United States Securities and Exchange Commission

Washington, D.C. 20549

Form 10-K

 þ Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934

For the Fiscal Year Ended December 31, 2006

Commission File Number 001-08007

Fremont General Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

Securities Registered Pursuant to Section 12(b) of the Act:

Common Stock, $1.00 par value

Fremont General Financing I — 9% Trust Originated Preferred Securities^(sm)

(Title of Each Class)

 

New York Stock Exchange

(Name of Each Exchange on Which Registered)

 

Securities Registered Pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  o Yes  þ No

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  o Yes  þ No

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed 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. o Yes   þNo

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).:

þ Large Accelerated Filer               o Accelerated Filer               o Non-Accelerated Filer

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes  þ No

 

The aggregate market value of the voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the last business day of the Registrant’s most recently completed second fiscal quarter, June 30, 2006:

 

Common Stock, $1.00 Par Value — $1,044,255,000

 

The number of shares outstanding of each of the issuer’s classes of common stock as of September 28, 2007:

 

Common Stock, $1.00 Par Value — 79,630,085 Shares

ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 2006

 

TABLE OF CONTENTS

 

PART I

Item 1. Business

 

OVERVIEW

Fremont General Corporation (“Fremont General” or when combined with its subsidiaries, the “Company”) is a financial services holding company. Fremont General’s financial services operations are consolidated within Fremont General Credit Corporation (“FGCC”), through its California industrial bank subsidiary, Fremont Investment & Loan (“FIL”). FIL offers certificates of deposit and savings and money market deposit accounts through its 22 retail banking branches in California. FIL’s deposit accounts are insured up to the maximum legal limit by the Federal Deposit Insurance Corporation (“FDIC”). During the fiscal year ended December 31, 2006, the Company was engaged in the commercial and residential (consumer) real estate lending businesses on a nationwide basis.

 

The reported consolidated assets and stockholders’ equity of the Company as of December 31, 2006 were $12.89 billion and $1.11 billion, respectively. The Company realized a net loss of $202.3 million for the year ended December 31, 2006.

 

Fremont General, a Nevada corporation, was incorporated in 1972. Its corporate office is located at 2425 Olympic Boulevard, 3rd Floor East, Santa Monica, California 90404 and its phone number is (310) 315-5500. Fremont General’s common stock is traded on the New York Stock Exchange under the symbol “FMT.” At December 31, 2006, the Company had approximately 3,500 employees, none of whom is represented by a collective bargaining agreement. As of December 31, 2006, officers and directors of the Company, their families and the Company’s benefit plans beneficially owned approximately 28% of Fremont General’s outstanding common stock.

 

Concurrently with the filing of this report, the Company is filing its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2007 and June 30, 2007. We urge you to read these reports, which can be obtained from Fremont General’s website at www.fremontgeneral.com, or the SEC’s website at www.sec.gov, or by contacting our Investor Relations Department at 310/315-5500 or by sending an email message to invrel@fmt.com.

 

SUBSEQUENT EVENTS

Losses on Whole Loan Sales; Decrease in Stockholders’ Equity.  During the first six months of 2007, the Company realized significant losses in its residential real estate business segment due, in large part, to the dramatic deterioration of the sub-prime real estate sector. During the first six months of 2007, the Company recorded a loss of $878.8 million on whole loan sales of residential real estate loans. This loss on whole loan sales and other factors resulted in a net loss of $855.8 million for the six months ended June 30, 2007. This in turn led to a reduction in stockholders’ equity from $1.11 billion at December 31, 2006 to $281.9 million as of June 30, 2007, a decrease of approximately $832.0 million. Stockholders’ equity per share decreased from $14.09 per share as of December 31, 2006 to $3.52 per share as of June 30, 2007.

 

Due to the Company’s exit from its residential real estate lending operations and sale of its commercial real estate lending business and related loan portfolio as described below, the Company will have a reduced revenue stream for at least the remainder of fiscal year 2007, relying on interest income as its primary source of revenue. The Company expects that it will experience a lower yield on its interest earning assets due to a higher concentration in short term investment grade securities. As a result, the Company expects that it will incur a net loss from continuing operations for at least the remainder of fiscal year 2007.

 

During the first six months of 2007, the Company recorded provisions of $517.7 million and $256.6 million to the valuation and repurchase reserves, respectively. For further information concerning the changes to these reserves see Notes 4 and 29 to the Notes to the Consolidated Financial Statements.

 

Exit from Sub-prime Mortgage Business; Cease and Desist Order.  On March 2, 2007, the Company announced that it intended to exit its sub-prime residential real estate lending operations. This move was consistent with regulatory guidelines issued that day, and was prompted by the Company’s receipt on February 27, 2007 of a proposed Cease and Desist Order (the “Order”) from the FDIC calling for the Company to make a variety of changes designed to restrict the level of lending in its sub-prime residential mortgage business as well as the

 

 

2006 ANNUAL REPORT     1

Company’s analysis of the deterioration of the sub-prime residential real estate market. On March 7, 2007, the Company announced that it had ceased entering into new funding commitments with respect to sub-prime mortgage loans, although it would honor remaining outstanding commitments.

 

On March 7, 2007, Fremont General, FGCC and FIL consented to the Order without admitting to the allegations contained in the Order.

 

The Order requires, among other things, that FIL make a variety of changes in its sub-prime residential loan origination business and also calls for certain changes in its commercial real estate lending business. As more fully described elsewhere in this report, the Company has exited its sub-prime residential real estate operations and has sold its commercial real estate lending business and related loan portfolio. In addition, the Order requires that FIL adopt a Capital Adequacy Plan to maintain adequate Tier-1 capital in relation to its risk profile. Further, the Order mandates various specific management requirements, including having and retaining qualified management acceptable to the FDIC and FIL’s California state regulator, and provides for enhanced regulatory oversight over FIL’s operations. The Order is more fully described in a Current Report on Form 8-K filed by the Company on March 7, 2007.

 

Residential Real Estate Transactions.  On March 21, 2007, the Company announced that FIL had entered into whole loan sale agreements to sell approximately $4 billion of its sub-prime residential real estate loans. On April 16, 2007, the Company announced that FIL had entered into an agreement to sell another $2.9 billion of sub-prime residential real estate loans, which represented the majority of the Company’s sub-prime residential loans held for sale that had not yet been sold. The Company is in discussions with various parties with respect to the sale of the Company’s sub-prime residential loan servicing platform and certain other assets. There can be no assurances that the Company will be able to enter into any transaction with respect to such business. In addition, given the significant market challenges that currently exist in the residential real estate sector, even if such transactions are completed, there can be no assurances that the consideration received in such sales will provide substantial benefit to the Company’s operating results or financial position.

 

Commercial Real Estate Transaction.  On July 2, 2007, FIL completed the disposition of its commercial real estate lending business and related loan portfolio to iStar Financial Inc. (“iStar”) pursuant to an Asset Purchase Agreement entered into on May 21, 2007. FIL sold its entire $6.27 billion commercial real estate loan portfolio to iStar and received $1.89 billion in cash plus a $4.21 billion participation interest in the sold portfolio. The $1.89 billion in cash represented 30% of the unpaid principal balance of the loan portfolio as of the closing, net of a purchase discount. The $4.21 billion participation interest in the total loan portfolio represented 70% of the unpaid principal balance of the loan portfolio as of the closing, net of a purchase discount. The participation interest bears interest at LIBOR + 150 basis points. FIL’s participation interest in the loan portfolio is governed by a participation agreement pursuant to which FIL is entitled to receive 70% of all principal payments on the loans sold to iStar, including with respect to any portion of the unfunded commitments with respect to such loans that are subsequently funded by iStar. Additionally, iStar purchased a majority of the non-loan assets used in the business for $50 million in cash. In connection with the transaction, iStar assumed all obligations with respect to the loan portfolio after the closing date (including the obligation to fund approximately $3.72 billion of existing unfunded commitments) and the obligations under certain assumed leases and intellectual property contracts. As of the closing date, iStar employed substantially all of the employees previously engaged in the Company’s commercial real estate lending business.

 

Transaction with Gerald J. Ford.  On May 21, 2007, Fremont General and FIL entered into an Investment Agreement with an entity controlled by Gerald J. Ford providing for the acquisition by an investor group led by Mr. Ford of a combination of approximately $80 million in exchangeable non-cumulative preferred stock of FIL and warrants to acquire additional common stock of Fremont General. On September 26, 2007, the Company announced that it had been advised by Mr. Ford that, in light of certain developments pertaining to Fremont General and FIL, Mr. Ford was not prepared to consummate such transactions on the terms set forth in the Investment Agreement. The Company said that, while it does not necessarily agree with the factual positions taken by Mr. Ford, it is in discussions with Mr. Ford concerning revised terms under which an entity controlled by Mr. Ford would proceed with an $80 million investment in exchangeable preferred stock of FIL and receive

 

 

2     FREMONT GENERAL CORPORATION

warrants to acquire additional common stock of Fremont General. There can be no assurances as to whether or when the parties may reach an agreement with respect to revised transaction terms.

