UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File No. 1-13219
Ocwen Financial Corporation
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(Exact name of registrant as specified in its charter)
Florida 65-0039856
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(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1661 Worthington Road, Suite 100, West Palm Beach, Florida 33409
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(Address of principal executive offices) (Zip Code)
(561) 682-8000
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer" and "large accelerated filer" in Rule 12b-2 of the Exchange Act:
Large Accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Number of shares of Common Stock, $0.01 par value, outstanding as of November 4,
2006: 63,004,126 shares.
OCWEN FINANCIAL CORPORATION
FORM 10-Q
INDEX
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PART I - FINANCIAL INFORMATION Page
----
Item 1. Interim Consolidated Financial Statements (Unaudited)............................................................ 3
Consolidated Balance Sheet at September 30, 2006 and December 31, 2005........................................... 3
Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2006 and 2005 ........... 4
Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2006 and 2005.. 5
Consolidated Statement of Changes in Stockholders' Equity for the Nine Months Ended September 30, 2006........... 6
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005...................... 7
Notes to Consolidated Financial Statements....................................................................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............................ 18
Item 3. Quantitative and Qualitative Disclosures About Market Risk....................................................... 37
Item 4. Controls and Procedures.......................................................................................... 38
PART II - OTHER INFORMATION
Item 1. Legal Proceedings................................................................................................ 39
Item 1A. Risk Factors..................................................................................................... 39
Item 6. Exhibits......................................................................................................... 39
Signatures................................................................................................................ 41
2
PART I - FINANCIAL INFORMATION
ITEM 1. INTERIM FINANCIAL STATEMENTS (Unaudited)
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
September 30, December 31,
2006 2005
------------ ------------
Assets
Cash ......................................................................... $ 192,232 $ 269,611
Trading securities, at fair value
Investment grade ......................................................... 222,611 1,685
Subordinates and residuals ............................................... 46,904 30,277
Loans held for resale, at lower of cost or market value ...................... 212,895 624,671
Advances ..................................................................... 304,374 219,716
Match funded advances ........................................................ 390,575 377,105
Mortgage servicing rights .................................................... 173,911 148,663
Receivables .................................................................. 58,265 68,266
Deferred tax assets, net ..................................................... 169,258 20,270
Premises and equipment, net .................................................. 36,347 40,108
Other assets ................................................................. 105,401 53,801
------------ ------------
Total assets ............................................................. $ 1,912,773 $ 1,854,173
============ ============
Liabilities and Stockholders' Equity
Liabilities
Match funded liabilities ................................................. $ 356,179 $ 339,292
Servicer liabilities ..................................................... 419,732 298,892
Lines of credit and other secured borrowings ............................. 367,635 626,448
Debt securities .......................................................... 150,329 154,329
Other liabilities ........................................................ 79,805 85,952
------------ ------------
Total liabilities ..................................................... 1,373,680 1,504,913
------------ ------------
Minority interest in subsidiaries ............................................ 1,905 1,853
Commitments and Contingencies (Note 9)
Stockholders' Equity
Common stock, $.01 par value; 200,000,000 shares authorized;
62,691,167 and 63,133,471 shares issued and outstanding at
September 30, 2006 and December 31, 2005, respectively ................ 627 631
Additional paid-in capital ............................................... 180,019 184,262
Retained earnings ........................................................ 355,787 163,198
Accumulated other comprehensive income (loss), net of taxes .............. 755 (684)
------------ ------------
Total stockholders' equity ............................................... 537,188 347,407
------------ ------------
Total liabilities and stockholders' equity ............................ $ 1,912,773 $ 1,854,173
============ ============
The accompanying notes are an integral part of these
consolidated financial statements
3
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except share data)
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
--------------------------------------------- ------------ ------------ ------------ ------------
