-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MxHjrZS+PhK4AFnByPUVWceRT62EphsuZka4RkyVWvEokm07nsH8rLhQ9NeWZAHz +XfWE88XUxV/i03R4VJ8sA== 0000950124-98-001792.txt : 19980401 0000950124-98-001792.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950124-98-001792 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 12 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOURCE ONE MORTGAGE SERVICES CORP CENTRAL INDEX KEY: 0000801543 STANDARD INDUSTRIAL CLASSIFICATION: ASSET-BACKED SECURITIES [6189] IRS NUMBER: 382011419 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-12898 FILM NUMBER: 98579926 BUSINESS ADDRESS: STREET 1: 27555 FARMINGTON RD CITY: FARMINGTON HILLS STATE: MI ZIP: 48334-3357 BUSINESS PHONE: 8104887000 MAIL ADDRESS: STREET 1: 27555 FARMINGTON ROAD CITY: FARMINGTON HILLS STATE: MI ZIP: 48334-3357 FORMER COMPANY: FORMER CONFORMED NAME: FIREMANS FUND MORTGAGE CORP DATE OF NAME CHANGE: 19911104 10-K 1 10-K 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to --------------- ------------------ Commission file number 1-12898 SOURCE ONE MORTGAGE SERVICES CORPORATION (Exact name of registrant as specified in its charter) Delaware 38-2011419 (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification no.) 27555 Farmington Road, Farmington Hills, Michigan 48334-3357 (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: (248) 488-7000 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED 8.42% CUMULATIVE PREFERRED STOCK, SERIES A NEW YORK STOCK EXCHANGE 9.375% QUARTERLY INCOME CAPITAL SECURITIES NEW YORK STOCK EXCHANGE (SUBORDINATED INTEREST DEFERRED DEBENTURES, DUE 2025)
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE Indicated 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. Yes X No . --- --- Indicate by check mark if disclosure of delinquent filers 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. [ ] THERE IS NO AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-AFFILIATES OF THE REGISTRANT. AS OF MARCH 27, 1998, THE NUMBER OF SHARES OF THE REGISTRANT'S COMMON STOCK OUTSTANDING WAS 3,211,881. DOCUMENTS INCORPORATED BY REFERENCE. Portions of the Registrant's Annual Report to Shareholders for the year ended December 31, 1997 (Parts I, II and IV). 2 PART I ITEM 1. BUSINESS GENERAL Source One Mortgage Services Corporation, a Delaware corporation (together with its subsidiaries, the "Company" or "Source One"), is one of the largest mortgage banking companies in the United States that is not affiliated with a commercial bank. As of December 31, 1997, the Company had a mortgage loan servicing portfolio totaling $26.5 billion, including $14.9 billion of loans subserviced for others, which is serviced on behalf of approximately 234 institutional investors and numerous other security holders. As of December 31, 1997, the Company had 129 retail branch offices in 26 states and originated $4.4 billion in mortgage loans for the year then ended. As a mortgage banker, the Company engages primarily in the business of producing and selling conforming and subprime residential mortgage loans, servicing conforming residential mortgage loans and subservicing residential mortgage loans for third parties. The Company's primary sources of revenue are net servicing revenue, net interest revenue, net gain on sale of mortgages, net gain on sale of servicing, earnings from unconsolidated affiliate and other revenue. The Company is also engaged, through certain of its subsidiaries, in the sale of credit-related insurance products (such as life, disability, health, accidental death and property and casualty insurance). The Company was incorporated in 1972 and is the successor to Citizens Mortgage Corporation which was organized in 1946. The Company is a wholly-owned subsidiary of White Mountains Holdings, Inc. ("White Mountains") (formerly Fund American Enterprises, Inc.) and its parent Fund American Enterprises Holdings, Inc. ("Fund American"), a Delaware corporation organized in 1980, which was formerly known as The Fund American Companies, Inc. and Fireman's Fund Corporation. The Company's principal executive offices are located at 27555 Farmington Road, Farmington Hills, Michigan 48334-3357; its telephone number is (248) 488-7000. INDUSTRY OVERVIEW Mortgage banking is the business of serving as a financial intermediary in (i) the origination and purchase of mortgage loans, (ii) the holding of such loans while aggregating sufficient loans to form appropriate mortgage-backed security pools, (iii) the subsequent sale of such loans through pools or directly to investors, and (iv) the ongoing management or servicing of such loans during the repayment period. Mortgage bankers generate revenue in each of the four stages of the mortgage banking process. MORTGAGE LOAN PRODUCTION The Company produces residential mortgage loans through a system of retail branch offices, a specialized marketing program, mortgage brokers and a correspondent network of banks, thrift institutions and other mortgage lenders. The existence of these mortgage production sources gives the Company the flexibility to shift its production between those sources as market conditions warrant and allows it to emphasize the production mode which is most economically advantageous. Loans produced, whether through origination or purchase, include conventional, conforming and subprime residential mortgage loans as well as conforming mortgage loans which are either insured by the Federal Housing Administration ("FHA") or partially guaranteed by the Veterans Administration ("VA") (government loans). In evaluating loans purchased through its correspondent network and loans originated through its broker network, the Company applies the same quality standards as required for loans originated by the Company itself. The Company's quality control department reviews a sample of the loans purchased to determine compliance with Company standards. It is a policy of the Company to primarily produce fixed rate mortgage loans. Fixed rate mortgages tend to capture a larger share of the market in a declining interest rate environment and are less susceptible to prepayment risk than adjustable-rate mortgages. Accordingly, in a rising interest rate environment, Source One Mortgage Services Corporation and Subsidiaries Form 10-K 1 3 consumer preference for adjustable-rate mortgages tends to increase, which could have an adverse impact on the Company's mortgage production operations. However, the possible adverse impact on mortgage production may be mitigated by the positive impact on the Company's servicing portfolio. In 1997, fixed rate mortgage originations accounted for approximately 88% of the Company's total mortgage loan production as compared to 90% in 1996. The following table sets forth selected information regarding the Company's mortgage loan production:
- ---------------------------------------------------------------------------------------------------------------------- (in millions) Year ended December 31, 1997 1996 1995 1994 1993 - ---------------------------------------------------------------------------------------------------------------------- FHA/VA $ 2,985 $ 2,035 $ 1,565 $ 2,065 $ 3,453 Conventional 1,418 1,796 1,287 2,521 7,999 - ---------------------------------------------------------------------------------------------------------------------- Total production $ 4,403 $ 3,831 $ 2,852 $ 4,586 $ 11,452 - ---------------------------------------------------------------------------------------------------------------------- Retail branch originations $ 1,339 $ 1,590 $ 1,347 $ 2,005 $ 4,922 Correspondent network acquisitions 2,552 1,640 1,157 1,081 2,643 Mortgage broker originations 390 369 196 696 1,708 Specialized marketing program originations 122 232 152 804 2,179 - ---------------------------------------------------------------------------------------------------------------------- Total production $ 4,403 $ 3,831 $ 2,852 $ 4,586 $ 11,452 - ----------------------------------------------------------------------------------------------------------------------
Mortgage loans originated by the Company are subject to a defined underwriting process in order to assess each prospective borrower's ability to repay the loan requested and the adequacy of each property as collateral. In addition, the Company is subject to the underwriting guidelines of FHA, VA, the Federal Home Loan Mortgage Corporation ("FHLMC" or "Freddie Mac") and the Federal National Mortgage Association ("FNMA" or "Fannie Mae"), as well as specific contractual requirements of institutional investors who have agreed to acquire mortgage loans originated by the Company. In response to increased industry competition for producing and servicing conforming mortgage loans, the Company has decided to broaden its product line by offering higher margin products. The Company has recently begun to produce 203(k) (FHA home improvement) loans, manufactured housing loans, subprime loans and 125% loan-to-value ("125% LTV") second mortgage loans. The 203(k) loans and the manufactured housing loans are being sold into agency pools with servicing retained. The subprime and 125% LTV loans are being originated for a fee and sold to third parties on a servicing released basis. The Company is currently expanding its capability to service and subservice subprime loans and to subservice 125% LTV loans. Although these higher margin products are a new focus for the Company, they accounted for less than 2% of total production in 1997 and are currently expected to account for less than 10% of total production in 1998. RETAIL BRANCH OFFICES. As of December 31, 1997, the Company had 129 retail branch offices in 26 states. Each office has sales representatives who originate mortgage loans through contacts with real estate brokers, builders, developers and others, as well as through direct contact with homebuyers. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 2 4 As of December 31, 1997, the Company's retail branch offices were located in the following states:
- ------------------------------------------------------------------------------------------------------------------- Number Number Number State of Offices State of Offices State of Offices - ------------------------------------------------------------------------------------------------------------------- California 29 Florida 4 Tennessee 2 Washington 20 Missouri 4 Arkansas 1 New York 10 Ohio 4 Georgia 1 Texas 8 Oregon 4 Kansas 1 Arizona 6 Alaska 2 Maryland 1 Michigan 6 Kentucky 2 Rhode Island 1 Nevada 6 Massachusetts 2 Vermont 1 Illinois 5 New Jersey 2 Virginia 1 Colorado 4 Pennsylvania 2 - -------------------------------------------------------------------------------------------------------------------
Most branch office originations are referred to regional operating centers for preparation of loan documentation, evaluation of compliance with the Company's underwriting conditions and closing of the loans. CORRESPONDENT NETWORK. The Company conducts a program through which it agrees to purchase mortgage loans from a network of banks, thrift institutions and other mortgage lenders. The funding price for such loans is set by the Company on a daily basis. In addition, the Company pays a premium for the release of servicing rights, which is negotiated on a case-by-case basis. As of December 31, 1997 there were approximately 236 participants in the Company's correspondent network, with no single participant or group of affiliated participants accounting for more than 12% of the Company's total mortgage loan originations. MORTGAGE BROKERS. The Company conducts a program through which it closes loans originated by a network of mortgage brokers. The funding price for such loans is set by the Company on a daily basis. The mortgage broker receives compensation equivalent to the difference between the Company's pricing schedule and the closing price. As of December 31, 1997 there were approximately 425 active participants in the Company's mortgage broker network, with no single broker or group of affiliated brokers accounting for more than 1% of the Company's total mortgage loan originations. SPECIALIZED MARKETING PROGRAM. The Company also generates mortgage loan originations primarily by responding to refinancing requests from the population of loans currently serviced by the Company. The products currently offered by the Specialized Marketing Program consist of purchase money first mortgages, home equity lines of credit, closed-end second mortgages, refinancing and relocation assistance. SALES OF LOANS The Company sells loans either through mortgage-backed securities issued pursuant to programs of the Government National Mortgage Association ("GNMA" or "Ginnie Mae"), FNMA and FHLMC or to private investors. Most loans are aggregated in pools of $1.0 million or more, which are purchased by private investors after having been guaranteed by GNMA, FNMA or FHLMC. Substantially all GNMA securities are sold without recourse to the Company for loss of principal in the event of a subsequent default by the mortgage borrower due to the underlying FHA and VA insurance. Prior to December 1992, substantially all conventional securities were sold with recourse to the Company to the extent of insufficient proceeds from private mortgage insurance, foreclosure and other recoveries. Since December 1992, conventional loans have been sold without recourse to the Company. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 3 5 The following table summarizes the principal amount of the Company's loans sold:
- -------------------------------------------------------------------------------------------------------------------- Year Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------------------------------------------- Principal Principal Principal amount Percentage amount Percentage amount Percentage (in millions) of total (in millions) of total (in millions) of total - -------------------------------------------------------------------------------------------------------------------- GNMA $ 2,763 65.55% $ 1,678 42.82% $ 1,252 46.30% FNMA 983 23.32 1,384 35.32 927 34.29 FHLMC 283 6.72 453 11.56 251 9.28 Other 186 4.41 404 10.30 274 10.13 - -------------------------------------------------------------------------------------------------------------------- Total loan sales $ 4,215 100.00% $ 3,919 100.00% $ 2,704 100.00% - --------------------------------------------------------------------------------------------------------------------
Servicing agreements relating to mortgage-backed securities issued pursuant to the programs of GNMA, FNMA and FHLMC require the Company to advance funds to make the required payments to investors in the event of a delinquency by the borrower. The Company expects that it would recover most funds advanced upon cure of default by the borrower or at foreclosure. However, in connection with VA partially guaranteed loans and certain conventional loans (which may be, at most, partially insured by private mortgage insurers), funds advanced may not cover losses due to potential declines in collateral value. The Company is subject to limited amounts of principal risk with respect to these loans since the insurer has the option to reimburse the servicer for the lower of fair market value of the property or the mortgage loan outstanding, in addition to the VA guarantee on the loan. In addition, most of the Company's servicing agreements for mortgage-backed securities typically require the payment to investors of a full month's interest on each loan although the loan may be paid off (by optional prepayment or foreclosure) other than on a month-end basis. In this instance, the Company is obligated to pay the investor interest at the pass-through rate from the date of the loan payoff through the end of that calendar month without reimbursement. The Company, through private placements and public offerings, has also sold mortgage loans through the issuance of mortgage pass-through certificates. The Company issued $521.7 million of real estate mortgage investment conduit ("REMIC") certificates through December 31, 1990. The Company is the primary servicer for these REMIC certificates, which were sold pursuant to five separate trusts that have no recourse provisions. The Company has not issued any mortgage pass-through certificates since 1990, however, the Company may offer additional mortgage pass-through certificates in the future if economic and market conditions warrant. Historically, the Company's sales of loans have generated net gains. However, if secondary market interest rates decline after the Company obtains a mandatory forward commitment for a loan, the loan may not close and the Company may incur a loss from the cost of covering its obligations under such commitment. If secondary market interest rates increase after the Company commits to an interest rate for a loan, and the Company has not obtained a forward commitment, the Company may incur a loss when the loan is subsequently sold. To minimize this risk, the Company obtains mandatory and optional forward commitments of up to 120 days to sell mortgage-backed securities with respect to all loans which have been funded and a substantial portion of loans in process ("pipeline") which it believes will close. The Company's risk management function closely monitors the mortgage loan pipeline to determine appropriate forward commitment coverage on a daily basis. In addition, the risk management area seeks to reduce counterparty risk by committing to sell mortgage loans only to approved dealers, with no dealer having in excess of 20% of current commitments. The Company currently transacts business with seventeen approved dealers. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 4 6 LOAN SERVICING Mortgage loan servicing consists primarily of (i) collecting principal, interest and funds to be escrowed for tax and insurance payments from mortgage loan borrowers; (ii) remitting principal and interest to mortgage loan investors; (iii) paying property taxes and insurance premiums on mortgaged property; (iv) in some cases, advancing uncollected payments to mortgage loan investors; (v) administering delinquent loans; (vi) supervising foreclosures in the event of unremedied defaults; and (vii) performing all related accounting and reporting activities. Servicing generates cash income in the form of fees, which represent a percentage of the declining outstanding principal amount of the loans serviced and are collected from each mortgage loan payment received plus any late charges. The Company currently retains the rights to service substantially all of the conforming mortgage loans it produces, while selling the rights to service its subprime and 125% LTV production. The Company is currently expanding its capability to service and subservice subprime loans and to subservice 125% LTV loans. In addition, the Company may acquire the rights to service or subservice a mortgage loan portfolio without originating or acquiring the underlying mortgage loans. The Company customarily makes such purchases of servicing rights from banks, thrift institutions and other mortgage lenders. The fees paid to acquire such servicing rights are negotiated on a case-by-case basis. The Company purchased the rights to service $.04 billion, $2.8 billion and $4.7 billion of mortgage loans from third parties during 1997, 1996 and 1995, respectively. During 1996 and through 1997, the Company forged a new strategy with respect to its servicing operations. A major focus of this strategy is reducing exposure to interest rate risk, which increases with the size of an owned servicing portfolio. To reduce the exposure, the Company took steps to reduce its owned servicing portfolio and expand its subservicing business in the first quarter of 1997. In February 1997, the Company sold $17.0 billion of its nonrecourse mortgage servicing portfolio to a third party for adjusted proceeds of $266.9 million and recognized a pretax loss of $4.3 million on the sale and related assumption of subservicing. The Company recorded an additional loss of $3.7 million in the fourth quarter of 1997 in connection with the amendment of the subservicing arrangement which extended the Company's subservicing responsibilities for one additional year at less favorable terms than the original agreement provided. The Company will continue to service these loans pursuant to a subservicing agreement at least until March 1999, June 1999 and August 1999 for FHLMC loans, GNMA loans and FNMA loans, respectively. The subservicing period can be extended for a maximum of one year beyond these dates at the option of the purchaser. During 1996 and 1995, the Company sold the rights to service a total of $3.3 billion and $11.0 billion respectively, of mortgage loans to third parties resulting in a pretax gain of $10.1 million and $40.0 million, respectively. In January 1998, the Company sold the rights to service approximately $1.1 billion of mortgage loans to third parties resulting in a pretax gain of approximately $2.0 million. The Company has entered into agreements to sell additional rights to service approximately $2.6 billion of mortgage loans to third parties. The Company expects to close the sale of rights to service approximately $2.1 billion of these mortgage loans by the end of March 1998 and the remainder during the second quarter of 1998 and expects to realize pretax gains on the sales. In 1994, the Company sold the rights to service $3.9 billion of mortgage loans to a third party and continued to service these loans pursuant to a subservicing agreement. The gain of $19.9 million was deferred and was being recognized over the five-year life of the subservicing agreement. In the fourth quarter of 1996, the third party sold the rights to service approximately $1.0 billion of these mortgage loans, representing approximately 25% of the total loans subserviced by the Company for the third party. Accordingly, the Company recognized an additional $2.4 million of the deferred gain in 1996, representing approximately 25% of the deferred balance at the time of sale. In the fourth quarter of 1997, the third party sold the rights to service the remaining portfolio of loans. As a result, the Company recognized the $4.4 million remaining balance of the deferred gain . In 1997 and 1996, the Company recognized deferred gains totaling $6.9 million and $6.1 million, respectively, as part of mortgage servicing revenue. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 5 7 The following table summarizes the changes in the Company's mortgage loan servicing portfolio, excluding loans sold but not transferred:
- -------------------------------------------------------------------------------------------------------------------- (in millions) Year ended December 31, 1997 1996 1995 1994 1993 - -------------------------------------------------------------------------------------------------------------------- Servicing portfolio owned at beginning of year $ 26,410 $ 27,792 $ 35,274 $ 38,403 $ 37,312 Mortgage loan production 4,403 3,831 2,852 4,586 11,452 Servicing acquisitions and other 36 2,789 4,674 3,707 6,368 - -------------------------------------------------------------------------------------------------------------------- Total servicing in 4,439 6,620 7,526 8,293 17,820 - -------------------------------------------------------------------------------------------------------------------- Regular payoffs 1,236 3,006 2,271 4,728 13,563 Sale of servicing 17,018 3,302 10,973 3,868 -- Principal amortization, foreclosures and other 968 1,694 1,764 2,826 3,166 - -------------------------------------------------------------------------------------------------------------------- Total servicing out 19,222 8,002 15,008 11,422 16,729 - -------------------------------------------------------------------------------------------------------------------- Servicing portfolio owned 11,627 26,410 27,792 35,274 38,403 - -------------------------------------------------------------------------------------------------------------------- Subservicing portfolio 14,919 2,791 4,039 4,294 -- - -------------------------------------------------------------------------------------------------------------------- Balance at end of year $ 26,546 $ 29,201 $ 31,831 $ 39,568 $ 38,403 ====================================================================================================================
The Company closely monitors the rate of delinquencies and foreclosures incident to its servicing portfolio. The following table summarizes the Company's delinquency and foreclosure experience with respect to residential mortgage loans serviced by the Company:
- --------------------------------------------------------------------------------------------------------------------- (% of total residential loans serviced and subserviced) December 31, 1997 1996 1995 1994 1993 - --------------------------------------------------------------------------------------------------------------------- 31-59 days past due 4.77% 4.74% 3.99% 3.15% 3.41% 60-89 days past due .96 .95 .70 .54 .58 90 days or more past due .62 .55 .59 .38 .45 - --------------------------------------------------------------------------------------------------------------------- Total delinquencies 6.35% 6.24% 5.28% 4.07% 4.44% - --------------------------------------------------------------------------------------------------------------------- Foreclosures 1.18% .93% .80% .77% .92% - ---------------------------------------------------------------------------------------------------------------------
The increase in delinquencies in 1997, 1996 and 1995, is primarily the result of servicing portfolio acquisitions made by the Company during the fourth quarters of 1996 and 1995. The delinquency rates of these portfolios, which the Company acquired on favorable terms considered to be reflective of these higher delinquency rates, were higher than the Company's historical average delinquency rate. The Company has established an allowance for mortgage loan losses which totaled $12.8 million and $15.4 million as of December 31, 1997 and 1996, respectively. Excluding the allowance of $2.6 million included in the balance at December 31, 1996 relating to a commercial real estate owned property the Company sold during 1997, the allowance for losses on the Company's owned servicing portfolio remained unchanged. In addition, the Company's valuation allowance for its capitalized servicing asset which relates to its principal recourse portfolio includes an $8.2 million and $7.3 million reserve at December 31, 1997 and 1996, respectively, for estimated losses on the corresponding loans. Considering the significant decrease in the size of its owned servicing portfolio during 1997, the Company believes that the allowances are adequate to provide for estimated uninsured losses on its mortgage servicing portfolio. The value of the Company's capitalized servicing asset is affected by changes in mortgage interest rates. Interest rates directly influence prepayment rates as well as other assumptions used in valuing the asset. In order to offset changes in the value of its capitalized servicing asset and to mitigate the effect on earnings of higher amortization and impairment which results from increased prepayment activity, the Company invests in various financial instruments. As interest rates decline, prepayment activity Source One Mortgage Services Corporation and Subsidiaries Form 10-K 6 8 generally increases, thereby reducing the value of the capitalized servicing asset, while the value of the financial instruments increases. Conversely, as interest rates increase, the value of the capitalized servicing asset increases while the value of such financial instruments decreases. The financial instruments utilized by the Company include interest rate floor contracts ("floors") and principal-only ("P/O") swaps. With respect to the floors, the Company is not exposed to losses in excess of its initial investment in the floors. The Company's exposure to loss in the P/O swaps is related to changes in the market value of the underlying P/O security over the life of the contract. RELATED ACTIVITIES In conjunction with its mortgage origination and servicing activities, the Company provides certain credit-related insurance products (such as life, disability, health, accidental death and property and casualty insurance) through subsidiaries. The insurance subsidiaries act as agents and receive fees based on premium value, but do not assume any insurance risk. Insurance products are sold through (i) solicitation at the time of mortgage application, (ii) direct mail solicitation shortly after mortgage loan closing, (iii) solicitation by a direct solicitor and (iv) resolicitation of the Company's servicing portfolio on an annual basis. At certain locations, personal solicitation by Company staff is permitted by state regulations which determine allowable insurance sales practices. The fees recognized under these programs were as follows:
- -------------------------------------------------------------------------------------------------------------------- (in thousands) Year ended December 31, 1997 1996 1995 1994 1993 - -------------------------------------------------------------------------------------------------------------------- Insurance revenue $ 4,240 $ 4,554 $ 4,762 $ 4,582 $ 5,039 - --------------------------------------------------------------------------------------------------------------------
CERTAIN BUSINESS CONDITIONS Changes in the economy or prevailing interest rates can have significant effects, including material adverse effects, on the mortgage banking business and the Company. Inflation and changes in interest rates can have differing effects on various aspects of the Company's business, particularly with respect to marketing gains and losses from the sale of mortgage loans, mortgage loan production, the value of the Company's servicing portfolio and net interest revenue. Historically, the Company's loan originations and loan production income have increased in response to falling interest rates and have decreased during periods of rising interest rates. Periods of low inflation and falling interest rates tend to reduce loan servicing income and the value of the Company's mortgage loan servicing portfolio because prepayments of mortgages increase and the average life of loan servicing rights is shortened. Conversely, periods of increasing inflation and rising interest rates tend to increase loan servicing income and the value of the Company's mortgage loan servicing portfolio because prepayments of mortgages decline and the average life of loan servicing rights is lengthened. To mitigate the Company's exposure to changes in market interest rates, the Company utilizes various derivative financial instruments. Refer to "Note 23 to the Consolidated Financial Statements" on pages 33-37 of the Company's 1997 Annual Report to Shareholders, herein incorporated by reference. COMPETITION The Company competes nationally and locally with other mortgage bankers, state and national banks, thrift institutions and insurance companies. National banks and thrift institutions have substantially more flexibility in their loan origination programs than the Company, which must originate loans meeting the standards of the secondary market. Mortgage lenders compete primarily with respect to price and service. Competition may also occur on mortgage terms and closing costs. The Company competes, in part, by using its commissioned sales force to maintain close relationships with real estate brokers, builders, developers and members of its correspondent and broker networks. In the opinion of management, no single mortgage lender dominates the industry. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 7 9 REGULATION The Company is subject to the rules and regulations of, and examinations by, investors and insurers, including, FNMA, FHLMC, GNMA, FHA and VA with respect to originating, selling and servicing mortgage loans. Lenders are required to submit audited financial statements annually and to maintain specified net worth levels which vary depending on the amount of loans serviced and annual production. Mortgage loan origination activities are also subject to fair housing laws, the Equal Credit Opportunity Act, the Federal Truth-in-Lending Act, the Real Estate Settlement Procedures Act, the Fair Credit Reporting Act, licensing laws, usury laws, the Home Mortgage Disclosure Act and the regulations promulgated thereunder which, among other things, prohibit discrimination in residential lending and require the disclosure of certain information to borrowers. There are various other state laws and regulations affecting the Company's mortgage banking and insurance operations. The Company's internal audit and quality control departments monitor compliance with these laws and regulations. EMPLOYEES As of December 31, 1997, the Company employed approximately 1,572 persons (of whom approximately 370 were engaged in loan servicing activities and approximately 1,202 were engaged in residential loan production activities, administrative and managerial responsibilities). None of the Company's employees are covered by a collective bargaining agreement. Management believes that the Company's employee relations are good. FORWARD-LOOKING STATEMENTS From time to time, the Company may publish forward-looking statements relating to such matters as anticipated financial performance, business prospects, new products and similar matters. Such information is often subject to risks and uncertainties. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause its actual results and experience to differ materially from the anticipated results or other expectations expressed in its forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Company's business include those discussed elsewhere herein (such as loan servicing, competition and regulation). ITEM 2. PROPERTIES The Company owns its principal executive offices in Farmington Hills, Michigan which house the majority of the Company's employees. The Company leases several other office facilities and operating equipment under cancelable and noncancelable agreements. Most leases contain renewal clauses. ITEM 3. LEGAL PROCEEDINGS Various claims have been made against the Company in the ordinary course of business. Management believes that any liabilities which could result from such claims would not materially affect the Company's financial position and results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 8 10 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Reported on page 4 of the Company's 1997 Annual Report to Shareholders, herein incorporated by reference. ITEM 6. SELECTED FINANCIAL DATA Reported on pages 3-4 of the Company's 1997 Annual Report to Shareholders, herein incorporated by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reported on pages 5-14 of the Company's 1997 Annual Report to Shareholders, herein incorporated by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial statements reported in the consolidated financial statements of the Company and the notes thereto and the report thereon of KPMG Peat Marwick LLP, independent auditors, appearing on pages 15-45 of the Company's Annual Report to Shareholders, herein incorporated by reference. Selected Quarterly Financial Data reported on page 46 of the Company's 1997 Annual Report to Shareholders, herein incorporated by reference. The report of Ernst & Young LLP, independent auditors, included as Exhibit 13(b) hereto. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On January 24, 1997, the Company, upon recommendation of the Audit Committee of the Board of Directors of its ultimate parent, Fund American Enterprises Holdings, Inc., appointed KPMG Peat Marwick LLP as its independent auditors for the fiscal year ending December 31, 1997, to replace Ernst & Young LLP ("Ernst & Young") effective upon the date of Ernst & Young's report on the consolidated financial statements of the Company for the year ended December 31, 1996. In connection with the audits of the two years ended December 31, 1996, there were no disagreements with Ernst & Young on any matter of accounting principles or practices, financial statement disclosure, or auditing scope and procedures which, if not resolved to their satisfaction, would have caused them to make reference in connection with their opinion to the subject matter of the disagreement. The Company has requested Ernst & Young to furnish a letter addressed to the Commission stating whether it agrees with the above statements. A copy of that letter, dated March 27, 1997, is filed as Exhibit 16 (a) hereto. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 9 11 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- -------------------------------------------------------------------------------------------------------------------- Board of Directors (as of March 27, 1998) Director Name Age Since - -------------------------------------------------------------------------------------------------------------------- Michael C. Allemang 55 1993 Raymond Barrette 47 1998 Terry L. Baxter 52 1994 Robert R. Densmore 49 1986 Mark A. Janssen 39 1997 Francis X. Mohan 58 1997 James H. Ozanne 54 1996 Roger K. Taylor 45 1995 - --------------------------------------------------------------------------------------------------------------------
Mr. Allemang has served as a director, Executive Vice President and Chief Financial Officer of the Company since November 1993. He was a director and Vice President of Fund American Enterprises, Inc. from August 1992 to December 1993. Mr. Allemang was formerly Senior Vice President of Fireman's Fund Insurance Company ("Fireman's Fund") from 1991 to 1992 and served as Vice President and Treasurer of Fund American from 1989 to 1991 and Vice President of Fireman's Fund from 1986 to 1991. Mr. Barrette has served as a director of the Company since February 1998. He has served as Executive Vice President and Chief Financial Officer of Fund American Enterprises Holdings, Inc. since November 1997. He holds the same positions with, and is a director of White Mountains Holdings, Inc. He is also a director of White Mountains Insurance Company and Fund American Enterprises, Inc. From 1994 to 1996, he was an actuarial consultant with Tillinghast-Towers Perrin. He joined Fireman's Fund Insurance Company in 1973 and held various positions with that company, including Chief Actuary and Chief Financial Officer. Prior to his departure in 1993, he was a Director and Executive Vice President of Fireman's Fund Insurance Company and President of its Personal Insurance Division. Mr. Baxter has served as a director of the Company since 1994. He served as Chairman of the Company from June 1996 to March 1997. He has served as President of White Mountains Holdings, Inc. since February 1997 and President of Fund American Enterprises, Inc. from January 1994 to February 1997. He was the Managing Director of the National Transportation Safety Board from 1990 to 1993, and prior to that was Senior Vice President of the National Bank of Washington. Mr. Baxter previously served as Assistant Director of The Office of Management and Budget under President Reagan and was a Vice President of GEICO Corporation. Mr. Baxter is also a director of Fund American Enterprises, Inc., Centricut, LLC., Main Street America Holdings, Inc., White Mountains Holdings, Inc. and White Mountains Insurance Company. Mr. Densmore has served as a director of the Company since 1986. He has served as Executive Vice President of the Company's Servicing Division since 1987. He was the Chief Financial Officer from 1978 to 1987. Mr. Densmore joined the Company in 1976. Mr. Janssen has served as a director of the Company since November 1997. He has served as Executive Vice President - Production and Capital Markets since 1997. He has also served as Executive Vice President of Capital Markets from 1996 to 1997, Senior Vice President of Finance from 1992 to 1996, Corporate Vice President and Controller from 1991 to 1992 and Vice President of the Financial Division from 1988 to 1992. Mr. Janssen joined the Company in 1981. Mr. Mohan has served as a director of the Company since November 1997. He assumed the position of President and Chief Executive Officer of the Company in September of 1997. Mr. Mohan was with Source One Mortgage Services Corporation and Subsidiaries Form 10-K 10 12 Beneficial Corporation from 1963 to 1997. He held various positions which included District Manager, Operating Vice President, Senior Vice President and President of several Beneficial subsidiaries. Mr. Ozanne has served as a director of the Company since August 1996. He has served as Chairman of the Company since March 1997 and as President of Fund American Enterprises, Inc. since February 1997. He is the founder and principal of Greenrange Partners. He was Chairman, President & Chief Executive Officer of Nations Financial Holdings Corporation (formerly U S WEST Capital Corporation) from 1989 to 1996. From 1983 to 1989 he was Executive Vice President, Asset Management and Consumer Groups, of General Electric Capital Corporation ("GECC"), Stamford, Connecticut and held other executive positions with GECC. He is currently a director of Financial Security Assurance Holdings Ltd.("FSA"), a publicly-held financial guaranty insurer with securities listed on the New York Stock Exchange. Mr. Taylor has served as a director of the Company since August 1995. He has served as President of FSA since November 1997 and its Chief Operating Officer since May 1993. He is also a member of FSA's management review committee for structured transactions and its underwriting committee for municipal transactions. Prior to joining FSA in 1990 as an advisor for its new municipal bond insurance business, Mr. Taylor was an Executive Vice President, founder and executive committee member of Financial Guaranty Insurance Company. He is also a director of FSA. COMMITTEES OF THE BOARD OF DIRECTORS The major committees of the Board of Directors, committee membership and the functions of those committees are described below. EXECUTIVE COMMITTEE. The members of the Executive Committee are: James H. Ozanne (Chairman), Terry L. Baxter and Francis X. Mohan. The Executive Committee has been delegated all of the powers and authority of the Board on all but such matters which are reserved to the Board by the Delaware General Corporate Law. AUDIT COMMITTEE. The members of the Audit Committee are: Roger K. Taylor (Chairman) and Raymond Barrette. The Audit Committee exercises the powers of the Board in the management of the business and affairs of the Company regarding the accounting, reporting and financial control practices of the Company. It reviews the qualifications of the independent certified public accountants, makes recommendations to the Board as to their selection, reviews the plan, fees and results of their audit and reviews their non-audit services and related fees. HUMAN RESOURCES COMMITTEE. The members of the Human Resources Committee are: Terry L. Baxter (Chairman), James H. Ozanne and Roger K. Taylor. The Human Resources Committee establishes compensation for executive officers of the Company. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 11 13
- --------------------------------------------------------------------------------------------------------------- EXECUTIVE OFFICERS (as of March 27, 1998) Executive Officer Name Age Position Since - --------------------------------------------------------------------------------------------------------------- Michael C. Allemang 55 Executive Vice President 1993 and Chief Financial Officer John A. Courson 55 Senior Vice President; 1990 President and Chief Executive Officer of Central Pacific Mortgage Company Robert R. Densmore 49 Executive Vice President 1983 Mark A. Janssen 39 Executive Vice President 1996 and Secretary Francis X. Mohan 58 President and 1997 Chief Executive Officer - ---------------------------------------------------------------------------------------------------------------
Mr. Courson has served as a Senior Vice President of the Company and President and Chief Executive Officer of Central Pacific Mortgage Company ("Central Pacific"), a wholly-owned subsidiary of the Company, since July 1990. Prior to that he was President and Chief Operating Officer of Fundamental Mortgage Corporation of Dallas, Texas. Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's directors and executive officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of the Company's equity securities. Officers, directors and greater than 10% stockholders are required by the Securities and Exchange Commission regulation to furnish the Company with copies of all Section 16(a) forms they file. To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required, all Section 16(a) filing requirements applicable to its officers, directors and greater than 10% beneficial owners were complied with during the year ended December 31, 1997, except for Messrs. Mark A. Janssen, Francis X. Mohan and Roger K. Taylor, each of whom inadvertently failed to file on a timely basis a Form 3. Each of them subsequently filed a Form 3. ITEM 11. EXECUTIVE COMPENSATION COMPENSATION OF EXECUTIVE OFFICERS The following table sets forth certain information regarding the salary, incentive compensation and benefits paid by the Company to its Chief Executive Officer, its four most highly compensated executive officers other than the Chief Executive Officer and its executive officer who retired during 1997 (collectively, the "Named Executive Officers") during each of the three most recent fiscal years. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 12 14 SUMMARY COMPENSATION TABLE
- --------------------------------------------------------------------------------------------------------------------- Annual Compensation Long Term Compensation Awards Payouts Other Long-term All Annual Incentive Other Name and Compensation SARs Plan Compensation Principal Position Year Salary Bonus (a) (#) Payouts (b) - --------------------------------------------------------------------------------------------------------------------- Francis X. Mohan 1997 $ 63,466 $ 300,000 $ - - $ - $ - President and Chief Executive Officer Robert R. Densmore 1997 $ 184,079 $ 30,000 $ - - $ - $ 4,800 Executive Vice President 1996 178,196 64,000 1,468 - 7,500 1995 166,748 34,500 10,698 - - 4,500 Michael C. Allemang 1997 $ 178,049 $ 30,000 $ - - $ - $ 4,800 Executive Vice President and 1996 172,136 62,000 9,000 - 7,500 Chief Financial Officer 1995 163,847 27,000 12,000 - - 4,500 Mark A. Janssen 1997 $ 152,043 $ 140,000 $ - - $ - $ 4,800 Executive Vice President 1996 125,033 75,000 9,000 - - 7,352 and Secretary 1995 109,160 22,000 12,000 - - 4,025 John A. Courson 1997 $ 212,056 $ 110,988 $ 12,000 - $ - $ 4,800 Senior Vice President; 1996 187,044 138,496 12,570 - - 7,500 President and Chief 1995 187,044 87,512 14,945 - - 4,500 Executive Officer of Central Pacific James A. Conrad (retired) 1997 $ 194,129 $ 50,724 $ - - $ - $310,365 (c) 1996 237,936 110,000 7,481 - - 7,500 1995 222,627 38,000 40,034 - - 4,500 - ------------------------------------------------------------------------------------------------------------------------
(a) Amounts shown for 1997 consist of the following: (i) Mr. Courson: reimbursement of automobile expenses. Amounts shown for 1996 consist of the following: (i) Mr. Densmore: reimbursement of automobile expenses; (ii) Mr. Allemang: reimbursement of automobile expenses; (iii) Mr. Janssen: reimbursement of automobile expenses; (iv) Mr. Courson: interest reimbursement of $570 on amounts paid to purchase investment contracts and reimbursement of automobile expenses; (v) Mr. Conrad: interest reimbursement of $2,309 on amounts paid to purchase investment contracts and reimbursement of automobile expenses. Amounts shown for 1995 consist of the following: (i) Mr. Densmore: reimbursement of automobile expenses; (ii) Mr. Allemang: reimbursement of automobile expenses; (iii) Mr. Janssen: reimbursement of automobile expenses; (iv) Mr. Courson: interest reimbursement of $2,945 on amounts paid to purchase investment contracts and reimbursement of automobile expenses; (v) Mr. Conrad: interest reimbursement of $32,578 on amounts paid to purchase investment contracts and reimbursement of automobile expenses. (b) Represents amounts allocated pursuant to the Company's employee stock ownership plan ("ESOP"), except for (c) below. (c) In addition to (b) above, amount includes: (i) payment of $305,565 pursuant to the Agreement between Mr. Conrad and the Company. INVESTMENT CONTRACTS AND STOCK APPRECIATION RIGHTS In 1993, certain directors and executive officers of the Company exchanged all their shares of the Company's Class B common stock for 1.558 units in an investment contract and 1.558 units of Stock Appreciation Rights ("SAR") for each Class B share held. The investment contract entitles the holder to receive the lesser of $86.625 or the closing price of Fund American's common stock on the day preceding exercise of the investment contract, multiplied by a factor of 1.223 in cash for each unit held. The units may be exercised at any time at the option of the holder. The SARs may be exercised at any time simultaneously with each exercised investment contract unit at the option of the holders thereof. The value of each SAR is equal to the difference between $86.625 and the closing price of Fund American's common stock on the date preceding the exercise of the SAR multiplied by a factor of 1.223. The following table summarizes SAR values as of December 31, 1997. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 13 15 AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES
- ---------------------------------------------------------------------------------------------------------------------- Number of Securities underlying Value of unexercised unexercised in-the-money SARs at fiscal year end (b) SARs at fiscal year-end (b) Shares acquired Value --------------------------- --------------------------- Name on exercise (a) realized Exercisable Unexercisable Exercisable Unexercisable - ---------------------------------------------------------------------------------------------------------------------- James A. Conrad 4,000 $ 181,835 0 0 $ 0 $ 0 Robert R. Densmore 12,000 772,980 0 0 0 0 John A. Courson 0 0 871 0 53,545 0 - ----------------------------------------------------------------------------------------------------------------------
(a) Represents the number of investment contract units with respect to which the SARs were exercised. (b) The number and value of unexercised SARs are based on shares of Fund American common stock. PENSION BENEFITS
- -------------------------------------------------------------------------------------------------------------------- Years of Service ------------------------------------------------------------------------------------------ Remuneration 15 20 25 30 35 - -------------------------------------------------------------------------------------------------------------------- $ 125,000 $ 30,000 $ 40,000 $ 50,000 $ 60,000 $ 70,000 150,000 36,000 48,000 60,000 72,000 84,000 175,000 42,000 56,000 70,000 84,000 98,000 200,000 48,000 64,000 80,000 96,000 112,000 225,000 54,000 72,000 90,000 108,000 126,000 250,000 60,000 80,000 100,000 120,000 140,000 300,000 72,000 96,000 120,000 144,000 168,000 400,000 96,000 128,000 160,000 192,000 224,000 450,000 108,000 144,000 180,000 216,000 252,000 500,000 120,000 160,000 200,000 240,000 280,000 ===================================================================================================================
The gross annual benefit paid is computed as a straight-life annuity reduced by .485% of average salary up to covered compensation; that is, the average of social security wage bases for the 35 years prior to retirement. The annual benefits shown in the above table are not reduced to reflect the limitations imposed by the Internal Revenue Code, which limit the annual benefits payable from qualified plans to any individual. The Company maintains a Supplemental Retirement Plan which is a non-qualified, unfunded deferred compensation plan. Under the plan, certain highly compensated employees affected by these limitations will receive additional retirement income payments from the Company so that their pension benefits will equal the amounts they would otherwise have been were it not for the limitations. Messrs. Mohan, Densmore, Allemang, Janssen and Courson participate in retirement plans under which they are entitled to receive estimated annual retirement benefits in accordance with the table shown above. Participants in the retirement plans are eligible to receive normal retirement benefits at age 65, reduced normal retirement benefits if qualified for early retirement or a deferred vested benefit if they terminate employment prior to retirement but after five years of service. In the fourth quarter of 1997, the Company's Board of Directors approved certain amendments to the Company's pension plan. The approved amendments included the expansion of eligibility requirements for early retirement from age 55 with ten years of service to the earlier of age 55 with ten years of service or age 50 with fifteen years of service for retirements beginning on or after January 1, 1997. Eligible compensation for Messrs. Mohan, Densmore, Allemang, Janssen and Courson includes base salary plus bonus received, but is limited to not more than one and one-third of base salary in total. Benefits accrued under the retirement plans are limited to eligible compensation of $160,000 for 1997 for each of the Named Executive Officers. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 14 16 Benefits under the retirement plans for a single person are computed on a straight-life basis and benefits for a married person are generally computed on a joint and 50% survivor basis, subject to each participant's right to elect alternative survivor benefits. As of December 31, 1997, Messrs. Mohan, Densmore, Allemang, Janssen and Courson had 0, 21, 4, 16 and 7 whole years of credited service, respectively, for purposes of computing their benefits under the retirement plans. COMPENSATION OF DIRECTORS Directors who are neither employees of the Company nor employees or directors of Fund American (Mr. Taylor) receive an annual retainer of $10,000 (or in the case of Messrs. Keller and Macklin, a pro rata amount for less than a full year's service) and a fee of $1,500 for each board meeting attended. In addition, the following amounts were paid during 1997: $8,750 to Mr. Ozanne as a consultant to the Company prior to serving as Chairman of the Company, $1,500 to Mr. Macklin as former Chairman of the Executive Committee, and $25,000 to Mr. Baxter as a consultant to the Company. EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL ARRANGEMENTS In connection with the September 1997 retirement of James A. Conrad as President and Chief Executive Officer of the Company and pursuant to a certain agreement between him and the Company dated October 22, 1997, the Company agreed to pay Mr. Conrad (who is currently 56 years of age) the following: (i) the balance of his ESOP account and the portion of any contribution by the Company to the ESOP which would have been allocated to this account had he retired as of December 31, 1997; (ii) salary continuance of $20,371 per month through December 1998; (iii) his bonus under the Company's Executive Incentive Compensation Plan for 1997 in accordance with established performance objectives; (iv) medical and dental benefit coverage he would have received had he remained a full time employee of the Company through December 31, 1998 and (v) pension benefits, to commence on January 1, 1999, he would have received had he retired at age 62 (representing 19.9 years of credited service). In connection with the employment of Mr. Mohan as President and Chief Executive Officer of the Company, the Company and Mr. Mohan entered into an employment agreement ("the Agreement"). The Agreement principally called for: (i) Mr. Mohan to receive an annual base salary of $250,000; (ii) Mr. Mohan to receive a bonus for 1997 equal to his base salary, provided he achieved specific performance objectives; (iii) Mr. Mohan to receive additional payments of $50,000 on November 1, 1997 and $200,000 on November 1, 1998 and 1999, provided that he is an employee of the Company on those dates; (iv) Mr. Mohan to participate in the Company's Long-Term Incentive Plan; (v) Mr. Mohan to participate in an investment and option program; and (vi) in the event Mr. Mohan is terminated without cause prior to December 31, 2000, Mr. Mohan to receive two years of base salary and vest immediately in any options. Amounts relating to 1997 are included in the "Summary Compensation Table" on page 13. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Human Resources Committee of the Board of Directors establishes compensation for executive officers of the Company. None of the members of the Human Resources Committee, namely Terry L. Baxter, James H. Ozanne and Roger K. Taylor, is, or was, an officer or employee of the Company or any of the Company's subsidiaries. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 15 17 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT As of March 27, 1998, there were two holders of the 3,211,881 shares of the Company's issued and outstanding common stock, with each share entitled to one vote, as follows:
- -------------------------------------------------------------------------------------------------------------------- Title of Name and address of Number of Percent Class beneficial owners shares owned of class - -------------------------------------------------------------------------------------------------------------------- Common stock White Mountains Holdings, Inc. 3,106,881 96.7% 80 South Main Street Hanover, NH 03755 Fund American Enterprises Holdings, Inc. 105,000 3.3% 80 South Main Street Hanover, NH 03755 - --------------------------------------------------------------------------------------------------------------------
The following table sets forth, as of March 27, 1998, beneficial ownership of Fund American common stock by each director of the Company and each of the current "Named Executive Officers" as defined herein.
