ITEM 1. BUSINESS
GENERAL
Aames Financial Corporation (the "Company") is a consumer finance company primarily engaged, through its subsidiaries, in the business of originating, purchasing, selling and servicing home equity mortgage loans secured by single family residences. Upon its formation in 1991, the Company acquired Aames Home Loan, a home equity lender founded in 1954. In August 1996, the Company acquired One Stop Mortgage, Inc. ("One Stop") which originates mortgage loans primarily through a broker network. In late fiscal 1997, the Company began originating small commercial loans on a limited basis that it currently sells on a whole loan basis servicing released.
The Company's principal market is borrowers whose financing needs are not being met by traditional mortgage lenders for a variety of reasons, including the need for specialized loan products or credit histories that may limit such borrowers' access to credit. The Company believes these borrowers continue to represent an underserved niche of the home equity loan market and present an opportunity to earn a superior return for the risk assumed. The residential mortgage loans originated and purchased by the Company, which include fixed and adjustable rate loans, are generally used by borrowers to consolidate indebtedness or to finance other consumer needs rather than to purchase homes.
The Company originates and purchases loans nationally through three production channels - retail, broker and correspondent. For the year ended June 30, 1998, the Company originated and purchased $2.38 billion of mortgage loans. The Company underwrites and appraises every loan it originates and generally reviews appraisals and re-underwrites all loans it purchases. In March 1998, the Company augmented its retail production by establishing One Stop Retail Direct ("Retail Direct"). Unlike the Company's traditional retail network, which uses a centralized marketing approach, Retail Direct uses a decentralized marketing approach at the branch level. See "- Mortgage Loan Production."
The Company retains the servicing on the loans it originates or purchases and securitizes. During fiscal 1998, the Company completed the transfer-in-house of $1.47 billion of loans previously subserviced for the Company by third parties. Of the Company's $4.15 billion servicing portfolio, only 5.0% was subserviced by a third party at June 30, 1998. Of the Company's $3.17 billion servicing portfolio at June 30, 1997, 53% was subserviced by a third party at that date. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Expenses."
During fiscal 1998, the Company continued its shift up the credit grade spectrum reflecting its previously announced strategic decision to diversify the loans it originates and purchases to include more of the higher credit grade loans. In fiscal 1998, of the total loans originated and purchased by the Company, 93% were A, A-, B and C credit grade loans and 7% were C- and D credit grade loans. In fiscal 1997, of the total loans originated and purchased by the Company, 82% were A, A-, B and C credit grade loans and 18% were C- and D credit grade loans, compared to 66% and 34%, respectively, in fiscal 1996. This diversification was accomplished primarily through the acquisition of One Stop in August 1996, which focuses on the higher credit grade spectrum, the decrease in C- and D originations in certain non-judicial foreclosure states and the adoption of different pricing structures by credit grade in the correspondent and retail divisions. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Revenue."
As a fundamental part of its business and financing strategy, the Company sells its loans to third party investors in the secondary market. The Company maximizes opportunities in its loan disposition transactions by
disposing of its loan production through a combination of securitizations and whole loan sales, depending on market conditions, profitability and cash flows. The Company sold $2.45 billion, $2.27 billion and $993 million of loans in the fiscal years ended June 30, 1998, 1997 and 1996, respectively. See "- Loan Disposition."
RECENT EVENTS
First Quarter Results. For the quarter ended September 30, 1998, the Company expects that it will achieve record loan volume of approximately $725 million from all production channels. Offsetting this strong loan growth is the negative impact of current conditions in the asset-backed mortgage and Treasury markets that negatively impacted the Company's securitization execution. Specifically, the Company's gain on sale resulting from its recent $650 million securitization is expected to be lower than in the past due to a significant loss on its hedge position which was not offset by enhanced securitization execution. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Management." These and other factors will have a significant negative impact on reported operating results for September 30, 1998.
Equity Infusion. On April 27, 1998, the Company issued 2.78 million shares of its common stock, or 9.9% of the Company's outstanding shares, to private entities controlled by Ronald Perelman and Gerald Ford, at a purchase price of $13.7625 per share, or approximately $38 million in the aggregate. Mr. Ford is the Chairman of the Board and Chief Executive Officer of Golden State Bancorp Inc. The purchase price represented the average of the closing sales prices of the Company's common stock on the New York Stock Exchange during the 15-day period preceding the signing of the agreement (March 19, 1998). As part of the agreement, the Company also issued warrants to these entities to purchase an aggregate additional 9.9% of the Company's stock at an exercise price of $17.2031 (125% of the purchase price of the stock), subject to customary anti-dilution provisions. The warrants are exercisable only upon a change in control of the Company and expire in three years. In addition, in April 1998 the Company appointed Howard Gittis, as nominee for Mr. Perelman, and Mr. Ford to the Company's Board of Directors. On September 24, 1998, Messrs. Gittis and Ford resigned from the Board of Directors.
Strategic Alternatives. The Company continues to retain Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ") as a financial advisor to develop strategic alternatives for the Company. DLJ continues to evaluate opportunities for the Company, including possible business combinations. The Company is currently in discussions with several entities, including Golden State Bancorp Inc., concerning various alternatives. No assurance can be given that any such opportunities will be consummated.
BUSINESS STRATEGY
For the three years prior to fiscal 1998, the Company's significant year-over-year growth was driven primarily by the increases in the volume of loans purchased in the bulk correspondent business and the sale of the Company's loan production in securitization transactions. These two business strategies significantly contributed to the Company's operating on a negative cash flow basis which was funded by the Company regularly accessing the public equity and debt markets. In the fourth quarter of fiscal 1997, primarily as a reaction to the uncertainties in those capital markets, the Company decided to reduce its bulk loan purchases and focus on the less cash intensive core retail and broker loan production units and its servicing divisions. Fiscal 1998's results reflect these strategic decisions in the record levels of retail and broker loan production, increased expenses for retail and broker loan office expansion and increased expenses to accommodate the significant increase in the Company's in-house servicing portfolio. The fiscal 1998 results also reflect the Company's new loan disposition strategy which includes a combination of securitizations and whole loan sales for cash. The Company intends to continue to pursue its growth strategy by (i) continuing to focus on its core loan production units; (ii) increasing its servicing portfolio and servicing capabilities; and (iii) diversifying its funding sources to become self-financing (i.e., the ability to obtain sufficient lines of credit to provide financing for assets created by the Company and the elimination of reliance on the public equity and debt markets). In particular, the Company intends to employ the following strategies:
Focus on Core Loan Production. During fiscal 1998, the Company expanded its Aames retail loan office network by adding 42 new retail offices and its broker network by adding 10 new broker offices. Further,
Retail Direct opened 5 offices during the fiscal year. The Company intends to continue to evaluate further expansion opportunities in its retail and broker operations and to expand its loan purchasing capabilities by building new relationships with independent mortgage brokers, with the goal of increasing market share in these areas. The Company began lending operations in the United Kingdom in April 1998 through a subsidiary of One Stop. The Company will continue to evaluate additional international opportunities. The Company regularly reviews its loan offerings and introduces new loan products to further meet the needs of its customers and increase its core loan production volume. During fiscal 1998, the Company began offering high loan-to-value ratio loans which it sells on a whole loan basis, and the Company is currently reviewing the feasibility of offering home equity lines of credit which would also be sold on a whole loan basis.
Increase Servicing Portfolio; Increase Margins and Develop Subservicing Capabilities. The Company plans to continue to build the size of its servicing portfolio to provide a stable and significant source of recurring revenue. At June 30, 1998, the Company's servicing portfolio was $4.15 billion, 5.0% of which was subserviced by third parties. The servicing portfolio at June 30, 1998 was up 31% from $3.17 billion at the end of the 1997 fiscal year, 53% of which was subserviced by third parties. By calendar year end, the Company intends to directly service all of its servicing portfolio. The Company expects to increase the size of its loan servicing portfolio by continuing to increase loan originations and purchases, completing new securitizations and subservicing on behalf of third parties. However, no assurance as to the Company's ability to accomplish these goals can be given.
Continue to Diversify Funding Sources and Become Self-Financing. The Company intends to continue to expand and diversify its funding sources by adding additional warehouse facilities, disposing of a portion of its loan production for cash in the whole loan market, and, subject to easing debt covenants restricting the Company's ability to obtain financing secured by its interest-only strips, adding credit facilities to finance the Company's interest-only strips and residual assets. However, no assurance as to the Company's ability to accomplish these goals can be given. The Company continues to improve its cash flows through such mechanisms as new securitization structures, as well as through decreasing bulk loan purchases which, while resulting in lower production volume in its correspondent unit, improves the Company's cash position. The Company also believes it will improve its cash flow by improving the efficiency of its servicing operations. Under certain circumstances, the Company would consider again accessing the public equity and debt markets.
The strategies discussed above contain forward-looking statements. Such statements are based on current expectations and are subject to risks, uncertainties and assumptions, including those discussed under "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Factors." Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or projected. Thus, no assurance can be given that the Company will be able to accomplish the above strategies.