 

Appointment of Independent Accountants.  On April 24, 2007, the Audit Committee of the Company’s board of directors engaged Squar, Milner, Peterson, Miranda & Williamson, LLP (“Squar Milner”) as the Company’s independent registered public accounting firm. Squar Milner replaced Grant Thornton LLP, which resigned from such position on March 27, 2007, as more fully described in the Company’s Current Report on Form 8-K filed on April 2, 2007.

 

Executive Officer Appointments.  Effective June 29, 2007, Alan W. Faigin, the Company’s Secretary, General Counsel and Chief Legal Officer, and Chief Legal Officer of FIL, was appointed interim President and Chief Executive Officer of FIL, replacing Kyle R. Walker. On July 9, 2007, Patrick E. Lamb submitted his voluntary resignation as the Company’s Senior Vice President, Treasurer, Chief Financial Officer and Chief Accounting Officer, citing his acceptance of a position with another company. Effective July 11, 2007, Ronald J. Nicolas, Jr., Executive Vice President and Chief Financial Officer of FIL, was appointed to the positions previously held by Mr. Lamb.

 

Employees.  On or around March 5, 2007, in connection with the Company’s determination to withdraw from the residential real estate loan origination business, the Company informed the majority of employees engaged in its sub-prime mortgage origination business that they were placed on paid leave and were subsequently terminated. Additionally, upon the sale of the Company’s commercial real estate lending business to iStar, approximately 131 employees became employees of iStar.

 

LENDING ACTIVITIES

During the fiscal year ended December 31, 2006, the Company’s lending operations consisted of:

 

 

During 2006, commercial loans were originated through independent loan brokers, the Company’s own marketing representatives and referrals from various financial intermediaries and financial institutions. The portfolio of commercial real estate loans held for investment before the allowance for loan losses was $6.49 billion at December 31, 2006. During 2006, residential real estate loans were originated through independent loan brokers. The portfolio of residential real estate loans held for sale was $4.95 billion at December 31, 2006.

 

 

2006 ANNUAL REPORT     3

COMMERCIAL REAL ESTATE LENDING

The Company sold its commercial real estate lending business and entire $6.27 billion commercial real estate loan portfolio to iStar and received $1.89 billion in cash plus a $4.21 billion participation interest in the sold portfolio. The Company no longer originates or owns commercial real estate loans. The Company received a participation interest in the loan portfolio sold to iStar with an outstanding principal balance of $4.04 billon as of August 31, 2007. The following is a discussion of the Company’s commercial real estate lending business and related loan portfolio as of December 31, 2006.

 

The commercial real estate lending operation’s portfolio, as of December 31, 2006, consisted of 383 commercial loans. These commercial loans were primarily short-term bridge and construction facilities which generally had maturities for up to five years. These loans, which were in senior positions, included facilities for various construction, conversion, acquisition, redevelopment and renovation purposes. The Company did not originate mezzanine or subordinated loans. It generally financed the construction of new structures or significant renovation or alteration to existing structures. This typically prohibited occupancy or the generation of rental revenue during the construction or renovation period. These loans were generally funded throughout the term as construction progressed. In 2005 and 2006, the Company had an emphasis on providing financing for various condominium conversion, construction and condotel projects. Approximately 54% of the commercial real estate portfolio outstanding at December 31, 2006 were loans for condominium related projects. These condominium projects often contained retail, hotel and other components. Approximately 65% of the commercial real estate loan balances outstanding were construction loans, 28% were bridge loans, 6% were permanent loans and 1% were single tenant credit loans. The majority of the commercial real estate loans originated were adjustable interest rate loans based upon six-month LIBOR and an applicable margin, and generally ranged in loan commitment size from $20 million to $100 million, with some loans for larger amounts. The Company’s loans held for investment, which were essentially all commercial real estate loans, are summarized as follows:

 

 

The Company originated commercial real estate loans nationwide through its nine regional production offices. The commercial real estate loans originated were substantially all held for the Company’s own portfolio. Loan origination was primarily through independent loan brokers and, to a lesser degree, directly through its own marketing representatives or referrals from various financial intermediaries and financial institutions. The products and capabilities of the commercial real estate lending operation were marketed through the use of trade advertising, direct marketing, newsletters and trade show attendance and sponsorship.

 

Commercial real estate loan participations to other financial institutions or investors were $202.0 million and $138.2 million as of December 31, 2006 and 2005, respectively. Commercial real estate new loan commitment volume, net of participations, remained constant at $5.90 billion in 2006 as compared to $5.90 billion in 2005.

 

 

4     FREMONT GENERAL CORPORATION

The following table shows the total commercial real estate new loan commitment volume, net of participations, for the periods indicated:

 

 

 

As of December 31, 2006, the average loan size was $17.1 million (or $20.8 million when loans under $1 million are excluded) and the weighted average loan-to-value ratio was approximately 72%, using the most current available appraised values and current loan balances outstanding. The following table details the commercial real estate loan portfolio as of December 31, 2006 by property collateral type and as to outstanding balances and total commitment amounts:

 

 

As of December 31, 2006, the Company had $5.02 billion in unfunded commitments for existing loans and $408.2 million in unfunded commitments for loans not yet booked, as compared to $3.40 billion and $410.5 million, respectively, as of December 31, 2005.

 

At December 31, 2006, approximately 19%, 15% and 12% of the Company’s commercial real estate loans were located in California, Florida and New York, respectively; no other state represented greater than 10% of the loan portfolio. The Company originated loans in 22 states during 2006 and held loans with the underlying property located in 30 states as of December 31, 2006. The real estate securing these loans included condominiums (construction, conversion and condotel), multi-family – other, office, retail, industrial, land

 

 

2006 ANNUAL REPORT     5

development, lodging and mixed-use properties. The loans in the portfolio were distributed by property type as follows as of the dates indicated:

 

 

The commercial real estate loan portfolio as of December 31, 2006, is stratified by loan size as follows (thousands of dollars, except percents and number of loans):

 

 

The commercial real estate loan portfolio included 27 separate loans with outstanding balances in excess of $50 million as of December 31, 2006. The Company’s largest single individual loan outstanding (net of participation) at December 31, 2006 was $103.6 million. The Company’s largest net commitment for a single loan at December 31, 2006 was $150.0 million (with $22.4 million outstanding); this commitment represents the maximum potential loan amount to the borrower; however, the amount available to borrow is generally subject to certain levels of completion or other factors on the underlying property.

 

At December 31, 2006, the Company had two loans collateralized by the same building property; each loan was for certain floors and purposes (one for condominiums and one for office space). The combined total loan commitment of the two loans was $156.6 million with a combined total outstanding loan balance of $151.5 million. As of December 31, 2006, there were nine groups of loans (separate loans on different properties) with common investors or equity sponsors for which the aggregate outstanding principal balance of the separate loans exceeded $100 million. The largest concentration is from one affiliated investment fund and totaled $210.4 million in loan principal outstanding with $343.8 million in total loan commitment and was comprised of five separate loans. All five of the loans under this concentration were performing as of December 31, 2006.

 

At December 31, 2006, 34 commercial real estate loans were classified as non-accrual, totaling $1.11 billion, and there was one commercial real estate property owned, totaling $299,000, which was acquired through or in lieu of foreclosure on loans. At December 31, 2006, there were no commercial real estate loans that were

 

 

6     FREMONT GENERAL CORPORATION

90 days or greater past due and on accrual status. There were also no loans restructured during 2006 and on accrual status as of December 31, 2006.

 

RESIDENTIAL REAL ESTATE LENDING

As described above, the Company has withdrawn from the sub-prime residential real estate loan origination business and has ceased entering into new funding commitments with respect to residential mortgage loans, as of March 2007, although the Company honored its then outstanding commitments. The following discussion relates to the residential real estate lending business as it was conducted in 2006 and is qualified in its entirety by the foregoing.

