Item 1.
Business
General
We are one of the nation’s largest independent automobile finance companies with 31 years of experience in the automobile finance industry. We believe that the automobile finance industry is the second largest consumer finance industry in the United States with over $684 billion of loan originations during 2003. We originate new and pre-owned automobile installment contracts, otherwise known as contracts, through our relationships with approximately 8,000 franchised and independent automobile dealers nationwide. We originated $6.0 billion of contracts during 2003 and managed a portfolio of $10.6 billion contracts at December 31, 2003.
For the year ended December 31, 2003, approximately 32% of our contract originations were for the purchase of new automobiles and approximately 68% of our contract originations were for the purchase of pre-owned automobiles. Approximately 83% of our contract originations were what we refer to as prime contracts, and approximately 17% of our contract originations were what we refer to as non-prime contracts. Our determination of whether a contract is categorized as prime, non-prime or other is based on a number of factors including the borrower’s credit history and our expectation of credit loss. All references made throughout this document regarding prime, non-prime or subprime automobile contracts are based on our determination.
We underwrite contracts through a credit approval process that is supported and controlled by a centralized, automated front-end system. This system incorporates proprietary credit scoring models and industry credit scoring models and tools, which enhance our credit analysts’ ability to tailor each contract’s pricing and structure to maximize risk-adjusted returns. We believe that as a result of our sophisticated credit and underwriting systems, we are able to earn attractive risk-adjusted returns on our contracts. For the year ended December 31, 2003, the average net interest spread on our automobile contract originations was 7.63% and the net interest spread on our managed automobile portfolio was 7.10% while net credit losses averaged 2.60% for the same period.
We structure our business to minimize operating costs while providing high quality service to our dealers. Those aspects of our business that require a local market presence are performed on a decentralized basis in our 39 offices. All other operations are centralized. We fund our purchases of contracts, on an interim basis, with deposits raised by our parent, Western Financial Bank, also known as the Bank, which are insured by the Federal Deposit Insurance Corporation, also known as the FDIC, and other borrowings of the Bank. These funds are made available to us through a series of intercompany agreements that are made under terms, rates and conditions that we believe to approximate arrangements we could enter into with outside third party relationships. For long-term financing, we issue automobile contract asset-backed securities. Since 1985, we have sold or securitized over $36.0 billion of contracts in 62 public offerings of asset-backed securities, making us the fourth largest issuer of such securities in the nation. We have employed a range of securitization structures and our most recent $1.5 billion issuance of asset-backed securities was structured as a senior/subordinated transaction with a weighted average interest rate of 2.36%. Our relationship with the Bank gives us a competitive advantage relative to other independent automobile finance companies by providing an additional liquidity source.
The following table presents a summary of our contracts purchased:
The History of WFS
Western Thrift & Loan Association, a California-licensed thrift and loan association, was founded in 1972. In 1973, Western Thrift Financial Corporation was formed as the holding company for Western Thrift & Loan Association. It later changed its name to Westcorp. In 1982, Westcorp acquired Evergreen Savings and Loan Association, a California-licensed savings and loan association, which became its wholly owned subsidiary. The activities of Western Thrift & Loan Association were merged into Evergreen Savings and Loan Association in 1982. Evergreen Savings and Loan Association’s name was changed ultimately to Western Financial Bank and the Bank ultimately became chartered as a federal savings institution.
Western Thrift & Loan Association was involved in automobile finance activities from its incorporation until its merger with Evergreen Savings and Loan Association. Since such time, the Bank continued the automobile finance activities of Western Thrift & Loan Association. In 1988, we were incorporated as a wholly owned consumer finance subsidiary of the Bank to provide non-prime automobile finance services, a market not serviced by the Bank’s automobile finance division.
In 1995, the Bank transferred its automobile finance division to us. In connection with that restructuring, the Bank transferred to us all assets relating to its automobile finance division, including the contracts held on balance sheet and all interests in the excess spread payable from outstanding securitization transactions. The Bank also transferred to us all of the outstanding stock of WFS Financial Auto Loans, Inc., also known as WFAL, and WFS Financial Auto Loans 2, Inc., also known as WFAL2, the securitization entities of the Bank, thereby making these companies our subsidiaries. In 1995, we sold approximately 20% of our shares in a public offering. At December 31, 2003, the Bank owned 84% of our common stock.
Market and Competition
The automobile finance industry is generally segmented according to the type of vehicle sold (new versus pre-owned) and the credit characteristics of the borrower (prime, non-prime or subprime). Based upon industry data, we believe that during 2003, prime, non-prime and subprime loan originations in the United States were $470 billion, $135 billion and $79 billion, respectively. The United States captive automobile finance companies, General Motors Acceptance Corporation, Ford Motor Credit Company and Chrysler Credit Corporation account for approximately 32% of the automobile finance market. We believe that the balance of the market is highly fragmented and that no other market participant has greater than a 5% market share. Other market participants include the captive automobile finance companies of other manufacturers, banks, credit unions, independent automobile finance companies and other financial institutions.
Our dealer servicing and underwriting capabilities and systems enable us to compete effectively in the automobile finance market. Our ability to compete successfully depends largely upon our strong personal relationships with dealers and their willingness to offer us contracts that meet our underwriting criteria. These relationships are fostered by the promptness with which we process and fund contracts, as well as the flexibility and scope of the programs we offer. We purchase the full spectrum of prime and non-prime contracts secured by both new and pre-owned vehicles.
The competition for contracts available within the prime and non-prime credit quality contract spectrum is more intense when the rate of automobile sales declines. Although we have experienced consistent growth for many years, we can give no assurance that we will continue to do so. Several of our competitors have greater financial resources than we have and may have a lower cost of funds. Many of our competitors also have longstanding relationships with automobile dealers and may offer dealers or their customers other forms of financing or services not provided by us. The finance company that provides floor planning for the dealer’s inventory is ordinarily one of the dealer’s primary sources of financing for automobile sales. We do not currently provide financing on dealers’ inventories. We also must compete with dealer interest rate subsidy programs offered by the captive automobile finance companies. However, these programs are not generally offered on pre-owned vehicles and are limited to certain models or loan terms that may not be attractive to many first time automobile purchasers.
Our Business Strategy
Our business objective is to maximize long-term profitability by efficiently purchasing and servicing prime and non-prime contracts that generate strong and consistent risk-adjusted returns. We achieve this objective by employing our business strategy, which includes the following key elements:
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produce consistent growth through our strong dealer relationships;
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price contracts to maximize risk-adjusted returns by using advanced technology and experienced underwriters;
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create operating efficiencies through technology and best practices;
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generate low cost liquidity through our funding sources, including positive operating cash flows; and
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record high quality earnings and maintain a conservative, well-capitalized balance sheet.
Produce Consistent Growth Through Our Strong Dealer Relationships
Over the past five years, we have experienced a compounded annual growth rate in contract purchases of 17%. We believe we provide a high degree of personalized service to our dealer base by marketing, underwriting and purchasing contracts on a local level. Our focus is to provide each dealer superior service by providing a single source of contact to meet the dealer’s prime and non-prime financing needs. We believe that the level of our service surpasses that of our competitors by making our business development representatives available any time a dealer is open, making prompt credit decisions, negotiating credit decisions within available programs by providing structural alternatives and funding promptly.
Growth of originations is primarily through increased dealer penetration. We intend to increase contract purchases from our current dealer base as well as develop new dealer relationships. Prior to 1995, we originated contracts in seven, primarily western, states. Subsequently, we increased our geographic penetration nationwide. Although our presence is well-established throughout the country, we believe that we still have opportunities to build market share, especially in those states that we entered since 1994. In addition, we have improved our dealer education and delivery systems in order to increase the ratio of contracts purchased to the number of applications received from a dealer, thereby improving the efficiency of our dealer relationships. We are also seeking to increase contract purchases through new dealer programs targeting high volume, multiple location dealers. These programs focus on creating relationships with dealers to achieve higher contract
originations and improving efficiencies. On a limited basis, we also originate loans directly from consumers and purchase loans from other automobile finance companies. Additionally, we continue to explore other distribution channels, including the Internet. In December 2001, we acquired an interest in DealerTrack Holdings, Inc., also known as DealerTrack, an Internet business-to-business portal that brings together finance companies and dealers. DealerTrack has signed up 40 finance companies and 23,800 dealers. As of December 31, 2003, we owned approximately 6.4% of DealerTrack. Currently, approximately 70% of our applications are processed through DealerTrack.
We are the largest originator of pre-owned automobile contracts in California by a two to one margin to our nearest competitor. Our leading market share in California provides us with economies of scale, thereby enabling us to earn a higher risk adjusted margin in this market. We are seeking to expand our market share in other states to achieve similar economies of scale.
Price Contracts to Maximize Risk-Adjusted Returns by Using Advanced Technology and Experienced Underwriters
Quality underwriting and servicing are essential to effectively assess and price for risk and to maximize risk-adjusted returns. We rely on a combination of credit scoring models, system-controlled underwriting policies and the judgment of our trained credit analysts to make risk-based credit and pricing decisions. We use credit scoring to differentiate applicants and to rank order credit risk in terms of expected default probability. Based upon this statistical assessment of credit risk, the underwriter is able to appropriately tailor contract pricing and structure.
To achieve the return anticipated at origination, we have developed a disciplined behavioral servicing process for the early identification and cure of delinquent contracts and for loss mitigation. In addition, we provide incentives to our associates based on credit performance and profitability measurements on both an individual and company level.
The following table shows the risk adjusted margins on contracts originated over the past several years:
(1)
Represents the rate on contracts originated during the periods indicated.
(2)
Represents the rate on managed contracts during the periods indicated.
Create Operating Efficiencies Through Technology and Best Practices
We evaluate all aspects of our operations in order to streamline processes and employ best practices throughout the organization. Our key technology systems implemented through this process include:
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automated front-end loan origination system that calculates borrower ratios, maintains lending parameters and approval limits, accepts electronic applications and directs applications to the appropriate credit analyst, all of which have reduced the cost of receiving, underwriting and funding contracts;
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custom designed proprietary scoring models that rank order the risk of loss occurring on a particular contract;
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behavioral delinquency management system, which improves our ability to queue accounts according to the level of risk, monitor collector performance and track delinquent automobile accounts;
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centralized and upgraded borrower services department, which includes remittance processing, interactive voice response technology and direct debit services;
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centralized imaging system that provides for the electronic retention and retrieval of account records; and
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data warehouse that provides analytical tools necessary to evaluate performance of our portfolio by multiple dimensions.
As a result of these efforts, we have reduced our operating costs as a percent of managed contracts to 2.4% for 2003 from a high of 4.5% during the first quarter of 1999. We will continue to evaluate new technology and best practices to further improve our operating efficiencies.
Generate Low Cost Liquidity Through Our Funding Sources, Including Positive Operating Cash Flows
Cash flows from our operations provide a significant source of liquidity for us. In addition, we are able to raise additional liquidity through the asset-backed securities market. Over the last year we held an average of approximately $572 million of unencumbered automobile contracts on our balance sheet, which provides another source of liquidity.
Record High Quality Earnings and Maintain a Conservative, Well-Capitalized Balance Sheet
Presenting high quality earnings and maintaining a conservative, well-capitalized balance sheet have been our focus since our founding in 1972. We believe this strategy ensures success over the long term, rather than providing extraordinary short-term results. Components of this strategy include accounting for our automobile securitizations as secured financings rather than sales, maintaining appropriate allowances for credit losses and holding a strong equity position.
Since March 2000, we have structured our automobile contract securitizations as secured financings. By accounting for these securitizations as secured financings, the contracts and asset-backed notes issued remain on our balance sheet with the earnings of the contracts in the trust and the related financing costs reflected over the life of the underlying pool of contracts as net interest income on our Consolidated Statements of Income. Additionally, no Retained Interest in Securitized Assets, also known as RISA, is recorded on the balance sheet with a corresponding non-cash gain on sale. The RISA must be written off over the life of a securitization. This asset is subject to impairment if assumptions made about the performance of a securitization are not realized. At December 31, 2002, the RISA created from asset-backed securities issued prior to April 2000 had been fully amortized. This compares with a high of $181 million or 58% of equity, net of tax, in 1997.
Our allowance for credit losses was $240 million at December 31, 2003 compared with $228 million at December 31, 2002. The increase in the allowance for credit losses was the result of a higher level of automobile contracts held on balance sheet. The allowance for credit losses as a percentage of owned contracts outstanding was 2.8% at December 31, 2003 compared with 2.9% at December 31, 2002. Based on the analysis we performed related to the allowance for credit losses as described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies,” we believe that our allowance for credit losses is currently adequate to cover probable losses in our contract portfolio that can be reasonably estimated.
Total shareholders’ equity, excluding accumulated other comprehensive loss, was $852 million or 8.7% of total assets at December 31, 2003. This compares with total shareholders’ equity of $688 million or 7.8% of total assets at December 31, 2002.
Operations
Locations
We currently originate contracts nationwide through our 39 offices. Each regional business center manager is accountable for the performance of contracts originated in that office throughout the life of the contracts, including acquisition, underwriting, funding and collection. We have two national service centers located in California and Texas with functions including data verification, records management, remittance processing, customer service call centers, automated dialers and asset recovery. We also maintain three regional bankruptcy and remarketing centers. Our corporate offices are located in Irvine, California.
Business Development
Our business development representatives are responsible for improving our relationship with existing dealers and enrolling and educating new dealers to increase the number of contracts originated. Business development managers within each regional business center provide direct management oversight to each business development representative. In addition, the director of sales and marketing provides oversight management to ensure that all business development managers and representatives are following overall corporate guidelines.
Business development representatives target selected dealers within their territory based upon volume, potential for business, financing needs of the dealers, and competitors that are doing business with such dealers. Before we decide to do business with a new dealer, we perform a review process of the dealer and its business. If we then determine to proceed, we enter into a non-exclusive dealership agreement with the dealer. This agreement contains certain representations regarding the contracts the dealer will sell to us. Due to the non-exclusive nature of our relationship with dealers, the dealers retain discretion to determine whether to sell contracts to us or another financial institution. The business development representative is responsible for educating the dealers’ finance managers about the types of contracts that meet our underwriting standards. We believe this education process helps to minimize the number of applications we receive that are outside of our underwriting guidelines, thereby increasing our efficiency and lowering our overall cost to originate contracts.
After the dealer relationship is established, the business development representative continues to actively monitor the relationship with the objective of maximizing the overall profitability of each dealer relationship within his or her territory. This includes monitoring the number of approved applications received from each dealer that are converted into contracts, verifying that the contracts meet our underwriting standards, monitoring the risk-based pricing of contracts acquired and reviewing the actual performance of the contracts purchased. To the extent that a dealer does not meet minimum conversion ratios, lending volume standards or overall profitability targets, the dealer may be precluded from sending us applications in the future. During the year our dealer base increased from approximately 7,800 to 8,000, primarily as a result of us expanding our nationwide presence. Our increase in volume is the result of this increase in our dealer base, in addition to funding more contracts from our existing dealers.
Underwriting and Purchasing of Contracts
The underwriting process begins when an application is sent to us via the Internet or faxed to our data entry service provider. During 2002, we outsourced our data entry process to a third-party provider to maximize efficiencies and reduce our costs due to the decreased volume of applications received via fax. Internet applications are automatically loaded into our front-end underwriting computer system. Our data entry service providers enter the applicant information from faxed applications into our front-end system. Once an application is in the front-end system, the system automatically obtains the applicant’s credit bureau information and calculates our proprietary credit score.
We use credit scoring to differentiate credit applicants and to rank order credit risk in terms of expected default probabilities. This enables us to tailor contract pricing and structure according to our statistical assessment of credit risk. For example, a consumer with a lower score would indicate a higher probability of default; therefore, we would structure and price the transaction to compensate for this higher default risk.
Multiple scorecards are used to accommodate the full spectrum of contracts we purchase. In addition to a credit score, the system highlights certain aspects of the credit application that have historically impacted the credit worthiness of the borrower.
Our credit analysts are responsible for properly structuring and pricing deals to meet our risk-based criteria. They review the applicant’s information and the structure and price of an application and determine whether to approve, decline or make a counteroffer to the dealer. Each credit analyst’s lending levels and approval authorities are established based on the individual analyst’s credit experience and portfolio performance, credit manager audit results and quality control review results. Higher levels of approvals are required for higher credit risk and are controlled by system driven parameters and limits. System driven controls include limits on minimum contract buy rates, contract terms, contract advances, payment to income ratios, debt to income ratios, collateral values and low side overrides.
Once a credit decision has been made, the computer system automatically sends a response to the dealer through the Internet or via fax specifying approval, denial or conditional approval. Conditional approval is based upon modification to the structure, such as an increase in the down payment, reduction of the term, or the addition of a co-signer. As part of the approval process, the credit analyst may require that some of the information be verified, such as the applicant’s income, employment, residence or credit history. The system increases efficiency by automatically denying approval in certain circumstances without additional underwriting being performed. These automated notices are controlled by parameters set by us, consistent with our credit policy.
If the dealer accepts the terms of the approval, the dealer is required to deliver the necessary documentation for each contract to us. Our funding group audits such documents for completeness and consistency with the application and provides final approval and funding of the contract. A direct deposit is made or a check is prepared and promptly sent to the dealer for payment. The dealer’s proceeds may include dealer participation for consideration of the acquisition of the contract. The completed contract file is then forwarded to our records center for imaging.
Under the direction of the Credit and Pricing Committee, the Chief Credit Officer oversees credit risk management, sets underwriting policy, monitors contract pricing, tracks compliance to underwriting policies and re-underwrites select contracts. If re-underwriting statistics are unacceptable, a portion of quarterly incentives are forfeited by the office that originated the contracts. Our internal quality control group reviews contracts on a statistical sampling basis to ensure adherence to established lending guidelines and proper documentation requirements. Credit managers within each regional business center provide direct management oversight to each credit analyst. In addition, the Chief Credit Officer provides oversight management to ensure that all credit managers and analysts are following overall corporate guidelines.
