Item 1. Business
This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include those related to the plans and objectives of management for future operations, projections of revenues, income, loan origination volume, earnings per share, capital expenditures, dividends, capital structure, economic performance and other expectations and beliefs concerning future developments and their potential effects on Fremont General Corporation (“Fremont”), and its subsidiaries (combined “the Company”). Actual developments and/or results could differ materially from those anticipated by the Company as a result of, among other things: the variability of business and economic conditions, the inherent difficulty of accurately forecasting revenues and expenses, the Company’s ability to sell its products, to make loans and to access capital resources and the associated costs of doing so, the accuracy in projecting loan loss and claims and policy reserves, changes in the frequency and severity of claims, the occurrence of catastrophic events, inability to secure regulatory approvals from, or certain determinations or actions by, the Federal Deposit Insurance Corporation (“FDIC”), the Department of Financial Institutions of the State of California (“DFI”) and the California Department of Insurance (“DOI”) on various matters, the ability of the Company to finalize an understanding in principal with the DOI related to its workers’ compensation insurance subsidiaries (See Discontinued Insurance Operations - Property and Casualty Insurance) or to complete an agreement that would transfer its workers’ compensation insurance new business, organization and facilities to a third party (see General), the impact of competition and pricing environments, changes in interest rates, effect of the performance of financial markets on investment income and fair values of loans and investments, adverse state and federal legislation, regulation and actions, adverse court decisions and judicial climate, changes in the medical, legal and rehabilitation cost control environment, increases in fraud and abuse, changes in loan and other asset valuations and general economic conditions and trends, and other risks and uncertainties detailed in this section and elsewhere in this Form 10-K and from time to time in Fremont’s other reports, press releases and filings with the Securities and Exchange Commission. The Company undertakes no obligation to publicly update such forward-looking statements.
General
Fremont General Corporation (“Fremont”), and its subsidiaries (combined “the Company”) is a financial services holding company. Fremont’s financial services’ segment is consolidated within Fremont General Credit Corporation (“FGCC”), which is engaged in commercial and consumer real estate lending nationwide through its California-chartered industrial bank subsidiary, Fremont Investment & Loan (“FIL”). Fremont’s operating strategy is to continue to grow its financial services business nationwide by focusing its resources on the development and expansion of profitable lending products and strong distribution channels, as well as on controlling expenses. Certain corporate revenues and expenses, comprised primarily of investment income, interest expense and certain general and administrative expenses, are not allocated by Fremont to FGCC or to the discontinued insurance operations.
Fremont, having experienced significant losses in recent years, decided in the fourth quarter of 2001 to discontinue its property and casualty insurance operation, which was primarily represented by the underwriting of workers’ compensation insurance policies. Fremont will attempt to sell the premium renewal rights (new business) of its workers’ compensation insurance operation (“Fremont Comp”) and transfer most of the organization and facilities to a third party. Fremont is currently in negotiations with another organization to accomplish this, but cannot yet predict a final resolution. Since making the decision to discontinue the workers’ compensation insurance operation, Fremont Comp has continued to write new business in an attempt to retain the value of the organization as negotiations are actively pursued. Fremont Comp intends to cease to accept new business upon completion of a transfer of
premium renewal rights to a third party or, failing such a transfer, during the second quarter of 2002. The Company intends to allow the liabilities (primarily loss and loss adjustment expense (“LAE”) reserves) related to its discontinued insurance business to run-off and estimates that the dedicated assets (primarily cash, investment securities, and reinsurance recoverables) supporting these operations, and all related future cash inflows, will be adequate to fund future obligations. As a result, the property and casualty insurance operation is accounted for as a discontinued operation using the liquidation basis of accounting and, accordingly, the Company’s operating results have been restated to reflect reporting in this manner for all periods presented.
The reported consolidated assets and stockholders’ equity of the Company as of December 31, 2001 were $8.0 billion (of which $2.6 billion were assets of the discontinued insurance operations) and $357.8 million, respectively. The Company reported income before taxes from continuing operations of $84.8 million and net income from continuing operations of $53.3 million for the year ended December 31, 2001. Additionally, the Company recognized $2.3 million in net income from its property and casualty insurance operations prior to its classification as a discontinued operation, as well as an extraordinary after tax gain of $4.9 million on the extinguishment of debt. Total net income for 2001 was $60.5 million.
Fremont, a Nevada corporation, was incorporated in 1972. Its corporate office is located at 2020 Santa Monica Boulevard, Suite 600, Santa Monica, California 90404 and its phone number is (310) 315-5500. The Company’s common stock is traded on the New York Stock Exchange under the symbol “FMT”. At December 31, 2001, the Company had approximately 1,600 employees, none of whom is represented by a collective bargaining agreement. The Company believes its relations with its employees are satisfactory. As of December 31, 2001, officers and directors of the Company, their families and the Company’s benefit plans beneficially owned approximately 33% of Fremont’s outstanding common stock.
Financial Services Operation
Fremont’s financial services primary operation is the origination of commercial and residential real estate loans on a nationwide basis. Fremont’s lending is done primarily on a senior and secured basis and it seeks to minimize credit exposure through conservative loan underwriting and appropriate loan to collateral valuations and cash flow coverages. Loans are originated through independent loan brokers, the Company’s own marketing representatives and referrals from various financial intermediaries and financial institutions. The financial services operation is primarily funded through deposit accounts that are insured by the FDIC.
In December of 1999, the Company discontinued its commercial finance (secured working capital lines of credit) lending activities through the sale of Fremont Financial Corporation (“Fremont Financial”), a subsidiary of FGCC, to FINOVA Capital Corporation, a subsidiary of The FINOVA Group, Inc. for approximately $708 million in cash and assumption of existing debt. In September of 2000, the Company also sold substantially all of the assets of its insurance premium financing business.
The outstanding loan portfolio of Fremont’s financial services operation has grown from $3.01 billion at December 31, 1998 to $3.86 billion at December 31, 2001. In addition, there were residential real estate loans of approximately $562.6 million under three securitizations at December 31, 2001 that are not included in the consolidated balance sheet. Fremont’s financial services operation earned $138.5 million, $102.2 million and $79.9 million in income before taxes for the years ended December 31, 2001, 2000 and 1999, respectively, on revenues of $482.9 million, $421.0 million and $411.6 million for the same respective periods. Included in the Company’s financial services operation’s income before taxes for the year ended December 31, 1999, is the recognition of a $10.3 million gain on the sale of Fremont Financial.
The Company’s financial services loan portfolio, as well as the amounts of loans held for sale (which are all residential real estate loans), as of the dates indicated, are summarized in the following table by loan type.
Commercial Real Estate Lending
The commercial real estate lending operation, as of December 31, 2001, consists of 632 loans in its loan portfolio. The Company originates commercial real estate loans nationwide through its nine regional production offices. Loan origination is primarily through independent loan brokers and, to a lesser degree, directly through its own marketing representatives. The products and capabilities of the commercial real estate lending operation are marketed through the use of trade advertising, direct marketing, newsletters and trade show attendance and sponsorship. The emphasis is on service oriented delivery highlighted by responsiveness and reliability. Loan structures are tailored to meet the needs and risk profiles of individual transactions. The commercial real estate lending philosophy is collateral focused with emphasis on selecting properties that generate stable or increasing income cash flow streams, have strong asset quality and proven sponsorship with defined business plans. Loan structures, particularly in the case of bridge loans, include hold backs for such items as funding of all renovation costs, tenant improvements, leasing commissions and interest carry until property stabilization. The origination of commercial real estate loans are generally held for the Company’s own portfolio. Commercial real estate loans are reported net of participations to other financial institutions or investors in the amount of $118.0 million and $138.3 million as of December 31, 2001 and 2000, respectively. During 2001, $11.9 million of commercial real estate loans were sold through direct whole loan sale or participation, and $35.0 million were sold during 2000. Commercial real estate loan origination volume increased 33% to $1.80 billion in 2001 from $1.36 billion in 2000. The commercial real estate loan portfolio grew to $3.55 billion or 91.5% of the financial services loan portfolio at December 31, 2001 from $2.92 billion or 83.7% of the financial services loan portfolio at December 31, 2000.
The commercial real estate loan portfolio is primarily secured by first mortgages on properties in California (48.3%) and, to a lesser degree, Virginia (6.5%), District of Columbia (5.6%), New York (5.1%) and Texas (5.0%). Loans were originated in 42 different states during 2001. The real estate securing these loans include a wide variety of property types including office, retail, industrial, multi-
family and mixed-use properties. The loans in the portfolio were distributed by property type as follows as of the dates indicated:
Loans include short-term bridge facilities for the renovation and lease-up of existing properties, as well as permanent loans which generally have terms for up to five years. Loans also include construction loans, which are loans for the construction of new structures, and also for additions or alterations to existing structures that prohibit occupancy or generation of rental revenue of the property during the construction period. Loans also include longer term single tenant credit loans, however, origination of these loans ceased during the first quarter of 2000. Bridge loans generally are interest-only for up to two year terms. Principal amortization for permanent loans is generally up to 25 years. Approximately 47% of the commercial real estate loan balances outstanding are bridge loans, 37% are permanent loans, 9% are single tenant credit loans and 7% are construction loans. The majority of the commercial real estate loans originated are adjustable interest rate loans based upon six-month LIBOR and an applicable margin, and generally range in loan size between $1 million and $35 million. The commercial real estate loan portfolio is stratified by loan size as follows (thousands of dollars):
The commercial real estate loan portfolio contains two loans in excess of $35 million as of December 31, 2001, the largest having an outstanding balance of $38.6 million. In addition, the portfolio has three concentrations by common investor or sponsor base that are in excess of $75 million. The largest concentration is from two affiliated investment funds (affiliated by common advisor) and totals $149.0 million, comprised of 7 separate loans. The second largest concentration is of five affiliated investment funds and totals $100.9 million, comprised of 10 separate loans. The other concentration is 15 loans, totaling $95.0 million, in transactions with a common developer and completed in partnership with various private and institutional investors. While the loans may have a common investor or sponsor base, each is made to a separate single asset ownership entity, which is collateralized by individual real estate projects. For some of these loans, as well as others in the portfolio, the Company has received guarantees of project completion and debt service from the sponsoring entity. All but one (in the amount of $14.4 million) of the loans under these three affiliate concentrations were performing as of December 31, 2001.
As of December 31, 2001, the average loan size was $5.6 million and the average loan-to-value ratio was 66.5%, using the most current available appraised values and current loan balances outstanding. At December 31, 2001, 13 commercial real estate loans were classified as non-accrual, totaling $68.9 million, and there were 3 commercial real estate properties owned, totaling $19.3 million, which were acquired through foreclosure on loans. In addition, 7 commercial real estate loans were 90 days or greater past due, but on accrual status. These loans totaled $15.6 million at December 31, 2001 and include loans that are contractually past maturity, but continue to make interest payments.
Residential Real Estate Lending
The Company’s residential real estate portfolio and loans held for sale, as of December 31, 2001 was comprised of approximately 7,300 loans. Residential real estate loans are originated nationwide through four regional production offices. Origination is done on a wholesale basis through independent loan brokers and through internal marketing representatives. The real estate securing these loans and the residential loans held for sale, are substantially all single family residences located in California (39.5%), and to a lesser degree Florida (8.4%), New York (8.0%), Illinois (5.3%) and New Jersey (5.2%). Loans were originated in 45 different states during 2001. Origination volume increased approximately 63% to $3.33 billion in 2001 from $2.04 billion in 2000. The growth in loan originations during 2001 was the result of further penetration of existing markets and the overall growth in the national sub-prime lending market. The residential real estate loan portfolio, excluding loans held for sale, was $195.6 million or 5.0% of financial services loan portfolio at December 31, 2001, down from $239.7 million or 6.9% of the financial services loan portfolio at December 31, 2000. This slight decrease in loans outstanding is due to an emphasis on selling residential loan production on a whole loan basis during 2001.