 

The residential real estate loans originated by the Company were primarily secured by first deeds of trust. These loans generally had principal amounts below $500,000, had maturities generally of 30 years and were underwritten in accordance with lending policies that included standards covering, among other things, collateral value, loan to value and the customer’s debt ratio and credit score. These loans generally were “hybrid” loans which had a fixed rate of interest for an initial period after origination, typically two to three years, after which the interest rate would be adjusted to a rate equal to the sum of six-month LIBOR and a margin as set forth in the mortgage note. This interest rate would then be adjusted at each six-month interval thereafter, subject to various lifetime and periodic rate caps and floors. The loans were generally made to borrowers who did not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, such as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) and are commonly known as “sub-prime” or “non-prime”. These borrowers generally had equity in the properties securing their loans, but had impaired or limited credit profiles or higher debt-to-income ratios than traditional mortgage lenders allow. These borrowers also included individuals who, due to self-employment or other circumstances, had difficulty verifying their income through conventional means.

 

To mitigate the higher potential for credit losses that accompanies these types of borrowers, the Company sought to maintain underwriting standards that required appropriate loan to collateral valuations. The underwriting guidelines were primarily intended to assess the ability and willingness of the potential borrower to repay the debt and to evaluate the adequacy of the mortgaged property as collateral for the loan. Generally the loans were underwritten with a view toward their resale into the secondary mortgage market through whole loan sales or securitization. During mid-2006, the Company made modifications to its loan origination parameters, with an objective of reducing its early payment delinquencies and overall loan repurchase levels. The Company’s actions were focused on reducing certain stated-income documentation loans and second mortgages, and increasing the overall credit profile of its loan originations. The Company also originated second lien mortgage loans; these had fixed rates of interest and were primarily originated contemporaneously with the origination of a first lien mortgage loan on the same property by the Company. During early 2007, however, the Company modified its underwriting guidelines to eliminate the origination of second mortgages.

 

The Company’s residential real estate loans were originated nationwide through five regional loan production offices (Brea, CA; Concord, CA; Downers Grove, IL; Tampa, FL; and Elmsford, NY). Origination was done on a wholesale basis nationally through independent loan brokers.

 

 

2006 ANNUAL REPORT     7

The Company’s loans held for sale, which are all residential real estate loans, are summarized as follows:

 

 

The Company’s residential real estate loans held for sale decreased to $4.95 billion at December 31, 2006 from $5.42 billion at December 31, 2005. During 2006, residential real estate loan originations decreased approximately 10% to $32.63 billion in 2006 from $36.24 billion in 2005. Loans were originated in 47 states during 2006, with the largest volume being originated in California (26.3%), Florida (13.8%) and New York (11.4%). The decrease in loan originations during 2006 was primarily the result of the Company changing its underwriting standards during the middle of 2006; these changes were done primarily to reduce the level of early payment defaults and to originate loans with better credit characteristics, such as a lower level of stated-income documentation loans, second mortgages and higher minimum and overall FICO scores. For stated-income documentation loans, certain types of loan applicants were qualified based upon monthly income as stated in the mortgage application; such loans typically have lower loan-to-value ratios and higher FICO scores than more traditional full-income documentation loans. The income is not verified to the extent of a full-income documentation loan; however, the income stated must be reasonable and customary for the applicant’s employment and location. During the latter half of 2005, the Company implemented pricing strategies designed to reduce the production volume of interest-only loans, while at the same time a 40-year amortization (due in 30 years) first mortgage product was introduced. Additionally, a 50-year amortization (due in 30 years) first mortgage product was introduced during the third quarter of 2006. The interest-only loans generally provide for no principal amortization for up to the first five years and are available on the 2/28 and 3/27 (e.g., 2 years fixed rate, then 28 years adjustable rate) products and the amortization of principal over the first several years is significantly less for the 40 year and 50 year mortgage as compared to the 30 year product. While interest-only loans were 23.7% of first lien loan production during 2005, they had decreased to 8.9% for 2006, while the 40 year loans increased from 6.7% to 25.9% and the

 

 

8     FREMONT GENERAL CORPORATION

50 year loans accounted for 11.6% of production for 2006 versus none in 2005. The second lien products are all fixed rate loans. The following tables profile the loan origination volume for the periods indicated:

 

 

 

2006 ANNUAL REPORT     9

 

During the fiscal year ended December 31, 2006, the residential real estate loan disposition strategy was to primarily utilize both whole loan sales and securitizations. During 2006, $32.41 billion in residential real estate loans were sold in whole loan sales to other financial institutions or through loan securitization transactions. The Company sought to maximize the premiums on whole loan sales and securitizations by closely monitoring the requirements of the various institutional purchasers, investors and rating agencies, and focusing on originating the types of loans that met their criteria and for which higher premiums were more likely to be realized. The Company also sought to maximize access to the secondary mortgage market by maintaining a number of relationships with the various institutions who purchase loans in this market. During 2006, the Company transacted whole loan sales with 21 different institutions, as compared to 21 and 24 in

 

 

10     FREMONT GENERAL CORPORATION

2005 and 2004, respectively. The table below shows the Company’s disposition of loans through such transactions by significant purchasers for the years indicated:

 

⁽¹⁾ Fremont Home Loan Trusts are the Company’s securitization entities.

 

In a whole loan sale, the Company enters into an agreement to sell the loans for cash, generally on a servicing released basis, but sometimes on a servicing retained basis. After the whole loan sale, the Company retains no interest in the underlying loans; however, during 2006, the Company typically serviced the loans on an interim basis (for compensation) for a period of time after the sale until the transfer of servicing was completed. As part of the sale process, the Company gives customary representations and warranties regarding the characteristics and the origination process of the loans, as well as generally committing to repurchase loans if a payment default occurs within a certain period following the date the loan is sold. The level of repurchases due to either a breach of a representation and warranty or due to an early payment default, as evidenced by the ratio of total repurchases to total loans sold and securitized in 2006, was 2.4% as compared to 0.9% and 0.7% in 2005 and 2004, respectively.

 

While the Company typically utilized whole loan sales as its primary loan disposition strategy, it also utilized securitizations in which the Company sold residential real estate loans to a qualifying special-purpose entity, which was established for the limited purpose of purchasing the loans and issuing interest bearing securities that represented interests in the loans. The securitization was treated as a sale and the loans sold were removed from the balance sheet of the Company. The Company would then add to its balance sheet the net cash received from the transaction as well as the fair value of retained residual interest in the securitization transaction. As of December 31, 2006, the Company performed the loan servicing functions on all 16 of the securitization transactions it completed since 2003; as such, it also recorded an asset for the mortgage servicing rights that it retained upon the completion of each securitization. During 2006, the Company entered into five securitizations totaling $6.94 billion in loan principal. During 2006, the Company generally attempted to minimize the amount of residual interests that it retained by structuring the transactions so that they included the issuance of net interest margin securities (or NIMs). The usage of NIMs concurrent with or shortly after a securitization allowed the Company to receive more of the consideration on the transaction in cash at the closing of the NIMs sale, rather than over the actual life of the loans.

 

Loan Servicing:

 

The Company was servicing approximately $26.77 billion and $22.25 billion of loans as of December 31, 2006 and 2005, respectively. The Company’s primary loan servicing platform is in Ontario, California; a second loan servicing center was opened in August 2006 in Irving, Texas to add capacity to the loan servicing operation. In

 

 

2006 ANNUAL REPORT     11

addition, during 2006 the Company continued to complete certain whole loan sales with servicing retained. The following is a breakdown of the loans being serviced by categorization as of December 31, 2006 and 2005:

 

 

FUNDING SOURCES

The commercial real estate and residential real estate lending activities were financed primarily through deposit accounts offered by FIL which are insured by the FDIC (See “Regulation and Supervision”). FIL offers certificates of deposit and savings and money market deposit accounts (insured by the FDIC up to the legal maximum) through its 22 retail banking 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. Under the Order, FIL is prohibited from accepting new or renewing existing brokered deposits; to accept new or renew brokered deposits, FIL must first obtain prior FDIC approval. Deposits totaled $9.99 billion at December 31, 2006 and are summarized as to type as follows:

 

 

Financing was available to FIL through advances from the Federal Home Loan Bank of San Francisco (“FHLB”). FIL maintained a credit line with the FHLB which has a maximum financing availability that is generally based upon a percentage of its qualifying pledged assets, to which the actual borrowing capacity is subject to collateralization and certain collateral sub-limits. FIL’s borrowing capacity can be withdrawn or limited by the FHLB if there is any significant change in the financial or operating condition of FIL. FIL’s maximum financing availability from the FHLB, based upon its level of qualifying pledged assets, was approximately $4.80 billion as of December 31, 2006.

 

The following table provides information concerning FIL’s maximum financing ability, advances, interest rates, collateral and outstanding balances on its FHLB credit line as of and for the periods indicated:

 

 

FIL also had a line of credit with the Federal Reserve Bank of San Francisco under its Primary Credit Program (the “Program”), and at December 31, 2006 had a borrowing capacity, based upon collateral pledged, of $517.9 million, with no amounts outstanding.