The following table sets forth information for contracts originated, contracts managed and number of dealers in the states in which we operate our business:
(1)
Represents number of dealers from which contracts were originated that remain outstanding in our servicing portfolio at December 31, 2003.
Servicing of Contracts
We service all of the contracts we purchase, both those held by us and those sold in automobile securitizations. The servicing process includes collecting and processing payments, responding to borrower inquiries, maintaining the security interest in the vehicle, maintaining physical damage insurance coverage and repossessing and selling collateral when necessary. During the second quarter of 2000, we implemented a new decision support system that incorporates behavioral scoring models. Additionally, in the second quarter of 2001, we began purchasing credit bureau information on all borrowers, which is updated each quarter. We believe these processes are the most efficient and effective collection methods.
We use monthly billing statements to serve as a reminder to borrowers as well as an early warning mechanism in the event a borrower has failed to notify us of an address change. Payments received in the mail or through our offices are processed by our centralized remittance processing center. To expedite the collection process, we accept payments from borrowers through automated payment programs including Internet banking, direct debits and third party payment processing services. Our customer service center uses interactive voice response technology to answer routine account questions and route calls to the appropriate service counselor.
Our fully integrated servicing, decision and collections system automatically forwards accounts to our automated dialer or regional collection centers based on the assessed risk of default or loss. Account assessment poses several courses of action, including delaying collection activity based on the likelihood of self curing, directing an account to the automated dialer for a predetermined number of days before forwarding it to a regional collections office, or directly forwarding to a loan service counselor in the regional office for accelerated collection efforts as early as when the contract is seven days past due. This process balances the efficiency of centralized collection efforts with the effectiveness of decentralized personal collection efforts. Our systems track delinquencies and chargeoffs, monitor the performance of our collection associates and assist in delinquency forecasting. To assist in the collection process, we can access original documents through our imaging system, which stores all the documents related to each contract. We limit deferments to a maximum of three over the life of the contract and rarely rewrite contracts.
If an account is delinquent and satisfactory payment arrangements are not made, the automobile is generally repossessed within 60 to 90 days of the date of delinquency, subject to compliance with applicable law. We use independent contractors to perform repossessions. The automobile remains in our custody for 10 days, or longer if required by applicable law, to provide the obligor the opportunity to redeem the automobile. If after the redemption period the delinquency is not cured, we write down the vehicle to fair value and reclassify the contract as a repossessed asset. After the redemption period expires, we prepare the automobile for sale. We sell substantially all repossessed automobiles through wholesale automobile auctions, subject to applicable law. We do not provide the financing on repossessions sold. We use regional remarketing departments to sell our repossessed vehicles. Once the vehicles are sold, we charge off any remaining deficiency balances. At December 31, 2003, repossessed automobiles outstanding managed by us were $10.3 million or 0.10% of the total managed contract portfolio compared with $16.4 million or 0.18% of the total managed contract portfolio at December 31, 2002.
It is our policy to charge off an account when it becomes contractually delinquent by 120 days, except for accounts that are in Chapter 13 bankruptcy, even if we have not yet repossessed the vehicle. At the time that a contract is charged off, all accrued interest is reversed. After chargeoff, we collect deficiency balances through our centralized asset recovery center. These efforts include contacting the borrower directly, seeking a deficiency judgment through a small claims court or instituting other judicial action where necessary. In some cases, particularly where recovery is believed to be less likely, the account may be assigned to a collection agency for final resolution. For those accounts that are in Chapter 13 bankruptcy and contractually past due 120 days, we reverse all accrued interest and recognize income on a cash basis. Additionally, we write down such contracts to fair value.
Transactions with Related Parties
Relationship with the Bank and its Controlling Parties
We believe that the transactions with affiliates described below are on terms no less favorable to us than could be obtained from unaffiliated parties. These transactions were approved by our Board of Directors and the Boards of Directors of the Bank and Westcorp, including their respective independent directors.
Intercompany Borrowings
We have various borrowing arrangements with the Bank, including long-term, unsecured debt and lines of credit designed to provide financing for us and our subsidiaries. These borrowings are the only source of liquidity we currently utilize outside of the asset-backed securities market. These borrowing arrangements, on an unconsolidated basis, provide the Bank with what it believes to be a market rate of return.
We borrowed $125 million from the Bank under the terms of a $125 million note executed in 1995. The $125 million note provided for principal payments of $25 million per year, commencing on April 30, 1999 and continuing through its final maturity, April 30, 2003. Interest payments on the $125 million note were due quarterly, in arrears, calculated at the rate of 7.25% per annum. The $125 million note was paid off in the third quarter of 2001. There was no outstanding balance on the $125 million note at December 31, 2003. Interest expense on this note totaled $0.5 million for the year ended December 31, 2001.
We borrowed $150 million from the Bank under the terms of a $150 million note, as amended. This note matures on August 1, 2007, although the Bank has the option to require payment in part or in full at any time prior to that date. Interest payments on the $150 million note are due quarterly in arrears, calculated at the rate of 8.875% per annum. Pursuant to the terms of this note, we may not incur any other indebtedness that is senior to the obligations evidenced by this note except for (i) indebtedness under the $125 million note, (ii) indebtedness collateralized or secured under the $1.8 billion line of credit discussed below and (iii) indebtedness for similar types of warehouse lines of credit. We made principal payments on this note totaling $7.2 million and $42.0 million during the years ended December 31, 2003 and 2002, respectively. There was $101 million outstanding on this note at December 31, 2003 compared with $108 million at December 31, 2002. Interest expense on this note totaled $9.1 million, $12.4 million and $10.1 million for the years ended December 31, 2003, 2002 and 2001, respectively.
Additionally, we borrowed $300 million from the Bank under the terms of a $300 million note in May 2002. This note matures on May 15, 2012. Interest payments on the $300 million note are due semi-annually, in arrears, calculated at the rate of 10.25% per annum. Pursuant to the terms of this note, we may not incur any other indebtedness that is senior to the obligations evidenced by this note except for (i) indebtedness under the $150 million note, (ii) indebtedness collateralized or secured under the $1.8 billion line of credit and (iii) indebtedness for similar types of warehouse lines of credit. There was $300 million outstanding on this note at December 31, 2003 and 2002. Interest expense on this note totaled $30.8 million and $20.3 million for the years ended December 31, 2003 and 2002, respectively.
We have a line of credit extended by the Bank permitting us to draw up to $1.8 billion as needed to be used in our operations. We do not pay a commitment fee for this line of credit. The line of credit terminates on December 31, 2004, although we may extend the term for additional periods of up to 60 months. There was no amount outstanding at December 31, 2003 and 2002. The average amount outstanding on the line was $14.7 million for 2003 and $50.5 million for 2002. The $1.8 billion line of credit carries an interest rate based on the one-month London Interbank Offered Rate, also known as LIBOR, and an interest spread of 125 basis points when unsecured and 90 basis points when secured. The Bank has the right under this line of credit to refuse to permit additional amounts to be drawn if, in the Bank’s discretion, the amount sought to be drawn will not be used to finance the purchase of contracts or other working capital requirements.
Some of our subsidiaries have entered into lines of credit with the Bank. These lines permit our subsidiaries to draw up to a total of $330 million to fund activities related to our securitizations. Of the total $330 million, $10 million terminates on December 1, 2006 and $320 million terminates on January 1, 2010, although the terms may be extended by these subsidiaries for additional periods of up to 60 months. At
December 31, 2003, the amount outstanding on these lines of credit totaled $21.8 million compared with $62.0 million at December 31, 2002. These lines of credit with the Bank held by our subsidiaries carry an interest rate based on one-month LIBOR and an interest spread of 112.5 basis points when unsecured and 62.5 basis points when secured.
Interest on the amounts outstanding under the lines of credit is paid monthly, in arrears, and is calculated on the daily average amount outstanding that month. Interest expense for these lines of credit totaled $1.0 million, $3.0 million and $8.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. For the years ended December 31, 2003, 2002 and 2001, the weighted average interest rates for the lines of credit were 2.28%, 2.74% and 4.43%, respectively. At December 31, 2003, 2002 and 2001, the weighted average interest rates for the lines of credit were 2.28%, 2.55% and 3.08%, respectively.
Short-Term Investment - Parent
We invest our excess cash at the Bank under an investment agreement. Prior to January 1, 2002, the Bank paid us an interest rate on this excess cash equal to the federal composite commercial paper rate. On January 1, 2002, the agreement was amended to revise the interest rate to the one-month LIBOR. The weighted average interest rate was 1.23%, 1.77% and 3.80% for the years ended December 31, 2003, 2002 and 2001, respectively. We held $764 million and $688 million excess cash with the Bank under the investment agreement at December 31, 2003 and 2002, respectively. The average investment during 2003 was $660 million compared with $561 million during 2002. Interest income earned by us under this agreement totaled $8.2 million, $10.2 million and $4.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. The interest rate was 1.17% at December 31, 2003 compared with 1.44% at December 31, 2002.
Reinvestment Contracts
Pursuant to a series of agreements to which we, the Bank and our subsidiary, WFAL2, among others, are parties, we have access to the cash flows of certain outstanding securitizations, including the cash held in the spread accounts for these securitizations. We are permitted to use that cash as we determine, including to originate contracts.
In certain securitizations, the Bank and WFAL2 have entered into a reinvestment contract that is deemed to be an eligible investment under the relevant securitization agreements. The securitization agreements require that all cash flows of the relevant trust and the associated spread accounts be invested in the applicable reinvestment contract. A limited portion of the invested funds may be used by WFAL2 and the balance may be used by the Bank. The Bank makes its portion available to us pursuant to the terms of the WFS Reinvestment Contract. Under the WFS Reinvestment Contract, we receive access to all of the cash available to the Bank under each trust reinvestment contract and are obligated to repay to the Bank an amount equal to the cash so used when needed by the Bank to meet its obligations under the individual trust reinvestment contracts. With the portion of the cash available to it under the individual trust reinvestment contracts, WFAL2 purchases contracts from us pursuant to the terms of the sale and servicing agreement.
In accordance with these agreements, the Bank and WFAL2 pledge property owned by each of them for the benefit of the trustee of each trust and the surety. We paid the Bank a fee equal to 12.5 basis points of the amount of collateral pledged by the Bank as consideration for the pledge of collateral and for our access to cash under the WFS Reinvestment Contract in 2003. Effective January 1, 2004, this fee was increased to 55 basis points. We paid the Bank $1.2 million, $1.2 million and $1.1 million for the years ended December 31, 2003, 2002 and 2001, respectively, for this purpose. As WFAL2 directly utilizes the cash made available to it to purchase contracts for its own account from us, no additional consideration from us is required to support WFAL2 ’s pledge of its property under the agreement with Financial Security Assurance Inc., also known as FSA. While we are under no obligation to repurchase contracts from WFAL2, to the extent WFAL2 needs to sell any such contracts to fund its repayment obligations under the trust reinvestment contracts, it is anticipated that we would prefer to purchase those contracts than for WFAL2 to sell those contracts to a third party. The WFS Reinvestment Contract, by its terms, is to remain in effect so long as any of the trust reinvestment contracts are an eligible investment for its related securitization. There was
$789 million and $944 million outstanding on the trust reinvestment contracts at December 31, 2003 and 2002, respectively.
Whole Loan Sales
We sold $1.7 billion and $1.4 billion of contracts to Westcorp in whole loan sales for the years ended December 31, 2003 and 2001, respectively. We sold no contracts to Westcorp for the year ended December 31, 2002. In these transactions, we received cash for the amount of the principal outstanding on the contracts plus a premium of $49.7 million and $44.3 million for the years ended December 31, 2003 and 2001, respectively. These premiums were recorded as a cash gain on sale, net of the write-off of outstanding dealer participation balances and the effect of hedging activities. These contracts were subsequently securitized by Westcorp and continue to be managed by us under the terms of the transactions.
On February 27, 2004, we sold $1.5 billion of contracts to Westcorp in a whole loan sale. As a result of selling contracts in a whole loan sale rather than securitizing them in a secured financing transaction, we recorded a cash gain on sale, net of the write-off of outstanding dealer participation balances and the effect of hedging activities, of $13.8 million related to the contracts sold. These receivables were subsequently securitized by Westcorp and continue to be managed by us under the terms of the securitization.
Tax Sharing Agreement
We and our subsidiaries are parties to an amended tax sharing agreement with Westcorp, the Bank and other subsidiaries of Westcorp, pursuant to which a consolidated federal tax return is filed for all of the parties to the agreement. Under this agreement, the tax due by the group is allocated to each member based upon the relative percentage of each member’s taxable income to that of all members. Each member pays Westcorp its estimated share of tax liability when otherwise due, but in no event may the amount paid exceed the amount of tax that would have been due if a member were to file a separate return. A similar process is used with respect to state income taxes for those states that permit the filing of a consolidated or combined return. Tax liabilities to states that require the filing of separate tax returns for each company are paid by each company. The term of the amended tax sharing agreement commenced on the first day of the consolidated return year beginning January 1, 2002 and continues in effect until the parties to the tax sharing agreement agree in writing to terminate it. See “Consolidated Financial Statements - Note 17 - Income Taxes.”
Management Agreements
We have entered into certain management agreements with the Bank and Westcorp pursuant to which we pay an allocated portion of certain costs and expenses incurred by the Bank and Westcorp with respect to services or facilities of the Bank and Westcorp used by us or our subsidiaries, including our principal office facilities, our field offices, and overhead and associate benefits pertaining to Bank and Westcorp associates who also provide services to us or our subsidiaries. Additionally, as part of these management agreements, the Bank and Westcorp have agreed to reimburse us for similar costs incurred. Net amounts paid to us by the Bank, Westcorp and their affiliates under these agreements were $4.1 million, $6.4 million and $5.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. The management agreements may be terminated by any party upon five days prior written notice without cause, or immediately in the event of the other party’s breach of any covenant, obligation, or duty contained in the applicable management agreement or for violation of law, ordinance, statute, rule or regulation governing either party to the applicable management agreement.
Supervision and Regulation
General
The following discussion describes federal and state laws and regulations that have a material effect on our business. These laws and regulations generally are intended to protect consumers, depositors, federal deposit insurance funds and the banking system as a whole, rather than stockholders and creditors. To the extent that this section refers to statutory or regulatory provisions, it is qualified in its entirety by reference to
these provisions. Further, these statutes and regulations are subject to change by Congress and federal or state regulators. A change in the laws, regulations or regulatory policies applicable to us could have a material effect on our business.
Bank Operations
The Bank and its subsidiaries are subject to examination and comprehensive regulation and reporting requirements by the Office of Thrift Supervision, also known as the OTS, the Bank’s primary federal regulator, as well as by the FDIC. The OTS is required to conduct a full scope, on-site examination of the Bank every twelve months. In addition, the Bank is subject to regulation by the Board of Governors of the Federal Reserve System, which governs reserves required to be maintained against deposits and other matters. The Bank also is a member of the FHLB of San Francisco, one of twelve regional banks for federally insured savings and loan associations and banks comprising the FHLB System. The FHLB System is under the supervision of the Federal Housing Finance Board. In addition, various other laws and regulations, such as the Gramm-Leach-Bliley Act, Federal Home Loan Bank Act, Community Reinvestment Act, Sarbanes-Oxley Act of 2002, and USA Patriot Act, directly or indirectly affect our business.
Since we are owned by the Bank, which is a federal savings association, we are subject to regulation and examination primarily by the OTS as well as by the FDIC. Our service corporation subsidiaries also are subject to regulation by the OTS and other applicable federal and state agencies. We and certain of our other subsidiaries are further regulated by various departments or commissions of the states in which they do business.
Automobile Lending Operations
We purchase automobile installment contracts in 45 states and are subject to both state and federal regulation of our automobile lending operations. We must comply with each state’s consumer finance, automobile finance, licensing and titling laws and regulations to the extent those laws and regulations are not pre-empted by OTS regulations or federal law.
The contracts we originate and service are subject to numerous federal and state consumer protection laws, including the Federal Truth-in-Lending Act, the Federal Trade Commission Act, the Fair Credit Billing Act, the Fair Credit Reporting Act, the Equal Credit Opportunity Act, the Fair and Accurate Credit Transactions Act, the California Rees-Levering Act, other retail installment sales laws and similar state laws. Most state consumer protection laws also govern the process by which we may repossess and sell an automobile pledged as security on a defaulted contract. We must follow those laws carefully in order to maximize the amount of money we can recover on a defaulted contract.
Affiliate Transaction Restrictions
The Home Owners’ Loan Act, also known as HOLA, limits the type of activities and investments in which the Bank or its subsidiaries may participate if the investment or activity involves an affiliate of the Bank. In addition, transactions between the Bank or its subsidiaries and an affiliate must be on terms that are at least as favorable to the Bank or its subsidiaries as are the terms of the transactions with unaffiliated companies. This permits the OTS to, as necessary, limit transactions between the Bank, Westcorp and the subsidiaries or affiliates of Westcorp or the Bank, and to limit any activities of Westcorp that might create a serious risk that the liabilities of Westcorp and its affiliates may be imposed on the Bank.
Investment Restrictions
HOLA regulations limit certain activities of the Bank and its operating subsidiaries to a percentage of the Bank’s total consolidated assets, excluding for these purposes, assets held by its service corporations. The Bank is precluded from holding consumer loans, including automobile contracts, on its consolidated balance sheet, in an aggregate principal balance in excess of 30% of its total consolidated assets. The limitation is increased to 35% of consolidated assets if all of the consumer loans in excess of the 30% limit are obtained by the Bank and
its operating subsidiaries directly from consumers. Our securitization activities are structured to enable the Bank to remove securitized automobile contracts from the HOLA consumer loan limitation calculation. As a result, securitized automobile contracts are not included in the calculation of the percentage of the Bank’s consolidated assets subject to either the 30% or 35% limitation on consumer loans. The Bank is precluded from holding commercial loans, including loans to our service corporations, on its consolidated balance sheet, in an aggregate principal balance in excess of 10% of its total consolidated assets. Commercial loans secured by real estate and small business loans with $2.0 million or less in outstanding principal are not included in the calculation of the percentage of commercial loans. The Bank is precluded from investing more than 2% of its consolidated assets in service corporations, although it may invest an additional 1% in service corporations devoted to community service activities as specified in the regulations. Retained earnings or losses from the operations of our service corporations are not included in the calculation of our investment in service corporations.