Substantially all of the residential real estate loans are secured by first deeds of trust. These loans generally have principal amounts below $350,000, have maturities generally of thirty years and are underwritten in accordance with lending policies that include standards covering, among other things, collateral value, loan to value and the customer’s debt ratio and credit score. These loans generally are “hybrid” loans which have a fixed rate of interest for an initial period after origination, typically two to three years, after which the interest rate will be adjusted to a rate equal to the sum of six-month LIBOR and a margin as set forth in the mortgage note. This interest rate will then be adjusted at each six-month interval thereafter, subject to various lifetime and periodic rate caps and floors. These loans have been originated using underwriting standards that are less stringent than the Federal National Mortgage Association’s guidelines and are commonly known as “sub-prime” loans. To mitigate the higher potential for credit losses that accompanies these types of borrowers, the Company attempts to maintain underwriting standards that require conservative loan to collateral valuations. (See “Risk Factors.”) Residential real estate loans, secured by first deeds of trust, originated during 2001 had an average loan size of $148,000. Approximately 78% of the loans were “2/28” hybrid loans (fixed rate of interest for 2 years, adjustable interest rate thereafter) and 33% of the loans were from the purchase of a residence and 67% were for the refinance of an existing residential real estate loan.
At December 31, 2001, the average single-family loan principal amount outstanding was approximately $135,000, and the average loan-to-value ratio for loans in portfolio and held for sale was 76.5%, using appraised values at the time of loan origination and current balances outstanding. Approximately 93% of the loans in portfolio and held for sale at December 31, 2001 were originated during 2001. At December 31, 2001, the Company had $19.2 million in residential real estate loans classified as non-accrual. Of the $19.2 million, $2.5 million were loans held in the portfolio and $16.7 million were loans classified as held for sale.
The residential real estate loan disposition strategy is primarily dependent upon market conditions and pricing, and may include whole loan sales, retaining loans in its portfolio, or securitization. During 2001, $2.82 billion in residential real estate loans were sold, comprised completely of whole loan sales to other financial institutions. During 2001, whole loan sales to two separate financial institutions represented approximately 92% of the $2.82 billion in total whole loan sales. One institution represented approximately 49% of the volume and the other approximately 43%. (See “Risk Factors.”) In 2000 and
1999, residential real estate loan sales totaled $2.06 billion and $1.75 billion, respectively. Of the $1.75 billion sold in 1999, $1.41 billion were sold through securitization transactions.
In the securitizations, the Company sells residential real estate loans to a special purpose entity, which is established for the limited purpose of purchasing the loans and issuing interest bearing securities that represent interests in the loans. The securitization is treated as a sale and the loans sold are removed from the balance sheet. The Company retains a residual interest in the securitization, which represents the right to receive certain net future cash flows from the loans. Most of the residual interests, however, are generally restricted until investors and other expenses have been paid or otherwise are subordinate to investors’ interests. (See “Risk Factors.”)
In a whole loan sale for cash, the Company enters into an agreement to sell the loans for cash, without recourse, generally on a servicing released basis. After the sale, the Company retains no interest in the underlying loans.
Syndicated Loans
The Company has interests in large syndicated commercial loans which are originated and serviced by other financial institutions. These loans are senior obligations of the borrowers and are secured by substantially all of the assets of the borrower and, if applicable, its subsidiaries. These loans are variable interest rate loans with rates based upon various LIBOR time periods and applicable margins. The loans are primarily in fixed-term loans, typically with maturities of approximately 7 years and with the substantial portion of the loan principal amortization coming in the year of maturity. The syndicated commercial loan portfolio was $113.5 million at December 31, 2001, or 2.9% of the financial services loan portfolio, as compared to $317.5 million or 9.1% of the financial services loan portfolio at December 31, 2000. These loans are originated through development of relationships with various financial institutions. As of December 31, 2001, the average outstanding loan balance was $5.4 million and there was one loan classified as non-accrual with a balance of $3.4 million. Loan commitments to a single borrower do not exceed $10 million. The Company ceased investing in syndicated commercial loans during 2001 due to market conditions and expects to downsize this portfolio further.
Funding Sources
The commercial and residential real estate lending and syndicated commercial loan activities are financed primarily through deposit accounts offered by the industrial bank and which are insured by the FDIC. (See “Industrial Bank Regulation.”) FIL offers certificates of deposit and installment investment certificates (which are similar to passbook savings accounts and money market accounts) insured by the FDIC to the legal maximum through its 18 branches in California. FIL typically offers higher interest rates to its depositors than do most full service financial institutions. At the same time, it has minimized the costs associated with its accounts by not offering traditional checking, safe deposit boxes, ATM access and other traditional retail services, which have higher maintenance costs. Deposits totaled $4.26 billion at December 31, 2001 and are summarized as to type as follows (thousands of dollars):
Additional financing is available to FIL from the Federal Home Loan Bank of San Francisco (“FHLB”). The financing by the FHLB is available at varying rates and terms. As of December 31, 2001, $956.1 million was available from the FHLB, with $309 million outstanding. In 2000, FIL obtained a line of credit with the Federal Reserve Bank of San Francisco, and at December 31, 2001 had a borrowing capacity of $125.8 million, with no amounts outstanding.
Competition
The financial services business competes in markets that are highly competitive and are characterized by factors that vary based upon product and geographic region. The markets in which it competes are typically characterized by a large number of competitors who compete based primarily upon price, terms and loan structure. The Company primarily competes with banks, mortgage, insurance, and finance companies, many of which are larger and have greater financial resources. The competitive forces of these markets could adversely affect net interest income, loan origination volume or net loan losses.
Discontinued Insurance Operations
The Company’s discontinued insurance operations consist primarily of its property and casualty insurance segment, which was engaged in the underwriting of workers’ compensation insurance business. This business was classified as discontinued in 2001. Discontinued insurance operations also include the Company’s assumed treaty and facultative reinsurance business and its life insurance business. The discontinued insurance operations’ assets at December 31, 2001 consisted of total assets of $2.57 billion, of which $1.25 billion were in cash and investment securities, and $992.4 million were in reinsurance recoverables. The Company estimates that the dedicated assets supporting these operations and all related future policy cash inflows will be adequate to fund future policy obligations. (See Note P of Notes to Consolidated Financial Statements.)
Property and Casualty Insurance
The property and casualty insurance operation segment posted net losses of $547.4 million and $94.7 million for the years ended December 31, 2000 and 1999, respectively. The significant net loss for 2000 is predominantly the result of increases in the gross liability for loss and LAE, and to a lesser degree, various non-recurring charges related to restructuring the property and casualty insurance operation. For 2001, the discontinued property and casualty insurance operation posted net income of $2.3 million prior to its classification as a discontinued operation.
As a result of the substantial operating losses for the property and casualty insurance operation in 2000, Fremont Comp entered into an agreement on November 27, 2000 with the California Department of Insurance (“DOI”) which provides for increased regulatory oversight and supervision. Due to this additional regulatory supervision, A.M. Best downgraded the workers’ compensation insurance subsidiaries rating to “E” (Under Regulatory Supervision) in December 2000. An “E” rating is a “Vulnerable” rating and severely limited the workers’ compensation insurance business’ ability to underwrite new and renewal workers’ compensation insurance policies. To enable the workers’ compensation insurance subsidiaries to continue to underwrite new and renewal business, a fronting facility with “A” rated (by A.M. Best) affiliates of Clarendon Insurance Group was entered into in May 2001. Fremont subsequently made the decision in the fourth quarter of 2001, that due to the significant losses in its property and casualty insurance operation for 2000 and 1999, continued negative trends in the industry and an inability to generate adequate premium volume under the Clarendon facility, to discontinue this line of business. In March 2002, Fremont reached an understanding in principal with the DOI, which is subject to being finalized in a written agreement, that would allow Fremont Comp to self-administer the run-off of policies currently in force by paying claims and operating expenses in the ordinary course of business, discount its workers’ compensation insurance loss and LAE reserves for statutory purposes for all accident years, and would ensure the protection of Fremont’s net operating loss carryforwards attributable to Fremont Comp. The agreement would also preserve Fremont’s interest in any realizable equity of Fremont Comp. Under the agreement, Fremont will have certain obligations for contributing capital to its discontinued workers’ compensation insurance subsidiaries. See Note P of Notes to Consolidated Financial Statements for further details. As of December 31, 2001, Fremont believes that Fremont Comp’s workers’ compensation insurance loss and LAE reserves are adequate and that Fremont Comp’s investment portfolio, and other assets, are sufficient to fund all future policy obligations.
In many cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer’s payment of that loss. To recognize liabilities for future unpaid losses, insurers establish reserves, which represent estimates of future amounts needed to pay claims with respect to insured events that have occurred. Reserves are also established for LAE reserves representing the estimated expenses of settling claims, including legal and other fees, and general expenses of administering the claims adjustment process. Associated with the liabilities for future unpaid losses and LAE are estimates of reinsurance recoverables related to these future unpaid losses and LAE, which are reported as assets.
Reserves for losses and LAE (“loss reserves”) are based not only on historical experience but also on management’s judgment of the effects of matters such as future economic and social forces likely to impact the insurer’s experience with the type of risk involved, circumstances surrounding individual claims, and trends that may affect the probable number and nature of claims arising from losses not yet reported. Consequently, loss reserves are inherently subject to a number of highly variable circumstances.
Loss reserves and reinsurance recoverables on unpaid losses are valued periodically using a variety of actuarial and statistical techniques for producing current estimates of expected claim costs and reinsurance recoveries. Claim frequency and severity and other economic and social factors are considered in the evaluation process, as are other factors that are judged to be appropriate modifiers of past experience.
Reinsurance is ceded primarily to reduce the liability on individual risks and to protect against catastrophic losses. Fremont Comp follows the industry practice of reinsuring a portion of its risks. For this coverage, Fremont Comp pays the reinsurer a portion of the premiums received on all covered policies.
Fremont Comp maintains excess of loss reinsurance treaties with various reinsurers. Effective for the year 2001, Fremont Comp had in place excess of loss reinsurance for new and renewal workers’ compensation insurance policies with effective dates of January 1, 2001 or after, that assumes liability for up to a maximum of $299,750,000 of loss and certain allocated loss adjustment expenses in excess of $250,000 per loss occurrence. The term of this coverage extends to August 1, 2002. Although reinsurance makes the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded, it does not legally discharge an insurer from its primary liability for the full amount of the policy liability. All of the foregoing reinsurance is with non-affiliated reinsurers. Fremont believes that the terms of its reinsurance contracts are consistent with industry practice and, based on its understanding of the reinsurers’ financial condition and reputations in the reinsurance marketplace, that its reinsurers are financially sound.
As of December 31, 2001, Gerling Global Reinsurance Corporation of America (“Gerling”) was the only reinsurer that accounted for more than 10% of Fremont Comp’s total reinsurance recoverables on paid and unpaid losses. Gerling represented approximately 30% of the total workers’ compensation insurance related reinsurance recoverables as of December 31, 2001. Gerling was rated “A” (Excellent) by A.M. Best at December 31, 2001.
