the representations and warranties contained in the loan purchase agreements entered into between the Company and WMC. The Company is in the process of requesting WMC to repurchase the additional loans pursuant to the terms of the loan purchase agreements. In the absence of a timely repurchase of these additional loans, the Company may seek to amend its complaint in the WMC Litigation or commence additional litigation against WMC.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information. Our common stock has traded on The Nasdaq Global Market, formerly The Nasdaq National Market, under the symbol “FCMC” since July 19, 2005. Prior to such date, our common stock was quoted on the Over-The-Counter Bulletin Board (“OTCBB”) under the symbol “FCSC.”
The following table sets forth the bid prices for the common stock on the OTCBB and the sales prices for the common stock on The Nasdaq Global Market, as applicable, for the periods indicated. Trading during these periods was limited and sporadic; therefore, the following quotes may not accurately reflect the true market value of the securities. Prices prior to July 19, 2005 reflect inter-dealer prices without retail markup or markdown or commissions and may not represent actual transactions, while prices from July 19, 2005 forward are as reported by The Nasdaq Global Market.
Delisting Proceedings. On January 2, 2008, the Company was notified by The Nasdaq Stock Market that our common stock had failed to maintain a minimum market value of publicly held shares of $5 million, as required for continued inclusion on the Nasdaq Global Market, and that if compliance with the minimum was not restored for at least ten consecutive trading days before April 1, 2008, our common stock would be delisted from The Nasdaq Global Market. We have not regained compliance with this requirement and expect to submit on April 1, 2008 our application for transfer of our listing to The Nasdaq Capital Market, which requires that we maintain only $1 million in minimum market value of publicly held shares. Our application for transfer will stay the delisting of our common stock from The Nasdaq Global Market while it is pending.
If we regain compliance with the minimum market value of publicly held shares requirement during this period, we will petition to retain our position on The Nasdaq Global Market. If our application for transfer to The Nasdaq Capital Market is not approved, because we have failed to maintain a bid price of $1.00 or for any other reason, our common stock will be delisted.
In addition, on February 20, 2008, we were notified by The Nasdaq Stock Market that for the last 30 consecutive business days, the bid price of our common stock closed below the minimum $1.00 per share required for continued inclusion on the Nasdaq Global Market. If we do not restore compliance with the minimum bid price requirement for at least 10 consecutive trading days before August 18, 2008, our common stock will be delisted from The Nasdaq Global Market.
Holders. As of March 23, 2008, there were approximately 432 record holders of the Company’s common stock.
Dividend Policy. We have not paid cash dividends on our common stock in recent years and do not expect to pay a cash dividend in the near future. We currently intend to retain future earnings to finance our operations and expand our business. Any future determination to pay cash dividends will be at the discretion of the board of directors and will depend upon a complete review and analysis of all relevant factors, including our financial condition, operating results, capital requirements and any other factors the board of directors deems relevant. In addition, the Forbearance Agreements expressly restrict payments to stockholders, which includes our ability to pay dividends.
Performance Graph. The following graph illustrates a comparison of the cumulative total stockholder return (change in stock price plus reinvested dividends) of Common Stock with the Russell 2000 index and a peer group for the period from December 31, 2002 through December 31, 2007. The measurement assumes a $100 investment on December 31, 2000. The peer group is made up of the following 10 publicly-held financial services companies: Asset Acceptance Capital Corp., Credit Acceptance Michigan, Encore Capital Group, Inc., Equifin, Inc., First Investors Financial Services Group, Inc., Microfinancial Incorporated, NfinanSe, Inc., Nicholas Financial, Inc., Noram Capital Holdings, Inc. and White River Capital, Inc. The comparisons in the graph are required by the Securities and Exchange Commission and are not intended to forecast or be indicative of possible future performance of the Common Stock, which performance could be affected by factors and circumstances outside of the Company’s control. Data for the Russell 2000 index and the peer group assume reinvestment of dividends.
Securities Authorized for Issuance Under Equity. The following table shows compensation plans (including individual compensation arrangements) under which equity securities are authorized for issuance, as of December 31, 2007.
Recent Sales of Unregistered Securities
None.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The selected financial data set forth below as of and for the years ended December 31, 2007, 2006, 2005, 2004 and 2003, have been derived from the Company’s audited consolidated financial statements. This information should be read in conjunction with Item 1. “Business” and Item 7.
Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as the audited financial statements and notes thereto included in Item 8. “Financial Statements.”
(1)
Debt discount was $232,365, $515,799 and $3,002,767 for 2007, 2006 and 2005, respectively.
(2)
Computed by dividing net income by average total assets for the period using beginning and ending period balances.
(3)
Computed by dividing net income by average equity for the period using beginning and ending period balances.
(4)
Computed by dividing total revenue by average total assets for the period using beginning and ending period balances.
(5)
Computed by dividing interest expense, inclusive of amortization of deferred financing costs, by average total assets for the period using beginning and ending period balances.
(6)
Computed by dividing collection, general and administrative expenses by average total assets for the period using beginning and ending period balances.
(7)
Computed by dividing collection, general and administrative expenses by total revenues less interest expense and amortization of deferred financing costs.
(8)
See Notes to the Consolidated Financial Statements for details on nonaccretable purchase discount.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes forward-looking statements. We have based these forward-looking statements on our current plans, expectations and beliefs about future events. In light of the risks, uncertainties and assumptions discussed under Item 1A. “Risk Factors” of this Annual Report on Form 10-K and other factors discussed in this section, there are risks that our actual experience will differ materially from the expectations and beliefs reflected in the forward-looking statements in this section and throughout this report. For more information regarding what constitutes a forward-looking statement, please refer to Item 1A. “Risk Factors.”
General
The following discussion of our operations and financial condition should be read in conjunction with our financial statements and notes thereto included elsewhere in this Form 10-K. In these discussions, most percentages and dollar amounts have been rounded to aid presentation. As a result, all such figures are approximations. The following management’s discussion and analysis of financial condition and results of operations is based on the amounts reported in the Company’s consolidated financial statements. These financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts. Changes in these estimates and assumptions could have a material effect on the Company’s consolidated financial statements.
Executive Summary
The Company had net losses of $8.6 million and $1.8 million for the years ended December 31, 2007 and 2006, respectively, compared with net income of $7.9 million for the year ended December 31, 2005. The net loss for the year ended December 31, 2007 was principally the result of a $274.6 million provision for loan losses, increased interest reversals for non-accrual loans, and the absence of gains on sales of loans, which was substantially offset by a net gain on debt forgiveness that arose from the Forbearance Agreements entered into on December 28, 2007 with the Company’s bank. Due principally to the rapid and substantial deterioration in
the housing and subprime mortgage markets and the concomitant deterioration in the performance of the Company’s loan portfolios, the Company reassessed its allowance for loan losses in the quarter ended September 30, 2007, which resulted in significantly increased estimates of inherent losses in its portfolios. The aggregate allowance for loan losses at December 31, 2007 was $254.7 million, compared with $53.3 million at December 31, 2006. As a result of the $300 million of debt that was forgiven by the bank under the terms of the Forbearance Agreements, the Company realized a net gain of $284.2 million. See “Management’s Discussion and Analysis - Year Ended December 31, 2007 Compared to Year Ended December 31, 2006.” See “Borrowings” for a description of the Forbearance Agreements.
Revenues for 2007 increased by 3% to $169.3 million, from 2006 revenues of $163.8 million, while interest expense (inclusive of amortization of deferred financing costs) increased by 24% to $145.9 million. During 2007, we closed acquisitions of residential mortgage loans with an aggregate face amount of $528.7 million and originated $291.6 million of subprime loans. The size of our total portfolio of aggregate net notes receivable, loans held for sale, loans held for investment and OREO at the end of 2007 grew to $1.58 billion from $1.56 billion at the end of 2006. Our total debt outstanding, including notes payable (term debt) and financing agreements, grew to $1.63 billion at the end of 2007, which excludes the $300 million of debt that was forgiven, from $1.58 billion at the end of 2006.
Stockholders’ equity decreased to $39.3 million at the end of 2007 from $47.6 million at December 31, 2006, and amounted to 2.32% of year-end assets.
In December 2006, pursuant to an agreement executed with our lender, all success fee obligations under all of our master credit facilities were eliminated in exchange for a cash settlement of $4.5 million. As a result of the elimination of our success fee liability, at December 31, 2006, success fee liability was $0 compared with $5.7 million at year-end 2005; and, the debt discount was reduced to $232,000 at year-end 2007, compared with $516,000 at year-end 2006 and $3.0 million at year-end 2005.
Application of Critical Accounting Policies and Estimates
The following discussion and analysis of financial condition and results of operations is based on the amounts reported in our consolidated financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. In preparing the consolidated financial statements, management is required to make various judgments, estimates and assumptions that affect the financial statements and disclosures. Changes in these estimates and assumptions could have a material effect on our consolidated financial statements. The following is a summary of the accounting policies believed by management to be those that require subjective and complex judgment that could potentially affect reported results of operations. Management believes that the estimates and judgments used in preparing these consolidated financial statements were the most appropriate at that time.
Notes Receivable and Income Recognition - The Company’s notes receivable portfolio consists primarily of secured real estate mortgage loans purchased from financial institutions, mortgage and finance companies. Such notes receivable are performing, non-performing or sub-performing at the time of purchase and are generally purchased at a discount from the principal balance remaining. Notes receivable are stated at the amount of unpaid principal, reduced by purchase discount and allowance for loan losses. Notes purchased after December 31, 2004 that meet the requirements of AICPA Statement of Position (SOP) No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (“SOP 03-3”) are stated net of purchase discount. The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past loan loss experience and other relevant factors. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for the underlying collateral when considered necessary.
In general, interest on the notes receivable is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. Accrual of interest on notes receivable, including impaired notes receivable, is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful. When interest accrual is discontinued, all unpaid accrued interest is reversed to interest income. Subsequent recognition of income occurs only to the extent payment is received, subject to management’s assessment of the collectibility of the remaining interest and principal. A non-accrual note is restored to an accrual status when collectibility of interest and principal is no longer in doubt and past due interest is recognized at that time.
Discounts on Acquired Loans - Effective January 1, 2005, as a result of the adoption of SOP 03-3, the Company was required to change its accounting for loans acquired subsequent to December 31, 2004 that have evidence of deterioration of credit quality since origination and for which it is probable, at the time of our acquisition, that the Company will be unable to collect all contractually required payments. For these loans, the excess of the undiscounted contractual cash flows over the undiscounted cash flows estimated by us at the time of acquisition is not accreted into income (nonaccretable discount). The amount representing the excess of cash flows estimated by us at acquisition over the purchase price is accreted into interest income over the life of the loan (accretable discount). The nonaccretable discount is not accreted into income.
If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting is used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan.
Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable discount are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable discount is transferred to the accretable discount and is accreted into interest income over the remaining life of the loan on the interest method. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through the allowance for loan losses.
There is judgment involved in estimating the amount of the loan’s future cash flows. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect our financial condition and results of operations. Depending on the timing of an acquisition, the initial allocation of discount may be made primarily to nonaccretable discount until the Company has boarded all loans onto its servicing system; at that time, any cash flows expected to be collected over the purchase price will be transferred to accretable discount. Generally, the allocation will be finalized no later than ninety days from the date of purchase.
For loans not addressed by SOP 03-3 that are acquired subsequent to December 31, 2004, the discount, which represents the excess of the amount of reasonably estimable and probable discounted future cash collections over the purchase price, is accreted into purchase discount using the interest method over the term of the loans. This is consistent with the method the Company utilizes for its accounting for loans purchased prior to January 1, 2005, except that for these loans an allowance allocation was also made at the time of acquisition.
Allowance for Loan Losses - The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past loan loss experience and other relevant factors. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for the underlying collateral when considered necessary. Management believes that the allowance for loan losses is adequate. The allowance for loan losses is a material estimate, which could change significantly in the near term.
Effective January 1, 2005, and as a result of the adoption of SOP 03-3, additions to the valuation allowances relating to newly acquired loans reflect only those losses incurred by us subsequent to acquisition. The Company no longer increases the allowances through allocations from purchase discount for loans that meet the requirements of SOP 03-3.
Originated Loans Held for Investment - During the third quarter of 2006, the Company modified its estimate of the collectibility of accrued interest on certain fully secured loans that are in the foreclosure process. The Company continues to accrue interest on secured real estate first mortgage loans originated by the Company up to a maximum of 209 days contractually delinquent with a recency payment in the last 179 days, and that are judged to be fully recoverable for principal and substantially all accrued interest based in many cases on a foreclosure analysis, which includes an updated estimate of the realizable value of the property securing the loan.
In general, interest on originated loans held for investment is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. The Company’s decision to revise its estimate of collectibility was based on recent collection information, which shows that the Company is collecting 100% of principal and between 90% to 100% of delinquent interest when these loans in the foreclosure process are paid off or settled.
The accrual of interest is discontinued when management believes, after considering economic and business conditions and collection efforts that the borrower’s financial condition is such that collection of interest is doubtful, which can be less than 209 days contractually delinquent with a recency payment in the last 179 days. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Subsequent recognition of income occurs only to the extent payment is received, subject to management’s assessment of the collectibility of the remaining interest and principal. A non-accrual loan is restored to an accrual status when the collectibility of interest and principal is no longer in doubt and past due interest is recognized at that time.
Other Real Estate Owned - Other real estate owned (“OREO”) consists of properties acquired through, or in lieu of, foreclosure or other proceedings and are held for sale and carried at the lower of cost or fair value less estimated costs to sell. Any write-down to fair value, less cost to sell, is charged to earnings based upon management’s continuing assessment of the fair value of the underlying collateral. OREO is evaluated periodically to ensure that the recorded amount is supported by current fair values and valuation allowances are recorded as necessary to reduce the carrying amount to fair value less estimated cost to sell. Revenue and expenses from the operation of OREO and changes in the valuation allowance are included in operations. Direct costs relating to the development and improvement of the property are capitalized, subject to the limit of fair value of the property, while costs related to holding the property are expensed. Gains or losses are included in operations upon disposal of the property.
Results of Operations
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Overview. The Company had a net loss of $8.6 million for the twelve months of 2007, compared with a net loss of $1.8 million for the twelve months of 2006, an increased loss of 391%. The net loss for the year ended December 31, 2007 was principally the result of a significantly higher provision for loan losses, increased interest reversals for non-accrual loans and the absence of gains from sales of loans, which was essentially offset by a significant net gain on debt forgiveness. Due principally to the rapid and substantial deterioration in the housing and subprime mortgage markets and the concomitant deterioration in the performance of the Company’s portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, the Company reassessed its allowance for loan losses as of September 30, 2007, which resulted in significantly increased estimates of inherent losses in its portfolios. As a result, the provision for loan losses increased to $274.6 million for the year ended December 31, 2007, compared with $9.8 million for the year ended December 31, 2006. The allowance for loan losses for all portfolios at December 31, 2007 aggregated $254.7 million, compared with $53.3 million at December 31, 2006. See “- Operating Expenses.” As a result of the Forbearance Agreements entered into on December 28,
2007 between Franklin and the bank, $300 million of outstanding borrowings owed to the bank was forgiven and will not have to be repaid. The effect of the debt forgiveness was a net gain of $284.2 million.
The Company’s loss per common share for the twelve months ended December 31, 2007 was $1.09 both on a diluted and a basic basis, compared to a loss per common share of $0.23 both on a diluted and basic basis for the twelve months ended December 31, 2006. Revenues increased by 3% to $169.3 million for the twelve months ended December 31, 2007, from $163.8 million for the twelve months ended December 31, 2006. During 2007, we acquired residential mortgage loans with an aggregate face amount of $528.7 million, $268.2 million of which were second liens on 1-4 family residential loans, and we originated $291.6 million of subprime 1-4 family first-lien mortgage loans. We increased the size of our total portfolio of net notes receivable, loans held for sale, loans held for investment and OREO at the end of 2007 to $1.58 billion from $1.56 billion at the end of 2006. Interest income increased by $14.1 million, or 10%, in 2007 compared with the full year 2006, due to the increase in our total loan portfolios, which was partially offset by increased interest reversals on non-accrual loans due to increased serious delinquencies in the Company’s loan portfolios. Correspondingly, our total debt outstanding grew to $1.63 billion at December 31, 2007, which excludes $300 million of debt that was eliminated as of December 28, 2007, from $1.58 billion at December 31, 2006. As a result of the increase of our total debt outstanding during the full year of 2007, interest expense (inclusive of amortization of deferred financing costs and success fees) increased by $28.2 million, or 24%, to $145.9 million, for 2007, compared with the full year 2006. Our average cost of funds during the twelve months ended December 31, 2007 decreased to 7.91% from 7.98% during the twelve months ended December 31, 2006. At December 31, 2007, the weighted average interest rate of borrowed funds was 7.46%. Collection, general and administrative expenses increased by $3.2 million, or 8%, to $41.4 million, during 2007 from $38.3 million for 2006, principally due to the operating expenses of the wholesale mortgage origination unit acquired early in 2007. Gains on loan sales decreased by $2.2 million to a loss of $305,000 in 2007. Gains on sales of OREO decreased by $1.2 million in 2007, from a gain of $1.9 million in 2006. The Company’s stockholders’ equity was $39.3 million at December 31, 2007, compared to $47.6 million of stockholders’ equity at December 31, 2006.
Revenues. Revenues increased by $5.5 million, or 3%, to $169.3 million during 2007, from $163.8 million during 2006. Revenues include interest income, purchase discount earned, gains on sales of notes receivable, gains on sales of originated loans, gains on sales of OREO and prepayment penalties and other income.
Interest income increased by $14.1 million or 10%, to $155.9 million during 2007 from $141.9 million during 2006. The increase in interest income reflected a 15% increase in the portfolios of gross notes receivable and loans held for investment, which was partially offset by a significant increase in interest reversals on non-accrual loans, principally in the notes receivable portfolio, during the twelve months ended December 31, 2007 compared to the twelve months ended December 31, 2006.