MORTGAGE LOAN PRODUCTION
The Company's principal loan product is a non-conforming home equity loan with a fixed principal amount and term to maturity which is typically secured by a first mortgage on the borrower's residence with either a fixed or adjustable interest rate. Non-conforming home equity loans are loans made to homeowners whose borrowing needs may not be met by traditional financial institutions due to credit exceptions or other factors and that generally cannot be marketed to agencies such as the Federal National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC"). In addition, the Company offers junior mortgages and other products in order to meet a wide variety of borrower needs. In fiscal 1998, the Company obtained its residential loans through three primary channels: retail, broker and correspondent. In late
fiscal 1997, the Company established a commercial loan division. In March 1998, the Company augmented its retail production channel by establishing Retail Direct.
The following table illustrates the sources of the Company's loan production during the periods indicated:
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(1) Calculated with respect to the interest rate at the time the loan is originated or purchased by the Company. (2) Includes commercial loans.
Aames Retail Loan Office Network. The Company originates home equity mortgage loans through its network of retail loan offices which, at June 30, 1998, consisted of 98 retail loan offices located in 32 states. Prior to fiscal year 1994, the Company's retail offices were located only in California. Since that time, the Company has aggressively pursued a strategy of expanding its retail loan office network nationwide. During the current fiscal year, the Company will continue to evaluate opportunities for further retail office expansion.
The Company selects areas in which to introduce or expand its retail presence on the basis of selected demographic statistics, marketing analyses and other criteria developed by the Company.
The Company's expansion of its retail loan office network has resulted in significant increases in retail loan production over the last three fiscal years. The Company originated $636 million, $437 million and $221 million of mortgage loans through this network in fiscal 1998, 1997 and 1996, respectively.
The Company generates applications for loans through its retail loan office network principally through a centralized multimedia advertising program, which relies primarily on the use of direct mailings to homeowners, television advertising, yellow-page listings and telemarketing. The Company believes that its advertising campaigns establish name recognition and serve to distinguish the Company from its competitors. The Company continually monitors the sources of its applications to determine the most effective methods and manner of advertising.
The Company's advertising invites prospective borrowers to call its headquarters office through the Company's toll-free telephone numbers. On the basis of an initial screening conducted at the time of the call, the Company's customer service representative makes a preliminary determination of whether the customer and the property meet the Company's lending criteria, and schedules an appointment with a loan officer in the retail loan office most conveniently located to the customer or in the customer's home. If the customer cannot schedule an appointment or is located in an area without a retail office, the representative refers the customer to a loan officer in a nearby retail loan office who takes the loan application by telephone.
The Company's loan officer at the local retail loan office assists the applicant in completing the loan application, arranges for an appraisal, orders a credit report from an independent, nationally recognized credit reporting agency and performs various other tasks in connection with the completion of the loan package. The loan package is then forwarded to the Company's headquarters office for review by underwriters and for loan approval. If the loan package is approved, the loan is funded by the Company. The Company's loan officers are trained to structure loans that meet the applicant's needs, while satisfying the Company's lending guidelines.
Retail Direct. In March 1998, the Company established a separate retail production unit, Retail Direct, to enable the Company to further penetrate the non-conforming home equity loan market. Unlike the Company's existing retail office network, which uses a centralized marketing approach, Retail Direct uses a decentralized marketing effort at the branch level. During the year ended June 30, 1998, $1.48 million in loans were originated through Retail Direct. Currently, Retail Direct is operating 7 offices in 5 states and expects to expand nationwide in the future.
Independent Mortgage Broker Network. Through its independent mortgage broker network, One Stop funded $1.05 billion, $741 million and $320 million in residential loans during the fiscal years ended June 30, 1998, 1997 and 1996, respectively. At June 30, 1998, One Stop operated 47 broker offices in 45 states and the United Kingdom and had approximately 4,600 approved mortgage brokers. During fiscal 1998, One Stop originated loans through approximately 2,100 brokers, no one of which accounted for more than 10% of One Stop's total originations. All loans originated by One Stop are underwritten in accordance with the Company's underwriting guidelines. Once approved, the loan is funded or purchased by One Stop directly.
The broker's role is to identify the applicant, assist in completing the loan application form, gather necessary information and documents and serve as One Stop's liaison with the borrower through the lending process. One Stop reviews and underwrites the applications submitted by the broker, approves or denies the application, sets the interest rate and other terms of the loan and, upon acceptance by the borrower and satisfaction of all conditions imposed by One Stop, funds the loan. Because brokers conduct their own marketing and employ their own personnel to complete loan applications and maintain contact with borrowers, originating loans through its broker network allows One Stop to increase its loan volume without incurring the higher marketing costs associated with increased retail originations.
Because mortgage brokers generally submit loan files to several prospective lenders simultaneously, consistent underwriting, quick response times and personal service are critical to successfully producing loans through independent mortgage brokers. To meet these requirements, One Stop strives to provide quick response
time to the loan application (generally within 24 hours). In addition, loan consultants and loan processors, including underwriters, are available in One Stop's branch offices to answer questions, assist in the loan application process and facilitate ultimate funding of the loan.
Correspondent Channel. The Company purchases closed loans from mortgage bankers and other financial institutions on a continuous or "flow" basis, and through bulk and mini-bulk purchases. During the fiscal years ended June 30, 1998, 1997 and 1996, $646 million, $1.17 billion and $628 million in loans were purchased through this correspondent channel. The Company believes that its flow and mini-bulk correspondent program represents a cost effective means of increasing loan production. In the fourth quarter of fiscal 1997, primarily as a reaction to the uncertainties in the public equity and debt markets, the Company decided to reduce its bulk loan purchases. This strategic decision decreased the amount of bulk loans purchased in fiscal 1998 compared to fiscal 1997.
Commercial Loans. In late fiscal 1997, One Stop established a commercial loan division through which it originates small commercial loans. The Company portfolios these loans until sufficient volume is accumulated to maximize the execution of whole loan sales on a servicing released basis. Generally, the size of the commercial loans range from $250,000 to $2.0 million in size and are secured by liens on commercial properties such as multifamily residences, retail establishments, office buildings, light industrial warehouse facilities and mobile home parks. The Company originated $53.9 million and $6.9 million of commercial loans during the fiscal years ended June 30, 1998 and 1997, respectively.
Underwriting. The Company underwrites every residential loan it originates and generally re-underwrites each loan it purchases. The Company's underwriting guidelines are designed to assess the adequacy of the real property as collateral for the loan and the borrower's creditworthiness. An assessment of the adequacy of the real property as collateral for the loan is primarily based upon an appraisal of the property and a calculation of the ratio (the "combined loan-to-value ratio") of all mortgages existing on the property (including the loan applied for) to the appraised value of the property at the time of origination. As a lender that specializes in loans made to credit impaired borrowers, the Company ordinarily makes home equity mortgage loans to borrowers with credit histories or other factors that would typically disqualify them from consideration for a loan from traditional financial institutions. Consequently, the Company's underwriting guidelines generally require lower combined loan-to-value ratios than would typically be the case if the borrower could qualify for a loan from a traditional financial institution. Creditworthiness is assessed by examination of a number of factors, including calculation of debt-to-income ratios, which is the sum of the borrower's monthly debt payments divided by the borrowers's monthly income before taxes and other payroll deductions, an examination of the borrower's credit history through standard credit reporting bureaus, and by evaluating the borrower's payment history with respect to existing mortgages, if any, on the property.
The underwriting of a mortgage loan to be originated or purchased by the Company includes a review of the completed loan package, which includes the loan application, a current appraisal, a preliminary title report and a credit report. All loan applications and all closed loans offered to the Company for purchase must be approved by the Company in accordance with its underwriting criteria. The Company regularly reviews its underwriting guidelines and makes changes when appropriate to respond to market conditions, the performance of loans representing a particular loan product or changes in laws or regulations.
Appraisers determine a property's value by reference to the sales prices of comparable properties recently sold, adjusted to reflect the condition of the property as determined through inspection. Appraisals on loans purchased as part of the Company's correspondent program are reviewed by Company appraisers or Company-qualified contract appraisers to assure that they meet the Company's standards.
The Company requires title insurance coverage issued on an American Land Title Association (or similar) form of title insurance on all residential properties securing mortgage loans it originates or purchases. The loan originator and its assignees are generally named as the insured. Title insurance policies indicate the lien position of the mortgage loan and protect the Company against loss if the title or lien position is not as indicated. The applicant is also required to maintain hazard and, in certain instances, flood insurance, in an amount sufficient to cover the new loan and any senior mortgage, subject to the maximum amount available under the National Flood Insurance Program.
Quality Control. The Company's quality control program is intended to (i) monitor and improve the overall quality of loan production generated by the Company's retail loan office network, independent mortgage broker network and correspondent program and (ii) identify and communicate to management existing or potential underwriting and loan packaging problems or areas of concern. The quality control file review examines compliance with the Company's underwriting guidelines and federal and state regulations. This is accomplished by focusing on: (i) the accuracy of all credit and legal information; (ii) a collateral analysis which may include a desk or field re-appraisal of the property and review of the original appraisal; (iii) employment and/or income verification; and (iv) legal document review to ensure that the necessary documents are in place.
Credit Grades.