Assumed Reinsurance and Life Insurance
The assumed treaty and facultative reinsurance business was discontinued between 1986 and 1991. The liabilities associated with this business are long term in duration and, therefore, this business continues to be subject to claims being reported. Claims under these reinsurance treaties include professional liability, product liability and general liability that include asbestos and environmental claims.
Prior to January 1, 1996, Fremont offered life insurance products, including annuities, credit life and disability insurance and term life insurance for consumers, through a subsidiary. Effective December 31, 1995 and January 1, 1996, this subsidiary entered into reinsurance and assumption
agreements with a reinsurer whereby assets and liabilities related to certain life insurance and annuity policies were ceded to the reinsurer. These reinsurance agreements are part of several other agreements that have collectively resulted in the discontinuation of the life insurance operation. The subsidiary continues to remain primarily obligated for approximately $50 million in statutory reserve value of annuities which, at December 31, 2001, have been fully co-insured with Great Southern Life Insurance Company (“Great Southern”). Fremont believes Great Southern is financially sound and able to meet its reinsurance obligations. Great Southern was rated “A” (Excellent) by A.M Best as of December 31, 2001.
Industrial Bank Regulation
The industrial bank is subject to supervision and regulation by the DFI and, as an insured institution, by the FDIC. None of the Company’s subsidiaries are regulated or supervised by the Office of Thrift Supervision, which regulates savings and loan institutions. Fremont is generally not directly regulated or supervised by the DFI, the FDIC, or any other bank regulatory authority, except with respect to guidelines concerning its relationship with its industrial bank subsidiary. The industrial bank is examined on a regular basis by both agencies. At December 31, 2001, the industrial bank was in compliance with the regulatory requirements of these agencies.
Federal and state regulations prescribe certain minimum capital requirements and the industrial bank is currently in compliance with such requirements. Federal and state regulatory authorities also have the power to prohibit or limit the payment of dividends by the industrial bank. (See “Risk Factors.”)
California Law. The industrial banking business conducted by the industrial bank is governed by the California Revised Banking Law (“Revised Banking Law”), which became effective September 30, 2000, and the rules and regulations of the Commissioner of the DFI.
The effect of the Revised Banking Law is that an industrial bank is now defined as a bank. All statutory and regulatory references to banks or commercial banks apply equally to industrial banks, including, for example, establishment and closure of branches and loan productions offices, investment authority, mergers and acquisitions, interstate banking and banking activities, and trust business. Essentially this means that the industrial bank may offer all loan and credit programs and deposit accounts that commercial banks may offer, with the significant exception that industrial banks are not authorized to offer demand deposit accounts. While FIL may not offer demand deposit accounts, it may offer negotiable orders of withdrawal accounts (NOW accounts) and money market deposit accounts (MMDA).
There are other differences in the Revised Banking Law from the former Industrial Loan Law. These include annual regulatory assessments equal to commercial banks and no charges for regular periodic regulatory examinations, elimination of limits on out of state lending, elimination of restrictions on affiliate transactions, application of Federal Reserve Regulation O, increase in the aggregate sum of obligations owing by a single borrower, and elimination of capital/thrift leverage ratios.
Maximum unsecured loans to one borrower is limited to 15% of shareholders’ equity, allowance for loan losses, and capital notes and debentures of an industrial bank. Maximum secured and unsecured loans to one borrower is limited to 25% of shareholders’ equity, allowance for loan losses, and capital notes and debentures of an industrial bank. Unsecured and secured obligations may not be combined in the same note. Separate notes are required. Loans secured by corporate stock of a single corporation are limited to 5% of the bank’s assets.
Prior approval must be obtained from the DFI before a person or entity acquires control of an industrial bank or its controlling person, i.e., the bank’s holding company. Control means direct or indirect ownership or power to vote 25% of the voting stock issued by a person or to direct management or its policies. There is a presumption, however, as there is under the Federal Deposit Insurance Act, that ownership or power of over 10% or more of the voting stock is presumed to constitute control. (See
“Federal Law”) In addition to filing with the FDIC, a separate letter filing must be made with the DFI for approval or to rebut the presumption.
Under the Revised Banking Law, the DFI may take possession of an industrial bank if, among other things, the tangible shareholders’ equity is less than the greater of 3% of the industrial bank’s total assets, or $1 million. Violations of a bank’s articles of incorporation or any California law, unsafe or unauthorized conduct of business, or unsafe or unsound conditions are also grounds for taking possession and for liquidation of an industrial bank.
Federal Law. The industrial bank’s deposits are insured by the FDIC to the full extent permitted by law. As an insurer of deposits, the FDIC issues regulations, conducts examinations, requires the filing of reports and generally supervises the operations of institutions to which it provides deposit insurance. The approval of the FDIC is required prior to any merger, consolidation or change in control or the establishment or relocation of any branch office of the industrial bank. This supervision and regulation is intended primarily for the protection of the insured deposit funds. Prior written notice to the FDIC is required to close a branch office. FDIC approval, however, is not required to open, relocate, or close a loan production office.
The industrial bank is subject to federal risk-based capital adequacy guidelines which provide a measure of capital adequacy and are intended to reflect the degree of risk associated with both on- and off-balance sheet items, including residential real estate loans sold with recourse, legally binding loan commitments and standby letters of credit. A financial institution’s risk-based capital ratio is calculated by dividing its qualifying capital by its risk-weighted assets. Financial institutions are generally expected to meet a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% of qualifying total capital must be in the form of core capital (“Tier 1”) - common stock, noncumulative perpetual preferred stock, minority interests in equity capital accounts of consolidated subsidiaries and allowed mortgage servicing rights, less all intangible assets other than allowed mortgage servicing rights and eligible purchased credit card relationships. Supplementary capital (“Tier 2”) consists of the allowance for loan and lease losses up to 1.25% of risk-weighted assets, cumulative perpetual preferred stock, long-term preferred stock (original maturity of at least 20 years), hybrid capital instruments, term subordinated debt and intermediate term preferred stock (original average maturity of five years or more). The maximum amount of Tier 2 capital which may be recognized for risk-based capital purposes is limited to 100% of Tier 1 capital (after any deductions for disallowed intangibles and certain deferred tax assets). The aggregate amount of term subordinated debt and intermediate term preferred stock that may be treated as Tier 2 capital is limited to 50% of Tier 1 capital. Certain other limitations and restrictions also apply. As of December 31, 2001, the industrial bank’s allowance for loan losses for Tier 2 capital was $53.4 million. At December 31, 2000, the Tier 2 capital of the industrial bank consisted of approximately $49.5 million of allowance for loan losses. The following table presents the industrial bank’s risk-based capital position at the dates indicated:
The FDIC has adopted a minimum leverage ratio which is intended to supplement risk-based capital requirements and to ensure that all financial institutions continue to maintain a minimum level of
core capital. The minimum leverage capital requirement for an FDIC-insured, state non-member bank, such as FIL, shall consist of a ratio of Tier 1 capital to average total assets of not less than 3%. This minimum only applies to the most highly-rated banks that are not anticipating or experiencing any significant growth. All other FDIC-insured, state non-member banks would need to meet a minimum leverage capital ratio at least 1% to 2% above this minimum. It is improbable, however, that an institution with a 3% core capital-to-total assets ratio would be rated in the highest category since a strong capital position is so closely tied to the rating system. Therefore, the “minimum” leverage ratio is, for all practical purposes, significantly above 3%. The following table presents the industrial bank’s leverage ratio (the ratio of Tier 1 capital to the quarterly average total assets) at the dates indicated:
The industrial bank is a “well-capitalized” institution at December 31, 2001 under the regulations promulgated under the Federal Deposit Insurance Corporation Improvement Act of 1991. A “well-capitalized” institution has a total risk-based capital ratio of at least 10%, has a Tier 1 risk-based capital ratio of at least 6%, has a leverage ratio of at least 5%, and is not subject to any written agreement, capital directive or prompt corrective action directive issued by the FDIC under Section 8 or Section 38 of the Federal Deposit Insurance Act to meet and maintain a specific capital level for any capital measure. The total risk-based capital ratio is the ratio of qualifying total capital to risk-weighted assets and the Tier 1 risk-based capital ratio is the ratio of Tier 1 capital to risk-weighted assets.
As a “well-capitalized” institution, the industrial bank’s annual FDIC insurance premiums currently are 1.9 cents per $100 of eligible domestic deposits. The insurance premium payable is subject to semi-annual adjustment. The FDIC, by the first day of the month preceding each semi-annual period, is required to notify each insured institution of its assessment risk-classification upon which the insurance premium assessment for the following period will be based. The FDIC has the authority to assess to all insured institutions collectively, additional premiums to cover losses and expenses associated with insuring deposits maintained at financial institutions and for other purposes it deems necessary. Currently the FDIC and Congress have under consideration a review of the status of the insurance fund which could result in increased insurance coverage of accounts as well as increased premium assessment.
In January of 2001, the FDIC, together with other federal banking regulatory agencies, issued a joint release entitled “Expanded Guidance for Sub-prime Lending Programs” which contains supplemental guidelines regarding sub-prime lending. The supplemental guidelines primarily apply to institutions with sub-prime lending program of 25% or more of the institution’s Tier 1 regulatory capital. The guidelines are intended to intensify examination scrutiny of institutions that target the sub-prime market. Institutions are examined on a case by case basis to determine the sufficiency of capital to support the risk of sub-prime lending. Generally, additional capital is required depending upon the additional risk assessment. Although there are differences between holding a portfolio of sub-prime loans and the securitization of such loans, each requires special attention to assure the adequacy of capital and proper risk management.
Limitations on Dividends. The industrial bank follows the limitations under the Revised Banking Law and its authorization to pay dividends is subject to provisions applicable to commercial banks, which is limited to the lesser of retained earnings or the industrial bank’s net income for its last three
fiscal years, less amount of any distributions made by the industrial bank or by any majority owned subsidiary of the industrial bank to the shareholders of the industrial bank during such period.
In policy statements, the FDIC has advised insured institutions that the payment of cash dividends in excess of current earnings from operations is inappropriate and may be cause for supervisory action. Under the Financial Institutions Supervisory Act and the Financial Institutions Reform, Recovery and Enforcement Act of 1989, federal regulators also have authority to prohibit financial institutions from engaging in business practices which are considered to be unsafe or unsound. It is possible that, depending upon the financial condition of the industrial bank and other factors, such regulators could assert that the payment of dividends in some circumstances might constitute unsafe or unsound practices and could prohibit or limit the payment of dividends.
Other Regulation. FIL is also subject to federal consumer protection laws, including the Truth In Savings Act, the Truth in Lending Act, the Community Reinvestment Act, the Real Estate Settlement Procedures Act, and the Gramm-Leach-Bliley Act with regard to privacy of consumer financial information.
Privacy. Federal laws have been recently enacted to protect the privacy of non-public personal information of consumers. The laws principally require banks and other financial companies to provide notices to their customers identifying what information is collected, whether the company intends to share such information with other companies, rights of customers, and the manner by which a customer can protect himself or herself. These laws give a customer the right to opt out of some sharing of personal financial information. California and other states either have enacted or have under consideration privacy laws which may either augment or make more restrictive the use of such information.