Purchase discount earned decreased by $4.0 million, or 44%, to $5.0 million during the twelve months ended December 31, 2007 from $8.9 million during the twelve months ended December 31, 2006. This decrease resulted primarily from decreased purchase discount available for accretion due to smaller purchase price discounts associated with the portfolios purchased in 2005 and 2006, a declining balance of purchase discount remaining for accretion from pre-2005 acquisitions and a slower rate of prepayments. In addition, approximately 80% of the purchase discount on 2007 acquisitions was recorded as “Nonaccretable discount,” which was allocated to cover expected future losses on these portfolios and, therefore, not accreted into income. We received $185.1 million of principal payments, including loan payoffs, from our portfolio of notes receivable during 2007 compared with $281.7 million of principal payments, including loan payoffs, during 2006.
Gain on sale of notes receivable decreased by $133,000, or 81%, to $31,000 for the twelve months ended December 31, 2007 from $164,000 for the twelve months ended December 31, 2006. The Company sold $22.3 million of performing lower-coupon notes receivable during 2007, as compared to $3.8 million in performing notes receivable and $161,000 of non-performing notes receivable during 2006.
Gain on sales of originated loans, which included a loss of approximately $828,000 on “Alt-A” loans both sold and transferred to portfolio at the lower of cost or market value, a gain of $155,000 on sales of Liberty Loans, a gain of $286,000 on sales of other loans originated for sale, and an $82,000 recovery of an unused portion of a repurchase reserve for loans sold in 2006, decreased by $2.2 million, or 116%, to a loss of $305,000 during the twelve months ended December 31, 2007, from a gain of $1.9 million during the twelve months ended December 31, 2006. The Company sold a total of $37.5 million of originated loans during the twelve months ended December 31, 2007, compared with $119.8 million of originated loans during the twelve months ended December 31, 2006. In the twelve months ended December 31, 2007, $14.1 million of Liberty Loans were sold for a net gain of $155,000. The average loss on loans sold, including the reserve recapture, was 0.82% during 2007 compared with an average gain of 1.56% during 2006. Excluding the reserve of $657,000 for anticipated loan repurchases, the average gain in 2006 was 2.43%. The decrease in the gain on loans sold was due to significant disruptions since the late spring of 2007 in the secondary mortgage market, particularly for subprime products.
Gain on sale of OREO decreased by $1.2 million, or 61%, to $748,000 during the twelve months ended December 31, 2007, from $1.9 million during the twelve months ended December 31, 2006. We sold 401 OREO properties with an aggregate carrying value of $26.6 million during the twelve months of 2007, as compared to 528 OREO properties with an aggregate carrying value of $30.4 million during the twelve months of 2006. The decrease in the gain on sales of OREO properties was due principally to the decline in housing values throughout most of the country during 2007.
Prepayment penalties and other income (principally late charges, recovered foreclosure costs and other servicing fees) decreased by $1.1 million, or 12%, to $7.9 million during 2007 from $9.0 million during 2006. This decrease was primarily due to a slower rate of loan payoffs in general and fewer payoffs of self-originated Liberty Loans from states where prepayment penalties are allowed, during the twelve months ended December 31, 2007, as compared with the corresponding period in 2006. This decrease was partially offset by increased late charges resulting primarily from the growth in the size of our loan portfolios and an increase in late payments. Total principal payments, principally comprised of prepayments, from the portfolio of loans held for investment (Liberty Loan portfolio) declined to $148.6 million in 2007, compared with $233.7 million in 2006.
Operating Expenses. Operating expenses increased by $296.5 million, or 178%, to $463.3 million during 2007 from $166.8 million during 2006. Total operating expenses include interest expense, collection, general and administrative expenses, provisions for loan losses, amortization of deferred financing costs and depreciation expense. Excluding the provision for loan losses, operating expenses increased by $31.6 million, or 20%, to $188.7 million during 2007 from $157.1 million in 2006.
Interest expense increased by $30.2 million, or 27%, to $143.3 million during the twelve months ended December 31, 2007, from $113.1 million during the twelve months ended December 31, 2006. This increase was the result of the increase in total debt, which was $1.63 billion as of December 31, 2007 as compared with $1.58 billion as of December 31, 2006, reflecting the additional borrowings to fund the growth in total assets during this period. Total debt as of December 27, 2007 was $1.93 billion, prior to the forgiveness of $300 million of the Company’s debt, which was 22% greater than the total debt at December 31, 2006. Our average cost of funds during the twelve months ended December 31, 2007 decreased to 7.91% from 7.98% during the twelve months ended December 31, 2006, reflecting repayments of older term debt with higher margins over LIBOR than the margins on new term debt. See “Borrowings.”
Collection, general and administrative expenses increased by $3.2 million, or 8%, to $41.4 million during 2007, from $38.3 million during 2006. Collection, general and administrative expenses as a percentage of average assets decreased slightly from 2.55% during the twelve months ended December 31, 2006 to 2.26% during 2007, while the Company’s total assets increased by 1% since December 31, 2006. The increase in collection, general and administrative expenses was the result of additional operating costs incurred from the wholesale origination unit acquired in February 2007. Salaries and employee benefits expenses increased by $2.4 million, or 14%, to $17.7 million during the twelve months of 2007, from $15.3 million during the same period in 2006, principally reflecting the addition of employees from the acquisition of the wholesale
origination unit. This increase was partially offset by a $1.2 million reduction in incentive compensation expenses, reflecting the granting of no restricted stock awards in 2007. Significant reductions in Tribeca’s origination workforce took place in the latter part of 2007 due to consolidation of Tribeca’s operations and reduced origination volumes, and therefore, the impact on salary and employee benefits expense from the reduction in personnel will not be fully realized until 2008. The Company ended 2007 with 207 employees as compared to 232 at the end of 2006. Legal fees, principally relating to increased activity with respect to foreclosures, increased by $1.9 million, or 35%, to $7.2 million from $5.3 million during the same period last year, reflecting increased foreclosure activity, principally from our Liberty Loan portfolio. Professional fees decreased by $499,000, or 16%, to $2.6 million from $3.1 million, principally due to decreased recruitment and consulting fees compared to the same period last year. Loan portfolio acquisition costs decreased by $1.1 million, or 44%, to $1.4 million in 2007 from $2.6 million during the twelve months ended December 31, 2006, principally due to reduced direct costs associated with decreased volumes of both portfolios purchased and portfolios considered for purchase compared to the same period last year. Other general and administrative expenses increased by $528,000, or 5%, to $10.5 million in 2007 from $10.0 million during the twelve months ended December 31, 2006, principally due to increased occupancy and other costs related to the acquisition of the wholesale origination unit.
The provision for loan losses increased by $264.9 million to $274.6 million during the twelve months ended December 31, 2007, from $9.8 million during the twelve months ended December 31, 2006, as a result of the Company’s reassessment of its allowance for loan losses during the third quarter of 2007. During 2007, the U.S. housing and subprime mortgage markets experienced rapid and substantial deterioration. This deterioration gave rise to industry-wide increases in mortgage delinquencies reflecting the decline in collateral values and related declines in borrowers’ equity in their homes, particularly with respect to subprime loans originated throughout the mortgage industry during 2005, 2006 and the early months of 2007, which were characterized by collateral values established at the height of the U.S. real estate market and also, often, by lax underwriting standards. Additionally, during the summer of 2007, there was a significant tightening of new credit throughout the mortgage lending industry, particularly in the subprime segment of the industry, which increased the difficulty for borrowers with imperfect credit histories to refinance their mortgages. In light of these factors, and their impact on the Company’s loan portfolios, a substantial portion of which is comprised of second lien mortgages purchased from others during the past several years, the Company reassessed its allowance for loan losses as of September 30, 2007. This reassessment resulted in significantly increased estimates of inherent losses in the portfolios of purchased loans, particularly the purchased second-lien loans, and originated subprime loans, which resulted in a provision of $262.7 million in the quarter ended September 30, 2007.
Amortization of deferred financing costs decreased by $2.0 million, or 43%, to $2.6 million during the twelve months of 2007 from $4.6 million during the twelve months of 2006. This decrease resulted primarily from a slower rate of prepayments on the Company’s loan portfolios, which caused reduced prepayments of our borrowed funds, coupled with a reduction of the origination fees charged by our lender to fund portfolio acquisitions and loan originations. Total principal payments, principally comprised of prepayments, on the Company’s loan portfolios aggregated $333.7 million during 2007, compared with $515.4 million during 2006. The origination fees for term debt were reduced from 0.75% to 0.50% for loans acquired after June 23, 2006, and from 1.00% to 0.50% for loans originated after June 30, 2005.
Depreciation expenses increased by $249,000, or 21%, to $1.4 million in the twelve months ended December 31, 2007. This increase was in part due to $485,000 in fixed assets purchased with the acquisition of the wholesale originations unit and new enhancements to our mortgage origination software.
Our pre-tax loss, before the gain on forgiveness of debt, increased by $291.0 million to a $294.1 million loss for 2007 from a pre-tax loss of $3.1 million during 2006 for the reasons set forth above. As a result of the Forbearance Agreements entered into on December 28, 2007 with the bank, $300 million of outstanding borrowings owed to the bank was forgiven and will not have to be repaid. The net gain on the debt forgiveness was $284.2 million.
During 2007, the Company had a tax benefit of $1.2 million, due to the loss incurred as compared to a tax benefit of $1.3 million in 2006.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Overview. The Company had a net loss of $1.8 million for the twelve months of 2006, compared with net income of $7.9 million for the twelve months of 2005, a decrease of 122%. Revenues increased by 35% to $163.8 million for the twelve months ended December 31, 2006, from $121.4 million for the twelve months ended December 31, 2005. Loss per common share for the twelve months ended December 31, 2006 was $0.23 both on a diluted and a basic basis, compared to earnings per common share of $1.09 and $1.19 for the twelve months ended December 31, 2005, respectively. During 2006, we acquired assets with an aggregate face amount of $621.4 million, $564.9 million of which were second liens on 1-4 family residential loans, and we originated $384.7 million of subprime 1-4 family residential mortgage loans. We increased the size of our total portfolio of net notes receivable, loans held for sale, loans held for investment and OREO at the end of 2006 to $1.56 billion from $1.25 billion at the end of 2005. Correspondingly, our total debt outstanding grew to $1.58 billion at December 31, 2006 from $1.26 billion at December 31, 2005. As a result of the increase of our total debt outstanding, and the impact of the dramatic 400-plus point rise in short-term interest rates since mid-2004 on our interest-sensitive borrowings, interest expense (inclusive of amortization of deferred financing costs and success fees) increased $45.2 million, or 62%, to $117.6 million, during the twelve months of 2006, compared with the same period in 2005. Our average cost of funds during the twelve months ended December 31, 2006 increased to 7.98% from 6.63% during the twelve months ended December 31, 2005. At December 31, 2006, the weighted average interest rate of borrowed funds was 7.99%. In December 2006, pursuant to an agreement executed with our lender, all success fee obligations under our master credit facilities were eliminated in exchange for a cash settlement of $4.5 million. As a result, success fee liability at December 31, 2006 was eliminated compared with $5.7 million at year-end 2005, and the debt discount was reduced to $516,000 at year-end 2006 from $3.0 million at year-end 2005. Collection, general and administrative expenses increased $9.6 million, or 33%, to $38.3 million, during 2006 from $28.7 million for 2005. The increase in collection, general and administrative expenses reflected for the most part the growth of the Company during the past two years. During the past twelve months, total assets increased 25% from December 31, 2005, while as a percentage of average assets, collection, general and administrative expenses decreased from 2.59% in 2005 to 2.55% in 2006. The provision for loan losses increased $5.0 million to $9.8 million in the twelve months ended December 31, 2006, principally due to higher default rates experienced in certain pools of loans purchased in mid-2004. Stockholders’ equity decreased by $41,000 to $47.6 million at year-end 2006.
Revenues. Revenues increased by $42.4 million, or 35%, to $163.8 million during 2006, from $121.4 million during 2005. Revenues include interest income, purchase discount earned, gains on sales of notes receivable, gains on sales of originated loans, gains on sales of OREO and prepayment penalties and other income.
Interest income increased by $42.8 million or 43%, to $141.9 million during 2006 from $99.0 million during 2005. The increase in interest income reflected the significant increase in the portfolio of gross notes receivable and loans held for investment, partially offset by an increase in loans held for investment that were placed on non-accrual, during the twelve months ended December 31, 2006 compared to the twelve months ended December 31, 2005.
Purchase discount earned decreased by $2.3 million, or 20%, to $8.9 million during the twelve months ended December 31, 2006 from $11.2 million during the twelve months ended December 31, 2005. This decrease resulted primarily from the increase in the purchase price of portfolios relative to unpaid principal at acquisition of portfolios purchased during 2005 and 2006, particularly in the second half of 2005, which resulted in less purchase discount available for accretion of discount compared with portfolios purchased in prior years, coupled with a lower balance of purchase discount available for accretion from pre-2005 acquisitions. In addition, principally all of the discount on 2006 acquisitions was recorded as “Nonaccretable discount,” which is not accreted into income. We received $281.7 million of principal payments from notes receivable during 2006 compared with $271.7 million of principal payments during 2005.
Gain on sale of notes receivable decreased by $1.1 million, or 87%, to $164,000 for the twelve months ended December 31, 2006 from $1.3 million for the twelve months ended December 31, 2005. The Company sold $3.8 million in performing notes receivable and $161,000 of non-performing notes receivable during 2006, as compared to a total of $13.6 million of performing notes receivable and non-performing notes receivable (credit card receivables) with a face amount of $23.5 million during 2005.
Gain on sale of originated loans increased by $595,000, or 47%, to $1.9 million during the twelve months ended December 31, 2006, from $1.3 million during the twelve months ended December 31, 2005. The gain on originated loans sold in 2006 declined to 1.56%, compared with 2.10% in 2005. The Company sold $119.8 million of originated loans during 2006, compared with $60.7 million of loans sold during 2005. $42.8 million of the loans sold in 2006 were estimated to be repurchased and its corresponding $657,000 gain was reserved and, therefore, excluded from the net gain, and another $7.5 million of loans that were originated specifically for sale to investors, but, for various reasons, did not meet investor requirements were sold at a loss. Excluding the loans that were expected to be repurchased, the average gain on loans sold increased to 2.43% during 2006 from 2.10% during 2005 due principally to the sale of $38.6 million of high yielding Liberty Loans that are generally held for investment. Excluding both the $42.8 million and $7.5 million of loans referred to above, the average gain on loans sold was 2.71% for the twelve months ended December 31, 2006.
Gain on sale of OREO increased by $160,000, or 9%, to $1.9 million during the twelve months ended December 31, 2006, from $1.8 million during the twelve months ended December 31, 2005. We sold 528 OREO properties with an aggregate carrying value of $30.4 million during the twelve months of 2006, as compared to 487 OREO properties in the aggregate carrying value of $30.7 million during the twelve months of 2005. The increase in the number of properties sold reflected the growth in our OREO inventory due to an increase in foreclosures as our notes receivable portfolio grew significantly during the past two years.
Prepayment penalties and other income (principally late charges, recovered foreclosure costs and other servicing fees) increased by $2.2 million, or 33%, to $9.0 million during 2006 from $6.8 million during 2005. This increase was primarily due to an increase in prepayment penalties received, as a result of increased loan pay offs, principally from originated Liberty Loans during the twelve months ended December 31, 2006, as compared with the twelve months ended December 31, 2005. This also was the result of the increased size of both our portfolio of purchased loans and loans held for investment, combined with continued relatively low mortgage interest rates. Increased late charges resulting primarily from the growth in the size of our loan portfolios as well as recovered legal costs due to increased legal settlement costs contributed to the increase.
Operating Expenses. Operating expenses increased by $59.9 million, or 56%, to $166.8 million during 2006 from $107.0 million during 2005. Total operating expenses include interest expense, collection, general and administrative expenses, provisions for loan losses, amortization of deferred financing costs and depreciation expense.
Interest expense increased by $44.7 million, or 65%, to $113.1 million during the twelve months ended December 31, 2006, from $68.3 million during the twelve months ended December 31, 2005. This increase was the result of the increase in total debt, which was $1.58 billion as of December 31, 2006 as compared with $1.26 billion as of December 31, 2005, reflecting additional borrowings to fund the growth in total assets during this period. The amortization of debt discount recognized from success fees increased to $1.9 million in 2006, compared with $1.2 million in 2005. In addition, our average cost of funds during the twelve months ended December 31, 2006 increased to 7.98% from 6.63% during the twelve months ended December 31, 2005, reflecting the continued dramatic rise in short-term interest rates and its effect on our interest-rate sensitive borrowings, substantially all of which are based on the 30-day LIBOR rate.
Collection, general and administrative expenses increased by $9.6 million, or 33%, to $38.3 million during 2006, from $28.7 million during 2005. Collection, general and administrative expenses as a percentage of average assets decreased slightly from 2.59% during the twelve months ended December 31, 2005 to 2.55% during 2006, while the Company’s total assets increased by 25% since December 31, 2005. Salaries and employee benefits expenses increased by $5.2 million, or 51%, reflecting an increase in the number of employees and stock option and restricted stock expenses for certain members of senior management
recognized in 2006. We ended 2006 with 232 employees as compared to 216 at the end of 2005. During 2006, we hired new employees at higher salary levels throughout the Company, the largest number of employees in the servicing and sales departments, to replace personnel who resigned or were terminated during the year. The use of contract staff to help accommodate the growth of the Company’s portfolios and an increase in health benefits costs also contributed to the year-over-year increase in total salaries and employee benefits expenses. During 2006, the cost of stock options and restricted stock and related expenses for certain senior executives totaled $1.6 million, compared with $762,000 for the twelve months ended December 31, 2005. Legal fees, principally relating to increased activity with respect to foreclosures, increased by $1.2 million, or 29%, to $5.3 million in 2006 from $4.1 million during the same period last year. The cost of outside services, such as appraisals and title searches, incurred in servicing delinquent loans increased by $980,000, or 95%, to $2.0 million during the twelve months ended December 31, 2006 from $1.0 million during 2005 due to increases in foreclosure activity as a result of a larger total portfolio of notes receivable, loans held for investment and certain loans purchased in various stages of delinquency and foreclosure. Professional fees increased by $983,000, or 46%, from $2.1 million during the twelve months ended December 31, 2005 due to increased audit, tax, consulting and recruiting fees. Loan portfolio acquisition costs increased by $654,000, or 34%, to $2.6 million in 2006 from $1.9 million during the twelve months ended December 31, 2005, principally due to increased direct costs associated with both portfolios purchased and portfolios considered for purchase compared to the same period last year. Other general and administrative expenses increased by $618,000, or 7%, to $10.0 million in 2006 from $9.4 million during the twelve months ended December 31, 2005, principally due to increased computer licensing and support expenses and increased imaging and scanning expenses.
