ITEM 1.
BUSINESS
The disclosures and explanations included in this Form 10-K do not include the impact particularly of the March 2009 Restructuring as described in “Overview - Recent Developments - March 2009 Restructuring” and the Amendment to Bosco Servicing Agreement as described in “Overview - Recent Developments - Amendment to Bosco Servicing Agreement.”
Overview
Recent Developments
March 2009 Restructuring. Effective March 31, 2009, Franklin Credit Holding Corporation (“Franklin Holding”), and certain of its wholly-owned direct and indirect subsidiaries (together with Franklin Holding, the “Company”), including Franklin Credit Management Corporation (“FCMC”) and Tribeca Lending Corp. (“Tribeca”), entered into a series of agreements (collectively, the “Restructuring Agreements”) with The Huntington National Bank (the “Bank” or “Huntington”), successor by merger to Sky Bank, pursuant to which the Company’s loans, pledges and guarantees with the Bank and its participating banks were substantially restructured, and approximately 83% of the Company’s portfolio of subprime mortgages was removed from the Company’s balance sheet and transferred to the balance sheet of Huntington Capital Financing, LLC (the “REIT”), a real estate investment trust wholly-owned by the Bank (the “Restructuring”). In connection with the Restructuring, the Company has engaged in a number of cost savings measures, including across the board salary reductions and reductions in staff that should result in improved financial performance of FCMC.
As a result of the Restructuring and the corporate reorganization that took effect December 19, 2008, FCMC is a viable, financially sound servicing company within the Franklin group of companies, with positive net worth and 30% of its equity free from the pledges to the Bank. In addition, FCMC has enhanced its ability to profitably grow its servicing business through the expected addition of third-party servicing contracts.
From the perspective of the Company and its stockholders, the Restructuring accomplished a number of overarching objectives, including:
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entry into a market-rate servicing agreement with the Bank enabling FCMC, which houses the Company’s servicing business, to generate fee income from servicing the Portfolio;
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release of 30% of the equity in FCMC from the Company’s pledges to the Bank, with the possibility of release of up to an additional 50% based on cash collections from servicing of the Portfolio over the next five years;
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entry into an amended $13.5 million credit facility with the Bank, including a $5 million draw facility; a $2 million revolving facility; and, a $6.5 million letter of credit facility to support various servicer licenses; and
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enabling of FCMC to seek additional third-party sub-servicing contracts in order to capitalize on its servicing and collection expertise and build its servicing revenue stream.
In order to accomplish these objectives, the Company (a) gave up ownership of a portion of FCMC, ranging from a minimum of 20% to a maximum of 70%, to the Bank at maturity of the Company’s legacy credit agreement with the Bank; (b) transferred 10% of its ownership of FCMC to the Company’s principal stockholder, Thomas Axon, for obtaining guaranties and pledges as a condition of the Restructuring, with a potential increase of an additional 10% to 20% upon the attainment of certain collection targets set by the Bank; and (c) agreed to a tax-free transfer of the Company’s tax basis in the loans and real estate owned properties that were transferred to the Bank.
The key attributes of the Restructuring, as they relate to the Company’s legacy indebtedness to the Bank, include:
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83% of the Portfolio was removed from the Company’s balance sheet and replaced by common shares and approximately $482 million of preferred shares in a Huntington National Bank REIT (together, the “REIT Securities”) having, in the aggregate, a value intended to approximate the fair market value of the portfolio transferred to the Bank as of March 31, 2009. The preferred shares have an annual cumulative dividend of 9%;
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principal and interest payments on approximately $1.4 billion of the legacy debt owed to the Bank and its participant banks are only due and payable to the extent of (a) dividends declared and paid on the REIT shares and 70%, or potentially less with a maximum reduction to 20%, of the amounts distributed by FCMC to Franklin Holding; (b) distributions made by the trust on the participant banks’ trust certificates from collections on the collateral; (c) any proceeds received from any other collateral; and/or (d) upon maturity or default; and
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the Bank’s recourse against FCMC and the Company under the legacy credit agreement is limited to 20% to 70% of FCMC’s common equity, based on amounts collected over time by FCMC’s servicing of the Portfolio. The Bank also will be entitled to receive 70% of the income distributions and dividends from FCMC, which may be reduced to 20% based on amounts collected from servicing of the portfolio, which will be used to make interest and/or principal payments on the debt owed to the Bank.
The Restructuring did not include approximately $41 million of the Company’s debt, which remains subject to the original terms of the debt agreements.
The servicing agreement, which can be terminated by the Bank for any reason and at any time, has an initial term of three years, which may be extended for one or two additional one-year periods, at the sole discretion of the Bank. During the term of the servicing agreement, FCMC may not enter into any other third-party servicing agreements to service any other assets that could likely impair its ability to service the Portfolio without the consent of the Bank, which cannot be unreasonably withheld.
The restructured debt consists of: approximately $857 million at an interest rate of one month LIBOR plus 2.25%; approximately $410 million at an interest rate of one month LIBOR plus 2.75%; and, approximately $125 million at an interest rate of 15%. The Company will not be required to make scheduled principal payments, although all amounts received in excess of accrued interest will be applied to reduce the debt outstanding. All remaining principal and interest will be due and payable at maturity of the legacy credit agreement, which on March 1, 2012. Based on the current cash flows described above, it is not expected that the Company will be able to repay any remaining principal and interest due on March 1, 2012. Under such circumstances, the Bank would have all available rights and remedies under the Legacy Credit Agreement.
In conjunction with the Restructuring, and at the request of the Bank, effective March 31, 2009, the Company exercised its right to terminate two non-amortizing fixed-rate interest rate swaps with the Bank, one with a notional amount of $150 million and the other with a notional amount of $240 million. The total termination fee for cancellation of the swaps was $8.2 million, which is payable only to the extent cash is available under the waterfall provisions of the Legacy Credit Agreement, and only after the first $857 million of debt has been paid in full. See “Management’s Discussion and Analysis - Borrowings - Forbearance Agreements with Lead Lending Bank.”
Amendment to Bosco Servicing Agreement. On May 28, 2008, Franklin entered into various agreements (the “Servicing Agreements”) to service on a fee-paying basis approximately $245 million in residential home equity line of credit mortgage loans for Bosco Credit LLC (“Bosco”). As of May 28, 2008, the membership interests in Bosco were held by Thomas J. Axon, Franklin’s Chairman and President, who owns and controls Bosco. The loans that are subject to the Servicing Agreements were acquired by Bosco on May 28, 2008, and the financing for Bosco was provided by a group of lenders led by the bank. Huntington no longer participates in the Bosco facility, but remains the administrative agent for the lenders to Bosco. Franklin also provided the loan analysis, due diligence and other services for Bosco on a fee-paying basis for the loans acquired by Bosco.
On February 27, 2009, the Company entered into an amendment (the “Amendment”) to the Bosco Servicing Agreements, dated as of May 28, 2008, by and between Franklin Credit and Bosco. The Amendment revises the order of priority of distributions to be made by the administrative agent for Bosco’s lenders. Specifically, the Amendment provides that, for the next 12 months, Franklin’s monthly servicing fee will be paid only after a monthly loan modification fee of $29,167 is paid to Bosco’s lenders. Additionally, the Amendments provide that, on each monthly payment date, if the aggregate amount of net collections is less than $1 million, 25% of Franklin’s servicing fee will be paid only after certain other monthly distributions are made, including, among other things, payments made by Bosco to repay its third-party indebtedness. The term of this provision is indefinite. If the amount of collections is not sufficient to make the required payments in any given month, the unpaid servicing fees due to Franklin, or portions thereof, will accrue and become due and payable the next month or in future months.
As used herein, except for the descriptions in “Recent Development - March 2009 Restructuring,” references to the “Company,” “FCHC,” “Franklin,” “we,” “our” and “us” refer to Franklin Credit Holding Corporation, collectively with its subsidiaries.
Going Concern Uncertainty
The Company has been and continues to be operating in an extraordinary and difficult environment, and has been significantly and negatively impacted by the unprecedented credit and economic market turmoil and most recently the recessionary economy. Particularly impacting Franklin has been the severe deterioration in the U.S. housing market and the nearly complete shutdown of the mortgage credit market for borrowers without excellent credit histories, and more recently the slowing economy with increasing unemployment. These unprecedented market conditions have adversely affected the Company’s portfolio of residential mortgage loans, particularly our second-lien mortgage loans, delinquencies, provisions for loan losses, operating losses and cash flows, which have resulted in a significant stockholders’ deficit of $464.5 million at December 31, 2008. The Company, under the terms of the Forbearance Agreements with its lead lending bank, has been since the latter part of 2007 expressly prohibited from acquiring or originating loans, and certain existing defaults under the Company’s existing credit facilities with the bank have been temporarily waived until the maturity of the forbearance agreements in May 2009. In addition, the Company’s Forbearance Agreements with The Huntington National Bank (“Huntington” or the “bank”), which are described below, contain affirmative covenants that the Company maintain and comply in all material respects with all governmental licenses and authorizations to hold and service mortgage loans and real estate owned properties. Any Forbearance Default under the Forbearance Agreements, or failure to successfully renew the Forbearance Agreements or enter into new credit facilities with Huntington prior to the scheduled maturity of the Forbearance Agreements in May 2009, could entitle Huntington to declare the Company’s indebtedness immediately due and payable and could result in the transfer of the Company’s rights as servicer of its loans (loans pledged to Huntington) to a third party. As a result, and based on the March 2009 Restructuring described above in “Recent Developments,” without the continued cooperation and assistance from Huntington, the consolidated FCHC’s ability to continue as a viable business is in doubt, and it may not be able to continue as a going concern. See “Management’s Discussion and Analysis - Borrowings - Forbearance Agreements with Lead Lending Bank - Recent Development - March 2009 Restructuring.”
Operating Losses and Stockholders’ Deficit
The Company had a net loss of $476.3 million for the twelve months ended December 31, 2008. The net loss for the year ended December 31, 2008 was driven principally by provisions for loan losses as the Company’s portfolios of residential 1-4 family loans continued to deteriorate throughout the year, and by a significant excess of interest-bearing liabilities over interest-paying loans, both of which are the result of the Company’s significant amount of delinquent residential 1-4 family loans. At December 31, 2008, approximately 57% and 48% of the Company’s borrowers were delinquent on a contractual and recency basis, respectively. As a result, the Company’s aggregate net interest income (interest income less interest expense) and non-interest income was not sufficient to support its general and administrative expenses. The significant provisions for loan losses of $458.1 million during the year ended December 31, 2008 was due principally to
the continued, substantial deterioration in the housing and subprime mortgage markets and, more recently, the slowing economy with increasing unemployment and the significant further deterioration in the performance of the Company’s portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, which resulted in significantly increased estimates of inherent losses in its portfolios and the need for substantial increases in reserves throughout the year. The Company had stockholders’ deficit of $464.5 million at December 31, 2008. The continuing deterioration in the U.S. housing market, including generally continuing housing price declines and the severe contraction of available mortgage credit for consumers without excellent credit histories, and most recently coupled with the recessionary economy and rapidly rising unemployment, likely will continue to widen the mismatch of the Company’s excess of interest-bearing borrowings over interest-paying loans and further negatively impact the credit quality of the Company’s portfolios. This likely would result in decreased net interest income, additional significant provisions for loan losses and increased operating losses in future quarters. See “Management’s Discussion and Analysis - Year Ended December 31, 2008 Compared to Year Ended December 31, 2007.” See “Risk Factors - Risks Related to Our Business.”
Licenses to Service Loans and December 2008 Corporate Reorganization
The requirements imposed by state mortgage finance licensing laws vary considerably. In addition to the requirement for a license to engage in mortgage origination and brokerage activities, many mortgage licensing laws impose a licensing obligation to service residential mortgage loans. Further, certain state collection agency licensing laws require entities collecting on current, delinquent or defaulted loans for others or to acquire such loans to be licensed as well. Once these licenses are obtained, state regulators impose additional ongoing obligations on licensees, such as maintaining certain minimum net worth or line of credit requirements. Generally, net worth is determined on a GAAP basis with the minimum net worth varying from state to state. The highest state minimum net worth requirement is $250,000. Further, in limited instances, the net worth calculation may not include recourse on any contingent liabilities. If the Company does not, among other things, meet these minimum net worth or line of credit requirements, state regulators may revoke or suspend the Company’s licenses and prevent the Company from continuing to service loans in such states, which would adversely affect the Company’s operations and financial condition and ability to attract new servicing customers.
The Company’s deficit net worth during 2008 resulted in the Company’s noncompliance with the requirements to maintain certain licenses in approximately 21 states. At that time, the regulators in these states could have taken a number of possible corrective actions in response to the Company’s non-compliance, including license revocation or suspension, requirement for the filing of a corrective action plan, denial of an application for a license renewal or a combination of the same, in which case the Company’s business would have been adversely affected. As a consequence of its deficit net worth, the Company was contacted by four state regulators to address its noncompliance with state laws. In October 2008, the Company was notified of such noncompliance by the state of West Virginia and, as a result, entered into an Assurance of Voluntary Compliance with the state’s Commissioner of Banking to assure the state that, as of November 30, 2008, the Company would meet the state’s statutory minimum net worth requirement of $250,000. In November 2008, the state of Ohio issued a Notice of Intent to Refuse Renewal unless the Company explained how it would meet the state’s minimum net worth requirement of $50,000. On December 2, 2008, the state of Washington notified the Company that the processing of its collection agency license renewal was being delayed pending the state’s review of the Company’s off-balance sheet liabilities to its corporate affiliate. Finally, on January 14, 2009, the state of Wisconsin issued the Company a Letter of Reprimand that cited its failure in 2008 to maintain the minimum net worth required of mortgage bankers registered in the state.
In order to address these and other issues, in December 2008, the Company completed a reorganization of its company structure for the principal purpose of restoring the required minimum net worth under the Company’s licenses to ensure that the Company is able to continue to service mortgage loans. Effective December 19, 2008, Franklin Credit Holding Corporation (“Franklin Holding”) became the parent company of Franklin Credit Management Corporation in the adoption of a holding company form of organizational structure. This reorganization (the “Reorganization”) resulted in Franklin Credit Management Corporation,
which holds the Company’s servicing platform, having positive net worth as a result of having assigned and transferred to a newly formed sister company ownership of the entities holding beneficial ownership of the Company’s loan portfolios and the related indebtedness and accordingly, being able to comply with applicable net worth requirements to maintain licenses to service and collect loans in various jurisdictions; and, is expected to enhance the Company’s ability to grow its servicing business and take advantage of other corporate restructuring opportunities should they become available. Other than the difference in their names, the certificate of incorporation, by-laws, authorized capital stock, outstanding capital stock, board of directors and officers of Franklin Holding are the same as those of Franklin Credit Management Corporation prior to the reorganization. No post-merger exchange of stock certificates was necessary, and the outstanding shares of Franklin Credit Management Corporation common stock have been automatically converted into an equal number of shares of Franklin Holding common stock. Franklin Holding’s common stock will continue to be quoted on the Pink Sheets under the symbol “FCMC.PK.”
The business operations and financial condition of the Company taken as a whole, including Franklin Credit Management Corporation, which holds the servicing platform, on a consolidated basis, including the Company’s consolidated substantial negative net worth, did not change as a result of the Reorganization. However, the resulting financial condition of Franklin Credit Management Corporation changed, inasmuch as it had a positive net worth at December 31, 2008.
Upon its compliance with the state’s minimum net worth requirement as a result of the Reorganization, the Company’s West Virginia license was renewed on December 30, 2008. Ohio terminated its Notice of Intent to Refuse Renewal on January 8, 2009. The state of Wisconsin also noted that the Company had tangible net worth in excess of $250,000 by December 31, 2008. As of the date of this filing, the Company’s net worth issue is still pending with the state of Washington. In addition to these four states, the Company may also be subject to future regulatory action in three other states, Michigan, Illinois and Massachusetts, because in those states the net worth calculation may not include recourse on any contingent liabilities, which would cause the Company’s net worth to be deemed negative by those states. In the summer of 2008, the Company formed a wholly-owned subsidiary, Franklin Credit Loan Servicing, LLC, a Delaware limited liability company, which does not have any liabilities or pledged assets and, therefore, is expected to become licensed in those three states and in the event that such states determine that FCMC does not meet the applicable net worth requirements, Franklin Credit Loan Servicing, LLC would, upon licensure, service loans in such states so that the Company overall has the required licenses to operate in all 50 states. While the Company believes that the required consent and cooperation of Huntington for the continued positive capitalization of this servicing subsidiary, and any other changes the Company determines to implement, which would enable the Company to retain its servicing and debt collection licenses with all or most states, would be obtained, there can be no assurance that such consents will be obtained and that the Company will be able to retain these licenses. If the Company fails to maintain its state licenses in good standing, the Company will breach its Forbearance Agreements with The Huntington National Bank. The Forbearance Agreements contain affirmative covenants that the Company maintain and comply in all material respects with all governmental licenses and authorizations to hold and service mortgage loans and real estate owned properties. If the Company breaches such covenants, which it did in 2008 by not complying with the minimum net worth requirements of certain states as described above, or Huntington determines that there has been a material adverse affect on the Company’s business and, in either instance, notice of the same is provided to the Company by Huntington, which Huntington has not as of the date of this filing provided to the Company, any such noticed event would be a default under the Forbearance Agreements, which would entitle Huntington to declare the Company’s indebtedness immediately due and payable and transfer the Company’s rights as servicer to a third party.
Delisting - The Nasdaq Capital Market
Our common stock was delisted from The Nasdaq Capital Market as of November 3, 2008, and is quoted under the stock symbol “FCMC.PK” on the “Pink Sheets,” a centralized quotation service for over-the counter securities. The Company is seeking to encourage brokers to arrange for its common stock to be quoted on the Over-The-Counter Bulletin Board. Prior to November 3, 2008, the Company’s common stock traded on The Nasdaq Capital Market. See “Risk Factors - Risks Related to Our Business.”
Franklin’s Business
We are a specialty consumer finance company that was, until December 28, 2007, primarily engaged in two related lines of business: (1) the acquisition, servicing and resolution of performing, reperforming and nonperforming residential mortgage loans and real estate assets; and (2) the origination of subprime mortgage loans, both for our portfolio and for sale into the secondary market. We specialized in acquiring and originating loans secured by 1-4 family residential real estate that generally fell outside the underwriting standards of Fannie Mae and Freddie Mac and involved elevated credit risk as a result of the nature or absence of income documentation, limited credit histories, higher levels of consumer debt or past credit difficulties. We typically purchased loan portfolios at a discount, and originated subprime loans with interest rates and fees calculated to provide us with a rate of return adjusted to reflect the elevated credit risk inherent in the types of loans we acquired and originated. Unlike many of our competitors, we generally held for investment the loans we acquired and a significant portion of the loans we originated. From inception through December 31, 2008, we had purchased and originated in excess of $4.73 billion in 1-4 family residential mortgage loans. As of December 31, 2008, we had total assets of $1.02 billion, our portfolios of notes receivable and loans held for investment, net totaled $882.6 million, and we had a stockholders’ deficit of $464.5 million.
In the past year, we have been seeking to begin providing services for third parties, on a fee-paying basis, which are directly related to our servicing operations and our portfolio acquisition experience with residential mortgage loans. We are actively seeking to (a) expand our servicing operations to provide servicing and collection services to third parties, particularly specialized collection services, and (b) capitalize on our experience to provide customized, comprehensive loan analysis and in-depth end-to-end transaction and portfolio management services to the residential mortgage markets. Some of these services include, in addition to servicing loans for others, performing 1-4 family residential portfolio stratification and analysis, pricing, due diligence, closing, and collateral transfer. These new business activities are subject to the consent of the bank, and we may not be successful in entering into or implementing any of these businesses in a meaningful way.
On May 28, 2008, Franklin entered into various agreements (the “Servicing Agreements”) to service on a fee-paying basis approximately $245 million in residential home equity line of credit mortgage loans for Bosco Credit LLC (“Bosco”). As of May 28, 2008, the membership interests in Bosco were held by Thomas J. Axon, Franklin’s Chairman and President, who owns and controls Bosco. The loans that are subject to the Servicing Agreements were acquired by Bosco on May 28, 2008, and the financing for Bosco was provided by a group of lenders led by the bank. Huntington no longer participates in the Bosco facility, but remains the administrative agent for the lenders to Bosco. Franklin also provided the loan analysis, due diligence and other services for Bosco on a fee-paying basis for the loans acquired by Bosco.
On December 28, 2007, Franklin entered into a series of agreements (the “Forbearance Agreements”) with The Huntington National Bank, successor by merger in July 2007 to Sky Bank (Sky Bank, prior to the merger, and Huntington, thereafter, are referred to as the “bank”), whereby the bank agreed to restructure approximately $1.93 billion of the Company’s indebtedness to it and its participant banks, forgave $300 million of such indebtedness for a restructuring fee of $12 million paid to the bank, and waived certain existing defaults (the “Restructuring”). See “Management’s Discussion and Analysis - Borrowings.” In November 2007, Franklin ceased to acquire or originate loans and, under the terms of the Forbearance Agreements, the Company is expressly prohibited from acquiring or originating loans.
On March 31, 2008, the Company entered into amendments to the Forbearance Agreements whereby, among other things, (a) Tribeca’s indebtedness to BOS (USA) Inc. ($44.8 million as of December 31, 2007) was effectively rolled into the Forbearance Agreements, resulting in the payoff and retirement of Tribeca’s debt facilities with BOS (USA) Inc. and BOS acquiring a participation interest under the Forbearance Agreements; and (b) the interest rate and date of commencement of the accrual of PIK interest on approximately $125 million of the Company’s indebtedness was modified as of March 31, 2008. See “Management’s Discussion and Analysis - Borrowings - Forbearance Agreements with Lead Lending Bank - March 2008 Modifications to Forbearance Agreements and Refinancing of BOS Loan.”
The Company entered into additional amendments to the Forbearance Agreements, effective August 15, 2008, whereby, among other things, (a) the minimum net worth covenant was eliminated, (b) the prescribed interest coverage ratios based on EBITDA were changed to ratios based on actual cash flows, and (c) the existing extension of an additional period of forbearance through July 31, 2008 in respect of the remaining Unrestructured Debt was extended to December 31, 2008, and absent the occurrence of an event of default, the bank agreed not to initiate collection proceedings against the Company in respect of any of the Unrestructured Debt. See “Management’s Discussion and Analysis - Borrowings - Forbearance Agreements with Lead Lending Bank - August 2008 Modifications to Forbearance Agreements.”
Concurrent with the Reorganization, the Company entered into a series of agreements with Huntington, its lead lending bank, which included, among other amendments, guaranties of the indebtedness to Huntington by various new entities in the Company’s structure and Huntington waiving the Company’s breach of its covenant to comply with all laws, rules and regulations to the extent such breach resulted from the Company’s failure to satisfy a minimum net worth requirement prior to the reorganization. In addition, the bank provided an extension of our period of forbearance until May 15, 2009 in respect of the remaining Unrestructured Debt. See “Management’s Discussion and Analysis - Borrowings - Forbearance Agreements with Lead Lending Bank - December 2008 Modifications to Forbearance Agreements.”
The Company had a net loss of $476.3 million for the twelve months ended December 31, 2008. The net loss for the year ended December 31, 2008 was driven principally by provisions for loan losses as its portfolios of residential 1-4 family loans continued to deteriorate throughout the year, and due to a significant excess of interest-bearing liabilities over interest-paying loans, both of which are the result of the Company’s significant amount of delinquent residential 1-4 family loans. Due principally to the continued and substantial deterioration in the housing and subprime mortgage markets, and most recently, the slowing economy with increasing unemployment and the resultant deterioration in the performance of the Company’s portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, the Company’s estimates of inherent losses in its portfolios continued to increase. As a result, the provision for loan losses increased to $458.1 million during the year ended December 31, 2008, compared with $274.6 million for the year 2007. See “Management’s Discussion and Analysis - Year Ended December 31, 2008 Compared to Year Ended December 31, 2007.”
As a result of the Forbearance Agreements entered into on December 28, 2007 with the bank, the Company’s principal business and operational activity during 2008 and as of December 31, 2008 is the servicing of its acquired and originated mortgage loans and real estate assets. Accordingly, discussions in this Form 10-K regarding loan acquisition and mortgage origination operations are of a historical nature, referring to those activities that the Company actively engaged in prior to entering into the Forbearance Agreements.
All disclosures and explanations included in this Form 10-K must be read in light of the Forbearance Agreements, the March 2009 Restructuring and the changed nature of the Company’s business.
Loan Servicing
We have invested heavily to create a loan servicing capability that is focused on collections, loss mitigation and default management. In general, we seek to ensure that the loans we service are repaid in accordance with the original terms or according to amended repayment terms negotiated with the borrowers. Because we expect our loans will experience above average delinquencies, erratic payment patterns and defaults, our servicing operation is focused on maintaining close contact with our borrowers and as a result, is more labor-intensive than traditional mortgage servicing operations. Through frequent communication we are able to encourage positive payment performance, quickly identify those borrowers who are likely to move into seriously delinquent status and promptly apply appropriate loss mitigation strategies. Our servicing staff employs a variety of collection strategies that we have developed to successfully manage serious delinquencies, bankruptcy and foreclosure. Additionally, we maintain a real estate department with experience in property management and the sale of residential properties.
Due Diligence Services
During the first quarter of 2008, capitalizing on our portfolio acquisition experience with residential mortgage loans, the Company began providing services for third parties not related to us or our lender, on a fee-paying basis. During 2008, we completed 13 due diligence or loan analysis and pricing assignments for third parties interested in acquiring mortgage loan pools, and in addition to the subservicing contract with Bosco, we obtained a very small subservicing contract to service loans for one of our due diligence services customers.
Loan Acquisitions
We are not seeking to acquire for the Company, and we did not acquire for the Company during 2008, any mortgage loans or mortgage assets.
Since commencing operations in 1990, and until December 28, 2007, we had become a nationally recognized buyer of portfolios of residential mortgage loans, both first and second-lien loans, and real estate assets from a variety of financial institutions in the United States, including mortgage banks, commercial banks and thrifts, other traditional financial institutions and other specialty finance companies. These portfolios generally consisted of one or more of the following types of mortgage loans:
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performing loans - loans to borrowers who are contractually current, but may have been delinquent in the past and which may have deficiencies relating to credit history, loan-to-value ratios, income ratios or documentation;
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reperforming loans - loans to borrowers who are not contractually current, but have recently made regular payments and where there is a good possibility the loans will be repaid in full; and
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nonperforming loans - loans to borrowers who are delinquent, not expected to cure, and for which a primary avenue of recovery is through the sale of the property securing the loan.
We sometimes refer collectively to these types of loans as “scratch and dent” or “S&D” loans.
We refer to the S&D loans we acquired as “notes receivable.” In 2007, we purchased notes receivable with an aggregate unpaid principal balance of $528.7 million at an aggregate purchase price equal to 83% of the face amount of the notes. Approximately 49% of the unpaid principal balance of the loans purchased was secured by first liens on residential 1-4 family properties; the remaining 51% was secured by second liens on residential properties.
Loan Originations
We are not seeking to originate for the Company, and we did not originate for portfolio or sale to others during 2008, any mortgage loans.
Until December 28, 2007, we conducted our loan origination business through our wholly-owned subsidiary, Tribeca Lending Corp. (“Tribeca”), which we formed in 1997 in order to capitalize on our experience in evaluating and servicing scratch and dent residential mortgage loans. We originated primarily subprime residential mortgage loans to individuals with serious financial difficulties and whose documentation, credit histories, income and other factors caused them to be classified as subprime borrowers and to whom, as a result, conventional mortgage lenders often would not make loans (“Liberty Loans”). The loans we originated typically carried interest rates that were significantly higher than those of prime loans and we believed had fairly conservative loan-to-value ratios at the time of origination. The principal factor in our underwriting guidelines was historically our determination of the borrower’s equity in his or her home and the related calculation of the loan-to-value ratio based on the appraised value of the property, and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan. In 2005, we began in an increasing number of cases to gather and analyze additional information that allowed us to assess to a reasonable degree the borrower’s ability and intent to repay the loan in connection with our credit decision. Throughout the first nine months of 2007, we made several credit tightening adjustments and/or modifications to our subprime loan origination programs, principally in response to the rapidly changing mortgage
origination and housing markets. We chose to focus our marketing efforts on this segment of the 1-4 family residential real estate mortgage market in order to capitalize on our experience in acquiring and servicing loans with similar credit risk characteristics.
In 2007, we originated $291.6 million in subprime mortgage loans, 89% of which were adjustable-rate (fixed-rate for the first two years) loans. We originated approximately 32% of our mortgage loans on a retail basis, and the remainder through our wholesale network of mortgage brokers. We hold the majority of mortgages we originated in our portfolio and have sold the remainder for cash in the whole-loan market.
As with loans we acquired, borrowers of loans we originated are a diverse population and no single borrower represents a significant portion of our loans. Our borrowers are located in 31 states, with approximately 55% of the aggregate amount of loans originated in 2007 being secured by property in New York and New Jersey. At December 31, 2008, approximately 59% of originated loans held for investment were secured by property in New York and New Jersey.
Financing
We historically financed both our acquisitions of mortgage loan portfolios and our loan originations through various long and short-term borrowing arrangements with Sky Bank, with which we had a strong relationship since the early 1990s.
In October 2004, we consolidated all of our arrangements with the bank relating to the term funding of loan acquisitions under a Master Credit and Security Agreement (“Master Credit Facility”). Under this Master Credit Facility, which had been extended to November 30, 2007, we requested loans to finance the purchase of pools of residential mortgage loans or refinance existing outstanding loans.
In the first quarter of 2006, Tribeca and certain of its subsidiaries entered into a Master Credit and Security Agreement (referred to as “Tribeca Master Credit Facility”) with the bank pursuant to which Tribeca could borrow term funds to finance originated loans temporarily financed under its Warehouse Facility. In the first quarter of 2006, Tribeca also entered into a $100 million Master Credit and Security Agreement with BOS (USA) Inc., an affiliate of the Bank of Scotland; $98 million under this facility was used to consolidate and refinance term loans previously made to Tribeca by the bank.
On December 28, 2007, Franklin entered into Forbearance Agreements with the bank, which substantially modified the borrowing arrangements summarized above and expressly terminated fundings for new acquisitions and originations under these credit facilities. See “Management’s Discussion and Analysis - Borrowings.”
Corporate History
We were formed in 1990 by, among others, Thomas J. Axon, our Chairman and President, and Frank B. Evans, Jr., one of our directors, for the purpose of acquiring consumer loan portfolios from the Resolution Trust Company, or RTC, and the Federal Deposit Insurance Corporation, or FDIC. We became a public company in December 1994, when we merged with Miramar Resources, Inc., a publicly traded oil and gas company that had emerged from bankruptcy proceedings in December 1993. The newly formed entity was renamed Franklin Credit Management Corporation. At the time of the merger, we divested substantially all of the remaining oil and gas assets directly owned by Miramar in order to focus primarily on the non-conforming sector of the residential mortgage industry. At that time, we decided to capitalize on our experience and expertise in acquiring and servicing loans from the RTC and the FDIC and began purchasing performing, reperforming and nonperforming residential mortgage loans from additional financial institutions. In 1997, we formed Tribeca to originate subprime residential mortgage loans.
December 2008 Corporate Reorganization
Franklin Credit Holding Corporation (“Franklin Holding,” and together with its direct and indirect subsidiaries, the “Company”) is the successor issuer to Franklin Credit Management Corporation, a Delaware corporation (the “Predecessor” or “FCMC”).
On December 19, 2008, the Company engaged in a series of transactions (the “Reorganization”) in which the Company:
(i) adopted a holding company form of organizational structure, with Franklin Holding serving as the new public-company parent;
(ii) transferred all of the equity and membership interests in FCMC’s direct subsidiaries to other entities in the reorganized corporate structure of the Company;
(iii) assigned legal record ownership of any loans in the Company’s portfolios held directly by FCMC and Tribeca Lending Corporation, a direct, wholly-owned subsidiary of FCMC (“Tribeca”), to other entities in the reorganized corporate structure of the Company; and,
(iv) amended its loan agreements with The Huntington National Bank (“Huntington”), its lead lending bank.
In the Reorganization, FCMC became a subsidiary of Franklin Holding and ceased to have any subsidiaries.
The Reorganization is expected to:
•
result in various licensing authorities evaluating FCMC’s servicing platform’s compliance with applicable license requirements (including net worth requirements) without reference to the loan portfolios and related indebtedness of the other entities in the reorganized corporate structure of the Company, and accordingly, with positive net worth; and,
•
enhance the Company’s flexibility to potentially grow its servicing business and take advantage of other corporate restructuring opportunities should they become available.
The business operations and financial condition of the Company, including the Company’s substantial negative net worth, did not change as a result of the Reorganization. However, by divesting itself of its subsidiaries, including those which are borrowers under the Company’s lending agreements with Huntington, FCMC’s financial condition changed from substantial negative net worth to positive net worth.
The Company’s common stock will continue to be quoted on the pink sheets under the symbol “FCMC.PK.”
Holding Company Structure
The Predecessor adopted a holding company form of organizational structure pursuant to the Agreement and Plan of Merger, by and among the Predecessor, Franklin Merger Sub, Inc., a Delaware corporation (“Merger Sub”), and Franklin Holding, dated as of December 19, 2008 (the “Merger Agreement”). To implement the Merger Agreement, the Predecessor filed a Certificate of Merger (the “Certificate of Merger”) with the Secretary of State of the State of Delaware on December 19, 2008.
The holding company organizational structure was adopted by means of a merger implemented in accordance with Section 251(g) of the Delaware General Corporation Law (the “DGCL”), which provides for the formation of a holding company structure without a vote of the stockholders of the constituent corporations. Pursuant to the terms of the Merger Agreement, Merger Sub merged with and into the Predecessor (the “Merger”), with the Predecessor being the surviving corporation. As a result of the Merger, which was consummated on December 19, 2008 (the “Effective Time”), the Predecessor became a direct, wholly-owned subsidiary of Franklin Holding.
In accordance with terms of the Merger Agreement:
(i) each share of common stock of the Predecessor (the “Predecessor Common Stock”) issued and outstanding immediately prior to the Merger was converted into a share of common stock of Franklin Holding (“Franklin Holding Common Stock”) having the same designations, rights, powers and preferences, and qualifications, limitations and restrictions thereof, as the share of Predecessor Common Stock so converted; and,
(ii) each share of capital stock of Merger Sub issued and outstanding immediately prior to the Merger was converted into a share of common stock of the Predecessor.
Except for certain amendments to the certificate of incorporation of the Predecessor effected in accordance with Section 251(g) of the DGCL in conjunction with the Merger, the provisions of the certificate of incorporation of Franklin Holding, including its authorized capital stock and the designations, rights, powers and preferences of such capital stock, and the qualifications, limitations and restrictions thereof, are identical to those of the Predecessor immediately prior to the Merger. As a result, no post-Merger exchange of stock certificates was made and outstanding shares of Predecessor Common Stock were automatically converted into shares of Franklin Holding Common Stock.
The provisions of the bylaws of Franklin Holding following the Merger are identical to the provisions of the bylaws of the Predecessor in effect immediately prior to the Merger. The directors of Franklin Holding immediately after the Merger are the same individuals as were directors of the Predecessor immediately prior thereto. The management of Franklin Holding following the Merger is the same as the management of the Predecessor immediately prior to the Merger. Similarly, FCMC continues after the Reorganization to have the same officers and directors that it had prior to the Reorganization.
The Company believes that the Merger qualifies as a tax-free reorganization under Section 351 of the Internal Revenue Code of 1986, as amended, and, as a result, the stockholders of the Predecessor will not recognize gain or loss for United States federal income tax purposes.
Separation of Serving Platform from Loan Portfolios
Concurrent with the Merger and the Company’s reorganization into a holding company structure, the Company took the following actions (the “Reallocation of Owned Assets”):
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assigned legal record ownership of all loans in the Company’s portfolio held directly by FCMC to Franklin Credit Trust Series I, a newly formed Delaware Business Trust (the “Franklin Trust”), of which Deutsche Bank National Trust Company serves as Certificate Trustee, Deutsche Bank Trust Company Delaware serves as Delaware Trustee and solely for purposes of perfecting its security interest, Huntington is the record certificate holder;
•
assigned legal record ownership of all loans in the Company’s portfolio held directly by Tribeca to Tribeca Lending Trust Series I, a newly formed Delaware Business Trust (the “Tribeca Trust,” and together with the Franklin Trust, the “Trusts”), of which Deutsche Bank National Trust Company serves as Certificate Trustee, Deutsche Bank Trust Company Delaware serves as Delaware Trustee and solely for purposes of perfecting its security interest, Huntington is the record certificate holder;
•
transferred to Franklin Credit Asset Corporation, a newly formed Delaware corporation and direct subsidiary of Franklin Holding (“Franklin Asset”) all of FCMC’s equity interests in any subsidiary of FCMC (other than Tribeca) that directly or indirectly holds beneficial interests in any of the loans in the Company’s portfolio and are the borrowers under the Company’s lending agreements with Huntington (together with Tribeca, the “Borrowers”);
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transferred to Franklin Holding all of FCMC’s equity interests in Tribeca; and,
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transferred to Franklin Holding all of FCMC’s membership interests in Franklin Credit Loan Servicing, LLC (“Franklin Servicing LLC”).
In connection with the Reallocation of Owned Assets, FCMC and Tribeca entered into a Master Trust Agreement, dated as of December 15, 2008 with Deutsche Bank National Trust Company and Deutsche Bank Trust Company Delaware.
Servicing
Except for a temporary period after acquiring a pool of loans when servicing may have been performed for us by the seller, we service substantially all of the loans in our portfolio, including both purchased and
originated loans, until resolution. At December 31, 2008, our servicing department consisted of 159 employees who managed 30,058 active loans. In addition, at December 31, 2008, we serviced approximately 2,686 home equity loans for Bosco. Our servicing operations are conducted in the following departments:
Loan Boarding and Administration. The primary objective of the loan boarding department is to ensure that newly acquired loans under contracts to service for others are properly transitioned from the prior servicer and are accurately boarded onto our servicing systems. Our loan boarding department audits loan information for accuracy to ensure that the loans conform to the terms provided in the original note and mortgage. The information boarded onto our systems provides us with a file that we use to automatically generate introductory letters to borrowers summarizing the terms of the servicing transfer of their loan, among other standard industry procedures.
The loan administration department performs typical duties related to the administration of loans, including incorporating modifications to terms of loans. The loan administration department also ensures the proper maintenance and disbursement of funds from escrow accounts and monitors non-escrow accounts for delinquent taxes and insurance lapses. For loans serviced with adjustable interest rates, the loan administration group ensures that adjustments are properly made and identified to the affected borrowers in a timely manner.
Customer Service. The primary objective of our customer service department is to obtain timely payments from borrowers, respond to borrower requests and resolve disputes with borrowers. Within 10 days of boarding newly acquired loans onto our servicing system, our customer service representatives contact each new borrower to welcome them to Franklin Credit Management Corporation and to gather and/or verify any missing information, such as loan balance, interest rate, contact phone numbers, place of employment, insurance coverage and all other pertinent information required to properly service the loan. The customer service group responds to all inbound customer calls for information requests regarding payments, statement balances, escrow balances and taxes, payoff requests, returned check and late payment fees. In addition, our customer service representatives process payoff requests and reconveyances.
Collections. The main objective of our collections department is to ensure loan performance through maintaining customer contact. Our collections group continuously reviews and monitors the status of collections and individual loan payments in order to proactively identify and solve potential collection problems. When a loan becomes seven days past due, our collections group begins making collection calls and generating past-due letters. Our collections group attempts to determine whether a past due payment is an aberration or indicative of a more serious delinquency. If the past due payment appears to be an aberration, we emphasize a cooperative approach and attempt to assist the borrower in becoming current or arriving at an alternative repayment arrangement. Upon a serious delinquency, by which we mean a delinquency of 61 days by a borrower, or the earlier determination by our collections group based on the evidence available that a serious delinquency is likely, the loan is typically transferred to our legal department where loss mitigation begins. We employ a range of strategies to modify repayment terms in order to enable the borrower to make payments and ultimately cure the delinquency, or focus on expediting the foreclosure process so that loss mitigation can begin as promptly as practicable.
Loss Mitigation. Our loss mitigation department, which consists of non-lawyer administrative staff experienced in collection work, manages and monitors the progress of seriously delinquent loans and loans which we believe will develop into serious delinquencies. In addition to maintaining contact with borrowers through telephone calls and collection letters, this department utilizes various strategies in an effort to reinstate an account or revive cash flow on an account. The loss mitigation department analyzes each loan to determine a collection strategy to maximize the amount and speed of recovery and minimize costs. The particular strategy is based upon each individual borrower’s past payment history, current credit profile, current ability to pay, collateral lien position and current collateral value. We employ a range of strategies depending on the specific situation, including the following:
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short-term repayment plans, or forbearance plans, when a delinquency can be cured within six months;
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loan modifications, when a delinquency cannot be cured within three months but the borrower has the financial ability to abide by the terms of the loan modification;
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short sales, when the borrower does not have the ability to repay and the equity in the property is not sufficient to satisfy the total amount due under the loan, but we accept the sale price of the property in full satisfaction of the debt in order to expedite the process for all parties involved;
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deeds-in-lieu, when the borrower does not have the ability to repay and the equity in the property is not sufficient to satisfy the total amount due, but we accept the deed in full satisfaction of the debt in order to expedite the process for all parties involved;
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assumptions, when the borrower wishes to relinquish responsibility to a third party and the prospective borrower demonstrates the ability to repay the loan;
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subordinations, when we have the second lien on a property and the first-lien holder wishes to refinance its loan, to which we will agree if the terms of the refinanced loan permit the borrower to repay our loan; and,
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deferment agreements, when we forgo collection efforts for a period of time, typically as a result of a hardship incurred by the borrower, such as a natural disaster or a death or illness in the family, as a result of which the borrower is temporarily unable to repay.