Real Estate Lending Practices. In addition to the federal Truth In Lending laws governing disclosure requirements and limitations upon residential mortgages and loans secured by a consumer’s principal dwelling, California and other states have enacted statutes which set certain restrictions on such loans, such as, limits on annual percentage interest rate thresholds, limitations on prepayment penalties, capacity to repay, prohibition against sale of certain insurance, and specific disclosures. California’s new law becomes effective July 1, 2002. The states’ laws are intended to curb and eliminate abusive lending practices. Several California municipalities have such laws under consideration. It is not expected that such enactments will have any material effect upon the residential real estate lending business of the industrial bank.
Risk Factors
Operating Results and Financial Condition May Vary
The Company’s profitability can be affected significantly by many factors including competition, the valuation of its loans and other assets, access to capital, funding sources, and secondary markets, the severity and frequency of claims, fluctuation in interest rates and the rate of inflation, legislation and regulations, court decisions, the judicial and regulatory climate and general economic conditions and trends, all of which are outside of the Company’s control. In addition, results may be affected by the ability to contain expenses and to implement appropriate technological changes. Any of these factors could contribute to significant variation in the Company’s results of operations within the different aspects of its business, or businesses taken as a whole, from quarter to quarter and from year to year.
During periods when economic conditions are unfavorable, the financial services business may not be able to originate new loan products or maintain the credit quality of its finance receivables, both in its portfolio and for those loans that have been securitized, at previously attained levels. This may result in increased levels of non-performing assets and net credit losses. Changes in market interest rates, or in the relationships between various interest rates, could cause interest margins to be reduced and may result in significant changes in the prepayment patterns of the Company’s finance receivables. These risk factors could adversely affect the value of the loans (both in portfolio and held for sale) and their related collateral, as well as the valuation of the residual interests in the securitized loans, both of which could
adversely affect the results of operations and financial condition. During 2001, the Company sold over 90% of their whole loan sales to two financial institutions and could be adversely impacted if one or both of the institutions ceased or severely limited such purchases. The Company attempts to limit such risk through the continued development of other such relationships. In addition, should the Company elect to monetize, in full or in part, its residual interests in securitized loans for liquidity or other purposes through the sale, or by other means, of these interests, the Company may realize, possibly significant, amounts less than the value of the interests as recorded in its financial statements due to the limited market for such residual interests and the timing and nature of such a transaction.
With respect to the discontinued insurance operations, changes in economic conditions can lead to increased claims due to the tendency of workers who are laid off to submit workers’ compensation insurance claims. Changes in the medical, rehabilitation and legal environment can impact the severity of claims and the average cost per claim. Changes in market interest rates and credit conditions can affect the amount of interest income that the Company earns on its investment portfolio, as well as the amount of realized gains or losses on specific holdings within the investment portfolio. The discontinued insurance operations include significant amounts of reinsurance recoverables. Reinsurance contracts do not relieve Fremont Comp from its obligations to policyholders. The failure of reinsurers to meet their obligations in a timely and complete manner could result in losses to the Company. Fremont Comp also has premium receivables and agents’ balances that represent amounts due from various third parties. Due to the discontinuance of the workers’ compensation insurance operations, there may be higher than normal delays in, or non-payment of, the amounts due. While an allowance for doubtful accounts has been established in an amount believed to be sufficient to cover such potentialities, higher than expected levels of delinquency and non-payment could have an adverse impact upon the run-off of the discontinued insurance operations. Legislative and regulatory changes can also cause uncertainty with respect to the Company’s discontinued workers’ compensation insurance business. In addition, the discontinued insurance operations could be adversely impacted if the operating expenses necessary to run-off the workers’ compensation insurance policy obligations are not maintained at appropriate levels.
Loss Reserves and Allowance for Loan Losses May Prove to Be Inadequate
The financial services business maintains an allowance for loan losses on its portfolio of finance receivables in amounts that the Company believes is sufficient to provide adequate protection against potential losses. The finance receivables originated, both for portfolio, sale and securitization, are generally non-conventional and non-investment grade loans. To mitigate for the somewhat higher potential risk of the lending that is primarily engaged in and for the impact that adverse economic developments could have on the finance receivables, the Company lends primarily on a senior and secured basis. The Company also attempts to carefully evaluate the underlying collateral that secures these loans and to maintain underwriting standards that are designed to effect appropriate loan to collateral valuations and cash flow coverages. Although the Company believes that its level of allowance is sufficient to cover potential credit losses, the allowance could prove to be inadequate due to unanticipated adverse changes in economic conditions or discrete events that adversely affect specific borrowers, industries or markets. Any of these changes could impair the Company’s ability to realize the expected value of the collateral securing certain of its finance receivables or the timing of the realization thereof. While the Company has recently experienced an increase in non-performing commercial real estate loans, it has not incurred a commensurate increase in its level of commercial real estate net loan charge-offs. The Company, however, can give no assurance that an increase in net loan charge-offs will not subsequently develop. The Company also originates a substantial number of larger loans, and even one problem loan could cause a sharp increase in the level of non-performing loans. A group of several large problem loans could cause the levels of non-performing loans and net-charge offs to significantly exceed historical levels previously experienced by the Company.
The discontinued insurance subsidiaries are required to maintain reserves to cover the ultimate liability for losses and LAE with respect to reported and unreported claims incurred as of the end of each accounting period. These loss reserves do not represent an exact calculation of liabilities, but instead are
estimates involving actuarial projections at a given time of what the ultimate settlement and administration of claims will cost, including estimates of reinsurance recoveries associated with the estimated claims costs. These projections are based on facts and circumstances then known, predictions of future events, estimates of future trends in claims frequency and severity, and judicial theories of liability, as well as other factors. The Company regularly reviews its reserving techniques, overall reserve position and reinsurance and, under an agreement with the DOI, the discontinued insurance subsidiaries are permitted to discount these loss reserves using a rate of 5.5%. In light of present facts, trends and legal interpretations, the Company believes that adequate provisions have been made for loss and LAE reserves, net of reinsurance recoverables, on a discounted basis, and that the assets will be sufficient to satisfy all policy obligations of the discontinued insurance subsidiaries. However, the establishment of appropriate gross loss and LAE reserves and reinsurance recoverables is an inherently uncertain process and there can be no certainty that currently established gross loss and LAE reserves and reinsurance recoverables will prove to be adequate in light of subsequent actual experience. Subsequent actual experience has resulted, and could result, in net loss and LAE reserves being too high or too low. Future loss and LAE development could require an increase in gross loss and LAE reserves or a decrease in reinsurance recoverables, which could adversely affect the Company’s ability to run-off the discontinued insurance operations in a manner that satisfies all policy obligations.
Competition May Adversely Affect the Company’s Market Share and Operating Results
The financial services business competes in markets that are highly competitive and are characterized by factors that vary based upon loan product and geographic region. The markets in which the Company competes are typically characterized by a large number of competitors who compete for loans based primarily upon price, terms and loan structure. The industrial bank also competes for deposits to fund its operations. Competition is highly price-sensitive and competitive forces could affect the industrial bank’s ability to source adequately priced deposits. The Company primarily competes with banks and mortgage and finance companies, many of which are larger and have greater financial resources. The competitive forces of these markets could adversely affect net finance income net gains on loan sales, loan origination volume or net credit losses.
Geographic Concentration of Business Could Adversely Affect the Company’s Operations
While the Company attempts to diversify its loan origination by geographic region, the geographic concentration of commercial and residential real estate loans remains in California. At December 31, 2001, approximately half of the commercial and residential real estate loans, both in portfolio and those loans that have been securitized, were collateralized by properties located in California. Adverse events in California, such as real estate market declines or the occurrence of natural disasters upon property located therein, may have a more significant adverse effect upon the operating results and financial condition than if a higher percentage of loans were collateralized by properties located outside California.
The discontinued workers’ compensation insurance operations have a significant concentration of in force policies in California. Of the total estimated annual premium in force at December 31, 2001, approximately 84% was California related. This concentration significantly increases the effect of variations in economic, legal and regulatory conditions in California upon the discontinued workers’ compensation insurance operations.
Regulatory Developments May Adversely Affect the Company’s Operations
The financial services businesses include an FDIC insured industrial bank subject to supervision and regulation by the DFI and the FDIC. Federal and state regulations prescribe certain minimum capital requirements and, while the industrial bank is currently in compliance with such requirements, in the future, additional contributions to the industrial bank may be necessary in order to maintain compliance with such requirements. Future changes in government regulation and policy could adversely
affect the banking industry. Such changes in regulations and policies may place restrictions on or make changes to the Company’s lending business and increase the costs of compliance and sourcing deposits.
As previously reported, the discontinued workers’ compensation insurance subsidiaries entered into an agreement on November 27, 2000 with the DOI in which the DOI is allowed additional regulatory supervision and oversight over their activities. Under the agreement, prior approval by the DOI is required for certain payments by the workers’ compensation insurance subsidiaries, including those to affiliates. These payments are generally for the reimbursement of certain expenses and for various services rendered. Previously, substantially all affiliate payments have been made to Fremont. Delay, or denial in whole or in part, by the DOI of such future payments may adversely impact the liquidity of Fremont. As of December 31, 2001, the Company believes that the discontinued insurance operation’s loss and LAE reserves are adequate and that the investment portfolio, and other assets, are sufficient to fund all future policy obligations. However, should the workers’ compensation insurance loss and LAE reserves experience significant adverse development, the DOI may institute various regulatory actions, including conservation. Should the Company’s significant workers’ compensation insurance subsidiaries come under regulatory conservation, or similar arrangement, this may cause an event of default under the Company’s senior notes (the “Senior Notes”) outstanding. If an event of default is declared under the Senior Notes, the outstanding principal may become immediately due and payable. The Company’s current financial position would not enable it to meet such an obligation and, as a result, the Company and the holders of its Senior Notes may pursue various alternatives. Such actions could have a significant adverse impact upon the Company and the holders of its various securities.
Item 2.
Item 2. Properties
The Company leases substantially all of its office facilities in various cities for its corporate and subsidiary operations. The Company considers these facilities to be adequate for its operating needs. See Note M to the Company’s Notes to Consolidated Financial Statements in this Annual Report on Form 10-K, which note is incorporated herein by reference.
Item 3.
Item 3. Legal Proceedings
Fremont and its subsidiaries and affiliates are parties to various legal proceedings, which in some instances include claims for punitive damages, most of which are considered routine and incidental to their business. The Company believes that ultimate resolution or settlement of such matters will not have a material adverse effect on its consolidated financial position.
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
The Company’s common stock is traded on the New York Stock Exchange (“NYSE”) under the trading symbol “FMT.” The following table sets forth the high and low sales prices of the Company’s common stock as reported as composite transactions on the NYSE and the cash dividends declared on the Company’s common stock during each quarter presented.
On December 31, 2001, the closing sale price of the Company’s common stock on the NYSE was $7.82 per share. There were 2,028 stockholders of record as of December 31, 2001.
The Company has paid cash dividends in every quarter since its initial public offering in 1977. While the Company intends to continue to pay dividends, the decision to do so is made quarterly by the Board of Directors and is dependent on the earnings of the Company, management’s assessment of future capital needs, and other factors.
Item 6.
Item 6. Selected Financial Data
(1)
In the fourth quarter 2001, the Company 	discontinued its property and casualty insurance segment, 	primarily the underwriting of workers’ compensation 	insurance policies. 1997 through 2000 amounts have been 	reclassified to discontinued insurance operations to conform to 	this presentation. 	
(2)
In 2000, the Company’s discontinued 	insurance operations recognized an increase in gross liability 	for losses totaling $450 million and $267.8 million of 	charges related to the restructuring for its workers’ 	compensation insurance operations. 	