 

In March 2007, following the issuance of the Order and the Company’s exit from the residential real estate lending business, the FHLB limited FIL’s borrowing capacity to existing outstanding debt of $3.67 billion. By March 31, 2007, FIL had utilized $2.30 billion in proceeds from loan sales and $618.0 million in debt from a warehouse lending facility to reduce the outstanding FHLB debt to $800.0 million. As of June 30, 2007,

 

 

12     FREMONT GENERAL CORPORATION

outstanding FHLB debt was zero and all pledged collateral was released by the FHLB to FIL. FIL does not currently maintain pledged collateral with the FHLB.

 

In the first quarter of 2007, FIL pledged eligible commercial real estate loans to the Federal Reserve Bank of San Francisco under the Program. There was no outstanding debt at any time during 2007 under the Program. In June 2007, in anticipation of the iStar Transaction, FIL removed all commercial real estate loans pledged as collateral under the Program. As of June 30, 2007, FIL did not maintain any pledged collateral with the Federal Reserve Bank. FIL does not currently maintain pledged collateral with the Federal Reserve Bank.

 

In connection with its residential real estate loan origination business, which the Company has exited, the Company had four “warehouse” lines of credit with well-established financial institutions as of December 31, 2006 which were intended to fund loans prior to their sale or securitization. As of December 31, 2006, these four facilities totaled $3.00 billion in total borrowing capacity of which $2.25 billion was on a committed basis. Borrowing availability was created under the facilities through the pledging of residential real estate loans held for sale. There were no amounts outstanding on any of the facilities at December 31, 2006. Each of the facilities was subject to certain conditions, including but not limited to financial and other covenants.

 

In the first quarter of 2007, in connection with the Company’s exit from the residential real estate lending business, FIL mutually terminated two of four existing warehouse financing lines and elected to allow one financing facility to expire. As of March 31, 2007, outstanding debt on the remaining warehouse facility was $618.0 million. On April 30, 2007 all outstanding debt on this facility was repaid. In June 2007, the remaining warehouse financing facility expired. As of June 30, 2007, FIL did not have any warehouse financing lines.

 

LIQUIDITY AND CAPITAL POSITION

As of June 30, 2007, the Company’s liquidity position was comprised of cash and high grade short term investments totaling $3.23 billion. To ensure that these funds remain a source of short term liquidity the Company currently anticipates that the composition of cash and short term investments will be predominantly invested in cash, cash equivalents and short-term U.S. government and agency securities.

 

As of March 31 and June 30, 2007, the Company’s capital position was adversely impacted by the operating losses as further described above. Due to these losses, the potential impact of ongoing restructuring efforts on earnings, the adverse market conditions described above and the terms of the Order, the Company has limited access to capital at this time. The Company has submitted a capital plan to the FDIC that addresses the restoration of capital to levels that are considered well capitalized under prevailing regulatory guidelines.

 

For a description of the risks relating to our liquidity, see Item 1A — Risk Factors — “Risks Relating to our Liquidity” beginning on page 19.

 

COMPETITION

During the fiscal year ended December 31, 2006, the Company competed in markets that were highly competitive and were characterized by factors that varied based upon product and geographic region. The markets in which it competed were typically characterized by a large number of competitors who competed based primarily upon price, terms and loan structure. The Company primarily competed with banks, mortgage lenders and finance companies, many of which are larger and have greater financial resources.

 

As a result of the withdrawal of the Company from the commercial and residential real estate loan origination businesses, the Company no longer competes with mortgage companies or other finance companies engaged in the commercial and residential real estate loan origination businesses.

 

DISCONTINUED INSURANCE OPERATIONS

The Company’s discontinued insurance operations consist primarily of its property and casualty insurance segment, which was engaged in the underwriting of workers’ compensation insurance business through its subsidiary, Fremont Indemnity Company (“Fremont Indemnity”). This business was classified as discontinued in 2001. Discontinued insurance operations also include the Company’s assumed treaty and facultative reinsurance business and its life insurance business. On July 2, 2002, a Letter Agreement of Run-Off and

 

 

2006 ANNUAL REPORT     13

Regulatory Oversight among the California Department of Insurance (“DOI”), Fremont Indemnity and the Company (the “Agreement”) was entered into which provided for mandatory and contingent cash contributions by the Company, and increased regulatory control over Fremont Indemnity. The Company, based upon the results of its year-end 2002 actuarial evaluations (which reflected adverse loss development), determined that the financial position of its discontinued insurance operations had experienced further deterioration. As a result, the Company no longer expected that it would recover any of its investment in, or any of its potential future cash contributions to, its discontinued insurance operations and, as a result, incurred a charge for its discontinued insurance operations in the fourth quarter of 2002. As a result of the restrictions contained in the Agreement with the DOI, the additional adverse loss development, and actions taken by the DOI in the fourth quarter of 2002 to further restrict Fremont Indemnity’s ability to direct the run-off of the discontinued business and manage the other activities of the insurance operations, the Company concluded that it no longer had effective control of these operations. Accordingly, the assets and liabilities of the discontinued workers’ compensation insurance operations as of December 31, 2002 were removed from the consolidated balance sheets. Fremont Indemnity was placed into regulatory liquidation in July of 2003. (See Note 22 of Notes to Consolidated Financial Statements.)

 

REGULATION AND SUPERVISION

FIL is a California industrial bank and, as such, is subject to the supervision and regulation by the Department of Financial Institutions of the State of California (“DFI”) and, as an insured depository institution, by the FDIC. Fremont General is not directly regulated or supervised by the DFI, the FDIC, or any other bank regulatory authority, except with respect to guidelines concerning its relationship with its industrial bank subsidiary. FIL is examined on a regular basis by both agencies.

 

As more fully described above, on March 7, 2007, Fremont General, FIL and FGCC consented to the Order issued by the FDIC without admitting to the allegations contained in the Order. The Order requires, among other things, that FIL make a variety of changes in its sub-prime residential loan origination business and also calls for certain changes in its commercial real estate lending business. In addition, the Order requires that FIL adopt a Capital Adequacy Plan to maintain adequate Tier 1 capital in relation to the risk profile of the Company. Further, the Order mandates various specific management requirements, including having and retaining qualified management acceptable to the FDIC and the DFI, and provides for enhanced regulatory oversight over FIL’s operations. In addition, pursuant to the Order, FIL may not operate inconsistently with the FDIC’s Interagency Advisory on Mortgage Banking, Interagency Expanded Guidance for Subprime Lending Programs and Section 23B of the Federal Reserve Act. The Order prohibits FIL from entering into any contract for services essential to the operations of FIL with any affiliate, without the prior written approval of the FDIC and the DFI. See Item 1. Business — Subsequent Events.

 

California Law.  The industrial banking business conducted by FIL is governed by the California Revised Banking Law (“Revised Banking Law”), which became effective September 30, 2000, and the rules and regulations of the Commissioner of the DFI. All statutory and regulatory references to banks or commercial banks apply equally to industrial banks. An industrial bank may offer all loan and credit programs and deposit accounts that commercial banks may offer, with the significant exception that industrial banks are not authorized to offer demand deposit accounts. While FIL may not offer demand deposit accounts, it may offer money market deposit accounts.

 

Federal Law.  FIL’s deposits are insured by the FDIC to the full extent permitted by law. As an insurer of deposits, the FDIC issues regulations, conducts examinations, requires the filing of reports and generally supervises the operations of institutions to which it provides deposit insurance. The approval of the FDIC is required prior to any merger, consolidation or change in control or the establishment or relocation of any branch office of FIL. This supervision and regulation is intended primarily for the protection of the Bank Insurance Fund maintained and administered by the FDIC.

 

Safety and Soundness Standards.  As required by the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) as amended, the federal banking agencies have adopted guidelines designed to assist the federal banking agencies in identifying and addressing potential safety and soundness concerns before capital becomes impaired. The guidelines set forth operational and managerial standards relating to: (i) internal controls, information systems, and internal audit systems, (ii) loan documentation, (iii) credit underwriting, (iv) asset growth, (v) earnings, and (vi) compensation, fees, and benefits. In addition, the federal

 

 

14     FREMONT GENERAL CORPORATION

banking agencies have also adopted safety and soundness guidelines with respect to asset quality and earnings standards. These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. Under these standards, an insured depository institution should: (i) conduct periodic asset quality reviews to identify problem assets, (ii) estimate the inherent losses in problem assets and establish allowances that are sufficient to absorb estimated losses, (iii) compare problem asset totals to capital, (iv) take appropriate corrective action to resolve problem assets, (v) consider the size and potential risks of material asset concentrations, and (vi) provide periodic asset quality reports with adequate information for management and the Board of Directors to assess the level of asset risk. These guidelines also set forth standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves.