- -------------------------------------------------------------------------------------------------------------------- Title of Name of Number of Percent Class beneficial owner shares owned (b) of class (c) - -------------------------------------------------------------------------------------------------------------------- Common stock (a) Michael C. Allemang 11 * Raymond Barrette 1,585 * Terry L. Baxter 140 * John A. Courson - * Robert R. Densmore - * Mark A. Janssen - * Francis X. Mohan - * James H. Ozanne 640 * Roger K. Taylor - * - --------------------------------------------------------------------------------------------------------------------
* Represents less than 1% of the outstanding shares. (a) Represents Fund American common stock pursuant to Item 403(b) of Regulation S-K of the Securities Act of 1933. (b) Except for Messrs. Barrette, Ozanne and Taylor, includes shares beneficially owned by the Company's Employee Stock Ownership Plan and 401(k) Savings Plan (whereby voting rights are exercised by the Plan's trustee and attributable under the terms of the Plan to such person). (c) Determined based on the beneficial ownership provisions specified in Rule 13d-3(d)(1) of the Exchange Act. Except to the extent indicated above, all executive officers and directors have (or share with their spouses) sole voting and investment power with respect to the shares for which they claim beneficial ownership. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to the terms of a tax allocation agreement between the Company and Fund American, Fund American has agreed to compensate the Company for the use of certain accumulated unrealized losses associated with the Company's common equity securities portfolio if such losses, when realized, can be utilized in Fund American's consolidated tax returns. During 1996, the Company sold $1.4 million of common equity securities to White Mountains for cash proceeds of $.5 million. The Company recognized a $.9 million pretax loss from the sale. In January 1997, the Company transferred $2.3 million of common equity securities to White Mountains in exchange for 21,239 shares of the Company's common stock held by White Mountains, which were retired by the Company. The Company recognized a $.3 million pretax gain from the transfer in the first quarter of 1997. In March 1997, the Company issued 105,000 shares of its common stock to Fund American for cash proceeds of $12.7 million. In addition, the Company issued 230,293 shares of its common stock to White Source One Mortgage Services Corporation and Subsidiaries Form 10-K 16 18 Mountains in exchange for 1.0 million shares of the common stock of Financial Security Assurance Holdings Ltd. ("FSA") valued at $27.8 million. The Company issued an additional 650,827 shares of its common stock to White Mountains effective in the second quarter of 1997 in exchange for 2.5 million shares of FSA common stock, 2.0 million shares of FSA convertible redeemable preferred stock and options to acquire 2.6 million shares of FSA common stock valued at $78.5 million, net of associated tax liabilities and other adjustments. In June 1997, the Company acquired an investment in U S WEST, Inc. ("U S West") redeemable preferred stock from Fund American for cash proceeds of $49.3 million. The investment, which is classified as available for sale, is a fixed maturity investment which is redeemable in September 2004 and may be redeemed at the option of U S West beginning in September 1999. The discount on this investment is being amortized over the anticipated life of the investment. The carrying value of this investment, which approximates fair value, totaled $49.4 million as of December 31, 1997. The Company recognized income from this investment of approximately $2.0 million in 1997. During 1997, Mr. Conrad received $346,500 upon the exercise of 4,000 investment contract units, and Mr. Densmore received $1,039,500 upon the exercise of 12,000 investment contract units. See discussion of "Investment Contracts and Stock Appreciation Rights" on pages 13 and 14. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 17 19 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a. (1) Financial Statements The Financial Statements applicable to Source One Mortgage Services Corporation and consolidated subsidiaries have been incorporated by reference herein from Source One Mortgage Services Corporation's 1997 Annual Report to Shareholders as they appear in the Index to Financial Statements and Financial Statement Schedules appearing on page 20 of this Annual Report on Form 10-K. (2) Financial Statement Schedules None. (3) Exhibits The exhibits required to be filed by Item 601 of Regulation S-K and by this form are listed on page 22 of this Annual Report on Form 10-K. The management contracts and compensatory plans or arrangements required to be filed as exhibits and included in such list of exhibits are as follows: Exhibit 10(a) Source One Mortgage Services Corporation Employee Stock Ownership and 401(k) Savings Plan and Trust Agreement, as amended and restated effective as of October 1, 1996 Exhibit 10(b) Form of Source One Mortgage Services Corporation Voluntary Deferred Compensation Plan Exhibit 10(c) First Amendment to Source One Mortgage Services Corporation Voluntary Deferred Compensation Plan Exhibit 10(d) Form of Source One Mortgage Services Corporation Retirement Plan, as amended and restated Exhibit 10(e) First Amendment to Source One Mortgage Services Corporation Retirement Plan Exhibit 10(f) Second Amendment to Source One Mortgage Services Corporation Retirement Plan Exhibit 10(g) Third Amendment to Source One Mortgage Services Corporation Retirement Plan Exhibit 10(h) Form of Source One Mortgage Services Corporation Retirement Plan Trust Agreement Exhibit 10(i) Source One Mortgage Services Corporation Supplemental Retirement Plan Exhibit 10(j) Source One Mortgage Services Corporation Stock Appreciation Rights Plan Exhibit 10(w) Investment Contract by and between Source One Mortgage Services Corporation and James A. Conrad Exhibit 10(x) Investment Contract by and between Source One Mortgage Services Corporation and John A. Courson Exhibit 10(y) Investment Contract by and between Source One Mortgage Services Corporation and Robert R. Densmore Exhibit 10(aa) Source One Mortgage Services Corporation Long Term Incentive Plan Source One Mortgage Services Corporation and Subsidiaries Form 10-K 18 20 Exhibit 10(ff) Incentive Agreement in the event of a sale of Source One Mortgage Services Corporation among certain Senior Officers of Source One Mortgage Services Corporation and Fund American Enterprises, Inc. Exhibit 10 (gg) Retirement Agreement dated June 5, 1996 between Source One Mortgage Services Corporation and Robert W. Richards Exhibit 10 (hh) Retirement Agreement dated October 22, 1997 between Source One Mortgage Services Corporation and James A. Conrad Exhibit 10 (jj) Employment Agreement by and between Source One Mortgage Services Corporation and Francis X. Mohan Source One Mortgage Services Corporation and Subsidiaries Form 10-K 19 21 Source One Mortgage Services Corporation and Subsidiaries Index to Financial Statements and Financial Statement Schedules (Item 14(a))
- ---------------------------------------------------------------------------------------------------------------- Annual Report page(s)* - ---------------------------------------------------------------------------------------------------------------- FINANCIAL STATEMENTS: Consolidated statements of condition as of December 31, 1997 and 1996..............................................................16 Consolidated statements of income for each of the years ended December 31, 1997, 1996 and 1995..................................................17 Consolidated statements of comprehensive income for each of the years ended December 31, 1997, 1996, and 1995.....................................18 Consolidated statements of stockholders' equity for each of the years ended December 31, 1997, 1996 and 1995...........................................19 Consolidated statements of cash flows for each of the years ended December 31, 1997, 1996 and 1995........................................20-21 Notes to consolidated financial statements...................................................22-45 OTHER FINANCIAL INFORMATION: Report of independent auditors..................................................................15 Selected quarterly financial data (Unaudited) ..................................................46 - ----------------------------------------------------------------------------------------------------------------
Schedules for which provision is made in Regulation S-X are not required under the related instructions or are inapplicable and, therefore, have been omitted or the information required is included in the consolidated financial statements or notes thereto. *Source One Mortgage Services Corporation's 1997 Annual Report to Shareholders. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 20 22 b. Reports on Form 8-K The Company filed 7 reports on Form 8-K during the fourth quarter of 1997. The dates and contents are described below: October 23, 1997 Reported Distribution Date Statements for October 25, November 1, November 1, and October 20, 1997 relating to the Source One Mortgage Services Corporation Agency MBS Multi-Class Pass-Through Certificates Series 1987-2, 1988-1, 1988-2 and 1990-1, respectively October 27, 1997 Reported Report to the Trustee and Report to the Certificate Holders for the month of October 1997 relating to the Source One Mortgage Services Corporation 11 1/2% Mortgage Pass-Through Certificates, Series A November 17, 1997 Third Amended and Restated Revolving Credit Agreement dated as of July 25, 1997 by and among Source One Mortgage Services Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage Company (subsidiaries of Source One Mortgage Services Corporation), and the First National Bank of Chicago, individually and as Administrative Agent and Certain Other Lenders Third Amended and Restated Security and Collateral Agency Agreement dated as of July 25, 1997 by and among Source One Mortgage Services Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage Company (subsidiaries of Source One Mortgage Services Corporation), The First National Bank of Chicago (in its capacity as administrative agent for the lenders) and National City Bank, Kentucky, as collateral agent November 25, 1997 Reported Distribution Date Statements for November 25, December 1, December 1, and November 20, 1997 relating to the Source One Mortgage Services Corporation Agency MBS Multi-Class Pass-Through Certificates Series 1987-2, 1988-1, 1988-2 and 1990-1, respectively November 25, 1997 Reported Report to the Trustee and Report to the Certificate Holders for the month of November 1997 relating to the Source One Mortgage Services Corporation 11 1/2% Mortgage Pass-Through Certificates, Series A December 29, 1997 Reported Distribution Date Statements for December 25, 1997, December 25, 1997, January 1, 1998, January 1, 1998 and December 20, 1997 relating to the Source One Mortgage Services Corporation Agency MBS Multi-Class Pass-Through Certificates Series 1987-1, 1987-2, 1988-1, 1988-2 and 1990-1, respectively December 29, 1997 Reported Report to the Trustee and Report to the Certificate Holders for the month of December 1997 relating to the Source One Mortgage Services Corporation 11 1/2% Mortgage Pass-Through Certificates, Series A Source One Mortgage Services Corporation and Subsidiaries Form 10-K 21 23 c. Exhibits Exhibit No. 3(a) Restated Certificate of Incorporation of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 4(a) of the February 28, 1994 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (b) Certificate of Designation for Series A Preferred Stock of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 3(b) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (c) Amended and Restated Bylaws of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 4(d) of Amendment No. 1 to the registration statement on Form S-3, Registration No. 33-71924) 4(a) Pooling and Servicing Agreement between Manufacturers Hanover Mortgage Corporation (now "Source One Mortgage Services Corporation") and National Bank of Detroit dated March 1, 1983 and relating to Mortgage Pass-Through Certificates, Series A, 11 1/2% Pass-Through Rate (incorporated by reference to Exhibit 4(a) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (b) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated September 25, 1987 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1987-1 (incorporated by reference to Exhibit 10(jj) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (c) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated January 28, 1988 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1987-2 (incorporated by reference to Exhibit 10(kk) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (d) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated March 30, 1988 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1988-1 (incorporated by reference to Exhibit 10(ll) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (e) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated June 28, 1988 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1988-2 (incorporated by reference to Exhibit 10(mm) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (f) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated July 30, 1990 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1990-1 (incorporated by reference to Exhibit 4(a) of the July 30, 1990 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (g) Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and National Bank of Detroit dated September 15, 1986 (incorporated by reference to Exhibit 4(a) of the registration statement on Form S-1, Registration No. 33-8562) Source One Mortgage Services Corporation and Subsidiaries Form 10-K 22 24 (h) First Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and National Bank of Detroit dated November 1, 1986 (incorporated by reference to Exhibit 4(b) of the registration statement on Form S-1, Registration No. 33-8562) (i) Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated November 21, 1988 (incorporated by reference to Exhibit 4(h) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (j) First Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated November 21, 1988 (incorporated by reference to Exhibit 4(i) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (k) Second Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated October 10, 1991 (incorporated by reference to Exhibit 4(k) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (l) Third Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated October 10, 1991 (incorporated by reference to Exhibit 4(l) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (m) Indenture between Source One Mortgage Services Corporation and The First National Bank of Chicago dated May 7, 1992 (incorporated by reference to Exhibit 19(a) of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-12898, formerly File No. 33-8562) (n) Resolutions of the Chairman of the Board of Source One Mortgage Services Corporation regarding the issuance of medium-term indebtedness adopted pursuant to authority delegated by the Board of Directors of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 19(b) of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-12898, formerly File No. 33-8562). (Said resolutions establish the terms of the Medium-Term Notes, Series B, of Source One Mortgage Services Corporation issuable under the Indenture between Source One Mortgage Services Corporation and The First National Bank of Chicago dated May 7, 1992) (o) Resolutions of the Chairman of the Board of Source One Mortgage Services Corporation regarding the issuance of a series of medium-term notes, Series B, entitled "9% Debentures due June 1, 2012" adopted pursuant to authority delegated by the Board of Directors of Source One Mortgage Services Corporation (incorporated by reference to Exhibit (i) of the Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-12898, formerly File No. 33-8562). (Said resolutions establish the terms of the 9% Debentures due June 1, 2012 of Source One Mortgage Services Corporation issued under the Indenture between Source One Mortgage Services Corporation and The First National Bank of Chicago dated May 7, 1992) (p) Indenture dated December 1, 1995 between Source One Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company, as trustee (incorporated by reference to Exhibit (a)(1) of Amendment No. 4 to the Report on Schedule 13E-4 filed with the Securities and Exchange Commission on December 21, 1995) (q) First Supplemental Indenture dated December 1, 1995 between Source One Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company, as trustee (incorporated by reference to Exhibit (a)(2) of Amendment No. 4 to the Report on Schedule 13E-4 filed with the Securities and Exchange Commission on December 21, 1995) Source One Mortgage Services Corporation and Subsidiaries Form 10-K 23 25 (r) Form of 8.25% Debentures due 1996 (incorporated by reference to Exhibit 4(p) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (s) Form of Medium-Term Note, Series A (incorporated by reference to Exhibit 4(q) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (t) Form of 8.875% Notes due 2001 (incorporated by reference to Exhibit 4(r) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (u) Form of 9% Debentures due 2012 (incorporated by reference to Exhibit 4(s) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (v) Specimen Certificate for 8.42% Cumulative Preferred Stock, Series A, of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 4(a) of the Quarterly Report on Form 10-Q for the quarter ended September 30, 1994, File No. 1-12898) (w) Form of 9.375% Quarterly Income Capital Securities (Subordinated Interest Deferrable Debentures, Due 2025); included in the First Supplemental Indenture dated December 1, 1995 between Source One Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company, as trustee (incorporated by reference to Exhibit (a)(2) of Amendment No. 4 to the Report on Schedule 13E-4 filed with the Securities and Exchange Commission on December 21, 1995) 10 Material Contracts (a) Source One Mortgage Services Corporation Employee Stock Ownership and 401(k) Savings Plan and Trust Agreement (as amended and restated effective as of October 1, 1996) (incorporated by reference to Exhibit 10(a) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (b) Form of Source One Mortgage Services Corporation Voluntary Deferred Compensation Plan (incorporated by reference to Exhibit 10(e) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (c) First Amendment to Source One Mortgage Services Corporation Voluntary Deferred Compensation Plan (incorporated by reference to Exhibit 10(g) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (d) Form of Source One Mortgage Services Corporation Retirement Plan, as amended and restated (incorporated by reference to Exhibit 10(hh) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (e) First Amendment to Source One Mortgage Services Corporation Retirement Plan (incorporated by reference to Exhibit 10(j) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (f) Second Amendment to Source One Mortgage Services Corporation Retirement Plan (incorporated by reference to Exhibit 10(k) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (g) Third Amendment to Source One Mortgage Services Corporation Retirement Plan (incorporated by reference to Exhibit 10(l) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (h) Form of Source One Mortgage Services Corporation Retirement Plan Trust Agreement (incorporated by reference to Exhibit 10(d) of the registration statement on Form S-1, Registration No. 33-8562) Source One Mortgage Services Corporation and Subsidiaries Form 10-K 24 26 (i) Source One Mortgage Services Corporation Supplemental Retirement Plan (incorporated by reference to Exhibit 10(n) of the Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-12898, formerly File No. 33-8562) (j) Source One Mortgage Services Corporation Stock Appreciation Rights Plan (incorporated by reference to Exhibit 10(c) of the Current Report on Form 8-K dated November 11, 1993, File No. 1-12898, formerly File No. 33-8562) (k) Third Amended and Restated Revolving Credit Agreement dated as of July 25, 1997 by and among Source One Mortgage Services Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage Company (subsidiaries of Source One Mortgage Services Corporation), and the First National Bank of Chicago, individually and as Administrative Agent and Certain Other Lenders (incorporated by reference to Exhibit 10(a) of the Current Report on Form 8-K dated November 17, 1997, File No. 1-12898) (l) Third Amended and Restated Security and Collateral Agency Agreement dated as of July 25, 1997 by and among Source One Mortgage Services Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage Company (subsidiaries of Source One Mortgage Services Corporation), The First National Bank of Chicago (in its capacity as administrative agent for the lenders) and National City Bank, Kentucky, as collateral agent (incorporated by reference to Exhibit 10(b) of the Current Report on Form 8-K dated November 17, 1997, File No. 1-12898) (m) Federal Tax Sharing Agreement dated as of January 1, 1991, and effective for taxable years beginning after December 31, 1990, by and among Fund American Enterprises Holdings, Inc. and Source One Mortgage Services Corporation (incorporated by reference to Exhibit 10(m) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (n) Eurocommercial Paper Program Agreement dated August 1, 1988 among Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the Dealers named therein (incorporated by reference to Exhibit 10(bb) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (o) Commercial Paper Dealer Agreement dated September 25, 1986 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Shearson Lehman Commercial Paper Inc. (incorporated by reference to Exhibit 10(cc) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (p) Commercial Paper Dealer Agreement dated September 23, 1986 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and First Boston Corporation (incorporated by reference to Exhibit 10(dd) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (q) Issuing and Paying Agency Agreement dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Manufacturers Hanover Trust Company (incorporated by reference to Exhibit 10(s) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (r) Amendment dated June 20, 1992 to Issuing and Paying Agency Agreement dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Manufacturers Hanover Trust Company (incorporated by reference to Exhibit 10(x) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) Source One Mortgage Services Corporation and Subsidiaries Form 10-K 25 27 (s) Amendment dated August 1, 1988 to Issuing and Paying Agency Agreement dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Manufacturers Hanover Trust Company (incorporated by reference to Exhibit 10(t) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (t) Letter of Representations dated November 23, 1990 relating to Issuing and Paying Agency Agreement dated September 18, 1986 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Morgan Guaranty Trust Company of New York (incorporated by reference to Exhibit 10(v) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (u) Depository Agreement dated June 16, 1993 between Source One Mortgage Services Corporation and The First National Bank of Chicago (incorporated by reference to Exhibit 10(a) of the Current Report on Form 8-K dated February 28, 1994, File No. 1-12898, formerly File No. 33-8562) (v) Stock Purchase Agreement dated December 15, 1995, between Source One Mortgage Services Corporation and Fund American Enterprises, Inc. (incorporated by reference to Exhibit 10(bb) of the Annual Report on Form 10-K for the year ended December 31, 1995, File No. 1-12898) (w) Investment Contract by and between Source One Mortgage Services Corporation and James A. Conrad (incorporated by reference to Exhibit 10(dd) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (x) Investment Contract by and between Source One Mortgage Services Corporation and John A. Courson (incorporated by reference to Exhibit 10(ee) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (y) Investment Contract by and between Source One Mortgage Services Corporation and Robert R. Densmore (incorporated by reference to Exhibit 10(ff) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (z) Investment Services Agreement dated November 13, 1991 between Source One Mortgage Services Corporation and Fund American Enterprises, Inc. (incorporated by reference to Exhibit 10(rr) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (aa) Source One Mortgage Services Corporation Long Term Incentive Plan (incorporated by reference to Exhibit 10(ii) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (bb) Loan Agreement dated August 10, 1995 by and between Source One Mortgage Services Corporation and Comerica Bank, as amended by an Amendment No. 1 to Loan Agreement dated 1995 and by an Amendment No. 2 to Loan Agreement dated July 10, 1996 (incorporated by reference to Exhibit 10(bb) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) Source One Mortgage Services Corporation and Subsidiaries Form 10-K 26 28 (cc) FNMA/FHLMC/GNMA Mortgage Servicing Purchase and Sale Agreement dated February 28, 1997, by and between Source One Mortgage Services Corporation and Chemical Mortgage Company (incorporated by reference to Exhibit 10(dd) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (dd) Mortgage Loan Interim Subservicing Agreement made as of March 1, 1997, by and between Chemical Mortgage Company and Source One Mortgage Services Corporation (incorporated by reference to Exhibit 10(ee) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (ee) Mortgage Loan Subservicing Agreement, by and between Chemical Mortgage Company and Source One Mortgage Services Corporation (incorporated by reference to Exhibit 10(ff) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (ff) Incentive Agreement in the event of a sale of Source One Mortgage Services Corporation among certain Senior Officers of Source One Mortgage Services Corporation and Fund American Enterprises, Inc. (incorporated by reference to Exhibit 10(ll) of the Annual Report on Form 10-K for the year ended December 31, 1995, File No. 1-12898) (gg) Retirement Agreement dated June 5, 1996 between Source One Mortgage Services Corporation and Robert W. Richards (incorporated by reference to Exhibit 10(hh) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (hh) Retirement Agreement dated October 22, 1997 between Source One Mortgage Services Corporation and James A. Conrad* (ii) Mortgage Loan Subservicing Agreement Extension Amendment, by and between Chemical Mortgage Company and Source One Mortgage Services Corporation* (jj) Employment Agreement by and between Source One Mortgage Services Corporation and Francis X. Mohan* 13 Annual Report to Security Holders (a) Source One Mortgage Services Corporation 1997 Annual Report to Shareholders. Such report, except for those portions which are expressly incorporated by reference in this Annual Report on Form 10-K, is furnished only for the information of the Commission and is not deemed filed as part hereof* (b) Audit opinion of Ernst & Young LLP* 16 (a) Letter of Ernst & Young LLP dated March 27, 1997 (incorporated by reference to Exhibit 16(a) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) 21 Subsidiaries of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 21 of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) 23 Consents of experts (a) Consent of KPMG Peat Marwick LLP* (b) Consent of Ernst & Young LLP* (c) Consent of Coopers & Lybrand L.L.P. dated March 27, 1998 relating to Financial Security Assurance Holdings Ltd.* 24 Powers of Attorney* 27 Financial Data Schedule* 99 The Consolidated Financial Statements of Financial Security Assurance Holdings Ltd. and the related Report of Independent Accountants as of December 31, 1997 and 1996 and for each of the three years in the period ended December 31, 1997* * Filed herewith Source One Mortgage Services Corporation and Subsidiaries Form 10-K 27 29 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Source One Mortgage Services Corporation Date: March 27, 1998 By: /s/ MICHAEL C. ALLEMANG ----------------------- Michael C. Allemang Executive Vice President, Chief Financial Officer and Director Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date - -------------------------------------------------------------------------------------------------------------------- * - ----------------------- James H. Ozanne Chairman and Director March 27, 1998 President, Chief Executive Officer and * Director (Principal Executive Officer) March 27, 1998 - ----------------------- Francis X. Mohan Executive Vice President, Chief Financial Officer and Director (Principal Financial /s/MICHAEL C. ALLEMANG Officer and Principal Accounting Officer) March 27, 1998 - ----------------------- Michael C. Allemang * Executive Vice President - Servicing and March 27, 1998 - ----------------------- Director Robert R. Densmore Executive Vice President, Production & * Capital Markets, Secretary and Director March 27, 1998 - ----------------------- Mark A. Janssen * Director March 27, 1998 - ----------------------- Terry L. Baxter * Director March 27, 1998 - ----------------------- Raymond Barrette * Director March 27, 1998 - ----------------------- Robert K. Taylor *By: /s/MICHAEL C. ALLEMANG Michael C. Allemang As Attorney-in-fact for the persons indicated - --------------------------------------------------------------------------------------------------------------------
Supplemental Information to be Furnished with Reports Filed Pursuant to Section 15(d) of the Act by Registrants Which Have Not Registered Securities Pursuant to Section 12 of the Act. The Company does not have any voting securities registered under Section 12 of the Act, and all of the Company's voting securities are held by two entities. Accordingly, no proxy statement, form of proxy or other proxy soliciting material has been, or will be, sent to more than 10 of the registrant's security holders with respect to any annual or other meeting of security holders. Source One Mortgage Services Corporation and Subsidiaries Form 10-K 28 30 EXHIBIT INDEX Exhibit No. Description 3(a) Restated Certificate of Incorporation of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 4(a) of the February 28, 1994 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (b) Certificate of Designation for Series A Preferred Stock of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 3(b) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (c) Amended and Restated Bylaws of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 4(d) of Amendment No. 1 to the registration statement on Form S-3, Registration No. 33-71924) 4(a) Pooling and Servicing Agreement between Manufacturers Hanover Mortgage Corporation (now "Source One Mortgage Services Corporation") and National Bank of Detroit dated March 1, 1983 and relating to Mortgage Pass-Through Certificates, Series A, 11 1/2% Pass-Through Rate (incorporated by reference to Exhibit 4(a) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (b) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated September 25, 1987 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1987-1 (incorporated by reference to Exhibit 10(jj) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (c) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated January 28, 1988 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1987-2 (incorporated by reference to Exhibit 10(kk) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (d) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated March 30, 1988 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1988-1 (incorporated by reference to Exhibit 10(ll) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (e) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated June 28, 1988 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1988-2 (incorporated by reference to Exhibit 10(mm) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (f) Deposit Trust Agreement between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the First National Bank of Chicago dated July 30, 1990 and relating to Agency MBS Multi-Class Pass-Through Certificates, Series 1990-1 (incorporated by reference to Exhibit 4(a) of the July 30, 1990 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (g) Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and National Bank of Detroit dated September 15, 1986 (incorporated by reference to Exhibit 4(a) of the registration statement on Form S-1, Registration No. 33-8562) 31 Exhibit No. Description (h) First Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and National Bank of Detroit dated November 1, 1986 (incorporated by reference to Exhibit 4(b) of the registration statement on Form S-1, Registration No. 33-8562) (i) Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated November 21, 1988 (incorporated by reference to Exhibit 4(h) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (j) First Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated November 21, 1988 (incorporated by reference to Exhibit 4(i) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (k) Second Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated October 10, 1991 (incorporated by reference to Exhibit 4(k) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (l) Third Supplemental Indenture between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and The First National Bank of Chicago dated October 10, 1991 (incorporated by reference to Exhibit 4(l) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (m) Indenture between Source One Mortgage Services Corporation and The First National Bank of Chicago dated May 7, 1992 (incorporated by reference to Exhibit 19(a) of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-12898, formerly File No. 33-8562) (n) Resolutions of the Chairman of the Board of Source One Mortgage Services Corporation regarding the issuance of medium-term indebtedness adopted pursuant to authority delegated by the Board of Directors of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 19(b) of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-12898, formerly File No. 33-8562). (Said resolutions establish the terms of the Medium-Term Notes, Series B, of Source One Mortgage Services Corporation issuable under the Indenture between Source One Mortgage Services Corporation and The First National Bank of Chicago dated May 7, 1992) (o) Resolutions of the Chairman of the Board of Source One Mortgage Services Corporation regarding the issuance of a series of medium-term notes, Series B, entitled "9% Debentures due June 1, 2012" adopted pursuant to authority delegated by the Board of Directors of Source One Mortgage Services Corporation (incorporated by reference to Exhibit (i) of the Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 1-12898, formerly File No. 33-8562). (Said resolutions establish the terms of the 9% Debentures due June 1, 2012 of Source One Mortgage Services Corporation issued under the Indenture between Source One Mortgage Services Corporation and The First National Bank of Chicago dated May 7, 1992) (p) Indenture dated December 1, 1995 between Source One Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company, as trustee (incorporated by reference to Exhibit (a)(1) of Amendment No. 4 to the Report on Schedule 13E-4 filed with the Securities and Exchange Commission on December 21, 1995) (q) First Supplemental Indenture dated December 1, 1995 between Source One Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company, as trustee (incorporated by reference to Exhibit (a)(2) of Amendment No. 4 to the Report on Schedule 13E-4 filed with the Securities and Exchange Commission on December 21, 1995) 32 Exhibit No. Description (r) Form of 8.25% Debentures due 1996 (incorporated by reference to Exhibit 4(p) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (s) Form of Medium-Term Note, Series A (incorporated by reference to Exhibit 4(q) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (t) Form of 8.875% Notes due 2001 (incorporated by reference to Exhibit 4(r) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (u) Form of 9% Debentures due 2012 (incorporated by reference to Exhibit 4(s) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) (v) Specimen Certificate for 8.42% Cumulative Preferred Stock, Series A, of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 4(a) of the Quarterly Report on Form 10-Q for the quarter ended September 30, 1994, File No. 1-12898) (w) Form of 9.375% Quarterly Income Capital Securities (Subordinated Interest Deferrable Debentures, Due 2025); included in the First Supplemental Indenture dated December 1, 1995 between Source One Mortgage Services Corporation and IBJ Schroeder Bank & Trust Company, as trustee (incorporated by reference to Exhibit (a)(2) of Amendment No. 4 to the Report on Schedule 13E-4 filed with the Securities and Exchange Commission on December 21, 1995) 10 Material Contracts (a) Source One Mortgage Services Corporation Employee Stock Ownership and 401(k) Savings Plan and Trust Agreement (as amended and restated effective as of October 1, 1996) (incorporated by reference to Exhibit 10(a) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (b) Form of Source One Mortgage Services Corporation Voluntary Deferred Compensation Plan (incorporated by reference to Exhibit 10(e) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (c) First Amendment to Source One Mortgage Services Corporation Voluntary Deferred Compensation Plan (incorporated by reference to Exhibit 10(g) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (d) Form of Source One Mortgage Services Corporation Retirement Plan, as amended and restated (incorporated by reference to Exhibit 10(hh) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (e) First Amendment to Source One Mortgage Services Corporation Retirement Plan (incorporated by reference to Exhibit 10(j) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (f) Second Amendment to Source One Mortgage Services Corporation Retirement Plan (incorporated by reference to Exhibit 10(k) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (g) Third Amendment to Source One Mortgage Services Corporation Retirement Plan (incorporated by reference to Exhibit 10(l) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (h) Form of Source One Mortgage Services Corporation Retirement Plan Trust Agreement (incorporated by reference to Exhibit 10(d) of the registration statement on Form S-1, Registration No. 33-8562) 33 Exhibit No. Description (i) Source One Mortgage Services Corporation Supplemental Retirement Plan (incorporated by reference to Exhibit 10(n) of the Annual Report on Form 10-K for the year ended December 31, 1989, File No. 1-12898, formerly File No. 33-8562) (j) Source One Mortgage Services Corporation Stock Appreciation Rights Plan (incorporated by reference to Exhibit 10(c) of the Current Report on Form 8-K dated November 11, 1993, File No. 1-12898, formerly File No. 33-8562) (k) Third Amended and Restated Revolving Credit Agreement dated as of July 25, 1997 by and among Source One Mortgage Services Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage Company (subsidiaries of Source One Mortgage Services Corporation), and the First National Bank of Chicago, individually and as Administrative Agent and Certain Other Lenders (incorporated by reference to Exhibit 10(a) of the Current Report on Form 8-K dated November 17, 1997, File No. 1-12898) (l) Third Amended and Restated Security and Collateral Agency Agreement dated as of July 25, 1997 by and among Source One Mortgage Services Corporation, The Mortgage Authority, Inc. and Central Pacific Mortgage Company (subsidiaries of Source One Mortgage Services Corporation), The First National Bank of Chicago (in its capacity as administrative agent for the lenders) and National City Bank, Kentucky, as collateral agent (incorporated by reference to Exhibit 10(b) of the Current Report on Form 8-K dated November 17, 1997, File No. 1-12898) (m) Federal Tax Sharing Agreement dated as of January 1, 1991, and effective for taxable years beginning after December 31, 1990, by and among Fund American Enterprises Holdings, Inc. and Source One Mortgage Services Corporation (incorporated by reference to Exhibit 10(m) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (n) Eurocommercial Paper Program Agreement dated August 1, 1988 among Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and the Dealers named therein (incorporated by reference to Exhibit 10(bb) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (o) Commercial Paper Dealer Agreement dated September 25, 1986 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Shearson Lehman Commercial Paper Inc. (incorporated by reference to Exhibit 10(cc) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (p) Commercial Paper Dealer Agreement dated September 23, 1986 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and First Boston Corporation (incorporated by reference to Exhibit 10(dd) of the September 22, 1988 Current Report on Form 8-K, File No. 1-12898, formerly File No. 33-8562) (q) Issuing and Paying Agency Agreement dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Manufacturers Hanover Trust Company (incorporated by reference to Exhibit 10(s) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (r) Amendment dated June 20, 1992 to Issuing and Paying Agency Agreement dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Manufacturers Hanover Trust Company (incorporated by reference to Exhibit 10(x) of the Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-12898, formerly File No. 33-8562) 34 Exhibit No. Description (s) Amendment dated August 1, 1988 to Issuing and Paying Agency Agreement dated June 19, 1987 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Manufacturers Hanover Trust Company (incorporated by reference to Exhibit 10(t) of the Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-12898, formerly File No. 33-8562) (t) Letter of Representations dated November 23, 1990 relating to Issuing and Paying Agency Agreement dated September 18, 1986 between Fireman's Fund Mortgage Corporation (now "Source One Mortgage Services Corporation") and Morgan Guaranty Trust Company of New York (incorporated by reference to Exhibit 10(v) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (u) Depository Agreement dated June 16, 1993 between Source One Mortgage Services Corporation and The First National Bank of Chicago (incorporated by reference to Exhibit 10(a) of the Current Report on Form 8-K dated February 28, 1994, File No. 1-12898, formerly File No. 33-8562) (v) Stock Purchase Agreement dated December 15, 1995, between Source One Mortgage Services Corporation and Fund American Enterprises, Inc. (incorporated by reference to Exhibit 10(bb) of the Annual Report on Form 10-K for the year ended December 31, 1995, File No. 1-12898) (w) Investment Contract by and between Source One Mortgage Services Corporation and James A. Conrad (incorporated by reference to Exhibit 10(dd) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (x) Investment Contract by and between Source One Mortgage Services Corporation and John A. Courson (incorporated by reference to Exhibit 10(ee) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (y) Investment Contract by and between Source One Mortgage Services Corporation and Robert R. Densmore (incorporated by reference to Exhibit 10(ff) of the Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-12898) (z) Investment Services Agreement dated November 13, 1991 between Source One Mortgage Services Corporation and Fund American Enterprises, Inc. (incorporated by reference to Exhibit 10(rr) of the Annual Report on Form 10-K for the year ended December 31, 1991, File No. 1-12898, formerly File No. 33-8562) (aa) Source One Mortgage Services Corporation Long Term Incentive Plan (incorporated by reference to Exhibit 10(ii) of the Annual Report on Form 10-K for the year ended December 31, 1994, File No. 1-12898) (bb) Loan Agreement dated August 10, 1995 by and between Source One Mortgage Services Corporation and Comerica Bank, as amended by an Amendment No. 1 to Loan Agreement dated 1995 and by an Amendment No. 2 to Loan Agreement dated July 10, 1996 (incorporated by reference to Exhibit 10(bb) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) 35 Exhibit No. Description (cc) FNMA/FHLMC/GNMA Mortgage Servicing Purchase and Sale Agreement dated February 28, 1997, by and between Source One Mortgage Services Corporation and Chemical Mortgage Company (incorporated by reference to Exhibit 10(dd) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (dd) Mortgage Loan Interim Subservicing Agreement made as of March 1, 1997, by and between Chemical Mortgage Company and Source One Mortgage Services Corporation (incorporated by reference to Exhibit 10(ee) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (ee) Mortgage Loan Subservicing Agreement, by and between Chemical Mortgage Company and Source One Mortgage Services Corporation (incorporated by reference to Exhibit 10(ff) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (ff) Incentive Agreement in the event of a sale of Source One Mortgage Services Corporation among certain Senior Officers of Source One Mortgage Services Corporation and Fund American Enterprises, Inc. (incorporated by reference to Exhibit 10(ll) of the Annual Report on Form 10-K for the year ended December 31, 1995, File No. 1-12898) (gg) Retirement Agreement dated June 5, 1996 between Source One Mortgage Services Corporation and Robert W. Richards (incorporated by reference to Exhibit 10(hh) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) (hh) Retirement Agreement dated October 22, 1997 between Source One Mortgage Services Corporation and James A. Conrad* (ii) Mortgage Loan Subservicing Agreement Extension Amendment, by and between Chemical Mortgage Company and Source One Mortgage Services Corporation* (jj) Employment Agreement by and between Source One Mortgage Services Corporation and Francis X. Mohan* 13 Annual Report to Security Holders (a) Source One Mortgage Services Corporation 1997 Annual Report to Shareholders. Such report, except for those portions which are expressly incorporated by reference in this Annual Report on Form 10-K, is furnished only for the information of the Commission and is not deemed filed as part hereof* (b) Audit opinion of Ernst & Young LLP* 16 (a) Letter of Ernst & Young LLP dated March 27, 1997 (incorporated by reference to Exhibit 16(a) of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) 21 Subsidiaries of Source One Mortgage Services Corporation (incorporated by reference to Exhibit 21 of the Annual Report on Form 10-K for the year ended December 31, 1996, File No. 1-12898) 23 Consents of experts (a) Consent of KPMG Peat Marwick LLP* (b) Consent of Ernst & Young LLP* (c) Consent of Coopers & Lybrand L.L.P. dated March 27, 1998 relating to Financial Security Assurance Holdings Ltd.