(3)
The Company sold Fremont Financial Corporation on 	December 20, 1999. 	
Item 7.
Item 7.
Management’s Discussion and Analysis 	of Financial Condition and Results of Operations
General
Fremont General Corporation (“Fremont”) is a financial services holding company. Fremont’s financial services’ segment is consolidated within Fremont General Credit Corporation (“FGCC”), which is engaged in commercial and consumer real estate lending nationwide through its California-chartered industrial bank subsidiary, Fremont Investment & Loan (“FIL”). Additionally, there are certain corporate revenues and expenses, comprised primarily of investment income, interest expense and certain general and administrative expenses, that are not allocated by Fremont to FGCC or to the discontinued insurance operations.
This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and notes thereto presented under Item 8.
Item 8. Financial Statements and Supplementary Data
The Company’s Consolidated Financial Statements, including supplementary data, are set forth in the “Index” on page 38 hereof.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information set forth under the subheadings “Election of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Proxy Statement for the 2002 Annual Meeting of Stockholders is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information set forth under the subheadings “Election of Directors,” “Compensation of Directors,” “Executive Officers,” “Summary Compensation Table,” “Summary Compensation Table - Explanations,” “Option/ SAR Grants In Last Fiscal Year,” “Option Exercises and Year-End Option Values,” “Aggregated Option/ SAR Exercises in Last Fiscal Year and Fiscal Year-End Option Values Table,” “Employment Agreements” and “Retirement and Other Benefit Plans,” in the Company’s definitive Proxy Statement for the 2002 Annual Meeting of Stockholders is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information set forth under the subheading “Principal and Management Stockholders” in the Company’s definitive Proxy Statement for the 2002 Annual Meeting of Stockholders is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information immediately following the captions “Election of Directors,” “Employment Agreements,” and “Certain Relationships and Related Transactions” in the Company’s definitive Proxy Statement for the 2002 Annual Meeting of Stockholders is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a)(1) and (a)(2) and (d) Financial Statements and Schedules. Reference is made to the “Index - Consolidated Financial Statements and Financial Statements Schedules - Annual Report on Form 10-K filed as part of this Annual Report.
(a)(3) and (c) Exhibits.
*
Management or compensatory plans or arrangements. 	
With respect to long-term debt instruments, the 	Registrant undertakes to provide copies of such agreements upon 	request by the Commission. 	
(b) Reports on Form 8-K. None.
FREMONT GENERAL CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULES
ANNUAL REPORT ON FORM 10-K
INDEX
REPORT OF INDEPENDENT AUDITORS
Stockholders and Board of Directors
Fremont General Corporation
We have audited the accompanying consolidated balance sheets of Fremont General Corporation and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Fremont General Corporation and subsidiaries at December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
ERNST & YOUNG LLP 	
Los Angeles, California
March 21, 2002
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
See notes to consolidated financial statements.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to consolidated financial statements.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
See notes to consolidated financial statements.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note A - Nature of Operations and Significant Accounting Policies
Fremont General Corporation (“Fremont”) is a financial services holding company engaged primarily in commercial and residential real estate lending through its industrial bank subsidiary, Fremont Investment and Loan (“FIL”). The industrial bank’s deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”). Commercial and residential real estate lending represented approximately 95% of loan interest revenues in 2001 (2000 - 90%; 1999 - 71%). Interest in syndicated commercial loans account for substantially all of the remaining loan interest revenues. In the fourth quarter of 2001, Fremont discontinued its remaining property and casualty insurance business, which consists primarily of workers’ compensation insurance operations. (See Note P for the liquidation accounting treatment of the discontinued insurance operations.) In December 1999, Fremont sold its commercial finance subsidiary that provided commercial working capital lines of credit (“commercial finance”).
The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The significant accounting policies that materially affect financial reporting are summarized below.
Consolidation: With the exception of the property and casualty subsidiaries which are reported as discontinued operations, the consolidated financial statements include the accounts and operations, after intercompany eliminations, of Fremont General Corporation and subsidiaries (“the Company”).
Use of Estimates: The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents: All highly liquid debt instruments with an original maturity of no more than three months are classified as cash equivalents.
Investment Securities Available for Sale: Investment securities available for sale are carried at fair value. Unrealized holding gains and losses on investments are included in accumulated other comprehensive income (loss) and reported as a separate component of stockholders’ equity, net of deferred taxes.
Realized investment gains and losses are included in other non-interest income based on specific identification of the investment sold.
Loans Receivable: Loans are reported at the principal amount outstanding, net of deferred fees and costs, loan participations by other financial institutions or investors, and the allowance for loan losses. Loan origination fees, net of direct incremental loan origination costs, are deferred and amortized to interest and fee income over the contractual life of the loan using the interest method. Commercial real estate loans are reported net of participations to other financial institutions or investors in the amount of $118.0 million and $138.3 million as of December 31, 2001 and 2000, respectively. The allowance is increased by provisions charged against operations and reduced by loan amounts charged off by management. The allowance is maintained at a level considered adequate to provide for inherent losses on loans based on management’s evaluation of the loan portfolio. While management uses all available information to estimate the level of the allowance for loan losses, future additions may be necessary based on changes in the amounts and timing of future cash flows expected due to changes in collateral values supporting loans, general economic conditions and borrowers’ financial conditions.
Management classifies loans as non-accrual generally when principal or interest is in default 90 days or more unless the loan has collateral sufficient to discharge the debt and management reasonably expects repayment of the debt or restoration to a current status in the near future. When a loan is placed on non-accrual status, any previously uncollected interest is reversed as a reduction of interest earned on
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
loans receivable and accrued interest receivable. Subsequent collections on non-accrual loans are applied as a reduction of principal. The Company’s charge-off policy is based on a monthly loan-by-loan review.
Loans Held for Sale and Real Estate Owned: Loans held for sale are comprised of residential real estate loans and are carried at the lower of aggregate amortized cost or market. Market values are based upon available market quotes for pools of similar loans. Loans transferred from portfolio to held for sale are marked to market upon transfer, with any loss being reflected as a charge-off. Amortized cost includes the unpaid loan principal balance, and direct and indirect costs of origination (including commissions and allocated corporate overhead costs), less the net amount of fees received from the borrower. Valuation adjustments to lower carrying values to market are recorded in current operations as a component of the gain or loss on residential loan sales. Interest earned on loans held for sale is recorded as interest income until date of sale. As of December 31, 2001, $16.6 million of loans held for sale were classified as non-accrual.
Real estate owned (“REO”) is primarily acquired through or in lieu of foreclosure on credits secured by real estate and is included in the financial statements under other assets at the lower of cost or estimated realizable value (net of estimated costs to sell). Estimated realizable values are based on an evaluation of numerous factors, including appraisals, sales of comparable assets and estimated market conditions. Loans transferred from portfolio to REO are marked to market, if necessary, upon transfer, with any loss being reflected as a charge-off. Gains on the subsequent sale of REO properties are included in non-interest income. Losses on the subsequent sale or periodic revaluation of REO properties, and the net costs of maintaining these properties, are included in non-interest expenses. Such gains and losses on REO have historically not been material.
Loan Sales: Loan sales are on a cash basis wherein the buyer acquires all future rights to the loans sold with no recourse to the Company. Gains and losses on these whole loan sales are recognized at the date of settlement and are based upon the difference between the cash received for the loans and the carrying cost of the loans. Gains and losses on whole loan sales are classified as non-interest income.
Residual Interests in Securitized Loans at Fair Value: The residual interests relate to residential real estate loans that the Company securitized and in which it retains the right to receive certain future cash flows, which are generally equal to the value of the principal and interest to be collected on the loans in excess of: (i) the principal and interest to be paid on the securities sold through a securitization trust to third party investors; and (ii) various contractual net servicing fees and other expenses. The residual interests are at estimated fair value. Since active market quotes are generally not available for residual interests, the Company determines fair value by computing the present value of the estimated net cash flows retained, using the dates that such cash flows are expected to be released to the Company (the cash-out method), at a discount rate that management considers to be commensurate with the risks associated with the cash flows. The Company recognized no initial net gain on the residual interests it retained above the carrying costs of the loans sold into the securitizations. The carrying costs included direct and indirect origination costs.
Deposits: Deposits consist of certificates of deposit and installment certificates (which are similar to passbook savings accounts and money market accounts) at FIL. Such balances are credited with interest at rates ranging from 2.35% to 6.85% at December 31, 2001. The estimated fair value of the deposits was $4,286,920,000 at December 31, 2001. (See Note G.)
Furniture and Equipment: Furniture and equipment are stated at cost, less accumulated depreciation. Generally depreciation is computed using the straight-line method over periods ranging from two to twelve years. Leasehold improvements are amortized over the terms of the lease. The net book value of these fixed assets (2001 - $9,270,000; 2000 - $11,562,000) is included in other assets.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Credit Risk: Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments, investment securities, commercial and residential real estate loans, syndicated commercial loans and residual interests in securitized residential real estate loans. The Company places its temporary cash investments and investment securities with high credit quality financial institutions and limits the amounts of credit exposure to any one financial institution. The Company attempts to limit the concentration of credit risk for commercial real estate loans by emphasizing first mortgage lending on a wide variety of properties that generate stable or increasing cash flow streams, have strong asset quality and proven sponsorship. At December 31, 2001 and 2000, there were 60 and 32 commercial real estate loans, respectively, each with loan balances in excess of $15 million, and 48% of the commercial real estate loan portfolio was secured by mortgages on properties located in California. Concentration of credit risk with respect to residential real estate loans is limited due to the large number of borrowers; however, approximately 40% of these loans (including loans held for sale) are from borrowers within the state of California. Syndicated commercial loans consist of interests in 21 senior and secured loans that range in the size of the amount outstanding from $2.2 million to $9.8 million and are not concentrated geographically or by industry. (Also see Note P - Discontinued Insurance Operations.)
Fair Values of Financial Instruments: The Company uses various methods and assumptions in estimating its fair value disclosures for financial instruments. For investment securities, fair values are determined from certain valuation services, as well as from quoted market prices. Loans receivable with variable rates, as well as deposits for passbook and money market type accounts, are deemed to be at fair value. The fair values of certificates of deposits, fixed rate real estate loans and other fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for similar accounts or loans to borrowers with similar credit ratings. Residual interests in securitized loans are estimated using discounted cash flow analyses using a discount rate considered commensurate with the risk associated with the cash flows.
For cash equivalents and short-term debt, the carrying amount of the Company’s borrowings approximates fair value. The fair value of the Company’s long-term debt and mandatorily redeemable preferred securities of a subsidiary Trust is based on quoted market prices, if available, or estimated using discounted cash flow analyses.
The carrying amounts and fair values of the Company’s financial instruments at December 31, 2001 are summarized in the following table:
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
New Accounting Standards: In June 2001, the Financial Accounting Standard Board (“FASB”) issued SFAS No. 141, “Business Combinations,” which eliminates the pooling method of accounting for all business combinations initiated after June 30, 2001, and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. The Company adopted this accounting standard, but has not initiated any business combinations since the June 30, 2001 effective date.
In June 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets,” which addresses the financial accounting and reporting standards for the acquisition of intangible assets outside of a business combination and for goodwill and other intangible assets subsequent to their acquisition. This accounting standard requires that goodwill be separately disclosed from other intangible assets in the balance sheet, and no longer be amortized but tested for impairment on a periodic basis. The provision of this accounting standard also requires the completion of a transitional impairment test within six months of adoption, with any impairments identified treated as a cumulative effect of a change in accounting principle. The Company will adopt this accounting standard effective January 1, 2002. Adoption of the Statement will not have a significant impact on the Company’s financial position and results of operations.