The provision for loan losses increased by $5.0 million, or 105%, to $9.8 million during the twelve months ended December 31, 2006, from $4.7 million during the twelve months ended December 31, 2005. This increase was primarily due to higher than expected default rates experienced in certain pools of loans purchased in mid-2004, and, to a lesser extent, to a larger portfolio of notes receivable.
Amortization of deferred financing costs increased by $464,000, or 11%, to $4.6 million during the twelve months of 2006 from $4.1 million during the twelve months of 2005. This increase resulted primarily from the growth in debt to fund the expansion of the portfolio of loans acquired and originated.
Depreciation expenses increased by $87,000, or 8%, to $1.2 million in the twelve months ended December 31, 2006, principally due to leasehold improvements related to the Company’s new office facility in New Jersey and the addition and upgrading of computer hardware and software.
Our pre-tax income decreased by $17.5 million, or 121%, to a loss of $3.1 million during 2006 from $14.4 million during 2005 for the reasons set forth above.
During 2006, the Company had a tax benefit of $1.3 million due to the loss incurred as compared to a tax provision of $6.6 million in 2005. The effective tax rate for 2005 was 46%.
Liquidity and Capital Resources
General
During 2007, we purchased 6,561 loans, approximately 51% of which were second-lien mortgages, with an aggregate face value of $528.7 million at an aggregate purchase price of $440.7 million, or 83% of face value. During 2007, we originated $291.6 million of loans through our origination subsidiary, Tribeca Lending Corporation. Originations were initially funded through borrowings under our warehouse facility, and loans originated for portfolio were subsequently funded with term debt under our Tribeca Master Credit Facility after transfer from the warehouse facility. In the first quarter of 2006, Tribeca and certain of its subsidiaries entered into master credit and security agreements with each of our principal lender, Sky Bank, and BOS (USA) Inc., an affiliate of Bank of Scotland, the proceeds of which were used to refinance and consolidate certain term loans with our principal lender. We ceased to acquire and originate loans in November 2007, and under the terms of the Forbearance Agreements, the Company can not originate or acquire mortgage loans or other assets without the prior consent of the bank.
We have one source of external funding to meet our liquidity requirements, in addition to the cash flow provided from borrower payments of interest and principal on mortgage loans. See “- Borrowings.” In addition, we have had the ability, from time to time, to sell loans in the secondary market. We have sold pools of acquired mortgage loans and newly originated Liberty Loans from time to time, and we have sold loans that we originated specifically for sale into the secondary market on a regular basis. Due to severe disruptions in the capital markets since mid-2007 and current secondary market conditions, particularly the severe contraction in secondary market liquidity for non-prime mortgage loan products, sales of loans in the near future are unlikely.
We are required to submit all payments we receive from our mortgage loans to a lockbox, from which we receive an operating allowance, which is subject to periodic review and approval by the bank, to sustain our business. Substantially all amounts submitted to the lockbox in excess of the agreed upon operating allowance are used to pay down amounts outstanding under our credit facilities with the bank and BOS. The operating allowance may not be sufficient to sustain our operations in the future, particularly for new business activities. If it is insufficient, there is no guarantee that the bank will increase our operating allowance, which could have a material adverse impact on our business.
Short-term Investments. The Company’s short-term investment portfolio includes U.S. treasury bills, investment-grade commercial paper and money market accounts. The Company’s investment policy is structured to provide an adequate level of liquidity in order to meet normal working capital needs, while taking minimal credit risk. At December 31, 2007, the Company had short-term investments of $4.7 million.
Cost of Funds. As of December 31, 2007, we had total borrowings of $1.63 billion, of which $1.54 billion was subject to the Forbearance Agreements and $89.4 million remained under our credit facilities. Substantially all of the debt under these facilities was incurred in connection with the purchase and origination of, and is secured by, our acquired loans (notes receivable), originated loans held for investment and OREO portfolios. At December 31, 2007, the interest rates on our term debt were as follows:
At December 31, 2007, the weighted average interest rate on term debt was 7.46%. Our warehouse facilities were utilized, until December 28, 2007, to fund Tribeca’s originations of loans and the acquisition of loans through our “Flow Acquisitions Group” pending sale to others or pending funding under our credit facilities for loans to be held in portfolio. The interest rate on the warehouse debt was 7.75% at December 31, 2006. At December 31, 2007, both warehouse facilities were discontinued.
Cash Flow from Operating, Investing and Financing Activities
Liquidity represents our ability to obtain adequate funding to meet our financial obligations. Our liquidity position was affected by mortgage loan purchase and origination volume, and is affected by mortgage loan payments, including prepayments, loan maturities and the amortization and maturity structure of borrowings under our credit facilities. In accordance with the terms of our credit facilities with our lenders, we received a cash allowance that had been adequate to meet our operating expenses. Such a cash allowance to meet our operating expenses is provided for under the Forbearance Agreements.
At December 31, 2007, we had cash and cash equivalents of $18.3 million compared with $4.0 million at December 31, 2006. Restricted cash of $40.3 million and $32.7 million at December 31, 2007 and 2006, respectively, was restricted under our credit agreements and lockbox facility with the bank.
Substantially all of our assets are invested in our portfolios of notes receivable, loans held for investment, OREO and loans held for sale. Primary sources of our cash flow for operating and investing activities have been borrowings under our various credit facilities, collections of interest and principal on notes receivable and loans held for investment and proceeds from sales of notes and OREO properties, and from time to time, sales of our newly originated loans that generally were held for investment. Primary uses of cash included purchases of notes receivable, originations of loans and for operating expenses. We have relied significantly upon our lender and the other banks that participate in the loans made to us by our lender to provide the funds necessary for the purchase of notes receivable portfolios and the origination of loans. While we have historically been able to finance these purchases and originations, we have not had, at any time since our inception, committed loan facilities in significant excess of the amount we currently have outstanding under our credit facilities. Franklin ceased to acquire and originate loans in November 2007, and under the terms of the Forbearance Agreements, the Company is expressly prohibited from acquiring or originating mortgage loans or other assets without the prior consent of the bank.
Net cash used in operating activities was $17.3 million during the twelve months ended December 31, 2007, compared with cash provided of $334,000 during the twelve months ended December 31, 2006. The decrease in cash provided by operating activities during the twelve months ended December 31, 2007 was due primarily to an increase of $6.9 million in the Company’s net loss from the net loss of $1.8 million for the twelve months ended December 31, 2006. The increase in the Company’s net loss, due principally to the increase of $264.9 million in the provision for loan losses, was offset by a gain of $284.3 million from the forgiveness of debt.
Net cash used in investing activities was $287.9 million in the twelve months ended December 31, 2007, compared to $326.7 million of cash used in the twelve months ended December 31, 2006. The decrease in cash used during the twelve months ended December 31, 2007 was primarily due to a decrease of $228.1 million of loans acquired and originated during the twelve months of 2007 compared to the twelve months of 2006. This decrease in cash used in 2007 was partially offset by a decrease of $181.7 million in principal collections received from the portfolios of notes receivable and loans held for investment.
Net cash provided by financing activities decreased to approximately $319.5 million during the twelve months ended December 31, 2007, from $326.5 million provided during the twelve months ended December 31, 2006. Proceeds from notes payable decreased by $121.9 million and proceeds from financing agreements decreased by $44.7 million because of reductions in both portfolios purchased and loans originated during this period. Net payoffs of notes payable and financing agreements declined by $207.2 million as a result of slower prepayments on the Company’s portfolios of notes receivable and loans held for investment. These changes were partially offset by an $18.1 million funding of the repurchase obligation in 2007, which was funded by an increase in the proceeds from notes payable, and the payment of a $12 million restructuring fee.
Offering of Common Stock
In early August 2005, we completed a public offering of 1,265,000 of shares of our common stock at a public offering price of $11.50 per share (including an exercise in full of the underwriter’s over allotment option to purchase 165,000 shares) pursuant to a registration statement that was declared effective by the Securities and Exchange Commission on July 19, 2005. The offering resulted in net proceeds to us and the addition to equity of approximately $12.6 million. As a result of the additional equity raised, in combination with retained earnings in 2005, total stockholders’ equity increased to $47.6 million at December 31, 2005 compared with $26.1 million at December 31, 2004. In conjunction with the public offering, the Company’s common stock ceased to be quoted on the Over-the-Counter Bulletin Board under the symbol “FCSC” and commenced trading on The Nasdaq National Market under the symbol “FCMC.” See Item 5. “Market for
Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Delisting Proceedings.”
Borrowings
As of December 31, 2007, the Company owed an aggregate of $1.63 billion under the Forbearance Agreements and the two remaining credit facilities excluded from the Forbearance Agreements with our lenders. These borrowings are shown in the Company’s financial statements as “Notes payable” (referred to as “term loans” herein) and “Financing agreements” (referred to as the “Warehouse Facility” or “Warehouse Facilities” herein).
Forbearance Agreements with Lead Lending Bank
On December 28, 2007, the Company entered into a series of agreements with the bank, pursuant to which the bank agreed to forbear with respect to certain defaults of the Company relating to the Company’s indebtedness to the bank and restructure approximately $1.93 billion of such indebtedness to the bank and its participant banks.
The Restructuring did not relate to:
•
$44.5 million of the Company’s indebtedness under the Master Credit and Security Agreement, dated as of October 13, 2004, as amended, by and among Franklin Credit, certain subsidiaries of Franklin Credit and the bank; and,
•
$44.8 million of Tribeca’s indebtedness to BOS (USA) Inc., an affiliate of Bank of Scotland, under the Master Credit and Security Agreement, dated March 24, 2006, by and among Tribeca, certain subsidiaries and BOS.
These amounts remain subject to the original terms specified in the applicable agreements (the “Unrestructured Debt”).
Loan Restructuring. Pursuant to the Restructuring:
•
the Company acknowledged, and the bank waived, certain existing defaults under the Company’s existing credit facilities with the bank;
•
Franklin Credit’s indebtedness to the bank was reduced by $300 million and Franklin Credit paid a restructuring fee of $12 million to the bank;
•
the remaining approximately $1.54 billion of outstanding indebtedness to the bank, including approximately $1.05 billion of outstanding indebtedness of Franklin Credit and approximately $491.1 million of outstanding indebtedness of Tribeca, was restructured into six term loans with modified terms and a maturity date of May 15, 2009; and,
•
the Company paid all of the accrued interest on its debt outstanding to the bank through December 27, 2007 and guaranteed payment and performance of the restructured indebtedness.
Terms of the Restructured Indebtedness. The following table summarizes the principal economic terms of the Company’s indebtedness immediately following the Restructuring.
(1)
The applicable interest rate is fixed at 10% per annum. Interest will be paid in kind during the term of the forbearance.
(2)
Tranche C requires no principal amortization. All principal is due at maturity.
(3)
Tranche D serves as a revolving credit line with a maximum availability of $5 million, and an additional $5 million which may be used for issuance of letters of credit.
(4)
Does not include a letter of credit facing fee of 0.125% per annum on the average daily undrawn amount of each issued and outstanding letter of credit.
The interest rate under the terms of the Forbearance Agreements that is the basis, or index, for the Company’s interest cost is the one-month London Interbank Offered Rate (“LIBOR”) plus applicable margins.
The following table compares the approximate weighted average interest rate of the Company’s indebtedness immediately prior to and following the Restructuring.
(1)
Includes the Unrestructured Debt.
Pursuant to the Forbearance Agreements, the bank is not required to provide any additional advances, except for those under the revolving credit or letter of credit portions of Tranche D.
Cash Flow. The Forbearance Agreements with respect to Franklin Credit, on the one hand, and Tribeca, on the other, provide a waterfall with respect to cash flow received in respect of collateral pledged in support of the related restructured indebtedness, net of approved, reimbursable operating expenses. Such cash flow is applied in the following order:
•
to pay interest in respect of Tranche A advances, Tranche B advances and, in the case of Franklin Credit, Tranche D advances, in that order;
•
to pay fees related to the Company’s letters of credit from the bank;
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to pay the minimum required principal payments in respect of Tranche A advances and Tranche B advances, in that order;
•
to prepay outstanding Tranche A advances;
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to prepay outstanding Tranche B advances;
•
to prepay Unrestructured Debt (excluding that owed to BOS);
•
in the case of Franklin Credit, to repay Tranche D advances, any letter of credit exposure, and any obligations in respect of any interest rate hedge agreements with the bank;
•
in the case of Franklin Credit, 90% of the available cash flow to repay interest and then principal of the Tranche C advances if Franklin Credit is acting as servicer of the underlying collateral, or 100% otherwise; and,
•
in the case of Franklin Credit and Tribeca, to pay any advances then outstanding in respect of the other’s indebtedness to the bank, other than for Unrestructured Debt.
Covenants; Events of Default. The Forbearance Agreements contain affirmative and negative covenants customary for restructurings of this type, including covenants relating to reporting obligations. The affirmative and negative covenants under all of the credit agreements between the Company and the bank, other than those under the Franklin Master Credit Agreement and under the Tribeca Master Credit and Security Agreement, dated as of February 28, 2006, as amended, were superseded by the covenants in the Forbearance Agreements. Additionally, any provisions of any of the credit agreements between the Company and the bank that conflict with or are subject of a discrepancy with the provisions of the Forbearance Agreements will be
superseded by the conflicting provision in the Forbearance Agreements. The Forbearance Agreements include covenants requiring that:
•
the Company’s reimbursable expenses in the ordinary course of business during each of the first two months after the date of the agreement will not exceed $2.5 million, excluding reimbursement of certain bank expenses after the date of the Restructuring, and thereafter, an amount provided for in an approved budget;
•
the Company will not originate or acquire mortgage loans or other assets, perform due diligence or servicing, broker loans, or participate in off-balance sheet joint ventures and special purpose vehicles, without the prior consent of the bank;
•
the Company will use its best efforts to obtain interest rate hedges acceptable to the bank in respect of the $1 billion of Tranche A indebtedness;
•
the Company will not make certain restricted payments to its stockholders or certain other related parties;
•
the Company will not engage in certain transactions with affiliates;
•
the Company will not incur additional indebtedness other than trade payables and subordinated indebtedness;
•
the Company together will maintain a minimum consolidated net worth of at least $5 million, plus a certain percentage, to be mutually agreed upon, of any equity investment in the Company after the date of the Restructuring;
•
the Company will together maintain a minimum liquidity of $5 million;
•
the Company will maintain prescribed interest coverage ratios based on EBITDA (as defined) to Interest Expense (as defined);
•
the Company will not enter into mergers, consolidations or sales of assets (subject to certain exceptions); and,
•
the Company will not, without the bank’s consent, enter into any material change in its capital structure that the bank or a nationally recognized independent public accounting firm determine could cause a consolidation of its assets with other persons under relevant accounting regulations.
The Forbearance Agreements contain events of default customary for facilities of this type, although they generally provide for no or minimal grace and cure periods.
Servicing. Franklin Credit will continue to service the collateral pledged by the Company under the Forbearance Agreements, subject to the bank’s right to replace Franklin Credit as servicer in the event of a default under the Forbearance Agreements or if the bank determines that Franklin Credit is not servicing the collateral in accordance with accepted servicing practices, as defined in the Forbearance Agreements. Franklin Credit may also, with the bank’s consent, and plans to, provide to third parties servicing of their portfolios, and other related services, on a fee paying basis.
Security. The Company’s obligations with respect to the restructured Franklin Credit indebtedness are secured by a first priority lien on all of the assets of Franklin Credit and its subsidiaries, other than those of Tribeca and Tribeca’s subsidiaries, and those securing the Unrestructured Debt. The Company’s obligations with respect to the restructured Tribeca indebtedness are secured by a first priority lien on all of the assets of Tribeca and Tribeca’s subsidiaries, except for those assets securing the Unrestructured Debt. In addition, pursuant to a lockbox arrangement, the bank controls substantially all sums payable to the bank in respect of any of the collateral.
Gain on Debt Forgiveness. The forgiveness of $300 million of the Company’s indebtedness to the bank resulted in the recognition of a $284.2 million net gain in the quarter ended December 31, 2007.
Recent Development - March 2008 Modifications to Forbearance Agreements and Refinancing of BOS Loan
On March 31, 2008, the Company entered into a series of agreements with the bank, which amended the Forbearance Agreements, which are referred to as the Forbearance Agreement Amendments.
Pursuant to the Forbearance Agreement Amendments, the bank extended an additional $43.3 million under Tribeca’s Tranche A and Tranche B facilities, (the “Additional Payoff Indebtedness”), to fund the complete payoff of the BOS Loan. Simultaneously, BOS acquired from the bank a participation interest in Tribeca’s Tranche A facility equal in amount to the Additional Payoff Indebtedness. The effect of these transactions was to roll Tribeca’s indebtedness to BOS into the Forbearance Agreements, to terminate any obligations of Tribeca under the BOS Loan and to BOS directly, and to transfer the benefit of the collateral interests previously securing the BOS Loan to secure the obligations under the Forbearance Agreements. As a result of the Forbearance Agreement Amendments, Tribeca’s indebtedness as of March 31, 2008, was $410,860,000 and $98,774,000 for Tranche A and Tranche B, respectively. In connection with the increased debt outstanding under the Amended Forbearance Agreements, Tribeca’s required monthly principal amortization amount under the Tranche A Facility was increased from $3,600,000 to $3,900,000 and that under the Tranche B Facility was increased from $250,000 to $275,000.