Seriously delinquent accounts not resolved through the loss mitigation activities described above are foreclosed or a judgment is obtained against the related borrower in accordance with state and local laws, with the objective of maximizing asset recovery in the most expeditious manner possible. This is commonly referred to as loss management. Foreclosure timelines are managed through a timeline report built into the loan servicing system. The report schedules milestones applicable for each state throughout the foreclosure process, which enhances our ability to monitor and manage the process. Properties acquired through foreclosure are transferred to our real estate department to manage eviction and marketing or renting of the properties. However, until foreclosure is completed, efforts at loss mitigation generally are continued.
In addition, our loss mitigation department manages loans by borrowers who have declared bankruptcy. The primary objective of the bankruptcy group within our loss mitigation department, which utilizes outside legal counsel, is to proactively monitor bankruptcy assets and outside legal counsel to ensure compliance with individual plans and to ensure recovery in the event of non-compliance.
Real Estate. Our real estate department manages all properties acquired by us upon foreclosure of a delinquent loan or through purchase as part of a loan portfolio in order to preserve their value and ensure that maximum returns are realized upon sale. We own real estate, or OREO, in various states that we acquired through foreclosure, a deed-in-lieu or past portfolio purchases. These properties are 1-4 family residences, co-ops and condos. We acquire or foreclose on property primarily with the intent to sell it at fair market value to recover a portion of the outstanding balance owed by the borrower. From time to time, OREO properties may be in need of repair or improvement in order to either increase the value of the property or reduce the time that the property is on the market. In those cases, the OREO property is evaluated independently and we make a determination of whether the additional investment would increase our return upon sale or rental of the property.
Recovery. Our recovery department’s primary objective is to maximize the recovery of unpaid principal on each seriously delinquent account by offering borrowers multiple workout solutions and/or negotiated settlements. When a loan becomes severely delinquent, we begin making calls on these accounts trying to obtain settlement or long-term solutions. The recovery unit performs a complete analysis of the borrower’s financial situation, taking into consideration lien structure, in order to determine the best course of action. Based on the results of our analysis, we determine to either continue collection efforts and a negotiated workout of settlement or seek judgment. The judgment process is managed through our Judgment Tracking System to ensure the judgment action proceeds in an expeditious manner and borrower status is monitored.
Quality Control. Our quality control department monitors all aspects of loan servicing from boarding through foreclosure. It is the department’s responsibility to ensure that the company’s policies and procedures are followed. Collection calls are monitored to ensure quality and compliance with the requirements of the federal Fair Debt Collection Practices Act and state collection laws. Monthly meetings with staff to discuss
individual quality control scores are held and, in certain cases, further training is recommended. Reviews of the controls for privacy and information safeguarding and document removal are conducted monthly.
Training. Our training department works with all departments of our servicing operations to ensure that the employees of all departments are fully informed of the procedures necessary to complete their required tasks. The department ensures all loan servicing employees are trained in the tenents of the Fair Debt Collection Act as well as in effective communication skills.
Competition for Servicing Business. The mortgage servicing and related services businesses are highly competitive. Competition for distressed asset and loss mitigation servicing has intensified in the past year due to the unprecedented difficult mortgage environment and severe credit tightening, coupled with the recent recessionary economy, which has been evidenced by increasing delinquencies and defaults, eroding real estate values and government mandated modification programs. Our competitors in the subservicing space include large servicers such as Bank of America, Wells Fargo and ResCap (GMAC), established subprime loan servicers such as Litton Loan Servicing, Ocwen Financial Corp., Wilshire Credit Corp. and Select Portfolio Servicing as well as newer entrants such as Acqura Loan Services, Wingspan and Marix. Franklin’s efforts to market its ability to adequately service mortgage loans for others is more difficult than many of its competitors because (a) we have not historically provided such services to unrelated third parties, (b) we are not a rated primary or special servicer of residential mortgage loans as designated by a rating agency, such as Standard and Poor’s, and (c) our consolidated financial condition reflects operating losses and deficit net worth.
Portfolio Characteristics
Overall Portfolio
At December 31, 2008, our portfolio (excluding OREO) consisted of $1.14 billion of notes receivable (inclusive of purchase discount not reflected on the face of the balance sheet) and $395.2 million of loans held for investment. There were no loans held for sale at December 31, 2008. Our total loan portfolio declined 20% to $1.54 billion at December 31, 2008, from $1.92 billion at December 31, 2007. During the year 2008, total portfolio payments, including prepayments, approximated $142.8 million and total loans charged off approximated $124.7 million. Throughout the Portfolio Characteristics section, unless otherwise indicated or required by the context of the description, all loan amounts refer to the unpaid principal balance (“UPB”). The following table sets forth information regarding the types of properties securing our loans.
(1)
The loans included in this category are principally small balance (less than $10,000) second-lien loans acquired, and are collateralized by residential real estate.
(2)
The loans included in this category are principally second-lien loans where the Company is aware that residential real estate collateral has been foreclosed by the first-lien holder.
Geographic Dispersion. The following table sets forth information regarding the geographic location of properties securing the loans in our portfolio at December 31, 2008:
Asset Quality
Delinquency. Because we specialized in acquiring and servicing loans with erratic payment patterns and an elevated level of credit risk, a portion of the loans we have acquired were in various stages of delinquency, foreclosure and bankruptcy when we acquired them. We monitor the payment status of our borrowers based on both contractual delinquency and recency delinquency. By contractual delinquency, we mean the delinquency of payments relative to the contractual obligations of the borrower. By recency delinquency, we mean the recency of the most recent full monthly payment received from the borrower. By way of illustration, on a recency delinquency basis, if the borrower has made the most recent full monthly payment within the past 30 days, the loan is shown as current regardless of the number of contractually delinquent payments. In contrast, on a contractual delinquency basis, if the borrower has made the most recent full monthly payment, but has missed an earlier payment or payments, the loan is shown as contractually delinquent. We classify a loan as in foreclosure when we determine that the best course of action to maximize recovery of unpaid principal balance is to begin the foreclosure process. We classify a loan as in bankruptcy generally when we receive notice of a bankruptcy filing from the bankruptcy court. We classify a previously delinquent or performing loan as modified when we have restructured the loan due principally to the borrower’s deteriorated financial situation, and, as a condition to the closing of the modification, received at least one full monthly payment at the time of the closing of the modification. Modified loans are classified as current on both a contractual and recency basis at the time of the modification. As of December 31, 2008, principally all of our loan modifications consisted of the deferral of the past due and uncollected interest or a reduction in the interest rate. Interest rate reduction modifications generally are for a period of one year, and for rate reduction modifications of delinquent loans, also incorporate a deferral of the past due and uncollected interest. Approximately 20% of our modified loans as of December 31, 2008 have been modified a second time due to the borrower’s difficulty in making payments in accordance with the initial modification.
During the past several months, due to the continued decline in housing prices nationally, the deterioration in mortgage markets, and most recently the slowing economy with increasing unemployment and the increased delinquency performance of the acquired and originated loans in the Company’s portfolios, including particularly the portfolio of acquired second-lien mortgage loans, we significantly added to our servicing staff and intensified our efforts to work with borrowers to modify their loans, and have moved more quickly to identify those borrowers who are likely to move into seriously delinquent status and are attempting to promptly apply appropriate loss mitigation and deficiency strategies to encourage positive payment performance. In addition, we segregated our deficiency unit into a separate department that primarily utilizes the
filing of a judgment action in order to seek some recovery from seriously delinquent borrowers, principally defaulted borrowers of second-lien mortgage loans.
During 2008, we completed approximately $425.0 million of loan modifications (unpaid principal balance), including interest rate reduction modifications on approximately $222.9 million of loans. As of December 31, 2008, total loan modifications amounted to $388.4 million, which included approximately $211.3 million of interest rate reductions. The average interest rate reduction on the $222.9 million of rate modified loans was approximately 4.58% at December 31, 2008, from an average of approximately 11.54% to an average of approximately 6.96%. As a result, these interest rate modifications will reduce interest income by as much as approximately $8.6 million on an annualized basis. Approximately 85% of all loan modifications as of December 31, 2008 were performing loans that were delinquent on a contractual basis less than 90 days at the time of modification, including approximately 67% that were in a current status on a contractual basis and granted modifications based on our evaluation of the borrower’s deteriorated financial situation. During 2008, approximately $78.4 million of modified loans were modified a second time due to the inability of borrowers to meet the terms of the original modification agreements. At December 31, 2007, loan modifications totaled $10.5 million.
The following tables provide a breakdown of the delinquency status of our notes receivable and loans held for investment as of the dates indicated, by unpaid principal balance.
Included in the foreclosure category are approximately $189.4 million of loans for which the Company has proceeded to file a judgment action against the borrower on the note personally instead of seeking to foreclose on the related collateral. Approximately $184.2 million of these loans are second-lien loans. Judgments have been obtained on approximately $6.0 million of loans, of which approximately $5.2 million are second-lien loans.
Included in the above table are second-lien mortgage loans in our notes receivable portfolio in the amount of $754.1 million, of which $334.3 million and $371.9 million were current on a contractual and recency basis, respectively. The legal status composition of the second-lien mortgage loans at December 31, 2008 was: $344.5 million, or 46%, are performing; $110.9 million, or 15%, are modified due to delinquency or the
borrower’s financial difficulty; $55.3 million, or 7%, are in bankruptcy; and, $243.4 million, or 32%, are in foreclosure (including $189.3 million where a judgment action has been filed against the borrower on the note personally or where judgments have been obtained). At December 31, 2008, $29.3 million of the modified second-lien loans was delinquent on a contractual basis, while $24.1 million of the modified second-lien loans was delinquent on a recency basis.
During 2007, particularly during the second half of the year, and continuing throughout 2008, due to declining housing prices in general and a rapid and severe credit tightening throughout the mortgage industry, particularly for subprime borrowers, total portfolio payoffs through borrower refinancing have declined significantly as it became more difficult for borrowers with any type of credit deficiency to refinance their loans. Total portfolio payoffs declined approximately 61% in the twelve months ended December 31, 2008 from the same twelve-month period in 2007. In addition, due principally to the increase in delinquent loans in the Company’s portfolio, which at December 31, 2008 comprised approximately 57% and 48% of the total portfolio on a contractual and recency basis, respectively, total portfolio principal collections, excluding loan payoffs, declined by approximately 15% during the twelve months ended December 31, 2008 compared with the same twelve-month period in 2007.
Included in the foreclosure category are approximately $39.0 million of loans for which the Company has proceeded to file a judgment action against the borrower on the note personally instead of seeking to foreclose on the related collateral, of which approximately $35.7 million are second-lien loans. Judgments were obtained on approximately $19.4 million of loans, of which approximately $18.2 million are second-lien loans.
Notes Receivable Portfolio
As of December 31, 2008, our notes receivable portfolio, which consists of purchased loans, included approximately 22,817 loans with an aggregate UPB of $1.14 billion, compared with approximately 28,865 loans with an aggregate UPB of $1.42 billion as of December 31, 2007. Impaired loans comprise and will continue to comprise a significant portion of our portfolio. Many of the loans we have acquired were impaired loans at the time of purchase. We generally purchased such loans at discounts and have considered the payment status, underlying collateral value and expected cash flows when determining our purchase price. While interest income generally is not accrued on impaired loans, interest and fees are received on a portion of loans classified as impaired. The following table provides a breakdown of the notes receivable portfolio by year:
*
Represents purchase discount not reflected on the face of the balance sheet in accordance with SOP 03-3 for loans acquired after December 31, 2004. Accretable discount is the excess of the loan’s estimated cash flows over the purchase prices, which is accreted into income over the life of the loan. Nonaccretable discount is the excess of the undiscounted contractual cash flows over the undiscounted cash flows estimated at the time of acquisition.
The following table provides a breakdown of the balance of our portfolio of notes receivable between fixed-rate and adjustable-rate loans, net of allowance for loan losses as of December 31, 2008 and December 31, 2007:
Impaired loans comprise and will continue to comprise a significant portion of our portfolio. Many of the loans we acquired were impaired loans at the time of purchase. We generally purchased such loans at discounts and considered the payment status, underlying collateral value and expected cash flows when determining our purchase price. While interest income generally is not accrued on impaired loans, interest and fees are received on a portion of loans classified as impaired.
Lien Position. The following table sets forth information regarding the lien position of the properties securing our portfolio of notes receivable at December 31, 2008 and December 31, 2007:
Loan Acquisitions
We purchased over $528.7 million of single-family residential mortgage loans in 2007. Approximately 49% of the loans purchased in 2007 were secured by first liens. We did not purchase any loans in 2008. The following table sets forth the amounts and purchase prices of our mortgage loan acquisitions during the previous two calendar years:
Notes Receivable Dispositions
In the ordinary course of our loan servicing process and through the periodic review of our portfolio of purchased loans, there are certain loans that, for various reasons, we determine to sell. We typically sell these loans on a whole-loan, servicing-released basis, for cash. The following table sets forth our dispositions of purchased loans during the previous two calendar years. There were no sales of previously purchased loans during the twelve months ended December 31, 2008.
Tribeca’s Loan Originations
The following table sets forth Tribeca’s loan originations, as well as dispositions, during the previous two calendar years. There were no Tribeca loans originated or sold during the twelve months ended December 31, 2008.
(1)
Originated ARM loans are principally fixed-rate for the first two years and six-month adjustable-rate for the remaining term.
(2)
Included in loss on sale for 2007 are: net gain of $155,000 on the sale of Liberty Loans; a net gain of $286,000 on the sale of other loans originated for sale; a net loss of $828,000 on “Alt-A” loans both sold and transferred to portfolio at the lower of cost or market value; and a net recovery of $82,000 for previously established early payment default reserves for Liberty Loans sold in 2006.
Property Types of Originated Loans Held for Investment. At December 31, 2008, Tribeca’s portfolio consisted of 1,728 loans with an aggregate unpaid principal balance of $395.2 million of previously originated loans that are held for investment. Tribeca’s portfolio of loans held for investment declined by $110.5 million, or 22%, as of December 31, 2008, from $505.7 million at December 31, 2007. During the year 2008, total
portfolio payments, including prepayments, approximated $60.1 million. The following table sets forth information regarding the types of properties securing Tribeca’s portfolio of loans held for investment.
*
UPB before net deferred fees and allowance for loan losses.
At December 31, 2008, Tribeca did not have any loans held for sale.
Geographic Dispersion of Originated Loans Held for Investment. The following table sets forth information regarding the geographic location of properties securing all loans held for investment at December 31, 2008:
*
UPB before net deferred fees and allowance for loan losses.
Delinquency. Because we specialized in originating residential mortgage loans for individuals with credit histories, income and/or factors that caused them to be classified as subprime borrowers, a substantially greater portion of the loans we originated experience varying degrees of delinquency, foreclosure and bankruptcy than those of prime lenders. We monitor the payment status of our borrowers based on both contractual delinquency and recency delinquency. By contractual delinquency, we mean the delinquency of payments relative to the contractual obligations of the borrower. By recency delinquency, we mean the recency of the most recent full monthly payment received from the borrower. By way of illustration, on a recency delinquency basis, if the borrower has made the most recent full monthly payment within the past 30 days, the loan is shown as current regardless of the number of contractually delinquent payments. In contrast, on a contractual delinquency basis, if the borrower has made the most recent full monthly payment, but has missed an earlier payment or payments, the loan is shown as contractually delinquent. We classify a loan as in foreclosure when we determine that the best course of action to maximize recovery of unpaid principal balance is to begin the foreclosure process. We classify a loan as in bankruptcy generally when we receive notice of a bankruptcy filing from the bankruptcy court. We classify a previously delinquent or performing loan as modified when we have restructured the loan due principally to the borrower’s deteriorated financial situation, and, as a condition to the closing of the modification, received at least one full monthly payment at the time
of the closing of the modification. Modified loans are classified as current on both a contractual and recency basis at the time of the modification. As of December 31, 2008 principally all of our modified loans consisted of the deferral of the past due and uncollected interest or a reduction in the interest rate. Interest rate reduction modifications generally are for a period of one year, and for the rate reduction modifications of delinquent loans, also incorporate a deferral of the past due and uncollected interest. Approximately 29% of our modified loans as of December 31, 2008 have been modified a second time due to the borrower’s difficulty in making payments in accordance with the initial modification.
During the past year, due to the continued decline in housing prices nationally, the deterioration in mortgage markets, and more recently the slowing economy with increasing unemployment and the increased delinquency performance of the originated loans in the Company’s portfolios, we have moved more quickly to identify those borrowers who are likely to move into seriously delinquent status and are attempting to promptly apply appropriate loss mitigation strategies to encourage positive payment performance. Accordingly, we have strengthened our servicing staff and intensifying our efforts to work with borrowers to modify their loans. During 2008, we completed approximately $182.6 million of loan modifications (unpaid principal balance), including interest rate reduction modifications on approximately $86.6 million of loans. As of December 31, 2008, total loan modifications amounted to $155.3 million, which included approximately $83.5 million of interest rate reductions. The average interest rate reduction on the $86.6 million of rate modified loans was approximately 4.41% at December 31, 2008, from an average of approximately 11.45% to an average of approximately 7.05%. Approximately 82% of the modifications as of December 31, 2008 were performing loans that were delinquent on a contractual basis less than 90 days at the time of modification, including approximately 61% that were in a current status on a contractual basis and granted modifications based on our evaluation of the borrower’s deteriorated financial situation. During 2008, approximately $44.5 million of modified loans were modified a second time due to the inability of borrowers to meet the terms of the original modification agreements. At December 31, 2008, $60.6 million, or approximately 39%, of modified loans were delinquent on a contractual basis, and $40.8 million, or approximately 26%, were delinquent on a recency basis. At December 31, 2007, loan modifications were less than $1.0 million.
The following tables provide a breakdown of the delinquency status of our loans held for investment portfolio as of the dates indicated, by principal balance.
Included in the foreclosure category are approximately $446,000 of loans for which the Company has proceeded to file a judgment action against the borrower on the note personally instead of seeking to foreclose on the related collateral. Approximately $401,000 of these loans are second-lien loans. Judgments have been obtained on approximately $150,000 of loans, all of which are second-lien loans.
During 2008, as our loans held for investment, principally Liberty Loans, became more seasoned, a significant portion of our Liberty Loans were modified or moved into the foreclosure process if a modification could not be structured. At December 31, 2008, $157.5 million of Liberty Loans, or 40% of the portfolio of loans held for investment were in our foreclosure process, compared with $180.8 million, or 36%, at December 31, 2007. Our Servicing department personnel evaluates the collateral of each loan in the foreclosure process for its estimated realizable value, utilizing updated BPOs; the estimated losses on future disposition, which were included in the allowance for loan losses, aggregated approximately $30.5 million at December 31, 2008. In addition, our experience with Liberty Loans is that a percentage of the loans in the foreclosure process pay off in full, including approximately 91% of all unpaid interest due at the time of payoff, prior to actual foreclosure sale. However, during 2008, particularly during the second half of the year, due to declining housing prices in general, severe credit tightening throughout the mortgage industry and the economic recession, total portfolio payoffs through borrower refinancing declined as it became more difficult for borrowers with any type of credit deficiency to refinance their loans. Portfolio payoffs declined approximately 61% in the fourth quarter ended December 31, 2008 from the third quarter ended September 30, 2008, and approximately 21% in the third quarter ended September 30, 2008 from the prior quarter. For the year 2008, total portfolio payments, including prepayments, declined approximately 60% from the year 2007.
Other Real Estate Owned
The following table sets forth our real estate owned, or OREO, portfolio and OREO sales during the previous two calendar years:
Government Regulation
The mortgage lending industry is highly regulated. Our business is regulated by federal, state and local government authorities and is subject to federal, state and local laws, rules and regulations, as well as judicial and administrative decisions that impose requirements and restrictions on our business. At the federal level, these laws, rules and regulations include:
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the Equal Credit Opportunity Act and Regulation B;
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the Truth in Lending Act and Regulation Z;
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the Home Ownership and Equity Protection Act;
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the Real Estate Settlement Procedures Act, and Regulation X;
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the Fair Credit Reporting Act;
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the Fair Debt Collection Practices Act;
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the Home Mortgage Disclosure Act, and Regulation C;
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the Fair Housing Act;
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the Telemarketing and Consumer Fraud and Abuse Prevention Act;
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the Telephone Consumer Protection Act;
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the Gramm-Leach-Bliley Act;
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the Servicemembers Civil Relief Act;
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the Fair and Accurate Credit Transactions Act; and
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the CAN-SPAM Act.
States have also in some instances enacted their own variants of the foregoing laws, rules and regulations, especially with respect to those laws, rules and regulations that address anti-predatory lending or privacy issues.
These laws, rules and regulations, among other things:
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impose licensing obligations and financial requirements on us;
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limit the interest rates, finance charges, and other fees that we may charge;
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prohibit discrimination both in the extension of credit and in the terms and conditions on which credit is extended;
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prohibit the payment of kickbacks for the referral of business incident to a real estate settlement service;
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impose underwriting requirements;
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mandate various disclosures and notices to consumers, as well as disclosures to governmental entities;
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mandate the collection and reporting of statistical data regarding our customers;
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require us to safeguard non-public information about our customers;
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regulate our collection practices;
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require us to combat money-laundering and avoid doing business with suspected terrorists;
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restrict the marketing practices we may use to find customers, including restrictions on outbound telemarketing; and
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in some cases, impose assignee liability on us as purchaser or seller of mortgage loans as well as the entities that purchase our mortgage loans.
Our failure to comply with these laws can lead to:
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civil and criminal liability, including potential monetary penalties;
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loss of servicing licenses or approved status required for continued business operations;
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demands for indemnification or loan repurchases from purchasers of our loans;
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legal defenses causing delay and expense;
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adverse effects on our ability, as servicer, to enforce loans;
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the borrower having the right to rescind or cancel the loan transaction;
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adverse publicity;
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individual and class action lawsuits;
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administrative enforcement actions;
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damage to our reputation in the industry; or
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inability to obtain credit to fund our operations.
Although we have systems and procedures directed to compliance with these legal requirements and believe that we are in material compliance with all applicable federal, state and local statutes, rules and regulations, we cannot provide assurance that more restrictive laws and regulations will not be adopted in the future, or that governmental bodies will not interpret existing laws or regulations in a more restrictive matter, which could render our current business practices non-compliant or which could make compliance more difficult or expensive. These applicable laws and regulations are subject to administrative or judicial interpretation, but some of these laws and regulations have been enacted only recently or may be interpreted infrequently or only recently and inconsistently. As a result of infrequent, sparse or conflicting interpretations, ambiguities in these laws and regulations may leave uncertainty with respect to permitted or restricted conduct under them. Any ambiguity under a law to which we are subject may lead to non-compliance with applicable regulatory laws and regulations. We actively analyze and monitor the laws, rules and regulations that apply to our business, as well as the changes to such laws, rules and regulations.
New Areas of Regulation
Regulatory and legal requirements are subject to change, making our compliance more difficult or expensive, or otherwise restricting our ability to conduct our business as it is now conducted. In particular, federal, state and local governments have become more active in the consumer protection area in recent years. For example, the federal Gramm-Leach-Bliley financial reform legislation imposes additional privacy obligations on us with respect to our applicants and borrowers. Several states have enacted privacy laws. For example, North Dakota and Vermont privacy laws require the affirmative consent of the consumer to certain information sharing. California has two privacy laws that relate to our operations, the California Financial Information Privacy Act and the California On-Line Privacy Protection Act, both of which impose additional notification obligations on us that are not preempted by existing federal law. Other states are also considering
adopting privacy legislation. If states adopt a variety of inconsistent state privacy legislation, our compliance costs could substantially increase. The Fair and Accurate Credit Transactions Act of 2003, enacted in December 2003, requires us to provide additional disclosures when we disapprove a loan application. Additional requirements apply to our use of consumer reports and our furnishing of information to the consumer reporting agencies. Additionally, Congress and the Department of Housing and Urban Development have finalized amendments which substantially reform RESPA and impose new duties and obligations. Moreover, several federal, state and local laws, rules and regulations have been adopted, or are under consideration, that are intended to protect consumers from predatory lending and servicing practices.
Local, state and federal legislatures, state and federal banking regulatory agencies, state attorneys general offices, the Federal Trade Commission, the Department of Justice, the Department of Housing and Urban Development and state and local governmental authorities have increased their focus on lending and servicing practices by some companies, primarily in the non-prime lending industry, sometimes referred to as “predatory lending” practices. Sanctions have been imposed by various agencies for practices such as charging excessive fees, imposing higher interest rates than the credit risk of some borrowers warrant, failing to disclose adequately the material terms of loans to borrowers and abrasive servicing and collections practices. The Office of the Comptroller of the Currency, the regulator of national banks, issued a final regulation in 2004 that prescribed an explicit anti-predatory lending standard without regard to a trigger test based on the cost of the loan. This regulation prohibits a national bank from, among other restrictions, making a loan based predominately on the foreclosure value of the borrower’s home, rather than the borrower’s repayment ability, including current and expected income, current obligations, employment status and relevant financial resources. This restriction would prevent national banks and their operating subsidiaries from purchasing the variation of the Liberty Loan where no assessment is made of the borrower’s ability to repay the loan.
On May 16, 2005, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration (the “Agencies”) jointly issued “Credit Risk Management Guidance for Home Equity Lending.” The guidance promotes sound credit risk management practices for institutions engaged in home equity lending (both home equity lines of credit and closed-end home equity loans). Among other risk factors, the Guidance cautions lenders to consider all relevant risk factors when establishing product offerings and underwriting guidelines, including a borrower’s income and debt levels, credit score (if obtained), and credit history, as well as the loan size, collateral value, lien position, and property type and location. It stresses that prudently underwritten home equity loans should include an evaluation of a borrower’s capacity to adequately service the debt, and that reliance on a credit score is insufficient because it relies on historical financial performance rather than present capacity to pay. While not specifically applicable to loans originated by Tribeca, the guidance is instructive of the regulatory climate covering low and no documentation loans, such as certain of Tribeca’s Liberty Loan products.
On June 29, 2007, the Agencies released their final statement on subprime mortgage lending to address certain concerns of the Agencies that subprime borrowers may not fully understand the risk and consequences of certain adjustable-rate mortgage products. The Agencies expressed particular concern with (1) marketing products to subprime borrowers offering low initial payments based on an introductory (“teaser”) rate that is considerably lower than the fully indexed rate; (2) approving borrowers without considering appropriate documentation of their income; (3) setting very high or no limits on payment or interest rate increases at reset periods; (4) loan product features likely to result in frequent refinancing to maintain an affordable monthly payment; (5) including substantial prepayment penalties and/or prepayment penalties that extend beyond the initial rate adjustment period; and (6) providing borrowers with inadequate information relative to product features, material loan terms and products risks.
The final statement identifies underwriting standards, consumer protection principles and control systems applicable to subprime mortgage loans that focus on the importance of evaluating the borrower’s ability to repay the debt by its final maturity at the fully indexed rate and providing information that enable consumers to understand material terms, costs, and risks. The Agencies caution their regulated institutions against making mortgage loans based predominately on the foreclosure or liquidation value of a borrower’s collateral rather than on the borrower’s ability to repay the mortgage according to its terms, inducing a borrower to repeatedly
refinance a loan in order to charge high points and fees each time a loan is refinanced and engaging in fraud or deception to conceal the true nature of the mortgage loan obligation. The Agencies also advised their regulated institutions that when underwriting higher risk loans, stated income and reduced documentation should be accepted only if there are mitigating factors that clearly minimize the need for direct verification of repayment capacity. A higher interest rate is not considered a mitigating factor. While the final statement, in part, discusses subprime products not offered by Tribeca such as loans with “teaser” rates, the final statement appears to apply strict standards for all types of subprime loans and is instructive of the regulatory climate concerning subprime mortgage loans, such as Tribeca’s Liberty Loan, where the lending decision was or may have been based entirely or primarily on the borrower’s equity in his or her home and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan. In addition, as with the 2006 Interagency Guidance on Nontraditional Mortgage Product Risks for mortgages where the borrower is able to defer repayment of principal for a period of time (interest only-loans and Pay Option ARMs), state regulators have adopted similar standards applicable to the institutions they regulate, which includes Tribeca. On July 17, 2007, the American Association of Residential Mortgage Regulators (AARMR), which is comprised of state officials with responsibility for regulating state licensed mortgage lenders and brokers, in conjunction with the Conference of State Bank Supervisors (CSBS) and the National Association of Consumer Credit Regulators (NACCA), issued a statement on subprime lending that is substantially similar to the Agencies’ final statement and which, as of March 2008, has been adopted in 34 states plus the District of Columbia.
A key mortgage industry tool for finding new borrowers is under recent attack in class action litigation across the country. Those class actions have been filed by attorneys seeking to capitalize on a 2004 decision of the Seventh Circuit Court of Appeals, Cole v. U.S. Capital, Inc. (“Cole”) interpreting the meaning of “firm offers of credit” under the Fair Credit Reporting Act (“FCRA”). A prescreened or firm offer is any offer of credit to a consumer that will be honored if the consumer is determined, based on information in a consumer report on the consumer, to meet the specific criteria used to select the consumer for the offer. Cole was the first case in the nation to hold that an offer of nominal “value” to the consumer, which could arise from a combination of factors such as a low dollar amount of the offered credit, ambiguous or contradictory terms, or complex approval procedures, may not actually qualify as a “firm offer” under FCRA, even if the stated amount is guaranteed. Recent courts to address the issue have split on the issue. Some of the courts in these recent cases have concluded that the defendant’s violation of FCRA was “willful.” FCRA distinguishes negligent or inadvertent non-compliance from “willful” violations by the damages that are available. Specifically, FCRA provides for statutory damages of $100-1,000 per violation for “willful” violations and permits punitive damages as well. By contrast, FCRA provides that a defendant whose non-compliance was merely negligent will be liable only for “actual damages sustained by the consumer as a result of the failure.” This distinction is significant because FCRA does not have a cap for statutory damages in a class action, unlike other federal statutes regulating consumer lending which cap statutory damages in a class action at a maximum of $500,000 or one percent of the creditor’s net worth, whichever is less. If we are named as a defendant in a firm offer class action, and the court were to find that the violation was willful, we could face substantial liability that could have a material adverse affect on our financial condition and operations.
HOEPA identifies a category of mortgage loans and subjects such loans to restrictions not applicable to other mortgage loans. Loans subject to HOEPA consist of loans on which certain points and fees or the annual percentage rate, known as the APR, exceed specified levels. Liability for violations of applicable law with regard to loans subject to HOEPA would extend not only to us, but to the institutional purchasers of our loans as well. It was our policy to seek not to originate loans that are subject to HOEPA or state and local laws discussed in the following paragraph or purchase high cost loans that violate such laws. On October 1, 2002, the APR and points and fees thresholds for determining loans subject to HOEPA were lowered, thereby expanding the scope of loans subject to HOEPA. Non-compliance with HOEPA and other applicable laws may lead to demands for indemnification or loan repurchases from our institutional loan purchasers, class action lawsuits and administrative enforcement actions.
Laws, rules and regulations have been adopted, or are under consideration, at the state and local levels that are similar to HOEPA in that they impose certain restrictions on loans on which certain points and fees or the APR exceeds specified thresholds, which generally are lower than under federal law. These restrictions
include prohibitions on steering borrowers into loans with high interest rates and away from more affordable products, selling unnecessary insurance to borrowers, flipping or repeatedly refinancing loans and making loans without a reasonable expectation that the borrowers will be able to repay the loans. If the numerical thresholds were miscalculated, certain variations of our Liberty Loan product, where the lending decision was or may have been based entirely or primarily on the borrower’s equity in his or her home and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan, would violate HOEPA and many of these state and local anti-predatory lending laws. In the past, we have sold a portion of our Liberty Loan production to third parties on a whole-loan, servicing-released basis. Compliance with some of these restrictions requires lenders to make subjective judgments, such as whether a loan will provide a “net tangible benefit” to the borrower. These restrictions expose a lender to risks of litigation and regulatory sanction no matter how carefully a loan is underwritten. The remedies for violations of these laws are not based on actual harm to the consumer and can result in damages that exceed the loan balance. In addition, an increasing number of these laws, rules and regulations seek to impose liability for violations on assignees, which may include our warehouse lenders and whole-loan buyers, regardless of whether the assignee knew of or participated in the violation.
RESPA prohibits the payment of fees for the mere referral of real estate settlement service business. This law does permit the payment of reasonable value for services actually performed and facilities actually provided unrelated to the referral. In the past, several lawsuits have been filed against mortgage lenders alleging that such lenders have made certain payments to independent mortgage brokers in violation of RESPA. These lawsuits generally have been filed on behalf of a purported nationwide class of borrowers alleging that payments made by a lender to a broker in addition to payments made by the borrower to a broker are prohibited by RESPA and are therefore illegal. On September 18, 2002, the Eleventh Circuit Court of Appeals issued a decision in Heimmermann v. First Union Mortgage Corp., which reversed the court’s earlier decision in Culpepper v. Irwin Mortgage Corp. in which the court found the yield spread premium payments received by a mortgage broker to be unlawful per se under RESPA. The Department of Housing and Urban Development responded to the Culpepper decision by issuing a policy statement (2001-1) taking the position that lender payments to mortgage brokers, including yield spread premiums, are not per se illegal. The Heimmermann decision eliminated a conflict that had arisen between the Eleventh Circuit and the Eighth and Ninth Circuit Courts of Appeals, with the result that all federal circuit courts that have considered the issue have aligned with the Department of Housing and Urban Development policy statement and found that yield spread premiums are not prohibited per se. If other circuit courts that have not yet reviewed this issue disagree with the Heimmermann decision, there could be a substantial increase in litigation regarding lender payments to brokers and in the potential costs of defending these types of claims and in paying any judgments that might result. In addition, proposed changes by the Federal Reserve Board to HOEPA in Regulation Z (Truth in Lending), would prohibit lenders from compensating mortgage brokers through yield spread premiums on all loans secured by a consumer’s principal dwelling, unless the broker previously entered into a written agreement with the consumer disclosing the broker’s total compensation and other facts. A new RESPA rule effective on January 1, 2010 will include the yield spread premium in the calculation of the mortgage broker’s total compensation and require more detailed closing costs disclosures to be provided to consumers at the time of loan origination. The new RESPA rule might usher in a new wave of litigation when mortgage lenders and brokers are subject to new compliance parameters.
In addition, the Federal Reserve Board has approved changes to HOEPA in Regulation Z, which implements the Truth in Lending Act. Effective October 1, 2009, the amendments create protections for a new category of loans called “higher-priced mortgage loans.” Under these amendments, companies that service mortgage loans will be required to credit consumers’ loan payments as of the date of receipt. Further, the HOEPA amendments expand the types of loans subject to early disclosures. Currently, transaction-specific early disclosures are only required for purchase money mortgage loans. When the amendments take effect, the early disclosures will be required with all closed-end non-purchase money mortgage loans, such as refinancings, closed-end home equity loans and reverse mortgage loans.
Compliance, Quality Control and Quality Assurance
We maintain a variety of quality control procedures designed to detect compliance errors. We have a stated anti-predatory lending and loan servicing policy that is communicated to all employees at regular training sessions. We track the results of internal quality assurance reviews and provide reports to the appropriate managers of the Company. Our servicing practices are reviewed regularly in connection with the due diligence performed by third parties that consider outsourcing their loan servicing to us. State regulators also review our practices and loan files and report the results back to us.
Privacy
Title V of the federal Gramm-Leach-Bliley Act (“GLBA”) obligates us to safeguard the information we maintain on our borrowers and to inform borrowers of our use of their non-public personal information. In addition to the requirements of GLBA, we are subject to compliance with state privacy laws. Whereas under GLBA, a borrower is required to affirmatively “opt-out” of certain of our information sharing practices, under the privacy laws of California, Vermont and North Dakota, the borrower must affirmatively “opt-in” to the same. California passed legislation known as the California Financial Information Privacy Act and the California On-Line Privacy Protection Act. Both pieces of legislation became effective on July 1, 2004, and impose additional notification obligations on us. Regulations have been proposed by several agencies and states that may affect our obligations to safeguard information. If other states or federal agencies adopt additional privacy legislation, our compliance costs could substantially increase.
Fair Credit Reporting Act
The Fair Credit Reporting Act provides federal preemption for lenders to share information with affiliates and certain third parties and to provide pre-approved offers of credit to consumers. Congress also amended the Fair Credit Reporting Act to place further restrictions on the use of information shared between affiliates, to provide new disclosures to consumers when risk based pricing is used in the credit decision, and to help protect consumers from identity theft. All of these provisions impose additional regulatory and compliance costs on us.
As discussed above under the heading “New Areas of Regulation,” there has been significant class action activity relating to prescreened offers of credit, which is a tool we used for finding potential borrowers, when we were originating loans. Many other mortgage lenders used prescreened credit offers to obtain new borrowers. We have not been named as a defendant in such a class action. However, if we were to be named in a class action alleging a violation of the Fair Credit Reporting Act’s prescreened offer provisions, and the court were to find that the violation was willful, we could face substantial liability that could have a material adverse affect on our financial condition and operations.
Home Mortgage Disclosure Act
In 2002, the Federal Reserve Board adopted changes to Regulation C promulgated under the Home Mortgage Disclosure Act (“HMDA”). Among other things, the new regulation requires lenders to report pricing data on loans that they originate with annual percentage rates that exceed the yield on treasury bills with comparable maturities by three percent. The expanded reporting took effect in 2004 for reports filed in 2005. A majority of our loans we originated in 2004 and thereafter were subject to the expanded reporting requirements.
The expanded reporting does not include additional loan information such as credit risk, debt-to-income ratio, LTV ratio, documentation level or other salient loan features that might impact pricing on individual loans. As a result, the reported information may lead to increased litigation and government scrutiny to determine if any reported disparities between prices paid by minorities and majorities may have resulted from unlawful discrimination. For example, the Civil Rights Division of the New York State Attorney General’s office has requested that certain large lenders provide it with supplementary information to explain the disparities in their reported HMDA data.
Telephone Consumer Protection Act and Telemarketing Consumer Fraud and Abuse Prevention Act
The Federal Communications Commission and the Federal Trade Commission adopted “do-not-call” registry requirements, which, in part, mandate that companies such as us maintain and regularly update lists of consumers who have chosen not to be called for marketing purposes. These requirements also mandate that we do not call consumers who have chosen to be on the list. Those prohibitions do not apply to calls made to a servicer’s existing customers. Several states have also adopted similar laws, with which we also seek to comply.
Environmental Matters
In the ordinary course of our business, prior to November 2007, we had from time to time acquired properties securing loans that were in default. In addition, loans that we purchased in the past that were initially not in default may subsequently be defaulted on by the borrower. In either case, it is possible that hazardous substances or waste, contamination, pollutants or sources thereof could be discovered on those properties after we acquire them. To date, we have not incurred any environmental liabilities in connection with our OREO, although there can be no guarantee that we will not incur any such liabilities in the future.
Employees
We recruit, hire, and retain individuals with the specific skills that complement our corporate growth and business strategies. As of December 31, 2008, we had 220 full time employees, of which 2 were employed by Tribeca, our origination subsidiary. At December 31, 2008, we had no part-time employees.
None of our employees are represented by a union or covered by a collective bargaining agreement. We believe our relations with our employees, under the Company’s current circumstances, are good. However, under the Company’s current circumstances, retaining key employees and hiring for certain critical positions is more challenging.
ITEM 1A.
ITEM 1A.
RISK FACTORS
Risks Related to Our Business
We may experience higher loan losses than we have reserved for in our financial statements.
Our loan losses could exceed the allowance for loan losses that we have reserved for in our financial statements. Reliance on historic loan loss experience may not be indicative of future loan losses. Regardless of the underwriting criteria we utilized at the time of purchase or origination, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of our loan collateral and problems affecting the credit and business of our borrowers. As a result of the rapid and substantial deterioration in the housing and credit markets, particularly the subprime mortgage market, and deterioration in the performance of our portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, and coupled with recent recessionary economic conditions, we have in 2007 and 2008 reassessed our allowance for loan losses and significantly increased estimates of inherent losses in our portfolios, which have resulted in significantly increased allowances for loan losses during both periods. Should the housing and credit markets continue to significantly deteriorate in 2009, or the economy experiences a more severe or prolonged recession, we could experience additional increases in our allowances for loan losses and/or charge-offs.
A prolonged economic slowdown or a lengthy or severe recession could harm our operations, particularly if it results in a decline in the real estate market.
The risks associated with our business are more acute during periods of economic slowdown or recession because these periods may be accompanied by decreased real estate values, loss of jobs as well as an increased rate of delinquencies, defaults and foreclosures. In particular, any material decline in real estate values would increase the loan-to-value ratios on loans that we hold and, therefore, weaken our collateral coverage, increase the likelihood of a borrower with little or no equity in his or her home defaulting and increase the possibility
of a loss if a borrower defaults. If the current economic slowdown continues to worsen, our business could experience even greater losses.
Our credit facilities require us to observe certain covenants, and our failure to satisfy such covenants could render us insolvent.