In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of,” and the accounting and reporting provisions of Accounting Principles Board (APB) Opinion No. 30, “Reporting the Results of Operations,” for a disposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company will adopt SFAS No. 144 as of January 1, 2002. Adoption of the Statement will not have a significant impact on the Company’s financial position and results of operations.
Reclassifications: Certain reclassifications of prior years’ amounts have been made to conform them with the current year’s presentation. This includes the necessary restatement of reporting the property and casualty insurance subsidiaries as part of discontinued insurance operations.
Note B - Cash and Cash Equivalents
Cash and cash equivalents at December 31, are summarized in the following table:
The Company’s cash and cash equivalent balances were unrestricted as of December 31, 2001 and 2000.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note C - Investment Securities Available for Sale
The amortized cost and fair values of investment securities available for sale are summarized in the following table:
The Company currently holds no derivative or other off-balance sheet arrangements.
The amortized cost and fair value of investment securities available for sale at December 31, 2001 by contractual maturity, are summarized in the following table:
The contractual maturities in the foregoing table may differ from actual maturities because certain borrowers have the right to sell or repay obligations with or without call or prepayment penalties. Most of the mortgage-backed securities provide for periodic payments through their lives.
Note D - Loans Receivable
Loans receivable consist primarily of commercial and residential real estate loans and syndicated commercial loans. Commercial real estate loans, which are primarily variable rate, represent loans secured primarily by first mortgages on property types such as office, retail, industrial, hotels/motels, multi-family and mixed-use properties, with loan terms that are generally up to five years. Residential real estate loans have loan terms for up to thirty years and are generally secured by first deeds of trust on single-family residences. Syndicated commercial loans are variable rate senior loans originated on both a revolving and fixed-term basis, generally not in excess of seven years. These loans are secured by substantially all of the assets of the borrower, and, if applicable, of its subsidiaries. In September 2000, the Company sold substantially all of its insurance premium finance loan portfolio. Insurance premium notes receivable were loans collateralized by security interests in return premiums.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Balances of loans receivable by product category are summarized as follows:
Balances of non-accrual loans receivable, real estate owned and accruing loans 90 days past due, are summarized in the following table by loan type:
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Accruing loans 90 days or more past due include loans that are contractually past maturity, but continue to make interest payments.
The Company employs a documented and systematic methodology in determining the adequacy of its allowance for loan losses, which assesses the risk and losses inherent in the portfolio, and represents the Company’s estimate of probable inherent losses which have occurred as of the date of the financial statements. Establishment of the allowance for loan losses involves determining reserves for individual loans that have been deemed impaired and for groups of loans that are evaluated collectively. Reviews are performed to set reserves for loans that have been individually evaluated and identified as loans which have probable losses; these loans are generally larger-balance commercial real estate and syndicated commercial loans, and reserve requirements are attributable to specific weaknesses evidenced by various factors such as a deterioration in the quality of the collateral securing the loan, payment delinquency or other events of default. Smaller-balance, homogeneous loans, such as residential real estate loans, and performing larger-balance loans that currently exhibit no significant identifiable weaknesses or impairment are evaluated on a collective basis. The allowance for loan losses methodology incorporated management’s judgement concerning the effect of recent economic events on portfolio performance. Activity in the allowance for loan losses is summarized in the following table:
At December 31, 2001 and 2000, the recorded investment in loans that are considered to be impaired was $91,592,000 and $69,964,000, respectively, all of which were on a non-accrual basis. The Company’s policy is to consider a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Evaluation of a loan’s impairment is based on the present value of expected cash flows or the fair value of the collateral, if the loan is collateral dependent. As a result of charge-offs, these impaired loans do not necessarily have a related specific allowance for loan loss allocated to them. However, the $91,592,000 and $69,964,000 of loans considered impaired have allocated specific allowances that totaled $14,938,000 and $9,792,000 at December 31, 2001 and 2000, respectively. The average net investment in impaired loans was $86,723,000, $49,638,000 and $29,703,000 for 2001, 2000 and 1999, respectively. Interest income that was recognized on the cash basis of accounting on loans classified as impaired during the year was $1,470,000, $898,000 and $999,000 for the years ended December 31, 2001, 2000 and 1999, respectively. Interest income foregone for loans on non-accrual status that had not performed in accordance with their original terms was $9,733,000, $4,572,000 and $2,262,000, for the years ended December 31, 2001, 2000 and 1999, respectively. At December 31, 2001 and 2000, there were no loans included in accrual status that had been modified in connection with troubled debt restructurings.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The carrying amounts and estimated fair values of loans receivable at December 31, 2001 and 2000 are summarized in the following table:
(1)
Includes other - consumer loans 	
The contractual maturities of loans receivable outstanding (shown net of deferred fees and costs) as of December 31, 2001 are summarized below:
(1)
Includes other - consumer loans 	
The Company monitors the relationship of fixed and variable rate loans and interest bearing liabilities in order to minimize interest rate risk. The Company’s loans are predominately variable rate. Residential real estate loans that are reflected as variable rate include loans that have a fixed rate of interest for an initial period after origination, typically two to three years, after which the interest rate will then be adjusted at each six month interval thereafter.
Note E - Residual Interests in Securitizations
In 1999, the Company securitized $1,411,383,000 of its residential real estate loans in three separate transactions. The remaining unpaid principal balance outstanding of the loans sold into these securitizations was $562,551,000, $1,000,410,000 and $1,288,832,000 as of December 31, 2001, 2000 and 1999, respectively. These loans carried a weighted average coupon rate of 10.10%, 10.36% and 9.94%
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
at December 31, 2001, 2000 and 1999, respectively. The following are the primary assumptions used in the valuation of the residual interests as of December 31, 2001:
The outstanding balance of the Company’s residual interests in the securitizations was $41.8 million as of December 31, 2001 and $52.1 million as of December 31, 2000. The amounts and timing of the cash flows to the Company from the securitizations are estimated after considering various economic and other factors, including prepayment speeds and delinquency, default and loss rates. To allow for variations in the determination of fair value, the Company recognized in 2000, as a charge against other non-interest income, a reduction in the valuation of its residual interests in the amount of $5.2 million.
Note F - Income Taxes
The major components of income tax expense (benefit) are summarized in the following table:
The significant change in state income tax in 2000, as compared to 2001 and 1999, is a result of a decision to increase by $5.8 million an accrual for certain pending state tax issues. In 2001, $4.7 million of the accrued amounts was reversed as a result of the expected favorable resolution of certain of these matters.
A reconciliation of the effective federal tax rates in the consolidated statements of operations with the prevailing federal income tax rate of 35% is summarized in the following table:
Net payments made (net cash received) for federal and state income taxes were $2,917,000, $(5,068,000), and $(12,132,000) for 2001, 2000, and 1999, respectively. In 2000, the Company received a refund of taxes paid in prior years and on deposit with the Internal Revenue Service (“IRS”) totaling
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$5,001,000. Included in 1999 tax payments is $9.1 million paid in settlement of an IRS review of tax losses carried back against prior years’ taxes paid. The majority of the amount paid was offset by an increase to the Company’s tax effect of its net loss carryforward as determined by the IRS in its review and is included in the Company’s total tax effect of net loss carryforwards of $220,828,000. Additionally, there was $1.4 million paid to the California Franchise Tax Board in 1999 in resolution of certain ongoing tax matters. These tax settlements had been accrued for in prior years. There exist certain California Franchise Tax matters pending resolution, of which the Company is not yet able to make a determination of their ultimate liability. The Company does not believe that the actual outcomes of these matters, which are expected to take several years to resolve, will have a material effect on the Company’s financial position or results of operations.
The deferred income tax balance includes the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and for income tax purposes. The components of the Company’s deferred tax assets as of December 31, 2001 and 2000 are summarized in the following table:
The Company’s principal deferred tax assets arise due to the net operating loss (“NOL”) carryforward, the discounting of liabilities for loss and loss adjustment expenses (“loss reserves”) which delays a portion of the loss reserve deduction for income tax purposes, the provision for doubtful loss accounts, certain accrued expenses, the accrual of dividends to policyholders, and certain employee benefit expenses. The majority of the Company’s NOL carryforward was generated in tax years 2000 and 1999, resulting primarily from the losses recognized in the Company’s discontinued insurance operations. (See Note P.) Additional NOL carryforward amounts were generated through amendments of prior years’ tax returns as well as the previously described settlement with the IRS in its review of certain tax losses carried back against prior years’ tax returns filed by the Company. At December 31,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2001, the Company’s net tax loss carryforwards totaled $631.0 million, which expire in years 2015 through 2021.
In assessing the realization of deferred income tax assets, the Company considers whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of deferred income tax assets depends upon the generation of future taxable income during the periods in which temporary differences become deductible. In the Company’s opinion, the deferred tax assets will be fully realized and no valuation allowance is necessary as the Company has the ability to generate sufficient future taxable income to realize the tax benefits. If future income is not generated as expected, a valuation allowance may need to be established.
Note G - Deposits
Deposits are insured by the FDIC and are summarized below by type with respective interest rate ranges as of December 31:
The certificates of deposit outstanding at December 31, 2001, mature as follows (dollars in thousands):
The table below summarizes the Company’s certificates of deposit as of December 31, 2001, which are in amounts of $100,000 or more, by maturity and by type.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Interest expense on deposits is summarized as follows:
Note H - Short-Term Debt
FIL is a member of the Federal Home Loan Bank system (“FHLB”) and at December 31, 2001 and 2000, had a borrowing capacity of $956.1 million and $449.2 million, respectively, with outstanding borrowings of $309 million and none, respectively, from the FHLB of San Francisco. FIL has pledged loans with a carrying value of $1,255.8 million and $812.0 million at December 31, 2001 and 2000, respectively, to secure any future borrowings. FIL’s borrowing capacity can be used to borrow under various FHLB loan programs, including adjustable and fixed-rate financing, for periods ranging from one day to 30 years, with a variety of interest rate structures available. The weighted average interest rate on the amount outstanding at December 31, 2001 was 1.75%. The borrowing capacity has no commitment fees or cost, requires minimum levels of investment in FHLB stock ($32.2 million and $7.3 million at December 31, 2001 and 2000, respectively), and can be withdrawn by the FHLB if there is any significant change in the financial or operating condition of FIL and is conditional upon its compliance with certain agreements covering advances, collateral maintenance, eligibility and documentation requirements. At December 31, 2001 and 2000, FIL was in compliance with all requirements.
In 1999, FIL obtained a line of credit with the Federal Reserve Bank of San Francisco, and at December 31, 2001 and 2000 had a borrowing capacity of $125.8 million and $168.8 million, respectively, with no outstanding borrowings or activity during 2001 or 2000. FIL has pledged loans with a carrying value of $167.8 million and $225.1 million at December 31, 2001 and 2000, respectively to the Federal Reserve. This line of credit is provided when all other sources of funds are not reasonably available, and such advances are made with the expectation that they will be repaid when the availability of the usual source of funds is restored, usually the next business day.