Revenue
Servicing and subservicing fees ......... $ 85,580 $ 75,776 $ 248,437 $ 219,807
Process management fees ................. 21,601 18,701 59,750 53,107
Other revenues .......................... 2,968 2,433 9,548 7,499
------------ ------------ ------------ ------------
Total revenue ....................... 110,149 96,910 317,735 280,413
------------ ------------ ------------ ------------
Operating expenses
Compensation and benefits ............... 21,331 23,722 69,038 72,449
Amortization of servicing rights ........ 27,082 22,975 81,034 73,020
Servicing and origination ............... 13,303 15,703 39,207 44,884
Technology and communications ........... 6,498 7,589 19,171 22,850
Professional services ................... 6,984 4,692 22,383 15,425
Occupancy and equipment ................. 4,785 4,517 14,584 13,330
Other operating expenses ................ 5,145 4,750 11,439 12,728
------------ ------------ ------------ ------------
Total operating expenses ............ 85,128 83,948 256,856 254,686
------------ ------------ ------------ ------------
Other income (expense)
Interest income ......................... 12,466 3,864 36,877 16,960
Interest expense ........................ (11,558) (8,340) (38,874) (25,852)
Gain (loss) on trading securities ....... 2,156 (742) 3,483 (3,409)
Loss on loans held for resale, net ...... (85) -- (1,306) --
Gain on debt repurchases ................ -- 897 25 897
Other, net .............................. (1,627) 1,586 4,141 4,014
------------ ------------ ------------ ------------
Other income (expense), net ......... 1,352 (2,735) 4,346 (7,390)
------------ ------------ ------------ ------------
Income before income taxes .................. 26,373 10,227 65,225 18,337
Income tax expense (benefit) ................ 9,403 2,282 (127,364) 5,097
------------ ------------ ------------ ------------
Net income .............................. $ 16,970 $ 7,945 $ 192,589 $ 13,240
============ ============ ============ ============
Earnings per share
Basic .................................... $ 0.27 $ 0.13 $ 3.06 $ 0.21
Diluted .................................. $ 0.25 $ 0.12 $ 2.71 $ 0.21
Weighted average common shares outstanding
Basic ..................................... 62,505,740 62,975,006 62,855,616 62,743,375
Diluted ................................... 71,689,432 77,397,469 71,798,615 63,843,041
The accompanying notes are an integral part of these
consolidated financial statements
4
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
Three months Nine months
--------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
-------------------------------------------------------------------- ------------ ------------ ------------ ------------
Net income ......................................................... $ 16,970 $ 7,945 $ 192,589 $ 13,240
Other comprehensive income (loss), net of taxes:
Change in unrealized foreign currency translation adjustment
arising during the period (1) .............................. 1,075 (219) 1,439 (458)
------------ ------------ ------------ ------------
Comprehensive income ............................................... $ 18,045 $ 7,726 $ 194,028 $ 12,782
============ ============ ============ ============
(1) Net of tax benefit (expense) of $(631) and $120 for the three months
and of $(845) and $247 for the nine months ended September 30, 2006 and
2005, respectively.
The accompanying notes are an integral part of these
consolidated financial statements
5
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006
(Dollars in thousands)
Accumulated
Other
Common Stock Additional Comprehensive
--------------------------- Paid-in Retained Income (Loss),
Shares Amount Capital Earnings Net of Taxes Total
------------ ----------- ------------ ------------ ----------- ------------
Balance at December 31, 2005 ........... 63,133,471 $ 631 $ 184,262 $ 163,198 $ (684) $ 347,407
Net income ............................. -- -- -- 192,589 -- 192,589
Issuance of common stock awards to
employees ............................ 77,011 1 660 661
Exercise of common stock options ....... 478,356 5 4,070 4,075
Repurchase of common stock ............. (1,000,000) (10) (10,990) -- -- (11,000)
Purchase of fractional shares in
connection with a reverse/forward
stock split .......................... (1,259) -- (14) -- -- (14)
Excess tax benefits related to share-
based awards ......................... -- -- 773 -- -- 773
Employee compensation -
Share-based awards ................... -- -- 1,228 -- -- 1,228
Director's compensation - Common
stock ................................ 3,588 -- 30 -- -- 30
Other comprehensive income,
net of taxes ......................... -- -- -- -- 1,439 1,439
------------ ----------- ------------ ------------ ----------- ------------
Balance at September 30, 2006 .......... 62,691,167 $ 627 $ 180,019 $ 355,787 $ 755 $ 537,188
============ =========== ============ ============ =========== ============
The accompanying notes are an integral part of these
consolidated financial statements
6
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
For the nine months ended September 30, 2006 2005
------------------------------------------------------------------------------------------- ------------ ------------
Cash flows from operating activities
Net income ................................................................................ $ 192,589 $ 13,240
Adjustments to reconcile net income to net cash provided (used) by operating activities
Net cash used by trading activities ................................................... (246,937) (26,091)
Purchases of loans held for resale .................................................... (191,425) --