* 24 Powers of Attorney* 27 Financial Data Schedule* 99 The Consolidated Financial Statements of Financial Security Assurance Holdings Ltd. and the related Report of Independent Accountants as of December 31, 1997 and 1996 and for each of the three years in the period ended December 31, 1997* * Filed herewith Source One Mortgage Services Corporation and Subsidiaries Form 10-K EX-10.(HH) 2 EXHIBIT 10(HH) 1 EXHIBIT 10 (hh) RELEASE AND TERMINATION AGREEMENT For value received, Source One Mortgage Services Corporation ("Source One"), a Delaware corporation, and James A. Conrad ("Conrad"), mutually agree as follows: 1. Resignation and Termination. Conrad hereby resigns from all positions which he now holds with Source One and any subsidiary or other related or affiliated corporation or other affiliated entity, including but not limited to his positions as a director, officer, committee member, and employee of Source One, effective as of the close of September 30, 1997 (the "Termination Date"). Moreover, all employment and other agreements, contracts, commitments and understandings between Source One and Conrad, whether written, oral or otherwise, other than this Agreement, are hereby terminated, ended and void as of the Termination Date. 2. Consideration. In consideration of the release, covenant not to sue, and other promises made by Conrad in paragraphs 4, 5, 6, 7, 8, 9, 10 and 11 of this Agreement, and in full accord, satisfaction and discharge of any and all obligations, agreements, contracts, commitments, understandings, or otherwise, Source One agrees: (a) to make supplemental payments (subject to applicable taxes and withholding) to Conrad and his spouse, if she survives him, (in addition to 2 any amounts which Conrad and his spouse are entitled to receive under the Source One Mortgage Services Corporation Retirement Plan (the "Retirement Plan") and the related Source One Mortgage Services Corporation Supplemental Retirement Plan (the "SRP")) commencing January 1, 1999 (the "Early Retirement Date") in the amount of $3,342.16 per month to Conrad for his lifetime and in the amount of $1,671.08 per month to his spouse, if she survives him, for her lifetime, provided, however, that Source One shall make such payments only if Conrad elects under Article IV, Section 2(a), of the Retirement Plan to have his Early Retirement Benefit (as defined in the Retirement Plan) commence on the Early Retirement Date. Notwithstanding the foregoing, if instead of the automatic qualified joint and survivor annuity under Article IV, Section 6(d), of the Retirement Plan Conrad should elect under Article IV, Section 6(b) of such plan an optional form of benefit actuarially equivalent to the lifetime annuity payable to him under such plan, the supplemental payments to Conrad and his spouse, if she survives him, under this Agreement shall be paid in the same manner and form as such optional -2- 3 form of benefit under the Retirement Plan, and the amounts of such supplemental payments shall be adjusted so that they are actuarially equivalent to the supplemental payments to Conrad for his lifetime (not including the supplemental payments to his spouse, if she survives him) described in the first sentence of this paragraph (a). Actuarial equivalence shall be determined in the same manner it is determined under the Retirement Plan. If Conrad should die before the Early Retirement Date, Source One will make supplemental payments to his spouse, if she survives him, and is living on the Early Retirement Date, (in addition to any amounts which she is entitled to receive under the Retirement Plan and SRP) commencing on the Early Retirement Date in the amount of $1,671.08 per month for her lifetime. (b) To continue Conrad's regular salary through December 31, 1998. (c) To continue to provide to Conrad the same life insurance, medical/hospital coverage and dental coverage that he would be entitled to had he remained a full time employee of Source One through December 31, 1998. -3- 4 (d) To continue Conrad's eligibility for a bonus under Source One's Executive Incentive Compensation Plan for 1997 in accordance with the performance objectives established by Source One's Board of Directors on or about August 21, 1997. (e) To pay Conrad, if Source One makes a contribution to the ESOP portion of the Source One Mortgage Services Corporation Employee Stock Ownership and 401(k) Plan for 1997, the excess of (i) the amount which would have been allocated to his account under the ESOP portion of such plan had he continued in employment with Source One at the rate of annual salary being paid to him on the Termination Date over (ii) the actual amount allocated to his account under the ESOP portion of such plan for 1997. (f) To treat Conrad as having attained the age of 60 years or more on September 30, 1997 for purposes of the agreement dated July 1, 1992 between Conrad and Source One relating to a membership in the Oakland Hills Country Club with the result that (i) paragraph 8 of such agreement shall apply, (ii) Source One will transfer all of its right, title and interest in, to and with respect to the Oakland Hills Country Club membership to Conrad as of September 30, 1997, and (iii) as of September 30, 1997 such membership shall be -4- 5 deemed to be the sole and exclusive property of Conrad and the agreement dated July 1, 1992 shall terminate and be of no further force or effect. Conrad will be responsible for all expenses incurred by him in connection with such membership after September 30, 1997. It is understood and agreed that the foregoing payments and benefits are good and valuable consideration for this Release and Termination Agreement, are in addition to all other compensation and benefits which have already been paid, or are owed, to Conrad, and do not constitute monies or benefits to which Conrad is otherwise entitled as part of his prior employment with Source One. 3. Other Benefits. In accordance with applicable documents and current policies with respect to retirees, Source One will (i) pay Conrad for his unused vacation days determined as of the Termination Date, namely 11.5 days, (ii) cause Conrad's account balances in the Source One Mortgage Services Corporation Employee Stock Ownership and 401(k) Plan to be paid to Conrad in accordance with the terms of such plan, (iii) continue to provide to Conrad from and after January 1, 1999 Blue Cross and Blue Shield medical and hospital coverage and life insurance coverage on the same basis such coverage is provided to other retirees from Source One, and (iv) continue from and after January 1, 1999 dental coverage for Conrad and his spouse for up to three years at -5- 6 his expense if elected by him. Medical and dental coverage will be subject to the same terms and conditions, including cost adjustments and other modifications, and possible termination, which apply to such coverage for other retirees. At Conrad's direction the amounts he will be required to pay for medical and dental coverage will be deducted from his monthly retirement payments. 4. Release by Conrad. In consideration of the payments and other items specified in Paragraph 2, Conrad, on behalf of himself and his heirs, legal representatives and assigns, hereby fully releases and forever discharges Source One, and its subsidiaries, parent and ultimate parent companies, other related companies and affiliates, divisions, units, successors, affiliates, shareholders, directors, officers, agents, and employees, (hereinafter "the Released Parties") of and from all actions, causes of action, claims, demands, compensatory, exemplary, statutory and punitive damages, costs, suits, debts, fees, charges, complaints, contracts, controversies, agreements, expenses, promises, judgments, damages and liability, and any and all consequential damages whatsoever, in law or in equity, which against the Released Parties, Conrad, individually or in any representative capacity, had, now has or may or shall have by reason of any matter, fact, representation, cause or thing of any conceivable kind and character whatsoever, and which have occurred up to the effective date of this Agreement, including -6- 7 specifically, but not by way of limitation, any and all claims of discrimination, wrongful discharge, breach of contract, fraud, promissory estoppel, misrepresentation, retaliation, all claims under or in connection with the Age Discrimination in Employment Act (ADEA), the Older Workers Benefit Protection Act, Title VII of the Civil Rights Act of 1964, the Civil Rights Act of 1991, the Employee Retirement Income Security Act of 1974, the Equal Pay Act, the Michigan Elliott-Larsen Civil Rights Act, the Michigan Handicappers' Civil Rights Act, the Michigan Workers Disability Compensation Act, The Americans with Disabilities Act, any other Michigan and federal statutes and the common law of the State of Michigan and the United States, actions based on tort, public policy, defamation, or injuries incurred on the job or incurred as a result of loss of employment, and any and all claims and demands of every conceivable kind based upon or in connection with or involving Conrad's employment and the termination of such employment. Notwithstanding the foregoing, nothing in this Waiver and General Release shall constitute a waiver of any claim or right of Conrad that may arise from events occurring after the date the Waiver and General Release is executed by Conrad, nor of the right to file a charge with or participate in an investigation conducted by the Equal Employment Opportunity Commission. You are, however, waiving your right to any monetary recovery in connection with such a charge. -7- 8 5. Complete Defense. In further consideration, Source One and Conrad do hereby covenant and agree that this Release and Termination Agreement shall be a full and complete defense to, and be used as a basis for an injunction against any action, suit, or any other proceeding which may be instituted, prosecuted or attempted by Conrad, his heirs, legal representatives, or assigns in breach hereof. 6. Waiver of Rights To Sue or Proceed. In further consideration thereof, Conrad, on behalf of himself, his heirs, legal representatives and assigns, hereby covenants with the Released Parties that he will not sue or proceed in any manner, whether at law or in equity, against any or all of them, for or on account of any claim of any nature whatsoever, including but not limited to any claim for injuries or compensatory, exemplary, statutory or punitive damages as a result of the events arising out of or relating in any way to Conrad's employment or the termination of Conrad's employment with Source One. If you violate this Release and Termination Agreement by suing Source One, then you may at Source One's option, be required to return all monies paid to you pursuant to Paragraph 2 plus the monetary equivalent of benefits you received pursuant to that paragraph, in which case Source One shall be released from its obligations to make further payments and to continue providing benefits pursuant to Paragraph 2. -8- 9 7. Waiver of Reinstatement and Reemployment. Conrad agrees and recognizes that his relationship with Source One and its affiliates and successors has been permanently and irrevocably severed and that neither Source One nor its successors have any obligation, contractual or otherwise, to rehire, reemploy, recall or hire him in the future. 8. Confidentiality of this Agreement. Conrad hereby agrees not to disclose either the fact that he has entered into a release and termination agreement with Source One or the terms of this Release and Termination Agreement, including, but not limited to, the amounts paid, to any person or entity, except his counsel or tax professional or accountant in the course of seeking tax or financial or legal advice. Any such counsel or tax advisor must be advised of this confidentiality provision, and agree to abide by it, prior to any disclosure. In addition, Conrad agrees that such nondisclosure is a material consideration for the Released Parties having entered into this Release and Termination Agreement, and that any such disclosure shall be a material and actionable breach of this Release and Termination Agreement. The parties further agree that they will not allow anyone to have access to or to view this Release and Termination Agreement, except as authorized above. 9. Confidential Information. Conrad agrees that he will hold in a fiduciary capacity for the benefit of the Fund American Group all Confidential Information and shall not communicate or -9- 10 divulge any Confidential Information to, or use any Confidential Information for the benefit of, any person (including himself) or entity other than an entity in the Fund American Group. For purposes of this Agreement "Fund American Group" means Fund American Enterprises Holdings, Inc. and any related company, including Source One, and their respective agents, employees, directors and officers. Also for purposes of this Agreement "Confidential Information" shall mean (i) information, not generally known, about the Fund American Group's clients, processes, services and products, whether written or not, including information relating to research, accounting, marketing, merchandising, selling and the identity of current and prospective customers and other client information and (ii) any confidential information entrusted to the Fund American Group by a client or customer thereof which the Fund American Group is obligated to keep confidential. Conrad agrees that he will return to Source One as soon as practicable after the Termination Date any documents or other written, recorded or graphic matter containing, relating or referring to any Confidential Information (and all copies thereof) in Conrad's possession or control. 10. No Disparaging Statements. Conrad agrees that he will not make any statement to any third party disparaging or criticizing, or otherwise take action to cast aspersions on, the management, business, affairs or property of any of the Fund American Group. -10- 11 11. No Soliciting of Employees. Conrad agrees that he will not solicit or cause to be solicited for employment on behalf of himself or on behalf of any person or entity (other than Source One or another member of the Fund American Group) any person who is employed by Source One or any other member of the Fund American Group at the time Conrad engages in the solicitation. 12. Purpose and Intent. Conrad understands and agrees that this Release and Termination Agreement is entered into for the purpose of avoiding further controversy with respect to any and all past, present, or future claims, demands, actions, obligations, damages, fees, interests, losses and expenses of any nature whatsoever arising from or by reason of any matter, act, omission or thing of any kind, whether known or unknown, foreseen or unforeseen, having occurred up to the effective date of this Agreement. The parties intend that this Agreement will irrevocably bar any action or claim whatsoever by Conrad against the Released Parties for any injuries or damages, whether known or unknown, sustained or to be sustained, as a result of the Released Parties' acts, omissions and conduct having occurred up to the effective date of this Agreement, including, but not limited to, the termination of Conrad's employment. 13. Waiting and Revocation Periods. Conrad expressly acknowledges that he has been advised and instructed that he has the right to consult an attorney and that he should review the terms of this Agreement with counsel of his own selection. Conrad -11- 12 further confirms that he has had more than twenty-one (21) days within which to consider the terms of this Agreement, that he has had the opportunity to review this Agreement with counsel of his own choice, that he has had ample time to study this Agreement, that he has carefully read the terms of this Agreement and is fully aware of the Agreement's contents and legal effects, and that he executes this Agreement voluntarily and of his own free will. Conrad expressly acknowledges that this Agreement constitutes a knowing and voluntary waiver under the Older Workers Benefit Protection Act and that this Waiver and General Release complies with the provisions of the Older Workers Benefit Protection Act. Conrad understands and agrees that this Agreement is revocable by any party for seven (7) days following the signing of this Agreement by both parties, and that this Agreement shall not become effective or enforceable until that revocation period has expired. This Agreement automatically becomes enforceable and effective on the eighth (8th) day after the date this Agreement is signed by all of the parties. This Agreement may be revoked by a writing sent certified mail by either party post-marked no later than the seventh (7th) day after the Agreement is signed by the last party (unless that day is a Sunday or a holiday, in which event the period is extended to the next day there is mail service). 14. Entire Agreement. This Release and Termination Agreement contains the entire agreement of the parties and -12- 13 supersedes all other agreements, written or otherwise. This Release and Termination Agreement cannot be altered or amended except in writing, which writing must be signed by Conrad and by the Chairman of Source One. In no event shall this Release and Termination Agreement be modified by any oral statements, agreements, commitments or understandings. 15. Free Act and Deed. Source One and Conrad acknowledge that they have reviewed this Release and Termination Agreement, understand its terms, and execute this Agreement as their free act and deed. Conrad further acknowledges that he has been afforded the opportunity to review this Release and Termination Agreement with counsel of his own choice and that he knowingly and voluntarily approves this Release and Termination Agreement. 16. Choice of Law and Severability. This Release and Termination Agreement shall be construed in accordance with the law of Michigan. If any provision of this Agreement shall for any reason be held invalid or unenforceable, such invalidity or unenforceability shall not affect any other provision hereof, but this Agreement shall, in such event, be construed as if such invalid and/or unenforceable provision had ever been contained herein. 17. Effective Date. The effective date of this Agreement is the eighth (8th) day after the date this Agreement is signed by all of the parties. -13- 14 Conrad has executed this Release and Termination Agreement this _____ day of ___________, 1997. THIS IS A RELEASE READ BEFORE SIGNING: WITNESSED: - ----------------------------- ------------------------------- James A. Conrad - ----------------------------- SOURCE ONE MORTGAGE SERVICES CORPORATION WITNESSED: By - ----------------------------- -------------------------- - ----------------------------- Its Chairman Dated: ---------------------- -14- EX-10.(II) 3 EXHIBIT 10(II) 1 Exhibit 10(ii) MORTGAGE LOAN SUBSERVICING AGREEMENT EXTENSION AMENDMENT THIS MORTGAGE LOAN SUBSERVICING AGREEMENT EXTENSION AMENDMENT ("Amendment") is dated as of December 11, 1997, by and between CHEMICAL MORTGAGE COMPANY, an Ohio corporation, with offices at 200 Old Wilson Bridge Road, Worthington, Ohio 43085-8500 ("Servicer") and SOURCE ONE MORTGAGE SERVICES CORPORATION, a Delaware corporation, with offices located at 27555 Farmington Road, Farmington Hills, Michigan 48334-3357 ("Subservicer"). WHEREAS, Servicer and Subservicer entered into a Mortgage Loan Subservicing Agreement ("Subservicing Agreement") to perform the administration and subservicing of certain mortgage loans the Servicing to which was purchased by the Servicer from the Subservicer pursuant to a FNMA/FHLMC/GNMA Mortgage Servicing Purchase and Sale Agreement ("Sale Agreement") between Servicer and Subservicer, dated as of February 28, 1997; and WHEREAS, the Servicer and Subservicer desire to amend the Subservicing Agreement and Sale Agreement as follows: A. Pursuant to Section 7 of the Subservicing Agreement, the Servicer elects to extend the term of the Subservicing Agreement for one (1) year as follows: for that portion of the Servicing which pertains to GNMA Mortgage Loans to May 31, 1999; for that portion of the Servicing which pertains to FNMA Mortgage Loans to July 31, 1999; and, for that portion of Servicing which pertains to FHLMC Mortgage Loans to March 15, 1999; provided, however, that notwithstanding the one hundred fifty (150) day minimum servicing period set forth in Section 7 of the Subservicing Agreement, in the event Servicer changes to first-of-the-month cut-off for the GNMA Mortgage Loans, the termination date for the Servicing of GNMA Mortgage Loans may be revised downward or upward by up to five (5) calendar days. Nothing in this paragraph shall affect Servicer's existing rights, pursuant to the terms and provisions of the Subservicing Agreement, to terminate Subservicer earlier for cause due to a breach of the Subservicing Agreement, as amended by the terms and provisions of this Amendment. B. Paragraph 1.23 Subservicing Fee is hereby amended to provided that effective June 1, 1998, the compensation to be paid to Subservicer under the Subservicing Agreement for subservicing any Mortgage Loan in existence on the first day of each month shall be $1.42 per Mortgage Loan. C. Subservicer has a long-term compensation plan which is acceptable to Servicer for the purpose of retaining key employees of Subservicer throughout the term of the Subservicing Agreement, as amended by this Amendment. This long-term compensation plan is attached as Exhibit B. 2 D. On or before January 15, 1998, Subservicer agrees to provide Servicer with an initial high level strategic business plan reflecting Subservicer's overall servicing objectives. On or before April 15, 1998, and quarterly thereafter, Subservicer shall provide Servicer with updates reflecting the execution of its business plan. Such business plan and results must be acceptable to Servicer in its reasonable discretion. E. Subservicer will cooperate in providing adequate support according to generally accepted practices of sellers of mortgage loan servicing in sale transactions. Such support shall include but not be limited to the following: 1. Performing the data mapping process, commencing in November 1997 and thereafter as reasonably requested by Servicer, for the transfer of servicing responsibilities. 2. Providing Servicer with conversion tapes, at Subservicer's cost, commencing in January 1998 and quarterly thereafter. 3. At Servicer's request, transferring the Servicing of any delinquent Mortgage Loan (i) which Servicer sells to a third party purchaser or (ii) which Servicer buys from an Investor as a result of the delinquency of the Mortgage Loan, from the appropriate Investor's account to Servicer's account. F. No interest will be paid by Servicer after the Approval Date on the Document Holdback portion of the Purchase Price which is described in the Sale Agreement. G. Subservicer will supply acceptable evidence to Servicer by December 31, 1997 that all of its investor accounting problems (e.g., any and all outstanding reconciliations and reconciling items, whether pertaining to custodial or clearing account reconciliations, proof of cash, pool to security, expected cash, cash outages on GNMA Mortgage Loans with Coopers & Lybrand, etc.) have been brought current and fully resolved. Additionally, commencing November 30, 1997, Subservicer shall provide Servicer with those reports described on Exhibit A, attached hereto and incorporated herein. Finally, subject to the ability of Transamerica to perform, by December 31, 1997, Subservicer will provide Servicer with evidence that all of the Mortgage Loans are covered by Transamerica "delinquency search only" tax service contracts effective through the Transfer Date. On the Transfer Date, such Transamerica contracts will become full service Transamerica contracts as described in the Sale Agreement. Subservicer will immediately fund all identified cash shortages. Any unidentified cash shortages can be researched by Subservicer up to sixty (60) days from the date of the outage. Any shortages not identified within the sixty (60) days will be immediately funded by Subservicer. Procedures and/or technology enhancements will be developed by Subservicer to ensure that issues that may cause recurring unidentified shortages can be identified and funded immediately by Subservicer. 2 3 H. Systems used by Subservicer to satisfy the requirements of the Subservicing Agreement containing or calling on a calendar function including, without limitation, any function indexed to the CPU clock, and any function providing specific dates or days, or calculating spans of dates or days, shall record, store, process, provide and where appropriate, insert true and accurate dates and calculations for dates and spans including and following, January 1, 2000. As part of its maintenance obligations, Subservicer shall assure that its system will have no lesser functionality with respect to records containing dates on or after January 1, 2000 than it had with respect to dates prior to January 1, 2000. I. That all other terms of the Subservicing Agreement and Sale Agreement remain in full force and effect and that only the amended provisions listed above shall constitute changes or additions to the Subservicing Agreement and Sale Agreement. IN WITNESS WHEREOF, each of the undersigned parties to this Amendment has caused this Amendment to be duly executed in its corporate name by one of its duly authorized officers, all as of the date first written above. SERVICER: ATTEST: CHEMICAL MORTGAGE COMPANY /s/ Ellen M. Clifford --------------------- By: [SIG] --------------------------- Title: Senior Vice President ------------------------ Date: December 11, 1997 ------------------------- SUBSERVICER: ATTEST: SOURCE ONE MORTGAGE SERVICES CORPORATION /s/ June Jacobs --------------------- By: [SIG] --------------------------- Title: President & CEO ------------------------ Date: 12-12-97 ------------------------- 3 4 EXHIBIT A SOURCE ONE INVESTOR REPORTS Fannie Mae - ---------- Proof of Custodials Proof of Security FNMA Completed Laser Schedules Freddie Mac - ----------- Proof of Custodials (listing all reconciling items and month originated) Loan Reconciliation Detail Report (listing all edits) Ginnie Mae - ---------- Trial Balance Comparison Report detailing discrepancies between 11710A and corresponding T/B Test of Expected P&I and Pool to Security Summary report of all pools with cash or security differences greater and less than $50 sorted by range code A 1,000 - over B 100.01 - 999.99 C 50.01 - 100.00 D (50) - 50 E (50.01) - (100) F (100) - (999.99) G (1,000) & less Total The 11714 remittance advice A listing of funds forwarded to GNMA (with GNMA required information per Memorandum #97-27 as unclaimed funds, with date forwarded and also returned if applicable. Copy of the 1041 and K1 forms following the year end filing with the IRS. Reconciliation of YTD Interest. EX-10.(JJ) 4 EXHIBIT 10(JJ) 1 EXHIBIT 10(jj) EMPLOYMENT AGREEMENT Frank Mohan James Ozanne Brewster, New York Chairman, Source One Mortgage Dear Frank, I am very pleased to offer you the position of President and Chief Executive Officer of Source One Mortgage Corporation. As we agreed you will begin employment on or before October 1, 1997. The following are the key terms of your employment: 1. Base salary of $250,000. 2. Short term annual bonus based on specific performance objectives with a maximum payout if all objectives are achieved of 100% of base salary. The 1997 award will not be prorated. 3. Payments to compensate you for your existing in the money stock options, stock grants and company car of $50,000 on November 1, 1997 and $200,000 each on November 1, 1998 and November 1, 1999. You must be employed by the company at each payment date in order to collect the payment. 4. Participation in our long term incentive plan which is now being revised. The key elements are as follows: Tied to and based on Source One book value Valuation based on three year average ROE Three three year traunches to be issued - 1998-00, 1999-01 and 2000-02 Payouts range from 0 to 12% ROE to 100% at a 15% ROE, 200% at a 20% ROE and 300% at a 25% ROE. Payments capped at 300% You will receive share grants equal to $150,000 of book value for each of the three traunches. 5. You will participate in an investment and option program identical in terms to the program in which I participate. You will have an opportunity to invest up to $150,000 in Source One stock at book value. Each dollar of investment will entitle you to five times that amount of five year options with strike prices at book value plus 4% per year. 6. If you are terminated without cause prior to December 31, 2000 you will receive two years of base pay and any options will vest immediately. Frank, I look forward to working with you. If you find the terms of this letter acceptable please initial and return a copy to me. Sincerely, James H. Ozanne EX-13.(A) 5 EXHIBIT 13(A) 1 EXHIBIT 13a TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS Back in 1946, Source One Mortgage Services Corporation laid the foundation for the Company that has evolved today. Just as a house that was built in 1946 would undergo renovations, so too has Source One. We started with four employees in a one-room office and, over the years, have upgraded to a 1,500 employee Company. What has always remained the same, however, is the foundation on which the Company was built. Our goal of providing a home for every loan has been apparent all along. Worthy goals are not achieved overnight and we're still working on the goal of providing a home for every loan. To that end, we've made some changes and some additions in 1997. It's true that our last year was a period of significant change for the Company. It was the first year of our operation under a strategic plan adopted to position us to return low ROE capital to our parent company while simultaneously shaping a more profitable business with the capital remaining in the Company. The sale of a $17 billion portfolio to Chase Mortgage for $267 million in February set the stage for the year. This transaction both liquified a low-return servicing asset and reduced our exposure to swings in interest rates. In conjunction with the sale, we negotiated the subservicing rights to this portfolio and began seeking other subservicing partners. Change isn't easy, making this a difficult year for the management and employees of Source One. We reduced our work force, added new products quickly, changed our focus from conventional to government originations, made changes in top management and our Board of Directors, all while we were completely restructuring our sales organization. We spent significant time and money renovating the Company in 1997 and have a major challenge before us in 1998 to execute the plan for which the groundwork was laid last year. We still have a lot of work to do, but in our judgement, we have the people and the plan to make Source One profitable again. Early 1998 results are solidly in the black. OPERATING RESULTS After a very slow start, our mortgage loan production grew 15% in 1997 to $4.4 billion. Unfortunately, we concluded the year with a net loss of $13.5 million compared with a net loss of $4.3 million the year before. We realized several strategic gains during the year including the reduction of our term debt with the proceeds received from the $17 billion servicing rights sale in February. We repurchased $119.6 million of 8.875% medium term notes due October 15, 2001. This repurchase resulted in a $6.0 million after tax loss. However, it reduces our future borrowing costs and frees up $138 million of assets that were being used to secure the noteholders. STRATEGIC DIRECTION The key to our success in 1998 is the addition of new products to supplement our conventional, FHA and VA loans. We now have in place a revamped, revitalized and streamlined sales organization with special, stand alone business units targeting sub-prime, 125% loan to value (125% LTV), 203(k) and manufactured housing products. The most important step in adding new, higher-margin products was the establishment of an exclusive sub-prime/125% LTV operation in Lagrangeville, New York. We have also consolidated similar or overlapping backroom functions that handle the loans both before and after they have been closed. The consolidation has reduced the number of times a loan is handled and moved within the Company. We continue to aggressively pursue subservicing business. To date, we have only been able to secure modest contracts for current and flow business. The marketplace appears to accept that the Company is no longer a candidate for sale to another firm and that attitude change should have a positive impact on our subservicing efforts. Preliminary 1998 profitability projections are very positive. All of our production and support people exhibit a renewed enthusiasm about the business and we see a strong commitment to meet or exceed our 1998 Business Plan. 1 2 TO OUR SHAREHOLDERS, EMPLOYEES AND CUSTOMERS SENIOR MANAGEMENT AND BOARD There were several significant management and Board of Directors changes during 1997. James H. Ozanne was named Chairman in March. He joined us from his role as President at Fund American Enterprises, Inc., and board member of Source One. James A. Conrad, former President and CEO, elected to take early retirement as did Lawrence J. Brady, Senior Vice President, Residential Division. Mark A. Janssen, Executive Vice President, previously responsible for Capital Markets, saw his duties expanded to include the Production Division. He was also named Secretary of the Company and a member of the Board of Directors. Allan L. Waters, Gordon S. Macklin and Robert P. Keller all elected to resign from the Board of Directors in order to pursue other activities. Raymond Barrette, Executive Vice President and Chief Financial Officer of Fund American Enterprises Holdings, Inc., joined the Board. We look forward to a long and mutually beneficial association. Susan L. Bowen, Senior Vice President, was named to oversee the sales and operations functions of the Production Division. Kathleen DeFrances was promoted to Senior Vice President in charge of the Residential Division. Pablo Sanchez joined the Company as a Senior Vice President responsible for our newly formed Sub-prime Unit. He joins the firm from his association with Beneficial. And, Frank Mohan was named President and CEO in September. With 35 years of experience as a senior consumer finance executive, Mohan arrived with a mandate to add more profitable products to our business mix and to return the overall Company to profitability. (The challenge continues, and we're making excellent headway.) IN CONCLUSION Our renovation efforts are just coming to fruition; metaphorically speaking, the paint has yet to dry. We realize 1998 will be a challenge. But, we are staffed and collectively committed to successfully accomplish the difficult goals we've set for ourselves. We have in place efficient production and servicing units which can originate and service not only conventional loans, but manufactured housing, sub-prime, government, 203(k) and 125% LTV products. Our Sub-prime Unit has strategically and impactfully enlisted the support of our Production Division and they will consciously focus their respective efforts toward writing higher margin sub-prime loans. We extend a genuine and sincere thanks to all of our dedicated employees who have stood by the Company during its difficult transition. Their diligence toward providing the highest quality service to both our mortgage and subservicing customers has given us the solid base from which we can continue to grow. Our collective thanks to our Board of Directors for its support and direction. And last, but certainly not least, a respectful thanks to our customers who have made all the years possible. Sincerely, Francis X. Mohan James H. Ozanne ------------------------ ---------------------- Francis X. Mohan James H. Ozanne President and CEO Chairman March 27, 1998 2 3 SELECTED CONSOLIDATED FINANCIAL DATA & CORPORATE INFORMATION*
INCOME STATEMENT DATA (in thousands, except per share amounts) - ------------------------------------------------------------------------------------------------------------------------------- Year Ended December 31, 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------------------- Total revenue $ 93,874 $ 148,680 $ 148,595 $ 142,493 $ 173,564 Total expenses 105,021 143,553 105,313 137,215 111,387 - ------------------------------------------------------------------------------------------------------------------------------- (Loss) income before income taxes, extraordinary loss and cumulative effect of accounting change (11,147) 5,127 43,282 5,278 62,177 Income tax (benefit) expense (3,617) 9,453 16,132 4,474 22,056 - ------------------------------------------------------------------------------------------------------------------------------- (Loss) income before extraordinary loss and cumulative effect of accounting change (7,530) (4,326) 27,150 804 40,121 Extraordinary loss on retirement of debt (5,975) - (902) - - Cumulative effect of accounting change (a) - - - (44,296) - - ------------------------------------------------------------------------------------------------------------------------------- Net (loss) income $ (13,505) $ (4,326) $ 26,248 $ (43,492) $ 40,121 - ------------------------------------------------------------------------------------------------------------------------------- Basic net (loss) income per common share (b): Before extraordinary loss and cumulative effect of accounting change $ (3.78) $ (3.57) $ 7.55 $ (1.65) $ 9.48 Basic net (loss) income per common share (5.79) (3.57) 7.20 (14.21) 9.48 - ------------------------------------------------------------------------------------------------------------------------------- Cash dividends per common share (c) $ - $ - $ - $ - $ 6.39 Cash dividends declared on common shares - - - - 26,616 Payment for common shares repurchased 2,638 - 120,000 122,000 - Insurance of common shares 119,040 - - - - - ------------------------------------------------------------------------------------------------------------------------------- COMPREHENSIVE INCOME STATEMENT DATA (d) - ------------------------------------------------------------------------------------------------------------------------------- Net (loss) income $ ( 13,505) $ (4,326) $ 26,248 $ (43,492) $ 40,121 Other comprehensive income (loss) 41,102 546 3,519 (3,779) 23,731 - ------------------------------------------------------------------------------------------------------------------------------- Comprehensive income (loss) $ 27,597 $ (3,780) $ 29,767 $ (47,271) $ 63,852 - ------------------------------------------------------------------------------------------------------------------------------- Basic comprehensive income (loss) per common share (b) $ 8.03 $ (3.33) $ 8.57 $ (15.28) $ 15.09 - ------------------------------------------------------------------------------------------------------------------------------- OPERATING DATA - ------------------------------------------------------------------------------------------------------------------------------- Total mortgage loan production (in millions) $ 4,403 $ 3,831 $ 2,852 $ 4,586 $ 11,452 Servicing portfolio at end of year (e): Balance (in millions) $ 26,546 $ 29,201 $ 31,831 $ 39,568 $ 38,403 Number of loans serviced (f) 438,261 478,779 494,051 543,428 518,972 Weighted average interest rate (f) 8.45% 8.48% 8.33% 8.14% 8.53% Weighted average net servicing fee (f) (g) .420% .422% .419% .410% .432% Percent delinquent (f) 6.35% 6.24% 5.28% 4.07% 4.44% Percent in process of foreclosure 1.18% .93% .80% .77% .92% Servicing rights acquisitions (in millions) $ 36 $ 2,789 $ 4,674 $ 3,707 $ 6,368 Sale of servicing rights (in millions) $ 17,018 $ 3,302 $ 10,973 $ 3,868 $ - Number of employees at end of year 1,572 1,682 1,680 2,055 3,060 - ------------------------------------------------------------------------------------------------------------------------------- BALANCE SHEET DATA (in thousands) December 31, - ------------------------------------------------------------------------------------------------------------------------------- Mortgage loans receivable $ 519,247 $ 314,937 $ 381,028 $ 210,472 $1,298,506 Capitalized servicing (net) (h) 181,025 410,939 397,071 530,450 666,666 Total assets 1,304,690 1,131,054 1,135,029 1,210,012 2,647,153 Senior debt 686,906 643,262 661,846 647,251 1,959,643 Subordinated debt 55,153 54,535 54,786 - - Total liabilities 849,641 816,297 812,785 733,925 2,095,153 Total stockholders' equity 455,049 314,757 322,244 476,087 552,000 - -------------------------------------------------------------------------------------------------------------------------------
*See accompanying notes to selected consolidated financial data. 3 4 NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA & CORPORATE INFORMATION (a) The 1994 amount reflects the cumulative after tax effect, as of January 1, 1994, of a change in the methodology used to measure impairment of the purchased mortgage servicing rights asset. (b) Basic net (loss) income and basic comprehensive income (loss) per common share amounts for all years presented are based on the weighted average number of common shares outstanding. (c) Cash dividends per common share were computed based on the total number of common shares outstanding as of the dividend record dates. (d) Comprehensive income includes net income (loss) and the net change in after tax unrealized investment gain (refer to Note 1 to the consolidated financial statements for further discussion). (e) Includes loans subserviced for others having a principal balance of $14.9 billion, $2.8 billion, $4.0 billion and $4.3 billion as of December 31, 1997, 1996, 1995 and 1994, respectively, except as noted. (f) Excludes interim servicing of loans having a principal balance of $1,651 million and $4,190 million as of December 31, 1994 and 1993, respectively. (g) Excludes loans subserviced for others as noted in (d) above. (h) Reflects a $68.1 million cumulative pretax effect adjustment to the purchased mortgage servicing rights asset as of January 1, 1994 relating to a change in the methodology used to measure its impairment. FORM 10-K The financial information contained in this report substantially conforms with the information required in the "Form 10-K" Annual Report filed by the Company with the Securities and Exchange Commission at the end of March 1998. Certain supplemental information appears in such Form 10-K that is not necessarily disclosed within this document. Copies of such Form 10-K (without exhibits) are available, without charge, upon request to the Corporate Secretary's Office, Source One Mortgage Services Corporation, 27555 Farmington Road, Farmington Hills, Michigan 48334-3357 (telephone: (248) 488-7000). BUSINESS The Company primarily engages in the business of producing and selling conforming and subprime residential mortgage loans, servicing conforming residential mortgage loans and subservicing residential mortgage loans for third parties. In response to increased industry competition for producing and servicing conforming mortgage loans, the Company has decided to broaden its product line by offering higher margin products. The Company has recently begun to produce 203(k) (FHA home improvement) loans, manufactured housing loans, subprime loans and 125% loan-to-value ("125% LTV") second mortgage loans. The 203(k) loans and the manufactured housing loans are being sold into agency pools with servicing retained. The subprime and 125% LTV loans are being originated for a fee and sold to third parties on a servicing released basis. The Company is currently expanding its capability to service and subservice subprime loans and to subservice 125% LTV loans. Although these higher margin products are a new focus for the Company, they accounted for less than 2% of total production in 1997 and are currently expected to account for less than 10% of total production in 1998. The Company's primary sources of revenue are net servicing revenue, net interest revenue, net gain on sale of mortgages, net gain on sale of servicing, earnings from unconsolidated affiliate and other revenue. The Company is also engaged, through certain of its subsidiaries, in the sale of credit-related insurance products (such as life, disability, health, accidental death and property and casualty insurance). MARKET FOR STOCK AND RELATED MATTERS There is no established public trading market for the Company's common stock. As of March 31, 1998, there were two holders of the 3,211,881 shares of the Company's issued and outstanding common stock, White Mountains Holdings, Inc. ("White Mountains") (formerly Fund American Enterprises, Inc.), and its parent Fund American Enterprises Holdings, Inc. ("Fund American"). No cash dividends on common stock were declared for the years ended December 31, 1997, 1996 or 1995. The Company's secured credit agreement contains covenants which limit its ability to pay dividends or make distributions on its capital in excess of preferred stock dividend and subordinated debt interest requirements each year. In addition, the Company must comply with certain financial covenants provided in its secured credit agreement, including restrictions relating to tangible net worth and leverage. The Company is currently in compliance with all such covenants. 4 5 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1997 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1996 SUMMARY - The Company reported a net loss of $13.5 million for the year ended December 31, 1997 compared to a net loss of $4.3 million for the year ended December 31, 1996. The 1997 net loss includes a $9.2 million pretax extraordinary loss on the early retirement of the Company's medium-term debt, a $8.0 million pretax loss on the sale of servicing to a third party and the related assumption of subservicing, a $3.0 million pretax charge relating to loans held for investment identified as held for sale, $3.1 million of pretax restructuring and compensation charges and a $17.7 million pretax increase in the valuation allowances for impairment of the Company's capitalized servicing asset. These amounts are partially offset by a $11.3 million net gain on financial instruments and $9.5 million pretax equity in earnings of an unconsolidated affiliate. The 1996 net income includes a $29.1 million pretax charge for the write-off of the Company's goodwill and other intangible assets, and a $.9 million pretax charge for impairment of its capitalized servicing asset. These amounts are partially offset by a $10.1 million pretax gain on the sale of servicing to a third party and a $9.9 million pretax net gain on financial instruments. The Company reported comprehensive income of $27.6 million for the year ended December 31, 1997 compared to a comprehensive loss of $3.8 million for the year ended December 31, 1996. Comprehensive income includes net income (loss) and the net change in after tax unrealized investment gain (refer to Note 1 to the consolidated financial statements for further discussion). The Company's 1997 unrealized investment gains are associated primarily with its investment in Financial Security Assurance Holdings Ltd. ("FSA"), an unconsolidated affiliate, which it acquired during 1997 (refer to Note 2 to the consolidated financial statements for further discussion). The Company's 1996 unrealized investment gains are associated with its investment in common equity securities. The Company's total mortgage servicing portfolio decreased to $26.5 billion as of December 31, 1997 from $29.2 billion as of December 31, 1996. As part of the Company's corporate strategy to minimize exposure to interest rate risk inherent in its servicing asset, the Company took steps to reduce the size of its owned servicing portfolio and expand its subservicing business in the first quarter of 1997. In February 1997, the Company sold $17.0 billion of its nonrecourse mortgage servicing portfolio to a third party for adjusted proceeds of $266.9 million and recognized a pretax loss of $8.0 million on the sale and the related assumption of subservicing. The following table illustrates the change in the Company's mortgage servicing portfolio mix primarily as a result of the sale:
- -------------------------------------------------------------------------- December 31, (in millions) 1997 1996 - -------------------------------------------------------------------------- Mortgage servicing portfolio owned $11,627 $26,410 Mortgage servicing portfolio subserviced for others 14,919 2,791 - -------------------------------------------------------------------------- Total mortgage servicing portfolio $26,546 $29,201 - --------------------------------------------------------------------------
The Company is continuing its efforts to expand its subservicing business. Concurrent with the above strategy, the Company also continued to act on its strategy to optimize returns on its owned servicing portfolio by buying and selling mortgage servicing rights based on the underlying risk and return characteristics. The Company purchased the rights to service $.04 billion and $2.8 billion of mortgage loans from third parties during 1997 and 1996, respectively. During 1996, the Company sold the rights to service $3.3 billion of mortgage loans for net proceeds of $55.9 million and a pretax gain of $10.1 million. Additional sales transactions may occur in the future when management deems it to be economically advantageous. Total mortgage production for the years ended December 31, 1997 and 1996 was $4.4 billion and $3.8 billion, respectively. Production related to refinancing activity made up 40% of total production for 1997 as compared to 33% for 1996. The increase in mortgage loan production in 1997 reflects overall lower market interest rates during 1997 and a corresponding increase in refinance activity from 1996. Mortgage loan payoffs for each of the years ended December 31, 1997 and 1996 were $3.0 billion. The average prepayment rate of the Company's total servicing portfolio was 10.5% for each of the years ended December 31, 1997 and 1996. The Company's prepayment experience is significantly influenced by fluctuations in mortgage interest rates, 5 6 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS although the effect is not immediate. While overall, mortgage interest rates were lower during 1997 than in 1996, there was a significant decline in rates in December of 1997. Therefore, the average prepayment rates for 1997 do not fully reflect the decrease in interest rates as of year end 1997. The average prepayment rates for the months of January and February 1998 were 11.6% and 21.9%, respectively. REVENUE - Mortgage servicing revenue decreased to $95.0 million in 1997 from $139.6 million in 1996. The decrease in mortgage servicing revenue is primarily due to the February 1997 servicing sale, slightly offset by increased subservicing revenue generated as a result of the sale. The subservicing fees, however, are significantly lower than the servicing fees earned on the Company's owned servicing portfolio. Amortization of capitalized servicing decreased $7.8 million during the year ended December 31, 1997 from the comparable 1996 period. Amortization includes a $17.7 million and $.9 million increase in the valuation allowances for impairment of the Company's capitalized servicing asset in 1997 and 1996, respectively. Excluding the effects of these charges, amortization expense decreased to $46.5 million in 1997 from $71.0 million in 1996. This decrease in amortization expense is primarily the result of a smaller servicing asset due to the February 1997 servicing sale. The impairment charge in 1997 is primarily a result of increased market consensus prepayment rates and a corresponding decrease in the fair value of the Company's capitalized servicing asset from year end 1996. In 1994, the Company sold the rights to service $3.9 billion of mortgage loans to a third party and continued to service these loans pursuant to a subservicing agreement. The gain of $19.9 million was deferred and was being recognized over the five-year life of the subservicing agreement. In the fourth quarter of 1996, the third party sold the rights to service approximately $1.0 billion of these mortgage loans, representing approximately 25% of the total loans subserviced by the Company for this third party. Accordingly, the Company recognized an additional $2.4 million of the deferred gain in 1996, representing approximately 25% of the deferred balance at the time of sale. In the fourth quarter of 1997, the third party sold the rights to service the remaining portfolio of loans. As a result, the Company recognized the $4.4 million remaining balance of the deferred gain. In 1997 and 1996, the Company recognized deferred gains totaling $6.9 million and $6.1 million, respectively, as part of mortgage servicing revenue in the consolidated statements of income. The Company invests in various financial instruments in order to offset changes in the value of its capitalized servicing asset and to mitigate the effect on earnings of higher amortization and impairment of the asset which results from increased prepayment activity that can occur with decreases in market interest rates. As interest rates decline, prepayment activity generally increases, thereby reducing the value of the capitalized servicing asset, while the value of the financial instruments increases. Conversely, as interest rates increase, the value of the capitalized servicing asset increases, while the value of the financial instruments decreases. The financial instruments utilized by the Company include interest rate floor contracts ("floors") and principal-only ("P/O") swap transactions. The floors are derivative contracts which derive their value from differences between the floor rate specified in the contract and market interest rates. The cash flow from the floors is equal to the difference between the floor rate and the prevailing interest rate applied to the notional amount. Payments are made to the Company only when the prevailing interest rates are below the floor rate. To the extent that prevailing interest rates decrease, the value of the floors increases, even if interest rates do not fall below the floor rate. To the extent that prevailing interest rates increase, the value of the floors decreases. However, the Company is not exposed to losses in excess of its initial investment in the floors. The P/O swaps are derivative contracts, the value of which is determined by changes in the value of the referenced P/O strip security. The payments received by the Company under the P/O swaps relate to the cash flows of the referenced P/O security. The payments made by the Company are based upon a notional amount tied to the market price and the remaining balance of the referenced P/O security multiplied by a floating rate indexed to the London Interbank Offered Rates for U.S. dollar deposits ("LIBOR"). The Company recognized a net gain on its financial instruments of $11.3 million and $9.9 million for the years ended 6 7 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OOPERATIONS December 31, 1997 and 1996, respectively. The 1997 net gain includes $2.0 million in realized losses from the sale of financial instruments slightly offset by net cash flows received and $13.3 million in unrealized gains due to a net increase in the fair value of the various financial instruments. The 1996 net gain includes $8.1 million in realized gains from the sale of financial instruments and net cash flows received and $1.8 million in unrealized gains due to a net increase in the fair value of the various financial instruments. As of December 31, 1997 and 1996, the carrying value of the financial instruments was $20.7 million and $8.0 million, respectively, and is included in investments in the consolidated statements of condition (refer to Note 11 to the consolidated financial statements for further discussion). Interest income increased to $45.8 million in 1997 from $40.8 million in 1996. The increase in interest income is primarily the result of interest income earned on the outstanding receivable balance from the February 1997 servicing sale, an increase in interest income from pool loan purchases due to a higher average asset balance and income earned on an investment acquired in the second quarter of 1997. This increase was slightly offset by a decrease in conventional mortgage loan production and the corresponding decrease in the average conventional mortgage loans receivable inventory. Interest expense decreased slightly to $35.4 million in 1997 from $36.0 million in 1996. This decrease is primarily due to the retirement of medium-term notes and long-term debentures during 1996, the early retirement of medium-term notes in 1997 and a reduction in debt from the cash proceeds received from the 1997 servicing sale. This decrease was almost entirely offset by a decrease in interest expense credits received on escrow and custodial funds held in trust accounts resulting from the decrease in the Company's owned servicing portfolio and an increase in short-term borrowings necessary to fund increased production. In 1997, the Company realized a $.3 million gain from the transfer of its remaining common equity securities to White Mountains in exchange for shares of the Company's common stock held by White Mountains, which were then retired by the Company. The 1996 realized loss of $.9 million was a result of the Company selling certain common equity securities to White Mountains for cash. All of the equity securities involved in such transactions were actively traded, readily marketable, listed on a national exchange and, for purposes of such transactions, were valued at their closing prices on the day preceding the date of each transaction. The Company realized a net investment loss of $1.0 million for the year ended December 31, 1997 compared to a net investment gain of $.6 million for the year ended December 31, 1996. These amounts include the write-down of certain investments to realizable value offset by certain realized gains related to a partnership investment. In mid-March 1997, the Board of Directors of Fund American and several of its subsidiaries approved a corporate restructuring plan that strengthened the Company by increasing its stockholders' equity. The most significant part of the plan was the contribution of the Company's investment in FSA by its direct parent. The Company recognized $9.5 million of equity in earnings of FSA for the year ended December 31, 1997 (refer to Notes 2 and 10 to the consolidated financial statements for further discussion). Net gain on mortgage sales decreased to $21.5 million in 1997 from $38.3 million in 1996. This decrease is primarily due to decreased capitalized originated mortgage servicing rights ("OMSR") income as a result of a change in the Company's mortgage loan production mix which included a proportionately higher volume of correspondent production, which generates lower OMSR income. At this time, the Company is uncertain if future originations will continue to be comprised of a proportionately higher volume of correspondent production. The decrease in the 1997 gain also reflects a $3.0 million pretax charge relating to mortgage loans held for investment which were identified for sale and marked down from amortized cost to current market value during the second quarter of 1997 (refer to Note 7 to the consolidated financial statements for further discussion). The Company recorded a $4.3 million pretax loss from the sale of $17.0 billion of nonrecourse mortgage servicing rights and the related assumption of subservicing in the first half of 1997. The Company recorded an additional loss of $3.7 million in the fourth quarter of 1997 in connection with the amendment of the subservicing arrangement which extended the Company's subservicing responsibilities for one additional year at less favorable terms than the original agreement provided. The Company will continue to service these loans pursuant to a subservicing agreement at least until March 1999, June 1999 and August 1999 for Federal Home Loan Mortgage Corporation ("FHLMC") loans, 7 8 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Government National Mortgage Association ("GNMA") loans and Federal National Mortgage Association ("FNMA") loans, respectively. The subservicing period can be extended for one additional year beyond these dates at the option of the purchaser. During 1996, the Company sold the rights to service $3.3 billion of its mortgage servicing portfolio and realized a pretax gain of $10.1 million. EXPENSES - Salaries and employee benefits expense was $54.8 million and $56.3 million for the years ended December 31, 1997 and 1996, respectively. Generally accepted accounting principles ("GAAP") require certain loan origination revenues to be netted against direct loan origination costs. Since salaries and employee benefits expense is the largest component of loan origination costs, approximately 90% of loan origination revenues are accounted for as a reduction to salaries and benefits expense as indicated in the following table:
- -------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 - -------------------------------------------------------------------------- Unadjusted salaries and employee benefits expense $74,405 $76,114 GAAP net origination revenues (19,611) (19,820) - -------------------------------------------------------------------------- GAAP salaries and employee benefits expense $54,794 $56,294 - --------------------------------------------------------------------------
The slight decrease in loan origination revenues, reflecting lower retail mortgage loan production during the year ended December 31, 1997 as compared to the same 1996 period, slightly offset the decrease in unadjusted salaries and employee benefits expense. The decrease in unadjusted salaries and employee benefits expense primarily reflects decreased headcount as a result of the Company's restructuring plan implemented in the second quarter of 1997, partially offset by higher loan officer commissions associated with the increase in total mortgage loan production in 1997 and an increase in the long term incentive plan accrual. The provision for loan losses was $8.6 million and $10.3 million for the years ended December 31, 1997 and 1996, respectively. The decrease in the 1997 provision is primarily due to lower loss volumes resulting from the decrease in the Company's owned servicing portfolio, a decrease in the average loss per loan and lower loss volumes on certain California residential mortgage loans in 1997. In addition, the 1997 provision includes a $.4 million charge related to the sale of a commercial real estate owned property in the second quarter of 1997. A valuation allowance of $2.6 million was included in the December 31, 1996 allowance for loan losses and $.9 million was charged to the 1996 provision for this property. In the fourth quarter of 1996, the Company wrote off the remaining carrying value of goodwill and certain other intangible assets totaling $29.1 million. It is the Company's policy to account for goodwill and other intangible assets at the lower of amortized cost or fair value. On an ongoing basis, management reviews the valuation and amortization of these assets. As a part of its ongoing review, management estimates the fair value of the Company's intangible assets, taking into consideration any events and circumstances which might have diminished their value. During 1996, the Company had been re-evaluating the recoverability of goodwill and certain other intangible assets and considered the impact of the following factors on its forecast of future operations (i) increased competition and industry consolidation which had adversely impacted the value of the Company's mortgage loan production and servicing operation; (ii) the attainment of a definitive agreement in the fourth quarter of 1996 to sell approximately $17.0 billion of the Company's mortgage servicing portfolio at essentially book value and (iii) a reduction in interest rates in the fourth quarter of 1996. Based on such valuation, the Company had determined that its projected results would not support the future amortization of the Company's remaining goodwill and certain other intangible assets of $29.1 million at December 31, 1996 and, therefore, wrote-off such assets. In April 1997, the Company's management approved and implemented a restructuring plan designed to reduce its operating costs in order to improve its financial performance. As part of this plan, the Company reduced its work force, primarily in overhead areas, by approximately 100 employees during the second quarter of 1997 to bring its overhead costs in line with its production and servicing operations. As a result, the Company recognized restructuring charges totaling $1.7 million during the second quarter of 1997. The amount includes approximately $1.6 million of employee separation costs, including severance payments, health care coverage and postemployment education benefits and $.1 million of miscellaneous expenses. As of December 31, 1997, $.1 8 9 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS million of these charges remained accrued in the Company's consolidated statement of condition. Other operating expenses were $26.6 million and $34.3 million for the year ended December 31, 1997 and 1996, respectively. The decrease in 1997 is primarily due to the elimination of amortization expense related to goodwill and certain other intangible assets which were written off at year end 1996. The Company's income tax provision for the year ended December 31, 1997 includes an additional provision for the effect of the February 1997 servicing sale. The 1996 provision was adversely impacted by the write-off of goodwill and other intangible assets at year end 1996. The total pretax write-off of these assets was $29.1 million and the related tax benefit was $3.2 million. The Company recognized an extraordinary loss of $6.0 million, net of income tax benefit, on the early retirement of $119.6 million of its outstanding 8.875% medium-term notes due October 15, 2001 in the second quarter of 1997. During the fourth quarter of 1996, the Company established a team to coordinate the identification, evaluation and implementation of changes to computer systems and applications necessary to achieve a year 2000 date conversion with no effect on customers or disruption to business operations. These actions are necessary to ensure that the systems and applications will recognize and process the year 2000 and beyond. Currently, the project is substantially complete and unit tested, with an estimated completion date in early 1998. At that time, testing of the full system will begin and is estimated to be complete well before the end of 1998. The cost of achieving year 2000 compliance is estimated to be less than $2.0 million above the cost of normal software upgrades and replacements. As of December 31, 1997 approximately $1.0 million had been spent on the project. The Company has initiated formal communications with all of its significant business partners to determine the extent to which the Company's interface systems are vulnerable to those third parties' failure to remedy their own year 2000 issues. There is no guarantee that the systems of other companies on which the Company's systems rely will be converted on a timely basis and will not have an adverse effect on the Company's systems. YEAR ENDED DECEMBER 31, 1996 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1995 SUMMARY - The Company reported a net loss of $4.3 million for the year ended December 31, 1996 as compared to net income of $26.2 million for the year ended December 31, 1995. The 1996 net loss reflects a $29.1 million pretax charge for the write-off of the Company's goodwill and other intangible assets and a $.9 million pretax charge for impairment of its capitalized servicing asset. These amounts were partially offset by a $10.1 million pretax gain on the sale of servicing to a third party and a $9.9 million pretax net gain on financial instruments. The 1995 net income includes a $28.0 million pretax charge for impairment of the capitalized servicing asset, $40.0 million of pretax gains on the sale of servicing to third parties and a $.8 million pretax net gain on financial instruments. The Company reported a comprehensive loss (which includes net income (loss) and the net change in after tax unrealized investment gain) of $3.8 million for the year ended December 31, 1996 as compared to comprehensive income of $29.8 million for the year ended December 31, 1995. The Company's 1996 and 1995 unrealized investment gains are associated with its investment in common equity securities. The Company's total mortgage servicing portfolio decreased to $29.2 billion as of December 31, 1996 from $31.8 billion as of December 31, 1995. The Company continued to act on its corporate strategy to optimize returns on its owned servicing portfolio by buying and selling mortgage servicing rights based on the underlying risk and return characteristics. The Company purchased the rights to service $2.8 billion and $4.7 billion of mortgage loans from third parties during 1996 and 1995, respectively. During 1996, the Company sold the rights to service $3.3 billion of mortgage loans for net proceeds of $55.9 million and a pretax gain of $10.1 million. During 1995, the Company sold a total of $11.0 billion in servicing rights to third parties for net proceeds of $199.1 million and a pretax gain of $40.0 million. Total mortgage production for the years ended December 31, 1996 and 1995 was $3.8 billion and $2.9 billion, respectively. Production related to refinancing activity made up 33% of total mortgage loan production for 1996 as 9 10 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS compared to 23% for 1995. The increase in mortgage loan production in 1996 reflects overall lower market interest rates during 1996 and a corresponding increase in refinancing activity from 1995 levels. Mortgage loan payoffs for the years ended December 31, 1996 and 1995 were $3.0 billion and $2.3 billion, respectively. The average prepayment rate of the Company's total servicing portfolio was 10.5% for the year ended December 31, 1996 as compared to 8.3% for 1995. The Company's prepayment experience is significantly influenced by fluctuations in mortgage interest rates, although the effect is not immediate. A steady decline in market interest rates for mortgage loans during 1995 in addition to average lower interest rates in 1996 contributed to the increase in mortgage loan prepayments during 1996. REVENUE - Mortgage servicing revenue decreased to $139.6 million in 1996 from $141.9 million in 1995. This decrease is primarily due to a lower average servicing portfolio balance during 1996 compared to 1995. This decrease was partially offset by the recognition of a portion of the Company's deferred gain on the 1994 sale of servicing rights. Amortization of capitalized servicing decreased $9.4 million during the year ended December 31, 1996 from the comparable 1995 period. Amortization includes a $.9 million and $28.0 million increase in the valuation allowances for impairment of the Company's capitalized servicing asset in 1996 and 1995, respectively. Excluding the effects of these charges, amortization expense increased to $71.0 million from $53.4 million for the years ended December 31, 1996 and 1995, respectively. The increase in amortization expense is primarily due to higher market consensus prepayment rates as well as a higher average servicing asset balance during 1996 as compared to 1995. The impairment charge in 1995 is a result of increased market consensus prepayment rates and a corresponding decrease in the fair value of the Company's capitalized servicing asset from year end 1994. In 1994, the Company sold the rights to service $3.9 billion of mortgage loans to a third party and continued to service these loans pursuant to a subservicing agreement. The gain of $19.9 million was deferred and was being recognized over the five-year life of the subservicing agreement. In the fourth quarter of 1996, the third party sold the rights to service approximately $1.0 billion of these mortgage loans, and as a result, the Company recognized an additional $2.4 million of the deferred gain. In 1996 and 1995, the Company recognized deferred gains totaling $6.1 million and $4.2 million, respectively, as part of mortgage servicing revenue in the consolidated statements of income. For the year ended December 31, 1996, the Company recognized a $9.9 million gain on its financial instruments as compared to a gain of $.8 million in 1995. The 1996 gain includes $8.1 million in realized gains from the sale of financial instruments and net cash flows received and $1.8 million in unrealized gains due to a net increase in the fair market value of various financial instruments. The 1995 gain includes unrealized gains due to a net increase in the fair market value of the financial instruments. As of December 31, 1996 and 1995, the carrying value of the financial instruments was $8.0 million and $3.5 million, respectively, and is included in investments in the consolidated statements of condition (refer to Note 11 to the consolidated financial statements for further discussion). Interest income increased to $40.8 million in 1996 from $37.7 million in 1995. The increase in interest income is indicative of the increase in production levels experienced in 1996 as compared to 1995. Interest expense increased to $36.0 million in 1996 from $27.3 million in 1995. This increase is due to the increase in short-term borrowings necessary to fund production as well as the additional expense related to the $56.0 million in principal amount of subordinated debentures issued in December 1995. The Company had net realized losses on the sale and exchange of securities with affiliates of $.9 million and $2.2 million for the years ended December 31, 1996 and 1995, respectively. The 1996 loss was a result of the Company selling its then remaining common equity securities to White Mountains for cash. The 1995 loss resulted from the transfer of $27.0 million of certain common equity securities to White Mountains in exchange for shares of the Company's common stock held by White Mountains, which were then retired by the Company. All of the equity securities involved in such transactions were actively traded, readily marketable, listed on a national exchange and, for purposes of such transactions, valued at their closing prices on the day preceding the date of each transaction. The net realized investment gain of $.6 million for the year ended December 31, 1996 includes a $1.4 million gain on 10 11 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS the return of a partnership investment, offset by the writedown of certain investments to realizable value. The net realized loss of $.5 million for the year ended December 31, 1995 primarily reflects net losses realized on the sale of the Company's common equity securities to third parties. Net gain on sale of mortgages increased to $38.3 million in 1996 from $24.0 million in 1995. The increase reflects increased production and related mortgage sales volumes in 1996. Other revenue was $18.1 million and $15.6 million for the years ended December 31, 1996 and 1995, respectively. The increase in other revenue, which consists primarily of insurance commissions and brokerage fees, was directly related to the increase in production volumes. EXPENSES - Salaries and employee benefits expense was $56.3 and $51.3 million for the years ended December 31, 1996 and 1995, respectively. Generally accepted accounting principles ("GAAP") require loan origination revenues to be netted against direct loan origination costs. Since salaries and employee benefits expense is the largest component of loan origination costs, approximately 90% of loan origination fees are accounted for as a reduction to salaries and employee benefits expense as illustrated in the following table:
- -------------------------------------------------------------------------- Year ended December 31, (in thousands) 1996 1995 - -------------------------------------------------------------------------- Unadjusted salaries and employee benefits expense $76,114 $68,807 GAAP net origination revenues (19,820) (17,550) - -------------------------------------------------------------------------- GAAP salaries and employee benefits expense $56,294 $51,257 - --------------------------------------------------------------------------
An increase in loan origination revenues, reflecting higher retail mortgage loan production in 1996, slightly offsets the increase in unadjusted salaries and employee benefits expense. Excluding the effects of loan origination revenues, salaries and employee benefits expense increased 11% in 1996 as compared to 1995. This increase reflects the additional personnel expenses and loan officer commissions associated with the Company's increased mortgage loan production in 1996. The provision for loan losses increased to $10.3 million in 1996 from $7.0 million in 1995. This increase is attributable to a higher average loss per loan, higher loss volumes relating to certain California residential mortgage loans and increased losses due to servicing portfolios acquired by the Company during the fourth quarters of 1995 and 1996. The delinquency rates of these acquired portfolios were higher than the Company's historical average delinquency rate. The Company purchased these portfolios for prices which were reflective of these higher delinquency rates. In addition, the 1996 provision includes a $.9 million charge to increase the valuation allowance of a certain commercial real estate owned property. The valuation allowance for this property totaled $2.6 million at December 31, 1996. In the fourth quarter of 1996, the Company wrote off the remaining carrying value of goodwill and certain other intangible assets totaling $29.1 million. Other operating expenses, which consist primarily of loan processing expenses and general office expenses, increased to $34.3 million in 1996 from $32.8 million in 1995. Loan processing expenses tend to decrease or increase with mortgage loan production. Accordingly, the increase in other operating expenses in 1996 reflects higher mortgage loan production in 1996 compared to 1995. LIQUIDITY AND CAPITAL RESOURCES The Company's primary cash flow requirements relate to funding mortgage loan production and investments in mortgage servicing rights. To meet these financing needs, the Company relies on short-term credit facilities, medium and long-term debt, early funding programs, cash flow from operations and until the investment downgrade described below, commercial paper borrowings. The Company also generates cash from the sale of servicing. Management believes capital resources will be sufficient to meet the Company's operating needs as well as to fund maturing medium and long-term debt. 11 12 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In July 1997, the Company amended and restated its secured revolving credit agreement to reflect a reduction in its borrowing requirements resulting from the cash proceeds received from the 1997 servicing sale. The provisions of the amended agreement decreased the Company's revolving credit facility from $750.0 million to $500.0 million, reduced borrowing costs by lowering the facility fee and will allow the Company to use proceeds from the servicing sale to pay additional dividends on its common stock of up to $75.0 million. The provisions also granted the Company the option to increase the size of the facility up to $750.0 million, with bank concurrence (refer to Note 23 to the consolidated financial statements). In order to fund increased production volumes and replace commercial paper financing no longer available as a result of the downgrade of the Company's debt rating as described below, the Company exercised its right under the agreement to request additional commitments in December 1997. With bank concurrence, the Company obtained additional commitments of $100.0 million which increased the available revolving facility to $600.0 million. Borrowings under the facility are secured primarily by the Company's mortgage loans receivable and pool loan purchases. The revolving credit facility expires on July 24, 1998. As of December 31, 1997, the Company had $559.0 million outstanding under this facility. As of December 31, 1996, the Company had no borrowings outstanding under the previous facility, however, the Company had $347.2 million of commercial paper borrowings outstanding. The Company must comply with certain financial covenants provided in its secured revolving credit facility, including restrictions relating to tangible net worth and leverage. In addition, the secured facility contains certain covenants which limit the Company's ability to pay dividends or make distributions of its capital in excess of preferred stock dividend and subordinated debt interest requirements each year. The Company is currently in compliance with all such covenants. The Company's $60.0 million unsecured revolving credit agreement was not extended in July 1997. This agreement was designed to give the Company benefit for escrow funds held in custodial banks. The Company continues to receive this benefit by replacing borrowings under this facility with borrowings under the bid loan provision of the Company's secured credit agreement. The Company's total bank facility borrowing capacity was not reduced by the termination of the unsecured agreement because borrowings under this agreement reduced the Company's ability to borrow up to the maximum amount under its secured credit facility. As of December 31, 1996, there was $45.0 million outstanding under the Company's unsecured agreement. The Company has a $650.0 million domestic commercial paper program. In November 1997, the Company's commercial paper rating was downgraded by Moody's from Prime-3 to Not Prime. In addition, in April 1997, the Company's commercial paper rating was downgraded by Standard & Poors from A-2 to A-3. As a result of the rating downgrade in November, the Company is not able to issue commercial paper and has replaced its commercial paper borrowings with borrowings under its $600.0 million revolving credit facility. The Company amended a short-term borrowing agreement in April 1997 which it had entered into August 1996. The provisions of the amended agreement increased the Company's facility from $25.0 million to $50.0 million. As a result of the rating downgrade in November 1997, the Company is not able to borrow under this agreement. As of December 31, 1996, there was $15.0 million outstanding under the original agreement. Central Pacific Mortgage Company ("Central Pacific"), a wholly-owned subsidiary of the Company, entered into a new unsecured revolving credit agreement in May 1997 under which it can borrow up to $15.0 million through June 1, 1998. Central Pacific amended this agreement in December 1997 to change certain reporting requirements and financial covenants. Borrowings under the agreement are guaranteed by the Company. As of December 31, 1997, there was $10.5 million outstanding under this agreement. As of December 31, 1996, there were no borrowings outstanding under the previous agreement which allowed for borrowings up to $10.0 million. Central Pacific must comply with certain financial covenants provided in its revolving credit agreement, including restrictions relating to tangible net worth and leverage. As guarantor, these covenants apply to the Company. Central Pacific is currently in compliance with all such covenants. 12 13 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Effective December 8, 1995, the Company exchanged and retired 2,239,061 shares of its 8.42% cumulative preferred stock, Series A, for $56.0 million principal amount of 9.375% subordinated interest deferrable debentures ("subordinated debentures"), due December 31, 2025. Interest on the subordinated debentures is paid quarterly in arrears at the annual rate of 9.375% on the last business day of each March, June, September and December. The first interest payment was made on December 29, 1995 for the period from November 1, 1995 (the last regular dividend payment date with respect to the preferred stock) through December 8, 1995 at the annual rate of 8.42% and from December 9, 1995 through December 31, 1995 at the annual rate of 9.375%. The purpose for the exchange was to improve the Company's after-tax cash flow since the interest payable on the subordinated debentures is deductible for federal income tax purposes, whereas dividends payable on the preferred stock are not. The subordinated debentures are redeemable at the option of the Company, in whole or in part, at any time on or after May 1, 1999. On or after such date, the subordinated debentures may be redeemed at the option of the Company at a price equal to 100% of the principal amount redeemed ($25 for each $25 principal amount of subordinated debenture), plus accrued and unpaid interest to the date fixed for redemption. In June 1992, the Company issued $100.0 million of 9% debentures due June 2012 under terms of a $250.0 million shelf registration statement filed with the Securities and Exchange Commission ("SEC") in April 1992. The debentures may not be redeemed by the Company prior to maturity. The proceeds were used for general corporate purposes. Under a $200.0 million shelf registration statement filed with the SEC in November 1988, the Company issued $40.0 million of medium-term notes in 1989, with a total weighted average interest rate of 9.65% due 1996, and in October 1991, the Company issued $160.0 million of 8.875% medium-term notes due October 2001. During 1995, the Company repurchased and retired $10.3 million of the medium-term notes due in 1996 and $21.6 million of the medium-term notes due in 2001. During 1996, the Company repaid the remaining $29.7 million of the medium-term notes due in 1996 on their maturity dates. In May 1997, the Company repurchased and retired $119.6 million of the medium-term notes due in 2001. In 1986, the Company issued $125.0 million of 8.25% debentures due November 1, 1996. The Company repurchased and retired $50.4 million of these debentures during 1995 and repaid the remaining $74.6 million on their maturity date in 1996. The Company has a dividend policy which may result in the payment of dividends on the Company's common stock, dependent upon the earnings, cash position and capital needs of the Company, limitations in credit agreements, general business conditions and other factors deemed relevant by the Company's Board of Directors. The Company did not declare any dividends on its common stock during 1997, 1996 or 1995 (refer to Note 23 to the consolidated financial statements). Quarterly cash dividends are paid on preferred stock at an annual rate of 8.42% or $2.105 per share, if declared by the Board of Directors, in arrears on the first day of each February, May, August and November. The Company paid cash dividends totaling $3.7 million, $3.7 million and $8.4 million on its preferred stock for the years ended December 31, 1997, 1996 and 1995, respectively. The preferred stock is not redeemable prior to May 1, 1999. On or after such date, the preferred stock may be redeemed at the option of the Company at a price of $25 per share, plus accrued and unpaid dividends to the redemption date. In January 1997, the Company transferred its remaining common equity securities with a market value of $2.6 million to White Mountains in exchange for 21,239 shares of the Company's common stock held by White Mountains, which were retired by the Company. In February 1997, the Company sold $17.0 billion of its nonrecourse mortgage servicing portfolio to a third party for adjusted proceeds of $266.9 million. The Company has used the proceeds of $242.6 million received from the sale through December 31, 1997 to reduce outstanding short-term debt and to retire $119.6 million of its 8.875% medium-term notes. The remaining balance of $27.3 million, including accrued interest, is reflected as a receivable from sale of servicing in the consolidated statement of condition as of December 31, 1997. The Company is currently evaluating its 13 14 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS options as to how it will utilize the remaining proceeds from the sale. These options include: (i) purchasing additional mortgage servicing rights from third parties; (ii) further reducing its outstanding indebtedness; (iii) reducing its outstanding preferred or common shareholders' equity or (iv) any combination of the foregoing. In March 1997, the Board of Directors of Fund American approved a corporate restructuring plan involving several of its subsidiaries including the Company. In accordance with this plan, the Company contracted to receive capital infusions from White Mountains of approximately $139 million (approximately $119 million net of associated tax liabilities and other adjustments) consisting primarily of common stock, convertible redeemable preferred stock and options to acquire common stock of FSA. During the first quarter of 1997, the Company issued 230,293 shares of its common stock to its White Mountains in exchange for 1.0 million shares of FSA common stock valued at $27.8 million and issued 105,000 shares of its common stock to Fund American for cash proceeds of $12.7 million. During the second quarter of 1997, the Company recorded the remaining contribution by White Mountains of $78.5 million of contracted net assets consisting of 2.5 million shares of FSA common stock, 2.0 million shares of FSA convertible redeemable preferred stock and options to acquire 2.6 million shares of FSA common stock in exchange for 650,827 shares of the Company's common stock. The capital infusions were undertaken to improve the Company's debt ratings and reduce the Company's borrowing costs. During 1996, the Company sold the rights to service a total of $3.3 billion of mortgage loans to a third party for net proceeds of $55.9 million, which were used for general corporate purposes. During 1995, the Company sold the rights to service a total of $11.0 billion of mortgage loans to third parties for net proceeds of $199.1 million, which were used to repurchase and retire debt, repurchase common stock and for general corporate purposes. During 1995, the Company transferred a total of $27.0 million of common equity securities and $93.0 million in cash and money market investments to White Mountains in exchange for 959,049 shares of the Company's common stock held by White Mountains, which were retired by the Company. The Company is currently considering further steps to restructure its debt including (i) the issuance of approximately $50.0 million of additional medium-term notes pursuant to an existing shelf registration and (ii) entering into interest rate swaps whereby the Company's obligation to pay a fixed rate of interest on a portion of its outstanding medium-term notes and debentures will be swapped for an obligation to pay a floating rate of interest. The Company believes that using floating rate debt to finance a larger portion of its mortgage servicing assets is prudent, since the value of such assets generally increases as interest rates increase, and declines as interest rates decrease. INFLATION Inflation and changes in interest rates can have differing effects on various aspects of the Company's business, particularly with respect to marketing gains and losses from the sale of mortgage loans, mortgage loan production, the value of the Company's servicing portfolio and net interest revenue. Historically, the Company's loan originations and loan production income have increased in response to falling interest rates and have decreased during periods of rising interest rates. Periods of low inflation and falling interest rates tend to reduce loan servicing income and the value of the Company's mortgage loan servicing portfolio because prepayments of mortgages increase and the average life of loan servicing rights is shortened. Conversely, periods of increasing inflation and rising interest rates tend to increase loan servicing income and the value of the Company's mortgage loan servicing portfolio because prepayments of mortgages decline and the average life of loan servicing rights is lengthened. In an attempt to mitigate the Company's exposure to changes in market interest rates, the Company utilizes various derivative financial instruments (refer to Note 11 to the consolidated financial statements). 14 15 REPORT OF INDEPENDENT AUDITORS THE BOARD OF DIRECTORS SOURCE ONE MORTGAGE SERVICES CORPORATION We have audited the accompanying consolidated statement of condition of Source One Mortgage Services Corporation and subsidiaries ("the Company") as of December 31, 1997, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We did not audit the financial statements of Financial Security Assurance Holdings Ltd. ("FSA") (a 12.1 percent owned equity investee company). The Company's investment in FSA at December 31, 1997, was $104 million, and its equity in earnings of FSA was $9.5 million for the year ended December 31, 1997. The financial statements of FSA were audited by other auditors, Coopers & Lybrand L.L.P., whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for FSA, is based solely on the report of the other auditors. The accompanying consolidated financial statements of the Company as of December 31, 1996, and for each of the years in the two-year period ended December 31, 1996, were audited by other auditors whose report thereon dated January 30, 1997, (except for Notes 7 and 22, as to which the date was March 21, 1997), on those statements included an explanatory paragraph that described the change in the Company's method of accounting for mortgage servicing rights discussed in Notes 1 and 3 to the consolidated financial statements. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audit and the report of the other auditors, the 1997 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Source One Mortgage Services Corporation and subsidiaries as of December 31, 1997, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. KPMG Peat Marwick LLP Detroit, Michigan January 29, 1998, except for Note 23 as to which the date is March 20, 1998 15 16 CONSOLIDATED STATEMENTS OF CONDITION