Note I - Long-Term Debt
Long-term debt is summarized in the following table:
In 1999, Fremont issued $425,000,000 of Senior Notes (“the Senior Notes”) that consist of $200,000,000 and $225,000,000 7.70% Senior Notes due 2004 and 7.875% Senior Notes due 2009, respectively. Total proceeds to Fremont were approximately $420,237,000. The Senior Notes may be redeemed at any time in whole or in part before maturity, but are not subject to sinking fund payments.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
These notes are unsecured senior indebtedness of Fremont ranking equally with Fremont’s existing and future unsubordinated indebtedness. Interest is payable on the notes semi-annually in March and September. During 2001, Fremont repurchased $8,500,000 and $27,000,000 par value of the 7.7% Senior Notes due 2004 and 7.875% Senior Notes due 2009, respectively with carrying values of $8,465,000 and $26,628,000 resulting in an extraordinary gain of $4,990,000, net of taxes of $3,093,000. During 2000, the Company repurchased $40,875,000 and $7,300,000 par value of the 7.7% Senior Notes due 2004 and 7.875% Senior Notes due 2009, respectively with carrying values of $40,626,000 and $7,194,000 resulting in an extraordinary gain of $12,024,000, net of taxes of $7,329,000.
In 1993, Fremont sold in a public offering an aggregate $373,750,000 principal amount at maturity of Liquid Yield Option Notes due October 12, 2013 (Zero Coupon-Subordinated) (the “LYONs”) at an issue price of $372.42 for a total net proceeds of approximately $135,000,000. The yield to maturity is 5% with no periodic payments of interest. Each LYON is convertible into 38.5735 shares of Fremont’s common stock and was non-callable for five years. Holders converted aggregate principal amounts of $20,000 and $3,654,000 of LYONs into 1,000 and 141,000 shares of Fremont’s common stock during 2000 and 1999, respectively. In addition, during 2000, $2,264,000 of outstanding LYONs with a carrying value of $1,166,000 were repurchased resulting in an extraordinary gain of $394,000, net of taxes.
The carrying amounts and the estimated fair values of long-term borrowings at December 31, 2001 are summarized in the following table:
Total interest payments were $254,594,000, $260,151,000, and $238,135,000 in 2001, 2000 and 1999, respectively. These payments represent interest expense on deposits of the industrial bank, short-term debt, long-term debt (excluding LYONs) and the Preferred Securities discussed in Note J.
Note J -
Company Obligated Mandatorily Redeemable 	Preferred Securities of Subsidiary Trust Holding Solely Company 	Junior Subordinated Debentures
In 1996, Fremont General Financing I, a statutory business trust (the “Trust”) and consolidated wholly-owned subsidiary of Fremont, sold $100 million of 9% Trust Originated Preferred SecuritiesSM (“the Preferred Securities”) in a public offering. The Preferred Securities represent preferred undivided beneficial interests in the assets of the Trust. Holders of the Preferred Securities are entitled to receive cumulative cash distributions at an annual rate of 9% of the liquidation amount of $25 per Preferred Security, payable quarterly. The proceeds from the sale of the Preferred Securities were invested in 9% Junior Subordinated Debentures of Fremont (“the Junior Subordinated Debentures”). The Junior Subordinated Debentures are the sole asset of the Trust.
The Preferred Securities will be redeemed upon maturity of the Junior Subordinated Debentures in 2026, subject to the election available to Fremont to extend the maturity up to 2045, and they may be redeemed, in whole or in part, at any time on or after March 31, 2001 and under certain specified circumstances. Fremont has the right to defer payments of interest on the Junior Subordinated Debentures, at any time, for up to 20 consecutive quarters. If interest payments on the Junior Subordinated Debentures are so deferred, distribution on the Preferred Securities will also be deferred.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Junior Subordinated Debentures rank pari passu with Fremont’s LYONs, and are subordinate and junior to all senior indebtedness of Fremont. (See Note I.) Payment of distributions out of cash held by the Trust, and payments on liquidation of the Trust or the redemption of the Preferred Securities are guaranteed by Fremont to the extent that the Trust has funds available to make such payments. Trust distributions of $9,000,000 in 2001, 2000 and 1999 were included in interest expense on long-term debt.
Note K - Stockholders’ Equity and Restrictions
Fremont is authorized to issue up to 2,000,000 shares of $.01 par value preferred stock; however, none has been issued.
During 2001 and 2000, Fremont issued 359,000 and 758,000 common shares with a fair value of $2,057,000 and $3,693,000 to fund employee benefit and stock-based compensation programs.
Stock award plans are provided for the benefit of certain key members of management that authorizes up to 11,609,000 shares of either stock rights or stock options to be allocable to participants. An aggregate of 917,500 and 2,195,000 shares of restricted stock were awarded at a weighted average fair value of $5.18 and $5.38 in 2000 and 1999, respectively; however, none were awarded in 2001. Restricted stock awards are generally amortized over 10 years. Amortization expense amounted to $6,814,000, $8,694,000 and $7,283,000 for 2001, 2000 and 1999, respectively. Unamortized amounts are reported as deferred compensation in the consolidated balance sheet.
During the years 1993 to 1997, stock options were granted at exercise prices equal to the fair value of the stock on the date of grant. Grantees vested at the rate of 25% per year beginning on the first anniversary of the grant that expire after ten years. Stock option grants are accounted for in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Because the exercise price of the options equaled the fair value of the stock on the date of the grant, no compensation expense was recognized. Pursuant to SFAS No. 123 (“SFAS 123”) “Accounting for Stock-Based Compensation,” the pro forma effects on both basic and diluted net loss per share, calculated as if the recognition and measurements provisions of SFAS 123 had been adopted, would have increased the loss per share by $0.02 for both years ended December 31, 2000 and 1999. For the year ended December 31, 2001, the pro forma basic and diluted earnings per share would not have changed. The pro forma effects are not likely to be representative of the effects on reported net income for future years because SFAS 123 has not been applied to options granted prior to January 1, 1995.
The Black-Scholes option pricing method was used to value the options as of the grant date with the following assumptions: risk-free interest rate of 5.68%; expected life of 7 years; expected volatility of 23% and expected dividend yield of 1.13%.
The stock option activity is summarized in the following table:
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The exercise prices of the option shares outstanding at December 31, 2001 range from $7.16 to $14.94. The weighted average remaining contractual life is 2.67 years for the 343,602 option shares that range from $7.16 to $7.84 per share and 5.13 years for the 1,388,000 option shares that range from $14.00 to $14.94 per share.
The number of shares exercisable at the end of the year and related weighted average exercise prices are summarized in the following table:
The portion of the consolidated stockholders’ equity represented by Fremont’s investment in its subsidiaries is subject to various laws and regulations, whereby amounts available for payment of dividends may be restricted. In December of 2000, FIL transferred, by way of dividend, all of its rights and obligations in one of its securitization transactions to Fremont General Credit Corporation (“FGCC”). FGCC is a wholly-owned subsidiary of Fremont. The dividend was comprised of the carrying value of the residual interest in the securitized loans plus servicing advance reimbursements receivable related to the securitization transaction. In January of 2001, FIL transferred, via dividend, all of its rights and obligations in its two remaining securitization transactions to FGCC.
Unrealized gains or losses on investment securities available-for-sale are included in other comprehensive income.
The components of total comprehensive income (loss) are summarized in the following table:
Note L - Employee Benefit Plans
The Company sponsors a 401(k) Plan and an Employee Stock Ownership Plan (“ESOP”) that covers substantially all employees with at least one year of service. Contribution expense for these plans amounted to $3,701,000, $4,173,000 and $5,735,000 for 2001, 2000 and 1999, respectively, of which $1,163,000, $2,721,000 and $2,941,000 related to the ESOP. Cash contributions to the ESOP, which relate to 2001, 2000 and 1999, were $2,753,000, $2,453,000 and $1,178,000, respectively. The contributions, which are generally discretionary, are based on total compensation of the participants.
Until January 2000 when Fremont paid off the bank loan to the ESOP, the ESOP had been leveraged. Shares that had been pledged as collateral had been reported as deferred compensation in the consolidated balance sheet. The annual contributions made by Fremont to the ESOP were used to repay the loan. As the debt was repaid, shares were released from collateral and were allocated to participants based on total compensation. Dividends received by the ESOP on its pledged shares amounting to $36,000 and $174,000 in 2000 and 1999, respectively, were also used to service these loans. Interest expense was $14,000 and $187,000 for 2000 and 1999, respectively.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2001 all 4,512,000 shares of Fremont stock owned by the ESOP were allocated to participants. Unearned shares acquired prior to January 1, 1993 were accounted for in accordance with the historical cost approach. Unearned shares acquired after December 31, 1992 were accounted for in accordance with the current fair value approach and were not considered outstanding for earnings per share purposes.
Note M - Commitments and Contingencies
The Company is a defendant in a number of legal actions arising primarily from claims made under insurance policies. Those actions have been considered in establishing the Company’s reported liabilities. Management and its legal counsel are of the opinion that the settlement of those actions will not have a material effect on the Company’s financial position or results of operations.
Total rental expense for 2001, 2000 and 1999, was $5,096,000, $5,421,000, and $6,363,000, respectively. The Company leases office facilities and certain equipment under non-cancelable operating leases, the terms of which range from one to ten years. Certain leases provide for an increase in the basic rental to compensate the lessor for increases in operating and maintenance costs. The leases also provide renewal options.
Under present leases, rental commitments are summarized in the following table (thousands of dollars):
FIL engages in whole loan sales, substantially all of which were residential real estate loans, and which were made without recourse, except for standard representations and warranties. Management believes that any liability related to the breach of these standard representations and warranties would not be significant.
At December 31, 2001 and 2000, FIL had total loan commitments of $835 million and $953 million, respectively, substantially all of which were related to commercial real estate loans pending funding or advances under existing loan agreements.
See Note P - Discontinued Insurance Operations, regarding Fremont’s commitment to provide capital to the discontinued workers’ compensation insurance subsidiaries.
Note N - Industrial Bank Regulatory Capital
FIL is required to maintain certain capital ratios. Failure to maintain these ratios would severely limit FIL’s ability to support its business growth and pay dividends, and would increase the amount of its FDIC insurance premiums. At December 31, 2001 and 2000, FIL is categorized as well-capitalized. There have been no conditions or events since December 31, 2001 that management believes would
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
change that categorization. The minimum ratios to be well-capitalized or adequately capitalized and FIL’s actual regulatory capital and ratios were as follows (thousands of dollars):
Note O - Disposition
On December 20, 1999, the Company sold its commercial finance subsidiary, Fremont Financial Corporation (“FFC”), to FINOVA Capital Corporation, a subsidiary of The FINOVA Group, Inc. The selling price was approximately $708 million in cash and assumption of existing debt. The sale resulted in a $10.3 million gain before taxes that is included in other non-interest income in the consolidated statement of operations for the year ended December 31, 1999. At the date of sale, FFC had $701 million of assets, year-to-date revenues of $82.1 million and $9.0 million of income before taxes. The operating results of FFC were consolidated until the date of sale.
Note P - Discontinued Insurance Operations
In the fourth quarter of 2001, the Company discontinued its property and casualty insurance operation, which was primarily represented by the underwriting of workers’ compensation insurance policies. The Company will attempt to sell the premium renewal rights (new business) of its workers’ compensation insurance operation (“Fremont Comp”) and transfer most of the organization and facilities to a third party. The Company is currently in negotiations with another organization to accomplish this, but cannot yet predict a final resolution. Since making the decision to discontinue the workers’ compensation insurance operation, Fremont Comp has continued to write new business in an attempt to retain the value of the organization as negotiations are actively pursued. Fremont Comp intends to cease to accept new business upon completion of a transfer of premium renewal rights to a third party or, failing such a transfer, during the second quarter of 2002. As of December 31, 2001, the Company believes that Fremont Comp’s workers’ compensation insurance loss and loss adjustment expenses (“LAE”) reserves are adequate and the Company intends to allow the liabilities (primarily loss and LAE reserves) related to this business to run-off and estimates that the dedicated assets (primarily cash, investment securities, and reinsurance recoverables) supporting these operations, and all related future cash inflows, will be adequate to fund future policy obligations. As a result, the property and casualty insurance operation is accounted for as a discontinued operation using the liquidation basis of accounting as prescribed under APB Opinion No. 30.