 

Federal regulations require banks to maintain adequate allowances for loan losses. The Company has an internal loan review staff that regularly reviews loan quality and ultimately reports to the Audit Committee. Management also performs an analysis which includes a detailed review of the classification and categorization of problem loans, assessment of the overall quality and collectibility of the loan portfolio, consideration of loan loss experience, trends in problem loans, concentrations of credit risk (by loan size, property types and geographic region), and current economic conditions. Based on this analysis, management, with the review and approval of the Audit Committee, determines the level of allowance required. The allowance for loan losses is allocated to different aspects of the loans held for investment, but the entire allowance is available for the loans held for investment portfolio in its entirety.

 

Federal and state banking agencies possess broad powers to take corrective and other supervisory action to resolve the problems of insured depository institutions, including but not limited to those institutions that fall below one or more prescribed minimum capital ratios. Under California law and the Federal Deposit Insurance Act, FIL may be placed into receivership by the DFI or the FDIC for a number of reasons, including the insolvency of FIL, the operation of FIL in an unsafe and unsound condition, a substantial dissipation of assets or earnings due to any violation of any statute or regulation or any unsafe or unsound practice, or the willful violation of a final cease and desist order.

 

Capital Standards.  Each federal banking agency has adopted risk-based capital regulations under which a banking organization’s capital is compared to the risk associated with its operations for both transactions reported on the balance sheet as assets as well as transactions which are off-balance sheet items, such as letters of credit and recourse arrangements. Under the capital regulations, the nominal dollar amounts of assets and the balance sheet equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as commercial loans.

 

In 1992, the FDIC adopted regulations that defined five capital categories for purposes of implementing the requirements under FDICIA. The five capital categories, which range from “well-capitalized” to “critically under-capitalized”, are based on the level of risk-based capital measures. The minimum risk-based capital ratios for Tier-1 capital to risk-weighted assets and total risk-based capital to risk-weighted assets to be classified as well-capitalized are 6.0% and 10.0%, respectively. At December 31, 2006 FIL’s Tier-1 capital and total risk-based capital ratios were 8.77% and 9.21%, respectively. The Order requires FIL to submit to the FDIC a capital plan that includes a Tier-1 capital ratio of not less than 14% of FIL’s total assets during the lifetime of the Order.

 

At March 31, 2007, FIL’s Tier-1 capital and total risk-based capital ratios were each 5.24% and at June 30, 2007, were each 5.19%.

 

In addition, bank regulatory agencies established a leverage ratio to supplement the risk-based capital guidelines. The leverage ratio is intended to ensure that adequate capital is maintained against risks other than credit risk. A minimum required ratio of Tier-1 capital to total assets of 3.0% is required for the highest quality bank holding companies that are not anticipating or experiencing significant growth. All other banking institutions must maintain a leverage ratio of 4.0% to 5.0% depending upon an institution’s particular risk profile. At December 31, 2006, FIL’s Tier-1 leverage ratio was 10.09%.

 

At March 31, 2007 and June 30, 2007, FIL’s Tier-1 leverage ratios were 5.22% and 4.53%, respectively.

 

 

2006 ANNUAL REPORT     15

Banking organizations that are experiencing or anticipating significant growth are expected to maintain capital ratios above the minimum levels. In addition to the uniform risk-based capital guidelines and leverage ratios that apply across the industry, the federal banking agencies have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios. The Order requires FIL to submit to the FDIC a capital plan that includes a Tier-1 capital ratio of not less than 14% of FIL’s total assets during the lifetime of the Order, which FIL submitted in August, 2007. There can be no assurance that the Company will achieve this capital level.

 

Limitations on Dividends.  FIL follows the limitations under the Revised Banking Law and its authorization to pay dividends is subject to provisions applicable to commercial banks, which is limited to the lesser of retained earnings or an industrial bank’s net income for its last three fiscal years, less the amount of any distributions made by an industrial bank or by any majority owned subsidiary of it to any of its stockholders during such period. However, with the prior approval of the DFI, an industrial bank may pay dividends up to the greatest of retained earnings, the industrial bank’s net income for its last fiscal year or the industrial bank’s net income for its current fiscal year.

 

In policy statements, the FDIC has advised insured institutions that the payment of cash dividends in excess of current earnings from operations is inappropriate and may be cause for supervisory action. Under the Financial Institutions Supervisory Act and the Financial Institutions Reform, Recovery and Enforcement Act of 1989, federal regulators also have authority to prohibit financial institutions from engaging in business practices which are considered to be unsafe or unsound. The Order expressly prohibits FIL from paying cash dividends without the prior written consent of the FDIC and the DFI. The Company believes it has very limited or no ability to pay cash dividends in the forseeable future.

 

Other Regulation.  FIL is also subject to federal consumer protection and other laws, including, but not limited to, the Truth In Savings Act, the Truth in Lending Act, the Community Reinvestment Act, the Real Estate Settlement Procedures Act, the Equal Credit Opportunity Act, the Home Ownership and Equity Protection Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Home Mortgage Disclosure Act, the Fair Housing Act, the USA Patriot Act, and the Gramm-Leach-Bliley Act. These laws, rules and regulations, among other things, impose licensing obligations, limit the interest rates and fees that can be charged, mandate disclosures and notices to consumers, mandate the collection and reporting of certain data regarding customers, regulate marketing practices and require the safeguarding of non-public information of customers.

 

The Sarbanes-Oxley Act of 2002.  On July 30, 2002, the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) was passed into law. The Sarbanes-Oxley Act applies to all companies required to file periodic reports with the United States Securities and Exchange Commission (“SEC”) and contains a number of significant changes relating to the responsibilities of directors, board committees, officers and auditors as well as reporting and governance obligations. The Company has implemented the necessary procedures and documentation to comply with the applicable current requirements of the Sarbanes-Oxley Act. Section 404 of the Sarbanes-Oxley Act requires that management assess the effectiveness of the Company’s internal control over financial reporting. The Company’s independent auditor is to then report on management’s assessment. The Company has incurred, and expects that it will continue to incur, additional personnel and outside professional costs as a result of complying with Section 404.

 

AVAILABLE INFORMATION: WEBSITE ACCESS TO PERIODIC REPORTS

The following information can be found on Fremont General’s website at www.fremontgeneral.com or can be obtained free of charge by contacting our Investor Relations Department at 310/315-5500 or by sending an e-mail message to invrel@fmt.com:

 

 

 

16     FREMONT GENERAL CORPORATION

 

 

We will provide any of this information without charge upon written request to, Fremont General Corporation, Investor Relations, 2425 Olympic Boulevard, Third Floor, Santa Monica, CA 90404, or by email request to invrel@fmt.com.

 

 

2006 ANNUAL REPORT     17

Item 1A. Risk Factors

 

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 our current expectations and beliefs concerning future developments and their potential effects upon us. These statements and our 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 us. Actual developments and/or results may differ significantly and adversely from our expected or currently reported results as a result of significant risks, uncertainties and factors, often beyond our control (as well as the various assumptions utilized in determining our expectations), and which include, but are not limited to, the following:

 

 

 

18     FREMONT GENERAL CORPORATION

 

 

We undertake no obligation to publicly update such forward-looking statements.

 

You should carefully consider the following risks in light of our current operating environment and regulatory status. The occurrence of any of the events described below could materially adversely affect our liquidity, results of operations and financial condition. Additional risks not presently known by us or that we currently deem immaterial may also have a materially adverse impact.

 

Risks Relating to Our Liquidity

 

The Company’s principal financing needs are to provide liquidity as needed for ongoing operations and obligations including the Company’s obligations with respect to its Senior Notes due 2009 and Junior Subordinated Debentures, of which approximately $165.9 million and $103.1 million, respectively, was outstanding as of December 31, 2006. The primary sources of funds to meet these needs include deposits, whole loan sales and capital. The Company’s ability to attract and retain deposits, to access the secondary markets, to transact whole loan sales of residential real estate loans held for sale, to access FHLB advances, to potentially obtain other sources of financing and to generate capital are critical to the Company’s ongoing operations. Market conditions, regulatory status and the Company’s financial condition, in particular FIL’s financial condition, are the primary factors governing the Company’s ability to maintain liquidity and to increase capital. Adverse developments in any of these factors could have a significant negative impact upon the Company.

 

As more fully discussed above, the Company has exited the sub-prime residential loan origination business and has sold its commercial real estate lending business and related loan portfolio to iStar. The Order imposes limitations on the ability of the Company to acquire or develop new income generating businesses without the prior written consent of the FDIC and the DFI. The inability to acquire or develop new income generating businesses may have a material adverse effect on the liquidity, financial condition and results of operation of the Company.