Our credit facilities with Huntington, as modified by the Forbearance Agreements and subsequent amendments, require us to comply with affirmative and negative covenants customary for restricted indebtedness, including covenants requiring that we will: not enter into mergers, consolidations or sales of assets (subject to certain exceptions); and, will not, without the bank’s consent, enter into any material change in our capital structure that the bank or a nationally recognized independent public accounting firm determines could cause a consolidation of our assets with other persons under relevant accounting regulations. See “Management’s Discussion and Analysis - Borrowings.”
In addition, under our credit facilities, if our controlling shareholder ceasing to possess, directly or indirectly, the power to direct our management and policies through his ownership of our voting stock, this could constitute an event of default, which, without a waiver from our lender, would cause our indebtedness to become immediately payable.
Subject to notice and cure period requirements where they are provided for, any unwaived and uncured breach of the covenants applicable to our debt with either of our lenders could result in acceleration of the amounts owed to such lender and the cross-default and acceleration of the indebtedness owing to the other lender.
If our lenders fail to renew our loans for additional terms or provide us with refinancing opportunities, our indebtedness will become due and payable in 2009.
Our unpaid principal balances owed to Huntington are generally based on amortization schedules, but mature in May 2009. The facilities do not include a commitment to refinance the remaining outstanding balance of the loans when they mature and there is no guarantee that our lenders will renew their loans at that time. Refusal to provide us with renewals or refinancing opportunities would cause our indebtedness to become immediately due and payable upon the contractual maturity of such indebtedness, which could result in our insolvency if we are unable to repay the debt.
If we do not comply with certain minimum servicing standards in the Forbearance Agreements with the bank, the bank can transfer our rights as servicer to a third party.
Under the terms of the Forbearance Agreements, we are entitled to continue to service the collateral we pledged under the Forbearance Agreements. However, the bank has the right to replace us as servicer in the event of a default or if the bank determines that we are not servicing the collateral in accordance with accepted servicing practices, as defined in the Forbearance Agreements. If the bank terminated us as servicer of the collateral our operations and financial condition would be adversely affected.
Our ability to fund operating expenses depends on our principal lender continuing to provide an adequate operating allowance.
We are required to submit all payments we receive from obligors under pledged mortgage loans to a lockbox, from which we receive an operating allowance, which is subject to periodic review and approval by the bank, to sustain our business. Substantially all amounts submitted to the lockbox in excess of the agreed upon operating allowance are used to pay down amounts outstanding under our credit facilities with Huntington. The operating allowance may not be sufficient to sustain our operations in the future, particularly for new business activities. If it is insufficient, there is no guarantee that the bank will increase our operating allowance, which could have a material adverse impact on our business.
Our business is sensitive to, and can be materially affected by, changes in interest rates.
Our business may be adversely affected by changes in interest rates, particularly changes that are unexpected in timing or size. The following are some of the risks we face related to an increase in interest rates:
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All of our borrowings bear interest at variable rates and we are only partially hedged through interest rate swaps and caps, while a significant majority of the loans in our portfolio have fixed rates. As a result, an increase in interest rates is likely to result in an increase in our interest expense without an offsetting increase in interest income. Further, our adjustable-rate loans typically provide for less frequent adjustments in response to rate increases than do our borrowings, and sometimes also include interest rate caps. To the extent this is the case, an increase in interest rates would result in a greater increase in our interest expense than in our interest income, which would adversely affect our profitability.
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An increase in interest rates would adversely affect the value that we would receive upon a sale of loans that bear interest at fixed rates, and our results of operations could be adversely affected.
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An increase in our borrowing costs without an offsetting increase in revenue would cause our cash flow to decrease, which in turn may have an adverse impact on our ability to meet our monthly debt service obligations. In the event we are unable to meet our monthly debt service obligations for this or for any other reason, we would be in default under the obligations of our credit facilities and our lenders would have the right to accelerate payments under these facilities.
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An increase in interest rates would result in a slowdown of borrower prepayments and a reduction of revenue as purchase discount accreted into income would decline. An increase in interest rates may also lead to an increase in our borrower defaults, if borrowers have difficulties making their adjustable-rate mortgage payments, and a corresponding increase in nonperforming assets, which could decrease our revenues and our cash flows, increase our loan servicing costs and our provision for loan losses, and adversely affect our profitability.
We are also subject to risks from decreasing interest rates. For example, a significant decrease in interest rates could increase the rate at which loans are prepaid and reduce our interest income in subsequent periods.
The bank may prevent our pursuing future business opportunities.
The Forbearance Agreements prohibit our originating or acquiring mortgage loans or other assets, entering into new business activities such as providing mortgage servicing, due diligence or brokerage services to third parties, making certain material changes to our capital structure or participating in off- balance sheet joint ventures and special purpose vehicles, without the prior consent of the bank. The bank’s withholding such consent could preclude our pursuing future business opportunities.
We use estimates for recognizing revenue on a majority of our portfolio investments and our earnings would be reduced if actual results are less than our estimates.
We recognize income from the purchase discount on our portfolio of notes receivable using the interest method. We use this method only if we can reasonably estimate the expected amount and timing of cash to be collected based on historic experience and other factors. We reevaluate estimated future cash flows quarterly. If future cash collections are less than what we estimated they would be, we would recognize less than anticipated purchase discount, which would reduce our earnings.
When we acquired S&D loans, the price we paid was based on a number of assumptions. Material differences between the assumptions we used in determining the value of S&D loans we acquired and our actual experience could harm our financial position.
The purchase price and carrying value of the S&D loans we previously acquired was determined largely by estimating expected future cash flows from such loans based on the delinquency, loss, prepayment speed and discount rate assumptions we used. If the amount and timing of actual cash flows are materially different
from our estimates, our cash flow and profitability would be materially adversely affected and we could be required to record further write-downs and/or increases to our reserves, which could adversely affect our financial condition.
If we do not obtain and maintain the appropriate state licenses, we will not be allowed to broker or service mortgage loans in some states, which would adversely affect our operations.
State mortgage finance licensing laws vary considerably. Most states and the District of Columbia impose a licensing obligation to broker or originate first and/or subordinate residential mortgage loans. In some of the states that impose a licensing obligation to broker or originate residential mortgage loans, the licensing obligation also arises to the purchase or sale of closed mortgage loans. Many of those mortgage licensing laws also impose a licensing obligation to service residential mortgage loans. In addition, certain state collection agency licensing laws require entities collecting on current, delinquent or defaulted loans for others or to acquire such loans to be licensed. If we are unable to obtain the appropriate state licenses or do not qualify for an exemption, our operations may be adversely affected.
Once these licenses are obtained, state regulators impose additional ongoing obligations on licensees, such as maintaining certain minimum net worth or line of credit requirements. Generally, net worth is determined on a GAAP basis with the minimum net worth varying from state to state. The highest state minimum net worth is $250,000. Further, in limited instances, the net worth calculation may not include recourse on any contingent liabilities. If the Company does not, among other things, meet these minimum net worth or line of credit requirements, the regulators may revoke or suspend the Company’s licenses and prevent the Company from continuing to service loans, which would adversely affect the Company’s operations and financial condition and ability to attract new servicing customers. The Company’s deficit net worth during 2008 resulted in its non-compliance with the requirements to maintain certain licenses in approximately 21 states. At that time, the regulators in these states could have taken a number of possible corrective actions in response to the Company’s non-compliance, including license revocation or suspension, requiring the Company to file a corrective action plan, fine assessment, denial of an application for renewal of a license, or a combination of the same, in which case the Company’s business would have been adversely affected. In fact, as a consequence of its deficit net worth, the Company was contacted by four state regulators to address its non-compliance with state laws. In October 2008, the Company was notified of such non-compliance by the state of West Virginia and, as a result, entered into an Assurance of Voluntary Compliance with the state’s Commissioner of Banking to assure the state that, as of November 30, 2008, the Company would meet the state’s statutory minimum net worth requirement of $250,000. Upon its compliance with the state’s minimum net worth requirement, the Company’s West Virginia license was renewed on December 30, 2008. On November 6, 2008, Ohio issued a Notice of Intent to Refuse Renewal of the Company’s license. Again, upon the Company’s compliance with the state’s minimum net worth requirement of $50,000, Ohio terminated the Notice of Intent to Refuse Renewal on January 8, 2009. On January 14, 2009, the state of Wisconsin issued the Company a Letter of Reprimand that cited its failure in 2008 to maintain the minimum net worth required of mortgage bankers registered in the state. Thereafter, the state of Wisconsin did note that the Company had tangible net worth in excess of $250,000 by December 31, 2008. On December 2, 2008, the state of Washington notified the Company that the processing of its collection agency license renewal was being delayed pending the state’s review of the Company’s off-balance sheet liabilities to its affiliate. As of the date of this filing, the Company is addressing this matter with the state of Washington.
In addition to these four states, the Company may also be subject to future regulatory action in three other states, Michigan, Illinois and Massachusetts, because in those states the net worth calculation may not include recourse on any contingent liabilities, which would cause the Company’s net worth to be deemed negative by those states. In the summer of 2008, the Company formed a wholly-owned subsidiary, Franklin Credit Loan Servicing, LLC, a Delaware limited liability company, which does not have any liabilities or pledged assets and, therefore, is expected to become licensed in those three states and in the event that such states determine that FCMC does not meet the applicable net worth requirements, Franklin Credit Loan Servicing, LLC would, upon licensure, service loans in such states so that the Company overall would have the required licenses to operate in all 50 states. While the Company believes that the required consent and cooperation of Huntington for the continued positive capitalization of FCMC (and, if necessary, Franklin
Credit Loan Servicing, LLC), and any other changes the Company determines to implement, which would enable the Company to retain its servicing and debt collection licenses with all or most states, would be obtained, there can be no assurance that such consents will be obtained and that the Company will be able to retain these licenses.
The Company’s failure to maintain its state licenses in good standing would breach its Forbearance Agreements with The Huntington National Bank. The Forbearance Agreements contain affirmative covenants that the Company maintain and comply in all material respects with all governmental licenses and authorizations to hold and service mortgage loans and real estate owned properties. If the Company breaches such covenants, which it did during 2008 by not complying with the minimum net worth requirements of certain states, or Huntington determines that there has been a material adverse affect on the Company’s business and, in either instance, notice of the same is provided to the Company by Huntington, any such noticed event would be a Forbearance Default under the Forbearance Agreements, which would entitle Huntington to declare the Company’s indebtedness immediately due and payable and transfer the Company’s rights as servicer to a third party.
A significant amount of the mortgage loans that we originated are secured by property in New York and New Jersey, and our operations could be harmed by economic downturns or other adverse events in these states.
A significant portion of Tribeca’s mortgage loan origination activity was concentrated in the northeastern United States, particularly in New York and New Jersey. Of the loans originated by Tribeca and held for investment as of December 31, 2008, a majority of the aggregate principal was secured by property in these two states. An overall decline in the economy or the residential real estate market, a continuing decline in home prices, or the occurrence of events such as a natural disaster or an act of terrorism in the northeastern United States could decrease the value of residential properties in this region. This could result in an increase in the risk of delinquency, default or foreclosure on mortgage loans in our portfolio, which could reduce our revenues, increase our loan losses and/or charge-offs and reduce our profitability.
We may not be adequately protected against the risks inherent in subprime residential mortgage loans.
The vast majority of the loans we originated were underwritten generally in accordance with standards designed for subprime residential mortgages. Mortgage loans underwritten under these underwriting standards are likely to experience rates of delinquency, foreclosure and loss that are higher, and may be substantially higher, than prime residential mortgage loans. A majority of the loans previously originated by Tribeca were made under a “limited documentation” program, which generally placed the most significant emphasis on the loan-to-value ratio based on the appraised value of the property, and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan. Our past underwriting and loan servicing practices may not afford adequate protection against the higher risks associated with loans made to such borrowers particularly in a poor housing and credit market or an economic recession. If we are unable to mitigate these risks, our cash flows, results of operations, financial condition and liquidity could be materially harmed.
A number of our second lien mortgage loans are subordinated to ARM or interest-only mortgages that may be subject to monthly payment increases, which may result in delinquencies and increase our risk of loss on these loans.
A number of the second lien mortgage loans that we acquired are subordinated to an adjustable rate mortgage held by a third party that was originated in a period of unusually low interest rates or originated with a below market interest rate, or to an interest-only mortgage. A substantial majority of these ARMs bore a fixed rate for the first two or three years of the loan, followed by annual interest and payment rate resets. As short-term interest rates generally rose from mid-2004 to the end of 2006, then generally held stable during 2007, followed by a decline in 2008, holders of ARM loans may face monthly payment increases following their first interest rate adjustment date. Similarly, interest-only loans typically require principal payments to be made after the first one or two years from the date of the loan. The decreased availability of refinancing alternatives has impacted the run-off that typically occurs as an ARM nears its first rate reset or the interest-only loans begin to require the payment of principal. Interest rate adjustments or principal becoming payable on first lien mortgages may also have a direct impact on a borrower’s ability to repay any underlying second
lien mortgage loan on a property. As a result, delinquencies on these loans may increase and our ability to recover the principal of these loans may be further adversely affected.
We are subject to losses due to fraudulent and negligent acts on the part of loan applicants, mortgage brokers, sellers of loans we acquired, vendors and our employees.
When we acquired and originated mortgage loans, we typically relied heavily upon information supplied by third parties, including the information contained in the loan application, property appraisal, title information and, employment and income stated on the loan application. If any of this information was intentionally or negligently misrepresented and such misrepresentation was not detected prior to the acquisition or funding of the loan, the value of the loan may end up being significantly lower than expected. Whether a misrepresentation was made by the loan applicant, the mortgage broker, another third party or one of our employees, we generally bear the risk of loss associated with the misrepresentation except when we purchased loans pursuant to contracts that include a right of return and the seller remains sufficiently creditworthy to render such right meaningful.
We may not be successful in entering into or implementing our planned business of providing servicing and other mortgage related services for other entities on a fee-paying basis.
The servicing and mortgage related services industries are highly competitive. The Company has not historically provided such services to unrelated third parties. Additionally, the absence of a rating by a statistical rating agency as a primary or special servicer of residential mortgage loans may make it difficult to compete or effectively market the Company’s ability to adequately service mortgage loans to entities that rely on such ratings as a factor in the selection of a servicer for their loans. If we do not succeed in entering the business of providing such services to third parties, or prove unable to provide such services on a profitable basis, such a failure could adversely affect our operations and financial condition.
The success and growth of our servicing business will depend on our ability to adapt to and implement technological changes, and any failure to do so could result in a material adverse effect on our business.
Our mortgage loan servicing business is dependent upon our ability to effectively adapt to technological advances, such as the ability to automate loan servicing, process borrower payments and provide customer information over the Internet, accept electronic signatures and provide instant status updates. The intense competition in our industry has led to rapid technological developments, evolving industry standards and frequent releases of new products and enhancements. The failure to acquire new technologies or technological solutions when necessary could limit our ability to remain competitive in our industry and our ability to increase the cost-efficiencies of our servicing operation, which would harm our business, results of operations and financial condition. Alternatively, adapting to technological changes in the industry to remain competitive may require us to make significant and costly changes to our loan servicing and information systems, which could in turn increase operating costs.
If we do not manage the changes in our businesses effectively, our financial performance could be harmed.
As we seek to engage in new businesses, our future growth could require capital resources beyond what we currently possess, which would place certain pressures on our infrastructure. Our future profitability will similarly depend on the proper management of our wind-down of the businesses we no longer operate. We will need to continue to upgrade and expand our financial, operational and managerial systems and controls, particularly our servicing systems and resources. If we do not manage the changes in our business effectively, our expenses could increase, our loan delinquencies and defaults could continue to accelerate and our business, liquidity and financial condition could be further significantly harmed.
The inability to attract and retain qualified employees could significantly harm our business.
We continually need to attract, hire and successfully integrate additional qualified personnel in an intensely competitive hiring environment in order to manage and operate our business. The market for skilled management, professional and loan servicing personnel is highly competitive. Competition for qualified
personnel may lead to increased hiring and retention costs. If we are unable to attract, successfully integrate and retain a sufficient number of skilled personnel at manageable costs, we will be unable to continue to service mortgage loans, which would harm our business, results of operations and financial condition. As our business evolves and we shift our focus from the acquisition and origination of residential mortgage loans to seeking to provide servicing and other mortgage related services for other entities, retaining key employees and hiring for certain critical positions can become more challenging.
An interruption in or breach of our information systems may result in lost business and increased expenses.
We rely heavily upon communications and information systems to conduct our business. Any failure, interruption or breach in security of or damage to our information systems or the third-party information systems on which we rely could cause us to be noncompliant with significant federal and state regulations relating to the handling of customer information, particularly with respect to maintaining the confidentiality of such information. A failure, interruption or breach of our information systems could result in regulatory action and litigation against us. We cannot assure that such failures or interruptions will not occur or if they do occur that they will be adequately addressed by us or the third parties on which we rely.
We are exposed to the risk of environmental liabilities with respect to properties to which we take title.
In the course of our business, we may foreclose on defaulted mortgage loans and take title to the properties underlying those mortgages. If we do take title, we could be subject to environmental liabilities with respect to these properties. Hazardous substances or wastes, contaminants, pollutants or sources thereof may be discovered on these properties during our ownership or after a sale to a third party. Environmental defects can reduce the value of and make it more difficult to sell such properties, and we may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation, and cleanup costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. These costs could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operation could be materially and adversely affected. Although we have not to date incurred any environmental liabilities in connection with our real estate owned, there can be no guarantee that we will not incur any such liabilities in the future.
A loss of our Chairman may adversely affect our operations.
Thomas J. Axon, our Chairman and President, is responsible for making substantially all of the most significant policy and managerial decisions in our business operations. These decisions are paramount to the success and future growth of our business. Mr. Axon is also instrumental in maintaining our relationship with Huntington and our operations under the terms of the Forbearance Agreements. A loss of the services of Mr. Axon could disrupt and adversely affect our operations.
Risks Related to Our Financial Statements
We may become subject to liability and incur increased expenditures as a result of the restatement of our financial statements.
The restatement of our previously issued financial statements in 2006 could expose us to government investigation or legal action. The defense of any such actions could cause the diversion of management’s attention and resources, and we could be required to pay damages to settle such actions or if any such actions are not resolved in our favor. Even if resolved in our favor, such actions could cause us to incur significant legal and other expenses. Moreover, we may be the subject of negative publicity focusing on any financial statement inaccuracies and resulting restatement and negative reactions from shareholders, creditors, or others with which we do business. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our securities to decline.
We may become subject to liability and incur increased expenditures as a result of our reassessment of our allowance for loan losses.
As a result of the rapid and substantial deterioration in the housing and credit markets, particularly the subprime mortgage sector, and deterioration in the performance of our portfolios of acquired and originated loans, we reassessed our allowance for loan losses during 2007 and 2008, which resulted in significantly increased estimates of inherent losses in our portfolios of loans and increased provisions for loan losses. These reassessments of our allowance for loan losses could expose us to legal action or government investigation. The defense of any such actions could cause the diversion of management’s attention and resources, and we could be required to pay damages to settle such actions or if any such actions are not resolved in our favor. Even if resolved in our favor, such actions could cause us to incur significant legal and other expenses. Moreover, we may be the subject of negative publicity focusing on the incurred allowance and negative reactions from shareholders, creditors, or others with which we do business. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our securities to decline.
Failures in our internal controls and disclosure controls and procedures could lead to material errors in our financial statements and cause us to fail to meet our reporting obligations.
Effective internal controls are necessary for us to provide reliable financial reports. Such controls are designed to provide reasonable, not absolute assurance that we are providing reliable financial reports. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there is only reasonable assurance that our controls will succeed in achieving their goals under all potential future conditions. If such controls fail to operate effectively, this may result in material errors in our financial statements. Deficiencies in our system of internal controls over financial reporting may require remediation, which could be costly. Failure to remediate such deficiencies or to implement required new or improved controls could lead to material errors in our financial statements, cause us to fail to meet our reporting obligations, and expose us to government investigation or legal action. Any of these results could cause investors to lose confidence in our reported financial information and could have a negative effect on the trading price of our common stock.
Risks Related to the Regulation of Our Industry
New legislation and regulations directed at curbing predatory lending practices could restrict our ability to price, sell, service or finance non-prime residential mortgage loans, which could adversely impact our earnings.
The Federal Home Ownership and Equity Protection Act, or HOEPA, identifies a category of residential mortgage loans and subjects such loans to restrictions not applicable to other residential mortgage loans. Loans subject to HOEPA consist of loans on which certain points and fees or the annual percentage rate, which is based on the interest rate and certain finance charges, exceed specified levels. Laws, rules and regulations have been adopted, or are under consideration, at the state and local levels that are similar to HOEPA in that they impose certain restrictions on loans that exceed certain cost parameters. These state and local laws generally have lower thresholds and broader prohibitions than under the federal law. The restrictions include prohibitions on steering borrowers into loans with high interest rates and away from more affordable products, selling unnecessary insurance to borrowers, flipping or repeatedly refinancing loans and originating loans without a reasonable expectation that the borrowers will be able to repay the loans without regard to the value of the mortgaged property.
Compliance with some of these restrictions requires lenders to make subjective judgments, such as whether a loan will provide a “net tangible benefit” to the borrower. These restrictions expose a lender to risks of litigation and regulatory sanction no matter how carefully a loan is underwritten and impact the way in which a loan is underwritten. The remedies for violations of these laws are not based on actual harm to the consumer and can result in damages that exceed the loan balance. Liability for violations of HOEPA, as well as violations of many of the state and local equivalents, would extend not only to us, but to assignees, which may include our warehouse lenders and whole-loan buyers, regardless of whether such assignee knew of or participated in the violation.
It was our policy not to originate loans that would be subject to HOEPA or similar state and local laws and not to purchase high cost loans that would have violated those laws. If we miscalculated the numerical thresholds described above, however, we may have mistakenly originated or purchased such loans and bear the related marketplace and legal risks and consequences. These thresholds below which we tried to originate loans created artificial barriers to production and limited the price at which we offered loans to borrowers and our ability to underwrite, originate, sell and finance mortgage loans. In a number of states, for example, proposed and recently enacted state and local anti-predatory lending laws and regulations broaden the trigger test for loans subject to restrictions. If the numerical thresholds were miscalculated, certain variations of our Liberty Loan product, where the lending decision may have been based entirely or primarily on the borrower’s equity in his or her home and not, or to a lesser extent, on a determination of the borrower’s ability to repay the loan, would violate HOEPA and many of these state and local anti-predatory lending laws. In the past, we have sold a portion of our Liberty Loan production to third parties on a whole-loan, servicing-released basis.
We purchased loans that are covered by one of these laws, rules or regulations only if, in our judgment, a loan was made in accordance with our strict legal compliance standards and without undue risk relative to litigation or to the enforcement of the loan according to its terms.
On November 15, 2007, the House of Representatives passed the Mortgage Reform and Anti-Predatory Lending Act of 2007. While the legislation was not formally taken up by the Senate during 2008, elements of the legislation have been under discussion by Congress since that time. Pending bills in the House and Senate would allow judges to rework first lien mortgages in bankruptcy proceedings, including lowering interest rates and extending the maturity. In 2008, several states adopted legislation establishing new consumer protections governing loan servicing practices and foreclosure procedures. Some of the provisions will impede or materially delay a holder’s ability to foreclose on certain mortgaged properties. There are proposed laws providing greater protections to consumers, pertaining to such activities as maintenance of escrow funds, timely crediting of payments received, limitation on ancillary income, responding to customer inquiries and requirements to conduct loss mitigation. The Federal Reserve Board has approved changes to HOEPA in Regulation Z, which implements the Truth in Lending Act, to protect consumers from unfair or deceptive home mortgage lending and advertising practices. Effective October 1, 2009, the amendments create protections for a new category of loans called “higher-priced mortgage loans.” Under these amendments, companies that service mortgage loans will be required to credit consumers’ loan payments as of the date of receipt. Further, the HOEPA amendments expand the types of loans subject to early disclosures. Currently, transaction-specific early disclosures are only required for purchase money mortgage loans. When the amendments take effect, the early disclosures will be required with all closed-end non-purchase money mortgage loans, such as refinancings, closed-end home equity loans and reverse mortgage loans.
The U.S. Department of Housing and Urban Development (HUD) has also finalized a rule which it maintains will simplify and improve the disclosure requirements for mortgage settlement costs under the Real Estate Settlement Procedures Act of 1974 (RESPA) to protect consumers from unnecessarily high settlement costs. The new RESPA rule effective on January 1, 2010 will include the yield spread premium in the calculation of the mortgage broker’s total compensation and require more detailed closing costs disclosures to be provided to consumers at the time of loan origination. The new RESPA rule might usher in a new wave of litigation when mortgage lenders and brokers are subject to new compliance parameters.
We cannot predict whether or in what form Congress or the various state and local legislatures may enact legislation affecting our business. We are evaluating the potential impact of these initiatives, if enacted, on our servicing practices and results of operations. As a result of these and other initiatives, we are unable to predict whether federal, state, or local authorities will require changes in our servicing practices in the future, including reimbursement of fees charged to borrowers, or will impose fines. These changes, if required, could adversely affect our profitability, particularly if we make such changes in response to new or amended laws, regulations or ordinances in states where we service a significant amount of mortgage loans.
The broad scope of our operations exposes us to risks of noncompliance with an increasing and inconsistent body of complex laws and regulations at the federal, state and local levels.
Because we may service and may have purchased and originated mortgage loans in all 50 states, we must comply with the laws and regulations pertaining to licensing, disclosure and substantive practices, as well as judicial and administrative decisions, of all of these jurisdictions, as well as an extensive body of federal laws and regulations. The volume of new or modified laws and regulations has increased in recent years, and government agencies enforcing these laws, as well as the courts, sometimes interpret the same law in different ways. The laws and regulations of each of these jurisdictions are different, complex and, in some cases, in direct conflict with each other. As our operations grow, it may be more difficult to identify comprehensively and to interpret accurately applicable laws and regulations and to employ properly our policies, procedures and systems and train our personnel effectively with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. State and local governmental authorities have focused on the lending and servicing practices of companies in the non-prime mortgage lending industry, sometimes seeking to impose sanctions for practices such as charging excessive fees, imposing interest rates higher than warranted by the credit risk of the borrower, imposing prepayment fees, failing to adequately disclose the material terms of loans and abusive servicing and collection practices.
Our failure to comply with this regulatory regimen can lead to:
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civil and criminal liability, including potential monetary penalties;
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loss of servicing licenses or approved status required for continued business operations;
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demands for indemnification or loan repurchases from purchasers of our loans;
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legal defenses causing delay and expense;
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adverse effects on our ability, as servicer, to enforce loans;
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the borrower having the right to rescind or cancel the loan transaction;
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adverse publicity;
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individual and class action lawsuits;
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administrative enforcement actions;
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damage to our reputation in the industry;
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inability to sell our loans; or
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inability to obtain credit to fund our operations.
Although we have systems and procedures directed to compliance with these legal requirements and believe that we are in material compliance with all applicable federal, state and local statutes, rules and regulations, we cannot assure you that more restrictive laws and regulations will not be adopted in the future, or that governmental bodies or courts will not interpret existing laws or regulations in a more restrictive manner, which could render our current business practices non-compliant or which could make compliance more difficult or expensive. These applicable laws and regulations are subject to administrative or judicial interpretation, but some of these laws and regulations have been enacted only recently, or may be interpreted infrequently or only recently and inconsistently. As a result of infrequent, sparse or conflicting interpretations, ambiguities in these laws and regulations may leave uncertainty with respect to permitted or restricted conduct under them. Any ambiguity under a law to which we are subject may lead to regulatory investigations, governmental enforcement actions or private causes of action, such as class action lawsuits, with respect to our compliance with applicable laws and regulations.
If financial institutions face exposure stemming from legal violations committed by the companies to which they provide financing or underwriting services, this could negatively affect the market for whole-loans and mortgage-backed securities.
In June 2003, a California jury found a warehouse lender and securitization underwriter liable in part for fraud on consumers committed by a lender to whom it provided financing and underwriting services. The jury found that the investment bank was aware of the fraud and substantially assisted the lender in perpetrating the fraud by providing financing and underwriting services that allowed the lender to continue to operate, and held it liable for 10% of the plaintiff’s damages. In December 2006, the appeal court affirmed the jury verdict on liability and remanded the matter for further proceedings on the proper calculation of damages. This is the first case we know of in which an investment bank was held partly responsible for violations committed by a mortgage lender customer. Shortly after the announcement of the jury verdict in the California case, the Florida Attorney General filed suit against the same financial institution, seeking an injunction to prevent it from financing mortgage loans within Florida, as well as damages and civil penalties, based on theories of unfair and deceptive trade practices and fraud. The suit claims that this financial institution aided and abetted the same lender involved in the California case in its commission of fraudulent representations in Florida. Admitting no liability, the investment bank settled this lawsuit out of court by agreeing to pay $400,000.00 and to review its practices. If other courts or regulators adopt this “aiding and abetting” theory, investment banks may face increased litigation as they are named as defendants in lawsuits and regulatory actions against the mortgage companies with which they do business. Some investment banks may exit the business, charge more for warehouse lending and reduce the prices they pay for whole-loans in order to build in the costs of this potential litigation. This could, in turn, have a material adverse effect on our results of operations, financial condition and business prospects.
We may be subject to fines or other penalties based upon the conduct of our independent brokers.
Mortgage brokers, from which we sourced some of our Tribeca loans, have parallel and separate legal obligations to which they are subject. While these laws may not explicitly hold the originating lenders responsible for the legal violations of mortgage brokers, increasingly federal and state agencies have sought to impose such assignee liability. For example, the FTC entered into a settlement agreement with a mortgage lender where the FTC characterized a broker that had placed all of its loan production with a single lender as the “agent” of the lender. The FTC imposed a fine on the lender in part because, as “principal,” the lender was legally responsible for the mortgage broker’s unfair and deceptive acts and practices. In the past, the United States Department of Justice has sought to hold a non- prime mortgage lender responsible for the pricing practices of its mortgage brokers, alleging that the mortgage lender was directly responsible for the total fees and charges paid by the borrower under the Fair Housing Act even if the lender neither dictated what the mortgage broker could charge nor kept the money for its own account. Accordingly, we may be subject to fines or other penalties based upon the conduct of our independent mortgage broker customers.
We are subject to reputational risks from negative publicity concerning the subprime mortgage industry.
The subprime mortgage industry in which we operate may be subject to periodic negative publicity, which could damage our reputation and adversely impact our earnings.
Reputation risk, or the risk to our business, earnings and capital from negative publicity, is inherent in our industry. There is a perception that the borrowers of subprime loans may be unsophisticated and in need of consumer protection. Accordingly, from time to time, consumer advocate groups or the media may focus attention on our services, thereby subjecting our industry to the possibility of periodic negative publicity.
We may also be negatively impacted if another company in the subprime mortgage industry or in a related industry engages in practices resulting in increased public attention to our industry. Negative publicity may also occur as a result of judicial inquiries and regulatory or governmental action with respect to the subprime mortgage industry. Negative publicity may result in increased regulation and legislative scrutiny of industry practices as well as increased litigation or enforcement actions by civil and criminal authorities. Additionally, negative publicity may increase our costs of doing business and adversely affect our profitability by impeding our ability to attract and retain customers and employees.
During the past several years, the press has widely reported certain industry related concerns, including rising delinquencies, the tightening of credit and more recently, increasing litigation. Some of the litigation instituted against subprime lenders is being brought in the form of purported class actions by individuals or by state or federal regulators or state attorneys general. The judicial climate in many states is such that the outcome of these cases is unpredictable. If we are subject to increased litigation due to such negative publicity, it could have a material adverse impact on our results of operations.
We are subject to significant legal and reputational risks and expenses under federal and state laws concerning privacy, use and security of customer information.
The federal Gramm-Leach-Bliley financial reform legislation imposes significant privacy obligations on us in connection with the collection, use and security of financial and other nonpublic information provided to us by applicants and borrowers. In addition, California, North Dakota and Vermont have enacted, and several other states are considering enacting, privacy or customer-information-security legislation with even more stringent requirements than those set forth in the federal law. Because laws and rules concerning the use and protection of customer information are continuing to develop at the federal and state levels, we expect to incur increased costs in our effort to be and remain in full compliance with these requirements. Nevertheless, despite our efforts we will be subject to legal and reputational risks in connection with our collection and use of customer information, and we cannot assure you that we will not be subject to lawsuits or compliance actions under such state or federal privacy requirements. To the extent that a variety of inconsistent state privacy rules or requirements are enacted, our compliance costs could substantially increase.
If many of our borrowers become subject to the Servicemembers Civil Relief Act of 2003, our cash flows and interest income may be adversely affected.
Under the Servicemembers Civil Relief Act of 2003, or the Civil Relief Act, a borrower who enters active military service after the origination of his or her mortgage loan generally may not be required to pay interest above an annual rate of 6%, and the lender is restricted from exercising certain enforcement remedies, including foreclosure, during the period of the borrower’s active duty status. The Civil Relief Act also applies to a borrower who was on reserve status and is called to active duty after origination of the mortgage loan. The Civil Relief Act was amended on July 30, 2008 by the Housing and Economic Recovery Act of 2008 to temporarily enhance protections for servicemembers relating to mortgages and mortgage foreclosures until December 31, 2010, by extending the protection period and stay of proceedings from 90 days to nine months and extending the interest rate limitation on mortgages from the period of military service to the period of military service and one year thereafter. Considering the large number of U.S. Armed Forces personnel on active duty and likely to be on active duty in the future, our cash flows and interest income may be adversely affected by compliance with this law.
Legislative action to provide mortgage relief may negatively impact our business.
As delinquencies, defaults and foreclosures in and of residential mortgages have increased dramatically, there are several federal, state and local initiatives to restrict our ability to foreclose and resell the property of a customer in default. Any restriction on our ability to foreclose on a loan, any requirement that we forego a portion of the amount otherwise due on a loan or any requirement that we modify any original loan terms is likely to negatively impact our business, financial condition, liquidity and results of operations. These initiatives have come in the form of proposed legislation and regulations, including those pertaining to federal bankruptcy laws, government investigations and calls for voluntary standard setting.
In 2008, several states adopted legislation establishing new consumer protections governing loan servicing practices and foreclosure procedures. Some of the provisions will impede or materially delay a holder’s ability to foreclose on certain mortgaged properties, which could materially increase the cost of foreclosure.
There are proposed laws providing greater protections to consumers, pertaining to such activities as maintenance of escrow funds, timely crediting of payments received, limitation on ancillary income, responding to customer inquiries and requirements to conduct loss mitigation. If such proposals are enacted, the cost to service could materially increase. Pending bills in the House and Senate would allow judges to rework first
lien mortgages in bankruptcy proceedings, including lowering interest rates and extending the maturity. These bills would also provide servicers more leeway in modifying mortgages. Regardless of whether a specific law is proposed or enacted, there are several federal and state government initiatives, including one set forth in the Homeowner Affordability and Stability Plan that seek to obtain the voluntary agreement of servicers to subscribe to a code of conduct or statement of principles or methodologies when working with borrowers facing foreclosure on their homes. Generally speaking, the principles call for servicers to reach out to borrowers before their loans “reset” with higher monthly payments that might result in a default by a borrower and seek to modify loans prior to the reset. Applicable servicing agreements, federal tax law and accounting standards limit the ability of a servicer to modify a loan before the borrower has defaulted on the loan or the servicer has determined that a default by the borrower is reasonably likely to occur. Servicing agreements generally require the servicer to act in the best interests of the note holders or at least not to take actions that are materially adverse to the interests of the note holders. Compliance with the code or principles must conform to these other contractual, tax and accounting standards. As a result, servicers have to confront competing demands from consumers and those advocating on their behalf to make home retention the overarching priority when dealing with borrowers in default, on the one hand, and the requirements of note holders to maximize returns on the loans, on the other.
Risks Related to Our Securities
Thomas J. Axon effectively controls our company, substantially reducing the influence of our other stockholders.
Thomas J. Axon, our Chairman and President, beneficially owns more than 45% of our outstanding common stock. As a result, Mr. Axon will be able to influence significantly the actions that require stockholder approval, including:
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the election of our directors; and
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the approval of mergers, sales of assets or other corporate transactions or matters submitted for stockholder approval.
Furthermore, the members of the board of directors as a group (including Mr. Axon) beneficially own a substantial majority of our outstanding common stock. As a result, our other stockholders may have little or no influence over matters submitted for stockholder approval. In addition, Mr. Axon’s influence and/or that of our current board members could preclude any unsolicited acquisition of us and consequently materially adversely affect the price of our common stock.
We have been delisted from The Nasdaq Stock Market, in which case the price and liquidity of our common stock and our ability to access the capital markets has been adversely affected.
Our common stock was delisted from The Nasdaq Capital Market as of November 3, 2008, and is quoted under the stock symbol “FCMC.PK” on the “Pink Sheets,” a centralized quotation service for over-the counter securities.
The delisting of our common stock has significantly affected the ability of investors to trade our securities and has negatively affected the value and liquidity of our common stock. In addition, our common stock now is subject to the rules promulgated under the Securities Exchange Act of 1934 relating to “penny stocks.” These rules require brokers who sell securities that are subject to the rules, and who sell to persons other than established customers and institutional accredited investors, to complete required documentation, make suitability inquiries of investors and provide investors with information concerning the risks of trading in the security. These requirements could make it more difficult to buy or sell our common stock in the open market. In addition, the delisting of our common stock could materially adversely affect our ability to raise capital, and could also have other negative results, including the potential loss of confidence by employees, the loss of institutional investor interest and fewer business development opportunities.
Our organizational documents, Delaware law and our credit facilities may make it harder for us to be acquired without the consent and cooperation of our board of directors, management and lender.
Several provisions of our organizational documents, Delaware law, and our credit facilities may deter or prevent a takeover attempt, including a takeover attempt in which the potential purchaser offers to pay a per share price greater than the current market price of our common stock.
Our classified board of directors will make it more difficult for a person seeking to obtain control of us to do so. Also, our supermajority voting requirements may discourage or deter a person from attempting to obtain control of us by making it more difficult to amend the provisions of our certificate of incorporation to eliminate an anti-takeover effect or the protections they afford minority stockholders, and will make it more difficult for a stockholder or stockholder group to put pressure on our board of directors to amend our certificate of incorporation to facilitate a takeover attempt. In addition, under the terms of our certificate of incorporation, our board of directors has the authority, without further action by the stockholders, to issue shares of preferred stock in one or more series and to fix the rights, preferences, privileges and restrictions thereof. The ability to issue shares of preferred stock could tend to discourage takeover or acquisition proposals not supported by our current board of directors.
Section 203 of the Delaware General Corporation Law, subject to certain exceptions, prohibits a Delaware corporation from engaging in any business combination with any interested stockholder (such as the owner of 15% or more of our outstanding common stock) for a period of three years following the date that the stockholder became an interested stockholder. The preceding provisions of our organizational documents, as well as Section 203 of the Delaware General Corporation Law, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management, even if such events would be in the best interests of our stockholders.
Under the terms of the Forbearance Agreements, we cannot enter into mergers, consolidations or sales of assets (subject to certain exceptions). In addition, we cannot, without the bank’s consent, enter into any material change in our capital structure that the bank or a nationally recognized independent public accounting firm determine could cause a consolidation of our assets with other persons under relevant accounting regulations.
In addition, if our controlling shareholder ceasing to possess, directly or indirectly, the power to direct our management and policies through his ownership of our voting stock constitutes an event of default under our credit facilities, which, without a waiver from our lender, would cause our indebtedness to become immediately payable and could result in our insolvency if we are unable to repay our debt.
Our quarterly operating results may fluctuate and cause our stock price to decline.
Because of the nature of our business, our quarterly operating results may fluctuate, or we may incur additional operating losses. Our results may fluctuate as a result of any of the following:
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the timing and amount of collections on loans in our portfolio;
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the rate of delinquency, default, foreclosure and prepayment on the loans we hold and service;
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changes in interest rates;
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deviations in the amount or timing of collections on loans from our expectations when we purchased or originated such loans;
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our inability to purchase and originate new mortgage loans for portfolio or for sale in the secondary mortgage market;
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our inability to successfully enter the new business of servicing loans for third parties;
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further declines in the estimated value of real property securing mortgage loans;
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increases in operating expenses associated with the changes in our business;
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general economic and market conditions; and
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the effects of state and federal tax, monetary and fiscal policies.
Many of these factors are beyond our control, and we cannot predict their potential effects on the price of our common stock. We cannot assure you that the market price of our common stock will not fluctuate or further significantly decline in the future.
Compliance with the rules of the market in which our common stock trades and proposed and recently enacted changes in securities laws and regulations are likely to increase our costs.
The Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by the Securities and Exchange Commission (the “SEC”) and the national securities exchanges have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices for public companies, including ourselves. These rules and regulations could also make it more difficult for us to attract and retain qualified executive officers and members of our board of directors, particularly to serve on our audit committee.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2.
PROPERTIES
On March 4, 2005, we entered into a sublease agreement with Lehman Brothers Holdings Inc. to sublease approximately 33,866 square feet of space on the 25th
floor at 101 Hudson Street, Jersey City, New Jersey for use as executive and administrative offices. Pursuant to the sublease, in 2008 we paid Lehman Brothers Holdings Inc. rent of approximately $68,697 per month. The term of the sublease is through December 30, 2010.
