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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition period from __________ to __________
COMMISSION FILE NUMBER 001-08007
FREMONT GENERAL CORPORATION
(Exact name of registrant as specified in its charter)
NEVADA 95-2815260
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2425 Olympic Boulevard
Santa Monica, California 90404
(Address of principal executive offices)
(Zip Code)
(310) 315-5500
(Registrant's telephone number, including area code)
NOT APPLICABLE
(Former Name or Former Address, if Changed Since Last Report)
Indicate by check mark whether the registrant: (1) has filed all reports
required by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No _
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No _
Indicate the number of shares outstanding of each of the issuer's classes
of common stock:
SHARES OUTSTANDING
CLASS JULY 31, 2005
Common Stock, $1.00 par value 77,878,000
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FREMONT GENERAL CORPORATION
INDEX
PART I - FINANCIAL INFORMATION
PAGE NO.
-------
Item 1. Financial Statements
Consolidated Balance Sheets
June 30, 2005 (Unaudited) and December 31, 2004 ........ 3
Consolidated Statements of Income
Three and Six Months Ended June 30, 2005 and 2004
(Unaudited) ............................................ 4
Consolidated Statements of Changes in Stockholders' Equity
June 30, 2005 and 2004 (Unaudited) ..................... 5
Consolidated Statements of Cash Flows
Six Months Ended June 30, 2005 and 2004 (Unaudited) .... 6
Consolidated Statements of Comprehensive Income
Three and Six Months Ended June 30, 2005 and 2004
(Unaudited) ............................................ 7
Notes to Consolidated Financial Statements (Unaudited).... 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ................................ 37
Item 3. Quantitative and Qualitative Disclosures About Market Risk . 60
Item 4. Controls and Procedures .................................... 61
PART II - OTHER INFORMATION
Item 1. Legal Proceedings .......................................... 62
Item 2. Unregistered Sales of Equity Securities and Use of
Proceeds ................................. ................. 63
Item 3. Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders ........ 64
Item 5. Not applicable.
Item 6. Exhibits.................................................... 64
Signatures ...................................................... 66
2
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31,
2005 2004
------------- ------------
(UNAUDITED)
(THOUSANDS OF DOLLARS)
ASSETS
Cash and cash equivalents ................................................... $ 1,422,815 $ 904,975
Investment securities classified as available for sale at fair value ........ 1,037 1,236
Federal Home Loan Bank ("FHLB") stock at cost ............................... 156,284 77,127
Loans held for sale - net ................................................... 5,489,368 5,454,692
Loans held for investment - net ............................................. 3,576,832 3,313,089
Mortgage servicing rights - net ............................................. 22,318 18,002
Residual interests in securitized loans at fair value ....................... 16,784 15,774
Accrued interest receivable ................................................. 32,122 34,121
Real estate owned ........................................................... 21,739 23,922
Premises and equipment - net ................................................ 59,886 54,347
Deferred income taxes ....................................................... 132,331 155,529
Other assets ................................................................ 67,759 53,182
------------- ------------
TOTAL ASSETS ........................................................... $ 10,999,275 $ 10,105,996
============= ============
LIABILITIES
Deposits:
Savings accounts .......................................................... $ 1,192,069 $ 1,283,223
Money market deposit accounts ............................................. 419,681 508,227
Certificates of deposit ................................................... 6,713,986 5,755,530
------------- ------------
8,325,736 7,546,980
Warehouse lines of credit ................................................... - -
Federal Home Loan Bank advances ............................................. 857,000 900,000
Senior Notes due 2009 ....................................................... 180,290 180,133
Liquid Yield Option Notes due 2013 ("LYONs") ................................ - 611
Junior Subordinated Debentures .............................................. 103,093 103,093
Other liabilities ........................................................... 335,493 361,531
------------- ------------
TOTAL LIABILITIES ...................................................... 9,801,612 9,092,348
Commitments and contingencies ............................................... - -
STOCKHOLDERS' EQUITY
Preferred stock, par value $ .01 per share - Authorized: 2,000,000 shares;
none issued ............................................................... - -
Common stock, par value $1 per share - Authorized: 150,000,000 shares;
Issued and outstanding: (2005 - 77,936,000 and 2004 - 77,241,000) ......... 77,936 77,241
Additional paid-in capital .................................................. 343,974 330,328
Retained earnings ........................................................... 832,933 663,580
Deferred compensation ....................................................... (61,369) (58,916)
Accumulated other comprehensive income ...................................... 4,189 1,415
------------- ------------
TOTAL STOCKHOLDERS' EQUITY ............................................. 1,197,663 1,013,648
------------- ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ............................. $ 10,999,275 $ 10,105,996
============= ============
The accompanying notes are an integral part of these statements.
3
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- -------------------------
2005 2004 2005 2004
--------- --------- --------- ---------
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE DATA)
INTEREST INCOME:
Interest and fee income on loans:
Residential ................................................... $ 125,764 $ 95,003 $ 236,775 $ 183,093
Commercial .................................................... 76,457 73,087 142,849 149,391
Other ......................................................... 84 165 183 274
--------- --------- ---------- ----------
202,305 168,255 379,807 332,758
Interest income - other ...................................... 8,645 2,774 13,067 4,978
--------- --------- --------- ---------
210,950 171,029 392,874 337,736
INTEREST EXPENSE:
Deposits ........................................................ 62,300 35,024 111,656 70,058
FHLB advances ................................................... 12,213 8,331 19,719 15,748
Warehouse lines of credit ....................................... 2,337 125 2,556 250
Senior Notes .................................................... 3,651 3,765 7,301 7,973
Junior Subordinated Debentures .................................. 2,319 2,319 4,639 4,639
Other ........................................................... 168 60 289 100
--------- --------- --------- ---------
82,988 49,624 146,160 98,768
Net interest income ............................................... 127,962 121,405 246,714 238,968
Provision for loan losses ......................................... (4,216) 146 (3,180) 16,545
--------- --------- --------- ---------
Net interest income after provision for loan losses ............... 132,178 121,259 249,894 222,423
NON-INTEREST INCOME:
Net gain on whole loan sales and securitizations
of residential real estate loans .............................. 91,964 127,050 200,324 249,246
Loan servicing income ........................................... 16,201 7,630 30,188 14,169
Mortgage servicing rights amortization and
impairment provision .......................................... (4,807) (4,514) (9,711) (5,884)
Impairment on residual assets ................................... (572) - (1,790) -
Other ........................................................... 5,784 6,471 9,465 13,105
--------- --------- --------- ---------
108,570 136,637 228,476 270,636
NON-INTEREST EXPENSE:
Compensation and related ........................................ 55,654 68,046 114,934 135,230
Occupancy ....................................................... 6,942 3,552 13,877 7,078
Other ........................................................... 28,119 23,249 48,348 46,009
--------- --------- --------- ---------
90,715 94,847 177,159 188,317
INCOME BEFORE INCOME TAXES ........................................ 150,033 163,049 301,211 304,742
INCOME TAX EXPENSE ................................................ 59,263 67,671 120,339 126,701
--------- --------- --------- ---------
NET INCOME ........................................................ $ 90,770 $ 95,378 $ 180,872 $ 178,041
========= ========= ========= =========
EARNINGS PER SHARE:
Basic ........................................................... $ 1.25 $ 1.32 $ 2.50 $ 2.49
Diluted ......................................................... 1.21 1.30 2.43 2.43
CASH DIVIDENDS DECLARED PER COMMON SHARE .......................... $ 0.08 $ 0.06 $ 0.15 $ 0.11
The accompanying notes are an integral part of these statements.
4
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
ACCUMULATED
ADDITIONAL OTHER
COMMON PAID-IN RETAINED DEFERRED COMPREHENSIVE
STOCK CAPITAL EARNINGS COMPENSATION INCOME TOTAL
------ ---------- --------- ------------ ------------- ----------
(THOUSANDS OF DOLLARS)
BALANCE AT DECEMBER 31, 2003 ................ $ 75,990 $ 296,000 $ 328,044 $ (35,889) $ 587 $ 664,732
Net income ................................ - - 178,041 - - 178,041
Cash dividends declared ................... - - (8,336) - - (8,336)
Conversion of LYONs ....................... 3 41 - - - 44
Stock options exercised ................... 792 14,828 - - - 15,620
Retirement of common stock ................ (12) (38) - 50 - -
Shares issued, acquired or allocated
for employee benefit plans .............. 393 8,595 - (39,600) - (30,612)
Amortization of restricted stock .......... - - - 7,027 - 7,027
Shares allocated to ESOP .................. - 4,829 - 15,215 - 20,044
Other adjustments ......................... - (2,700) - 3,740 - 1,040
Net change in unrealized gain on
investments and residual interests,
net of deferred taxes .................... - - - - (371) (371)
-------- ---------- --------- ------------ ------------- ------------
BALANCE AT JUNE 30, 2004 .................... $ 77,166 $ 321,555 $ 497,749 $ (49,457) $ 216 $ 847,229
======== ========== ========= ============ ============= ============
BALANCE AT DECEMBER 31, 2004 ................ $ 77,241 $ 330,328 $ 663,580 $ (58,916) $ 1,415 $ 1,013,648
Net income ................................ - - 180,872 - - 180,872
Cash dividends declared ................... - - (11,519) - - (11,519)
Conversion of LYONs ....................... 35 560 - - - 595
Retirement of common stock ................ (34) (174) - 208 - -
Shares issued, acquired or allocated
for employee benefit plans .............. 694 15,013 - (35,459) - (19,752)
Amortization of restricted stock .......... - - - 9,832 - 9,832
Shares allocated to ESOP .................. - (1,368) - 25,832 - 24,464
Change in cost of common stock
held in trust ........................... - - - (5,632) - (5,632)
Other adjustments ......................... - (385) - 2,766 - 2,381
Net change in unrealized gain on
investments and residual interests,
net of deferred taxes ................... - - - - 2,774 2,774
-------- ---------- --------- ------------ ------------- -----------
BALANCE AT JUNE 30, 2005 .................... $ 77,936 $ 343,974 $ 832,933 $ (61,369) $ 4,189 $ 1,197,663
======== ========== ========= ============ ============= ===========
The accompanying notes are an integral part of these statements.
5
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
---------------------------------
2005 2004
------------- -------------
(THOUSANDS OF DOLLARS)
OPERATING ACTIVITIES
Net income ................................................................ $ 180,872 $ 178,041
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Provision for loan losses ............................................... (3,180) 16,545
Increase in mortgage servicing rights ................................... (14,027) (11,718)
Increase in residual interests in securitized loans ..................... (3,752) (4,593)
Cash from residual interests in securitized loans ....................... 9,892 -
Deferred income tax expense ............................................. 21,349 23,729
Depreciation, amortization and impairment of retained interests ......... 23,285 14,773
Decrease in accrued interest ............................................ 1,999 152
Change in other assets .................................................. (13,876) (22,786)
Increase in borrower principal and interest due investors ............... 29,437 18,278
Increase in accrued Employee Stock Ownership Plan ....................... 13,553 27,319
Increase in premium recapture and repurchase reserve .................... 12,127 7,675
Increase in deferred compensation obligation ............................ 10,768 11,803
Decrease in federal and state income taxes payable ...................... (46,556) (11,883)
Change in accrued incentive compensation ................................ (42,556) 6,092
Change in accounts payable and other liabilities ........................ 19,299 (2,685)
------------- -------------
NET CASH PROVIDED BY OPERATING ACTIVITIES BEFORE LOANS HELD FOR
SALE ACTIVITY ........................................................ 198,634 250,742
Originations of residential real estate loans held for sale ............. (16,856,044) (10,582,438)
Sale of and payments received from residential real estate loans
held for sale .......................................................... 16,817,068 9,803,647
------------- -------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES .................. 159,658 (528,049)
INVESTING ACTIVITIES
Originations and advances funded for loans held for portfolio ............. (1,583,933) (1,290,659)
Payments received from and sales of loans held for portfolio .............. 1,329,128 1,300,979
Decrease in investment securities available for sale ...................... 190 400
Net purchases of FHLB stock ............................................... (79,157) (20,462)
Purchases of premises and equipment ....................................... (13,328) (12,923)
------------- -------------
NET CASH USED IN INVESTING ACTIVITIES ................................ (347,100) (22,665)
FINANCING ACTIVITIES
Deposits accepted, net of repayments ...................................... 778,756 451,177
FHLB advances, net of repayments .......................................... (43,000) 212,000
Extinguishment of LYONs and Senior Notes .................................. (30) (29,574)
Dividends paid ............................................................ (10,691) (7,506)
Stock options exercised ................................................... - 11,602
Increase in deferred compensation plans ................................... (19,753) (30,023)
------------- -------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ............................... 705,282 607,676
Change in cash and cash equivalents ......................................... 517,840 56,962
Cash and cash equivalents at beginning of period .......................... 904,975 835,651
------------- -------------
Cash and cash equivalents at end of period .................................. $ 1,422,815 $ 892,613
============= =============
The accompanying notes are an integral part of these statements.
6
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------- -------------------------
2005 2004 2005 2004
-------- -------- ---------- ---------
(THOUSANDS OF DOLLARS)
Net income ......................................................... $ 90,770 $ 95,378 $ 180,872 $ 178,041
Other comprehensive income (loss):
Net change in unrealized gains (losses) during the period:
Residual interests in securitized loans ........................ 6,110 (4,124) 4,632 (578)
Investment securities .......................................... (1) (26) (9) (41)
-------- -------- --------- ---------
6,109 (4,150) 4,623 (619)
Less deferred income tax expense (benefit) ....................... 2,444 (1,660) 1,849 (248)
-------- -------- --------- ---------
Other comprehensive net income (loss) ....................... 3,665 (2,490) 2,774 (371)
-------- -------- --------- ---------
TOTAL COMPREHENSIVE NET INCOME ..................................... $ 94,435 $ 92,888 $ 183,646 $ 177,670
======== ======== ========= =========
The accompanying notes are an integral part of these statements.
7
FREMONT GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1: BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of
Fremont General Corporation ("Fremont General") and its subsidiaries (together
the "Company"), including the Company's principal operating subsidiary, Fremont
Investment & Loan ("FIL"), a California chartered industrial bank which is
engaged in commercial and residential real estate lending on a nationwide basis.
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America
("GAAP"). All intercompany balances and transactions have been eliminated in
consolidation.
The preparation of the financial statements in conformity with GAAP
requires management to make estimates and assumptions that materially affect the
reported amounts of assets and liabilities and the disclosure of contingent
liabilities at the date of the financial statements and revenues and expenses
during the reporting period. Actual results could differ from those estimates.
In the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for the fair presentation of the interim
financial statements have been included. The operating results for the three and
six month periods ended June 30, 2005 are not necessarily indicative of the
results that may be expected for the year ended December 31, 2005.
The unaudited interim consolidated financial statements should be read in
conjunction with the consolidated financial statements and related notes thereto
included in the Company's Annual Report on Form 10-K for the year ended December
31, 2004. Certain prior period amounts have been reclassified to conform to the
current period presentation.
NOTE 2: NEW ACCOUNTING STANDARDS
In March 2005, the United States Securities and Exchange Commission ("SEC")
issued Staff Accounting Bulletin No. 107 ("SAB 107") to provide public companies
additional guidance in applying the provisions of Statement of Financial
Accounting Standards No. 123(R), Share-Based Payment ("SFAS No. 123R"). SAB 107
expresses the SEC staff's views regarding the interaction between SFAS No. 123R
and certain SEC rules and regulations and provides further information regarding
the valuation of share-based payment arrangements for public companies.
Subsequent to issuing SAB 107, in April 2005, the SEC adopted a new rule that
allows companies to implement SFAS No. 123R at the beginning of their next
fiscal year. Prior to the adoption of this new rule, calendar year-end companies
would have been required to implement SFAS No. 123R as of the beginning of the
third quarter of 2005. The Company does not believe
8
that the adoption of SFAS No. 123R or the application of the guidance in SAB 107
will have a significant impact on the Company's financial position or results of
operations.
In March 2005, the Financial Accounting Standards Board ("FASB") issued
FASB Staff Position ("FSP") FIN 46(R)-5: Implicit Variable Interests under FASB
Interpretation No. 46 (Revised December 2003), Consolidation of Variable
Interest Entities ("FIN 46(R)-5"). This FSP was issued to address whether a
reporting enterprise should consider whether it holds an implicit variable
interest in a variable interest entity ("VIE") or potential VIE when specific
conditions exist. FIN 46(R)-5 also provides additional guidance defining
implicit variable interests as implied financial interests in an entity that
change with changes in the fair value of the entity's net assets exclusive of
variable interests. The Company does not believe that the adoption of FIN
46(R)-5 will have a significant impact on the Company's financial position or
results of operations.
NOTE 3: CASH AND CASH EQUIVALENTS
Cash and cash equivalents, as of the dates indicated, are summarized in the
following table:
JUNE 30, DECEMBER 31,
2005 2004
----------- -----------
(THOUSANDS OF DOLLARS)
Cash on hand ................................................................ $ 248 $ 257
FHLB shareholder transaction account ........................................ 1,128,026 710,354
Federal Reserve account ..................................................... 2,093 2,030
U. S. Government Agency money market fund ................................... 117,630 147,297
Market interest rate account ................................................ 10 13
Non-interest bearing deposits in other financial institutions ............... 174,808 45,024
----------- -----------
Cash and cash equivalents ................................................... $ 1,422,815 $ 904,975
=========== ===========
The FHLB shareholder transaction account represents a short-term
interest-bearing transaction account with the Federal Home Loan Bank of San
Francisco. The Company's cash and cash equivalent balances were unrestricted as
of June 30, 2005 and December 31, 2004.
9
NOTE 4: LOANS HELD FOR SALE
Loans held for sale consist solely of residential real estate loans
(primarily first trust deeds, but also second trust deeds) which are aggregated
prior to their sale and are carried at the lower of aggregate cost, or estimated
fair value. Estimated fair values are based upon current secondary market prices
for loans with similar coupons, maturities and credit quality.
The Company's residential real estate loans have loan terms for up to
thirty years and are typically secured by first deeds of trust on single-family
residences. The Company's residential real estate loans held for sale typically
have a significant concentration (generally 75% or above) of "hybrid" loans
which have a fixed rate of interest for an initial period (generally two years)
after origination, after which the interest rate is adjusted to a rate equal to
the sum of six-month LIBOR and a margin as set forth in the mortgage note. The
interest rate then adjusts at each six-month interval thereafter, subject to
various lifetime and periodic rate caps and floors. The loans are generally made
to borrowers who do not satisfy all of the credit, documentation and other
underwriting standards prescribed by conventional mortgage lenders and loan
buyers, such as Fannie Mae and Freddie Mac, and are commonly referred to as
"sub-prime" or "non-prime" loans.
A valuation reserve is maintained for certain non-performing loans and
other loans held for sale based upon the Company's estimate of inherent losses.
Provisions for the valuation reserve are charged against gain on sale of loans.
The following table details the loans held for sale as of the dates indicated:
10
JUNE 30, DECEMBER 31,
2005 2004
----------- -----------
(THOUSANDS OF DOLLARS)
Loan principal balance:
1st trust deeds ........................................................... $ 4,960,655 $ 5,036,724
2nd trust deeds ........................................................... 516,448 383,039
----------- -----------
5,477,103 5,419,763
Basis adjustment for fair value hedge accounting ............................ 1,375 (1,327)
Net deferred direct origination costs ....................................... 65,544 74,514
----------- -----------
5,544,022 5,492,950
Less: Valuation reserve .................................................... (54,654) (38,258)
----------- -----------
Loans held for sale - net ................................................... $ 5,489,368 $ 5,454,692
=========== ===========
Loans held for sale on non-accrual status ................................... $ 18,263 $ 11,874
=========== ===========
Since most of the loans that are held for sale are sold within 60 days, the
amount of loans held for sale that are classified as non-accrual or become real
estate owned, is generally small. Loans held for sale may include loans
repurchased from previous whole loan sale transactions and securitizations. In
the ordinary course of business, as the loans held for sale are sold, the
Company makes standard industry representations and warranties about the loans.
The Company may have to subsequently repurchase certain loans due to defects
that occurred in the origination of the loan. Such defects are categorized as
documentation errors, underwriting errors, or fraud. In addition, the Company is
generally required to repurchase loans that experience first payment defaults
(and in limited cases, second payment defaults). If there are no such defects or
early payment defaults, the Company has no commitment to repurchase loans sold.
During the second quarter of 2005, the Company repurchased a total of $47.7
million in loans, as compared to $20.2 million in the second quarter of 2004.
The Company maintains a reserve for the effect of loans estimated to be
repurchased that require a valuation reserve upon repurchase, which is included
in other liabilities and totaled $10.2 million and $4.8 million as of June 30,
2005 and December 31, 2004, respectively. Provisions for the repurchase reserve
are charged against gain on sale of loans.
The Company also maintains a reserve for premium recapture that represents
the estimate of potential refunds of premiums received on previously completed
loan sales (due to early loan prepayments or for certain loans repurchased from
prior sales) that may occur under the provisions of the various agreements
entered into for the sale of loans held for sale; this reserve totaled $6.1
million and $3.9 million as of June 30, 2005 and December 31, 2004,
respectively, and is included in other liabilities. Provisions for the premium
recapture reserve are charged against gain on sale of loans.
11
NOTE 5: LOANS HELD FOR INVESTMENT
Loans held for investment consist of the Company's commercial real estate
loans. Commercial real estate loans, which are primarily variable rate
(generally based upon six-month LIBOR and a margin), represent loans secured
primarily by first mortgages on properties such as multi-family, office, retail,
industrial, land development, lodging, and commercial mixed-use properties. The
commercial real estate loans are comprised of permanent, bridge and construction
loans of relatively short duration (rarely more than five years in length of
term and typically shorter, such as two to three years).
As of June 30, 2005, the Company had $2.2 billion in unfunded commitments
for existing loans and $258.4 million in unfunded commitments for loans not yet
booked, as compared to $1.8 billion and $218.8 million, respectively, as of
December 31, 2004. Due to the variability in the timing of the funding of these
unfunded commitments, and the extent to which they are ultimately funded, these
amounts should not generally be used as a basis for predicting future
outstanding loan balances.
Commercial real estate loans are reported net of participations to other
financial institutions or investors in the amount of $169.7 million and $131.6
million as of June 30, 2005 and December 31, 2004, respectively. The Company's
commercial real estate loans also include mezzanine loans (second mortgage
loans, which are subordinate to the senior or first mortgage loans) in the
amounts of $20.5 million and $48.3 million as of June 30, 2005 and December 31,
2004, respectively.
The Company currently does not carry any residential real estate loans held
for investment as it has done in prior periods. The following tables further
detail the net loans held for investment for the periods indicated:
12
JUNE 30, 2005
-------------------------------------------
COMMERCIAL
REAL ESTATE OTHER TOTAL
----------- ------- -----------
(THOUSANDS OF DOLLARS)
Loans outstanding ............................................... $ 3,938,084 $ 4,356 $ 3,942,440
Participations sold ............................................. (169,656) - (169,656)
----------- ------- -----------
Loans outstanding, net of participations sold ................... 3,768,428 4,356 3,772,784
Unamortized deferred origination fees and costs ................. (35,996) - (35,906)
----------- ------- -----------
Loans outstanding before allowance for loan losses .............. 3,732,432 4,356 3,736,788
Allowance for loan losses ....................................... (159,909) (47) (159,956)
----------- ------- -----------
Loans held for investment - net ................................. $ 3,572,523 $ 4,309 $ 3,576,832
=========== ======= ===========
DECEMBER 31, 2004
------------------------------------------
COMMERCIAL
REAL ESTATE OTHER TOTAL
----------- ------- -----------
(THOUSANDS OF DOLLARS)
Loans outstanding ............................................... $ 3,647,490 $ 4,526 $ 3,652,016
Participations sold ............................................. (131,635) - (131,635)
----------- ------- -----------
Loans outstanding, net of participations sold ................... 3,515,855 4,526 3,520,381
Unamortized deferred origination fees and costs ................. (35,767) - (35,767)
----------- ------- -----------
Loans outstanding before allowance for loan losses .............. 3,480,088 4,526 3,484,614
Allowance for loan losses ....................................... (171,471) (54) (171,525)
----------- ------- -----------
Loans held for investment - net ................................. $ 3,308,617 $ 4,472 $ 3,313,089
=========== ======= ===========
The following table sets forth information regarding the Company's
commercial real estate loans on non-accrual status and restructured loans on
accrual status. In cases where a borrower experiences financial difficulties and
the Company makes certain concessionary modifications to contractual terms
(typically a reduction of the interest rate charged), the loan is classified as
a restructured (accruing) loan if the loan is performing in accordance with the
agreed upon modified loan terms and projected cash proceeds are deemed
sufficient to repay both principal and interest. Restructured loans are
presented as such in the period of restructure and the three subsequent
quarters.
13
JUNE 30, DECEMBER 31,
2005 2004
-------- -----------
(THOUSANDS OF DOLLARS)
Non-accrual commercial real estate loans held for investment .................. $ 33,113 $ 82,289
======== ===========
Restructured commercial real estate loans on accrual status ................... $ 12,412 $ 9,302
======== ===========
The Company employs a documented and systematic methodology in determining
the adequacy of its allowance for loan losses, which assesses the risk of losses
inherent in the portfolio, and represents the Company's estimate of probable
inherent losses in the loan portfolio as of the date of the financial
statements. The allowance for loan losses methodology incorporates management's
judgment concerning the effect of recent economic events on portfolio
performance, as well as concentration factors (such as property types,
geographic regions and loan sizes). Activity in the allowance for loan losses is
summarized in the following tables:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- -------------------------
2005 2004 2005 2004
--------- --------- --------- ---------
(THOUSANDS OF DOLLARS)
Beginning balance ................................. $ 171,941 $ 220,816 $ 171,525 $ 213,591
Provision for loan losses ......................... (4,216) 146 (3,180) 16,545
Charge-offs ....................................... (8,197) (6,388) (12,180) (15,784)
Recoveries ........................................ 428 152 3,791 374
--------- --------- --------- ---------
Net charge-offs ............................. (7,769) (6,236) (8,389) (15,410)
--------- --------- --------- ---------
Ending balance .................................... $ 159,956 $ 214,726 $ 159,956 $ 214,726
========= ========= ========= =========
In addition to its allowance for loan losses, the Company maintains an
allowance for unfunded commercial real estate loan commitments on existing loans
and, to a lesser degree, loans not yet funded; this allowance totaled $8.6
million and $7.1 million as of June 30, 2005 and December 31, 2004,
respectively, and is included in other liabilities.
14
NOTE 6: REAL ESTATE OWNED
The Company's real estate owned ("REO") consists of property acquired
through or in lieu of foreclosure on loans secured by real estate. REO is
reported in the financial statements at the lower of cost or estimated
realizable value (net of estimated costs to sell). REO consisted of the
following types of property as of the periods indicated:
JUNE 30, DECEMBER 31,
2005 2004
--------- -----------
(THOUSANDS OF DOLLARS)
Commercial real estate ...................................................... $ 18,106 $ 21,344
Residential real estate ..................................................... 3,633 2,578
-------- -----------
Real estate owned ........................................................... $ 21,739 $ 23,922
======== ===========
NOTE 7: MORTGAGE SERVICING RIGHTS
At the time of securitization or sale of loans on a whole loan basis with
servicing rights retained, the Company analyzes whether the benefits of
servicing are greater than or less than adequate compensation and, as a result,
records a mortgage servicing rights asset or liability ("MSR"), respectively.
The estimated fair value of the Company's mortgage servicing rights at June 30,
2005 and December 31, 2004 was $22.3 million and $18.0 million, respectively.
The following tables summarize the activity in the Company's mortgage servicing
rights asset as of the periods indicated:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------- -----------------------
2005 2004 2005 2004
-------- -------- -------- --------
(THOUSANDS OF DOLLARS)
Beginning balance ................................... $ 23,196 $ 11,438 $ 20,044 $ 6,898
Additions from securitization transactions ........ 6,391 5,808 14,027 11,718
Amortization ...................................... (5,062) (2,037) (9,547) (3,407)
-------- -------- -------- --------
Ending balance before valuation allowance ........... 24,525 15,209 24,524 15,209
Valuation allowance
Beginning balance ................................. (2,462) - (2,042) -
Provision for temporary impairment ................ 255 (2,477) (164) (2,477)
-------- -------- -------- --------
Ending balance .................................... (2,207) (2,477) (2,206) (2,477)
-------- -------- -------- --------
Mortgage servicing rights - net ..................... $ 22,318 $ 12,732 $ 22,318 $ 12,732
======== ======== ======== ========
15
As servicer, the Company is required to make certain advances on specific
loans it is servicing, to the extent such advances are deemed collectible by the
Company, from collections related to the individual loan. The total amount
outstanding of such servicing advances was $8.7 million and $5.3 million at June
30, 2005 and December 31, 2004, respectively, and is included in other assets.
The fair value of the MSRs is derived from the net positive cash flows
associated with the servicing agreements. The Company determines the fair value
of the MSRs at the time of securitization and at each reporting date by the use
of a cash flow model that incorporates prepayment speeds, discount rate and
other key assumptions management believes are consistent with assumptions other
major market participants use in valuing the MSRs. The Company determined, as
part of its on-going assessment of the assumptions used to value its MSRs, to
increase the discount rate utilized to 15.0% during the first quarter of 2005.
The key economic assumptions used in subsequently measuring the fair value of
the Company's MSRs as of the periods indicated are as follows:
JUNE 30, DECEMBER 31,
2005 2004
-------- -----------
Weighted-average life (years) .............................................. 1.5 1.5
Weighted-average annual prepayment speed ................................... 48.2% 48.5%
Weighted-average annual discount rate ...................................... 15.0% 10.0%
NOTE 8: RESIDUAL INTERESTS IN SECURITIZED LOANS
Residual interests in loan securitizations are recorded as a result of the
sale of residential real estate loans through a securitization transaction and
the subsequent issuance of net interest margin securities ("NIMs") to monetize
the residual interest from the original securitization transaction.
Residual interests represent the discounted expected future residual cash
flows from the securitizations that inure to the Company's benefit subject to
prepayment, net lifetime credit losses and other factors. The following tables
summarize the activity of the Company's residual interests:
16
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2005 2004 2005 2004
-------- -------- -------- --------
(THOUSANDS OF DOLLARS)
Beginning balance at fair value .................................... $ 12,449 $ 13,741 $ 15,774 $ 6,530
Additions to residual interests .................................... 1,467 1,574 3,752 4,593
Interest accretion ................................................. 2,969 948 4,307 1,594
Cash received ...................................................... (5,639) - (9,892) -
Fair value adjustment .............................................. 6,110 (4,124) 4,633 (578)
Permanent impairment ............................................... (572) - (1,790) -
-------- -------- -------- --------
Residual interests in securitized loans at fair value .............. $ 16,784 $ 12,139 $ 16,784 $ 12,139
======== ======== ======== ========
Loans sold through securitization transactions are done so on a
non-recourse basis to off-balance sheet qualified special purpose entities
("QSPEs"), except for representations and warranties customary within the
mortgage banking industry. In a NIM transaction, the certificates representing
the residual interest in certain excess cash flows from the original
securitization transaction are transferred to a QSPE, which issues
interest-bearing securities. The net proceeds from the sale of these NIM
securities, along with a residual interest certificate, represents the
consideration received by the Company. The residual interest certificate
retained from a NIM transaction is subordinate to the NIM securities issued
until the NIM securities are paid in full. The residual interests retained from
the NIM transactions are classified as "available-for-sale" securities and are
measured at fair value; any unrealized gains or losses from adjustments to the
estimated fair value, net of deferred taxes, are reported as part of accumulated
other comprehensive income, which is a separate component of stockholders'
equity. In the original securitizations and NIM transactions, a two-tier
structure is utilized in which the loans are first sold to a special purpose
corporation (referred to as the Depositor), which then transfers the loans to
the QSPE. The Company's only ownership interest from its securitization
transactions is reflected in the retained residual interests from the NIM
transactions of $16.8 million as detailed above.
As of June 30, 2005, a total of $4.5 billion in loan principal was
outstanding from the Company's securitization transactions. The total amount of
loan principal originally securitized in these transactions was $6.3 billion.
The Company determines the estimated fair values of the residual interests
retained from the NIM transactions by discounting the expected net cash flows to
be received utilizing the cash-out method. The Company uses the forward LIBOR
curve for estimating interest rates on the adjustable rate loans and the
variable rate securities, and utilizes other assumptions that management
believes are consistent with assumptions other major market participants would
use to estimate the fair value of similar residual
17
interests. Key economic assumptions used in subsequently measuring the fair
value of the Company's residual interests as of the periods indicated are as
follows:
JUNE 30, DECEMBER 31,
2005 2004
-------- -----------
Weighted-average life (years) .............................................. 1.6 1.6
Weighted-average annual prepayment speed (CPR) ............................. 46.4% 45.7%
Weighted-average lifetime credit losses .................................... 4.5% 4.5%
Weighted-average annual discount rate ...................................... 20.0% 20.0%
NOTE 9: DERIVATIVE FINANCIAL INSTRUMENTS
The Company utilizes derivative financial instruments in connection with
its interest rate risk management activities. In accordance with its interest
rate risk strategy, the Company currently utilizes a combination of forward
sales commitments and Eurodollar futures contracts to hedge its residential
loans held for sale and a certain portion of its unfunded pipeline of interest
rate lock commitments. These derivatives are intended to reduce the risk of
adverse fair value changes in certain interest rate environments. The Company's
forward sales commitments represent obligations to sell loans at a specific
price and date in the future; therefore, the value of these commitments increase
as interest rates increase. Short Eurodollar futures contracts are standardized
exchange-traded contracts, the values of which are tied to spot Eurodollar rates
at specified future dates. The value of these futures contracts increase when
interest rates rise. Conversely, the value of the forward sales commitments and
the short Eurodollar positions decrease when interest rates decrease, while the
related loans are expected to increase in value. The values of the loans, the
forward sales commitments and the Eurodollar positions may not move in
corresponding amounts and time frames and may result in a negative or positive
impact on earnings in any given period. In accordance with Statement of
Financial Accounting Standards No. 133, Accounting for Derivatives and Hedging
Activities, as amended and interpreted ("SFAS No. 133"), the derivative
financial instruments are reported at their fair value.
At June 30, 2005, the Company's commitments to sell forward its residential
real estate loans to third party investors in whole loan sales transactions were
approximately $4.12 billion at various rates and terms. The Company
distinguishes commitments to sell forward loans in two categories, allocated and
unallocated. At June 30, 2005, allocated and unallocated forward sale
commitments notional amounts were $870.0 million and $3.25 billion,
respectively. Allocated forward sales commitments are contractual sales
18
agreements whereby a specific pool of loans is agreed upon to be sold to
specific buyers at a contractually agreed upon date and price. In accordance
with SFAS No. 133, the allocated forward sales commitments are accounted for as
fair value hedges designated to specific pools of loans that have been
contractually agreed upon for sale. Unallocated forward sales commitments are
agreements that provide a fixed price on a pool of loans not yet specified,
these commitments are treated as economic hedges (and are not currently
designated as accounting hedges) and are classified as free-standing
derivatives. Changes in the fair value of both the unallocated and allocated
forward sales commitments are reported as a component of gain on sale of
residential real estate loans and as either other assets or liabilities, as
applicable. The amount of hedge ineffectiveness related to allocated forward
sales commitments is immaterial.
At June 30, 2005, the Company had a pipeline of loans in process of
approximately $2.29 billion in new residential real estate loans, generally
subject to the potential borrower meeting the conditions of the loan approval.
The Company conditionally quotes interest rates to potential borrowers, which
are then subject to adjustment by the Company if any such conditions are not
satisfied. Since the Company generally funds the loans at the rates
conditionally approved, the quotes are considered to constitute interest rate
locks. These interest rate lock commitments, which generally are for 30 days,
are treated as free-standing derivatives and are carried at their estimated fair
value with any changes recorded as a component of gain on sale of residential
real estate loans. Fair value is estimated based upon the change in the fair
value of the underlying mortgage loans as adjusted for the probability of a
certain amount of loans in the pipeline not funding within the terms of the
initial rate lock. The change in fair value is measured from the date of the
interest rate lock and, therefore, at the time of issuance, the value of the
interest rate lock is zero.
The Company's Eurodollar futures contracts are currently treated as
economic hedges and are not currently designated as accounting hedges and are
classified as free-standing derivatives. As of June 30, 2005, the Company had in
place short Eurodollar futures positions covering loan principal of $1.30
billion and $721.1 million for its loans held for sale and its unfunded loan
pipeline, respectively. Eurodollar futures are utilized in an effort to offset
the changes in value related to the loan inventory and pipeline without the
necessity of restricting certain loan inventory or pipeline loans to a specific
forward sale commitment. Eurodollar futures are carried at their fair value with
any changes recorded as a component of gain on sale of residential real estate
loans. Gains or losses on Eurodollar futures are recognized when such positions
are closed out, typically when a forward sale commitment is entered into. The
Company's Eurodollar futures contracts are collateralized by maintenance of a
margin account which had a balance of $7.5 million as of June 30, 2005.
19
The estimated fair values of the Company's derivatives were as follows
(included in other assets or liabilities, as applicable, in the consolidated
balance sheets) for the periods indicated:
JUNE 30, DECEMBER 31,
2005 2004
-------- ----------
(THOUSANDS OF DOLLARS)
Forward sale commitments ................................................... $ (6,590) $ 2,739
Eurodollar futures ......................................................... 562 (22)
Interest rate lock commitments ............................................. (561) (1,100)
-------- ----------
$ (6,589) $ 1,617
======== ==========
NOTE 10: GAIN ON SALE AND SECURITIZATION OF RESIDENTIAL REAL ESTATE LOANS
The Company routinely sells and securitizes residential mortgage loans into
the secondary market. Gains or losses are recognized at the date of settlement
and when the Company has transferred control over the loans to either a
transaction-specific securitization trust or to a third-party purchaser. The
amount of gain or loss for loan sales or securitizations is based upon the
difference between the net sales proceeds received, including any retained
interests, and the allocated carrying amount of the loans (which includes the
costs directly incurred with the origination of the loans, net of origination
points and fees received, which are deferred and recognized when the loans are
sold). The following tables present the detailed components of the gain on sale
and securitization of loans:
20
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ----------------------------
2005 2004 2005 2004
----------- ----------- ------------ ------------
(THOUSANDS OF DOLLARS)
Whole loan sales of residential real estate loans ............... $ 8,776,193 $ 4,385,574 $ 14,625,502 $ 8,180,889
Securitizations of residential real estate loans ................ 981,717 790,125 2,191,566 1,622,758
----------- ----------- ------------ -----------
Total loan sales and securitizations - net of repurchases .. $ 9,757,910 $ 5,175,699 $ 16,817,068 $ 9,803,647
=========== =========== ============ ===========
Gross premium recognized on loan sales and securitizations ...... $ 268,120 $ 208,849 $ 469,816 $ 408,077
Provision for premium recapture and reversal .................... (10,038) (4,249) (17,594) (12,942)
Net gain (loss) on derivative instruments ....................... (25,573) 1,678 (8,385) 3,629
Direct costs of loan originations - net ......................... (125,464) (75,081) (221,657) (140,153)
----------- ----------- ------------ -----------
107,045 131,197 222,180 258,611
Provision for valuation and repurchase reserves ................. (15,081) (4,147) (21,856) (9,365)
----------- ----------- ------------ -----------
Net gain on sale ........................................... $ 91,964 $ 127,050 $ 200,324 $ 249,246
=========== =========== ============ ===========
The net gain or (loss) on derivative instruments included in the net gain
on sale of residential real estate loans consists of the following items:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------- -----------------------
2005 2004 2005 2004
--------- ------- --------- -------
(THOUSANDS OF DOLLARS)
Eurodollar futures:
Change in fair value .......................................... $ (2,912) $ - $ 585 $ -
Net realized loss ............................................. (18,874) - (1,839) -
Transaction expenses and other ................................ (517) - (1,042) -
--------- ------- --------- -------
(22,303) - (2,296) -
Change in fair value of:
Interest rate lock commitments ................................ 725 1,212 538 1,417
Forward sales commitments ..................................... (11,208) (1,084) (9,330) 2,494
Interest rate cap contracts ................................... - 1,550 - (282)
Loans held for sale subject to fair value hedges .............. 7,213 - 2,703 -
--------- ------- --------- -------
Net gain (loss) on derivative instruments ....................... $ (25,573) $ 1,678 $ (8,385) $ 3,629
========= ======= ========= =======
21
NOTE 11: LOAN SERVICING INCOME
In addition to the securitized loans that it services, the Company also
services loans sold to other financial institutions on an interim basis (until
servicing is transferred to another party). The following tables present the
components of loan servicing income for the Company:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------- ----------------------
2005 2004 2005 2004
-------- ------- -------- --------
(THOUSANDS OF DOLLARS)
Servicing fee income:
Securitization transactions ..................................... $ 5,214 $ 2,583 $ 9,593 $ 4,351
Interim ......................................................... 7,768 4,175 14,276 7,972
Other ........................................................... 641 - 1,472 -
Ancillary income (1) :
Securitization transactions ..................................... 927 426 1,774 705
Interim and other ............................................... 1,136 700 2,259 1,524
Other ............................................................... 515 (254) 814 (383)
-------- ------- -------- --------
Loan servicing income ............................................... $ 16,201 $ 7,630 $ 30,188 $ 14,169
======== ======= ======== ========
(1) Ancillary income represents all service-related contractual fees retained
by the Company and consists primarily of late payment charges.
NOTE 12: INCOME TAXES
The major components of income tax expense are summarized in the following
tables:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ------------------------
2005 2004 2005 2004
-------- -------- --------- ---------
(THOUSANDS OF DOLLARS)
Federal:
Current ........................................................... $ 39,644 $ 36,006 $ 79,973 $ 78,361
Deferred .......................................................... 9,383 15,272 19,056 20,957
-------- -------- --------- ---------
49,027 51,278 99,029 99,318
-------- -------- --------- ---------
State:
Current ........................................................... 6,980 12,682 19,017 24,611
Deferred .......................................................... 3,256 3,711 2,293 2,772
-------- -------- --------- ---------
10,236 16,393 21,310 27,383
-------- -------- --------- ---------
Total tax provision ................................................. $ 59,263 $ 67,671 $ 120,339 $ 126,701
======== ======== ========= =========
22
The deferred income tax balance includes the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and for income tax purposes. The components of the Company's
deferred tax assets are summarized in the following table:
JUNE 30, DECEMBER 31,
2005 2004
--------- -----------
(THOUSANDS OF DOLLARS)
Deferred tax assets:
Mark-to-market on loans held for sale .................................... $ 75,253 $ 77,758
Allowance for loan losses ................................................ 73,098 79,029
Compensation related items ............................................... 19,396 28,459
State income and franchise taxes ......................................... 7,880 20,982
Other - net .............................................................. - 70
--------- -----------
Total deferred tax assets .............................................. 175,627 206,298
Deferred tax liabilities:
Loan origination costs ................................................... (33,142) (45,559)
Mortgage servicing ....................................................... (6,987) (5,210)
Other - net .............................................................. (3,167) -
--------- -----------
Total deferred tax liabilities ........................................ (43,296) (50,769)
--------- -----------
Net deferred tax asset ................................................... $ 132,331 $ 155,529
========= ===========
In assessing the realization of deferred income tax assets, the Company
considers whether it is more likely than not that the deferred income tax assets
will be realized. The ultimate realization of deferred income tax assets depends
in part upon the generation of future taxable income during the periods in which
temporary differences become deductible. In the Company's opinion, the deferred
tax assets will be fully realized and no valuation allowance is necessary as the
Company has the ability to generate sufficient future taxable income to realize
the tax benefits.
The Company has accrued the expected maximum tax and interest exposure for
tax matters that are either in the process of resolution or have been identified
as having the potential for adjustment. These matters primarily consist of
issues relating to the discontinued insurance operations, the apportionment of
income to various states and the deduction of certain expenses.
23
NOTE 13: DEBT - FREMONT GENERAL CORPORATION
The debt of Fremont General is detailed in the following table; none of the
Fremont General debt is guaranteed by FIL:
JUNE 30, DECEMBER 31,
2005 2004
--------- -----------
(THOUSANDS OF DOLLARS)
Senior Notes due 2009,
less discount (2005 - $1,160; 2004 - $1,317) ............................. $ 180,290 $ 180,133
Liquid Yield Option Notes due 2013, ("LYONs")
less discount (2004 - $339) ............................................... - 611
Junior Subordinated Debentures .............................................. 103,093 103,093
--------- -----------
$ 283,383 $ 283,837
========= ===========
On May 27, 2005, the Company notified the LYONs holders that it would
redeem the entire principal amount of LYONs outstanding on June 30, 2005 at the
redemption price equal to $664.37 per $1,000 principal amount. Prior to the
redemption, holders had the option to convert LYONs into common stock of the
Company of the rate of 38.5757 shares per $1,000 principal amount.
Fremont General's 9% Junior Subordinated Debentures are the sole asset of
Fremont General Financing I, a statutory business trust (the "Trust")
wholly-owned by Fremont General. The Trust issued, and has outstanding, $100
million of 9% Trust Originated Preferred SecuritiesSM (the "Preferred
Securities") which represent preferred undivided beneficial interests in the
Trust.
24
NOTE 14: DEPOSITS, FHLB ADVANCES AND WAREHOUSE LINES OF CREDIT - FREMONT
INVESTMENT & LOAN
FIL utilizes the issuance of deposits, which are insured up to the maximum
legal limit by the Federal Deposit Insurance Corporation, Federal Home Loan Bank
("FHLB") advances and warehouse lines of credit in funding its operations.
As of June 30, 2005, the weighted-average interest rate for savings and
money market deposit accounts was 2.94% and for certificates of deposit it was
3.37%. The weighted-average interest rate for all deposits at June 30, 2005 was
3.29%.
Certificates of deposit as of June 30, 2005 are detailed by maturity and
rates as follows:
MATURING BY WEIGHTED
AMOUNT JUNE 30, AVERAGE RATE
----------- ------------ ------------
(THOUSANDS
OF DOLLARS)
$ 6,647,946 2006 3.36%
12,763 2007 2.75%
3,464 2008 4.24%
49,172 2009 5.85%
641 2010 2.02%
----------- ------------
$ 6,713,986 3.37%
=========== ============
Of the total certificates of deposit outstanding at June 30, 2005, $1.6
billion were obtained through brokers.
25
Interest expense on deposits is summarized as follows:
THREE MONTHS ENDED JUNE 30,
2005 2004
--------- --------
(THOUSANDS OF DOLLARS)
Savings and money market deposit accounts ................................... $ 10,928 $ 8,567
Certificates of deposit ..................................................... 51,515 26,512
Penalties for early withdrawal .............................................. (143) (55)
--------- --------
$ 62,300 $ 35,024
========= ========
SIX MONTHS ENDED JUNE 30,
2005 2004
--------- --------
(THOUSANDS OF DOLLARS)
Savings and money market deposit accounts ................................... $ 20,768 $ 16,874
Certificates of deposit ..................................................... 91,116 53,292
Penalties for early withdrawal .............................................. (228) (108)
--------- --------
$ 111,656 $ 70,058
========= ========
Total interest payments on deposits were $59.9 million and $37.9 million,
for the three month periods ended June 30, 2005 and 2004, respectively, and
$108.4 million and $72.0 million, for the six months ended June 30, 2005 and
2004, respectively.
FIL is a member of the Federal Home Loan Bank system, and as such maintains
a credit line with the FHLB of San Francisco that is based upon a percentage of
its total regulatory assets, subject to collateralization requirements and
certain collateral sub-limits. Advances are primarily collateralized by
residential loans held for sale, and to a lesser extent, by certain commercial
loans held for investment. The maximum amount of credit which the FHLB will
extend varies from time to time in accordance with their policies. FIL's maximum
financing availability, based upon its level of regulatory assets and subject to
the amount and type of collateral pledged and their respective advance rates,
was $3.79 billion as of June 30, 2005. At June 30, 2005 and December 31, 2004,
FIL had an approximate maximum borrowing capacity based upon its pledged loan
collateral of $2.52 billion and $2.11 billion, respectively, with outstanding
borrowings of $857.0 million and $900.0 million, respectively. All borrowings
mature within one year. FIL pledged loans with a carrying value of $2.81 billion
and $2.37 billion at June 30, 2005 and December 31, 2004, respectively, to
secure the current and any future borrowings. FIL's borrowing capacity can be
used to borrow under various FHLB loan programs, including adjustable and
fixed-rate financing, for periods ranging from one day to 30 years, with a
variety of interest rate structures available. The weighted-average interest
rate on the amount outstanding at June 30, 2005 was 2.40%. The borrowing
capacity has no
26
commitment fees or cost, requires minimum levels of investment in FHLB stock
(FIL receives dividend income on its investment in FHLB stock), and can be
withdrawn by the FHLB if there is any significant change in the financial or
operating condition of FIL and is conditional upon its compliance with certain
agreements covering advances, collateral maintenance, eligibility and
documentation requirements. At June 30, 2005, FIL was in compliance with all
requirements of its FHLB credit facility.
Total interest payments on advances from the FHLB were $12.3 million and
$8.3 million, for the three month periods ended June 30, 2005 and 2004,
respectively, and $19.7 million and $15.7 million, for the six months ended June
30, 2005 and 2004, respectively.
FIL has a line of credit with the Federal Reserve Bank of San Francisco
("Federal Reserve") and, at June 30, 2005 and December 31, 2004, had a borrowing
capacity, based upon collateral pledged, of $286.4 million and $159.0 million
respectively, with no outstanding borrowings at June 30, 2005 or December 31,
2004. FIL pledged loans with a carrying value of $381.8 million and $212.1
million at June 30, 2005 and December 31, 2004, respectively to the Federal
Reserve. This line of credit is provided when all other sources of funds are not
reasonably available and any such advances are made with the expectation that
they will be repaid when the availability of the usual source of funds is
restored, usually the next business day.
During 2003, FIL established three separate warehouse lines of credit to
facilitate the funding of residential real estate loans prior to their sale or
securitization. The total funding capacity available at June 30, 2005 under the
three facilities was $2.5 billion, of which $1.25 billion was committed. There
were no amounts outstanding on these facilities at June 30, 2005. Borrowings, if
any, under each of the facilities are secured by loans held for sale as pledged
by FIL. Each of the facilities is subject to certain conditions, including, but
not limited to, financial and other covenants including the maintenance of
certain capital and liquidity levels. At June 30, 2005, FIL was in compliance
with all financial and other covenants related to these facilities.
27
NOTE 15: OTHER LIABILITIES
The following table details the composition of the Company's other
liabilities as of the dates indicated:
JUNE 30, DECEMBER 31,
2005 2004
--------- -----------
(THOUSANDS OF DOLLARS)
Deferred compensation obligation ........................................... $ 49,933 $ 33,495
Borrower principal and interest due investors .............................. 41,028 11,591
Borrower escrow collections payable ........................................ 33,376 23,091
Accrued incentive compensation ............................................. 32,115 74,671
State income tax liability ................................................. 31,998 50,887
Accounts payable ........................................................... 21,074 22,950
Premium recapture and repurchase reserve ................................... 16,271 8,645
Federal income tax liability ............................................... 20,603 50,652
Accrued Employer Stock Ownership Plan expense .............................. 18,981 29,892
Interest payable ........................................................... 16,639 12,755
Rate lock and forwards liability ........................................... 9,693 1,433
Allowance for unfunded loan commitments .................................... 8,603 7,087
Dividends payable to shareholders .......................................... 6,235 5,407
Other ...................................................................... 28,944 28,975
--------- -----------
Other liabilities ..................................................... $ 335,493 $ 361,531
========= ===========
NOTE 16: DEFERRED COMPENSATION
Stock award plans are provided for the benefit of certain key members of
management that authorize shares of either stock rights or stock options to be
allocable to participants. Restricted stock awards are amortized to compensation
expense over the service period of the awards that vary from two to ten years.
Unamortized amounts are reported as deferred compensation.
The Company periodically contributes cash to a grantor stock ownership
trust ("GSOP") in order to pre-fund contributions to various employee benefit
plans (e.g., 401(K) match, Employee Stock Ownership Plan contribution, etc.).
The Company consolidates the GSOP under the provisions of Financial Accounting
Standards Board Interpretation No. 46R, Consolidation of Variable Interest
Entities. The GSOP uses the contributed cash to acquire shares of the Company's
common stock and the shares held by the GSOP are recorded at fair value and
treated as treasury stock for purposes of calculating the Company's basic and
diluted earnings per share.
28
The Company also maintains a Supplemental Executive Retirement Plan
("SERP") and Excess Benefit Plan ("EBP"); both of which are deferred
compensation plans designed to provide certain employees the ability to receive
benefits that would be otherwise lost under the Company's qualified retirement
plans due to statutory or other limits on salary deferral and matching
contributions.
The following table details the composition of the Company's deferred
compensation balance (which is reported as a component of stockholders' equity)
as of the periods indicated:
JUNE 30, DECEMBER 31,
2005 2004
-------- -----------
(THOUSANDS OF DOLLARS)
Unamortized restricted stock awards ........................................ $ 32,092 $ 26,183
SERP and EBP ............................................................... 17,497 11,865
GSOP ....................................................................... 11,780 20,868
-------- -----------
Deferred compensation ................................................. $ 61,369 $ 58,916
======== ===========
NOTE 17: INDUSTRIAL BANK REGULATORY CAPITAL
FIL is subject to various regulatory capital requirements under California
and Federal regulations. Failure to meet minimum capital requirements can result
in regulatory agencies initiating certain mandatory and possibly additional
discretionary actions that, if undertaken, could have a direct material effect
on the consolidated financial statements. Under capital adequacy guidelines and
the regulatory framework for prompt corrective action, FIL must meet specific
capital guidelines that involve quantitative measures of its assets, liabilities
and certain off-balance sheet items as calculated under regulatory accounting
practices. FIL's capital amounts, requirements and classifications are also
subject to qualitative judgments by its regulators about components, risk
weightings and other factors. Banking institutions that are experiencing or
anticipating significant growth are generally expected to maintain capital
ratios above minimum levels.
As of June 30, 2005, FIL's regulatory capital exceeded all minimum
requirements to which it is subject and the most recent notification from the
FDIC categorized FIL as "well-capitalized". To be categorized as
"well-capitalized", the institution must maintain capital ratios as set forth in
the following table; the FDIC and FIL, however, have agreed that FIL will
maintain a Tier-1 Leverage Ratio of at least 8.5%. There have been no conditions
or events since that notification that management believes have changed FIL's
categorization as "well-capitalized". As of June 30, 2005, FIL's Tier-1 Leverage
Ratio was 12.05%. Management does not anticipate any difficulties in maintaining
a Tier-1 Leverage Ratio of at least 8.5%. FIL's actual regulatory amounts and
the related standard regulatory minimum ratios required to
29
qualify as well capitalized are detailed in the table below.
JUNE 30, 2005
--------------------
MINIMUM ACTUAL
REQUIRED RATIO
-------- ------
Tier-1 Leverage Capital ..................................................... 5.00% 12.05%
Risk-Based Capital:
Tier-1 .................................................................... 6.00% 18.34%
Total ..................................................................... 10.00% 19.62%
DECEMBER 31, 2004
---------------------
MINIMUM ACTUAL
REQUIRED RATIO
-------- ------
Tier-1 Leverage Capital ..................................................... 5.00% 12.71%
Risk-Based Capital:
Tier-1 .................................................................... 6.00% 17.26%
Total ..................................................................... 10.00% 18.54%
Regulatory capital is assessed for adequacy by three measures: Tier-1
Leverage Capital, Tier-1 Risk-Based Capital and Total Risk-Based Capital. FIL's
Tier-1 Leverage Capital includes common stockholder's equity, a certain portion
of its mortgage servicing rights not includable in regulatory capital and other
adjustments. Tier-1 Leverage Capital is measured with respect to average assets
during the quarter. The Tier-1 Risk-Based Capital ratio is calculated as a
percent of risk-weighted assets at the end of the quarter. FIL's Total
Risk-Based Capital includes the allowable amount of its allowance for loan
losses (the allowable amount includable is limited to 1.25% of gross
risk-weighted assets). The Total Risk-Based Capital ratio is calculated as a
percent of risk-weighted assets at the end of the quarter. The following table
details the calculation of the respective capital amounts at FIL at the dates
indicated:
30
JUNE 30, DECEMBER 31,
2005 2004
----------- -----------
(THOUSANDS OF DOLLARS)
Common stockholder's equity at FIL .......................................... $ 1,423,860 $ 1,239,701
Less:
Disallowed portion of mortgage servicing rights ........................... (2,232) (1,800)
Unrealized gains on available-for-sale securities ......................... (4,189) (1,413)
----------- -----------
Total Tier-1 Capital ........................................................ 1,417,439 1,236,488
Add:
Allowable portion of the allowance for loan losses ........................ 98,611 92,178
----------- -----------
Total Risk-Based Capital (Tier-1 and Tier-2) ................................ $ 1,516,050 $ 1,328,666
=========== ===========
NOTE 18: COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET ACTIVITIES
The Company is a defendant in a number of legal actions arising in the
ordinary course of business and from the discontinuance of the insurance
operations. Management and its legal counsel are of the opinion that the
settlement of these actions, individually or in the aggregate, will not have a
material effect on the Company's business, financial position or results of
operations.
On June 2, 2004, the State of California Insurance Commissioner John
Garamendi (the "Commissioner"), as statutory liquidator of Fremont Indemnity
Company ("Fremont Indemnity"), filed suit in Los Angeles Superior Court against
Fremont General alleging the improper utilization by Fremont General of certain
net operating loss deductions ("NOLs") allegedly belonging to its Fremont
Indemnity subsidiary (the "Fremont Indemnity case") and misrepresentation and
concealment. This complaint involves issues that Fremont General considers were
resolved in an agreement among the California Department of Insurance, Fremont
Indemnity and Fremont General (the "Agreement"). The Agreement, dated July 2,
2002, was executed on behalf of the California Department of Insurance by the
Honorable Harry Low, the State of California Insurance Commissioner at that
time. Fremont General has honored all of its obligations under the Agreement.
On January 25, 2005, the Company's motions to dismiss the lawsuit brought
by the Commissioner, on behalf of Fremont Indemnity, against the Company were
argued and heard before the Superior Court of the State of California (the
"Court"). On January 26, 2005 the Court issued its rulings dismissing all the
causes of action in the complaint without leave to amend, except for the 7th
cause of action for alleged concealment by the Company of a potential
reinsurance dispute, which was dismissed with leave to amend. The Court also
found that the Company had properly utilized the NOLs in accordance with the
Agreement.
31
In addition, the Court rejected the Commissioner's request for findings that the
Company's use of the NOLs and worthless stock deduction were voidable
preferences and/or fraudulent transfers. The Court also rejected the
Commissioner's request for injunctive relief to force the Company to amend its
prior consolidated income tax returns to remove and forgo the worthless stock
deduction for its investment in Fremont Indemnity.
On May 2, 2005 the Commissioner filed an amended complaint with regard to
the 7th cause of action on behalf of Fremont Indemnity against the Company
alleging intentional misrepresentation, concealment and promissory fraud, which
induced the Commissioner to first enter into the Agreement. On July 15, 2005,
the Court dismissed the amended complaint with 20 days leave to amend. On August
4, 2005, the Commissioner filed a further amendment to the complaint, again
alleging intentional misrepresentation, concealment and promissory fraud. The
Company continues to believe that the complaint lacks merit.
The Commissioner filed a second complaint against Fremont General on behalf
of Fremont Indemnity as successor in interest to Comstock Insurance Company
("Comstock"), a former affiliate of Fremont Indemnity, which was subsequently
merged into Fremont Indemnity. This case alleged similar causes of action
regarding the usage of the NOLs as in the Fremont Indemnity case as well as
improper transactions with other insurance subsidiaries and affiliates of
Fremont Indemnity. This matter was deemed a related case to the Fremont
Indemnity case. On April 22, 2005, the Court dismissed, without leave to amend,
the entire complaint. This ruling does not address or necessarily have legal
effect on the related Fremont Indemnity case. On July 22, 2005, the Company
received a Notice of Appeal to the Court's April 22, 2005 dismissal of the
complaint. The Company continues to believe that this litigation is without
merit.
The Company, in relation to one of its commercial real estate lending
transactions, has participated in a standby letter of credit which represents a
conditional obligation of the Company; this letter of credit guarantees the
performance of a borrower to a third party in the amount of approximately $17.5
million.
NOTE 19: OPERATIONS BY REPORTABLE SEGMENT
The Company manages its operations based on the types of products and
services offered by each of its strategic business units. Based on that approach
the Company has grouped its products and services into two reportable segments
- Commercial and Residential Real Estate.
32
The Commercial Real Estate segment originates commercial real estate loans
on a nationwide basis marketed through the use of trade advertising, direct
marketing, newsletters and trade shows. Loans originated consist primarily of
bridge, construction and permanent loans. Substantially all of the loans
originated are held in the Company's loan portfolio.
The Residential Real Estate segment originates non-prime or sub-prime loans
nationally through independent brokers on a wholesale basis. These loans are
then primarily sold to third party investors on a servicing-released basis, or,
to a lesser extent, securitized. Net interest income is recognized on these
loans during the period that the Company holds them for sale. In addition,
servicing income is realized on the loans sold into the Company's
securitizations and on loans sold to other parties on an interim basis.
Management measures and evaluates each of these segments based on total
revenues generated, net interest income and pre-tax operating results. The
results of operations include certain allocated corporate expenses as well as
interest expense charged back to the segments for the use of funds generated by
the Company's corporate and retail banking operations. Interest expense is
allocated among the residential and commercial segments using treasury rates
matched to the terms of the respective loans plus a spread to cover the expenses
of the retail banking operations.
Certain expenses that are centrally managed at the corporate level such as
provision for income taxes and other general corporate expenses are excluded
from the measure of segment profitability reviewed by management. Therefore, the
Company has included these expenses along with the results of the Company's
retail banking operation, which does not meet the definition of a reportable
segment, in the Other category. Historical periods have been restated to conform
to this presentation.
Intersegment eliminations shown in the table below relate to the credit
allocated to the retail banking operations for operating funds provided to the
two reportable segments.
33
RESIDENTIAL COMMERCIAL INTERSEGMENT TOTAL
REAL ESTATE REAL ESTATE OTHER ELIMINATIONS CONSOLIDATED
----------- ----------- ----------- ------------ ------------
(THOUSANDS OF DOLLARS)
Three Months ended June 30, 2005
Total revenues .................................... $ 232,317 $ 81,007 $ 77,283 $ (71,087) $ 319,520
Net interest income ............................... 71,384 45,687 10,891 - 127,962
Provision for loan losses ......................... - (4,213) (3) - (4,216)
Net gain on whole loan sales and securitizations
of residential real estate loans ................ 91,964 - - - 91,964
Mortgage servicing rights amortization ............ (5,062) - - - (5,062)
Compensation and related .......................... 25,453 5,898 24,303 - 55,654
Other non-interest expense ........................ 12,047 2,687 13,385 - 28,119
Income (loss) before income taxes ................. 115,239 43,667 (8,873) - 150,033
Total consolidated assets ......................... 5,549,942 3,609,216 1,840,117 - 10,999,275
Three Months ended June 30, 2004
Total revenues .................................... $ 228,556 $ 77,170 $ 43,248 $ (41,308) $ 307,666
Net interest income ............................... 68,340 50,472 2,593 - 121,405
Provision for loan losses ......................... (350) (111) 607 - 146
Net gain on whole loan sales and securitizations
of residential real estate loans ................ 127,050 - - - 127,050
Mortgage servicing rights amortization ............ (2,037) - - - (2,037)
Compensation and related .......................... 40,003 8,862 19,181 - 68,046
Other non-interest expense ........................ 7,817 1,944 13,488 - 23,249
Income (loss) before income taxes ................. 149,003 43,181 (29,135) - 163,049
Total consolidated assets ......................... 5,377,498 3,694,461 1,303,715 - 10,375,674
34
RESIDENTIAL COMMERCIAL INTERSEGMENT TOTAL
REAL ESTATE REAL ESTATE OTHER ELIMINATIONS CONSOLIDATED
----------- ----------- -------------- ------------ ------------
(THOUSANDS OF DOLLARS)
Six Months ended June 30, 2005
Total revenues .................................... $ 461,551 $ 150,628 $ 136,972 $ (127,801) $ 621,350
Net interest income ............................... 141,688 86,868 18,158 - 246,714
Provision for loan losses ......................... (1) (3,173) (6) - (3,180)
Net gain on whole loan sales and securitizations
of residential real estate loans ................ 200,324 - - - 200,324
Mortgage servicing rights amortization ............ (9,547) - - - (9,547)
Compensation and related .......................... 60,476 12,561 41,897 - 114,934
Other non-interest expense ........................ 22,762 1,043 24,543 - 48,348
Income (loss) before income taxes ................. 248,977 80,571 (28,337) - 301,211
Total consolidated assets ......................... 5,549,942 3,609,216 1,840,117 - 10,999,275
Six Months ended June 30, 2004
Total revenues .................................... $ 447,059 $ 154,199 $ 88,425 $ (81,311) $ 608,372
Net interest income ............................... 132,374 102,983 3,611 - 238,968
Provision for loan losses ......................... 6,291 10,548 (294) - 16,545
Net gain on whole loan sales and securitizations
of residential real estate loans ................ 249,246 - - - 249,246
Mortgage servicing rights amortization ............ (3,407) - - - (3,407)
Compensation and related .......................... 79,774 17,718 37,738 - 135,230
Other non-interest expens ......................... 17,001 6,714 22,294 - 46,009
Income (loss)before income taxes .................. 282,128 71,872 (49,258) - 304,742
Total consolidated assets ......................... 5,377,498 3,694,461 1,303,715 - 10,375,674
35
NOTE 20: EARNINGS PER SHARE
Earnings per share have been computed based on the weighted-average number
of shares. The following tables set forth the computation of basic and diluted
earnings per share:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------- -----------------------
2005 2004 2005 2004
-------- ---------- ---------- ----------
(THOUSANDS OF SHARES AND DOLLARS,
EXCEPT PER SHARE DATA)
Net income
(numerator for basic earnings per share) .......................... $ 90,770 $ 95,378 $ 180,872 $ 178,041
Effect of dilutive securities:
LYONs ............................................................. 4 5 8 10
-------- -------- -------- ---------
Net income available to common stockholders after assumed
conversions (numerator for diluted earnings per share) ............ $ 90,774 $ 95,383 $ 180,880 $ 178,051
======== ======== ========= =========
Weighted-average shares
(denominator for basic earnings per share) ........................ 72,759 72,027 72,271 71,632
Effect of dilutive securities using the treasury stock method
for restricted stock and stock options:
Restricted stock ................................................ 1,132 1,371 1,023 1,357
Employee benefit plans .......................................... 1,203 - 1,090 -
Stock options ................................................... 87 129 97 129
LYONs ........................................................... 33 40 34 40
-------- -------- --------- ---------
Dilutive potential common shares .................................... 2,455 1,540 2,244 1,526
-------- -------- --------- ---------
Adjusted weighted-average shares and assumed conversions
(denominator for diluted earnings per share) ...................... 75,214 73,567 74,515 73,158
======== ======== ========= =========
Basic earnings per share ............................................ $ 1.25 $ 1.32 $ 2.50 $ 2.49
======== ======== ========= =========
Diluted earnings per share .......................................... $ 1.21 $ 1.30 $ 2.43 $ 2.43
======== ======== ========= =========
36
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This report may contain "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934, and are made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. Such forward-looking
statements and the currently reported results are based upon the current
expectations and beliefs of Fremont General Corporation ("Fremont") and its
subsidiaries (combined "the Company") concerning future developments and their
potential effects upon the Company. These statements and the Company's results
reported herein are not guarantees of future performance or results and there
can be no assurance that actual developments and economic performance will be as
anticipated by the Company. Actual developments and/or results may differ
significantly and adversely from the Company's expected or currently reported
results as a result of significant risks, uncertainties and factors, often
beyond the Company's control (as well as the various assumptions utilized in
determining the Company's expectations), and which include, but are not limited
to, the following:
o the variability of general and specific economic conditions and trends, and
changes in, and the level of, interest rates;
o the impact of competition and pricing environments on loan and deposit
products and the resulting effect upon the Company's net interest margin
and net gain on sale;
o changes in the Company's ability to originate loans, and any changes in the
cost and volume of loans originated as a result thereof, and the
effectiveness of the Company's interest risk management, including hedging,
of its funded and unfunded loans;
o the ability to access the necessary capital resources in a cost-effective
manner to fund loan originations, the condition of the whole loan sale and
securitization markets and the timing of sales and securitizations;
o the ability of the Company to sell or securitize the residential real
estate loans it originates, the pricing of existing and future loans, and
the net premiums realized upon the sale of such loans;
o the ability of the Company to sell certain of the commercial real estate
loans and foreclosed real estate in its portfolio and the net proceeds
realized upon the sale of such;
o the impact of changes in the commercial and residential real estate
markets, and changes in the fair values of the Company's assets and loans,
including the value of the underlying real estate collateral;
o the ability to effectively manage the Company's growth in assets and
volume, including its lending concentrations, and to maintain acceptable
levels of credit quality;
o the ability to collect and realize the amounts outstanding, and the timing
thereof, of loans and foreclosed real estate;
o the variability in determining the level of the allowance for loan losses
and the fair value of the mortgage servicing rights and residual interests
in securitizations;
o the effect of certain determinations or actions taken by, or the inability
to secure regulatory approvals from, the Federal Deposit Insurance
Corporation, the Department of Financial Institutions of the State of
California or other regulatory bodies on various matters;
o the ability of the Company to maintain cash flow sufficient for it to meet
its debt service and other obligations;
o the ability to maintain effective compliance with laws and regulations and
control expenses, particularly in periods of significant growth for the
Company;
37
o the impact and cost of adverse state and federal legislation and
regulations, litigation, court decisions and changes in the judicial
climate;
o the impact of changes in federal and state tax laws and interpretations,
including tax rate changes, and the effect of any adverse outcomes from the
resolution of issues with taxing authorities;
o the ability to maintain an effective system of internal and financial
disclosure controls, and to identify and remediate any control
deficiencies, under the requirements of Section 404 of the Sarbanes-Oxley
Act of 2002; and
o other events, risks and uncertainties discussed elsewhere in this Form
10-Q, the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2004, and from time to time in Fremont's other reports, press
releases and filings with the Securities and Exchange Commission.
The Company undertakes no obligation to publicly update such
forward-looking statements.
OVERVIEW
Fremont General Corporation ("Fremont General" or when combined with its
subsidiaries "the Company") is a holding company which is engaged in lending
operations through its indirectly wholly-owned subsidiary, Fremont Investment &
Loan ("FIL"). FIL is a California state-chartered industrial bank. Fremont
General is not a "bank holding company" as defined for regulatory purposes.
FIL has two primary lending operations, commercial and residential real
estate, both of which are done on a nationwide basis. FIL's commercial real
estate lending operation includes nine regional offices and, as of June 30,
2005, had loans outstanding in 36 states. The residential real estate lending
platform originated loans from 46 states through its five regional loan
production centers during the second quarter of 2005. FIL funds its operations
primarily through deposit accounts sourced in California that are insured up to
the maximum legal limit by the Federal Deposit Insurance Corporation ("FDIC")
and, to a lesser extent, advances from the Federal Home Loan Bank of San
Francisco ("FHLB"). As such, FIL is regulated by the FDIC and the Department of
Financial Institutions of the State of California ("DFI").
FIL's residential real estate lending operation originates first and, to a
lesser degree, second mortgage loans on a wholesale basis through a network of
independent mortgage brokers. FIL offers mortgage products that are designed for
borrowers who do not generally satisfy the credit, documentation or other
underwriting standards prescribed by conventional mortgage lenders, such as
Fannie Mae and Freddie Mac and are commonly referred to as "non-prime" or
"sub-prime". These borrowers generally have considerable equity in the
properties securing their loans, but have impaired or limited credit profiles or
higher debt-to-income ratios than conventional mortgage lenders allow. The
borrowers also include individuals who, due to self-employment or other
circumstances, have difficulty documenting their income through conventional
means. FIL seeks to mitigate its exposure to credit risk through underwriting
standards that strive to ensure appropriate loan to collateral valuations. All
of the residential real estate loans that FIL originates are currently either
sold in whole loan sales to various financial institutions or, to a
38
lesser extent, securitized and sold to various investors. The Company has
retained some of these loans as held for investment in prior periods and may do
so again in the future.
FIL's commercial real estate lending operation provides first mortgage
financing on various types of income producing properties. The commercial real
estate loans that FIL originates are all held for investment, with some loans
participated out to reduce credit limit exposures. Loans are originated through
broker and borrower relationships and the borrowers are typically mid-size
developers and owners seeking a loan structure that provides limited recourse
and is short-term, providing bridge or construction financing for comprehensive
construction, renovation, repositioning and lease-up of existing or new
properties. To manage the credit risk involved in this lending, FIL is focused
on the value and quality of the collateral and the quality and experience of the
parties with whom it does business. The size of loan commitments originated
generally range from $10 million to $60 million, with some loans for larger
amounts.
The Company's two operating lines of business are designed to be somewhat
counter-cyclical and to provide balance in varying economic cycles; however,
both of the Company's operating businesses are influenced by the overall
condition of the economy, in particular the interest rate environment and, as a
result, experience cyclicality in volume, loan losses and earnings. The Company
strives to manage its operations so as to optimize operational efficiency and to
maintain risks within acceptable parameters. The Company's lending operations
generate income as follows:
o All of the residential real estate loans originated are currently sold for
varying levels of gain through whole loan sales to other financial
institutions, and to a lesser degree, to various investors through
securitization transactions. A held for sale valuation reserve, a loan
repurchase reserve and a premium recapture reserve are maintained and
adjusted through provisions (which are either an expense or a credit to
income) that are recognized in the consolidated statements of income. Net
interest income is recognized on the loans originated during the period
that the Company holds them for sale. Servicing income is realized on the
loans sold into the Company's securitizations and on an interim basis for
loans sold to other financial institutions.
o Commercial real estate loans, which are held for investment, generate net
interest income on the difference between the rates charged on the loans
and the cost of borrowed funds. An allowance for loan losses is maintained
and adjusted through provisions (which are either an expense or a credit to
income) that are recognized in the consolidated statements of income.
The principal market risks the Company faces are interest rate risk, which
is the risk that the valuation of the Company's interest-sensitive loans and
liabilities and its net interest income will change due to changes in interest
rates, and liquidity risk, which is the ability of the Company to access the
necessary funding and capital resources, in a cost-effective manner, to fund its
loan originations or to sell its loans held for sale. The Company endeavors to
mitigate interest rate risk by attempting to match the rate reset (or repricing)
characteristics of its assets with its liabilities. The Company also utilizes
forward loan sale
39
commitments to provide liquidity and to hedge its loans held for sale. The
objective of the Company's interest rate and liquidity risk management
activities is to reduce the risk of operational disruption and to reduce the
volatility in income caused by changes in interest rates; however, the mortgage
banking industry is inherently subject to income volatility due to the effect of
interest rate variations on loan production volume, premiums realized on loan
sales and securitizations, as well as loan pre-payment patterns, which in turn
affects the valuation of the Company's residual interests and mortgage servicing
rights, as well as the amount of loan servicing income realized.
This discussion and analysis should be read in conjunction with the
Consolidated Financial Statements and notes thereto presented under Item 1, and
the Company's Annual Report on Form 10-K for the fiscal year ended December 31,
2004.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company's discussion and analysis of its financial condition and
results of operations are based upon its consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States of America ("GAAP"). The preparation of these
financial statements requires the Company to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses. On an
on-going basis, the Company evaluates its estimates, which are based on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
The Company has identified four accounting policies as being critical
because they require more significant judgment and estimates about matters that
may differ from the estimates determined under different assumptions or
conditions. These critical accounting policies relate to the gain on whole loan
sales and securitizations, allowance for loan losses, derivatives and income
taxes. The critical accounting policies and estimates are further discussed in
Management's Discussion and Analysis in the Annual Report on Form 10-K for the
fiscal year ended December 31, 2004.
EARNINGS PERFORMANCE
The Company reported income before income taxes of $150.0 million for the
second quarter of 2005 as compared to $163.0 million for the second quarter of
2004. For the first six months of 2005, income before income taxes totaled
$301.2 million, as compared to $304.7 million for the first six months of 2004.
The decrease in income before income taxes for the second quarter and first six
months of 2005 represent decreases of 8.0% and 1.2% over the results for the
second quarter and first six months of 2004, respectively. This is primarily a
result of decreased levels of the net gain on whole loan sales and
40
securitizations of residential real estate loans, partially offset by a lower
provision for loan losses, an increase in net interest income and loan servicing
income, as well as a reduction in non-interest expense.
The Company reported net income of $90.8 million for the second quarter of
2005. This is compared to net income of $95.4 million for the second quarter of
2004. For the first six months of 2005, net income totaled $180.9 million, as
compared to $178.0 million for the first six months of 2004.
NET INTEREST INCOME
The Company recorded net interest income for the second quarter and first
six months of 2005 of $128.0 million and $246.7 million as compared to $121.4
million and $239.0 million for the second quarter and first six months of 2004,
respectively. The increase in net interest income is primarily a result of an
increase in the average interest-earning assets, primarily the residential real
estate loans held for sale. Total average interest-earning assets increased 16%
to $11.6 billion during the second quarter of 2005, as compared to $10.0 billion
during the second quarter of 2004. The net interest income margin as a
percentage of average interest-earning assets decreased to an annualized 4.42%
for the second quarter of 2005 from 4.88% for the second quarter of 2004. Total
average interest-earning assets increased 13% to $11.0 billion for the first six
months of 2005, as compared to $9.7 billion during the first six months of 2004.
The net interest income margin decreased to an annualized 4.52% for the first
six months of 2005 from 4.94% for the first six months of 2004. Net interest
income is impacted by the volume, mix and rate of interest-earning assets and
interest-bearing liabilities. The decrease in the Company's net interest margin
is due primarily to higher funding costs relative to the yields realized on
loans outstanding during the second quarter and first six months of 2005. In
particular, yields on the Company's residential real estate loans held for sale
remained essentially static during the first six months of 2005, while the
underlying cost of funds increased during the same period.
The following tables identify the consolidated interest income, interest
expense, average interest-earning assets and interest-bearing liabilities, and
net interest margins, as well as an analysis of changes in net interest income
due to volume and rate changes, for the second quarter and first six months of
2005 and 2004:
41
THREE MONTHS ENDED JUNE 30,
-------------------------------------------------------------------------------
2005 2004
------------------------------------- ------------------------------------
AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST COST BALANCE INTEREST COST
------------ --------- ------ ------------ --------- -------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Interest-earning assets (1):
Commercial real estate loans .................. $ 3,864,369 $ 76,457 7.94% $ 3,937,043 $ 73,087 7.47%
Residential real estate loans (2) ............. 6,971,662 125,849 7.24% 5,639,187 95,090 6.78%
Syndicated commercial loans ................... - - - 4,464 78 7.03%
Residual interests in securitized loans ....... 18,823 2,969 63.27% 10,077 948 37.84%
Cash equivalents and investment securities .... 752,416 5,675 3.03% 412,866 1,826 1.78%
------------ --------- ------ ------------ --------- -------
Total interest-earning assets .............. $ 11,607,270 $ 210,950 7.29% $ 10,003,637 $ 171,029 6.88%
============ ========= ====== ============ ========= =======
Interest-bearing liabilities:
Time deposits ................................. $ 6,510,178 $ 51,396 3.17% $ 5,202,471 $ 26,433 2.04%
Savings deposits .............................. 1,640,279 10,904 2.67% 1,780,940 8,590 1.94%
FHLB advances ................................. 1,823,463 12,213 2.69% 1,864,626 8,331 1.80%
Warehouse lines of credit ..................... 230,658 2,337 4.06% - 125 -
Senior Notes due 2004 ......................... - - - - - -
Senior Notes due 2009 ......................... 181,450 3,650 8.05% 186,716 3,765 8.07%
LYONs ......................................... 386 7 7.27% 646 8 4.98%
Junior Subordinated Debentures ................ 103,093 2,320 9.00% 103,093 2,320 9.00%
Other ......................................... 29,166 161 2.21% 10,272 52 2.04%
------------ --------- ------ ------------ --------- -------
Total interest-bearing liabilities .......... $ 10,518,673 $ 82,988 3.16% $ 9,148,764 $ 49,624 2.18%
============ ========= ====== ============ ========= =======
Net interest income ............................. $ 127,962 $ 121,405
========= =========
Percent of average interest-earning assets:
Interest income ............................... 7.29% 6.88%
Interest expense .............................. 2.87% 2.00%
------ -------
Net interest margin ........................... 4.42% 4.88%
====== =======
(1) Average loan balances include non-accrual loan balances.
(2) Includes loans held for sale and other.
42
SIX MONTHS ENDED JUNE 30,
-------------------------------------------------------------------------------
2005 2004
------------------------------------- ------------------------------------
AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST COST BALANCE INTEREST COST
------------ --------- ------ ------------ --------- -------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Interest-earning assets (1):
Commercial real estate loans .................. $ 3,743,649 $ 142,849 7.69% $ 3,973,393 $ 149,391 7.56%
Residential real estate loans (2) ............. 6,601,538 236,959 7.24% 5,357,741 183,289 6.88%
Syndicated commercial loans ................... - - - 5,206 78 3.01%
Residual interests in securitized loans ....... 17,050 4,307 50.94% 8,954 1,594 35.80%
Cash equivalents and investment securities .... 635,183 8,759 2.78% 388,318 3,384 1.75%
------------ --------- ------ ------------ --------- -------
Total interest-earning assets .............. $ 10,997,420 $ 392,874 7.20% $ 9,733,612 $ 337,736 6.98%
============ ========= ====== ============ ========= =======
Interest-bearing liabilities:
Time deposits ................................. $ 6,204,962 $ 90,963 2.96% $ 5,196,973 $ 53,185 2.06%
Savings deposits .............................. 1,694,871 20,693 2.46% 1,759,686 16,873 1.93%
FHLB advances ................................. 1,586,223 19,719 2.51% 1,690,698 15,748 1.87%
Warehouse lines of credit ..................... 115,966 2,556 4.44% - 250 -
Senior Notes due 2004 ......................... - - - 9,471 372 7.86%
Senior Notes due 2009 ......................... 181,450 7,301 8.05% 188,708 7,601 8.06%
LYONs ......................................... 480 15 6.30% 650 17 5.26%
Junior Subordinated Debentures ................ 103,093 4,639 9.00% 103,093 4,639 9.00%
Other ......................................... 27,140 274 2.04% 8,310 83 2.01%
------------ --------- ------ ------------ --------- -------
Total interest-bearing liabilities .......... $ 9,914,185 $ 146,160 2.97% $ 8,957,589 $ 98,768 2.22%
============ ========= ====== ============ ========= =======
Net interest income ............................. $ 246,714 $ 238,968
========= =========
Percent of average interest-earning assets:
Interest income ............................... 7.20% 6.98%
Interest expense .............................. 2.68% 2.04%
------ -------
Net interest margin ........................... 4.52% 4.94%
====== =======
(1) Average loan balances include non-accrual loan balances.
(2) Includes loans held for sale and other.
43
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2005 COMPARED TO 2004 2005 COMPARED TO 2004
-------------------------------------- -------------------------------------
CHANGE DUE TO CHANGE DUE TO
------------------------ -----------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL
------- ---------- --------- --------- -------- --------
(THOUSANDS OF DOLLARS)
Cash equivalent and investment
securities ................................ $ 2,492 $ 1,357 $ 3,849 $ 3,208 $ 2,167 $ 5,375
Loans:
Commercial real estate .................. (1,438) 4,808 3,370 (8,767) 2,225 (6,542)
Residential real estate ................. 24,045 6,716 30,761 44,617 9,066 53,683
Other ................................... 1,388 553 1,941 2,073 549 2,622
-------- ---------- --------- --------- --------- -------
Total Loans .............................. 23,995 12,077 36,072 37,923 11,840 49,763
-------- ---------- --------- --------- --------- -------
Total increase in interest income ......... 26,487 13,434 39,921 41,131 14,007 55,138
-------- ---------- --------- --------- --------- -------
Time deposits ............................. (10,324) (14,639) (24,963) (14,777) (23,001) (37,778)
Savings deposits .......................... 935 (3,249) (2,314) 791 (4,611) (3,820)
FHLB advances ............................. 276 (4,158) (3,882) 1,299 (5,270) (3,971)
Warehouse lines of credit ................. (2,212) - (2,212) (2,306) - (2,306)
Senior Notes due 2004 and 2009 ............ 115 - 115 672 - 672
LYONs ..................................... 1 - 1 2 - 2
Junior Subordinated Debentures ............ - - - - - -
Other ..................................... (104) (5) (109) (190) (1) (191)
-------- ---------- --------- --------- --------- -------
Total decrease in interest expense ........ (11,313) (22,051) (33,364) (14,509) (32,883) (47,392)
-------- ---------- --------- --------- --------- -------
Increase (decrease) in net interest
income ................................... $ 15,174 $ (8,617) $ 6,557 $ 26,622 $ (18,876) $ 7,746
======== ========== ========= ========= ========= ==========
NON-INTEREST INCOME
WHOLE LOAN SALES AND SECURITIZATIONS OF RESIDENTIAL REAL ESTATE LOANS
The gain on the sale of residential real estate loans decreased from $127.1
million in the second quarter of 2004 to $92.0 million for the second quarter of
2005 in spite of a significant increase in the volume of loans sold and
securitized in the second quarter of 2005 as compared to the second quarter of
2004. For the first six months of 2005, the gain on the sale of residential real
estate loans decreased to $200.3 million, as compared to $249.2 million for the
first six months of 2004. The decrease in gain on sale is primarily attributable
to the realization of lower gross premiums on loans sold and securitized in the
second quarter and first six months of 2005, as compared to the second quarter
and first six months of 2004, as a result of lower interest rate margins
reflecting increased price competition in the non-prime mortgage origination
market.
A total of $9.8 billion in loans were sold (including loans sold via
securitization) during the second quarter of 2005, as compared to loan sales and
securitizations of $5.2 billion during the second quarter of 2004. For the first
six months of 2005, a total of $16.8 billion in loans were sold (including loans
sold via securitization), as compared to loan sales of $9.8 billion during the
first six months of 2004. The average gross premium on loans sold and
securitized during the second quarter of 2005 was 2.75% as compared to an
average of 4.04% for the second quarter of 2004. For the first six months of
2005, the average gross premium on loans sold was 2.79% as compared to an
average of 4.16% for the first six months of 2004.
44
The Company realized a net loss on its derivative instruments utilized to
hedge the impact of interest rate volatility on its residential real estate
lending activities during the second quarter and first six months of 2005. This
net loss primarily resulted from a decrease in the underlying interest rate
indices (primarily the two-year swap rate) which conversely had a positive
impact upon the gross loan sale and securitization premiums realized during the
same period. During the first quarter of 2005, the Company realized a net gain
on its hedging activities. Such premiums and the gain or loss on derivative
instruments have exhibited, and are expected to continue to exhibit, variability
(often significant) based on various economic and interest rate environments, as
well as on the Company's loan sale and hedging activity levels and their timing.
The Company also reported higher provisions for valuation and repurchase
reserves for the second quarter and first six months of 2005 (0.16% and 0.13% of
total net loan sales and securitizations, respectively), as compared to the
similar periods in 2004 (0.08% and 0.09%, respectively). This is primarily due
to relative increases in loan repurchases in 2005 and the level of second
mortgages in the loans held for sale as of June 30, 2005. The Company is in the
process of enhancing its estimation methodology for its valuation and repurchase
reserves; this process may result in different levels of provisions in future
periods. The net gain percentage (the net gain after direct costs, net gains or
losses on derivative instruments, provisions for premium recapture and valuation
and repurchase reserves, divided by net loans sold) on these sales decreased
from 2.46% in the second quarter of 2004 to 0.93% in the second quarter of 2005.
For the first six months of 2005, the gain percentage on these sales decreased
to 1.19% as compared to 2.56% in the first six months of 2004.
45
The following tables provide the amounts of loans sold during the
respective periods and additional detail on the gain on sale:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ---------------------------
2005 2004 2005 2004
----------- ----------- ----------- ----------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Whole loan sales of residential real estate loans ............... $ 8,776,193 $ 4,385,574 $ 14,625,502 $ 8,180,889
Securitizations of residential real estate loans ................ 981,717 790,125 2,191,566 1,622,758
----------- ----------- ------------ -----------
Total loan sales and securitization - net of repurchases ........ $ 9,757,910 $ 5,175,699 $ 16,817,068 $ 9,803,647
============ =========== ============ ===========
Gross premium recognized on loan sales and securitizations ...... $ 268,120 $ 208,849 $ 469,816 $ 408,077
Provision for premium recapture and reversal .................... (10,038) (4,249) (17,594) (12,942)
Net gain (loss) on derivative instruments ....................... (25,573) 1,678 (8,385) 3,629
Direct costs of loan originations - net of origination points
and fees ....................................................... (125,464) (75,081) (221,657) (140,153)
----------- ----------- ------------ -----------
107,045 131,197 222,180 258,611
Provision for valuation and repurchase reserves ................. (15,081) (4,147) (21,856) (9,365)
----------- ----------- ------------ -----------
Net gain on sale .......................................... $ 91,964 $ 127,050 $ 200,324 $ 249,246
=========== =========== ============ ===========
Gross premium recognized on loan sales and securitizations ...... 2.75% 4.04% 2.79% 4.16%
Provision for premium recapture and reversal .................... (0.10%) (0.08%) (0.10%) (0.13%)
Net gain (loss) on derivative instruments ....................... (0.27%) 0.03% (0.05%) 0.04%
Direct costs of loan originations - net of origination points
and fees ...................................................... (1.29%) (1.45%) (1.32%) (1.42%)
----------- ----------- ----------- -----------
1.09% 2.54% 1.32% 2.65%
Provision for valuation and repurchase reserves ................. (0.16%) (0.08%) (0.13%) (0.09%)
----------- ----------- ----------- -----------
Net gain on sale ........................................... 0.93% 2.46% 1.19% 2.56%
=========== =========== =========== ===========
o Percentages are of total loan sales and securitizations, net of
repurchases, during the period indicated.
o Premium recapture and reversal is the reversal or recapture of premium on
loans sold which either prepay early per the terms of each sales contract
or for certain loans repurchased from prior sales; includes some interest
adjustment on loans repurchased.
o Provision for valuation and repurchase reserves represents adjustments to
the valuation allowance for the Company's held for sale loans and
adjustments to the Company's repurchase reserve for the effect of loans
estimated to be repurchased.
46
LOAN SERVICING AND OTHER NON-INTEREST INCOME
The components of the Company's loan servicing and other non-interest
income for the second quarter and first six months of 2005 and 2004 are
indicated in the following tables:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2005 2004 2005 2004
-------- -------- -------- --------
(THOUSANDS OF DOLLARS)
Loan Servicing Income:
Servicing fee income:
Securitization transactions ....................... $ 5,214 $ 2,583 $ 9,593 $ 4,351
Interim ........................................... 7,768 4,175 14,276 7,972
Other ............................................. 641 - 1,472 -
-------- -------- -------- --------
13,623 6,758 25,341 12,323
Ancillary income .................................. 2,063 1,126 4,033 2,229
Other ............................................. 515 (254) 814 (383)
-------- -------- -------- --------
$ 16,201 $ 7,630 $ 30,188 $ 14,169
======== ======== ======== ========
MSR Amortization and Impairment:
MSR amortization .................................. $ (5,062) $ (2,037) $ (9,547) $ (3,407)
MSR impairment provision .......................... 255 (2,477) (164) (2,477)
-------- -------- -------- --------
$ (4,807) $ (4,514) $ (9,711) $ (5,884)
======== ======== ======== ========
Other Non-Interest Income:
Prepayment fees:
Commercial real estate .......................... $ 420 $ 2,646 $ 1,381 $ 3,211
Residential real estate ......................... 712 2,286 1,274 3,854
Commercial real estate transaction fees ........... 3,773 1,420 5,836 2,144
All other ......................................... 879 119 974 3,896
-------- -------- --------- ---------
$ 5,784 $ 6,471 $ 9,465 $ 13,105
======== ======== ========= =========
The Company's loan servicing income (which is all related to residential
real estate), before mortgage servicing rights amortization and impairment
provision, increased from $7.6 million in the second quarter of 2004 to $16.2
million for the second quarter of 2005. For the first six months of 2005 loan
servicing income was $30.2 million versus $14.2 million for the first six months
of 2004. This increase was due to an increase in residential real estate loan
origination volume, which resulted in an increase in loan securitization
activity and higher levels of interim servicing during the second quarter and
first six months of 2005 as compared to the second quarter and first six months
of 2004. The additional loan securitization activity also created a higher level
of MSRs, which resulted in an increase in the amortization (expense) of the MSRs
in 2005 versus 2004.
The Company was servicing approximately $21.0 billion in principal balance
of loans as of June 30, 2005. The Company intends to continue to service the
loans held for sale and those loans it securitizes; however, it currently does
not contemplate servicing a significant amount of loans sold to other parties
for
47
more than on an interim basis. The following is a breakdown of the principal
balance of the loans being serviced by categorization as of the periods
indicated:
JUNE 30, DECEMBER 31,
2005 2004
-------- -----------
(MILLIONS OF DOLLARS)
Loans in securitizations ................................................... $ 4,485 $ 3,172
Loans held for sale ........................................................ 5,477 5,420
Loans sold and serviced on an interim basis ................................ 11,022 6,364
-------- -----------
$ 20,984 $ 14,956
======== ===========
PROVISION FOR LOSSES
The provision for loan losses decreased from $146,000 in the second quarter
of 2004 to a $4.2 million credit to income for the second quarter of 2005. For
the first six months of 2005, the provision for loan losses was a $3.2 million
credit to income versus a $16.5 million expense for the first six months of
2004. The decrease in the provision was primarily a result of a significant
decrease in the net charge-offs and level of non-accrual loans experienced for
the commercial real estate loans held for investment during 2005. In addition,
the Company has continued to reduce its exposure to commercial real estate loans
secured by hotel and lodging properties which have been the majority of the
non-accrual loans and net charge-offs in prior periods. The provision for loan
losses represents the current period expense (or credit to income) associated
with maintaining an appropriate allowance for loan losses. The loan loss
provision for each period is dependent upon many factors, including loan growth,
net charge-offs, changes in the composition and concentrations of the loan
portfolio, the number and balances of non-accrual loans, delinquencies, the
level of restructured loans, assessment by management of the inherent risk in
the portfolio, the value of the underlying collateral and the general economic
conditions in the commercial real estate markets in which the Company lends.
Periodic fluctuations in the provision for loan losses and the allowance for
loan losses result from management's on-going assessment of their adequacy.
NON-INTEREST EXPENSE
Non-interest expense decreased during the second quarter and first six
months of 2005, as compared to the second quarter and first six months of 2004.
Compensation expense for the second quarter of 2005 represented most of the
change as it decreased to $55.7 million from $68.0 million in the second quarter
of 2004. The decrease is due primarily to an increase in the capitalization
level of direct loan origination costs and, to a lesser degree, lower levels of
accrued incentive compensation, partially offset by increased compensation
expense related to the higher residential real estate loan origination volume
and an increase in the loan servicing portfolio. The Company decreased its
internal commission costs related to its residential real estate loan production
during 2005 as compared to 2004, thus limiting the amount of
48
increase in compensation expense associated with an increase in residential real
estate loan production. Compensation and non-compensation related operating
expenses are detailed in the following tables:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- -------------------------
2005 2004 2005 2004
-------- -------- --------- ----------
(THOUSANDS OF DOLLARS)
Compensation and related ........................................... $ 55,654 $ 68,046 $ 114,934 $ 135,230
Occupancy .......................................................... 6,942 3,552 13,877 7,078
Other .............................................................. 28,119 23,249 48,348 46,009
--------- --------- --------- ---------
Total non-interest expense ......................................... $ 90,715 $ 94,847 $ 177,159 $ 188,317
========= ========= ========= =========
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- ------------------------
2005 2004 2005 2004
--------- --------- --------- ---------
(THOUSANDS OF DOLLARS)
Total compensation and related ..................................... $ 125,803 $ 117,747 $ 250,353 $ 227,457
Deferral of loan origination costs (1) ............................. (70,149) (49,701) (135,419) (92,227)
--------- --------- --------- ---------
Compensation and related ........................................... $ 55,654 $ 68,046 $ 114,934 $ 135,230
========= ========= ========= =========
(1) Incremental direct costs associated with the origination of loans are
deferred when incurred. For residential real estate loans, when the related
loan is sold, the deferred costs are included as a component of net gain on
sale.
Other non-interest expense for the second quarter and first six months of
June 30, 2005 and 2004 is summarized below:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2005 2004 2005 2004
-------- -------- -------- --------
(THOUSANDS OF DOLLARS)
Legal, professional and other outside services ..................... $ 7,327 $ 7,935 $ 12,775 $ 12,998
Information technology ............................................. 3,948 3,106 7,269 5,645
Printing, supplies and postage ..................................... 3,990 2,866 7,595 5,634
Advertising and promotion .......................................... 2,740 2,354 5,442 4,187
Auto and travel .................................................... 2,137 2,101 4,267 3,965
Leasing and loan expense ........................................... 1,351 455 3,304 3,035
Net real estate owned expenses ..................................... 195 214 (4,635) 2,618
Telephone .......................................................... 1,296 1,012 2,157 1,794
All other .......................................................... 5,135 3,206 10,174 6,133
-------- -------- -------- --------
Other expenses ..................................................... $ 28,119 $ 23,249 $ 48,348 $ 46,009
======== ======== ======== ========
49
INCOME TAXES
Income tax expense of $59.3 million and $67.7 million for the quarters
ended June 30, 2005 and 2004, represent effective tax rates of 39.5% and 41.5%,
respectively, on income before income taxes of $150.0 million and $163.0 million
for the same respective periods. For the six month periods ended June 30, 2005
and 2004, income tax expense of $120.3 million and $126.7 million, represent
effective tax rates of 40.0% and 41.6%, respectively, on income before income
taxes of $301.2 million and $304.7 million for the same respective periods. The
decreases in effective tax rates during 2005 are primarily a result of the
changing geographic mix of the Company's operations which has resulted in more
of the Company's taxable income being subject to tax in states with lower tax
rates. The effective tax rates for all periods presented are different than the
Federal enacted tax rate of 35%, due mainly to various apportioned state income
tax provisions resulting from the Company's nationwide lending operations.
REVIEW OF FINANCIAL CONDITION
LOANS HELD FOR SALE
The Company's residential real estate loans held for sale have held steady
at $5.5 billion at December 31, 2004 and June 30, 2005. During the second
quarter of 2005, residential real estate loan originations totaled $9.24 billion
as compared to $5.89 billion for the second quarter of 2004. During the first
six months of 2005, residential real estate loan originations totaled $17.01
billion as compared to $10.98 billion for the first six months of 2004. The
following table details the loans held for sale as of the dates indicated:
JUNE 30, DECEMBER 31,
2005 2004
----------- -----------
(THOUSANDS OF DOLLARS)
Loan principal balance:
1st trust deeds .......................................................... $ 4,960,655 $ 5,036,724
2nd trust deeds ........................................................... 516,448 383,039
----------- -----------
5,477,103 5,419,763
Basis adjustment for fair value hedge accounting ............................ 1,375 (1,327)
Net deferred direct origination costs ..................................... 65,544 74,514
Less: Valuation reserve .................................................. (54,654) (38,258)
----------- -----------
Loans held for sale - net ................................................. $ 5,489,368 $ 5,454,692
=========== ===========
50
The following tables profile the loan origination volume for the periods
indicated:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------------- ------------------------------
2005 2004 2005 2004
------------ ----------- ------------ ------------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
LOAN ORIGINATION VOLUME BY LIEN POSITION:
Firsts ...................................................... $ 8,433,079 $ 5,549,589 $ 15,593,510 $ 10,435,561
Seconds ..................................................... 810,600 341,906 1,411,841 549,035
----------- ----------- ------------ -----------
$ 9,243,679 $ 5,891,495 $ 17,005,351 $ 10,984,596
=========== =========== ============ ============
FOR FIRST MORTGAGES ORIGINATION VOLUME ONLY:
Average loan size ........................................... $ 241,166 $ 211,550 $ 237,829 $ 209,530
Weighted-average coupon ..................................... 7.15% 6.83% 7.10% 6.86%
Average bureau credit score (FICO) .......................... 624 621 623 621
Average loan-to-value (LTV) ................................. 81.0% 80.9% 81.0% 81.4%
Percentage of interest-only loan volume ..................... 27.0% 20.2% 26.3% 16.7%
Product Mix:
ARM - 2/28 .................................................. 85.7% 78.6% 86.1% 75.1%
ARM - 3/27 .................................................. 2.9% 4.5% 2.9% 4.1%
ARM - 5/25 .................................................. 0.9% 0.0% 0.9% 0.0%
Fixed ....................................................... 10.5% 16.9% 10.1% 20.8%
----------- ----------- ------------ ------------
100.0% 100.0% 100.0% 100.0%
=========== =========== ============ ============
LOAN PURPOSE:
Purchase .................................................... 49.5% 42.8% 47.6% 40.5%
Refinance ................................................... 50.5% 57.2% 52.4% 59.5%
----------- ----------- ------------- ------------
100.0% 100.0% 100.0% 100.0%
=========== =========== ============= ============
FOR SECOND MORTGAGES ORIGINATION VOLUME ONLY:
Average loan size ........................................... $ 50,751 $ 40,952 $ 49,102 $ 39,255
Weighted-average coupon ..................................... 9.99% 10.43% 10.02% 10.58%
Average bureau credit score (FICO) .......................... 650 651 649 648
FIRST & SECOND MORTGAGES - ORIGINATION BY GEOGRAPHIC DISPERSION:
California .................................................. 27.9% 37.1% 29.0% 37.5%
New York .................................................... 11.1% 10.1% 11.0% 11.2%
Florida ..................................................... 10.6% 7.7% 10.2% 7.8%
New Jersey .................................................. 6.8% 6.5% 6.9% 5.2%
Maryland .................................................... 5.5% 3.9% 5.3% 3.7%
All other states ............................................ 38.1% 34.7% 37.6% 34.6%
----------- ----------- ------------- ------------
100.0% 100.0% 100.0% 100.0%
=========== =========== ============= ============
LOANS HELD FOR INVESTMENT
The Company's net loans held for investment before the allowance for loan
losses was approximately $3.74 billion at June 30, 2005, as compared to $3.48
billion at December 31, 2004. The following tables show the total commercial
real estate new loan commitment volume for the periods indicated:
51
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ----------------------------
2005 2004 2005 2004
----------- ---------- ----------- -----------
(THOUSANDS OF DOLLARS)
Senior loans .................................................... $ 1,157,062 $ 644,775 $ 2,217,735 $ 1,030,358
Mezzanine loans .................................................. - - - 11,350
----------- ---------- ----------- -----------
$ 1,157,062 $ 644,775 $ 2,217,735 $ 1,041,708
=========== ========== =========== ===========
Average senior loan size originated .............................. $ 28,221 $ 21,493 $ 29,181 $ 21,259
=========== ========== =========== ===========
The following table shows detail for the Company's loans held for
investment outstanding as of the dates indicated:
JUNE 30, 2005 DECEMBER 31, 2004
-------------------------- --------------------------
AMOUNT % OF TOTAL AMOUNT % OF TOTAL
----------- ---------- ----------- ----------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Commercial real estate loans:
Bridge ........................................................ $ 1,613,630 43 % $ 1,512,532 43 %
Construction ................................................. 1,238,396 33 % 1,020,370 29 %
Permanent .................................................... 777,115 20 % 805,760 23 %
Single tenant credit ......................................... 139,287 4 % 177,193 5 %
----------- ------------ ----------- ------------
3,768,428 100 % 3,515,855 100 %
Other .......................................................... 4,356 - % 4,526 - %
----------- ------------ ----------- ------------
3,772,784 100 % 3,520,381 100 %
Net deferred loan fees and origination costs ................... (35,996) (1)% (35,767) (1)%
---------- ------------ ----------- ------------
3,736,788 99 % 3,484,614 99 %
Allowance for loan losses ...................................... (159,956) (4)% (171,525) (5)%
----------- ------------ ----------- ------------
Loans held for investment - net ................................ $ 3,576,832 95 % $ 3,313,089 94 %
=========== ============ =========== ============
As of June 30, 2005, approximately 30.6% and 15.3% of the Company's
commercial real estate loans outstanding were secured by properties located
within California and New York, respectively; no other state except Florida
(12.7%) represented greater than 10% of the loan portfolio. The real estate
securing these loans includes a wide variety of property types including
multi-family, office, retail, industrial, land development, lodging and
mixed-use properties. The loans in the portfolio were distributed by property
type as follows as of the dates indicated:
52
JUNE 30, DECEMBER 31,
2005 2004
------- -----------
Multi-family - Condominiums ................................................. 33% 25%
Office ...................................................................... 16% 18%
Land Development ............................................................ 13% 12%
Commercial Mixed-Use ........................................................ 10% 12%
Industrial .................................................................. 8% 11%
Retail ...................................................................... 7% 7%
Multi-family - Other ........................................................ 6% 5%
Hotels & Lodging ............................................................ 4% 5%
Special Purpose ............................................................. 3% 5%
-------- -----------
100% 100%
======= ===========
The following table stratifies the commercial real estate loans held for
investment by loan amounts outstanding as of June 30, 2005:
NUMBER TOTAL LOANS
LOAN SIZE RANGE OF LOANS OUTSTANDING %
------------------------------ -------- ----------- ---
(THOUSANDS
OF DOLLARS)
$0 - $ 1 million ................. 86 $ 11,860 1%
> $1 million - $ 5 million ................. 117 330,568 9%
> $5 million - $10 million ................. 95 701,402 19%
> $10 million - $15 million ................. 42 510,620 13%
> $15 million - $20 million ................. 26 444,127 12%
> $20 million - $30 million ................. 16 393,458 10%
> $30 million - $40 million ................. 17 583,346 15%
> $40 million - $50 million ................. 5 222,776 6%
> $50 million ............................... 9 570,271 15%
-------- ----------- ---
413 $ 3,768,428 100%
======== =========== ===
As of June 30, 2005, the average loan size was $9.1 million (or $11.5
million when loans under $1 million are excluded) and the average loan-to-value
ratio was approximately 73%, using the most current available appraised values
and current loan balances outstanding.
The Company's largest single individual commercial real estate loan
outstanding (net of participation) at June 30, 2005 was $84.0 million with a
total loan commitment of $84.0 million. The Company's largest net commitment for
a single loan at June 30, 2005 was $101.5 million; this represents the maximum
potential loan amount to the borrower. As of June 30, 2005, the largest
concentration of loans (separate loans on different properties) which have a
common investor or equity sponsor totaled $121.3 million in loan principal
outstanding and $215.0 million in total loan commitment and is comprised of
seven separate loans, all of which were performing as of June 30, 2005.
53
The following tables provide additional information related to the
Company's commercial real estate non-accrual loans, foreclosed assets ("REO"),
restructured loans on accrual status and accruing loans past due 90 days or
more, as well as reflect the related net loss experience and allowance for loan
loss reconciliation applicable to the loans held for investment as of and for
the respective periods ended as shown below:
JUNE 30, DECEMBER 31,
2005 2004
-------- -----------
(THOUSANDS OF DOLLARS,
EXCEPT PERCENTS)
COMMERCIAL REAL ESTATE:
Non-accrual loans held for investment ("HFI") ............................... $ 33,113 $ 82,289
Real estate owned / foreclosed assets (REO) ................................. 18,106 21,344
-------- -----------
Total non-performing assets ................................................. $ 51,219 $ 103,633
======== ===========
Accruing loans past due 90 days or more ..................................... $ - $ -
======== ===========
Restructured loans on accrual status: ...... ................................ $ 12,412 $ 9,302
======== ===========
Non-accrual loans to total loans HFI ........................................ 0.89% 2.36%
Allowance for loan losses to total loans HFI ................................ 4.28% 4.92%
Allowance for loan losses to non-accrual loans .............................. 483.0% 208.4%
54
THREE MONTHS ENDED JUNE 30, 2005
-------------------------------------------------------
COMMERCIAL RESIDENTIAL
REAL ESTATE REAL ESTATE OTHER TOTAL
----------- ----------- ------- ---------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Beginning allowance for loan losses .............................. $ 171,891 $ - $ 50 $ 171,941
Provision for loan losses ........................................ (4,213) - (3) (4,216)
Charge-offs ...................................................... (8,197) - - (8,197)
Recoveries ....................................................... 428 - - 428
----------- ----------- ------- ---------
Net charge-offs ................................................ (7,769) - - (7,769)
----------- ----------- ------- ---------
Ending allowance for loan losses ................................. $ 159,909 $ - $ 47 $ 159,956
=========== =========== ======= =========
Net loan charge-offs to average total loans
held for investment ............................................ 0.81% 0.00% 0.00% 0.81%
=========== =========== ======= =========
THREE MONTHS ENDED JUNE 30, 2004
-------------------------------------------------------
COMMERCIAL RESIDENTIAL
REAL ESTATE REAL ESTATE OTHER TOTAL
----------- ----------- ------- ---------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Beginning allowance for loan losses .............................. $ 196,504 $ 22,186 $ 2,126 $ 220,816
Provision for loan losses ........................................ (111) (350) 607 146
Charge-offs ...................................................... (4,955) (197) (1,236) (6,388)
Recoveries ....................................................... 37 33 82 152
----------- ----------- ------- ---------
Net charge-offs ................................................ (4,918) (164) (1,154) (6,236)
----------- ----------- ------- ---------
Ending allowance for loan losses ................................. $ 191,475 $ 21,672 $ 1,579 $ 214,726
=========== =========== ======= =========
Net loan charge-offs to average total loans
held for investment ............................................ 0.50% 0.07% 103.97% 0.51%
=========== =========== ======= =========
55
SIX MONTHS ENDED JUNE 30, 2005
------------------------------------------------------------
COMMERCIAL RESIDENTIAL
REAL ESTATE REAL ESTATE OTHER TOTAL
----------- ----------- -------- ---------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Beginning allowance for loan losses .............................. $ 171,471 $ - $ 54 $ 171,525
Provision for loan losses ........................................ (3,172) (1) (7) (3,180)
Charge-offs ...................................................... (12,180) - - (12,180)
Recoveries ....................................................... 3,790 1 - 3,791
----------- ----------- -------- ---------
Net charge-offs ................................................ (8,390) 1 - (8,389)
----------- ----------- -------- ---------
Ending allowance for loan losses ................................. $ 159,909 $ - $ 47 $ 159,956
=========== =========== ======== =========
Net loan charge-offs to average total loans
held for investment ............................................ 0.45% 0.00% 0.00% 0.45%
=========== =========== ======== =========
SIX MONTHS ENDED JUNE 30, 2004
--------------------------------------------------------
COMMERCIAL RESIDENTIAL
REAL ESTATE REAL ESTATE OTHER TOTAL
----------- ----------- ------- ---------
(THOUSANDS OF DOLLARS, EXCEPT PERCENTS)
Beginning allowance for loan losses .............................. $ 194,957 $ 15,643 $ 2,991 $ 213,591
Provision for loan losses ........................................ 10,548 6,291 (294) 16,545
Charge-offs ...................................................... (14,166) (382) (1,236) (15,784)
Recoveries ....................................................... 136 120 118 374
----------- ----------- -------- ---------
Net charge-offs ................................................ (14,030) (262) (1,118) (15,410)
----------- ----------- -------- ---------
Ending allowance for loan losses ................................. $ 191,475 $ 21,672 $ 1,579 $ 214,726
=========== =========== ======== =========
Net loan charge-offs to average total loans
held for investment ............................................ 0.71% 0.06% 43.19% 0.63%
=========== =========== ========= =========
There were eight commercial real estate non-accrual loans held for
investment (the largest having a balance of $11.1 million) totaling $33.1
million, or 0.9% of the total loans held for investment, as of June 30, 2005. At
December 31, 2004 there were 13 commercial real estate loans totaling $82.3
million on non-accrual status, which represented 2.5% of the total loans held
for investment as of that date. Loans secured by hotel and lodging properties
represented 59% and 55% of the total commercial real estate loans on non-accrual
status as of June 30, 2005 and December 31, 2004, respectively.
REO related to commercial real estate loans was $18.1 million at June 30,
2005, consisting of six properties (the largest having a balance of $7.2
million), which were acquired through or in lieu of foreclosure on loans secured
by real estate. At December 31, 2004 there were eight commercial real estate
properties owned, totaling $21.3 million.
The level of non-performing assets fluctuates and specific loans can have a
material impact upon the total. Consideration must be given that, due to the
secured nature of the Company's loans and the presence of larger-balance loans,
the classification, and the timing thereof, of an individual loan as non-
56
accrual or REO can have a significant impact upon the level of total
non-performing assets, without necessarily a commensurate increase in loss
exposure.
The allowance for loan losses, as a percentage of total loans held for
investment decreased to 4.28% as of June 30, 2005, as compared to 4.92% as of
December 31, 2004. Total net charge-offs in the second quarter of 2005 totaled
$7.8 million, as compared to $6.2 million for the second quarter of 2004. In
both periods, substantially all of the charge-offs related to commercial real
estate loans. The net charge-off ratio for commercial real estate loans for the
first six months of 2005 was 0.45% as compared to 0.71% for the first six months
of 2004. Loans secured by hotel and lodging properties represented (4.8%) and
72.3% of the total commercial real estate net (recoveries)/charge-offs for the
first six months of 2005 and 2004, respectively.
LIQUIDITY AND CAPITAL RESOURCES
The commercial and residential real estate lending activities are financed
primarily through deposit accounts offered by FIL and which are insured by the
FDIC. FIL offers certificates of deposit and savings and money market deposit
accounts (insured by the FDIC to the legal maximum) through its 19 branches in
California. FIL minimizes the costs associated with its accounts by not offering
traditional checking, safe deposit boxes, ATM access and other traditional
retail services. Deposits totaled $8.33 billion at June 30, 2005 and are
summarized as to type as follows:
NUMBER OF TOTAL
ACCOUNTS DEPOSITS
--------- -----------
(THOUSANDS
OF DOLLARS)
Savings and money market deposit accounts ................................... 32,175 $ 1,611,750
Certificates of deposit:
Retail .................................................................... 109,922 5,139,782
Brokered .................................................................. - 1,574,204
-----------
$ 8,325,736
===========
FIL is also eligible for financing through the Federal Home Loan Bank of
San Francisco ("FHLB"), from which financing is available based upon advance
rates on certain pledged collateral and at various rates and terms. At June 30,
2005, FIL had a borrowing capacity with the FHLB of $2.52 billion, of which
$857.0 million was borrowed and outstanding. The $2.52 billion in borrowing
capacity was based upon a total of $2.81 billion in pledged loan collateral at
June 30, 2005. FIL's maximum financing availability, based upon its regulatory
assets and subject to the amount of collateral pledged and the related advance
rates, was approximately $3.79 billion as of June 30, 2005.
57
To add flexibility and capacity to its ability to fund the origination of
residential real estate loans, the Company currently maintains three separate
warehouse lines of credit. The total funding capacity of these three facilities
was $2.5 billion at June 30, 2005. Borrowings, if any, under each of the
facilities are secured by loans held for sale as pledged by FIL. There were no
amounts outstanding at June 30, 2005. The three facilities are summarized as
follows:
o $1 billion master repurchase facility ($500 million committed) with Goldman
Sachs Mortgage Company expiring in February 2006, secured by certain
residential real estate loans held for sale, interest at one-month LIBOR
plus a margin of 0.45%.
o $1 billion master loan and security facility ($500 million committed) with
Greenwich Capital Financial Products expiring in September 2005, secured by
certain residential real estate loans held for sale, interest at one-month
LIBOR plus a margin of 0.45%.
o $500 million master repurchase facility ($250 million committed) with
Credit Suisse First Boston Mortgage Capital expiring in January 2006,
secured by certain residential real estate loans held for sale, interest at
overnight LIBOR plus a margin of 0.50%.
Each of the facilities is subject to certain conditions, including but not
limited to financial and other covenants. At June 30, 2005, FIL was in
compliance with all financial and other covenants under these facilities.
In addition, FIL has a line of credit with the Federal Reserve Bank of San
Francisco ("FRB") with a borrowing capacity of $286.4 million at June 30, 2005.
There were no amounts outstanding under the line of credit with the FRB at June
30, 2005.
The Company's residential loan disposition strategy is to primarily utilize
whole loan sales and, to a lesser extent, securitizations. The Company attempts
to build multiple whole loan sale relationships to achieve diversity and enhance
market liquidity. During the first six months of 2005, the Company had
transacted whole loan sales with 16 different financial institutions, the
largest institution representing 20.4% of the total whole loan sales volume
during this period.
As a holding company, Fremont General currently pays its operating
expenses, interest expense, taxes, obligations under its various employee
benefit plans, and stockholders' dividends, and meets its other obligations
primarily from its cash on hand and intercompany tax payments and benefit plan
reimbursements from FIL. During 2002 and 2003, Fremont General had significant
net operating loss carryforwards which were used to offset taxable income
generated by FIL. As a result, intercompany payments of federal income tax
obligations from FIL, which were otherwise payable to taxing authorities, were
available for use by Fremont General for general working capital purposes. The
last of the net operating loss carryforwards were fully utilized during 2003 and
only current operating losses at Fremont
58
General will offset taxable income generated by FIL; as a result, during 2004
and 2005, Fremont General paid most of the federal income taxes it received from
FIL to the federal taxing authorities. Dividends of $5.4 million and $3.8
million were paid on Fremont General's common stock in the quarters ended June
30, 2005 and 2004, respectively; however, no assurance can be given that future
common stock dividends will be declared.
There exist certain California Franchise Tax matters pending resolution, of
which Fremont General is not yet able to make a determination of their ultimate
liability, but does not believe that the actual outcomes of these matters will
adversely impact its liquidity. It is expected that the final resolution of
these matters may take several years.
Fremont General has cash and cash equivalents of $117.9 million at June 30,
2005 and no debt maturities until March of 2009.
OFF-BALANCE SHEET ACTIVITIES
In the second quarter of 2005, the Company continued to securitize a
certain amount of its residential real estate loans. Securitization is a process
of transforming the loans into securities, which are sold to investors. The
loans are first sold to a special purpose corporation, which then transfers
them to a qualifying special-purpose entity (a "QSPE") which is legally isolated
from the Company. The QSPE, in turn, issues interest-bearing securities,
commonly known as asset-backed securities, that are secured by the future cash
flows to be derived from the securitized loans. The QSPE uses the proceeds from
the issuance of the securities to pay the purchase price of the securitized
loans. The Company does not utilize unconsolidated special-purpose entities as a
mechanism to remove non-performing assets from the consolidated balance sheets.
Securitization is used by the Company to provide an additional source of
liquidity. The QSPEs are not consolidated into the Company's financial
statements since they meet the criteria established by SFAS No. 140, "Accounting
for the Transfers and Servicing of Financial Assets and Extinguishment of
Liabilities." In general, those criteria require the QSPE to be isolated and
distinct from the transferor (the Company), to be limited to permitted
activities, and have defined limits on the assets it can hold and the permitted
sales, exchanges or distributions of its assets.
During the second quarter of 2005, the Company securitized $982.9 million
in residential real estate loans. The investors and the QSPEs do not have any
recourse to the Company if the cash flows generated by the securitized loans are
inadequate to service the securities issued by the QSPEs. At the close of each
securitization, the Company removes from its balance sheet the carrying value of
the loans securitized and adds to its balance sheet the estimated fair value of
the assets obtained in consideration for the loans which generally include the
cash received (net of transaction expenses), retained junior class securities
(referred to as residual interests) and mortgage servicing rights.
59
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The Company is subject to market risk resulting primarily from the impact
of fluctuations in interest rates upon balance sheet financial instruments such
as loans, debt and derivatives. Changes in interest rates can affect loan
interest income, gains on the sale of residential real estate loans, interest
expense, loan origination volume, net investment income, and total stockholders'
equity. The level of gain on the sale of residential real estate loans is
dependent upon the level of loan origination volume, the premium paid by the
purchasers of such loans and the gain or loss realized from hedging activities.
Each of these factors, in turn, are highly dependent upon changes in, and the
level of, interest rates and other economic factors. The Company may experience
a decrease in the amount of gain it realizes should significant interest rate
volatility occur or if other economic factors have a negative impact on the
value and volume of the loans the Company originates. The objective of the asset
and liability management activities is to provide the highest level of net
interest and investment income and to seek cost effective sources of capital,
while maintaining acceptable levels of interest rate and liquidity risk.
The Company is subject to interest rate risk resulting from differences
between the rates on, and repricing characteristics of, interest-earning loans
held for investment (and loans held for sale) and the rates on, and repricing
characteristics of, interest-bearing liabilities used to finance its loans such
as deposits and debt. Interest rate gaps may arise when assets are funded with
liabilities having different repricing intervals or different market indices to
which the instruments' interest rate is tied and to this degree, earnings will
be sensitive to interest rate changes. Additionally, interest rate gaps could
develop between the market rate and the interest rate on loans in the loan
portfolio, which could result in borrowers' prepaying their loan obligations.
The Company attempts to match the characteristics of interest rate sensitive
assets and liabilities to minimize the effect of fluctuations in interest rates.
For the Company's financial instruments, the expected maturity date does not
necessarily reflect the net market risk exposure because certain instruments are
subject to interest rate changes before expected maturity. With respect to the
Company's residential real estate loans held for sale and its unfunded loan
pipeline, the Company attempts to minimize its interest rate risk exposure
through forward loan sale commitments and other financial instruments, such as
Eurodollar futures contracts. These other financial instruments meet the
definition of a derivative under generally accepted accounting principles and,
accordingly, they are recorded in the consolidated financial statements at fair
value.
The Company is reliant upon the secondary mortgage market for execution of
its whole loan sales and securitizations of residential real estate loans. While
the Company strives to maintain adequate levels of liquidity support and capital
to withstand certain disruptions in the secondary mortgage market, a significant
disruption could adversely impact the Company's ability to fund, sell,
securitize or finance its residential real estate loan origination volume,
leading to reduced gains on sale and a corresponding decrease in revenue and
earnings. A deterioration in performance of the residential real estate loans
after
60
being sold in whole loan sales and securitizations could adversely impact the
availability and pricing of such future transactions.
Quantitative and qualitative disclosures about the Company's market risk
are included in the Company's Annual Report on Form 10-K for the fiscal year
ended December 31, 2004. There have been no material changes in such risks or in
the Company's asset and liability management activities during the six months
ended June 30, 2005.
ITEM 4. CONTROLS AND PROCEDURES
As of June 30, 2005, the Company evaluated the effectiveness of the design
and operation of the Company's disclosure controls and procedures. The
evaluation was performed under the supervision and with the participation of the
Company's management, including the Chief Executive Officer ("CEO") and Chief
Financial Officer ("CFO"). Based on that evaluation, the Company's management,
including the CEO and CFO, and its audit committee, have concluded that the
Company's disclosure controls and procedures were effective as of June 30, 2005.
There have been no changes in the Company's internal controls over
financial reporting that occurred in the last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal controls over financial reporting.
61
PART II - OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
The Company is a defendant in a number of legal actions arising in the
ordinary course of business and from the discontinuance of the insurance
operations. Management and its legal counsel are of the opinion that the
settlement of these actions, individually or in the aggregate, will not have a
material effect on the Company's business, financial position or results of
operations.
On June 2, 2004, the State of California Insurance Commissioner John
Garamendi (the "Commissioner"), as statutory liquidator of Fremont Indemnity
Company ("Fremont Indemnity"), filed suit in Los Angeles Superior Court against
Fremont General alleging the improper utilization by Fremont General of certain
net operating loss deductions ("NOLs") allegedly belonging to its Fremont
Indemnity subsidiary (the "Fremont Indemnity case") and misrepresentation and
concealment. This complaint involves issues that Fremont General considers were
resolved in an Agreement among the California Department of Insurance, Fremont
Indemnity and Fremont General (the Agreement"). The Agreement, dated July 2,
2002, was executed on behalf of the California Department of Insurance by the
Honorable Harry Low, the State of California Insurance Commissioner at that
time. Fremont General has honored all of its obligations under the Agreement.
On January 25, 2005, the Company's motions to dismiss the lawsuit brought
by the Commissioner, on behalf of Fremont Indemnity, against the Company were
argued and heard before the Superior Court of the State of California (the
"Court"). On January 26, 2005 the Court issued its rulings dismissing all the
causes of action in the complaint without leave to amend, except for the 7th
cause of action for alleged concealment by the Company of a potential
reinsurance dispute, which was dismissed with leave to amend. The Court also
found that the Company had properly utilized the NOLs in accordance with the
Agreement. In addition, the Court rejected the Commissioner's request for
findings that the Company's use of the NOLs and worthless stock deduction were
voidable preferences and/or fraudulent transfers. The Court also rejected the
Commissioner's request for injunctive relief to force the Company to amend its
prior consolidated income tax returns to remove and forgo the worthless stock
deduction for its investment in Fremont Indemnity.
On May 2, 2005 the Commissioner filed an amended complaint with regard to
the 7th cause of action on behalf of Fremont Indemnity against the Company
alleging intentional misrepresentation, concealment and promissory fraud, which
induced the Commissioner to first enter into the Agreement. On July 15, 2005,
the Court dismissed the amended complaint with 20 days leave to amend. On August
4, 2005, the Commissioner filed a further amendment to the complaint, again
alleging intentional misrepresentation, concealment and promissory fraud. The
Company continues to believe that the complaint lacks merit.
62
The Commissioner filed a second complaint against Fremont General on behalf
of Fremont Indemnity as successor in interest to Comstock Insurance Company
("Comstock"), a former affiliate of Fremont Indemnity, which was subsequently
merged into Fremont Indemnity. This case alleged similar causes of action
regarding the usage of the NOLs as in the Fremont Indemnity case as well as
improper transactions with other insurance subsidiaries and affiliates of
Fremont Indemnity. This matter was deemed a related case to the Fremont
Indemnity case. On April 22, 2005, the Court dismissed, without leave to amend,
the entire complaint. This ruling does not address or necessarily have legal
effect on the related Fremont Indemnity case. On July 22, 2005, the Company
received a Notice of Appeal to the Court's April 22, 2005 dismissal of the
complaint. The Company continues to believe that this litigation is without
merit.
ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ISSUER PURCHASES OF EQUITY SECURITIES
------------------------------------------------------------------------------------------------------------------------------
(c) TOTAL NUMBER (d) MAXIMUM NUMBER
(a )TOTAL (b) AVERAGE OF SHARES (OR UNITS) (OR APPROXIMATE DOLLAR
NUMBER OF PRICE PAID PURCHASED AS PART VALUE) OF SHARES (OR
SHARES PER SHARE OF PUBLICLY UNITS) THAT MAY YET BE
(OR UNITS) (OR UNIT) ANNOUNCED PLANS PURCHASED UNDER THE
PERIOD PURCHASED (1) (1)(2) OR PROGRAMS PLANS OR PROGRAMS
----------------------------------- ------------- ------------ ------------------- -----------------------
April 1-30, 2005 19,432 $ 0.41 19,432
------------------------------------------------------------------------------------------------------------------------------
May 1-31, 2005 3,183 $ 4.42 3,183
------------------------------------------------------------------------------------------------------------------------------
June 1-30, 2005 28,128 $ 24.01 28,128
------------------------------------------------------------------------------------------------------------------------------
Total 50,743 $ 13.74 50,743 4,324,857
=============================================================================================================================
(1) Shares of common stock acquired by the Company from participants through
purchases of shares under certain employee benefit plans at fair value
and/or reacquisition of shares under its restricted stock program at $0 per
share.
(2) Excluding the purchases of 21,566 restricted stock shares, the average
price per share was $23.90 for the three months ended June 30,2005.
63
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
a) The Annual Meeting of Stockholders was held on May 19, 2005.
b) The following directors were elected to serve until the next Annual
Meeting of Stockholders or until their successors have been elected
and qualified:
James A. McIntyre Robert F. Lewis
Louis J. Rampino Russell K. Mayerfeld
Wayne R. Bailey Dickinson C. Ross
Thomas W. Hayes
c) The directors named in (b) above were elected. The results of the
voting of the 74,223,124 shares represented at the meeting are
summarized in the following table:
VOTES
FOR WITHHELD
---------- ---------
J. A. McIntyre 72,123,179 2,099,945
W. R. Bailey 72,150,239 2,072,885
T. W. Hayes 73,194,737 1,028,387
R. F. Lewis 72,742,731 1,480,393
R. K. Mayerfeld 73,156,405 1,066,719
L. J. Rampino 72,108,587 2,114,537
D. C. Ross 72,708,993 1,516,131
d) The appointment of the accounting firm of Ernst & Young LLP as the
Corporation's Independent Auditors was ratified. The results of the
voting of the 74,223,124 shares represented at the meeting are
summarized in the following table:
FOR AGAINST ABSTAINED
---------- ------- ---------
73,251,379 944,674 27,071
ITEM 6: EXHIBITS
EXHIBIT
NO. DESCRIPTION
------- -----------------------------------------------------------------
3.1 Restated Articles of Incorporation of Fremont General
Corporation. (Incorporated by reference to Exhibit 3.1 to the
Registrant's Quarterly Report on Form 10-Q, for the period ended
June 30, 1998, Commission File Number 1-8007.)
3.2 Certificate of Amendment of Articles of Incorporation of Fremont
General Corporation. (Incorporated by reference to Exhibit 3.2 to
the Registrant's Annual Report on Form 10-K, for the fiscal year
ended December 31, 1998, Commission File Number 1-8007.)
3.3(a) Amended and Restated Bylaws of Fremont General Corporation.
(Incorporated by reference to Exhibit 3.3 to the Registrant's
Annual Report on Form 10-K, for the fiscal year ended December
31, 1995, Commission File Number 1-8007.)
64
EXHIBIT
NO. DESCRIPTION
------- -----------------------------------------------------------------
3.3(b) Fremont General Corporation Bylaw Amendment Adopted by the
Board of Directors on November 30, 2003. (Incorporated by
reference to Exhibit 3.3(b) to the Registrant's Annual Report on
Form 10-K, for the fiscal year ended December 31, 2003,
Commission File Number 1-8007.)
3.3(c) Fremont General Corporation Bylaw Amendment Adopted by the
Board of Directors on March 16, 2004. (Incorporated by reference
to Exhibit 3.1 to the Registrant's Quarterly Report on Form 10-Q,
for the period ended June 30, 2004, Commission File Number
1-8007.)
4.1 Form of Stock Certificate for Common Stock of the Registrant.
(Incorporated by reference to Exhibit 4.1 to the Registrant's
Annual Report on Form 10-K, for the fiscal year ended December
31, 2000, Commission File Number 1-8007.)
4.2 Indenture with respect to Liquid Yield Option Notes Due 2013
between the Registrant and Deutsche Bank Trust Company Americas
(formerly Bankers Trust Company.) (Incorporated by reference to
Exhibit 4.4 to the Registrant's Registration Statement on Form
S-3 filed on October 1, 1993, Registration Number 33-68098.)
4.3 Notice of Redemption to the Holders of Liquid Yield Option Notes
due 2013.
4.4 Indenture with respect to the 9% Junior Subordinated Debentures
among the Registrant, the Trust and Bank of New York (originated
with First Interstate Bank of California), a New York Banking
Corporation, as trustee. (Incorporated by reference to Exhibit
4.3 to the Registrant's Annual Report on Form 10-K, for the
fiscal year ended December 31, 1995, Commission File Number
1-8007.)
4.5 Amended and Restated Declaration of Trust with respect to the 9%
Trust Originated Preferred Securities among the Registrant, the
Regular Trustees, Chase Bank (USA), a Delaware banking
corporation, as Delaware trustee, and JPMorgan Chase Bank,
National Association, as Institutional Trustee. (Incorporated by
reference to Exhibit 4.5 to the Registrant's Annual Report on
Form 10-K, for the fiscal year ended December 31, 1995,
Commission File Number 1-8007.)
4.6 Preferred Securities Guarantee Agreement between the Registrant
JP Morgan Chase Bank, National Association, as Preferred
Guarantee Trustee. (Incorporated by reference to Exhibit 4.6 to
the Registrant's Annual Report on Form 10-K, for the fiscal year
ended December 31, 1995, Commission File Number 1-8007.)
4.7 Common Securities Guarantee Agreement by the Registrant.
(Incorporated by reference to Exhibit 4.7 to the Registrant's
Annual Report on Form 10-K, for the fiscal year ended December
31, 1995, Commission File Number 1-8007.)
4.8 Form of Preferred Securities. (Included in Exhibit 4.5).
(Incorporated by reference to Exhibit 4.8 to the Registrant's
Annual Report on Form 10-K, for the fiscal year ended December
31, 1995, Commission File Number 1-8007.)
31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
With respect to long-term debt instruments, the Registrant undertakes to provide
copies of such agreements upon request by the Commission.
65
SIGNATURES
Pursuant to the requirements 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.
FREMONT GENERAL CORPORATION
Date: August 9, 2005 /s/ LOUIS J. RAMPINO
-----------------------------------------
Louis J. Rampino
President and Chief Executive Officer
Date: August 9, 2005 /s/ PATRICK E. LAMB
-----------------------------------------
Patrick E. Lamb
Senior Vice President, Chief Financial
Officer, Chief Accounting Officer and
Treasurer
(Principal Accounting Officer)