Capital Requirements
As a federally chartered savings bank, the Bank is subject to certain minimum capital requirements imposed by the Financial Institutions Reform, Recovery and Enforcement Act, also known as FIRREA, and the Federal Deposit Insurance Corporation Improvement Act, also known as FDICIA. FDICIA separates all financial institutions into one of five capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” To be considered “well capitalized,” an institution must have a ratio of total risk-based capital to risk-weighted assets of 10.0% or greater, a Tier 1 risk-based capital ratio to risk-weighted assets of 6.0% or greater, a leverage ratio of 5.0% or greater and not be subject to any OTS order. To be “adequately capitalized,” an institution must have a total risk-based capital ratio of not less than 8.0%, a Tier 1 risk-based capital ratio of not less than 4.0% and a leverage ratio of not less than 4.0%. Any institution that is neither well-capitalized nor adequately capitalized will be considered undercapitalized. In addition, HOLA and the OTS regulations require savings associations to maintain “tangible capital” in an amount not less than 1.5% of adjusted total assets and “core capital” in an amount not less than 3% of adjusted total assets.
HOLA mandates that the OTS promulgate capital regulations that include capital standards no less stringent than the capital standards applicable to national banks. The OTS in its regulations has defined total risk-based capital as core capital plus supplementary capital less direct equity investments not permissible to national banks (subject to a phase-in schedule) and reciprocal holdings that other depository institutions may count in their regulatory capital. Supplementary capital is limited to 100% of core capital. Supplementary capital is comprised of permanent capital instruments not included in core capital, general valuation loan and lease loss allowance, and maturing capital instruments such as subordinated debentures. At December 31, 2003, the Bank had two debenture issuances remaining, one with an outstanding balance excluding discounts and issuance costs of $101 million and an interest rate of 8.875% due in 2007 and a second with an outstanding balance excluding discounts and issuance costs of $300 million and an interest rate of 9.625% due in 2012. Pursuant to the approval from the OTS to treat those debentures as supplementary capital, the total amount of debentures issued by the Bank that may be included as supplementary capital may not exceed the total amount of the Bank’s core capital. The amount of the 8.875% debentures that may be included as supplementary capital began to decrease at the rate of 20% of the amount originally outstanding per year, net of redemptions, on August 1, 2002. The 9.625% debentures will not begin to be phased out as supplementary capital until May 15, 2007.
The Bank currently meets all capital requirements to which it is subject and satisfies the requirements of a “well capitalized” institution. Because the Bank is “well capitalized,” it may accept brokered deposits without restriction. Federal regulators must take prompt corrective action to resolve the problems of insured depository institutions that fall below certain capital ratios.
Distributions
The OTS has adopted regulations for determining if capital distributions of a savings association are permitted. Capital distributions are permissible unless the Bank would be undercapitalized, the proposal raises
safety and soundness concerns, or violates a prohibition in any statute, regulation or agreement between the Bank and the OTS.
The Bank also is subject to certain limitations on the payment of dividends by the terms of the indentures for its debentures. Those limitations are more severe than the OTS capital distribution regulations. Under the most restrictive of those limitations arising in connection with the Bank’s sale of its debentures, the greatest capital distribution that the Bank could currently make is $218 million.
Insurance of Accounts
The FDIC administers the Savings Association Insurance Fund, also known as SAIF. Deposits with the Bank are insured through the SAIF to the maximum amount permitted by law, which is currently $100,000. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has either engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC.
Subprime Lending Programs
The OTS, along with other federal banking regulatory agencies, has adopted guidance pertaining to subprime lending programs. Pursuant to the guidance, lending programs that provide credit to borrowers whose credit histories reflect specified negative characteristics, such as recent bankruptcies or payment delinquencies, are deemed to be subprime lending programs. Many of the loans that we originate possess one or more of the factors identified in the guidance as indicative of a subprime loan. Pursuant to the guidance, examiners may require that an institution with a subprime lending program hold additional capital that ranges from one and one-half to three times the normal capital required for similar loans made to borrowers who are not subprime borrowers. Because many of the loans we originate possess one or more of the factors identified in the guidance as indicative of a subprime loan, the Bank maintains its capital levels higher than those otherwise required by the OTS. The maintainance of higher capital levels by the Bank may slow our growth, require us to raise additional capital or sell assets, all of which would negatively impact our earnings. We cannot predict whether the Bank will be required by the OTS to hold additional capital with respect to those automobile contracts we hold as to which the borrowers are deemed by the OTS to be subprime borrowers.
Taxation
Federal Income Taxes
We file federal and certain state tax returns as part of a consolidated group that includes the Bank and Westcorp, the holding company parent of the Bank. We file other state returns as a separate entity. Tax liabilities from the consolidated returns are allocated in accordance with our tax sharing agreement based on the relative taxable income or loss of each entity on a stand-alone basis.
During 2003, the Internal Revenue Service completed their examination of our returns for the tax years ended December 31, 1997 through 1999. All additional tax and interest related to the examination have been paid, which amount was not material to our Consolidated Statements of Income. There were no penalties assessed as a result of this examination.
California Franchise Tax and Other State Provisions
At the end of 2003, we had a tax presence in approximately 38 states. However, we expect that approximately 50% of the activity of the group and the resulting income will be taxed as California source income, with the remaining amounts apportioned or allocated outside California.
The California franchise tax applicable to financial corporations is higher than the rate of tax applicable to non-financial corporations because it includes an amount “in lieu” of local personal property and business license taxes paid by non-financial corporations, but not generally paid by financial institutions. For taxable years ending on or after December 31, 1995, the tax rate for a financial corporation is equal to the tax rate on a
regular corporation plus 2%. For income years beginning after January 1, 1997, the California regular corporate tax rate is 8.84% and the financial corporation tax rate is 10.84%.
We compute our taxable income for California purposes on a unitary basis, or as if we were one business unit, and file one combined California franchise tax return with Westcorp and its other subsidiaries excluding Westhrift Life Insurance. We, as part of that combined return, are under examination by the California Franchise Tax Board and various other state taxing authorities for tax years 1998 through 2001. We do not anticipate any significant changes based upon these examinations.
Subsidiaries
The following subsidiaries are included in our Consolidated Financial Statements.
WFS Financial Auto Loans, Inc.
WFAL is a wholly owned, Nevada based, limited purpose operating subsidiary. WFAL was organized primarily for the purpose of purchasing contracts that we originate and securitizing them in the asset-backed securities market. All sales to securitization trusts directly from WFAL were treated as sales for accounting purposes. WFAL has not purchased any automobile contracts since March 2000. In January 2003, we regained control over the assets of the outstanding securitization trusts accounted for as sales for accounting purposes and consolidated all remaining contracts and related notes payable on automobile secured financing outstanding under these trusts. At December 31, 2003, WFAL had $129 million in notes payable on automobile secured financing outstanding.
WFS Financial Auto Loans 2, Inc.
WFAL2 is a wholly owned, Nevada based, limited purpose operating subsidiary. WFAL2 purchases contracts that are then used as collateral for its reinvestment contract activities. See “Transactions with Related Parties - Reinvestment Contracts.”
WFS Funding Inc.
WFS Funding, Inc., also known as WFSFI, is a wholly owned, Nevada based, limited purpose service corporation subsidiary. WFSFI was incorporated for the purpose of providing conduit financings. WFSFI completed a $775 million and a $650 million conduit financing transaction during January 2002 and December 2001, respectively. Both of these conduit financing transactions were paid off as of December 31, 2002.
WFS Investments, Inc.
WFS Investments, Inc. also known as WFSII, is a wholly owned, California based, limited purpose operating subsidiary. WFSII was incorporated for the purpose of purchasing limited ownership interests in owner trusts in connection with securitization transactions. WFSII is limited by its Articles of Incorporation from engaging in any business activities not incidental or necessary to its stated purpose.
WFS Receivables Corporation
WFS Receivables Corporation, also known as WFSRC, is a wholly owned, Nevada based, limited purpose service corporation subsidiary. WFSRC was incorporated for the purpose of purchasing contracts that we originate and securitizing them in the asset-backed securities market. Securitizations originated by WFSRC are guaranteed under a financial guaranty insurance policy issued by FSA. Securitization transactions in which contracts are sold through WFSRC are treated as secured financings for accounting purpose. At December 31, 2003, WFSRC had $3.7 billion in notes payable on automobile secured financing outstanding.
WFS Receivables Corporation 3
WFS Receivables Corporation 3, also known as WFSRC3, is a wholly owned, Nevada based, limited purpose service corporation subsidiary. WFSRC3 was organized for the purpose of purchasing contracts that we originate and securitizing them in the asset-backed securities market. Securitizations originated by WFSRC3 include senior notes that are credit enhanced through the issuance of subordinated notes. Securitization transactions in which contracts are sold through WFSRC3 are treated as secured financings for accounting purposes. At December 31, 2003, WFSRC3 had $4.3 billion in notes payable on automobile secured financing outstanding.
WFS Web Investments
WFS Web Investments, also known as WFSWEB, is a wholly owned, California based, limited purpose service corporation subsidiary. WFSWEB was incorporated for the purpose of investing in an Internet service company called DealerTrack. Our investment in DealerTrack provides us with the opportunity to be involved with a company that provides a business-to-business Internet portal specifically designed for the indirect automobile lending market.
Associates
At December 31, 2003, we had 2,015 full-time and 47 part-time associates. None of our associates are represented by a collective bargaining unit or union. We believe that we have good relations with our associates.
Item 2.
Item 2.
Properties
At December 31, 2003, we owned one property in Texas. Additionally, we leased 39 properties at various locations in various states.
Our executive offices are located at 23 Pasteur, Irvine, California and are leased from the Bank. The remaining leased properties are used as automobile lending regional business centers and other operating centers. At December 31, 2003, the net book value of property and leasehold improvements was approximately $16.1 million. We lease space at one location from a company controlled by the Chairman of the Board of our company and majority shareholder of Westcorp.
Item 3.
Item 3.
Legal Proceedings
We or our subsidiaries are involved as parties to certain legal proceedings incidental to our business, including Lee, et al. v. WFS Financial Inc, United States District Court, Middle District of Tennessee at Nashville, No. 3-02-0570 filed June 17, 2002 (a putative class action raising claims under the Equal Credit Opportunity Act) and other similar cases. We are vigorously defending these actions and do not believe that the outcome of these proceedings will have a material effect upon our financial condition, results of operations and cash flows.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity and Related Stockholder Matters
Price Range by Quarter
Our common stock has been publicly traded since 1995 on the Nasdaq National Market® under the symbol WFSI. The following table illustrates the high and low sale prices by quarter in 2003 and 2002 as reported by Nasdaq, which prices are believed to represent actual transactions:
We had 2,865 shareholders of our common stock at February 27, 2004. The number of shareholders was determined by the number of record holders, including the number of individual participants, in security position listings.
Dividends
We have not declared or paid any cash dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. We are not currently under any regulatory or contractual limitations on our ability to declare or pay dividends.
Item 6.
Item 6.
Selected Financial Data
The following table presents summary audited financial data for the years ended December 31, 2003, 2002, 2001, 2000 and 1999. Since this table is only a summary and does not provide all of the information contained in our financial statements, including the related notes, you should read our Consolidated Financial Statements contained elsewhere herein. Certain amounts from the prior years’ Consolidated Financial Statements have been reclassified to conform to the current year presentation.
(1)
Accumulated other comprehensive loss excluded from shareholders’ equity.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and notes thereto and other information included or incorporated by reference herein.
Overview
Our primary sources of revenue are net interest income and noninterest income. Net interest income is the difference between the income earned on interest earning assets and the interest paid on interest bearing liabilities. We generate interest income from our loan portfolio and short-term investments. We fund our loan portfolio with securitizations, lines of credit, notes payable to the Bank and equity.
Noninterest income is primarily made up of revenues generated from the sale and servicing of contracts. The primary components of noninterest income include late charges and other collection related fee income on managed contracts, retained interest income or expense, gain on sale of contracts, and contractual servicing income on contracts in securitization transactions treated as sales for accounting purposes. Since March 2000, we have structured our securitizations as secured financings and no longer record non-cash gain on sale at the time of each securitization or record subsequent contractual servicing and retained interest income, the valuation of which is based upon subjective assumptions. Rather, the earnings of the contracts in the trust and the related financing costs are reflected over the life of the underlying pool of contracts as net interest income. In addition, our provision for credit losses has increased as we hold securitized loans on our balance sheet.
Our decision to account for our securitizations as secured financings rather than as sales was based upon a business philosophy that focuses on presenting high quality, cash-based earnings and maintaining a conservative, well-capitalized balance sheet. We believe that a presentation in which assets and liabilities remain on the balance sheet for securitization transactions treated as secured financings provides a better understanding of our business and the inherent risks associated with our securitizations. Since March 2000, in order to account for some of our securitizations as secured financings rather than as sales, those securitizations include a provision that provides us with the right to repurchase contracts at any time as defined under Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The percentage of contracts that we may repurchase was increased from 10% to 20% as of March 2000. Other securitization transactions since March 2000 allow the securitization trust to invest in and sell other financial assets. We believe that our decision to make these accounting changes created a transitional period during which our earnings were adversely impacted as we built our on balance sheet portfolio of loans. This change affects the comparability of our financial statements from 2000 through 2003.
For more than 30 years, we believe that our business model has been successful in a variety of environments. Nationwide recession, high unemployment, weak wholesale auction values, record personal bankruptcies and record low interest rates created a challenging operating landscape in 2003. Through it all, we kept credit losses under control, maintained strong net interest margins and leveraged our operating platform to produce record net income. The following are highlights for 2003:
•
We produced record earnings of $162 million in net income, a 97% increase over 2002.
•
Earnings per share increased to a record $3.95 per share.
•
Net interest income rose 28% to $602 million while risk adjusted spreads were nearly identical to 2002.
•
Credit losses declined in 2003 to 2.60% of contracts.
•
Operating expenses represent 2.4% of average managed contracts, our most efficient year ever.
•
We originated $6.0 billion in automobile contracts through our relationships with 8,000 dealers throughout the country.
•
Our portfolio of automobile contracts of $10.6 billion consists of more than 80% prime credit quality contracts.
•
Delinquencies at year end were 2.9% of total outstanding contracts, which is 0.6% lower than a year earlier.
•
We successfully expanded our securitization program by offering senior/subordinated securities on a regular basis.
•
We currently manage over $10 billion of securities outstanding under our securitization program.
Business Risks
Our operating results and financial condition could be adversely affected by any of the following business risks. In addition to the risks described below, we may encounter risks that are not currently known to us or that we currently deem immaterial, which may also impair our business operations.
Regulatory Requirements May Restrict Our Ability to Do Business
The Bank and its subsidiaries are subject to inspection and regulation by the OTS pursuant to HOLA. The OTS is the primary federal banking agency responsible for its supervision and regulation. The OTS has the power to enforce HOLA and its regulations by a variety of actions ranging from a memorandum of understanding to cease and desist proceedings under the Federal Deposit Insurance Act. The OTS can take such action based solely upon its determination that we have violated one or more of the laws or regulations to which we are subject or that any aspect of our business is being conducted in an unsafe or unsound manner. As such, the OTS has broad powers to, among other things, require us to change our business practices, hold additional capital and change management. Such action could have a material adverse impact on our business and may impact our securities prices, including our common stock, and access to the capital markets.
HOLA limits the amount of our consumer loans, commercial loans and investment in service corporations. See “Business - Supervision and Regulation - Investment Restrictions.” Our securitization activities are structured to enable the Bank to remove securitized automobile contracts from the HOLA consumer loan limitation calculation. Changes in the OTS’s interpretation of HOLA as it affects our securitization activities could cause us to change the manner in which we securitize automobile contracts or to limit our acquisition of such contracts, thereby negatively impacting the price of our common stock. Furthermore, if we are unable to continue to securitize the automobile contracts we purchase, this regulatory limitation may force us to limit our acquisition of new automobile contracts, thereby adversely affecting our ability to remain a preferred source of financing for the dealers from whom we purchase automobile contracts, or cause the Bank to fail the regulatory limitations. Any such limitations may also have a material adverse effect on our financial position, liquidity and results of operations. In addition, other regulatory actions taken by the OTS could have a negative impact on the price of our common stock.
OTS Guidance Regarding Subprime Lending May Affect the Bank’s Capital Requirements
The OTS, along with other federal banking regulatory agencies, has adopted guidance pertaining to subprime lending programs. Pursuant to the guidance, lending programs which provide credit to borrowers whose credit histories reflect specified negative characteristics, such as recent bankruptcies or payment delinquencies, are deemed to be subprime lending programs for regulatory purposes. Many of the contracts that we originate possess one or more of the factors identified in the guidance as indicative of a subprime loan for this purpose. Pursuant to the guidance, examiners may require that an institution with a lending program deemed to be subprime hold additional capital that ranges from one and one-half to three times the normal capital required for similar loans made to borrowers who are not deemed to be subprime borrowers.
Because many of the automobile contracts we originate possess one or more of the factors identified in the guidance as indicative of a subprime loan, the Bank maintains its capital levels higher than would otherwise be required by regulations. Maintenance of higher capital levels by the Bank may slow our growth, require us to raise additional capital or sell assets, all of which could negatively impact our earnings. We cannot predict to what extent the Bank may be required to hold additional capital with respect to those automobile contracts we hold as to which the borrowers are deemed by the OTS to be subprime borrowers.
Other Regulatory Requirements May Affect Our Ability to Do Business
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, limitations on the amount, duration and charges, including interest rates, for various categories of loans, requirements as to the form and content of finance contracts and other documentation, and restrictions on collection practices and creditors’ rights. So long as we are an operating subsidiary of the Bank, licensing and certain other of these requirements are not applicable to us due to federal preemption.
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 loan. The Equal Credit Opportunity Act prohibits creditors from discriminating against loan 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 laws, which requires us to reduce the interest rate charged on each loan to customers who have subsequently joined the military.