- ------------------------------------------------------------------------------------------------------------------------- December 31, (in thousands, except for share and per share amounts) 1997 1996 - ------------------------------------------------------------------------------------------------------------------------- ASSETS - ------------------------------------------------------------------------------------------------------------------------- Cash $ 3,134 $ 923 Investments 86,239 46,555 Investment in unconsolidated affiliate (net) 192,137 - Mortgage loans receivable 519,247 314,937 Pool loan purchases 149,791 131,539 Loans held for investment 5,191 17,984 Capitalized servicing (net) 181,025 410,939 Receivable from sale of servicing 27,324 - Common equity securities (net) - 2,312 Mortgage claims receivable and real estate acquired (net of allowance for loan losses of $12,800 in 1997 and $15,400 in 1996) 41,199 57,119 Premises and equipment 22,171 28,054 Other assets 77,232 120,692 - ------------------------------------------------------------------------------------------------------------------------- Total assets $ 1,304,690 $ 1,131,054 ========================================================================================================================= LIABILITIES AND STOCKHOLDERS' EQUITY - ------------------------------------------------------------------------------------------------------------------------- Liabilities: Senior debt $ 686,906 $ 643,262 Subordinated debt 55,153 54,535 Accounts payable and other liabilities 107,582 118,500 - ------------------------------------------------------------------------------------------------------------------------- Total liabilities 849,641 816,297 ========================================================================================================================= Stockholders' Equity: Preferred stock, $.01 par value, 12,000,000 shares authorized, 1,760,939 shares of 8.42% cumulative Series A (aggregate liquidation preference of $44,023) issued and outstanding as of December 31, 1997 and 1996 18 18 Common stock, $.01 par value, 8,000,000 shares authorized, 3,211,881 and 2,247,000 shares issued and outstanding as of December 31, 1997 and 1996, respectively 32 22 Paid-in capital 462,480 346,088 Accumulated other comprehensive income 41,102 - Retained deficit (48,583) (31,371) - ------------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 455,049 314,757 - ------------------------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 1,304,690 $ 1,131,054 =========================================================================================================================
See accompanying notes to consolidated financial statements. 16 17 CONSOLIDATED STATEMENTS OF INCOME
- ----------------------------------------------------------------------------------------------------------------------------- Year ended December 31, (in thousands, except for per share amounts) 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------------------------- REVENUE - ----------------------------------------------------------------------------------------------------------------------------- Mortgage servicing revenue $ 94,952 $ 139,578 $ 141,883 Amortization of capitalized servicing (64,150) (71,936) (81,385) Net gain on financial instruments 11,271 9,904 840 - ----------------------------------------------------------------------------------------------------------------------------- Net servicing revenue 42,073 77,546 61,338 - ----------------------------------------------------------------------------------------------------------------------------- Interest income 45,754 40,826 37,669 Interest expense (35,362) (36,018) (27,348) - ----------------------------------------------------------------------------------------------------------------------------- Net interest revenue 10,392 4,808 10,321 - ----------------------------------------------------------------------------------------------------------------------------- Net realized investment gain (loss) on sale and exchange of securities with affiliates 326 (855) (2,159) Net realized investment (loss) gain (1,048) 623 (544) Equity in earnings of unconsolidated affiliate 9,507 - - Net gain on sale of mortgages 21,497 38,346 24,015 Net (loss) gain on sale of servicing and assumption of subservicing (8,032) 10,080 40,041 Other 19,159 18,132 15,583 - ----------------------------------------------------------------------------------------------------------------------------- Total revenue 93,874 148,680 148,595 ============================================================================================================================= EXPENSES - ----------------------------------------------------------------------------------------------------------------------------- Salaries and employee benefits 54,794 56,294 51,257 Office occupancy and equipment 13,289 13,619 14,326 Provision for loan losses 8,610 10,260 6,956 Write-off of goodwill and other intangible assets - 29,128 - Restructuring charges 1,727 - - Other operating expenses 26,601 34,252 32,774 - ----------------------------------------------------------------------------------------------------------------------------- Total expenses 105,021 143,553 105,313 - ----------------------------------------------------------------------------------------------------------------------------- (Loss) income before income taxes and extraordinary loss (11,147) 5,127 43,282 Income tax (benefit) expense (3,617) 9,453 16,132 - ----------------------------------------------------------------------------------------------------------------------------- (Loss) income before extraordinary loss (7,530) (4,326) 27,150 Extraordinary loss on repurchase of debt (net of income tax benefit of $3,217 in 1997 and $486 in 1995) (5,975) - (902) - ----------------------------------------------------------------------------------------------------------------------------- Net (loss) income (13,505) (4,326) 26,248 Less dividends on preferred stock 3,707 3,707 7,634 - ----------------------------------------------------------------------------------------------------------------------------- Net (loss) income applicable to common stock $ (17,212) $ (8,033) $ 18,614 ============================================================================================================================= Basic net (loss) income per common share: Before extraordinary loss $ (3.78) $ (3.57) $ 7.55 Extraordinary loss (2.01) - (.35) - ----------------------------------------------------------------------------------------------------------------------------- Basic net (loss) income per common share $ (5.79) $ (3.57) $ 7.20 =============================================================================================================================
See accompanying notes to consolidated financial statements. 17 18 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
- ------------------------------------------------------------------------------------------------------------------------------ Year ended December 31, (in thousands, except for per share amounts) 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------------ Net (loss) income $ (13,505) $ (4,326) $ 26,248 Other comprehensive income, net of tax Unrealized gains (losses) on investments: Unrealized holding gain (loss) arising during year (net of income tax expense (benefit) of $22,245, $(5) and $914 for 1997, 1996 and 1995, respectively) 41,314 (10) 1,697 Less: reclassification adjustment for (gains) losses included in net income (net of income tax (expense) benefit of $(114), $299 and $981 for 1997, 1996 and 1995, respectively) (212) 556 1,822 - ------------------------------------------------------------------------------------------------------------------------------ Other comprehensive income 41,102 546 3,519 - ------------------------------------------------------------------------------------------------------------------------------ Comprehensive income (loss) 27,597 (3,780) 29,767 Less dividends on preferred stock 3,707 3,707 7,634 - ------------------------------------------------------------------------------------------------------------------------------ Comprehensive income (loss) applicable to common stock $ 23,890 $ (7,487) $ 22,133 ============================================================================================================================== Basic comprehensive income (loss) per common share $ 8.03 $ (3.33) $ 8.57 ==============================================================================================================================
See accompanying notes to consolidated financial statements. 18 19 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
- -------------------------------------------------------------------------------------------------------------------------------- Year ended December 31, 1997, 1996 and 1995 (in thousands, except for share and per share amounts) - -------------------------------------------------------------------------------------------------------------------------------- Accumulated Total Other Retained Stock- Preferred Common Paid-in Comprehensive Earnings holders' Stock Stock Capital Income (Deficit) Equity - --------------------------------------------------------------------------------------------------------------------------------- Balances at January 1, 1995 $ 40 $ 32 $ 522,032 $ (4,065) $ (41,952) $ 476,087 Net income - - - - 26,248 26,248 Change in unrealized investment gain (net) - - - 3,519 - 3,519 Repurchase of 959,049 shares of common stock, $.01 par value, from parent - (10) (119,990) - - (120,000) Exchange of 2,239,061 shares of 8.42% cumulative Series A preferred stock, $.01 par value (aggregate liquidation preference of $25 per share) for 9.375% subordinated debentures (22) - (55,954) - - (55,976) Preferred dividends declared of $2.105 per share - - - - (7,634) (7,634) ================================================================================================================================ Balances at December 31, 1995 18 22 346,088 (546) (23,338) 322,244 Net loss - - - - (4,326) (4,326) Change in unrealized investment gain (net) - - - 546 - 546 Preferred dividends declared of $2.105 per share - - - - (3,707) (3,707) ================================================================================================================================ Balances at December 31, 1996 18 22 346,088 - (31,371) 314,757 Net loss - - - - (13,505) (13,505) Change in unrealized investment gain (net) - - - 41,102 - 41,102 Repurchase of 21,239 shares of common stock, $.01 par value, from parent - - (2,638) - - (2,638) Issuance of 105,000 shares of common stock, $.01 par value, to parent - 1 12,674 - - 12,675 Issuance of 230,293 shares of common stock, $.01 par value, to parent - 2 27,797 - - 27,799 Issuance of 650,827 shares of common stock, $.01 par value, to parent - 7 78,559 - - 78,566 Preferred dividends declared of $2.105 per share - - - - (3,707) (3,707) - -------------------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1997 $ 18 $ 32 $ 462,480 $ 41,102 $ (48,583) $ 455,049 ================================================================================================================================
See accompanying notes to consolidated financial statements. 19 20 CONSOLIDATED STATEMENTS OF CASH FLOWS
- ---------------------------------------------------------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 1995 - ---------------------------------------------------------------------------------------------------------------------------- OPERATING ACTIVITIES - ---------------------------------------------------------------------------------------------------------------------------- Net (loss) income $ (13,505) $ (4,326) $ 26,248 Noncash items included in the determination of net (loss) income: Amortization of capitalized servicing 64,150 71,936 81,385 Write-off of goodwill and other intangible assets - 29,128 - Net unrealized gain on financial instruments (13,323) (1,820) (840) Provision for loan losses 8,610 10,260 6,956 Depreciation and amortization 6,586 8,825 7,347 Write down of loans held for investment identified as held for sale 3,000 - - Loss on sale of financial instruments 2,205 - - Net realized loss on investments 722 232 2,703 Amortization of goodwill - 2,090 2,090 Loss (gain) on sale of servicing and assumption of subservicing 8,032 (10,080) (40,041) Amortization of deferred gain on sale of servicing (6,885) (6,139) (4,188) Undistributed earnings from unconsolidated affiliate (8,668) - - Mortgage loan production (4,403,281) (3,831,639) (2,852,017) Mortgage loan sales and amortization 4,198,971 3,897,730 2,681,461 Net increase (decrease) in accounts payable and other liabilities 15,950 (15,002) 18,749 Net decrease in other assets 31,154 5,433 3,985 Net change in current and deferred income taxes receivable and payable (12,160) (10,158) 16,849 Extraordinary loss on repurchase of debt 5,975 - 902 - ---------------------------------------------------------------------------------------------------------------------------- Net cash (used) provided by operating activities (112,467) 146,470 (48,411) - ---------------------------------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES - ---------------------------------------------------------------------------------------------------------------------------- Collections on and sales of pool loan purchases, mortgage claims receivable and real estate acquired 274,158 175,289 210,876 Additions to pool loan purchases, mortgage claims receivable and real estate acquired (285,100) (205,745) (172,650) Additions to capitalized mortgage servicing rights (139,500) (88,578) (120,786) Net proceeds from sales of servicing 242,628 11,706 181,109 Additions to long-term investments (53,958) (6,188) (3,654) Principal payments received on long-term investments 385 408 1,088 Net decrease (increase) in short-term investments 24,141 (14,354) 26,412 Proceeds from sale of common equity securities to affiliates - 514 - Proceeds from sales of common equity securities - - 21,390 Net disposition (acquisition) of premises and equipment 914 (1,410) 185 Net decrease (increase) in loans held for investment 9,793 2,517 (726) - ---------------------------------------------------------------------------------------------------------------------------- Net cash provided (used) by investing activities $ 73,461 $ (125,841) $ 143,244 - ----------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 20 21 CONSOLIDATED STATEMENTS OF CASH FLOWS
- -------------------------------------------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 1995 - -------------------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES - -------------------------------------------------------------------------------------------------------------- Proceeds from issuance of commercial paper $ 5,785,634 $ 5,140,110 $ 4,050,417 Repayments on commercial paper (6,147,814) (5,034,543) (3,819,904) Net increase (decrease) in credit agreement borrowings 524,470 (20,497) (133,978) Retirement of debt (129,872) (104,350) (85,872) Net proceeds from issuance of common stock 12,675 - - Repurchase of common stock from parent - - (92,980) Dividends paid on preferred stock (3,707) (3,707) (8,420) Other (169) (865) (1,190) - -------------------------------------------------------------------------------------------------------------- Net cash provided (used) by financing activities 41,217 (23,852) (91,927) - -------------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash 2,211 (3,223) 2,906 Cash at beginning of year 923 4,146 1,240 - -------------------------------------------------------------------------------------------------------------- Cash at end of year $ 3,134 $ 923 $ 4,146 - --------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 21 22 NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES ORGANIZATION Source One Mortgage Services Corporation (together with its subsidiaries, the "Company") was incorporated in 1972 and is the successor to Citizens Mortgage Corporation which was organized in 1946. The Company is a wholly-owned subsidiary of White Mountains Holdings, Inc. (formerly Fund American Enterprises, Inc.) and its parent Fund American Enterprises Holdings, Inc. ("Fund American"), a Delaware corporation organized in 1980, which was formerly known as The Fund American Companies, Inc. and Fireman's Fund Corporation. The Company is one of the largest mortgage banking companies in the United States that is not affiliated with a commercial bank. As of December 31, 1997, the Company had a mortgage loan servicing portfolio totaling $26.5 billion, including $14.9 billion of loans subserviced for others, which is serviced on behalf of approximately 234 institutional investors and numerous other security holders. As of December 31, 1997, the Company had 129 retail branch offices in 26 states and originated $4.4 billion in mortgage loans for the year then ended. As a mortgage banker, the Company primarily engages in the business of producing and selling conforming and subprime residential mortgage loans, servicing conforming residential mortgage loans and subservicing residential mortgage loans for third parties. Its sources of revenue are net servicing revenue, net interest revenue, net gain on sale of mortgages, net gain on sale of servicing, earnings from unconsolidated affiliate and other revenue. Through subsidiaries, the Company also provides credit-related insurance products (such as life, disability, health, accidental death and property and casualty insurance). BASIS OF PRESENTATION The accompanying consolidated financial statements of the Company include the accounts of Central Pacific Mortgage Company, a wholly-owned subsidiary of the Company, (together with its subsidiaries, "Central Pacific") and all other subsidiaries, and have been prepared in accordance with generally accepted accounting principles. Significant intercompany transactions have been eliminated in consolidation. The financial statements include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of the Company. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain amounts in prior year financial statements have been reclassified to conform with the current year presentation. Fund American acquired the stock of the Company in 1986. The purchase price paid for the Company in 1986 was in excess of historical book value of the Company's net assets. The excess purchase price allocated to identifiable assets was amortized primarily over 5 to 20 years depending on asset type and prior to December 1996, the portion allocated to goodwill was amortized over 20 years. During 1996, the Company had been re-evaluating the recoverability of goodwill and certain other intangible assets. The Company considered the impact of the following factors on its forecast of future operations (i) increased competition and industry consolidation which had adversely impacted the value of the Company's mortgage loan production and servicing operation; (ii) the attainment of a definitive agreement in the fourth quarter of 1996 to sell approximately $17.0 billion of the Company's mortgage servicing portfolio at essentially book value and (iii) a reduction in interest rates in the fourth quarter of 1996. Based on such valuation, the Company had determined that its projected results would not support the future amortization of the Company's remaining goodwill and certain other intangible assets of $29.1 million at December 31, 1996 and, therefore, wrote-off such assets. ACCOUNTING STANDARDS RECENTLY ADOPTED The Company adopted certain provisions of Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" which supersedes SFAS No. 122, "Accounting for Mortgage Servicing Rights" as of January 1, 1997. SFAS No. 125 eliminates the distinction 22 23 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS between "normal" servicing rights and excess servicing receivables and changes the Company's method of measuring the value of its capitalized servicing asset. SFAS No. 125 is effective for transfers and servicing of financial assets beginning in fiscal year 1997. The effective date for certain provisions of SFAS No. 125 has been deferred to fiscal year 1998. SFAS No. 125 prohibits retroactive application, therefore, the reported results for 1996 and 1995 are in accordance with prior accounting standards. The adoption of SFAS No. 125 as it relates to the valuation of capitalized servicing is discussed in Note 3 to the consolidated financial statements. The Company adopted the provisions of SFAS No. 128, "Earning per Share" in December 1997. SFAS No. 128 simplifies the calculation of earnings per share and is intended to make the U.S. standard more comparable to the new international standard. The adoption of SFAS No. 128 resulted in no change to the method by which the Company calculates its earnings per share but replaces the Company's historic presentation of "earnings per share" with a presentation of "basic earnings per share". These provisions have been applied retroactively, and therefore, the 1996 and 1995 earnings per share amounts disclosed are directly comparable to the 1997 amounts. The Company adopted the provisions of SFAS No. 130, "Reporting Comprehensive Income" as of December 31, 1997. SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components (such as changes in net unrealized investment gains and losses) in a financial statement that is displayed with the same prominence as other financial statements. In accordance with the adoption of SFAS No. 130, the Company now reports comprehensive income on a separate statement. Comprehensive income includes net income and any changes in equity from non-owner sources that bypass the income statement. The purpose of reporting comprehensive income is to report a measure of all changes in equity of an enterprise that result from recognized transactions and other economic events of the period other than transactions with owners in their capacity as owners. Application of SFAS No. 130 will not impact amounts previously reported for net income or affect the comparability of previously issued financial statements. The adoption of SFAS No. 128 and SFAS No. 130 resulted in a change in financial statement disclosures only and had no effect on the Company's financial position or results of operations. INVESTMENTS Investments primarily consist of the following: short-term investments stated at cost; real estate investment conduit ("REMIC") residuals considered held to maturity and carried at amortized cost using a method which approximates the effective yield method of amortization on a prospective basis; investment partnership interests reported using the cost method of accounting since the Company's interests are minor (less than 5%) and a fixed maturity investment considered available for sale and stated at fair value with unrealized gains and losses, if any, reported net of tax, as a component of accumulated other comprehensive income in stockholders' equity. The discount on the investment is being amortized into income over the anticipated life of the investment. DERIVATIVE FINANCIAL INSTRUMENTS The Company uses interest rate floor contracts and principal-only swaps in order to manage the exposure to interest rate risk inherent in its servicing asset (collectively "Financial Instruments"). Although SFAS No. 115 requires that these Financial Instruments be classified as held for trading purposes, the Company does not consider these investments to be speculative holdings. The Financial Instruments are carried at fair value and are included in investments in the consolidated statements of condition. Unrealized gains and losses arising from changes in the value of these instruments are recorded in net gain on financial instruments in the consolidated statements of income. Gains and losses occurring from the termination, maturity, sale or extinguishment of the Financial Instruments are recorded immediately in net gain on financial instruments in the consolidated statements of income. INVESTMENT IN UNCONSOLIDATED AFFILIATE Investment in unconsolidated affiliate consists of the Company's investment in common stock, redeemable preferred stock and options to acquire common stock of Financial Security Assurance Ltd. ("FSA"). The Company accounts for its investment in FSA common stock using the equity method. The Company accounts for its investment in FSA preferred 23 24 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS stock and options under the provisions of SFAS No. 115 whereby, the investments are classified as available for sale and reported at fair value as of the balance sheet date, with related unrealized investment gains and losses excluded from earnings and reported, net of tax, as a component of accumulated other comprehensive income in stockholders' equity. MORTGAGE LOANS RECEIVABLE Mortgage loans receivable are stated at the lower of aggregate cost or fair value, including the fair value of commitments to originate and commitments to sell mortgage loans. Conventional mortgage loans are placed on a nonaccrual basis when delinquent ninety days or more as to interest or principal. Interest on delinquent Federal Housing Administration ("FHA") insured loans is accrued at the insured rate beginning on the sixty-first day of delinquency. Interest on delinquent Veterans Administration ("VA") guaranteed loans is accrued at the loan rate during the period of delinquency. RECOGNITION OF REVENUES RELATED TO MORTGAGE LOANS RECEIVABLE Discounts from the origination of mortgage loans receivable are deferred and recognized as adjustments to gain or loss on sale. Gains and losses from the sale of mortgage loans are recognized when proceeds are received. Loan origination fees, net of certain direct costs, have been deferred and are recognized as income when the related mortgage loans are sold. POOL LOAN PURCHASES Pool loan purchases, which are carried at cost, represent FHA insured, VA guaranteed and conventional loans which were either delinquent or in the process of foreclosure at the time they were purchased from Government National Mortgage Association ("GNMA"), Federal National Mortgage Association ("FNMA") or Federal Home Loan Mortgage Corporation ("FHLMC") mortgage-backed security pools that the Company services. Following the purchase of these loans, interest is accrued at a rate based on expected recoveries. LOANS HELD FOR INVESTMENT Loans held as permanent investments are stated at the lower of cost or market value determined at the time the permanent investment decisions were made. The amount of discount, if any, is amortized to income over the anticipated life of the investment. CAPITALIZED SERVICING Capitalized servicing includes certain costs incurred in the origination and acquisition of mortgage servicing rights ("originated and purchased servicing") which are deferred and amortized over the expected life of the loan. The total cost of acquiring mortgage loans either through origination activities or purchase transactions, is allocated between the mortgage servicing rights and the loans based on their relative fair values. The fair values of mortgage servicing rights are estimated by calculating the present value of the expected future net cash flows associated with such rights, incorporating assumptions that market participants would use in their estimates of future servicing income and expense. A current market rate is used to discount estimated future net cash flows. Impairment of mortgage servicing rights is measured on a disaggregated basis by stratifying the mortgage servicing rights based on one or more predominant risk characteristics of the underlying loans. Impairment is recognized through a valuation allowance for each individual stratum. The valuation allowance for the Company's principal recourse portfolio includes a reserve for estimated losses on the corresponding loans. Through 1996, capitalized servicing also included, as a separate component, the present value of future servicing revenue in excess of normal servicing revenue on loans sold with servicing retained ("excess servicing") which was deferred and amortized using a method that relates the anticipated servicing revenue to total projected servicing revenue to be received over the expected life of the loan. Impairment tests for excess servicing were performed on a disaggregated basis. The original discount rate was used to discount excess servicing future cash flows (refer to Note 3 to the consolidated financial statements for further discussion). 24 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS RECOGNITION OF REVENUES RELATED TO SERVICING MORTGAGE LOANS Mortgage servicing revenue represents fees earned for servicing real estate mortgage loans owned by investors and late charge income. The servicing fees are calculated based on the outstanding principal balances of the loans serviced and are recognized together with late charge income when received. COMMON EQUITY SECURITIES Common equity securities are classified as available for sale and carried at fair value. Unrealized gains and losses, net of tax, are recorded as a separate component of stockholders' equity with no corresponding credit or charge to net income. Realized gains and losses from sales of common equity securities are based on the specific identification method. MORTGAGE CLAIMS RECEIVABLE AND REAL ESTATE ACQUIRED Mortgage claims receivable represent claims filed primarily with FHA and VA and are carried at cost less an estimated allowance for amounts which are not fully recoverable from claims filed with the underlying mortgage insuring agencies. Real estate acquired is stated at the lower of fair value less estimated selling costs or the recorded balance satisfied at the date of acquisition determined on an individual property basis. Costs relating to holding the properties are charged to expense as incurred. The allowance for loan losses is based upon an analysis of the mortgage loan servicing portfolio and reflects an amount which, in management's judgment, is adequate to provide for estimated losses. PREMISES AND EQUIPMENT Premises and equipment, including leasehold improvements and systems and programming software, are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed on a straight-line method over the estimated useful lives of the related assets or over the lease terms, whichever period is shorter. BASIC NET INCOME PER SHARE Basic net income per share amounts were computed based on the weighted average total number of common shares outstanding. There were 2,973,999, 2,247,000 and 2,584,450 weighted average common shares outstanding for the years ended December 31, 1997, 1996 and 1995, respectively. DIVIDENDS PER SHARE Cash dividends per share were computed based on the total number of common shares outstanding as of the dividend record dates. NOTE 2. INVESTMENT IN UNCONSOLIDATED AFFILIATE In March 1997, the Company issued 230,293 shares of its common stock to White Mountains in exchange for 1.0 million shares of the common stock of FSA valued at $27.8 million. The value of the Company's common stock represented the book value of the stock as of December 31, 1996. The value of the FSA common stock represented White Mountains' equity carrying value of such assets at that time. Additionally, the Company agreed to issue shares of its common stock to White Mountains in exchange for the remainder of its FSA holdings, the value of which was determined at that time. Effective the second quarter of 1997, upon receipt of insurance regulatory and lender approvals, the Company received White Mountains' remaining FSA holdings. The Company issued an additional 650,827 shares of its common stock to White Mountains in exchange for 2.5 million shares of FSA common stock, 2.0 million shares of FSA convertible redeemable preferred stock and options to acquire 2.6 million shares of FSA common stock valued at $78.5 million, net of associated tax liabilities and other adjustments. At December 31, 1997, the Company owned 3.5 million shares of FSA common stock. This represented approximately 12.1% of the total shares of FSA common stock outstanding at that time. In addition, Fund American had voting rights 25 26 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS to an additional 3.9 million shares of FSA common stock at December 31, 1997, raising the consolidated entity's voting control of FSA to approximately 24.0%. At December 31, 1997, the Company also owned FSA options and preferred stock which, in total, give the Company the right to acquire up to 4.6 million additional shares of FSA common stock for aggregate consideration of $125.7 million. The Company accounts for its investment in FSA common stock using the equity method. FSA is a leading Aaa/AAA writer of financial guaranty insurance whose common stock is publicly traded on the New York Stock Exchange. The market value of the FSA common stock as of December 31, 1997, as quoted on the New York Stock Exchange, exceeded the Company's carrying value of the FSA common stock on the equity method. The Company accounts for its investments in FSA options and preferred stock under the provisions of SFAS No. 115 whereby the investments are reported at fair value as of the balance sheet date, with related unrealized investment gains and losses, net of tax, excluded from earnings and reported as a component of accumulated other comprehensive income in stockholders' equity. The following table summarizes financial information for FSA, which was derived from the audited financial statements of FSA as of and for the period indicated:
===================================================================================== (in millions) 1997 - ------------------------------------------------------------------------------------- FSA balance sheet data - ------------------------------------------------------------------------------------- Total investments $ 1,432 Total assets 1,901 Deferred premium revenue 595 Loss and loss adjustment expense reserves 75 Preferred shareholder's equity 1 Common shareholders' equity 882 - ------------------------------------------------------------------------------------- FSA income statement data - ------------------------------------------------------------------------------------- Gross premiums written $ 236 Net premiums written 173 Net premiums earned 110 Net investment income 72 Net income 101 =====================================================================================
The following table summarizes the amounts recorded by the Company:
===================================================================================== (in millions) 1997 - ------------------------------------------------------------------------------------- Investment in FSA common stock $ 104 Investment in FSA options and preferred stock 88 - ------------------------------------------------------------------------------------- Total investment in FSA 192 - ------------------------------------------------------------------------------------- Equity in earnings from FSA common stock (a) 10 Equity in net unrealized investment gains (losses) from FSA's investment portfolio, before tax (b) 2 Unrealized investment gains on FSA options and preferred stock, before tax (b) 61 =====================================================================================
(a) Recorded net of related amortization of goodwill. (b) Recorded directly to stockholders' equity as a component of accumulated other comprehensive income. 26 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3. CAPITALIZED SERVICING For the years ended December 31, 1997, 1996 and 1995, the Company estimated the fair values of its mortgage servicing rights by calculating the present value of the expected net future cash flows associated with such rights. In making those estimates, the Company incorporated assumptions that market participants would use in their estimates of future servicing income and expense. In 1997 and 1996, the Company evaluated the predominant risk characteristics (prepayment, default and operational) on its owned servicing portfolio. The Company stratified the portfolio by interest rate, loan type (investor), original term to maturity and principal recourse. In 1996, as a result of the pending sale of $17.0 billion of the Company's nonrecourse mortgage servicing portfolio, the Company valued the $17.0 billion portfolio as one stratum using the market price as determined by the third party purchaser. The Company measured impairment of its owned servicing portfolio using assumptions that market participants would use to value their estimates of future net servicing revenue. In estimating fair value, the Company used market consensus prepayment rates and discounted the net future cash flows using discount rates that approximated the current market rates of 10.5% for conventional loans, 12.0% for insured loans and 21.0% for recourse loans for those years. The fair value of each stratum was computed and compared to its recorded book value to determine if an impairment valuation allowance, or recovery of a previously established allowance, was required. In 1995, to measure impairment of its mortgage servicing rights, the Company stratified the related mortgage loan servicing portfolio based on its predominant risk characteristics which were determined to be prepayment, default and operational risks. This resulted in stratification by interest rate, loan type (investor) and original term to maturity. In estimating fair value, the Company used market consensus prepayment rates and discounted the net future cash flows using discount rates that approximated then current market rates of 10.5% for conventional loans and 12.0% for insured loans. The fair value of each stratum was computed and compared to its recorded book value to determine if an impairment valuation allowance, or recovery of a previously established valuation allowance, was required. As a result of the 1997 sale of $17.0 billion of nonrecourse mortgage servicing rights, the Company's principal recourse portfolio became a more significant component of its total remaining owned servicing portfolio. Included in the Company's calculation for measuring impairment of its capitalized servicing asset is an $8.2 million and $7.3 million reserve for estimated recourse losses on the corresponding loans in determining the fair value of its principal recourse portfolio as of December 31, 1997 and 1996, respectively. The discount rate and prepayment assumptions are significant factors used in estimating the fair value of the Company's mortgage servicing rights and could be significantly impacted by changes in interest rates. Accordingly, it is likely that management's estimate of the fair value of the mortgage servicing rights could change in the near term due to changes in interest rates. In 1997, the Company adopted certain provisions of SFAS No. 125 which eliminated the distinction between "normal" servicing rights and excess servicing receivables. Therefore, in adopting SFAS No. 125, the Company combined its "normal" mortgage servicing rights and its excess servicing receivables. The Company estimated the fair value of the combined asset based on the methodology described above, which did not materially effect the Company's 1997 results. Prior to the adoption of SFAS No. 125, the Company estimated the fair value of its capitalized excess servicing asset by discounting the anticipated future cash flows over the estimated life of the related loans. In making these estimates, the Company used "interest only strip" interest rates as quoted by market participants to determine the appropriate discount rates and prepayment speed assumption rates that are based on interest rates, loan types and original term of maturity. The discount rate used to capitalize excess servicing ranged from 12.0% to 12.6% for 1996 and was 12.0% for 1995. For the years ended December 31, 1996 and 1995, the weighted average discount rates inherent in the carrying amount of the capitalized excess servicing asset were 10.4% and 10.0%, respectively. 27 28 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes the fair value of mortgage servicing rights and certain characteristics of the Company's servicing portfolio related to those mortgage servicing rights as of December 31, 1997:
========================================================================================================================= Fair Value Weighted Mortgage Principal Average Weighted Weighted Servicing Balance Interest Average Average Rights Serviced Rate Maturity Service Fee Loan Type (in thousands) (in millions) (in percent) (in months) (in percent) - ------------------------------------------------------------------------------------------------------------------------- Fixed Rate: Insured $ 102,200 $ 5,314 8.85% 291 .46% Conventional 44,933 2,515 8.13 273 .39 Recourse 28,654 2,413 8.60 205 .49 Adjustable Rate 12,391 418 7.09 326 .53 - ------------------------------------------------------------------------------------------------------------------------- Total $ 188,178 $ 10,660 8.56% 269 .46% =========================================================================================================================
The above table excludes $773 million of principal balance of mortgage loans serviced related to originations not capitalized prior to the adoption of SFAS No. 122. The following table summarizes changes in the Company's capitalized servicing asset:
Deferred Gain on Total Mortgage Valuation Sale of Capitalized (in thousands) Servicing Allowance Subservicing Servicing Servicing - -------------------------------------------------------------------------------------------------------------------------------- Balances at January 1, 1995 $ 547,662 $ - $ - $ (17,212) $ 530,450 Additions 102,878 - - - 102,878 Scheduled amortization (52,853) - - - (52,853) Impairment/unscheduled amortization (564) (27,968) - - (28,532) Amortization of deferred gain - - - 4,188 4,188 Sales (159,060) - - - (159,060) - -------------------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1995 438,063 (27,968) - (13,024) 397,071 Additions 125,514 - - - 125,514 Scheduled amortization (69,932) - - - (69,932) Impairment/unscheduled amortization (1,076) (928) - - (2,004) Amortization of deferred gain - - - 6,139 6,139 Sales (45,849) - - - (45,849) - -------------------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1996 446,720 (28,896) - (6,885) 410,939 Additions 90,412 (1,259) - - 89,153 Scheduled amortization (37,537) - (8,880) - (46,417) Impairment/unscheduled amortization - (17,270) (463) - (17,733) Amortization of deferred gain - - - 6,885 6,885 Sales (273,667) 2,285 9,580 - (261,802) - -------------------------------------------------------------------------------------------------------------------------------- Balances at December 31, 1997 $ 225,928 $ (45,140) $ 237 $ - $ 181,025 ================================================================================================================================