In addition, the Forbearance Amendment Agreements modified the Forbearance Agreements with respect to the Franklin Master Credit Facility (the “Franklin Forbearance Agreement”):
•
to provide that Tranche C interest shall not accrue until the first business day after all outstanding amounts under the Tranche A facility have been paid in full;
•
to increase the Tranche C interest rate to 20% from and after such time it begins to accrue;
•
to extend an additional period of forbearance through July 31, 2008, from May 15, 2008, in respect of the remaining Unrestructured Loans; and,
•
to increase the maximum availability under the Tranche D line of credit to $10,000,000 for working capital and general corporate purposes to enable the Company to purchase real property in which it may have a lien, and for purposes of meeting licensing requirements.
Additionally, the Forbearance Agreement Amendments modified the Forbearance Agreements to (a) join additional subsidiaries of the Company as borrowers and parties to the forbearance agreements and other loan documents; and (b) extend the time periods or modify the requirements for the Company and the Company’s other subsidiaries to satisfy certain requirements of the Forbearance Agreements.
After giving effect to the Forbearance Agreement Amendments, the waterfall of payments has been adjusted to provide that periodic amounts constituting additional periodic payments of interest required under any interest hedging agreement may be paid after interest on the Tranche A and Tranche B advances, payments of interest and principal with respect to Tranche C advance shall be deferred until after payment of the Tranche D advance, and to provide for cash payment reserves for certain contractual obligations, taxes and $10,000,000 of cash payment reserves in the aggregate for fees, expenses, required monthly principal amortization and interest owing to the Bank.
The bank also waived any defaults under the Forbearance Agreements for the period through and including March 31, 2008, and consented to the origination by the Company of certain mortgage loans to refinance existing mortgage loans which the bank has approved for purchase and subsequent sale in the secondary market or which the bank determines are qualified for purchase by Fannie Mae or Freddie Mac.
Master Credit Facilities - Term Loans
The summary that follows describes the terms of the Company’s credit facilities in effect prior to entering into the Forbearance Agreements on December 28, 2007 described above, which substantially modified such facilities, except for the Unrestructured Debt.
General. In October 2004, the Company, and its finance subsidiaries, excluding Tribeca, entered into a master credit and security agreement (the “Franklin Master Credit Facility”) with Huntington National Bank, an Ohio banking corporation, which we refer to as the bank, our lender or Huntington. Under this master credit facility, we requested term loans to finance the purchase of residential mortgage loans or refinance existing outstanding loans under this facility. The facility did not include a commitment to additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were therefore subject to our lender’s discretion as well as any regulatory limitations to which our lender was subject. At December 31, 2007, $44.5 million remained outstanding under this facility (a portion of the Unrestructured Debt), and the interest rate continues to be based on the Federal Home Loan Bank of Cincinnati 30-day advance rate plus margins of 2.35% and 2.50%.
In February 2006, Tribeca and certain of its subsidiaries entered into the Tribeca Master Credit Facility with Huntington, pursuant to which certain Tribeca subsidiaries borrowed term loans to finance their origination of loans Tribeca previously financed under its warehouse line of credit with Huntington and consolidate and refinance prior term loans made by Huntington to such subsidiaries. The facility did not include a commitment for additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were subject to our lender’s discretion, as well as any regulatory limitations to which Huntington was subject. At December 31, 2007, $0 remained outstanding under this facility.
Interest Rates and Fees. Interest on the term loans, up to December 28, 2007, was payable monthly at a floating rate equal to the highest Federal Home Loan Bank of Cincinnati 30-day advance rate as published daily by Bloomberg under the symbol FHL5LBRI, or the “30-day advance rate,” plus the applicable margin in effect prior to August 2006 as follows:
August 2006 Modifications to Huntington National Bank Financing Arrangements
In August 2006, the master credit facilities were modified to reduce the interest rate on all debt originated under the master credit facilities before July 1, 2005 by 25 basis points effective October 1, 2006. This rate was lowered by an additional 25 basis points effective January 1, 2007.
December 2006 Modifications to Huntington National Bank Financing Arrangements
In December 2006, the master credit facilities were modified to change the interest rate on term loans funded under the master credit facilities after November 14, 2006 for loans originated by Tribeca and purchases of second mortgages by the Company to the Federal Home Loan Bank of Cincinnati 30-day advance rate as published daily by Bloomberg under the symbol FHL5LBRI (the “30-day advance rate”), plus the applicable margin as follows:
Additionally, the interest rate payable to Huntington National Bank on term loans funded under the Franklin Master Credit Facility after November 14, 2006 in respect of purchases of first mortgages by the Company was the 30-day advance rate, plus the applicable margin as follows:
As a result of these modifications, effective January 1, 2007, and up to December 28, 2007, the interest rate on term borrowings under our Master Credit Facilities was based on a floating rate equal to the 30-day advance rate, plus the applicable margin as follows:
Upon each closing of a loan after June 23, 2006, we were required to pay an origination fee equal to 0.50% of the amount of the loan unless otherwise agreed to by our lender. For loans funded between July 1, 2005 and June 23, 2006, under the Franklin Master Credit Facility, the origination fee paid was 0.75% of the amount of the loan (0.50% for loans funded under the Tribeca Master Credit Facility), and for loans funded prior to July 1, 2005, the origination fee paid was 1% of the amount of the loan unless otherwise agreed to by our lender.
Principal; Prepayments; Termination of Commitments. The unpaid principal balance of each loan was amortized over a period of twenty years, but matured three years after the date the loan was made. Historically, our lender had agreed to extend the maturities of such loans for additional three-year terms upon their maturity. We were required to make monthly payments of the principal on each of our outstanding loans.
In the event there was a material and adverse breach of the representations and warranties with respect to a pledged mortgage loan that was not cured within 30 days after notice by our lender, we would have been required to repay the loan with respect to such pledged mortgage loan in an amount equal to the price at which such mortgage loan could readily be sold (as determined by our lender).
Covenants; Events of Default. The Master Credit Facilities contain affirmative, negative and financial covenants customary for financings of this type, including, among other things, a covenant under the Franklin Master Credit Facility that we and our subsidiaries together maintain a minimum net worth of at least $10 million; and, a covenant under the Tribeca Master Credit Facility that Tribeca and its subsidiaries, together, maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of at least $750,000. These master credit facilities contain events of default customary for facilities of this type (with customary grace and cure periods, as applicable).
Security. Our obligations under the Franklin Master Credit Facility are secured by a first priority lien on loans that are financed by proceeds of loans made to us under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, our lender is entitled to receive substantially all sums payable to us in respect of any of the collateral. Tribeca’s and its subsidiary borrowers’ obligations under the Tribeca Master Credit Facility are secured by a first priority lien on loans originated by Tribeca or such subsidiary that are financed or refinanced by proceeds of loans made to Tribeca or its borrowers under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, Huntington is entitled
to receive substantially all sums payable to Tribeca and any subsidiary borrower in respect of any of the collateral.
Bank of Scotland Term Loan
In March 2006, Tribeca and one of Tribeca’s subsidiaries (the “Tribeca Subsidiary Borrower”) entered into a $100 million Master Credit and Security Agreement (the “BOS Loan”) with BOS (USA) Inc., an affiliate of Bank of Scotland. $98.2 million of proceeds of the BOS Loan were used to consolidate and refinance prior term loans made to certain Tribeca subsidiaries. Interest on the BOS Loan is payable monthly at a floating rate equal to the 30-day advance rate plus an applicable margin as follows:
The unpaid principal balance of the BOS Loan is amortized over a period of 20 years, but matures in March 2009. The Tribeca Subsidiary Borrower is required to make monthly amortization payments and payments of interest on the BOS Loan. The facility does not include a commitment to additional lendings or a commitment to refinance the remaining outstanding balance of the loan when it matures. The outstanding balance of the BOS Loan was $44.8 million (a portion of the Unrestructured Debt) at December 31, 2007.
The facility contains affirmative, negative and financial covenants customary for financings of this type, including, among other things, covenants that require Tribeca and its subsidiaries, together, to maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of $750,000. The facility contains events of default customary for facilities of this type. At December 31, 2007, Tribeca was not in compliance with these and other covenants and has not received a waiver of noncompliance. Any unwaived or uncured breach of these covenants could, subject to notice and opportunity to cure where provided for in the applicable credit agreements, cause an acceleration of the outstanding BOS Loan and result in cross-default and possible acceleration of the indebtedness owed to the bank under the Forbearance Agreements. As described in “Recent Development - March 2008 Modifications to Forbearance Agreements and Refinancing of BOS Loan,” the BOS Loan was paid off and effectively rolled into the Forbearance Agreements.
Tribeca’s and the Tribeca subsidiary borrower’s obligations under the facility are secured by (i) a first priority lien on loans acquired by the Tribeca Subsidiary Borrower that are refinanced by the proceeds of the BOS Loan and (ii) a second priority lien on collateral securing loans made to Tribeca or its subsidiaries under the Tribeca Master Credit Facility described above. In addition, pursuant to a lockbox arrangement, BOS is entitled to receive substantially all sums payable to Tribeca and the Tribeca Subsidiary Borrower in respect of any of the primary collateral under the facility. Tribeca’s BOS Loan and the Tribeca Master Credit Facility are cross-collateralized.
Warehouse Facilities
Tribeca Warehouse. In October 2005, Tribeca entered into a Warehousing Credit and Security Agreement (the “Tribeca Warehouse Facility”) with our lender, which modified previous warehouse lending agreements. In April 2006, our lender increased the commitment to $60 million. Interest on advances was payable monthly at a rate per annum equal to the greater of (i) a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points or (ii) 5%.
The Tribeca Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. Tribeca also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of Tribeca’s obligations under the Tribeca
Warehouse Facility, which was secured by substantially all of Tribeca’s personal property. As of December 28, 2007, this facility was terminated.
Flow Warehouse. In August 2006, we entered into a new $40 million Flow Warehousing Credit and Security Agreement (the “Flow Warehouse Facility”) for a term of one year with our lender to accumulate loans acquired by the Company on a flow basis prior to consolidating such loans into term debt. This warehouse facility was renewed in August 2007 by Huntington for $20 million and for a term of one year. As of December 28, 2007, this facility was terminated.
Interest on advances was payable monthly at a rate per annum equal to a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points.
The Flow Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. The Company also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of the Company’s obligations under the Flow Warehouse Facility, which was secured by substantially all our personal property.
Elimination of Success Fees
In June 2006, the Company received from Sky Bank a letter (the “June Modification Letter”) modifying the Franklin Master Credit Facility between the Company and all of its subsidiaries other than Tribeca and the Tribeca Master Credit and Security Agreement among Tribeca, Sky Bank and certain subsidiaries of Tribeca. Pursuant to the June Modification Letter, Franklin and Tribeca were no longer required to pay Sky Bank a success fee upon the successful payoff of term loans made on or after June 26, 2006 under the master credit facilities.
In December 2006, the Company, Tribeca and Sky Bank entered into an Amendment (the “Amendment”) to the Franklin Master Credit Facility and the Tribeca Master Credit Facility (together with the Franklin Master Credit Facility, the “Master Credit Facilities”). Pursuant to the Amendment, Sky Bank agreed to the elimination of all success fee obligations under the Master Credit Facilities relating to term loans made before June 26, 2006, in consideration of the Company’s agreement to pay $4.5 million to Sky Bank. As a result of these amendments, neither the Company nor Tribeca will have any further success fee obligations upon payoff of term loans under any credit facilities.
Interest Rate Caps
On August 29, 2006, the Company purchased a $300 million (notional amount) one-month LIBOR cap with a strike price of 5.75% at a price of $101,000, and on August 30, 2006, the Company purchased a $500 million (notional amount) one-month LIBOR cap with a strike price of 6.0% at a price of $60,000. Both cap agreements expired on August 31, 2007.
On September 5, 2007, the Company purchased a $200 million (notional amount) one-month LIBOR cap with a strike price of 5.75% at a price of $102,000, and on September 6, 2007, the Company purchased a $400 million (notional amount) one-month LIBOR cap with a strike price of 6.0% at a price of $90,000. Both cap agreements are non-amortizing and will be in effect for one year. The cap resets match the interest rate resets on a portion of the Company’s term debt. These caps will limit the Company’s exposure to increased borrowing costs on $200 million of term debt should the 30-day LIBOR rate exceed 5.75%, and on a total of $600 million of term debt should such rate exceed 6.0%. The interest rate caps are not designated as hedging instruments for accounting purposes; therefore, a change in the fair market value of the caps is recognized as gain or loss in earnings in the current period.
The following table presents the contract/notional and fair value amounts of all derivative transactions at December 31, 2007:
Recent Development
Effective February 27, 2008, the Company entered into $725 million (notional amount) of fixed-rate interest rate swaps in order to effectively stabilize the future interest payments on a portion of its interest-sensitive borrowings. The fixed-rate swaps are for periods ranging from one to four years, are non-amortizing, and are in effect for the respective full terms of each swap agreement. These swaps will effectively fix the Company’s interest costs on a portion of its borrowings regardless of increases or decreases in the one-month LIBOR. The interest rate swaps were executed with the bank and are for the following terms: $220 million notional amount for one year at a fixed rate of 2.62%; $390 million notional amount for two-years at a fixed rate of 2.79%; $70 million notional amount for three years at a fixed rate of 3.11%; and, $45 million notional amount for four years at a fixed rate of 3.43%.
Under these swap agreements, the Company will make interest payments to its bank at fixed rates and will receive interest payments from its bank on the same notional amounts at variable rates based on LIBOR. Effective December 28, 2007, the Company pays interest on its interest-sensitive borrowings, principally based on one-month LIBOR plus applicable margins. Accordingly, the Company has established a fixed rate plus applicable margins on $725 million of its borrowings for the next year, $505 million for two years, $115 million for three years and $45 million for four years.
Financing Activities and Contractual Obligations
Below is a schedule of the Company’s contractual obligations and commitments at December 31, 2007:
In January 2007, the Company repurchased $17.2 million of Liberty loans previously sold to investors. The Company recorded a liability at December 31, 2006 for a reserve for the estimated losses of $444,000. At December 31, 2007, the Company was not subject to any claims by any purchasers of loans sold.
Up until December 28, 2007, interest rates on our borrowings were indexed to the monthly Federal Home Loan Bank of Cincinnati 30-day LIBOR advance rate or Prime rate, as more fully described above. Effective December 28, 2007, principally all of our floating-rate borrowings are indexed to the one-month LIBOR rate, and accordingly will increase or decrease over time. Minimum contractual obligations are based on minimum required principal payments, including balloon maturities of loans under the Forbearance Agreements or the master credit facilities. Actual payments will vary depending on actual cash collections and loan sales.
Historically, our lender has extended the maturities and balloon payments, although there is no assurance that it will continue to do so.
Safe Harbor Statement
Statements contained herein that are not historical fact may be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are subject to a variety of risks and uncertainties. There are a number of important factors that could cause actual results to differ materially from those projected or suggested in forward-looking statements made by the Company. These factors include, but are not limited to: (i) unanticipated changes in the U.S. economy, including changes in business conditions such as interest rates, changes in the level of growth in the finance and housing markets, such as slower or negative home price appreciation; (ii) the Company’s relations with the Company’s lenders and such lenders’ willingness to waive any defaults under the Company’s agreements with such lenders; (iii) increases in the delinquency rates of borrowers, (iv) the availability of clients holding sub-prime borrowers for servicing by the Company on a fee paying basis; (vi) changes in the statutes or regulations applicable to the Company’s business or in the interpretation and enforcement thereof by the relevant authorities; (vii) the status of the Company’s regulatory compliance; (viii) the Company’s success in entering new business activities of providing mortgage-related services for other entities, particularly servicing loans for others, in which the Company has no prior experience with servicing loans for others; and (ix) other risks detailed from time to time in the Company’s SEC reports and filings. Additional factors that would cause actual results to differ materially from those projected or suggested in any forward-looking statements are contained in the Company’s filings with the Securities and Exchange Commission, including, but not limited to, those factors discussed under the captions “Risk Factors,” “Interest Rate Risk” and “Real Estate Risk” in the Company’s Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, which the Company urges investors to consider. The Company undertakes no obligation to publicly release the revisions to such forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrences of unanticipated events, except as otherwise required by securities, and other applicable laws. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to release publicly the results on any events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various types of market risk in the normal course of business, including the impact of interest rate changes, real estate, delinquency and default risks of the loans in our portfolio, and changes in corporate tax rates. A material change in these rates or risks could adversely affect our operating results and cash flows.
Impact of Inflation
The Company measures its financial condition and operating results in historical dollars without considering changes in the purchasing power of money over time due to inflation, although the impact of inflation is reflected in increases in the costs of our operations. Substantially all of the Company’s assets and liabilities are monetary in nature, and therefore, interest rates have a greater impact on our performance than the general effects of inflation. Because the Company’s borrowings are highly sensitive to changes in short-term interest rates, any increase in inflation, which often gives rise to increases in interest rates, could materially impact the Company’s financial performance.
Interest Rate Risk
Interest rate fluctuations can adversely affect our operating results and present a variety of risks, including the risk of a mismatch between the repricing of interest-earning assets and borrowings, variances in the yield curve and changing prepayment rates on notes receivable, loans held for investment and loans held for sale.
Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Conditions such as inflation, recession, unemployment, money supply and other factors beyond our control may also affect interest rates. Fluctuations in market interest rates are neither predictable nor controllable and may have a material adverse effect on our business, financial condition and results of operations.