Originations of loans held for resale ................................................. (619,049) (203,945)
Principal payments received on loans held for resale .................................. 50,685 292
Proceeds from sales and securitizations of loans held for resale ...................... 1,284,686 124,464
Premium amortization (discount accretion) on securities, net .......................... (3,408) 423
Amortization of servicing rights ...................................................... 81,034 73,020
Depreciation and other amortization ................................................... 9,857 9,578
Provision for bad debts and charge-offs ............................................... 3,638 5,991
Loss (gain) on trading securities ..................................................... (3,483) 3,409
Loss on loans held for resale, net .................................................... 1,306 --
Gain on sale of real estate ........................................................... (1,468) (1,909)
Gain on sale of deposits .............................................................. -- (1,750)
Loss on investments in affordable housing properties .................................. (38) 1,717
Reversal of valuation allowance in deferred tax asset ................................. (145,211) (843)
Gain on repurchase of debt ............................................................ (25) (897)
Excess tax benefits related to share-based awards ..................................... (773) --
Increase in advances and match funded advances ........................................ (98,128) (84,541)
Decrease (increase) in deferred tax asset other than reversal of valuation allowance .. (3,777) 226
Decrease in receivables and other assets, net ......................................... 5,553 56,603
Increase (decrease) in servicer liabilities ........................................... 47,451 (5,916)
Increase (decrease) in other liabilities, net ......................................... (9,491) 10,797
Other ..................................................................................... (2,340) 2,582
------------ ------------
Net cash provided (used) by operating activities .......................................... 351,246 (23,550)
------------ ------------
Cash flows from investing activities
Principal payments received on match funded loans ..................................... -- 1,819
Purchase of mortgage servicing rights ................................................. (102,198) (56,708)
Principal payments received on loans held for investment .............................. 280 6,769
Purchases, originations and funded commitments on loans held for investment ........... -- (218)
Additions to premises and equipment ................................................... (3,796) (8,339)
Proceeds from the sale of real estate and affordable housing properties ............... 2,005 12,723
Investment in an unconsolidated entity ................................................ (45,809) --
Proceeds from the sale of a subsidiary ................................................ -- 4,337
Net cash from consolidated variable interest entity ................................... 247 --
------------ ------------
Net cash used by investing activities ..................................................... (149,271) (39,617)
------------ ------------
Cash flows from financing activities
Decrease in deposits and escrow deposits .............................................. -- (210,850)
Sale of deposits ...................................................................... -- (165,741)
Premium received on sale of deposits .................................................. -- 1,500
Proceeds from (repayments of) lines of credit and other secured borrowings, net ....... (285,497) 47,655
Proceeds from match funded liabilities, net ........................................... 16,888 46,149
Repurchase of debt securities ......................................................... (3,865) (10,569)
Excess tax benefits related to share-based awards ..................................... 773 --
Repurchase of common stock ............................................................ (11,014) --
Exercise of common stock options ...................................................... 3,361 805
------------ ------------
Net cash used by financing activities ..................................................... (279,354) (291,051)
------------ ------------
Net decrease in cash ...................................................................... (77,379) (354,218)
Cash at beginning of period ............................................................... 269,611 542,891
------------ ------------
Cash at end of period ..................................................................... $ 192,232 $ 188,673
============ ============
The accompanying notes are an integral part of these
consolidated financial statements
7
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(Dollars in thousands, except share data)
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
Ocwen Financial Corporation ("OCN"), through its subsidiaries, is
engaged in business activities related to residential and commercial servicing,
consumer unsecured debt collections and loan origination services. At September
30, 2006, OCN owned all of the outstanding stock of its primary subsidiaries:
Ocwen Loan Servicing, LLC ("OLS"), Investors Mortgage Insurance Holding Company
and Ocwen Financial Solutions, Private Limited ("India"). Effective June 30,
2005, Ocwen Federal Bank FSB (the "Bank"), a wholly owned subsidiary,
voluntarily terminated its status as a federal savings bank and dissolved, a
process we refer to as "debanking".