On July 27, 2005, we entered into a lease agreement with 101 Hudson Leasing Associates to lease approximately 6,856 square feet of space on the 37th
floor at 101 Hudson Street, Jersey City, New Jersey for use as administrative offices. Pursuant to the lease, in 2008 we paid 101 Hudson Leasing Associates rent of approximately $15,569 per month. The term of the lease is through December 30, 2010. After December 30, 2010, we will lease both the 25th
floor space and the 37th
floor space directly from 101 Hudson Leasing Associates. The term of this combined lease will be through December 30, 2013 for approximately $114,808 per month. In addition, we leased approximately 228 square feet of office space in Trevose, Pennsylvania under a lease agreement that was extended in March 2008 on a month-to-month basis through November 30, 2008. The monthly lease payment for the Trevose office was not significant, and as of December 31, 2008, the lease was terminated. On August 1, 2008, Franklin entered into a lease agreement with Patelco Credit Union to lease 1,500 square feet of space in Concord, California for rent of approximately $4,750 per month, which we can terminate upon 60 days notice to the landlord.
Our Tribeca subsidiary currently maintains its corporate headquarters on the 37th
floor at 101 Hudson Street, Jersey City, New Jersey. We had leased two other offices for Tribeca, one of which was in Trevose, Pennsylvania (approximately 1,000 square feet) under a lease agreement that was extended in December 2007 on a month-to-month basis through October 31, 2008, and the other of which is in Marlton, New Jersey (approximately 2,426 square feet) under a lease agreement with a term that was extended to July 31, 2009. The monthly lease payment for the Trevose office was not significant, and as of December 31, 2008, the lease was terminated. The monthly lease payment for the Marlton office was approximately $6,025 in 2008. At December 31, 2008, the Marlton office space was not being utilized by Tribeca, and the remaining lease payments of $63,727 were accrued and other non-usable fixed assets of $245,971 were written off.
On February 13, 2006, Tribeca entered into a lease agreement with 18 Harrison Development Associates, an entity controlled by Thomas J. Axon, to lease approximately 950 square feet on the 5th floor
at 18 Harrison Street, New York, New York for use as additional office space. The term of the lease was through February 12, 2007, at approximately $4,880 per month, and the option to extend the lease for an additional period of one year at a rate of approximately $5,124 per month was exercised. The lease was extended in February 2007, and expired unrenewed in February 2008.
As part of its acquisition of the wholesale mortgage origination unit in February 2007, Tribeca assumed the lease obligation for office space located in Bridgewater, New Jersey, for approximately 14,070 square feet. The term of the lease is through January 31, 2011 at approximately $20,621 per month. At December 31, 2007, the space was not being utilized by Tribeca, and it is being marketed for sublease. Due to adverse market conditions for rental commercial space of this type, the remaining lease payments of $596,774 were accrued and other non-usable fixed assets of $208,991 were written off in 2008.
On March 30, 2007, we entered into a lease agreement with 101 Hudson Leasing Associates to lease approximately 6,269 square feet of space on the 37th
floor at 101 Hudson Street, Jersey City, New Jersey for use as administrative offices. Pursuant to the lease, in 2008 we paid 101 Hudson Leasing Associates rent of approximately $16,717 per month. The term of the lease is through December 31, 2013.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
We are involved in routine litigation matters incidental to our business related to the enforcement of our rights under mortgage loans we hold, none of which is individually material. In addition, because we originated and service mortgage loans throughout the country, we must comply with various state and federal lending laws and we are routinely subject to investigation and inquiry by regulatory agencies, some of which arise from complaints filed by borrowers, none of which is individually material.
Franklin Credit Management Corporation v. WMC Mortgage LLC
On February 6, 2008, the Company commenced an action in the Supreme Court of the State of New York, County of New York captioned Franklin Credit Management Corporation v. WMC Mortgage LLC, successor to WMC Mortgage Corp., (the “First WMC Litigation”). The First WMC Litigation arises from the Company’s purchase of approximately $170 million of second mortgages from WMC Mortgage Corp. (“WMC”), an affiliate of General Electric Company. In the First WMC Litigation, the Company seeks damages in an amount not less than $35.5 million resulting from breaches of the representations and warranties contained in the loan purchase agreements entered into between the Company and WMC. WMC has served an Answer to the Complaint generally denying the allegations.
On August 15, 2008, the Company commenced a second action in the Supreme Court of the State of New York, County of New York captioned Franklin Credit Management Corporation v. WMC Mortgage LLC, successor to WMC Mortgage Corp., (the “Second WMC Litigation”). In the Second WMC Litigation, the Company seeks damages in an amount not less than $36.8 million resulting from breaches of representations and warranties contained in the loan purchase agreements entered into between the Company and WMC with respect to second mortgages purchased from WMC during 2006. These second mortgages were not the subject of the First WMC Litigation. WMC has served an Answer to the Complaint generally denying the allegations.
The First WMC Litigation and the Second WMC Litigation have been consolidated for all purposes by the Court. The consolidated action is currently in the document discovery phase which is scheduled to end on July 17, 2009. No trial date has been set.
Franklin Credit Management Corporation v. Decision One Mortgage Company, LLC and HSBC Finance Corporation
As previously disclosed by the Company, on February 13, 2008, the Company commenced an action in the Supreme Court of the State of New York captioned Franklin Credit Management Corporation v. Decision One Mortgage Company, LLC and HSBC Finance Corporation, for breaches of certain loan purchase agreements based on a failure of Decision One Mortgage Company, LLC (“Decision One”) to repurchase loans it sold to the Company and for which an early payment default occurred. HSBC Finance Corporation (“HSBC”) guaranteed Decision One’s obligations with respect to certain loans. On March 25, 2008, the defendants served their answer generally denying the Company’s allegations; included as part of the answer were counterclaims by Decision One for attorneys’ fees and indemnification under the subject loan purchase agreements.
On December 8, 2008, the Company filed a First Amended Complaint which added claims based on additional breaches of the loan purchase agreements at issue in the original complaint, as well as breaches of other loan purchase agreements between the Company and Decision One, resulting from Decision One’s failure to repurchase loans it sold to the Company and for which an early payment default occurred. The First Amended Complaint sought damages from Decision One in an amount not less that $8.75 million; of this amount the Company alleged that HSBC was liable for not less that $4.4 million as a result of its guaranty.
On December 31, 2008, defendants served their answers to the First Amended Complaint similarly denying the Company’s allegations. As before, Decision One asserted counterclaims for attorneys’ fees and indemnification under the subject loan purchase agreements, which counterclaims the Company denied.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information. Our common stock was traded on The Nasdaq Global Market, formerly The Nasdaq National Market, under the symbol “FCMC” from July 19, 2005 to November 3, 2008. Since such date, our common stock has been quoted on the “Pink Sheets,” a centralized quotation service for over-the-counter securities, under the symbol “FCMC.PK.”
The following table sets forth the bid prices for the common stock and the sales prices for the common stock on The Nasdaq Global Market and Pink Sheets, as applicable, for the periods indicated. Trading during these periods was limited and sporadic; therefore, the following quotes may not accurately reflect the true market value of the securities. Prices since November 3, 2008 reflect inter-dealer prices without retail markup or markdown or commissions and may not represent actual transactions, while prices prior to such date are as reported by The Nasdaq Global Market.
Holders. As of March 24, 2009, there were approximately 407 record holders of the Company’s common stock.
Dividend Policy. We have not paid cash dividends on our common stock in recent years and do not expect to pay a cash dividend in the near future. We currently intend to retain future earnings to finance our operations and expand our business. Any future determination to pay cash dividends will be at the discretion of the board of directors and will depend upon a complete review and analysis of all relevant factors, including our financial condition, operating results, capital requirements and any other factors the board of directors deems relevant. In addition, the Forbearance Agreements expressly restrict payments to stockholders, which includes our ability to pay dividends.
Securities Authorized for Issuance Under Compensation Plans. The following table shows compensation plans (including individual compensation arrangements) under which equity securities are authorized for issuance, as of December 31, 2008.
Recent Sales of Unregistered Securities
None.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
Not applicable because the Company is a Smaller Reporting Company.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes forward-looking statements. We have based these forward-looking statements on our current plans, expectations and beliefs about future events. In light of the risks, uncertainties and assumptions discussed under Item 1A. “Risk Factors” of this Annual Report on Form 10-K and other factors discussed in this section, there are risks that our actual experience will differ materially from the expectations and beliefs reflected in the forward-looking statements in this section and throughout this report. For more information regarding what constitutes a forward-looking statement, please refer to Item 1A. “Risk Factors.”
General
The following discussion of our operations and financial condition should be read in conjunction with our financial statements and notes thereto included elsewhere in this Form 10-K. In these discussions, most percentages and dollar amounts have been rounded to aid presentation. As a result, all such figures are approximations. The following management’s discussion and analysis of financial condition and results of operations is based on the amounts reported in the Company’s consolidated financial statements. These financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts. Changes in these estimates and assumptions could have a material effect on the Company’s consolidated financial statements.
Going Concern Uncertainty
The Company has been and continues to be operating in an extraordinary and difficult environment, and has been significantly and negatively impacted by the unprecedented credit and economic market turmoil and most recently the recessionary economy. Particularly impacting Franklin has been the severe deterioration in the U.S. housing market and the nearly complete shutdown of the mortgage credit market for borrowers without excellent credit histories, and more recently the slowing economy with increasing unemployment. These unprecedented market conditions have adversely affected the Company’s portfolio of residential mortgage loans, particularly our second-lien mortgage loans, delinquencies, provisions for loan losses, operating losses and cash flows, which have resulted in a significant stockholders’ deficit of $464.5 million at December 31, 2008. The Company, under the terms of the Forbearance Agreements with its lead lending bank, has been since the latter part of 2007 expressly prohibited from acquiring or originating loans, and certain existing defaults under the Company’s existing credit facilities with the bank have been temporarily waived until the maturity of the forbearance agreements in May 2009. In addition, the Company’s Forbearance Agreements with The Huntington National Bank (“Huntington” or “the bank”), which are described below, contain affirmative covenants that the Company maintain and comply in all material respects with all governmental licenses and authorizations to hold and service mortgage loans and real estate owned properties. Any Forbearance Default under the Forbearance Agreements, or failure to successfully renew the Forbearance Agreements or enter into new credit facilities with Huntington prior to the scheduled maturity of the Forbearance Agreements in May 2009, could entitle Huntington to declare the Company’s indebtedness immediately due and payable and could result in the transfer of the Company’s rights as servicer of its loans (loans pledged to Huntington) to a third party. As a result, and based on the March 2009 Restructuring described above in “Recent Developments,” without the continued cooperation and assistance from Huntington, the consolidated FCHC’s ability to continue as a viable business is in doubt, and it may not be able to continue as a going concern. See “- Borrowings - Forbearance Agreements with Lead Lending Bank - Recent Development - March 2009 Restructuring.”
Executive Summary
The Company had a net loss of $476.3 million for the year ended December 31, 2008, compared with a net loss of $8.6 million for the year ended December 31, 2007. The net loss for the year ended December 31, 2008 was principally the result of a $458.1 million provision for loan losses and interest reversals for non-
accrual loans. Due principally to the substantial deterioration in the housing and subprime mortgage markets and, more recently, the slowing economy with increasing unemployment, and the concomitant deterioration in the performance of the Company’s loan portfolios, the Company reassessed its allowance for loan losses throughout the year 2008, which resulted in significantly increased estimates of inherent losses in its portfolios and increased allowances for loan losses. The aggregate allowance for loan losses at December 31, 2008 was $521.0 million, compared with $254.7 million at December 31, 2007. The net loss for the year ended December 31, 2007 included a $274.6 million provision for loan losses, which was substantially offset by a net gain on debt forgiveness that arose from the Forbearance Agreements entered into on December 28, 2007 with the Company’s bank. See “Management’s Discussion and Analysis - Year Ended December 31, 2008 Compared to Year Ended December 31, 2007.”
Revenues for 2008 decreased by 35% to $109.9 million, from 2007 revenues of $169.3 million, while interest expense (inclusive of amortization of deferred financing costs) decreased by 46% to $79.4 million. Due principally to the significant increase in the allowance for loan losses, loan charge-offs, and since we did not acquire or originate any residential mortgage loans during the twelve months ended December 31, 2008, the size of our total portfolio of net notes receivable, loans held for investment and OREO at the end of 2008 decreased to $943.4 million from $1.58 billion at the end of 2007. Our total debt outstanding, including notes payable (term debt) and financing agreements, decreased to $1.44 billion at the end of 2008, from $1.63 billion at the end of 2007.
We had stockholders’ deficit of $464.5 million at December 31, 2008, compared to stockholders’ equity of $39.3 million at the end of 2007.
Application of Critical Accounting Policies and Estimates
The following discussion and analysis of financial condition and results of operations is based on the amounts reported in our consolidated financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. In preparing the consolidated financial statements, management is required to make various judgments, estimates and assumptions that affect the financial statements and disclosures. Changes in these estimates and assumptions could have a material effect on our consolidated financial statements. The following is a summary of the accounting policies believed by management to be those that require subjective and complex judgment that could potentially affect reported results of operations. Management believes that the estimates and judgments used in preparing these consolidated financial statements were the most appropriate at that time.
Notes Receivable and Income Recognition - The notes receivable portfolio consists primarily of secured real estate mortgage loans purchased from financial institutions and mortgage and finance companies. Such notes receivable were performing, non-performing or sub-performing at the time of purchase and were generally purchased at a discount from the principal balance remaining. Notes receivable are stated at the amount of unpaid principal, reduced by purchase discount and allowance for loan losses. The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past loan loss experience and other relevant factors. In connection with the determination of the allowance for loan losses, management obtains independent property valuations for the underlying collateral when considered necessary.
In general, interest on the notes receivable is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. Accrual of interest on notes receivable, including impaired notes receivable, is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Subsequent recognition of income occurs only to the extent payment is received,
subject to management’s assessment of the collectibility of the remaining interest and principal. A non-accrual note is restored to an accrual status when collectibility of interest and principal is no longer in doubt and past due interest is recognized at that time.
In general, interest on modified notes receivable is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. Except for certain performing loans that are modified by a reduction in the interest rate, while all accrued and unpaid interest is reversed, and in these cases interest at the new modified interest rate is accrued, a nonaccrual note is restored to an accrual status when collectibility of interest and principal is expected to be fully recovered. Accrual of interest on modified loans is discontinued when the loan is contractually delinquent 90 days. When interest accrual is discontinued on modified loans contractually delinquent 90 days, all unpaid accrued interest is reversed against interest income.
Discounts on Acquired Loans - Effective January 1, 2005, as a result of the required adoption of SOP 03-3, the Company was required to change its accounting for loans acquired subsequent to December 31, 2004, which have evidence of deterioration of credit quality since origination and for which it is probable, at the time of our acquisition, that the Company will be unable to collect all contractually required payments. For these loans, the excess of the undiscounted contractual cash flows over the undiscounted cash flows estimated by us at the time of acquisition is not accreted into income (nonaccretable discount). The amount representing the excess of cash flows estimated by us at acquisition over the purchase price is accreted into purchase discount earned over the life of the loan (accretable discount). The nonaccretable discount is not accreted into income. If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting may be used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan.
Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable discount are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable discount is transferred to the accretable discount and is accreted into interest income over the remaining life of the loan on the interest method. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through the allowance for loan losses.
There is judgment involved in estimating the amount of the loan’s future cash flows. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect our financial condition and results of operations. Depending on the timing of an acquisition, the initial allocation of discount generally will be made primarily to nonaccretable discount until the Company has boarded all loans onto its servicing system; at that time, any cash flows expected to be collected over the purchase price will be transferred to accretable discount. Generally, the allocation will be finalized no later than ninety days from the date of purchase.
Allowance for Loan Losses - The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past delinquency experience, delinquency migration experience, loan loss experience and other relevant factors. In connection with the determination of the allowance for loan losses, management obtains independent property valuations for the underlying collateral when considered necessary. Management believes as of December 31, 2008, that the allowance for loan losses is adequate. The allowance for loan losses is a material estimate, which could change significantly in the near term.
Originated Loans Held for Investment - In general, interest on originated loans held for investment is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. The Company accrues interest on secured real estate first mortgage loans originated by the Company up to a maximum of 209 days contractually delinquent with a recency payment in the last
179 days, and that are judged to be fully recoverable for both principal and accrued interest, based principally on a foreclosure analysis that includes an updated estimate of the realizable value of the property securing the loan.
The accrual of interest is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful, which can be less than 209 days contractually delinquent with a recency payment in the last 179 days. When interest accrual is discontinued, the unpaid accrued interest on certain loans in the foreclosure process is not reversed against interest income where the current estimate of the value of the underlying collateral exceeds 110% of the outstanding loan balance. For all other loans held for investment, all unpaid accrued interest is reversed against interest income when interest accrual is discontinued. Except for certain loan modifications, subsequent recognition of income occurs only to the extent payment is received, subject to management’s assessment of the collectibility of the remaining interest and principal. Except for certain performing loans that are modified by a reduction in the interest rate, while all accrued and unpaid interest is reversed, and in these cases interest at the new modified interest rate is accrued, a nonaccrual note is restored to an accrual status when collectibility of interest and principal is expected to be fully recovered.
Other Real Estate Owned - Other real estate owned (“OREO”) consists of properties acquired through, or in lieu of, foreclosure or other proceedings and are held for sale and carried at the lower of cost or fair value less estimated costs to sell. Any write-down to fair value, less cost to sell, is charged to provision for loan losses based upon management’s continuing assessment of the fair value of the underlying collateral. OREO is evaluated periodically to ensure that the recorded amount is supported by current fair values and valuation allowances are recorded as necessary to reduce the carrying amount to fair value less estimated cost to sell. Revenue and expenses from the operation of OREO and changes in the valuation allowance are included in operations. Direct costs relating to the development and improvement of the property are capitalized, subject to the limit of fair value of the property, while costs related to holding the property are expensed in the current period. Gains or losses are included in operations upon disposal of the property.
Derivatives - As part of the Company’s interest-rate risk management process, we entered into interest rate cap agreements in 2006 and 2007, and interest rate swap agreements in 2008. In accordance with Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”), as amended and interpreted, derivative financial instruments are reported on the consolidated balance sheets at their fair value.
Interest rate caps are recorded at fair value. The interest rate caps are not designated as hedging instruments for accounting purpose, and unrealized changes in fair value are recognized in the period in which the changes occur and realized gains and losses are recognized in the period when such instruments are settled.
Franklin’s management of interest-rate risk predominantly includes the use of plain-vanilla interest-rate swaps to synthetically convert a portion of its LIBOR-based variable-rate debt to fixed-rate debt. In accordance with SFAS 133, derivative contracts hedging the risks associated with expected future cash flows are designated as cash flow hedges. The Company formally documents at the inception of its SFAS 133 hedges all relationships between hedging instruments and the related hedged items, as well as its interest rate risk management objectives and strategies for undertaking various accounting hedges. Additionally, we use regression analysis at the inception of the hedge and for each reporting period thereafter to assess the derivative’s hedge effectiveness in offsetting changes in the cash flows of the hedged items. The Company discontinues hedge accounting if it is determined that a derivative is not expected to be or has ceased to be highly effective as a hedge, and then reflects changes in the fair value of the derivative in earnings. All of the Company’s interest-rate swaps qualify for cash flow hedge accounting, and are so designated.
Changes in the fair value of derivatives designated as cash flow hedges, in our case the swaps, are recorded in accumulated other comprehensive loss (“AOCL”) within stockholders’ equity to the extent that the hedges are effective. Any hedge ineffectiveness is recorded in current period earnings. If a derivative instrument in a cash flow hedge is terminated or the hedge designation is removed, or a forecasted transaction will not occur, related amounts in AOCL are reclassified into earnings in that period.
Results of Operations
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
Overview. The Company had a net loss of $476.3 million for the twelve months of 2008, compared with a net loss of $8.6 million for the twelve months of 2007. Due principally to the rapid and substantial deterioration in the U.S. housing and subprime mortgage markets and deterioration in the performance of the Company’s portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, and the resultant significantly increased estimates of inherent losses in its portfolios described above during both twelve month periods, the Company’s provision for loan losses was $458.1 million in the twelve months ended December 31, 2008, compared with $274.6 million in the twelve months ended December 31, 2007. In addition, the significant increase of loans on nonaccrual status, and the resultant interest reversals for nonaccrual loans, negatively impacted the Company’s operations and net loss. At December 31, 2008, nonaccrual loans increased to approximately $851.2 million, an increase of 40% from $623.0 million at December 31, 2007. The allowance for loan losses for all portfolios at December 31, 2008 was $521.0 million, compared with $254.7 million at December 31, 2007, and the amount of nonaccretable purchase discount at December 31, 2008 and 2007 was $97.6 million and $102.1 million, respectively. The Company had a stockholders’ deficit of $464.5 million at December 31, 2008, compared to stockholders’ equity of $39.3 million at December 31, 2007.
The Company had a net loss of $476.3 million for the twelve months of 2008, compared with a net loss of $8.6 million for the twelve months of 2007. The Company had a loss per common share for the twelve months ended December 31, 2008 of $59.67 both on a diluted and basic basis, compared to a loss per common share of $1.09 on both a diluted and basic basis for the twelve months ended December 31, 2007. The size of our total portfolio of net notes receivable, loans held for investment and OREO at December 31, 2008 decreased to $943.4 million from $1.58 billion at December 31, 2007. Revenues decreased by 35% to $109.9 million for the twelve months ended December 31, 2008, from $169.3 million for the twelve months ended December 31, 2007. Our total debt outstanding decreased to $1.44 billion at December 31, 2008 from $1.63 billion at December 31, 2007. As a result of the decrease of our total debt, the restructuring of our debt, including $300 million of debt forgiveness in December 2007, no interest on $125 million of our debt and the benefit of a decline of approximately 400 basis points in one-month LIBOR since January 1, 2008 on our interest-sensitive borrowings, interest expense (inclusive of amortization of deferred financing costs and success fees) decreased by $66.4 million, or 46%, during the twelve months ended December 31, 2008 compared with the same period in 2007. Collection, general and administrative expenses increased by $7.0 million, or 17%, to $48.5 million during the twelve months ended December 31, 2008, from $41.4 million for the same period in 2007. The provision for loan losses increased by $183.5 million to $458.1 million in the twelve months ended December 31, 2008.
Revenues. Revenues decreased by $59.3 million, or 35%, to $109.9 million during 2008, from $169.3 million during 2007. Revenues include interest income, purchase discount earned, gains on sales of notes receivable, gains on sales of originated loans, gains on sales of OREO, third-party acquisition services fees, subservicing fees, other servicing fees and other income.
Interest income decreased by $62.8 million, or 40%, to $93.1 million during the twelve months ended December 31, 2008 from $155.9 million during the twelve months ended December 31, 2007. The decrease in interest income reflected an approximate 40% increase in loans on nonaccrual (from $623.0 million at December 31, 2007 to $851.2 million at December 31, 2008) due to increased serious delinquencies in the Company’s loan portfolios, which caused an increase in interest reversals for nonaccrual loans and a reduction in the amount of loans on accrual status during the twelve months ended December 31, 2008 compared to the twelve months ended December 31, 2007. The impact of interest reversals on loans placed on nonaccrual during the twelve months ended December 31, 2008 and 2007 was approximately $27.5 million and $16.2 million, respectively.
Purchase discount earned decreased by $2.4 million, or 48%, to $2.6 million during the twelve months of 2008 from $5.0 million during the twelve months of 2007. This decrease resulted principally from a significantly slower rate of prepayments from the acquired notes receivable loan portfolio. We received
$82.8 million of principal payments from notes receivable during the twelve months ended December 31, 2008, compared with $185.1 million of principal payments during the same period in 2007.
There were no gains on sales of notes receivable as the Company did not sell any previously acquired (purchased) loans during the twelve months ended December 31, 2008. The Company realized a gain on sales of notes receivable of $31,000 from sales of $22.3 million of performing low-coupon notes receivable during the twelve months ended December 31, 2007.
The Company did not sell any previously originated loans (loans held for investment) during the twelve months ended December 31, 2008, compared with $37.5 million of originated loans sold during the twelve months ended December 31, 2007. The average loss on loans sold in 2007 was 0.82%, which included a net gain of $155,000 on the sale of Liberty Loans, a net gain of $286,000 on the sale of other loans originated for sale, a net loss of $828,000 on “Alt-A” loans both sold and transferred to portfolio at the lower of cost or market value, and a net recovery of $82,000 for previously established early payment default reserves for Liberty Loans sold in 2006. In the fourth quarter of 2007, the Company suspended its sales of originated loans due to unfavorable market conditions, and as of November 2007, the Company ceased to originate loans.
Gain on sale of OREO increased by $1.5 million, or 196%, to $2.2 million during the twelve months ended December 31, 2008, from $748,000 during the twelve months ended December 31, 2007. We sold 490 OREO properties with an aggregate carrying value of $41.6 million during the twelve months of 2008, as compared to 401 OREO properties with an aggregate carrying value of $26.6 million during the twelve months of 2007. The increase in the gain on sales of OREO properties was due principally to certain Liberty Loans acquired through the foreclosure process with property values in excess of carrying values, which were sold during the twelve months of 2008.
Servicing fees and other income (principally third-party acquisition services fees and subservicing fees, late charges and prepayment penalties) increased by $4.1 million, or 52%, to $12.0 million during the twelve months ended December 31, 2008 from $7.9 million during the corresponding period last year. This increase was primarily due to an increase of approximately $1.7 million in recoveries of outside foreclosure attorney costs from delinquent borrowers that were the result of new loss mitigation activities (loan modification programs), approximately $1.9 million in subservicing fees from a new third-party servicing contract (Bosco) that began during the quarter ended June 30, 2008, approximately $728,000 in due diligence fees received for due diligence services provided to third parties, and increased late charges resulting primarily from the increase in delinquencies. These increases were partially offset by a decrease of approximately $1.2 million in prepayment penalties due to a slower rate of loan payoffs in general and fewer payoffs from states where prepayment penalties are allowed.
Operating Expenses. Operating expenses increased by $124.3 million, or 27%, to $587.6 million during the twelve months of 2008 from $463.3 million during the same period in 2007. Total operating expenses include interest expense, collection, general and administrative expenses, provisions for loan losses, amortization of deferred financing costs and depreciation expense.
Interest expense decreased by $64.8 million, or 45%, to $78.5 million during the twelve months ended December 31, 2008, from $143.3 million during the twelve months ended December 31, 2007. This decrease was principally the result of a lower average cost of funds during the twelve months ended December 31, 2008 of 5.14%, compared to 7.91% during the twelve months ended December 31, 2007, reflecting the restructuring in December 2007 of the interest rate terms of our debt, including the forgiveness of $300 million of our debt, an interest rate of 0% on $125 million of our debt, and a decline of approximately 400 basis points in one-month LIBOR since January 1, 2008. On February 27, 2008, the Company entered into $725 million (notional amount) of fixed-rate interest rate swaps, and on April 30, 2008, the Company entered into an additional $275 million (notional amount) of fixed-rate interest rate swaps, in order to limit the negative effect of a rise in short-term interest rates by effectively stabilizing the future interest payments on a portion of its variable-rate debt. Because short-term interest rates actually declined in the months following the purchase of these swaps, these interest rate swaps increased the Company’s interest cost by $2.4 million. At December 31, 2008, the weighted average interest rate of our borrowed funds, exclusive of the interest rate swaps, was 3.95%, compared with 7.46% at December 31, 2007.
Collection, general and administrative expenses increased by $7.0 million, or 17%, to $48.5 million during the twelve months ended December 31, 2008, from $41.4 million during the corresponding period in 2007. Collection, general and administrative expenses as a percentage of average assets increased to 3.57% during the twelve months ended December 31, 2008 from 2.26% during the twelve months ended December 31, 2007, due principally to the Company’s reduced balance sheet. The increase in collection, general and administrative expenses was principally the result of increased servicing costs due to increased delinquencies and defaults in our loan portfolios. Salaries and employee benefits expenses increased $306,000, or 2%, to $18.0 million during the twelve months ended December 31, 2008, from $17.7 million during the twelve months ended December 31, 2007, due to the expansion of our Servicing Department and an increase in servicing personnel, which was principally offset by reductions in staff throughout all other areas of the Company (reductions that began in late 2007) due to our withdrawal from all loan acquisition and origination activities. While the number of servicing employees increased to 159 at December 31, 2008, from 105 employees at December 31, 2007, we ended the year with a Company total of 220 employees, compared to a Company total of 207 employees at the end of 2007. Legal fees relating to increased collection and loss mitigation activities increased by $3.4 million, or 59%, to $9.2 million from $5.8 million during the same period last year. This increase reflected the cost of outside legal services for increased foreclosure, bankruptcy and judgment activities for the delinquent loans in our portfolios. The Company also experienced an increase in corporate legal expenditures, principally related to the restructuring of our debt with our lenders, the reorganization of the structure of our Company in December 2008 and the WMC litigation, of $1.5 million, or 106%, to $2.9 million from $1.4 million during the same twelve-month period last year. These corporate legal expenses included the reimbursement of legal costs incurred by our lending banks for the restructuring of our debt and the reorganization of the structure of our Company. Servicing expenses related to the maintenance and management of OREO increased by approximately $3.1 million to $4.2 million during the twelve months of 2008, from $1.1 million during the same twelve-month period last year, primarily due to the growth in the OREO portfolio and payments of delinquent property taxes. In addition, third-party servicing expenses related to our collection, loss mitigation and deficiency operations increased by $621,000 to $3.7 million from $3.1 million, primarily due to an increase in the volume of properties placed on our forced placed insurance policy due to the continued deterioration of our loan portfolios as compared to the twelve months ended December 31, 2007. Professional fees increased by $61,000, or 2%, to $2.7 million from $2.6 million, principally due to increased outside tax and audit fees and a special consulting fee related to a potential restructuring of the Company’s debt and loan portfolios, compared to the same period last year. Loan acquisition costs decreased by $1.4 million as the Company did not acquire pools of mortgage loans in the twelve months of 2008. Various other general and administrative expenses decreased by approximately $492,000 during the twelve months ended December 31, 2008, principally due to reduced costs throughout the Company’s operations reflecting the impact of the Forbearance Agreements entered into on December 28, 2007 on our business activities, principally the stoppage of all acquisitions and originations of loans which was partially offset by $661,000 of lease accruals for vacated Tribeca Lending office space.
During the twelve months ended December 31, 2008, the U.S. housing and subprime mortgage markets experienced continued deterioration. This deterioration continued to give rise to industry-wide increases in mortgage delinquencies reflecting the decline in collateral values and related declines in borrowers’ equity in their homes, particularly with respect to subprime loans originated throughout the mortgage industry during 2005, 2006 and the early months of 2007. These deteriorating conditions in the housing and subprime mortgage markets, coupled with the U.S. economy entering a recessionary period in the latter part of 2008, continued to negatively impact the credit quality of the Company’s portfolios throughout the twelve months of 2008, particularly with regard to the second-lien mortgage loan portfolio. As a result, the Company significantly increased its estimates of inherent losses in its portfolios of loans, particularly its purchased second-lien mortgage loans, which resulted in a provision for loan losses of $458.1 million during the twelve months ended December 31, 2008. During the twelve months ended December 31, 2007, the provision for loan losses was $274.6 million due to the rapid and substantial deterioration in the subprime mortgage and housing markets that developed during this period, which negatively impacted the credit quality of the Company’s portfolios, particularly with regard to the second-lien mortgage loan portfolio. As a result, the
Company significantly increased its estimates of inherent losses in the portfolios of purchased loans, particularly its purchased second-lien mortgage loans, in the twelve month period ended December 31, 2007.
Amortization of deferred financing costs decreased by $1.6 million, or 62%, to $1.0 million during the twelve months of 2008 from $2.6 million during the twelve months of 2007. This decrease resulted primarily from a slower rate of prepayments on all portfolios of loans, which caused reduced prepayments of our borrowed funds, and from the elimination of $300 million of debt as of December 28, 2007.
Depreciation expenses increased by $125,000, or 9%, to $1.5 million in the twelve months ended December 31, 2008. This increase was principally due to the write-off of approximately $454,000 of obsolete and unused leasehold improvements, office furniture and equipment in vacated office space, which was partially offset by fully depreciated assets during the past twelve months and a reduction in assets purchased compared with the same period in 2007.
Our pre-tax loss increased by $467.8 million to a $477.7 million loss for 2008, from a pre-tax loss of $9.8 million during 2007 for the reasons set forth above.
The Company recorded a tax benefit of $1.3 million during the twelve months ended December 31, 2008, compared with a tax benefit of $1.2 million recorded during the twelve months ended December 31, 2007.
Liquidity and Capital Resources
General
We ceased to acquire and originate loans in November 2007, and under the terms of the Forbearance Agreements, the Company cannot originate or acquire mortgage loans or other assets without the prior consent of the bank.
We have one source of external funding to meet our liquidity requirements, in addition to the cash flow provided from borrower payments of interest and principal on mortgage loans. See “- Borrowings.” In addition, we have had the ability, from time to time, to sell loans in the secondary market. Prior to 2008, we sold pools of acquired mortgage loans and newly originated Liberty Loans from time to time, and we sold loans that we originated specifically for sale into the secondary market on a regular basis. Due to severe disruptions in the capital markets since mid-2007 and current secondary market conditions, particularly the severe contraction in secondary market liquidity for non-prime mortgage loans, sales of loans in the near future are unlikely.
We are required to submit all payments we receive from our mortgage loans to a lockbox, from which we receive an operating allowance, which is subject to periodic review and approval by the bank, to sustain our business. Substantially all amounts submitted to the lockbox in excess of the agreed upon operating allowance are used to pay down amounts outstanding under our credit facilities with the bank. The operating allowance may not be sufficient to sustain our operations in the future, particularly for new business activities. If it is insufficient, there is no guarantee that the bank will increase our operating allowance, which could have a material adverse impact on our business.
Short-term Investments. The Company’s short-term investment portfolio at December 31, 2007 included principally U.S. treasury bills and investment-grade commercial paper. The Company’s investment policy is structured to provide an adequate level of liquidity in order to meet normal working capital needs, while taking minimal credit risk. As of December 31, 2008, all of the Company’s unrestricted cash was invested in money market accounts and certificates of deposits held at The Huntington National Bank.
Cost of Funds. As of December 31, 2008, we had total borrowings of $1.44 billion, of which $1.40 billion was subject to the Forbearance Agreements and $40.9 million remained under a credit facility excluded from the Forbearance Agreements. Substantially all of the debt under these facilities was incurred in connection with the purchase and origination of, and is secured by, our acquired loans (notes receivable),
originated loans held for investment and OREO portfolios. At December 31, 2008, the interest rates on our term debt were as follows:
*
0% interest at least until maturity of the Forbearance Agreements in May 2009, or until all outstanding amounts under the Tranche A debt have been paid in full.
At December 31, 2008, the weighted average interest rate on term debt was 3.95%. Our warehouse facilities were utilized, until December 28, 2007, to fund Tribeca’s originations of loans and the acquisition of loans through our “Flow Acquisitions Group” pending sale to others or pending funding under our credit facilities for loans to be held in portfolio. At December 31, 2007, both warehouse facilities were discontinued.
Cash Flow from Operating, Investing and Financing Activities
Liquidity represents our ability to obtain adequate funding to meet our financial obligations. Our liquidity position was affected by mortgage loan purchase and origination volume, and is affected by mortgage loan payments, including prepayments, loan maturities and the amortization and maturity structure of borrowings under our credit facilities. In accordance with the terms of our credit facilities with our lenders, we received a cash allowance that was adequate to meet our operating expenses. Such a cash allowance to meet our operating expenses is provided for under the Forbearance Agreements.
At December 31, 2008, we had cash and cash equivalents of $21.4 million compared with $18.3 million at December 31, 2007. Restricted cash of $27.9 million and $40.3 million at December 31, 2008 and 2007, respectively, was restricted under our credit agreements and lockbox facility with the bank.
Substantially all of our assets are invested in our portfolios of notes receivable, loans held for investment, and OREO. Primary sources of our cash flow for operating and investing activities have been borrowings under our various credit facilities, collections of interest and principal on notes receivable and loans held for investment and proceeds from sales of notes and OREO properties, and from time to time, sales of our newly originated loans that generally were held for investment. Primary uses of cash included purchases of notes receivable, originations of loans and for operating expenses. We relied significantly upon our lender and the other banks that participated in the loans made to us by our lender to provide the funds necessary for the purchase of notes receivable portfolios and the origination of loans. While we historically had been able to finance these purchases and originations, we have not had, at any time since our inception, committed loan facilities in significant excess of the amount we currently had outstanding under our credit facilities. We ceased to acquire and originate loans in November 2007, and under the terms of the Forbearance Agreements, we are expressly prohibited from acquiring or originating mortgage loans or other assets without the prior consent of the bank.
Net cash used in operating activities was $16.7 million during the twelve months ended December 31, 2008, compared with cash used of $17.3 million during the twelve months ended December 31, 2007. The decrease in cash provided by operating activities during the twelve months ended December 31, 2008 was due primarily to an increase of $467.7 million in the Company’s net loss from the net loss of $8.6 million for the twelve months ended December 31, 2007.
Net cash provided by investing activities was $205.4 million in the twelve months ended December 31, 2008, compared to $287.9 million of cash used in the twelve months ended December 31, 2007. The decrease in cash used during the twelve months ended December 31, 2008 was primarily due to our not acquiring or originating loans in 2008. This decrease in cash used in 2008 was partially offset by a decrease of $190.9 million in principal collections received from the portfolios of notes receivable and loans held for investment.
Net cash used in financing activities was approximately $185.5 million during the twelve months ended December 31, 2008, compared to $319.5 million provided during the twelve months ended December 31, 2007. The decrease in cash provided during 2008 was due to the reasons set forth above.
Borrowings
As of December 31, 2008, the Company owed an aggregate of $1.44 billion under the Forbearance Agreements and the one remaining credit facility excluded from the Forbearance Agreements with our lenders. These borrowings are shown in the Company’s financial statements as “Notes payable” (referred to as “term loans” herein) and “Financing agreements” (referred to as the “Warehouse Facility” or “Warehouse Facilities” herein).
Forbearance Agreements with Lead Lending Bank
On December 28, 2007, the Company entered into a series of agreements with the bank, pursuant to which the bank agreed to forbear with respect to certain defaults of the Company relating to the Company’s indebtedness to the bank and restructure approximately $1.93 billion of such indebtedness to the bank and its participant banks.
The Restructuring did not relate to:
•
$44.5 million of the Company’s indebtedness under the Master Credit and Security Agreement, dated as of October 13, 2004, as amended, by and among Franklin Credit, certain subsidiaries of Franklin Credit and the bank; and,
•
$44.8 million of Tribeca’s indebtedness to BOS (USA) Inc., an affiliate of Bank of Scotland, under the Master Credit and Security Agreement, dated March 24, 2006, by and among Tribeca, certain subsidiaries and BOS.
These amounts remain subject to the original terms specified in the applicable agreements (the “Unrestructured Debt”).
Loan Restructuring. Pursuant to the Restructuring:
•
the Company acknowledged, and the bank waived, certain existing defaults under the Company’s existing credit facilities with the bank;
•
Franklin Credit’s indebtedness to the bank was reduced by $300 million and Franklin Credit paid a restructuring fee of $12 million to the bank;
•
the remaining approximately $1.54 billion of outstanding indebtedness to the bank, including approximately $1.05 billion of outstanding indebtedness of Franklin Credit and approximately $491.1 million of outstanding indebtedness of Tribeca, was restructured into six term loans with modified terms and a maturity date of May 15, 2009; and,
•
the Company paid all of the accrued interest on its debt outstanding to the bank through December 27, 2007 and guaranteed payment and performance of the restructured indebtedness.
Terms of the Restructured Indebtedness. The following table summarizes the principal economic terms of the Company’s indebtedness immediately following the Restructuring.
(1)
The applicable interest rate is fixed at 10% per annum. Interest will be paid in kind during the term of the forbearance.
(2)
Tranche C requires no principal amortization. All principal is due at maturity.
(3)
Tranche D serves as a revolving credit line with a maximum availability of $5 million, and an additional $5 million which may be used for issuance of letters of credit.
(4)
Does not include a letter of credit facing fee of 0.125% per annum on the average daily undrawn amount of each issued and outstanding letter of credit.
The interest rate under the terms of the Forbearance Agreements that is the basis, or index, for the Company’s interest cost is the one-month London Interbank Offered Rate (“LIBOR”) plus applicable margins.
The following table compares the approximate weighted average interest rate of the Company’s indebtedness immediately prior to and following the Restructuring.
(1)
Includes the Unrestructured Debt.
Pursuant to the Forbearance Agreements, the bank is not required to provide any additional advances, except for those under the revolving credit or letter of credit portions of Tranche D.
Cash Flow. The Forbearance Agreements with respect to Franklin Credit, on the one hand, and Tribeca, on the other, provide a waterfall with respect to cash flow received in respect of collateral pledged in support of the related restructured indebtedness, net of approved, reimbursable operating expenses. Such cash flow is applied in the following order:
•
to pay interest in respect of Tranche A advances, Tranche B advances and, in the case of Franklin Credit, Tranche D advances, in that order;
•
to pay fees related to the Company’s letters of credit from the bank;
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to pay the minimum required principal payments in respect of Tranche A advances and Tranche B advances, in that order;
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to prepay outstanding Tranche A advances;
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to prepay outstanding Tranche B advances;
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to prepay Unrestructured Debt (excluding that owed to BOS);
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in the case of Franklin Credit, to repay Tranche D advances, any letter of credit exposure, and any obligations in respect of any interest rate hedge agreements with the bank;
•
in the case of Franklin Credit, 90% of the available cash flow to repay interest and then principal of the Tranche C advances if Franklin Credit is acting as servicer of the underlying collateral, or 100% otherwise; and,
•
in the case of Franklin Credit and Tribeca, to pay any advances then outstanding in respect of the other’s indebtedness to the bank, other than for Unrestructured Debt.