The Company’s operating results will depend in large part on differences between the interest earned on its assets and the interest paid on its borrowings. Most of the Company’s assets, consisting primarily of mortgage notes receivable, generate fixed returns and have remaining contractual maturities in excess of five years, while the majority of originated loans held for investment generate fixed returns for the first two years and six-month adjustable returns thereafter. We funded the origination and acquisition of these assets with highly interest rate-sensitive borrowings. In most cases, the interest income from our assets will respond more slowly to interest rate fluctuations than the cost of our borrowings, creating a mismatch between interest earned on our interest-yielding assets and the interest paid on our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, will significantly impact our net interest income and, therefore, net income. Our borrowings, until December 28, 2007, bore interest at rates that fluctuated with the FHLB Bank of Cincinnati 30-day advance rate or, to a lesser extent, the prime rate. As of December 28, 2007, the effective date of the Forbearance Agreements, with the exception of the Unrestructured Debt and $125 million of fixed-rate debt, our borrowings bear interest at rates that fluctuate with one-month LIBOR. Based on approximately $1.63 billion of borrowings under our credit facilities outstanding at December 31, 2007, a 1% instantaneous and sustained increase in both LIBOR and prime rates could increase quarterly interest expense by as much as approximately $4.1 million, pre-tax, which would negatively impact our quarterly after-tax net income. Due to our liability-sensitive balance sheet, increases in these rates will decrease both net income and the market value of our net assets. During the term of the existing interest rate caps, the offsetting benefit of the interest rate caps could reduce the quarterly negative impact of a 1% instantaneous and sustained increase in the one-month LIBOR rate by approximately $1.3 million, pre-tax. In addition, subsequent to December 31, 2007, the Company entered into interest rate swaps as of February 27, 2008, which will further reduce the Company’s exposure to future increases in interest costs on $725 million of its borrowings due to increases in one-month LIBOR during the next twelve months; on $505 million for the next two years; on $115 million for the next three years; and, on $45 million for the next four years. See “Management’s Discussion and Analysis - Borrowings.”
The value of our assets may be affected by prepayment rates on investments. Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic and other factors beyond our control. Consequently, such prepayment rates cannot be predicted with certainty. When we originated and purchased mortgage loans, we expected that such mortgage loans would have a measure of protection from prepayment in the form of prepayment lockout periods or prepayment penalties. In periods of declining mortgage interest rates, prepayments on mortgages generally increase. In addition, the market value of mortgage investments may, because of the risk of prepayment, benefit less from declining interest rates than other fixed-income securities. Conversely, in periods of rising interest rates, prepayments on mortgages generally decrease, in which case we would not have the prepayment proceeds available to accelerate the paydown of our borrowings. Under certain interest rate and prepayment scenarios we may fail to recoup fully our cost of acquisition of certain investments. During most of 2007, due to declining U.S. housing prices in general and a rapid and severe credit tightening throughout the industry, portfolio payoffs through borrower refinancing have been declining as it has become more difficult for borrowers, particularly borrowers with any type of credit deficiency, to refinance their loans.
Real Estate Risk
Residential property values are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions, which may be adversely affected by industry slowdowns and other factors; local real estate conditions (such as the supply of housing or the rapid increase in home values). Decreases in property values reduce the value of the collateral and the
potential proceeds available to a borrower to repay our mortgage loans, which could cause us to suffer losses on the ultimate disposition of foreclosed properties.
We purchased and originated principally fixed and adjustable rate residential mortgage loans, both first and second liens, which are secured primarily by the underlying single-family properties. Because the vast majority of our loans are to non-prime borrowers, delinquencies and foreclosures are substantially higher than those of prime mortgage loans, and if not serviced actively and effectively could result in an increase in losses on dispositions of properties acquired through foreclosure, or in the case of second lien loans, through writeoff of defaulted loans. In addition, a decline in real estate values would reduce the value of the residential properties securing our loans, which could lead to an increase in borrower defaults, reductions in interest income and increased losses on the disposition of foreclosed properties.
During 2007, and particularly during the third quarter of 2007, the deterioration in the housing and subprime mortgage markets, particularly declining home values, continued and accelerated. Additionally, during the third quarter of 2007, there was a significant tightening of credit availability throughout the mortgage lending industry, and particularly in the subprime segment of the industry. These market events increased and are expected to continue to result in increased delinquencies, defaults and losses on residential 1-4 family loans.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements required by this Item are included herein, beginning on page of this report.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Management’s Annual Report on Internal Control Over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, and Controller and affected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with policies and procedures may deteriorate.
With the participation of the Chief Executive Officer, the Chief Financial Officer, the Chief Operating Officer and the Controller, our management conducted an evaluation of the effectiveness of our system of internal control over financial reporting as of December 31, 2007 based on the framework set forth in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management has concluded that our internal control over financial reporting was effective as of December 31, 2007.
This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to the attestation by our registered public accounting firm pursuant to the rules of the Securities and Exchange Commission that permit us to provide only management’s report in this Annual Report on Form 10-K.
Disclosure Controls and Procedures
As of December 31, 2007, the end of the period covered by this Annual Report on Form 10-K, the Company’s management, including the Company’s Chief Executive Officer, Chief Financial Officer and Controller, evaluated the effectiveness of the Company’s disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2007, the Company’s disclosure controls and procedures over financial reporting were effective.
Changes in Internal Controls over Financial Reporting
As previously disclosed in Note 2 of the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005 and further described in Item 9A. of such Annual Report, the Company had identified material weaknesses as defined by the Public Company Accounting Oversight Board (United States) with respect to certain accounting and reporting matters. In connection with the Company’s 2005 Annual Report on Form 10-K, the Company restated its previously issued financial statements for the years 2004 and 2003, for the first three quarters in 2005 and the quarterly periods in 2004. The Company has strengthened its accounting department in order to remedy the identified material weaknesses. During the fourth fiscal quarter of 2006, the Company’s management determined that such material weaknesses had been remediated. There were no other changes in the Company’s internal control over financial reporting during the Company’s fourth fiscal quarter ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2007, the registrant’s most recent fiscal year, and is incorporated herein by reference.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2007, the registrant’s most recent fiscal year, and is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2007, the registrant’s most recent fiscal year, and is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2007, the registrant’s most recent fiscal year, and is incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2007, the registrant’s most recent fiscal year, and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The following documents are filed as part of Form 10-K:
(1) Financial Statements.
The financial statements required by Item 8 are included herein, beginning on page of this report.
(2) Financial Statement Schedules.
The financial statement schedules required by Item 8 are included in the financial statements (or are either not applicable or not significant).
(3) Exhibits.
*
Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FRANKLIN CREDIT MANAGEMENT CORPORATION
By:
/s/ ALEXANDER GORDON JARDIN
Chief Executive Officer
April 2, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Franklin Credit Management Corporation
Jersey City, New Jersey
We have audited the accompanying consolidated balance sheets of Franklin Credit Management Corporation and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Franklin Credit Management Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2, the Company changed its method of accounting for certain purchased notes receivable as of January 1, 2005.
/s/ Deloitte & Touche LLP
New York, New York
April 2, 2008
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2007 AND 2006
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2007, 2006 and 2005
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
YEARS ENDED DECEMBER 31, 2007, 2006 and 2005
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2007, 2006 and 2005
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2007, 2006 and 2005
1.
ORGANIZATION AND BUSINESS
As used herein references to the “Company,” “FCMC,” “we,” “our” and “us” refer to Franklin Credit Management Corporation, collectively with its subsidiaries.
We are a specialty consumer finance company that was, until December 28, 2007, primarily engaged in two related lines of business: (1) the acquisition, servicing and resolution of performing, reperforming and nonperforming residential mortgage loans and real estate assets; and (2) the origination of subprime mortgage loans, both for our portfolio and for sale into the secondary market. We specialized in acquiring and originating loans secured by 1-4 family residential real estate that generally fell outside the underwriting standards of Fannie Mae and Freddie Mac and involved elevated credit risk as a result of the nature or absence of income documentation, limited credit histories, higher levels of consumer debt or past credit difficulties. We typically purchased loan portfolios at a discount, and originated subprime loans with interest rates and fees, calculated to provide us with a rate of return adjusted to reflect the elevated credit risk inherent in the types of loans we acquired and originated. Unlike many of our competitors, we generally held for investment the loans we acquired and a significant portion of the loans we originated.
On December 28, 2007, Franklin entered into a series of agreements (the “Forbearance Agreements”) with The Huntington National Bank, successor by merger in July 2007 to Sky Bank (Sky Bank, prior to the merger, and Huntington, thereafter, are referred to as the “bank”), whereby the bank agreed to restructure approximately $1.93 billion of the Company’s indebtedness to it and its participant banks, forgave $300 million of such indebtedness for a restructuring fee of $12 million paid to the bank, and waived certain existing defaults (the “Restructuring”). See Note 5. In November 2007, Franklin ceased to acquire or originate loans and, under the terms of the Forbearance Agreements, the Company is expressly prohibited from acquiring or originating loans.
From inception through December 31, 2007, we had purchased and originated in excess of $4.73 billion in mortgage loans. As of December 31, 2007, we had total assets of $1.69 billion and our portfolios of notes receivable and loans held for investment, net, totaled $1.53 billion.
In August 2005, we completed a public offering of 1,265,000 of shares of our common stock at a public offering price of $11.50 per share (including an exercise in full of the underwriter’s over allotment option to purchase 165,000 shares). This follow-on public offering resulted in net proceeds to us and the addition to equity of approximately $12.6 million. In conjunction with the public offering, the Company’s common stock ceased to be quoted on the Over-the-Counter Bulletin Board under the symbol “FCSC” and commenced trading on The Nasdaq Global Market, formerly The Nasdaq National Market, under the symbol “FCMC.”
2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Certain amounts in prior years have been reclassified to conform to the current year’s presentation.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates of the Company are the allowance for loan losses, the allocation of discount between accretable and nonaccretable, income taxes, and the continuing assessment of the fair value of the underlying collateral of other real estate owned. The Company’s estimates
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and assumptions primarily arise from risks and uncertainties associated with interest rate volatility and credit exposure. Although management is not currently aware of any factors that would significantly change its estimates and assumptions in the near term, future changes in market trends and conditions may occur which could cause actual results to differ materially.
Operating Segments - SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, requires companies to report financial and descriptive information about their reportable operating segments, including segment profit or loss, certain specific revenue and expense items, and segment assets. The Company has two reportable operating segments: (i) portfolio asset acquisition and resolution; and (ii) mortgage banking. The portfolio asset acquisition and resolution segment acquires performing, reperforming or nonperforming notes receivable and promissory notes from financial institutions and mortgage and finance companies, and services and collects such notes receivable through enforcement of terms of the original note, modification of original note terms and, if necessary, liquidation of the underlying collateral. The mortgage-banking segment originates or purchases, subprime residential mortgage loans from individuals whose credit histories, income and other factors cause them to be classified as subprime borrowers. (See Note 9).
Earnings Per Share - Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the year. Diluted earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding, including the dilutive effect, if any, of stock options outstanding, warrants and restricted stock calculated under the treasury stock method. The effects of warrants, restricted stock units and stock options are excluded from the computation of diluted earnings per common share in periods in which the effect would be antidilutive. Dilutive potential common shares are calculated using the treasury stock method. For the year ended December 31, 2007, 370,000 options were not included in the computation of earnings per share because they were antidilutive.
Cash and Cash Equivalents - Cash and cash equivalents includes cash certificates of deposit with original maturities of three months or less, with the exception of restricted cash, which is reported separately on the Company’s balance sheets. The Company maintains accounts at banks, which at times may exceed federally insured limits. The Company has not experienced any losses from such concentrations.
Restricted Cash - Restricted cash includes interest and principal collections received on the Company’s portfolio of notes receivable and loans held for investment, substantially all of which is required to pay down current debt obligations with its lending banks.
Short-term Investments - The Company’s short-term investments include U.S. treasury bills, investment-grade commercial paper and money market accounts. The Company’s short-term investment policy is structured to provide an adequate level of liquidity with minimal credit risk in order to meet normal working capital needs and expansion of the loan portfolio. All short-term investments are classified as available for sale securities and recorded at fair value.
Notes Receivable and Income Recognition - The notes receivable portfolio consists primarily of secured real estate mortgage loans purchased from financial institutions and mortgage and finance companies. Such notes receivable were performing, non-performing or sub-performing at the time of purchase and were generally purchased at a discount from the principal balance remaining. Notes receivable are stated at the amount of unpaid principal, reduced by purchase discount and allowance for loan losses. Notes purchased are stated net of purchase discount. The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past loan loss experience and other relevant factors. In
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
connection with the determination of the allowance for loan losses, management obtains independent appraisals for the underlying collateral when considered necessary.
In general, interest on the notes receivable is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. Accrual of interest on notes receivable, including impaired notes receivable, is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Subsequent recognition of income occurs only to the extent payment is received, subject to management’s assessment of the collectibility of the remaining interest and principal. A non-accrual note is restored to an accrual status when collectibility of interest and principal is no longer in doubt and past due interest is recognized at that time.
Discounts on Acquired Loans - Effective January 1, 2005, as a result of the required adoption of SOP 03-3, the Company was required to change its accounting for loans acquired subsequent to December 31, 2004, which have evidence of deterioration of credit quality since origination and for which it is probable, at the time of our acquisition, that the Company will be unable to collect all contractually required payments. For these loans, the excess of the undiscounted contractual cash flows over the undiscounted cash flows estimated by us at the time of acquisition is not accreted into income (nonaccretable discount). The amount representing the excess of cash flows estimated by us at acquisition over the purchase price is accreted into purchase discount earned over the life of the loan (accretable discount). The nonaccretable discount is not accreted into income. If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting may be used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan.
Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable discount are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable discount is transferred to the accretable discount and is accreted into interest income over the remaining life of the loan on the interest method. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through the allowance for loan losses.
There is judgment involved in estimating the amount of the loan’s future cash flows. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect our financial condition and results of operations. Depending on the timing of an acquisition, the initial allocation of discount generally will be made primarily to nonaccretable discount until the Company has boarded all loans onto its servicing system; at that time, any cash flows expected to be collected over the purchase price will be transferred to accretable discount. Generally, the allocation will be finalized no later than ninety days from the date of purchase.
For loans not addressed by SOP 03-3 that are acquired subsequent to December 31, 2004, the discount, which represents the excess of the amount of reasonably estimable and probable discounted future cash collections over the purchase price, is accreted into purchase discount earned using the interest method over the term of the loans. This is consistent with the method the Company utilizes for its accounting for loans purchased prior to January 1, 2005, except that for these loans an allowance allocation was also made at the time of acquisition.
Allowance for Loan Losses - The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
estimates of the current value of underlying collateral, past loan loss experience and other relevant factors. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for the underlying collateral when considered necessary. Management believes that the allowance for loan losses is adequate. The allowance for loan losses is a material estimate, which could change significantly in the near term. See Note 3 for accretable and nonaccretable discounts.
During the twelve months ended December 31, 2007, the U.S. housing and subprime mortgage markets experienced rapid and substantial deterioration. This deterioration gave rise to industry-wide increases in mortgage delinquencies reflecting the decline in collateral values and related declines in borrowers’ equity in their homes, particularly with respect to subprime loans originated throughout the mortgage industry during 2005, 2006 and the early months of 2007, which were characterized by collateral values established at the height of the U.S. real estate market and also, often, by lax underwriting standards. Additionally, during the quarter ended September 30, 2007, there was a significant tightening of new credit throughout the mortgage lending industry, particularly in the subprime segment of the industry, which increased the difficulty for borrowers with imperfect credit histories to refinance their mortgages. In light of these factors, and their impact on the Company’s portfolio, a substantial portion of which is comprised of second mortgages purchased from others during the past several years, the Company reassessed its allowance for loan losses as of September 30, 2007. This reassessment resulted in significantly increased estimates of inherent losses in the portfolios of purchased loans, particularly the purchased second-lien loans, and originated subprime loans, which resulted in an increase in the provision for loan losses of $264,882,469 during the year ended December 31, 2007, compared with a provision of $9,750,393 the year ended December 31, 2006. The allowance for loan losses at December 31, 2007 was $254,661,653, compared with $53,290,841 at December 31, 2006.
Effective January 1, 2005, and as a result of the adoption of SOP 03-3, additions to the allowance for loan losses relating to newly acquired loans reflect only those losses incurred by us subsequent to acquisition. The Company no longer increases the allowances through allocations from purchase discount for loans that meet the requirements of SOP 03-3.
Gain on Debt Forgiveness - During the year ended December 31, 2007, in connection with the settlement of obligations involving Huntington, the Company recognized a gain of $284.2 million under SFAS No. 15. SFAS No. 15. Paragraph 13 states: “A debtor that transfers its receivables from third parties, real estate, or other assets to a creditor to settle fully a payable shall recognize a gain on restructuring of payables. The gain shall be measured by the excess of (i) the carrying amount of the payable settled (the face amount increased or decreased by applicable accrued interest and applicable unamortized premium, discount, finance charges, or issue costs) over (ii) the fair value of the assets transferred to the creditor.”
The Company believes that the $300 million that the creditor forgave with no recourse, should be accounted for based on the above guidance and the gain of approximately $284.2 million recognized in the December 31, 2007 consolidated financial statements. Under SFAS No. 15 “Accounting by Debtors and Creditors for Troubled Debt Restructurings,” a troubled debt restructuring typically occurs when a debtor is experiencing financial difficulties, and as a result, a concession is granted by the creditor to the debtor. EITF 02-4 “Determining Whether a Debtor’s Modification or Exchange of Debt Instruments in within the Scope of FASB Statement No. 15” provides additional guidance on whether the debtor is experiencing financial difficulties and whether or not a concession has been granted.
Paragraph 6 of EITF 02-4 provides a model to be applied by a debtor when determining whether a modification of debt is within the scope of SFAS 15. In part, it states that if: (a) the debtor is experiencing financial difficulties and (b) that the creditor granted a concession then the modification is within the scope of SFAS 15. The Company has determined that it has met the requirements SFAS 15 for this transaction.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Based on this guidance the carrying amount of the payables was determined by taking the face amount of the debt adjusted for the items noted above. All accrued interest on the term loans was paid through the date of the restructuring and the face amount of the loans was adjusted for the small debt discount and the deferred financing fees to determine the carrying amount for purposes of applying FAS 15 and EITF 96-19.