In connection with the February 1997 servicing sale and related subservicing assumption, the Company recorded a subservicing asset of approximately $13.3 million. The value of the asset represents the net present value of projected net cash flows over the subservicing period including a profit margin. In December 1997, the subservicing agreement was amended to extend the Company's subservicing responsibilities for one additional year at less favorable terms than the original agreement provided. Accordingly, the net carrying value of the subservicing asset reflects a reduction of approximately $3.7 million which represents the net present value of projected net cash flows over the extended subservicing period including a profit margin. The asset is being amortized on a straight line basis over the subservicing period and tested for impairment. 28 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS During 1994, the Company sold the rights to service $3.9 billion of mortgage loans to a third party for net proceeds of $70.2 million and continued to service these loans pursuant to a subservicing agreement. Accordingly, the Company recorded a deferred gain on the sale which was being recognized as income over the five-year life of the subservicing agreement. In the fourth quarter of 1996, the third party sold the rights to service approximately $1.0 billion of these mortgage loans, representing approximately 25% of the total loans subserviced by the Company for this third party. Accordingly, the Company recognized an additional $2.4 million of the deferred gain in 1996 as mortgage servicing revenue, representing approximately 25% of the deferred balance at the time of the sale. In the fourth quarter of 1997, the third party sold the remaining portfolio of loans. As a result, the Company recognized the remaining balance of the $4.4 million deferred gain as mortgage servicing revenue. NOTE 4. COMMON EQUITY SECURITIES AND INVESTMENTS In June 1997, the Company acquired an investment in U S WEST, Inc. ("U S West") redeemable preferred stock from Fund American for cash proceeds of $49.3 million. The investment, which is classified as available for sale, is a fixed maturity investment which is redeemable in September 2004 and may be redeemed at the option of U S West beginning in September 1999. The discount on this investment is being amortized over the anticipated life of the investment. The carrying value of this investment, which approximates fair value, totaled $49.4 million as of December 31, 1997. The Company recognized income from this investment of approximately $2.0 million in 1997, which is included in interest income in the consolidated statement of income. In December 1996, the Company received shares of certain common equity securities with a market value of $2.3 million as a return of a partnership investment. The resulting gain of $1.4 million is included in the determination of income in 1996. In January 1997, the Company transferred these shares to White Mountains in exchange for 21,239 shares of the Company's common stock held by White Mountains, which were retired by the Company. The Company realized a pretax gain of $.3 million on the transfer. In January 1996, the Company sold its then remaining $1.4 million of common equity securities to White Mountains for cash proceeds of $.5 million. The Company realized a pretax loss of $.9 million on the sale. All of the equity securities involved in such transactions were actively traded, readily marketable, listed on a national exchange and, for purposes of such transactions, valued at their reported closing prices on the day preceding the date of each transaction. The fair value of the portfolio of common equity securities is as follows:
- ----------------------------------------------------------------------------------------------------------------------- December 31, (in thousands) 1997 1996 - ----------------------------------------------------------------------------------------------------------------------- Common equity securities at adjusted cost $ - $ 2,312 Gross unrealized losses - - - ----------------------------------------------------------------------------------------------------------------------- Common equity securities at fair value $ - $ 2,312 =======================================================================================================================
The carrying value of debt securities, which is included in investments in the consolidated statements of condition, approximates fair value and is as follows:
======================================================================================================================= December 31, (in thousands) 1997 1996 - ----------------------------------------------------------------------------------------------------------------------- Debt securities at fair value which approximates amortized cost $ - $ 1,577 =======================================================================================================================
The change in net unrealized investment loss on the portfolio of common equity securities has been charged to stockholders' equity as follows:
======================================================================================================================= Year ended December 31, (in thousands) 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------------------- Net unrealized investment loss at beginning of year $ - $ (546) $ (4,065) Decrease in gross unrealized gains - - (1,068) Decrease in gross unrealized losses - 840 6,481 Decrease in deferred income tax expense - (294) (1,894) - ----------------------------------------------------------------------------------------------------------------------- Net unrealized investment loss at end of year $ - $ - $ (546) =======================================================================================================================
29 30 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5. MORTGAGE LOANS RECEIVABLE The following table summarizes mortgage loans receivable:
======================================================================================================================= December 31, (in thousands) 1997 1996 - ----------------------------------------------------------------------------------------------------------------------- Adjustable rate mortgage loans, weighted average interest rates of 6.36% and 6.60% as of December 31, 1997 and 1996, respectively $ 51,589 $ 35,077 Fixed rate 5 year through 25 year mortgage loans, weighted average interest rates of 7.68% and 7.73% as of December 31, 1997 and 1996, respectively 60,382 51,160 Fixed rate 30 year mortgage loans, weighted average interest rates of 7.76% and 8.19% as of December 31, 1997 and 1996, respectively 404,996 228,067 - ----------------------------------------------------------------------------------------------------------------------- 516,967 314,304 Net premiums 2,280 633 - ----------------------------------------------------------------------------------------------------------------------- Total mortgage loans receivable $ 519,247 $ 314,937 =======================================================================================================================
NOTE 6. POOL LOAN PURCHASES The following table summarizes pool loan purchases:
============================================================================================================ Principal Balance (in thousands) Number of Loans - ------------------------------------------------------------------------------------------------------------ December 31, 1997 1996 1997 1996 - ------------------------------------------------------------------------------------------------------------ Loan Type: FHA $ 103,067 $ 89,922 1,781 1,621 VA 43,349 35,341 669 592 Conventional 3,375 6,276 45 75 - ------------------------------------------------------------------------------------------------------------ Total pool loan purchases $ 149,791 $ 131,539 2,495 2,288 ============================================================================================================
NOTE 7. LOANS HELD FOR INVESTMENT In the second quarter of 1997, the Company identified for sale a majority of its mortgage loans held for investment and marked them down from amortized cost to current market value. The Company recognized a $3.0 million pretax charge to net gain on sale of mortgages as a result of establishing a valuation allowance for these loans. As of December 31, 1997, these loans totaled approximately $10.2 million, net of the valuation allowance, of which $4.5 million are included in loans held for investment and $5.7 million are included in mortgage claims receivable and real estate acquired in the consolidated statement of condition. NOTE 8. OTHER ASSETS The following table summarizes other assets:
============================================================================================== December 31, (in thousands) 1997 1996 - ---------------------------------------------------------------------------------------------- Escrow advances $ 11,825 $ 18,878 Interest receivable - pool loan purchases 10,225 11,900 Current income tax receivable (Note 16) 9,058 - Notes receivable 8,000 7,000 Amount due from sale of servicing 354 46,823 Deferred income tax receivable (Note 16) - 18,210 Other 37,770 17,881 - ---------------------------------------------------------------------------------------------- Total other assets $ 77,232 $ 120,692 ==============================================================================================
30 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9. SENIOR AND SUBORDINATED DEBT Senior and Subordinated Debt consists of the following:
- --------------------------------------------------------------------------------------------------- December 31, (in thousands) 1997 1996 - --------------------------------------------------------------------------------------------------- Commercial paper, weighted average interest rate of 5.69% as of December 31, 1996 $ - $ 362,180 Credit agreements, weighted average interest rates of 6.34% and 6.19% as of December 31, 1997 and 1996, respectively 569,470 45,000 8.875% medium-term notes due October 15, 2001 18,723 138,355 9.0% debentures due June 1, 2012 100,000 100,000 9.375% subordinated debentures, due December 31, 2025 55,976 55,976 Less unamortized discount, premium and issuance costs (net) (2,110) (3,714) - -------------------------------------------------------------------------------------------------- Total senior and subordinated debt $ 742,059 $ 697,797 ===================================================================================================
COMMERCIAL PAPER The Company has a $650.0 million domestic commercial paper program backed by its secured credit agreement. In November 1997, the Company's commercial paper rating was downgraded by Moody's from Prime-3 to Not Prime. In addition, in April 1997, the Company's commercial paper rating was downgraded by Standard & Poors from A-2 to A-3. As a result of the rating downgrade in November, the Company is not able to issue commercial paper and has replaced its commercial paper borrowings with borrowings under its $600.0 million committed bank facility. The weighted average number of days to maturity of commercial paper outstanding as of December 31, 1996 was 22.8 days. CREDIT AGREEMENTS The Company amended and restated its secured revolving credit agreement in July 1997, to reflect a reduction in its borrowing requirements resulting from the cash proceeds received from the 1997 servicing sale. The provisions of the amended agreement decreased the Company's revolving credit facility from $750.0 million to $500.0 million, reduced borrowing costs by lowering the facility fee and will allow the Company to use proceeds received from the servicing sale to pay additional dividends on its common stock of up to $75.0 million. The provisions also granted the Company the option to increase the size of the facility up to $750.0 million, with bank concurrence (refer to Note 23 to the consolidated financial statements). In order to fund increased production volumes and replace commercial paper financing no longer available as a result of the downgrade of the Company's debt rating as described above, the Company exercised its right under the agreement to request additional commitments in December 1997. With bank concurrence, the Company obtained additional commitments of $100.0 million which increased the available revolving facility to $600.0 million. Borrowings under the facility are secured primarily by the Company's mortgage loans receivable and pool loan purchases. The revolving credit facility expires on July 24, 1998. As of December 31, 1997, the Company had $559.0 million outstanding under this facility. As of December 31, 1996, the Company had no outstanding borrowings under the previous facility. The Company's $60.0 million unsecured revolving credit agreement was not extended in July 1997. This agreement was designed to give the Company benefit for escrow funds held in custodial banks. The Company continues to receive this benefit by replacing borrowings under this facility with borrowings under the bid loan provision of the Company's secured credit agreement. The Company's total bank facility borrowing capacity was not reduced by the termination of the unsecured agreement because borrowings under this agreement reduced the Company's ability to borrow up to the maximum amount under its secured credit facility. As of December 31, 1996, there was $45.0 million outstanding under the Company's unsecured agreement. The Company must comply with certain financial covenants provided in its secured revolving credit facility, including restrictions relating to tangible net worth and leverage. In addition, the Company's secured facility contains certain 31 32 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS covenants which limit its ability to pay dividends or make distributions of its capital in excess of preferred stock dividend and subordinated debt interest requirements each year. The Company is currently in compliance with all such covenants. Under the credit agreements described above, the Company receives interest expense credits as a result of holding escrow and custodial funds in trust accounts at non-affiliated banks. The Company amended a short-term borrowing agreement in April 1997 which it had entered into August 1996. The provisions of the amended agreement increased the Company's facility from $25.0 million to $50.0 million. As a result of the rating downgrade in November 1997, the Company is not able to borrow under this agreement. As of December 31, 1996, there was $15.0 million outstanding under the original agreement. Central Pacific entered into a new unsecured revolving credit agreement in May 1997 under which it can borrow up to $15.0 million through June 1, 1998. Central Pacific amended this agreement in December 1997 to change certain reporting requirements and financial covenants. Borrowings under the agreement are guaranteed by the Company. As of December 31, 1997, there was $10.5 million outstanding under this agreement. As of December 31, 1996, there were no borrowings outstanding under the previous agreement which allowed for borrowings up to $10.0 million. Central Pacific must comply with certain financial covenants provided in its revolving credit agreement, including restrictions relating to tangible net worth and leverage. As guarantor, these covenants apply to the Company. Central Pacific is currently in compliance with all such covenants. MEDIUM-TERM NOTES AND DEBENTURES In June 1992, the Company issued $100.0 million of 9% debentures due June 2012 under terms of a $250.0 million shelf registration statement filed with the Securities and Exchange Commission ("SEC") in April 1992. The debentures may not be redeemed by the Company prior to maturity. The proceeds were used for general corporate purposes. In October 1991, the Company issued $160.0 million of 8.875% medium-term notes due October 2001. In May 1997, the Company repurchased and retired $119.6 million of these medium-term notes. As a result, the Company recognized an extraordinary loss of approximately $6.0 million, net of approximately $3.2 million of associated income tax benefit. In 1995, the Company repurchased and retired $21.6 million of these medium-term notes. SUBORDINATED DEBENTURES Effective December 8, 1995, the Company exchanged and retired 2,239,061 shares of its 8.42% cumulative preferred stock, Series A, for $56.0 million principal amount of 9.375% subordinated interest deferrable debentures ("subordinated debentures"), due December 31, 2025. Interest on the subordinated debentures is paid quarterly in arrears at the annual rate of 9.375% on the last business day of each March, June, September and December. The first interest payment was made on December 29, 1995 for the period from November 1, 1995 (the last regular dividend payment date with respect to the preferred stock) through December 8, 1995 at the annual rate of 8.42% and from December 9, 1995 through December 31, 1995 at the annual rate of 9.375%. The subordinated debentures are redeemable at the option of the Company, in whole or in part, at any time on or after May 1, 1999. On or after such date, the subordinated debentures may be redeemed at the option of the Company at a price equal to 100% of the principal amount redeemed ($25 for each $25 principal amount of subordinated debenture), plus accrued and unpaid interest to the date fixed for redemption. Aggregate maturities of medium-term notes, debentures and subordinated debentures, excluding discount, premium and issuance costs, for the five calendar years after December 31, 1997 are as follows:
- ------------------------------------------------------------------------------------------------------- (in thousands) 1998 1999 2000 2001 2002 Thereafter Total - -------------------------------------------------------------------------------------------------------- $ - $ - $ - $18,723 $ - $155,976 $174,699 ========================================================================================================
32 33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10. STOCKHOLDERS' EQUITY In March 1997, the Company issued 105,000 shares of its common stock to Fund American for cash proceeds of $12.7 million. In addition, the Company issued 230,293 shares of its common stock to White Mountains in exchange for 1.0 million shares of the common stock of FSA valued at $27.8 million. The Company issued an additional 650,827 shares of its common stock to White Mountains effective in the second quarter of 1997 in exchange for 2.5 million shares of FSA common stock, 2.0 million shares of FSA convertible redeemable preferred stock and options to acquire 2.6 million shares of FSA common stock valued at $78.5 million, net of associated tax liabilities and other adjustments. Stockholders' equity includes accumulated other comprehensive income composed of unrealized gains and losses on the investments in FSA convertible redeemable preferred stock and options to acquire FSA common stock, net of tax. In January 1997, the Company transferred its remaining common equity securities with a market value of $2.6 million to White Mountains in exchange for 21,239 shares of the Company's common stock held by White Mountains, which were retired by the Company. At December 31, 1997, the Company had 1,760,939 shares of 8.42% cumulative preferred stock, Series A ("preferred stock") issued and outstanding. The Company is authorized to issue 12,000,000 shares of preferred stock. In December 1995, the Company exchanged and retired 2,239,061 shares of its preferred stock for $56.0 million principal amount of 9.375% subordinated debentures, due December 31, 2025. The preferred stock is not redeemable prior to May 1, 1999. On or after such date, the preferred stock may be redeemed at the option of the Company at a price of $25 per share, plus accrued and unpaid dividends to the redemption date. The preferred stock ranks senior to the common stock as to dividends and upon the distribution of assets in the event of any liquidation, dissolution, or winding up of the Company. Issued and outstanding shares of the preferred stock are subordinate as to dividends and upon liquidation, to the outstanding debt of the Company. Quarterly cash dividends are paid on preferred stock at an annual rate of 8.42% or $2.105 per share, if declared by the Board of Directors, in arrears on the first day of each February, May, August and November. Dividends on the preferred stock accrue on a daily basis whether or not there are funds legally available for the payment of such dividends and whether or not such dividends are declared. In connection with sales of rights to service a total of $11.0 billion of mortgage loans to third parties during 1995, the Company transferred a total of $27.0 million of common equity securities and $93.0 million in cash and money market investments to White Mountains in exchange for 959,049 shares of the Company's common stock held by White Mountains, which were retired by the Company. NOTE 11. FINANCIAL INSTRUMENTS FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK The Company utilizes derivative financial instruments in the management of interest rate risk. The Company's use of derivative financial instruments is primarily limited to commitments to extend credit, mandatory forward commitments, interest rate floor contracts ("floors") and principal-only ("P/O") swaps. Although SFAS No. 115 requires that these financial instruments be classified as held for trading purposes, the Company does not consider these investments to be speculative holdings. The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and reduce its own exposure to fluctuations in interest rates. These financial instruments primarily include commitments to extend credit and mandatory forward commitments. Those instruments involve, to varying degrees, elements of credit and market risk in excess of the amount recognized in the consolidated statements of condition. The contract or notional amounts of those instruments reflect the extent of risk the Company has in the instruments. 33 34 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company's exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for commitments to extend credit ("mortgage loan pipeline") is represented by the contractual notional amount of those instruments. The Company's locked mortgage loan pipeline that is expected to close totaled $284.5 million and $175.7 million as of December 31, 1997 and 1996, respectively. Fixed rate commitments result in the Company having market risk as well as credit risk. Variable rate commitments result primarily in credit risk. The amount of collateral required upon extension of credit is based on the Company's credit evaluation of the mortgagor and consists of the mortgagor's residential property. The Company obtains mandatory forward commitments of up to 120 days to sell mortgage-backed securities to hedge the market risk associated with a substantial portion of the mortgage loan pipeline that is expected to close and all mortgage loans receivable. As of December 31, 1997 and 1996, the Company had approximately $776.8 million and $454.6 million of mandatory forward commitments outstanding, respectively. If secondary market interest rates decline after the Company obtains a mandatory forward commitment for a loan, the loan may not close and the Company may incur a loss from the cost of covering its obligations under such commitment. If secondary market rates increase before the Company obtains a mandatory forward commitment for a loan and the loan closes, the Company may realize a loss when the loan is subsequently sold. The Company's risk management function closely monitors the mortgage loan pipeline to determine appropriate forward commitment coverage on a daily basis in order to manage the risk inherent in these off-balance-sheet financial instruments. In addition, the risk management area seeks to reduce counterparty risk by committing to sell mortgage loans only to its seventeen approved dealers, with no dealer having in excess of 20% of current commitments. The Company sells loans either through mortgage-backed securities issued pursuant to programs of GNMA, FNMA, FHLMC or through whole loan sales to investors. Most loans are aggregated in pools of $1.0 million or more, which are purchased by institutional investors after having been guaranteed by GNMA, FNMA or FHLMC. Substantially all GNMA securities are sold without recourse to the Company for loss of principal in the event of a subsequent default by the mortgage borrower due to underlying FHA or VA insurance. Prior to December 1992, substantially all conventional securities were sold with recourse to the Company to the extent of insufficient proceeds from private mortgage insurance, foreclosure and other recoveries. Since December 1992, conventional loans have been sold without recourse to the Company. Servicing agreements relating to mortgage-backed securities issued pursuant to the programs of GNMA, FNMA and FHLMC require the Company to advance funds to make the required payments to investors in the event of a delinquency by the borrower. The Company expects that it would recover most funds advanced upon default by the borrower or at foreclosure. However, in connection with VA partially guaranteed loans and certain conventional loans (which may be, at most, partially insured by private mortgage insurers), funds advanced may not cover losses due to potential declines in collateral value. The Company is subject to limited amounts of principal risk with respect to these loans since the insurer has the option to reimburse the servicer for the lower of fair market value of the property or the mortgage loan outstanding, in addition to the VA guarantee on the loan. In addition, most of the Company's servicing agreements for mortgage-backed securities typically require the payment to investors of a full month's interest on each loan although the loan may be paid off (by optional prepayment or foreclosure) other than on a month-end basis. In this instance, the Company is obligated to pay the investor interest at the pass-thru rate from the date of the loan payoff through the end of that calendar month without reimbursement. As of December 31, 1997, 1996 and 1995, the Company serviced approximately $5.4 billion, $13.5 billion and $10.7 billion of GNMA loans in its owned servicing portfolio, respectively, and $2.5 billion, $2.9 billion and $3.5 billion of conventional loans with recourse, respectively. In order to cover loan losses that may result from these servicing arrangements and other losses, the Company has provided an allowance for loan losses of $12.8 million, $15.4 million and $13.5 million as of December 31, 1997, 1996 34 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS and 1995, respectively. In addition, the valuation allowance for the Company's capitalized servicing asset related to its principal recourse portfolio includes an $8.2 million and $7.3 million reserve for estimated losses on the corresponding loans at December 31, 1997 and 1996, respectively. Management believes these amounts are adequate to cover unreimbursed foreclosure advances and principal losses, including losses on loans with recourse. In order to offset changes in the value of its capitalized servicing asset and to mitigate the effect on earnings of higher amortization and impairment of the asset which results from increased prepayment activity, the Company invests in various financial instruments. As interest rates decline, prepayment activity generally increases, thereby reducing the value of the capitalized servicing asset, while the value of the financial instruments increases. Conversely, as interest rates increase, the value of the capitalized servicing asset increases, while the value of such financial instruments decreases. The financial instruments utilized by the Company include interest rate floor contracts ("floors") and principal-only ("P/O") swaps. The floors derive their value from the 10 year constant maturity treasury yield index. The floor strike rates range from 4.00% to 6.14%. To the extent that market interest rates increase, the value of the floor declines. However, the Company is not exposed to losses in excess of its initial investment in the floors. The total notional principal amount of the floors was $.7 billion and $1.0 billion as of December 31, 1997 and December 31, 1996, respectively. As of December 31, 1997 and 1996, the carrying value of the Company's open floors was $8.2 million and $4.8 million, respectively. The floors have remaining terms ranging from 3 to 5 years. The value of the P/O swaps is determined by changes in the value of the underlying P/O strip security. The payments received by the Company under the P/O swaps relate to the cash flows of the referenced P/O security. The payments made by the Company are based upon a notional amount tied to the market price and the remaining balance of the underlying P/O security, multiplied by a floating rate indexed to LIBOR. The Company's exposure to loss in the P/O swaps is related to changes in the market value of the underlying P/O security over the life of the contract. The remaining original notional value of the P/O swaps was $98.1 million and $50.0 million as of December 31, 1997 and 1996, respectively. The carrying value of the P/O swaps was $12.5 million and $3.2 million as of December 31, 1997 and 1996, respectively. The P/O swaps have remaining terms ranging from 3 to 4 years. The floors and P/O swaps are carried at market value and are included in investments in the consolidated statements of condition. Realized and unrealized gains and losses are recorded in net gain on financial instruments in the consolidated statements of income. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company determines the estimated fair value of its financial instruments using appropriate market information and valuation methodologies. Considerable judgment is required to interpret the market information to develop the estimates of fair value. As a result, the estimates provided herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The following methods and assumptions were used by the Company to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND INVESTMENTS For cash, short-term investments and fixed maturity investments the carrying value equals or approximates fair value. For interest rate floor contracts and P/O swaps, fair value is estimated based on quoted market prices for those or similar investments and is equal to the carrying value. For investments in REMIC residuals, for which there are no quoted market prices, fair value is estimated based on discounted cash flow analyses, using interest only strip interest rates, prepayment speed assumptions and LIBOR rates, taking into consideration the characteristics of the related collateral. For investment partnership interests fair value is determined as the equity method value calculated from the audited partnership financial statements. 35 36 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MORTGAGE LOANS RECEIVABLE For mortgage loans receivable, fair value is estimated using quoted market prices for securities backed by similar loans. POOL LOAN PURCHASES For pool loan purchases, fair value is estimated based on discounted cash flow analyses, using the Company's short-term incremental borrowing rate, quoted market prices for securities backed by similar loans or actual prices at which the loans were subsequently sold. LOANS HELD FOR INVESTMENT In 1997, the Company identified for sale the majority of its loans held for investment and marked them down from amortized cost to current market value, and therefore, the carrying amount for these loans equals fair value. Prior to 1997, fair value was estimated using quoted market prices for securities backed by similar loans. CAPITALIZED EXCESS SERVICING For capitalized excess servicing, fair value is estimated by computing the anticipated revenue to be received over the life of the related loans based on market consensus prepayment rates, discounted using quoted interest only strip interest rates. RECEIVABLE FROM SALE OF SERVICING For receivable from sale of servicing, carrying value equals or approximates fair value. COMMON EQUITY SECURITIES For common equity securities, fair value is based on quoted market prices and is equal to the carrying value. LOANS IN FORECLOSURE AND MORTGAGE CLAIMS RECEIVABLE For these financial instruments, fair value is estimated by discounting anticipated future cash flows using the Company's short-term incremental borrowing rate. DEBT For commercial paper and credit agreements (short-term debt), the carrying amount approximates fair value. For debentures and medium-term notes (long-term debt), fair value is estimated by discounting future cash flows using the Company's incremental borrowing rates for similar types of borrowing arrangements. For subordinated debentures (long-term debt), fair value is based on quoted market prices. 36 37 NOTE TO CONSOLIDATED FINANCIAL STATEMENTS OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS Fair value for commitments to sell mortgage loans is based on the current settlement values of those commitments, net of the face amounts of the commitments. Fair value for commitments to extend credit is based on current quoted market prices for securities backed by similar loans, net of the principal amounts of the commitments. The estimated fair values of the Company's financial instruments are as follows:
- --------------------------------------------------------------------------------------------------- December 31, 1997 1996 - --------------------------------------------------------------------------------------------------- Carrying Fair Carrying Fair (in thousands) Amount Value Amount Value - --------------------------------------------------------------------------------------------------- Financial Assets: Cash $ 3,134 $ 3,134 $ 923 $ 923 Investments Interest rate floor contracts 8,153 8,153 4,825 4,825 Principal-only swaps 12,508 12,508 3,185 3,185 Other 65,578 75,092 38,545 38,354 Mortgage loans receivable 519,247 529,260 314,937 315,895 Pool loan purchases 149,791 150,175 131,539 135,841 Loans held for investment 5,191 5,191 23,351 23,289 Capitalized excess servicing n/a(a) n/a(a) 38,672 39,617 Receivable from sale of servicing 27,324 27,324 - - Common equity securities - - 2,312 2,312 Loans in foreclosure and mortgage claims receivable (net) (b) 35,579 34,905 38,387 37,714 - --------------------------------------------------------------------------------------------------- Financial Liabilities: Short-term debt $ 569,399 $ 569,399 $406,205 $ 406,205 Long-term debt 172,660 186,978 291,592 322,715 Off-Balance-Sheet Financial Instruments: Mandatory forward commitments n/a 1,642 n/a (160) Commitments to extend credit expected to close (pipeline) n/a 6,498 n/a 1,879 - ---------------------------------------------------------------------------------------------------
(a) Information is not applicable as a result of the Company's adoption of SFAS No. 125. Refer to notes 1 and 3 to the consolidated financial statements. (b) Excludes $5.6 million and $13.1 million of real estate owned in 1997 and 1996, respectively. The Company's investments in FSA options and preferred stock are not presented in the table above. These financial instruments are accounted for under the provisions of SFAS No. 115 and are carried on the consolidated statement of condition at fair value (refer to Note 2 to the consolidated financial statements). 37 38 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12. MORTGAGE SERVICING The Company's portfolio of mortgages serviced, including loans subserviced, interim servicing contracts and those under contract to acquire and excluding loans sold but not transferred, totaled $26.5 billion, $29.2 billion and $31.8 billion as of December 31, 1997, 1996 and 1995, respectively. The Company's portfolio of mortgages serviced as of December 31, 1997 is summarized below:
Weighted Average ---------------------------------------------------------- Net Remaining Principal Loan Interest Servicing Contractual Balance Serviced Balance Rate Fee Rate Life Loan Type (in millions) (in thousands) (in percent) (in percent) (in months) - --------------------------------------------------------------------------------------------------------------------- Residential Conventional $ 5,521 $ 68 8.37% .424% 240 FHA 3,916 57 8.80 .427 297 VA 2,124 62 8.42 .403 298 Commercial 66 889 7.45 .176 163 - -------------------------------------------------------------------------------------------------------------------- $ 11,627 $ 63 8.52% .420% 269 Subservicing 14,919 - -------------------------------------------------------------------------------------------------------------------- Total mortgage servicing portfolio $ 26,546 $ 61 8.45% (a) 249 ====================================================================================================================
(a) This amount would be calculated as a combination of two different measurements, the net servicing fee earned on the Company's owned servicing portfolio and the subservicing fee earned on its subservicing portfolio, which is not calculated as a percentage of the outstanding principal balance serviced, and therefore, would not be meaningful. The servicing fee rates in the table above are shown after deducting any fees. Guarantee fees, when applicable, range from six basis points for governmental loans up to approximately thirty basis points for certain conventional loans. Certain loans sold to private investors have no guarantee fees. The following table summarizes the Company's owned mortgage servicing portfolio by interest rate range:
- ----------------------------------------------------------------------------------------------------------------------------------- December 31, 1997 1996 - ----------------------------------------------------------------------------------------------------------------------------------- Weighted Weighted Number Principal Average Number Principal Average of Balance Interest Rate of Balance Interest Rate Interest Rate Range Loans (in millions) (in percent) Loans (in millions) (in percent) - ---------------------------------------------------------------------------------------------------------------------------------- 5.99% and lower 843 $ 66 5.41% 1,239 $ 87 5.50% 6.00%-6.49% 1,823 159 6.13 5,449 288 6.22 6.50%-6.99% 4,166 319 6.66 15,369 1,111 6.68 7.00%-7.49% 12,968 729 7.17 42,363 2,395 7.11 7.50%-7.99% 29,240 2,455 7.63 58,622 4,104 7.60 8.00%-8.49% 27,989 2,280 8.13 60,852 4,337 8.10 8.50%-8.99% 32,178 1,867 8.59 77,061 4,047 8.58 9.00%-9.49% 13,452 722 9.07 37,714 2,052 9.06 9.50%-9.99% 29,142 1,420 9.55 69,548 3,618 9.57 10.00% and above 32,488 1,610 10.49 83,585 4,371 10.49 - ----------------------------------------------------------------------------------------------------------------------------------- Total 184,289 $ 11,627 8.52% 451,802 $ 26,410 8.59% ====================================================================================================================================
38 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table summarizes the Company's owned mortgage servicing portfolio by location of property:
- ------------------------------------------------------------------------------------------------------------------------------------ December 31, 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------------ Percentage Percentage of Principal of Principal Number Principal Balance of Number Principal Balance of of Balance Servicing of Balance Servicing State Loans (in millions) Portfolio Loans (in millions) Portfolio - ------------------------------------------------------------------------------------------------------------------------------------ California 20,459 $ 1,889 16.3% 60,547 $ 4,955 18.7% New York 22,118 1,162 10.0 42,195 2,441 9.2 Texas 15,655 736 6.3 29,851 1,513 5.7 Washington 7,889 690 5.9 23,048 1,692 6.4 Florida 12,894 663 5.7 28,361 1,408 5.3 Michigan 10,773 520 4.5 25,553 1,019 3.9 New Jersey 7,088 503 4.3 13,689 895 3.4 Illinois 6,335 420 3.6 16,704 1,036 3.9 Maryland 5,020 362 3.1 8,966 534 2.0 Ohio 6,658 357 3.1 15,772 656 2.5 Other* 69,400 4,325 37.2 187,116 10,261 39.0 - ------------------------------------------------------------------------------------------------------------------------------------ Total 184,289 $ 11,627 100.0% 451,802 $ 26,410 100.0% ====================================================================================================================================
*No other state constitutes more than 3.1% of the Company's owned servicing portfolio as of December 31, 1997. The above tables exclude loans subserviced for others having a principal balance of $14,919 million and $2,791 million as of December 31, 1997 and 1996, respectively. Escrow funds of approximately $196.8 million, $207.8 million and $236.0 million as of December 31, 1997, 1996 and 1995, respectively, relating to mortgages serviced and subserviced, are held in non-interest bearing accounts at non-affiliated banks and are not included in the consolidated financial statements. The Company has in force an errors and omissions policy in the amount of $20 million. Primary fidelity coverage up to a limit of $35 million is provided under a Fund American master policy, for which the Company pays a portion of the premium. NOTE 13. RESTRUCTURING CHARGES In April 1997, the Company's management approved and implemented a restructuring plan designed to reduce its operating costs in order to improve its financial performance. As part of this plan, the Company reduced its work force, primarily in overhead areas, by approximately 100 employees during the second quarter of 1997 to bring its overhead costs in line with its production and servicing operations. As a result, the Company recognized restructuring charges totaling $1.7 million during the second quarter of 1997. The amount includes approximately $1.6 million of employee separation costs, including severance payments, health care coverage and postemployment education benefits and $.1 million of miscellaneous expenses. As of December 31, 1997, $.1 million of these charges remained accrued in the Company's consolidated statements of condition. In 1994, the Company implemented a restructuring plan to bring its mortgage loan production network in line with anticipated levels of mortgage loan production as a result of a contracting mortgage loan origination market. As of December 31, 1997 and 1996, $.2 million and $.5 million, respectively, remained accrued in the Company's consolidated statements of condition relating to future lease expenses for closed facilities. 39 40 NOTE TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14. LEASE COMMITMENTS The Company has entered into a number of noncancelable operating lease agreements with respect to premises and equipment. The minimum annual rental commitments under these leases as of December 31, 1997 are as follows:
- -------------------------------------------------------------------- (in thousands) 1998 1999 2000 2001 2002 Total - -------------------------------------------------------------------- $2,263 $1,057 $696 $359 $234 $4,609 ====================================================================
Leases for branches which were closed as a result of the Company's restructuring plan implemented in 1994 are included in the table above. As of December 31, 1997, $.2 million of future lease payments remained accrued in the Company's consolidated statement of condition, and therefore, do not represent future operating expenses. Total rental expense for the years ended December 31, 1997, 1996 and 1995 was $3.9 million, $4.5 million and $4.6 million, respectively. Some leases contain escalation clauses that correspond with increased real estate taxes, other operating expenses and/or renewal options that call for increased rents when the leases are renewed. NOTE 15. OTHER OPERATING EXPENSES The following table summarizes other operating expenses:
- -------------------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 1995 - -------------------------------------------------------------------------------------- Telephone $ 3,948 $ 4,316 $ 4,015 Professional services 3,587 3,376 1,649 Travel and entertainment 1,989 1,885 1,808 Office supplies and printing 1,903 2,063 1,768 Postage 1,812 2,119 1,985 Software systems 1,501 1,669 1,427 Bank charges 861 1,618 1,948 Amortization of goodwill - 2,090 2,090 Other 11,000 15,116 16,084 - -------------------------------------------------------------------------------------- Total other operating expenses $ 26,601 $ 34,252 $ 32,774 ======================================================================================
NOTE 16. INCOME TAXES The Company files a consolidated federal income tax return with Fund American. Federal income tax expense is provided substantially on a separate return basis. As of December 31, 1997, the Company had recorded $39.1 million of deferred tax liability relating to accumulated unrealized gains and equity in earnings of an investment in an unconsolidated affiliate, of which $13.9 million was recorded as part of the initial exchange. As of December 31, 1995, the Company had recorded $.3 million of deferred tax assets relating to accumulated unrealized losses on the portfolio of common equity securities. The Company files state income tax returns on a stand-alone basis. The following table summarizes federal income taxes due from or (to) Fund American:
- --------------------------------------------------------------------------------------- December 31, (in thousands) 1997 1996 - --------------------------------------------------------------------------------------- Net current taxes $ 9,058 $ (5,746) - --------------------------------------------------------------------------------------- Net deferred taxes (17,219) 18,210 =======================================================================================
40 41 NOTE TO CONSOLIDATED FINANCIAL STATEMENTS Total income tax (benefit) expense is as follows:
- -------------------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 1995 - -------------------------------------------------------------------------------------- Current income taxes: Federal $ (4,396) $ 17,280 $ 11,847 State and local 1,352 144 248 Deferred (benefit) expense (573) (7,971) 4,037 - -------------------------------------------------------------------------------------- Total income tax (benefit) expense $ (3,617) $ 9,453 $ 16,132 ======================================================================================
The current federal income tax (benefit) expense for the years ended December 31, 1997 and 1995, as shown above, excludes a benefit of $3.2 million and $.5 million, respectively, which relates to the extraordinary loss on the repurchase and retirement of debt which has been reported as a net amount in the consolidated statements of income. Deferred tax (benefit) expense for the years ended December 31, 1997, 1996 and 1995 represents the net change in the deferred tax asset or liability during the year. Deferred income taxes arise from temporary differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. The deferred tax (benefit) expense for the years ended December 31, 1997, 1996 and 1995, shown above excludes deferred tax expense of $22.1 million, $.3 million and $1.9 million, respectively. The 1997 expense is associated with unrealized gains on the Company's investment in an unconsolidated affiliate which were recorded directly to stockholders' equity. The 1996 and 1995 expenses are associated with unrealized gains and losses on the common equity securities portfolio which were recorded directly to stockholders' equity. The following table summarizes the types of temporary differences giving rise to the net deferred tax assets and net deferred tax liabilities:
- ------------------------------------------------------------------------------------------------------------------------------- December 31, (in thousands) 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------- Deferred Deferred Deferred Deferred Tax Tax Tax Tax Assets Liabilities Assets Liabilities - ------------------------------------------------------------------------------------------------------------------------------- Purchase accounting adjustments $ - $ 5,520 $ - $ 6,219 Unrealized gain on investment in unconsolidated affiliate (net) - 36,002 - - Equity in earnings of unconsolidated affiliate - 3,095 - - Unrealized gain on financial instruments - 4,597 - 931 Capitalized servicing 26,163 - 18,384 - Allowance for loan losses 4,803 - 4,838 - Depreciation - 2,159 - 2,583 Deferred bi-weekly income 969 - 1,351 - Accrued postretirement benefits 1,279 - 1,181 - Other, net 7,921 6,981 6,739 4,550 - ---------------------------------------------------------------------------------------------------------------------------- Total $ 41,135 $ 58,354 $ 32,493 $ 14,283 ============================================================================================================================
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences. Accordingly, no valuation allowances have been provided as of December 31, 1997 and 1996. 41 42 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A reconciliation of taxes, calculated using the federal statutory rate of 35%, to income tax expense follows:
------------------------------------------------------------------------------ Year ended December 31, (in thousands) 1997 1996 1995 ------------------------------------------------------------------------------ Tax (benefit) expense at federal statutory rate $ (3,902) $ 1,795 $15,149 Write-off of goodwill and other intangible assets - 6,960 - Purchase accounting adjustments - 732 732 Dividends received deduction (706) - (35) State taxes 879 94 161 Other, net 112 (128) 125 ------------------------------------------------------------------------------ Total income tax (benefit) expense $ (3,617) $ 9,453 $16,132 ==============================================================================
NOTE 17. PENSION PLAN The Company has a defined benefit pension plan covering most of its employees. Benefits under the plan are based on years of service and the employees' highest average compensation over five consecutive years in their last ten years of employment. The Company's policy is to fund the pension plan in amounts which comply with the minimum funding requirements specified by the Employee Retirement Income Security Act. Cash contributions made to the plan for the years ended December 31, 1997, 1996 and 1995 totaled $.6 million, $1.3 million and $1.7 million, respectively. Plan assets primarily consist of common stock and corporate bond mutual funds. In the fourth quarter of 1997, the Company's Board of Directors approved certain amendments to the Company's pension plan. The approved amendments included the expansion of eligibility requirements for early retirement from age 55 with ten years of service to the earlier of age 55 with ten years of service or age 50 with fifteen years of service for retirements beginning on or after January 1, 1997. In addition, the accrual rate for years of benefit service was reduced from 1.6% to 1.2% for years of service credited on and after January 1, 1998. The Company expects the net effect of these amendments will be to reduce the future cost and funding requirements of the plan. The following table sets forth the plan's funded status and the related amounts recognized in the Company's consolidated statements of condition:
- -------------------------------------------------------------------------------------------------------------------- December 31, (in thousands) 1997 1996 - -------------------------------------------------------------------------------------------------------------------- Actuarial present value of benefit obligation: Accumulated benefit obligation, including vested benefits of $19,269 and $16,627 in 1997 and 1996, respectively $ 20,960 $ 18,586 Effect of future projected salary increases 6,015 5,138 - -------------------------------------------------------------------------------------------------------------------- Projected benefit obligation 26,975 23,724 Plan assets at fair value (24,669) (20,942) - -------------------------------------------------------------------------------------------------------------------- Projected benefit obligation in excess of plan assets 2,306 2,782 Unrecognized net gain (loss) 931 (1,111) Unrecognized prior service cost 87 871 Unrecognized net obligation at transition - (11) - -------------------------------------------------------------------------------------------------------------------- Accrued pension cost included in accounts payable and other liabilities $ 3,324 $ 2,531 ====================================================================================================================
42 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A summary of the components of net periodic pension costs is as follows:
- ----------------------------------------------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------------- Service cost for benefits earned during the year $ 1,448 $ 1,578 $ 1,354 Interest cost on projected benefit obligation 1,718 1,633 1,388 Actual return on plan assets (3,752) (1,998) (3,801) Net amortization and deferral 1,973 892 2,613 - ----------------------------------------------------------------------------------------------------------------- Net periodic pension cost $ 1,387 $ 2,105 $ 1,554 =================================================================================================================
Assumptions used in the determination of the projected benefit obligation were: - ----------------------------------------------------------------------------------------------------------------- December 31, 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------------- Discount rate 7.0% 7.25% 7.0% Rate of increase in compensation levels 4.5% 5.0% 6.0% Expected long-term rate of return on assets 8.0% 8.0% 8.0% =================================================================================================================
NOTE 18. POSTRETIREMENT BENEFITS The Company has an unfunded postretirement benefit plan which provides for postretirement health care and life insurance benefits. Postretirement life insurance benefits are provided to substantially all employees. Postretirement health care benefits are provided to substantially all employees hired prior to January 1, 1991. The Company provides for term life insurance coverage based on the employees' annual earnings and length of service. Postretirement health care benefits are contributory, whereby the Company provides for 87.5% of medical costs to retirees who retired prior to January 1, 1993. Effective January 1, 1993, the plan was amended to provide for a portion of monthly retiree medical costs, based on years of service, to retirees who retire on or after January 1, 1993. A summary of the components of net periodic postretirement benefit cost is as follows:
- -------------------------------------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 1995 - -------------------------------------------------------------------------------------------------------- Service cost $ 94 $ 110 $ 86 Interest cost 256 239 250 - -------------------------------------------------------------------------------------------------------- Net periodic postretirement benefit cost $ 350 $ 349 $ 336 ========================================================================================================
The following table sets forth the plan's funded status and the related amounts recognized in the Company's consolidated statements of condition:
- ---------------------------------------------------------------------------------------------------------- December 31, (in thousands) 1997 1996 - ---------------------------------------------------------------------------------------------------------- Accumulated postretirement benefit obligation: Retired participants $ 2,255 $ 1,868 Fully eligible active participants 739 533 Other active participants 801 1,009 - ---------------------------------------------------------------------------------------------------------- Total accumulated postretirement benefit obligation 3,795 3,410 Plan assets at fair value - - - ---------------------------------------------------------------------------------------------------------- Accrued postretirement benefit obligation in excess of plan assets 3,795 3,410 Unrecognized prior service cost (157) - Unrecognized net gain 15 67 - ---------------------------------------------------------------------------------------------------------- Accrued postretirement benefit cost included in accounts payable and other liabilities $ 3,653 $ 3,477 =========================================================================================================
43 44 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS An 8.6% annual rate of increase in the per capita costs of covered health care benefits was assumed for 1998, gradually decreasing to 5.0% by the year 2007 and remaining at that level thereafter. Increasing the assumed health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1997 by 5.0% and increase the aggregate of the service cost and interest cost components of net periodic postretirement benefit cost for 1997 by 4.1%. A discount rate of 7.0% and 7.25% was used to determine the accumulated postretirement benefit obligation as of December 31, 1997 and 1996, respectively. NOTE 19. STOCK PLANS In 1986, the Company established an Employee Stock Ownership Plan ("ESOP") to enable employees to have an equity interest in the Company. The Company redeemed all the shares of Class B common stock held by the ESOP in November 1993 for $4.6 million in cash. Management subsequently used that cash to invest in Fund American common stock. The assets currently held by the ESOP consist substantially of Fund American common stock. Effective in the fourth quarter of 1993, the ESOP was amended to allow employees who terminate their employment with the Company, and who are vested in the ESOP, to receive their distribution in cash or shares of Fund American common stock. Contributions to the ESOP are determined at the discretion of the Board of Directors. Effective October 1, 1996, the Company amended its ESOP to include employees of White Mountains as eligible employees and to add an employee savings plan feature under Section 401(k) of the Internal Revenue Code of 1986. Eligible employees may contribute to the plan up to 14% of their salary not to exceed the maximum allowable under Internal Revenue Service guidelines. Contributions are invested at the direction of the employee in one or more funds or can be directed to purchase common stock of Fund American at fair market value. In the fourth quarter of 1997, the Company's Board of Directors approved certain amendments to the Company's ESOP to be effective as of January 1, 1998. The most significant of the amendments provided for the Company's ESOP contribution to be changed to a 401(k) matching contribution. The matching contribution is equal to a certain percentage of employee contributions, up to a maximum of 5%, which is dependent on the Company's annual return on equity. In addition, the amendment provided for the transfer of all of the participant accounts in the ESOP portion of the plan to the 401(k) portion of the plan. This will allow the participants to direct the investment of the Company's contributions among the various investment options. In connection with the exchange of Class B common stock, the Company established a Stock Appreciation Rights ("SAR") plan under which certain officers of the Company received stock appreciation rights in exchange for their shares of Class B common stock. The SARs may be exercised any time at the option of the holders thereof. The value of each SAR is equal to the difference between $86.625 and the closing price of Fund American's common stock on the date preceding the exercise of the SAR multiplied by a factor of 1.223. The Company has a long-term incentive plan which provides for the granting of stock-based and cash incentive awards to key senior management employees of the Company. Awards under the plan are payable upon the achievement of specified financial goals covering four overlapping three-year periods beginning January 1, 1994, 1995, 1996 and 1997. NOTE 20. CONTINGENCIES Various claims have been made against the Company in the ordinary course of business. Management believes that any liabilities which could result would not materially affect the Company's financial position or results of operations. 44 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 21. RELATED-PARTY TRANSACTIONS As discussed in Notes 4 and 10, the Company had various related-party transactions with Fund American and White Mountains. The Company also has a tax allocation agreement with Fund American. The Company believes that all of the above transactions were on terms that were reasonable and competitive. Additional transactions of this nature may be expected to take place in the ordinary course of business in the future. NOTE 22. SUPPLEMENTAL CASH FLOW INFORMATION For purposes of reporting cash flows, cash includes cash on hand and amounts on deposit at banks, excluding custodial bank accounts. The following table provides additional cash and noncash information not presented elsewhere in the consolidated financial statements:
- ---------------------------------------------------------------------------------------------- Year ended December 31, (in thousands) 1997 1996 1995 - ---------------------------------------------------------------------------------------------- Interest paid $ 43,563 $ 57,172 $ 48,975 - ---------------------------------------------------------------------------------------------- Income taxes paid $ 8,268 $ 18,650 $ 345 - ---------------------------------------------------------------------------------------------- Noncash investing and financing activities: Exchange of common equity securities for shares of common stock from parent (Note 4) $ 2,638 $ - $ 27,020 Receivable from sale of servicing rights 27,324 - - Capital contribution from parent in exchange for investment in unconsolidated affiliate (Note 2) 106,365 - - Acquisition of common equity securities as a return of partnership investment, net (Note 4) - 2,312 - Exchange of 2,239,061 shares of 8.42% cumulative Series A preferred stock for 9.375% subordinated debentures (Note 10) - - 55,976 ==============================================================================================
NOTE 23. SUBSEQUENT EVENTS In March 1998, the Company paid dividends on its common stock totaling $25.0 million. In March 1998, the Company increased and amended its $600.0 million secured revolving credit agreement. The Company exercised its right under the agreement to request additional commitments, with bank concurrence, increasing its available revolving facility to $701.0 million to meet increased borrowing requirements resulting from increased production volumes. The provisions of the amendment allow the Company to more fully utilize the facility by easing its restrictions with respect to the Company's use of its subprime production as collateral and its repurchase of delinquent loans out of mortgage pools. 45 46 SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data for 1997 and 1996 is shown in the following table. The quarterly financial data includes, in the opinion of management, all necessary recurring adjustments for a fair presentation of the results of operations for the interim periods. - ------------------------------------------------------------------------------------------------------ Quarters Ended March June September December (in thousands, except for per share amounts) 31 30 30 31 - ------------------------------------------------------------------------------------------------------ 1997 Total revenue $25,561 $ 17,949 (b) $24,732 $25,632 Income (loss) before extraordinary loss 187 (6,291)(b) 1,088 (2,514) (c) Extraordinary loss - (5,975) - - Net income (loss) 187 (12,266)(b) 1,088 (2,514) (c) Comprehensive (loss) income (120) 1,154 (b) 23,504 3,059 (c) - ------------------------------------------------------------------------------------------------------ Basic net (loss) income per common share before extraordinary loss (a) $ (.33) $(2.25) $ .05 $ (1.07) Extraordinary loss per common share - (1.86) - - Basic net (loss) income per common share (a) (.33) (4.11) .05 (1.07) Basic comprehensive (loss) income per common share (a) (.47) .07 7.03 .66 - ------------------------------------------------------------------------------------------------------ 1996 Total revenue $48,684 $39,762 $39,859 $20,375 Net income (loss) 13,294 5,922 8,258 (31,800) (d) Comprehensive income (loss) 13,840 5,922 8,258 (31,800) (d) - ------------------------------------------------------------------------------------------------------ Basic net income (loss) per common share (a) $5.50 $2.22 $3.26 $ (14.55) Basic comprehensive income (loss) per common share (a) 5.75 2.22 3.26 (14.56) - ------------------------------------------------------------------------------------------------------
(a) After deducting dividends on preferred stock. (b) Includes a $3.0 million pretax write-down of loans held for investment, $1.7 million of pretax restructuring charges and a $1.1 million pretax loss on the February 1997 servicing sale and related assumption of subservicing. (c) Includes a $3.7 million loss related to the February 1997 servicing sale and related assumption of subservicing and $1.4 million pretax of various one-time charges. (d) Includes a $29.1 million pretax write-off of the Company's goodwill and other intangible assets. 46 47 BOARD AND SENIOR OFFICERS BOARD OF DIRECTORS Michael C. Allemang Executive Vice President and Chief Financial Officer Source One Mortgage Services Corporation Raymond Barrette Executive Vice President and Chief Financial Officer Fund American Enterprises Holdings, Inc. Terry L. Baxter* President White Mountains Holdings, Inc. Robert R. Densmore Executive Vice President Source One Mortgage Services Corporation Mark A. Janssen Executive Vice President and Secretary Source One Mortgage Services Corporation Francis X. Mohan* President and Chief Executive Officer Source One Mortgage Services Corporation James H. Ozanne* Chairman Source One Mortgage Services Corporation Roger K. Taylor President and Chief Operating Officer Financial Security Assurance Holdings Ltd. * Member of the Executive Committee of the Board SENIOR OFFICERS Francis X. Mohan President and Chief Executive Officer Michael C. Allemang Executive Vice President and Chief Financial Officer Robert R. Densmore Executive Vice President Servicing Mark A. Janssen Executive Vice President - Production & Capital Markets and Secretary Susan L. Bowen Senior Vice President Production Division John J. Cleary Senior Vice President Loan Administration Kathleen M. DeFrances Senior Vice President Residential Division E. Roger Everett Senior Vice President Production Operations Patrick D. Gillies Senior Vice President Delinquency Administration John L. Jansen Senior Vice President Human Resources William C. Manasco Senior Vice President Information Services Pablo Sanchez, Jr. Senior Vice President Subprime Division Phillip W. Shepard Senior Vice President Residential District Charles D. Taylor Senior Vice President Information Services Central Pacific Mortgage Company John A. Courson President and Chief Executive Officer 47 48 CORPORATE ADDRESS Source One Mortgage Services Corporation 27555 Farmington Road Farmington Hills, Michigan 48334-3357 (248) 488-7000 48 EX-13.(B) 6 EXHIBIT 13(B) 1 Exhibit 13(b) REPORT OF INDEPENDENT AUDITORS We have audited the consolidated statement of condition of Source One Mortgage Services Corporation and subsidiaries ("the Company") as of December 31, 1996 and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the two years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Source One Mortgage Services Corporation and subsidiaries as of December 31, 1996 and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP Detroit, Michigan January 30, 1997 EX-23.(A) 7 EXHIBIT 23(A) 1 EXHIBIT 23(a) CONSENT OF INDEPENDENT AUDITORS The Board of Directors Source One Mortgage Services Corporation We consent to incorporation by reference in this Annual Report on Form 10-K of Source One Mortgage Services Corporation of our report dated January 28, 1998, except for Note 23, as to which the date is March 20, 1998, relating to the consolidated statement of condition of Source One Mortgage Services Corporation and subsidiaries as of December 31, 1997, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for the year then ended, which report appears in the December 31, 1997 Annual Report to Shareholders of Source One Mortgage Services Corporation. We consent to incorporation by reference in the registration statement (No. 33-47025) on Form S-3, the registration statement (No. 33-71924) on Form S-3 and the registration statement (No. 33-62765) on Form S-4 of Source One Mortgage Services Corporation, and in the related Prospectuses, of our report dated January 28, 1998, except for Note 23, as to which the date is March 20, 1998, relating to the consolidated statement of condition of Source One Mortgage Services Corporation and subsidiaries as of December 31, 1997, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for the year then ended, which report is incorporated by reference in the December 31, 1997, Annual Report on Form 10-K of Source One Mortgage Services Corporation. /s/ KPMG Peat Marwick LLP Detroit, Michigan March 26, 1998 EX-23.(B) 8 EXHIBIT 23(B) 1 Exhibit 23(b) CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation in this Annual Report (Form 10-K) of Source One Mortgage Services Corporation and subsidiaries of our report dated January 30, 1997, with respect to the consolidated financial statements of Source One Mortgage Services Corporation and subsidiaries incorporated by reference in the Annual Report (Form 10-K) of Source One Mortgage Services Corporation and subsidiaries for the year ended December 31, 1997. /s/ Ernst & Young LLP Detroit, Michigan March 27, 1998 EX-23.(C) 9 EXHIBIT 23(C) 1 EXHIBIT 23(c) CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference (from the 1997 Annual Report on Form 10-K filed by Financial Security Assurance Holdings Ltd. ("FSA") - in which filing our report was incorporated by reference from FSA's Annual Report to Shareholders) in the Registration Statements, as amended, pertaining to Medium-Term Notes Series B (Form S-3, No. 33-47025), Series A Preferred Stock (Form S-3, No. 33-71924) and Quarterly Income Capital Securities ("QUICS") (Form S-4, No. 33-62765) of Source One Mortgage Services Corporation of our report dated January 26, 1998 with respect to the consolidated financial statements of Financial Security Assurance Holdings Ltd. and Subsidiaries as of December 31, 1997 and 1996 and for each of the three years in the period ended December 31, 1997. /s/ Coopers & Lybrand L.L.P. New York, New York March 27, 1998 EX-24 10 EXHIBIT 24 1 EXHIBIT 24 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that James H. Ozanne does hereby make, constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert L. Densmore, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- James H. Ozanne 2 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that Robert R. Densmore does hereby make, constitute and appoint Mark A. Janssen, Michael C. Allemang, and Francis X. Mohan, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- Robert R. Densmore 3 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that Raymond Barrette does hereby make, constitute and appoint Mark A. Janssen, Michael C. Allemang and Robert R. Densmore, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- Raymond Barrette 4 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that Francis X. Mohan does hereby make, constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert R. Densmore, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- Francis X. Mohan 5 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that Michael C. Allemang does hereby make, constitute and appoint Mark A. Janssen, Robert R. Densmore, and Francis X. Mohan, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- Michael C. Allemang 6 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that Terry Baxter does hereby make, constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert R. Densmore, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- Terry Baxter 7 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that Mark A. Janssen does hereby make, constitute and appoint Michael C. Allemang, Robert L. Densmore and Francis X. Mohan, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- Mark A. Janssen 8 SOURCE ONE MORTGAGE SERVICES CORPORATION KNOW ALL MEN by these presents that Roger K. Taylor does hereby make, constitute and appoint Mark A. Janssen, Michael C. Allemang, and Robert R. Densmore, and each of them, the true and lawful attorney-in-fact of the undersigned, with full power of substitution and revocation, for and in the name, place and stead of the undersigned, to execute and deliver the Annual Report on Form 10-K of Source One Mortgage Services Corporation for the year ended December 31, 1997, and any and all amendments thereto; such Form 10-K and each such amendment to be in such form and to contain such terms and provisions as said attorney or substitute shall deem necessary or desirable; giving and granting unto said attorney, or to such person or persons as in any case may be appointed pursuant to the power of substitution herein given, full power and authority to do and perform any and every act and thing whatsoever requisite, necessary or, in the opinion of said attorney or substitute, able to be done in and about the premises as fully and to all intents and purposes as the undersigned might or could do if personally present, hereby ratifying and confirming all that said attorney for such substitute shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has duly executed this instrument as of the 23rd day of March, 1998. -------------------------- Roger K. Taylor EX-27 11 EXHIBIT 27
5 12-MOS DEC-31-1997 JAN-01-1997 DEC-31-1997 3,134 0 0 0 0 0 22,171 0 1,304,690 0 0 0 18 32 454,999 1,304,690 0 93,874 0 105,021 0 8,610 35,362 (11,147) (3,617) (7,530) 0 (5,975) 0 (13,505) (5.79) 0
EX-99 12 EXHIBIT 99 1 EXHIBIT 99 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of Financial Security Assurance Holdings Ltd.: We have audited the accompanying consolidated balance sheets of Financial Security Assurance Holdings Ltd. and Subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. /s/ Coopers & Lybrand L.L.P. New York, New York January 26, 1998 2 [Page 26 of 1997 Annual Report to Shareholders] FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data)
December 31, December 31, ASSETS 1997 1996 ------------ ------------ Bonds at market value (amortized cost of $1,230,479 and $1,058,417) $1,268,158 $1,072,439 Equity investments at market value (cost of $29,430 and $8,336) 30,539 8,336 Short-term investments 132,931 73,641 ---------- ---------- Total investments 1,431,628 1,154,416 Cash 12,475 8,146 Deferred acquisition costs 171,098 146,233 Prepaid reinsurance premiums 173,123 151,224 Reinsurance recoverable on unpaid losses 30,618 29,875 Receivable for securities sold 20,623 -- Other assets 61,079 47,848 ---------- ---------- TOTAL ASSETS $1,900,644 $1,537,742 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Deferred premium revenue $ 595,196 $ 511,196 Losses and loss adjustment expenses 75,417 72,079 Deferred federal income taxes 56,872 41,167 Ceded reinsurance balances payable 11,199 12,599 Payable for securities purchased 72,979 14,390 Notes payable 130,000 30,000 Accrued expenses and other liabilities 76,621 55,051 ---------- ---------- TOTAL LIABILITIES 1,018,284 736,482 ---------- ---------- COMMITMENTS AND CONTINGENCIES Preferred stock (3,000,000 shares authorized; 2,000,000 issued and outstanding; par value of $.01 per share) 20 20 Common stock (50,000,000 shares authorized; 32,276,301 issued; par value of $.01 per share) 323 323 Additional paid-in capital - preferred 680 680 Additional paid-in capital - common 693,851 695,118 Unrealized gain on investments (net of deferred income tax provision of $13,575 and $4,908) 25,212 9,114 Accumulated earnings 231,124 142,721 Deferred equity compensation 26,181 12,069 Less treasury stock at cost (3,521,847 and 2,303,407 shares held) (95,031) (58,785) ---------- ---------- TOTAL SHAREHOLDERS' EQUITY 882,360 801,260 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,900,644 $1,537,742 ========== ==========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 2 3 [Page 27 of 1997 Annual Report to Shareholders] FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data)
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- REVENUES: Net premiums written (net of premiums ceded of $63,513, $55,965 and $33,166, of which $38,105, $35,299 and $20,582 were ceded to affiliates) $ 172,878 $ 121,000 $ 77,576 Increase in deferred premium revenue (63,367) (30,552) (8,229) --------- --------- --------- Premiums earned (net of premiums ceded of $41,198, $38,723 and $38,013) 109,511 90,448 69,347 Net investment income 72,085 65,064 48,965 Net realized gains 11,522 3,189 5,120 Other income 9,303 297 3,841 --------- --------- --------- TOTAL REVENUES 202,421 158,998 127,273 --------- --------- --------- EXPENSES: Losses and loss adjustment expenses: Related to Merger -- -- 15,400 Other (net of reinsurance recoveries of $3,605, ($2,249) and $9,101, of which $3,199, ($3,084) and $7,111 were ceded to affiliates) 9,156 6,874 6,258 Policy acquisition costs 27,962 23,829 16,888 Other operating expenses 26,804 18,524 13,685 --------- --------- --------- TOTAL EXPENSES 63,922 49,227 52,231 --------- --------- --------- INCOME BEFORE INCOME TAXES 138,499 109,771 75,042 --------- --------- --------- Provision (benefit) for income taxes: Current 30,960 27,227 23,187 Deferred 7,037 1,784 (3,183) --------- --------- --------- Total provision 37,997 29,011 20,004 --------- --------- --------- NET INCOME $ 100,502 $ 80,760 $ 55,038 ========= ========= ========= Basic earnings per common share $ 3.35 $ 2.64 $ 2.13 ========= ========= ========= Diluted earnings per common share $ 3.25 $ 2.61 $ 2.13 ========= ========= =========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 3 4 [Page 28 of 1997 Annual Report to Shareholders] FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollars in thousands, except per share data)
Additional Additional Unrealized Paid-In Paid-In Gain Deferred Preferred Common Capital - Capital - (Loss) on Accumulated Equity Treasury Stock Stock Preferred Common Investment Earnings Compensation Stock Total ----- ----- --------- ------ ---------- -------- ------------ ----- ----- BALANCE, December 31, 1994 $ 20 $ 262 $ 680 $544,266 $(21,709) $ 25,647 $ -- $ (3,730) $545,436 Net income for the year 55,038 55,038 Net change in unrealized gain on investments (net of deferred income taxes of $22,421) 41,640 41,640 Issuance of common stock - 6,051,661 shares 61 151,987 152,048 Dividends paid on common stock ($0.32 per share) (8,275) (8,275) Deferred equity compensation 6,504 6,504 Purchase of 591,714 shares of common stock (14,444) (14,444) -------- -------- -------- -------- --------- -------- -------- ------- -------- BALANCE, December 31, 1995 20 323 680 696,253 19,931 72,410 6,504 (18,174) 777,947 Net income for the year 80,760 80,760 Net change in unrealized loss on investments (net of deferred income tax benefit of $5,823) (10,817) (10,817) Dividends paid on common stock ($0.35 per share) (10,536) (10,536) Deferred equity compensation 5,565 5,565 Purchase of 1,529,131 shares of common stock (40,611) (40,611) Other common stock transactions (1,135) (1,135) Adjustment to prior-year disposal of subsidiary 87 87 -------- -------- -------- -------- -------- -------- -------- -------- -------- BALANCE, December 31, 1996 20 323 680 695,118 9,114 142,721 12,069 (58,785) 801,260 Net income for the year 100,502 100,502 Net change in unrealized gain on investments (net of deferred income taxes of $8,667) 16,098 16,098 Dividends paid on common stock ($0.405 per share) (12,099) (12,099) Deferred equity compensation 17,781 17,781 Deferred equity payout 187 (3,287) 56 (3,044) Purchase of 162,573 shares of common stock (5,434) (5,434) Issuance of 125,106 shares of treasury stock for options exercised 688 (382) 3,042 3,348 Forward share transactions: Settlements with employees and directors (2,142) (2,142) Settlements with counterparties (33,910) (33,910) -------- -------- -------- -------- -------- -------- -------- -------- -------- BALANCE, December 31, 1997 $ 20 $ 323 $ 680 $693,851 $ 25,212 $231,124 $ 26,181 $(95,031) $882,360 ======== ======== ======== ======== ======== ======== ======== ======== ========
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 4 5 [Page 29 of 1997 Annual Report to Shareholders] FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Cash flows from operating activities: Premiums received, net $ 171,145 $ 124,540 $ 85,481 Policy acquisition and other operating expenses paid, net (43,279) (32,266) (36,067) Recoverable advances received (paid) (7,629) 10,213 (9,419) Losses and loss adjustment expenses paid (6,463) (15,473) (4,954) Net investment income received 65,662 63,533 41,939 Federal income taxes paid (19,797) (34,595) (15,890) Interest paid (5,158) (2,115) (95) Other (2,017) (4,253) 9,872 ----------- ----------- ----------- Net cash provided by operating activities 152,464 109,584 70,867 ----------- ----------- ----------- Cash flows from investing activities: Proceeds from sales of bonds 1,078,226 1,117,473 624,802 Proceeds from maturities of bonds 32,468 2,965 606 Purchases of bonds (1,254,274) (1,150,024) (713,799) Net gain on sale of subsidiaries 7,986 -- -- Purchases of property and equipment (3,097) (2,188) (999) Payment for purchase of subsidiary, net of cash acquired -- -- (11,447) Net decrease (increase) in short-term investments (55,551) (18,586) 56,689 ----------- ----------- ----------- Net cash used for investing activities (194,242) (50,360) (44,148) ----------- ----------- ----------- Cash flows from financing activities: Issuance of notes payable, net 125,905 -- -- Repayment of notes payable (30,000) -- -- Dividends paid (12,099) (10,536) (8,275) Treasury stock, net (36,246) (41,660) (14,444) Payment of management notes -- -- (5,624) Other (1,453) -- -- ----------- ----------- ----------- Net cash provided by (used for) financing activities 46,107 (52,196) (28,343) ----------- ----------- ----------- Net increase (decrease) in cash 4,329 7,028 (1,624) Cash at beginning of year 8,146 1,118 2,742 ----------- ----------- ----------- Cash at end of year $ 12,475 $ 8,146 $ 1,118 =========== =========== ===========
Continued The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 5 6 FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED (Dollars in thousands)
Year EndedDecember 31, ---------------------- 1997 1996 1995 ---- ---- ---- Reconciliation of net income to net cash flows from operating activities: Net income $ 100,502 $ 80,760 $ 55,038 Decrease (increase) in accrued investment income (2,504) (578) 124 Increase in deferred premium revenue and related foreign exchange adjustment 62,101 29,622 8,141 Increase in deferred acquisition costs (24,865) (13,282) (10,305) Increase (decrease) in current federal income taxes payable 7,891 (7,368) 7,297 Increase (decrease) in unpaid losses and loss adjustment expenses 2,596 (8,023) 14,587 Increase in amounts withheld for others 133 52 30 Provision (benefit) for deferred income taxes 10,309 1,784 (3,183) Net realized gains on investments (11,522) (3,189) (5,120) Deferred equity compensation 14,299 5,565 5,735 Depreciation and accretion of bond discount (2,802) (1,735) (5,735) Net gain on sale of subsidiaries (7,986) -- -- Change in other assets and liabilities 4,312 25,976 4,258 ----------- ----------- ----------- Cash provided by operating activities $ 152,464 $ 109,584 $ 70,867 =========== =========== ===========
Additional common stock was issued in relation to the Merger in 1995. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 6 7 [Pages 30 - 44 of 1997 Annual Report to Shareholders] FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 1. ORGANIZATION AND OWNERSHIP Financial Security Assurance Holdings Ltd. (the Company) is a holding company incorporated in the State of New York. The Company is principally engaged (through its insurance subsidiaries) in providing financial guaranty insurance on asset-backed and municipal obligations. The Company's underwriting policy is to insure asset-backed and municipal obligations that it determines would be of investment-grade quality without the benefit of the Company's insurance. The asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. The municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers' taxing power and of special revenue bonds and other special obligations of states and local governments that are supported by the issuers' ability to impose and collect fees and charges for public services or specific projects. Financial guaranty insurance written by the Company guarantees payment when due of scheduled payments on an issuer's obligation. In the case of a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation's original payment schedule or, at its option, to pay such amounts on an accelerated basis. The Company expects to continue to emphasize a diversified insured portfolio characterized by insurance of both asset-backed and municipal obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company's insured portfolio consists primarily of asset-backed and municipal obligations originated in the United States, but the Company has also written and continues to pursue business in Europe and the Pacific Rim. On December 20, 1995, a subsidiary of the Company merged (the Merger) with Capital Guaranty Corporation (CGC). The Merger provided for each CGC share to be exchanged for 0.6716 share of the Company's common stock and cash of $5.69. The Company issued in the aggregate 6,051,661 common shares and paid aggregate cash consideration of $51,300,000. At December 31, 1995, the Company was owned 50.3% by U S WEST, Inc. (U S WEST), 7.8% by Fund American Enterprises Holdings, Inc. (Fund American), 6.1% by The Tokio Marine and Fire Insurance Co., Ltd. (Tokio Marine) and 35.8% by the public and employees. At December 31, 1996, the Company was owned 40.4% by U S WEST, 11.5% by Fund American, 6.4% by Tokio Marine and 41.7% by the public and employees. At December 31, 1997, the Company was owned 42.1% by U S WEST, 12.0% by Fund American, 6.7% by Tokio Marine and 39.2% by the public and employees. These percentages are calculated based upon outstanding shares, which are reduced by treasury shares as presented in these financial statements. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying financial statements have been prepared in accordance with generally accepted accounting principles (GAAP), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 6). The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities in the Company's consolidated balance sheets at December 31, 1997 and 1996 and the reported amounts of revenues and expenses in the consolidated statements of income during the years ended December 31, 1997, 1996 and 1995. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses and the deferral and amortization of deferred policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows: 7 8 Basis of Presentation The consolidated financial statements include the accounts of the Company and its direct and indirect wholly owned subsidiaries, FSA Portfolio Management Inc., CGC, Transaction Services Corporation, Financial Security Assurance Inc. (FSA), FSA Insurance Company, Financial Security Assurance of Oklahoma, Inc. and Financial Security Assurance (U.K.) Limited (collectively, the Subsidiaries). All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the 1997 presentation. The Merger was accounted for on a purchase accounting basis. In view of the short period between the date of the Merger, December 20, 1995, and the year-end, the date of the Merger for accounting purposes is considered to be December 31, 1995. As a result, the accounting for the Merger has no effect on the Company's consolidated statement of income for the year ended December 31, 1995, except for the recording of $15,400,000 in losses and loss adjustment expenses to increase FSA's general reserve to provide for the insured portfolio assumed by FSA in the Merger (see Notes 17 and 19). Investments Investments in debt securities designated as available for sale are carried at market value. Any resulting unrealized gain or loss is reflected as a separate component of shareholders' equity, net of applicable deferred income taxes. All of the Company's long-term investments are classified as available for sale. Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities, and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at market value, which approximates cost. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. To manage adverse movements in interest rates, the Company uses exchange traded futures and options. Primarily, these contracts are designated as hedges of specific identified securities and any gains or losses on these hedges are deferred and included as part of the Company's unrealized gains or losses in stockholders' equity until the disposition of the hedged assets. The Company will discontinue to account for these contracts as hedges if there ceases to be a high correlation between the change in price of the hedged assets and the hedge. Other derivative positions, also in exchange traded futures contracts, that are not accounted for as hedges are marked-to-market on a daily basis, and any gains or losses are included in capital gains or losses. Premium Revenue Recognition Gross and ceded premiums are earned in proportion to the amount of risk outstanding over the expected period of coverage. Deferred premium revenue and prepaid reinsurance premiums represent the portion of premium that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized. Losses and Loss Adjustment Expenses A case basis reserve for unpaid losses and loss adjustment expenses is recorded at the present value of the estimated loss when, in management's opinion, the likelihood of a future loss is probable and determinable at the balance sheet date. The estimated loss on a transaction is discounted using current risk-free rates. The general reserve is calculated by applying a loss factor to the total net par amount outstanding of the Company's insured obligations over the term of such insured obligations and discounting the result at risk-free rates. The loss factor used for this purpose has been determined based upon an independent rating agency study of bond defaults and the Company's portfolio characteristics and history. The general reserve is available to be applied against future additions or accretions to existing case basis reserves or to new case basis reserves to be established in the future. Management of the Company periodically evaluates its estimates for losses and loss adjustment expenses and establishes reserves that management believes are adequate to cover the ultimate net cost of claims. The reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not differ from such estimates. The Company will, on an 8 9 ongoing basis, monitor these reserves and may periodically adjust such reserves based on the Company's actual loss experience, its future mix of business, and future economic conditions. Deferred Acquisition Costs Deferred acquisition costs comprise those expenses that vary with and are primarily related to the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission income on premiums ceded to reinsurers. Deferred acquisition costs and the cost of acquired business are amortized over the period in which the related premiums are earned. Recoverability of deferred acquisition costs is determined by considering anticipated losses and loss adjustment expenses. Federal Income Taxes The provision for income taxes consists of an amount for taxes currently payable and a provision for tax consequences deferred to future periods reflected at current income tax rates. Earnings per Common Share In 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share (EPS), specifying the computation, presentation and disclosure requirements for EPS (see Note 20). The new standard defines "basic" and "diluted" earnings per share. Basic earnings per share are based on average basic shares outstanding, which is calculated by adding shares earned but not issued under the Company's equity bonus and performance share plans to the average common shares outstanding. Diluted earnings per share are based on average diluted shares outstanding, which is calculated by adding shares contingently issuable under stock options, the performance share plan and the Company's convertible preferred stock to the average basic shares outstanding. All earnings per share have been restated to reflect the adoption of SFAS No. 128. 3. INVESTMENTS Bonds at amortized cost of $11,025,000 and $17,669,000 at December 31, 1997 and 1996, respectively, were on deposit with state regulatory authorities as required by insurance regulations. Consolidated net investment income consisted of the following (in thousands):
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Bonds $ 65,422 $ 61,740 $ 43,789 Equity investments 1,393 928 -- Short-term investments 7,206 3,966 6,070 Investment expenses (1,936) (1,570) (894) -------- -------- -------- Net investment income $ 72,085 $ 65,064 $ 48,965 ======== ======== ========
The credit quality of the investment portfolio at December 31, 1997 was as follows:
Percent of Rating Investment Portfolio -------------------- ---------------------- AAA 69.1% AA 16.0 A 11.5 BBB 1.1 Other 2.3
9 10 The amortized cost and estimated market value of bonds were as follows (in thousands):