The dealers that originate automobile contracts 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.
The Bank is subject to routine periodic examinations by the OTS on a variety of financial and regulatory matters. The Bank’s most recent annual safety and soundness examination by the OTS was completed in July 2003.
Adverse Economic Conditions May Impact Our Profitability
Delinquencies, defaults, repossessions and credit losses generally increase during periods of economic slowdown, recession or higher unemployment. 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 loss in the event of default. Significant increases in the inventory of pre-owned automobiles during periods of economic recession also may depress the prices at which repossessed automobiles may be sold or delay the timing of these sales. Because a portion of our borrowers are considered non-prime borrowers, the actual rates of delinquencies, defaults, repossessions and credit losses on these contracts are higher than those experienced in the general automobile finance industry for borrowers considered to be prime borrowers 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 non-prime contracts through the underwriting criteria and collection methods we employ, we cannot assure you that these criteria or methods will afford adequate protection against these risks. Any sustained period of increased delinquencies, defaults, repossessions, credit losses or servicing costs could adversely affect our financial position, liquidity and results of operations and our ability to enter into future securitizations.
Interest Rate Fluctuations May Impact Our Profitability
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 contracts. As interest rates change, our gross interest rate spread on new originations may increase or decrease depending upon the interest rate environment. In addition, the rates charged on the contracts originated or purchased from dealers are limited by statutory maximums, restricting our opportunity to pass on increased interest costs. We believe that our profitability and liquidity could be adversely affected during any period of changing interest rates, possibly to a material degree. We monitor the interest rate environment and employ our hedging strategies designed to mitigate the impact of changes in interest rates. We cannot assure you that our hedging strategies will mitigate the impact of changes in interest rates.
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 usually do not cover the outstanding balance of the contracts, and the resulting deficiencies are charged off. Decreased auction proceeds resulting from the depressed prices at which pre-owned automobiles may be sold during periods of economic slowdown or recession will result in higher credit losses for us. Furthermore, depressed wholesale prices for pre-owned automobiles may result from significant liquidations of rental or fleet inventories and from increased volume of trade-ins due to promotional financing programs offered by new vehicle manufacturers. There can be no assurance that our recovery rates will stabilize or improve in the future.
The Ownership of Our Common Stock Is Concentrated, Which May Result in Conflicts of Interest and Actions That Are Not in the Best Interests of Our Other Stockholders
Ernest S. Rady is the founder, Chairman of the Board of Directors and Chief Executive Officer of Westcorp. Mr. Rady is also the Chairman of the Board of Directors and Chief Executive Officer of the Bank and is our Chairman of the Board of Directors. Mr. Rady is the beneficial owner of approximately 54% of the outstanding shares of common stock of Westcorp and is able to exercise significant control over our company. The Westcorp common stock ownership of Mr. Rady enables him to elect all of Westcorp’s directors and effectively control the vote on all matters submitted to a vote of Westcorp, including mergers, sales of all or substantially all of our assets, “going private” transactions, conversions and other corporate restructurings or reorganizations. Because of the significant block of Westcorp common stock controlled by Mr. Rady, decisions may be made that, while in the best interest of Mr. Rady, may not be in the best interest of other stockholders.
We May Not Be Able to Generate Sufficient Operating Cash Flows to Run Our Automobile Finance Operations
Our automobile finance operations require substantial operating cash flows. Operating cash requirements include premiums paid to dealers for acquisition of automobile contracts, expenses incurred in connection with the securitization of automobile contracts, capital expenditures for new technologies and ongoing operating costs. Our primary source of operating cash is the excess cash flows received from securitizations and contracts held on the balance sheet. The timing and amount of excess cash flows from contracts varies based on a number of factors, including:
•
the rates and amounts of loan 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. We have exceeded performance thresholds in the past and may do so again in the future.
Any adverse change in these factors could reduce or eliminate excess cash flows to us. Although we currently have positive operating cash flows, we cannot assure you that we will continue to generate positive cash flows in the future, which could have a material adverse effect on our financial position, liquidity and results of operations.
Changes in Our Securitization Program Could Adversely Affect Our Liquidity and Earnings
Our business depends on our ability to aggregate and sell automobile contracts in the form of asset-backed securities. These sales generate cash proceeds that allow us to repay amounts borrowed and to purchase additional automobile contracts. Changes in our asset-backed securities program could materially adversely affect our earnings or ability to purchase and resell automobile contracts on a timely basis. Such changes could include, among other things, 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 automobile contracts we intend to sell to conform to insurance company and rating agency requirements.
If we are unable to effectively securitize our automobile contracts, we may have to reduce or even curtail our automobile contract purchasing activities, which would have a material adverse effect on our financial position, liquidity and results of operations.
We Expect Our Operating Results to Continue to Fluctuate, Which May Adversely Impact Our Business
Our results of operations have fluctuated in the past and are expected to fluctuate in the future. Factors that could affect our quarterly earnings include:
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variations in the volume of automobile contracts originated, which historically tend to be lower in the first and fourth quarters of the year;
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interest rate spreads;
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the effectiveness of our hedging strategies;
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credit losses, which historically tend to be higher in the first and fourth quarters of the year;
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amount and timing of whole loan sale transactions; and
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operating costs.
Critical Accounting Policies
Management believes critical accounting policies are important to the portrayal of our financial condition and results of operations. Critical accounting policies require difficult and complex judgments because they rely on estimates about the effect of matters that are inherently uncertain due to the impact of changing market conditions. The following is a summary of accounting policies we consider critical.
Securitization Transactions and Whole Loan Sales
Contracts sold by us to our special purpose entity subsidiaries in connection with securitization transactions are treated as having been sold for bankruptcy purposes. The subsequent transfer of such
contracts to the securitization trust is treated as a secured financing under generally accepted accounting principles, also known as GAAP. For GAAP purposes, the contracts are retained on the balance sheet with the securities issued to finance the contracts recorded as notes payable on automobile secured financing. We record interest income on the securitized contracts and interest expense on the notes issued through the securitization transactions.
We occasionally sell contracts to Westcorp in whole loan sales. We recognize a cash gain on a whole loan sale equal to the cash premium received adjusted for the write-off of dealer participation balances and the effect of hedging activities.
As servicer of these contracts, we hold and remit funds collected from the borrowers on behalf of the trustee pursuant to reinvestment contracts that we have entered into or we may send funds to a trustee to be held until the distribution dates, depending on the terms of our securitizations. For loans sold in securitization transactions that were treated as sales and loans sold to Westcorp that we continue to service, these amounts are reported as amounts held on behalf of trustee on our Consolidated Statements of Financial Condition.
Allowance for Credit Losses
Management determines the amount of the allowance for credit losses based on a review of various quantitative and qualitative analyses. Quantitative analyses include the review of chargeoff trends by loan program and loan type, analysis of cumulative losses and evaluation of credit loss experience by credit tier and geographic location. Other quantitative analyses include the evaluation of the size of any particular asset group, the concentration of any credit tier, the level of nonperformance and the percentage of delinquency.
Qualitative analyses include trends in chargeoffs over various time periods and at various statistical midpoints and high points, the severity of depreciated values of repossessions or foreclosures, trends in the number of days repossessions are held in inventory, trends in the number of loan modifications, trends in delinquency roll rates, trends in deficiency balance collections both internally and from collection agencies, trends in custom scores and the effectiveness of our custom scores and trends in the economy generally or in specific geographic locations. Despite these analyses, we recognize that establishing allowance for credit losses is not an exact science and can be highly judgmental in nature.
The analysis of the adequacy of the allowance for credit losses is not only dependent upon effective quantitative and qualitative analyses, but also effective loan review and asset classification. We classify our assets in accordance with regulatory guidance into five categories: Pass, Special Mention, Substandard, Doubtful and Loss. Based upon our asset classifications, we establish general and specific valuation allowances.
General valuation allowances are determined by applying various factors to loan balances that are classified as Pass, Special Mention, Substandard or Doubtful. Specific valuation allowances represent loan amounts that are classified as Loss. Some assets may be split into more than one asset classification due to fair value or net realizable value calculations.
All contracts that are 60 to 90 days delinquent are automatically classified as Special Mention. Any contract that is 90 or more days delinquent is automatically classified as Substandard. Any contract where the borrower has filed for bankruptcy or the vehicle has been repossessed by us and is subject to a redemption period is classified as Substandard, with the difference between the wholesale book value and contract balance classified as Loss.
The allowance for credit losses is increased by charging the provision for credit losses and decreased by actual losses on the loans, by reversing the allowance for credit losses through the provision for credit losses when the amount of loans held on balance sheet is reduced through securitization transactions treated as sales and whole loan sales, or based on credit trends or economic conditions.
Derivatives and Hedging Activities
The contracts originated and held by us are fixed rate and, accordingly, we have exposure to changes in interest rates. To protect against potential changes in interest rates affecting interest payments on future securitization transactions, we may enter into various hedge agreements prior to closing the transaction. The market value of these hedge agreements is designed to respond inversely to changes in interest rates. Because of this inverse relationship, we can effectively lock in a gross interest rate spread at the time of entering into the hedge transaction. Gains and losses on these agreements are recorded in accumulated other comprehensive income (loss), net of tax, on our Consolidated Statements of Financial Condition. Any ineffective portion is recognized in interest expense during that period if the hedge is greater than 100% effective. Upon completion of the securitization transaction, the gains or losses are recognized in full as an adjustment to the gain or loss on the sale of the contracts if the transaction is treated as a sale or amortized on a level yield basis over the duration of the notes issued if the transaction is treated as a secured financing.
If we issue variable rate notes payable in connection with our securitization activities, we may also enter into interest rate swap agreements in order to hedge our variable interest rate exposure on future interest payments. See “Quantitative and Qualitative Disclosure About Market Risk.” The fair value of the interest rate swap agreements is included in notes payable on automobile secured financing, and any change in the fair value is reported as accumulated other comprehensive income (loss), net of tax, on our Consolidated Statements of Financial Condition. Any ineffective portion is recorded in interest expense during that period if the hedge is greater than 100% effective. Related interest income or expense is settled on a monthly or quarterly basis and recognized as an adjustment to interest expense in our Consolidated Statements of Income.
We may also enter into interest rate swap agreements or other derivatives that we choose not to designate as hedges or that do not qualify for hedge accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, also known as SFAS No. 133. These derivatives pertain to variable rate notes issued in conjunction with the securitization of our contracts. Any change in the market value of such derivatives and income or expense recognized on such derivatives is recorded to noninterest income.
Off Balance Sheet Arrangements
Prior to April 1, 2000, our securitization transactions were structured as sales for accounting purposes. Under this structure the notes issued by our unconsolidated securitization trusts were not recorded as a liability on our Consolidated Statements of Financial Condition. Effective January 1, 2003, we regained control over assets of the securitization trusts for all of our outstanding securitization transactions treated as sales for accounting purposes, excluding loans sold in whole loan sales. We recorded $525 million of automobile contracts and the related notes payable on automobile secured financing on our Consolidated Statements of Financial Condition and have eliminated all remaining off balance sheet amounts related to these transactions. At December 31, 2003, we had no off balance sheet arrangements.
Results of Operations
Net Interest Income
Net interest income is affected by our interest rate spread, which is the difference between the rate earned on our interest earning assets and the rate paid on our interest bearing liabilities, and the relative amounts of our interest earning assets and interest bearing liabilities. Net interest income totaled $602 million, $471 million and $313 million for the years ended December 31, 2003, 2002 and 2001, respectively. The increase in net interest income for the past three years is primarily the result of us holding a greater percentage of contracts on balance sheet even as overall net interest margins declined.
The following table presents information relative to the average balances and interest rates on an owned basis for the periods indicated:
The total interest rate spread decreased 30 basis points for 2003 compared with 2002 due to a decrease of 100 basis points in the yield on interest earning assets while the cost of funds decreased only 70 basis points. The total interest rate spread decreased 129 basis points in 2002 compared with 2001 due to a decrease in the yield on interest earning assets of 192 basis points and a decrease in the cost of funds of 63 basis points. The decrease in the yield on interest earning assets is due primarily to originating a higher percentage of prime credit quality contracts and a lower interest rate environment. The decrease in the cost of funds is due primarily to a lower interest rate environment.
The following table sets forth the changes in net interest income attributable to changes in volume (change in average portfolio volume multiplied by prior period average rate) and changes in rates (change in weighted average interest rate multiplied by prior period average portfolio balance):
(1)
In the analysis of interest changes due to volume and rate, the changes due to the volume/rate variance (the combined effect of change in weighted average interest rate and change in average portfolio balance) were allocated proportionately based on the absolute value of the volume and rate variances. If there was no balance in the previous year, the total change was allocated to volume.
Provision for Credit Losses
We maintain an allowance for credit losses to cover probable losses that can be reasonably estimated for contracts held on the balance sheet. The allowance for credit losses is increased by charging the provision for credit losses and decreased by actual losses on such contracts or by reversing the allowance for credit losses through the provision for credit losses when the amount of contracts held on balance sheet is reduced through securitization transactions treated as sales and from whole loan sales. The level of the allowance is based principally on the outstanding balance of contracts held on balance sheet and historical loss trends. We believe that the allowance for credit losses is currently adequate to absorb probable losses in our owned portfolio that can be reasonably estimated.
The provision for credit losses was $234 million, $249 million and $144 million for the years ended December 31, 2003, 2002 and 2001, respectively. Net chargeoffs were $222 million, $158 million and $79.0 million for the same respective periods. The decrease in provision for credit losses from 2002 to 2003 was the result of holding a greater percentage of prime credit quality contracts, which require a lower percentage of allowance for credit losses. The increase in the provision for credit losses from 2001 to 2002 was the result of a greater amount of contracts held on balance sheet.
Noninterest Income
Automobile Lending Income
Since the first quarter of 2000, we have not completed a securitization that has been accounted for as an off balance sheet arrangement. For transactions treated as off balance sheet arrangements prior to April 2000, we recorded a non-cash gain equal to the present value of the estimated future cash flows from the portfolio of contracts sold less the write-off of dealer participation balances and the effect of hedging activities. For these securitizations, net interest earned on the contracts sold was recognized over the life of the transactions as contractual servicing income and retained interest income or expense. Effective January 1, 2003, we regained control over assets of the securitization trusts for all of our outstanding securitization transactions treated as sales for accounting purposes, excluding loans sold in whole loan sales. We no longer recognize retained interest income or expense or contractual servicing income for these securitization transactions on our Consolidated Statements of Income. Rather, we recognize interest income on automobile contracts held in these trusts and record interest expense on notes payable on automobile secured financings.
We occasionally sell contracts to Westcorp in whole loan sales. These contracts are subsequently securitized by Westcorp and continue to be managed by us under the terms of such securitizations. We recognize a cash gain on a whole loan sale equal to the cash premium received adjusted for the write-off of dealer participation balances and the effect of hedging activities. Additionally, we recognize contractual servicing income on these contracts.
The components of servicing income were as follows:
Fee income consists primarily of documentation fees, late charges and deferment fees on our managed portfolio, including contracts securitized in transactions accounted for as sales and secured financings, as well as contracts sold in whole loan sales and contracts not securitized. The increase in fee income is due to the growth in our average managed portfolio to $10.1 billion in 2003 from $8.8 billion in 2002 and $7.6 billion in 2001.
According to the terms of each securitization, we earn contractual servicing income on the outstanding balance of securitized contracts. For accounting purposes, this income is only recognized on contracts sold through securitizations treated as sales and whole loan sales. Contractual servicing income earned by us relating to sales to securitization trusts totaled approximately $10.7 million and $23.0 million for the years ended December 31, 2002 and 2001, respectively. There was no contractual servicing income earned by us relating to sales to securitization trusts for the year ended December 31, 2003. The decline was due to our transition to treating our securitizations as secured financings rather than as sales as well as our regaining control over the assets of the trusts for all our outstanding securitization transactions previously treated as sales for accounting purposes. Contractual servicing income earned by us relating to the whole loan sales to Westcorp totaled approximately $31.8 million, $51.1 million and $62.8 million for the years ended December 31, 2003, 2002 and 2001, respectively.
The average balance of the sold portfolio, excluding the loans sold in whole loan sales on which we do not recognize retained interest income, was $840 million in 2002. There was no retained interest expense for the year ended December 31, 2003 as a result of reconsolidating all remaining off balance sheet trusts on January 1, 2003. For accounting purposes, this expense is recognized only on contracts sold through securitizations treated as sales. Retained interest expense is dependent upon the average excess spread on the contracts sold, credit losses, the size of the sold portfolio and the amount of amortization of the RISA. The
retained interest expense recognized in 2002 and 2001 was the result of higher chargeoffs on our sold portfolio as well as revised estimates of further chargeoffs due to continued slowing in the economy. Net chargeoffs on the sold portfolio were $30.4 million in 2002 and $50.4 million in 2001. The outstanding sold portfolio had a weighted average gross interest rate spread of 6.71% and 6.97% in 2002 and 2001, respectively.
Gain on Sale of Contracts
The following table sets forth our contract sales and securitizations and related gains on sales:
(1)
Represents loans sold to Westcorp and subsequently securitized by Westcorp.
(2)
Information for 2002, 2001 and 1999 includes $775 million, $650 million, and $500 million, respectively, of contracts securitized in a privately placed conduit facility.
(3)
Net of the write-off of outstanding dealer participation balances and the effect of hedging activities.
(4)
Included in gain on sale of contracts.
Contract Sales and Securitizations
The following table lists each of our public securitizations:
(1)
Represents only the note payable amounts outstanding at the date indicated.
(2)
Represents the difference between the original weighted average annual percentage rate, also known as APR, and the estimated weighted average securitization rate on the closing date of the securitization.
(3)
Redeemed on January 20, 2004.
(4)
Redeemed on February 20, 2004.
(5)
Represents loans sold to Westcorp and subsequently securitized by Westcorp. We manage these contracts pursuant to an agreement with Westcorp and the securitization trust.