Covenants; Events of Default. The Forbearance Agreements contain affirmative and negative covenants customary for restructurings of this type, including covenants relating to reporting obligations. The affirmative and negative covenants under all of the credit agreements between the Company and the bank, other than those under the Franklin Master Credit Agreement and under the Tribeca Master Credit and Security Agreement, dated as of February 28, 2006, as amended, were superseded by the covenants in the Forbearance Agreements. Additionally, any provisions of any of the credit agreements between the Company and the bank that conflict with or are subject of a discrepancy with the provisions of the Forbearance Agreements will be superseded by the conflicting provision in the Forbearance Agreements. The Forbearance Agreements include covenants requiring that:
•
the Company’s reimbursable expenses in the ordinary course of business during each of the first two months after the date of the agreement will not exceed $2.5 million, excluding reimbursement of certain bank expenses after the date of the Restructuring, and thereafter, an amount provided for in an approved budget;
•
the Company will not originate or acquire mortgage loans or other assets, perform due diligence or servicing, broker loans, or participate in off-balance sheet joint ventures and special purpose vehicles, without the prior consent of the bank;
•
the Company will use its best efforts to obtain interest rate hedges acceptable to the bank in respect of the $1 billion of Tranche A indebtedness;
•
the Company will not make certain restricted payments to its stockholders or certain other related parties;
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the Company will not engage in certain transactions with affiliates;
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the Company will not incur additional indebtedness other than trade payables and subordinated indebtedness;
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the Company together will maintain a minimum consolidated net worth of at least $5 million, plus a certain percentage, to be mutually agreed upon, of any equity investment in the Company after the date of the Restructuring;
•
the Company will together maintain a minimum liquidity of $5 million;
•
the Company will maintain prescribed interest coverage ratios based on EBITDA (as defined) to Interest Expense (as defined);
•
the Company will not enter into mergers, consolidations or sales of assets (subject to certain exceptions); and,
•
the Company will not, without the bank’s consent, enter into any material change in its capital structure that the bank or a nationally recognized independent public accounting firm determine could cause a consolidation of its assets with other persons under relevant accounting regulations.
The Forbearance Agreements contain events of default customary for facilities of this type, although they generally provide for no or minimal grace and cure periods.
Servicing. Franklin Credit will continue to service the collateral pledged by the Company under the Forbearance Agreements, subject to the bank’s right to replace Franklin Credit as servicer in the event of a default under the Forbearance Agreements or if the bank determines that Franklin Credit is not servicing the collateral in accordance with accepted servicing practices, as defined in the Forbearance Agreements. Franklin
Credit may also, with the bank’s consent, and plans to, provide to third parties servicing of their portfolios, and other related services, on a fee paying basis.
Security. The Company’s obligations with respect to the restructured Franklin Credit indebtedness are secured by a first priority lien on all of the assets of Franklin Credit and its subsidiaries, other than those of Tribeca and Tribeca’s subsidiaries, and those securing the Unrestructured Debt. The Company’s obligations with respect to the restructured Tribeca indebtedness are secured by a first priority lien on all of the assets of Tribeca and Tribeca’s subsidiaries, except for those assets securing the Unrestructured Debt. In addition, pursuant to a lockbox arrangement, the bank controls substantially all sums payable to the bank in respect of any of the collateral.
Gain on Debt Forgiveness. The forgiveness of $300 million of the Company’s indebtedness to the bank resulted in the recognition of a $284.2 million net gain in the quarter ended December 31, 2007.
March 2008 Modifications to Forbearance Agreements and Refinancing of BOS Loan
On March 31, 2008, the Company entered into a series of agreements with the bank, which amended the Forbearance Agreements, which are referred to as the Forbearance Agreement Amendments.
Pursuant to the Forbearance Agreement Amendments, the bank extended an additional $43.3 million under Tribeca’s Tranche A and Tranche B facilities, (the “Additional Payoff Indebtedness”), to fund the complete payoff of the BOS Loan. Simultaneously, BOS acquired from the bank a participation interest in Tribeca’s Tranche A facility equal in amount to the Additional Payoff Indebtedness. The effect of these transactions was to roll Tribeca’s indebtedness to BOS into the Forbearance Agreements, to terminate any obligations of Tribeca under the BOS Loan and to BOS directly, and to transfer the benefit of the collateral interests previously securing the BOS Loan to secure the obligations under the Forbearance Agreements. As a result of the Forbearance Agreement Amendments, Tribeca’s indebtedness as of March 31, 2008, was $410,860,000 and $98,774,000 for Tranche A and Tranche B, respectively. In connection with the increased debt outstanding under the Amended Forbearance Agreements, Tribeca’s required monthly principal amortization amount under the Tranche A Facility was increased from $3,600,000 to $3,900,000 and that under the Tranche B Facility was increased from $250,000 to $275,000.
In addition, the Forbearance Amendment Agreements modified the Forbearance Agreements with respect to the Franklin Master Credit Facility (the “Franklin Forbearance Agreement”):
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to provide that Tranche C interest shall not accrue until the first business day after all outstanding amounts under the Tranche A facility have been paid in full;
•
to increase the Tranche C interest rate to 20% from and after such time it begins to accrue;
•
to extend an additional period of forbearance through July 31, 2008, from May 15, 2008, in respect of the remaining Unrestructured Loans; and,
•
to increase the maximum availability under the Tranche D line of credit to $10,000,000 for working capital and general corporate purposes to enable the Company to purchase real property in which it may have a lien, and for purposes of meeting licensing requirements.
Additionally, the Forbearance Agreement Amendments modified the Forbearance Agreements to (a) join additional subsidiaries of the Company as borrowers and parties to the forbearance agreements and other loan documents; and (b) extend the time periods or modify the requirements for the Company and the Company’s other subsidiaries to satisfy certain requirements of the Forbearance Agreements.
After giving effect to the Forbearance Agreement Amendments, the waterfall of payments has been adjusted to provide that periodic amounts constituting additional periodic payments of interest required under any interest hedging agreement may be paid after interest on the Tranche A and Tranche B advances, payments of interest and principal with respect to Tranche C advance shall be deferred until after payment of the Tranche D advance, and to provide for cash payment reserves for certain contractual obligations, taxes and
$10,000,000 of cash payment reserves in the aggregate for fees, expenses, required monthly principal amortization and interest owing to the Bank.
The bank also waived any defaults under the Forbearance Agreements for the period through and including March 31, 2008, and consented to the origination by the Company of certain mortgage loans to refinance existing mortgage loans which the bank has approved for purchase and subsequent sale in the secondary market or which the bank determines are qualified for purchase by Fannie Mae or Freddie Mac.
August 2008 Modification to Forbearance Agreements
The Company entered into additional amendments to the Forbearance Agreements, effective August 15, 2008, whereby, among other things, (a) the minimum net worth covenant was eliminated, (b) the prescribed interest coverage ratios based on EBITDA were changed to ratios based on actual cash flows, (c) cash flows available for debt service shall include all of the Company’s cash receipts, including its cash revenues from providing subservicing and other services for third parties, and (d) the existing extension of an additional period of forbearance through July 31, 2008 in respect of the remaining Unrestructured Debt was extended to December 31, 2008, and absent the occurrence of an event of default, the bank agreed not to initiate collection proceedings against the Company in respect of any of the Unrestructured Debt. In addition, all identified forbearance defaults, including the minimum net worth covenant, that existed at the time of the August 2008 Modification were waived. As a result, the Company currently is in compliance with all of the terms of the Forbearance Agreements, with the exception of the minimum debt service payments with regards to the Unrestructured Debt and the failure of the Company to comply with minimum net worth requirements under certain governmental licenses to hold and service mortgage loans.
Unrestructured Debt
The Company failed to make the minimum monthly debt service payments due on July 5, 2008 through September 5, 2008 in the aggregate amount of $1.3 million from the cash flows received from the collateral supporting the Unrestructured Debt, as required by the Master Credit Agreement in respect of the Unrestructured Debt (remaining debt due to a participant bank that is not a party to the Forbearance Agreements). The Company, however, made up the aggregate shortfall of approximately $409,000 in the required minimum payments from its own cash account during 2008. See “Recent Development - March 2009 Restructuring” in this section.
December 2008 Modification to Forbearance Agreements
Concurrent with the merger and the Company’s reorganization into a holding company structure, and the reallocation of owned assets, the Company entered into a series of agreements with Huntington (the “Amendments to the Forbearance Agreements”), pursuant to which the Company amended its loan agreements with Huntington as follows:
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Franklin Asset became a borrower under the Company’s lending agreements with Huntington;
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the Trusts became guarantors for the Borrowers’ indebtedness to Huntington;
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FCMC, Franklin Asset and the Trusts each pledged its assets, including any equity interests in any of the Borrowers, as security for the Borrowers’ indebtedness to Huntington;
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Franklin Servicing LLC agreed to service, if necessary, the Company’s mortgage loans in selected states;
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the Company agreed to maintain in effect one or more interest rate hedge agreements in an aggregate notional principal amount of not less than $1 billion, or such lesser amount as Huntington in its sole discretion may approve;
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the Company’s Tranche D facility was amended to provide for (i) a revolving credit facility and letter of credit facility in the aggregate outstanding amount of $10 million, with a sublimit of $5 million, and,
in addition, (ii) a separate letter of credit facility pursuant to which Huntington may issue letters of credit in its discretion, with a sublimit of $5.5 million;
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Huntington agreed to waive the Company’s breach of covenant to comply with all laws, rules and regulations to the extent such breach results from the Company’s failure to satisfy a minimum net worth requirement; and,
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the covenant requiring FCMC and each of the Borrowers to maintain liquidity of at least $5 million was deleted.
In addition, effective immediately after the filing of the certificate of merger:
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Franklin Holding became a guarantor for the Borrowers’ indebtedness to Huntington; and,
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Franklin Holding pledged its assets, including any equity interests in any of the Borrowers, as security for the Borrowers’ indebtedness to Huntington.
The Forbearance Agreements continue to be subject to a scheduled maturity date of May 15, 2009.
Recent Development - March 2009 Restructuring
On March 31, 2009, Franklin Credit Holding Corporation (“Franklin Holding”), and certain of its wholly-owned direct and indirect subsidiaries (together with Franklin Holding, the “Company”), including Franklin Credit Management Corporation (“FCMC”) and Tribeca Lending Corp. (“Tribeca”), entered into a series of agreements (collectively, the “Restructuring Agreements”) with The Huntington National Bank (the “Bank”), successor by merger to Sky Bank, pursuant to which the Company’s loans, pledges and guarantees with the Bank and its participating banks were substantially restructured, and approximately 83% of the Company’s portfolio of subprime mortgages was removed from the Company’s balance sheet and transferred to the balance sheet of Huntington Capital Financing, LLC (the “REIT”), a real estate investment trust wholly-owned by the Bank (the “Restructuring”). In connection with the Restructuring, the Company has engaged in a number of cost savings measures, including across the board salary reductions and reductions in staff that should result in improved financial performance of FCMC.
The Restructuring did not relate to approximately $41 million of the Company’s indebtedness under the Master Credit and Security Agreement, dated as of October 13, 2004, as amended, by and among FCMC, certain subsidiaries of FCMC and the Bank (the “Franklin Master Agreement”). This amount (the “Unrestructured Debt”) remains subject to the original terms specified in the applicable agreements. All collections in respect of these loans will continue to be applied in accordance with the Company’s existing Forbearance Agreements, the maturity date of which the Bank has committed to extend from May 15, 2009 to June 30, 2009, and under which the Bank has committed that there will be no events of default should the collections in respect of these loans be insufficient to make any minimum monthly payments otherwise required under the Franklin Master Agreement until June 30, 2009. Upon expiration of the Forbearance Agreement with respect to the Unrestructured Debt, the Bank, with notice, could call an event of default under the Licensing Credit Agreement (as defined below) and the Legacy Credit Agreement (as defined below).
In conjunction with the Restructuring, and at the request of the Bank, effective March 31, 2009, the Company exercised its right to terminate two non-amortizing fixed-rate interest rate swaps with the Bank, one with a notional amount of $150 million and the other with a notional amount of $240 million. The total termination fee for cancellation of the swaps was $8.2 million, which is payable only to the extent cash is available under the waterfall provisions of the Legacy Credit Agreement, and only after the first $857 million of debt has been paid in full. The Company has other non-amortizing fixed-rate interest rate swaps with the Bank, which were not terminated.
Background. The severe deterioration in the U.S. housing market and the nearly complete shutdown of the mortgage credit market for borrowers without excellent credit histories, and more recently the severe economic slowdown and rapidly rising unemployment, severely degraded the value of the portfolio of subprime 1-4 family mortgage loans and assets acquired and originated by the Company (the “Portfolio”), particularly its second-lien mortgage loans, and resulted in increased delinquencies, provisions for loan losses
and operating losses, and decreased cash flows, during the past two years. The impact on the Company’s operations has been severe, and has included:
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a substantial and growing shortfall in cash collections from the Portfolio relative to the Company’s debt service obligations owed to the Bank;
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a substantial and growing shortfall in the value of the Company’s assets, relative to the amounts owed to the Bank under the facility agreements for the Company’s outstanding debt with the Bank;
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concern by potential servicing customers and other constituencies over the continued viability of the Company in its current form, including the viability of FCMC, the Company’s servicing platform, which the Company believes as of December 31, 2008 to be financially sound on a unpledged, stand alone basis;
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concern that the Bank was increasingly likely to:
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cease granting necessary waivers and forbearances with respect to Company defaults under the Company’s various credit facilities; and
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declare a default with respect to the credit facilities and foreclose on the assets of the Company, substantially all of which were pledged to the Bank, especially in light of communications from the Bank indicating that it was seeking greater and more direct control over the collection guidelines related to the assets in the Portfolio and may have needed to foreclose on the Portfolio if it were not able to consummate a transaction like the Restructuring in which it was able to gain control over the Portfolio while keeping the credit facilities outstanding. Such a foreclosure would have left no value for the Company’s stockholders.
In order to address these issues, accommodate the concerns of the Bank to take advantage of what the Company believes is the best option to preserve value for its stockholders, the Company negotiated and entered into the Restructuring, which has been approved by the Company’s Board of Directors.
Executive Summary. Key attributes of the Restructuring, as they relate to the Company’s legacy indebtedness to the Bank include:
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in exchange for the transfer of that part of the Portfolio underlying the Bank Trust Certificates (as defined below), the Company received common membership interests and Class C preferred membership interests in the REIT having in the aggregate a value intended to approximate the fair market value of that portion of the Portfolio transferred to the Bank, which as of March 31, 2009 was approximately $481.5 million (the “REIT Securities”). The preferred membership interests have a liquidation value of $100,000 per unit and an annual cumulative dividend rate of 9% of such liquidation value. The REIT Securities replaced the above referenced loans on the Company’s balance sheet;
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principal and interest payments in respect of the Legacy Credit Agreement are only due and payable to the extent of cash flow of the Company, which cash flow would include dividends declared and paid in respect of the REIT Securities, 70% of the amounts distributed by FCMC to the Company or any other assets of the Company, other than the retained interest in FCMC (as discussed below); and
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the Bank’s recourse in respect of the Legacy Credit Agreement is limited to the assets and stock of Franklin Holding’s subsidiaries, excluding the assets of FCMC and a portion of FCMC’s stock, representing not less than twenty percent and not more than seventy percent of FCMC’s common equity, based on the amounts received by the Bank from the cash collections from FCMC’s servicing of the Portfolio as discussed in more detail below. The Bank, in regard to the payment of principal and interest on its loan, also is entitled to receive seventy percent of the distributions and dividends from FCMC, which percentage share may be reduced to twenty percent based upon the Bank’s receipt of the agreed amounts of net remittances from the Portfolio summarized below.
From the perspective of the Company and its stockholders, the Restructuring accomplished a number of overarching objectives, including:
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release of thirty percent of the equity in FCMC, which is wholly owned by the Company, from the Company’s pledges to the Bank in respect of its legacy credit agreement, with the possibility of release of up to an additional fifty percent, based upon the Bank’s receipt of the agreed amounts of net remittances from the Portfolio, summarized below (the “Net Remittances”), from March 31, 2009, the effective date of the Legacy Credit Agreement (the “Legacy Effective Date”), through the term of the Legacy Credit Agreement; the Bank shall reduce its interest in the equity in FCMC, as collateral, in accordance with the following collection levels:
provided, however, (i) if Net Remittances do not reach the minimum Level 1 amount prior to the first anniversary of the Legacy Effective Date, but reach the minimum Level 2 amount prior to the third anniversary of the Legacy Effective Date, the Bank shall retain, as collateral, 55% of the FCMC equity instead of 50%, as currently scheduled, and any subsequent reductions in the amount of FCMC equity pledged to the Bank shall be 10% smaller than the reductions currently scheduled; and provided further that (ii) if Net Remittances do not reach the minimum Level 1 amount prior to the first anniversary of the Legacy Effective Date and do not reach the minimum Level 2 amount prior to the third anniversary of the Legacy Effective Date, then the schedule for release of the equity interests in FCMC currently pledged to the Bank shall be as follows: (x) upon attaining the minimum Level 3 amount, the pledged equity interests in FCMC shall reduce 25% (from 70% to 45%); (y) upon attaining the minimum Level 4 amount, the pledged equity interests in FCMC shall reduce an additional 10% (from 45% to 35%), and (z) upon attaining the minimum Level 5 amount, the pledged equity interests in FCMC shall reduce an additional 10% (from 35% to 25%);
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entry into a servicing agreement enabling the Company to receive fee income in respect of its continued servicing of the transferred Portfolio; and
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entry into amended credit facilities in the aggregate principal amount of $13.5 million, including a $5 million facility for working capital and to support various servicer licenses, a $2 million revolving facility and a $6.5 million letter of credit facility to support various servicer licenses.
Among the most significant costs of accomplishing these objectives were:
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the possible transfer of ownership of a portion of FCMC, including a minimum of twenty percent and a maximum of seventy percent, to the Bank at maturity of the Company’s Legacy Credit Agreement with the Bank, unless further extended if the Company is not otherwise able to satisfy or refinance the Legacy Credit Agreement prior to maturity;
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the transfer of ten percent of ownership of FCMC to the Company’s principal stockholder as the cost of obtaining certain guarantees and pledges required by the Bank as a condition of the restructuring, subject to increase to an additional ten percent should the pledge of common shares of FCMC by Franklin Holding to the Bank be reduced upon the attainment by FCMC of certain net collection targets set by the Bank with respect to the Portfolio;
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entry into a service agreement with respect to FCMC’s continued servicing of the Portfolio that allows the Bank to terminate such servicing and, concomitantly, FCMC’s fee income from servicing the Portfolio; and
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in part as a result of a tax basis transfer, the Company may incur significant income tax liabilities at termination of the Legacy Credit Agreement, liquidation of the Company or any of its direct or indirect subsidiary companies, or certain other Company events such as a de facto liquidation. The amount of any tax liability that the Company may incur is not certain since any such calculations need to be performed on a company by company basis and are influenced by a number of factors including, but not limited to, the ability to use prior year losses and future results of operations.
Restructuring Agreements. In connection with the Restructuring, the Company and its subsidiaries have:
1. Transferred of substantially all of the Portfolio in exchange for the REIT Securities.
Pursuant to the terms of a Transfer and Assignment Agreement, certain subsidiaries of the Company (the “Franklin Transferring Entities”) transferred approximately 83% of the Portfolio to a newly formed Delaware statutory trust (“New Trust”) in exchange for the following trust certificates (collectively, the “Trust Certificates”):
(a) an undivided 100% interest of the Bank’s portion of consumer mortgage loans (the “Bank Consumer Loan Certificate”);
(b) an undivided 100% interest in the Bank’s portion of consumer REO assets (the “Bank Consumer REO Certificate”, and together with the Bank Consumer Loan Certificate, the “Bank Trust Certificates”);
(c) an undivided 100% interest in the portion of consumer mortgage loan assets allocated to the M&I Marshall & Ilsley Bank (“M&I”) and BOS (USA) Inc. (“BOS”) (M&I and BOS collectively, the “Participants”) (the “Participants Consumer Loan Certificate”); and
(d) an undivided 100% interest in Participants’ portion of the consumer REO assets (the “Participants Consumer REO Certificate”, and together with the Participants Consumer Loan Certificate, the “Participants Trust Certificates”).
The Bank Trust Certificates represent approximately 83.27961% of the assets transferred to New Trust considered in the aggregate (such portion, the “Bank Contributed Assets”) and the Participants Trust Certificates represent approximately 16.72039% of the assets transferred to New Trust considered in the aggregate.
Pursuant to the Transfer and Assignment Agreement, the Franklin Transferring Entities made certain representations, warranties and covenants to New Trust related to the Portfolio. To the extent any Franklin Selling Entity breaches any such representations, warranties and covenants and the Franklin Transferring Entities are unable to cure such breach, New Trust has recourse against the Franklin Transferring Entities (provided that recourse to FCMC is limited solely to instances whereby FCMC transferred REO property FCMC did not own) (the “Reacquisition Parties”). In such instances, the Reacquisition Parties are obligated to repurchase any mortgage loan or REO property and indemnify New Trust, the Bank, the Administrator (as defined below), the holders of the Trust Certificates and the trustees to the trust agreement. The Franklin Transferring Entities provided representations and warranties, including but not limited to correct information, loans have not been modified, loans are in force, valid lien, compliance with laws, licensing, enforceability of the mortgage loans, hazardous substances, fraud, and insurance coverage. In addition, the Franklin Transferring Entities agreed to provide certain collateral documents for each mortgage loan and REO property transferred (except to the extent any collateral deficiency was disclosed to New Trust). To the extent any collateral deficiency exists with respect to such mortgage loan or REO property and the Franklin Transferring Entities do not cure such deficiency, the Reacquisition Parties shall be obligated to repurchase such mortgage loan. In connection with the reacquisition of any asset, the price to be paid by the Reacquisition Parties for such asset (the “Reacquisition Price”) shall be as agreed upon by the Administrator and the applicable Reacquisition Party; provided, however, should such parties not promptly come to agreement, the Reacquisition Price shall be as determined by the Administrator in good faith using its sole discretion.
The subsidiaries then transferred the Trust Certificates to a newly formed Delaware limited liability company, Franklin Asset, LLC, in exchange for membership interests in Franklin Asset, LLC. Franklin Asset, LLC then contributed the Bank Trust Certificates to a newly formed Delaware limited liability company,
Franklin Asset Merger Sub, LLC, in exchange for membership interests in Franklin Asset Merger Sub, LLC (Franklin Asset, LLC retained the Participant Trust Certificates). Franklin Merger Sub, LLC merged with and into a Huntington National Bank wholly-owned subsidiary of the REIT (“REIT Sub”) and Franklin Asset, LLC received the REIT Securities having in the aggregate a value equal to the estimated fair market value of the loans underlying the Bank Trust Certificates, which as of March 31, 2009 was approximately $481.5 million, in exchange for its membership interests in Franklin Asset Merger Sub, LLC. The preferred REIT Securities have a liquidation value of $100,000 per unit and an annual cumulative dividend rate of 9% of such liquidation value. If there is a reacquisition required to be made by the Reacquisition Parties under the Transfer and Assignment Agreement, Franklin Asset, LLC will return such number of Class C Preferred Shares of Huntington Capital Financing Stock that is equal in value to the Reacquisition Price (as defined in the Transfer and Assignment Agreement).
2. Amended and restated substantially all of its outstanding debt.
Pursuant to the terms of the Amended and Restated Credit Agreement (Legacy) (the “Legacy Credit Agreement”), the Company and its subsidiaries amended and restated substantially all of their indebtedness currently subject to a certain First Amended and Restated Forbearance Agreement and Amendment to Credit Agreements, dated December 19, 2008, and a certain First Amended and Restated Tribeca Forbearance Agreement and Amendment to Credit Agreements, dated December 19, 2008 (the “Forbearance Agreements”). As more fully described below, pursuant to the terms of the Legacy Credit Agreement, (1) the Participant Trust Certificates were collaterally assigned to the Bank as collateral for the loans as modified pursuant to the terms of the Legacy Credit Agreement (the “Restructured Loans”); (2) all net collections received by New Trust in connection with the portion of the Portfolio represented by the Bank Trust Certificates will be paid to the REIT Sub or its subsidiaries; (3) the REIT Securities were pledged to the Bank as collateral for the Restructured Loans; (4) the Company pledged seventy percent (70%) of the common equity in FCMC to the Bank as collateral for the Restructured Loans; and (5) Franklin Holding and FCMC were released from existing guarantees of the Restructured Loans, including Franklin Holding’s pledge of 100% of the outstanding shares of FCMC, in exchange for providing certain limited recourse guarantees relating to the Restructured Loans, wherein the Bank agreed to exercise only limited recourse against property encumbered by the pledge agreement (the “Pledged Collateral”) made in connection with the Legacy Credit Agreement, provided Franklin Holding and FCMC, respectively, any designee acting under the authority thereof or any subsidiary of either Franklin Holding or FCMC did not (i) commission any act fraud or material misrepresentation in respect of the Pledged Collateral; (ii) divert, embezzle or misapply proceeds, funds or money and/or other property relating in any way to the Pledged Collateral; (iii) breach any covenant under the Legacy Credit Agreement; or (iv) conduct any business activities to perform diligence services, to service mortgage Loans or REO Properties or any related activities, directly or indirectly, other than by FCMC and Franklin Credit Loan Servicing, LLC.
The terms of the Legacy Credit Agreement vary according to the three tranches of loans covered by the Legacy Credit Agreement. Tranche A includes outstanding debt in the approximate principal sum of $857 million bearing interest at a per annum rate equal to one month LIBOR plus 2.25% per annum, payable monthly in arrears on the outstanding principal balance of the related advances. Tranche B includes outstanding debt in the approximate principal sum of $410 million bearing interest at a per annum rate equal to one month LIBOR plus 2.75% per annum, payable monthly in arrears on the outstanding principal balance of the related advances. Tranche C includes outstanding debt in the approximate principal sum of $125 million bearing interest at a per annum rate equal to 15%, payable monthly in arrears on the outstanding principal balance of the related advances. In the event of a default, the applicable interest rate will increase to 5% over the rate otherwise applicable to the respective tranche.
All cash available for each tranche shall be used to pay cash interest to the extent cash is available, and any accrued interest for which cash is not available will be added to the principal sum of such tranche. Cash payments on each tranche will be made from: (i) any cash or other assets of the borrowers (Tribeca and certain subsidiaries of Tribeca and Franklin Credit Asset Corporation), (ii) dividends and distributions on the REIT Securities, all of which shall be applied as a non pro rata distribution solely to the Bank’s pro rata share of such tranche (until paid in full), (iii) all distributions made by New Trust on the Participant Trust Certificates,
all of which shall be applied as a non pro rata distribution to the Participants’ pro rata shares of such tranche (until paid in full), and (iv) from any proceeds received from any other collateral, which will be applied pursuant to a waterfall provision described more fully in the Legacy Credit Agreement. The borrowers will not be required to make scheduled principal payments, provided that all amounts received by any borrower in excess of accrued interest, whether from collateral or otherwise, shall be applied to reduce the principal sum. All remaining principal and interest will be due and payable at maturity of the Legacy Credit Agreement on March 1, 2012. Based on the current cash flows described above, it is not expected that that the Company will be able to repay remaining principal and interest due on March 1, 2012. Under such circumstances, the Bank would have all available rights and remedies under the Legacy Credit Agreement.
The Legacy Credit Agreement contains representations, warranties, covenants and events of default (“The Legacy Credit Agreement Defaults”) that are customary in transactions similar to the restructuring. Some, but not all, of the Legacy Credit Agreement defaults will create an event of default under the Licensing Credit Facility and the Servicing Agreement (as defined below). In addition, the Company has agreed to seek shareholder approval to amend the Certificate of Incorporation of FCMC to delete the provision, adopted pursuant to Section 251(g) of the General Corporation Law of the State of Delaware in connection with the Company’s December 2008 corporate reorganization, that requires the approval of the stockholders of Franklin Holding in addition to the stockholders of FCMC for any action or transaction, other than the election or removal of directors, that would require the approval of the stockholders of FCMC. If such amendment is not passed on or prior to June 30, 2009, which will require approval by holders of at least two thirds of the shares of the Company then entitled to vote at an election of directors, the failure to pass such amendment shall constitute an event of default under the Legacy Credit Agreement. Under such circumstances, the Bank would be entitled to foreclose on all of the assets of the Company, including on Franklin Holdings’ pledge of 70% of the stock of FCMC.
The Legacy Credit Facility is secured by a first priority security interest in (i) the REIT Shares; (ii) the Participant Trust Certificates; (iii) an undivided 16.72039% interest in the consumer mortgage loans and REO properties transferred to New Trust; (iv) 70% of all equity interests in FCMC, and 100% equity interests in all other direct and indirect subsidiaries of Franklin Holding, pledged by Franklin Holding (subject to partial releases of such equity interests under “Cumulative Collective Targets” under the terms relating to the Servicing Agreement); (v) all amounts owing pursuant to any deposit account or securities account of any Company entities bound to the Legacy Credit Facility (other than Franklin Holding), (vi) a first mortgage in real property interests at 6 Harrison Street, Unit 6, New York, New York; (vii) all monies owing to any borrower from any taxing authority; (viii) any commercial tort or other claim of FCMC, Holding, or any borrower, including FCMC’s right, title and interest in claims and actions with respect to certain loan purchase agreements and other interactions of FCMC with various entities engaged in the secondary mortgage market; (ix) certain real property interests of FCMC in respect to the proprietary leases under the existing Forbearance Agreements if not transferred to New Trust; (x) a second priority lien on cash collateral held as security for the Licensing Facility to FCMC; and (xi) any monies, funds or sums due or received by any Borrower in respect of any program sponsored by any Governmental Authority, any federal program, federal agency or quasi-governmental agency, including without limitation any fees received, directly or indirectly, under the U.S. Treasury Homeowners Affordability and Stability Plan. Any security agreement, acknowledgement or other agreement in respect of a lien or encumbrance on any asset of New Trust shall be non-recourse in nature and shall permit New Trust to distribute, without qualification, 83.27961% of all net collections received by New Trust to the REIT Sub and its subsidiaries irrespective of any event or condition in respect of the Legacy Credit Agreement.
All collections received by New Trust, provided that an event of default has not occurred and is continuing, shall go first to the payment of monthly servicing fees, which shall be paid one month in advance, under the Servicing Agreement and then to (i) Administration Fees, expenses and costs (if any), (ii) pro rata to the owner trustee, certificate trustee and each custodian for any due and unpaid fees and expenses of such trustee and/or custodian, and (iii) to the pro-rata ownership of the Trust Certificates. All amounts received pursuant to the Participants Trust Certificates shall be distributed pursuant to the applicable “Waterfall” provisions.
3. Entered into an amended and restated credit agreement to fund FCMC’s licensing obligations and working capital.
Franklin Holding and FCMC have entered into an Amended and Restated Credit Agreement (Licensing) (the “Licensing Credit Agreement”) which includes a credit limit of $13,500,000, composed of a secured (i) revolving line of credit (“Revolving Facility”) up to the principal amount outstanding at any time of $2,000,000, (ii) up to the aggregate stated amount outstanding at any time for letters of credit of $6,500,000, and (iii) a draw credit facility (“Draw Facility”) up to the principal amount outstanding at any time of $5,000,000. The Revolving Facility and the letters of credit shall be used to assure that all state licensing requirements of FCMC are met and to pay approved expenses of the Company. The Draw Facility shall be used to provide for working capital of FCMC, and amounts drawn and repaid under this facility cannot be reborrowed.
The principal sum shall be due and payable in full on the earlier of the date that the Licensing Agreement is due and payable in full pursuant to the terms of this facility, whether by acceleration or otherwise, or at maturity on March 29, 2010. Advances under the Revolving Facility shall bear interest at the one-month reserve adjusted LIBOR Rate plus a margin of 8%. Advances under the Draw Facility shall bear interest at the one-month reserve adjusted LIBOR Rate plus a margin of 6%. Interest on both the Revolving Facility and the Draw Facility shall be paid prior to any distributions pursuant to stock ownership or stock pledges of equity interests in FCMC. After any default, all advances and letters of credit shall bear interest at 5% in excess of the rate of interest then in effect.
The Licensing Credit Agreement contains warranties, representations, covenants and events of default that are customary in transactions similar to the restructuring.
The Licensing Facility is secured by (i) a first priority security interest in FCMC’s cash equivalents in a controlled account maintained at the Bank in an amount satisfactory to the Bank, but not less than $8,500,000, (ii) blanket existing lien on all personal property of FCMC, (iii) a second mortgage in real property interests at 6 Harrison Street, Unit 6, New York, New York, (iv) a first Mortgage in certain real property interests at 350 Albany Street, New York, New York; and (v) any monies or sums due FCMC in respect of any program sponsored by any Governmental Authority, including without limitation any fees received, directly or indirectly, under the U.S. Treasury Homeowners Affordability and Stability Plan.
The Draw Facility is guaranteed by Thomas J. Axon, Chairman of the Board of Directors and a principal stockholder of the Company. Mr. Axon’s Guaranty shall be secured by a first priority and exclusive lien on commercial real estate, at a loan to value ratio satisfactory to the Bank. In consideration for his guaranty, the Bank and the Company’s Audit Committee each has consented to the payment to Mr. Axon equal to 10% of FCMC’s common shares, subject to a further payment of up to an additional 10% in FCMC’s common shares should the pledge of common shares of FCMC by Franklin Holding to the Bank be reduced upon attainment by FCMC of certain net collection targets set by the Bank with respect to the Portfolio.
4. Entered into a servicing agreement with the New Trust.
The servicing agreement (the “Servicing Agreement”) governs the servicing by FCMC, as the servicer (the “Servicer”) of the Portfolio transferred to New Trust. New Trust and/or the Bank as the administrator of New Trust (the “Administrator”) have significant control over all aspects of the servicing of the Portfolio based on (i) a majority of the Servicer’s actions or Servicer’s utilization of any subservicer or subcontractor is contingent on the Servicer receiving explicit instructions or consent from New Trust or Administrator, (ii) compliance with work rules and an approval matrix provided by the Bank and (iii) monthly meetings between New Trust and the Servicer.
All collections by the Servicer are remitted to a collection account and controlled through the Bank’s lockbox account. The Administrator shall transfer the collection amounts from the lockbox account to a certificate account whereby the funds shall flow through the trust agreement’s “Waterfall” as described above. The Servicer’s servicing fees and servicing advance reimbursements are paid in advance provided an event of default has not occurred. If an event of default has occurred, the Servicer’s servicing fees and servicing
advances are the third remittance in the “Waterfall,” following remittances for payment of Administrator, custodian and trustee fees.
New Trust’s indemnification obligation to the Servicer is limited to the collections from the Portfolio. In addition, the Servicer will be indemnified by New Trust only for a breach of corporate representations and warranties or if the Administrator forces the Servicer to take an action that results in a loss to the Servicer.
The Servicer is required to maintain net worth of approximately $7.6 million and net income before taxes of $800,000 for the most recent twelve month period or an event of default will be deemed to have occurred. In addition to typical servicer events of default and the defaults listed above, the Servicing Agreement contains the following events of default: (i) certain defaults under the Legacy Loan Agreement would trigger an event of default under the Servicing Agreement, (ii) failure to adopt a servicing action plan as directed by the Administrator would trigger an event of default, (iii) any event of default under the Licensing Loan Agreement would trigger an event of default under the Servicing Agreement, and (iv) failure of Servicer to satisfy certain gross collection targets if determined to be the result of a failed servicing practice as determined by the Bank per a servicing audit would trigger an event of default.
The Servicing Agreement shall have an initial term of three years which may be extended for one or two additional one year periods at the sole discretion of New Trust. During the first year of the agreement, Servicer shall receive a termination fee for each loan to the extent the servicing is terminated by the Bank for any reason other than a default under the terms of the servicing agreement. During the term of the servicing agreement, FCMC may not enter into any other third-party servicing agreements to service any other assets that could likely impair its ability to service the Portfolio without the consent of the Bank, which cannot be unreasonably withheld.
Master Credit Facilities - Term Loans
The summary that follows describes the terms of the Company’s credit facilities in effect prior to entering into the Forbearance Agreements on December 28, 2007 described above, which substantially modified such facilities, except for the Unrestructured Debt.
General. In October 2004, the Company, and its finance subsidiaries, excluding Tribeca, entered into a master credit and security agreement (the “Franklin Master Credit Facility”) with Huntington National Bank, which we refer to as the bank, our lender or Huntington. Under this master credit facility, we requested term loans to finance the purchase of residential mortgage loans or refinance existing outstanding loans under this facility. The facility did not include a commitment to additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were therefore subject to our lender’s discretion as well as any regulatory limitations to which our lender was subject. At December 31, 2007, $44.5 million remained outstanding under this facility (a portion of the Unrestructured Debt), and the interest rate continues to be based on the Federal Home Loan Bank of Cincinnati 30-day advance rate plus margins of 2.60% and 2.75%.
In February 2006, Tribeca and certain of its subsidiaries entered into the Tribeca Master Credit Facility with Huntington, pursuant to which certain Tribeca subsidiaries borrowed term loans to finance their origination of loans Tribeca previously financed under its warehouse line of credit with Huntington and consolidate and refinance prior term loans made by Huntington to such subsidiaries. The facility did not include a commitment for additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were subject to our lender’s discretion, as well as any regulatory limitations to which Huntington was subject. At December 31, 2007, $0 remained outstanding under this facility.
Interest Rates and Fees. Interest on the term loans, up to December 28, 2007, was payable monthly at a floating rate equal to the highest Federal Home Loan Bank of Cincinnati 30-day advance rate as published
daily by Bloomberg under the symbol FHL5LBRI, or the “30-day advance rate,” plus the applicable margin in effect prior to August 2006 as follows:
August 2006 Modifications to Huntington National Bank Financing Arrangements
In August 2006, the master credit facilities were modified to reduce the interest rate on all debt originated under the master credit facilities before July 1, 2005 by 25 basis points effective October 1, 2006. This rate was lowered by an additional 25 basis points effective January 1, 2007.
December 2006 Modifications to Huntington National Bank Financing Arrangements
In December 2006, the master credit facilities were modified to change the interest rate on term loans funded under the master credit facilities after November 14, 2006 for loans originated by Tribeca and purchases of second mortgages by the Company to the Federal Home Loan Bank of Cincinnati 30-day advance rate as published daily by Bloomberg under the symbol FHL5LBRI (the “30-day advance rate”), plus the applicable margin as follows:
Additionally, the interest rate payable to Huntington National Bank on term loans funded under the Franklin Master Credit Facility after November 14, 2006 in respect of purchases of first mortgages by the Company was the 30-day advance rate, plus the applicable margin as follows:
As a result of these modifications, effective January 1, 2007, and up to December 28, 2007, the interest rate on term borrowings under our Master Credit Facilities was based on a floating rate equal to the 30-day advance rate, plus the applicable margin as follows:
Upon each closing of a loan after June 23, 2006, we were required to pay an origination fee equal to 0.50% of the amount of the loan unless otherwise agreed to by our lender. For loans funded between July 1, 2005 and June 23, 2006, under the Franklin Master Credit Facility, the origination fee paid was 0.75% of the amount of the loan (0.50% for loans funded under the Tribeca Master Credit Facility), and for loans funded
prior to July 1, 2005, the origination fee paid was 1% of the amount of the loan unless otherwise agreed to by our lender.
Principal; Prepayments; Termination of Commitments. The unpaid principal balance of each loan was amortized over a period of twenty years, but matured three years after the date the loan was made. Historically, our lender had agreed to extend the maturities of such loans for additional three-year terms upon their maturity. We were required to make monthly payments of the principal on each of our outstanding loans.
In the event there was a material and adverse breach of the representations and warranties with respect to a pledged mortgage loan that was not cured within 30 days after notice by our lender, we would have been required to repay the loan with respect to such pledged mortgage loan in an amount equal to the price at which such mortgage loan could readily be sold (as determined by our lender).
Covenants; Events of Default. The Master Credit Facilities contain affirmative, negative and financial covenants customary for financings of this type, including, among other things, a covenant under the Franklin Master Credit Facility that we and our subsidiaries together maintain a minimum net worth of at least $10 million; and, a covenant under the Tribeca Master Credit Facility that Tribeca and its subsidiaries, together, maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of at least $750,000. These master credit facilities contain events of default customary for facilities of this type (with customary grace and cure periods, as applicable).
Security. Our obligations under the Franklin Master Credit Facility are secured by a first priority lien on loans that are financed by proceeds of loans made to us under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, our lender is entitled to receive substantially all sums payable to us in respect of any of the collateral. Tribeca’s and its subsidiary borrowers’ obligations under the Tribeca Master Credit Facility are secured by a first priority lien on loans originated by Tribeca or such subsidiary that are financed or refinanced by proceeds of loans made to Tribeca or its borrowers under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, Huntington is entitled to receive substantially all sums payable to Tribeca and any subsidiary borrower in respect of any of the collateral.