The Company assigns a credit grade (A, A-, B, C, C- and D) to each loan it originates or purchases depending on the risk profile of the loan, with the higher credit grades exhibiting a lower risk profile and the lower credit grades exhibiting increasingly higher risk profiles. Generally, the higher credit grade loans have higher loan-to-value ratios and carry a lower interest rate. The following chart generally outlines certain parameters of the credit grades of the Company's underwriting guidelines for its residential loans at August 12, 1998:
The following tables present certain information about the Company's loan production through its retail loan office network, independent mortgage broker network and correspondent program during fiscal 1998, 1997 and 1996:
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1998
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1997
LOAN ORIGINATIONS AND PURCHASES IN FISCAL 1996
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(1) Calculated with respect to the interest rate at the time the loan is originated or purchased by the Company, as applicable.
LOAN DISPOSITION
The Company disposes of its loan production through a combination of securitizations and whole loan sales, although the Company currently anticipates that securitization will be its primary disposition strategy for the near future. Securitization is a cost competitive source of capital compared to other debt financing sources available to the Company. The Company generally seeks to dispose of substantially all of its quarterly loan production each quarter. The Company applies the net proceeds of the loan dispositions, whether through securitizations or whole loan sales, to pay down its warehouse facilities in order to make these facilities available for future funding of mortgage loans.
The Company securitized or sold in the secondary market $2.45 billion, $2.27 billion and $993 million of loans in the fiscal years ended June 30, 1998, 1997 and 1996, respectively. Of the Company's 26 securitization transactions totaling $5.57 billion completed through June 30, 1998, $4.09 billion has been credit-enhanced by monoline insurance to receive ratings of "Aaa" by Moody's Investors Service, Inc. ("Moody's") and "AAA" by Standard & Poor's Ratings Group, a Division of The McGraw-Hill Companies ("S&P") and, in some cases, "AAA" by Fitch IBCA, Inc. ("Fitch"). The remaining $1.48 billion of securitization transactions utilized a senior/subordinated structure in which the senior tranches received ratings of "Aaa" by Moody's, "AAA" by S&P and "AAA" by Fitch. In a senior/subordinated structure, the senior certificate holders are protected from losses by outstanding subordinated certificates and overcollateralization, rather than a monoline insurance policy.
Each agreement that the Company has entered into in connection with its securitizations requires either the overcollateralization of the trust or the establishment of a reserve account that may initially be funded by cash deposited by the Company. The Company's interest in each overcollateralization amount and reserve account is reflected on the Company's Consolidated Financial Statements as "residual assets" and is recorded as of the time such amounts are received by the trust. If losses exceed the amount of the overcollateralization or the reserve account, as applicable, the credit-enhancement aspects of the trust are triggered. In a securitization credit-enhanced by a monoline insurance policy, any further losses experienced by holders of the senior interests in the related trust will be paid under such policy. To date, there have been no claims on any monoline insurance policy obtained in any of the Company's securitizations. In a senior/subordinated structure, losses in excess of the overcollateralization amount generally are allocated first to the holders of the subordinated interests and then to the holders of the senior interests of the trust. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources -- Loan Sales" and "- Risk Factors - -- Delinquencies and Losses in Securitization Trusts; Right to Terminate Mortgage Servicing; Negative Impact on Cash Flow."
In a whole loan sale for cash, the Company generally enters into an agreement to sell the loans for cash on a servicing released basis. After the sale, the Company retains no interest in the underlying loans.
LOAN SERVICING
Servicing includes collecting and remitting loan payments, accounting for principal and interest, contacting delinquent borrowers, managing borrower defaults and liquidating foreclosed properties. The Company retains the servicing rights to the residential loans it originates or purchases and securitizes. In its whole loan sale strategy, the Company evaluates the feasibility of selling loans on a servicing retained or servicing released basis. To date, all of the Company's whole loan sales have been done on a servicing released basis. The following table sets forth certain information regarding the Company's servicing portfolio for the periods indicated:
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(1) Includes $82 million in loans serviced on an interim basis.
The Company directly services substantially all newly originated or purchased loans. As a result of the recent transfer in-house of loans previously serviced by a third party, the Company currently directly services substantially all of its servicing portfolio. The Company believes that continued technology and processing enhancements will provide it with improved margins on its servicing. The Company anticipates that during fiscal 1999 it will begin subservicing for third parties which will provide a new source of servicing revenue. However, no assurance can be given that the Company will be successful in its attempts to generate subservicing business.
The agreements between the Company and the real estate mortgage investment conduit ("REMIC") or owner trusts established in connection with securitizations typically require the Company to advance interest (but not principal) on delinquent loans to the holders of the senior interests in the related trust. The agreements also require the Company to make certain servicing advances (e.g., for property taxes or hazard insurance) unless the Company determines that such advances would not be recoverable. Realized losses on the loans are paid out of the related loss reserves established by the Company at the time of securitization or paid out of principal and interest payments on overcollateralized amounts as applicable, and if necessary, from the related monoline insurance policy or the subordinated interests.
In the case of securitizations credit-enhanced by monoline insurance, the agreements also typically provide that the Company may be terminated as servicer by the monoline insurance company (or by the trustee with the consent of the monoline insurance company) upon certain events of default, including the Company's failure to perform its obligations under the servicing agreement, the rate of over 90-day delinquency (including properties acquired by foreclosure and not sold) exceeding specified limits, losses on liquidation of collateral exceeding certain limits, any payment being made by the monoline insurance company under its policy, and certain events of bankruptcy or insolvency. At June 30, 1998, 12 trusts representing approximately 25.0% (by dollar volume) of the Company's servicing portfolio exceeded the specified delinquency rate, although the servicing rights of the Company have not been terminated. Seven of the 12 trusts plus one additional trust representing approximately 10% (by dollar volume) of the Company's servicing portfolio exceeded specified loss limits at June 30, 1998. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Factors -- Delinquencies and Losses in Securitization Trusts; Right to Terminate Mortgage Servicing; Negative Impact on Cash Flow." In the case of the Company's senior/subordinated securitization transactions, holders of 51% of the certificates may terminate the servicer upon certain events of default generally relating to certain levels of loss experience, but not delinquency rates. No such events of default have occurred to date in the Company's senior/subordinated securitizations.
The Company receives a servicing fee based on a percentage of the declining principal balance of each loan serviced. Servicing fees are collected by the Company out of the borrower's monthly payments. In addition, the Company, as servicer, generally receives all late fees and assumption charges paid by the borrower on loans serviced directly by the Company, as well as other miscellaneous fees for performing
various loan servicing functions. The Company also generally receives any prepayment fees paid by borrowers.
The Company's servicing portfolio is subject to reduction by normal monthly principal amortization, by prepayment and by foreclosure. It is the Company's strategy to build and retain its core servicing portfolio. In July 1998, the Company sold its subsidiary that serviced $55.7 million in loans for private investors for consideration that was immaterial to the Company. The Company had discontinued originating private investor loans in August 1997.
In general, revenue from the Company's loan servicing portfolio may be adversely affected by competitive market conditions that result in lower mortgage interest rates or accelerated prepayment activity, subject to the receipt by the Company of prepayment fee income. In some states in which the Company currently operates, prepayment fees may be limited or prohibited by applicable law.
The following table illustrates the mix of credit grades in the Company's servicing portfolio as of June 30, 1998:
COLLECTIONS, DELINQUENCIES AND FORECLOSURES
The Company sends borrowers a monthly billing statement approximately ten days prior to the monthly payment due date. Although borrowers generally make loan payments within ten to fifteen days after the due date (the "grace period"), if a borrower fails to pay the monthly payment within the grace period, the Company commences collection efforts by notifying the borrower of the delinquency. In the case of borrowers in the "B," "C," "C-" and "D" credit grades, collection efforts begin immediately after the due date. The Company continues contact with the borrower to determine the cause of the delinquency and to obtain a commitment to cure the delinquency at the earliest possible time.
As a general matter, if efforts to obtain payment have not been successful, a pre-foreclosure notice will be sent to the borrower immediately after the due date of the next subsequently scheduled installment (five days after the initial due date for C- and D credit grades), providing 30 days' notice of impending foreclosure action. During the 30-day notice period, collection efforts continue and the Company evaluates various legal
options and remedies to protect the value of the loan, including arranging for extended prepayment terms, accepting a deed-in-lieu of foreclosure, entering into a short sale (a sale for less than the outstanding principal amount) or commencing foreclosure proceedings. If no substantial progress has been made in collecting delinquent payments from the borrower, foreclosure proceedings will begin. Generally, the Company will have commenced foreclosure proceedings when a loan is 45 to 100 days delinquent, depending upon credit grade, other credit considerations or borrower bankruptcy status.
Servicing and collection practices change over time in accordance with, among other things, the Company's business judgment, changes in portfolio performance and applicable laws and regulations.
Loans originated or purchased by the Company are secured by mortgages, deeds of trust, security deeds or deeds to secure debt, depending upon the prevailing practice in the state in which the property securing the loan is located. Depending on local law, foreclosure is effected by judicial action or nonjudicial sale, and is subject to various notice and filing requirements. In general, the borrower, or any person having a junior encumbrance on the real estate, may cure a monetary default by paying the entire amount in arrears plus other designated costs and expenses incurred in enforcing the obligation during a statutorily prescribed reinstatement period. Generally, state law controls the amount of foreclosure expenses and costs, including attorneys' fees, which may be recovered by a lender, the minimum time required to foreclose and the reinstatement or redemption rights of the borrower.