Operating Expenses
Operating expenses totaled $241 million, $213 million and $205 million for the years ended December 31, 2003, 2002 and 2001, respectively. Operating expenses as a percentage of average managed contracts were 2.4% in 2003 compared with 2.4% in 2002 and 2.7% in 2001. The improvement in operating efficiencies from 2001 to 2003 was achieved through the centralization and automation of certain processes as well as the deployment of new technologies.
The efficiencies realized include increasing the conversion ratios on contracts purchased through dealer education, automating the loan application and underwriting system, increasing the percentage of applications received via the Internet, outsourcing the data entry process, centralizing the verification process, and implementing proprietary credit scorecards and electronic funds transfers for our dealers. Operating efficiencies also include implementing automated dialers, centralizing and upgrading payment processing and asset recovery processes, upgrading toll free lines for customer service and interactive voice response technology, implementing direct debit for our borrowers, imaging for record retention and retrieval, and implementing a new behavioral scoring collection system.
Currently, we pay a monthly management fee to the Bank and Westcorp, which covers various administrative expenses. Additionally, the Bank and Westcorp pay fees to us for information technology and other services. The management fee is based on the actual costs incurred and estimates of actual usage. We believe that the management fee approximates the cost to perform these services on our own behalf or to acquire them from third parties. We have the option under the management agreements to procure these services on our own should it be more economically beneficial for us to do so. See “Business - Transactions with Related Parties - Management Agreements.”
Income Taxes
We file federal and certain state tax returns as part of a consolidated group that includes the Bank and Westcorp. We file other state tax returns as a separate entity. Tax liabilities from the consolidated returns are allocated in accordance with a tax sharing agreement based on the relative income or loss of each entity on a stand-alone basis. Our effective tax rate was approximately 40% in 2003 compared with 36% in 2002 and 39% in 2001. The relatively lower effective tax rate for the year ended December 31, 2002 was a result of a one-time benefit of new legislation enacted by the State of California that eliminated the use of the reserve method of accounting for bad debts for large banks and financial corporations for taxable income purposes for tax years after January 1, 2002. In the first year of this change, 50% of the ending reserve amount deducted from taxable income in prior periods was included in California taxable income. The remaining 50% of the reserve was not required to be recaptured into income but rather represented a permanent difference between GAAP and California tax accounting. The deferred tax liability related to this permanent difference was eliminated from our balance sheet and the state income tax provision for 2002 was reduced accordingly. See “Business - Transactions with Related Parties - Tax Sharing Agreement.”
Financial Condition
Overview
We originated $6.0 billion and $5.4 billion of contracts for the years ended December 31, 2003 and 2002, respectively. As a result of higher contract originations, our portfolio of managed contracts reached $10.6 billion at December 31, 2003, up from $9.4 billion at December 31, 2002.
Amounts Due from Trusts
The excess cash flows generated by contracts sold to each of the securitization trusts are deposited into spread accounts in the name of the trustee under the terms of the securitizations. In addition, at the time a securitization closes, the Bank advances additional monies to our subsidiary that originated the securitization trust to initially fund these spread accounts. As these spread accounts reach the balances required by the trust,
excess amounts are released to us and are used to pay down these amounts. The amounts due from trusts represent initial advances made to spread accounts and excess cash flows that were still under obligation to be held in the spread accounts for securitizations treated as sales. There were no amounts due from trusts at December 31, 2003 compared with $101 million at December 31, 2002. The decrease is the result of us regaining control over the assets of the trusts for all our outstanding securitizations treated as sales for accounting purposes, excluding loans sold to Westcorp and subsequently securitized by Westcorp.
Retained Interest in Securitized Assets
None of our securitization transactions in 2003, 2002 or 2001 were treated as sales. Therefore, we did not record any retained interest in securitized assets.
The following table sets forth the components of the RISA:
(1)
The change in unrealized gain/loss on RISA represents temporary changes in valuation including changes in the discount rate based on the current interest rate environment. Such amounts will not be realized unless the RISA is sold. Changes in prepayment and credit loss assumptions for the RISA are other than temporary in nature and impact the value of the RISA. Such other than temporary differences are immediately recognized in income as a component of retained interest income or expense.
(2)
There were no restrictions on the RISA.
The balance of contracts 30 days or more delinquent included in securitization transactions treated as sales for accounting purposes totaled $35.2 million at December 31, 2002. Net chargeoffs for these securitization trusts totaled $30.4 million and $50.4 million for the years ended December 31, 2002 and 2001, respectively.
Asset Quality
Overview
We provide financing in a market where there is a risk of default by borrowers. Chargeoffs directly impact our earnings and cash flows. To minimize the amount of credit losses we incur, we monitor delinquent accounts, promptly repossess and remarket vehicles, and seek to collect on deficiency balances. See “Business - Operations.”
We calculate delinquency based on the contractual due date. The following table sets forth information with respect to the delinquency of our portfolio of contracts managed, which includes contracts that are owned by us and contracts that have been sold but are managed by us:
(1)
Excludes Chapter 13 bankruptcy accounts greater than 120 days past due of $45.6 million and $41.5 million at December 31, 2003 and 2002, respectively.
The following table sets forth information with respect to repossessions in our portfolio of contracts managed:
The following table sets forth information with respect to actual credit loss experience on our portfolio of contracts managed:
The decrease in delinquency and credit loss experience for 2003 compared to 2002 was primarily a result of our originating a higher percentage of prime credit quality contracts and some stabilization of wholesale pre-owned car prices. The increase in credit loss experience for 2002 compared to 2001 was a result of a slowing economy.
Cumulative static pool losses are another means of analyzing contract quality. The cumulative static pool loss of a securitization is the cumulative amount of losses actually recognized, net of recoveries, as to the contracts securitized, up to and including a given month, divided by the original principal balance of the contracts in that securitization. The following table sets forth the cumulative static pool loss ratios by month for all outstanding securitized pools:
Cumulative Static Pool Loss Curves
At December 31, 2003
(1)
Represents the number of months since the inception of the securitization.
(2)
Represents the original percentage of prime automobile contracts securitized within each pool.
(3)
Represents loans sold to Westcorp in whole loan sales and subsequently securitized by Westcorp. We manage these contracts pursuant to an agreement with Westcorp and the securitization trust.
Nonperforming Assets
Nonperforming loans, also known as NPLs, are defined as Chapter 13 bankruptcy accounts contractually past due over 120 days. For those accounts, all accrued interest is reversed and income is recognized on a cash basis. For the years ended December 31, 2003, 2002 and 2001, interest on NPLs excluded from interest income was $2.7 million, $2.7 million and $2.2 million, respectively.
Nonperforming assets, also known as NPAs, consist of NPLs and repossessed automobiles. Repossessed automobiles are carried at a fair value. NPAs were $49.3 million at December 31, 2003 compared with $37.5 million at December 31, 2002. NPAs represented 0.5% of total assets at December 31, 2003 compared with 0.4% at December 31, 2002. There were no impaired loans at December 31, 2003 or 2002.
Allowance for Credit Losses
Our allowance for credit losses was $240 million at December 31, 2003 compared with $228 million at December 31, 2002. We have decreased our percentage of allowance for credit losses from 2.9% at December 31, 2002 to 2.8% at December 31, 2003 as we have originated a higher percentage of prime credit quality contracts. Based on the analyses we performed related to the allowance for credit losses as described under “Critical Accounting Polices,” we believe that our allowance for credit losses is currently adequate to cover probable losses in our contract portfolio that can be reasonably estimated.
The following table sets forth the activity in the allowance for credit losses:
Capital Resources and Liquidity
Overview
We require substantial capital resources and cash to support our business. Our ability to maintain positive cash flows from operations is the result of consistent managed growth, favorable loss experience and efficient operations.
Principal Sources of Cash
Contract Sales and Securitizations
Our primary source of funds is the ability to aggregate and securitize contracts in the form of asset-backed securities or sell contracts through whole loan sales. These transactions generate cash proceeds that allow us to repay amounts borrowed and to purchase additional contracts. Since 1985, we have sold or
securitized over $36.0 billion of automobile contracts in 62 public offerings, making us the fourth largest issuer by dollar amount of such securities in the nation.
Collections of Principal and Interest from Contracts and Release of Cash from Spread Accounts
The collection of principal and interest from contracts originated and securitized and the release of cash from spread accounts is another significant source of funds for us. Collections of principal and interest are deposited into collection accounts established in connection with each securitization or into our accounts for non-securitized contracts. Pursuant to reinvestment contracts entered into in connection with securitizations guaranteed under a financial guarantee insurance policy issued by FSA, we receive access to the amounts deposited into collection accounts and amounts held in the spread accounts for these securitizations. We use those amounts so received in our daily operations to fund the purchase of contracts or to cover the day to day costs of our operations. If delinquency or chargeoff rates in a securitization exceed established triggers, amounts required to be held in spread accounts will increase, requiring additional pledged collateral. We may bear additional expense due to an increase in required collateral. If the reinvestment contracts were no longer deemed an eligible investment, which determination would be made by the rating agencies or FSA, we would no longer have the ability to use this cash in the ordinary course of business and would need to obtain alternative financing, which may only be available on less attractive terms. See “Business - Transactions with Related Parties - Reinvestment Contracts.” If we were unable to obtain additional financing, we may have to curtail our contract purchasing activities, which would also have a material adverse effect on our financial position, liquidity and results of operations. Also, a significant increase in credit losses could have a material adverse impact on our collections of principal and interest from contracts.
Pursuant to the securitization agreements for our securitizations that are credit enhanced through the issuance of subordinated notes, we receive cash released from the trustee from the spread accounts on such transactions once the spread accounts reach predetermined funding levels. The amounts released from these spread accounts represent the return of the initial deposits to such accounts as well as the release of excess spread on the securitized contracts.
Principal and interest collections on contracts owned by us and contracts securitized under a financial guarantee insurance policy issued by an unaffiliated third-party company and release of cash from spread accounts on securitizations that are credit enhanced through the issuance of subordinated notes totaled $4.3 billion, $4.9 billion and $4.4 billion for the years ended December 31, 2003, 2002 and 2001, respectively. The increase in principal and interest collections is primarily due to an increase in the amount of contracts managed.
Borrowings from Parent
Our parent company is a federally insured savings institution. It has the ability to raise significant amounts of liquidity by attracting both short-term and long-term deposits from the general public, commercial enterprises and institutions by offering a variety of accounts and rates. The Bank may also raise funds by issuing commercial paper, obtaining advances from the Federal Home Loan Bank, also known as the FHLB, and selling securities under agreements to repurchase and utilizing other borrowings. We are able to utilize these liquidity sources through agreements we have entered into with our parent. These include notes, lines of credit and the WFS Reinvestment Contract.
These financing arrangements provide us with another source of liquidity beyond the secondary markets, thereby providing a source of short-term funding. The availability of these financing sources depends upon factors outside of our control, including regulatory issues such as the capital requirements of the Bank and availability of funds at the Bank. If the Bank were unable to extend this financing to us, we would need to replace it with outside sources. If we were unable to replace these sources, we would need to curtail our contract purchasing activities, which would have a material adverse effect on our financial position and results of operations and negatively impact our ability to remain a preferred source of financing for the dealers from which we purchase contracts.
Conduit Financing
We have previously entered into secured conduit financing transactions using an automobile receivable securitization structure for short-term financing needs. For the years ended December 31, 2002 and 2001, we issued $775 million and $650 million of notes secured by contracts through conduit facilities established in January 2002 and December 2001, respectively. We terminated the December 2001 facility in March 2002 in conjunction with a $1.8 billion public asset-backed securitization. The January 2002 facility was terminated in May 2002 in conjunction with a $1.8 billion public asset-backed securitization. We did not enter into a secured conduit financing in 2003.
Equity Offerings
We completed rights offerings in March 2002 and May 2001 which raised $110 million and $116 million of equity through the issuance of 6.1 million and 6.4 million additional common shares at a price of $18.00 and $18.25 per share, respectively. With the completion of the March 2002 offering, the number of our common shares issued and outstanding increased by 18% to 41.1 million shares, compared with an increase of 22% to 35.0 million shares in May 2001.
Of the 6.1 million and 6.4 million additional common shares issued in 2002 and 2001, the Bank purchased 5.2 million and 5.3 million shares in the amount of $94.4 million and $96.5 million, respectively. At December 31, 2003, the Bank owned 84% of our common stock.
Principal Uses of Cash
Acquisition of Contracts
Our most significant use of cash is for the acquisition of contracts. We acquire these contracts through our nationwide relationship with franchised and select independent automobile dealers. We purchased $6.0 billion of contracts in 2003 compared with $5.4 billion in 2002 and $4.9 billion in 2001.
Payments of Principal and Interest on Securitizations
Under the terms of our reinvestment contract on securitizations guaranteed under a financial guarantee insurance policy issued by FSA, we fund quarterly payments of interest and principal to these security holders derived from the cash flows received on the securitized contracts that we service. Payments of principal and interest to security holders totaled $3.8 billion in 2003 compared with $5.5 billion and $3.7 billion in 2002 and 2001, respectively. Payments of principal and interest in 2002 included $1.5 billion of payments on conduit financings.
Amounts Paid to Dealers
Consistent with industry practice, we generally pay dealer participation to the originating dealer for each contract purchased. Participation paid to dealers during 2003 totaled $141 million compared with $129 million and $120 million in 2002 and 2001, respectively. Typically, the acquisition of contracts higher up the prime credit quality spectrum requires a higher amount of participation paid to the dealer due to increased level of competition for such contracts. The amount of participation paid to dealers increased primarily as a result of an increase in the amount of contracts purchased.
Advances to Spread Accounts
At the time a securitization transaction closes, we are required to advance monies to initially fund the spread account. On senior/subordinated securitizations, the spread account balance is invested in eligible mutual fund investments by the trustee. The advanced monies are included in restricted cash on our Consolidated Statements of Financial Condition. The amount of such initial advances included in restricted cash was $21.7 million at December 31, 2003 compared with $12.5 million at December 31, 2002.
Operating Our Business
Our largest operating expenditure is salaries and benefits paid to our associates. Other expenditures include occupancy, collection, repossession, telephone and data processing costs. We also use substantial amounts of cash in capital expenditures for automation and new technologies to remain competitive and to become more efficient. See “Business - Our Business Strategy - Create Operating Efficiencies Through Technology and Best Practices.”
Contractual Obligations
The following table lists our contractual obligations:
(1)
Includes the effects of hedging activities.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosure About Market Risk
Fluctuations in interest rates and early prepayment of contracts are the primary market risks facing us. The Credit and Pricing Committee is responsible for setting credit and pricing policies and for monitoring credit quality. Our Asset/ Liability Committee is responsible for the management of interest rate and prepayment risks. Asset/liability management is the process of measuring and controlling interest rate risk through matching the maturity and repricing characteristics of interest earning assets with those of interest bearing liabilities.
The Asset/ Liability Committee closely monitors interest rate and prepayment risks on a consolidated basis with our parent and recommends policies for managing such risks. The primary measurement tool for evaluating this risk is the use of interest rate shock analysis. This analysis simulates the effects of an instantaneous and sustained change in interest rates (in increments of 100 basis points) on our assets and liabilities and measures the resulting increase or decrease to our net portfolio value, also known as NPV. NPV is the discounted value of the future cash flows (or “paths” of cash flows in the presence of options based on volatility assumptions and an arbitrage free Monte Carlo simulation method to achieve the current market price) of all assets minus all liabilities whose value is affected by interest rate changes plus the book value of non-interest rate sensitive assets minus the book value of non-interest rate sensitive liabilities. It should be noted that shock analysis is objective but not entirely realistic in that it assumes an instantaneous and isolated set of events. The NPV ratio is the ratio of the NPV to the market value of our assets as calculated above. In general, an increase in interest rates would more adversely affect our NPV than would a decrease in interest rates.
The contracts originated and held by us are fixed rate and, accordingly, we have exposure to changes in interest rates. To protect against potential changes in interest rates affecting interest payments on future securitization transactions, we may enter into various hedge agreements prior to closing the transaction. We enter into Euro-dollar future contracts and forward agreements in order to hedge our future interest payments on our notes payable on automobile secured financing. The market value of these hedge agreements is designed to respond inversely to changes in interest rates. Because of this inverse relationship, we can effectively lock in a gross interest rate spread at the time of entering into the hedge transaction. Gains and losses on these agreements are recorded in accumulated other comprehensive income (loss), net of tax, on our Consolidated Statements of Financial Condition. Any ineffective portion is recognized in interest expense during that period if the hedge is greater than 100% effective. Upon completion of the securitization transaction, the gains or losses are recognized in full as an adjustment to the gain or loss on the sale of the contracts if the securitization transaction is treated as a sale or amortized on a level yield basis over the duration of the notes issued if the transaction is treated as a secured financing. These hedge instruments are settled daily, and therefore, there are no related financial instruments recorded on the Consolidated Statements of Financial Condition. Credit risk related to these hedge instruments is minimal. As a result of our approach to interest rate risk management and our hedging strategies, we do not anticipate that changes in interest rates will materially affect our results of operations or liquidity, although we can provide no assurance.
As we issued certain variable rate notes payable in connection with our securitization activities, we also entered into interest rate swap agreements in order to hedge our variable interest rate exposure on future interest payments. The fair value of the interest rate swap agreements is included in notes payable on automobile secured financing, and any change in the fair value is reported as accumulated other comprehensive income (loss), net of tax, on our Consolidated Statements of Financial Condition. Any ineffective portion is recorded in interest expense during that period if the hedge is greater than 100% effective. Related interest income or expense is settled on a quarterly basis and recognized as an adjustment to interest expense in our Consolidated Statements of Income.
We have entered into interest rate swap agreements or other derivatives that we choose not to designate as hedges or that do not qualify for hedge accounting under SFAS No. 133. These derivatives pertain to variable rate notes issued in conjunction with the securitization of our contracts. Any change in the market value of such derivatives and any income or expense recognized on such derivatives is recorded to noninterest income.
The Asset/ Liability Committee monitors our hedging activities to ensure that the value of hedges, their correlation to the contracts being hedged and the amounts being hedged continue to provide effective protection against interest rate risk. The amount and timing of hedging transactions are determined by our senior management based upon the monitoring activities of the Asset/ Liability Committee. As a result of our approach to interest rate risk management and our hedging strategies, we do not anticipate that changes in interest rates will materially affect our results of operations or liquidity, although we can provide no assurance in this regard. There were no material changes in market risks in the current year compared with the prior year.