Bank of Scotland Term Loan
In March 2006, Tribeca and one of Tribeca’s subsidiaries (the “Tribeca Subsidiary Borrower”) entered into a $100 million Master Credit and Security Agreement (the “BOS Loan”) with BOS (USA) Inc., an affiliate of Bank of Scotland. $98.2 million of proceeds of the BOS Loan were used to consolidate and refinance prior term loans made to certain Tribeca subsidiaries. Interest on the BOS Loan is payable monthly at a floating rate equal to the 30-day advance rate plus an applicable margin as follows:
The unpaid principal balance of the BOS Loan is amortized over a period of 20 years, but matures in March 2009. The Tribeca Subsidiary Borrower is required to make monthly amortization payments and payments of interest on the BOS Loan. The facility does not include a commitment to additional lendings or a commitment to refinance the remaining outstanding balance of the loan when it matures. The outstanding balance of the BOS Loan was $44.8 million (a portion of the Unrestructured Debt) at December 31, 2007.
The facility contains affirmative, negative and financial covenants customary for financings of this type, including, among other things, covenants that require Tribeca and its subsidiaries, together, to maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of $750,000. The facility contains events of default customary for facilities of this type. At December 31, 2007, Tribeca was not in compliance with these and other covenants and has not received a waiver of noncompliance. Any unwaived or uncured breach of these covenants could, subject to notice and opportunity to cure where provided for in the applicable credit agreements, cause an acceleration of the outstanding BOS Loan and result in cross-
default and possible acceleration of the indebtedness owed to the bank under the Forbearance Agreements. As described in “March 2008 Modifications to Forbearance Agreements and Refinancing of BOS Loan,” the BOS Loan was paid off and effectively rolled into the Forbearance Agreements.
Tribeca’s and the Tribeca subsidiary borrower’s obligations under the facility are secured by (i) a first priority lien on loans acquired by the Tribeca Subsidiary Borrower that are refinanced by the proceeds of the BOS Loan and (ii) a second priority lien on collateral securing loans made to Tribeca or its subsidiaries under the Tribeca Master Credit Facility described above. In addition, pursuant to a lockbox arrangement, BOS is entitled to receive substantially all sums payable to Tribeca and the Tribeca Subsidiary Borrower in respect of any of the primary collateral under the facility. Tribeca’s BOS Loan and the Tribeca Master Credit Facility are cross-collateralized.
Warehouse Facilities
Tribeca Warehouse. In October 2005, Tribeca entered into a Warehousing Credit and Security Agreement (the “Tribeca Warehouse Facility”) with our lender, which modified previous warehouse lending agreements. In April 2006, our lender increased the commitment to $60 million. Interest on advances was payable monthly at a rate per annum equal to the greater of (i) a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points or (ii) 5%.
The Tribeca Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. Tribeca also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of Tribeca’s obligations under the Tribeca Warehouse Facility, which was secured by substantially all of Tribeca’s personal property. As of December 28, 2007, this facility was terminated.
Flow Warehouse. In August 2006, we entered into a new $40 million Flow Warehousing Credit and Security Agreement (the “Flow Warehouse Facility”) for a term of one year with our lender to accumulate loans acquired by the Company on a flow basis prior to consolidating such loans into term debt. This warehouse facility was renewed in August 2007 by Huntington for $20 million and for a term of one year. As of December 28, 2007, this facility was terminated.
Interest on advances was payable monthly at a rate per annum equal to a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points.
The Flow Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. The Company also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of the Company’s obligations under the Flow Warehouse Facility, which was secured by substantially all our personal property.
Interest Rate Caps
On August 29, 2006, the Company purchased a $300 million (notional amount) one-month LIBOR cap with a strike price of 5.75% at a price of $101,000, and on August 30, 2006, the Company purchased a $500 million (notional amount) one-month LIBOR cap with a strike price of 6.0% at a price of $60,000. Both cap agreements expired on August 31, 2007.
On September 5, 2007, the Company purchased a $200 million (notional amount) one-month LIBOR cap with a strike price of 5.75% at a price of $102,000, and on September 6, 2007, the Company purchased a $400 million (notional amount) one-month LIBOR cap with a strike price of 6.0% at a price of $90,000. Both cap agreements expired on September 30, 2008.
Interest Rate Swaps
Effective February 27, 2008, the Company entered into $725 million (notional amount) of fixed-rate interest rate swaps in order to effectively stabilize the future interest payments on a portion of its interest-sensitive borrowings. The fixed-rate swaps are for periods ranging from one to four years, are non-amortizing, and are in effect for the respective full terms of each swap agreement. These swaps will effectively fix the Company’s interest costs on a portion of its borrowings regardless of increases or decreases in one-month LIBOR. The interest rate swaps were executed with the Company’s lead lending bank and are for the following terms: $220 million notional amount for one year at a fixed rate of 2.62%; $390 million notional amount for two-years at a fixed rate of 2.79%; $70 million notional amount for three years at a fixed rate of 3.11%; and, $45 million notional amount for four years at a fixed rate of 3.43%.
Effective April 30, 2008, the Company entered into an additional $275 million (notional amount) of fixed-rate interest rate swaps in order to effectively stabilize the future interest payments on a portion of its interest-sensitive borrowings. The fixed-rate swaps are for a period of three years, are non-amortizing, and at a fixed rate of 3.47%. These swaps will reduce further the Company’s exposure to future increases in interest costs on a portion of its borrowings due to increases in one-month LIBOR during the remaining terms of the swap agreements. The interest rate swaps were executed with the Company’s lead lending bank.
Under these swap agreements, the Company will make interest payments to its lead lending bank at fixed rates and will receive interest payments from its lead lending bank on the same notional amounts at variable rates based on LIBOR. Effective December 28, 2007, the Company pays interest on its interest-sensitive borrowings, principally based on one-month LIBOR plus applicable margins. Accordingly, Franklin established a fixed rate plus applicable margins on $1.00 billion of its borrowings, which at the time of entering into the swap agreements ranged from one year to four years. The weighted average fixed rate of the total $1.00 billion of swaps is approximately 2.99%. See “Management’s Discussion and Analysis - Borrowings - Forbearance Agreements with Lead Lending Bank - Recent Development - March 2009 Restructuring.”
The following table presents the notional and fair value amounts of the interest rate swaps at December 31, 2008.
*
Determined in accordance with SFAS 157 based upon a “Level 2” valuation methodology.
The net effect of the interest rate swaps for the twelve months ended December 31, 2008 was $2.4 million, which increased our interest expense. The estimated fair value of the swaps at December 31, 2008 was a negative $27.8 million, which increased stockholders’ deficit (other accumulated comprehensive loss). The fair value of the interest-rate swaps in the future will fluctuate as LIBOR interest rates change and as the remaining term of the swaps becomes shorter.
Safe Harbor Statement
Statements contained herein that are not historical fact may be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are subject to a variety of risks and uncertainties. There are a number of important factors that could cause actual results to differ materially from those projected or suggested in forward-looking statements made by the Company. These factors include, but are not limited to: (i) unanticipated changes in the U.S. economy, including changes in business conditions such as interest rates, changes in
the level of growth in the finance and housing markets, such as slower or negative home price appreciation; (ii) the Company’s relations with the Company’s lenders and such lenders’ willingness to waive any defaults under the Company’s agreements with such lenders; (iii) increases in the delinquency rates of the Company’s borrowers, (iv) the availability of third parties holding subprime mortgage debt for servicing by the Company on a fee-paying basis; (v) changes in the statutes or regulations applicable to the Company’s business or in the interpretation and enforcement thereof by the relevant authorities; (vi) the status of the Company’s regulatory compliance; and (vii) other risks detailed from time to time in the Company’s SEC reports and filings. Additional factors that would cause actual results to differ materially from those projected or suggested in any forward-looking statements are contained in the Company’s filings with the SEC, including, but not limited to, those factors discussed under the captions “Risk Factors,” “Interest Rate Risk” and “Real Estate Risk” in the Company’s Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, which the Company urges investors to consider. The Company undertakes no obligation to publicly release the revisions to such forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrences of unanticipated events, except as otherwise required by securities, and other applicable laws. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to release publicly the results on any events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various types of market risk in the normal course of business, including the impact of interest rate changes, real estate, delinquency and default risks of the loans in our portfolio, and changes in corporate tax rates. A material change in these rates or risks could adversely affect our operating results and cash flows.
Interest Rate Risk
Interest rate fluctuations can adversely affect our operating results and present a variety of risks, including the risk of a mismatch between the repricing of interest-earning assets and borrowings, variances in the yield curve and changing prepayment rates on notes receivable, loans held for investment and loans held for sale.
Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Conditions such as inflation, recession, unemployment, money supply and other factors beyond our control may also affect interest rates. Fluctuations in market interest rates are neither predictable nor controllable and may have a material adverse effect on our business, financial condition and results of operations.
In addition to the performance of the loans in our portfolios, the Company’s operating results depend in large part on differences between the interest earned on its assets and the interest paid on its borrowings. Most of the Company’s assets, consisting primarily of mortgage notes receivable, generate fixed returns and have remaining contractual maturities in excess of five years, while the majority of originated loans held for investment generate fixed returns for the first two years and six-month adjustable returns thereafter. As of December 28, 2007, the effective date of the Forbearance Agreements, our borrowings are based on one-month LIBOR. Prior to December 28, 2007, we funded the origination and acquisition of these assets with borrowings that had interest rates based on the monthly Federal Home Loan Bank of Cincinnati (“FHLB”) 30-day advance rate. In most cases, the interest income from our assets will respond more slowly to interest rate fluctuations than the cost of our borrowings, creating a mismatch between interest earned on our interest-yielding assets and the interest paid on our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, will significantly impact our net interest income and, therefore, net income. Our borrowings bear interest at rates that fluctuate with one-month LIBOR. We currently use interest-rate derivatives, essentially interest-rate swaps, to hedge our interest rate exposure by converting a significant portion of our highly interest-sensitive borrowings from variable-rate payments to fixed-rate payments. Based on approximately $321.2 million of unhedged interest-rate sensitive borrowings outstanding at December 31, 2008, a 1% instantaneous and sustained increase in the one-month LIBOR rate could increase quarterly interest expense by as much as approximately $803,000, pre-tax, during the remaining terms of the swap agreements, which would
negatively impact our quarterly after-tax net income or loss. Due to our liability-sensitive balance sheet, increases in these rates will decrease both net income, or increase net loss, and the market value of our net assets. If the Company’s existing swap contracts expire, and are not renewed, a 1% instantaneous and sustained increase in the one-month LIBOR rate would have the effect of increasing quarterly interest expense by approximately $3.3 million, pre-tax. See “Management’s Discussion and Analysis - Borrowings.”
The value of our assets may be affected by prepayment rates on investments. Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic and other factors beyond our control. Consequently, such prepayment rates cannot be predicted with certainty. When we originated and purchased mortgage loans, we expected that such mortgage loans would have a measure of protection from prepayment in the form of prepayment lockout periods or prepayment penalties. In periods of declining mortgage interest rates, prepayments on mortgages generally increase. In addition, the market value of mortgage investments may, because of the risk of prepayment, benefit less from declining interest rates than other fixed-income securities. Conversely, in periods of rising interest rates, prepayments on mortgages generally decrease, in which case we would not have the prepayment proceeds available to accelerate the paydown of our borrowings. Under certain interest rate and prepayment scenarios we may fail to recoup fully our cost of acquisition of certain investments. During most of 2007 and throughout 2008, due to declining U.S. housing prices in general and a rapid and severe credit tightening throughout the industry, portfolio payoffs through borrower refinancing have been declining as it has become more difficult for borrowers, particularly borrowers with any type of credit deficiency, to refinance their loans.
Real Estate Risk
Residential property values are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions, which may be adversely affected by industry slowdowns and other factors; local real estate conditions (such as the supply of housing or the rapid increase in home values). Decreases in property values reduce the value of the collateral and the potential proceeds available to a borrower to repay our mortgage loans, which could cause us to suffer losses on the ultimate disposition of foreclosed properties.
We purchased and originated principally fixed and adjustable rate residential mortgage loans, both first and second liens, which are secured primarily by the underlying single-family properties. Because the vast majority of our loans are to non-prime borrowers, delinquencies and foreclosures are substantially higher than those of prime mortgage loans, and if not serviced actively and effectively could result in an increase in losses on dispositions of properties acquired through foreclosure, or in the case of second lien loans, through writeoff of defaulted loans. In addition, a decline in real estate values would reduce the value of the residential properties securing our loans, which could lead to an increase in borrower defaults, reductions in interest income and increased losses on the disposition of foreclosed properties.
During 2007, particularly during the third quarter of 2007, and throughout 2008, the deterioration in the housing and subprime mortgage markets, particularly declining home values, continued and accelerated. During the third quarter of 2007, there was a significant tightening of credit availability throughout the mortgage lending industry, and particularly in the subprime segment of the industry, which has not abated. These market events, in combination with the U.S. economy entering a recessionary cycle in the last quarter of 2008, increased and are expected to continue to result in increased delinquencies, defaults and losses on residential 1-4 family loans.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements required by this Item are included herein, beginning on page of this report.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A(T).
ITEM 9A(T).
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures designed to provide reasonable assurance that information required to be disclosed by the Company in reports filed or submitted under the Securities Exchange Act of 1934, as amended (“Exchange Act”) is (i) recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to the Company’s management, including the Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and Controller, as appropriate, to allow timely decisions regarding disclosure.
As of December 31, 2008, the end of the period covered by this Annual Report on Form 10-K, the Company’s management, including the Company’s Chief Executive Officer, Chief Operating Officer, Chief Financial Officer and Controller, evaluated the effectiveness of the Company’s disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Exchange Act. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2008, the Company’s disclosure controls and procedures were not effective as a result of the material weakness in internal control over financial reporting, as discussed below.
Management’s Annual Report on Internal Control Over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting is a process designed by, or under the supervision of, our Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, and Controller and affected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with policies and procedures may deteriorate.
With the participation of the Chief Executive Officer, the Chief Financial Officer, the Chief Operating Officer and the Controller, our management conducted an evaluation of the effectiveness of our system of internal control over financial reporting as of December 31, 2008 based on the framework set forth in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management has concluded that our internal control over financial reporting was not effective as of December 31, 2008.
As of December 31, 2008 there were not appropriate controls in place to ensure that the allowance policy was appropriately applied to the portfolio of notes receivable when policy changes were made and as a result, a material adjustment was recorded to the allowance for loan losses. The Company has identified this deficiency as a material weakness as defined by the Public Company Accounting Oversight Board (United States). Management has evaluated this weakness and will implement the necessary corrective action effective for the filing of the Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2009.
This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to the attestation by our registered public accounting firm pursuant to the temporary rules of the SEC that permit us to provide only management’s report in this Annual Report on Form 10-K.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The Company has adopted a code of ethics and business conduct that applies to its officers, directors and employees, including without limitation, the Company’s Chief Executive Officer, President, Chief Operating Officer and Chief Financial Officer. The Code of Ethics and Business Conduct is available on the Company’s website at www.franklincredit.com.
The other information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2008, the Company’s most recent fiscal year, and is incorporated herein by reference.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2008, the Company’s most recent fiscal year, and is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2008, the Company’s most recent fiscal year, and is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2008, the Company’s most recent fiscal year, and is incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information required under this Item is contained in the Company’s definitive proxy statement, which will be filed within 120 days of December 31, 2008, the Company’s most recent fiscal year, and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The following documents are filed as part of Form 10-K:
(1) Financial Statements.
The financial statements required by Item 8 are included herein, beginning on page of this report.
(2) Financial Statement Schedules.
The financial statement schedules required by Item 8 are included in the financial statements (or are either not applicable or not significant).
(3) Exhibits.
*
Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FRANKLIN CREDIT HOLDING CORPORATION
By:
/s/ ALEXANDER GORDON JARDIN
Chief Executive Officer
April 10, 2009
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Franklin Credit Holding Corporation
Jersey City, New Jersey
We have audited the accompanying consolidated balance sheets of Franklin Credit Holding Corporation and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity/(deficit), and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Franklin Credit Holding Corporation and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements for the year ended December 31, 2008 have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company’s recurring losses from operations, stockholders’ deficit, and potential defaults under its lending agreements raise substantial doubt about its ability to continue as a going concern. Management’s plans concerning these matters are also discussed in Note 1 to the financial statements. The financial statements do not include any adjustments that might result from this uncertainty.
/s/ Deloitte & Touche LLP
New York, New York
April 9, 2009
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY/(DEFICIT)
YEARS ENDED DECEMBER 31, 2008 AND 2007
For the year ended December 31, 2008, the total comprehensive loss amounted to $504.1 million, which was comprised of the net loss of $476.3 million and the net unrealized loss on derivatives of $27.8 million.
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2008 AND
1.
BASIS OF PRESENTATION AND BUSINESS
As used herein references to the “Company,” “FCHC,” “Franklin,” “we,” “our” and “us” refer to Franklin Credit Holding Corporation, collectively with its subsidiaries.
Going Concern
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has been and continues to be operating in an extraordinary and difficult environment, and has been significantly and negatively impacted by the unprecedented credit and economic market turmoil and most recently the slowing economy with increasing unemployment. Particularly impacting Franklin has been the severe deterioration in the U.S. housing market and the nearly complete shutdown of the mortgage credit market for borrowers without excellent credit histories, and most recently the slowing economy with increasing unemployment. These unprecedented market conditions have adversely affected the Company’s portfolio of residential mortgage loans, particularly our second-lien mortgage loans, delinquencies, provisions for loan losses, operating losses and cash flows, which have resulted in a significant stockholders’ deficit of $464.5 million at December 31, 2008. The Company, under the terms of the Forbearance Agreements with the Huntington National Bank (“Huntington” or the “bank”), has been since the latter part of 2007 expressly prohibited from acquiring or originating loans, and certain existing defaults under the Company’s existing credit facilities with the bank have been temporarily waived until the maturity of the forbearance agreements in May 2009. In addition, the Company’s Forbearance Agreements with Huntington, which are described below, contain affirmative covenants that the Company maintain and comply in all material respects with all governmental licenses and authorizations to hold and service mortgage loans and real estate owned properties. Any Forbearance Default under the Forbearance Agreements, or failure to successfully renew the Forbearance Agreements or enter into new credit facilities with Huntington prior to the scheduled maturity of the Forbearance Agreements in May 2009, could entitle Huntington to declare the Company’s indebtedness immediately due and payable and could result in the transfer of the Company’s rights as servicer of its loans (loans pledged to Huntington) to a third party. In March 2009, the Company entered into Restructuring Agreements with Huntington, which are described in Note 14. The Restructuring Agreements addressed many of the issues noted above, but as discussed in Note 14, there continues to be provisions that would allow Huntington to declare an event of default if certain actions are not taken. As a result, without the continued cooperation and assistance from Huntington, the Company’s ability to continue as a viable business is in doubt. These matters raise substantial doubt about the Company’s ability to continue as a going concern.
Operating Losses and Stockholders’ Deficit
The Company had a net loss of $476.3 million for the twelve months ended December 31, 2008. The net loss was driven principally by provisions for loan losses as the Company’s portfolios of residential 1-4 family loans deteriorated throughout the year, and by a significant excess of interest-bearing liabilities over interest-paying loans, both of which are the result of the Company’s significant amount of delinquent residential 1-4 family loans. At December 31, 2008, approximately 57% and 48% of the Company’s borrowers were delinquent on a contractual and recency basis, respectively. As a result, the Company’s aggregate net interest income (interest income less interest expense) and non-interest income was not sufficient to support its general and administrative expenses. The significant provisions for loan losses of $458.1 million during the year ended December 31, 2008 was due principally to the continued, substantial deterioration in the housing and subprime mortgage markets, and most recently the slowing economy with increasing unemployment and the significant deterioration in the performance of the Company’s portfolios of acquired and originated loans, including particularly the portfolio of acquired second-lien mortgage loans, which resulted in significantly increased estimates of inherent losses in its portfolios and the need for substantial increases in reserves throughout the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
year. The Company had stockholders’ deficit of $464.5 million at December 31, 2008. The deterioration in the U.S. housing market, including generally continuing housing price declines and the severe contraction of available mortgage credit for consumers without excellent credit histories, and rapidly rising unemployment, likely will continue to widen the mismatch of the Company’s excess of interest-bearing borrowings over interest-paying loans and further negatively impact the credit quality of the Company’s portfolios, which likely would result in decreased net interest income and additional significant provisions for loan losses resulting in increased operating losses in future quarters.
Licenses to Service Loans and December 2008 Corporate Reorganization
The requirements imposed by state mortgage finance licensing laws vary considerably. In addition to the requirement for a license to engage in mortgage origination and brokerage activities, many mortgage licensing laws impose a licensing obligation to service residential mortgage loans. Further, certain state collection agency licensing laws require entities collecting on current, delinquent or defaulted loans for others or to acquire such loans to be licensed as well. Once these licenses are obtained, state regulators impose additional ongoing obligations on licensees, such as maintaining certain minimum net worth or line of credit requirements. Generally, net worth is determined on a GAAP basis with the minimum net worth varying from state to state. The highest state minimum net worth requirement is $250,000. Further, in limited instances, the net worth calculation may not include recourse on any contingent liabilities. If the Company does not, among other things, meet these minimum net worth or line of credit requirements, state regulators may revoke or suspend the Company’s licenses and prevent the Company from continuing to service loans in such states, which would adversely affect the Company’s operations and financial condition and ability to attract new servicing customers.
The Company’s deficit net worth during 2008 resulted in the Company’s noncompliance with the requirements to maintain certain licenses in approximately 21 states. At that time, the regulators in these states could have taken a number of possible corrective actions in response to the Company’s non-compliance, including license revocation or suspension, requirement for the filing of a corrective action plan, denial of an application for a license renewal or a combination of the same, in which case the Company’s business would have been adversely affected. As a consequence of its deficit net worth, the Company was contacted by four state regulators to address its noncompliance with state laws. In October 2008, the Company was notified of such noncompliance by the state of West Virginia and, as a result, entered into an Assurance of Voluntary Compliance with the state’s Commissioner of Banking to assure the state that, as of November 30, 2008, the Company would meet the state’s statutory minimum net worth requirement of $250,000. In November 2008, the state of Ohio issued a Notice of Intent to Refuse Renewal unless the Company explained how it would meet the state’s minimum net worth requirement of $50,000. On December 2, 2008, the state of Washington notified the Company that the processing of its collection agency license renewal was being delayed pending the state’s review of the Company’s off-balance sheet liabilities to its corporate affiliate. Finally, on January 14, 2009, the state of Wisconsin issued the Company a Letter of Reprimand that cited its failure in 2008 to maintain the minimum net worth required of mortgage bankers registered in the state.
In order to address these issues, in December 2008, the Company completed a reorganization of its company structure for the principal purpose of restoring the required minimum net worth under the Company’s licenses to ensure that the Company is able to continue to service mortgage loans. Effective December 19, 2008, Franklin Credit Holding Corporation (“Franklin Holding”) became the parent company of Franklin Credit Management Corporation in the adoption of a holding company form of organizational structure. This reorganization (the “Reorganization”) resulted in Franklin Credit Management Corporation, which holds the Company’s servicing platform, having positive net worth as a result of having assigned and transferred to a newly formed sister company ownership of the entities holding beneficial ownership of the Company’s loan portfolios and the related indebtedness and accordingly, being able to comply with applicable net worth requirements to maintain licenses to service and collect loans in various jurisdictions; and, is expected to
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
enhance the Company’s ability to grow its servicing business and take advantage of other corporate restructuring opportunities should they become available. Other than the difference in their names, the certificate of incorporation, by-laws, authorized capital stock, outstanding capital stock, board of directors and officers of Franklin Holding are the same as those of Franklin Credit Management Corporation prior to the reorganization. No post-merger exchange of stock certificates was necessary, and the outstanding shares of Franklin Credit Management Corporation common stock have been automatically converted into an equal number of shares of Franklin Holding common stock. Franklin Holding’s common stock will continue to be quoted on the Pink Sheets under the symbol “FCMC.PK.”
The business operations and financial condition of the Company taken as a whole, including Franklin Credit Management Corporation, which holds the servicing platform, on a consolidated basis, including the Company’s consolidated substantial negative net worth, did not change as a result of the Reorganization. However, the resulting financial condition of Franklin Credit Management Corporation changed, inasmuch as it had a positive net worth at December 31, 2008.
Upon its compliance with the state’s minimum net worth requirement as a result of the Reorganization, the Company’s West Virginia license was renewed on December 30, 2008. Ohio terminated its Notice of Intent to Refuse Renewal on January 8, 2009. The state of Wisconsin also noted that the Company had tangible net worth in excess of $250,000 by December 31, 2008. As of the date of this filing, the Company’s net worth issue is still pending with the state of Washington. In addition to these four states, the Company may also be subject to future regulatory action in three other states, Michigan, Illinois and Massachusetts, because in those states the net worth calculation may not include recourse on any contingent liabilities, which would cause the Company’s net worth to be deemed negative by those states. In the summer of 2008, the Company formed a wholly-owned subsidiary, Franklin Credit Loan Servicing, LLC, a Delaware limited liability company, which does not have any liabilities or pledged assets and, therefore, is expected to become licensed in those three states and in the event that such states determine that FCMC does not meet the applicable net worth requirements, Franklin Credit Loan Servicing, LLC would, upon licensure, service loans in such states so that the Company overall would have the required licenses to operate in all 50 states. While the Company believes that the required consent and cooperation of Huntington for the continued positive capitalization of this servicing subsidiary, and any other changes the Company determines to implement, which would enable the Company to retain its servicing and debt collection licenses with all or most states, would be obtained, there can be no assurance that such consents will be obtained and that the Company will be able to retain these licenses. If the Company fails to maintain its state licenses in good standing, the Company will breach its Forbearance Agreements with The Huntington National Bank. The Forbearance Agreements contain affirmative covenants that the Company maintain and comply in all material respects with all governmental licenses and authorizations to hold and service mortgage loans and real estate owned properties. If the Company breaches such covenants, which it did in 2008 by not complying with the minimum net worth requirements of certain states as described above, or Huntington determines that there has been a material adverse affect on the Company’s business and, in either instance, notice of the same is provided to the Company by Huntington, which Huntington has not as of the date of this filing provided to the Company, any such noticed event would be a default under the Forbearance Agreements, which would entitle Huntington to declare the Company’s indebtedness immediately due and payable and transfer the Company’s rights as servicer to a third party.
Amendments to Lending Agreements
On December 28, 2007, Franklin entered into a series of agreements (the “Forbearance Agreements”) with The Huntington National Bank, successor by merger in July 2007 to Sky Bank (Sky Bank, prior to the merger, and Huntington, thereafter, are referred to as the “bank”), whereby the bank agreed to restructure approximately $1.93 billion of the Company’s indebtedness to it and its participant banks, forgave $300 million of such indebtedness for a restructuring fee of $12 million paid to the bank, and waived certain existing defaults (the “Restructuring”). See Note 5. In November 2007, Franklin ceased to acquire or originate loans
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and, under the terms of the Forbearance Agreements, the Company is expressly prohibited from acquiring or originating loans.
On March 31, 2008, the Company entered into amendments to the Forbearance Agreements whereby, among other things, (a) the indebtedness of Franklin’s direct, wholly-owned subsidiary (“Tribeca”) to BOS (USA) Inc. ($44.8 million as of December 31, 2007) was effectively rolled into the Forbearance Agreements, resulting in the payoff and retirement of Tribeca’s debt facilities with BOS (USA) Inc. and BOS acquiring a participation interest under the Forbearance Agreements; and (b) the interest rate and date of commencement of the accrual of PIK (payment in kind) interest on approximately $125 million of the Company’s indebtedness was modified as of March 31, 2008. See Note 5.
The Company entered into additional amendments to the Forbearance Agreements, effective August 15, 2008, whereby, among other things, (a) the minimum net worth covenant was eliminated, (b) the prescribed interest coverage ratios based on EBITDA were changed to ratios based on actual cash flows, and (c) the existing extension of an additional period of forbearance through July 31, 2008 in respect of the remaining Unrestructured Debt was extended to December 31, 2008, and absent the occurrence of an event of default, the bank agreed not to initiate collection proceedings against the Company in respect of any of the Unrestructured Debt. See Note 5.
On December 19, 2008, the Company engaged in a series of transactions (the “Reorganization”) in which the Company: (a) adopted a holding company form of organizational structure, with Franklin Holding serving as the new public-company parent; (b) transferred all of the equity and membership interests in Franklin Credit Management Corporation’s (“FCMC”) direct subsidiaries to other entities in the reorganized corporate structure of the Company; (c) assigned legal record ownership of any loans in the Company’s portfolio held directly by FCMC and Tribeca Lending Corporation, to other entities in the reorganized corporate structure of the Company; and (d) amended its loan agreements with Huntington, its lead lending bank.
In the Reorganization, FCMC became a subsidiary of Franklin Holding and ceased to have any subsidiaries. Franklin Credit Holding Corporation (“Franklin Holding,” and together with its direct and indirect subsidiaries, the “Company”) is the successor issuer to Franklin Credit Management Corporation, a Delaware corporation (the “Predecessor” or “FCMC”). The Reorganization was accounted for as a transaction between entities under common control at carrying value.
The Company’s common stock is quoted on the pink sheets under the symbol “FCMC.PK.”
Concurrent with the Reorganization, the Company entered into a series of agreements with Huntington, its lead lending bank, which included, among other amendments, guaranties of the indebtedness to Huntington by various new entities in the Company’s structure and Huntington waiving the Company’s breach of its covenant to comply with all laws, rules and regulations to the extent such breach resulted from the Company’s failure to satisfy a minimum net worth requirement prior to the Reorganization. See Note 5.
Franklin’s Business
We are a specialty consumer finance company that was, until December 28, 2007, primarily engaged in two related lines of business: (1) the acquisition, servicing and resolution of performing, reperforming and nonperforming residential mortgage loans and real estate assets; and (2) the origination of subprime mortgage loans, both for our portfolio and for sale into the secondary market. We specialized in acquiring and originating loans secured by 1-4 family residential real estate that generally fell outside the underwriting standards of Fannie Mae and Freddie Mac and involved elevated credit risk as a result of the nature or absence of income documentation, limited credit histories, higher levels of consumer debt or past credit difficulties. We typically purchased loan portfolios at a discount, and originated subprime loans with interest rates and fees calculated to provide us with a rate of return adjusted to reflect the elevated credit risk inherent in the types of loans we acquired and originated. Unlike many of our competitors, we generally held for investment the loans
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
we acquired and a significant portion of the loans we originated. From inception through December 31, 2008, we had purchased and originated in excess of $4.73 billion in mortgage loans. As of December 31, 2008, we had total assets of $1.02 billion, our portfolios of notes receivable and loans held for investment, net totaled $882.6 million, and our stockholders’ deficit was $464.5 million.
In the past year, the Company has been seeking to begin providing services for third parties, on a fee-paying basis, which are directly related to our servicing operations and our portfolio acquisition experience with residential mortgage loans. We are actively seeking to (a) expand our servicing operations to provide similar servicing and collection services to third parties, and (b) capitalize on our experience to provide customized, comprehensive loan analysis and in-depth end-to-end transaction and portfolio management services to the residential mortgage markets. Some of these services include, in addition to servicing loans for others, performing 1-4 family residential portfolio stratification and analysis, pricing, due diligence, closing, and collateral transfer. These new business activities are subject to the consent of Huntington, and we may not be successful in entering into or implementing any of these businesses in a meaningful way.
On May 28, 2008, Franklin entered into various agreements (the “Servicing Agreements”) to service on a fee-paying basis approximately $245 million in residential home equity line of credit mortgage loans for Bosco Credit LLC (“Bosco”). As of May 28, 2008, the membership interests in Bosco were held by Thomas J. Axon, Franklin’s Chairman and President, who owns and controls Bosco. The loans that are subject to the Servicing Agreements were acquired by Bosco on May 28, 2008, and the financing for Bosco was provided by a group of lenders led by the bank. Huntington no longer participates in the Bosco facility, but remains the administrative agent for the lenders to Bosco. Franklin also provided the loan analysis, due diligence and other services for Bosco on a fee-paying basis for the loans acquired by Bosco.
2.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates of the Company are the allowance for loan losses and the continuing assessment of the fair value of the underlying collateral of other real estate owned. The Company’s estimates and assumptions primarily arise from risks and uncertainties associated with interest rate volatility and credit exposure. Although management is not currently aware of any factors that would significantly change its estimates and assumptions in the near term, future changes in market trends and conditions may occur which could cause actual results to differ materially.
Operating Segments - Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”) requires companies to report financial and descriptive information about their reportable operating segments, including segment profit or loss, certain specific revenue and expense items, and segment assets. The Company has two reportable operating segments: (i) portfolio asset acquisition and resolution; and (ii) mortgage banking. The portfolio asset acquisition and resolution segment, prior to 2008, acquired performing, reperforming or nonperforming notes receivable and promissory notes from financial institutions and mortgage and finance companies, and services and collects such notes receivable through enforcement of terms of the original note, modification of original note terms and, if necessary, liquidation of the underlying collateral. The mortgage-banking segment, prior to 2008, originated or purchased, subprime residential mortgage loans from individuals whose credit histories, income and other factors cause them to be classified as subprime borrowers. The Company continues to service its portfolios of loans. (See Note 9).
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Earnings Per Share - Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the year. Diluted earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding, including the dilutive effect, if any, of stock options outstanding, warrants and restricted stock calculated under the treasury stock method. The effects of warrants, restricted stock units and stock options are excluded from the computation of diluted earnings per common share in periods in which the effect would be antidilutive. Dilutive potential common shares are calculated using the treasury stock method. For the years ended December 31, 2008 and 2007, 582,000 and 370,000 options, respectively, were not included in the computation of earnings per share because they were antidilutive.
Cash and Cash Equivalents - Cash and cash equivalents includes cash certificates of deposit with original maturities of three months or less, with the exception of restricted cash, which is reported separately on the Company’s balance sheets. The Company maintains accounts at banks, which at times may exceed federally insured limits. The Company has not experienced or expects to incur any losses from such concentrations.
Restricted Cash - Restricted cash includes interest and principal collections received on the Company’s portfolio of notes receivable and loans held for investment, substantially all of which is required to pay down current debt obligations with its lending banks.
Short-term Investments - The Company’s short-term investments include U.S. treasury bills, investment-grade commercial paper and money market accounts. The Company’s short-term investment policy is structured to provide an adequate level of liquidity with minimal credit risk in order to meet normal working capital needs and expansion of the loan portfolio. All short-term investments are classified as available for sale securities and carried at fair value.
Notes Receivable and Income Recognition - The notes receivable portfolio consists primarily of secured real estate mortgage loans purchased from financial institutions and mortgage and finance companies. Such notes receivable were performing, non-performing or sub-performing at the time of purchase and were generally purchased at a discount from the principal balance remaining. Notes receivable are carried at the amount of unpaid principal, reduced by purchase discount and allowance for loan losses. Notes purchased are carried net of purchase discount. The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past loan loss experience and other relevant factors. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for the underlying collateral on an ongoing basis in accordance with company policy.
In general, interest on the notes receivable is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. Accrual of interest on notes receivable, including impaired notes receivable, is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Subsequent recognition of income occurs only to the extent payment is received, subject to management’s assessment of the collectibility of the remaining interest and principal. A non-accrual note is restored to an accrual status when collectibility of interest and principal is no longer in doubt and past due interest is recognized at that time.
Interest on modified notes receivable is generally calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. Except for certain performing
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
loans that are modified by a reduction in the interest rate, while all accrued and unpaid interest is reversed and in these cases, interest at the new modified interest rate is accrued, a nonaccrual note is restored to an accrual status when collectibility of interest and principal is expected to be fully recovered. Accrual of interest on modified loans is discontinued when the loan is contractually delinquent 90 days. When interest accrual is discontinued on modified loans contractually delinquent 90 days, all unpaid accrued interest is reversed against interest income.
Discounts on Acquired Loans - Effective January 1, 2005, as a result of the required adoption of SOP 03-3, the Company was required to change its accounting for loans acquired subsequent to December 31, 2004, which have evidence of deterioration of credit quality since origination and for which it is probable, at the time of our acquisition, that the Company will be unable to collect all contractually required payments. For these loans, the excess of the undiscounted contractual cash flows over the undiscounted cash flows estimated by us at the time of acquisition is not accreted into income (nonaccretable discount). The amount representing the excess of cash flows estimated by us at acquisition over the purchase price is accreted into purchase discount earned over the life of the loan (accretable discount). The nonaccretable discount is not accreted into income. If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting may be used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan.
Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable discount are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable discount is transferred to the accretable discount and is accreted into interest income over the remaining life of the loan on the effective interest method. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through the allowance for loan losses.
There is significant judgment involved in estimating the amount of the loan’s future cash flows. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect our financial condition and results of operations. Depending on the timing of an acquisition, the initial allocation of discount generally will be made primarily to nonaccretable discount until the Company has boarded all loans onto its servicing system; at that time, any cash flows expected to be collected over the purchase price will be transferred to accretable discount. Generally, the allocation will be finalized no later than ninety days from the date of purchase.
For loans not addressed by SOP 03-3 that are acquired subsequent to December 31, 2004, the discount, which represents the excess of the amount of reasonably estimable and probable discounted future cash collections over the purchase price, is accreted into purchase discount earned using the interest method over the term of the loans. This is consistent with the method the Company utilizes for its accounting for loans purchased prior to January 1, 2005, except that for these loans an allowance allocation was also made at the time of acquisition.
Allowance for Loan Losses - The Company reviews its loan portfolios upon purchase of loan pools, at loan boarding, and on a frequent basis thereafter to determine an estimate of the allowance necessary to absorb probable loan losses in its portfolios. Management’s judgment in determining the adequacy of the allowance for loan losses is based on an evaluation of loans within its portfolios, the known and inherent risk characteristics and size of the portfolio, the assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past loan loss experience and other relevant factors. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for the underlying collateral on an ongoing basis in accordance with company policy. Management believes that the allowance for loan losses is adequate. The allowance for loan losses is a material estimate, and this estimate could change significantly in the near term.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
During 2007 and 2008, the U.S. housing and subprime mortgage markets experienced rapid and substantial deterioration. This deterioration gave rise to industry-wide increases in mortgage delinquencies reflecting the decline in collateral values and related declines in borrowers’ equity in their homes, particularly with respect to subprime loans originated throughout the mortgage industry during 2005, 2006 and the early months of 2007, which were characterized by collateral values established at the height of the U.S. real estate market and also, often, by lax underwriting standards. Additionally, during 2007 and 2008, there was a significant tightening of new credit throughout the mortgage lending industry, particularly in the subprime segment of the industry, which increased the difficulty for borrowers with imperfect credit histories to refinance their mortgages. In light of these factors, in combination with a recessionary economy that began in late 2008, and the impact on the Company’s portfolio, a substantial portion of which is comprised of second mortgages purchased from others during the past several years, the Company reassessed its allowance for loan losses in 2007 and 2008, which resulted in significantly increased estimates of inherent losses in the portfolios of purchased loans, particularly the purchased second-lien loans, and originated subprime loans, and the need for substantial increases in reserves. As a result, the provision for loan losses amounted to $458,121,989 during the year ended December 31, 2008 and $274,632,862 for the year ended December 31, 2007. The allowance for loan losses at December 31, 2008 was $520,969,251, compared with 254,661,653 at December 31, 2007.
Effective January 1, 2005, and as a result of the adoption of SOP 03-3, additions to the allowance for loan losses relating to newly acquired loans reflect only those losses incurred by us subsequent to acquisition. The Company no longer increases the allowances through allocations from purchase discount for loans that meet the requirements of SOP 03-3.
Gain on Debt Forgiveness - During the year ended December 31, 2007, in connection with the troubled debt restructuring involving Huntington, the Company recognized a gain of $284.2 million.
Originated Loans Held for Investment - In general, interest on originated loans held for investment is calculated based on contractual interest rates applied to daily balances of the principal amount outstanding using the accrual method. The Company accrues interest on secured real estate first mortgage loans originated by the Company up to a maximum of 209 days contractually delinquent with a recency payment in the last 179 days, and that are judged to be fully recoverable for both principal and accrued interest, based principally on a foreclosure analysis that includes an updated estimate of the realizable value of the property securing the loan.
The accrual of interest is discontinued when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful, which can be less than 209 days contractually delinquent with a recency payment in the last 179 days. When interest accrual is discontinued, the unpaid accrued interest on certain loans in the foreclosure process is not reversed against interest income where the current estimate of the value of the underlying collateral exceeds 110% of the outstanding loan balance. For all other loans held for investment, all unpaid accrued interest is reversed against interest income when interest accrual is discontinued. Except for certain loan modifications, subsequent recognition of income occurs only to the extent payment is received, subject to management’s assessment of the collectibility of the remaining interest and principal. Except for certain performing loans that are modified by a reduction in the interest rate, while all accrued and unpaid interest is reversed and in these cases, interest at the new modified interest rate is accrued, a nonaccrual note is restored to an accrual status when collectibility of interest and principal is expected to be fully recovered.
Other Real Estate Owned - Other real estate owned (“OREO”) consists of properties acquired through, or in lieu of, foreclosure or other proceedings and are held for sale and carried at the lower of cost or fair value less estimated costs to sell. Any write-down to fair value, less cost to sell, is charged to provision for loan losses based upon management’s continuing assessment of the fair value of the underlying collateral. OREO is evaluated quarterly to ensure that the recorded amount is supported by current fair values and
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
valuation allowances are recorded as necessary to reduce the carrying amount to fair value less estimated cost to sell. Revenue and expenses from the operation of OREO and changes in the valuation allowance are included in operations. Direct costs relating to the development and improvement of the property are capitalized, subject to the limit of fair value of the property, while costs related to holding the property are expensed in the current period. Gains or losses are included in operations upon disposal of the property.