Although foreclosure sales are typically public sales, frequently no third-party purchaser bids in excess of the lender's lien because of the difficulty of determining the exact status of title to the property, the possible deterioration of the property during the foreclosure proceedings and a requirement that the purchaser pay for the property in cash or by cashier's check. Thus, the Company often purchases the property from the trustee or referee through a credit bid in an amount up to the principal amount outstanding under the loan, accrued and unpaid interest, servicing advances and the expenses of foreclosure. Depending upon market conditions, the ultimate proceeds of the sale may not equal the Company's investment in the property.
The following table sets forth delinquency, foreclosure, loss and reserve information relating to the Company's servicing portfolio for the periods indicated:
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(1) Delinquent loans are loans for which more than one payment is past due.
(2) The delinquency and foreclosure percentages are calculated on the basis of the total dollar amount of mortgage loans originated or purchased by the Company and, in each case, serviced by the Company and any subservicers as of the end of the periods indicated. Percentages for fiscal year 1996 have not been restated to include delinquencies of loans originated by One Stop. The Company believes any such adjustment would not be material.
(3) At June 30, 1998, the dollar volume of loans delinquent more than 90 days in the Company's 12 REMIC trusts formed in November 1992, December 1992 and June 1993 and during the period from December 1994 to December 1996 exceeded the permitted limit in the related pooling and servicing agreements. Seven of those trusts plus one additional trust exceeded certain loss limits. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources;" and "- Risk Factors -- Delinquencies and Losses in Securitization Trusts; Right to Terminate Mortgage Servicing; Negative Impact on Cash Flow".
(4) The servicing portfolio used in percentage calculations includes $82 million of loans subserviced by the Company on an interim basis at June 30, 1998.
(5) Represents loans which are in foreclosure but as to which foreclosure proceedings have not concluded.
(6) Represents properties acquired following a foreclosure sale and still serviced by the Company.
(7) The increase in the number of loans foreclosed and principal amount of loans foreclosed in 1997 and 1998 relative to 1996 is due to the larger and more seasoned servicing portfolio.
(8) Represents losses net of gains on foreclosed properties sold during the periods indicated excluding the one-time charge referred to in footnote (9) below.
(9) Represents a one-time reversal of $6.0 million to the loss reserve recorded in March 1998 resulting from the Company's delay in recording information transferred from a third party servicer regarding loan payoffs. The amount was not sufficiently material to require adjustment of previously reported receivables or the reserve.
(10) Does not include the one-time charge referred to in footnote (9) above.
(11) Represents period end reserves for future liquidation losses.
The Company's servicing portfolio has grown over the periods presented. However, because foreclosures and losses typically occur months or years after a loan is originated, data relating to delinquencies, foreclosures and losses as a percentage of the current portfolio can understate the risk of future delinquencies, losses or foreclosures.
COMPETITION
The Company faces intense competition in the business of originating, purchasing and selling mortgage loans. The Company's competitors in the industry include other consumer finance companies, mortgage banking companies, investment banks, commercial banks, credit unions, thrift institutions, credit card issuers and insurance companies. Many of these competitors are substantially larger and have considerably greater financial, technical and marketing resources than the Company. In addition, many financial services organizations that are much larger than the Company have formed national loan origination networks or purchased home equity lenders offering loan products directed at the target market of the Company. Competition among industry participants can take many forms, including convenience in obtaining a loan, customer service, marketing and distribution channels, amount and term of the loan, loan origination fees and interest rates. In addition, the current level of gains realized by the Company and its competitors on the sale of non-conforming loans could attract additional competitors into this market. Additional competition may lower the rates the Company can charge borrowers and increase the price paid for purchased loans, thereby potentially lowering gain on future loan sales and securitizations. To the extent any of these competitors significantly expand their activities in the Company's market, the Company could be materially adversely affected. Fluctuations in interest rates and general economic conditions may also affect the Company's competition. During periods of rising rates, competitors that have locked in lower rates to potential borrowers may have a competitive advantage. During periods of declining rates, competitors may solicit the Company's customers to refinance their loans.
The Company believes its competitive strengths include: (i) emphasizing customer service to attract borrowers; (ii) providing a high level of service to brokers and their customers; (iii) offering competitive loan programs for borrowers whose needs are not met by conventional mortgage lenders; (iv) providing convenient locations for its retail, Retail Direct and broker offices and national geographic coverage in origination channels; and emphasizing customer service in its loan servicing division.
REGULATION
The Company's operations are subject to extensive regulation, supervision and licensing by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of its operations. The Company's consumer lending activities are subject to the Federal Truth-in-Lending Act and Regulation Z (including the Home Ownership and Equity Protection Act of 1994), the Federal Equal Credit Opportunity Act, as amended, and Regulation B, the Fair Credit Reporting Act of 1970, as amended, the Federal Real Estate Settlement Procedures Act and Regulation X, the Home Mortgage Disclosure Act, the Federal Debt Collection Practices Act and the National Housing Act of 1934, as well as other federal and state statutes and regulations affecting the Company's activities. The Company is also subject to the rules and regulations of, and examinations by, state regulatory authorities with respect to originating, processing, underwriting, selling, securitizing and servicing loans. These rules and regulations, among other things, impose licensing obligations on the Company, establish eligibility criteria for mortgage loans, prohibit discrimination, govern inspections and appraisals of properties and credit reports on loan applicants, regulate assessment, collection, foreclosure and claims handling, investment and interest payments on escrow balances and payment features, mandate certain disclosures and notices to borrowers and, in some cases, fix maximum interest rates, fees and mortgage loan
amounts. Failure to comply with these requirements can lead to loss of approved status, certain rights of rescission for mortgage loans, class action lawsuits and administrative enforcement action. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Risk Factors -- Government Regulation."
In the course of its business, the Company may acquire properties as a result of foreclosure. There is a risk that hazardous or toxic waste could be found on such properties. In such event, the Company could be held responsible for the cost of cleaning up or removing such waste, and such cost could exceed the value of the underlying properties.
The Company is also subject to various other federal and state laws regulating the issuance and sale of securities, relationships with entities regulated by the Employee Retirement Income Security Act of 1974, as amended, and other aspects of its business.
EMPLOYEES
At June 30, 1998, the Company employed 1,642 persons. The Company has satisfactory relations with its employees.
ITEM 2.
ITEM 2. PROPERTIES
The executive and administrative offices of the Company are located at 350 S. Grand Avenue, Los Angeles, California, and consist of approximately 178,000 square feet. The lease on these premises extends through February 2012. The Company also continues to lease space at its former headquarters location at 3731 Wilshire Boulevard, Los Angeles, California, which it will use for its telemarketing operations and future expansion of production related operations. This lease expires in October 2008. The executive and administrative offices of One Stop are located at 3347 Michaelson Drive, Irvine, California, and consist of approximately 46,911 square feet. The lease on these premises extends through July 31, 2003.
The Company and One Stop also lease space for their branch offices. These facilities aggregate approximately 339,000 square feet and are leased under terms which vary as to duration. In general, the leases expire between 1998 and 2002, and provide for rent escalations tied to either increases in the lessor's operating expenses or fluctuations in the consumer price index in the relevant geographical area.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company and certain of its present and former officers have been named in consolidated class actions filed in the United States District Court, Marc Dauber, et al. v. Aames Financial Corporation et al., Case No. 97-6714 (JMI) consolidated with Case Nos. 97-8095 (JMI) and 97-6814 (JMI), alleging violations of federal securities laws and in a parallel class action filed in Los Angeles County Superior Court of the State of California, Polin, et al. v. Aames Financial Corporation, et al., Case No. BC 177236, alleging violations of California securities laws. In the state action, plaintiffs represent a certified class of persons who purchased the Company's stock between January 29, 1997 and April 30, 1997. In the federal actions, the complaints on file identify a class period from January 23, 1996 through April 30, 1997, but in the as yet unfiled consolidated amended federal complaint the class period alleged has been shortened to match the state action.
The Company and the plaintiffs have entered into an agreement in principle for the settlement of the claims asserted in these parallel federal and state court actions. This settlement is subject to approval of the parties of the documentation required to evidence the settlement, which documentation will be filed with the
courts, and is further conditioned upon receiving preliminary and final approval by the appropriate courts. The Company believes that the settlement is in its best interests and will not have a material adverse impact on the Company's consolidated financial position or results of operations. By entering into this settlement in principle, the Company and its present and former officers and directors do not admit any wrongdoing and, in fact, deny any wrongdoing.
The Company is involved in litigation arising in the normal course of business. The Company believes that any liability with respect to such legal actions, individually or in the aggregate, is not likely to be material to the Company's consolidated financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
No matter was submitted during the fourth quarter of fiscal 1998 to a vote of the security holders of the Company.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In November 1995, the Company's common stock began trading under the symbol AAM on the New York Stock Exchange (NYSE). Prior to that time, the Company's common stock traded on the NASDAQ National Market under the symbol AAMS. The following table sets forth the range of high and low sale prices and per share cash dividends declared for the periods indicated. All share prices and cash dividends through February 21, 1997 have been adjusted to reflect the three-for-two stock split in the form of a stock dividend effected on that date and the three-for-two stock split in the form of a stock dividend effected on May 17, 1996.