Basis of presentation
The accompanying unaudited interim consolidated financial statements
have been prepared in conformity with the instructions of the Securities and
Exchange Commission ("SEC") to Form 10-Q and SEC Regulation S-X, Article 10,
Rule 10-01 for interim financial statements. Accordingly, they do not include
all of the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements. In
our opinion, the accompanying unaudited financial statements contain all
adjustments, consisting only of normal recurring accruals, necessary for a fair
presentation. The results of operations and other data for the three and nine
months ended September 30, 2006 are not necessarily indicative of the results
that may be expected for any other interim period or for the entire year ending
December 31, 2006. The unaudited consolidated financial statements presented
herein should be read in conjunction with the audited consolidated financial
statements and related notes thereto included in our Annual Report on Form 10-K
for the year ended December 31, 2005.
In preparing the consolidated financial statements, we are required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities at the dates of the balance sheet and revenues and expenses for the
periods covered. Material estimates that are particularly significant in the
near or medium term relate to our valuation of securities, servicing rights,
intangibles and deferred tax assets, as well as to our determination of
valuation allowances for other asset categories. Actual results could differ
from those estimates and assumptions.
Prior to debanking, our consolidated financial statements followed the
presentation requirements of Regulation S-X, Article 9, Bank Holding Companies.
As a result of debanking, effective December 31, 2005, we revised the
presentation of our consolidated financial statements to better align our
presentation with the growth and significance of loan servicing and loan
origination services, our principal businesses. The principal change in our
consolidated financial statements for the periods presented as compared to the
presentation in prior periods is in the format of our consolidated statement of
operations. In adopting the new format for our consolidated statement of
operations, we have made a number of reclassifications of expenses. The most
significant of these reclassifications has been to report as operating expenses
amounts that were netted against the revenues that were previously reported as
servicing and related fees. These expenses are directly related to the
generation of revenues and are reported in our consolidated statement of
operations as amortization of servicing rights and as components of servicing
and origination. Servicing and origination includes expenses of $8,989 and
$26,776 for the three and nine months ended September 30, 2005, respectively,
that had previously been netted against revenues reported in servicing and other
fees. Similarly, expenses previously included in loan expenses on the
consolidated statement of operations are also principally reported as components
of servicing and origination expense.
Revenues that are associated with our Residential Origination Services
business segment are reported in a separate revenue category, process management
fees. These revenues were previously reported as a component of servicing and
related fees. Other categories of income, including interest income and interest
expense, which were previously reported as revenues but which were not related
to the operations of our principal business segments, are reported in other
income (expense).
In addition, we created a new liability caption, servicer liabilities,
in our consolidated balance sheet. This caption represents amounts that we have
collected from borrowers that will be remitted to off-balance sheet custodial
accounts, paid directly to investment trusts or refunded to borrowers.
Previously, the amounts included in servicer liabilities had been reported
either as escrow deposits or as reductions of our cash balances.
8
Amounts included in our 2005 consolidated financial statements have
been reclassified to conform to these changes in presentation in our
consolidated statement of operations as well as to conform to certain other,
less significant, reclassifications that have been made in our consolidated
financial statements in 2006.
Principles of Consolidation
We evaluate special purpose entities first for classification as a
"qualifying special purpose entity" ("QSPE") as specified by Financial
Accounting Standards Board ("FASB") Statement of Financial Accounting Standards
No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities" ("SFAS No. 140"). Where we determine that a
special purpose entity is classified as a QSPE, it is excluded from our
consolidated financial statements. Where we determine that a special purpose
entity is not classified as a QSPE, it is further evaluated for classification
as a variable interest entity ("VIE") as specified by FASB Interpretation No.
46, "Consolidation of Variable Interest Entities", as revised. When a special
purpose entity meets the definition of a VIE, and OCN is identified as the
primary beneficiary of the entity, it is included in our consolidated financial
statements. The most significant of the VIEs identified during the reporting
periods is engaged in the origination, acquisition and subsequent securitization
or sale of subprime single family residential loans. During the second quarter
of 2006, our voting interest in this consolidated VIE exceeded 50%, and we now
treat it as a majority-owned subsidiary. The creditors of the remaining VIEs
have no recourse against OCN.