The following table provides information about our derivative financial instruments and other financial instruments used that are sensitive to changes in interest rates. For contracts and liabilities with contractual maturities, 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 prepayment of contracts. For interest rate swap agreements, the table presents notional amounts and, as applicable, weighted average interest rates by contractual maturity date. Notional amounts are used to calculate the contractual payments to be exchanged under the contracts.
Glossary
ALLOWANCE FOR CREDIT LOSSES: An account established to cover probable credit losses. If we believe an automobile contract is uncollectible, we set aside in the allowance account a portion of earnings equal to the difference between unpaid principal and the market value of the contract. If the contract is charged off, we reduce the principal balance and the allowance by equal amounts.
ASSET-BACKED SECURITIES: Securities that are backed by financial assets such as automobile contracts.
AUTOMOBILE CONTRACTS: Closed-end loans secured by a first lien on a vehicle.
BOOK VALUE PER COMMON SHARE: The value of a share of common stock based on the values at which the assets are recorded on the balance sheet determined by dividing shareholders’ equity excluding accumulated other comprehensive income or loss by the total number of common shares outstanding.
CHARGEOFF: A contract written off as uncollectible.
CHARGEOFF RATE: Net annualized chargeoffs divided by average contracts outstanding for the period.
CONDUIT FINANCING: A transaction involving the transfer of a pool of assets to a trust, wherein securities representing undivided interests in, or obligations of, the trust are purchased by an investor that issues short-term notes. The transaction is treated as a secured financing.
CORE CAPITAL: A capital measure applicable to savings institutions. The Bank’s core capital is comprised of common shareholders’ equity (excluding certain components of accumulated other comprehensive income or loss), minority interest in includable consolidated subsidiaries, less investments in and advances to nonincludable subsidiaries.
CORE CAPITAL RATIO: A regulatory measure of capital adequacy. The Bank’s core capital ratio is core capital to total assets adjusted for assets in certain subsidiaries that cannot be included and certain unrealized gains or losses on certain securities and cash flow hedges.
DEALER PARTICIPATION: The amount paid to a dealer for the purchase of an automobile contract in excess of the principal amount financed.
DELINQUENCY: A method of determining aging of past due accounts based on the status of payments under the contract.
DERIVATIVES: Interest rate swaps, futures, forwards, option contracts or other financial instruments used for asset and liability management purposes. These instruments derive their values or contractually determined cash flows from the price of an underlying asset or liability, reference rate, index or other security.
DEFERRED TAX ASSET: An asset attributable to deductible temporary differences and carryforwards. A deferred tax asset is measured using the applicable enacted tax rate and provisions of the enacted tax law.
DEFERRED TAX LIABILITY: A liability attributable to taxable temporary differences. A deferred tax liability is measured using the applicable enacted tax rate and provisions of the enacted law.
EARNING PER SHARE (EPS): The most common method of expressing a company’s profitability. Its purpose is to indicate how effective an enterprise has been in using the resources provided by common shareholders. EPS is usually presented in two ways: basic EPS and diluted EPS. The computation of basic EPS includes other instruments that are equivalent to common stock. Diluted EPS includes all instruments that have the potential of causing additional shares of common stock to be issued, such as unexercised stock options.
EURO-DOLLAR FUTURES CONTRACTS: Futures contracts used as a hedge to lock in a gross spread on a future securitization transaction prior to closing the transaction.
FEE INCOME: Income from documentation fees, late charges, deferment fees, transaction processing fees, and other fees.
FHLB: The Federal Home Loan Bank, a network of twelve regional Federal Home Loan Banks chartered by Congress in 1932 to ensure financial institutions have access to money to lend to consumers for home mortgages.
FORWARD AGREEMENTS: Contracts to exchange payments on a specified future date, based on a market change in interest rates from trade date to contract settlement date.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP): Accounting rules and conventions defining acceptable practices in preparing financial statements in the United States of America. The Financial Accounting Standards Board (FASB), an independent self-regulatory organization, is the primary source of accounting rules.
HEDGE: A derivative instrument designed to reduce or eliminate risk, such as interest rate risk. To be treated as a hedge under GAAP, the instrument must meet certain requirements as defined under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, also known as SFAS 133. Under SFAS 133, a derivative must be expected to be highly effective in reducing the hedged risk in order to utilize the special accounting allowed for hedges. In addition, the hedge must be assessed as being highly effective on an ongoing basis throughout its life. The ineffective portion of a hedge is recorded in earnings immediately.
HOLDING COMPANY: A corporation or other entity that owns a majority of stock or securities of one or more other corporations, thus obtaining control of the other corporations.
INTEREST BEARING LIABILITIES: The sum of deposits, notes, subordinated debt and other borrowings on which interest expense is incurred.
INTEREST EARNING ASSETS: The sum of loans and investments on which interest income is earned.
INTEREST RATE SPREAD: The difference between the yield on interest earning assets and the rate paid on interest bearing liabilities.
INTEREST RATE SWAP: A contract between two parties to exchange interest payments on a notional amount for a specified period. Typically, one party makes fixed rate payments, while the other party makes payments using a variable rate. Such a transaction is commonly used to manage the asset or liability sensitivity of a balance sheet by converting fixed rate assets or liabilities to floating rates, or vice versa.
LIBOR: London Interbank Offered Rate, which is a widely quoted market rate that is frequently the index used to determine the rate at which our subsidiaries or we borrow funds.
LIQUIDITY: A measure of how quickly we can convert assets to cash or raise additional cash by issuing debt.
MANAGED CONTRACTS or MANAGED PORTFOLIO: Automobile contracts on the balance sheet plus contracts sold in whole loan sales and contracts securitized in transactions treated as sales under GAAP, which we continue to service.
NET CHARGEOFFS or NET CREDIT LOSSES: The amount of automobile contracts written off as uncollectible, net of the recovery of contracts previously written off as uncollectible.
NET INTEREST INCOME: Interest income and loan fees on interest earning assets less the interest expense incurred on all interest bearing liabilities.
NET INTEREST MARGIN: Interest income from automobile contracts and other interest earning assets reduced by interest expense as a percentage of the average balance of such interest earning assets.
NET YIELD ON AVERAGE INTEREST EARNING ASSETS: The average interest rate earned on interest earning assets less the average interest rate paid on interest bearing liabilities.
NONACCRUAL CONTRACTS: Automobile contracts on which we no longer accrue interest because ultimate collection is unlikely.
NONINTEREST EXPENSE: All expenses other than interest expense.
NONINTEREST INCOME: All income other than interest income.
NONPERFORMING LOANS (NPLs): Chapter 13 bankruptcy accounts greater than 120 days delinquent.
NON-PRIME BORROWERS: Borrowers who have overcome past credit difficulties.
NOTIONAL AMOUNT: The principal amount of a financial instrument on which a derivative transaction is based. In an interest rate swap, for example, the notional amount is used to calculate the interest rate cash flows to be exchanged. No exchange of principal occurs.
OWNED CONTRACTS: Contracts held on our balance sheet.
PRIME BORROWERS: Borrowers who have strong credit histories.
PROVISION FOR CREDIT LOSSES: A charge to earnings to recognize that all contracts will not be fully paid. The amount is determined based on such factors as our actual loss experience, management’s expectations of probable credit losses, as well as current economic trends.
REINVESTMENT CONTRACTS: A series of agreements between WFS, the Bank and WFAL2 through which WFS has access to the cash flows of certain securitizations. Under such agreements, collections of principal and interest on the contracts in the securitization trust and funds in the spread account are invested at either the Bank or WFAL2. Funds invested at the Bank are collateralized by mortgage-backed securities and made available to WFS through the WFS Reinvestment Contract. Funds invested at WFAL2 are collateralized by automobile contracts, which WFAL2 purchases from WFS.
RETAINED INTEREST IN SECURITIZED ASSETS (RISA): An asset that represents our contractual right to receive interest and other cash flows from our securitization trusts after the investors receive their contractual return.
RETAINED INTEREST INCOME OR EXPENSE: The excess cash flows on the contracts sold through securitizations treated as sales less the amortization of the retained interest in securitized assets. The excess cash flows represent all cash received on the contracts securitized less payments to investors for principal and interest.
RETURN ON AVERAGE MANAGED CONTRACTS: A financial measurement of our overall performance. Return on average managed contracts is the ratio of net income divided by average managed contracts.
RETURN ON AVERAGE SHAREHOLDERS’ EQUITY: A measure of how effective a business has been in investing its net worth. Return on equity is expressed as a ratio, calculated by dividing net income by average equity excluding accumulated other comprehensive income or loss.
RISK-ADJUSTED MARGIN: The net interest margin less the chargeoff rate.
RISK-WEIGHTED ASSETS: An amount used in determining risk-based capital ratios applicable to savings institutions. The amount of risk-weighted assets is calculated by taking the face amount of assets on and off the balance sheet and applying a factor based on the inherent risk of such assets as defined by regulation.
SECURED FINANCING: A transaction where interests in a pool of financial assets, such as automobile contracts, are sold to investors. The contracts are transferred to a trust that issues interests that are sold to investors. The contracts and related debt remain on our balance sheet.
SECURITIZATION: A transaction involving the transfer of a pool of assets to a trust, wherein securities representing undivided interests in, or obligations of, the trust are purchased by investors. The securities are
repaid by the cash flows from the assets transferred to the trust. The transaction is treated as either a secured financing or a sale, depending on the terms of the transaction.
SFAS: Statement of Financial Accounting Standards.
SHAREHOLDERS’ EQUITY: A balance sheet amount that represents the total investment in the corporation by holders of common stock.
SPREAD ACCOUNT: An account of a securitization trust into which excess cash flows generated by the contracts securitized are deposited. The terms of the account, which vary with each securitization, typically state a maximum balance, generally expressed as a percentage of the current principal balance of the notes and certificates. The initial deposit is generally funded by the company securitizing the assets and is expressed as a percentage of the original balance of the notes and certificates. Once the required or maximum spread account balance is reached, the excess is typically released to the certificate holder.
SUBORDINATED DEBENTURES: Borrowing in the form of an unsecured note, debenture, or other debt instrument, which in the event of the debtor’s bankruptcy, has a claim to the assets of the debtor with a lower priority than other classes of debt.
SUBSIDIARY: An organization controlled by another organization or company.
SUPPLEMENTARY CAPITAL: Instruments that qualify as additional regulatory capital for total risk-based capital measurement. The Bank’s supplementary capital includes subordinated debentures and general valuation loan and lease loss allowance limited to 1.25% of risk-weighted assets. Supplementary capital is limited to 100% of core capital.
TANGIBLE CAPITAL: A capital measure applicable to savings institutions. The Bank’s tangible capital is the same as its core capital because the Bank does not have any intangible assets that would be deducted from core capital to derive tangible capital.
TIER 1 RISK-BASED CAPITAL: A capital measure applicable to savings institutions. The Bank’s tier 1 risk-based capital equals core capital less a dollar-for-dollar reduction for its residual interests in securitized assets and other recourse obligations.
TIER 1 RISK-BASED CAPITAL RATIO: A regulatory measurement of capital adequacy. The ratio of the Bank’s tier 1 risk-based capital to risk-weighted assets.
TOTAL RISK-BASED CAPITAL: A capital measure applicable to savings institutions. The Bank’s total risk-based capital equals its tier 1 risk-based capital plus supplementary capital.
TOTAL RISK-BASED CAPITAL RATIO: A regulatory measurement of capital adequacy. The ratio of total risk-based capital to risk-weighted assets.
WFS REINVESTMENT CONTRACT: An agreement between the Bank and us whereby the Bank allows us to utilize the funds invested in the reinvestment contract at the Bank. In return for the use of such funds, we pay the Bank a fee as consideration for its pledge of collateral by the Bank.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Our Consolidated Financial Statements begin on page of this report.
Item 9.
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Disclosure controls and procedures are designed to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operations of our disclosure controls and procedures within 90 days of the filing date of this annual report. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures are effective. There has been no significant change in our internal controls or in other factors that could significantly affect the controls and procedures subsequent to the date of their evaluation.
PART III
Certain information required by Part III is omitted from this report, as we will file a definitive proxy statement, also known as the Proxy Statement, within 120 days after the end of our fiscal year pursuant to Regulation 14A of the Securities Exchange Act of 1934 for our Annual Meeting of Shareholders to be held April 26, 2004, and the information included therein is incorporated herein by reference.
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
Information regarding directors appears under the caption “Election of Directors” in the Proxy Statement and is incorporated herein by reference. Information regarding executive officers appears under the caption “Executive Officers Who Are Not Directors” in the Proxy Statement and is incorporated herein by reference. Information regarding Section 16(a) Beneficial Ownership Reporting Compliance appears under that caption in the Proxy Statement and is incorporated herein by reference.
Item 11.
Item 11.
Executive Compensation
Information regarding executive compensation appears under the caption “Compensation of Executive Officers” in the Proxy Statement and is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management
Information regarding security ownership of certain beneficial owners and management appears under the caption “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement and is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions
None.
Item 14.
Item 14.
Principal Accounting Fees and Services
Information regarding principal accounting fees and services appears under the caption “Audit Fees; Audit Related Fees; Tax Fees; and Other Fees” in the Proxy Statement and is incorporated herein by reference.
PART IV
Item 15.
Item 15.
Financial Statement Schedules, Exhibits and Reports on Form 8-K
(a) List of documents filed as part of this report:
(1) Financial Statements
The following consolidated financial statements and report of independent auditors for us and our subsidiaries are included in this report commencing on page:
Report of Independent Auditors
Consolidated Statements of Financial Condition at December 31, 2003 and 2002
Consolidated Statements of Income for the years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules
Schedules to the consolidated financial statements are omitted because the required information is inapplicable or the information is presented in our consolidated financial statements or related notes.
(3) Exhibits
(1)
Exhibits previously filed with WFS Financial Inc Registration Statement on Form S-1 (File No. 33-93068), filed August 8, 1995 incorporated herein by reference under Exhibit Number indicated.
(2)
Exhibits previously filed with Westcorp Registration Statement on Form S-1 (File No. 33-4295), filed May 2, 1986 incorporated herein by reference under Exhibit Number indicated.
(3)
Exhibits previously filed with Westcorp Registration Statement on Form S-4 (File No. 33-34286), filed April 11, 1990 incorporated herein by reference under Exhibit Number indicated.
(4)
Exhibits previously filed with Westcorp Registration Statement on Form S-8 (File No. 33-43898), filed December 11, 1991 incorporated herein by reference under Exhibit Number indicated.
(5)
Amendment No. 1, dated as of July 14, 1995 to the WFS Financial Inc. Registration Statement on Form S-1 (File No. 33-93068) incorporated herein by reference under Exhibit Number indicated.
(6)
Exhibit previously filed as Exhibit 4.1 to the WFS Registration Statement on Form S-8 (File No. 333-40121), filed November 13, 1997, and incorporated herein by reference.
(7)
Exhibits previously filed with Westcorp Registration Statement on Form S-8 (File No. 333-11039), filed August 29, 1996 incorporated herein by reference under Exhibit Number indicated.
(8)
Employment Agreement dated February 27, 1998 between WFS Financial Inc, Westcorp and Lee A. Whatcott (will be provided to the SEC upon request).
(9)
Employment Agreement, dated November 15, 1998 between WFS Financial Inc, Westcorp and Mark Olson (will be provided to the SEC upon request).
(10)
Exhibits previously filed with Annual Report on Form 10-K of WFS Financial Inc for the year ended December 31, 1998 (File No. 33-93068) as filed on or about March 31, 1999.
(11)
Exhibits previously filed with WFS Financial Inc Registration Statements on Form S-2 (File No. 333-91277) filed November 19, 1999 and subsequently amended on January 20, 2000 incorporated by reference under Exhibit Number indicated.
(12)
Exhibits previously filed with Annual Report on Form 10-K of WFS Financial Inc for the year ended December 31, 2001 as filed on or about March 29, 2002.
(13)
Exhibits previously filed with Annual Report on Form 10-K of WFS Financial Inc for the year ended December 31, 2002 as filed on or about March 27, 2003.
(14)
Exhibit previously filed with Westcorp Registration Statements on Form S-3 (File No. 333-110244) filed November 5, 2003 and subsequently amended on November 10, 2003 incorporated by reference under Exhibit Number indicated.
(b) Report on Form 8-K
On October 23, 2003, we filed a current report on Form 8-K dated October 21, 2003, reporting information under Items 7, 9 and 12.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
WFS FINANCIAL INC
Dated: March 11, 2004
By: /s/ THOMAS A. WOLFE
Thomas A. Wolfe
President and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following on behalf of the registrant in the capacities and on the dates indicated.
WFS FINANCIAL INC AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED FINANCIAL STATEMENTS
AND REPORT OF INDEPENDENT AUDITORS
REPORT OF INDEPENDENT AUDITORS
Shareholders and Board of Directors
WFS Financial Inc
We have audited the accompanying consolidated statements of financial condition of WFS Financial Inc and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2003. These consolidated financial statements are the responsibility of WFS Financial Inc’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of WFS Financial Inc and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States.
ERNST & YOUNG LLP
Los Angeles, California
January 20, 2004
WFS FINANCIAL INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
See accompanying notes to consolidated financial statements.
WFS FINANCIAL INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements.
WFS FINANCIAL INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(1)
The pre-tax amount of unrealized gains and losses on retained interest in securitized assets was $0.9 million and $1.4 million for the year ended December 31, 2002 and 2001, respectively.
(2)
The pre-tax amount of unrealized losses on cash flow hedges was $23.1 million for the year ended December 31, 2003 compared with $100 million and $71.6 million for the years ended December 31, 2002 and 2001, respectively.
(3)
The pre-tax amount of unrealized losses on cash flow hedges reclassified into earnings was $58.0 million for the year ended December 31, 2003 compared with $59.8 million and $21.0 million for the years ended December 31, 2002 and 2001, respectively. The amount reclassified into earnings in 2001 includes $1.8 million of the $4.8 million cumulative effect adjustment related to the adoption of SFAS No. 133.