- ------------------------ * As reported by Bloomberg
As of August 12, 1998, the Company had 205 stockholders of record. Since its initial public offering on December 3, 1991, the Company has consistently paid quarterly cash dividends on its common stock. The Company declared and subsequently paid an aggregate of $0.13 per share in dividends for the fiscal year ended June 30, 1998, representing approximately 9.4% of its net income for the period. The Board of Directors of the Company reviews the Company's dividend policy at least annually in light of the earnings, cash position and capital needs of the Company, general business conditions and other relevant factors. Bank agreements generally limit the Company's ability to pay dividends if such payment would result in an event
of default under the agreements. The Company's Indenture relating to its 9.125% Senior Notes due 2003 prohibits the payment of dividends if the aggregate amount of such dividends since October 26, 1996 exceeds the sum of (a) 25% of the Company's net income during that period; (b) net cash proceeds from any securities issuances; and (c) proceeds from the sale of certain investments. The Company's Indenture of Trust relating to its 10.50% Senior Notes due 2002 restricts the payment of dividends to an amount which does not exceed (i) $2.0 million, plus (ii) 50% of the Company's aggregate net income for each fiscal year after the year ended June 30, 1994, plus (iii) 100% of the net proceeds received by the Company on offerings of its equity securities after December 31, 1994.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data for the Company for the five year period ended June 30, 1998 have been derived from the audited Consolidated Financial Statements. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and Notes thereto and other financial information included herein. The selected consolidated financial data gives pro forma effect to the acquisition of One Stop in August 1996.
------------ (1) Represents net income divided by the average servicing portfolio for the fiscal year presented.
(2) Computed on loans originated or purchased during the period.
(3) The weighted average initial combined loan-to-value ratio is determined by dividing the sum of all loans secured by the junior or senior mortgages on the property by the appraised value at origination.
(4) Represents the sum of interest-only strips, residual assets and mortgage servicing rights. See Note 1 of Notes to Consolidated Financial Statements.
(5) Excludes nonrecurring charges; $32 million (pre-tax) for fiscal 1997.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with Item 6. Selected Financial Data and Item 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are attached to this report:
Reports of Independent Accountants Consolidated Balance Sheets at June 30, 1998 and 1997 Consolidated Statements of Income for Fiscal Years Ended June 30, 1998, 1997 and 1996 Consolidated Statements of Stockholders' Equity for Fiscal Years Ended June 30, 1998, 1997 and 1996 Consolidated Statements of Cash Flows for Fiscal Years Ended June 30, 1998, 1997 and 1996 Notes to Consolidated Financial Statements
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
Information regarding directors and executive officers of the Registrant will appear in the proxy statement for the 1998 Annual Meeting of Stockholders or an amendment to this Form 10-K, and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation will appear in the proxy statement for the 1998 Annual Meeting of Stockholders or an amendment to this Form 10-K, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information regarding security ownership of certain beneficial owners and management will appear in the proxy statement for the 1998 Annual Meeting of Stockholders or an amendment to this Form 10-K, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions will appear in the proxy statement for the 1998 Annual Meeting of Stockholders or an amendment to this Form 10-K, and is incorporated by this reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Financial Statements:
See Financial Statements listed as part of Item 8. Financial Statements and Supplementary Data.
(b) Financial Statement Schedules:
Schedule 6 Property, Plant and Equipment. Schedule 7 Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment.
See pages and attached to this report.
(c) Exhibits - Management Contracts and Compensatory Plans:
-----------------
(1) Incorporated by reference from Registrant's Registration Statement on Form S-1, File No. 33-43237.
(2) Incorporated by reference from Registrant's Registration Statement on Form S-1, File No. 33-62400.
(3) Incorporated by reference from Registrant's Registration Statement, File No. 333-01312.
(4) Incorporated by reference from Registrant's Registration Statement on Form 8-A, File No. 33-13660.
(5) Incorporated by reference from Registrant's Registration Statement on Form S-2, File No. 33-88516.
(6) Incorporated by reference from Registrant's Annual Report on Form 10-K for the year ended June 30, 1995.
(7) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996.
(8) Incorporated by reference from Registrant's Registration Statement on Form S-2, File No. 33-91640.
(9) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q for the quarter ended December 31, 1995.
(10) Incorporated by reference from Registrant's Annual Report on Form 10-K for the year ended June 30, 1996, filed with the Commission on September 16, 1996.
(11) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996.
(12) Incorporated by reference from Registrant's Registration Statement on Form S-8 dated January 6, 1997.
(13) Incorporated by reference from Registrant's Current Report on Form 8-K dated April 24, 1998.
(14) Incorporated by reference from Registrant's Current Report on Form 8-K dated September 11, 1996.
(15) Incorporated by reference from Registrant's Annual Report on Form 10-K for the year ended June 30, 1997.
(16) Incorporated by reference from Registrant's Registration Statement on Form S-8 dated July 24, 1998.
(17) Incorporated by reference from Registrant's Current Report on Form 8-K dated April 27, 1998.
(18) Incorporated by reference from Registrant's Registration Statement on Form 8-A/A dated April 27, 1998.
(19) Incorporated by reference from Registrant's Current Report on Form 8-K dated March 25, 1998.
(e) Reports on Form 8-K:
During the last quarter of the fiscal year ended June 30, 1998, the Company filed (i) a Current Report on Form 8-K dated April 24, 1998 (earliest event reported April 10, 1998), reporting information under Item 5 with respect to the execution of the Second Amended and Restated Mortgage Loan Warehousing Agreement by and among the Company, ACC, NationsBank of Texas, N.A. and the lenders from time to time party thereto; and (ii) a Current Report on Form 8-K dated April 27, 1998 (earliest event reported April 27, 1998), reporting information under Item 5 with respect to the acquisition of shares of the Company's common stock and warrants to purchase the common stock by Thirty-Five East Investments LLC and Turtle Creek Revocable Trust.
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.
AAMES FINANCIAL CORPORATION (Registrant)
Dated: By: /s/ Cary H. Thompson ----------------------- ----------------------------- Cary H. Thompson Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
Management Contracts and Compensatory Plans:
- -------------------
(1) Incorporated by reference from Registrant's Registration Statement on Form S-1, File No. 33-43237.
(2) Incorporated by reference from Registrant's Registration Statement on Form S-1, File No. 33-62400.
(3) Incorporated by reference from Registrant's Registration Statement, File No. 333-01312.
(4) Incorporated by reference from Registrant's Registration Statement on Form 8-A, File No. 33-13660.
(5) Incorporated by reference from Registrant's Registration Statement on Form S-2, File No. 33-88516.
(6) Incorporated by reference from Registrant's Annual Report on Form 10-K for the year ended June 30, 1995.
(7) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1996.
(8) Incorporated by reference from Registrant's Registration Statement on Form S-2, File No. 33-91640.
(9) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q for the quarter ended December 31, 1995.
(10) Incorporated by reference from Registrant's Annual Report on Form 10-K for the year ended June 30, 1996, filed with the Commission on September 16, 1996.
(11) Incorporated by reference from Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996.
(12) Incorporated by reference from Registrant's Registration Statement on Form S-8 dated January 6, 1997.
(13) Incorporated by reference from Registrant's Current Report on Form 8-K dated April 24, 1998.
(14) Incorporated by reference from Registrant's Current Report on Form 8-K dated September 11, 1996.
(15) Incorporated by reference from Registrant's Annual Report on Form 10-K for the year ended June 30, 1997.
(16) Incorporated by reference from Registrant's Registration Statement on Form S-8 dated July 24, 1998.
(17) Incorporated by reference from Registrant's Current Report on Form 8-K dated April 27, 1998.
(18) Incorporated by reference from Registrant's Registration Statement on Form 8-A/A dated April 27, 1998.
(19) Incorporated by reference from Registrant's Current Report on Form 8-K dated March 25, 1998.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Aames Financial Corporation
In our opinion, based upon our audits and the report of other auditors, the accompanying consolidated balance sheets and the related consolidated statements of income, of stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Aames Financial Corporation and its subsidiaries (the "Company") at June 30, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 1998, in conformity with generally accepted accounting principles. 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 did not audit the financial statements of One Stop Mortgage, Inc., a wholly-owned subsidiary, which statements reflect total revenues of $7 million for the period from August 24, 1995 (inception) through June 30, 1996. Those statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for One Stop Mortgage, Inc. is based solely on the report of the other auditors. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for the opinion expressed above.
As discussed in Note 1 to the consolidated financial statements, the Company adopted accounting standards that changed its method of accounting for transfers and servicing of financial assets during the year ended June 30, 1997 and its method of accounting for mortgage servicing rights for the year ended June 30, 1996.
The audits referred to above also included an audit of the financial statement schedules listed in Item 14. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
Los Angeles, California August 6, 1998
INDEPENDENT AUDITORS' REPORT
The Board of Directors One Stop Mortgage, Inc.
We have audited the statements of operations, changes in stockholders' equity and cash flows of One Stop Mortgage, Inc. (the Company) for the period January 1, 1996 through June 30, 1996 and the period August 24, 1995 (inception) through December 31, 1995. These financial statements, which are not separately presented herein, 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 generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations of One Stop Mortgage, Inc. and its cash flows for the period January 1, 1996 through June 30, 1996 and the period August 24, 1995 (inception) through December 31, 1995 in conformity with generally accepted accounting principles.
/s/ KPMG PEAT MARWICK LLP
Orange County, California August 16, 1996
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these financial statements
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of these financial statements
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AAMES FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
OPERATIONS
Aames Financial Corporation (the "Company" or "Aames") is a consumer finance company primarily engaged, through its subsidiaries, in the business of originating, purchasing, selling, and servicing home equity mortgages secured by single family residences. At June 30, 1998, Aames operated 98 retail loan offices serving 32 states. At June 30, 1998, 12 of the 98 branches were located in California. Its wholly-owned subsidiary, One Stop Mortgage, Inc. ("One Stop") operated 46 offices located in 45 states and one international office located in England. At June 30, 1998, 4 of the 46 domestic branches were located in California. The Company originates and purchases loans on a nationwide basis through three production channels--retail, broker and correspondent. For the years ended June 30, 1998 and 1997, the Company originated and purchased $2.38 billion and $2.35 billion of mortgage loans, respectively. The Company's principal market is borrowers whose financing needs are not being met by traditional mortgage lenders for a variety of reasons, including the need for specialized loan products or credit histories that may limit such borrowers' access to credit. Loans originated by the Company are extended on the basis of the equity in the borrower's property and the creditworthiness of the borrower. The aggregate outstanding balance of loans serviced by the Company was $4.15 billion and $3.17 billion at June 30, 1998 and June 30, 1997, respectively (which include $206 million and $1.67 billion of loans at June 30, 1998 and June 30, 1997, respectively, serviced for the Company by unaffiliated subservicers under subservicing agreements).
LOAN SALES
The Company's ability to sell loans originated and purchased by it in the secondary market is necessary to generate cash proceeds to pay down its warehouse facilities and fund new originations and purchases. The ability of the Company to sell loans in the secondary market on acceptable terms is essential for the continuation of the Company's loan origination and purchase operations.
ACQUISITION OF ONE STOP
On August 28, 1996, the Company acquired One Stop, through the merger of a wholly-owned subsidiary of the Company into One Stop, in a tax-free exchange accounted for as a pooling of interests, in which the Company issued approximately 3.49 million shares (adjusted for the three-for-two stock split in the form of a stock dividend in February 1997) of its common stock, par value $.001 per share ("common stock"), and assumed options granted to key employees to purchase approximately 563,000 shares (adjusted for the three-for-two stock split in the form of a stock dividend in February 1997) of common stock. Under the pooling rules, the costs incurred by the Company and One Stop in consummating the merger were expensed in the first quarter of fiscal 1997. All prior years financial statements have been restated to include One Stop.
The following table shows the pro-forma effect of the merger:
One Stop's operations, from the period July 1, 1996 through August 28, 1996, were immaterial to restate separately.
PRINCIPLES OF ACCOUNTING AND CONSOLIDATION
The consolidated financial statements of the Company include the accounts of Aames and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
CASH IN TRUST
The Company services loans on behalf of customers. In such capacity, certain monies are collected and placed in segregated trust accounts, which totaled $57.8 million and $28.3 million at June 30, 1998 and June 30, 1997, respectively. These accounts and corresponding liabilities are not included in the accompanying balance sheet.
EQUIPMENT AND IMPROVEMENTS
Equipment and improvements are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are being recorded utilizing straight-line and accelerated methods over the following estimated useful lives:
REVENUE RECOGNITION
The Company adopted Statement of Financial Accounting Standards ("SFAS") 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 125") effective January 1, 1997. The adoption of SFAS 125 did not have a material effect on the Company's results of operations for the year ended June 30, 1997. As a result of the adoption of SFAS 125, the Company records amounts previously categorized as "Excess servicing gains" in the Consolidated Statements of Income as "Gain on sale of loans." Additionally, the Company now records the right to future interest income that exceeds contractually specified servicing fees and previously recorded as "Excess servicing receivable" as an investment security called "Interest-only strips." The Company has classified this asset as a trading security and during the year ended June 30, 1998, recorded a net unrealized gain of $19.5 million on the valuation of this security. SFAS 125 requires that this mark-to-market adjustment be reported separately from "Gain on sale of loans."
In fiscal year 1996, the Company adopted SFAS 122. Under SFAS 122, the Company recognized originated mortgage servicing rights ("OMSRs") as assets separate from the mortgage loans to which the OMSRs relate based on their respective fair values. Prior to SFAS 122, the Company allocated the entire cost of originating or purchasing mortgage loans to the carrying value of such mortgage loans. The effect of adopting SFAS 122 was to increase the net income of the Company for the fiscal year ended June 30,1996, by $5.7 million, or $0.21 per fully diluted weighted average share.
In a securitization, the Company conveys loans that it has originated or purchased to a separate entity (such as a trust or trust estate) in exchange for cash proceeds and an interest in the loans securitized represented by the non-cash gain on sale of loans. The cash proceeds are raised through an offering of the pass-through certificates or bonds evidencing the right to receive principal payments on the securitized loans and the interest rate on the certificate balance or on the bonds. The gain on sale of loans represents the difference between the proceeds (including premiums) from the sale, net of related transaction costs, and the allocated carrying amount of the loans sold. The allocated carrying amount is determined by allocating the original amount of the loan (including premiums paid on loans purchased) between the portion sold and any retained interests (interest-only strip), based on their relative fair values at the date of transfer. The interest-only strip represents, over the estimated life of the loans, the present value of the excess of the weighted average coupon on each pool of loans sold over the sum of the interest rate paid to investors, the contractual servicing fee (currently .50%) and a monoline insurance fee, if any, adjusted for the reserve for loan losses. Unrealized gains or losses include the recognition of an unrealized gain or loss which represents the initial difference between the allocated carrying amount and the fair market value of the interest-only strip at the date of sale. Each agreement that the Company has entered into in connection with its securitizations requires either the overcollateralization of the trust or the establishment of a reserve account that may initially be funded by cash deposited by the Company. The Company's interest in each overcollateralization amount and reserve account is reflected on the Company's Consolidated Financial Statements as "residual assets" and is recorded as of the time such amounts are received by the trust.
The Company determines the present value of the cash flows at the time each securitization transaction closes using certain estimates made by management at the time the loans are sold. These estimates include: (i) future rate of prepayment; (ii) discount rate used to calculate present value; and (iii) the provision for credit losses on loans sold. There can be no assurance of the accuracy of management's estimates.
Additionally, upon sale or securitization of servicing retained mortgages, the Company capitalizes mortgage servicing rights separate from the loan. The Company determines fair value based on the present value of estimated net future cash flows related to servicing income. The cost allocated to the servicing rights is amortized in proportion to and over the period of estimated net future servicing fee income. The Company periodically reviews capitalized servicing rights for valuation impairment. This review is performed on a disaggregated basis for the predominant risk characteristics of the underlying loans which are loan type and origination date. At June 30, 1998 and 1997, there were no valuation allowances on mortgage servicing rights.
INCOME TAXES
Taxes are provided on substantially all income and expense items included in earnings, regardless of the period in which such items are recognized for tax purposes. The Company uses an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, the Company generally considers all expected future events other than the enactment of changes in the tax law or rates.
RISK MANAGEMENT
The Company's earnings may be directly affected by the level of and fluctuation in interest rates and the level of prepayment in the Company's securitizations. The Company currently hedges its fixed rate pipeline and some LIBOR-based tranches in its fixed rate securitizations, and continues to explore other avenues of risk mitigation, although none have been employed to date. The current fixed rate hedge products utilized are swap agreements with third parties that sell United States Treasury securities not yet purchased and the purchase of Treasury put options. The hedge instrument used on the existing LIBOR-based tranches secured by fixed rate mortgages is an interest rate contract with a specified LIBOR rate cap. The amount and timing of hedging transactions are determined by members of the Company's senior management. The Company is currently reevaluating its current hedging policy.
CASH AND CASH EQUIVALENTS
At June 30, 1998, the Company had $12.3 million in cash, of which $1.6 million was held in a restricted account in connection with the securitization closed in June 1998. These funds were released to the Company in July 1998.
LOANS HELD FOR SALE
Loans held for sale are carried at the lower of aggregate cost or market value. Market value is determined by current investor yield requirements.
ACCOUNTS RECEIVABLE
Accounts receivable primarily consisted of pool related advances, accrued interest receivable and various servicing advances.
RESIDUAL ASSETS
In connection with its securitization transactions, the Company initially deposits with a trustee cash or the required overcollateralization amount, and subsequently deposits a portion of the servicing spread collected on the related loans. The amounts set aside ($195 million at June 30, 1998 and $113 million at June 30, 1997) are available for distribution to investors in the event of certain shortfalls in amounts due to investors. These amounts are subject to increase up to maximum subordination amounts as specified in the related securitization documents. Cash amounts on deposit are invested in certain instruments as permitted by the related securitization documents. To the extent amounts on deposit exceed specified levels, distributions are made to the Company and, at the termination of the related trust, any remaining amounts on deposit are distributed to the Company.