 

As a result of the aforementioned transactions, the Company’s exit from its residential real estate lending operations and sale of its commercial real estate lending business and related loan portfolio, the Company will have a reduced revenue stream for at least the remainder of fiscal year 2007, relying on interest income as its primary source of revenue. The Company expects that it will experience a lower yield on its interest earning assets due to a higher concentration in short term investment grade securities. As a result, the Company expects that it will incur a net loss from continuing operations for at least the remainder of fiscal year 2007.

 

As a holding company, Fremont General primarily pays its operating expenses, interest expense, taxes, obligations under its various employee benefit plans, stockholders’ dividends and other obligations, including with respect to its Senior Notes due 2009 and Junior Subordinated Debentures, from its cash on hand, dividends from FIL through FGCC, intercompany tax payments and benefit plan reimbursements from FIL. The Order expressly prohibits FIL from paying cash dividends without the prior written consent of the FDIC and the DFI. Should future dividends from FIL be limited (for example, if FIL’s regulators do not grant their consent to the payment of cash dividends), Fremont General may require funds from other sources (such as debt borrowings or equity infusions), which may be limited in availability, to meet its obligations. Fremont General’s Board of Directors has not declared any dividends since the fourth quarter of 2006. The Company believes it has very limited or no ability to pay cash dividends in the foreseeable future.

 

Following the Company’s announcement of its receipt of a proposed order to cease and desist from the FDIC and its inability to file its Annual Report on Form 10-K within the prescribed due date, the major rating agencies downgraded the Company’s ratings in a series of actions. Standard & Poor’s lowered the senior unsecured debt ratings of the Company to ’B–’ and placed the ratings on Credit Watch Negative. Moody’s lowered the Company’s senior unsecured debt rating to ’Caa3’ and placed the ratings on outlook of credit negative. These or further downgrades may adversely affect the Company’s ability to access capital and will likely result in more stringent covenants and higher interest rates under the terms of any future indebtedness. These debt and financial strength ratings are current opinions of the rating agencies. As such, they may be

 

 

2006 ANNUAL REPORT     19

changed, suspended or withdrawn at any time by the rating agencies as a result of changes in, or unavailability of, information or based on other circumstances. Ratings may also be withdrawn at the request of the Company’s management. These ratings actions could adversely affect the Company’s liquidity, financial condition and results of operation. The Company’s ability to access the capital markets is very limited as a result of the factors described herein. If it were able to access capital, it would likely be with disadvantageous conditions and pricing reflecting current factors.

 

Risks Relating to Our Withdrawal From the Residential Real Estate Loan Origination Business

 

We may not be able to enter into any transaction with a third party involving the disposition of the Company’s residential real estate operations and may incur material charges in connection with the cessation of such business.

 

On March 2, 2007, the Company announced that it had determined to exit its sub-prime residential real estate loan origination operations. The Company has entered into discussions with various parties with respect to the possible sale or other disposition of the Company’s sub-prime residential real estate servicing platform and other related assets, but there can be no assurance that the Company will be able to enter into a transaction involving such residential platform. If the Company does not dispose of its sub-prime residential real estate servicing platform, it may close these operations. The Company has and may continue to incur material charges in connection with the withdrawal from the residential real estate loan servicing business, including charges related to facilities and employees, which may have a material adverse impact upon the financial condition and results of operations of the Company.

 

Adverse changes in the whole loan markets may affect our ability to sell our residential mortgage loans held for sale for acceptable prices.

 

The value of the Company’s residential mortgage loans held for sale depends on a number of factors, including general economic conditions, interest rates, the value of the underlying collateral and legislative and regulatory actions. In addition, the Company relies on other financial institutions, primarily investment banks, to purchase mortgage loans in the whole loan market. Adverse changes in the whole loan markets, such as those currently being experienced, may affect the Company’s ability to sell its remaining residential mortgage loans held for sale for acceptable prices, which may have a material adverse effect upon the financial condition and results of operations of the Company. In addition, the Company’s residential real estate loans held for sale are exposed to changes in their fair value due to changes in interest rates.

 

We may be required to repurchase mortgage loans if we breach representations and warranties or if a payment default occurs within up to the first three months following the date the loan was sold, which could harm our financial condition and results of operations.

 

When the Company sells mortgage loans in whole loan sales to other financial institutions, it is required to make customary representations and warranties about such mortgage loans to the purchaser. The Company’s whole loan sale agreements require it to repurchase or substitute mortgage loans in the event of a breach of a representation or warranty given to the purchaser or if there exists a misrepresentation during the mortgage loan origination process. In addition, the Company may be required to repurchase mortgage loans as a result of an early payment default on a mortgage loan. The repurchased mortgage loans typically can only be financed or sold at a discount to their repurchase price, if at all. Significant repurchase activity could harm the Company’s cash flow, results of operations and financial condition.

 

The Company maintains a repurchase reserve for the estimated losses expected to be realized when the repurchased loans are sold. Determining the amount of this reserve requires management to make subjective judgments about issues that are inherently uncertain. There is a likelihood that materially different amounts would be recorded under different conditions or using different assumptions. We cannot provide assurance that we will not make significant adjustments to the repurchase reserves in subsequent periods.

 

Risks Relating to Our Participation Interest

 

As discussed above, FIL sold its entire $6.27 billion commercial real estate loan portfolio to iStar and received $1.89 billion in cash plus a $4.21 billion participation interest in the sold portfolio. The $1.89 billion in cash represented 30% of the unpaid principal balance of the loan portfolio as of the closing, net of a purchase discount. The $4.21 billion participation interest in the total loan portfolio represented 70% of the unpaid

 

 

20     FREMONT GENERAL CORPORATION

principal balance of the loan portfolio as of the closing, net of a purchase discount. The participation interest bears interest at LIBOR + 150 basis points.

 

The sale price of the portfolio was approximately 97% of the unpaid principal balance of the loans sold and the participation interest initially represented 70% of such amount so that, effectively, a 3% discount on such unpaid principal balance was reflected in the participation interest. Accordingly, even if iStar, as servicer of the portfolio of loans underlying the participation interest, were to realize only 97% of the unpaid principal balance of the loans it purchased, FIL would realize 100% of the principal amount of the participation interest. Moreover, at the closing of the transaction, iStar assumed FIL loan commitments totaling approximately $3.72 billion. Insofar as 70% of the repayments of principal on those incremental fundings (in addition to 70% of the principal repayments on the loans purchased by iStar at the closing of the sale of the portfolio) must be used to pay down the principal amount of FIL’s participation interest, FIL’s participation interest is effectively credit-enhanced as and to the extent iStar funds these loan commitments. Nevertheless, a number of factors could limit the ability of iStar, as servicer, to realize the full unpaid principal balance of the loans underlying the participation interest. For example, if a commercial real estate borrower defaults on a loan but does not have sufficient assets to satisfy the loan, iStar, as servicer, may suffer a loss of principal or interest. Additionally, in the event of a borrower bankruptcy, iStar, as servicer, may not have full recourse to the assets of the borrower, or the assets of the borrower may not be sufficient to satisfy the borrower’s obligations under the loan, and thus the participation interest may not be paid in full. Furthermore, the loan portfolio underlying the participation interest includes loans made to developers to construct prospective projects. The primary risks to the owner of construction loans are the potential for cost over-runs, the developer’s failing to meet a project delivery schedule and the inability of a borrower to sell or refinance the project at completion and repay the loan. There could be losses on a loan if the borrower is unable to sell the project or refinance the loan. In the event that iStar, as servicer, realizes losses in excess of the credit-enhancement features of the participation interest, FIL will not receive the full principal amount of its participation interest.

 

Risks Relating to Our Compliance With Applicable Regulatory Requirements and Developments

 

FIL is subject to supervision and regulation by the FDIC and the DFI. As a regulated industrial bank, FIL’s good standing with its regulators is of fundamental importance to the continuation of its business.

 

As more fully described in Part I, Item 1, “Business”, on March 7, 2007, Fremont General, FIL and FGCC consented to the Order issued by the FDIC without admitting to the allegations contained in the Order. The Order requires, among other things, that FIL make a variety of changes in its sub-prime residential loan origination business and also calls for certain changes in its commercial real estate lending business. In addition, the Order requires that FIL adopt a Capital Adequacy Plan to maintain adequate Tier-1 capital in relation to its risk profile. Further, the Order mandates various specific management requirements, including having and retaining qualified management acceptable to the FDIC and the DFI, and provides for enhanced regulatory oversight over FIL’s operations. As more fully described above, the Company has exited the sub-prime residential loan origination business and has sold its commercial real estate lending business and related loan portfolio to iStar.