Originated Loans Held for Sale - The loans held for sale consist primarily of secured real estate first and second mortgages originated by the Company. Such loans held for sale are performing and are carried at lower of cost or market. The gain/loss on sale is recorded as the difference between the carrying amount of the loan and the proceeds from sale on a loan-by-loan basis. The Company records a sale upon settlement and when the title transfers to the seller.
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee has the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through either (a) an agreement that entitles and obligates the Company to repurchase or redeem them before their maturity or (b) the ability to unilaterally cause the holder to return specific assets.
Gains or losses resulting from loan sales are recognized at the time of sale, based on the difference between the net sales proceeds and the carrying value of the loans sold.
Certain whole-loan sale contracts include provisions requiring the Company to repurchase a loan if a borrower fails to make one or more of the first loan payments due on the loan. In addition, an investor may request that the Company refund a portion of the premium paid on the sale of mortgage loans if a loan is prepaid in full within a certain amount of time from the date of sale. The Company records a provision for estimated repurchases and premium recapture on loans sold, which is charged to gain on sale of loans.
Originated Loans Held for Investment - During the third quarter of 2006, the Company modified its estimate of the collectibility of accrued interest on certain fully secured loans that are in the foreclosure process. As a result, the Company continues to accrue interest on secured real estate first mortgage loans originated by the Company up to a maximum of 209 days contractually delinquent with a recency payment in the last 179 days, and that are judged to be fully recoverable for both principal and accrued interest based on a foreclosure analysis, which includes an updated estimate of the realizable value of the property securing the loan.
In general, interest on originated loans held for investment is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. The Company’s decision to revise its estimate of collectibility was based on recent collection information, which shows that the Company is collecting 100% of principal and between 90% to 100% of delinquent interest when these loans in the foreclosure process are paid off or settled.
The accrual of interest is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful, which can be less than 209 days contractually delinquent with a recency payment in the last 179 days. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Subsequent recognition of income occurs only to the extent payment is received, subject to management’s assessment of the collectibility of the remaining interest and principal. A non-accrual loan is restored to an accrual status when the collectibility of interest and principal is no longer in doubt and past due interest is recognized at that time.
Other Real Estate Owned - Other real estate owned (“OREO”) consists of properties acquired through, or in lieu of, foreclosure or other proceedings and are held for sale and carried at the lower of cost or fair
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
value less estimated costs to sell. Any write-down to fair value, less cost to sell, is charged to earnings based upon management’s continuing assessment of the fair value of the underlying collateral. OREO is evaluated periodically to ensure that the recorded amount is supported by current fair values and valuation allowances are recorded as necessary to reduce the carrying amount to fair value less estimated cost to sell. Revenue and expenses from the operation of OREO and changes in the valuation allowance are included in operations. Direct costs relating to the development and improvement of the property are capitalized, subject to the limit of fair value of the property, while costs related to holding the property are expensed. Gains or losses are included in operations upon disposal of the property.
Derivatives - As part of our interest rate management process, we entered into interest rate cap agreements in 2006 and 2007. It is not our policy to use derivatives to speculate on interest rates. In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, derivative financial instruments are reported on the consolidated balance sheets at their fair value.
Interest rate caps are recorded at fair value. The interest rate caps are not designated as hedging instruments for accounting purpose, unrealized changes in fair value are recognized in the period in which the changes occur and realized gains and losses are recognized in the period when such instruments are settled.
The Company follows the accounting required by Statement 133 Implementation Issue No. B36 (“B36”) for the bifurcation of an embedded derivative related to success fees currently and potentially payable to our principal lender following the repayment of notes payable. B36 requires the success fee to be bifurcated from the notes payable and recorded as an embedded derivative at fair value each reporting period. Fair value has been determined by discounting the estimated future success fee payments at an appropriate discount rate. See Note 5 for a description of success fees. The Company did not hold any other derivative financial instruments at December 31, 2007.
As notes payable are issued, the fair value of the embedded derivative related to success fees is recorded as a liability with an offset to debt discount. The debt discount is amortized to interest expense over the estimated repayment of the related notes payable. As discussed in Note 5, on December 1, 2006, the Company and its lender reached an agreement to eliminate the success fee.
Building, Furniture and Equipment - Building, furniture and equipment, including leasehold improvements, is recorded at cost net of accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from 3 to 40 years. Amortization of leasehold improvements is computed using the straight-line method over the lives of the related leases or useful lives of the related assets, whichever is shorter. Maintenance and repairs are expensed as incurred.
Deferred Financing Costs - Deferred financing costs, which include origination fees incurred in connection with obtaining term loan financing from our banks, are deferred and are amortized over the term of the related loan. See Note 5 for a description of origination fees.
Retirement Plan - The Company maintains a savings plan, which is intended to qualify under Section 401(k) of the Internal Revenue Code. All employees are eligible to be a participant in the plan. The plan provides for voluntary contributions by participating employees in amounts up to 20% of their annual compensation, subject to certain limitations. Currently, the Company matches 50% up to a maximum of 3% of salary. The Company contributed $101,833, $111,192 and $109,882 in 2007, 2006 and 2005, respectively.
Income Taxes - Income taxes are accounted for under SFAS No. 109, Accounting for Income Taxes, which requires an asset and liability approach in accounting for income taxes. This method provides for deferred income tax assets or liabilities based on the temporary difference between the income tax basis of assets and liabilities and their carrying amount in the consolidated financial statements. Deferred tax assets
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of the enactment of the changes.
Prepayment Penalties and Other Income - Prepayment penalties and other income consists of prepayment penalties, late charges, and other miscellaneous income. Such income is recognized on a cash basis.
Fair Value of Financial Instruments - SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information of financial instruments, whether or not recognized in the balance sheets, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. SFAS No. 107 excludes certain financial instruments and all non-financial assets and liabilities from its disclosure requirements. Accordingly, the aggregate fair value amounts do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:
a.
Cash, Restricted Cash, Accrued Interest Receivables, Other Receivable and Accrued Interest Payable - The carrying values reported in the consolidated balance sheets are a reasonable estimate of fair value.
b.
Short-term Investments - These investments mature monthly; therefore, the carrying values reported in the consolidated balance sheets are a reasonable estimate of fair value.
c.
Notes Receivable - Fair value of the net note receivable portfolio is estimated by discounting the estimated future cash flows using the interest method. The fair value of notes receivable at December 31, 2007 and 2006 was equivalent to their carrying value of $1,048,072,698 and $1,109,191,446, respectively.
d.
Loans Held for Investment, Loans Held for Sale - The carrying values reported in the consolidated balance sheets are a reasonable estimate of fair value. The fair value of loans held for investment at December 31, 2007 and 2006 was equivalent to their carrying value of $477,704,144 and $422,682,795, respectively. The fair value of loans held for sale at December 31, 2006 was equivalent to their carrying value of $4,114,284. There were no loans held for sale at December 31, 2007.
e.
Short-term Borrowings - The interest rates on financing agreements and other short-term borrowings reset on a monthly basis; therefore, the carrying amounts of these liabilities approximate their fair value. The fair value at December 31, 2007 and 2006 was $1,033,073 and $55,962,315, respectively.
f.
Long-term Debt - The interest rate on the Company’s long-term debt (notes payable) is a variable rate that resets monthly; therefore, the carrying value reported in the balance sheet approximates fair value at $1,628,537,798 and $1,520,217,264 at December 31, 2007 and 2006, respectively.
Comprehensive Income - SFAS No. 130, Reporting Comprehensive Income, defines comprehensive income as the change in equity of a business enterprise during a period from transactions and other events and
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
circumstances, excluding those resulting from investments by and distributions to stockholders. The Company had no items of other comprehensive income; therefore, net income was the same as its comprehensive income for all periods presented.
Stock-Based Compensation Plans - The Company maintains share-based payment arrangements under which employees are awarded grants of restricted stock, non-qualified stock options, incentive stock options and other forms of stock-based payment arrangements. Prior to January 1, 2006, the Company accounted for these awards under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) as permitted under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Accordingly, compensation cost for stock options was not recognized as long as the stock options granted had an exercise price equal to the market price of the Company’s common stock on the date of grant. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) using the modified-prospective transition method. Under this transition method, compensation cost recognized beginning January 1, 2006 includes compensation cost for all share-based payment arrangements issued, but not yet vested as of December 31, 2005, based on the grant date fair value and expense attribution methodology determined in accordance with the original provisions of SFAS 123. Compensation cost for all share-based payment arrangements granted subsequent to December 31, 2005, is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). In addition, the effect of forfeitures on restricted stock (if any), is estimated when recognizing compensation cost. Results for prior periods have not been recast for the adoption of SFAS No. 123(R).
Prior to adoption of SFAS 123(R), the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS 123(R) requires the cash flows resulting from the tax benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows.
The compensation cost recognized in income was $376,330 and $689,753 for the years ended December 31, 2007 and 2006, respectively.
Prior to January 1, 2006, our Stock Incentive Plan was accounted for under the recognition and measurement principles of APB Opinion 25 and related interpretations. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all awards:
(1)
The stock-based compensation cost, net of related tax effects, included in the determination of net income - as reported.
(2)
The stock-based compensation cost, net of related tax effects, that would have been included in the determination of net income if the fair value based method had been applied to all awards.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company did not elect the fair value option for any of its existing financial instruments on the effective date and has not determined whether or not we will elect this option for any eligible financial instruments that we acquire in the future.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 enhances existing guidance for measuring assets and liabilities using fair value. Prior to the issuance of SFAS 157, guidance for applying fair value was incorporated in several accounting pronouncements. SFAS 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. Under SFAS 157, fair value measurements are disclosed by level within that hierarchy. While SFAS 157 does not add any new fair value measurements, it does change current practice. Changes to practice include: (1) a requirement for an entity to include its own credit standing in the measurement of its liabilities; (2) a modification of the transaction price presumption; (3) a prohibition on the use of block discounts when valuing large blocks of securities for broker-dealers and investment companies; and (4) a requirement to adjust the value of restricted stock for the effect of the restriction even if the restriction lapses within one year. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Management is currently evaluating the effect of the statement, if any, on the Company’s results of operations and financial condition.
On July 13, 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting and reporting for income taxes where interpretation of the tax law may be uncertain. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax uncertainties with respect to positions taken or expected to be taken in income tax returns. We adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” an interpretation of FASB Statement No. 109 (FIN 48), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with FASB Statement 109, “Accounting for Income Taxes,” and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.
Based on our evaluation, we have concluded that there are no significant uncertain tax positions, requiring recognition in our financial statements. Our evaluation was performed for the tax years ended 2003 through 2006, which remain open to examination by major tax jurisdictions to which we are subject as of December 31, 2007.
We may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to our financial results. Should we receive an assessment for interest and/or penalties, it would be classified in the financial statements as collection, general and administrative expenses.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3.
NOTES RECEIVABLE, LOANS HELD FOR INVESTMENT AND LOANS HELD FOR SALE, PURCHASE DISCOUNT AND ALLOWANCE FOR LOAN LOSSES
Notes receivable consist principally of residential one-to-four family mortgage loans as of December 31, 2007 and 2006 secured as follows:
Originated loans held for sale of $0 and $4,114,284 as of December 31, 2007 and 2006, respectively, represent residential one-to-four family (real estate secured) mortgage loans originated by the Company.
Originated loans held for investment represent residential one-to-four family real estate mortgage loans as of December 31, 2007 and 2006 secured as follows:
*
Excludes $17.0 million of loans, net of fees, sold to investors, which the Company committed to repurchase, that are included on the face of the balance sheet at December 31, 2006.
The Company originated $291.6 million and $355 million in loans held for investment during the years ended December 31, 2007 and 2006, respectively. During 2007, due to significant capital market disruptions that took place during the latter part of 2007, $4,409,835 of “Alt-A” loans originated for sale were transferred to loans held for investment, net of a lower of cost or market adjustment.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of December 31, 2007, contractual maturities of notes receivable and originated loans held for investment, net of the allowance for loan losses and nonaccretable discount, were as follows:
It is the Company’s experience that a portion of the notes receivable and loans held for investment portfolio may be refinanced or repaid before contractual maturity dates. The above tabulation, therefore, is not to be regarded as a forecast of future cash collections. During the years ended December 31, 2007, 2006 and 2005, cash collections of principal amounts totaled approximately $334 million, $515 million and $375 million, respectively, and the ratios of these cash collections to average principal balances were approximately 19%, 34% and 30%, respectively.
Changes in the allowance for loan losses on notes receivable for the years ended December 31, 2007, 2006 and 2005 are as follows:
Changes in the allowance for loan losses on loans held for sale and loans held for investment for the years ended December 31, 2007, 2006 and 2005 are as follows:
Write-downs for declines in the estimated net realizable value of OREO resulted in a provision for loan losses in the amount of $10,509,590, $4,751,175 and $166,638 during 2007, 2006 and 2005, respectively.
At December 31, 2007, 2006 and 2005, principal amounts of notes receivable included approximately $330 million, $251 million and $245 million, respectively, of notes for which there was no accrual of interest
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
income. The following information relates to impaired notes receivable, which include all such notes receivable as of and for the years ended December 31, 2007, 2006 and 2005:
At December 31, 2007, 2006 and 2005, the principal amount of loans held for investment included loans on non-accrual status of approximately $182 million, $110 million and $56 million, respectively.
In the normal course of business, the Company restructures or modifies terms of certain loans to enhance the collectibility of such loans.
As of December 31, 2007 and December 31, 2006, the unpaid principal balance of mortgage loans being serviced by the Company for others was $420,152 and $457,944, respectively. Mortgage loans serviced for others are not included on the Company’s consolidated balance sheets.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table sets forth certain information relating to the activity in the accretable and nonaccretable discounts for principal, which are shown as a component of notes receivable principal on the balance sheet, in accordance with SOP 03-3 for the period indicated:
The Company purchased $528.7 million of loans subject to SOP 03-3 during 2007. The outstanding balance of notes receivable subject to SOP 03-3 at December 31, 2007 was $1.14 billion. The allowance for loan losses related to loans subject to SOP 03-3 was $167.5 million at December 31, 2007 and $1.2 million at December 31, 2006. The allowance was increased during 2007 by a charge to provision for loan losses in the amount of $169.2 million.
During 2007, the U.S. housing and subprime mortgage markets experienced rapid and substantial deterioration. This deterioration gave rise to industry-wide increases in mortgage delinquencies reflecting the decline in collateral values and related declines in borrowers’ equity in their homes, particularly with respect to subprime loans originated throughout the mortgage industry during 2005, 2006 and the early months of 2007, which were characterized by collateral values established at the height of the U.S. real estate market and also, often, by lax underwriting standards. Additionally, during the summer of 2007, there was a significant tightening of new credit throughout the mortgage lending industry, particularly in the subprime segment of the industry, which increased the difficulty for borrowers with imperfect credit histories to refinance their mortgages. In light of these factors, and their impact on the Company’s loan portfolios, a substantial portion of which is comprised of second mortgages purchased from others during the past several years, the Company reassessed its allowance for loan losses as of September 30, 2007. This reassessment resulted in significantly increased estimates of inherent losses in the portfolios of purchased loans, particularly the purchased second-lien loans, and originated subprime loans, which resulted in a provision of $262.7 million in the quarter ended September 30, 2007. The provision for 2007 was $274.6 million.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
4.
BUILDING, FURNITURE AND EQUIPMENT
At December 31, 2007 and 2006, building, furniture and equipment consisted of the following:
5.
NOTES PAYABLE
On December 28, 2007, Franklin entered into a series of agreements (the “Forbearance Agreements”) with The Huntington National Bank, successor by merger in July 2007 to Sky Bank (Sky Bank, prior to the merger, and Huntington, thereafter, are referred to as the “bank”), whereby the bank agreed to restructure approximately $1.93 billion of the Company’s indebtedness to it and its participant banks, forgave $300 million of such indebtedness for a restructuring fee of $12 million paid to the bank, and waived certain existing defaults (the “Restructuring”). In November 2007, Franklin ceased to acquire or originate loans and, under the terms of the Forbearance Agreements, the Company is expressly prohibited from acquiring or originating loans.
As of December 31, 2007, we had total borrowings of $1.63 billion, of which $1.54 billion was subject to the Forbearance Agreements and $89.4 million remained under our credit facilities. Substantially all of the debt under these facilities was incurred in connection with the purchase and origination of, and is secured by, our acquired notes, originated loans held for investment and OREO portfolios. At December 31, 2007, the interest rates on our notes payable (term debt) were as follows:
At December 31, 2007 and 2006, the weighted average interest rate on our term debt was 7.46% and 7.99%, respectively.
Aggregate contractual maturities of all notes payable at December 31, 2007 are as follows:
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Forbearance Agreements with Lead Lending Bank
On December 28, 2007, the Company entered into a series of agreements with the bank, pursuant to which the bank agreed to forbear with respect to certain defaults of the Company relating to the Company’s indebtedness to the bank and restructure approximately $1.93 billion of such indebtedness to the bank and its participant banks. The Forbearance Agreements mature on May 15, 2009.
The Restructuring did not relate to:
•
$44.5 million of the Company’s indebtedness under the Master Credit and Security Agreement, dated as of October 13, 2004, as amended, by and among Franklin Credit, certain subsidiaries of Franklin Credit and the bank; and,
•
$44.8 million of Tribeca’s indebtedness to BOS (USA) Inc., an affiliate of Bank of Scotland, under the Master Credit and Security Agreement, dated March 24, 2006, by and among Tribeca, certain subsidiaries and BOS.
These amounts remain subject to the original terms specified in the applicable agreements (the “Unrestructured Debt”).