DEBT ISSUANCE COSTS
At June 30, 1998 and 1997, the Company had an unamortized balance of debt issuance costs of $7.2 million and $8.41 million, respectively, related to the issuance of $23.0 million of 10.5% Senior Notes due 2002, the issuance of $115 million of 5.5% Convertible Subordinated Debentures due 2006 and the issuance of $150 million of 9.125% Senior Notes due 2003. This balance is included in "Prepaid and other" on the Consolidated Balance Sheets and is amortized into expense over the life of the related debt.
EARNINGS PER SHARE
Basic earnings per share of common stock is computed using the weighted average number of shares of common stock outstanding during each period. For fully diluted earnings per share, the conversion of shares related to the Company's 5.5% Convertible Subordinated Debentures due 2006 is included as well as the average number of stock options outstanding.
All references in the accompanying Consolidated Balance Sheets, Consolidated Statements of Earnings and Notes to Consolidated Financial Statements to the number of common shares and share amounts have been restated to reflect the three-for-two stock splits in the form of stock dividends effected on February 21, 1997 and May 17, 1996, and the Company's presentation of basic Earnings per Share ("EPS") under the adoption of FAS 128 in fiscal year 1998.
RECLASSIFICATIONS
Certain amounts related to 1997 and 1996 have been reclassified to conform to the 1998 presentation.
ADOPTION OF RECENT ACCOUNTING STANDARDS
In October 1995, the Financial Accounting Standards Board ("FASB") released SFAS 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). This statement establishes methods of accounting for stock-based compensation plans. SFAS 123 is effective for fiscal years beginning after December 15, 1995. The Company adopted SFAS 123 in fiscal year 1997. The adoption of SFAS 123 did not have a material effect on the financial position of the Company. See Note 9.
In February 1997, the FASB issued SFAS 128, "Earnings Per Share" ("SFAS 128") which establishes standards for computing and presenting earnings per share ("EPS") by replacing the presentation of primary EPS with a presentation of basic EPS. Primary EPS includes common stock equivalents while basic EPS excludes them. This change simplifies the computation of EPS. It also requires dual presentation of basic and fully diluted EPS on the face of the income statement for all entities with complex capital structures. The Company adopted SFAS 128 effective December 31, 1997.
In February 1997, the FASB issued SFAS 129, "Disclosure of Information about Capital Structure" ("SFAS 129"). SFAS 129 establishes disclosure requirements regarding pertinent rights and privileges of outstanding securities. Examples of disclosure items regarding securities include, though are not limited to, items such as dividend and liquidation preferences, participation rights, call prices and dates, conversion or exercise prices or rates. The number of shares issued upon conversion, exercise or satisfaction of required conditions during at least the most recent annual fiscal period and any subsequent interim period must also be disclosed. Disclosure of liquidation preferences of preferred stock in the equity section of the Balance Sheet is also required. The Company adopted SFAS 129 for the fiscal year 1998.
In June 1997, FASB issued SFAS 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes disclosure standards for reporting comprehensive income in a full set of general purpose financial statements. SFAS 130 is effective for fiscal years beginning after December 15, 1997. The adoption of this standard is not expected to have an impact on the Company's financial position or results of operations.
In June 1997, the FASB issued SFAS 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131") which is effective for periods beginning after December 15, 1997. SFAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The adoption of this standard is not expected to have an impact on the Company's financial position or results of operations.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," effective for fiscal years beginning after June 15, 1999. SFAS No. 133 requires companies to record derivatives on the balance sheet as assets and liabilities, measured at fair value.
Gains and losses resulting from changes in the values of those derivatives would be accounted for as components of comprehensive income depending on the use of the derivative and whether it qualifies for hedge accounting. The Company has not determined the impact that adoption of this standard will have on its future consolidated financial statements. The Company plans to adopt SFAS No. 133 by July 1, 2000, as required.
NOTE 2 NONRECURRING CHARGES
In fiscal 1997, the Company incurred $32.0 million of nonrecurring charges. Approximately $25.0 million of these charges were recognized in August 1996 directly related to the acquisition of One Stop. The remaining amount relates to a reserve for relocating corporate headquarters recorded in the first quarter and to severance and other strategic decisions made in the fourth quarter.
NOTE 3 INTEREST-ONLY STRIPS AND MORTGAGE SERVICING RIGHTS
The activity in the interest-only strips is summarized as follows:
The activity in mortgage servicing rights is summarized as follows:
The Company determines fair value for both the interest-only strips and the mortgage servicing rights based on rates used to discount the future cash flows, which were 10.8% and 11.4% for the years ended June 30, 1998 and 1997, respectively. The Company retains a certain amount of credit risk on loans securitized. The Company had reserves of $50.3 million and $43.6 million at June 30, 1998 and 1997, respectively, related to these credit risk obligations, which are netted against the interest-only strips. The weighted average loss reserves were 1.93% and 1.50% of the amount securitized for the years ended June 30, 1998 and 1997, respectively.
The interest-only strips and the mortgage servicing rights are amortized over the estimated lives of the loans to which they relate. At June 30, 1998 and 1997, the unamortized balance of the interest-only strips was $360 million and $270 million, respectively.
NOTE 4 EQUIPMENT AND IMPROVEMENTS
Equipment and improvements consisted of the following:
NOTE 5 BORROWINGS AND REVOLVING WAREHOUSE FACILITIES
Borrowings consist of the following:
Maturities on borrowings are as follows:
Amounts outstanding under revolving warehouse facilities:
NOTE 6 INCOME TAXES
The provision for income taxes consists of the following:
The financial statement balances at June 30, 1998 and 1997 are as follows:
Deferred tax liabilities (assets) consists of the following:
Effective tax rate calculation for fiscal year ended June 30, 1998:
Effective tax rate calculation for fiscal year ended June 30, 1997:
For 1996 the Company's effective tax rate was computed using the appropriate statutory rates with no significant differences.
NOTE 7 COMMITMENTS AND CONTINGENCIES
The Company leases office space under operating leases expiring at various dates through February 2012. In addition, in February 1996, the Company entered into an operating lease for an airplane, which expires February 2006. Total rent expense related to operating leases amounted to $9.1 million, $5.3 million and $3.2 million, for the years ended June 30, 1998, 1997 and 1996, respectively. Certain leases have provisions for renewal options and/or rental increases at specified increments or in relation to increases in the Consumer Price Index (as defined). As of June 30, 1998, listed below are future minimum rental payments required under non-cancelable operating leases that have initial or remaining terms in excess of one year:
LITIGATION
In the ordinary course of its business, the Company is subject to claims made against it by borrowers and private investors arising from, among other things, losses that are claimed to have been incurred as a result of alleged breaches of fiduciary obligations, misrepresentations, errors and omissions of employees and officers of the Company, incomplete documentation and failures by the Company to comply with various laws and regulations applicable to its business. The Company believes that liability with respect to any currently asserted claims or legal action is not likely to be material to the Company's financial position or results of operations; however, any claims asserted in the future may result in legal expenses which could have a material adverse effect on the Company's financial position and results of operations.
EMPLOYMENT AND SEVERANCE AGREEMENTS
The Chief Executive Officer has an employment agreement with the Company expiring on June 30, 2001, which provides for a base salary and a performance bonus measured against a target return on equity. In addition, certain options were granted thereunder. (See "Note 9 - Notes to Consolidated Financial Statements.") The agreement also provides that, in the event of a termination without cause or in the event of certain changes in control, the Company shall pay two years base salary plus an amount equal to his performance bonus over the previous eight quarters.
The President has an employment agreement with the Company expiring on August 26, 2003, which provides for a base salary and quarterly performance bonuses of between $1.35 million and $1.65 million depending on broker and retail loan production. The agreement also provides that, in the event of a termination without cause, the Company will pay an amount equal to the base salary for the remaining term of the agreement, plus $30 million minus the performance bonuses paid prior to termination ("performance payment"). In the event of a change in control, the Company will pay the performance payment.
Certain other members of management have employment or severance agreements which provide for enhanced severance and other benefits upon a change in control, as defined in the agreements.
NOTE 8 FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosures of the estimated fair value of financial instruments as of June 30, 1998 and 1997 are made by the Company using available market information, historical data, and appropriate valuation methodologies. However, considerable judgment is required to interpret market and historical data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange.
The use of different market assumptions and/or estimation methodologies may have a material
effect on the estimated fair value amounts.
The fair value estimates as of June 30, 1998 and 1997 are based on pertinent information available to management as of the respective dates. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been revalued for purposes of these financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.
The following describes the methods and assumptions used by the Company in estimating fair values:
Cash and cash equivalents are based on the carrying amount which is a reasonable estimate of the fair value.
Loans held for sale are based on current investor yield requirements.
Interest-only strips and mortgage servicing rights are based on the expected future cash flows using assumptions based on Company-specific and industry information as well as the Company's historical experience.