 

The Company believes that the transaction with Gerald J. Ford, described in Part I, Item 1, “Business,” would have in large part addressed the requirements contained in the Order with respect to having and retaining qualified management, and would have increased FIL’s Tier-1 capital ratio. Pursuant to the Investment Agreement, at the closing of the transaction, Mr. Ford would be elected Chairman of the Board of directors of each of Fremont General and FIL, Carl Webb, an associate of Mr. Ford, would be named a director and Chief Executive Officer of each of Fremont General and FIL, and J. Randy Staff, also an associate of Mr. Ford, would be named Chief Financial Officer of each of Fremont General and FIL. Additionally, the $80 million investment in exchangeable non-cumulative preferred stock of FIL would qualify as Tier-1 capital. Mr. Ford has advised the Company that he is not prepared to consummate these transactions on the terms set forth in the Investment Agreement. Although the Company is currently in discussions with Mr. Ford concerning revised investment terms, there can be no assurances as to whether or when the parties may reach an agreement with respect to revised transaction terms, or whether any revised terms will address the requirements of the Order. In the event that discussions with Mr. Ford are abandoned, the Company intends to explore all of its other strategic alternatives. Additionally, the Company has already undertaken efforts to identify potential new management personnel regardless of the occurrence of a transaction with Mr. Ford or any other

 

 

2006 ANNUAL REPORT     21

transaction. In the event that the Company is unable to consummate an investment transaction with Mr. Ford or any other party or to otherwise obtain new management and raise capital, it will continue to be out of compliance with certain of the terms contained in the Order.

 

The Company cannot predict the further impact of the Order upon the Company’s business, financial condition or results of operations. In addition, the Company cannot predict whether the FDIC or the DFI will take any further action with respect to FIL or any of its affiliates, or, if any such further action were taken, whether such action, including the actions described in Part I, Item 1. “Business — Regulation and Supervision,” would have a material adverse effect on the Company or any of its affiliates.

 

Risks Relating to Pending and Potential Legal Proceedings

 

We are named as a defendant in a number of lawsuits seeking significant monetary damages and injunctive relief. See Item 3 — “Legal and Regulatory Proceedings” for a description of material legal actions in which we are involved. Additional litigation may be filed against us or disputes may arise in the future concerning these or other business practices. The Company believes that the lawsuits described in Item 3 are without merit and intends to vigorously defend them. However, the outcome of litigation and other legal matters is always uncertain and could materially adversely affect our liquidity, financial condition and results of operations.

 

Risks Relating to Our Retention of Key Employees and Management Personnel

 

The Company’s success has been and will continue to be influenced by its ability to attract and retain key employees and management personnel, including senior and middle management. The Company’s ability to attract and retain key employees and management personnel may be adversely affected as a result of the Order, the Company’s exit from the residential real estate loan origination business, the sale of its commercial real estate lending business and related risks and uncertainties.

 

 

22     FREMONT GENERAL CORPORATION

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

The Company leases substantially all of its office facilities in various cities for its corporate and subsidiary operations. The Company considers these facilities to be adequate for its operating needs.

 

Item 3. Legal Proceedings

 

In addition to the litigation discussed below, the Company is a defendant in a number of legal actions or regulatory proceedings arising in the ordinary course of business, from the discontinuance of the insurance operations and from regulatory examinations conducted by the FDIC and the DFI.

 

Enron Corp., et al v. J. P. Morgan Securities, et al:

In November 2003, the Trustee for Enron Corporation filed voidable preference and fraudulent conveyance actions in the United States District Court for the Southern District of New York, Case No. 03-92677, seeking return of money from the Company for the redemption of Enron commercial paper prior to maturity and during the preference period. The initial Complaint and First Amended Complaint alleged Enron redeemed $5 million of its commercial paper from the Company. On February 14, 2007, Enron filed a Second Amended Complaint which revised the claim against the Company from $5 million to $25 million. This increase represents the $20 million Enron allegedly redeemed from the Company’s former workers compensation insurance companies, now in liquidation. The Company does not believe there is any legal authority for a voidable preference or fraudulent conveyance against it for the alleged redemption of securities held by its subsidiaries. No trial date has been set. The case is currently in the discovery phase. The Company cannot predict the outcome and intends to vigorously defend against it.

 

The Bank of New York v. Fremont General Corporation:

In December 2003, The Bank of New York filed a complaint against the Company in the United States District Court for the Central District of California, Los Angeles Division, Case No. 03-9238, seeking return of approximately $14 million transferred from a custodial account with The Bank of New York when those sums were maintained as security for the Superintendent of the New York State Department of Insurance. The Bank of New York seeks return of those sums under a variety of theories. Trial has been completed in this matter resulting in a complete judgment for the Company. The Bank of New York appealed to the Ninth Circuit. Oral argument was heard on July 9, 2007. A decision by the Ninth Circuit is expected in the near future.

 

Fremont Indemnity Company (in Liquidation) v. Fremont General Corporation, et al:

On June 2, 2004, the State of California Insurance Commissioner (the “Commissioner”), as statutory liquidator of Fremont Indemnity Company (“Fremont Indemnity”), filed suit in Los Angeles Superior Court against the Company alleging it improperly utilized certain net operating loss deductions (“NOLs”) allegedly belonging to Fremont Indemnity (the “Fremont Indemnity Case”). This complaint involves issues that were considered resolved in an agreement among the California Department of Insurance, Fremont Indemnity and the Company (the “Letter Agreement”). The Letter 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. The Company has honored all of its obligations under the Letter Agreement. On July 16, 2004, the Commissioner filed a First Amended Complaint (“FAC”) adding a cause of action for concealment of an alleged reinsurance dispute and is seeking to rescind the Letter 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 FAC without leave to amend, except for the 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 Letter Agreement. In addition, the Court rejected the Commissioner’s request for findings that the Company’s use of the NOLs and worthless stock

 

 

2006 ANNUAL REPORT     23

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 a Second Amended Complaint (“SAC”) 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 Letter Agreement. On July 15, 2005, the Court dismissed the SAC with 20 days leave to amend. On August 4, 2005, the Commissioner filed a Third Amended Complaint (“TAC”) again alleging intentional misrepresentation, concealment and promissory fraud.

 

On November 22, 2005, the Court dismissed the remaining cause of action in the TAC, finding that the “Plaintiff still failed to plead any affirmative misrepresentation which is actionable.” The Court also found that the “pleading is inadequate as to damage allegations.” This ruling by the Court dismissed the only remaining cause of action in the lawsuit originally brought by the Commissioner on behalf of Fremont Indemnity against Fremont General, first reported on June 17, 2004.

 

On February 28, 2007, the Court of Appeal of the State of California reversed the trial court’s dismissal and sent the case back to the trial court for further proceedings. The Company continues to believe that this lawsuit is without merit and intends to vigorously defend against it.

 

Fremont Indemnity Company (in Liquidation as Successor in Interest to Comstock Insurance Company) v. Fremont General Corporation, et al:

The Commissioner filed an additional and separate complaint against the Company 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 February 28, 2007, the Court of Appeal of the State of California reversed the trial court’s dismissal and sent the case back to the trial for further proceedings. The Company continues to believe that this lawsuit is without merit and intends to vigorously defend against it.

 

Gerling Global Reinsurance Corporation of America v.
Fremont General Corporation, et al:

On July 27, 2005, Gerling Global Reinsurance Corporation of America (“Gerling”) filed a lawsuit in Federal District Court (the “Court”) against the Company arising out of a reinsurance treaty between Gerling and Fremont Indemnity alleging 1) Fraud/Intentional Misrepresentation and Concealment; 2) Breach of Fiduciary Duty; 3) Willful and Wanton Misconduct; 4) Negligent Misrepresentation; 5) Gross Negligence; 6) Tortuous Interference with Contract; 7) Unjust Enrichment; and 8) Breach of Contract for allegedly improper underwriting practices by Fremont Indemnity during 1998 and 1999. In October 2005, Gerling filed a First Amended Complaint (“FAC”) alleging 1) Fraud/Intentional Misrepresentation and Concealment; 2) Inducement to Breach and Breach of Fiduciary Duty and Duty of Utmost Good Faith; 3) Willful and Wanton Misconduct; 4) Negligent Misrepresentation; 5) Gross Negligence; 6) Tortuous Interference with Contract; 7) Unjust Enrichment; and 8) Inducement to Breach and Breach of Contract.