At December 31, 2007, the BOS Loan was not included in the Forbearance Agreements between the Company and the bank. The existing BOS facility contains affirmative, negative and financial covenants customary for financings of this type, including, among other things, covenants that require Tribeca and its subsidiaries, together, to maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of $750,000. The facility contains events of default customary for facilities of this type. At December 31, 2007, Tribeca was not in compliance with these and other covenants and has not received a waiver of noncompliance. Any unwaived or uncured breach of these covenants could, subject to notice and opportunity to cure where provided for in the applicable credit agreements, cause an acceleration of the outstanding BOS Loan and result in cross-default and possible acceleration of the indebtedness owed to the bank under the Forbearance Agreements. See Note 14 for a description of the amendment to the Forbearance Agreements.
Loan Restructuring. Pursuant to the Restructuring:
•
the Company acknowledged, and the bank waived, certain existing defaults under the Company’s existing credit facilities with the bank;
•
Franklin Credit’s indebtedness to the bank was reduced by $300 million and Franklin Credit paid a restructuring fee of $12 million to the bank;
•
the remaining approximately $1.54 billion of outstanding indebtedness to the bank, including approximately $1.05 billion of outstanding indebtedness of Franklin Credit and approximately $491.1 million of outstanding indebtedness of Tribeca, was restructured into six term loans with modified terms and a maturity date of May 15, 2009; and,
•
the Company paid all of the accrued interest on its debt outstanding to the bank through December 27, 2007 and guaranteed payment and performance of the restructured indebtedness.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Terms of the Restructured Indebtedness. The following table summarizes the principal economic terms of the Company’s indebtedness immediately following the Restructuring.
(1)
The applicable interest rate is fixed at 10% per annum. Interest will be paid in kind during the term of the forbearance.
(2)
Tranche C requires no principal amortization. All principal is due at maturity.
(3)
Tranche D serves as a revolving credit line with a maximum availability of $5 million, and an additional $5 million which may be used for issuance of letters of credit.
(4)
Does not include a letter of credit facing fee of 0.125% per annum on the average daily undrawn amount of each issued and outstanding letter of credit.
The interest rate under the terms of the Forbearance Agreements that is the basis, or index, for the Company’s interest cost is the one-month London Interbank Offered Rate (“LIBOR”) plus applicable margins.
The following table compares the approximate weighted average interest rate of the Company’s indebtedness immediately prior to and following the Restructuring.
(1)
Includes the Unrestructured Debt.
Pursuant to the Forbearance Agreements, the bank is not required to provide any additional advances, except for those under the revolving credit or letter of credit portions of Tranche D.
Cash Flow. The Forbearance Agreements with respect to Franklin Credit, on the one hand, and Tribeca, on the other, provide a waterfall with respect to cash flow received in respect of collateral pledged in support of the related restructured indebtedness, net of approved, reimbursable operating expenses. Such cash flow is applied in the following order:
•
to pay interest in respect of Tranche A advances, Tranche B advances and, in the case of Franklin Credit, Tranche D advances, in that order;
•
to pay fees related to the Company’s letters of credit from the bank;
•
to pay the minimum required principal payments in respect of Tranche A advances and Tranche B advances, in that order;
•
to prepay outstanding Tranche A advances;
•
to prepay outstanding Tranche B advances;
•
to prepay Unrestructured Debt (excluding that owed to BOS);
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
•
in the case of Franklin Credit, to repay Tranche D advances, any letter of credit exposure, and any obligations in respect of any interest rate hedge agreements with the bank;
•
in the case of Franklin Credit, 90% of the available cash flow to repay interest and then principal of the Tranche C advances if Franklin Credit is acting as servicer of the underlying collateral, or 100% otherwise; and,
•
in the case of Franklin Credit and Tribeca, to pay any advances then outstanding in respect of the other’s indebtedness to the bank, other than for Unrestructured Debt.
Covenants; Events of Default. The Forbearance Agreements contain affirmative and negative covenants customary for restructurings of this type, including covenants relating to reporting obligations. The affirmative and negative covenants under all of the credit agreements between the Company and the bank, other than those under the Franklin Master Credit Agreement and under the Tribeca Master Credit and Security Agreement, dated as of February 28, 2006, as amended, were superseded by the covenants in the Forbearance Agreements. Additionally, any provisions of any of the credit agreements between the Company and the bank that conflict with or are subject of a discrepancy with the provisions of the Forbearance Agreements will be superseded by the conflicting provision in the Forbearance Agreements. The Forbearance Agreements include covenants requiring that:
•
the Company’s reimbursable expenses in the ordinary course of business during each of the first two months after the date of the agreement will not exceed $2.5 million, excluding reimbursement of certain bank expenses after the date of the Restructuring, and thereafter, an amount provided for in an approved budget;
•
the Company will not originate or acquire mortgage loans or other assets, perform due diligence or servicing, broker loans, or participate in off-balance sheet joint ventures and special purpose vehicles, without the prior consent of the bank;
•
the Company will use its best efforts to obtain interest rate hedges acceptable to the bank in respect of the $1 billion of Tranche A indebtedness;
•
the Company will not make certain restricted payments to its stockholders or certain other related parties;
•
the Company will not engage in certain transactions with affiliates;
•
the Company will not incur additional indebtedness other than trade payables and subordinated indebtedness;
•
the Company together will maintain a minimum consolidated net worth of at least $5 million, plus a certain percentage, to be mutually agreed upon, of any equity investment in the Company after the date of the Restructuring;
•
the Company will together maintain a minimum liquidity of $5 million;
•
the Company will maintain prescribed interest coverage ratios, based on EBITDA (as defined) to Interest Expense (as defined);
•
the Company will not enter into mergers, consolidations or sales of assets (subject to certain exceptions); and,
•
the Company will not, without the bank’s consent, enter into any material change in its capital structure that the bank or a nationally recognized independent public accounting firm determine could cause a consolidation of its assets with other persons under relevant accounting regulations.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Forbearance Agreements contain events of default customary for facilities of this type, although they generally provide for no or minimal grace and cure periods.
Servicing. Franklin Credit will continue to service the collateral pledged by the Company under the Forbearance Agreements, subject to the bank’s right to replace Franklin Credit as servicer in the event of a default under the Forbearance Agreements or if the bank determines that Franklin Credit is not servicing the collateral in accordance with accepted servicing practices, as defined in the Forbearance Agreements. Franklin Credit may also, with the bank’s consent, and plans to, provide to third parties servicing of their portfolios, and other related services, on a fee paying basis.
Security. The Company’s obligations with respect to the restructured Franklin Credit indebtedness are secured by a first priority lien on all of the assets of Franklin Credit and its subsidiaries, other than those of Tribeca and Tribeca’s subsidiaries, and those securing the Unrestructured Debt. The Company’s obligations with respect to the restructured Tribeca indebtedness are secured by a first priority lien on all of the assets of Tribeca and Tribeca’s subsidiaries, except for those assets securing the Unrestructured Debt. In addition, pursuant to a lockbox arrangement, the Company’s lender controls substantially all sums payable to the bank in respect of any of the collateral.
Master Credit Facilities - Term Loans
The summary that follows describes the terms of the Company’s Master Credit Facilities in effect prior to entering into the Forbearance Agreements on December 28, 2007 described above, which substantially modified such facilities, except for the Unrestructured Debt.
General. In October 2004, the Company, and its finance subsidiaries, excluding Tribeca, entered into a master credit and security agreement (the “Franklin Master Credit Facility”) with Huntington National Bank, an Ohio banking corporation, which we refer to as our lender or Huntington. Under this master credit facility, we requested term loans to finance the purchase of residential mortgage loans or refinance existing outstanding loans under this facility. The facility did not include a commitment to additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were therefore subject to our lender’s discretion as well as any regulatory limitations to which our lender was subject. At December 31, 2007, $44.5 million remained outstanding under this facility (a portion of the Unrestructured Debt), and the interest rate continues to be based on the Federal Home Loan Bank of Cincinnati 30-day advance rate plus margins of 2.35% and 2.50%.
In February 2006, Tribeca and certain of its subsidiaries entered into the Tribeca Master Credit Facility with Huntington, pursuant to which certain Tribeca subsidiaries borrowed term loans to finance their origination of loans Tribeca previously financed under its warehouse line of credit with Huntington and consolidate and refinance prior term loans made by Huntington to such subsidiaries. The facility did not include a commitment for additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were subject to our lender’s discretion, as well as any regulatory limitations to which Huntington was subject. At December 31, 2007, $0 remained outstanding under this facility.
Interest Rates and Fees. Interest on the term loans, up to December 28, 2007, was payable monthly at a floating rate equal to the highest Federal Home Loan Bank of Cincinnati 30-day advance rate as published
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
daily by Bloomberg under the symbol FHL5LBRI, or the “30-day advance rate,” plus the applicable margin in effect prior to August 2006 as follows:
Elimination of Success Fees
In June 2006, the Company received from Sky Bank a letter (the “June Modification Letter”) modifying the Franklin Master Credit Facility between the Company and all of its subsidiaries other than Tribeca and the Tribeca Master Credit and Security Agreement among Tribeca, Sky Bank and certain subsidiaries of Tribeca. Pursuant to the June Modification Letter, Franklin and Tribeca were no longer required to pay Sky Bank a success fee upon the successful payoff of term loans made on or after June 26, 2006 under the master credit facilities.
In December 2006, the Company, Tribeca and Sky Bank entered into an Amendment (the “Amendment”) to the Franklin Master Credit Facility and the Tribeca Master Credit Facility (together with the Franklin Master Credit Facility, the “Master Credit Facilities”). Pursuant to the Amendment, Sky Bank agreed to the elimination of all success fee obligations under the Master Credit Facilities relating to term loans made before June 26, 2006, in consideration of the Company’s agreement to pay $4.5 million to Sky Bank. As a result of these amendments, neither the Company nor Tribeca will have any further success fee obligations upon payoff of term loans under any credit facilities.
August 2006 Modifications to Huntington National Bank Financing Arrangements
In August 2006, the master credit facilities were modified to reduce the interest rate on all debt originated under the master credit facilities before July 1, 2005 by 25 basis points effective October 1, 2006. This rate was lowered by an additional 25 basis points effective January 1, 2007.
December 2006 Modifications to Huntington National Bank Financing Arrangements
In December 2006, the master credit facilities were modified to change the interest rate on term loans funded under the master credit facilities after November 14, 2006 for loans originated by Tribeca and purchases of second mortgages by the Company to the Federal Home Loan Bank of Cincinnati 30-day advance rate as published daily by Bloomberg under the symbol FHL5LBRI (the “30-day advance rate”), plus the applicable margin as follows:
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Additionally, the interest rate payable to Huntington National Bank on term loans funded under the Franklin Master Credit Facility after November 14, 2006 in respect of purchases of first mortgages by the Company was the 30-day advance rate, plus the applicable margin as follows:
As a result of these modifications, effective January 1, 2007, and up to December 28, 2007, the interest rate on term borrowings under our Master Credit Facilities was based on a floating rate equal to the 30-day advance rate, plus the applicable margin as follows:
Upon each closing of a loan after June 23, 2006, we were required to pay an origination fee equal to 0.50% of the amount of the loan unless otherwise agreed to by our lender. For loans funded between July 1, 2005 and June 23, 2006, under the Franklin Master Credit Facility, the origination fee paid was 0.75% of the amount of the loan (0.50% for loans funded under the Tribeca Master Credit Facility), and for loans funded prior to July 1, 2005, the origination fee paid was 1% of the amount of the loan unless otherwise agreed to by our lender.
Principal; Prepayments; Termination of Commitments. The unpaid principal balance of each loan was amortized over a period of twenty years, but matures three years after the date the loan was made. Historically, our lender had agreed to extend the maturities of such loans for additional three-year terms upon their maturity. We were required to make monthly payments of the principal on each of our outstanding loans.
In the event there was a material and adverse breach of the representations and warranties with respect to a pledged mortgage loan that was not cured within 30 days after notice by our lender, we would have been required to repay the loan with respect to such pledged mortgage loan in an amount equal to the price at which such mortgage loan could readily be sold (as determined by our lender).
Covenants; Events of Default. The Master Credit Facilities contain affirmative, negative and financial covenants customary for financings of this type, including, among other things, a covenant under the Franklin Master Credit Facility that we and our subsidiaries together maintain a minimum net worth of at least $10 million; and, a covenant under the Tribeca Master Credit Facility that Tribeca and its subsidiaries, together, maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of at least $750,000. These master credit facilities contain events of default customary for facilities of this type (with customary grace and cure periods, as applicable). Pursuant to the Restructuring, the bank waived certain existing defaults under the Company’s master credit facilities for both Franklin and Tribeca.
Security. Our obligations under the Franklin Master Credit Facility are secured by a first priority lien on loans that are financed by proceeds of loans made to us under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, our lender is entitled to receive substantially all sums payable to us in respect of any of the collateral. Tribeca’s
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and its subsidiary borrowers’ obligations under the Tribeca Master Credit Facility are secured by a first priority lien on loans originated by Tribeca or such subsidiary that are financed or refinanced by proceeds of loans made to Tribeca or its borrowers under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, Huntington is entitled to receive substantially all sums payable to Tribeca and any subsidiary borrower in respect of any of the collateral.
Bank of Scotland Term Loan
In March 2006, Tribeca and one of Tribeca’s subsidiaries (the “Tribeca Subsidiary Borrower”) entered into a $100 million Master Credit and Security Agreement (the “BOS Loan”) with BOS (USA) Inc., an affiliate of Bank of Scotland. $98.2 million of proceeds of the BOS Loan were used to consolidate and refinance prior term loans made to certain Tribeca subsidiaries. Interest on the BOS Loan is payable monthly at a floating rate equal to the 30-day advance rate plus an applicable margin as follows:
The unpaid principal balance of the BOS Loan is amortized over a period of 20 years, but matures in March 2009. The Tribeca Subsidiary Borrower is required to make monthly amortization payments and payments of interest on the BOS Loan. The facility does not include a commitment to additional lendings or a commitment to refinance the remaining outstanding balance of the loan when it matures. The outstanding balance of the BOS Loan was $44.8 million (a portion of the Unrestructured Debt) at December 31, 2007.
The facility contains affirmative, negative and financial covenants customary for financings of this type, including, among other things, covenants that require Tribeca and its subsidiaries, together, to maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of $750,000. The facility contains events of default customary for facilities of this type. At December 31, 2007, Tribeca was not in compliance with these and other covenants and has not received a waiver of noncompliance. Any unwaived or uncured breach of these covenants could, subject to notice and opportunity to cure where provided for in the applicable credit agreements, cause an acceleration of the outstanding BOS Loan and result in cross-default and possible acceleration of the indebtedness owed to the bank under the Forbearance Agreements. See Note 14 for a description of the amendment to the Forbearance Agreements.
Tribeca’s and the Tribeca subsidiary borrower’s obligations under the facility are secured by (i) a first priority lien on loans acquired by the Tribeca Subsidiary Borrower that are refinanced by the proceeds of the BOS Loan and (ii) a second priority lien on collateral securing loans made to Tribeca or its subsidiaries under the Tribeca Master Credit Facility described above. In addition, pursuant to a lockbox arrangement, BOS is entitled to receive substantially all sums payable to Tribeca and the Tribeca Subsidiary Borrower in respect of any of the primary collateral under the facility. Tribeca’s BOS Loan and the Tribeca Master Credit Facility are cross-collateralized.
6.
FINANCING AGREEMENTS
The summary that follows describes the terms of the Company’s financing agreements in effect prior to entering into the Forbearance Agreements on December 28, 2007 described above, which substantially modified such agreements.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company and Tribeca have the following financing agreements:
Warehousing Credit and Security Agreement
In October 2005, Tribeca entered into a Warehousing Credit and Security Agreement (the “Tribeca Warehouse Facility”) with our lender, which modified previous warehouse lending agreements. In April 2006, our lender increased the commitment to $60 million. Interest on advances was payable monthly at a rate per annum equal to the greater of (i) a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points or (ii) 5%.
The Tribeca Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. Tribeca also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of Tribeca’s obligations under the Tribeca Warehouse Facility, which was secured by substantially all of Tribeca’s personal property. As of December 28, 2007, this facility was terminated.
Flow Warehousing Credit and Security Agreement
In August 2006, we entered into a new $40 million Flow Warehousing Credit and Security Agreement (the “Flow Warehouse Facility”) for a term of one year with our lender to accumulate loans acquired by the Company on a flow basis prior to consolidating such loans into term debt. This warehouse facility was renewed in August 2007 by Huntington for $20 million and for a term of one year. As of December 28, 2007, this facility was terminated.
Interest on advances was payable monthly at a rate per annum equal to a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points.
The Flow Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. The Company also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of the Company’s obligations under the Flow Warehouse Facility, which was secured by substantially all our personal property.
Other Credit Facilities
The Company and the bank have entered into a credit facility, which provides the Company with the ability to borrow a maximum of $4 million at a rate equal to the Bank’s prime rate less 50 basis points per annum. The credit facility may be utilized to pay real estate taxes or to purchase the underlying collateral of certain nonperforming real estate secured loans. Principal repayment of each respective advance is due six months from the date of such advance and interest is payable monthly. Prior to March 2005, this credit facility provided a maximum loan amount of $2.5 million at a rate equal to the Bank’s prime rate plus 200 basis points per annum. Effective in October 2006, the rate was changed to the Bank’s prime rate less 50 basis points per annum. Effective December 28, 2007, the line of credit is provided for by the terms of the Forbearance Agreements and was increased to $5 million. As of December 31, 2007 and 2006, $1,033,073 and $1,289,155, respectively, were outstanding on this credit facility. The credit facility is secured by a first priority security interest in the respective notes receivable, any purchased real estate, payments received under the notes receivable, and collateral securing the notes of certain loan portfolios.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company had a line of credit with another bank, which provided the Company with an unsecured line of credit to borrow a maximum of $150,000 at a rate equal to such bank’s prime rate plus 1% per annum. As of December 31, 2007, the amount outstanding was $0 and the line of credit had been closed. At December 31, 2006, $36,726 was outstanding on this line of credit.