In March 2002, Fremont reached an understanding in principal with the California Department of Insurance (“DOI”), which is subject to being finalized in a written agreement, that would allow Fremont Comp to self-administer the run-off of policies currently in force by paying claims and operating expenses in the ordinary course of business, discount its workers’ compensation insurance loss and LAE reserves for statutory purposes at 5.5% for all accident years, and would ensure the protection of Fremont’s net operating loss carryforwards attributable to Fremont Comp. The agreement would also preserve Fremont’s interest in the ultimate realizable equity, if any, of Fremont Comp. Under the
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
agreement, Fremont would make additional capital contributions of $7.25 million each year for three years beginning with 2002 (currently Fremont is obligated under an agreement with the DOI dated November 27, 2000 to pay $6 million per year for each of those years). Beginning in 2005 and through 2008, Fremont would have a contingent payment obligation to make capital contributions of up to $13.25 million each year (for 2005, the $6 million obligation under the agreement with the DOI dated November 27, 2000 would no longer be applicable). The extent, if any, of these contingent support obligations would be dependent upon the deemed adequacy each year of Fremont Comp’s statutory surplus and workers’ compensation insurance loss and LAE reserves. Thus, the contingent capital contributions would be subject to future payment only if in any subject year that statutory surplus and loss reserves were deemed to be inadequate. As of December 31, 2001, the Company believes that Fremont Comp’s workers’ compensation insurance loss and LAE reserves are adequate and that Fremont Comp’s investment portfolio, and other assets, are sufficient to fund all future policy obligations.
During the period 1986 to 1991, the Company discontinued all of its assumed reinsurance operations, as well as certain other insurance operations. These operations consisted primarily of facultative and treaty reinsurance covering primary and excess property and casualty insurance coverages.
The Company’s life insurance subsidiary entered into reinsurance and assumption agreements with a reinsurer whereby substantially all of the subsidiary’s universal life insurance business was ceded to the reinsurer effective December 31, 1995, and all the annuity business was ceded to the reinsurer effective January 1, 1996. As a result of these agreements, the life insurance subsidiary essentially terminated its operating activities. Since these operations were previously included in the property and casualty insurance segment, the residual life insurance operations are now included in discontinued insurance operations.
Discontinued insurance operations are accounted for using the liquidation basis of accounting whereby all future cash inflows and outflows are considered in determining whether dedicated assets are sufficient to meet all future obligations. The adequacy of the assets dedicated to fund the liabilities of discontinued operations is determined by: (i) estimating the ultimate remaining liabilities; (ii) discounting these liabilities using estimates of payment patterns and investment yields derived from the dedicated investment portfolio; and (iii) comparing and limiting this discounted estimate of liabilities to the dedicated assets. The estimated liabilities for loss and LAE include the accumulation of estimates for losses and claims reported prior to the balance sheet dates, estimates (based primarily on projections of historical developments) of claims incurred but not reported and estimates of expenses for investigating and adjusting all incurred and unadjusted claims. These amounts, prior to discounting, are management’s best estimates of the ultimate costs of settlement, net of subrogation and salvage recoveries, which are necessarily subject to the inherent variability of future changes in economic, legal and social conditions. The effective discount rate used in estimating the reserves for loss and LAE as of December 31, 2001, for purposes of discontinued operations and liquidation basis accounting was less than the statutory rate of 5.5%.
Statements of financial condition and results of operations for the discontinued insurance operations are as follows (the statement of results of operations for 2001 is for the period ended September 30,
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2001; effective October 1, 2001, the liquidation basis of accounting was adopted upon the classification of the property and casualty insurance operation as discontinued):
Statutory surplus for all discontinued insurance operations, as reported for regulatory purposes, and giving effect to the permitted practice which allows Fremont Comp to discount its loss and LAE reserves, was $48.8 million and $230.4 million at December 31, 2001 and 2000, respectively. Upon adopting the liquidation basis of accounting for its discontinued property and casualty insurance operations, the Company increased its reserves for loss and LAE by $137 million on an undiscounted basis. The Company then discounted its property and casualty insurance loss and LAE reserves. The increase in the loss and LAE resulted primarily from the effects of an increase in the gross loss and LAE reserves under workers’ compensation insurance policies. This increase was determined through an evaluation of several factors, including increased severity trends observed for accident years 2000 and prior, and the ongoing uncertainty within the workers’ compensation industry as to the underlying causes and consequent ultimate impact of both increased claim severity and an acceleration in the payment of claims. The increased severity experienced by the Company, as well as a continuing industry-wide acceleration in paid losses over the past several years, has resulted in significant increases in the projection of total industry-wide losses and LAE. This variability was considered in determining that the dedicated assets supporting its discontinued insurance operations, and all related future cash inflows, will be adequate to fund future policy obligations. At December 31, 2001, for the discontinued property and casualty insurance operation, the dedicated assets exceeded the discounted estimate of loss and LAE reserves and other liabilities by approximately $121 million. This amount is a result of the fact that no gain on the discontinued insurance operations can be recorded until such time as realization is certain.
Reinsurance recoverables on unpaid losses represent estimates of that portion of the estimated liabilities for loss and LAE that will be recovered after the balance sheet date from various reinsurers under contracts of reinsurance in place for current and prior years and are necessarily subject to the impact of future changes in economic and social conditions, as well as other various factors. Reinsurance contracts do not relieve the discontinued insurance subsidiaries of its obligations to its policyholders. The failure of reinsurers to meet their obligations in a timely and complete manner could have an adverse
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
impact upon the discontinued insurance operations. The Company evaluates the financial condition and economic characteristics of its reinsurers in an effort to minimize its exposure to reinsurer failures. As of December 31, 2001, Gerling Global Reinsurance Corporation of America (“Gerling”) was the only reinsurer that accounted for more than 10% of the total reinsurance recoverables. Gerling represented approximately 30% of such recoverables on that date. The effect of ceded reinsurance on loss and LAE for the discontinued property and casualty insurance operations was a decrease in expenses of $119.6 million, $235.0 million and $344.7 million for the three years ended December 31, 2001, 2000 and 1999, respectively. The discontinued property and casualty insurance operations had in place excess of loss reinsurance for new and renewal workers’ compensation insurance policies with effective dates of January 1, 2001, or after, that assumes liability for up to a maximum of $299.75 million of loss and certain LAE in excess of $250,000 per loss occurrence.
The significant net loss from discontinued insurance operations during 2000 was the result of increases in the gross liability for loss and LAE totaling $450.0 million under workers’ compensation insurance policies, $267.8 million of charges related to the restructuring of the workers’ compensation insurance operation, and $44.1 million of other non-recurring charges. The increase in the loss and LAE of $450.0 million recognized in 2000 resulted primarily from the effects of a significant increase in the gross loss and LAE reserves under workers’ compensation insurance policies effective in or prior to 1999. This reserve action was determined through an evaluation of several factors, including increased severity trends observed subsequent to December 31, 1999 relating to the 1999 and prior accident years, increased variability of actuarial indications, and increased uncertainty within the workers’ compensation industry as to the underlying causes and consequent ultimate impact of both increases in claim severity and an acceleration in the payment of claims. These severity increases covered both medical and indemnity costs, and was above levels adjusted for estimated inflation. The frequency of claims, however, was observed to have remained stable or slightly lower. The increasing severity on the 1999 accident year, coupled with a continuing industry-wide acceleration in paid losses observed by the Company, resulted in significant increases in the projections of total industry-wide losses and LAE. Paid losses by the property and casualty insurance subsidiaries attributable to workers’ insurance policies were
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$809.7 million, $847.3 million and $872.4 million for the three years ended December 31, 2001, 2000 and 1999, respectively.
The amortized cost and fair value of cash and invested assets of the discontinued operations as of December 31, 2001 are summarized in the following table:
The amortized cost and fair value of fixed maturity investments at December 31, 2001 by contractual maturity, are summarized in the following table:
The contractual maturities in the foregoing table may differ from actual maturities because certain borrowers have the right to sell or repay obligations with or without call or prepayment penalties. Most of the mortgage-backed securities provide for periodic payments through their lives. The average maturity of the fixed income portfolio was 4.89 years at December 31, 2001. During 2001, the investment yield earned, excluding realized gains and losses, on the average investment securities of the discontinued insurance operations, was 7.13%.
External rating agencies are utilized to establish quality ratings for its investments. As of December 31, 2001, all investments held by the discontinued insurance operations are current as to principal and interest, with no investment in default. Concentrations of credit risk for the discontinued insurance operations is generally limited due to the large number of such investments and their distribution across many different industries and geographic regions. Investments at amortized cost included in fixed maturity investments and non-redeemable preferred stock that in total exceed 10% of consolidated stockholders’ equity at December 31, 2001 are summarized in the following table:
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Using Standard & Poor’s, Moody’s and Fitch’s rating services, the quality mix of the discontinued insurance operations investment portfolio at December 31, 2001 is summarized in the following table (using Standard & Poor’s and Fitch’s rating scale):
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note Q - Parent Company Only Condensed Financial Statements
CONDENSED BALANCE SHEETS
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED STATEMENTS OF OPERATIONS
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CONDENSED STATEMENTS OF CASH FLOWS
Note R - Operations by Reportable Segment
In the fourth quarter of 2001, the Company discontinued its property and casualty insurance segment. The Company’s business is now engaged in one reportable segment; financial services. Additionally, there are certain corporate revenues and expenses, comprised primarily of investment income, interest expense and certain general and administrative expenses, that are not allocated to its reportable segment.
The following data for the years ended December 31, 2001, 2000 and 1999 provide certain information necessary for reportable segment disclosure, as well as a reconciliation to total consolidated
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
financial information. Interest revenue is reported net of interest expense. This net interest revenue is used to assess segment performance.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note S - Earnings Per Share
Earnings per share have been computed based on the weighted average number of shares. The following table sets forth the computation of basic and diluted earnings per share:
For additional disclosures regarding the LYONs, the stock options and restricted stock see Notes I and K.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Note T - Quarterly Results of Operations (Restated) (Unaudited)
The quarterly results presented below have been restated and differ from amounts previously reported in Form 10-Q due to the reclassification of the property and casualty insurance segment to discontinued insurance operations.
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The loss from discontinued insurance operations in the quarter ended June 30, 2000 was predominately the result of increases in the gross liability for loss and loss adjustment expenses totaling $450.0 million under workers’ compensation insurance policies.
The quarter ended December 31, 2000 includes $267.8 million of charges to discontinued insurance operations related to the restructuring of the workers’ compensation insurance operation in addition to $44.1 million of other non-recurring charges.
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, on the 29th day of March 2002.
FREMONT GENERAL CORPORATION 	
By:
/s/ PATRICK E. LAMB 	
Patrick E. Lamb 	
Title:
Senior Vice President, Controller and 	
Principal Accounting Officer 	
(Principal Accounting Officer) 	
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated.