ITEM 1.
BUSINESS
GENERAL
Triad Financial Corporation (the “Company”) was incorporated as a California corporation on May 19, 1989. We engage primarily in the business of purchasing and servicing automobile retail installment sales contracts originated by automobile dealers located throughout the United States. We also originate automobile loans directly to consumers. In this document, we collectively refer to these retail installment sales contracts and loans as “contracts.” We specialize in providing financing to consumers with limited credit histories, modest incomes or those who have experienced prior credit difficulties, generally referred to as “non-prime” borrowers.
We are a national automobile finance company with more than 18 years experience in the automobile finance industry. We provide financing to consumers for purchases of new and used automobiles through dealer and direct channels. In our dealer channel, we purchase automobile installment contracts from our active network of approximately 4,300 franchised and select independent automobile dealerships located in 37 states. In our direct channel, we provide financing directly to consumers who are referred to us by internet-based consumer finance marketing and finance companies or who contact us directly via our RoadLoans.com website. Our direct lending operations are currently licensed to do business in 47 states. We originated $1,346.5 million, $2,650.3 million and $1,880.2 million of contracts during the years ended December 31, 2007, 2006 and 2005, respectively. We managed a portfolio of approximately $3,868.6 million of contracts at December 31, 2007.
Before we finance any contract, it must pass our underwriting and credit approval process, which is supported and controlled by a centralized computer system that has automated features. The final funding approval for each contract is performed by one of our dedicated and experienced credit officers. Our system incorporates our independently-developed proprietary credit scoring models, which enhance our credit officers’ ability to maximize profitability through risk-based pricing.
We accumulate the contracts we finance until we have a sufficiently large group of contracts that we can subsequently securitize. In a securitization transaction, we sell eligible contracts to a trust, which then issues asset-backed securities that are sold to investors. The proceeds of the securitization are used to repay our warehouse facilities, providing additional funds to originate new contracts. We also service our contracts, both prior to and after securitization, through our servicing group, which performs customer service, contract and payment processing functions and monitors repossessions and remarketing functions.
From June 1999 through April 29, 2005, the Company was a wholly-owned subsidiary of Fairlane Credit, LLC, a wholly-owned subsidiary of Ford Motor Credit Company, or “Ford Credit”.
On April 29, 2005, a newly formed entity, Triad Holdings Inc. and its wholly-owned subsidiary, Triad Acquisition Corp., acquired all of the outstanding capital stock of the Company from Fairlane Credit, LLC, or the “Acquisition”. As part of the Acquisition, Triad Acquisition Corp. was merged with and into Triad Financial Corporation with the Company being the surviving corporation. Triad Holdings Inc. is beneficially owned by Hunter’s Glen/Ford Ltd. and affiliates of Goldman, Sachs & Co. and GTCR Golder Rauner, L.L.C.
In accordance with the guidelines for accounting for business combinations, the purchase price paid by Triad Holdings Inc., plus related purchase accounting adjustments, have been recorded in our financial statements for the period subsequent to April 29, 2005. This has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the “successor” period beginning April 30, 2005. Information for all “predecessor” periods prior to the acquisition are presented using our historical basis of accounting.
Our administrative offices are located at 7711 Center Avenue, Suite 200, Huntington Beach, California 92647 and our telephone number is (714) 373-8300. Our website address is www.triadfinancial.com. All reports filed under the Securities Exchange Act of 1934 are available on our website. Our website and the
information included therein are not part of this annual report. As used herein, the terms “Company”, “we”, “us” and “our” refer collectively to Triad Financial Corporation.
History of Triad
We were formed in 1989 and originally focused on prime lending and automobile leasing. In 1993, we shifted our focus entirely to non-prime lending. In 1998, we became a subsidiary of ContiFinancial Corporation, a consumer and commercial finance company. In June 1999, we were acquired by a subsidiary of Ford Motor Company. From June 1999 until the Acquisition, we operated independently as a wholly-owned subsidiary of Ford Motor Company. We have grown our total managed receivables from approximately $849.6 million at December 31, 1999 to approximately $3.9 billion at December 31, 2007.
Our Competitive Strengths
We believe we have meaningful competitive advantages that allow us to compete effectively in the non-prime automobile finance market in the United States. Our key competitive strengths are:
Sourcing Customers Through Dealer and Direct Channels. We originate contracts through both dealer and direct origination channels. Throughout 2007, we purchased contracts indirectly from dealers located in 37 states throughout the country from our operations center in North Richland Hills, Texas. Those aspects of our dealer origination business that require a local market presence are performed by regional and area sales managers and representatives who solicit new dealers and ongoing applications and facilitate communication between dealers and our production teams without requiring us to lease physical office space for these functions. We operate in markets in which we believe we can achieve targeted returns.
Our direct origination activities are centralized in our North Richland Hills, Texas facility and serve consumers in 47 states. We receive a majority of direct applications through referrals from third-party business partners, which are internet-based consumer finance marketing and finance companies. The balance are received through our website, www.RoadLoans.com. We offer consumers financing for use in refinancing an existing contract, purchasing a leased vehicle or purchasing a car from a private party or a franchised dealer, in each case, on terms that are consistent with our dealer program. We launched our direct origination business in 2000 and for the year ended December 31, 2007, 62.0% of all our originations were generated through our direct channel.
Utilizing Proprietary Credit Scoring Models for Risk-Based Pricing. Our underwriting function utilizes a proprietary custom scorecard, and our Risk Management department continuously studies our performance data to refine our scoring models. They are designed to enable us to tailor each contract’s pricing to a statistical assessment of the underlying credit risk. We created our credit scoring system from our consumer demographic and portfolio performance databases.
Maintaining an Experienced Risk Management Team. Our risk management team is responsible for monitoring the origination process, supporting management’s initiatives, tracking collateral value trends and pricing to achieve targeted portfolio returns. Our risk management team also provides strategic guidance, manages projects to improve collections and contract performance and develops statistical pricing models and subsequent calibration.
Managing Our Portfolio Through Technology and Best Practices. Our centralized portfolio management group continuously develops and monitors collection strategies for our contracts in order to improve portfolio performance. We establish goals regarding delinquent accounts on a monthly basis, develop strategic initiatives for the collections processes and actively manage account handling to maximize account collections and reduce operating expenses. All portfolio management services are conducted from our offices in North Richland Hills, Texas.
Developing Significant Funding and Liquidity Sources. Throughout most of 2007, we had two committed warehouse facilities and two committed residual facilities collectively providing us with ongoing availability to borrow up to $1,500.0 million in the aggregate, subject to borrowing base limitations and renewal. On October 26, 2007, the Company’s $750.0 million warehouse and residual facilities with Goldman
Sachs Mortgage Company, due October 2007, were paid off. On January 10, 2008, we entered into a warehouse facility with Barclays Bank PLC. This facility provides up to $500.0 million of funding for automobile retail installment sales contract receivables originated or purchased by us.
Since August 2002, we have securitized $10.9 billion of contracts in one private and eleven public offerings of asset-backed securities. We securitized $847.1 million of receivables in May 2007 and $670.4 million of receivables in November 2007.
Based on our anticipated level of originations, we believe our cash flow from operations, available cash and available borrowings under our warehouse and residual facilities will provide us with sufficient liquidity to fund contract originations on an interim basis until a sufficient amount of receivables can be pooled together for subsequent securitizations. However, the unprecedented disruptions that we have been experiencing in the asset-backed securitization markets, particularly those involving non-prime and sub-prime borrowers, may require us to adjust our origination goals.
Our Business Strategy
Our goals are to maximize profitability through risk-based pricing and measured growth and create superior relationships with dealers and other business partners. To accomplish these objectives, we employ the following strategies:
Disciplined Growth in Dealer and Direct Channels. We plan to continue to pursue originations of contracts that meet our underwriting standards and profitability targets in both our dealer and direct channels.
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Dealer Channel. The overall slowdown in the market, coupled with the initiatives we undertook in 2007 to provide better accessibility to our dealer customers, provide us with an opportunity to significantly increase the credit quality of the contracts we purchase. Although we decreased our overall dealer base throughout 2007, we were able to maintain a steady level of production among borrowers who appear to have better credit characteristics. We plan to continue to expand on this initiative, and selectively enroll new dealers who prefer this hands-on approach.
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Direct Channel. As the awareness and growth of the internet increases, we believe that the credit applicants will use the internet with increasing frequency in the selection of auto finance providers. In 2007, we increased our marketing efforts to enhance the brand awareness of our direct lending brand, www.RoadLoans.com, through media campaigns and sponsorship of a NASCAR team. We have expanded this relationship in 2008, with a goal of increasing volume from applications received directly through our website, www.RoadLoans.com, as well as volume from repeat RoadLoans customers. We will continue to evaluate our relationships with our business partners, as we look to maintain and strengthen relationships with those who provide us with a steady stream of qualified applicants.
Enhancement of Scoring Models with New Data. We will continue to review and enhance our proprietary credit scoring models on an ongoing basis by validating our proprietary scorecards through the comparison of actual versus projected performance by score and incorporating data we derive in our lending business. We plan to update our scorecards periodically based on this new information and our correlations relating to receivables performance in an effort to effectively manage our contract origination processes and manage our credit risk. We have derived our proprietary scorecards independently over time and will continue to refine them. Based in part on enhancements to our credit scoring models implemented in December 2001, we have decreased our overall net charge-offs as a percentage of average total managed receivables from 8.6% in 2002, to 6.1% in 2005 and 5.8% in 2006. Net charge-offs as a percentage of total managed receivables increased to 8.0% in 2007 due to higher than expected credit losses on receivables originated after the acquisition. We introduced our third generation scorecard for our dealer channel in December 2005 and our first direct channel scorecard in January 2007. These scorecards were created based on our consumer demographic and portfolio performance databases. While we employ a credit scoring system in the credit approval process, credit scoring does not eliminate credit risk. Other factors, including adverse determinations in evaluating contracts for purchase and national or regional economic conditions could negatively affect the credit quality of our receivables portfolio.
Portfolio and Account Management Improvement. We continue to develop and implement enhancements to our collection process and improve information reporting to management and staff with the objective of operating efficiently while continuing to improve our contract performance. These enhancements include implementing and refining automatic dialer functionality to increase the effectiveness of calls to delinquent customers, adding call optimization capabilities to increase the probability of reaching delinquent customers when called. In 2006, we began utilizing new credit scorecards with statistically-assessed behavioral scoring information to project the relative probability that individual accounts will default, which gave us the ability to devote additional resources to those accounts.
Diversification of Funding Sources Throughout most of 2007, we relied on two warehouse facilities and two residual facilities, with aggregate commitments to fund up to $1,500.0 million, subject to borrowing base limitations. On October 26, 2007, the Company’s $750.0 million warehouse and residual facilities with Goldman Sachs Mortgage Company, due October 2007, were paid off. On January 10, 2008, we entered into a warehouse facility with Barclays Bank PLC. This facility provides up to $500.0 million of funding for automobile retail installment sales contract receivables originated or purchased by us. Our warehouse facility with Barclays and our warehouse and residual facility with Citigroup Global Markets Realty Corp. have multi-year terms and staggered maturity dates to enable us to maintain liquidity over time. We plan to continue to seek out additional providers of financial guaranty insurance in our securitization transactions and will continue to explore other forms of securitization financing, including transactions structured without reliance on financial guaranty insurance.
Industry Overview
General. The non-prime automobile finance industry is very competitive. The automobile finance market is highly fragmented and is served by a variety of financial entities, including captive finance affiliates of major automotive manufacturers, banks, thrifts, credit unions and independent finance companies. Providers of automobile financing have traditionally competed on the basis of interest rates charged, the quality of credit accepted, the flexibility of contract terms offered and the quality of service provided to dealers and customers. In seeking to establish ourselves as one of the principal financing sources at the dealers we serve, we compete predominantly on the basis of our high level of service and strong dealer relationships and by offering flexible contract terms. In our direct channel, our competitive strengths are our prompt response times to all applicants, regardless of source, and our willingness to extend credit to online applicants who might not qualify for direct loans from more traditional financing sources. There can be no assurance that we will be able to compete successfully in this market or against our competitors.
Market Characteristics. The non-prime automobile finance industry has certain characteristics which affect a finance company’s strategy, including the following:
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Centralized Operations Serving Diverse Markets. Contract performance in the non-prime automobile finance market varies regionally depending on each region’s economic vitality. To achieve economies of scale, some automobile finance companies have centralized origination and collections operations and utilize technology, proprietary performance data and third-party databases to effectively determine risk levels and recommend best practice solutions.
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Lenders Compete on the Basis of Price and Service. Providers of automobile financing have traditionally competed on the basis of interest rates charged, the quality of credit accepted, the flexibility of contract terms offered and the quality of service provided to dealers and customers. In order to compete effectively on a national scale, lenders must develop an efficient origination platform by providing incentives to employees to deliver targeted service levels while pricing contracts to achieve targeted returns.
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Increased Risk of Non-payment or Default. The rates of delinquencies, defaults, repossessions and losses on contracts with non-prime borrowers are higher than that experienced in the automobile finance industry generally. Underwriting criteria and collection methods are, therefore, tailored to manage the higher risks inherent in contracts to non-prime borrowers.
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Need for Significant Funding Capacity. Providing financing to non-prime borrowers on a national basis requires substantial capital.
Automobile Finance Operations
Target Market
We specialize in non-prime financing to customers who generally would not qualify for traditional financing such as that provided by commercial banks or automobile manufacturers’ captive finance companies. These customers generally have lower than average income, limited credit history, past credit problems, or some combination thereof. Because we serve customers who are unable to meet the credit standards imposed by most traditional automobile financing sources, we generally charge higher interest rates than those charged by traditional financing sources. As we provide financing in a relatively high-risk market, we also expect to sustain a higher level of credit losses than traditional automobile financing sources.
Dealer Channel Marketing. In our capacity as an indirect sales finance company, we focus our marketing activities on automobile dealerships, primarily manufacturer franchised dealerships. We select these dealers based on the type of vehicles sold and the extent of their non-prime loan activity. We will purchase contracts from non-franchise dealers if we are satisfied with their financial strength and stability. We prefer to finance late-model low-mileage used vehicles and moderately priced new vehicles. Approximately 86% of the retail installment sales contracts we purchased in 2007 were originated by manufacturer franchised dealers and 14% by select independent dealers. During 2007, we purchased retail installment sales contracts from approximately 4,300 dealers. No dealer location accounted for more than 0.3% of the total volume of retail installment sales contracts.
Dealer relationships are actively monitored with the objective of maximizing the volume of credit applications received from the dealer that meet our underwriting standards and profitability objectives. Due to the non-exclusive nature of our relationships with dealerships, the dealerships retain discretion to determine whether to obtain financing for their customers from us or from another source. We employ local sales representatives that manage a territory of dealers. They regularly telephone and visit dealers in their territory to solicit new business and to answer any questions dealers may have regarding our financing programs and capabilities. To increase the effectiveness of these contacts, marketing personnel have access to our management information systems, which detail current information regarding the number of credit applications submitted by a dealership, our responses and the reasons why particular applications were rejected. Dealers that do not consistently meet either our profitability returns or efficiency parameters are often deactivated.
Direct Channel Marketing. Our direct channel, or “RoadLoans,” marketing initiatives include standard web methods of advertising such as opt-in email, where customers elect to receive email messages from us, search engine optimization and search engine pay-per-click advertising. In addition, we contract with several loan business partners such as LendingTree.com and have contractual relationships with numerous marketing companies similar to LendingTree. We also work with online banking institutions, which refer customers to us whose credit profiles do not meet their credit policies and procedures. We have also been increasing our print, radio and television marketing efforts in order to increase the brand awareness of our direct lending brand, www.RoadLoans.com. In 2007, we undertook a partial sponsorship of a NASCAR team to increase brand awareness among that sports’ spectators.
Underwriting, Purchasing and Originating Contracts
Proprietary Credit Scoring System and Risk-Based Pricing. We utilize a proprietary credit scoring system to support the credit approval process. The credit scoring system was developed through statistical analysis of our consumer demographic and portfolio databases. Credit scoring is used to differentiate credit applicants and to categorize credit risk in terms of expected default rates, which enables us to evaluate credit applications for approval and tailor contract pricing and structure according to this statistical assessment of credit risk. For example, a consumer with a lower score would indicate a higher probability of default and, therefore, we would either decline the application, or, if approved, compensate for this higher default risk through the structuring and pricing of the transaction.
Our credit scoring system considers data contained in the customer’s credit application and credit bureau report as well as the structure of the proposed contract and produces a statistical assessment of these attributes. This assessment is used to segregate applicant risk profiles and determine whether the risk is acceptable, as well as our pricing for that risk. Our credit scorecards are validated periodically through the comparison of actual versus projected performance by score.
We endeavor to refine our proprietary scorecards based on new information and identify correlations relating to contract performance. We expect to introduce a new scorecard for use in both channels in mid-2008.
While we employ a credit scoring system in the credit approval process, credit scoring does not eliminate credit risk. Other factors, including adverse determinations in evaluating contracts for purchase and national or regional economic conditions could negatively affect the credit quality of our receivables portfolio.
Dealer Channel Approval Process. Production personnel have a specific credit authority based upon their experience and historical contract portfolio results as well as established credit scoring parameters. Our application processing includes controls designed to ensure that credit decisions comply with our credit scoring strategies and underwriting policies and procedures.
All of our credit applications are received electronically from dealers and automatically entered into our loan origination system, which accesses a credit bureau report and computes a credit score.
Our underwriting and collateral guidelines, including credit scoring parameters, form the basis for the credit decision. A designated credit officer must approve any exceptions to credit policies. After completion of the credit analysis, an underwriter makes a final decision regarding the application: approval, conditional approval or rejection. A conditional approval is an agreement by us to purchase the contract under certain specific conditions as determined by us. Once a dealer chooses the company as its funding source, it assembles the contract package in accordance with our requirements.
Upon receipt of contract packages, we verify certain applicant income, employment and residency information when required by our credit policies. We also scan the primary contract documentation to create electronic images and forward the originals to our off-site vendor for storage.
The contract processing department reviews the contract packages for proper documentation and regulatory compliance. We attempt to maintain a two-day turn-around time from the date we receive a complete funding package until we purchase the contract from the dealer. All contract purchases are without recourse to the selling dealers. However, the dealer makes certain representations as to the validity of the contract and compliance with certain laws, and indemnifies us against any claims, defenses and set-offs that may be asserted against us because of the acts or omissions of the dealer, among other things. Funding packages with deficiencies are not funded and are returned to the submitting dealer. Pursuant to our agreement with our dealers, a dealer is required to apply for a certificate of title reflecting our first lien security interest in the automobile that was financed. All of our contracts are fully amortizing with substantially equal monthly installments and substantially all of our contracts originated in the dealer channel contain interest rates computed using a simple interest calculation.
Direct Channel Approval Process. Our direct channel provides customers with financing that may be used to refinance existing vehicle loans, purchase leased vehicles or purchase automobiles from a private party or a franchised dealer. We offer these programs to consumers in most states through our relationships with loan business partners, which are internet-based consumer finance marketing and finance companies that have online lending and application generation sources. We also receive applications through our own website, www.RoadLoans.com.
Consumers complete a credit application online, and submit the application to RoadLoans or one of our business partners via the internet. Upon receipt, we enter application data into our loan origination system, which screens the applicants’ state of residence, stated income and age. Following this initial screening, our loan origination system accesses a credit bureau report and computes a proprietary credit score. An underwriter reviews new applications which meet our minimum score parameters for approval or decline, and we send our decision via email to the applicant, followed by an appropriate adverse action notice if required.
Our approval email contains the terms of our credit offer, including the amount for which the applicant qualifies.
We mail a fulfillment package to each approved applicant. The applicant then selects a vehicle that meets our program requirements, negotiates the price as if paying with cash, and completes the sale transaction with a RoadLoansChecksm. If all conditions for the loan are met, the seller is authorized to deposit the RoadLoansChecksm for funding.
Upon funding, we acquire a security interest in the vehicle that the borrower purchased with our loan proceeds, the selling dealer completes the necessary documentation to place our name on the title as lien holder, and the seller submits the paperwork to the appropriate government agency to perfect our security interest. In the case of person-to-person purchasing, an agent will complete the title work on behalf of RoadLoans and ensure that the requisite documents are executed. All of our direct contracts are fully amortizing with substantially equal monthly installments and contain interest rates computed using a simple interest calculation. Customers who seek to refinance their existing loans secured by motor vehicles apply through the same sources as those seeking loans to purchase new or used vehicles. The customers who are approved are sent a fulfillment package. They must complete the package and return it to us. We send the payoff check to his/her lender who, upon receipt of the payoff check, releases its lien on the vehicle so that our first lien may be perfected.
Servicing and Collections Procedures
General. Our servicing responsibilities consist of collecting, processing and posting customer payments, responding to customer inquiries, initiating contact with customers who are delinquent, maintaining our security interest in financed vehicles or other collateral, repossessing and liquidating collateral when necessary and generally monitoring each contract and the related collateral. We service all contracts that we originate and purchase.
Approximately 15 days before a customer’s first payment due date and each month thereafter, we mail the customer a billing statement directing the customer to mail payments to a lockbox bank for deposit in a lockbox account. Payment receipt data is electronically transferred from our lockbox bank to us for posting to our contract accounting system. Payments may also be received directly by us from customers or through third-party vendors, such as Western Union. We perform all of our servicing and collection functions at our North Richland Hills, Texas facility.
In our collections activities, we use a predictive dialing system to make phone calls to customers whose payments are past due. The predictive dialer is a computer-controlled telephone dialing system that simultaneously dials phone numbers of multiple customers from a file of records extracted from our database. Once a live voice responds to the automated dialer’s call, the system automatically transfers the call to a collector and the relevant account information to the collector’s computer screen. The system also tracks and notifies collections management of phone numbers that the system has been unable to reach within a specified number of days, thereby promptly identifying for management all customers who cannot be reached by telephone. By eliminating the time spent on attempting to reach customers, the system gives a single collector the ability to speak with a greater number of customers daily.
As an account becomes more seriously delinquent, it moves to one of our later-stage collection units. The objective of these collectors is to prevent the account from becoming further delinquent. After a scheduled payment on an account becomes between 60 and 90 days contractually delinquent, we typically initiate repossession of the financed vehicle. We may repossess a financed vehicle without regard to the length of payment delinquency if an account is deemed uncollectable, the financed vehicle is deemed to be in danger of being damaged, destroyed or hidden, the customer deals in bad faith or the customer voluntarily surrenders the collateral.
At times, we offer payment extensions to customers who have encountered temporary financial difficulty, hindering their ability to pay as contracted. The collector reviews a customer’s past payment history and assesses the customer’s ability to make future payments. Exceptions to our extension policies and guidelines
for extensions must be approved by designated personnel. While payment extensions are initiated and approved in the collections department, our portfolio management group determines the total frequency of extensions per month and recommended allocation. For example, seasonal delinquency and payment trends may influence our decision to grant more (or fewer) extensions in a given month. At December 31, 2007, approximately 27.4% of our total managed receivables had received an extension.
Repossessions. Repossessions are subject to required statutory procedures, which may include one or more customer notifications, a waiting period prior to disposition of the repossessed automobile and return of personal items to the customer. Some jurisdictions provide the customer with reinstatement rights and most provide the borrower with a right to redeem the vehicle. Legal requirements, particularly in the event of bankruptcy, may restrict our ability to repossess or to dispose of the repossessed vehicle. Repossessions must be approved by a collections officer. The repossession assignments are handled by independent repossession firms engaged directly by us or by service companies who maintain relationships with companies who perform repossession work. Upon repossession and after any waiting period, the repossessed automobile is sold at auction. We do not sell any vehicles on a retail basis. The proceeds from the sale of automobiles at auction, together with any other recoveries, are credited against the balance of the contract. Auction proceeds from sale of the repossessed vehicle and other recoveries are usually not sufficient to cover the outstanding balance of the contract, and the resulting deficiency is charged-off. We may pursue collection of deficiencies when appropriate. If the auction proceeds from the sale of the repossessed vehicle exceed the outstanding balance of the contract, a refund is sent to the customer. The amount of the refund is calculated in accordance with the applicable law of the jurisdiction where the auction sale occurred, and generally comprises the amount in excess of the contract’s outstanding balance, less any late fees, accrued interest, auction fees and amounts owed to any junior lienholders.
Charge-Off Policy. Our policy is to charge off a contract in the month in which the borrower becomes 120 days contractually delinquent if we have not previously repossessed the related vehicle. If a vehicle has been repossessed, and the underlying contract is an owned receivable, we charge off the underlying receivable upon repossession, taking into account the estimated value of our collateral, with a reconciliation upon liquidation. For sold receivables, the debt is charged off upon liquidation of the collateral. The net charge-off represents the difference between the actual net sales proceeds and the amount of the delinquent contract, including accrued interest on our owned receivables. Accrual of finance charge income is suspended on accounts that are more than 30 days contractually delinquent.
Risk Management
Overview. Our risk management group prepares regular credit indicator packages reviewing portfolio performance at various levels of detail including total company, region, state and dealer. Various daily reports and analytical data also are generated by our management information systems. This information is used to monitor effectiveness of the collection process. Risk management works with operational management in establishing monthly and quarterly performance targets and leads strategic initiatives prioritized to improve business effectiveness. This group also regularly reviews the performance of our credit scoring system and is responsible for the development and enhancement of our credit scorecards.
Our production management group is responsible for monitoring the contract approval process and new account programs, supporting the supervisory role of senior operations management and improving operational efficiencies.
Behavioral Scoring. We use statistically-based behavioral assessment models to project the relative probability that an individual account will default and to validate the credit scoring system after the contract has aged for a sufficient period of time, generally six months. Default probabilities are calculated for each borrower independent of the credit score. Projected default rates from the behavioral assessment models and credit scoring systems are compared and analyzed to monitor the effectiveness of our credit strategies.
Compliance Audits. Our internal quality control and internal audit departments conduct regular reviews of contract origination operations, processing and servicing, collections and other functional areas. The primary objective of the reviews is to identify risks and associated controls and measure compliance with our
written policies and procedures as well as regulatory matters. We perform reviews of compliance with underwriting policies, completeness of contract documentation and applicant data investigation. We distribute written reports to departmental managers and officers for response and follow-up. Our senior executive management team also reviews these results and responses.
Securitization of Receivables
Since August 2002, we have pursued a strategy of securitizing our receivables to diversify our funding, improve liquidity and obtain a cost-effective source of funds for the purchase of additional automobile finance contracts. Prior to the Acquisition, we applied the net proceeds from securitizations to pay down borrowings under our existing credit facility with Ford Credit. Since the Acquisition, we have used the net proceeds from our securitizations to pay down our warehouse facilities, thereby increasing availability thereunder for further contract purchases. Since August 2002, we have securitized over approximately $10.9 billion of automobile receivables.
In our securitizations, we, through wholly-owned subsidiaries, transfer automobile receivables to newly-formed securitization trusts which issue one or more classes of asset-backed securities. The asset-backed securities are, in turn, sold to investors.
We typically arrange for a financial guaranty insurance policy to achieve a high-grade credit rating on the asset-backed securities issued by the securitization trusts. Since August 2002, the financial guaranty insurance policies have been primarily provided by Ambac Assurance Corporation, or “Ambac”, and Financial Security Assurance Inc., or “FSA”, collectively referred to as “Guarantee Insurance Providers”, each of which is a monoline insurer, which insures the payment of principal and interest due on the asset-backed securities. We have limited reimbursement obligations to these Guarantee Insurance Providers; however, credit enhancement requirements, including security interests for the benefit of the insurers of certain restricted cash accounts and subordinated interests in trusts, provide a source of funds to cover shortfalls in collections and to reimburse the insurer for any claims which may be made under the policies issued with respect to our securitizations. There have been no claims under any insurance policies in our securitization transactions.
The credit enhancement requirements for our securitizations include restricted cash accounts that are generally established with an initial deposit. Funds would be withdrawn from the restricted cash accounts to cover any shortfalls in amounts payable on the asset-backed securities. Funds generated from securitization transactions insured by Guarantee Insurance Providers are also available to be withdrawn upon an event of default to reimburse the Guarantee Insurance Providers, as applicable, for draws on their respective financial guaranty insurance policies. We are entitled to receive amounts from the restricted cash accounts to the extent the amounts deposited exceed predetermined required minimum levels.
Each Guarantee Insurance Provider has a security interest in the restricted cash accounts and investments in trust receivables with respect to securitization transactions it has insured. If the security interest is foreclosed upon in the event of a payment by the Guarantee Insurance Provider under one of its insurance policies, or the occurrence of certain material adverse changes in our business, the Guarantee Insurance Provider would control all of the restricted cash accounts, and investments in trust receivables with respect to securitization transactions it has insured. The terms of each insured securitization also provide that, under certain tests relating to delinquencies and losses, cash may be retained in the restricted cash account and not released to us until increased minimum levels of credit enhancement requirements have been reached and maintained.
Regulation
Our operations are subject to regulation, supervision and licensing under various federal, state and local statutes, ordinances and regulations.
In most states in which we operate, a consumer credit regulatory agency regulates and enforces laws relating to consumer lenders and sales finance agencies such as us. Such rules and regulations generally provide for licensing of sales finance agencies and/or direct lenders, limitations on the amount, duration and
charges, including interest rates, for various categories of contracts, requirements as to the form and content of finance contracts and other documentation, and restrictions on collection practices and creditors’ rights. In certain states, we are subject to periodic examination by state regulatory authorities. Some states in which we operate do not require special licensing or provide extensive regulation of our business.
We are also subject to extensive federal regulation, including the Truth in Lending Act, the Equal Credit Opportunity Act and the Fair Credit Reporting Act. These laws require us to provide certain disclosures to prospective borrowers and protect against discriminatory lending practices and unfair credit practices. The principal disclosures required under the Truth in Lending Act include the terms of repayment, the total finance charge and the annual percentage rate charged on each contract. The Equal Credit Opportunity Act prohibits creditors from discriminating against contract applicants on the basis of, among other factors, race, color, sex, age or marital status. Pursuant to Regulation B promulgated under the Equal Credit Opportunity Act, creditors are required to make certain disclosures regarding consumer rights and advise consumers whose credit applications are not approved of the reasons for the rejection. In addition, the credit scoring system we use must comply with the requirements for such a system as set forth in the Equal Credit Opportunity Act and Regulation B. The Fair Credit Reporting Act requires us to provide certain information to consumers whose credit applications are not approved on the basis of a report obtained from a consumer reporting agency. Additionally, we are subject to the Gramm-Leach-Bliley Act, which requires us to maintain privacy with respect to certain consumer data in our possession and to periodically communicate with consumers on privacy matters. We are also subject to the Servicemembers Civil Relief Act and similar state legislation, which require us to reduce the interest rate charged on each contract to customers who have subsequently joined, enlisted, been inducted or called to active military duty and may restrict the exercise of remedies against such customers.
The dealers who originate automobile finance contracts that we purchase also must comply with both state and federal credit and trade practice statutes and regulations. Failure of the dealers to comply with these statutes and regulations could result in consumers having rights of rescission and other remedies that could have an adverse effect on us.
We believe that we maintain all material licenses and permits required for our current operations and are in substantial compliance with all applicable local, state and federal regulations. There can be no assurance, however, that we will be able to maintain all requisite licenses and permits, and the failure to satisfy those and other regulatory requirements could have a material adverse effect on our operations. Further, the adoption of additional, or the revision of existing, rules and regulations could have a material adverse effect on our business.
Competition
Competition in the field of non-prime automobile finance is intense. The automobile finance market is highly fragmented and is served by a variety of financial entities, including the captive finance affiliates of major automotive manufacturers, banks, thrifts, credit unions and independent finance companies. Many of these competitors have substantially greater financial resources and lower costs of funds than we do. In addition, our competitors often provide financing on terms more favorable to automobile purchasers or dealers than we offer. Many of these competitors also have long-standing relationships with automobile dealerships and may offer dealerships or their customers other forms of financing, including dealer floor plan financing and leasing, which we do not provide. Providers of automobile financing have traditionally competed on the basis of interest rates charged, the quality of credit accepted, the flexibility of contract terms offered and the quality of service provided to dealers and customers. In seeking to establish ourselves as one of the principal financing sources for the dealers and business partners we serve, we compete predominantly on the basis of our high level of service and strong dealer and business partner relationships and by offering flexible contract terms. There can be no assurance that we will be able to compete successfully in this market or against these competitors.
The Sarbanes-Oxley Act of 2002
We expect to incur significant costs in connection with our compliance with Sarbanes-Oxley, particularly with Section 404 thereof, which requires management to undertake an assessment of the adequacy and effectiveness of our internal controls over financial reporting and requires our auditors to attest to, and report on, management’s assessment and the operating effectiveness of these controls. We are required to be in compliance with the provisions of Section 404 at and for the year ended December 31, 2007 and an auditor attestation will be required at and for the year ended December 31, 2008.
Employees
As of December 31, 2007, we employ approximately 1,200 persons in 24 states. None of our employees are a part of a collective bargaining agreement, and we believe our relationships with our employees are satisfactory.
ITEM 1A.
ITEM 1A.
RISK FACTORS
Our ability to continue to purchase contracts and to fund our business is dependent on a number of financing sources.
Dependence on Warehouse and Residual Facilities. We are a finance company that is highly dependent on obtaining financing to originate contracts. We depend on our warehouse and residual facilities to finance our purchase and funding of contracts pending securitization and our working capital needs. At December 31, 2007, our warehouse and residual facilities with Citibank Global Markets Realty Corp. provide for available borrowings of up to an aggregate amount of approximately $750.0 million on an ongoing basis, subject to borrowing base limitations and renewal. At December 31, 2007, we had advances outstanding under our warehouse and residual facilities totaling $334.4 million. On January 10, 2008, we entered into a warehouse facility with Barclays Bank PLC. This facility provides up to $500.0 million of funding for automobile retail installment sales contract receivables originated or purchased by us.
These financing resources may not continue to be available to us beyond their current maturity dates at reasonable terms or at all. The availability of these financing sources depends on factors outside of our control. If we are unable to extend or replace these facilities or arrange warehouse and residual facilities, we will have to curtail contract purchasing and originating activities, which would have a material adverse effect on our financial position, liquidity and results of operations.
Dependence on Securitization Transactions. Our business depends on our ability to aggregate and sell automobile installment contracts in the form of privately and publicly offered asset-backed securities. These sales generate cash proceeds that allow us to repay amounts borrowed under our warehouse facilities and to finance additional contracts. In addition, historically, our sale of contracts to a securitization trust in preparation for a securitization created an accounting gain-on-sale that became a material part of our reported earnings. Beginning in 2005, we structured our securitizations so that the receivables and related securitization indebtedness would remain on our balance sheet. Changes in our asset-backed securities program could materially adversely affect our earnings or ability to purchase and resell automobile installment contracts on a timely basis. In addition to our change in accounting for securitization transactions, other changes could include a:
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delay in the completion of a planned securitization;
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negative market perception of us; and
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failure of the contracts we intend to sell to conform to financial guaranty or rating agency requirements.
Various factors, both external and internal, may make it difficult for us to achieve our goals for the upcoming year. The past several months have seen unprecedented turmoil in the global credit markets in general, and the asset-backed securitization markets in particular. The Company executed an insured securitization in November 2007, and there have been no subsequent insured, non-prime automobile asset-backed securities issued publicly as of February 29, 2008.
The well-publicized problems involving credit insurance providers may also have an impact on our ability to successfully execute on our 2008 business plan. Recently, AMBAC, Inc., which has provided credit enhancement insurance on three of our seven securitization transactions since May 2005, announced that they would discontinue underwriting certain structured finance businesses, including auto loan securitizations. Those companies that continue to provide credit enhancement insurance may be less likely to do so at the rates and on the terms at which prior transactions were executed in 2006 and early 2007.
Credit losses in our securitized transactions executed in the latter part of 2006 have been greater than those experienced in prior years. The target loss performance ratios on two of these trusts were exceeded in December 2007 and January 2008 respectively, resulting in greater credit enhancement requirements, and a delay in cash distributions to the Company. While these events can be cured, there is no assurance that these loss ratios will not be exceeded in the future.
Based on the early delinquency and loss performance of our 2006 vintage originations, we slowed production in the 4th quarter of 2006, and continued to scale back our production volume throughout 2007, especially in our dealer channel. As a result, a greater proportion of our 2007 vintage contracts were originated through our direct lending channel, which has historically experienced lower delinquencies and losses than our dealer channel. In addition, we adjusted our pricing in our direct channel to attract more borrowers who had better credit histories than our typical borrower. We believe these changes will result in an improvement in overall credit quality for the 2007 vintage, but there can be no assurance that other macroeconomic factors, such as the rising costs of consumer goods and energy products, will not continue to affect overall pool performance.
Anticipating the possibility that there will be limited accessibility to the securitization markets, we have continued to revise our credit origination strategies. In 2007, we began the process of selectively reducing the number of dealers from which we purchase contracts, and this process has continued in the first quarter of 2008. We have also reduced staff among our sales and underwriting departments, and have made changes to our credit underwriting criteria. In our direct channel, we have ceased accepting on-line applications from some sources, and have implemented similar changes to our credit underwriting criteria.
We believe these changes will enable us to maintain a robust credit originations process in 2008. However, if the asset-backed securities market suffers from further deterioration, or the credit markets do not begin to stabilize and rebound, we may have to make further adjustments to our targeted origination volumes.
Our ability to execute securitization transactions, and the cost of and liquidity obtained from them, is dependent on our ability to obtain financial guaranty insurance policies to support these transactions.
Since 2002, all of our securitizations have utilized credit enhancement in the form of financial guaranty insurance policies provided by Guarantee Insurance Providers. Under these insurance policies, if the securitization trust fails to pay principal or interest on the insured securities when due, then the Guarantee Insurance Providers will be required to pay such amounts. We obtain these insurance policies in order to achieve ratings ranging from A-1+/Prime-1/F1+ to AAA/Aaa/AAA on the insured securities issued in the securitization transactions. These ratings may reduce the costs of securitizations relative to alternative forms of financing available to us and enhance the marketability of these transactions to investors in asset-backed securities. If our future securitizations are not similarly rated our funding costs may be higher. Our insurance providers are not required to insure our future securitizations and their willingness to do so is subject to many factors beyond our control, including concentrations of risk with any given insurance provider, the insurance providers’ own rating considerations, their ability to cede this risk to reinsurers and the performance of the portion of our portfolio for which the insurers have provided insurance.
We anticipate that credit enhancement requirements for future securitizations will be at least equal to our current levels requiring the use of additional liquidity to support our securitization program. A downgrade in any of our Guarantee Insurance Provider’s credit ratings, their withdrawal of credit enhancement, an increase in required credit enhancement levels or the lack of availability of alternative credit enhancements, such as reinsurance or senior subordinated structures, for our securitization program could result in higher interest costs for our future securitizations and larger initial cash deposit requirements. The absence of a financial guaranty insurance policy may also impair the marketability of our securitizations. These events could have a material adverse effect on our financial position, liquidity and results of operations.
We believe that we may be required to utilize securitization structures involving the purchase of a financial guaranty insurance policy in order to execute securitization transactions based on current market conditions. If we are unable to obtain financial guaranty insurance at all or on terms acceptable to us and, as a result, are unable to execute securitization transactions on a regular basis, we would not have sufficient funds to meet our liquidity needs and, in such event, we would be required to revise the scale of our business, including the possible discontinuation of contract origination activities, which would have a material adverse effect on our ability to achieve our business and financial objectives.
A loss of contractual servicing rights could have a material adverse effect on our business.
As servicer of all our securitized automobile contracts, we are entitled to receive contractual servicing fees. Our base servicing fees are earned at 2.25% per annum on the outstanding balance of contracts securitized and our supplemental servicing fees include fees and charges paid by obligors, such as late fees and extension fees. Each Guarantee Insurance Provider, as guarantor, can terminate our right to act as servicer for the securitizations it has guaranteed upon the occurrence of events defined in the sale and servicing agreements for securitized contracts, such as our bankruptcy or material breach of warranties or covenants, including covenants to maintain a specified level of delinquency, default or loss rate with respect to the receivables included in the applicable securitization trust. At December 31, 2007, no such termination events had occurred with respect to any of the trusts formed by us. We also are entitled to receive servicing fees under our warehouse facilities. The lenders under our warehouse facilities can terminate our right to act as servicer under these facilities upon the occurrence of specified servicer termination events similar to the servicer termination provisions of our securitizations. The termination of any or all of our servicing rights under our securitizations or the warehouse facilities would have a material adverse effect on our financial position, liquidity and results of operations by reducing our pre-tax income by the amount of our servicing fee income. For the year ended December 31, 2007, we received $6.2 million in base servicing fee income and $1.6 million in supplemental servicing fee income from our securitization trusts.
We may not be able to generate sufficient operating cash flows to meet our operating expenses.
Our automobile finance operations require substantial operating cash flows. Operating cash requirements include premiums paid to dealers for acquisition of retail installment contracts, premiums paid to our business partners for referring direct loans to us, expenses incurred in connection with the securitization of receivables, capital expenditures for new technologies, debt service and ongoing operating costs. Our primary sources of operating cash are the excess cash flows received from securitizations, servicing fee income and contracts held by us prior to their securitization. The timing and amount of excess cash flows from securitizations and contracts varies based on a number of factors, including:
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the rates and amounts of contract delinquencies, defaults and net credit losses;
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how quickly and at what price repossessed vehicles can be resold;
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the ages of the contracts in the portfolio;
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levels of voluntary prepayments; and
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the terms of our securitizations, which include performance based triggers requiring higher levels of credit enhancements to the extent credit losses or delinquencies exceed certain thresholds.
Any adverse change in these factors could reduce or eliminate excess cash flows to us. Although we currently have positive operating cash flows, we may not continue to generate positive cash flows in the future. Our inability to do so could have a material adverse effect on our financial position, liquidity and results of operations.
Defaults and prepayments on contracts purchased or originated by us could adversely affect our results of operations and cash flows.
Our results of operations, financial condition and liquidity depend, to a material extent, on the performance of contracts purchased and held by us as well as the subsequent performance of receivables sold to securitization trusts. Obligors under contracts acquired or originated by us may default or prepay on the contracts at any time. We bear the full risk of losses resulting from defaults that occur while we own the contracts.
In the event of a default under the contracts we hold, the collateral value of the financed vehicle usually does not cover the outstanding contract balance and costs of recovery. We maintain an allowance for credit losses on contracts held for investment by us, which reflects management’s estimates of inherent losses for these contracts. If the allowance is inadequate, we would recognize as an expense the losses in excess of that
allowance, and our results of operations could be adversely affected. Under the terms of the securitizations, we are not able to securitize defaulted contracts and contracts greater than 30 days delinquent held by us. Under the terms of our warehouse facilities, we are able to borrow, subject to specified limitations, against contracts greater than 30 days delinquent, but at a lower advance rate.
We also retain a substantial portion of the default and prepayment risk associated with the receivables that were sold pursuant to our securitizations. A large component of the gain historically recognized on these sales and the corresponding assets recorded on our balance sheet are credit enhancement assets which consist of investments in trust receivables and restricted cash. Credit enhancement assets are calculated on the basis of management’s assumptions concerning, among other things, defaults. Actual defaults may vary from management’s assumptions, possibly to a material degree, which could adversely affect the value of our credit enhancement assets, which totaled $27.0 million at December 31, 2007. If the change in assumptions and the impact of the change on the value of the credit enhancement assets were deemed other than temporary, we would record a charge to income. In addition, an increase in defaults would reduce the size of our servicing portfolio, which would reduce our servicing fee income and adversely affect our results of operations and cash flow. Although we believe that we have made reasonable assumptions as to the future cash flows of the various pools of receivables that have been sold in securitization transactions, actual rates of default may differ from those assumed, and other assumptions may be required to be revised upon future events.
Generally, the form of credit enhancement agreement we enter into with Guarantee Insurance Providers in connection with securitization transactions contains specified limits on the delinquency and loss rates on the receivables included in each securitization trust. If, at any measurement date, the delinquency, default or loss rate with respect to any trust were to exceed the specified limits, provisions of the credit enhancement agreement would automatically increase the level of credit enhancement required for that trust, if a waiver were not obtained. During the period in which the specified delinquency and loss rates were exceeded, excess cash flow, if any, from the trust would be used to fund the increased credit enhancement levels instead of being distributed to us, which would have an adverse effect on our cash flow.
At December 31, 2007, the cumulative net loss ratio for the Company’s 2006-C securitization trust exceeded one of its target ratios. As a result, the credit enhancement requirement to maintain cash reserves as a percentage of the portfolio immediately increased from 2% to 3%, resulting in a delay in cash distributions to the Company. This requirement will remain at 3% until the trust is back in compliance with its target for three consecutive months. At January 31, 2008, the cumulative net loss ratio for the Company’s 2006-B securitization trust exceeded one of its target ratios as well. That credit enhancement requirement also immediately increased from 2% to 3%, where it will remain until the trust is back in compliance with its target for three consecutive months. We estimate that $5 million to $20 million of cash otherwise distributable from the trusts will be used to increase credit enhancements for the insurer rather than being released to us. It is possible that the net loss ratios on other securitization trusts may exceed targeted levels, which would result in increased credit enhancement levels on those trusts as well. If this were to occur, and although we believe we have sufficient liquidity, we may be required to decrease contract origination activities, and implement other expense reductions, if securitization distributions are materially decreased for a prolonged period of time.
Failure to implement our business strategy could adversely affect our operations.
Our financial position and results of operations depend on our management’s ability to execute our business strategy. Key factors involved in the execution of our business strategy include:
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achieving the desired contract purchase volume;
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continued and successful use of proprietary scoring models for risk assessment and risk-based pricing;
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the use of sophisticated risk management techniques;
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continued investment in technology to support operating efficiency and growth; and
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continued access to significant funding and liquidity sources.
Our failure or inability to execute any element of our business strategy could materially adversely affect our financial position, liquidity and results of operations.
There is a high degree of risk associated with non-prime borrowers.
We specialize in purchasing and servicing non-prime automobile receivables. Non-prime borrowers are associated with higher-than-average delinquency and default rates. While we believe that we effectively manage these risks with our proprietary credit scoring system, risk-based contract pricing and other underwriting policies and collection methods, these criteria or methods may be ineffective in the future in reducing default risk or properly pricing contracts. In the event that we underestimate the default risk or under-price contracts that we purchase, our financial position, liquidity and results of operations may be adversely affected, possibly to a material degree. While we employ a credit scoring system in the credit approval process, credit scoring does not eliminate credit risk. Adverse determinations in evaluating contracts for purchase could negatively affect the credit quality of our receivables portfolio.
We are subject to general economic conditions beyond our control. Adverse general economic events, including periods of economic weakness, could have a material adverse impact on our business.
During periods of economic slowdown or recession, delinquencies, defaults, repossessions and losses generally increase. These periods also may be accompanied by decreased consumer demand for automobiles and declining values of automobiles securing outstanding contracts, which weakens collateral coverage and increases the amount of a loss in the event of default. Significant increases in the inventory of used automobiles during periods of economic recession may also depress the prices at which repossessed automobiles may be sold or delay the timing of these sales. Because we focus on non-prime borrowers, the actual rates of delinquencies, defaults, repossessions and losses on these contracts are higher than those experienced in the general automobile finance industry and could be more dramatically affected by a general economic downturn. In addition, during an economic slowdown or recession, our servicing costs may increase without a corresponding increase in our servicing fee income. While we seek to manage the higher risk inherent in contracts made to non-prime borrowers through the underwriting criteria and collection methods we employ, these criteria or methods may not afford adequate protection against these risks. Any sustained period of increased delinquencies, defaults, repossessions or losses or increased servicing costs could also adversely affect our financial position, liquidity and results of operations and our ability to enter into future securitizations.
Geographic concentrations of our contracts may adversely affect payments on the contracts.
Adverse economic conditions, natural disasters or other factors affecting any state or region where a high concentration of obligors resides could adversely affect collections on the contracts and increase the delinquency or credit loss rates of our contracts. At December 31, 2007, obligors with respect to approximately 20.3%, 12.8%, 8.0%, 5.5% and 4.9% of our total managed receivables based on the contracts’ remaining principal balances were located in Texas, California, Florida, Georgia, and Illinois respectively. If adverse economic conditions, natural disasters or other factors occur that affect these regions, or if obligors in these regions experience financial difficulties, a significant number of obligors may not be able to pay, may not make timely payments or may be more prone to filing for bankruptcy protection.
In our direct channel, we depend on a number of third parties and the Internet to provide us with applications, and a decline in applications from these sources could result in a decrease in contract originations.
In our direct channel, in addition to originations through our RoadLoans website, we rely on third-party business partners to refer customers to us. Our top three third-party relationships in our direct channel generate approximately 43% of our direct contract originations based on both the number of contracts originated and the dollar amount of contracts originated. Our current business partners may not continue to refer customers to us on current terms or at all, and we may not be able to establish relationships with new business partners on terms acceptable to us. Our inability to maintain our current relationships with these companies or the loss of
one or more these relationships and our failure or inability to replace those which are lost may result in a decrease in contract originations in our direct channel.
In addition, because of our reliance on the internet to provide us with credit applicants, if the internet were to become less accessible due to increased access fees or concerns about privacy, credit applicants could cease to use it as a source for their automobile financing needs.
Our business is highly seasonal which may cause our results of operations and cash flows to fluctuate from quarter to quarter.
We historically have experienced and expect to continue to experience quarterly fluctuations in our net income and cash flows. We generally experience a decrease in collections in the last two to three months of each year due to consumers’ spending in anticipation of the holiday months and in the first month of the following year due to consumer spending in the previous holiday period. Collections generally tend to increase after income tax refunds are received by our customers. We expect this trend to continue for the foreseeable future. Any decrease in our collections, whether because of general economic conditions, a slowdown in the economy, increased unemployment or other factors, could have a material adverse effect on our business, financial condition and results of operations for the entire year.
Wholesale auction values may impact our profitability.
We sell repossessed automobiles at wholesale auction markets located throughout the United States. Auction proceeds from the sale of repossessed vehicles and other recoveries are usually not sufficient to cover the outstanding balance of the contract, and the resulting deficiency is charged off. Decreased auction proceeds resulting from the depressed prices at which used automobiles may be sold during periods of economic slowdown or recession will result in higher credit losses for us. Furthermore, depressed wholesale prices for used automobiles may result from significant liquidations of rental or fleet inventories or from increased volume of trade-ins due to promotional financing programs offered by new vehicle manufacturers. Our recoveries as a percentage of net charge-offs were 43.2%, 46.7% and 44.6% in 2007, 2006 and 2005, respectively. Our recovery rates may be lower in the future, which could result in higher charge-offs and losses for us.
Our customers may not maintain adequate insurance on our collateral, which could lead to greater losses.
All of our borrowers are required to maintain insurance on their vehicles, either as a matter of state law or pursuant to their contracts, or both. Some borrowers will allow their insurance to lapse from time to time. We have not historically obtained collateral protection insurance on these vehicles, even though most states allow creditors to do so. We have not done this because the cost of such coverage is difficult to recoup from the customers, and the litigation risks involved in maintaining such a program can be significant. Our losses attributable to lapses in insurance coverage have not been material in nature, but there can be no assurance that such losses will remain immaterial.
Our profitability may be directly affected by the level of and fluctuations in interest rates.
Our profitability may be directly affected by the level of and fluctuations in interest rates, which affects the gross interest rate spread we earn on our receivables. As the level of interest rates increases, our gross interest rate spread on new originations will generally decline because the rates charged on the contracts originated are limited by statutory maximums, restricting our opportunity to pass on increased interest costs to consumers. We believe that our profitability and liquidity could be adversely affected during any period of higher interest rates, possibly to a material degree. Fed funds rates decreased during 2007 to 4.25%, a decrease of 1.0% as compared to 2006. The Federal Reserve reduced rates an additional 1.25% in January 2008 and 0.75% in March 2008 pushing the fed funds rate to 2.25%. We monitor the interest rate environment and may employ pre-funding and other hedging strategies, such as interest rate swap agreements, designed to mitigate
the impact of changes in interest rates. However, pre-funding or other hedging strategies may not mitigate the impact of changes in interest rates.
Our inability to recruit or retain senior management or other qualified personnel could have an adverse impact on our operations.
We depend on the continued services of our senior executive officers. The loss of any key officer could have a material adverse effect on our business, financial condition and results of operations. We do not carry key man insurance for any of our management executives.
Competition to hire personnel possessing the skills and experience we require could contribute to an increase in our employee turnover rate. High turnover or an inability to attract and retain qualified replacement personnel could have an adverse effect on our delinquency, default and net loss rates and, ultimately, our financial condition, results of operations and liquidity.
The auto finance business is highly competitive.
The auto finance business is highly competitive. The automobile finance market is highly fragmented and is served by a variety of financial entities including thrifts, captive auto finance companies owned by major automobile manufacturers, banks, credit unions, savings associations and independent consumer finance companies that conduct business in the geographic regions in which we operate. Many of these competitors have greater financial and marketing resources than we have. On occasion, the captive finance companies provide financing on terms significantly more favorable to auto purchasers than we can offer. For example, the captive finance companies can offer special low interest loan programs as incentives to purchasers of selected models of automobiles manufactured by their respective affiliated manufacturers.
Many of our competitors also have long-standing relationships with automobile dealers and may offer dealers or their customers other forms of financing, including dealer floor plan financing and leasing, which we do not provide. Providers of automobile financing have traditionally competed on the basis of interest rates charged, the quality of credit accepted, the flexibility of contract terms offered and the quality of service provided to dealers and customers. In seeking to establish our position as one of the principal financing sources of the dealers we serve and a leading direct lender, we compete predominantly on the basis of our high level of dealer service and strong dealer and business partner relationships and by offering flexible contract terms. If we are unable to compete successfully in this market or against these competitors our business would be affected adversely.
Regulatory requirements may have a material adverse effect on our business, financial condition or operating results.
Our operations are subject to regulation, supervision and licensing under various federal, state and local statutes, ordinances and regulations.
In most states in which we operate, a consumer credit regulatory agency regulates and enforces laws relating to consumer lenders and sales finance agencies such as us. These rules and regulations generally provide for licensing of sales finance agencies and direct lenders, limitations on the amount, duration and charges, including interest rates, for various categories of contracts, requirements as to the form and content of finance contracts and other documentation, and restrictions on collection practices and creditors’ rights. In certain states, we are subject to periodic examination by state regulatory authorities.
We are also subject to extensive federal regulation, including the Truth in Lending Act, the Equal Credit Opportunity Act and the Fair Credit Reporting Act. These laws require us to provide certain disclosures to prospective borrowers and protect against discriminatory lending practices and unfair credit practices. The principal disclosures required under the Truth in Lending Act include the terms of repayment, the total finance charge and the annual percentage rate charged on each contract. The Equal Credit Opportunity Act prohibits creditors from discriminating against credit applicants on the basis of race, color, sex, age or marital status. Pursuant to Regulation B promulgated under the Equal Credit Opportunity Act, creditors are required to make
certain disclosures regarding consumer rights and advise consumers whose credit applications are not approved of the reasons for the rejection. In addition, the credit scoring system we use must comply with the requirements for such a system as set forth in the Equal Credit Opportunity Act and Regulation B. The Fair Credit Reporting Act requires us to provide certain information to consumers whose credit applications are not approved on the basis of a report obtained from a consumer reporting agency. Additionally, we are subject to the Gramm-Leach-Bliley Act, which requires us to maintain privacy with respect to certain consumer data in our possession and to periodically communicate with consumers on privacy matters. We are also subject to the Servicemembers Civil Relief Act, and similar state legislation, which require us to reduce the interest rate charged on contracts to customers who have subsequently enlisted, been inducted or called to active military duty and may restrict the exercise of remedies against such customers.
The dealers who originate automobile finance contracts that we purchase also must comply with both state and federal credit and trade practice statutes and regulations. Failure of the dealers to comply with these statutes and regulations could result in consumers having rights of rescission and other remedies that could have an adverse effect on us.
We believe that we maintain all material licenses and permits required for our current operations and are in substantial compliance with all applicable local, state and federal regulations. There can be no assurance; however, that we will be able to maintain all requisite licenses and permits, and the failure to satisfy those and other regulatory requirements could have a material adverse effect on our operations. Further, the adoption of additional, or the revision of existing, rules and regulations could have a material adverse effect on our business.
Various laws and other factors may limit the collection of payments on our contracts and repossession of the vehicles.
State and federal laws, including consumer bankruptcy laws, may prohibit, limit or delay repossession and sale of the vehicles to recover on defaulted automobile contracts. As a result, we may experience delays in receiving payments and suffer losses. Additional factors that may affect our ability to recoup the full amount due on an automobile contract include:
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our failure to file amendments to or receive certificates of title relating to the vehicles;
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depreciation of the financed vehicles;
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damage or loss of any financed vehicle; and
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the application of federal and state bankruptcy and insolvency laws.
We are parties to litigation matters that could adversely affect our financial condition, results of operations and cash flows.
As a consumer finance company, we are subject to various consumer claims and litigation seeking damages and statutory penalties, based upon, among other things, usury, disclosure inaccuracies, wrongful repossession, wrongful collection procedures, violations of bankruptcy stay provisions, certificate of title disputes, fraud and breach of contract. Some litigation against us could take the form of class action lawsuits by consumers. As the assignee of finance contracts originated by dealers, we may also be named as a co-defendant in lawsuits filed by consumers principally against dealers. The damages and penalties claimed by consumers in these types of matters can be substantial. The relief requested by the plaintiffs varies, but includes requests for compensatory, statutory and punitive damages.
Any adverse resolution of the litigation pending or threatened against us could have a material adverse effect on our financial condition, results of operations or cash flows.
We may pursue strategic acquisitions and expansion opportunities, which could have an adverse impact on our business.
We may, from time to time, consider acquiring complementary companies or businesses. To do so, we would need to identify suitable acquisition candidates, negotiate acceptable acquisition terms and obtain appropriate financing. Any acquisition that we pursue, whether or not successfully completed, may involve risks, including:
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the diversion of our capital and our management’s attention from other business issues and opportunities;
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difficulties in successfully integrating companies that we acquire, including personnel, financial systems and operations;
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material adverse effects on our operating results, particularly in the fiscal quarters immediately following the acquisition as it is integrated into our operations; and
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the incurrence of debt and contingent liabilities and impairment charges related to goodwill and other intangible assets, any of which could harm our business and financial condition.
Further, we will need to continue to effectively manage the expansion of our existing operations in order to execute our growth strategy of entering into new markets and expanding in existing markets. Growth may strain our existing resources. It is possible that our management, employees, systems and facilities currently in place may not be adequate to accommodate future growth. In this situation, we will have to improve our operational, financial and management controls, reporting systems and procedures. If we are unable to effectively manage our growth, our operations and financial results may be adversely affected.
Our financial products and services are complex, depend on a myriad of complex networks and technologies and may be subject to software or hardware errors or failures that could lead to an increase in our costs, reduction of our revenues or damage to our reputation.
Our products and services, and the networks and third-party services upon which our financial products and services are based, are complex and may contain undetected errors or may suffer unexpected failures. We are exposed to the risk of failure of our proprietary computer systems, some of which are deployed, operated, monitored and supported by third parties, whom we do not control. We rely on third parties to detect and respond to errors and failures in our proprietary computer systems. We also rely on third parties for software development and system support. We are exposed to the risk of failure of the computer systems that are owned, operated and managed by third parties, whom we do not control.
If we are unable to protect our intellectual property adequately, we may lose a valuable competitive advantage or be forced to incur costly litigation to protect our rights.
Our success depends on developing and protecting our intellectual property, including our proprietary scorecards. We rely on the terms of license agreements, as well as copyright, patent, trademark and trade secret laws to protect our intellectual property. We also rely on other confidentiality and contractual agreements and arrangements with our employees, affiliates, business partners and customers to establish and protect our intellectual property and similar proprietary rights. If we are unable to protect our intellectual property, our operations and financial results may be adversely affected.
Our substantial indebtedness could adversely affect our business and results of operations.
We have a significant amount of indebtedness. At December 31, 2007, we had on a consolidated basis outstanding indebtedness of $3,679.1 million. This level of indebtedness could:
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make it more difficult for us to meet all our obligations to creditors, who could then require us to, among other things, restructure our indebtedness, sell assets or raise additional debt or equity capital;
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require us to dedicate a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for operations and future business opportunities;
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limit our ability to borrow additional amounts for working capital, capital expenditures, debt service requirements, execution of our growth strategy or general corporate purposes;
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limit our flexibility in planning for, and reacting to, changes in our business and in our industry, which could make us more vulnerable to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation;
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place us at a disadvantage compared to our competitors that have less debt; and
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make it more difficult for us to satisfy the obligations of our notes.
Any of the above listed factors could materially adversely affect our business and results of operations.
Our indenture governing our notes and our warehouse and residual facilities restricts our operations.
Our indenture governing our notes restricts our ability to, among other things:
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sell or transfer assets, other than through warehousing and securitization activities;
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incur additional debt;
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repay other debt;
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pay dividends;
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make certain investments or acquisitions;
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repurchase or redeem capital stock;
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engage in mergers or consolidations; and
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engage in certain transactions with subsidiaries and affiliates.
Our warehouse and residual facilities and our indenture governing our notes require us to comply with certain financial ratios, covenants and asset quality maintenance requirements. These restrictions may interfere with our ability to obtain financing or to engage in other necessary or desirable business activities.
If we cannot comply with the requirements of our indenture governing our notes and our warehouse and residual facilities, we may be required to repay immediately all of the outstanding debt under them. If our debt payments were accelerated, our assets might not be sufficient to fully repay our debt. These lenders may require us to use all of our available cash to repay our debt, foreclose upon their collateral or prevent us from making payments to other creditors on certain portions of our outstanding debt.
We may not be able to obtain a waiver of these provisions or refinance our debt, if needed. In such a case, our financial condition, liquidity and results of operations would suffer.
We will continue to require significant amounts of cash to fund our operations.
We require substantial amounts of cash to fund our contract purchases and originations and securitization activities, including credit enhancement obligations. We expect to continue to require substantial amounts of cash to fund our operations.
In addition to requiring cash to fund contract purchases pending their securitization, we will also require cash to fund:
•
credit enhancement requirements in connection with the securitization of the receivables;
•
interest and principal payments under our warehouse and residual facilities, our notes and other indebtedness;
•
fees and expenses incurred in connection with the servicing of securitized receivables;
•
capital expenditures for technology and facilities;
•
ongoing operating expenses; and
•
income tax payments.
Our primary sources of liquidity in the future are expected to be:
•
borrowings under our warehouse and residual facilities;
•
securitizations of receivables;
•
cash flow received from securitization trusts;
•
cash flow from operating activities other than securitizations of receivables;
•
servicing fees from securitization trusts and our warehouse facilities; and
•
further issuances of debt or equity securities, depending on capital market conditions.
We believe that we will continue to require the execution of securitization transactions and the renewal of our warehouse and residual facilities in order to fund our future liquidity needs. If these sources of funding are unavailable to us on a regular basis or are only available on terms unacceptable to us, we will be required to significantly decrease contract origination activities and implement expense reductions, all of which may have a material adverse affect on our ability to achieve our business and financial objectives.
Our change from gain-on-sale to on-balance sheet accounting for our securitization transactions will significantly impact our future results of operations compared to our historical results.
Historically, we have structured our securitization transactions to meet the criteria for sales of auto receivables under generally accepted accounting principles in the United States of America, or “GAAP.” Thus, for all securitizations completed prior to April 29, 2005, we recorded a gain-on-sale of receivables when we sold the auto receivables to a securitization trust based on the net present value of expected excess cash flows from the securitized receivables. Following the Acquisition, we altered the accounting of our future securitization transactions to meet the criteria for on-balance sheet reporting. This change will significantly impact our future results of operations compared to our historical results. In particular, as a result of this change, our provision for credit losses and our net margin have increased significantly, with our provision for credit losses increasing initially at a greater rate than our net margin. In addition, our securitization income and net income have decreased, with no change to our cash flows, as a result of this accounting change. Accordingly, our historical results may not be indicative of our future results. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2.
PROPERTIES
Our executive offices are located at 7711 Center Ave., Suite 200, Huntington Beach, California 92647 in a 28,186 square foot office space lease that expires in 2011.
We also lease 164,812 square feet of office space in North Richland Hills, Texas under a lease that expires in 2012.
During 2007, the Company moved its loss recovery, remarketing, risk management, human resources and corporate legal functions to North Richland Hills, Texas. The Company is currently in the process of designating North Richland Hills, Texas as its corporate headquarters.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
As a consumer finance company, we are subject to various consumer claims and litigation seeking damages and statutory penalties, based upon, among other things, usury, disclosure inaccuracies, wrongful repossession, wrongful collection procedures, violations of bankruptcy stay provisions, certificate of title disputes, fraud and breach of contract. Some litigation against us may take the form of class action lawsuits by consumers. As the assignee of finance contracts originated by dealers, we may also be named as a co-defendant in lawsuits filed by consumers principally against dealers. The damages and penalties claimed by consumers in these types of matters can be substantial. The relief requested by the plaintiffs varies, but includes requests for compensatory, statutory and punitive damages.
We believe that we have taken prudent steps to address the litigation risks associated with our business activities. We are vigorously defending the litigation against us and, while we are unable to estimate a range of possible losses with respect to our pending litigation due to the preliminary stages of most of our proceedings, we do not believe that the outcome of these proceedings, individually or in the aggregate, will have a material effect on our financial condition, results of operations or cash flows.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
There is no trading market for our common stock. All of the outstanding shares of our common stock are held by Triad Holdings Inc.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
Set forth below is selected historical consolidated financial data. We derived the historical statement of income and balance sheet data for the periods indicated from our consolidated financial statements. We have derived the selected historical consolidated financial data at December 31, 2007, 2006 and 2005, for the years ended December 31, 2007 and 2006 and for the period April 30, 2005 through December 31, 2005 from our audited financial statements. We have derived the selected historical financial data at December 31, 2004 and 2003, for the period January 1, 2005 through April 29, 2005 and for the years ended December 31, 2004 and 2003 from the predecessor’s audited financial statements. The information presented below should be read in conjunction with, and qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our audited historical consolidated financial statements and related notes and other financial information appearing elsewhere in this document.
(1)
As a result of the terms of the Acquisition, we determined that there was an impairment of goodwill and recorded a $61.2 million pre-tax charge to earnings in 2004.
(2)
To assist in the evaluation of our financial results and to make it easier to understand our results of operations, the “predecessor” period (January 1 through April 29, 2005) and the “successor” period (April 30 through December 31, 2005) have been combined for the year ended December 31, 2005. These combined results should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this document for information on items impacting the comparability of predecessor and successor periods.
(3)
Total managed receivables consist of our total owned receivables and our total sold receivables in securitization transactions.
(4)
Net margin as reflected on the consolidated statements of income for the successor period (years ended December 31, 2007 and 2006 and the period April 30, 2005 through December 31, 2005) includes $29.4 million, $56.4 million and $83.6 million, respectively, of premium amortization related to our predecessor finance receivables held for investment and our receivables repurchased from gain on sale trusts. Excluding the $29.4 million, $56.4 million and $83.6 million of premium amortization, owned net margin as a percentage of average owned receivables would have been 11.5%, 12.3% and 14.3%, respectively.
(5)
In April 2004, we changed our charge-off policy such that all owned contracts which are more than 120 days delinquent are charged off, regardless of whether an obligor under the owned contract has filed for bankruptcy. Previously, we charged-off owned contracts with bankrupt obligors upon resolution of their bankruptcy cases. As a result of this change, net charge-offs for the year ended December 31, 2004 included a one-time charge-off of $32.6 million for contracts over 120 days delinquent with obligors who had filed for bankruptcy but whose bankruptcy cases had not yet been resolved. Excluding this one-time charge-off, our net charge-offs as a percentage of average owned and average total managed receivables would have been 5.6% and 6.6%, respectively, for the year ended December 31, 2004.
(6)
For purposes of calculating the ratio of earnings to fixed charges, earnings represent income (loss) before income taxes plus fixed charges. Fixed charges consist of total interest expense and one-third of rental expenses, which management believes are representative of the interest component of all operating leases. Earnings, as defined, were insufficient to cover our fixed charges for 2007 by $16.1 million.
(7)
Total managed net interest margin is the difference between (a) financing revenue, fee and other income earned on our total managed receivables and (b) the cost to fund the receivables and the cost of debt incurred for general corporate purposes. Total managed net interest margin is a calculation that assumes that securitized receivables have not been sold and are still on our consolidated balance sheet. Total managed net interest margin is not a measurement of financial performance determined under generally accepted accounting principles and should not be considered as an alternative to any other measures of performance determined under generally accepted accounting principles. We evaluate the profitability of our financing activities based partly upon the net margin related to our total managed receivables, including owned receivables and sold receivables. We use this information to analyze trends in the components of the profitability of our total managed receivables portfolio. Analysis of net margin on a total managed basis helps us to determine which origination channels and finance products are most profitable, guide us in making pricing decisions for finance products and indicates if sufficient spreads exist between our revenues and cost of funds to cover operating expenses and achieve corporate profitability objectives. Additionally, net interest margin on a total managed basis facilitates comparisons of our results with other finance companies that do not securitize their receivables and in the future will assist in comparisons of our results with other finance companies that, due to the structure of their securitization transactions, are not required to account for the securitization of their receivables as sales.
The following is a reconciliation of net interest margin as reflected on our consolidated statements of income to our total managed net interest margin:
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our historical consolidated financial statements covers periods before the consummation of the Transactions. From June 1999 through April 29, 2005, the Company was a wholly owned subsidiary of Fairlane Credit, LLC, a wholly-owned subsidiary of Ford Motor Credit Company, or “Ford Credit”. On April 29, 2005, a newly formed entity, Triad Holdings Inc. and its wholly-owned subsidiary, Triad Acquisition Corp., acquired all of the outstanding capital stock of the Company from Fairlane Credit, LLC, or the “Acquisition”. As part of the Acquisition, Triad Acquisition Corp. was merged with and into Triad Financial Corporation with the Company being the surviving corporation.
In accordance with the guidelines for accounting for business combinations, the purchase price paid by Triad Holdings Inc. plus related purchase accounting adjustments have been pushed-down and recorded in our financial statements for the period subsequent to April 29, 2005. This has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the “successor” period beginning April 30, 2005. Information for all “predecessor” periods prior to the Acquisition are presented using our historical basis of accounting.
To assist in the evaluation of our financial results and to make it easier to understand our results of operations, the “predecessor” period (January 1 through April 29, 2005) and the “successor” period (April 30 through December 31, 2005) have been combined for the year ended December 31, 2005. The following discussion and analysis of results of operations contains information on items impacting the comparability of the predecessor and successor periods.
The statements in the discussion and analysis regarding our expectations regarding the performance of our business, our liquidity and capital resources and other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors.” Our actual results may differ materially from those contained in or implied by any of these forward-looking statements.
General
Historically, we have generated earnings and cash flow primarily from the purchase, origination, retention, subsequent securitization and servicing of retail installment contracts and loans secured by automobiles. We purchase retail installment contracts from franchised and select independent automobile dealerships and originate auto loans directly to consumers. As used in this document, “contracts” include retail installment contracts originated by dealers and purchased by us and note and security agreements evidencing loans made directly by us to consumers. To fund the purchase and origination of receivables, we rely upon warehouse and residual credit facilities. During the period from June 1999 through July 2002, we did not securitize any auto receivables and held all auto receivables in our portfolio. Since August 2002, we have completed twelve securitizations of auto receivables. Prior to our May 2005 securitization transaction, all of our securitizations were accounted for as sales in accordance with accounting principles generally accepted in the United States of America, or “GAAP”.
We periodically sell receivables to securitization trusts, or “Trusts,” that, in turn, sell asset-backed securities to investors. Beginning with our May 2005 securitization, we made a decision to alter the structure of our securitization transactions to no longer meet the criteria for sales of auto receivables, but instead to meet the criteria for on-balance sheet reporting. Accordingly, following a securitization accounted for as a secured financing, the receivables and the related securitization indebtedness will remain on our balance sheet. We recognize finance revenue and fee income on the receivables and interest expense on the securities issued in the securitization and record a provision for credit losses over the life of the securitization. The principal changes to our securitization structures that result in the differing accounting treatment include the right of the trust to enter into interest rate derivative contracts with respect to retained interests and also allows the servicer to sell charged-off finance receivable contracts. Provisions such as these preclude the use of sale treatment in accordance with Statement of Financial Accounting Standards, or “SFAS”, No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.
For all securitizations accounted for as sales, we recognized a gain upon the sale of receivables to the Trusts, which represented the difference between the sale proceeds to us, net of transaction costs, and our net carrying value of the receivables, plus the present value of the estimated future excess cash flows to be received by us over the life of the securitization. Excess cash flows result from the difference between the interest received from the obligors on the receivables and the interest paid to investors in the asset-backed securities, net of credit losses and expenses. Excess cash flows from the Trusts are initially utilized to fund credit enhancement requirements in order to attain specific credit ratings for the asset-backed securities issued by the Trusts. Once predetermined credit enhancement requirements are reached and maintained, excess cash flows are distributed to us. In addition to excess cash flows, we earn monthly base servicing fee income of 2.25% per annum on the outstanding principal balance of receivables securitized, or “sold receivables,” and collect other fees such as late charges and extension fees as servicer for those Trusts.
Critical Accounting Policies and Use of Estimates
We prepare our financial statements in conformity with generally accepted accounting principles, which require management to make certain estimates that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Due to the inherent uncertainty involved in determining these estimates, actual results reported in future periods may differ from these estimates and could therefore affect the value of our assets and liabilities.
Critical estimates inherent within our financial statements include the carrying value of predecessor finance receivables held for investment and the allowance for credit losses.
Predecessor Finance Receivables Held For Investment
The carrying value of our finance receivables owned as of the acquisition date was adjusted to fair market value taking into account future expected credit losses, projected prepayments, and a required rate of return commensurate with the associated risk. Expected credit losses were based on factors such as historical credit loss trends, the credit quality of the acquired portfolio, trends in historical and projected used vehicle values and general economic measures. The expected credit loss assumptions are reviewed periodically, and should it be determined that actual losses are exceeding expected losses, we may be required to increase our estimate of expected losses, which would reduce the carrying value in the consolidated balance sheet and record an impairment charge to earnings in the consolidated statements of operations. A premium resulting from the revaluation of our predecessor finance receivables held for investment to fair market value in connection with the purchase transaction is being amortized against owned net interest margin over the remaining life of the receivables.
Allowance For Credit Losses
The allowance for credit losses is maintained at a level adequate to cover probable incurred credit losses related to impaired receivables originated subsequent to April 29, 2005 and classified as held for investment as of the date of the financial statements, taking into account the credit quality of the portfolio, historical credit loss trends, trends in projected used car values and general economic factors. We continuously evaluate actual portfolio performance of our finance receivables as compared to our assumptions. Should we determine that the portfolio performance, including delinquencies, defaults and net charge-offs, is worse than expected, we may be required to increase our allowance for credit losses. This increase in our allowance for credit losses would reduce the carrying value of our finance receivables held for investment and would also result in a higher provision for credit losses in the consolidated statements of operations.
Components of Revenues and Expenses
Most of our revenues are generated from the purchase and origination of receivables, other interest income, and securitization and servicing of our automobile installment contracts. Our revenues include financing revenue, other interest income, income related to sales of receivables and other income. We earn financing revenue from contracts we purchase and originate. Other interest income includes: (1) residual
interest income on the retained interest in securitized assets we retain from securitization transactions; and (2) income on our restricted cash accounts. Our servicing income includes: (1) the base servicing fee income we receive from the Trusts for servicing the receivables in those Trusts; and (2) the supplemental servicing fee income we receive from servicing the receivables in those Trusts. Our other income includes fees we collect on receivables, such as late charges, extension fees, proceeds from sales of gap insurance and extended service contracts, referral fees received from other lenders and payment convenience fees. Our other income also includes gains and losses on our interest rate swap agreements and gains and losses related to the repurchase of receivables from gain on sale trusts.
Our costs and expenses consist of interest expense, operating expenses, provision for credit losses and provision for income taxes. Our interest expense is the amount of interest and fees we pay on borrowings used to finance our purchase and origination of receivables and working capital needs. Our operating expenses represent costs associated with operating our dealer and direct channels and servicing our receivables, including rent and occupancy expense, compensation expense and servicing costs and prior to April 30, 2005, repossession and remarketing fees. Our provision for credit losses represents the charge necessary to maintain our allowance for credit losses at a level considered adequate to cover probable credit losses on receivables that are held for investment and originated subsequent to April 29, 2005.
Results of Operations
Year Ended December 31, 2007 as Compared to Year Ended December 31, 2006
Our net loss was $10.6 million for the year ended December 31, 2007 as compared to net income of $13.7 million for 2006. The decrease in net income was primarily due to a higher provision for credit losses, a decline in revenue from other sources and higher operating expenses partially offset by higher net interest margin. Our 2007 results included $17.5 million in losses on our derivative financial instruments and $5.3 million in expenses related to the transition of certain functions to our North Richland Hills, Texas facility.
Net Interest Margin
Our revenues are primarily generated from the purchase, origination, retention, subsequent securitization and servicing of auto receivables. Our average owned finance receivables outstanding are summarized as follows:
Average owned finance receivables increased by 9.9% for the year ended December 31, 2007 as compared to 2006. This increase was primarily attributable to an increased level of loan originations during 2006. We purchased and originated $1,346.5 million of contracts during the year ended December 31, 2007 as compared to $2,650.3 million during 2006. This decrease in originations was primarily due to lower levels of originations in our dealer channel. In response to higher than expected losses on receivables originated during 2006, we modified our contract origination strategy to better manage our credit risk, which resulted in lower volume levels during the last quarter of 2006 and 2007.
The average new contract size was $18,793 for the year ended December 31, 2007 as compared to $18,619 for the year ended December 31, 2006. The average annual percentage rate on contracts purchased and originated was 14.7% and 17.2% during the years ended December 31, 2007 and 2006, respectively. This decrease was due to an increased concentration of contracts from our direct channel during 2007, which had a lower weighted-average coupon. Our yields were also impacted by the implementation of new proprietary scorecards for the direct channel during the first quarter of 2007, combined with new pricing strategies within the direct channel designed to attract customers with higher expected credit quality.
Net interest margin on our owned finance receivables is summarized as follows:
The 9.8% increase in net interest margin for the year ended December 31, 2007 as compared to 2006 was due to an increase in financing income and other interest income, partially offset by an increase in interest expense.
The increase in financing income was due to increase in our average owned receivables and a lower level of premium amortization, partially offset by a decrease in yields on new contract originations. Effective April 30, 2005, we adjusted predecessor finance receivables held for investment to fair market value taking into account future expected credit losses and a required rate of return commensurate with the associated risk in connection with the purchase transaction. Financing income was reduced by $29.4 million and $56.4 million of premium amortization for the year ended December 31, 2007 and 2006, respectively, related to these receivables and receivables repurchased from gain on sale trusts. Excluding the premium amortization, the average yield on receivables for the years ended December 31, 2007 and 2006 would have been 16.2% and 17.1%, respectively.
During 2007 and 2006, expected cash flows from predecessor finance receivables held for investment and receivables repurchases from gain on sale trusts were reevaluated and determined to be greater than originally expected. This resulted in a reclassification of cash flows from nonaccretable discount to accretable discount. This also resulted in a higher net yield being recognized on these receivables which is expected to continue in future periods.
Other interest income increased to $35.8 million for the year ended December 31, 2007 as compared to $34.9 million for 2006. This increase was mainly due to the realization of $14.2 million in previously unrealized gains on our retained interest in securitized assets, combined with an increase in interest income received on restricted cash accounts, partially offset by a decrease in residual interest income caused by lower retained interest in securitized asset balances.
The increase in interest expense was due to both a higher cost of funds and higher average debt levels. Our effective cost of funds was 5.8% for the year ended December 31, 2007 as compared to 5.7% for the year ended December 31, 2006. This increase in our effective cost of funds was primarily due to higher interest rates on our 2006 and 2007 securitization transactions. Average debt outstanding was $3,777.3 million and $3,559.2 million for 2007 and 2006, respectively.
Provision for Credit Losses
Our provision for credit losses was $284.5 million for the year ended December 31, 2007 as compared to $256.8 million for 2006. Our provision for credit losses increased as a result of the increase in size of the portfolio of finance receivables originated subsequent to the Acquisition, an increase in the average age of the portfolio and higher net charge-offs, partially offset by lower net charge-offs on our recent direct channel originations with higher expected credit quality. The increase in net charge-offs is attributable to a number of factors including higher than expected losses on receivables originated during 2006, the impact of a larger percentage of those 2006 receivables reaching the age at which higher delinquencies and losses are more likely to occur and higher mandatory charge-offs.
Servicing Income
Servicing income decreased to $7.8 million for the year ended December 31, 2007 as compared to $22.0 million for the year ended December 31, 2006. Servicing income represents servicing fees and late fees collected on sold receivables. The decrease in servicing income for the year ended December 31, 2007 as compared to the year ended December 31, 2006 was primarily attributable to the declining balance of our sold receivables.
Other Income (Expense)
Other income (expense) is summarized as follows:
Our other income (expense) includes customer fees we collect on owned finance receivables, such as late charges and extension fees, proceeds from sales of gap insurance and extended service contracts, referral fees received from other lenders, payment convenience fees, gains and losses on our derivative financial instruments and losses related to the repurchase of receivables from gain on sale trusts.
Customer fees decreased to $18.9 million for year ended December 31, 2007 as compared to $20.0 million for the year ended December 31, 2006 primarily due to a decrease in late charges collected attributable to rising delinquencies.
Our derivative financial instruments are recognized on our consolidated balance sheet at fair value with changes in the value recorded in earnings as a component of other income (expense). Our derivative financial instruments include forward-starting swap agreements utilized to lock in the cost of funds on outstanding notional amounts of receivables prior to their securitization. During 2007, our derivative financial instruments also included interest rate swap agreements utilized to convert variable rate exposure on our 2007 securitization transactions to fixed rates. For the year ended December 31, 2007, our $17.5 million in losses on derivative financial instruments was comprised of $9.7 million in losses on our interest rate swap agreements and $7.8 million in losses on our forward-starting swap agreements. These losses were a result of a declining interest rate environment throughout the latter half of the year. For the year ended December 31, 2006, our $0.7 million in gains on derivative financial instruments were comprised entirely of gains on our forward-starting swap agreements.
Other decreased to an expense of $5.3 million for the year ended December 31, 2007 as compared to income of $1.0 million for the year ended December 31 2006 primarily due to a $7.0 million loss recorded on the repurchase of receivables from gain on sale trusts during 2007.
Expenses
Operating expenses were $146.8 million for the year ended December 31, 2007 as compared to $138.6 million for the year ended December 31, 2006. The $8.2 million increase in operating expenses for the year ended December 31, 2007 as compared to 2006 was due to higher levels of compensation and employee benefits and advertising expenses, partially offset by a decrease in system and data processing expenses. Additionally, operating expenses for the year ended December 31, 2007 included $5.3 million in expenses related to the transition of certain functions to our North Richland Hills, Texas facility and a $1.6 million payment to a former chief executive officer for the repurchase of his option shares vested as of his July 2005 termination date. Operating expenses for the year ended December 31, 2006 included a $2.0 million charge
associated with sale of extended service contracts. Annualized operating expenses as a percentage of average total managed receivables were 3.6% for the year ended December 31, 2007 as compared to 3.3% for the year ended December 31, 2006.
Income Taxes
We recognized an income tax benefit of $5.5 million for the year ended December 31, 2007 as compared to tax expense of $8.9 million for the year ended December 31, 2006. Our effective income tax rate was 34.3% and 39.6% for the year ended December 31, 2007 and 2006, respectively. Our income tax benefit for the year ended December 31, 2007 was partially offset by $0.7 million recognized for the potential payment of interest.
Credit Quality
We provide financing in relatively high-risk markets, and, therefore, anticipate a corresponding higher level of delinquencies and charge-offs.
Provisions for credit losses are charged to operations in amounts sufficient to maintain the allowance for credit losses on the balance sheet at a level considered adequate to cover our probable incurred credit losses related to impaired held for investment receivables as of the date of the balance sheet. Receivables held for investment are charged-off to the allowance for credit losses at the earlier of repossession of the collateral or when the account is otherwise deemed uncollectable. Predecessor finance receivables held for investment were adjusted to fair market value in connection with the purchase transaction taking into account future expected credit losses and a required rate of return commensurate with the associated risk.
The following table presents certain data related to our owned finance receivables:
The increase in the allowance for credit losses as a percentage of receivables at December 31, 2007 as compared to December 31, 2006 was due to the continued aging of our owned finance receivables held for investment. As of December 31, 2007 and 2006, the finance receivables held for investment are aged, on a weighted average basis, 14.2 months and 8.0 months, respectively.
Finance receivables that are (1) more than 30 days delinquent, but not yet in repossession, and (2) in repossession are summarized as follows:
Delinquencies in our receivables portfolio may vary from period to period based upon credit quality, the average age of the portfolio, seasonality within the calendar year and economic factors. Due to our target customer base, a relatively high percentage of accounts become delinquent at some point in the life of a contract and there is a fairly high rate of account movement between current and delinquent status in the portfolio. Total delinquencies were higher at December 31, 2007 as compared to December 31, 2006 due, in part, to an increase in the average age of our portfolio. Specifically, as the receivables originated in 2006 increase in age, a larger percentage of that vintage is reaching the stage at which higher delinquencies and losses are more likely to occur. Additional reasons for the rising delinquencies include macroeconomic factors, servicing practices and credit characteristics of the portfolio.
We at times offer payment extensions, in accordance with our policies and guidelines, to consumers to assist them when temporary financial difficulties interfere with their ability to make scheduled payments. Our policies and guidelines, as well as certain contractual restrictions in our securitization transactions, limit the number and frequency of extensions that may be granted. An account for which all delinquent payments are extended is classified as current at the time the extension is granted, resulting in lower delinquencies. Thereafter, such account’s delinquency status is determined in the same manner as any other account.
We evaluate the results of our extension strategies based upon the portfolio performance on accounts that have been extended versus accounts that have not been extended over the same period of time and as a result of that evaluation, we make periodic adjustments to our extension strategy. We believe that payment extensions granted according to our policies and guidelines are an effective portfolio management technique and result in higher ultimate cash collections from the portfolio.
Payment extensions as a percentage of owned finance receivables outstanding are summarized as follows:
As the finance receivables portfolio ages, more accounts become eligible for extensions. Payment extensions as a percentage of total owned finance receivables increased to 26.8% at December 31, 2007 as compared with 16.7% at December 31, 2006, mainly driven by an increase in 1-2 times payment extensions, which increased to 26.1% at December 31, 2007 as compared to 16.4% at December 31, 2006. We have
guidelines concerning when accounts become eligible for extensions, including a requirement that the borrower has made a minimum of six installment payments. At December 31, 2007, nearly all of the finance receivable accounts originated during 2006 were extension-eligible. As a result, a greater proportion of extensions were granted on accounts originated in 2006 than to those accounts originated in other years. This factor, as well as the increase in the average age of the overall portfolio, contributed to the increase in the number of extensions granted. In addition, we adopted a strategy to increase the number of extensions granted as our historical data indicated that contracts extended are more likely than not to result in additional collections over the life of the contract. We continue to monitor our extension strategy, and we believe that the judicious use of payment extensions is an effective portfolio management technique.
Payment extensions do not have a direct impact on the amount of our finance receivables charged-off and the corresponding credit quality ratios. Payment extensions may, however, impact the timing of these charge-offs in the event a previously extended account is ultimately charged-off. Additionally, the impact of payment extensions is considered in determining the allowance for credit losses and the resulting provision for credit losses.
Charge-off data with respect to our average owned finance receivables is summarized as follows:
(1)
Mandatory charge-offs represent accounts charged-off in full with no recovery amounts realized at time of charge-off.
(2)
Net charge-offs for our owned portfolio include charge-offs from our finance receivables held for investment, our predecessor finance receivables held for investment and our finance receivables repurchased from gain on sale trusts.
Annualized net charge-offs as a percentage of our average owned finance receivables outstanding may vary from period to period based upon the credit quality of the portfolio, average age of the portfolio and economic factors. The increase in annualized net charge-offs as a percentage of average owned finance receivables to 8.0% for the year ended December 31, 2007 as compared to 5.5% for the year ended December 31, 2006 was due to higher charge-offs and a decrease in recoveries as a percentage of charge-offs. The increase in charge-offs was due to an increase in the average age of our portfolio, higher than expected credit losses on receivables originated in 2006 and higher mandatory charge-offs. The increase in mandatory charge-offs was due to, among other things, an increase in the average days to repossess, which resulted in a greater percentage of accounts reaching 120 days’ delinquency prior to the recovery of the collateral. The decrease in recoveries as a percentage of charge-offs was primarily due to a higher level of mandatory charge-offs.
Total Managed Information
We evaluate the profitability of our lending activities based partly upon our total managed auto finance receivables portfolio, including both owned finance receivables and sold finance receivables. We have historically securitized our receivables in transactions that met the criteria for a sale of such receivables. The net margin and credit quality information presented below on a total managed basis assumes that securitized and sold receivables had not been sold and are still on our consolidated balance sheet. Accordingly, no gain on
sale or servicing fee income would have been recognized. Instead, finance charge and fee income would be recognized over the life of the securitized receivables as accrued, and interest expense and other costs related to the asset-backed securities would be recognized as incurred.
We use this information to analyze trends in the components of the profitability of our total managed receivables portfolio. Analysis of this data on a total managed basis helps us to determine which origination channels and finance products are most profitable, guide us in making pricing decisions for finance products and indicates if sufficient spreads exist between our revenues and cost of funds to cover operating expenses and achieve corporate profitability objectives. Additionally, total managed information facilitates comparisons of our results with other finance companies that do not securitize their receivables or other finance companies that securitize their receivables in securitization transactions that do not meet the criteria for sales of receivables. Total managed information is not a measurement of financial performance under GAAP and should not be considered as an alternative to any other measures of performance determined under GAAP.
Beginning with our May 2005 securitization transaction, we altered the structure of our securitization transactions to no longer meet the criteria for sales of auto receivables, but instead to meet the criteria for on-balance sheet reporting. Accordingly, following a securitization accounted for as a secured financing, the receivables and the related securitization indebtedness will remain on our balance sheet. Additionally, we will recognize finance revenue and fee income on the receivables and interest expense on the securities issued in the securitization and record a provision for credit losses over the life of the securitization. As a result of this change, our provision for credit losses and our net margin increased significantly, with our provision for credit losses increasing initially at a greater rate than our net margin because we began recording a provision for credit losses upon the purchase of each contract. In addition, our securitization income decreased and net income initially decreased, with no change to our cash flows, as a result of this accounting change.
Our average total managed finance receivables outstanding are summarized as follows:
Total Managed Net Interest Margin
Net interest margin for our total managed receivables portfolio are summarized as follows:
Reconciliation of net interest margin as reflected in our consolidated statements of income to total managed net interest margin is summarized as follows:
Net interest margin as a percentage of average total managed receivables is summarized as follows:
Net interest margin as a percentage of average total managed receivables decreased to 11.0% for the year ended December 31, 2007 as compared to 12.2% for the year ended December 31, 2006. This decrease in net interest margin was due to a decrease in yield on receivables combined with an increase in average cost of funds. The decrease in yield was mainly due to a greater volume of loans in our direct channel to customers with higher expected credit quality. The increase in our cost of funds was primarily due to higher interest rates on our 2006 and 2007 securitization transactions and higher losses on our interest rate swaps. Excluding gain (losses) on our forward- starting swap agreements, annualized net interest margin as a percentage of average total managed receivables would have been 11.2% for the year ended December 31, 2007 as compared to 12.2% for the year ended December 31, 2006.
Total Managed Credit Quality
We have periodically sold receivables in securitization transactions to Trusts and retained an interest in the receivables sold in the form of retained interest in securitized assets. Retained interests in securitized assets are reflected on our balance sheet at fair value, calculated based upon the present value of estimated excess future cash flows from the Trusts using, among other assumptions, probable future cumulative credit losses on the receivables sold. Charge-offs of receivables that have been sold to Trusts decrease the amount of excess future cash flows from the Trusts. If such charge-offs are expected to exceed our original probable cumulative credit losses, the fair value of retained interest in securitized assets could be written down through an impairment charge to earnings.
Certain data related to our total managed receivables finance receivable portfolio are summarized as follows:
Receivables that are (1) more than 30 days delinquent, but not yet in repossession, and (2) in repossession are summarized as follows:
Delinquencies in our total managed receivables portfolio may vary from period to period based upon credit quality, the average age of the portfolio, seasonality within the calendar year and economic factors. Delinquencies for our total managed portfolio were higher at December 31, 2007 as compared to December 31,
2006 due, in part, to an increase in the average age of our portfolio. Specifically, as the receivables originated in 2006 increase in age, a larger percentage of that vintage is reaching the stage at which higher delinquencies and losses are more likely to occur. Additional reasons for the rising delinquencies include macroeconomic factors, servicing practices and credit characteristics of the portfolio.
We at times offer payment extensions, in accordance with our policies and guidelines, to consumers to assist them when temporary financial difficulties interfere with their ability to make scheduled payments. Our policies and guidelines, as well as certain contractual restrictions in our securitization transactions, limit the number and frequency of extensions that may be granted. An account for which all delinquent payments are extended is classified as current at the time the extension is granted. Thereafter, such account is aged based on the timely payment of future installments in the same manner as any other account, resulting in lower delinquencies.
We evaluate the results of our extension strategies based upon the portfolio performance on accounts that have been extended versus accounts that have not been extended over the same period of time and as a result of that evaluation, we make periodic adjustments to our extension strategy. We believe that payment extensions granted according to our policies and guidelines are an effective portfolio management technique and result in higher ultimate cash collections from the portfolio.
The following is a summary of payment extensions as a percentage of owned, sold and total managed receivables outstanding:
As of December 31, 2007 and 2006, the total managed finance receivables are aged, on a weighted average basis, 19.4 months and 15.6 months, respectively. As the total managed finance receivables portfolio ages, more accounts become eligible for extensions. We have guidelines concerning when accounts become eligible for extensions, including a requirement that the borrower has made a minimum of six installment payments. At December 31, 2007, nearly all of the finance receivable accounts originated during 2006 were extension-eligible. As a result, a greater proportion of extensions were granted on accounts originated in 2006 than to those accounts originated in other years. This factor, as well as the increase in the average age of the overall portfolio, contributed to the increase in the number of extensions granted. In addition, we adopted a strategy to increase the number of extensions granted as our historical data indicated that contracts extended are more likely than not to result in additional collections over the life of the contract. At December 31, 2007 and December 31, 2006, our sold receivables portfolio was more seasoned than our owned receivables and
therefore, had a higher level of extensions. We continue to monitor our extension strategy, and we believe that the judicious use of payment extensions is an effective portfolio management technique.
Payment extensions do not have a direct impact on the amount of our finance receivables charged-off and the corresponding credit quality ratios. Payment extensions may, however, impact the timing of these charge-offs in the event a previously extended account is ultimately charged-off. Additionally, the impact of payment extensions is considered in determining the allowance for credit losses and the resulting provision for credit losses.
Charge-off data with respect to our finance receivables portfolio is summarized as follows:
(1)
Mandatory charge-offs represent accounts charged-off in full with no recovery amounts realized at time of charge-off.
(2)
Net charge-offs for our owned portfolio include charge-offs from our finance receivables held for investment, our predecessor finance receivables held for investment and our finance receivables repurchased from gain on sale trusts.
Net charge-offs as a percentage of our average total managed finance receivables outstanding may vary from period to period based upon the credit quality of the portfolio, average age of the portfolio and economic factors. The increase in annualized net charge-offs as a percentage of average total managed finance receivables to 8.0% for the year ended December 31, 2007 as compared to 5.8% for the year ended December 31, 2006 was due to higher charge-offs and a decrease in recoveries as a percentage of charge-offs. The increase in charge-offs was due to an increase in the average age of our portfolio, higher than expected credit losses on receivables originated in 2006 and higher mandatory charge-offs. The increase in mandatory charge-offs was due to, among other things, an increase in the average days to repossess which resulted in a greater percentage of accounts reaching 120 days’ delinquency prior to the recovery of the collateral. The decrease in recoveries as a percentage of charge-offs was primarily due to a higher level of mandatory charge-offs.
Year Ended December 31, 2006 as Compared to Year Ended December 31, 2005
Our net income was $13.7 million for the year ended December 31, 2006, compared to $48.3 million for 2005. The decrease in net income was primarily due to higher provision for credit losses and lower other revenues, partially offset by higher net interest margin and lower expenses.
Net Interest Margin
Our revenues are primarily generated from the purchase, origination, retention, subsequent securitization and servicing of auto receivables. Our average owned finance receivables outstanding are summarized as follows:
Average owned finance receivables increased by 57.5% for the year ended December 31, 2006 as compared to 2005. This increase was primarily attributable to an increase in new loan originations. We purchased and originated $2,650.3 million of contracts during 2006, compared to $1,880.2 million during 2005. This increase was due to a higher level of originations in our dealer channel resulting from increased efforts to sign up new dealers combined with the introduction of our third generation scorecard in December 2005.
The average new contract size was $18,619 for the year ended December 31, 2006, compared to $18,066 for 2005. The average annual percentage rate on contracts purchased and originated was 17.2% and 16.1% during the years ended December 31, 2006 and 2005, respectively.
Net interest margin on our owned finance receivables is summarized as follows:
The 59.4% increase in net interest margin for the year ended December 31, 2006 as compared to 2005 was due to an increase in financing income partially offset by an increase in interest expense combined with a decrease in other interest income. Net interest margin included $56.4 million and $83.6 million of premium amortization for the year ended December 31, 2006 and for the period April 30, 2005 through December 31, 2005, respectively, related to our predecessor finance receivables held for investment and our receivables repurchased from gain on sale trusts.
The increase in financing income was due to both an increase in our average owned receivables and an increase in our average yield on receivables. The increase in our average yield on receivables to 15.5% for the year ended December 31, 2006 from 13.0% in 2005 was due in part to an increase in pricing, together with a shift to an increased concentration of contracts with a higher weighted-average coupon due to higher credit risk, combined with lower net premium amortization. Effective April 30, 2005, we adjusted predecessor finance receivables held for investment to fair market value taking into account future expected credit losses and a required rate of return commensurate with the associated risk in connection with the purchase transaction. Financing income was reduced by $56.4 million and $83.6 million of premium amortization for the year ended December 31, 2006 and 2005, respectively, related to these receivables and receivables
repurchased from gain on sale trusts. Excluding the premium amortization, the average yield on receivables for the years ended December 31, 2006 and 2005 would have been 17.1% and 16.7%, respectively.
During 2006, expected cash flows from predecessor finance receivables held for investment were reevaluated and determined to be greater than originally expected. This resulted in a reclassification of cash flows from nonaccretable discount to accretable discount. This also resulted in a higher net yield being recognized on these receivables during 2006 which is expected to continue in future periods.
Other interest income decreased to $34.9 million for the year ended December 31, 2006, compared to $53.8 million for 2005. This decrease was mainly due to a decrease in residual interest income caused by lower retained interest in securitized asset balances, partially offset by an increase in interest income received on restricted cash accounts.
The increase in interest expense was due to both a higher cost of funds and higher average debt levels. Our effective cost of funds was 5.7% for the year ended December 31, 2006, as compared to 4.7% for the year ended December 31, 2005, due to both higher interest rates and a greater concentration of higher-cost forms of borrowing, including our warehouse and residual loan facilities, securitization notes payable and senior notes payable. Average debt outstanding was $3,559.2 million and $2,280.7 million for 2006 and 2005, respectively.
Provision for Credit Losses
Our provision for credit losses was $256.8 million for the year ended December 31, 2006 as compared to $58.9 million for 2005. Our provision for credit losses increased significantly as a result of the increase in size of the portfolio as well as an increase in the average age, or seasoning, of the portfolio and higher net charge-offs. In addition, we experienced higher than expected losses on receivables originated after the Acquisition.
Servicing Income
Servicing income is summarized as follows:
Servicing income decreased to $22.0 million for the year ended December 31, 2006, compared to $35.9 million for the year ended December 31, 2005. Servicing income represents servicing fees and late fees collected on sold receivables and is partially offset by impairment charges on our retained interest. The decrease in servicing income for the year ended December 31, 2006 as compared to 2005 was primarily related to a decrease in servicing fee income caused by lower average sold receivable balances. There were no impairment charges on our retained interest in securitized assets during the year ended December 31, 2006.
Other Income
Other income is summarized as follows:
Our other income includes customer fees we collect on owned finance receivables, such as late charges and extension fees, proceeds from sales of gap and warranty insurance policies and payment convenience fees, and gains on derivative financial instruments. Excluding gains on derivative financial instruments, the increase in other income for the year ended December 31, 2006 as compared to 2005 was primarily due to higher customer fees attributable to higher owned receivable balances. Our derivative financial instruments are recognized on our consolidated balance sheet at fair value with changes in the value recorded in earnings as a component of other income.
Expenses
Operating expenses were $138.6 million for the year ended December 31, 2006, compared to $125.7 million for the year ended December 31, 2005. The $12.9 million increase in operating expenses for the year ended December 31, 2006 as compared to 2005 was due in part to a $2.0 million charge related to the sale of extended service contracts combined with higher costs associated with increased loan application volume, increased servicing costs related to portfolio growth and our decision to maintain lower account-to-collector ratios, together with higher compensation expense, higher outside contractor fees and higher data processing expenses. By comparison, 2005 expenses were higher due to $7.4 million in one-time charges attributable to relocation, severance and litigation settlement expenses and an additional $6.5 million incurred for the period January 1, 2005 through April 29, 2005 due to our decision to treat repossession and remarketing expenses as a component of credit losses rather than as operating expense. Annualized operating expenses as a percentage of average total managed receivables remained unchanged at 3.3% for the years ended December 31, 2006 and 2005.
Other expenses were $0 and $30.5 million for the years ended December 31, 2006 and 2005, respectively. Prior to April 30, 2005, other expenses represented write-downs to market value on loans that no longer met our securitization and sale criteria and that were subsequently transferred from our held for sale portfolio to our held for investment portfolio. In connection with our April 29, 2005 acquisition, all finance receivables were classified as held for investment, as we have the ability and intent to hold these receivables until maturity.
Income Taxes
Income tax expense was $8.9 million for the year ended December 31, 2006, as compared to $29.7 million in 2005. Our effective income tax rate was 39.6% for 2006 and 39.3% for the period April 30, 2005 through December 31, 2005. Prior to April 30, 2005, our effective income tax rate was 37.7% and was based on our intercompany tax sharing agreement with Ford Credit. The rate differential was due to an increase in the state tax rate as a result of the Acquisition.
Credit Quality
We provide financing in relatively high-risk markets, and, therefore, anticipate a corresponding higher level of delinquencies and charge-offs.
Provisions for credit losses are charged to operations in amounts sufficient to maintain the allowance for credit losses on the balance sheet at a level considered adequate to cover our probable incurred credit losses related to impaired held for investment receivables as of the date of the balance sheet. Receivables held for investment are charged-off to the allowance for credit losses at the earlier of repossession of the collateral or when the account is otherwise deemed uncollectable. Predecessor finance receivables held for investment were adjusted to fair market value in connection with the purchase transaction taking into account future expected credit losses and a required rate of return commensurate with the associated risk.
Certain data related to our owned finance receivables are summarized as follows:
The increase in the allowance for credit losses as a percentage of receivables at December 31, 2006 as compared to December 31, 2005 was due to the continued aging of our owned finance receivables held for investment. As of December 31, 2006 and 2005, the finance receivables held for investment are aged, on a weighted average basis, 8.0 months and 3.3 months, respectively.
Finance receivables that are (1) more than 30 days delinquent, but not yet in repossession, and (2) in repossession are summarized as follows:
Delinquencies in our receivables portfolio may vary from period to period based upon credit quality, the average age of the portfolio, seasonality within the calendar year and economic factors. Due to our target customer base, a relatively high percentage of accounts become delinquent at some point in the life of a contract and there is a fairly high rate of account movement between current and delinquent status in the portfolio. Total delinquencies, including repossessions, were higher at December 31, 2006 as compared to December 31, 2005, due to an increase in the average age, or seasoning, of our owned portfolio combined with a higher delinquency trend in the contracts originated subsequent to the Acquisition and the strategic decision to allow our pool of receivables greater than 60 days delinquent more time to make payments prior to repossession.
We at times offer payment extensions, in accordance with our policies and guidelines, to consumers to assist them when temporary financial difficulties interfere with their ability to make scheduled payments. Our policies and guidelines, as well as certain contractual restrictions in our securitization transactions, limit the
number and frequency of extensions that may be granted. An account for which all delinquent payments are extended is classified as current at the time the extension is granted resulting in lower delinquencies. Thereafter, such account’s delinquency status is determined in the same manner as any other account.
We evaluate the results of our extension strategies based upon the portfolio performance on accounts that have been extended versus accounts that have not been extended over the same period of time. We believe that payment extensions granted according to our policies and guidelines are an effective portfolio management technique and result in higher ultimate cash collections from the portfolio.
Payment extensions as a percentage of owned finance receivables outstanding is summarized as follows:
Payment extensions as a percentage of total owned finance receivables increased to 16.7% at December 31, 2006 compared with 10.9% in 2005, mainly driven by an increase in 1-2 times payment extensions which increased to 16.4% at December 31, 2006 as compared to 10.6% in same period last year. The increase in payment extensions is primarily due to an increase in the average age, or seasoning, of our portfolio. In addition, we adopted a strategy to increase the number of extensions granted on a seasonal basis, as our historical data indicated that contracts extended are more likely than not to result in additional collections over the life of the contract. We continue to monitor our extension strategy, and we believe that the judicious use of payment extensions is an effective portfolio management technique.
Payment extensions do not have a direct impact on the amount of our finance receivables charged-off and the corresponding credit quality ratios. Payment extensions may, however, impact the timing of these charge-offs in the event a previously extended account is ultimately charged-off. Additionally, the impact of payment extensions is considered in determining the allowance for credit losses and the resulting provision for credit losses.
Charge-off data with respect to our average owned finance receivables is summarized as follows:
(1)
Mandatory charge-offs represent accounts charged-off in full with no recovery amounts realized at time of charge-off.
(2)
Net charge-offs for our owned portfolio include charge-offs from our finance receivables held for investment, our predecessor finance receivables held for investment and our finance receivables repurchased from gain on sale trusts.
Net charge-offs as a percentage of our average owned finance receivables outstanding may vary from period to period based upon the credit quality of the portfolio, average age or seasoning of the portfolio and economic factors. The increase in net charge-offs as a percentage of average owned finance receivables to 5.5% for the year ended December 31, 2006 as compared to 4.3% for 2005 was primarily due to higher charge-offs. The increase in charge-offs was due to an increase in the average age, or seasoning, of our portfolio combined with the inclusion of repossession and remarketing expenses as a component of credit losses as well as higher than expected credit losses on receivables originated after the Acquisition. Subsequent to April 29, 2005, repossession and remarketing expenses on our owned finance receivables are no longer classified as operating expenses, but rather a component of credit losses on charged-off receivable balances. The decrease in recoveries as a percentage of charge-offs were primarily attributable to the inclusion of repossession and remarketing expenses as a component of credit losses beginning April 30, 2005.
Total Managed Information
We evaluate the profitability of our lending activities based partly upon our total managed auto finance receivables portfolio, including both owned finance receivables and sold finance receivables. We have historically securitized our receivables in transactions that met the criteria for a sale of such receivables. The net margin and credit quality information presented below on a total managed basis assumes that securitized and sold receivables had not been sold and are still on our consolidated balance sheet. Accordingly, no gain on sale or servicing fee income would have been recognized. Instead, finance charge and fee income would be recognized over the life of the securitized receivables as accrued, and interest expense and other costs related to the asset-backed securities would be recognized as incurred.
We use this information to analyze trends in the components of the profitability of our total managed receivables portfolio. Analysis of this data on a total managed basis helps us to determine which origination channels and finance products are most profitable, guide us in making pricing decisions for finance products and indicates if sufficient spreads exist between our revenues and cost of funds to cover operating expenses and achieve corporate profitability objectives. Additionally, total managed information facilitates comparisons of our results with other finance companies that do not securitize their receivables or other finance companies that securitize their receivables in securitization transactions that do not meet the criteria for sales of receivables. Total managed information is not a measurement of financial performance under GAAP and should not be considered as an alternative to any other measures of performance determined under GAAP.
Beginning with our May 2005 securitization transaction, we altered the structure of our securitization transactions to no longer meet the criteria for sales of auto receivables, but instead to meet the criteria for on-balance sheet reporting. Accordingly, following a securitization accounted for as a secured financing, the receivables and the related securitization indebtedness will remain on our balance sheet. Additionally, we will recognize finance revenue and fee income on the receivables and interest expense on the securities issued in the securitization and record a provision for credit losses over the life of the securitization. As a result of this change, our provision for credit losses and our net margin have increased significantly, with our provision for credit losses increasing initially at a greater rate than our net margin because we began recording a provision for credit losses upon the purchase of each contract. In addition, our securitization income and net income have decreased, with no change to our cash flows, as a result of this accounting change.
Our average total managed finance receivables outstanding are summarized as follows:
Total Managed Net Interest Margin
Net interest margin for our total managed receivables portfolio are summarized as follows:
Reconciliation of net interest margin as reflected in our consolidated statements of income to total managed net interest margin is summarized as follows:
Net interest margin as a percentage of average total managed receivables is summarized as follows:
Net interest margin as a percentage of average total managed receivables decreased to 12.2.% for the year ended December 31, 2006 as compared to 13.3% for the same period last year. This decrease was mainly due to higher interest expense. The increase in interest expense was due to higher interest rates, the impact of lower gains on interest rate swaps, and higher cost forms of borrowing. Excluding gain (losses) on interest rate swaps, annualized net interest margin as a percentage of average total managed receivables would have been 12.2% and 13.1%, respectively, for the year ended December 31, 2006 and 2005.
Total Managed Credit Quality
We have periodically sold receivables in securitization transactions to Trusts and retained an interest in the receivables sold in the form of retained interests in securitized assets. Retained interests in securitized assets are reflected on our balance sheet at fair value, calculated based upon the present value of estimated excess future cash flows from the Trusts using, among other assumptions, probable future cumulative credit losses on the receivables sold. Charge-offs of receivables that have been sold to Trusts decrease the amount of excess future cash flows from the Trusts. If such charge-offs are expected to exceed our original probable cumulative credit losses, the fair value of retained interest in securitized assets could be written down through an impairment charge to earnings.
Certain data related to our total managed receivables finance receivable portfolio are summarized as follows:
Receivables that are (1) more than 30 days delinquent, but not yet in repossession, and (2) in repossession are summarized as follows:
Delinquencies in our total managed receivables portfolio may vary from period to period based upon credit quality, the average age or seasoning of the portfolio, seasonality within the calendar year and economic factors. Delinquencies for our total managed portfolio were higher at December 31, 2006 compared to 2005 due to a higher delinquency trend in the contracts originated subsequent to the Acquisition and the strategic decision to allow our pool of receivables greater than 60 days delinquent more time to make payments prior to repossession.
We at times offer payment extensions, in accordance with our policies and guidelines, to consumers to assist them when temporary financial difficulties interfere with their ability to make scheduled payments. Our policies and guidelines, as well as certain contractual restrictions in our securitization transactions, limit the number and frequency of extensions that may be granted. An account for which all delinquent payments are extended is classified as current at the time the extension is granted resulting in lower delinquencies. Thereafter, such account’s delinquency status is determined in the same manner as any other account.
We evaluate the results of our extension strategies based upon the portfolio performance on accounts that have been extended versus accounts that have not been extended over the same period of time. We believe that payment extensions granted according to our policies and guidelines are an effective portfolio management technique and result in higher ultimate cash collections from the portfolio.
The following is a summary of payment extensions as a percentage of owned, sold and total managed receivables outstanding:
The increase in payment extensions is primarily due to an increase in the average age, or seasoning, of our portfolio. At December 31, 2006 and 2005, our sold receivables portfolio was more seasoned than our owned receivables and therefore, had a higher level of extensions. In addition, we adopted a strategy to increase the number of extensions granted on a seasonal basis, as our historical data indicated that contracts extended are more likely than not to result in additional collections over the life of the contract. We continue to monitor our extension strategy, and we believe that the judicious use of payment extensions is an effective portfolio management technique.
Payment extensions do not have a direct impact on the amount of our finance receivables charged-off and the corresponding credit quality ratios. Payment extensions may, however, impact the timing of these charge-offs in the event a previously extended account is ultimately charged-off. Additionally, the impact of payment extensions is considered in determining the allowance for credit losses and the resulting provision for credit losses.
Charge-off data with respect to our finance receivables portfolio is summarized as follows:
(1)
Mandatory charge-offs represent accounts charged-off in full with no recovery amounts realized at time of charge-off.
(2)
Net charge-offs for our owned portfolio include charge-offs from our finance receivables held for investment, our predecessor finance receivables held for investment and our finance receivables repurchased from gain on sale trusts.
Net charge-offs as a percentage of average total managed receivables outstanding may vary from period to period based upon credit quality, the average age or seasoning of the portfolio and economic factors. Net charge-offs as a percentage of average total managed receivables were 5.8% for the year ended December 31, 2006 as compared to 6.1% for 2005.
The decrease in annualized net charge-offs as a percentage of average total managed finance receivables was primarily due to increases in recoveries as a percentage of charge-offs partially offset by higher charge-offs in the owned portfolio. The increase in recoveries as a percentage of charge-offs was primarily due to increases in recovery rates from auction sales.
Liquidity and Capital Resources
General
Our primary sources of cash are borrowings on our warehouse and residual loan facilities, securitization notes payable and senior notes payable. Prior to April 30, 2005, our primary source of cash had been advances from Ford Credit and sales of auto receivables to Trusts in securitization transactions. Our primary uses of cash have been purchases of receivables, operating costs and expenses and funding credit enhancement requirements for securitization transactions and debt service requirements.
Net cash provided by (used in) operating activities was $285.4 million, $252.4 million and $(213.0) million during 2007, 2006 and 2005, respectively. Cash flows from operating activities are affected by net income (loss) as adjusted for non-cash items, including depreciation and amortization, provisions for credit losses, deferred income taxes, accretion of present value discount, amortization of purchase premiums, impairment charges and gains and losses. The $285.4 million of cash flows provided by operating activities for the year ended December 31, 2007 was primarily due to $284.5 million of provision for credit losses partially offset by $10.6 million of net loss. The $252.4 million of cash flows provided by operating activities for the year ended December 31, 2006 was primarily due to $13.7 million of net income combined with $256.8 million of provision for credit losses. The $213.0 million of cash flows used in operating activities for the year ended December 31, 2005 was primarily due to $627.4 million in purchases of receivables held for sale for the year ended December 31, 2005 partially offset by $215.3 million in collections on finance receivables held for sale and $48.3 million in net income.
Net cash used in investing activities was $1.1 million, $1,485.5 million and $1,178.0 million in 2007, 2006 and 2005, respectively. Cash flows from investing activities are highly dependent upon purchases of and collections on finance receivables held for investment. The $1,484.4 million decrease in cash flows used in investing activities for the year ended December 31, 2007 as compared to 2006 was primarily due to a $1,302.4 million decrease in purchases of finance receivables held for investment. The $307.5 million increase in cash flows used in investing activities for the year ended December 31, 2006 as compared to 2005 was primarily due to a $1,402.4 million increase in purchases of finance receivables held for investment and a $131.0 million increase in repurchases from gain on sale trusts, partially offset by a $666.1 million increase in collections on finance receivables held for investment. Additionally, cash flows used in investing activities for the year ended December 31, 2005 included $553.5 million related to the acquisition of Triad Financial Corporation
Net cash (used in) provided by financing activities was $(292.2) million, $1,248.2 million and $1,410.5 million in 2007, 2006 and 2005, respectively. Cash flows from financing activities reflect the net change in amounts required to be borrowed under our various revolving and term borrowing facilities. The $292.2 million of cash used in financing activities for the year ended December 31, 2007 was due to $1,436.1 million in payments on securitization notes, $194.7 million in net change in warehouse and residual credit facilities and $30.0 million in redemption of preferred stock, partially offset by $1,373.4 million in proceeds from issuance of securitization notes. The $1,248.2 million of cash provided by financing activities for the year ended December 31, 2006 was due to $2,830.0 million in proceeds from issuance of securitization notes and $30.0 million in proceeds from issuance of preferred stock, partially offset by $1,144.0 million in payments on securitization notes and $406.7 million in net change in warehouse and residual credit facilities. The $1,410.5 million of cash provided by financing activities for the year ended December 31, 2005 was due to $2,009.2 million in proceeds from issuance of securitization notes and $935.8 million in net change in warehouse and residual credit facilities, partially offset by $1,564.6 million in net change in due to Ford Credit.
Prior to the Acquisition, we had an agreement with Ford Credit that provided us with advances to purchase retail installment sale contracts from dealers, to originate loans directly to consumers and to supply our working capital. Our agreement with Ford Credit had been in effect since March 5, 2003, was automatically extended on March 15 of each year and had a maturity date of March 15, 2006. The agreement provided for a maximum of $3.0 billion of advances to us. The agreement provided for payment of a fixed interest rate for the existing term loan and a variable interest rate derived from published market indices for the existing revolving loan. These agreements were terminated in connection with the Acquisition and all amounts due to Ford Credit thereunder were repaid.
Throughout most of 2007, we had two warehouse lending facilities and two residual facilities. We used borrowings under these facilities initially to fund a portion of the purchase price of the Acquisition and to repay amounts due to Ford Credit. The warehouse facilities funded most of our ongoing origination and acquisition of contracts, and the residual facilities provided us with working capital. Special purpose subsidiaries are the borrowers under these facilities.
The Company’s warehouse and residual loan facilities with Goldman Sachs Mortgage Company, due October 2007, were paid off on October 26, 2007. The funds necessary to pay off the facilities were obtained through the transfer of collateral to, and simultaneous additional advances on the Company’s other warehouse and residual facilities, due April 2009 with Citigroup Global Markets Realty Corp.
On January 10, 2008, we entered into a warehouse facility with Barclays Bank PLC. This facility provides up to $500.0 million of funding for automobile retail installment sales contract receivables originated or purchased by us. The facility has a two year commitment but may expire after 364 days if the liquidity facility is not renewed. The Company will provide a guarantee under the warehouse facility equal to 10% of the amount outstanding at the time the guarantee is drawn.
Based on our anticipated level of originations, we believe our cash flow from operations, available cash and available borrowings under our warehouse and residual facilities will provide us with sufficient liquidity to fund originations on an interim basis until a sufficient amount of receivables can be pooled together for subsequent securitizations. In anticipation of continued uncertainty in the securitization markets in the near term, we have taken steps to adjust our origination targets by, among other things, reducing the number of dealers from whom we buy contracts, and discontinuing or modifying our relationships with companies that provide us with direct loan applications. We believe the steps we have taken to adjust our origination targets are sufficient to address the problems currently being experienced in the asset-backed securitization market for non-prime loan originations. In the event that the securitization market does not become more conducive to transactions, we may be forced to take further steps to further reduce our loan originations. Subject to these market conditions, we plan to continue to access the securitization market throughout the year in order to obtain additional liquidity.
Contractual and Long-Term Debt Obligations
The following table summarizes the scheduled payments under our contractual long-term debt obligations at December 31, 2007:
Securitizations
We completed twelve auto receivables securitization transactions from August 2002 through December 31, 2007. In these transactions, we securitized approximately $10.9 billion of automobile receivables, issuing $9.9 billion of class A notes. The proceeds from the transactions were primarily used to repay borrowings outstanding under our previous intercompany credit facility with Ford Credit and our warehouse facilities.
We have pursued a strategy of securitizing our receivables to diversify our funding, improve liquidity and obtain a cost-effective source of funds for the purchase of additional automobile finance contracts. In general, we believe that the securitization program provides us with necessary working capital at rates that are much lower than we could obtain through our own unsecured or secured corporate debt obligations.
At December 31, 2007, the cumulative net loss ratio for the Company’s 2006-C securitization trust exceeded one of its target ratios. As a result, the credit enhancement requirement to maintain cash reserves as a percentage of the portfolio immediately increased from 2% to 3%, resulting in a delay in cash distributions to the Company. This requirement will remain at 3% until the trust is back in compliance with its target for three consecutive months. At January 31, 2008, the cumulative net loss ratio for the Company’s 2006-B securitization trust exceeded one of its target ratios as well. That credit enhancement requirement also immediately increased from 2% to 3%, where it will remain until the trust is back in compliance with its target for three consecutive months.
Deterioration in the economy could cause one or more of the ratios to exceed the targeted levels, resulting in stress on our liquidity position. If that occurred, we could be required to significantly decrease contract origination activities, and implement other significant expense reductions, if securitization distributions to us are materially decreased for a prolonged period of time.
The past several months have seen unprecedented turmoil in the global credit markets in general, and the asset-backed securitization markets in particular. The Company executed an insured securitization in November 2007, and there have been no subsequent insured, non-prime automobile asset-backed securities issued publicly as of February 29, 2008.
The well-publicized problems involving credit insurance providers may also have an impact on our ability to execute securitizations. Recently, AMBAC, Inc., which has provided credit enhancement insurance on three of our securitization transactions since May 2005, announced that they would not provide such insurance on automobile securitizations in the future. Those companies that continue to provide credit enhancement insurance may be less likely to do so at the rates and on the terms at which prior transactions were executed in 2006 and early 2007.
Anticipating the possibility that there will be limited access to the securitization markets, we have continued to revise our credit origination strategies. We have continued to selectively reduce the number of dealers from which we purchase contracts. We have also reduced staff among our sales and underwriting departments, and have made changes to our credit underwriting criteria. In our direct channel, we have ceased accepting on-line applications from some sources, and have implemented similar changes to our credit underwriting criteria.
We believe these changes will enable us to maintain a robust credit originations process in 2008. However, if the asset-backed securities market suffers from further deterioration, or the credit markets do not begin to stabilize and rebound, we may have to make further adjustments to our targeted origination volumes.
We believe that we will continue to require the execution of securitization transactions, along with borrowings under our warehouse and residual facilities, in order to fund our future liquidity needs. There can be no assurance that funding will be available to us through these sources or, if available, that it will be on terms acceptable to us. If these sources of funding are unavailable to us on a regular basis, we may be required to significantly decrease contract origination activities and implement significant expense reductions, all of which may have a material adverse affect on our ability to achieve our business and financial objectives.
During 2005, 2006 and 2007 we completed two, three and two securitizations, respectively. Our last securitization was in November 2007. Subject to market conditions and origination volume, we expect that we will continue to access the securitization markets.
Off-Balance Sheet Arrangements
Prior to our May 2005 securitization transaction, we structured our securitization transactions to meet the criteria for sales of finance receivables. Under this structure, notes issued by our unconsolidated qualified special purpose finance subsidiaries are not recorded as a liability on our consolidated balance sheets. Beginning with the securitization completed in May 2005, our securitization transactions are being structured to meet the criteria for on-balance sheet reporting.
Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities including an amendment of FASB Statement No. 115” (“SFAS 159”) which provides companies with an option to report selected financial assets and liabilities at fair value. The standard’s objective is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The Company has elected not to report any assets or liabilities at fair value in accordance with SFAS No. 159.
In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” which provides enhanced guidance for using fair value to measure assets and liabilities. The standard applies whenever other standards require or permit assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Early adoption is permitted. The Company does not anticipate the adoption of SFAS No. 157 to have a material impact on its statement of financial condition, its statement of operations or its cash flows.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
General
Our earnings are affected by changes in interest rates as a result of our dependence upon the issuance of fixed and variable rate securities and the incurrence of variable rate debt to fund the purchase of auto finance
contracts. Fluctuations in market interest rates impact the interest payments required under our warehouse and residual facilities, as well as the interest to be paid in future securitization transactions. We may utilize several strategies to minimize the impact of interest rate fluctuations on our net interest income, including the use of derivative financial instruments and the regular securitization of auto finance contracts.
Warehouse and Residual Facilities
In our contract origination process, we purchase auto finance contracts and make loans that bear fixed interest rates and are pledged to secure borrowings under our warehouse facilities. Amounts borrowed under our warehouse facilities will bear variable interest rates. We intend to utilize our warehouse facilities to fund receivables until we accumulate a portfolio of sufficient size to securitize. To mitigate the risk of fluctuations in interest rates prior to a securitization, we have utilized forward-starting swap agreements on a periodic basis. If interest rates are above the forward-starting swap rate on the pricing date of a securitization, the purchaser of the forward-starting swap agreement will pay us for the increase in interest rates. Likewise, if interest rates are below the locked rate on the pricing date of a securitization, we will pay the purchaser of the forward-starting swap agreement for the decrease in interest rates. Therefore, regardless of whether interest rates increase or decrease between the date auto finance contracts are originated and the date these contracts are securitized, we will have locked in the cost of funds on outstanding notional amounts and the gross interest rate spread of our auto finance contracts. Unlike traditional swaps, a forward-starting swap has only one cash exchange at settlement. We may also utilize a swaption collar strategy. In this strategy, we buy a payer swaption and sell a receiver swaption, thereby limiting our cost of funds to an upper and lower bound, or strike level. We will make payment if interest rates fall below the lower strike rate and receive a payment if interest rates rise above the higher strike rate. If rates remain between the upper and lower strike rates, then no payment is made. Other derivative financial instruments may be utilized if considered advantageous by us in managing the risk of interest rate fluctuations.
Our derivative financial instruments are recognized on our consolidated balance sheet at fair value with changes in the value recorded in earnings as a component of other income. Our derivative financial instruments include forward-starting swap agreements utilized to lock in the cost of funds on outstanding notional amounts of receivables prior to their securitization. During 2007, our derivative financial instruments also included interest rate swap agreements utilized to convert variable rate exposure on our 2007 securitization transactions to fixed rates. For the year ended December 31, 2007, our $17.5 million in losses on derivative financial instruments was comprised of $9.7 million in losses on our interest rate swap agreements and $7.8 million in losses on our forward-starting swap agreements. These losses were a result of a declining interest rate environment throughout the latter half of the year. For the year ended December 31, 2006, our $0.7 million in gains on derivative financial instruments were comprised entirely of gains on forward-starting swap agreements.
Throughout 2005, 2006 and 2007, we utilized forward-starting swap agreements to lock in the cost of funds on outstanding notional amounts of receivables prior to their securitization. We have entered into only one forward- starting swap agreement since October 2007 due to the uncertainty in the interest rate environment. We continue to evaluate this strategy and may resume the use of forward-starting swap agreements in the future.
Our residual credit facility is indexed to the one-month London Interbank Offered Rate (“LIBOR”) and is secured by residual assets pledged to the facility. Additionally, the residual facility bears a varying spread to LIBOR depending upon the amount advanced in the residual facility and the value of the pledged residual assets. The value of the pledged residual assets will be regularly assessed based on expected future cash flows. Changes in market interest rates could change the discount rate used to value the pledged residual assets and alter the value of the residual assets and cause the agreed upon spread to LIBOR to increase or decrease. We intend to utilize the residual facility to provide credit enhancements and support our working capital needs and may utilize derivative financial instruments to minimize the risk of interest rate fluctuations if deemed appropriate.
Securitizations
We plan to access the securitization market to provide for long-term funding of our contracts. The interest rates demanded by investors in our future securitization transactions will depend on prevailing market interest rates for comparable transactions and the general interest rate environment. We may utilize several strategies to minimize the impact of interest rate fluctuations on our net interest income, including the use of derivative financial instruments, the regular securitization of contracts and pre-funding securitizations.
In our securitization transactions, we sell fixed rate contracts to Trusts that then issue either fixed rate or floating rate securities to investors. The fixed rates on securities issued by the Trusts are indexed to market interest rate swap spreads for transactions of similar duration and do not fluctuate during the term of the securitization. The floating rates on securities issued by the Trusts are indexed to LIBOR and fluctuate periodically based on movements in LIBOR. We have utilized derivative financial instruments, such as interest rate swap agreements, to convert variable rate exposures of the Trusts on these floating rate securities to fixed rates, thereby locking in the gross interest rate spread to be earned by the Trusts over the life of each securitization. Derivative financial instruments purchased by us do not impact the amount of cash flows to be received by holders of the asset-backed securities issued by the Trusts. These instruments serve to offset the impact of increased or decreased interest paid by the Trusts on floating rate asset-backed securities and, therefore, the cash flows to be received by us from the Trusts.
We may also pre-fund securitizations, thereby allowing us to lock in borrowing costs with respect to auto finance contracts subsequently delivered to the Trusts. To pre-fund a securitization, we will issue more asset-backed securities than necessary to cover contracts initially sold or pledged to the Trust. The proceeds from the pre-funded portion are held in an escrow account until additional contracts are delivered to the Trust in amounts up to the pre-funded balance held in the escrow account. We will incur an expense in pre-funded securitizations during the period between the initial securitization and the subsequent delivery of contracts equal to the difference between the interest earned on the proceeds held in the escrow account and the interest rate paid on the asset-backed securities outstanding.
Interest Rate Swap Agreements
We periodically enter into interest rate swap agreements whereby we pay a fixed interest rate and receive a variable interest rate. If interest rates increase and are above the starting-swap rate on the settlement date, the market value of the forward-starting swap is positive, and we will receive an amount from the counterparty equal to such market value. Likewise, if the market value is negative on the settlement date, we will pay an amount to the counterparty equal to such market value. These agreements are intended to ensure the economics of future securitization transactions and minimize the risk of interest rate fluctuations on our gross interest rate margin prior to the execution of securitization transactions.
Interest Rate Sensitivity
The following tables provide information about our financial assets and liabilities, as well as our existing derivative financial instruments that are sensitive to changes in interest rates at December 31, 2007 and 2006. For contracts and liabilities with contractual maturities secured by contracts, the table presents principal cash flows and related weighted average interest rates by contractual maturities, as well as our historical experience of the impact of interest rate fluctuations on the credit loss and prepayment of contracts. For our existing forward-starting and interest rate swap agreements, the table presents the notional amount and weighted average interest rate by contractual maturity date. The notional amount is used to calculate the contractual payment to be exchanged under the contract.
The following table provides information about our interest rate-sensitive financial instruments by expected maturity as of December 31, 2007.
The following table provides information about our interest rate-sensitive financial instruments by expected maturity as of December 31, 2006.
Our existing receivables held for sale were reclassified as held for investment as we ceased using gain-on-sale accounting as of the close of the Acquisition. With respect to held for investment receivables, credit loss and prepayment assumptions are consistent with our historical experience. Our residual assets are estimated to be realized in future periods using discount rate, prepayment and credit loss assumptions consistent with our historical experience. The principal amounts of the warehouse and residual facilities have been classified based on their expected payoff. We expect to replace the funding of the held for investment receivables pledged to the warehouse facilities with future securitization transactions.
The notional amount on the forward-starting swap agreement is based on contractual terms. The notional amount does not represent amounts exchanged by parties and, thus, is not a measure of our exposure to loss through this agreement.
Management monitors the interest rate environment and may employ pre-funding and other hedging strategies designed to mitigate the impact of changes in interest rates. However, we can provide no assurance that pre-funding or other hedging strategies will mitigate the impact of changes in interest rates. Our profitability may be directly affected by the level of and fluctuations in interest rates, which affects the gross interest rate spread we earn on our receivables. As the level of interest rates increases, our gross interest rate spread on new originations will generally decline because the rates charged on the contracts we originated or purchased from dealers are limited by statutory maximums, restricting our opportunity to pass on increased interest costs to consumers. We believe that our profitability and liquidity could be adversely affected during any period of higher interest rates, possibly to a material degree. Fed funds rates decreased during 2007 to 4.25%, a decrease of 1.0% as compared to 2006. The Federal Reserve reduced rates an additional 1.25% in January 2008 and 0.75% in March 2008 pushing the fed funds rate to 2.25%.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
The following financial statements and reports of independent registered public accounting firm are included herein:
Report of Management on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of the Company’s internal control over financial reporting. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007. In making its assessment of the effectiveness of the Company’s internal control over financial reporting, management of the Company has utilized the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on management’s assessment, we concluded that, as of December 31, 2007, the Company’s internal control over financial reporting is effective based on those criteria.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
/s/ Daniel D. Leonard
Daniel D. Leonard
President & Chief Executive Officer
Date: March 28, 2008
/s/ Mike L. Wilhelms
Mike L. Wilhelms
Senior Vice President & Chief Financial Officer
Date: March 28, 2008
Report of Independent Registered Public Accounting Firm
To The Board of Directors and Stockholder
of Triad Financial Corporation:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholder’s equity and cash flows present fairly, in all material respects, the financial position of Triad Financial Corporation (the “Successor Company”) and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for the years ended December 31, 2007 and 2006 and the period from April 30, 2005 through December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Dallas, Texas
March 28, 2008
Report of Independent Registered Public Accounting Firm
To The Board of Directors and Stockholder
of Triad Financial Corporation:
In our opinion, the accompanying consolidated statements of operations, stockholder’s equity and cash flows present fairly, in all material respects, the results of the operations and cash flows of Triad Financial Corporation (the “Predecessor Company”) and its subsidiaries for the period from January 1, 2005 through April 29, 2005 in conformity with accounting principles generally accepted in the United States of America. 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 audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 audit provides a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Dallas, Texas
March 28, 2008
TRIAD FINANCIAL CORPORATION
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
TRIAD FINANCIAL CORPORATION
Consolidated Statements of Operations
The accompanying notes are an integral part of these consolidated financial statements.
TRIAD FINANCIAL CORPORATION
Consolidated Statements of Stockholder’s Equity
The accompanying notes are an integral part of these consolidated financial statements.
TRIAD FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
Triad Financial Corporation
Notes to Consolidated Financial Statements
1.
Organization and Nature of Business
Triad Financial Corporation (the “Company”) was incorporated as a California corporation on May 19, 1989. The Company engages primarily in the business of purchasing and servicing automobile retail installment sales contracts (“Contracts”) originated by automobile dealers located throughout the United States. The Company also originates automobile loans directly to consumers. The Company specializes in providing financing to consumers with limited credit histories, modest incomes or those who have experienced prior credit difficulties, generally referred to as “non-prime” borrowers.
From June 1999 through April 29, 2005, the Company was a wholly-owned subsidiary of Fairlane Credit, LLC, a wholly-owned subsidiary of Ford Motor Credit Company (“Ford Credit”).
On April 29, 2005, a newly formed entity, Triad Holdings Inc. (“Triad Holdings”) and its wholly-owned subsidiary, Triad Acquisition Corp., acquired all of the outstanding capital stock of the Company from Fairlane Credit, LLC (the “Acquisition”). As part of the Acquisition, Triad Acquisition Corp. was merged with and into Triad Financial Corporation with the Company being the surviving corporation. Triad Holdings is beneficially owned by Hunter’s Glen/Ford Ltd. and affiliates of Goldman, Sachs & Co. and GTCR Golder Rauner, L.L.C.
In accordance with the guidelines for accounting for business combinations, the purchase price paid by Triad Holdings, plus related purchase accounting adjustments, have been recorded in our consolidated financial statements for the period subsequent to April 29, 2005. This has resulted in a new basis of accounting reflecting the fair market value of our assets and liabilities for the successor period beginning April 30, 2005.
As of the acquisition date, we recorded our assets and liabilities at their estimated fair values. The purchase price paid by Triad Holdings plus acquisition and closing costs, exceeded the fair value of net assets acquired, resulting in approximately $30.4 million of goodwill.
2.
Accounting Policies
Basis of Presentation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, all of which are Delaware corporations, Triad Financial Special Purpose Corporation, Triad Financial Special Purpose LLC, Triad Financial Residual Special Purpose LLC, and Triad Financial Warehouse Special Purpose LLC (the “Subsidiaries”). Triad Financial Warehouse Special Purpose LLC includes its wholly-owned subsidiary, Triad Automobile Receivables Warehouse Trust, a Delaware trust.
Certain reclassifications have been made to prior period amounts to conform to the current period presentation.
Cash Equivalents
Investments in highly liquid securities with original maturities of 90 days or less are included in cash and cash equivalents.
Restricted Cash
Cash pledged to support securitization transactions and warehouse loan facilities is deposited into restricted accounts and recorded on the Company’s consolidated balance sheets as restricted cash.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
Finance Receivables
Finance receivables are classified as held for investment and carried at amortized cost, net of an allowance for credit losses, as the Company has the ability and intent to hold these receivables until maturity. Financing income for finance receivables originated and purchased subsequent to the Acquisition is recognized using the interest method based on contractual cash flows. Premiums and discounts and origination costs are deferred and amortized as adjustments to financing income over the estimated life of the related receivables.
In connection with the Acquisition, the carrying value of our predecessor finance receivables held for investment owned as of the Acquisition was adjusted to fair market value taking into account future expected credit losses and a required rate of return commensurate with the associated risk. The carrying value of our finance receivables repurchased from gain on sale trusts was recorded at fair market value upon repurchase, taking into account future expected credit losses and a required rate of return commensurate with the associated risk. Financing income on these receivables includes interest income recognized using the interest method based on contractual cash flows and taking into account expected prepayments and is net of premium amortization.
The accrual of financing income is suspended on accounts when they are deemed impaired. Accounts are generally deemed impaired when they are 30 days past due. We generally recognize interest income on impaired contracts on a cash basis when received.
Prior to April 30, 2005, finance receivables that we originated were classified as held for sale and recorded at cost including any premiums and net of any non-refundable acquisition fees paid by the seller and deferred origination costs. Thereafter, these held for sale receivables were carried at the lower of cost or market on an aggregate basis with any write-downs to market recorded as a charge to earnings and reflected in other expenses. Market value for these receivables was based on prices for similar receivables in the securitization markets.
Sale of Receivables
All securitization transactions executed by the Company subsequent to April 29, 2005 have been accounted for as secured financings in accordance with accounting principles generally accepted in the United States of America (“GAAP”). These transaction structures allow the trust to enter into interest rate derivative contracts with respect to retained interests and also allow the servicer the discretion to sell charged-off finance receivable contracts. No charged-off receivables were sold in 2007, 2006 or 2005.
Prior to April 30, 2005, finance receivables were sold in securitization transactions that were accounted for as sales of finance receivables in accordance with GAAP. These transaction structures involved the Company surrendering control over these assets by selling finance receivables to off-balance sheet securitization entities. The securitization entities issued interest-bearing securities collateralized by future collections on the sold receivables.
Estimated gains or losses from the sale of finance receivables were recognized in the period in which the sale occurred. In determining the gain or loss on each qualifying sale of finance receivables, the investment in the sold receivables pool was allocated between the portions sold and the portions retained based on their relative fair values at the date of sale. The Company retained certain interests in the sold receivables. These retained interests included subordinated certificates, restricted cash and interest-only strips held for the benefit of securitization entities. These retained interests are classified as securities available for sale and are reported at fair value. If there is a decline in fair value and it is judged to be other than temporary, the individual security is written down to fair value and the amount of the write-down is included in earnings. If there is a change in fair value and it is judged to be temporary, the securities are recorded at fair value with unrealized gains and losses recorded, net of tax, as a separate component of accumulated other comprehensive income in stockholder’s equity. In securitization transactions accounted for as a sale of receivables, the Company retains
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
the servicing rights and receives a servicing fee. Since the servicing fee adequately compensates us for retaining the servicing rights, no servicing asset or liability is recorded and the fee is recognized as collected over the remaining term of the related sold finance receivables.
Allowance for Credit Losses
The allowance for credit losses is our estimate of incurred credit losses related to held for investment receivables as of the date of the financial statements. This allowance is based on such factors as the credit quality of the portfolio, historical credit loss trends, trends in projected used car values and general economic factors. Finance receivables are charged to the allowance for credit losses when an account is deemed to be uncollectible. This charge takes into account the estimated value of any collateral. Recoveries on finance receivables previously charged off as uncollectible are credited to the allowance for credit losses.
Charge-offs on predecessor finance receivables held for investment and finance receivables repurchased from gain on sale trusts are charged against the Company’s probable future expected credit losses established as a component of the asset’s net carrying value.
Charge-Off Policy
Our policy is to charge off owned receivables in the month in which the borrowers become 120 days contractually delinquent if we have not previously repossessed the related vehicle. If a vehicle has been repossessed, and the underlying contract is an owned receivable, we charge off the underlying receivable upon repossession, taking into account the estimated value of our collateral, with a reconciliation upon liquidation. For sold receivables, the debt is charged off upon liquidation of the collateral. The net charge-off represents the difference between the actual net sales proceeds and the amount of the delinquent contract, including accrued interest, on our owned receivables. Accrual of finance charge income is suspended on accounts that are more than 30 days contractually delinquent.
Derivative Financial Instruments
In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities”, our interest rate swap agreements outstanding are recognized on our consolidated balance sheet at fair value with changes in the value recorded in earnings as a component of other income. Fair value is calculated using current market values for similar instruments with the same remaining maturities.
Fixed Assets
Fixed assets are carried at cost less accumulated depreciation. Fixed assets owned as of the acquisition date were adjusted to fair market value and are being depreciated over their remaining useful lives.
Depreciation is calculated principally on the straight-line method over their remaining useful lives of the assets as follows:
Depreciation expense totaled $9.3 million for the year ended December 31, 2007. Depreciation expense totaled $8.4 million for the year ended December 31, 2006, $2.7 million for the period January 1, 2005 through April 29, 2005 and $5.6 million for the period April 30, 2005 through December 31, 2005.
Leasehold improvements are stated at cost and depreciated over the useful lives of the improvements or term of the lease, whichever is less.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
Upon sale or retirement, the cost of assets and related accumulated depreciation is eliminated from the respective accounts, and the resulting gain or loss is included in operations. Repairs and maintenance expenses are charged to operations as incurred.
Goodwill
In accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”, the Company reviews its goodwill for impairment annually and when events or changes in circumstances indicate the carrying amount may not be recoverable. Management evaluates the recoverability of goodwill by comparing the carrying value of the Company’s only reporting unit to its fair value.
Income Taxes
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”, resulting in two components of income tax expense; current and deferred. Current income tax expense approximates taxes to be paid or refunded for the current period. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years which those temporary differences are expected to be recovered or settled.
Effective January 1, 2007, the Company accounts for uncertainty in income taxes recognized in the financial statements in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 requires that a more likely than not threshold be met before the benefit of a tax position may be recognized in the financial statements and prescribes how such benefit should be measured. It also provides guidance on derecognition, measurement, classification, interest and penalties, interim accounting periods, disclosure and transition. FIN 48 requires that the new standard be applied to the balances of the assets and liabilities as of the beginning of the period of adoption and that any corresponding adjustment be made to the opening balance of retained earnings. The Company’s adoption of FIN 48 is further described in Note 10.
Stock-Based Compensation
Effective July 1, 2005, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”, revised 2004, (“SFAS 123R”) prospectively for all awards granted, modified or settled after June 30, 2005. The Company adopted the standard by using the modified prospective method which is one of the adoption methods provided for under SFAS 123R. SFAS 123R, which revised Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”, requires that the cost resulting from all share-based payment transactions be measured at fair value and recognized in the financial statements. Additionally, on July 1, 2005, the Company adopted Staff Accounting Bulletin No. 107 “Share-Based Payment”, which the SEC issued in March 2005 to provide its view on the valuation of share-based payment arrangements for public companies.
Use of Estimates
The preparation of the financial statements, in conformity with generally accepted accounting principles, requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be based upon amounts that differ from those estimates. The primary estimates inherent within
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
these financial statements include the market value adjustments recorded in connection with purchase accounting, the allowance for credit losses and the fair value of retained interests in securitized assets.
3.
Finance Receivables
Finance receivables at December 31, 2007 and 2006 are summarized as follows:
Prior to April 30, 2005, finance receivables that we originated were classified as held for sale and carried at the lower of cost or market on an aggregate basis with any write-downs to market recorded as a charge to earnings and reflected in other expenses. The amount of write-downs to market value charged to earnings and reflected in other expenses totaled $30.5 million for the period January 1, 2005 through April 29, 2005.
The aggregate unpaid principal balances of finance receivables more than 60 days past due were $156.0 million at December 31, 2007 and $97.3 million at December 31, 2006.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The activity in the predecessor finance receivables held for investment for the periods indicated is summarized as follows:
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The activity in the finance receivables repurchased from gain on sale trusts for the years ended December 31, 2007 and 2006 is summarized as follows:
During 2007 and 2006 expected cash flows from predecessor finance receivables held for investment and receivables repurchased from gain on sale trusts were reevaluated and determined to be greater than originally expected. This resulted in a reclassification of cash flows from nonaccretable discount to accretable discount. This also resulted in a higher net yield being recognized on these receivables, which is expected to continue in future periods.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
4.
Allowance For Credit Losses
The changes in the allowance for credit losses for the periods indicated are summarized as follows:
The allowance for credit losses is maintained at a level adequate to cover incurred credit losses related to receivables originated subsequent to April 29, 2005 and classified as held for investment as of the date of the financial statements, taking into account the credit quality of the portfolio, historical credit loss trends, trends in projected used car values and general economic factors.
The carrying value of predecessor finance receivables held for investment was adjusted to fair market value taking into account future expected credit losses and a required rate of return commensurate with the associated risk.
5.
Sales of Receivables
Servicing Portfolio
The Company retains servicing rights for receivables sold in securitization transactions meeting the criteria for sales of receivables. The activity in the servicing portfolio for the periods indicated are summarized as follows:
The aggregate unpaid principal balances of sold finance receivables more than 60 days past due were $5.2 million at December 31, 2007 and $18.0 million at December 31, 2006. Credit losses, net of recoveries, totaled $18.2 million and $53.9 million for the years ended December 31, 2007 and 2006, respectively, $49.0 million for the period January 1, 2005 through April 29, 2005 and $87.0 million for the period April 30, 2005 through December 31, 2005.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
Retained Interest in Securitized Assets
The components of the retained interest in securitized assets, carried at fair value, at December 31, 2007 and 2006 are summarized as follows:
The Company’s retained interests in securitization transactions includes the value associated with future cash flows generated from overcollateralization and any excess spread amounts. Overcollateralization receivable represents the difference between securitized receivables outstanding and notes outstanding.
Retained interests in securitized assets are recorded at fair value. The fair value of retained interests is determined based on calculating the present value of the projected cash flows to be received using management’s best estimates of key assumptions, including discount rate, prepayment rate and credit losses.
Retained interests in securitized assets are net of an estimated amount owed to Ford Credit pursuant to a contractual agreement entered into with Ford Credit at the closing of the Acquisition. We made payments to Ford Credit totaling $9.8 million during the year ended December 31, 2007 pursuant to the agreement. The estimated present value of the remaining payments that will be due to Ford Credit pursuant to the agreement is approximately $15.6 million. The exact amount of these remaining payments will not be known until the last of five securitizations entered into by the Company prior to the Acquisition are called. The Company anticipates that these payments will continue through the second quarter of 2008 when the last of the five securitizations is expected to be called. The exact amount of the remaining payments to Ford Credit will be dependent upon, among other things, the performance of the contracts and loans in the respective pools and the net collections ultimately received on those loans.
Accrued servicing fees due from the securitization trusts are included in accounts receivable in our consolidated balance sheets. The amount of accounts receivable representing receivables from securitization trusts totaled $8.6 million at December 31, 2007 and $9.7 million at December 31, 2006.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The activity in the retained interest in securitized assets for the periods indicated is summarized as follows:
At December 31, 2007, the key assumptions utilized in determining fair value of our retained interest in securitized assets include a discount rate of 16%, an ABS rate of 1.40 and an expected cumulative lifetime loss of 11.3%.
The Company has not presented the expected weighted-average life assumption used in determining the gain on sale and in measuring the fair value of retained interest in securitized assets due to the stability of this attribute over time. A significant portion of the Company’s prepayment experience relates to defaults that are considered in the cumulative lifetime loss assumption. The Company’s voluntary prepayment experience on its gain on sale receivables portfolio typically has not fluctuated significantly with changes in market interest rates or other economic or market factors.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
At December 31, 2007, the estimated decreases in fair value of our retained interests in securitized assets as a result of an immediate 10% and 20% adverse change in key assumptions utilized in determining fair value are as follows:
The effect of a variation in a particular assumption on the fair value of retained interests in securitized assets was calculated without changing any other assumptions and changes in one factor may result in changes in another.
Expected static pool credit losses related to outstanding securitized receivables were 11.3% at December 31, 2007. To calculate the static pool credit losses, actual and projected future credit losses are added together and divided by the original balance of each pool of assets.
6.
Revolving Credit Facilities
Amounts outstanding under our warehouse and residual loan facilities at December 31, 2007 and 2006 are summarized as follows:
Facility amount advances outstanding and collateral pledged under our warehouse and residual loan facilities at December 31, 2007 are summarized as follows:
Our warehouse loan facility with Citibank Global Markets Realty Corp. provides for borrowings up to $750.0 million less amounts drawn on our corresponding residual facility. Our residual loan facility provides for borrowings up to $125.0 million. Our warehouse and residual loan facilities bear interest at a floating rate. At December 31, 2007, the interest rate on our warehouse loan facility was 5.05% and the interest rate on our residual loan facility was 7.10%.
The Company’s warehouse and residual loan facilities with Goldman Sachs Mortgage Company, due October 2007, were paid off on October 26, 2007. The funds necessary to pay off these facilities were obtained through the transfer of collateral to, and simultaneous additional advances on the Company’s other warehouse and residual facilities, due April 2009.
On January 10, 2008, we entered into a warehouse facility with Barclays Bank PLC. This facility provides up to $500.0 million of funding for automobile retail installment sales contract receivables originated
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
or purchased by us. The facility has a two year commitment but may expire after 364 days if the liquidity facility is not renewed.
The Company will provide a guarantee under each warehouse facility equal to 10% of the amount outstanding at the time the guarantee is drawn on by the lender.
Under the terms of our revolving credit facilities, the Company transfers eligible collateral, including finance receivables and retained interests in securitized assets, to special purpose finance subsidiaries of the Company. These subsidiaries pledge collateral to secure advances under the facilities, pursuant to advance formulas and available credit. These subsidiaries then forward funds to the Company in consideration for the transfer of eligible collateral. While these subsidiaries are included in the Company’s consolidated financial statements, they are separate legal entities and the collateral and other assets they hold are legally owned by these subsidiaries and are not available to creditors of the Company or its other subsidiaries.
The Company’s warehouse and residual loan facility agreements also contain various covenants requiring minimum financial ratios, asset quality and portfolio performance ratios, including net loss, delinquency and repossession ratios. Failure to meet any of these covenants could result in an event of default under these agreements. If an event of default occurs under these agreements, the lenders could elect to declare all amounts outstanding under these agreements to be immediately due and payable, enforce their interest against collateral pledged under these agreements or restrict the Company’s ability to obtain additional borrowings under these agreements. As of December 31, 2007, the Company was in compliance with all covenants under its warehouse and residual loan facility agreements.
Interest expense for the years ended December 31, 2007 and 2006 includes $14.4 million and $17.7 million, respectively, of expense incurred to Goldman Sachs Mortgage Company. Interest expense for the period April 30, 2005 through December 31, 2005 includes $12.1 million of expense incurred to Goldman Sachs Mortgage Company.
7.
Securitization Notes Payable
Securitization notes payable represent debt issued by the Company in securitization transactions accounted for as secured financings. Securitization notes payable outstanding at December 31, 2007 are summarized as follows:
(a)
Maturity date represents final legal maturity of securitization notes payable. Securitization notes payable are expected to be paid based on amortization of the finance receivables pledged to the Trusts.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
Under the terms of our securitization transactions, the Company transfers finance receivables to special purpose finance subsidiaries of the Company. While these subsidiaries are included in the Company’s consolidated financial statements, these subsidiaries are separate legal entities and the collateral and other assets held by these subsidiaries are legally owned by these subsidiaries and are not available to creditors of the Company or its other subsidiaries.
Capitalized financing costs with an unamortized balance of $7.5 million at December 31, 2007 are being amortized over the expected term of the securitization transactions. Capitalized financing costs include $1.5 million in remaining unamortized underwriting fees paid to Goldman, Sachs & Co., an affiliate of one of our equity investors.
All of the Company’s securitization transactions are covered by financial guaranty insurance policies, which agreements provide that if certain portfolio performance ratios (delinquency or cumulative net loss triggers) in a Trust’s pool of receivables exceeded certain targets, the specified credit enhancement levels would be increased by increasing the required spread account level. At December 31, 2007, the cumulative net loss ratio for the Company’s 2006-C securitization trust exceeded one of its target ratios. As a result, the credit enhancement requirement to maintain cash reserves as a percentage of the portfolio immediately increased from 2% to 3%, resulting in a delay in cash distributions to the Company. This requirement will remain at 3% until the trust is back in compliance with its target for three consecutive months. At January 31, 2008, the cumulative net loss ratio for the Company’s 2006-B securitization trust exceeded one of its target ratios as well. That credit enhancement requirement also immediately increased from 2% to 3%, where it will remain until the trust is back in compliance with its spread cap target for three consecutive months.
Agreements with the Company’s guarantee insurance providers contain additional specified targeted portfolio performance ratios. If, at any measurement date, the targeted portfolio performance ratios with respect to any insured Trust were to exceed these additional levels, provisions of the agreements permit the Company’s guaranty insurance providers to terminate the Company’s servicing rights to the receivables sold to that Trust. These financial guaranty insurance policies also contain minimum financial ratio requirements. Except as discussed above, the Company was in compliance with its agreements with its guarantee insurance providers at December 31, 2007.
8.
Senior Notes Payable
On April 29, 2005, Triad Acquisition Corp. issued $150.0 million of Senior Notes in a private placement to qualified institutional buyers pursuant to Rule 144A under the Securities Act, to certain accredited investors pursuant to Rule 501 under the Securities Act, and to non-U.S. persons in reliance on Regulation S under the Securities Act. The Notes also included a registration rights agreement requiring the Company to file a registration statement under the Securities Act and to consummate an exchange offer after the effective date of the registration statement. The exchange offer was consummated on January 9, 2006. In connection with the Acquisition, Triad Acquisition Corp. was merged with and into Triad Financial Corporation.
The Notes have a stated coupon of 11.125% and were issued at a discount to yield 11.25%. The Notes mature on May 1, 2013 but can be redeemed, in whole or in part, on or after May 1, 2010, at specified redemption prices, and on or after May 1, 2012, at par value.
Capitalized financing costs with an unamortized balance of $4.0 million at December 31, 2007 are being amortized over the contractual term of the notes. Capitalized financing costs include $2.8 million in remaining unamortized fees paid to Goldman, Sachs & Co., an affiliate of one of our equity investors.
9.
Preferred Stock
On June 30, 2006, the Company sold 1,500,000 shares of Non-Voting Preferred Stock to Triad Holdings for an aggregate purchase price of $30,000,000 in cash. No underwriting discounts or commissions were paid.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The Non-Voting Preferred Stock was issued without registration under the Securities Act in reliance on Section 4(2) of the Securities Act based on Triad Holdings investment intent, financial and business matters sophistication and other typical investment representations. To the extent declared by the board of directors of the Company, quarterly dividends were payable at an annual rate of 10.5%. Triad Holdings pledged its Non-Voting Preferred Stock of Triad Financial Corporation to secure its loan with Citigroup Global Markets Realty Corp. The Non-Voting Preferred Stock was redeemed at par on April 27, 2007.
For the year ended December 31, 2007, the Company declared and settled through intercompany transactions dividends of $787,500 based on an annual rate of 10.5% to Triad Holdings.
10.
Income Taxes
The provision for income taxes and the reconciliation between the federal statutory income tax rate and the effective income tax rate for the periods indicated are summarized as follows:
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2007 and 2006 are summarized as follows:
On January 1, 2007, the Company adopted the provisions of FIN 48. Upon adoption of FIN 48, the Company identified certain tax positions for which deductibility is highly certain, but for which there is uncertainty as to the timing of such deductibility. As a result, the Company reclassified approximately $3.4 million of tax benefit from its deferred tax liability to its FIN 48 current tax liability.
The changes in the Company’s gross unrecognized tax benefits are summarized as follows:
If recognized, the $3.8 million unrecognized tax benefit would have no impact on the Company’s effective tax rate.
The Company’s policy is to recognize interest and/or penalties related to income tax matters as a component of income tax expense. At December 31, 2007, the Company had accrued $0.7 million net of tax benefit recognized for the potential payment of interest.
The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. All tax periods subsequent to the Acquisition are open to examination by the Internal Revenue Service and the states to which we are subject to tax
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
11.
Derivative Financial Instruments
At December 31, 2007, the Company had interest rate swap agreements with external third parties with underlying notional amounts of $1.7 billion. These agreements were valued at a loss of $10.5 million at December 31, 2007. Other income (expense) for the year ended December 31, 2007 included $17.5 million in losses on our interest rate swap agreements. Other income (expense) for the year ended December 31, 2006 included $0.7 million in gains on our interest rate swap agreements. Other income (expense) included gains on our interest rate swap agreements of $5.2 million for the period January 1, 2005 through April 29, 2005 and $2.2 million for the period April 30, 2005 through December 31, 2005.
12.
Commitments and Contingencies
Various legal actions, governmental proceedings and other claims are pending or may be instituted or asserted in the future against the Company and its subsidiaries. As a consumer finance company, the Company is subject to various consumer claims and litigation seeking damages and statutory penalties, based upon, among other things, usury, disclosure inaccuracies, wrongful repossession, violations of bankruptcy stay provisions, certificate of title disputes, fraud, breach of contract and discriminatory treatment of credit applicants. Some litigation against the Company could take the form of class action complaints by consumers. As the assignee of finance contracts originated by dealers, the Company may also be named as a co-defendant in lawsuits filed by consumers principally against dealers. The damages and penalties claimed by consumers in these types of matters can be substantial. The relief requested by the plaintiffs varies but can include requests for compensatory, statutory and punitive damages.
Litigation is subject to many uncertainties, the outcome of individual litigated matters is not predictable with assurance and it is reasonably possible that some of the foregoing matters could be decided unfavorably to the Company or the subsidiary involved. Although the amount of liability at December 31, 2007 with respect to these matters cannot be ascertained, the Company believes that any resulting liability would not materially affect the consolidated financial position, results of operations or cash flows of the Company and its subsidiaries.
Under the management agreement among the Company, Triad Holdings LLC (98.9% owner of Triad Holdings), Triad Holdings and Hunter’s Glen/Ford Ltd., the parties engaged Hunter’s Glen/Ford as a financial and management consultant. During the term of the engagement, Hunter’s Glen/Ford will provide Gerald J. Ford to serve as the chief executive officer of Triad LLC and executive chairman of the Company as specified in the agreement and will provide Carl B. Webb and J. Randy Staff, or similarly qualified individuals, to furnish a portion of the services required by the management agreement. The Company agreed to pay Hunter’s Glen/Ford Ltd a management fee of $1.5 million per annum for the services described above.
During the third quarter of 2007, the Company entered into a consulting agreement with Carl B. Webb. Under the terms of the agreement, Mr. Webb will provide consulting services to the Company in return for a fee of $250,000 per annum. This consulting agreement was amended in the first quarter of 2008 to change the annual fee to $500,000.
In July 2007, the Company announced that it would be transitioning certain functions from its Huntington Beach, California facility to its North Richland Hills, Texas facility. These functions include loss recovery, remarketing, risk management, human resources and corporate legal. The Company also announced that it would be designating North Richland Hills, Texas as its corporate headquarters. This transition was substantially completed by the end of 2007. During 2007, the Company recorded charges totaling $5.3 million related to the transition, of which $1.5 million was accrued at December 31, 2007.
In December 2007, the Company entered into an agreement with Kevin Harvick, Inc. regarding the sponsorship of a NASCAR team for the 2008 racing season. Under the terms of that agreement, the Company will pay $2.8 million in sponsorship fees in 2008.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The Company’s operations are conducted from leased facilities under noncancellable lease agreements accounted for as operating leases. The Company also leases certain equipment. Rental expense charged to operations amounted to $4.2 and $4.1 million for the years ended December 31, 2007 and 2006, respectively. Rental expense charged to operations totaled $1.4 million for the period January 1, 2005 through April 29, 2005 and $3.0 million for the period April 30, 2005 through December 31, 2005.
Future minimum rental commitments under all noncancellable leases at December 31, 2007 are summarized as follows:
13.
Stock-Based Compensation
Following the closing of the Acquisition, Triad Holdings adopted a stock plan under which employees, officers, directors and consultants of the Company could be granted options to purchase shares of Triad Holdings’ common stock. The maximum number of shares available for grant is equal to approximately 8% of the fully diluted shares of Triad Holdings. The stock options vest annually, generally at the rate of 20% per year, provided the grantees continue to provide services to the Company. All options not exercised expire ten years after the date of grant.
Because the Company is considered to be nonpublic under SFAS 123R, the Company elected to use the formula value (book value) method to calculate compensation expense, in which the Company remeasures its liability each period. The awards are liability-classified based on a repurchase feature of the option agreements. The Company has elected to use a straight-line vesting attribution method for awards granted upon its adoption of SFAS 123R.
The Company recorded compensation expense of $2.1 million and $0.9 million for stock-based employee compensation for the years ended December 31, 2007 and 2006, respectively. Compensation expense for the year ended December 31, 2007 included a $1.6 million payment to a former chief executive officer for the repurchase of his option shares vested as of his July 2005 termination date. The Company granted 366,000 options during the year ended December 31, 2007. The Company granted 1.0 million and 4.0 million options during years ended December 31, 2006 and 2005, respectively. Since the inception of the plan, no options have been exercised.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
A summary of stock option activity under the Company’s stock option plan is summarized as follows:
14.
Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of Statement of Financial Accounting Standards No. 107, “Disclosure about Fair Value of Financial Instruments” (“SFAS 107”). Fair value estimates methods and assumptions, set forth below for our financial instruments, are made solely to comply with requirements of SFAS 107 and should be read in conjunction with our consolidated financial statement and related notes.
The estimated fair value of financial instruments has been determined by the Company using available market information and appropriate valuation methodologies available to management at December 31, 2007 and 2006. However, considerable judgment is required to interpret market data in order to develop 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. Furthermore, fair values disclosed hereinafter do not reflect any premium or discount that could result from offering the instruments for sale. Potential taxes and other expenses that would be incurred in an actual sale or settlement are not reflected in amounts disclosed.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The estimated fair values and related carrying amounts of the Company’s financial instruments are as follows:
The methods and assumptions used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value are explained below:
Cash and Cash Equivalents - The carrying amounts are considered to be a reasonable estimate of fair value since these investments bear interest at market rates and have maturities of less than 90 days.
Cash Restricted - The carrying amounts are considered to be a reasonable estimate of fair value.
Finance Receivables Held For Investment - The fair value of finance receivables is estimated by discounting future net cash flows expected to be collected using a current risk-adjusted rate.
Retained Interest in Securitized Assets - The fair value of retained interest in securitized assets is estimated by discounting the associated future net cash flows using discount rate, prepayment and credit loss assumptions similar to the Company’s experience.
Interest Rate Swap Agreements - The fair value is based on quoted market prices.
Revolving Credit Facilities - Revolving credit facilities have variable rates of interest and maturities of three years or less. Therefore, the carrying value is considered to be a reasonable estimate of fair value.
Securitization Notes Payable - The fair value is based on quoted market prices, when available. If quoted market prices are not available, the market value is estimated by discounting future net cash flows expected to be settled using a current risk-adjusted rate.
Senior Notes Payable - The fair value of senior notes is estimated based on rates currently available for debt with similar terms and remaining maturities.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
15.
Quarterly Financial Data (unaudited)
The following table summarizes quarterly financial results :
We have revised certain amounts previously reported in our unaudited interim consolidated financial statements for the second and third quarters of 2007 to correct errors related to the accounting for interest rate derivative contracts entered into in the second quarter of 2007. During the fourth quarter of 2007, the Company discovered that its gains (losses) on its interest rate swap agreements previously reported in its unaudited interim consolidated financial statements for the second and third quarters of 2007 were incorrect because the effect of one of its interest rate swap agreements was omitted. As a result of the errors, the Company’s other income was understated by $1.0 million for the three months ended June 30, 2007 and overstated by $3.6 million for the three months ended September 30, 2007. The Company’s net cash flows were not impacted by these errors.
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
The impact of the revisions is summarized as follows:
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
Triad Financial Corporation
Notes to Consolidated Financial Statements - (Continued)
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
I.
Revised Quarterly Consolidated Financial Statements
As discussed in Note 15 to the consolidated financial statements contained in Item 8 of this Annual Report on Form 10-K, we have revised our unaudited consolidated interim financial information for the second and third quarters of 2007 to correct errors related to interest rate swap gains (losses) in such consolidated financial statements and financial information. As a result of these corrections, we have made appropriate changes to the design and maintenance of adequate controls over the preparation, review, presentation and disclosure of amounts related to our derivative financial instruments.
II.
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, management of the Company has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of December 31, 2007 (“Evaluation Date”). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures are effective (i) to ensure that information required to be disclosed in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms; and (ii) to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.
The Report of Management on Internal Control Over Financial Reporting is included in Item 8 of this Annual Report on Form 10-K. There was no change in the Company’s internal control over financial reporting during the quarter ended December 31, 2007, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
The Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or internal controls will prevent all possible error and fraud. The Company’s disclosure controls and procedures are, however, designed to provide reasonable assurance of achieving their objectives, and the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s financial controls and procedures are effective at that reasonable assurance level.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The directors and principal officers of Triad, and their positions and ages at February 28, 2008, are as follows:
(1)
Appointed as a Director in November 2007 to replace Jonathan D. Fiorello who was appointed as a director in February 2007 and resigned as a director in November 2007.
The present principal occupations and recent employment history of each of our executive officers and directors listed above is as follows:
Daniel D. Leonard currently serves as our President and Chief Executive Officer, which positions he assumed in June 2007. Prior to his appointment as President and CEO, Mr. Leonard served as our Senior Vice President - Portfolio Management, a position he held since May 2003. He has over 30 years experience in the finance industry. Prior to joining Triad, Mr. Leonard served from 1991 in several positions with California Federal Bank, including as its Senior Vice President - Consumer and Business Banking, Senior Vice President - Retail Distribution, and most recently as President of its subsidiary, Auto One Acceptance Corp., an auto loan financing company. Prior to joining California Federal Bank, Mr. Leonard served in several senior management positions with BankAmerica Corp.
Mike L. Wilhelms currently serves as our Senior Vice President and Chief Financial Officer and joined Triad in September 1997 as Controller. Prior to joining Triad, Mr. Wilhelms served from 1993 to 1997 as an Assurance Manager at KPMG Peat Marwick LLP, during which time he specialized in the non-prime finance industry with auto and mortgage finance companies and worked on several auto and mortgage asset-backed securitizations. Mr. Wilhelms is also a certified public accountant.
Paul E. Dacus has served as our Senior Vice President - Risk Management since February 2005. Prior to joining Triad, Mr. Dacus served from April 2004 with Centrix Financial where he was the Manager of the Risk Management Department. Prior to Centrix, Mr. Dacus was the Senior Vice President for Risk Management at Auto One Acceptance Corporation from January 1996 to August 2003. Mr. Dacus has
extensive background in risk analysis, score card development, portfolio analysis and statistical modeling. Mr. Dacus is also a Chartered Financial Analyst.
Scott A. France currently serves as our SVP - Portfolio Management and joined Triad in August 2007. Prior to joining Triad, Mr. France served for 11 years as Senior Vice President Call Center Operations and Executive Vice President Portfolio Services at AmeriCredit where he was responsible for Collections, Loss Recovery, Asset Remarketing, Bankruptcy Management. Prior to AmeriCredit, Mr. France worked for World Omni Financial Corp. for 12 years in Credit, Collections and Portfolio Servicing.
Chris A. Goodman currently serves as our Senior Vice President - Direct Originations and has been with Triad since September 2001. He has over 17 years of automotive and leadership experience. Prior to joining Triad, Mr. Goodman served from 1995 in several roles with TranSouth Financial, a consumer finance company, including as its National Sales Manager and as the head of its Direct Lending Division. Prior to joining TranSouth Financial, Mr. Goodman spent five years as a consultant training finance managers, worked on the retail side of an auto dealership and owned a regional finance company that originated and sold loans to other lending institutions.
Mark A. Kelly currently serves as our Senior Vice President - Director of Risk Management and Product Development and joined Triad in June 2007 as Senior Vice President. Prior to joining Triad, Mr. Kelly was with Hunter’s Glen Ford, Ltd. in the acquisition group. Previously, Mr. Kelly served as an executive vice president and chief financial officer of Auto One Acceptance Corporation, where he was responsible for financial accounting, risk management, and regulatory compliance.
Timothy M. O’Connor has served as our General Counsel since May 2005. Prior to joining Triad, Mr. O’Connor served as Vice President in the Legal Department of CitiFinancial Auto from 2002 to 2005. He also served as General Counsel for Auto One Acceptance Corporation from 1998 to 2002 and was a Senior Vice President of California Federal Bank from 1994 to 2002. He has more than 20 years experience representing financial institutions as both in-house and outside counsel.
David L. Satterfield currently serves as our Senior Vice President - Dealer Channel Originations and joined Triad in February 2007 as Senior Vice President. Prior to joining Triad, Mr. Satterfield served for four years as a Senior Vice President and director of the Strategic Business Group for CitiFinancial Auto. Previously, Mr. Satterfield served as executive vice president and chief credit officer of Auto One Acceptance Corporation, where he was responsible for sub-prime originations, and director of Operations for Auto One Houston Credit Center. Mr. Satterfield also served as vice president and regional manager of Bank of America’s Dealer Financial Services group.