 

On December 12, 2005, the Company’s Motion to Dismiss the FAC was argued and heard before the Court. On December 15, 2005, the Court issued its Order dismissing with prejudice Gerling’s Third through Sixth Causes of Action, which asserted claims for Willful and Wanton Misconduct, Negligent Misrepresentation, Gross Negligence and Tortuous Interference with Contract, and also dismissed with prejudice that part of Gerling’s Eighth Cause of Action that alleged Inducement to Breach of Contract. The Court also dismissed the Breach of Contract claim, but granted Gerling leave to replead that claim.

 

In January 2006, Gerling filed a Second Amended Complaint (“SAC”) alleging 1) Fraud/Intentional Misrepresentation and Concealment; 2) Breach of Fiduciary Duty and Duty of Utmost Good Faith;

 

 

24     FREMONT GENERAL CORPORATION

3) Unjust Enrichment; and 4) Breach of Contract. On March 6, 2006, Fremont General’s Motion to Dismiss this SAC were argued and heard before the Court. On its own motion, the Court converted the Motion to Dismiss to a Motion for Summary Judgment and ordered that it be reset for hearing following limited discovery on the statute of limitations issues raised in the Motion.

 

On January 8, 2007, The Court heard oral argument on the Company’s Motion for Summary Judgment. On January 11, 2007, the Court granted the Company’s Motion thereby dismissing the case. On February 5, 2007, Gerling filed its Notice of Appeal. Initial briefs have been filed. A hearing date has not yet been set.

 

Insurance Commissioner v. Rampino, et al:

On or about October 12, 2006, the California Insurance Commissioner, as Liquidator on behalf of Fremont Indemnity, filed a First Amended Complaint against certain former directors and officers of Fremont Indemnity for Breach of Fiduciary Duty. The Complaint alleges the defendant’s breached their fiduciary duties by orchestrating and allowing Fremont Indemnity to engage in an inappropriate underwriting scheme that caused injury to Fremont Indemnity’s reinsurers which in turn injured Fremont Indemnity by settlements it made with those reinsurers. The allegations in this complaint are substantially the same as those alleged by Gerling Global in its lawsuit. Although neither the Company nor any of its affiliates are defendants in this lawsuit, it is indemnifying and defending these directors and officers pursuant to the indemnification clause in Fremont General’s bylaws. The case is currently in the discovery phase. Trial is currently scheduled to commence on April 14, 2008. The Company believes the lawsuit is without merit and intends to vigorously defend this matter.

 

Order To Cease & Desist:

As more fully described above, on March 7, 2007, Fremont General, FIL and FGCC consented to the Order issued by the FDIC without admitting to the allegations contained in the Order. The Order requires, among other things, that FIL make a variety of changes in its sub-prime residential loan origination business and also calls for certain changes in its commercial real estate lending business. In addition, the Order requires that FIL adopts a Capital Adequacy Plan to maintain adequate Tier 1 capital in relation to the risk profile of the Company. Further, the Order mandates various specific management requirements, including having and retaining qualified management acceptable to the FDIC and the DFI, and provides for enhanced regulatory oversight over FIL’s operations.

 

The Company cannot predict the cost of compliance with the Order or the impact of the Order upon the Company’s business, financial condition or results of operation.

 

ERISA Complaints:

In April through June of 2007, six complaints seeking class certification were filed in the United States District Court for the Central District of California against the Company and various officers, directors and employees by participants in the Company’s Investment Incentive Plan (401(k) and Employee Stock Ownership Plan (collectively “the Plans”) alleging violations of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) in connection with Company stock held by the Plans. The six complaints have been consolidated in a single proceeding. This litigation is still in its early stages. No trial date has been set. The Company believes the lawsuit is without merit and intends to vigorously defend this matter.

 

Securities Complaints:

In September 2007, three separate complaints seeking class certification were filed in the United States District Court for the Central District of California against the Company and various officers and directors alleging violations of federal securities laws in connection with published statements by the Company regarding its loan portfolio and loans held for resale during the period from May 9, 2006 through February 27, 2007. Management expects these lawsuits will be consolidated into a single proceeding. This litigation is still in its early stages. No trial date has been set. The Company believes these lawsuits are without merit and intends to vigorously defend these matters.

 

 

2006 ANNUAL REPORT     25

NAACP Litigation:

On July 11, 2007, the National Association for the Advancement of Colored People filed a lawsuit seeking class certification in United States District Court, Central District of California, against FIL and several other large home mortgage loan originators, alleging discriminatory lending practices. The lawsuit seeks injunctive relief and attorney fees, but not monetary damages, to enjoin defendants from the alleged discriminatory practices and to modify their conduct to comport with the law. The lawsuit has not yet been served on FIL. The Company believes the lawsuit is without merit with respect to FIL and intends to defend against it vigorously should FIL be served.

 

Massachusetts Attorney General Action:

In October, 2007, the Office of the Attorney General of the Commonwealth of Massachusetts filed a lawsuit in Massachusetts Superior Court in Suffolk County on behalf of borrowers in Massachusetts, alleging that Fremont General and FIL engaged in unfair or deceptive practices in connection with the origination and servicing of residential mortgage loans. The complaint seeks injunctive relief, equitable relief for Massachusetts borrowers and civil penalties. The case is in its very early stages and the Company cannot predict the outcome or the effect it will have on its financial condition. However, the Company disagrees with the allegations in the lawsuit and intends to vigorously defend against it.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

None.

 

 

26     FREMONT GENERAL CORPORATION

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Fremont General’s common stock is traded on the New York Stock Exchange (“NYSE”) under the trading symbol “FMT.” The following table sets forth the high and low sales prices of Fremont General’s common stock as reported as composite transactions on the NYSE and the cash dividends declared on the common stock during each quarter presented.

 

 

On September 28, 2007, the closing sale price of Fremont General’s common stock on the NYSE was $3.90 per share. There were 1,547 stockholders of record as of September 28, 2007.

 

The decision to pay dividends is made quarterly by the Board of Directors and is dependent on the earnings of the Company, management’s assessment of future capital needs and other factors, including the receipt of dividends from FIL. The Order expressly prohibits FIL from paying cash dividends without the prior written consent of the FDIC and the DFI. The Board of Directors has not declared any dividends since the fourth quarter of 2006. The Company believes it has very limited or no ability to pay cash dividends in the foreseeable future.

 

 

2006 ANNUAL REPORT     27

EQUITY COMPENSATION PLAN INFORMATION

The following table sets forth for each of the Company’s equity compensation plans, the number of shares of our common stock subject to outstanding stock options and Stock Rights, the weighted-average exercise price of outstanding options, and the number of shares remaining available for future award grants as of December 31, 2006.

 

 

ISSUER PURCHASES OF EQUITY SECURITIES

The following table sets forth the issuer purchases of equity securities during the fourth quarter of 2006.

 

 

STOCK PRICE PERFORMANCE

The following Stock Price Performance Graph includes comparisons required by the SEC. The Graph does not constitute soliciting material and should not be deemed filed or incorporated by reference into any other Company filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Company specifically incorporates this information by reference therein.

 

The graph below compares cumulative total return (i.e., change in stock price plus reinvestment of dividends) of Fremont General’s common stock measured against the five year cumulative total return of the Standard & Poor’s (“S&P”) Smallcap 600 Index, S&P 600 Index for Banks and a Peer Group made up of the 13 companies,

 

 

28     FREMONT GENERAL CORPORATION

excluding Fremont, selected by S&P to comprise S&P’s SmallCap 600 Index for Thrifts and Mortgage Finance, which are comparisons selected by the Company as appropriate peer groups. Peer groups that appeared in Fremont General’s 2003 Proxy Statement were discontinued by S&P when it restructured some of its Global Industry Classification Standard indexes, including the Financials sector. The Company has selected peer groups in the S&P 600 that it believes are similar to those used in our previously filed Proxy Statements with the SEC. S&P created the Thrifts and Mortgage Finance Index in its Financials sector, but because the index was new in 2003 it has no historical data beyond that date. The Peer Group is an attempt to approximate what the S&P 600 Index for Thrifts and Mortgage Finance history would have been had it existed for five years and is comprised of the companies that make up the S&P 600 Index for Thrifts and Mortgage Finance. The stock price performance shown in this graph is not necessarily indicative of, and not intended to suggest future stock price performance.

 

Comparison of Five Year Cumulative Total Returns
Among Fremont General Corporation, S&P Smallcap 600 Index,
S&P 600 Index for Banks and Peer Group⁽¹⁾

 

 

 

 

Assumes $100 invested on December 31, 2001, as adjusted for stock splits and dividends. Total returns assume dividends reinvested on ex-date.

 

 

2006 ANNUAL REPORT     29

Item 6. Selected Financial Data