See accompanying notes to consolidated financial statements.
WFS FINANCIAL INC AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
WFS FINANCIAL INC AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements include our accounts and the accounts of our subsidiaries. We are a majority owned subsidiary of Western Financial Bank, also known as the Bank, which is a wholly owned subsidiary of Westcorp, our ultimate parent company. All significant intercompany transactions and accounts have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform with the current year’s presentation.
Effective January 1, 2003, we regained control over assets of the securitization trusts for all of our outstanding securitization transactions treated as sales for accounting purposes, excluding loans sold in whole loan sales. We regained control of these assets when each trust was given the ability to invest in financial assets not related to the securitization of contracts. In accordance with paragraph 55 of Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, also known as SFAS No. 140, and Emerging Issues Task Force 02-9, Accounting for Changes that Result in a Transferor Regaining Control of Financial Assets Sold, we recorded $525 million of automobile contracts and the related notes payable on automobile secured financing on our Consolidated Statements of Financial Condition and have eliminated all remaining amounts due from trusts and amounts held on behalf of trustee for these transactions. We no longer recognize retained interest income or expense or contractual servicing income for these securitization transactions on our Consolidated Statements of Income. Rather, we recognize interest income on automobile contracts held in these trusts and record interest expense on notes payable on automobile secured financings. These loans were considered in the overall evaluation of the adequacy of our allowance for credit losses.
During the first quarter of 2003, Chapter 13 bankruptcy accounts greater than 120 days were reclassified to contracts receivable and the related reserves were reclassified to the allowance for credit losses on the Statement of Financial Condition. Previously, such amounts were reported as nonperforming assets and were included in other assets on the Statement of Financial Condition. The 2002 amounts have been reclassified accordingly. These loans were considered in the overall evaluation of the adequacy of our allowance for credit losses for the periods presented.
During the second quarter of 2003, various cash amounts related to certain securitization transactions were reclassified to restricted cash on the Statement of Financial Condition. Previously, such amounts were reported as a reduction of notes payable on automobile secured financing on the Statement of Financial Condition. The 2002 amounts have been reclassified accordingly.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Nature of Operations
We are a consumer finance company that specializes in the purchase, securitization and servicing of fixed rate consumer automobile contracts. We purchase contracts from automobile dealers on a nonrecourse basis and originate loans directly with consumers. We only have one reportable segment.
Cash and Due from Banks
Cash and due from banks include cash and short-term investments, which have no material restrictions as to withdrawal or usage.
Restricted Cash
Restricted cash represents amounts that are held by the trustee until such cash is released under the terms of the securitization agreements.
Contracts Receivable
Our contract portfolio consists of contracts purchased from automobile dealers on a nonrecourse basis and contracts financed directly with the consumer. If pre-computed finance charges are added to a contract, they are added to the contract balance and carried as an offset against the contract balance as unearned discounts. Amounts paid to dealers are capitalized as dealer participation and amortized over the life of the contract.
Allowance for Credit Losses
The allowance for credit losses is maintained at a level that we believe is adequate to absorb probable losses in the on balance sheet contract portfolio that can be reasonably estimated. Our determination of the adequacy of the allowance is based on an evaluation of the portfolio, past credit loss experience, current economic conditions, volume, pending contract sales, growth and composition of the contract portfolio, and other relevant factors. The allowance is increased by provisions for credit losses charged against income.
Nonaccrual Contracts
We continue to accrue interest income on contracts until the contracts are charged off, which occurs automatically after the contracts are past due 120 days except for accounts that are in Chapter 13 bankruptcy. At the time that a contract is charged off, all accrued interest is reversed. For those accounts that are in Chapter 13 bankruptcy and contractually past due greater than 120 days, all accrued interest is reversed and income is recognized on a cash basis. For the years ended December 31, 2003 and 2002, the amount of accrued interest reversed was not material.
Premises and Equipment
Premises and equipment are recorded at cost less accumulated depreciation and amortization and are depreciated over their estimated useful lives principally using the straight-line method for financial reporting and accelerated methods for tax purposes. Leasehold improvements are amortized over the lives of the respective leases or the service lives of the improvements, whichever is shorter. Useful lives for premises and equipment are 5 to 39 years for buildings and improvements, 5 to 7 years for furniture and equipment, 3 to 5 years for computers and software, and 5 to 15 years for all other premises and equipment.
Repossessed Assets
All accounts for which collateral has been repossessed and the redemption period has expired are reclassified from contracts receivable to repossessed assets at fair value with any adjustment recorded against the allowance for credit losses. Repossessed assets were included in other assets on the Consolidated Statements of Financial Condition and are not material.
Nonperforming Assets
Nonperforming assets consist of nonperforming contracts that are defined as all nonaccrual contracts and repossessed assets. Nonperforming assets were included in other assets on the Consolidated Statements of Financial Condition and are not material.
Securitization Transactions
Automobile contract asset-backed securitization transactions are treated as either sales or secured financings for accounting purposes depending upon the securitization structure. In September 2000, the Financial Accounting Standards Board, also known as the FASB, issued Statement of Financial Accounting
Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, also known as SFAS No. 140, to replace Statement of Financial Accounting Standards No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, also known as SFAS No. 125. SFAS No. 140 revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, but it generally carries over most of SFAS No. 125’s provisions without reconsideration. SFAS No. 140 defines the criteria used to evaluate securitization structures in determining the proper accounting treatment. These criteria pertain to whether or not the transferor has surrendered control over the transferred assets. If a securitization transaction meets all the criteria defined in SFAS No. 140, the transaction is required to be treated as a sale. If any one of the criteria is not met, the transaction is required to be treated as a secured financing. Since March 31, 2000, our securitization transactions included certain provisions which allow us to effectively maintain control over the transferred assets. As a result, these securitization transactions are required to be treated as secured financings. Our securitization transactions prior to March 31, 2000 did not give us this right and, therefore, we were required to treat such transactions as sales.
For securitization transactions treated as sales, we recorded a non-cash gain equal to the present value of the estimated future cash flows on a cash out basis, net of the write-off of dealer participation and gains or losses on hedges. We determined whether or not we must record a servicing asset or liability by estimating future servicing revenues, including servicing fees, late charges, other ancillary income, and float benefit, less the actual cost to service the loans.
In determining the fair value of our retained interest in securitized assets, also known as RISA, we evaluated the cost basis of contracts relative to the fair value of such contracts and the fair value of the RISA recorded. The RISA was capitalized and amortized over the expected life of the underlying contracts. Net interest income and servicing fees earned on these contracts are recognized over the life of the securitization transactions as contractual servicing income, retained interest income and other fee income. The amortization of the RISA was calculated so as to recognize retained interest income on an effective yield basis. These amounts were reported as automobile lending income on our Consolidated Statements of Income.
RISA was classified in a manner similar to available for sale securities and as such was marked to market each quarter. Market value changes were calculated by discounting estimated future cash flows using the current market discount rate. Any changes in the market value of the RISA were reported as accumulated other comprehensive income (loss), net of tax, on our Consolidated Statements of Financial Condition. On a quarterly basis, we evaluated the carrying value of the RISA in light of the actual performance of the underlying contracts and made adjustments to reduce the carrying value, if appropriate.
For securitization transactions treated as secured financings, the contracts are retained on the balance sheet with the securities issued to finance the contracts recorded as notes payable on automobile secured financing. We record interest income on the securitized contracts and interest expense on the notes issued through the securitization transactions.
The excess cash flows generated by securitized contracts are deposited into spread accounts in the name of the trustee under the terms of the securitization transactions. In addition, we advance additional monies to initially fund these spread accounts. For securitization transactions treated as sales, amounts due to us held in the spread accounts and servicing income earned by us for which we have not yet received repayment from the trust are reported as amounts due from trust on our Consolidated Statements of Financial Condition.
As servicer of these contracts, we hold and remit funds collected from the borrowers on behalf of the trustee pursuant to reinvestment contracts that we have entered into for most securitizations. For securitization transactions treated as sales, these amounts are reported as amounts held on behalf of trustee on our Consolidated Statements of Financial Condition.
Interest Income and Fee Income
Interest income is earned in accordance with the terms of the contracts. For pre-computed contracts, interest is earned monthly, and for simple interest contracts, interest is earned daily. Interest income on certain
contracts is earned using the effective yield method and classified as interest receivable to the extent not collected and reported in accrued interest receivable on the Consolidated Statements of Financial Condition. Other contracts use the sum of the month’s digits method, which approximates the effective yield method.
We defer premiums paid to dealers. The net amount is amortized as an adjustment to the related contracts’ yield over their contractual life. Fees for other services are recorded as income when earned.
Interest Expense
Interest expense is recognized when incurred. Our level yield calculation for notes payable on automobile secured financing includes the interest on the notes, underwriting discounts, hedge gains or losses and swap payments.
Income Taxes
We file consolidated federal and state tax returns as part of a consolidated group that includes the Bank and Westcorp. Our taxes are paid in accordance with a tax sharing agreement that allocates taxes based on the relative income or loss of each entity on a stand-alone basis.
Fair Value of Financial Instruments
Fair value information about financial instruments is reported using quoted market prices for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rates and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and in many cases, could not be realized in immediate settlement of the instruments. Fair values for certain financial instruments and all non-financial instruments are not required to be disclosed. Accordingly, the aggregate fair value amounts presented do not necessarily represent the underlying value of our financial position.
We use the following methods and assumptions in estimating our fair value disclosures for financial instruments:
Cash and due from banks: The carrying amounts reported in the Consolidated Statements of Financial Condition for cash and due from banks approximate those assets’ fair values.
Restricted cash: The carrying amounts reported in the Consolidated Statements of Financial Condition approximate those assets’ fair values.
Investment securities available for sale: Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Contracts receivable: The fair values for contracts are estimated using discounted cash flow analysis based on interest rates currently being offered for contracts with similar terms to borrowers of similar credit quality.
Interest rate swap agreements: The fair value is estimated by obtaining market quotes from brokers or internally valuing when market quotes are not readily available.
Lines of credit - parent, notes payable on automobile secured financing and notes payable - parent: The fair value is estimated by using discounted cash flow analyses based on our current incremental borrowing rates for similar types of borrowing arrangements.
Amounts held on behalf of trustee: The carrying amounts reported in the Consolidated Statements of Financial Condition approximate their fair value.
Derivative Financial Instruments
Effective January 1, 2001, we adopted Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, also known as SFAS No. 133, which requires all derivatives to be recorded on the balance sheet at fair value. Changes in the fair value of derivatives designated as hedges are either offset against the change in fair value of the hedged assets, liabilities or firm commitments directly through income or recognized through accumulated other comprehensive income (loss) on the balance sheet until the hedged items are recognized in earnings, depending on the nature of the hedges. The ineffective portion of a derivative’s change in fair value for a cash flow hedge will be recognized in accumulated other comprehensive income (loss) on the balance sheet if the hedge is less than 100% effective or in earnings if the hedge is greater than 100% effective. We employ regression analysis and discounted cash flow analysis to test the effectiveness of our hedges on a quarterly basis. All of our derivative instruments that are designated as hedges are treated as cash flow hedges under SFAS No. 133.
The contracts originated and held by us are fixed rate and, accordingly, we have exposure to changes in interest rates. To protect against potential changes in interest rates affecting interest payments on future securitization transactions, we enter into various hedge agreements. We enter into Euro-dollar futures contracts and forward agreements in order to hedge our future interest payments on our notes payable on automobile secured financing. The market value of these hedge agreements responds inversely to changes in interest rates. Because of this inverse relationship, we can effectively lock in a gross interest rate spread at the time of entering into the hedge transaction. Gains and losses on these agreements are recorded in accumulated other comprehensive income (loss), net of tax. Any ineffective portion is recognized in interest expense during that period if the hedge is greater than 100% effective. Upon completion of the securitization, the gains or losses are recognized in full as an adjustment to the gain or loss on the sale of the contracts if the securitization is treated as a sale or amortized on a level yield basis over the duration of the notes issued if the transaction is treated as a secured financing. These hedge instruments are settled daily, and therefore, there are no related financial instruments recorded on the Consolidated Statements of Financial Condition. Credit risk related to these hedge instruments is minimal.
As we issued certain variable rate notes payable, we also entered into interest rate swap agreements in order to hedge our variable interest rate exposure on future interest payments. The fair value of the interest rate swap agreements is included in notes payable on automobile secured financing, and any change in the fair value is reported as accumulated other comprehensive income (loss), net of tax, on our Consolidated Statements of Financial Condition. Any ineffective portion is recorded in interest expense during that period if the hedge is greater than 100% effective. Related interest income or expense is settled on a quarterly basis and recognized as an adjustment to interest expense in our Consolidated Statements of Income.
We also enter into interest rate swap agreements or other derivatives that we choose not to designate as hedges or that do not qualify for hedge accounting under SFAS No. 133. These derivatives pertain to variable rate notes issued in conjunction with the securitization of our contracts. Any change in the market value of such derivatives and any income or expense recognized on such derivatives is recorded to noninterest income.
As part of the adoption of SFAS No. 133 in 2001, we recorded a cumulative effect adjustment to accumulated other comprehensive income (loss) of $4.8 million, net of tax, which represents the deferred loss on our Euro-dollar futures contracts outstanding at January 1, 2001. Of the $4.8 million, $1.8 million was reclassified into earnings during 2001.
Accounting Pronouncements
In July 2001, the FASB issued Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations, also known as SFAS No. 143, in which retirement obligations would be recorded as a liability using the present value of the estimated cash flows and a corresponding amount would be capitalized as part of the asset’s carrying amount. The capitalized asset retirement cost would be amortized to expense over the asset’s useful life using a systematic and rational allocation method. The estimate of the asset retirement obligation will change and have to be revised over time. SFAS No. 143 is effective for fiscal
years beginning after June 15, 2002. The adoption of SFAS No. 143 did not have a material effect on our earnings or financial position.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities, also known as SFAS No. 146, in which liabilities for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liabilities are incurred. SFAS No. 146 eliminated the recognition of certain costs associated with exit or disposal activities that were previously recognized as liabilities at a plan (commitment) date under Emerging Issues Task Force Issue No. 94-3 that did not meet the definition of a liability in FASB Concepts Statement No. 6, Elements of Financial Statements. SFAS No. 146 is effective for disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material effect on our earnings or financial position.
In December 2002, the FASB issued SFAS No. 148. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the method used on reported results. SFAS No. 148 provides two additional transition methods for entities that adopt Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, also know as SFAS No. 123. Both of these methods avoid the ramp-up effects arising from prospective application of the fair value based method. SFAS No. 148 does not permit the use of the original SFAS No. 123 method of transition for changes to the fair value based method made in fiscal years beginning after December 15, 2003. This statement also requires disclosure of comparable information for all companies regardless of which method of accounting for stock-based employee compensation. SFAS No. 148 improves the timeliness of disclosures by requiring their inclusion in financial reports for interim periods. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. We adopted the disclosure provisions of SFAS No. 148 on December 31, 2002 and the prospective application method of transition to the fair value based method in the first quarter of 2003. Neither the disclosure adoption nor the accounting adoption had a material effect on our earnings or financial position.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, also known as FIN No. 46. FIN No. 46 changes the consolidation requirements by requiring a variable interest entity to be consolidated by a company if that company is subject to the majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. In addition, FIN No. 46 requires disclosures about variable interest entities that the company is not required to consolidate but in which it has a significant variable interest. The consolidation requirements of FIN No. 46 apply to variable interest entities created after January 31, 2003 and apply to existing variable interest entities in the first fiscal year or interim period beginning after December 15, 2003. The adoption of FIN No. 46 did not have a material effect on our earnings or financial position.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, also known as SFAS No. 149. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133. The adoption of SFAS No. 149 did not have a material effect on our earnings or financial position.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, also known as SFAS No. 150. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. The adoption of SFAS No. 150 did not have a material effect on our earnings or financial position.
Note 2 -
Investment Securities Available for Sale
Investment securities available for sale is comprised of owner trust certificates retained on securitization transactions treated as sales. The balances of these investment securities were none and $3.3 million at December 31, 2003 and 2002, respectively. The book value of these investment securities approximated fair value.
Note 3 -
Net Contracts Receivable
Net contracts receivable consisted of the following:
Contracts managed by us totaled $10.6 billion and $9.4 billion at December 31, 2003 and 2002, respectively. Of the $10.6 billion contracts managed at December 31, 2003, $8.6 billion were owned by us and $2.0 billion were owned by Westcorp, our ultimate parent. Of the $9.4 billion contracts managed at December 31, 2002, $7.8 billion were owned by us, $1.1 billion were owned by Westcorp, and $525 million were owned by securitization trusts. Nonperforming loans, or loans on which we have discontinued the accrual of interest income, included in net loans receivable were $40.6 million and $25.4 million at December 31, 2003 and 2002, respectively. Repossessed assets were $8.7 million and $12.1 million at December 31, 2003 and 2002, respectively, and are included in other assets on our Consolidated Statement of Financial Condition.
Note 4 -
Allowance for Credit Losses
Changes in the allowance for credit losses were as follows:
Note 5 -
Retained Interest in Securitized Assets
None of our securitization transactions in 2003, 2002 or 2001 were treated as sales. Therefore, we did not record any retained interest in securitized assets.
The following table presents the activity of the RISA:
(1)
The change in unrealized gain/loss on RISA represents temporary changes in valuation including changes in the discount rate based on the current interest rate environment. Such amounts will not be realized unless the RISA is sold. Changes in prepayment and credit loss assumptions for the RISA are other than temporary in nature and impact the value of the RISA. Such other than temporary differences are immediately recognized in income as a component of retained interest income.
(2)
There were no restrictions on the RISA.
The balance of contracts 30 days or more delinquent included in securitization transactions treated as sales for accounting purposes totaled $35.2 million at December 31, 2002. Net chargeoffs for securitization trusts totaled $30.4 million and $50.4 million for the years ended December 31, 2002 and 2001, respectively.
Note 6 - Premises and Equipment
Premises and equipment consisted of the following:
Note 7 - Intercompany Agreements
We borrowed $150 million from the Bank under the terms of a $150 million note at a rate of 8.875% per annum with a maturity date in August 2007. We had amounts outstanding on this note of $101 million and $108 million as of December 31, 2003 and 2002, respectively. Interest payments on this note are due quarterly, in arrears. Interest expense on the note totaled $9.1 million, $12.4 million and $10.1 million for the years ended December 31, 2003, 2002 and 2001, respectively.
During 2001, we made a final paydown of $11.2 million on a note payable to the Bank with a maturity date in April 2003. Under the original terms of the note, interest payments on the note were due quarterly, in
arrears, at a rate of 7.25% per annum. Interest expense on the note was $0.5 million for the year ended December 31, 2001.
We borrowed $300 million under the terms of a $300 million note in May 2002. This note matures on May 15, 2012. Interest payments on the $300 million note are due semi-annually, in arrears, calculated at the rate of 10.25% per annum. Pursuant to the terms of this note, WFS may not incur any other indebtedness that is senior to the obligations evidenced by this note except for (i) indebtedness under the $150 million note (ii) indebtedness collateralized or secured under the $1.8 billion line of credit and (iii) indebtedness for similar types of warehouse lines of credit. There was $300 million outstanding on this note at both December 31, 2003 and 2002, respectively. Interest expense on this note totaled $30.8 million and $20.3 million for the years ended December 31, 2003 and 2002, respectively.
We have a secured line of credit from the Bank permitting us to draw up to $1.8 billion as needed to be used in our operations. The secured line of credit terminates on December 31, 2004, although the term may be extended by us for additional periods of up to 60 months. There was no amount outstanding on this line of credit at both December 31, 2003 and 2002, respectively. Some of our subsidiaries have entered into lines of credit with the Bank. These lines permit us to draw up to a total of $330 million to fund our initial deposits to spread accounts on securitization transactions. Of the total $330 million, $10 million terminates on December 1, 2006 and $320 million terminates on January 1, 2010, although the terms may be extended by us for additional periods of up to 60 months. At December 31, 2003, the amount outstanding on these lines of credit totaled $21.8 million compared with $62.0 million at December 31 2002.
The $1.8 billion line of credit carries an interest rate based on the one-month LIBOR and an interest spread of 125 basis points when unsecured and 90 basis points when secured. The Bank has the right under this line of credit to refuse to permit additional amounts to be drawn if, in the Bank’s discretion, the amount sought to be drawn will not be used to finance the purchase of contracts or other working capital requirements. The $330 million in lines of credit held by our subsidiaries with the Bank carry an interest rate based on one-month LIBOR and an interest spread of 112.5 basis points when unsecured and 62.5 basis points when secured. Interest on the amounts outstanding under the lines of credit is paid monthly, in arrears, and is calculated on the daily average amount outstanding that month. Interest expense totaled $1.0 million, $3.0 million and $8.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. The weighted average interest rates for the lines of credit were 2.28%, 2.74% and 4.43% for the years ended December 31, 2003, 2002 and 2001, respectively. The weighted average interest rates for the lines of credit were 2.28%, 2.55% and 3.08% at December 31, 2003, 2002 and 2001, respectively.
We also invest our excess cash at the Bank at an interest rate based on the federal composite commercial paper rate. The weighted average interest rates were 1.23%, 1.77% and 3.80% for the years ended December 31, 2003, 2002 and 2001, respectively. The interest rate was 1.17% at December 31, 2003 compared to 1.44% at December 31, 2002. We held $764 million and $688 million excess cash with the Bank under the investment agreement at December 31, 2003 and 2002, respectively. Interest income earned under this agreement totaled $8.2 million, $10.2 million and $4.9 million for the years ended December 31, 2003, 2002 and 2001, respectively.
We have entered into certain management agreements with the Bank and Westcorp pursuant to which we pay a portion of certain costs and expenses incurred by the Bank and Westcorp with respect to services or facilities of the Bank and Westcorp used by us or our subsidiaries, including our principal office facilities, our field offices, and overhead and associate benefits pertaining to Bank and Westcorp associates who also provide services to us or our subsidiaries. Additionally, as part of these management agreements, the Bank and Westcorp have agreed to reimburse us for similar costs incurred. Net amounts paid to us by the Bank, Westcorp and their affiliates under these agreements were $4.1 million, $6.4 million and $5.9 million for the years ended December 31, 2003, 2002 and 2001, respectively.
In connection with our securitization transactions, we entered into a reinvestment contract with the Bank which allows us access to the cash flows of each of the outstanding securitization transactions and the cash held in each spread account for each of those transactions. We are permitted to use that cash as we determine,
including in our ordinary business activities. We paid the Bank $1.2 million, $1.2 million and $1.1 million for the years ended December 31, 2003, 2002 and 2001, respectively, pursuant to these agreements.
Note 8 - Notes Payable on Automobile Secured Financing
For the years ended December 31, 2003 and 2002, we issued $4.2 billion and $6.9 billion of notes secured by automobile contracts, of which $4.2 billion and $6.2 billion were through public transactions and no amounts and $775 million, respectively, were through conduit facilities. We had no amount outstanding on the conduit facilities at December 31, 2003 and 2002. We terminated our $775 million conduit facility in May 2002.
Interest payments on the public transactions based on the respective note’s interest rate are due either monthly or quarterly, in arrears. Interest payments on the conduit facilities were due monthly, in arrears, based on the respective note’s interest rate. Interest expense on all notes payable on automobile secured financing, including interest payments under interest rate swap agreements, totaled $349 million for the year ended December 31, 2003, compared with $313 million and $212 million for the years ended December 31, 2002 and 2001, respectively.
The stated maturities of our notes payable on automobile secured financing and their weighted average interest rates, including the effect of interest rate swap agreements on variable rate notes payable, were as follows:
Note 9 - Whole Loan Sales
We sold $1.7 billion and $1.4 billion of contracts to Westcorp, our parent company in whole loan sales for the years ended December 31, 2003 and 2001, respectively. These receivables were subsequently securitized by Westcorp and continue to be managed by us under the terms of the securitization. As a result of selling contracts in a whole loan sale rather than securitizing them in a secured financing transaction, we recorded cash gain on sale, net of the write-off of outstanding dealer participation balances and the effect of hedging activities, of $18.7 million and $6.7 million related to the contracts sold in 2003 and 2001, respectively.
Note 10 - Commitments and Contingencies
Future minimum payments under noncancelable operating leases on premises and equipment with terms of one year or more were as follows:
In certain cases, these agreements include various renewal options and contingent rental agreements. Rental expense for premises and equipment totaled $5.9 million, $5.6 million and $5.4 million for the years ended December 31, 2003, 2002 and 2001, respectively.
We have pledged certain contracts in amounts totaling $375 million and $474 million as of December 31, 2003 and 2002, respectively, relative to amounts held on behalf of trustee including amounts related to securitization transactions treated as secured financings.
We or our subsidiaries are involved as a party in certain legal proceedings incidental to our business. We do not believe that the outcome of these proceedings will have a material effect upon our financial condition, results of operations and cash flows.
Note 11 - Accumulated Other Comprehensive Loss, Net of Tax
The following table summarizes the components of accumulated other comprehensive loss, net of tax:
(1)
All cash flow hedges are structured to hedge future interest payments on borrowings.
Note 12 - Comprehensive Income
The following table presents the components of comprehensive income, net of related tax, for the periods indicated:
Note 13 - Equity Offerings
We completed rights offerings in March 2002 and May 2001 that raised $110 million and $116 million of equity through the issuance of 6.1 million and 6.4 million additional common shares at a price of $18.00 and $18.25 per share, respectively. With the completion of the March 2002 offering, the number of our common shares issued and outstanding increased by 18% to 41.1 million shares, compared with an increase of 22% to 35.0 million shares in May 2001.
Of the 6.1 million and 6.4 million additional common shares issued in 2002 and 2001, the Bank purchased 5.2 million and 5.3 million shares in the amount of $94.4 million and $96.5 million, respectively. At December 31, 2003, the Bank owned 84% of our common stock.
Note 14 - Dividends
We have not declared or paid any cash dividends on our common stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. We are not currently under any regulatory or contractual limitations on our ability to declare or pay dividends.
Note 15 - Servicing Income
Servicing income consisted of the following components:
Fee income consists primarily of documentation fees, late charges, deferment fees and other servicing fees. According to the terms of each securitization transaction, we earn contractual servicing income on the outstanding balance of contracts serviced. For the year ended December 31, 2003, there was no contractual servicing income received by us relating to sales to securitization trusts, compared with $10.7 million and $23.0 million for the years ended December 31, 2002 and 2001, respectively. For the year ended December 31, 2003, contractual servicing fees received by us relating to whole loan sales to Westcorp totaled $31.8 million, compared with $51.1 million and $62.8 million for the years ended December 31, 2002 and 2001, respectively.
Note 16 - Employee Benefit Plans
We participate in Westcorp’s employee benefit programs, which vary on the types of associates covered and the benefits received. These plans include the Westcorp Employee Stock Ownership and Salary Savings Plan, the Executive Deferral Plan, the Long Term Incentive Plan and Stock Option Plan.
The Westcorp Employee Stock Ownership Plan, also known as the ESOP, covers essentially all associates who have completed six months of service, excluding contract or temporary employees. Contributions to the ESOP are discretionary and determined by the Board of Directors of Westcorp within limits set forth under the Employee Retirement Income Security Act of 1974. These contributions are allocated to the associate’s account based upon years of service and annual compensation. All shares purchased by the ESOP are allocated to associates who participate in the ESOP. The Salary Savings Plan, also known as the 401(k) Plan, covers essentially all associates who have completed three months of service, excluding contract or temporary employees. Contributions to the 401(k) Plan are guaranteed and based on a fixed percent of the associate’s payroll deferral for the calendar year. Contributions to the ESOP and 401(k) Plan totaled $5.8 million, $2.8 million and $8.4 million in 2003, 2002 and 2001, respectively. Compensation expense related to the ESOP and 401(k) Plan totaled $9.8 million, $1.4 million and $4.8 million in 2003, 2002 and 2001, respectively. As of December 31, 2003, the ESOP and 401(k) plan held a total of 1,844,293 shares of Westcorp’s common stock.
The Executive Deferral Plan, also known as the EDP, covers a select group of our management or highly compensated associates as determined by Westcorp’s Board of Directors. The EDP is designed to allow participants to defer a portion of their compensation on a pre-tax basis and earn tax-deferred interest on these deferrals. The EDP also provides for us to match portions of the amounts contributed by our associates at the discretion of Westcorp’s Board of Directors. For the year ended December 31, 2003, expense related to the EDP for Westcorp and its subsidiaries totaled $2.1 million compared with $0.7 million and $0.3 million for the years ended December 31, 2002 and 2001, respectively.
The Long Term Incentive Plan, also known as the LTIP, covers certain key executive officers in which such officers will be entitled to receive a fixed incentive amount provided that Westcorp’s tangible net book value per common share as of December 31, 2004 equals or exceeds $28.08, as adjusted at Westcorp’s sole discretion, and the executive officer remains continuously employed by Westcorp or its subsidiaries through April 30, 2005. For the year ended December 31, 2003, Westcorp expensed $0.9 million, compared with $0.8 million and $0.9 million in 2002 and 2001, respectively, related to the LTIP.
The Westcorp Stock Option Plan covers a select group of associates and directors. Under the plan, Westcorp has reserved a total of 3,000,0000 shares of its common stock for future issuance. As of December 31, 2003, a total of 2,185,750 shares were available for future grants. The options may be exercised within seven years after the date of the grant.
Note 17 - Income Taxes
Income tax expense consisted of the following:
A reconciliation of total tax provisions and the amounts computed by applying the statutory federal income tax rate of 35% to income before taxes is as follows:
(1)
State tax for 2002 includes the result of a one-time benefit of legislation enacted by the State of California which eliminated the use of reserve method of accounting for bad debts for large banks and financial corporations for taxable income purposes for tax years after January 1, 2002.
Deferred taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Amounts previously reported as current and deferred income tax expense have been reclassified. Such changes to the components of the expense occur because all tax alternatives available to us are not known for a number of months subsequent to year end.
Significant components of our deferred tax assets and liabilities were as follows:
Note 18 - Fair Value of Financial Instruments
The estimated fair values of our financial instruments were as follows:
The methods and assumptions used in estimating the fair values of our financial instruments are included in Note 1.
Note 19 - Financial Instrument Agreements
Our interest rate swap agreements are with counterparties to exchange, at specified intervals, the difference between fixed rate and floating rate interest amounts calculated by reference to an agreed notional amount and a specified index. We pay a fixed interest rate and receive a floating interest rate on all of our interest rate swap agreements. At December 31, 2003 the terms of our interest rate swap agreements were to pay a weighted average fixed rate of 4.0% and to receive a weighted average variable rate of 1.4%, with expiration dates ranging from 2004 to 2010 and collateral requirements generally ranging from 3% to 4%. At December 31, 2002, the terms of our interest rate swap agreements were to pay a weighted average fixed rate of 4.1% and to receive a weighted average variable rate of 1.7%, with expiration dates ranging from 2004 to 2010 and collateral requirements generally ranging from 3% to 4%. Variable interest rates may change in the future.
Notional amounts do not represent amounts exchanged with counterparties and, therefore, are not a measure of our exposure to loss through our use of these agreements. The amounts exchanged are determined by reference to the notional amounts and the other terms of the agreements.
The current credit exposure under these agreements is limited to the fair value of the agreements with a positive fair value at the reporting date. Master netting agreements are arranged or collateral is obtained through physical delivery of, or rights to, securities to minimize our exposure to credit losses in the event of nonperformance by counterparties to financial instruments. We use only highly rated counterparties and further reduce our risk by avoiding any material concentration with a single counterparty.
For the year ended December 31, 2003, the unrealized loss on cash flow hedges was $13.8 million, net of taxes of $9.2 million, compared to $59.2 million, net of taxes of $41.2 million, for the year ended December 31, 2002. We reclassified $34.8 million and $35.3 million, net of tax, into earnings which is included in interest expense on the Consolidated Statements of Income for the years ended December 31, 2003 and 2002, respectively. The amount recognized in earnings due to ineffectiveness was immaterial. As a result of selling contracts in a whole loan sale rather than securitizing them in a secured financing transaction, we reclassified into earnings approximately $3.7 million of hedge gains in 2003 and $4.0 million of hedge losses in 2001, net of tax, from accumulated other comprehensive loss related to hedges of future interest payments on the forecasted secured financing. The hedge gain or loss was included in the gain on sale on the Consolidated Statements of Income. We estimate that we will reclassify into earnings during the next twelve months approximately $7 million to $10 million of the unrealized loss on these instruments that was recorded in accumulated other comprehensive loss as of December 31, 2003.
Note 20 - Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
Note 21 - Quarterly Results of Operations (Unaudited)
The following is a summary of unaudited quarterly results of operations for 2002 and 2003. Certain quarterly amounts have been adjusted to conform with the year-end presentation.
Note 22 - Subsequent Events (Unaudited)
On February 27, 2004, we sold $1.5 billion of contracts to Westcorp, our parent company in a whole loan sale. These receivables were subsequently securitized by Westcorp and continue to be managed by us under the terms of the securitization. As a result of selling contracts in a whole loan sale rather than securitizing them in a secured financing transaction, we recorded a cash gain on sale, net of the write-off of outstanding dealer participation balances and the effect of hedging activities, of $13.8 million related to the contracts sold.
EXHIBIT INDEX
(1)
Exhibits previously filed with WFS Financial Inc Registration Statement on Form S-1 (File No. 33-93068), filed August 8, 1995 incorporated herein by reference under Exhibit Number indicated.
(2)
Exhibits previously filed with Westcorp Registration Statement on Form S-1 (File No. 33-4295), filed May 2, 1986 incorporated herein by reference under Exhibit Number indicated.
(3)
Exhibits previously filed with Westcorp Registration Statement on Form S-4 (File No. 33-34286), filed April 11, 1990 incorporated herein by reference under Exhibit Number indicated.
(4)
Exhibits previously filed with Westcorp Registration Statement on Form S-8 (File No. 33-43898), filed December 11, 1991 incorporated herein by reference under Exhibit Number indicated.
(5)
Amendment No. 1, dated as of July 14, 1995 to the WFS Financial Inc. Registration Statement on Form S-1 (File No. 33-93068) incorporated herein by reference under Exhibit Number indicated.
(6)
Exhibit previously filed as Exhibit 4.1 to the WFS Registration Statement on Form S-8 (File No. 333-40121), filed November 13, 1997, and incorporated herein by reference.
(7)
Exhibits previously filed with Westcorp Registration Statement on Form S-8 (File No. 333-11039), filed August 29, 1996 incorporated herein by reference under Exhibit Number indicated.
(8)
Employment Agreement dated February 27, 1998 between WFS Financial Inc, Westcorp and Lee A. Whatcott (will be provided to the SEC upon request).
(9)
Employment Agreement, dated November 15, 1998 between WFS Financial Inc, Westcorp and Mark Olson (will be provided to the SEC upon request).
(10)
Exhibits previously filed with Annual Report on Form 10-K of WFS Financial Inc for the year ended December 31, 1998 (File No. 33-93068) as filed on or about March 31, 1999.
(11)
Exhibits previously filed with WFS Financial Inc Registration Statements on Form S-2 (File No. 333-91277) filed November 19, 1999 and subsequently amended on January 20, 2000 incorporated by reference under Exhibit Number indicated.
(12)
Exhibits previously filed with Annual Report on Form 10-K of WFS Financial Inc for the year ended December 31, 2001 as filed on or about March 29, 2002.
(15)
Exhibits previously filed with Annual Report on Form 10-K of WFS Financial Inc for the year ended December 31, 2002 as filed on or about March 27, 2003.
(16)
Exhibit previously filed with Westcorp Registration Statements on Form S-3 (File No. 333-110244) filed November 5, 2003 and subsequently amended on November 10, 2003 incorporated by reference under Exhibit Number indicated.