7.
INCOME TAXES
Components of the (benefit)/provision for income taxes for the years ended December 31, 2007, 2006 and 2005 are as follows:
A reconciliation of the anticipated income tax expense (computed by applying the Federal statutory income tax rate to income before income tax expense) to the provision for income taxes in the accompanying consolidated statements of income for the years ended December 31, 2007, 2006 and 2005 is as follows:
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The tax effects of temporary differences that gave rise to deferred income tax assets and deferred tax liabilities at December 31, 2007 and 2006 are presented below:
The Company has recorded a valuation allowance of $4.1 million, as the Company has determined that it is more likely than not that all of the deferred tax assets will not be fully realizable.
As of December 31, 2007, the Company had tax net operating loss carryforwards with various states totaling approximately $71.0 million. As of December 31, 2007, the company had federal tax net operating loss carryforwards of approximately $1.6 million. The net operating loss carryforwards expire in various years beginning in 2014 through 2027.
8.
STOCK-BASED COMPENSATION
The Company awarded stock options to certain officers and directors under the Franklin Credit Management Corporation 1996 Stock Incentive Plan (the “Plan”) as amended. The Compensation Committee of the Board of Directors (the “Compensation Committee”) determines which eligible employees or directors will receive awards, the types of awards to be received, and the terms and conditions thereof.
Options granted under the Plan may be designated as either incentive stock options or non-qualified stock options. The Compensation Committee determines the terms and conditions of the option, including the time or times at which an option may be exercised, the methods by which such exercise price may be paid, and the form of such payment. Options are generally granted with an exercise price equal to the market value of the Company’s stock at the date of grant. These option awards generally vest over 1 to 3 years and have a contractual term of 10 years.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company estimated the fair value of stock options granted on the date of grant using the Black-Scholes option-pricing model. The table below presents the assumptions used to estimate the fair value of stock options granted on the date of grant using the Black-Scholes option-pricing model for the years ended December 31, 2007, 2006 and 2005. The risk-free rate for periods within the contractual life of the stock option is based on the U.S. Treasury yield curve in effect at the time of grant. The Company uses historical data to estimate stock option exercise. The expected term of stock options granted is derived from the output of the model and represents the period of time that stock options granted are expected to be outstanding. The estimates of fair value from these models are theoretical values for stock options and changes in the assumptions used in the models could result in materially different fair value estimates. The actual value of the stock options will depend on the market value of the Company’s common stock when the stock options are exercised.
Transactions in stock options for the years ended December 31, 2007, 2006 and 2005 under the plan are summarized as follows:
The weighted average remaining contractual term and aggregate intrinsic value of options outstanding and exercisable was 4.82 years and $23,400, as of December 31, 2007.
During 2007, 2006 and 2005, there were 15,000, 15,000 and 106,500 options granted, respectively.
FRANKLIN CREDIT MANAGEMENT CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company has the following options outstanding at December 31, 2007:
As of December 31, 2007, all compensation cost related to the Company’s stock option awards had been recognized.
At December 31, 2007, the Company had 10,000 warrants outstanding at an exercise price of $5.00. There were no warrants exercised during 2007.
Stock Incentive Plan
On May 24, 2006, the shareholders approved the 2006 Stock Incentive Plan. This approval authorized and reserved 750,000 shares for grant under the 2006 stock incentive plan. Awards can consist of non-qualified stock options, incentive stock options, stock appreciation rights, shares of restricted stock, restricted stock units, shares of unrestricted stock, performance shares and dividend equivalent rights are authorized. Grants of non-qualified stock options, incentive stock options and stock appreciation rights under the 2006 Stock Incentive Plan generally qualify as “performance-based compensation” under Section 162(m) of the Internal Revenue Code, and, therefore, are not subject to the provisions of Section 162(m), which disallow a federal income tax deduction for certain compensation in excess of $1 million per year paid to the Company’s Chief Executive Officer and each of its four other most highly compensated executive officers.
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Restricted Stock - Restricted shares of the Company’s common stock have been awarded to certain executives. The stock awards are subject to restrictions on transferability and other restrictions, and step vest over a three year period.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A summary of the status of the Company’s restricted stock awards as of December 31, 2007, 2006 and 2005 and changes during the period then ended is presented below:
During 2007, the total fair value of the Company’s restricted stock that vested during 2007 was $260,586.
As of December 31, 2007, there was $481,806 of unrecognized compensation cost related to the Company’s restricted stock awards, which will be recognized over a weighted average period of 2.25 years.
9.
SEGMENTS
The Company has two reportable operating segments: (i) portfolio asset acquisition and resolution; and (ii) mortgage banking. The portfolio asset acquisition and resolution segment acquires performing, nonperforming, nonconforming and sub-performing notes receivable and promissory notes from financial institutions, mortgage and finance companies, and services and collects such notes receivable through enforcement of original note terms, modification of original note terms and, if necessary, liquidation of the underlying collateral. The mortgage-banking segment originates or purchases for sale and investment purposes residential mortgage loans to individuals whose credit histories, income and other factors cause them to be classified as subprime borrowers.
The Company’s management evaluates the performance of each segment based on profit or loss from operations before unusual and extraordinary items and income taxes.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
PORTFOLIO ASSET ACQUISITION AND RESOLUTION
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
MORTGAGE BANKING
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
10.
CERTAIN CONCENTRATIONS
The following table summarizes percentages of total principal balances by the geographic location of properties securing the loans in our portfolios of notes receivable, loans held for investment and loans held for sale at December 31, 2007 and December 31, 2006:
Such real estate mortgage loans held are collateralized by real estate with a concentration in these states. Accordingly, the collateral value of a substantial portion of the Company’s real estate mortgage loans held and real estate acquired through foreclosure is susceptible to changes in market conditions in these states. In the event of sustained adverse economic or housing price conditions, it is possible that the Company could experience a negative impact in its ability to collect on existing real estate mortgage loans held, or liquidate foreclosed assets in these states, which could impact the Company’s related loan loss estimates.
During 2007, the U.S. housing and subprime mortgage markets experienced rapid and substantial deterioration. This deterioration gave rise to industry-wide increases in mortgage delinquencies reflecting the decline in collateral values and related declines in borrowers’ equity in their homes, particularly with respect to subprime loans originated throughout the mortgage industry during 2005, 2006 and the early months of 2007, which were characterized by collateral values established at the height of the U.S. real estate market and also, often, by lax underwriting standards. Additionally, during the summer of 2007, there was a significant tightening of new credit throughout the mortgage lending industry, particularly in the subprime segment of the industry, which increased the difficulty for borrowers with imperfect credit histories to refinance their mortgages. In light of these factors, and their impact on the Company’s loan portfolios, a substantial portion of which is comprised of second mortgages purchased from others during the past several years, the Company reassessed its allowance for loan losses as of September 30, 2007. This reassessment resulted in significantly increased estimates of inherent losses in the portfolios of purchased loans, particularly the purchased second-lien loans, and originated subprime loans, which resulted in a provision of $262.7 million in the quarter ended September 30, 2007.
Financing - Substantially all of the Company’s existing debt is with one financial institution.
11.
COMMITMENTS AND CONTINGENCIES
Operating Leases - During 2005, the Company entered into two operating lease agreements for corporate office space, which contain provisions for future rent increases, rent-free periods, or periods in which rent payments are reduced (abated). The total amount of rental payments due over the lease term is being
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
charged to rent expense on the straight-line method over the term of the lease. The difference between rent expense recorded and the amount paid is credited or charged to “Accrued expenses,” which is included in “Accounts payable and accrued expenses” on the balance sheets. Rent expenses for 2007, 2006 and 2005 were $1,372,442, $1,029,781 and, $1,696,089 (inclusive of $718,041 of lease termination costs), respectively.
The combined future minimum lease payments as of December 31, 2007 are as follows:
Substantially all of the Company’s office equipment is leased under multiple operating leases. The combined future minimum lease payments as of December 31, 2007 are as follows:
Capital Leases - The Company entered into a lease for office furniture for its new corporate office in Jersey City under an agreement that is classified as a capital lease. The cost of the furniture under this capital lease is included on the balance sheets as “Building, furniture and equipment” and was $916,890 at December 31, 2007. Accumulated amortization of the leased furniture at December 31, 2007 was $443,164. Amortization of assets under capital leases is included in depreciation expense.
The combined future minimum lease payments required under the capital lease as of December 31, 2007 are as follows:
Legal Actions - The Company is involved in legal proceedings and litigation arising in the ordinary course of business. In the opinion of management, the outcome of such proceedings and litigation currently pending will not materially affect the Company’s financial statements.
Certain whole-loan sale contracts include provisions requiring the Company to repurchase a loan if a borrower fails to make one or more of the first loan payments due on the loan after the date of sale. In addition, the purchaser may require that the Company refund a portion of the premium paid on the sale of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
mortgage loans if a loan is prepaid in full within a certain amount of time from the date of sale. The Company records a provision for estimated repurchases and premium recapture on loans sold, which is charged to gain on sale of loans.
At December 31, 2007, the Company did not have any remaining potential repurchase obligations.
12.
RELATED PARTY TRANSACTIONS
The Company subleased approximately 2,500 square feet of office space on the 5th floor at Six Harrison Street in New York, New York, from RMTS Associates, LLC, of which Thomas J. Axon, the Company’s Chairman and President, owns 80%. Pursuant to the lease, the Company paid RMTS rent of approximately $48,200 in 2005. This lease was terminated on August 31, 2005.
On May 12, 2005, the Company entered into a Termination Agreement (the “Six Harrison Termination Agreement”) by and among RMTS, LLC, a New York limited liability company of which Mr. Axon owns 80% (the “Sublessor”), James Thomas Realty, a New York limited liability corporation (the “Landlord”) of which Mr. Axon owns 90% and Frank B. Evans, Jr., a member of the Company’s Board of Directors, owns 10%, and the Company. Under the Six Harrison Termination Agreement, the Landlord and the Sublessor agreed, in connection with the Company’s planned relocation of operations to Jersey City, New Jersey, to the early termination of the Company’s sublease for approximately 2,500 square feet of office space at Six Harrison Street in New York, New York, which was due to expire in August 2009, in consideration of the Company’s payment of $125,000 to the Landlord.
The Company leased approximately a total of 7,400 square feet of office space at 185 Franklin Street in New York, New York from 185 Franklin Street Development Associates, a limited partnership, of which 185 Franklin Street Development Corp., which is wholly-owned by Mr. Axon, is the general partner. Pursuant to the sublease, the Company paid 185 Franklin Street Development Associates rent of $19,500 per month in 2005. These leases were also terminated on August 31, 2005.
On May 12, 2005, the Company entered into a Termination Agreement (the “185 Franklin Termination Agreement”) with 185 Franklin Street Development Associates L.P., a New York limited partnership (the “185 Franklin Lessor”), the general partner of which is owned by an entity that is owned by Mr. Axon. Pursuant to the termination agreement, the 185 Franklin Lessor agreed, in connection with the Company’s planned relocation of operations to Jersey City, New Jersey, to the early termination of the Company’s leases for approximately 7,400 square feet of office space at 185 Franklin Street in New York, New York, which were due to expire on dates ranging from February 2008 through October 2008, in consideration of the Company’s payment of $462,859 to the 185 Franklin Lessor.
On February 13, 2006, Tribeca entered into a lease agreement with 18 Harrison Development Associates, an entity controlled by Thomas J. Axon, to lease approximately 950 square feet on the 5th floor at 18 Harrison Street, New York, New York for use as additional office space. The term of the lease was through February 12, 2007, at approximately $4,880 per month, and the option to extend the lease for an additional period of one year at a rate of approximately $5,124 per month was exercised. The lease was extended in February 2007, and expired unrenewed in February 2008.
During 2006, the Company entered into a month-to-month agreement with its Chairman and President, Thomas J. Axon, for use of a condominium apartment unit at 300 Albany Street in New York, New York for corporate housing. The Company paid $18,000 and $27,000 under this agreement, respectively, in 2007 and 2006.
At December 31, 2007 and 2006, respectively, the Company had an outstanding receivable from an affiliate, RMTS Associates of $6,152 and $234,069. This receivable represents various operating expenses that are paid by the Company and then reimbursed by RMTS. In 2007, the Company wrote off $204,634 of aged
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
receivables from RMTS Associates due to non-payment. Discussions with RMTS are continuing regarding the actual amounts to which the Company is entitled to be reimbursed for the receivables in dispute.
13.
QUARTERLY FINANCIAL INFORMATION (Unaudited)
Consolidated Statements of Income
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
14.
SUBSEQUENT EVENTS
On February 6, 2008, the Company commenced an action in the Supreme Court of the State of New York, County of New York styled: Franklin Credit Management Corp. v. WMC Mortgage LLC, successor to WMC Mortgage Corp. (the “WMC Litigation”). The WMC Litigation arises from the Company’s purchase of approximately $170 million of second mortgages during 2006 from WMC Mortgage Corp. (“WMC”), an affiliate of General Electric Corporation. Through the WMC Litigation, the Company seeks damages in an amount not less than $35.5 million resulting from breaches of the representations and warranties contained in the loan purchase agreements entered into between the Company and WMC. The Defendant has not yet filed an Answer in the WMC Litigation.
In connection with the WMC Litigation, the Company is in the process of conducting a review of the second lien mortgages purchased from WMC during 2006. In connection with the review, the Company has identified approximately $31 million of additional loans which do not conform to the representations and warranties contained in the loan purchase agreements entered into between the Company and WMC. The Company is in the process of requesting WMC to repurchase the additional loans pursuant to the terms of the loan purchase agreements. In the absence of a timely repurchase of these additional loans, the Company may seek to amend its complaint in the WMC Litigation or commence additional litigation against WMC.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Effective February 27, 2008, the Company entered into $725 million (notional amount) of fixed-rate interest rate swaps in order to effectively stabilize the future interest payments on a portion of its interest-sensitive borrowings. The fixed-rate swaps are for periods ranging from one to four years, are non-amortizing, and are in effect for the respective full terms of each swap agreement. These swaps will effectively fix the Company’s interest costs on a portion of its borrowings regardless of increases or decreases in the one-month LIBOR. The interest rate swaps were executed with the bank and are for the following terms: $220 million notional amount for one year at a fixed rate of 2.62%; $390 million notional amount for two-years at a fixed rate of 2.79%; $70 million notional amount for three years at a fixed rate of 3.11%; and, $45 million notional amount for four years at a fixed rate of 3.43%.
Under these swap agreements, the Company will make interest payments to its bank at fixed rates and will receive interest payments from its bank on the same notional amounts at variable rates based on LIBOR. Effective December 28, 2007, the Company pays interest on its interest-sensitive borrowings, principally based on one-month LIBOR plus applicable margins. Accordingly, the Company has established a fixed rate plus applicable margins on $725 million of its borrowings for the next year, $505 million for two years, $115 million for three years and $45 million for four years.
On March 31, 2008, the Company entered into a series of agreements with the bank, which amended the Forbearance Agreements, which are referred to as the Forbearance Agreement Amendments.
Pursuant to the Forbearance Agreement Amendments, the bank extended an additional $43.3 million under Tribeca’s Tranche A and Tranche B facilities, (the “Additional Payoff Indebtedness”), to fund the complete payoff of the BOS Loan. Simultaneously, BOS acquired from the bank a participation interest in Tribeca’s Tranche A facility equal in amount to the Additional Payoff Indebtedness. The effect of these transactions was to roll Tribeca’s indebtedness to BOS into the Forbearance Agreements, to terminate any obligations of Tribeca under the BOS Loan and to BOS directly, and to transfer the benefit of the collateral interests previously securing the BOS Loan to secure the obligations under the Forbearance Agreements. As a result of the Forbearance Agreement Amendments, Tribeca’s indebtedness as of March 31, 2008, was $410,860,000 and $98,774,000 for Tranche A and Tranche B, respectively. In connection with the increased debt outstanding under the Amended Forbearance Agreements, Tribeca’s required monthly principal amortization amount under the Tranche A Facility was increased from $3,600,000 to $3,900,000 and that under the Tranche B Facility was increased from $250,000 to $275,000.
In addition, the Forbearance Amendment Agreements modified the Forbearance Agreements with respect to the Franklin Master Credit Facility (the “Franklin Forbearance Agreement”):
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to provide that Tranche C interest shall not accrue until the first business day after all outstanding amounts under the Tranche A facility have been paid in full;
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to increase the Tranche C interest rate to 20% from and after such time it begins to accrue;
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to extend an additional period of forbearance through July 31, 2008, from May 15, 2008, in respect of the remaining Unrestructured Loans; and,
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to increase the maximum availability under the Tranche D line of credit to $10,000,000 for working capital and general corporate purposes to enable the Company to purchase real property in which it may have a lien, and for purposes of meeting licensing requirements.
Additionally, the Forbearance Agreement Amendments modified the Forbearance Agreements to (a) join additional subsidiaries of the Company as borrowers and parties to the forbearance agreements and other loan documents; and (b) extend the time periods or modify the requirements for the Company and the Company’s other subsidiaries to satisfy certain requirements of the Forbearance Agreements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
After giving effect to the Forbearance Agreement Amendments, the waterfall of payments has been adjusted to provide that periodic amounts constituting additional periodic payments of interest required under any interest hedging agreement may be paid after interest on the Tranche A and Tranche B advances, payments of interest and principal with respect to Tranche C advance shall be deferred until after payment of the Tranche D advance, and to provide for cash payment reserves for certain contractual obligations, taxes and $10,000,000 of cash payment reserves in the aggregate for fees, expenses, required monthly principal amortization and interest owing to the Bank.
The bank also waived any defaults under the Forbearance Agreements for the period through and including March 31, 2008, and consented to the origination by the Company of certain mortgage loans to refinance existing mortgage loans which the bank has approved for purchase and subsequent sale in the secondary market or which the bank determines are qualified for purchase by Fannie Mae or Freddie Mac.