Derivatives - As part of the Company’s interest-rate risk management process, we entered into interest rate cap agreements in 2006 and 2007, and interest rate swap agreements in 2008. In accordance with “Accounting for Derivative Instruments and Hedging Activities,” (SFAS 133), as amended and interpreted, derivative financial instruments are reported on the consolidated balance sheets at their fair value.
Interest rate caps are recorded at fair value. The interest rate caps are not designated as hedging instruments for accounting purpose, unrealized changes in fair value are recognized in the period in which the changes occur and realized gains and losses are recognized in the period when such instruments are settled.
Franklin’s management of interest-rate risk predominantly includes the use of plain-vanilla interest-rate swaps to synthetically convert a portion of its LIBOR-based variable-rate debt to fixed-rate debt. In accordance with SFAS 133, derivative contracts hedging the risks associated with expected future cash flows are designated as cash flow hedges. The Company formally documents at the inception of its SFAS 133 hedges all relationships between hedging instruments and the related hedged items, as well as its interest risk management objectives and strategies for undertaking various accounting hedges. Additionally, we use regression analysis at the inception of the hedge and for each reporting period thereafter to assess the derivative’s hedge effectiveness in offsetting changes in the cash flows of the hedged items. The Company discontinues hedge accounting if it is determined that a derivative is not expected to be or has ceased to be highly effective as a hedge, and then reflects changes in the fair value of the derivative in earnings. All of the Company’s interest-rate swaps qualify for cash flow hedge accounting, and are so designated.
As of December 31, 2008, the notional amount of the Company’s fixed-rate interest rate swaps totaled $1.00 billion, representing approximately 76% of the Company’s outstanding variable rate debt. The fixed-rate interest rate swaps are expected to reduce the Company’s exposure to future increases in interest costs on a portion of its borrowings due to increases in one-month LIBOR during the remaining terms of the swap agreements. All of our interest rate swaps were executed with the Company’s lead lending bank. On March 5, 2009, $220 million of one-year interest rate swaps matured, which have not been replaced.
Changes in the fair value of derivatives designated as cash flow hedges, in our case the swaps, are recorded in accumulated other comprehensive loss (“AOCL”) within stockholders’ equity to the extent that the hedges are effective. Any hedge ineffectiveness is recorded in current period earnings. If a derivative instrument in a cash flow hedge is terminated, the hedge designation is removed, or the hedge accounting criteria are no longer met, the Company will discontinue the hedge relationship. As of December 31, 2008, the Company removed the hedge designations for their cash flow hedges as it is improbable that the hedged cash flows will occur. As a result, the Company will continue to report amounts in AOCL related to these hedges unless it becomes probable that the forecasted transactions will not occur by the end of the original specified time period. The amounts in AOCL will be amortized to earnings as cash flows occur. During the twelve months ended December 31, 2008, the net impact to interest expense of our existing cash flow hedges was an increase of $2.4 million.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table presents the notional and fair value amounts of the interest rate swaps at December 31, 2008.
*
Determined in accordance with SFAS 157 based upon a “Level 2” valuation methodology.
The net effect of the interest rate swaps for the twelve months ended December 31, 2008 was $2.4 million, which increased our interest expense. The estimated fair value of the swaps at December 31, 2008 was a negative $27.8 million, which increased stockholders’ deficit (AOCL).
Fair Value Measurements
SFAS 157 establishes a three-tier hierarchy for fair value measurements based upon the transparency of the inputs to the valuation of an asset or liability and expands the disclosures about instruments measured at fair value. A financial instrument is categorized in its entirety and its categorization within the hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels are described below.
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Level 1 - Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
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Level 2 - Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets and inputs that are observable for the asset of liability, either directly or indirectly, for substantially the full term of the financial instrument. Fair values for these instruments are estimated using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows.
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Level 3 - Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Fair values are initially valued based upon transaction price and are adjusted to reflect exit values as evidenced by financing and sale transactions with third parties.
Fair values for over-the-counter interest rate contracts are determined from market observable inputs, including the LIBOR curve and measures of volatility, used to determine fair values are considered Level 2, observable market inputs.
The fair values of derivative instruments on the Company’s financial statements at December 31, 2008 are as follows:
Building, Furniture and Equipment - Building, furniture and equipment, including leasehold improvements, is recorded at cost net of accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from 3 to 40 years. Amortization of leasehold improvements is computed using the straight-line method over the lives of the related leases or useful lives of the related assets, whichever is shorter. Maintenance and repairs are expensed as incurred.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Deferred Financing Costs - Deferred financing costs, which include origination fees incurred in connection with obtaining term loan financing from our banks, are deferred and are amortized over the term of the related loan.
Retirement Plan - The Company maintains a savings plan, which is intended to qualify under Section 401(k) of the Internal Revenue Code. All employees are eligible to be a participant in the plan. The plan provides for voluntary contributions by participating employees in amounts up to 20% of their annual compensation, subject to certain limitations. Currently, the Company matches 50% up to a maximum of 3% of salary. The Company contributed $98,664 and $101,833 in 2008 and 2007, respectively.
Income Taxes - Income taxes are accounted for under Accounting for Income Taxes (“SFAS 109”), which requires an asset and liability approach in accounting for income taxes. This method provides for deferred income tax assets or liabilities based on the temporary difference between the income tax basis of assets and liabilities and their carrying amount in the consolidated financial statements. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of the enactment of the changes.
Servicing Fees and Other Income - Servicing fees and other income consists of prepayment penalties, fees for servicing loans for third parties, due diligence fees for services provided to third parties, late charges, and other miscellaneous income. With the exception of servicing and due diligence fees for services provided to third parties, such income is recognized on a cash basis.
Fair Value of Financial Instruments - Disclosures about Fair Value of Financial Instruments, (“SFAS 107”) requires disclosure of fair value information of financial instruments, whether or not recognized in the balance sheets, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. SFAS 107 excludes certain financial instruments and all non-financial assets and liabilities from its disclosure requirements. Accordingly, the aggregate fair value amounts do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:
a.
Cash, Restricted Cash, Accrued Interest Receivables, Other Receivable and Accrued Interest Payable - The carrying values reported in the consolidated balance sheets are a reasonable estimate of fair value.
b.
Short-term Investments - These investments mature monthly; therefore, the carrying values reported in the consolidated balance sheets are a reasonable estimate of fair value.
c.
Notes Receivable - Fair value of the net note receivable portfolio is estimated by discounting the estimated future cash flows using the interest method. The fair value of notes receivable at December 31, 2008 approximated $304 million based on an independent valuation as of February 28, 2009.
d.
Loans Held for Investment - The fair value of loans held for investment at December 31, 2008 approximated $274 million based on an independent valuation as of February 28, 2009.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
e.
Short-term Borrowings - The interest rates on financing agreements and other short-term borrowings reset on a monthly basis; therefore, the carrying amounts of these liabilities approximate their fair value.
f.
Long-term Debt - The fair value of the Company’s long-term debt (notes payable) at December 31, 2008 approximated $578 million.
Stock-Based Compensation Plans - The Company maintains share-based payment arrangements under which employees are awarded grants of restricted stock, non-qualified stock options, incentive stock options and other forms of stock-based payment arrangements. Prior to January 1, 2006, the Company accounted for these awards under the recognition and measurement provisions of Accounting for Stock Issued to Employees (“APB 25”) as permitted under Accounting for Stock-Based Compensation (“SFAS 123”). Accordingly, compensation cost for stock options was not recognized as long as the stock options granted had an exercise price equal to the market price of the Company’s common stock on the date of grant. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123 (revised 2004), Share-Based Payment, (“SFAS 123(R)”) using the modified-prospective transition method. Under this transition method, compensation cost recognized beginning January 1, 2006 includes compensation cost for all share-based payment arrangements issued, but not yet vested as of December 31, 2005, based on the grant date fair value and expense attribution methodology determined in accordance with the original provisions of SFAS 123. Compensation cost for all share-based payment arrangements granted subsequent to December 31, 2005, is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). In addition, the effect of forfeitures on restricted stock (if any), is estimated when recognizing compensation cost. Results for prior periods have not been recast for the adoption of SFAS 123(R).
Prior to adoption of SFAS 123(R), the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS 123(R) requires the cash flows resulting from the tax benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows.
The compensation cost recognized in income was $291,610 and $376,330 for the years ended December 31, 2008 and 2007, respectively.
Recent Accounting Pronouncements
In February 2007, the Financial Accounting Standards Board (“FASB”) issued The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. This accounting standard for the Company was effective for financial statements beginning January 1, 2008. The Company did not elect the fair value option for any of its existing financial instruments on the effective date and has not determined whether or not it will elect this option for any eligible financial instruments that it acquires in the future.
In September 2006, the FASB issued Fair Value Measurements (“SFAS 157”). SFAS 157 enhances existing guidance for measuring assets and liabilities using fair value. Prior to the issuance of SFAS 157, guidance for applying fair value was incorporated in several accounting pronouncements. SFAS 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. Under SFAS 157, fair value measurements are disclosed by level within that hierarchy. While SFAS 157 does not add any new fair value measurements, it does change current practice. Changes to practice include: (1) a requirement for an entity to include its own credit standing
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
in the measurement of its liabilities; (2) a modification of the transaction price presumption; (3) a prohibition on the use of block discounts when valuing large blocks of securities for broker-dealers and investment companies; and (4) a requirement to adjust the value of restricted stock for the effect of the restriction even if the restriction lapses within one year. SFAS 157 was effective for financial statements beginning January 1, 2008. Adoption of SFAS 157 did not have a significant impact on the Company’s financial position or results of operations.
On July 13, 2006, the FASB released Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109 (FIN 48). FIN 48 clarifies the accounting and reporting for income taxes where interpretation of the tax law may be uncertain. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax uncertainties with respect to positions taken or expected to be taken in income tax returns. We adopted the provisions of FIN 48 on January 1, 2007, which prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.
Based on our evaluation, we have concluded that there are no significant uncertain tax positions, requiring recognition in our financial statements. Our evaluation was performed for the tax years ended 2005 through 2008, which remain open to examination by major tax jurisdictions to which we are subject as of December 31, 2008.
We may from time to time be assessed interest or penalties by major tax jurisdictions, although any such assessments historically have been minimal and immaterial to our financial results. Should we receive an assessment for interest and/or penalties, it would be classified in the financial statements as collection, general and administrative expenses.
3.
NOTES RECEIVABLE, LOANS HELD FOR INVESTMENT AND LOANS HELD FOR SALE, PURCHASE DISCOUNT AND ALLOWANCE FOR LOAN LOSSES
Notes receivable, net of accretable and nonaccretable discounts, consist principally of residential one-to-four family mortgage loans as of December 31, 2008 and 2007 secured as follows:
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Originated loans held for investment, represent residential one-to-four family real estate mortgage loans as of December 31, 2008 and 2007 secured as follows:
There were no loans held for sale at December 31, 2008 or 2007.
As of December 31, 2008, contractual maturities of notes receivable and originated loans held for investment, net of the allowance for loan losses and nonaccretable discount, are as follows:
It is the Company’s experience that a portion of the notes receivable and loans held for investment portfolio may be refinanced or repaid before contractual maturity dates. The above tabulation, therefore, is not to be regarded as a forecast of future cash collections. During the years ended December 31, 2008 and 2007, cash collections of principal amounts totaled approximately $143 million and $334 million, respectively, and the ratios of these cash collections to average principal balances were approximately 8% and 19%, respectively.
Changes in the allowance for loan losses on notes receivable for the years ended December 31, 2008 and 2007 are as follows:
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Changes in the allowance for loan losses on loans held for investment for the years ended December 31, 2008 and 2007 are as follows:
Write-downs for declines in the estimated net realizable value of OREO resulted in a provision for loan losses in the amount of $45,319,736 and $10,509,590 during 2008 and 2007, respectively.
At December 31, 2008 and 2007, principal amounts of notes receivable included approximately $615 million and $330 million, respectively, of notes for which there was no accrual of interest income. The following information relates to impaired notes receivable, which include all such notes receivable as of and for the years ended December 31, 2008 and 2007:
At December 31, 2008 and 2007, the principal amount of loans held for investment included loans on non-accrual status of approximately $236 million and $182 million, respectively.
In the normal course of business, the Company restructures or modifies terms of certain loans to enhance the collectibility of such loans. We classify a previously delinquent or performing loan as modified when we have restructured the loan due to the borrower’s deteriorated financial situation, and, as a condition to the closing of the modification, received at least one full monthly payment at the time of the closing of the modification. As of December 31, 2008, principally all of the modified loans consisted of the deferral of the past due and uncollected interest or a reduction in the interest rate. Interest rate reduction modifications generally are for a period of one year, and for rate reduction modifications of delinquent loans, also incorporate a deferral of the past due and uncollected interest.
During the past year, due to the continued decline in housing prices nationally, the deterioration in mortgage markets, the recessionary economy and the increased delinquency performance of the acquired and originated loans in the Company’s portfolios, we have moved more quickly to identify those borrowers who
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
are likely to move into seriously delinquent status and are attempting to promptly apply appropriate loss mitigation strategies to encourage positive payment performance. We have aggressively strengthened our servicing staff and intensified our efforts to work with borrowers to modify their loans.
As of December 31, 2008 and December 31, 2007, the unpaid principal balance of mortgage loans being serviced by the Company for others was $243.4 million and $420,152, respectively. Mortgage loans serviced for others are not included on the Company’s consolidated balance sheets.
The following table sets forth certain information relating to the activity in the accretable and nonaccretable discounts for principal, which are shown as a component of notes receivable principal on the balance sheet, in accordance with SOP 03-3 for the period indicated:
The outstanding balance of notes receivable subject to SOP 03-3 at December 31, 2008 was $938.9 million. The allowance for loan losses related to loans subject to SOP 03-3 was $405.1 million at December 31, 2008 and $167.5 million at December 31, 2007. The allowance was increased during 2008 by a charge to provision for loan losses in the amount of $237.6 million.
4.
BUILDING, FURNITURE AND EQUIPMENT, NET
At December 31, 2008 and 2007, building, furniture and equipment, net consisted of the following:
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
5.
NOTES PAYABLE
On December 28, 2007, Franklin entered into a series of agreements (the “Forbearance Agreements”) with The Huntington National Bank, successor by merger in July 2007 to Sky Bank (Sky Bank, prior to the merger, and Huntington, thereafter, are referred to as the “bank”), whereby the bank agreed to restructure approximately $1.93 billion of the Company’s indebtedness to it and its participant banks, forgave $300 million of such indebtedness for a restructuring fee of $12 million paid to the bank, and waived certain existing defaults (the “Restructuring”). In November 2007, Franklin ceased to acquire or originate loans and, under the terms of the Forbearance Agreements, the Company is expressly prohibited from acquiring or originating loans. See Note 14 for a discussion of the March 2009 Restructuring.
As of December 31, 2008, we had total borrowings of $1.44 billion, of which $1.40 billion was subject to the Forbearance Agreements and $40.9 million remained under a credit facility excluded from the Forbearance Agreements. Substantially all of the debt under these facilities was incurred in connection with the purchase and origination of, and is secured by, our acquired notes, originated loans held for investment and OREO portfolios. At December 31, 2008, the interest rates on our notes payable were as follows:
*
0% interest at least until maturity of the Forbearance Agreements in May 2009, or until all outstanding amounts under the Tranche A debt have been paid in full.
At December 31, 2008 and 2007, the weighted average interest rate on our term debt was 3.95% and 7.46%, respectively.
Aggregate contractual maturities of all notes payable at December 31, 2008 are as follows:
•
$40.9 million in Unrestructured Debt matured on December 31, 2008; however, notice of default has not yet been issued by the bank; and,
•
$1.40 billion will mature on May 15, 2009 in accordance with the terms of the Forbearance Agreements.
Forbearance Agreements with Lead Lending Bank
On December 28, 2007, the Company entered into a series of agreements with the bank, pursuant to which the bank agreed to forbear with respect to certain defaults of the Company relating to the Company’s indebtedness to the bank and restructure approximately $1.93 billion of such indebtedness to the bank and its participant banks. The Forbearance Agreements mature on May 15, 2009.
The Restructuring did not relate to:
•
$44.5 million of the Company’s indebtedness under the Master Credit and Security Agreement, dated as of October 13, 2004, as amended, by and among Franklin Credit, certain subsidiaries of Franklin Credit and the bank; and,
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
•
$44.8 million of Tribeca’s indebtedness to BOS (USA) Inc., an affiliate of Bank of Scotland, under the Master Credit and Security Agreement, dated March 24, 2006, by and among Tribeca, certain subsidiaries and BOS.
These amounts remain subject to the original terms specified in the applicable agreements (the “Unrestructured Debt”).
At December 31, 2007, the BOS Loan was not included in the Forbearance Agreements between the Company and the bank. The existing BOS facility contains affirmative, negative and financial covenants customary for financings of this type, including, among other things, covenants that require Tribeca and its subsidiaries, together, to maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of $750,000. The facility contains events of default customary for facilities of this type. At December 31, 2007, Tribeca was not in compliance with these and other covenants and has not received a waiver of noncompliance. Any unwaived or uncured breach of these covenants could, subject to notice and opportunity to cure where provided for in the applicable credit agreements, cause an acceleration of the outstanding BOS Loan and result in cross-default and possible acceleration of the indebtedness owed to the bank under the Forbearance Agreements. See below for a description of the amendment to The Forbearance Agreements.
Loan Restructuring. Pursuant to the Restructuring:
•
the Company acknowledged, and the bank waived, certain existing defaults under the Company’s existing credit facilities with the bank;
•
Franklin Credit’s indebtedness to the bank was reduced by $300 million and Franklin Credit paid a restructuring fee of $12 million to the bank;
•
the remaining approximately $1.54 billion of outstanding indebtedness to the bank, including approximately $1.05 billion of outstanding indebtedness of Franklin Credit and approximately $491.1 million of outstanding indebtedness of Tribeca, was restructured into six term loans with modified terms and a maturity date of May 15, 2009; and,
•
the Company paid all of the accrued interest on its debt outstanding to the bank through December 27, 2007 and guaranteed payment and performance of the restructured indebtedness.
Terms of the Restructured Indebtedness. The following table summarizes the principal economic terms of the Company’s indebtedness immediately following the Restructuring.
(1)
The applicable interest rate is fixed at 10% per annum. Interest will be paid in kind during the term of the forbearance.
(2)
Tranche C requires no principal amortization. All principal is due at maturity.
(3)
Tranche D serves as a revolving credit line with a maximum availability of $5 million, and an additional $5 million which may be used for issuance of letters of credit.
(4)
Does not include a letter of credit facing fee of 0.125% per annum on the average daily undrawn amount of each issued and outstanding letter of credit.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The interest rate under the terms of the Forbearance Agreements that is the basis, or index, for the Company’s interest cost is the one-month London Interbank Offered Rate (“LIBOR”) plus applicable margins.
Pursuant to the Forbearance Agreements, the bank is not required to provide any additional advances, except for those under the revolving credit or letter of credit portions of Tranche D.
Cash Flow. The Forbearance Agreements with respect to Franklin Credit, on the one hand, and Tribeca, on the other, provide a waterfall with respect to cash flow received in respect of collateral pledged in support of the related restructured indebtedness, net of approved, reimbursable operating expenses. Such cash flow is applied in the following order:
•
to pay interest in respect of Tranche A advances, Tranche B advances and, in the case of Franklin Credit, Tranche D advances, in that order;
•
to pay fees related to the Company’s letters of credit from the bank;
•
to pay the minimum required principal payments in respect of Tranche A advances and Tranche B advances, in that order;
•
to prepay outstanding Tranche A advances;
•
to prepay outstanding Tranche B advances;
•
to prepay Unrestructured Debt (excluding that owed to BOS);
•
in the case of Franklin Credit, to repay Tranche D advances, any letter of credit exposure, and any obligations in respect of any interest rate hedge agreements with the bank;
•
in the case of Franklin Credit, 90% of the available cash flow to repay interest and then principal of the Tranche C advances if Franklin Credit is acting as servicer of the underlying collateral, or 100% otherwise; and,
•
in the case of Franklin Credit and Tribeca, to pay any advances then outstanding in respect of the other’s indebtedness to the bank, other than for Unrestructured Debt.
Covenants; Events of Default. The Forbearance Agreements contain affirmative and negative covenants customary for restructurings of this type, including covenants relating to reporting obligations. The affirmative and negative covenants under all of the credit agreements between the Company and the bank, other than those under the Franklin Master Credit Agreement and under the Tribeca Master Credit and Security Agreement, dated as of February 28, 2006, as amended, were superseded by the covenants in the Forbearance Agreements. Additionally, any provisions of any of the credit agreements between the Company and the bank that conflict with or are subject of a discrepancy with the provisions of the Forbearance Agreements will be superseded by the conflicting provision in the Forbearance Agreements. The Forbearance Agreements include covenants requiring that:
•
the Company’s reimbursable expenses in the ordinary course of business during each of the first two months after the date of the agreement will not exceed $2.5 million, excluding reimbursement of certain bank expenses after the date of the Restructuring, and thereafter, an amount provided for in an approved budget;
•
the Company will not originate or acquire mortgage loans or other assets, perform due diligence or servicing, broker loans, or participate in off-balance sheet joint ventures and special purpose vehicles, without the prior consent of the bank;
•
the Company will use its best efforts to obtain interest rate hedges acceptable to the bank in respect of the $1 billion of Tranche A indebtedness;
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
•
the Company will not make certain restricted payments to its stockholders or certain other related parties;
•
the Company will not engage in certain transactions with affiliates;
•
the Company will not incur additional indebtedness other than trade payables and subordinated indebtedness;
•
the Company together will maintain a minimum consolidated net worth of at least $5 million, plus a certain percentage, to be mutually agreed upon, of any equity investment in the Company after the date of the Restructuring;
•
the Company will together maintain a minimum liquidity of $5 million;
•
the Company will maintain prescribed interest coverage ratios, based on EBITDA (as defined) to Interest Expense (as defined);
•
the Company will not enter into mergers, consolidations or sales of assets (subject to certain exceptions); and,
•
the Company will not, without the bank’s consent, enter into any material change in its capital structure that the bank or a nationally recognized independent public accounting firm determine could cause a consolidation of its assets with other persons under relevant accounting regulations.
The Forbearance Agreements contain events of default customary for facilities of this type, although they generally provide for no or minimal grace and cure periods.
Servicing. Franklin will continue to service the collateral pledged by the Company under the Forbearance Agreements, subject to the bank’s right to replace Franklin as servicer in the event of a default under the Forbearance Agreements or if the bank determines that Franklin is not servicing the collateral in accordance with accepted servicing practices, as defined in the Forbearance Agreements. Franklin Credit may also, with the bank’s consent, and plans to, provide to third parties servicing of their portfolios, and other related services, on a fee-paying basis.
Security. The Company’s obligations with respect to the restructured Franklin Credit indebtedness are secured by a first priority lien on all of the assets of Franklin Credit and its subsidiaries, other than those of Tribeca and Tribeca’s subsidiaries, and those securing the Unrestructured Debt. The Company’s obligations with respect to the restructured Tribeca indebtedness are secured by a first priority lien on all of the assets of Tribeca and Tribeca’s subsidiaries, except for those assets securing the Unrestructured Debt. In addition, pursuant to a lockbox arrangement, the Company’s lender controls substantially all sums payable to the bank in respect of any of the collateral.
March 2008 Modifications to Forbearance Agreements and Refinancing of BOS Loan
On March 31, 2008, the Company entered into a series of agreements with the bank, which amended the Forbearance Agreements, which are referred to as the Forbearance Agreement Amendments.
Pursuant to the Forbearance Agreement Amendments, the bank extended an additional $43.3 million under Tribeca’s Tranche A and Tranche B facilities, (the “Additional Payoff Indebtedness”), to fund the complete payoff of the BOS Loan. Simultaneously, BOS acquired from the bank a participation interest in Tribeca’s Tranche A facility equal in amount to the Additional Payoff Indebtedness. The effect of these transactions was to roll Tribeca’s indebtedness to BOS into the Forbearance Agreements, to terminate any obligations of Tribeca under the BOS Loan and to BOS directly, and to transfer the benefit of the collateral interests previously securing the BOS Loan to secure the obligations under the Forbearance Agreements. As a result of the Forbearance Agreement Amendments, Tribeca’s indebtedness as of March 31, 2008, was
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$410,860,000 and $98,774,000 for Tranche A and Tranche B, respectively. In connection with the increased debt outstanding under the Amended Forbearance Agreements, Tribeca’s required monthly principal amortization amount under the Tranche A Facility was increased from $3,600,000 to $3,900,000 and that under the Tranche B Facility was increased from $250,000 to $275,000.
In addition, the Forbearance Amendment Agreements modified the Forbearance Agreements with respect to the Franklin Master Credit Facility (the “Franklin Forbearance Agreement”):
•
to provide that Tranche C interest shall not accrue until the first business day after all outstanding amounts under the Tranche A facility have been paid in full;
•
to increase the Tranche C interest rate to 20% from and after such time it begins to accrue;
•
to extend an additional period of forbearance through July 31, 2008, from May 15, 2008, in respect of the remaining Unrestructured Loans; and,
•
to increase the maximum availability under the Tranche D line of credit to $10,000,000 for working capital and general corporate purposes to enable the Company to purchase real property in which it may have a lien, and for purposes of meeting licensing requirements.
Additionally, the Forbearance Agreement Amendments modified the Forbearance Agreements to (a) join additional subsidiaries of the Company as borrowers and parties to the forbearance agreements and other loan documents; and (b) extend the time periods or modify the requirements for the Company and the Company’s other subsidiaries to satisfy certain requirements of the Forbearance Agreements.
After giving effect to the Forbearance Agreement Amendments, the waterfall of payments has been adjusted to provide that periodic amounts constituting additional periodic payments of interest required under any interest hedging agreement may be paid after interest on the Tranche A and Tranche B advances, payments of interest and principal with respect to Tranche C advance shall be deferred until after payment of the Tranche D advance, and to provide for cash payment reserves for certain contractual obligations, taxes and $10,000,000 of cash payment reserves in the aggregate for fees, expenses, required monthly principal amortization and interest owing to the Bank.
The bank also waived any defaults under the Forbearance Agreements for the period through and including March 31, 2008, and consented to the origination by the Company of certain mortgage loans to refinance existing mortgage loans which the bank has approved for purchase and subsequent sale in the secondary market or which the bank determines are qualified for purchase by Fannie Mae or Freddie Mac.
August 2008 Modification to Forbearance Agreements
The Company entered into additional amendments to the Forbearance Agreements, effective August 15, 2008, whereby, among other things, (a) the minimum net worth covenant was eliminated, (b) the prescribed interest coverage ratios based on EBITDA were changed to ratios based on actual cash flows, (c) cash flows available for debt service shall include all of the Company’s cash receipts, including its cash revenues from providing subservicing and other services for third parties, and (d) the existing extension of an additional period of forbearance through July 31, 2008 in respect of the remaining Unrestructured Debt was extended to December 31, 2008, and absent the occurrence of an event of default, the bank agreed not to initiate collection proceedings against the Company in respect of any of the Unrestructured Debt. In addition, all identified forbearance defaults, including the minimum net worth covenant, that existed at the time of the August 2008 Modification were waived. As a result, the Company currently is in compliance with all of the terms of the Forbearance Agreements, with the exception of the minimum debt service payments with regards to the Unrestructured Debt and the failure of the Company to comply with minimum net worth requirements under certain governmental licenses to hold and service mortgage loans.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Unrestructured Debt
The Company has failed to make the minimum monthly debt service payments due on July 5, 2008 through September 5, 2008 in the aggregate amount of $1.3 million from the cash flows received from the collateral supporting the Unrestructured Debt, as required by the Master Credit Agreement in respect of the Unrestructured Debt (remaining debt due to a participant bank that is not a party to the Forbearance Agreements). The Company, however, has made up the aggregate shortfall of approximately $409,000 in the required minimum payments from its own cash account during 2008. See Note 14 for a discussion of the March 2009 Restructuring.
December 2008 Modification to Forbearance Agreements
Concurrent with the merger and the Company’s reorganization into a holding company structure, and the reallocation of owned assets, the Company entered into a series of agreements with Huntington (the “Amendments to the Forbearance Agreements”), pursuant to which the Company amended its loan agreements with Huntington as follows:
•
Franklin Asset became a borrower under the Company’s lending agreements with Huntington;
•
the Trusts became guarantors for the Borrowers’ indebtedness to Huntington;
•
FCMC, Franklin Asset and the Trusts each pledged its assets, including any equity interests in any of the Borrowers, as security for the Borrowers’ indebtedness to Huntington;
•
Franklin Servicing LLC agreed to service, if necessary, the Company’s mortgage loans in selected states;
•
the Company agreed to maintain in effect one or more interest rate hedge agreements in an aggregate notional principal amount of not less than $1 billion, or such lesser amount as Huntington in its sole discretion may approve;
•
the Company’s Tranche D facility was amended to provide for (i) a revolving credit facility and letter of credit facility in the aggregate outstanding amount of $10 million, with a sublimit of $5 million, and, in addition, (ii) a separate letter of credit facility pursuant to which Huntington may issue letters of credit in its discretion, with a sublimit of $5.5 million;
•
Huntington agreed to waive the Company’s breach of covenant to comply with all laws, rules and regulations to the extent such breach results from the Company’s failure to satisfy a minimum net worth requirement; and
•
the covenant requiring FCMC and each of the Borrowers to maintain liquidity of at least $5 million was deleted.
In addition, effective immediately after the filing of the certificate of merger:
•
Franklin Holding became a guarantor for the Borrowers’ indebtedness to Huntington; and
•
Franklin Holding pledged its assets, including any equity interests in any of the Borrowers, as security for the Borrowers’ indebtedness to Huntington.
The Forbearance Agreements continue to be subject to a scheduled maturity date of May 15, 2009.
Master Credit Facilities - Term Loans
The summary that follows describes the terms of the Company’s Master Credit Facilities in effect prior to entering into the Forbearance Agreements on December 28, 2007 described above, which substantially modified such facilities, except for the Unrestructured Debt.
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
General. In October 2004, the Company, and its finance subsidiaries, excluding Tribeca, entered into a master credit and security agreement (the “Franklin Master Credit Facility”) with Huntington National Bank, an Ohio banking corporation, which we refer to as our lender or Huntington. Under this master credit facility, we requested term loans to finance the purchase of residential mortgage loans or refinance existing outstanding loans under this facility. The facility did not include a commitment to additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were therefore subject to our lender’s discretion as well as any regulatory limitations to which our lender was subject. At December 31, 2008, $40.9 million remained outstanding under this facility (the remaining portion of the Unrestructured Debt), and the interest rate continues to be based on the Federal Home Loan Bank of Cincinnati 30-day advance rate plus margins of 2.60% and 2.75%.
In February 2006, Tribeca and certain of its subsidiaries entered into the Tribeca Master Credit Facility with Huntington, pursuant to which certain Tribeca subsidiaries borrowed term loans to finance their origination of loans Tribeca previously financed under its warehouse line of credit with Huntington and consolidate and refinance prior term loans made by Huntington to such subsidiaries. The facility did not include a commitment for additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were subject to our lender’s discretion, as well as any regulatory limitations to which Huntington was subject. At December 31, 2008 and 2007, $0 remained outstanding under this facility.
consolidate and refinance prior term loans made by Huntington to such subsidiaries. The facility did not include a commitment for additional lendings or a commitment to refinance existing outstanding term loans when they matured, which were subject to our lender’s discretion, as well as any regulatory limitations to which Huntington was subject. At December 31, 2008 and 2007, $0 remained outstanding under this facility.
Interest Rates and Fees. Interest on the term loans, up to December 28, 2007, was payable monthly at a floating rate equal to the highest Federal Home Loan Bank of Cincinnati 30-day advance rate as published daily by Bloomberg under the symbol FHL5LBRI, or the “30-day advance rate,” plus the applicable margin in effect prior to August 2006 as follows:
August 2006 Modifications to Huntington National Bank Financing Arrangements
In August 2006, the master credit facilities were modified to reduce the interest rate on all debt originated under the master credit facilities before July 1, 2005 by 25 basis points effective October 1, 2006. This rate was lowered by an additional 25 basis points effective January 1, 2007.
December 2006 Modifications to Huntington National Bank Financing Arrangements
In December 2006, the master credit facilities were modified to change the interest rate on term loans funded under the master credit facilities after November 14, 2006 for loans originated by Tribeca and purchases of second mortgages by the Company to the Federal Home Loan Bank of Cincinnati 30-day advance
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rate as published daily by Bloomberg under the symbol FHL5LBRI (the “30-day advance rate”), plus the applicable margin as follows:
Additionally, the interest rate payable to Huntington National Bank on term loans funded under the Franklin Master Credit Facility after November 14, 2006 in respect of purchases of first mortgages by the Company was the 30-day advance rate, plus the applicable margin as follows:
As a result of these modifications, effective January 1, 2007, and up to December 28, 2007, the interest rate on term borrowings under our Master Credit Facilities was based on a floating rate equal to the 30-day advance rate, plus the applicable margin as follows:
Upon each closing of a loan after June 23, 2006, we were required to pay an origination fee equal to 0.50% of the amount of the loan unless otherwise agreed to by our lender. For loans funded between July 1, 2005 and June 23, 2006, under the Franklin Master Credit Facility, the origination fee paid was 0.75% of the amount of the loan (0.50% for loans funded under the Tribeca Master Credit Facility), and for loans funded prior to July 1, 2005, the origination fee paid was 1% of the amount of the loan unless otherwise agreed to by our lender.
Principal; Prepayments; Termination of Commitments. The unpaid principal balance of each loan was amortized over a period of twenty years, but matures three years after the date the loan was made. Historically, our lender had agreed to extend the maturities of such loans for additional three-year terms upon their maturity. We were required to make monthly payments of the principal on each of our outstanding loans.
In the event there was a material and adverse breach of the representations and warranties with respect to a pledged mortgage loan that was not cured within 30 days after notice by our lender, we would have been required to repay the loan with respect to such pledged mortgage loan in an amount equal to the price at which such mortgage loan could readily be sold (as determined by our lender).
Covenants; Events of Default. The Master Credit Facilities contain affirmative, negative and financial covenants customary for financings of this type, including, among other things, a covenant under the Franklin Master Credit Facility that we and our subsidiaries together maintain a minimum net worth of at least $10 million; and, a covenant under the Tribeca Master Credit Facility that Tribeca and its subsidiaries, together, maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of
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at least $750,000. These master credit facilities contain events of default customary for facilities of this type (with customary grace and cure periods, as applicable). Pursuant to the Restructuring, the bank waived certain existing defaults under the Company’s master credit facilities for both Franklin and Tribeca.
Security. Our obligations under the Franklin Master Credit Facility are secured by a first priority lien on loans that are financed by proceeds of loans made to us under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, our lender is entitled to receive substantially all sums payable to us in respect of any of the collateral. Tribeca’s and its subsidiary borrowers’ obligations under the Tribeca Master Credit Facility are secured by a first priority lien on loans originated by Tribeca or such subsidiary that are financed or refinanced by proceeds of loans made to Tribeca or its borrowers under the facility. The collateral securing each loan cross-collateralizes all other loans made under this facility. In addition, pursuant to a lockbox arrangement, Huntington is entitled to receive substantially all sums payable to Tribeca and any subsidiary borrower in respect of any of the collateral.
Bank of Scotland Term Loan
In March 2006, Tribeca and one of Tribeca’s subsidiaries (the “Tribeca Subsidiary Borrower”) entered into a $100 million Master Credit and Security Agreement (the “BOS Loan”) with BOS (USA) Inc., an affiliate of Bank of Scotland. $98.2 million of proceeds of the BOS Loan were used to consolidate and refinance prior term loans made to certain Tribeca subsidiaries. Interest on the BOS Loan was payable monthly at a floating rate equal to the 30-day advance rate plus an applicable margin as follows:
The unpaid principal balance of the BOS Loan was amortized over a period of 20 years, but matures in March 2009. The Tribeca Subsidiary Borrower was required to make monthly amortization payments and payments of interest on the BOS Loan. The facility did not include a commitment to additional lendings or a commitment to refinance the remaining outstanding balance of the loan when it matures. The outstanding balance of the BOS Loan was $44.8 million (a portion of the Unrestructured Debt) at December 31, 2007. Pursuant to the March 2008 Amendments to the Forbearance Agreements, the BOS term loan was refinanced and rolled into the Forbearance Agreements. As a result, there was no Unrestructured Debt for the BOS Loan.
The facility contained affirmative, negative and financial covenants customary for financings of this type, including, among other things, covenants that require Tribeca and its subsidiaries, together, to maintain a minimum net worth of at least $3.5 million and rolling four-quarter pre-tax net income of $750,000. The facility contained events of default customary for facilities of this type. At December 31, 2007, Tribeca was not in compliance with these and other covenants and has not received a waiver of noncompliance. Any unwaived or uncured breach of these covenants could have, subject to notice and opportunity to cure where provided for in the applicable credit agreements, caused an acceleration of the outstanding BOS Loan and resulted in cross-default and possible acceleration of the indebtedness owed to the bank under the Forbearance Agreements.
Tribeca’s and the Tribeca subsidiary borrower’s obligations under the facility were secured by (i) a first priority lien on loans acquired by the Tribeca Subsidiary Borrower that are refinanced by the proceeds of the BOS Loan and (ii) a second priority lien on collateral securing loans made to Tribeca or its subsidiaries under the Tribeca Master Credit Facility described above. In addition, pursuant to a lockbox arrangement, BOS was entitled to receive substantially all sums payable to Tribeca and the Tribeca Subsidiary Borrower in respect of
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any of the primary collateral under the facility. Tribeca’s BOS Loan and the Tribeca Master Credit Facility were cross-collateralized.
6.
FINANCING AGREEMENTS
The summary that follows describes the terms of the Company’s financing agreements in effect prior to entering into the Forbearance Agreements on December 28, 2007 described above, which substantially modified such agreements.
The Company and Tribeca also had the following financing agreements:
Warehousing Credit and Security Agreement
In October 2005, Tribeca entered into a Warehousing Credit and Security Agreement (the “Tribeca Warehouse Facility”) with our lender, which modified previous warehouse lending agreements. In April 2006, our lender increased the commitment to $60 million. Interest on advances was payable monthly at a rate per annum equal to the greater of (i) a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points or (ii) 5%.
The Tribeca Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. Tribeca also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of Tribeca’s obligations under the Tribeca Warehouse Facility, which was secured by substantially all of Tribeca’s personal property. As of December 28, 2007, this facility was terminated.
Flow Warehousing Credit and Security Agreement
In August 2006, we entered into a new $40 million Flow Warehousing Credit and Security Agreement (the “Flow Warehouse Facility”) for a term of one year with our lender to accumulate loans acquired by the Company on a flow basis prior to consolidating such loans into term debt. This warehouse facility was renewed in August 2007 by Huntington for $20 million and for a term of one year. As of December 28, 2007, this facility was terminated.
Interest on advances was payable monthly at a rate per annum equal to a floating rate equal to the Wall Street Journal Prime Rate minus 50 basis points.
The Flow Warehouse Facility was secured by a lien on all of the mortgage loans delivered to our lender or in respect of which an advance has been made as well as by all mortgage insurance and commitments issued by insurers to insure or guarantee pledged mortgage loans. The Company also assigned all of its rights under third-party purchase commitments covering pledged mortgages and the proceeds of such commitments and its rights with respect to investors in the pledged mortgages to the extent such rights were related to pledged mortgages. In addition, we provided a guaranty of the Company’s obligations under the Flow Warehouse Facility, which was secured by substantially all our personal property.
Other Credit Facilities
The Company and the bank have entered into a credit facility, which provides the Company with the ability to borrow a maximum of $4 million at a rate equal to the Bank’s prime rate less 50 basis points per annum. The credit facility may be utilized to pay real estate taxes or to purchase the underlying collateral of certain nonperforming real estate secured loans. Principal repayment of each respective advance is due six
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months from the date of such advance and interest is payable monthly. Prior to March 2005, this credit facility provided a maximum loan amount of $2.5 million at a rate equal to the Bank’s prime rate plus 200 basis points per annum. Effective in October 2006, the rate was changed to the Bank’s prime rate less 50 basis points per annum. Effective December 28, 2007, the line of credit is provided for by the terms of the Forbearance Agreements and was increased to $5 million. As of December 31, 2008 and 2007, $1,958,011 and $1,033,073, respectively, were outstanding on this credit facility. The credit facility is secured by a first priority security interest in the respective notes receivable, any purchased real estate, payments received under the notes receivable, and collateral securing the notes of certain loan portfolios.
The Company had a line of credit with another bank, which provided the Company with an unsecured line of credit to borrow a maximum of $150,000 at a rate equal to such bank’s prime rate plus 1% per annum. As of December 31, 2007, the amount outstanding was $0 and the line of credit had been closed.
7.
INCOME TAXES
Components of the (benefit)/provision for income taxes for the years ended December 31, 2008 and 2007 are as follows:
A reconciliation of the anticipated income tax expense (computed by applying the Federal statutory income tax rate to income before income tax expense) to the provision for income taxes in the accompanying consolidated statements of income for the years ended December 31, 2008 and 2007 is as follows:
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The tax effects of temporary differences that gave rise to deferred income tax assets and liabilities at December 31, 2008 and 2007 are presented below:
The Company has recorded a valuation allowance of $189.8 million, inclusive of $9.9 million that was recorded in other comprehensive income, and $4.1 million as of December 31, 2008 and 2007, respectively, as the Company has determined that it is more likely than not that all of the deferred tax assets will not be fully realizable.
As of December 31, 2008, the Company had tax net operating loss carryforwards with various states totaling approximately $130.5 million. As of December 31, 2008, the Company had federal tax net operating loss carryforwards of approximately $62.8 million. The net operating loss carryforwards expire in various years beginning in 2015 through 2028.
8.
STOCK-BASED COMPENSATION
The Company awarded stock options to certain officers and directors under the Franklin Credit Management Corporation 1996 Stock Incentive Plan (the “Plan”) as amended. The Compensation Committee of the Board of Directors (the “Compensation Committee”) determines which eligible employees or directors will receive awards, the types of awards to be received, and the terms and conditions thereof.
Options granted under the Plan may be designated as either incentive stock options or non-qualified stock options. The Compensation Committee determines the terms and conditions of the option, including the time or times at which an option may be exercised, the methods by which such exercise price may be paid, and the form of such payment. Options are generally granted with an exercise price equal to the market value of the
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Company’s stock at the date of grant. These option awards generally vest over 1 to 3 years and have a contractual term of 10 years.
The Company estimated the fair value of stock options granted on the date of grant using the Black-Scholes option-pricing model. The table below presents the assumptions used to estimate the fair value of stock options granted on the date of grant using the Black-Scholes option-pricing model for the years ended December 31, 2008 and 2007. The risk-free rate for periods within the contractual life of the stock option is based on the U.S. Treasury yield curve in effect at the time of grant. The Company uses historical data to estimate stock option exercise. The expected term of stock options granted is derived from the output of the model and represents the period of time that stock options granted are expected to be outstanding. The estimates of fair value from these models are theoretical values for stock options and changes in the assumptions used in the models could result in materially different fair value estimates. The actual value of the stock options will depend on the market value of the Company’s common stock when the stock options are exercised.
Transactions in stock options for the years ended December 31, 2008 and 2007 under the plan are summarized as follows:
The weighted average remaining contractual term and aggregate intrinsic value of options outstanding and exercisable was 3.99 years and $0, as of December 31, 2008.
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The Company has the following options outstanding at December 31, 2008:
Compensation cost related to the Company’s stock option awards was $50,964 for the year ended December 31, 2008. As of December 31, 2008, unrecognized compensation cost related to the Company’s stock option awards was $198,154, which will be recognized over a weighted average period of 3.31 years.
At December 31, 2008, the Company had 10,000 warrants outstanding at an exercise price of $5.00. There were no warrants exercised during 2008.
Stock Incentive Plan
On May 24, 2006, the shareholders approved the 2006 Stock Incentive Plan. This approval authorized and reserved 750,000 shares for grant under the 2006 stock incentive plan. Awards can consist of non-qualified stock options, incentive stock options, stock appreciation rights, shares of restricted stock, restricted stock units, shares of unrestricted stock, performance shares and dividend equivalent rights are authorized. Grants of non-qualified stock options, incentive stock options and stock appreciation rights under the 2006 Stock Incentive Plan generally qualify as “performance-based compensation” under Section 162(m) of the Internal Revenue Code, and, therefore, are not subject to the provisions of Section 162(m), which disallow a federal income tax deduction for certain compensation in excess of $1 million per year paid to the Company’s Chief Executive Officer and each of its four other most highly compensated executive officers.
•
Restricted Stock - Restricted shares of the Company’s common stock have been awarded to certain executives. The stock awards are subject to restrictions on transferability and other restrictions, and step vest over a three year period.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A summary of the status of the Company’s restricted stock awards as of December 31, 2008 and 2007 and changes during the period then ended is presented below:
During 2008, the total fair value of the Company’s restricted stock that vested during 2008 was $240,646.
As of December 31, 2008, there was $283,375 of unrecognized compensation cost related to the Company’s restricted stock awards, which will be recognized over a weighted average period of 1.09 years.
9.
SEGMENTS
The Company has two reportable operating segments: (i) portfolio asset acquisition and resolution; and (ii) mortgage banking. The portfolio asset acquisition and resolution segment, prior to 2008, acquired performing, nonperforming, nonconforming and sub-performing notes receivable and promissory notes from financial institutions, mortgage and finance companies, and serviced and collected such notes receivable through enforcement of original note terms, modification of original note terms and, if necessary, liquidation of the underlying collateral. The mortgage-banking segment, prior to 2008, originated or purchased for sale and investment purposes residential mortgage loans to individuals whose credit histories, income and other factors caused them to be classified as subprime borrowers. The Company continues to service its portfolios of loans, which operations are included in the portfolio asset acquisition and resolution segment.
The Company’s management evaluates the performance of each segment based on profit or loss from operations before unusual and extraordinary items and income taxes.
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PORTFOLIO ASSET ACQUISITION AND RESOLUTION
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MORTGAGE BANKING
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10.
CERTAIN CONCENTRATIONS
The following table summarizes percentages of total principal balances by the geographic location of properties securing the loans in our portfolios of notes receivable and loans held for investment at December 31, 2008 and December 31, 2007:
Such real estate mortgage loans held are collateralized by real estate with a concentration in these states. Accordingly, the collateral value of a substantial portion of the Company’s real estate mortgage loans held and real estate acquired through foreclosure is susceptible to changes in market conditions in these states. In the event of sustained adverse economic or housing price conditions, it is possible that the Company could experience a negative impact in its ability to collect on existing real estate mortgage loans held, or liquidate foreclosed assets in these states, which could impact the Company’s related loan loss estimates.
During 2007 and 2008, the U.S. housing and subprime mortgage markets experienced rapid and substantial deterioration, and in the latter part of 2008, the U.S. economy entered a recessionary period. These negative operating environments have given rise to industry-wide increases in mortgage delinquencies reflecting the decline in collateral values and related declines in borrowers’ equity in their homes, particularly with respect to subprime loans originated throughout the mortgage industry during 2005, 2006 and the early months of 2007, which were characterized by collateral values established at the height of the U.S. real estate market and also, often, by lax underwriting standards. Additionally, during the summer of 2007, there was a significant tightening of new credit throughout the mortgage lending industry, particularly in the subprime segment of the industry, which continues to make it very difficult for borrowers with imperfect credit histories to refinance their mortgages. In light of these factors, and their impact on the Company’s loan portfolios, a substantial portion of which is comprised of second mortgages purchased from others during the past several years, the Company throughout 2008 significantly increased estimates of inherent losses in the portfolios of purchased loans, particularly the purchased second-lien loans, and originated subprime loans, which resulted in a provision of $458.1 million for the twelve months ended December 31, 2008.
Financing - Substantially all of the Company’s existing debt is with one financial institution.
11.
COMMITMENTS AND CONTINGENCIES
Operating Leases - During 2005, the Company entered into two operating lease agreements for corporate office space, which contain provisions for future rent increases, rent-free periods, or periods in which rent payments are reduced (abated). The total amount of rental payments due over the lease term is being
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
charged to rent expense on the straight-line method over the term of the lease. The difference between rent expense recorded and the amount paid is credited or charged to “Accrued expenses,” which is included in “Accounts payable and accrued expenses” on the balance sheets. The Company’s aggregate rent expenses for 2008 and 2007 were $1,973,322 and $1,372,442, respectively.
The combined future minimum lease payments as of December 31, 2008 are as follows:
As part of its acquisition of the wholesale mortgage origination unit in February 2007, Tribeca assumed the lease obligation for office space located in Bridgewater, New Jersey, for approximately 14,070 square feet. The term of the lease is through January 31, 2011 at approximately $20,621 per month. At December 31, 2007, the space was not being utilized by Tribeca, and it is being marketed for sublease. Due to adverse market conditions for rental commercial space of this type, the remaining lease payments of $596,774 were accrued and other non-usable fixed assets of $208,991 were written off in 2008.
Substantially all of the Company’s office equipment is leased under multiple operating leases. The combined future minimum lease payments as of December 31, 2008 are as follows:
Capital Leases - The Company entered into a lease for office furniture for its new corporate office in Jersey City under an agreement that is classified as a capital lease. The cost of the furniture under this capital lease is included on the balance sheets as “Building, furniture and equipment” and was $916,890 at December 31, 2008. Accumulated amortization of the leased furniture at December 31, 2008 was $626,542. Amortization of assets under capital leases is included in depreciation expense.
The combined future minimum lease payments required under the capital lease as of December 31, 2008 are as follows:
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Legal Actions - The Company is involved in legal proceedings and litigation arising in the ordinary course of business. In the opinion of management, the outcome of such proceedings and litigation currently pending will not materially affect the Company’s financial statements.
Certain whole-loan sale contracts include provisions requiring the Company to repurchase a loan if a borrower fails to make one or more of the first loan payments due on the loan after the date of sale. In addition, the purchaser may require that the Company refund a portion of the premium paid on the sale of mortgage loans if a loan is prepaid in full within a certain amount of time from the date of sale. The Company records a provision for estimated repurchases and premium recapture on loans sold, which is charged to gain on sale of loans.
At December 31, 2008, the Company did not have any remaining potential repurchase obligations.
Franklin Credit Management Corporation v. WMC Mortgage LLC
On February 6, 2008, the Company commenced an action in the Supreme Court of the State of New York, County of New York captioned Franklin Credit Management Corporation v. WMC Mortgage LLC, successor to WMC Mortgage Corp., (the “First WMC Litigation”). The First WMC Litigation arises from the Company’s purchase of approximately $170 million of second mortgages from WMC Mortgage Corp. (“WMC”), an affiliate of General Electric Company. In the First WMC Litigation, the Company seeks damages in an amount not less than $35.5 million resulting from breaches of the representations and warranties contained in the loan purchase agreements entered into between the Company and WMC. WMC has served an Answer to the Complaint generally denying the allegations.
On August 15, 2008, the Company commenced a second action in the Supreme Court of the State of New York, County of New York captioned Franklin Credit Management Corporation v. WMC Mortgage LLC, successor to WMC Mortgage Corp., (the “Second WMC Litigation”). In the Second WMC Litigation, the Company seeks damages in an amount not less than $36.8 million resulting from breaches of representations and warranties contained in the loan purchase agreements entered into between the Company and WMC with respect to second mortgages purchased from WMC during 2006. These second mortgages were not the subject of the First WMC Litigation. WMC has served an Answer to the Complaint generally denying the allegations.
The First WMC Litigation and the Second WMC Litigation have been consolidated for all purposes by the Court. The consolidated action is currently in the document discovery phase which is scheduled to end on July 17, 2009. No trial date has been set.
Franklin Credit Management Corporation v. Decision One Mortgage Company, LLC and HSBC Finance Corporation
As previously disclosed by the Company, on February 13, 2008, the Company commenced an action in the Supreme Court of the State of New York captioned Franklin Credit Management Corporation v. Decision One Mortgage Company, LLC and HSBC Finance Corporation, for breaches of certain loan purchase agreements based on a failure of Decision One Mortgage Company, LLC (“Decision One”) to repurchase loans it sold to the Company and for which an early payment default occurred. HSBC Finance Corporation (“HSBC”) guaranteed Decision One’s obligations with respect to certain loans. On March 25, 2008, the defendants served their answer generally denying the Company’s allegations; included as part of the answer were counterclaims by Decision One for attorneys’ fees and indemnification under the subject loan purchase agreements.
On December 8, 2008, the Company filed a First Amended Complaint which added claims based on additional breaches of the loan purchase agreements at issue in the original complaint, as well as breaches of other loan purchase agreements between the Company and Decision One, resulting from Decision One’s failure to repurchase loans it sold to the Company and for which an early payment default occurred. The First
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Amended Complaint sought damages from Decision One in an amount not less that $8.75 million; of this amount the Company alleged that HSBC was liable for not less that $4.4 million as a result of its guaranty.
On December 31, 2008, defendants served their answers to the First Amended Complaint similarly denying the Company’s allegations. As before, Decision One asserted counterclaims for attorneys’ fees and indemnification under the subject loan purchase agreements, which counterclaims the Company denied.
12.
RELATED PARTY TRANSACTIONS
On February 13, 2006, Tribeca entered into a lease agreement with 18 Harrison Development Associates, an entity controlled by Thomas J. Axon, to lease approximately 950 square feet on the 5th floor at 18 Harrison Street, New York, New York for use as additional office space. The term of the lease was through February 12, 2007, at approximately $4,880 per month, and the option to extend the lease for an additional period of one year at a rate of approximately $5,124 per month was exercised. The lease was extended in February 2007, and expired unrenewed in February 2008.
During 2006, the Company entered into a month-to-month agreement with its Chairman and President, Thomas J. Axon, for use of a condominium apartment unit at 300 Albany Street in New York, New York for corporate housing. The Company paid $18,000 under this agreement in both 2008 and 2007.
At December 31, 2008 and 2007, respectively, the Company had an outstanding receivable from an affiliate, RMTS Associates, of $12,388 and $6,152. This receivable represents various operating expenses that are paid by the Company and then reimbursed by RMTS. In 2007, the Company wrote off $204,634 of aged receivables from RMTS Associates due to non-payment.
On May 28, 2008, Franklin entered into various agreements (the “Servicing Agreements”) to service on a fee-paying basis approximately $245 million in residential home equity line of credit mortgage loans for Bosco Credit LLC (“Bosco”). Bosco was organized by Franklin. As of May 28, 2008, the initial membership interests in Bosco were issued to Thomas J. Axon, Franklin’s Chairman and President. The loans that are subject to the Servicing Agreements were acquired by Bosco on May 28, 2008, and the financing for Bosco was provided by a group of lenders led by the bank. Huntington no longer participates in the Bosco facility, but remains the administrative agent for the lenders to Bosco. Franklin also provided the loan analysis, due diligence and other services for Bosco on a fee-paying basis for the loans acquired by Bosco. At December 31, 2008, the Company had an outstanding receivable from Bosco for servicing fees and certain administrative services rendered in the amount of $616,638. See Note 14.
On August 18, 2008, Franklin agreed to the payment of a 5% commission, with respect to its force-placed insurance program to a related party, Hudson Servicing Solutions, LLC (“Hudson”), a procuror of force-placed insurance products for the mortgage industry. The sole member of Hudson is RMTS, LLC, of which Thomas J. Axon, Franklin’s Chairman and President, is the majority owner. Hudson’s commission was $69,000 for 2008.
On March 31, 2009, the Company transferred ten percent of its ownership in common stock of FCMC to its Chairman and President, Thomas J. Axon, as the cost of obtaining certain guarantees and pledges from Mr. Axon, which were required by The Huntington National Bank (the “Bank”) as a condition of the restructuring entered into by the Company and certain of its wholly-owned direct and indirect subsidiaries on March 31, 2009. Mr. Axon is also entitled to a grant of up to an additional ten percent of the common stock of FCMC from the Company should the pledge of common shares of FCMC by the Company to the Bank, as part of the restructuring, be reduced upon the attainment by FCMC of certain net collection targets set by the Bank. See Note 14.
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13.
QUARTERLY FINANCIAL INFORMATION (Unaudited)
Consolidated Statements of Operations
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14.
SUBSEQUENT EVENTS
March 2009 Restructuring
On March 31, 2009, Franklin Credit Holding Corporation (“Franklin Holding”), and certain of its wholly-owned direct and indirect subsidiaries (together with Franklin Holding, the “Company”), including Franklin Credit Management Corporation (“FCMC”) and Tribeca Lending Corp. (“Tribeca”), entered into a series of agreements (collectively, the “Restructuring Agreements”) with The Huntington National Bank (the “Bank”), successor by merger to Sky Bank, pursuant to which the Company’s loans, pledges and guarantees with the Bank and its participating banks were substantially restructured, and approximately 83% of the Company’s portfolio of subprime mortgages was removed from the Company’s balance sheet and transferred to the balance sheet of Huntington Capital Financing, LLC (the “REIT”), a real estate investment trust wholly owned by the Bank (the “Restructuring”). In connection with the Restructuring, the Company has engaged in a number of cost savings measures, including across the board salary reductions and reductions in staff that should result in improved financial performance of FCMC.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Restructuring did not relate to approximately $41 million of the Company’s indebtedness under the Master Credit and Security Agreement, dated as of October 13, 2004, as amended, by and among FCMC, certain subsidiaries of FCMC and the Bank (the “Franklin Master Agreement”). This amount (the “Unrestructured Debt”) remains subject to the original terms specified in the applicable agreements. All collections in respect of these loans will continue to be applied in accordance with the Company’s existing Forbearance Agreements, the maturity date of which the Bank has committed to extend from May 15, 2009 to June 30, 2009, and under which the Bank has committed that there will be no events of default should the collections in respect of these loans be insufficient to make any minimum monthly payments otherwise required under the Franklin Master Agreement until June 30, 2009. Upon expiration of the Forbearance Agreement with respect to the Static Loans, the Bank, with notice, could call an Event of Default under the Licensing Credit Agreement (as defined below) and the Legacy Credit Agreement (as defined below).
Background. The severe deterioration in the U.S. housing market and the nearly complete shutdown of the mortgage credit market for borrowers without excellent credit histories, and more recently the severe economic slowdown and rapidly rising unemployment, severely degraded the value of the portfolio of subprime 1-4 family mortgage loans and assets acquired and originated by the Company (the “Portfolio”), particularly its second-lien mortgage loans, and resulted in increased delinquencies, provisions for loan losses and operating losses, and decreased cash flows, during the past two years. The impact on the Company’s operations has been severe, and has included:
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a substantial and growing shortfall in case collections from the Portfolio relative to the Company’s debt service obligations owed to the Bank;
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a substantial and growing shortfall in the value of the Company’s assets, relative to the amounts owed to the Bank under the facility agreements for the Company’s outstanding debt with the Bank;
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concern by potential servicing customers and other constituencies over the continued viability of the Company in its current form, including the viability of FCMC, the Company’s servicing platform, which the Company believes as of December 31, 2008 to be financially sound on a unpledged, stand alone basis;
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concern that the Bank was increasingly likely to:
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cease granting necessary waivers and forbearances with respect to Company defaults under the Company’s various credit facilities; and
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declare a default with respect to the credit facilities and foreclose on the assets of the Company, substantially all of which were pledged to the Bank, especially in light of communications from the Bank indicating that it was seeking greater and more direct control over the assets in the Portfolio and was contemplating its remedies if a transaction like the Restructuring was not consummated by the end of the first quarter of 2009, and thus leaving no value for the Company’s stockholders.
In order to address these issues, accommodate the concerns of the Bank to take advantage of what the Company believes is the best option to preserve value for its stockholders, the Company negotiated and entered into the Restructuring, which has been approved by the Company’s Board of Directors.
Executive Summary. Key attributes of the Restructuring, as they relate to the Company’s legacy indebtedness to the Bank include:
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in exchange for the transfer of the loans underlying the Bank Trust Certificates (as defined below), the Company received common membership interests and Class C preferred membership interests in the REIT having in the aggregate a value equal to the estimated fair market value of that portion of the Portfolio transferred to the Bank, which as of March 31, 2009 was approximately $481.5 million (the “REIT Securities”). The preferred membership interests have a liquidation value of $100,000 per unit
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
and an annual dividend rate of 9% of such liquidation value. The REIT Securities replaced the above referenced loans on the Company’s balance sheet;
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principal and interest payments in respect of the Legacy Credit Agreement are only due and payable to the extent of dividends declared and paid in respect of the REIT Securities and 70% of the amounts distributed by FCMC to the Company or upon maturity or default under the credit agreements; and
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the Bank’s recourse in respect of the Legacy Credit Agreement is limited to the assets and stock of Franklin Holding’s subsidiaries, excluding the assets of FCMC and a portion of FCMC’s stock, representing not less than twenty percent and not more than seventy percent of FCMC’s common equity, based on the amounts received by the Bank from the cash collections from FCMC’s servicing of the Portfolio as discussed in more detail below. The Bank also will be entitled to receive seventy percent of the distributions and dividends from FCMC, which percentage share may be reduced to twenty percent based upon the Bank’s receipt of the agreed amounts of net remittances from the Portfolio summarized below.
From the perspective of the Company and its stockholders, the Restructuring accomplished a number of overarching objectives, including:
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release of thirty percent of the equity in FCMC, which is wholly owned by the Company, from the Company’s pledges to the Bank in respect of its legacy credit agreement, with the possibility of release of up to an additional fifty percent, based upon the Bank’s receipt of the agreed amounts of net remittances from the Portfolio, summarized below (the “Net Remittances”), from March 31, 2009, the effective date of the Legacy Credit Agreement (the “Legacy Effective Date”), through the term of the Legacy Credit Agreement; the Bank shall reduce its interest in the equity in FCMC in accordance with the following collection levels:
provided, however, (i) if Net Remittances do not reach the minimum Level 1 amount prior to the first anniversary of the Legacy Effective Date, but reach the minimum Level 2 amount prior to the third anniversary of the Legacy Effective Date, the Bank shall retain, as collateral, 55% of the FCMC equity instead of 50%, as currently scheduled, and any subsequent reductions in the amount of FCMC equity pledged to the Bank shall be 10% smaller than the reductions currently scheduled; and provided further that (ii) if Net Remittances do not reach the minimum Level 1 amount prior to the first anniversary of the Legacy Effective Date and do not reach the minimum Level 2 amount prior to the third anniversary of the Legacy Effective Date, then the schedule for release of the equity interests in FCMC currently pledged to the Bank shall be as follows: (x) upon attaining the minimum Level 3 amount, the pledged equity interests in FCMC shall reduce 25% (from 70% to 45%); (y) upon attaining the minimum Level 4 amount, the pledged equity interests in FCMC shall reduce an additional 10% (from 45% to 35%), and (z) upon attaining the minimum Level 5 amount, the pledged equity interests in FCMC shall reduce an additional 10% (from 35% to 25%);
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entry into a servicing agreement enabling the Company to receive fee income in respect of its continued servicing of the transferred Portfolio; and
FRANKLIN CREDIT HOLDING CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
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entry into amended credit facilities in the aggregate principal amount of $13.5 million, including a $5 million facility for working capital and to support various servicer licenses, a $2 million revolving facility and a $6.5 million letter of credit facility to support various servicer licenses.
Among the most significant costs of accomplishing these objectives were:
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the possible transfer of ownership of a portion of FCMC, including a minimum of twenty percent and a maximum of seventy percent, to the Bank at maturity of the Company’s Legacy Credit Agreement with the Bank, unless further extended if the Company is not otherwise able to satisfy or refinance the Legacy Credit Agreement prior to maturity;
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the transfer of ten percent of ownership of FCMC to the Company’s principal stockholder as the cost of obtaining certain guarantees and pledges required by the Bank as a condition of the restructuring, subject to increase to an additional ten percent should the pledge of common shares of FCMC by Franklin Holding to the Bank be reduced upon the attainment by FCMC of certain net collection targets set by the Bank with respect to the Portfolio;
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entry into a service agreement with respect to FCMC’s continued servicing of the Portfolio that allows the Bank to terminate such servicing and, concomitantly, FCMC’s fee income from servicing the Portfolio; and
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in part as a result of a tax basis transfer, the Company may incur significant income tax liabilities at termination of the Legacy Credit Agreement, liquidation of the Company or any of its direct or indirect subsidiary companies, or certain other Company events such as a de facto liquidation. The amount of any tax liability that the Company may incur is not certain since any such calculations need to be performed on a company by company basis and are influenced by a number of factors including, but not limited to, the ability to use prior year losses and future results of operations.
Restructuring Agreements. In connection with the Restructuring, the Company and its subsidiaries have:
1.
Transferred of substantially all of the Portfolio in exchange for the REIT Securities.
Pursuant to the terms of a Transfer and Assignment Agreement, certain subsidiaries of the Company (the “Franklin Transferring Entities”) transferred approximately 83% of the Portfolio to a newly formed Delaware statutory trust (“New Trust”) in exchange for the following trust certificates (collectively, the “Trust Certificates”):
(a) an undivided 100% interest of the Bank’s portion of consumer mortgage loans (the “Bank Consumer Loan Certificate”);
(b) an undivided 100% interest in the Bank’s portion of consumer REO assets (the “Bank Consumer REO Certificate”, and together with the Bank Consumer Loan Certificate, the “Bank Trust Certificates”);
(c) an undivided 100% interest in the portion of consumer mortgage loan assets allocated to the M&I Marshall & Ilsley Bank (“M&I”) and BOS (USA) Inc. (“BOS”) (M&I and BOS collectively, the “Participants”) (the “Participants Consumer Loan Certificate”); and
(d) an undivided 100% interest in Participants’ portion of the consumer REO assets (the “Participants Consumer REO Certificate”, and together with the Participants Consumer Loan Certificate, the “Participants Trust Certificates”).
The Bank Trust Certificates represent approximately 83.27961% of the assets transferred to New Trust considered in the aggregate (such portion, the “Bank Contributed Assets”) and the Participants Trust Certificates represent approximately 16.72039% of the assets transferred to New Trust considered in the aggregate.
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Pursuant to the Transfer and Assignment Agreement, the Franklin Transferring Entities made certain representations, warranties and covenants to New Trust related to the Portfolio. To the extent any Franklin Selling Entity breaches any such representations, warranties and covenants and the Franklin Transferring Entities are unable to cure such breach, New Trust has recourse against the Franklin Transferring Entities (provided that recourse to FCMC is limited solely to instances whereby FCMC transferred REO property FCMC did not own) (the “Reacquisition Parties”). In such instances, the Reacquisition Parties are obligated to repurchase any mortgage loan or REO property and indemnify New Trust, the Bank, the Administrator (as defined below), the holders of the Trust Certificates and the trustees to the trust agreement. The Franklin Transferring Entities provided representations and warranties, including but not limited to correct information, loans have not been modified, loans are in force, valid lien, compliance with laws, licensing, enforceability of the mortgage loans, hazardous substances, fraud, and insurance coverage. In addition, the Franklin Transferring Entities agreed to provide certain collateral documents for each mortgage loan and REO property transferred (except to the extent any collateral deficiency was disclosed to New Trust). To the extent any collateral deficiency exists with respect to such mortgage loan or REO property and the Franklin Transferring Entities do not cure such deficiency, the Reacquisition Parties shall be obligated to repurchase such mortgage loan. In connection with the reacquisition of any asset, the price to be paid by the Reacquisition Parties for such asset (the “Reacquisition Price”) shall be as agreed upon by the Administrator and the applicable Reacquisition Party; provided, however, should such parties not promptly come to agreement, the Reacquisition Price shall be as determined by the Administrator in good faith using its sole discretion.
The subsidiaries then transferred the Trust Certificates to a newly formed Delaware limited liability company, Franklin Asset, LLC, in exchange for membership interests in Franklin Asset, LLC. Franklin Asset, LLC then contributed the Bank Trust Certificates to a newly formed Delaware limited liability company, Franklin Asset Merger Sub, LLC, in exchange for membership interests in Franklin Asset Merger Sub, LLC (Franklin Asset, LLC retained the Participant Trust Certificates). Franklin Merger Sub, LLC merged with and into a Huntington National Bank wholly-owned subsidiary of the REIT (“REIT Sub”) and Franklin Asset, LLC received the REIT Securities having in the aggregate a value equal to the estimated fair market value of the loans underlying the Bank Trust Certificates, which as of March 31, 2009 was approximately $481.5 million, in exchange for its membership interests in Franklin Asset Merger Sub, LLC. The preferred REIT Securities have a liquidation value of $100,000 per unit and an annual cumulative dividend rate of 9% of such liquidation value. If there is a reacquisition required to be made by the Reacquisition Parties under the Transfer and Assignment Agreement, Franklin Asset, LLC will return such number of Class C Preferred Shares of Huntington Capital Financing Stock that is equal in value to the Reacquisition Price (as defined in the Transfer and Assignment Agreement).
2.
Amended and restated substantially all of its outstanding debt.
Pursuant to the terms of the Amended and Restated Credit Agreement (Legacy) (the “Legacy Credit Agreement”), the Company and its subsidiaries amended and restated substantially all of their indebtedness currently subject to a certain First Amended and Restated Forbearance Agreement and Amendment to Credit Agreements, dated December 19, 2008, and a certain First Amended and Restated Tribeca Forbearance Agreement and Amendment to Credit Agreements, dated December 19, 2008 (the “Forbearance Agreements”). As more fully described below, pursuant to the terms of the Legacy Credit Agreement, (1) the Participant Trust Certificates were collaterally assigned to the Bank as collateral for the loans as modified pursuant to the terms of the Legacy Credit Agreement (the “Restructured Loans”); (2) all net collections received by New Trust in connection with the portion of the Portfolio represented by the Bank Trust Certificates will be paid to the REIT Sub or its subsidiaries; (3) the REIT Securities were pledged to the Bank as collateral for the Restructured Loans; (4) the Company pledged seventy percent (70%) of the common equity in FCMC to the Bank as collateral for the Restructured Loans; and (5) Franklin Holding and FCMC were released from existing guarantees of the Restructured Loans, including Franklin Holding’s pledge of 100% of the outstanding shares of FCMC, in exchange for providing certain limited recourse guarantees relating to the Restructured
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Loans, wherein the Bank agreed to exercise only limited recourse against property encumbered by the pledge agreement (the “Pledged Collateral”) made in connection with the Legacy Credit Agreement, provided Franklin Holding and FCMC, respectively, any designee acting under the authority thereof or any subsidiary of either Franklin Holding or FCMC did not (i) commission any act fraud or material misrepresentation in respect of the Pledged Collateral; (ii) divert, embezzle or misapply proceeds, funds or money and/or other property relating in any way to the Pledged Collateral; (iii) breach any covenant under the Legacy Credit Agreement; or (iv) conduct any business activities to perform diligence services, to service mortgage Loans or REO Properties or any related activities, directly or indirectly, other than by FCMC and Franklin Credit Loan Servicing, LLC.
The terms of the Legacy Credit Agreement vary according to the three tranches of loans covered by the Legacy Credit Agreement. Tranche A includes outstanding debt in the approximate principal sum of $857 million bearing interest at a per annum rate equal to one month LIBOR plus 2.25% per annum, payable monthly in arrears on the outstanding principal balance of the related advances. Tranche B includes outstanding debt in the approximate principal sum of $410 million bearing interest at a per annum rate equal to one month LIBOR plus 2.75% per annum, payable monthly in arrears on the outstanding principal balance of the related advances. Tranche C includes outstanding debt in the approximate principal sum of $125 million bearing interest at a per annum rate equal to 15%, payable monthly in arrears on the outstanding principal balance of the related advances. In the event of a default, the applicable interest rate will increase to 5% over the rate otherwise applicable to the respective tranche.
All cash available for each tranche shall be used to pay cash interest to the extent cash is available, and any accrued interest for which cash is not available will be added to the principal sum of such tranche. Cash payments on each tranche will be made from: (i) any cash or other assets of the borrowers (Tribeca and certain subsidiaries of Tribeca and Franklin Credit Asset Corporation), (ii) dividends and distributions on the REIT Securities, all of which shall be applied as a non pro rata distribution solely to the Bank’s pro rata share of such tranche (until paid in full), (iii) all distributions made by New Trust on the Participant Trust Certificates, all of which shall be applied as a non pro rata distribution to the Participants’ pro rata shares of such tranche (until paid in full), and (iv) from any proceeds received from any other collateral, which will be applied pursuant to a waterfall provision described more fully in the Legacy Credit Agreement. The borrowers will not be required to make scheduled principal payments, provided that all amounts received by any borrower in excess of accrued interest, whether from collateral or otherwise, shall be applied to reduce the principal sum. All remaining principal and interest will be due and payable at maturity of the Legacy Credit Agreement on March 1, 2012. Based on the current cash flows described above, it is not expected that the Company will be able to repay remaining principal and interest due on March 1, 2012. Under such circumstances, the Bank would have all available rights and remedies under the Legacy Credit Agreement.
The Legacy Credit Agreement contains representations, warranties, covenants and events of default (“The Legacy Credit Agreement Defaults”) that are customary in transactions similar to the restructuring. Some, but not all, of the Legacy Credit Agreement defaults will create an event of default under the Licensing Credit Facility and the Servicing Agreement (as defined below). In addition, the Company has agreed to seek shareholder approval to amend the Certificate of Incorporation of FCMC to delete the provision, adopted pursuant to Section 251(g) of the General Corporation Law of the State of Delaware in connection with the Company’s December 2008 corporate reorganization, that requires the approval of the stockholders of Franklin Holding in addition to the stockholders of FCMC for any action or transaction, other than the election or removal of directors, that would require the approval of the stockholders of FCMC. If such amendment is not passed on or prior to June 30, 2009, which will require approval by holders of at least two thirds of the shares of the Company then entitled to vote at an election of directors, the failure to pass such amendment shall constitute an event of default under the Legacy Credit Agreement. Under such circumstances, the Bank would be entitled to foreclose on all of the assets of the Company, including on Franklin Holdings’ pledge of 70% of the stock of FCMC.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Legacy Credit Facility is secured by a first priority security interest in (i) the REIT Shares; (ii) the Participant Trust Certificates; (iii) an undivided 16.72039% interest in the consumer mortgage loans and REO properties transferred to New Trust; (iv) 70% of all equity interests in FCMC, and 100% equity interests in all other direct and indirect subsidiaries of Franklin Holding, pledged by Franklin Holding (subject to partial releases of such equity interests under “Cumulative Collective Targets” under the terms relating to the Servicing Agreement); (v) all amounts owing pursuant to any deposit account or securities account of any Company entities bound to the Legacy Credit Facility (other than Franklin Holding), (vi) a first mortgage in real property interests at 6 Harrison Street, Unit 6, New York, New York; (vii) all monies owing to any borrower from any taxing authority; (viii) any commercial tort or other claim of FCMC, Holding, or any borrower, including FCMC’s right, title and interest in claims and actions with respect to certain loan purchase agreements and other interactions of FCMC with various entities engaged in the secondary mortgage market; (ix) certain real property interests of FCMC in respect to the proprietary leases under the existing Forbearance Agreements if not transferred to New Trust; (x) a second priority lien on cash collateral held as security for the Licensing Facility to FCMC; and (xi) any monies, funds or sums due or received by any Borrower in respect of any program sponsored by any Governmental Authority, any federal program, federal agency or quasi-governmental agency, including without limitation any fees received, directly or indirectly, under the U.S. Treasury Homeowners Affordability and Stability Plan. Any security agreement, acknowledgement or other agreement in respect of a lien or encumbrance on any asset of New Trust shall be non-recourse in nature and shall permit New Trust to distribute, without qualification, 83.27961% of all net collections received by New Trust to the REIT Sub and its subsidiaries irrespective of any event or condition in respect of the Legacy Credit Agreement.
All collections received by New Trust, provided that an event of default has not occurred and is continuing, shall go first to the payment of monthly servicing fees, which shall be paid one month in advance, under the Servicing Agreement and then to (i) Administration Fees, expenses and costs (if any), (ii) pro rata to the owner trustee, certificate trustee and each custodian for any due and unpaid fees and expenses of such trustee and/or custodian, and (iii) to the pro-rata ownership of the Trust Certificates. All amounts received pursuant to the Participants Trust Certificates shall be distributed pursuant to the applicable “Waterfall” provisions.
3.
Entered into an amended and restated credit agreement to fund FCMC’s licensing obligations and working capital.
Franklin Holding and FCMC have entered into an Amended and Restated Credit Agreement (Licensing) (the “Licensing Credit Agreement”) which includes a credit limit of $13,500,000, composed of a secured (i) revolving line of credit (“Revolving Facility”) up to the principal amount outstanding at any time of $2,000,000, (ii) up to the aggregate stated amount outstanding at any time for letters of credit of $6,500,000, and (iii) a draw credit facility (“Draw Facility”) up to the principal amount outstanding at any time of $5,000,000. The Revolving Facility and the letters of credit shall be used to assure that all state licensing requirements of FCMC are met and to pay approved expenses of the Company. The Draw Facility shall be used to provide for working capital of FCMC, and amounts drawn and repaid under this facility cannot be reborrowed.
The principal sum shall be due and payable in full on the earlier of the date that the Licensing Agreement is due and payable in full pursuant to the terms of this facility, whether by acceleration or otherwise, or at maturity on March 29, 2010. Advances under the Revolving Facility shall bear interest at the one-month reserve adjusted LIBOR Rate plus a margin of 8%. Advances under the Draw Facility shall bear interest at the one-month reserve adjusted LIBOR Rate plus a margin of 6%. Interest on both the Revolving Facility and the Draw Facility shall be paid prior to any distributions pursuant to stock ownership or stock pledges of equity interests in FCMC. After any default, all advances and letters of credit shall bear interest at 5% in excess of the rate of interest then in effect.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Licensing Credit Agreement contains warranties, representations, covenants and events of default that are customary in transactions similar to the restructuring.
The Licensing Facility is secured by (i) a first priority security interest in FCMC’s cash equivalents in a controlled account maintained at the Bank in an amount satisfactory to the Bank, but not less than $8,500,000, (ii) blanket existing lien on all personal property of FCMC, (iii) a second mortgage in real property interests at 6 Harrison Street, Unit 6, New York, New York, (iv) a first Mortgage in certain real property interests at 350 Albany Street, New York, New York; and (v) any monies or sums due FCMC in respect of any program sponsored by any Governmental Authority, including without limitation any fees received, directly or indirectly, under the U.S. Treasury Homeowners Affordability and Stability Plan.
The Draw Facility is guaranteed by Thomas J. Axon, Chairman of the Board of Directors and a principal stockholder of the Company. Mr. Axon’s Guaranty shall be secured by a first priority and exclusive lien on commercial real estate, at a loan to value ratio satisfactory to the Bank. In consideration for his guaranty, the Bank and the Company’s Audit Committee each has consented to the payment to Mr. Axon equal to 10% of FCMC’s common shares, subject to a further payment of up to an additional 10% in FCMC’s common shares should the pledge of common shares of FCMC by Franklin Holding to the Bank be reduced upon attainment by FCMC of certain net collection targets set by the Bank with respect to the Portfolio.
4.
Entered into a servicing agreement with the New Trust.
The servicing agreement (the “Servicing Agreement”) governs the servicing by FCMC, as the servicer (the “Servicer”) of the Portfolio transferred to New Trust. New Trust and/or the Bank as the administrator of New Trust (the “Administrator”) have significant control over all aspects of the servicing of the Portfolio based on (i) a majority of the Servicer’s actions or Servicer’s utilization of any subservicer or subcontractor is contingent on the Servicer receiving explicit instructions or consent from New Trust or Administrator, (ii) compliance with work rules and an approval matrix provided by the Bank and (iii) monthly meetings between New Trust and the Servicer.
All collections by the Servicer are remitted to a collection account and controlled through the Bank’s lockbox account. The Administrator shall transfer the collection amounts from the lockbox account to a certificate account whereby the funds shall flow through the trust agreement’s “Waterfall” as described above. The Servicer’s servicing fees and servicing advance reimbursements are paid in advance provided an event of default has not occurred. If an event of default has occurred, the Servicer’s servicing fees and servicing advances are the third remittance in the “Waterfall,” following remittances for payment of Administrator, custodian and trustee fees.
New Trust’s indemnification obligation to the Servicer is limited to the collections from the Portfolio. In addition, the Servicer will be indemnified by New Trust only for a breach of corporate representations and warranties or if the Administrator forces the Servicer to take an action that results in a loss to the Servicer.
The Servicer is required to maintain net worth of approximately $7.6 million and net income before taxes of $800,000 for the most recent twelve month period or an event of default will be deemed to have occurred. In addition to typical servicer events of default and the defaults listed above, the Servicing Agreement contains the following events of default: (i) certain defaults under the Legacy Loan Agreement would trigger an event of default under the Servicing Agreement, (ii) failure to adopt a servicing action plan as directed by the Administrator would trigger an event of default, (iii) any event of default under the Licensing Loan Agreement would trigger an event of default under the Servicing Agreement, and (iv) failure of Servicer to satisfy certain gross collection targets if determined to be the result of a failed servicing practice as determined by the Bank per a servicing audit would trigger an event of default.
The Servicing Agreement shall have an initial term of three years which may be extended for one or two additional one year periods at the sole discretion of New Trust. During the first year of the agreement, Servicer
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
shall receive a termination fee for each loan to the extent the servicing is terminated by the Bank for any reason other than a default under the terms of the servicing agreement. During the term of the servicing agreement, FCMC may not enter into any other third-party servicing agreements to service any other assets that could likely impair its ability to service the Portfolio without the consent of the Bank, which cannot be unreasonably withheld.
Amendment to Bosco Servicing Agreement
On February 27, 2009, the Company entered into an amendment (the “Amendment”) to its servicing agreement, dated as of May 28, 2008, by and between Franklin Credit and Bosco. The Amendment revises the order of priority of distributions to be made by the administrative agent for Bosco’s lenders. Specifically, the Amendment provides that, for the next 12 months, Franklin’s monthly servicing fee will be paid only after a monthly loan modification fee of $29,167 is paid to Bosco’s lenders. Additionally, the Amendments provide that, on each monthly payment date, if the aggregate amount of net collections is less than $1 million, 25% of Franklin’s servicing fee will be paid only after certain other monthly distributions are made, including, among other things, payments made by Bosco to repay its third-party indebtedness. The term of this provision is indefinite. If the amount of collections is not sufficient to make the required payments in any given month, the unpaid servicing fees due to Franklin, or portions thereof, will accrue and become due and payable the next month or in future months.