Gerald J. Ford is currently Chairman of the Board of Directors of First Acceptance Corporation and has been since 1996. Mr. Ford was Chairman of the Board of Directors and Chief Executive Officer of Golden State Bancorp and its predecessors from 1994 to 2002. During that period, Mr. Ford also served as Chairman of the Board of Directors and Chief Executive Officer of Golden State Bancorp’s wholly-owned subsidiary, California Federal Bank, FSB. Additionally, Mr. Ford served as a Director of Auto One Acceptance Corporation, a wholly-owned auto finance subsidiary of California Federal Bank, FSB. Mr. Ford was Chairman of the Board of Directors and Chief Executive Officer of First Gibraltar Bank, FSB from 1988 to 1993. Mr. Ford was the principal shareholder, Chairman of the Board of Directors and Chief Executive Officer of First United Bank Group, Inc. and its predecessors from 1975 to 1994. Mr. Ford is currently a Director of Hilltop Holdings, Inc., Scientific Games Corporation, Freeport-McMoRan Copper & Gold Co. and McMoRan Exploration Co. Mr. Ford also served as a Director of AmeriCredit Corp. from June 2003 until he resigned in August 2004. Mr. Ford currently is on the Board of Trustees of Southern Methodist University and was formerly the Chairman of the Board.
Carl B. Webb resigned as President and Chief Executive Officer in June 2007, and now serves as Co-Chairman of the Board of Directors of the Company. Mr. Webb has served as a director since April 29, 2005. He was President and Chief Operating Officer of Golden State Bancorp and its predecessors from 1994 to 2002. During that period, Mr. Webb also served as President and Chief Operating Officer of Golden State Bancorp’s wholly-owned subsidiary, California Federal Bank, FSB. Additionally, Mr. Webb served as a
Director of Auto One Acceptance Corporation, a wholly-owned auto finance subsidiary of California Federal Bank, FSB. Prior to Golden State Bancorp, Mr. Webb was the President and Chief Operating Officer of First Gibraltar Bank, FSB from 1988 to 1993. Mr. Webb was the President of the First National Bank of Lubbock, Texas from 1983 to 1989. Mr. Webb is currently a Director of Hilltop Holdings, Inc., MacAndrews & Forbes Worldwide Corp., and AMB Property Corporation.
Peter C. Aberg is head of FICC-Advisory in the Mortgage Department of Goldman, Sachs & Co., a leading global investment banking, securities and investment management firm. He joined Goldman Sachs in 1985 as an Associate in debt capital markets. Mr. Aberg became a Vice President in 1986 and worked in structured finance from 1987 to 1997. He became a Managing Director in 1998 and a Partner in 2002.
Philip A. Canfield is a Principal of GTCR Golder Rauner, L.L.C. and has worked at GTCR since 1992. His primary area of focus is information technology investments. In addition, Mr. Canfield is experienced in general business services investments. Mr. Canfield serves on the board of Solera Holdings, Inc. and several private companies in GTCR’s portfolio. Prior to joining GTCR, Mr. Canfield was employed in the corporate finance department of Kidder, Peabody & Co. Incorporated where he focused on public offerings and merger and acquisitions.
Aaron D. Cohen is a Vice President with GTCR Golder Rauner, L.L.C. and has been with GTCR since April 2003. Prior to joining GTCR, Mr. Cohen worked as an analyst at the private equity firm of Hicks, Muse, Tate & Furst from 2000. He worked as an analyst in the Mergers & Acquisitions Group of Salomon Smith Barney from 1998 to 2000. Mr. Cohen is currently a director of Wilton Products, Inc., a GTCR private portfolio company.
David A. Donnini is a Principal of GTCR Golder Rauner, L.L.C., which he joined in 1991. Prior to joining GTCR, he worked as a management consultant at Bain & Company. He received a BA in Economics from Yale University. He also holds an MBA from Stanford University. In addition to his service on the board of Triad, Mr. Donnini serves on the boards of Coinmach Service Corp., Prestige Brands Holdings, Inc., Syniverse Technologies, Inc. and several private GTCR portfolio companies.
Donald J. Edwards is Managing Principal of Flexpoint Partners, LLC, an equity investment firm. From July 2002 to April 2004, Mr. Edwards served as President and Chief Executive Officer of First Acceptance Corporation, formerly known as Liberté Investors Inc. From 1994 to 2002, Mr. Edwards was a Principal at GTCR Golder Rauner, L.L.C., where he headed the firm’s healthcare investment effort. Prior to joining GTCR, Mr. Edwards was an Associate at Lazard Frères & Co. LLC. Mr. Edwards is a Director of First Acceptance Corporation.
Stuart A. Katz is a Managing Director of Goldman, Sachs & Co. in the Principal Investment Area and Co-Head of its financial services investment activities. Mr. Katz is a Managing Director of the general partners of the GS Funds (and certain successor funds), the primary vehicles through which The Goldman Sachs Group, Inc. conducts its privately negotiated equity investment activities. Mr. Katz joined Goldman Sachs in 1996 and worked in the London office of the Principal Investment Area during the period from 1997 to 1999 and serves on the boards of various GS Fund private companies. Mr. Katz is a member of the board of directors of Validus Holdings, Ltd. and Capmark Financial Group, Inc.
Gaurav Seth is a Vice President of Goldman, Sachs & Co. in its Americas Special Situations Group (AmSSG) and is head of AmSSG’s Asset Investing business, focused primarily on the financial services, real estate and leasing sectors. Mr. Seth joined Goldman Sachs in 1998 and serves on the boards of various private companies in which AmSSG has invested.
J. Randy Staff was Executive Vice President and Chief Financial Advisor of Golden State Bancorp and its predecessors from 1994 to 2002, where Mr. Staff was primarily responsible for mergers and acquisitions. During that period, Mr. Staff also served as Executive Vice President and Chief Financial Advisor of Golden State Bancorp’s wholly-owned subsidiary, California Federal Bank, FSB. Additionally, Mr. Staff served as a Director and an interim President of Auto One Acceptance Corporation, a wholly-owned auto finance subsidiary of California Federal Bank, FSB. From 1973 to 1994, Mr. Staff was a Partner specializing in financial services at KPMG. Mr. Staff currently serves as a director of Hilltop Holdings, Inc., and is Chairman
of the Board of Directors and the majority shareholder of the American Bank, N.A., Dallas, Texas and the Citizens State Bank, Jackson County, Texas and has been since 1987 and 1985, respectively.
Family Relationships
There are no family relationships between any of our executive officers or directors.
Code of Ethics
Our Corporate Governance Committee reviewed and approved the Company’s Business Conduct Manual and Ethics Code, or the “Ethics Code”, which provides, among other things, an employee hotline to report suspected violations of our policies in this regard. The program is monitored by the Office of General Counsel. There have been no reports received either through this hotline number of by any other medium since the Ethics Code was introduced. Those who wish to review a copy of the Ethics Code can do so by contacting the Office of General Counsel at Triad Financial Corporation, 5201 Rufe Snow Drive, North Richland Hills, Texas, 76180.
Board Meetings
The Board of Directors convenes quarterly and will conduct other meetings from time to time in order to address issues that arise which require board approval. In addition to full board meetings, the following committees made up board members meet as needed to address the items delegated to them by the full board:
Audit Committee
The Audit Committee of the company meets no less frequently than quarterly to discuss, among other things, audit results presented by the company’s independent auditors and filings required to be made by the company from time to time. In addition to the members of the committee, the outside auditors, the Director of Internal Audit, the Chief Financial Officer and others may be asked to join and make presentations at such meetings. Mr. J. Randy Staff, who serves as Chairman of the Audit Committee, has been designated as the financial expert. He is joined on the Committee by Mr. David A. Donnini, Mr. Donald J. Edwards and Mr. Aaron D, Cohen. Mr. Staff is not independent as defined in Rule 4200(a)(15) of the Nasdaq Marketplace Rules.
Nominating and Corporate Governance Committee
The Nominating and Governance Committee of the company meets periodically to, among other things, approve the slate of officers for the Company and, if applicable, establish approval and contracting authority for such officers. Mr. Peter C. Aberg serves as chairman of this committee, and Mr. Gerald J. Ford, Mr. Philip A. Canfield and Mr. Carl B. Webb serve on the committee as well.
All committees are authorized to meet telephonically in order to conduct the tasks required of them.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
COMPENSATION DISCUSSION AND ANALYSIS
In this Compensation Discussion and Analysis, we address the compensation paid to our executive officers listed in the Summary Compensation Table that immediately follows this discussion. We refer to these executives as the “Senior Executive Officers.”
Since the Acquisition, the Compensation Committee has, upon consideration of the recommendations of the Co-Chairmen of the Board and/or the CEO, determined the salary component for Senior Executive compensation. The Compensation Committee, also based on the recommendations of the Co-Chairmen of the Board and the CEO, sets the performance criteria and target levels for Senior Executive Officers (other than the CEO) with respect to potential annual incentive payments for the upcoming year. Our process begins with establishing corporate performance objectives for the year. The Compensation Committee and our Co-
Chairmen of the Board discuss strategic objectives and performance targets. We review the appropriateness of the financial measures used in our incentive plan and the degree of difficulty in achieving specific performance targets.
The recommendations to the Compensation Committee for Senior Executive Officer’s compensation, and the Compensation Committee’s review of those recommendations, are based primarily upon an assessment of corporate performance and potential to enhance long-term stockholder value in determining the amount and mix of compensation elements, and whether each particular payment or award provides an appropriate incentive and reward for performance that sustains and enhances long-term shareholder value. Key factors affecting our judgment include: (1) performance compared to the financial, operational and strategic goals established at the beginning of the year; (2) nature, scope and level of responsibilities; (3) achievement of our financial results, particularly with respect to key metrics such as credit quality, revenue, earnings and return on equity; (4) effectiveness in leading our initiatives to increase productivity and stockholder value; and (5) contribution to our commitment to corporate responsibility, including success in creating a culture of compliance with both applicable laws and our ethics policies.
We may also consider each Senior Executive Officer’s current salary and the appropriate balance between incentives for long-term and short-term performance.
Since the Acquisition in April 2005, we have used three categories of eligible compensation for the Senior Executives: base salary, annual incentive payments and stock option grants. As a privately held corporation, the Board of Directors sought to align the interests of the Senior Executives with those of the investors. In that regard, the board, in 2005, adopted the 2005 Long Term Incentive Plan for Triad Holdings Inc., or the “2005 Plan” for the Senior Executive Officers of the Company. Grants were made to the Senior Executive Officers under the 2005 Plan shortly after its adoption. Additional grants were made in 2006 to certain Senior Executive Officers, and the Compensation Committee also approved the award of grants to other key employees, to be based upon recommendations from their supervisors, subject to the approval of the President and CEO. No grants were made to the existing Senior Executive Officers in 2007, although two of the Senior Executive Officers who joined the Company in 2007 were awarded stock option grants at the time they joined the Company.
Compensation Consultant
Neither the Company nor the Compensation Committee retained any compensation consultants during 2007. In 2005, we established compensation levels using a limited benchmarking survey, relying on data provided to us by our independent compensation consultant, Towers Perrin. During 2007, the Compensation Committee reviewed the compensation packages of the Senior Executive Officers, and approved changes to the base salary of a number of those individuals. We will continue to monitor the compensation practices of our competitors and similarly situated financial institutions to ensure that our salary structure and benefits offered to our Senior Executive Officers remains competitive, so that we may attract and retain talented and experienced leaders.
Overview of Compensation Philosophy and Program
The Compensation Committee believes that the most effective executive compensation program is one that is designed to reward the achievement of specific annual, long-term and strategic goals by the Company, and which aligns the executives’ interests with those of the shareholders by rewarding performance above established goals, with the ultimate objective of improving shareholder value. The Compensation Committee evaluates both performance and compensation to ensure that the Company maintains its ability to attract and retain superior employees in key positions and that compensation provided to the Senior Executive Officers remains competitive relative to the compensation paid to similarly situated executives in our industry. To that end, the Compensation Committee believes executive compensation packages provided by the Company to its Senior Executive Officers should include both cash and stock-based compensation that reward performance as measured against established goals.
The following compensation objectives are considered in setting the compensation programs for our Senior Executive Officers:
•
drive and reward performance which supports our core values;
•
provide a significant percentage of total compensation that is “at-risk,” or variable, based on predetermined performance criteria;
•
design competitive total compensation and rewards programs to enhance our ability to attract and retain knowledgeable and experienced Senior Executive Officers; and
•
set compensation and incentive levels that reward significant achievement.
We believe the adjustments made to the salaries of our Senior Executive Officers in 2007 achieved the goal of providing competitive salaries, but we will continue to informally monitor the compensation practices in the financial services industry.
Role of Senior Executives in Compensation Decisions
The Co-Chairmen of the Board, or the “Co-Chairmen”, annually review the performance of the Senior Executive Officers, including the Chief Executive Officer. The conclusions resulting from their recommendations, including proposed salary adjustments and annual award amounts, are then presented to the Compensation Committee for consideration and approval. The Compensation Committee can exercise its discretion in modifying those recommendations.
Compensation Elements and Rationale for Pay Mix Decisions
To reward both short and long-term performance in the compensation program and in furtherance of our compensation objectives noted above, the compensation philosophy for our Senior Executive Officers includes the following four principles:
(1) Compensation should be related to the Company’s performance
We believe that a significant portion of a Senior Executive Officer’s compensation should be tied to the overall Company performance measured against our financial goals and objectives. During periods when performance meets or exceeds the established objectives, Senior Executive Officers should be paid at or more than expected levels, respectively. When our performance does not meet key objectives, incentive award payments, if any, should be less than such levels.
(2) Incentive compensation should represent a large portion of a Senior Executive’s total compensation
We intend to minimize the amount of fixed compensation paid to Senior Executive Officers in order to minimize costs when our performance is not optimal. A significant portion of compensation should be paid in the form of short-term and long-term incentives, which are calculated and paid based primarily on financial measures of profitability and shareholder value creation. Senior Executive Officers are incented to increase our profitability and shareholder return in order to earn the major portion of their compensation.
(3) Compensation levels should be competitive
The Compensation Committee believes that a competitive compensation program enhances our ability to attract and retain Senior Executive Officers. They have been empowered by the board with the flexibility to ensure that the compensation program is competitive with that provided by comparable firms.
(4) Incentive compensation should balance short-term and long-term performance
The Compensation Committee seeks to achieve a balance between encouraging strong short-term annual results and ensuring our long-term viability and success. To reinforce the importance of balancing these perspectives, Senior Executive Officers will be provided both short and long term incentives. Short term
incentives are embodied in our annual incentive plans, while, for the longer term, we provide Senior Executive Officers and a number of key employees with the opportunity to become indirect shareholders of Triad.
Metrics Used in Compensation Programs
The Compensation Committee, working with the CEO in the first quarter of 2007, adopted a general outline of performance-based metrics for defining Senior Executive Officer incentive compensation during 2007. These metrics (the “Performance Metrics”) are defined, and their use in Senior Executive Officer’s annual compensation is described below:
Credit Quality: While there is a loss expectation inherent in the loans we originate and the contracts we purchase, we seek to manage the credit quality of the overall portfolio through prudent servicing practices with respect to the loans and contracts already booked, and through sound underwriting practices across all channels.
Profit Before Taxes: This measurement takes into account overall earnings, whether they came from the pool of receivables acquired at the closing of the Acquisition, or from the contracts originated since that time.
Operating Costs: This final financial metric is based on a targeted percentage set at the beginning of the fiscal year. The Senior Executive Officers are encouraged to control expenditures in order to meet or exceed the established goals.
For the 2007 Fiscal Year, the Compensation Committee approved the inclusion of a discretionary aspect to the Incentive Compensation of the Senior Executive Officers. These performance metrics were adopted again by the Compensation Committee for the 2008 Fiscal Year.
Review of Senior Executive Officer Performance
In addition to considering the recommendations made by the Co- Chairmen, the Compensation Committee has the opportunity to meet with the Senior Executive Officers at various times during the year, which allows them to consider and independently assess each individual’s performance and contribution.
Components of the Executive Compensation Program
We believe the total compensation and benefits program for the Senior Executive Officers should consist of the following:
•
base salaries;
•
annual incentive payment;
•
long-term incentive compensation, through stock option grants; and
•
other customary health and welfare benefits.
Base Salaries
During 2007, several changes were made among the Senior Executive Officers, including the promotion of Mr. Leonard to the position of President and Chief Executive Officer, and the hiring of a new Director of Dealer Channel Originations, a new Director of Portfolio Servicing and a new Director of Risk Management and Product Development. Senior Executive Officers’ base salaries had remained virtually unchanged since the Acquisition. Base salaries are determined by evaluating the level of responsibility and experience of the Senior Executive Officers, together with the Company’s performance.
When considering the base salary of the Senior Executive Officers for fiscal year 2007, the Co-Chairmen and the Compensation Committee took into account our 2006 performance, the changes to the composition of the Senior Executive team, as well as long and short-term goals, such as:
•
meeting pre-tax income goals;
•
successful management of portfolio and institutional risk;
•
maintenance of overall credit quality with respect to both existing and newly originated loans; and
•
the adherence to the cost structure.
The Compensation Committee, together with the Co-Chairmen, may adjust base salaries when, among other factors:
•
the current compensation demonstrates a significant deviation from the market data;
•
it wishes to recognize outstanding individual performance; and
•
it wishes to recognize an increase in responsibility.
Annual Incentive Compensation
The incentive compensation awarded annually provides Senior Executive Officers with the opportunity to earn cash bonuses based on the achievement of specific Company goals. The CEO, together with the Compensation Committee, designs the annual incentive component of our compensation program to align Senior Executive Officers’ pay with our annual (short term) performance. Incentive bonuses are generally paid in the first quarter of each year for the prior fiscal year’s performance.
The Compensation Committee approves a target incentive payout as a percentage of the base salary earned during the incentive period for each Senior Executive Officer. The incentive target percentage represents the Senior Executive Officer’s annual bonus opportunity if the annual performance goals of the incentive plan are achieved.
For 2007, the Compensation Committee approved the Performance Metrics. Each Performance Metric has a weight within the plan.
Performance targets are established at levels that are achievable, but require better than expected planned performance. Each of the Senior Executive Officers received an annual bonus based on our overall performance.
The amount to be paid to each Senior Executive Officer as an annual incentive for 2007 is determined by analyzing our results with respect to the Performance Metrics previously discussed. The Compensation Committee analyzes the Senior Executive Officers’ performance for the year and then determines the incentive level based upon the analysis with target awards that are based upon a percentage of base salary. The Compensation Committee, on the recommendation of the Co-Chairmen, sets minimum, target and maximum levels for each component of the Performance Metrics for the annual cash incentive compensation. Payments of annual incentive compensation are based upon the achievement of such objectives for the current year.
Stock Options
Grants of stock options to Senior Executive Officers, employees and others who provide services to the Company have been made under the 2005 Plan. We believe that grants of stock options serve as effective long- term incentives for Senior Executives that encourage them to remain with the Company and continue to excel in their performance.
Each stock option permits the Grantee, generally for a period of ten years, to purchase one share of stock of Triad Holdings Inc., or Holdings, at the exercise price, which is the book value per share of the stock as of the most recently reported quarter on the date of grant. Since the stock of Holdings is not publicly traded, we believe this method of valuation is an appropriate reflection of the true value of the unexercised vested option shares as a particular date. Stock options granted initially to the Senior Executives in 2005 were based on the value per share of Holdings as of the closing of the Acquisition. Stock options have value only to the extent the value of Holdings stock on the date of exercise exceeds the exercise price. Options are generally exercisable in five equal installments beginning the date of the grant date and continue annually thereafter on the anniversary of the grant date, or the month ending immediately prior to the anniversary of the grant date.
The number of stock options granted to Senior Executive Officers is shown on the Grant of Plan-Based Awards Table below. Additional information on these grants, including the number of shares subject to each grant, is also shown in the Grant of Plan-Based Awards Table. The Outstanding Equity Awards at Fiscal Year End Table below shows the value of these awards at December 31, 2007.
Our stock option program is a vital element of our drive to develop and motivate the leaders who will sustain our performance as we continue to expand the business. It also provides real incentives for our key employees to sustain and enhance our long-term performance, because it links the potential financial gain for these employees to the long term value of Holding’s stock price. Both the Co-Chairmen and the Compensation Committee believe that the superior performance of these individuals will contribute significantly to our future success.
Various persons are involved in the stock option granting process. Upon consideration of the recommendation of the Co-Chairmen, the Compensation Committee approves stock option grants to Senior Executive Officers and others who provide vital services to the Company. Option grants to other key employees are made from time to time with the approval of the President and CEO, on the recommendation of the Senior Executive Officers to whom they report. Our General Counsel and the Vice President of Human Resources oversee the stock option practices and administration of the 2005 Plan. The Chief Financial Officer has established procedures that provide for consistency and accuracy in determining the fair market value of options and the expense regarding the stock option grants in compliance with FAS 123(R).
An important objective of the 2005 Plan is to strengthen the relationship between the long-term value of Holding’s stock price and the potential financial gain for the Senior Executive Officers, key employees and other beneficiaries of the 2005 Plan. Stock options provide Senior Executive Officers (as well as employees and others providing services to the Company) with the opportunity to purchase Holdings’ stock at a price fixed on the grant date regardless of future market price. Accordingly, a stock option becomes valuable only if Holdings’ stock price increases above the option exercise price and the holder of the option remains employed by the Company. In addition, stock options link a portion of the recipient’s compensation to shareholders’ interests by providing an incentive to increase the value of the Company.
Option holders generally forfeit any unvested options if their employment with us terminates. In such event, their right to exercise vested option shares terminates on the date of termination. To the extent that the book value of the most recently completed quarter exceeds the strike price, they will be paid the difference for each vested option share. All granted options will vest upon a change in control of the Company.
Options Exercised - 2007
None of the Senior Executive Officers exercised any of the Vested Option Shares available for exercise during 2007.
Other Equity Incentive Plans
The 2005 Plan only authorizes the grant of stock options in Holdings. Neither the Company nor Holdings offers any stock appreciation rights, Employee Stock Purchase Plans, restricted stock plans, or other plans providing for equity or equity-based compensation.
Retirement, Health and Welfare Benefits
We offer a variety of health and welfare programs to all eligible employees. The Senior Executive Officers generally are eligible for the same benefit programs on the same basis as the rest of the Company’s employees. The health and welfare programs are intended to protect employees against catastrophic loss and encourage a healthy lifestyle. Our health and welfare programs include medical, prescription drug, dental, vision, life insurance and accidental death and disability. We provide short-term disability, long-term disability and basic life insurance at no cost to the employees who qualify for such benefits. We offer a qualified 401(k) savings plan. All Company employees, including Senior Executive Officers, are generally eligible to participate in the 401(k) plan. We do not offer any pension plans or similar benefits to our employees.
Employment Agreements and Arrangements
We entered into an employment agreement, or the “Goodman Agreement” with Mr. Chris Goodman in 2005. The Agreement provides for a minimum annual salary of $255,000. The Goodman Agreement provides that he will serve as Director of the RoadLoans Division of the Company for a three-year period or until the earlier to occur (if at all) of his termination or resignation. The Agreement provides that Mr. Goodman is eligible for our employee benefit plans and other benefits provided in the same manner and to the same extent as our other employees. The Goodman Agreement also contains confidentiality provisions and a covenant not to solicit employees or clients during his employment term and for three years following the termination of his employment. In August 2007, the Company and Mr. Goodman entered into an amended and Restated Employment Agreement, under the terms of which Mr. Goodman’s salary was increased to $270,000. The amended agreement has an initial term of three years, and contains an annual renewal provision unless either party seeks to terminate it.
In February 2007, we hired Mr. David Satterfield as Senior Vice President and Director of Dealer Channel Originations. In connection with his joining the Company, we entered into an employment agreement, or the Satterfield Agreement” with Mr. Satterfield. The Satterfield Agreement provides for a minimum annual salary of $270,000. It also provides that he will serve in that capacity for an initial term of three years, and contains an automatic renewal provision on the anniversary of his hire date.
No other Senior Executive Officers or other employees of the Company had contracts of employment as of the end of 2006. The Company had an employment agreement with Mr. James M. Landy, the former president of the Company. Mr. Landy’s agreement was dated April 29, 2005, and was terminated when he was terminated in July 2005. Mr. Landy continued to receive periodic payments under the terms of that employment agreement through June 2007.
During the third quarter of 2007, the Company entered into a consulting agreement with Carl B. Webb. Under the terms of the agreement, Mr. Webb will provide consulting services to the Company in return for a fee of $250,000 per annum. In the first quarter of 2008, the consulting agreement was amended to change the annual fee to $500,000.
Non-Qualified Deferred Compensation Plans
We do not have any Non-Qualified Deferred Compensation Plans.
Change in Control Agreements
We have no Change in Control Agreements with any of the Senior Executive Officers of the Company or with any other employee as of the end of 2007, although both the Goodman and the Satterfield Agreements contain provisions that allow for either agreement to be terminated upon a change in control. Under the 2005 Plan, all options granted will vest upon a change in control.
Indemnification of Officers and Directors of Triad
We have no indemnification agreements with any of our Senior Executive Officers or with any other employee. However, our articles of incorporation and bylaws provide that all our officers and directors will be indemnified by us to the fullest extent permissible under the California Corporations Code from and against all expenses, judgments, fines, settlements and other amounts actually and reasonably incurred in connection with such person’s status as our agent. We have purchased and maintain insurance on behalf of our agents, including our officers and directors, against any liability asserted against them in such capacity or arising out of such agents’ status as officers or directors.
Stock Ownership Guidelines
We have not adopted at this time any guidelines that address the ownership of our stock or that of Holdings.
Tax Implications of Executive Compensation
Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”) places a limit of $1,000,000 on the amount of compensation that may be deducted by the Company in any year with respect to the CEO or any other Senior Executive unless the compensation is performance-based compensation as described in Section 162(m) and the related regulations. At the present time, we do not pay any compensation to our Senior Executives that may not be deductible, including discretionary bonuses or other types of compensation.
Compensation Committee
The Compensation Committee of the company meets from time to time to discuss matters pertaining to the salaries, wages and benefits to be paid to employees. While there is no fixed schedule for these meetings, there will generally be a meeting in the first quarter of each year to ratify bonus pools for the previous year, and to approve the compensation plan proposed by management for the new year. This Committee is chaired by Mr. David A. Donnini, and the other members are Mr. Gerald J. Ford, Mr. Stuart A. Katz, Mr. Gaurav Seth and Mr. Donald J. Edwards.
Compensation Committee Report
The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis for the 2007 fiscal year with the Company’s management. Based on the review and discussions, the Compensation Committee recommended to the Company’s Board of Directors that the Compensation Discussion and Analysis be included in this annual report on Form 10-K.
David A. Donnini (Chairman)
Gerald J. Ford
Stuart A. Katz
Guarav Seth
Donald J. Edwards
Compensation Committee Interlocks and Insider Participation
For a description of the transactions between us and our directors and entities affiliated with such directors, see “Certain Relationships and Related Transactions and Director Independence.” None of our executive officers has served as a member of the board of directors or compensation committee of another entity that had one or more of its executive officer that had one or more of its executive officers servicing as a member of our board of directors.
Compensation of Directors
We do not compensate the directors currently serving on our board of directors, although we entered into a consulting agreement with Mr. Webb at the time he resigned as President and CEO and became the Co-Chairman of the Board. To the extent any future directors are neither our employees nor our principal equity sponsors, such directors may receive fees. We expect the amount of such fees will be commensurate with amounts offered to directors of companies similar to ours.
Summary Compensation Table
The following table sets forth services rendered in all capacities to us for the year ended December 31, 2007 for our President and Chief Executive Officer, our Chief Financial Officer, and the three most highly compensated executive officers as of December 31, 2007:
(1)
For each of the stock option grants, the value shown is what is also included in the Company’s financial statements per FAS 123(R). See footnote 14 to the Company’s consolidated financial statements included in this annual report for a complete description of the FAS 123(R) valuation. The actual number of awards granted in 2007 is shown in the “Grants of Plan Based Awards” table included in this filing.
(2)
Mr. Webb stepped down as President and CEO in June 2007. Effective August 1, 2007, he entered into a Consulting Agreement with the Company that will pay him $250,000 annually. He received $3,846 as the Company contribution to his 401(k) Plan.
(3)
Includes $9,000 and $8,800 in 2007 and 2006, respectively, Company contribution to 401(k) Plan and $15,000 in car allowance in 2007 and 2006.
(4)
Includes $9,000 and $7,936 in 2007 and 2006, respectively, Company contribution to 401(k) Plan and $15,000 in car allowance in 2007 and 2006.
(5)
Mr. Satterfield joined the Company in February 2007 and received a signing bonus of $200,000.
(6)
Includes $8,930 and $7,044 in 2007 and 2006, respectively, Company contribution to 401(k) Plan and $15,000 in car allowance in 2007 and 2006.
Grant of Plan-Based Awards Table
The following table summarizes information regarding awards granted under the 2005 Plan during 2007 to our Senior Executives:
(1)
Mr. Webb stepped down as President and CEO in June 2007.
The exercise price is the book value per share of the stock as of the most recently reported quarter prior to the date of grant. Since the stock of Holdings is not publicly traded, we believe this method of valuation is an appropriate reflection of the true value of the unexercised vested option shares as of a particular date.
Outstanding Equity Awards at Fiscal Year-End
(1)
Mr. Webb stepped down as President and CEO in June 2007.
Options Exercised and Stock Vested in Fiscal 2007
No stock options were exercised in fiscal year 2007.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
PRINCIPAL STOCKHOLDERS
Triad is a wholly-owned subsidiary of Triad Holdings Inc., which we refer to as “Triad Holdings.” The following table sets forth certain information as of March 14, 2008, regarding the beneficial ownership of common stock of Triad Holdings by (i) each person we know to be the beneficial owner of more than 5% of its outstanding common stock, (ii) each member of the board of directors of Triad Holdings (which is identical to the board of directors of Triad) and our Named Executive Officers, and (iii) each of our directors and executive officers as a group. To our knowledge, each such stockholder has sole voting and investment power as to the common stock shown unless otherwise noted. Beneficial ownership of the common stock listed in the table has been determined in accordance with the applicable rules and regulations promulgated under the Exchange Act.
*
Represents less than 1%
(1)
Each of the principal stockholders holds ownership interests directly in Triad Holdings, LLC, or “Triad LLC,” and none of the principal stockholders hold any common stock of Triad Holdings directly. Triad Holdings is controlled by Triad LLC, which owns approximately 98.9% of the common stock of Triad Holdings directly. Amounts shown reflect the beneficial ownership of the principal stockholders in Triad Holdings through their ownership in Triad LLC. The ownership interests in Triad LLC consist of preferred units and common units. See “Certain Relationships and Related Transactions and Director Independence - Limited Liability Company Agreement of Triad Holdings, LLC” for more information.
(2)
Amounts shown reflect the aggregate interest held by MTGLQ Investors, L.P., which is a wholly-owned subsidiary of The Goldman Sachs Group, Inc. (“GS Group”), and investment partnerships, of which
affiliates of GS Group are the general partner or managing general partner. These investment partnerships, which we refer to as the “GS Funds” (together with MTGLQ Investors, L.P., the “GS Entities”), are GS Capital Partners 2000, L.P., GS Capital Partners 2000 Offshore, L.P., GS Capital Partners 2000 GmbH & Co. Beteiligungs KG, GS Capital Partners 2000 Employee Fund, L.P. and Goldman Sachs Direct Investment Fund 2000, L.P. Each of Peter Aberg and Stuart Katz is a managing director of Goldman, Sachs & Co., an affiliate of GS Group and the investment manager of certain of the GS Funds. Mr. Aberg, Mr. Katz, Goldman, Sachs & Co. and GS Group each disclaims beneficial ownership of the shares owned directly or indirectly by the GS Funds, except to the extent of their pecuniary interest therein, if any. Mr. Aberg, Mr. Katz and Goldman, Sachs & Co. each disclaims beneficial ownership of the shares owned by MTGLQ Investors, L.P., except to the extent of their pecuniary interest therein, if any. The shares are included four times in the table under the beneficial ownership of each of Mr. Aberg, Mr. Katz, the GS Entities and all directors and executive officers as a group. The address for each of these beneficial owners is c/o Goldman, Sachs & Co., 85 Broad Street, New York, New York 10004.
(3)
Amounts shown reflect the aggregate interest held by GTCR Fund VIII, L.P., GTCR Fund VIII/B, L.P. and GTCR Co-Invest II, L.P., which we collectively refer to as the “GTCR Funds.” Messrs. Donnini and Canfield are each principals and/or members of GTCR Golder Rauner II, L.L.C. (“GTCR II”). GTCR II is the general partner of GTCR Co-Invest II, L.P. and GTCR Partners VIII, L.P., which is the general partner of GTCR Fund VIII, L.P. and GTCR Fund VIII/B, L.P. Accordingly, Messrs. Donnini and Canfield may be deemed to beneficially own the shares owned by the GTCR Funds. Each such person disclaims beneficial ownership of any such shares in which he does not have a pecuniary interest. The address of each such person and the GTCR Funds is c/o GTCR Golder Rauner, L.L.C., 6100 Sears Tower, Chicago, IL 60606. The shares are included four times in the table under the beneficial ownership of each of Mr. Canfield, Mr. Donnini, the GTCR Funds and all directors and executive officers as a group.
(4)
Amounts shown include shares owned through Hunter’s Glen/Ford. Because Gerald J. Ford is one of two general partners of Hunter’s Glen/Ford, and the sole stockholder of Ford Diamond Corporation, a Texas corporation, and the other general partner of Hunter’s Glen/Ford, Gerald J. Ford is considered the beneficial owner of the shares of Triad owned by Hunter’s Glen/Ford. The address of each such person is c/o Hunter’s Glen/Ford Ltd., 200 Crescent Court, Suite 1350, Dallas, TX 75201.
(5)
Represents options to acquire 210,000 shares of common stock of Triad Holdings.
(6)
Represents options to acquire 210,000 shares of common stock of Triad Holdings.
(7)
Represents options to acquire 150,000 shares of common stock of Triad Holdings.
(8)
Represents options to acquire 80,000 shares of common stock of Triad Holdings.
(9)
Represents options to acquire 150,000 shares of common stock of Triad Holdings.
(10)
Includes options to acquire 300,000 shares of common stock of Triad Holdings.
(11)
Includes options to acquire 1,540,000 shares of common stock of Triad Holdings.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
In connection with the Transactions, we entered into a unit purchase agreement, stockholders agreement, registration rights agreement, management agreement and stock purchase agreement and our principal stockholders entered into a limited liability company agreement, all as further described below.
Relationship with Ford Credit
Prior to the Transactions, Triad was a wholly-owned subsidiary of Fairlane Credit LLC. Fairlane Credit is a wholly-owned subsidiary of Ford Credit. When we were a subsidiary of Ford Credit, we received financing support and technical and administrative advice and services from Ford Credit. At December 31, 2005, we owed Ford Credit $52.3 million. This note payable was repaid during 2006.
Unit Purchase Agreement
In connection with the closing of the Transactions, Triad Holdings, LLC, or “Triad LLC,” entered into a unit purchase agreement with the GTCR Funds, the GS Entities and Hunter’s Glen/Ford pursuant to which the GTCR Funds, the GS Entities and Hunter’s Glen/Ford acquired a strip of preferred units and common units of Triad LLC for an aggregate purchase price of $114.8 million.
Limited Liability Company Agreement of Triad Holdings, LLC
Capitalization. Triad is indirectly controlled by Triad LLC. Triad LLC has authorized preferred units and common units under the terms of its limited liability company agreement. Each class of units represents a fractional part of the membership interests of Triad LLC.
The preferred units of Triad LLC accrue dividends at a rate of 6% per annum, compounded annually. Upon any liquidation or other distribution by Triad LLC, holders of preferred units will be entitled to an amount equal to the original investment in such preferred units, plus any accrued and unpaid preferred yield, before any payments may be made to holders of common units. The common units represent the common equity of Triad LLC. After payment of (1) the accrued and unpaid preferred yield on the preferred units and (2) the return of the invested capital by the preferred unitholders, the holders of common units will be entitled to any remaining proceeds of any liquidation or other distribution by Triad LLC pro rata according to the number of common units held by such holder.
The indenture governing the notes generally limits the ability of Triad to pay cash distributions to its equityholders, other than distributions in amounts approximately equal to the tax liability of members of Triad LLC, unless certain conditions are satisfied. Because Triad LLC’s only significant assets will be the equity securities of its subsidiaries, it likely will not have sufficient funds to make distributions to its members, other than quarterly tax distributions.
Board of Managers. The board of managers generally has the exclusive authority to manage and control the business and affairs of Triad LLC. Under the terms of the limited liability company agreement, the board is initially composed of the following ten members:
•
three representatives designated by the GS Entities, who initially were Peter C. Aberg, Stuart A. Katz and Lance West. Mr. West resigned in April 2006 and was replaced by Daniel J. Pillemer, who in turn was replaced by Jonathon D. Fiorello in February 2007, who in turn was replaced by Gaurav Seth in November 2007;
•
three representatives designated by the GTCR Funds, who initially were Philip A. Canfield, David A. Donnini and David I. Trujillo. Mr. Trujillo resigned in March 2006, and was replaced by Aaron D. Cohen;
•
three representatives designated by Hunter’s Glen/Ford, who initially were Donald J. Edwards, J. Randy Staff and Carl B. Webb; and
•
the LLC’s chief executive officer, who initially was Gerald J. Ford.
With respect to each of the foregoing equity sponsors (that is, the GS Entities, the GTCR Funds and Hunter’s Glen/Ford), so long as it and its respective affiliates continue to hold at least 50%, 25% and one of the common units purchased by it and its affiliates under the unit purchase agreement, it will have the right to designate three, two and one representative(s) to the board of Triad LLC, respectively. However, if the GS Entities and their affiliates continue to hold at least 50% of the common units purchased by them and their affiliates under the unit purchase agreement, which we refer to as the “Goldman Common Units,” and the GTCR Funds and their affiliates no longer hold any of the common units purchased by them and their affiliates under the unit purchase agreement, which we refer to as the “GTCR Common Units,” then the GS Entities will have the right to designate one additional representative (for a total of four representatives) so long as the GS Entities and their affiliates continue to hold at least 50% of the Goldman Common Units. Similarly, if the GTCR Funds and their affiliates continue to hold at least 50% of the GTCR Common Units and the GS Entities and their affiliates no longer hold any Goldman Common Units, then GTCR will have the
right to designate one additional representative (for a total of four representatives) so long as GTCR and its affiliates continue to hold at least 50% of the GTCR Common Units.
Restrictions on Transfer. The limited liability company agreement provides for customary rights of first offer, tag-along rights, drag-along rights and other restrictions on transfer similar to those set forth in the stockholders agreement (described below under the caption “- Stockholders Agreement”).
Buy/Sell Right. Upon a triggering event (defined below), Hunter’s Glen/Ford will have the right to make a fully financed offer to purchase all of the units and other interests in Triad LLC from the other equity sponsors and their respective affiliates at a price specified by Hunter’s Glen/Ford, which we refer to as “Buy/Sell Right.” Upon exercise of the Buy/Sell Right by Hunter’s Glen/Ford, the other equity sponsors will each have the right to either accept Hunter’s Glen/Ford’s offer and sell its units or elect to purchase the units and other interests of Triad LLC held by Hunter’s Glen/Ford at the same price and on the same other customary terms as offered by Hunter’s Glen/Ford. If both of the other equity sponsors elect to sell, then Hunter’s Glen/Ford must purchase the units of the other equity sponsors and their respective affiliates. If both of the other equity sponsors elect to purchase the units of Hunter’s Glen/Ford, then Hunter’s Glen/Ford must sell its units to the other equity sponsors and their respective affiliates. If either of the other equity sponsors elects to sell and the other elects to purchase, then the other equity sponsor electing to purchase will have the right to decide whether to purchase both Hunter’s Glen/Ford’s and the other equity sponsor’s entire interest in the Triad LLC or change its election and sell its interests to Hunter’s Glen/Ford. A “triggering event” may occur if, without the prior written consent of Hunter’s Glen/Ford, either the board of managers of Triad LLC or the other equity sponsors cause the management agreement (described below under the caption “- Management Agreement”) to be terminated other than for cause, fail to pay any amount owed to Hunter’s Glen/Ford under the management agreement when due, remove Gerald J. Ford as chief executive officer of Triad LLC or as executive chairman of Triad Holdings other than for cause, or eliminate or materially reduce Hunter’s Glen/Ford’s or Mr. Ford’s responsibilities with respect to Triad LLC or Triad Holdings other than for cause.
Stockholders Agreement
Concurrently with the closing of the Transactions, Triad Holdings entered into a stockholders agreement with Triad LLC and James M. Landy. The stockholders agreement provides that:
•
the board of directors of Triad Holdings will have the same composition as the board of managers of Triad LLC described above plus one additional director who will be the chief executive officer of Triad Holdings;
•
the stockholders of Triad Holdings will have customary rights of first offer with respect to specified transfers of shares of Triad Holdings by other stockholders, which would allow the other stockholders to purchase a pro rata portion of the shares proposed to be transferred in proportion to the number of shares held by such other stockholders participating in such purchase on a fully diluted basis;
•
the stockholders of Triad Holdings, other than Triad LLC, will have customary tag-along rights with respect to specified transfers by Triad LLC of shares of Triad Holdings, which would enable them to transfer their shares on the same terms and conditions as Triad LLC;
•
Triad LLC will have drag-along rights with respect to Triad Holdings shares owned by the other stockholders of Triad Holdings, which would require the other stockholders to sell their units in connection with a sale of Triad Holdings that is approved by the board of directors of Triad Holdings and the board of managers of Triad LLC;
•
the stockholders of Triad Holdings will not transfer their shares of Triad Holdings without the prior written consent of Triad LLC, except as specified in the stockholders agreement; and
•
Triad Holdings must obtain the prior written consent of Triad LLC before taking specified actions.
Registration Rights Agreement
Under the registration rights agreement entered into in connection with the closing of the Transactions, the holders of a majority of the Goldman registrable securities, the holders of a majority of the GTCR registrable securities and the holders of a majority of the Hunter’s Glen/Ford registrable securities, each as defined in the registration rights agreement, each have the right at any time after an underwritten initial public offering of the common stock of Triad Holdings with gross proceeds of at least $50.0 million, subject to specified conditions, to request Triad Holdings or any subsidiary to register any or all of their securities under the Securities Act on Form S-1, which we refer to as a “long-form registration,” at the expense of Triad Holdings, or on Form S-2 or Form S-3, which we refer to as a “short-form registration,” at the expense of Triad Holdings provided that the aggregate offering value of registrable securities to be registered in a short-form registration must equal at least $10.0 million. Triad Holdings is not required, however, to effect any long-form registration within 90 days after the effective date of a previous long-form registration or a previous registration in which the holders of registrable securities were given the piggyback rights in the following sentence (without any reduction). At the expense of Triad Holdings, all holders of registrable securities are entitled to the inclusion of such securities in any registration statement used by Triad Holdings to register any offering of its equity securities (other than pursuant to a demand registration or in connection with an initial public offering of the common stock of Triad Holdings or a registration on Form S-4 or Form S-8). Each security holder of Triad Holdings will be a party to the registration rights agreement.
Management Agreement
Under the management agreement among Triad, Triad LLC, Triad Holdings and Hunter’s Glen/Ford, Triad LLC and Triad engaged Hunter’s Glen/Ford as a financial and management consultant. During the term of the engagement, Hunter’s Glen/Ford will provide Gerald J. Ford to serve as the chief executive officer of Triad LLC and executive chairman of Triad as specified in the agreement and will provide Carl Webb and J. Randy Staff or similarly qualified individuals to furnish a portion of the services required by the management agreement. Mr. Ford’s responsibilities include setting corporate strategy, overseeing the performance of the chief executive officer of Triad and Triad Holdings, naming senior executives of Triad and Triad Holdings (other than the chief executive officer and chief financial officer, who will be named and approved by the boards of directors of Triad and Triad Holdings), and recommending compensation of such executives to the boards. The management agreement also contains standard indemnification provisions whereby Triad and Triad Holdings will indemnify Hunter’s Glen/Ford against specified claims relating to specified actions taken by Hunter’s Glen/Ford under the management agreement.
We agreed to pay Hunter’s Glen/Ford a management fee of $1.5 million per annum for the services described above. This management fee is payable monthly in arrears on the last day of each month. The management fee is payable starting on the closing date of the Transactions, continuing during the service period of the management agreement and, upon termination of the service period for specified reasons (other than for cause), through the fifth anniversary of the closing of the Transactions or through the first anniversary of the termination of the service period, if later. If the service period is terminated by Triad LLC for cause, we will continue to pay the management fee through the first anniversary of the termination of the service period. Our obligation to pay the management fee will also cease upon a sale of Triad or Triad Holdings or upon the consummation of an underwritten initial public offering of the common stock of Triad Holdings with gross proceeds of at least $50.0 million. The service period will end on the earlier of (1) termination by Hunter’s Glen/Ford or Triad LLC upon at least 90 days prior notice and (2) upon a closing of the Buy/Sell Right in which Hunter’s Glen/Ford sells all of its units in Triad LLC.
The management agreement also provides for the purchase by Hunter’s Glen/Ford and its co-investors of common units of Triad LLC for a nominal purchase price, which we refer to as the “carried common units.” The carried common units will be subject to quarterly vesting over a five-year period. Upon the occurrence of a sale of Triad or Triad Holdings, the consummation of an underwritten initial public offering of the common stock of Triad Holdings with gross proceeds of at least $50.0 million or a termination of the service period for any reason (other than voluntary termination by Hunter’s Glen/Ford or a termination by Triad LLC for cause), all unvested carried common units will become vested. Upon a voluntary termination of the service period by
Hunter’s Glen/Ford, all further vesting of unvested carried common units will cease and such units will be subject to repurchase by Triad LLC at their original cost. Upon termination of the service period by Triad LLC for cause, vesting will be accelerated by one year and all remaining unvested carried common units will cease vesting and will be subject to repurchase by Triad LLC at their original cost.
Stock Purchase Agreement
On December 23, 2004, Triad Holdings and its wholly-owned subsidiary, Triad Acquisition Corp., entered into a stock purchase agreement pursuant to which Triad Acquisition Corp. agreed to acquire all of the outstanding capital stock of Triad Financial Corporation from Fairlane Credit LLC, a wholly-owned subsidiary of Ford Motor Credit Company. We refer to this transaction as the “Acquisition.” Triad Holdings and Triad Acquisition were newly formed holding companies beneficially owned by affiliates of Goldman, Sachs & Co., GTCR Golder Rauner, L.L.C. and Hunter’s Glen/Ford.
The stock purchase agreement also contains customary indemnification provisions. As provided in the stock purchase agreement, you are not entitled to rely on any of the provisions of the stock purchase agreement, including the representations and warranties contained in the stock purchase agreement.
Our Warehouse and Residual Facilities
As part of the Transactions, an affiliate of Goldman, Sachs & Co. and an affiliate of Citigroup each provided a warehouse lending facility and a residual facility to us. Affiliates of Goldman, Sachs & Co. and Citigroup also acted as the initial purchasers of the outstanding notes and affiliates of Goldman, Sachs & Co. are equity sponsors of our company. See “Principal Stockholders” for more information on our equity ownership.
The Company’s warehouse and residual loan facilities with Goldman Sachs Mortgage Company, due October 2007, were paid off on October 26, 2007. The funds necessary to pay off these facilities were obtained through the transfer of collateral to, and a simultaneous additional advance on the Company’s other warehouse and residual facilities, due April 2009.
On January 10, 2008, we entered into a warehouse facility with Barclays Bank PLC. This facility provides up to $500 million of funding for automobile retail installment sales contract receivables originated or purchased by us. The facility has a two year commitment but may expire after 364 days if the liquidity facility is not renewed.
Interest expense for the warehouse and residual loan facilities for the years ended December 31, 2007 and 2006 and for the period April 30, 2005 through December 31, 2005 includes $12.7 million, $17.7 million and $12.1 million, respectively, of expense incurred to Goldman Sachs Mortgage Company.
Capitalized financing costs with an unamortized balance of $7.5 million at December 31, 2007 are being amortized over the expected term of the securitization transactions. Capitalized financing costs include $1.5 million in remaining unamortized underwriting fees paid to Goldman, Sachs & Co., an affiliate of one of our equity investors.
Capitalized financing costs with an unamortized balance of $4.0 million at December 31, 2007 are being amortized over the contractual term of the notes. Capitalized financing costs include $2.8 million in remaining unamortized fees paid to Goldman, Sachs & Co., an affiliate of one of our equity investors.
Warehouse Facilities
Each of the two initial warehouse facilities initially provided a maximum of $975.0 million of committed funding. Each warehouse facility maximum commitment was reduced to $750.0 million upon completion of our first term securitization on May 26, 2005. The available amount of the commitment under each warehouse facility at any time will be reduced by the amount drawn on the related residual facility at such time.
The Company’s warehouse and residual loan facilities with Goldman Sachs Mortgage Company, due October 2007, were paid off on October 26, 2007. The funds necessary to pay off these facilities were
obtained through the transfer of collateral to, and simultaneous additional advance on the Company’s other warehouse and residual facilities, due April 2009.
On January 10, 2008, we entered into a warehouse facility with Barclays Bank PLC. This facility provides up to $500 million of funding for automobile retail installment sales contract receivables originated or purchased by us. The facility has a two year commitment but may expire after 364 days if the liquidity facility is not renewed.
The collateral of each warehouse facility includes the pool of contracts pledged on a first priority basis to the related lender, along with related assets and proceeds, including funds in accounts. Under each warehouse facility, the other lender receives a subordinated security interest in the collateral. In addition, the cash flows from the collateral on a warehouse facility are available to support repayment of the amounts owing to the applicable lender under its residual facility and the other lender’s warehouse facilities.
Triad provided a guarantee under each of the warehouse facilities equal to 10% of the amount outstanding on each facility at the time a guarantee is drawn, if at all. If Triad is required to fund any portion of a guarantee, Triad will be reimbursed for such payment prior to any required cross- collateralization payments to the lenders under any of the warehouse or residual facilities.
Each warehouse facility has a borrowing base, which determines the maximum amount available to be borrowed. The advance rate used to establish each borrowing base, for contracts that are current or not more than 30 days delinquent, is the lower of (1) an agreed percentage of the face amount of the contracts and (2) the net amount of proceeds that is estimated to be receivable upon a securitization of those contracts. The advance rate decreases as the delinquency on the contracts increases.
Collections on contracts in each warehouse facility are set aside in a collection account. On a monthly basis, these collections will be applied to pay interest and fees owing to the applicable warehouse lender, servicing fees, amounts owing on interest rate hedges, backup servicer expenses, and reduction of principal in an amount sufficient to maintain compliance with the borrowing base. If any amounts are unpaid under the residual facility, those amounts will be paid to the extent of available remaining cash flow. The warehouse Special Purpose Entity, or SPE, will be entitled to retain, and to distribute to Triad, any remaining amounts.
A warehouse facility cannot be drawn unless all conditions precedent are met. Material conditions include:
•
the amount outstanding on the warehouse facility after the draw cannot exceed the borrowing base under that warehouse facility;
•
no material adverse change; and
•
no default or event of default.
Triad is the servicer for the collateral pledged to the warehouse facilities. Servicer termination events under the warehouse facilities include a change of control of Triad, a payment default or acceleration on other Triad debt and an event of default under the warehouse facility.
Under the warehouse facilities, events of default, many of which are subject to grace periods, include:
•
failure to pay principal or interest when due;
•
breaches of representations, warranties and covenants;
•
a payment default under any of our other debt or securitizations or the acceleration of any other debt or any securitization;
•
a change of control;
•
a failure of the lenders to have a first priority perfected security interest in any material portion of the collateral;
•
unsatisfied judgments against us in excess of $1.0 million;
•
a bankruptcy of warehouse borrower, servicer or residual borrower;
•
servicer termination;
•
failure to maintain a satisfactory interest rate hedging program; and
•
a material adverse change.
The warehouse facilities contain a covenant that no event of default or similar event relating to the delinquency rate or cumulative loss rate of the contracts relating to our term securitizations shall occur. The warehouse facilities also contain several financial covenants, including a minimum net worth requirement. Negative covenants of the warehouse facilities include restrictions on:
•
entering into any transaction that adversely affects the collateral or the lenders;
•
investments not in the ordinary course of business;
•
loans or other advances by borrower; and
•
selling a material portion of its contracts if, following such sale, the total outstanding principal amount would exceed the borrowing base, after giving effect to the application of proceeds from such sale.
Residual Facility
Our residual facility provides a maximum of $125.0 million of funding. We established a SPE as the borrower under the residual facility. The residual SPE acquired the residual interests in the term securitizations currently held by another SPE, which includes class B notes, certificates and the interests in the spread accounts. Interest under the residual facility accrues at a margin over LIBOR. The interest margin increases as the amount outstanding the residual facility, as a percentage of the borrowing base, increases. The interest margin under the residual facility is significantly higher than the interest margin under the warehouse facility as of December 31, 2007.
The advance rates under the residual facility are an agreed upon percentage of the market value determined by the lender for the subordinated note collateral, such as the Class B notes, and the other collateral, such as our other residual interests in securitizations.
The collateral of the residual facility includes the pool of residual assets pledged along with related assets and proceeds, including funds in accounts. In addition, the cash flows from the collateral on a residual facility are available to support repayment of the amounts owing to the lender under its warehouse facility.
Triad provided a guarantee under its residual facility equal to 10% of the amount outstanding on the facility at the time a guarantee is drawn, if at all. If Triad is required to fund any portion of a guarantee, Triad will be reimbursed for such payment prior to any required cross- collateralization payments to the lenders under any of the warehouse or residual facilities.
The residual SPE cannot draw on a residual facility unless all conditions precedent are met. Material conditions include:
•
compliance with the borrowing base;
•
no material adverse change; and
•
no default or event of default.
Collections on residual interests will be set aside in a collection account. On a monthly basis, these collections will be applied to pay interest and fees owing to the residual lender, and to reductions of principal in an amount sufficient to maintain compliance with the borrowing base. If any amounts are unpaid under the lender’s warehouse facility, those amounts will be paid to the extent of available remaining cash flow. The residual SPE will be entitled to retain, and to distribute to Triad, any remaining amounts.
Under the residual facility, events of default, many of which are subject to grace periods, include:
•
failure to pay principal or interest when due;
•
breach of a covenant or term;
•
any false representation or warranty;
•
impermissible liens on the collateral;
•
the bankruptcy of Triad or an affiliate;
•
the lender ceasing to have a first priority perfected security interest;
•
a payment default under any of our other debt or securitizations or the acceleration of any other debt or any securitization;
•
a material adverse change;
•
a servicer default; and
•
a change of control.
Board of Directors
The board is currently comprised of ten directors, none of whom qualifies as an independent director set forth in Rule 4200(a)(15) of the Nasdaq Marketplace rules. Because affiliates of our equity sponsors indirectly own approximately 100% of the voting common stock of Triad Holdings, we would be a “controlled company” within the meaning of Rule 4350(c)(5) of the Nasdaq Marketplace rules, which would qualify for exemptions from certain corporate governance rules of The Nasdaq Stock Market LLC, including that the board of directors be composed of a majority of independent directors.
Policies and Procedures for Related Party Transactions
As a private company, our board of directors generally reviews our related party transactions, although we have not historically had formal policies and procedures regarding the review and approval of related party transactions.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES.
The following table presents fees for professional services rendered by PricewaterhouseCoopers LLP for the audit of the Company’s annual financial statements for fiscal 2007 and 2006 and fees billed for audit-related services, tax services and all other services rendered to the Company by PricewaterhouseCoopers LLP for fiscal 2007 and 2006.
The Audit Committee has established a policy to pre-approve all audit and non-audit services performed by the independent registered public accounting firm (“independent auditor”) in order to assure that the provision of such services does not impair the auditor’s independence. Based on the information presented to the Audit Committee by PricewaterhouseCoopers LLP and the Company’s management, the Audit Committee has pre-approved defined audit, audit-related, tax and other services for fiscal year 2007 up to specific cost
levels. Any proposed services exceeding pre-approved cost levels require specific pre-approval by the Audit Committee. The policy provides that the Audit Committee review, at each regularly scheduled meeting, a report summarizing the services provided by the independent auditor and all fees relating thereto. The policy also prohibits the independent auditor from providing services that are prohibited under the Sarbanes-Oxley Act of 2002.
All fees reported under the headings Audit-Related Fees, Tax Fees, and All Other Fees for 2007 were pre-approved by the Audit Committee, which concluded that the provision of such services by PricewaterhouseCoopers LLP was compatible with the maintenance of that firm’s independence in the conduct of its auditing functions. Accordingly, none of these fees reported under the headings were approved by the Audit Committee pursuant to federal regulations that permit the Audit Committee to waive its pre-approval requirement under certain circumstances.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
EXHIBIT INDEX
*
Management contract or compensatory plan or arrangement.
+
Filed herewith
SIGNATURES
Pursuant to the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:
Date: March 28, 2008
/s/ Daniel D. Leonard
Daniel D. Leonard
President & Chief Executive Officer
Date: March 28, 2008
/s/ Mike L. Wilhelms
Mike L. Wilhelms
Senior Vice President & Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated below.
EXHIBIT INDEX
*
Management contract or compensatory plan or arrangement.
+
Filed herewith