Gross Gross Amortized Unrealized Unrealized Estimated December 31, 1997 Cost Gains Losses Market Value - ----------------- ---- ----- ------ ------------ U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 122,817 $ 799 $ (454) $ 123,162 Obligations of states and political subdivisions 777,042 40,187 (135) 817,094 Foreign securities 48,078 -- (6,126) 41,952 Mortgage-backed securities 195,567 2,213 (27) 197,753 Corporate securities 66,014 1,375 (501) 66,888 Asset-backed securities 20,961 349 (1) 21,309 ---------- ---------- ---------- ---------- Total $1,230,479 $ 44,923 $ (7,244) $1,268,158 ========== ========== ========== ========== December 31, 1996 U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 55,619 $ 1,103 $ (557) $ 56,165 Obligations of states and political subdivisions 661,831 15,208 (2,870) 674,169 Foreign securities 15,019 197 (71) 15,145 Mortgage-backed securities 177,818 1,432 (906) 178,344 Corporate securities 76,760 381 (403) 76,738 Asset-backed securities 71,370 680 (172) 71,878 ---------- ---------- ---------- ---------- Total $1,058,417 $ 19,001 $ (4,979) $1,072,439 ========== ========== ========== ==========
The change in net unrealized gains (losses) consisted of (in thousands):
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Bonds $ 23,657 $(16,640) $ 64,061 Equity investments 1,109 -- -- -------- -------- -------- Change in net unrealized gains (losses) $ 24,766 $(16,640) $ 64,061 ======== ======== ========
10 11 The amortized cost and estimated market value of bonds at December 31, 1997 and 1996, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
December 31, 1996 December 31, 1997 ----------------- ----------------- Estimated Estimated Amortized Market Amortized Market Cost Value Cost Value ---- ----- ---- ----- Due in one year or less $ 4,009 $ 4,007 $ 38,305 $ 38,626 Due after one year through five years 70,283 70,007 57,531 57,712 Due after five years through ten years 208,986 208,170 105,495 105,848 Due after ten years 730,673 766,912 607,898 620,031 Mortgage-backed securities (stated maturities of 4 to 39 years) 195,567 197,753 177,818 178,344 Asset-backed securities (stated maturities of 2 to 30 years) 20,961 21,309 71,370 71,878 ---------- ---------- ---------- ---------- Total $1,230,479 $1,268,158 $1,058,417 $1,072,439 ========== ========== ========== ==========
Proceeds from sales of bonds during 1997, 1996 and 1995 were $1,131,317,000, $1,118,112,000 and $608,773,000, respectively. Gross gains of $12,659,000, $15,335,000 and $12,434,000 and gross losses of $1,440,000, $12,146,000 and $7,314,000 were realized on sales in 1997, 1996 and 1995, respectively. To hedge against changes in yields on certain one-year corporate securities, the Company entered into a series of Eurodollar futures contracts, which were marked-to-market on a daily basis. These contracts were accounted for as hedges. At year-end 1996, the net unrealized loss on the contracts, included in the Company's unrealized gains in the stockholders' equity section, was not material. The aggregate notional amount of these contracts was $83,728,000 as of December 31, 1996. The Company held open positions in U.S. Treasury bond futures contracts with an aggregate notional amount of $33,300,000 and $20,600,000 as of December 31, 1997 and 1996, respectively. Such positions are marked-to-market on a daily basis, and for the years ended December 31, 1997 and 1996, the Company reported net realized gains of $190,000 and $923,000, respectively, which are included in gross realized capital gains, above. 4. DEFERRED ACQUISITION COSTS Acquisition costs deferred for amortization against future income and the related amortization charged to expenses are as follows (in thousands):
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Balance, beginning of period $ 146,233 $ 132,951 $ 91,839 --------- --------- --------- Costs deferred during the period: Ceding commission income (18,956) (15,956) (9,836) Assumed commission expense 31 38 55 Premium taxes 5,554 3,718 2,537 Compensation and other acquisition costs 66,198 49,311 34,437 --------- --------- --------- Total 52,827 37,111 27,193 --------- --------- --------- Costs amortized during the period (27,962) (23,829) (16,888) --------- --------- --------- Balance of acquired subsidiary -- -- 30,807 --------- --------- --------- Balance, end of period $ 171,098 $ 146,233 $ 132,951 ========= ========= =========
11 12 5. OTHER OPERATING EXPENSES Total salary expense and related benefits included in other operating expenses were $19,796,000, $14,596,000 and $12,046,000 for the years ended December 31, 1997, 1996 and 1995, respectively. 6. STATUTORY ACCOUNTING PRACTICES GAAP for the Subsidiaries differs in certain significant respects from accounting practices prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices: - Upfront premiums on municipal business are recognized as earned when related principal and interest have expired rather than over the expected coverage period; - Acquisition costs are charged to operations as incurred rather than as related premiums are earned; - A contingency reserve (rather than a general loss reserve) is computed based on the following statutory requirements: (i) For all policies written prior to July 1, 1989, an amount equal to 50% of cumulative earned premiums less permitted reductions, plus; (ii) For all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either 1/60th or 1/80th of the total required for each category, less permitted reductions; - Certain assets designated as "non-admitted assets" are charged directly to statutory surplus but are reflected as assets under GAAP; - Federal income taxes are provided only on taxable income for which income taxes are currently payable; - Accruals for deferred compensation are not recognized; - Purchase accounting adjustments are not recognized; - Bonds are carried at amortized cost; - Surplus notes are recognized as surplus rather than a liability. A reconciliation of net income for the calendar years 1997, 1996 and 1995 and shareholders' equity at December 31, 1997, 1996 and 1995, reported by the Company on a GAAP basis, to the amounts reported by the Subsidiaries on a statutory basis, is as follows (in thousands):
Net Income: 1997 1996 1995 ---- ---- ---- GAAP BASIS $ 100,502 $ 80,760 $ 55,038 Non-insurance companies net loss (gain) (243) 95 (50) Premium revenue recognition (23,130) (5,518) (4,805) Losses and loss adjustment expenses incurred 4,653 (2,138) 10,871 Deferred acquisition costs (24,865) (12,482) (10,305) Deferred income tax provision (benefit) 8,025 911 (3,055) Amortization of bonds 56 566 1,195 Accrual of deferred compensation, net 26,681 12,737 5,663 Other (61) 1,404 (1,580) --------- --------- -------- STATUTORY BASIS $ 91,618 $ 76,335 $ 52,972 ========= ========= ========
12 13
December 31, ------------------------------ Shareholders' Equity: 1997 1996 1995 ---- ---- ---- GAAP BASIS $ 882,360 $ 801,260 $ 777,947 Non-insurance companies liabilities, net 15,500 14,072 12,039 Premium revenue recognition (74,863) (51,760) (46,248) Loss and loss adjustment expense reserves 34,313 29,660 31,798 Deferred acquisition costs (171,098) (146,233) (132,951) Contingency reserve (287,694) (227,139) (183,967) Unrealized gain on investments, net of tax (43,027) (14,084) (30,298) Deferred income taxes 59,867 41,682 43,205 Accrual of deferred compensation 41,451 18,390 5,653 Surplus notes 50,000 -- -- Other (12,841) (17,043) (16,492) --------- --------- --------- STATUTORY BASIS (SURPLUS) $ 493,968 $ 448,805 $ 460,686 ========= ========= ========= SURPLUS PLUS CONTINGENCY RESERVE $ 781,661 $ 675,944 $ 644,653 ========= ========= =========
7. FEDERAL INCOME TAXES For periods prior to May 13, 1994, the date of the initial public offering when the Company became less than 80% owned by U S WEST, the Company and its Subsidiaries joined with U S WEST and its subsidiaries in filing a consolidated federal income tax return. Under a U S WEST practice, an income tax benefit or liability was allocated to the Company to the extent that benefits were usable or additional liabilities were incurred by U S WEST due to the Company's inclusion in the U S WEST tax returns. For each year since the Company's acquisition by U S WEST, the Company's resulting income tax provision has been the same as if the allocation of taxes were based on a separate return calculation. For the Subsidiaries, under a separate tax sharing agreement with U S WEST, the allocation of income taxes was based upon separate return calculations, which provided that benefits or liabilities created by the Subsidiaries were allocated to the Subsidiaries regardless of whether the benefits were usable or additional liabilities were incurred in the U S WEST tax returns. For periods subsequent to May 12, 1994, the Company and all members of its group elected to file consolidated federal income tax returns. The calculation of each member's tax benefit or liability was controlled by a tax sharing agreement that based the allocation of such benefit or liability upon a separate return calculation. The cumulative balance sheet effects of deferred tax consequences are (in thousands):
December 31, ------------ 1997 1996 ---- ---- Deferred acquisition costs $ 59,884 $ 51,182 Deferred premium revenue adjustments 8,424 3,520 Unrealized capital gains 15,618 7,952 Contingency reserves 38,037 30,893 Market discounts 2,016 1,950 --------- --------- Total deferred tax liabilities 123,979 95,497 --------- --------- Loss and loss adjustment expense reserves (12,009) (10,381) Deferred compensation (21,503) (10,730) Tax credits (1,807) (7,861) Tax and loss bonds (30,520) (22,526) Other, net (1,268) (2,832) --------- --------- Total deferred tax assets (67,107) (54,330) --------- --------- Total deferred income taxes $ 56,872 $ 41,167 ========= =========
No valuation allowance was necessary at December 31, 1997 or 1996. 13 14 A reconciliation of the effective tax rate with the federal statutory rate follows:
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Tax at statutory rate 35.0% 35.0% 35.0% Tax-exempt interest (7.9) (8.9) (8.5) Other 0.3 0.3 0.2 ---- ---- ---- Provision for income taxes 27.4% 26.4% 26.7% ==== ==== ====
8. SHAREHOLDERS' EQUITY On September 2, 1994, the Company issued to Fund American 2,000,000 shares of Series A, non-dividend paying, voting, convertible preferred stock having an aggregate liquidation preference of $700,000. The preferred stock is convertible, at the option of the holder upon payment of the conversion price therefor, into an equal number of shares of common stock (subject to anti-dilutive adjustment). The conversion price per share (subject to anti-dilutive adjustment) is $29.65. The preferred stock will be redeemed (if then outstanding) on May 13, 2004 at a redemption price of $0.35 per share. Fund American is entitled to one vote per share of preferred stock, voting together as a single class with the holders of common stock on all matters upon which holders of common stock are entitled to vote. As the holder of the preferred stock, Fund American is not entitled to receive dividends or other distributions of any kind payable to shareholders of the Company, except that, in the event of the liquidation, dissolution or winding up of the Company, it is entitled to receive out of the assets of the Company available therefor, before any distribution or payment is made to the holders of common stock or to any other class of capital stock of the Company ranking junior to the Company's preferred stock, liquidation payments in the amount of $0.35 per share. Fund American may not transfer the preferred stock, except to one of its majority-owned subsidiaries. On December 20, 1995, CGC merged with a subsidiary of the Company. The Merger provided for each CGC share to be exchanged for 0.6716 share of the Company's common stock and cash of $5.69. The Company issued in the aggregate 6,051,661 common shares and paid aggregate cash consideration of $51,300,000. In May 1996, the Company repurchased 1,000,000 shares of its common stock from U S WEST for a purchase price of $26.50 per share. At the same time, the Company also entered into forward agreements with National Westminster Bank Plc and Canadian Imperial Bank of Commerce (the Counterparties) in respect of 1,750,000 shares (the Forward Shares) of the Company's common stock. Under the forward agreements, the Company has the obligation either: (i) to purchase the Forward Shares from the Counterparties for a price equal to $26.50 per share plus carrying costs or (ii) to direct the Counterparties to sell the Forward Shares, with the Company receiving any excess or making up any shortfall between the sale proceeds and $26.50 per share plus carrying costs in cash or additional shares, at its option. Simultaneous with the Company entering into the forward agreements, the Company made the economic benefit and risk of 750,000 of these shares available for subscription by certain of the Company's employees and directors. When an individual participant exercises Forward Shares under the subscription program, the Company settles with the participant but does not necessarily close out the corresponding forward share position with the Counterparties. The cost of these settlements during 1997 was $2,142,000 and was charged to additional paid-in capital. By the fourth quarter of 1997, such exercises by participants had increased the number of shares allocated to the Company from 1,000,000 shares to 1,187,800 shares. During the fourth quarter of 1997, the Company purchased 1,187,800 Forward Shares for $33,910,000 by exercising rights under the forward agreements. At December 31, 1997, as a result of the Company's exercise, the repurchased shares are held as treasury stock, and the remaining 562,200 Forward Shares were allocated to the subscription program. 14 15 9. DIVIDENDS AND CAPITAL REQUIREMENTS Under New York Insurance Law, FSA may pay a dividend to the Company without the prior approval of the Superintendent of the New York State Insurance Department only from earned surplus subject to the maintenance of a minimum capital requirement. In addition, the dividend, together with all dividends declared or distributed by FSA during the preceding twelve months, may not exceed the lesser of 10% of its policyholders' surplus shown on FSA's last filed statement, or adjusted net investment income, as defined, for such twelve-month period. As of December 31, 1997, FSA had $49,846,000 available for the payment of dividends over the next twelve months. In addition, the New York Superintendent has approved the repurchase by FSA of up to $75,000,000 of its shares from the Company through December 31, 1998, pursuant to which FSA has repurchased $66,500,000 of its shares through December 31, 1997. 10. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES The Company has a credit arrangement aggregating $150,000,000 at December 31, 1997, which is provided by commercial banks and intended for general application to transactions insured by the Subsidiaries. At December 31, 1997, there were no borrowings under this arrangement, which expires on November 23, 1999. In addition, there are credit arrangements assigned to specific insured transactions. In August 1994, FSA entered into a facility agreement with Canadian Global Funding Corporation and Hambros Bank Limited. Under the agreement, FSA can arrange financing for transactions subject to certain conditions. The amount of this facility was $186,911,000, of which $100,911,000 was unutilized at December 31, 1997. FSA has a standby line of credit commitment in the amount of $240,000,000 with a group of international Aaa/AAA-rated banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $230,000,000 or 5.75% of average annual debt service of the covered portfolio. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations including certain installment premiums and other collateral. This commitment has a term beginning on April 30, 1997 and expiring on April 30, 2004 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 1997. In connection with the Merger, the Company assumed $30,000,000 of CGC's senior notes. Interest on these notes was paid semiannually at the rate of 7.05% per annum. These notes were repaid in September 1997. On September 18, 1997, the Company issued $130,000,000 of 7.375% Senior Quarterly Income Debt Securities (Senior QUIDS) due September 30, 2097 and callable without premium or penalty on or after September 18, 2002. Interest on these notes is paid quarterly beginning on December 31, 1997. Debt issuance costs of $4,300,000 are being amortized over the life of the debt. The Company used the proceeds to repay the CGC senior notes described above, to augment capital in the Subsidiaries, to repurchase Forward Shares (see Note 8) and for general corporate purposes. 11. EMPLOYEE BENEFIT PLANS The Subsidiaries maintain both a qualified and a non-qualified non-contributory defined contribution pension plan for the benefit of all eligible employees. The Subsidiaries' contributions are based upon a fixed percentage of employee compensation. Pension expense, which is funded as accrued, amounted to $2,535,000, $2,215,000 and $1,898,000 for the years ended December 31, 1997, 1996 and 1995, respectively. The Subsidiaries have an employee retirement savings plan for the benefit of all eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by the Internal Revenue Service (IRS Code, Section 401(k)). The Subsidiaries' contributions are discretionary, and none have been made. 15 16 During 1991, the Subsidiaries established the Profit Participation Plan as a long-term incentive compensation plan for the benefit of certain of its employees. Prior to the Company's initial public offering in 1994, the Company adopted a Supplemental Restricted Stock Plan. Pursuant to this plan, awards of outstanding units to existing employees under the Profit Participation Plan were valued at $0.20 per dollar of award ($0.70 per dollar of award in the case of 1994 regular units granted thereunder) and, at the election of each outstanding employee, were exchanged for restricted shares of common stock valued at the initial public offering price of $20.00 per share. All employees of the Company, including all senior executives, exchanged their outstanding interests in the Profit Participation Plan for restricted shares of common stock at the public offering price under the Supplemental Restricted Stock Plan. In exchange for an accrued balance of $7,126,000 in such Profit Participation Plan, the Company issued 356,345 shares of restricted stock. This transaction was treated as a non-cash financing transaction for cash flow purposes. The stock was restricted because ownership of the shares by employees required continued employment. The shares vested ratably over a three-year period on July 1, 1994, 1995 and 1996. Pursuant to the 1993 Equity Participation Plan, 1,810,780 shares of common stock, subject to anti-dilutive adjustment, were reserved for awards of options, restricted shares of common stock, and performance shares to employees for the purpose of providing, through the grant of long-term incentives, a means to attract and retain key personnel and to provide to participating officers and other key employees long-term incentives for sustained high levels of performance. Shares available under the 1993 Equity Participation Plan were increased from 1,810,780 to 2,110,780 in May 1995. The 1993 Equity Participation Plan also contains provisions that permit the Human Resources Committee to pay all or a portion of an employee's bonuses in the form of shares of common stock credited to the employees at a 15% discount from current market value and paid to employees five years from the date of award. Up to an aggregate of 10,000,000 shares may be allocated to such equity bonuses. Common stock to pay performance shares, stock options and equity bonus awards is acquired by the Company through open-market purchases by a trust established for such purpose. During 1994, under the Company's 1993 Equity Participation Plan, the Company granted to officers and employees, in respect of future performance, non-qualified options to purchase an aggregate of 1,099,000 shares of common stock, of which 39,000 were forfeited and 1,060,000 were still outstanding at December 31, 1994, substantially all of which have an exercise price of $20.00 per share. (As described below, 1,025,500 of these options were converted to performance shares.) The foregoing options vest, subject to continuation of employment and other terms of the option grants, at the rate of 20% per year, for five one-year periods, with the first period ending on July 1, 1994. Such options expire ten years after the effective dates of their grant. In the fourth quarter of 1994, holders of outstanding stock options under the 1993 Equity Participation Plan were offered the right to exchange such stock options for an equal number of performance shares under such Plan. Also, as a result of the Merger, the Company granted stock options to acquire an aggregate of 169,956 shares of common stock with strike prices ranging from $18.63 to $23.53 per share to employees of CGC in exchange for outstanding stock options of CGC. During 1997, employees acquired 125,106 shares subject to options at an average strike price of $22.32 per share and with an average market price of $41.47 per share. In addition, options to purchase 20,194 shares were forfeited during 1997. Giving effect to such exchange and subsequent awards, at December 31, 1997, there were outstanding 1,366,375 performance shares and options to purchase 56,656 shares of common stock. Performance shares granted under the 1993 Equity Participation Plan were as follows:
Outstanding Granted Earned Forfeited Outstanding Market at Beginning During During During at End Price at of Year the Year the Year the Year of Year Grant Date ------- -------- -------- -------- ------- ---------- 1995 1,025,500 83,650 -- -- 1,109,150 $19.250 1996 1,109,150 282,490 -- 17,300 1,374,340 25.250 1997 1,374,340 253,057 201,769 59,253 1,366,375 35.500
The Company applies APB Opinion 25 and related Interpretations in accounting for its performance shares. The Company estimates the final cost of these performance shares and accrues for this expense over the performance period. The accrued expense for the performance shares was $29,500,000, $13,741,000 and $5,744,000 for the years ended December 31, 1997, 1996 and 1995, respectively. In tandem with this accrued expense, the Company estimates those performance shares that it expects to settle in stock and records this amount in stockholders' equity as deferred compensation. The remainder of the accrual, which represents the amount of performance shares that the Company estimates it will settle in cash, is recorded in accrued expenses and other liabilities. In 1996, the Company adopted disclosure provisions of SFAS No. 123. Had the compensation cost for the Company's performance shares been determined based upon the provisions of SFAS No. 123, there would have been no effect on the Company's reported net income and earnings per share. 16 17 In November 1994, the Company appointed an independent trustee authorized to purchase shares of the Company's common stock in open market transactions, at times and prices determined by the trustee. These purchases are intended to fund future obligations relating to equity bonuses, performance shares and stock options under the 1993 Equity Participation Plan and are presented as treasury stock in these financial statements. During 1997, 1996 and 1995, the total number of shares purchased by the trust was 162,573, 529,131 and 591,714, respectively, at a cost of $5,434,000, $14,111,000 and $14,444,000, respectively. In 1996 and 1995, the Company also repurchased stock from its employees in satisfaction of withholding taxes on shares distributed under its restricted stock plan. The Company does not currently provide post-retirement benefits, other than under its defined contribution plans, to its employees, nor does it provide post-employment benefits to former employees. 12. COMMITMENTS AND CONTINGENCIES The Company and its Subsidiaries lease office space and equipment under non-cancelable operating leases, which expire at various dates through 2005. Future minimum rental payments are as follows (in thousands):
Year Ended December 31, ----------------------- 1998 $ 2,477 1999 2,440 2000 2,301 2001 2,014 2002 1,739 Thereafter 5,071 ------- Total $16,042 =======
Rent expense for the years ended December 31, 1997, 1996 and 1995 was $4,067,000, $3,816,000 and $3,712,000, respectively. During the ordinary course of business, the Subsidiaries have become parties to certain litigation. Management believes that these matters will be resolved with no material financial impact on the Company. 13. REINSURANCE The Subsidiaries reinsure portions of their risks with affiliated (see Note 15) and unaffiliated reinsurers under quota share treaties and on a facultative basis. The Subsidiaries' principal ceded reinsurance program consisted in 1997 of two quota share treaties and three automatic facultative facilities. One treaty covered all of the Subsidiaries' approved regular lines of business, except U.S. municipal obligation insurance. Under this treaty in 1997, the Subsidiaries ceded 9.75% of each covered policy, up to a maximum of $19,500,000 insured principal per policy. At their sole option, the Subsidiaries could have increased, and in certain instances did increase, the ceding percentage to 19.5% up to $39,000,000 of each covered policy. A second treaty covered the Subsidiaries' U.S. municipal obligation insurance business. Under this treaty in 1997, the Subsidiaries ceded 9% of each covered policy that is classified by the Subsidiaries as providing U.S. municipal bond insurance as defined by Article 69 of the New York Insurance Law up to a limit of $24,000,000 per single risk, which is defined by revenue source. At their sole option, the Subsidiaries could have increased, and in certain instances did increase, the ceding percentage to 35% up to $93,333,000 per single risk. These cession percentages under both treaties were reduced on smaller-sized transactions. Under the three automatic facultative facilities in 1997, the Subsidiaries at their option could allocate up to a specified amount for each reinsurer (ranging from $4,000,000 to $50,000,000 depending on the reinsurer) for each transaction, subject to limits and exclusions, in exchange for which the Subsidiaries agreed to cede in the aggregate a specified percentage of gross par insured by the Subsidiaries. Each of the treaties and automatic facultative facilities allowed the Subsidiaries to withhold a ceding commission to defray their expenses. The Subsidiaries also employed non-treaty, quota share facultative reinsurance on various transactions in 1997 in keeping with prior practices. In 1997, the Subsidiaries also implemented facultative first-loss reinsurance on selected asset-backed transactions. 17 18 In the event (which management considers to be highly unlikely) that any or all of the reinsuring companies were unable to meet their obligations to the Subsidiaries, the Subsidiaries would be liable for such defaulted amounts. The Subsidiaries have also assumed reinsurance of municipal obligations from unaffiliated insurers. Amounts reinsured were as follows (in thousands):
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Written premiums ceded $ 63,513 $ 55,965 $33,166 Written premiums assumed 1,352 1,873 1,684 Earned premiums ceded 41,713 38,723 38,013 Earned premiums assumed 5,121 6,020 2,759 Loss and loss adjustment expense payments ceded 2,862 29,408 3,060 Loss and loss adjustment expense payments assumed 2 3 3 Incurred losses and loss adjustment expenses ceded 3,605 (2,249) 9,101 Incurred losses and loss adjustment expenses assumed 161 38 81 December 31, ------------ 1997 1996 ---- ---- Principal outstanding ceded $24,547,361 $20,292,615 Principal outstanding assumed 1,670,468 1,995,752 Deferred premium revenue ceded 173,123 151,224 Deferred premium revenue assumed 14,128 18,929 Loss and loss adjustment expense reserves ceded 30,618 29,875 Loss and loss adjustment expense reserves assumed 865 705
14. OUTSTANDING EXPOSURE AND COLLATERAL The Company's policies insure the scheduled payments of principal and interest on asset-backed and municipal obligations. The principal amount insured (in millions) as of December 31, 1997 and 1996 (net of amounts ceded to other insurers of $10,129 and $9,601 of asset-backed and $14,418 and $10,691 of municipal, respectively) and the terms to maturity are as follows:
December 31, 1997 December 31, 1996 ----------------- ----------------- Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal - ----------------- ------------ --------- ------------ --------- 0 to 5 Years $ 7,553 $ 2,230 $ 7,424 $ 1,571 5 to 10 Years 5,637 5,683 3,920 3,841 10 to 15 Years 2,858 8,257 1,461 6,272 15 to 20 Years 524 14,340 714 11,433 20 Years and Above 11,917 16,479 9,681 12,877 ------- ------- ------- ------- Total $28,489 $46,989 $23,200 $35,994 ======= ======= ======= =======
18 19 The principal amount ceded as of December 31, 1997 and 1996 and the terms to maturity are as follows (in millions):
December 31, 1997 December 31, 1996 ----------------- ----------------- Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal - ----------------- ------------ --------- ------------ --------- 0 to 5 Years $ 3,828 $ 965 $ 3,695 $ 769 5 to 10 Years 2,118 1,693 2,413 1,192 10 to 15 Years 553 2,078 452 1,479 15 to 20 Years 257 3,005 302 2,345 20 Years and Above 3,373 6,677 2,739 4,906 ------- ------- ------- ------- Total $10,129 $14,418 $ 9,601 $10,691 ======= ======= ======= =======
The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, by diversifying its portfolio and by maintaining rigorous collateral requirements on asset-backed obligations. The gross principal amounts of insured obligations in the asset-backed insured portfolio are backed by the following types of collateral (in millions):
Net of Amounts Ceded Ceded December 31, December 31, ------------ ------------ Types of Collateral 1997 1996 1997 1996 - ------------------- ---- ---- ---- ---- Residential mortgages $12,928 $10,987 $ 3,665 $ 3,077 Consumer receivables 10,659 7,548 4,601 3,735 Government securities 787 1,477 120 449 Pooled corporate obligations 3,004 1,663 540 852 Commercial mortgage portfolio: Commercial real estate 98 113 418 463 Corporate secured 55 66 481 619 Investor-owned utility obligations 643 791 229 266 Other asset-backed obligations 315 555 75 140 ------- ------- ------- ------- Total asset-backed obligations $28,489 $23,200 $10,129 $ 9,601 ======= ======= ======= =======
The asset-backed insured portfolio, which aggregated $38,618,244,000 principal before reinsurance at December 31, 1997, was collateralized by assets with an estimated fair value of $44,382,716,000. At December 31, 1996, it aggregated $32,792,722,000 principal before reinsurance and was collateralized by assets with an estimated fair value of $38,323,180,000. Such estimates of fair value are calculated at the inception of each insurance policy and are changed only in proportion to changes in exposure. At December 31, 1997, the estimated fair value of collateral and reserves over the principal insured averaged from 100% for commercial real estate to 172% for corporate secured obligations. At December 31, 1996, the estimated fair value of collateral and reserves over the principal insured averaged from 100% for commercial real estate to 168% for corporate secured obligations. Collateral for specific transactions is generally not available to pay claims related to other transactions. The amounts of losses ceded to reinsurers are determined net of collateral. The gross principal amount of insured obligations in the municipal insured portfolio includes the following types of issues (in millions):
Net of Amounts Ceded Ceded December 31, December 31, ------------ ------------ Types of Issues 1997 1996 1997 1996 - --------------- ---- ---- ---- ---- General obligation bonds $17,101 $12,523 $ 3,182 $2,423 Housing revenue bonds 1,770 1,794 955 1,033 Municipal utility revenue bonds 5,892 4,671 2,294 1,472 Health care revenue bonds 3,924 2,854 2,175 2,049 Tax-supported bonds (non-general obligation) 11,210 8,805 3,526 2,152 Transportation revenue bonds 1,972 1,479 1,041 436 Other municipal bonds 5,120 3,868 1,245 1,126 ------- ------- ------- ------- Total municipal obligations $46,989 $35,994 $14,418 $10,691 ======= ======= ======= =======
19 20 In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitization, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not deemed by the Company to be significant given other more relevant measures of diversification such as issuer or industry. The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The following table sets forth, by state, those states in which municipalities located therein issued an aggregate of 2% or more of the Company's net par amount outstanding of insured municipal securities as of December 31, 1997:
Net Par Percent of Total Ceded Par Number Amount Municipal Net Par Amount State of Issues Outstanding Amount Outstanding Outstanding ----- --------- ----------- ------------------ ----------- (in millions) (in millions) California 403 $ 7,832 16.7% $ 1,929 New York 281 4,307 9.2 2,163 Pennsylvania 231 3,125 6.6 650 New Jersey 207 2,730 5.8 1,260 Florida 103 2,669 5.7 817 Texas 294 2,472 5.3 669 Illinois 274 1,851 3.9 254 Massachusetts 101 1,460 3.1 553 Michigan 147 1,417 3.0 409 Minnesota 129 1,152 2.5 111 Wisconsin 179 1,138 2.4 206 All Other States 1,190 15,575 33.1 4,528 Non-U.S 29 1,261 2.7 869 ------- ------- ----- ------- Total 3,568 $46,989 100.0% $14,418 ======= ======= ===== =======
15. RELATED PARTY TRANSACTIONS The Subsidiaries ceded premiums of $21,216,000, $19,890,000 and $13,061,000 to Tokio Marine for the years ended December 31, 1997, 1996 and 1995, respectively. The amounts included in prepaid reinsurance premiums at December 31, 1997 and 1996 for reinsurance ceded to Tokio Marine were $53,603,000 and $44,634,000, respectively. Reinsurance recoverable on unpaid losses ceded to Tokio Marine was $613,000 and $477,000 at December 31, 1997 and 1996, respectively. The Subsidiaries ceded premiums of $16,890,000, $15,409,000 and $7,522,000 on a quota share basis to affiliates of U S WEST for the years ended December 31, 1997, 1996 and 1995, respectively, of which $351,000, $372,000 and $629,000, respectively, were ceded to Commercial Reinsurance Company (Commercial Re). The amounts included in prepaid reinsurance premiums for reinsurance ceded to these affiliates were $51,980,000 and $49,649,000 at December 31, 1997 and 1996, respectively, of which $5,554,000 and $8,728,000, respectively, were ceded to Commercial Re. The amounts of reinsurance recoverable on unpaid losses ceded to these affiliates at December 31, 1997 and 1996 were $24,195,000 and $23,473,000, respectively, of which $20,335,000 and $19,170,000, respectively, were ceded to Commercial Re. The Commercial Re reinsurance agreement was subject to, and received, the non-disapproval of the State of New York Insurance Department due to its nature as an affiliate transaction. FSA has taken credit for the reinsurance ceded to Commercial Re. 20 21 16. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Bonds -- The carrying amount of bonds represents fair value. The fair value of bonds is based upon quoted market price. Short-term investments -- The carrying amount is fair value, which approximates cost due to the short maturity of these instruments. Cash, receivable for investments sold and payable for investments purchased -- The carrying amount approximates fair value because of the short maturity of these instruments. Deferred premium revenue, net of prepaid reinsurance premiums -- The carrying amount of deferred premium revenue, net of prepaid reinsurance premiums, represents the Company's future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance contract. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the premiums that would be paid under a reinsurance agreement with a third party to transfer the Company's financial guaranty risk, net of that portion of the premiums retained by the Company to compensate it for originating and servicing the insurance contracts. Installment premiums -- Consistent with industry practice, there is no carrying amount for installment premiums since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be paid under a reinsurance agreement with a third party to transfer the Company's financial guaranty risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract. Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses -- The carrying amount is fair value, which is the present value of the expected cash flows for specifically identified claims and potential losses in the Company's insured portfolio.
December 31, 1997 December 31, 1996 ----------------- ----------------- (In thousands) Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value ------ ---------- ------ ---------- Assets: Bonds $1,268,158 $1,268,158 $1,072,439 $1,072,439 Short-term investments 132,931 132,931 73,641 73,641 Cash 12,475 12,475 8,146 8,146 Receivable for securities sold 20,623 20,623 -- -- Liabilities: Deferred premium revenue, net of prepaid reinsurance premiums 422,073 295,451 359,972 251,980 Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses 44,799 44,799 42,204 42,204 Notes payable 130,000 131,612 30,000 30,000 Payable for investments purchased 72,979 72,979 14,390 14,390 Off-balance-sheet instruments: Installment premiums -- 116,888 -- 102,988
21 22 17. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES The Company's liability for losses and loss adjustment expenses consists of the case basis and general reserves. Activity in the liability for losses and loss adjustment expenses is summarized as follows (in thousands):
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Balance at January 1 $ 72,079 $ 111,759 $ 91,130 Less reinsurance recoverable 29,875 61,532 55,491 --------- --------- --------- Net balance at January 1 42,204 50,227 35,639 Incurred losses and loss adjustment expenses: Current year 5,400 5,300 3,000 Prior years 3,756 1,574 3,258 Related to Merger -- -- 15,400 Paid losses and loss adjustment expenses: Current year (2,850) -- -- Prior years (3,711) (14,897) (7,070) --------- --------- --------- Net balance December 31 44,799 42,204 50,227 Plus reinsurance recoverable 30,618 29,875 61,532 --------- --------- --------- Balance at December 31 $ 75,417 $ 72,079 $ 111,759 ========= ========= =========
During 1995, the Company increased its general reserve by $6,258,000, of which $3,000,000 was for originations of new business and $3,258,000 was to reestablish the general reserve for transfers from general reserves to case basis reserves. During 1995, the Company transferred $10,788,000 from its general reserve to case basis reserves associated predominantly with certain residential mortgage and timeshare receivables transactions. Also in December 1995, FSA recognized a one-time increase of $15,400,000 to the general reserve to provide for the insured portfolio it had assumed in the Merger with CGC in a manner consistent with the Company's reserving methodology. Prior to the Merger, CGC did not maintain a general reserve. Giving effect to all the 1995 events, the general reserve totaled $31,798,000 at December 31, 1995. During 1996, the Company increased its general reserve by $6,874,000, of which $5,300,000 was for originations of new business and $1,574,000 was to reestablish a portion of the general reserve that had previously been transferred to case basis reserves. During 1996, the Company transferred $9,012,000 from its general reserve to case basis reserves associated predominantly with certain residential mortgage and timeshare receivables transactions. Giving effect to these transfers, the general reserve totaled $29,660,000 at December 31, 1996. During 1997, the Company increased its general reserve by $9,156,000, of which $5,400,000 was for originations of new business and $3,756,000 was to reestablish a portion of the general reserve that had previously been transferred to case basis reserves. During 1997, the Company transferred $4,503,000 from its general reserve to case basis reserves associated predominantly with certain residential mortgage transactions. Giving effect to these transfers, the general reserve totaled $34,313,000 at December 31, 1997. Reserves for losses and loss adjustment expenses are discounted at risk-free rates. The amount of discount taken was approximately $19,779,000, $17,944,000 and $15,276,000 at December 31, 1997, 1996 and 1995, respectively. 22 23 18. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
(In thousands, except share data) First Second Third Fourth Full Year ----- ------ ----- ------ --------- 1997 Gross premiums written $41,111 $90,995 $42,470 $61,815 $236,391 Net premiums written 27,184 67,495 28,911 49,288 172,878 Net premiums earned 24,774 27,561 27,204 29,972 109,511 Net investment income 16,361 17,121 17,920 20,683 72,085 Losses and loss adjustment expenses 2,285 2,156 2,426 2,289 9,156 Income before taxes 27,266 35,058 37,896 38,279 138,499 Net income 20,250 25,233 27,225 27,794 100,502 Basic earnings per common share 0.67 0.84 0.91 0.93 3.35 Diluted earnings per common share 0.66 0.82 0.88 0.90 3.25 1996 Gross premiums written $52,580 $44,762 $38,994 $40,630 $176,966 Net premiums written 34,139 30,726 28,449 27,686 121,000 Net premiums earned 22,734 19,750 21,637 26,327 90,448 Net investment income 15,682 15,986 16,467 16,929 65,064 Losses and loss adjustment expenses 1,625 1,530 1,482 2,237 6,874 Income before taxes 26,234 25,211 22,948 35,378 109,771 Net income 19,544 18,748 17,210 25,258 80,760 Basic earnings per common share 0.62 0.61 0.57 0.84 2.64 Diluted earnings per common share 0.62 0.60 0.57 0.83 2.61
19. PRO FORMA RESULTS OF ACQUISITION (UNAUDITED) The unaudited consolidated results of operations (in thousands, except per share data) on a pro forma basis as though the Merger had been consummated on January 1, 1995, excluding the effect of the one-time general reserve charge in 1995 of $15,400, were as follows:
December 31, 1995 ---- Total revenues $157,150 Total expenses 44,239 Earnings per common share 2.53
The pro forma information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the Merger been consummated as of January 1, 1995, nor is it necessarily indicative of future operating results. 23 24 20. EARNINGS PER SHARE In 1997, the Company adopted SFAS No. 128 specifying the computation, presentation and disclosure requirements for EPS. The new standard defines "basic" and "diluted" earnings per share. Basic earnings per share are based on average basic shares outstanding, which is calculated by adding shares earned but not issued under the Company's equity bonus and performance share plans to the average common shares outstanding. Diluted earnings per share are based on average diluted shares outstanding, which is calculated by adding shares contingently issuable under stock options, the performance share plan and the Company's convertible preferred stock to the average basic shares outstanding. The calculations of average basic and diluted common shares outstanding are as follows (in thousands):
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Average common shares outstanding 29,858 30,547 25,797 Shares earned but unissued under stock-based compensation plans 170 80 59 ------ ------ ------ Average basic common shares outstanding 30,028 30,627 25,856 Shares contingently issuable under: Stock-based compensation plans 395 268 43 Convertible preferred stock 490 -- -- ------ ------ ------ Average diluted common shares outstanding 30,913 30,895 25,899
21. RECENTLY ISSUED ACCOUNTING STANDARDS In February 1997, the Securities and Exchange Commission (SEC) issued Financial Reporting Release No. 48, Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments (FRR No. 48). FRR No. 48 amends rules and forms for registrants and requires clarification and expansion of existing disclosures for derivative financial instruments, other financial instruments and derivative commodity instruments, as defined therein. The amendments require enhanced disclosure with respect to these derivative instruments in the footnotes to the financial statements. Additionally, the amendments expand existing disclosure requirements to include quantitative and qualitative discussions with respect to market risk inherent in market-risk-sensitive instruments such as equity and fixed-maturity securities, as well as derivative instruments. In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. Comprehensive income is defined as the change in stockholders' equity during a period from transactions and other events and circumstances from non-owner sources and includes net income and all changes in stockholders' equity except those resulting from investments by owners and distributions to owners. SFAS No. 130 requires that an enterprise (i) classify items of other comprehensive income by their nature in a financial statement and (ii) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required. Also in June 1997, the Financial Accounting Standards Board issued SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual and interim financial statements and requires presentation of a measure of profit or loss, certain specific revenue and expense items and segment assets. It also establishes standards for related disclosures about products and services, geographic areas and major customers, superseding most of SFAS No. 14, Financial Reporting for Segments of a Business Enterprise. 24 25 SFAS No. 131 requires that a public business enterprise report financial and descriptive information about its reportable operating segments. Generally, financial information is required to be reported on the basis that is used internally for evaluating segment performance and deciding how to allocate resources to segments. The enterprise must report information about revenues derived, major customers, and countries in which it earns revenues and holds assets, regardless of whether that information is used in making operating decisions. However, SFAS No. 131 does not require an enterprise to report information that is not prepared for internal use if reporting would be impracticable. SFAS No. 131 is effective for financial statements for periods beginning after December 15, 1997. SFAS No. 131 need not be applied to interim financial statements in the initial year of its application, but comparative information for interim periods in the initial year of application is to be reported in financial statements of the interim periods in the third year of application. The Company is in the process of determining the effect of these standards on its financial statements. 25 -----END PRIVACY-ENHANCED MESSAGE-----