Amounts outstanding under revolving warehouse facilities are short term in nature and generally bear market rates of interest and therefore, are based on the carrying amount which is a reasonable estimate of fair value.
Borrowings are based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities.
Hedge positions are based on quoted market prices.
NOTE 9 EMPLOYEE BENEFIT PLANS
401(K) RETIREMENT SAVINGS PLAN
The Company sponsors a 401(k) Retirement Savings Plan, a defined contribution plan.
Substantially all employees are eligible to participate in the plan after reaching the age of 21 and completion of six months of service. Contributions are made from employees' elected salary deferrals. Employer contributions are determined at the beginning of the plan year at the option of the employer. For fiscal years 1998, 1997 and 1996, the Company's contribution to the plan aggregated $549,000, $432,000 and $252,000, respectively.
DEFERRED COMPENSATION PLAN
In April 1997, the Company implemented a Deferred Compensation Plan for highly compensated employees and directors of the Company. The plan is unfunded and non-qualified. Eligible participants may defer a portion of their compensation and receive a Company matching amount up to 4% of their annual base salary. The Company may also make discretionary contributions to the plan. For the 1998 fiscal year, the Company made $203,700 of discretionary contributions to the plan.
STOCK BASED COMPENSATION
The Company has reserved 5,450,000 shares of the common stock for issuance under its 1991 Stock Incentive Plan, 1995 Stock Incentive Plan, 1996 Stock Incentive Plan, 1997 Stock Option Plan and 1997 Non-Qualified Stock Option Plan. Under these plans, the Company may grant incentive and non-qualified options to eligible participants that may vest immediately on the date of grant or in accordance with a vesting schedule, as determined in the sole discretion of the Compensation Committee of the Company's Board of Directors. The exercise price is based on the closing price of the common stock on the day before the date of grant. Each option plan provides for a term of 10 years. The Company has also granted options outside of these plans, on terms established by the Compensation Committee. A summary of the Company's stock option plans and arrangements as of June 30, 1998, 1997 and 1996 and changes during the years then ended are as follows:
(1) Includes options assumed in One Stop acquisition.
The number of options exercisable at June 30, 1998 and 1997, was 2,324,755 and 1,563,722, respectively. The weighted-average fair value of options granted during 1998 and 1997 was $18.56 and $13.83, respectively.
The Company applies APB Opinion 25 and related interpretations in accounting for its stock-based compensation plans and arrangements. No compensation cost has been recognized for its stock option plan. If compensation cost for the stock option plan and arrangements had been determined based on the fair value at the grant dates for awards under this plan consistent with the method prescribed by SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
NOTE 10 STOCKHOLDERS' EQUITY
The Company issued a three-for-two stock split in the form of a stock dividend on February 21, 1997 to stockholders of record on February 10, 1997. The split was effected as a dividend of one share of common stock for every two shares of common stock outstanding. After giving effect to this stock split, the Company had 27.8 million shares outstanding at June 30, 1998.
The Company issued a three-for-two stock split in the form of a stock dividend on May 17, 1996 to stockholders of record on May 6, 1996. The split was effected as a dividend of one share of common stock on every two shares of common stock outstanding. After giving effect to this stock split, the Company had 23.8 million shares outstanding at June 30, 1997.
On October 10, 1996, the Company completed the sale of 3.62 million shares of common stock in a public offering. The proceeds to the Company from the offering, net of expenses, were $118 million.
The Company's bank agreements generally limit the Company's ability to pay dividends to an amount equal to 85% of its net income. In addition, the Company's indentures relating to its 10.5% Senior Notes due 2002 and 9.125% Senior Notes due 2003 place certain restrictions on the payment of dividends and the encumbrance of additional indebtedness based on the Company's net worth.
In June 1996, the Board of Directors of the Company declared a dividend distribution of one preferred stock purchase right ("Right") on each share of the Company's common stock outstanding on July 12, 1996. Each Right, when exercisable, entitles the holder to purchase from the Company one one-hundredth of a share of Preferred Stock, par value $0.001 per share, of the Company at a price of $100.00, subject to adjustments in certain cases to prevent dilution.
The Rights will become exercisable (with certain limited exceptions provided in the Rights agreement) following the 10th day after (a) a person or group announces acquisition of 15 percent or more of the common stock, (b) a person or group announces commencement of a tender offer, the consummation of which would result in ownership by the person or group of 15 percent or more of the common stock, (c) the filing of a registration statement for an exchange offer of 15 percent or more of the common stock under the Securities Act of 1933, as amended, or (d) the Company's board of continuing directors determines that a person is an "adverse person," as defined in the Rights agreement.
On April 27, 1998, the Company issued 2.78 million shares of its common stock, or 9.9% of the Company's outstanding shares, to private entities controlled by Ronald Perelman and Gerald Ford, at a purchase price of $13.7625 per share, or approximately $38 million. The purchase price represented the average of the closing sales prices of the Company's common stock on the New
York Stock Exchange during the 15-day period preceding the signing of the agreement (March 19, 1998). As part of the agreement, the Company also issued warrants to these entities to purchase an aggregate additional 9.9% of the Company's stock at an exercise price of $17.2031 (125% of the purchase price of the stock), subject to customary anti-dilution provisions. The warrants are exercisable only upon a change in control of the Company and expire in three years.
EPS BASIC TO FULLY DILUTED RECONCILIATION
NOTE 11 SUBSIDIARY GUARANTORS
In October 1996, the Company completed an offering of its 9.125% Senior Notes due 2003 which were guaranteed by all of the Company's subsidiaries, all of which are wholly-owned. The guarantees are joint and several, full, complete and unconditional. There are no restrictions on the ability of such subsidiaries to transfer funds to the Company in the form of cash dividends, loans or advances. The Company is a holding company with limited assets or operations other than its investments in its subsidiaries. Separate financial statements of the guarantors are not presented because the aggregate total assets, net earnings and net equity of such subsidiaries are substantially equivalent to the total assets, net earnings and net equity of the Company on a consolidated basis.
NOTE 12 QUARTERLY FINANCIAL DATA (UNAUDITED)
NOTE 13 FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET ACTIVITIES
Securitizations - Hedging Interest Rate Risk
The most significant variable in the determination of gain on sale in a securitization is the spread between the weighted average coupon on the securitized loans and the pass-through interest rate. In the interim period between loan origination or purchase and securitization of such loans, the Company is exposed to interest rate risk. The majority of loans are securitized within 90 days of origination or purchase. However, a portion of the loans are held for sale or securitization for as long as twelve months (or longer, in very limited circumstances) prior to securitization. If interest rates rise during the period that the mortgage loans are held, the spread between the weighted average interest rate on the loans to be securitized and the pass-through interest rates on the securities to be sold (the latter having increased as a result of market interest rate movements) would narrow. Upon securitization, this would result in a reduction of the Company's
related gain on sale. The Company mitigates this exposure through swap agreements with third parties that sell United States Treasury securities not yet purchased and the purchase of Treasury Put Options. Hedge gains or losses are initially deferred and subsequently included in gain on sale upon completion of the securitization. With respect to the Company's securitizations, gain on sale included hedge losses of $1.30 million and $3.04 million in fiscal 1998 and 1997, respectively. These hedging activities help mitigate the risk of absolute movements in interest rates but they do not mitigate the risk of a widening in the spreads between pass-through certificates and U.S. Treasury securities with comparable maturities.
Credit Risk
The Company is exposed to on-balance sheet credit risk related to its receivables and interest-only strips and residual certificates. The Company is exposed to off-balance sheet credit risk related to loans which the Company has committed to originate or purchase.
The Company is a party to financial instruments with off-balance sheet credit risk in the normal course of business. These financial instruments include commitments to extend credit to borrowers and commitments to purchase loans from correspondents. The Company has a first or second lien position on all of its loans, and the combined loan-to-value ratio ("CLTV") permitted by the Company's mortgage underwriting guidelines generally may not exceed 90%. The CLTV represents the combined first and second mortgage balances as a percentage of the appraised value of the mortgaged property, with the appraised value determined by an appraiser with appropriate professional designations. A title insurance policy is required for all loans.
Warehousing Exposure
The Company utilizes warehouse financing facilities to facilitate the holding of mortgage loans prior to securitization. As of June 30, 1998 and 1997, the Company had total warehouse facilities available in the amount of $950 million and $600 million, respectively; the total outstanding related to these facilities was $141 million and $137 million at June 30, 1998 and 1997, respectively. Warehouse facilities are typically for a term of one year or less and are designated to fund mortgages originated within specified underwriting guidelines. The majority of the assets remain in the facilities for a period of up to 90 days at which point they are securitized and sold to institutional investors. As these amounts are short term in nature and/or generally bear market rates of interest, the contractual amounts of these instruments are reasonable estimates of their fair values.
AAMES FINANCIAL CORPORATION RULE 12-06 PROPERTY PLANT AND EQUIPMENT FISCAL YEARS 1998, 1997 AND 1996
AAMES FINANCIAL CORPORATION RULE 12-07 ACCUMULATED DEPRECIATION DEPLETION AND AMORTIZATION OF PROPERTY PLANT AND EQUIPMENT FISCAL YEARS 1998, 1997 AND 1996