All material intercompany accounts and transactions have been
eliminated in consolidation. We report minority interests in our majority-owned
subsidiaries as a separate item on our consolidated balance sheets. Minority
interest in our earnings is included in other income (expense), net, on our
consolidated statements of operations.
Cash and Cash Equivalents
Cash includes both interest-bearing and non-interest-bearing deposits
with financial institutions. Other highly liquid investments when purchased with
a maturity of three months or less are considered to be cash equivalents and are
included in investment grade trading securities.
NOTE 2 CURRENT ACCOUNTING PRONOUNCEMENTS
SFAS No. 123(R), "Share-Based Payment" and Staff Accounting Bulletin
No. 107 (SAB 107),"Share-Based Payment". SFAS No. 123(R) requires a public
entity to measure the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair value of the award.
That cost is recognized over the period during which an employee is required to
provide service in exchange for the award - the requisite service period. The
determination of compensation expense under SFAS 123(R) also includes the
estimation of expected forfeitures, which we previously recognized as incurred.
Prior to January 1, 2006, we followed the guidance of Accounting Principles
Board ("APB") Opinion No. 25, which provided for accounting for share-based
compensation using the intrinsic value method and recognizing compensation costs
for such stock options to the extent that the exercise price was less than the
price of the stock at the grant date.
Effective January 1, 2006, we adopted the provisions of SFAS No.
123(R), using the modified prospective method. Accordingly, results for prior
periods have not been restated. Compensation and benefits expense for the nine
months ended September 30, 2006 includes $795 ($578 after tax) related to stock
options. As a result of adopting FAS 123(R), incremental compensation expense
related to stock options for the nine months ended September 30, 2006 was $371
($269 after tax).
There were no new option grants during the nine months ended September
30, 2006, however, 478,356 stock options were exercised and 49,881 were
forfeited during that period. At September 30, 2006, a total of 3,752,237 stock
options were outstanding, of which 2,940,975 were exercisable. Cash received
from the exercise of stock options during the nine months ended September 30,
2006 was $3,361. Financing cash inflows for that same period include $737 of tax
benefits arising from related tax deductions that reduce the amount of income
taxes that would otherwise be payable. The total intrinsic value of stock
options exercised, which is defined as the amount by which the market value of
the stock on the date of exercise exceeds the exercise price, was $2,884 for the
nine months ended September 30, 2006. As of September 30, 2006, unrecognized
compensation costs related to non-vested stock options amounted to $2,114, which
will be recognized over a weighted-average remaining requisite service period of
approximately 2.5 years.
SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments." In
February 2006, the FASB issued SFAS No. 155 as an amendment to SFAS No. 133 and
SFAS No. 140. SFAS No. 155 allows financial instruments that have embedded
derivatives to be accounted for as a whole (eliminating the need to bifurcate
the derivative from its host) if the holder elects to account for the whole
instrument on a fair value basis. The standard also: a) Clarifies which
interest-only strips and principal-only strips are not subject to the
requirements of Statement 133; b) Establishes a requirement to evaluate
interests in securitized financial assets to identify interests that are
freestanding derivatives or that are hybrid financial instruments that contain
an embedded derivative requiring bifurcation; c) Clarifies that concentrations
of credit risk in the form of subordination are not embedded derivatives; and d)
Amends Statement 140 to eliminate the prohibition on a qualifying
9
special-purpose entity from holding a derivative financial instrument that
pertains to a beneficial interest other than another derivative financial
instrument. SFAS No. 155 is effective for all financial instruments acquired or
issued after the beginning of an entity's first fiscal year that begins after
September 15, 2006. We believe that the adoption of SFAS No.155 will not have a
material impact on our consolidated financial statements.
SFAS No. 156, "Accounting for Servicing of Financial Assets-an
amendment of FASB Statement No. 140." FASB issued SFAS No. 156 in March 2006 as
an amendment to SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities", with respect to the
accounting for separately recognized servicing assets and liabilities.
Recognition of a servicing asset or liability would be required each time an
entity commits to service a financial asset through a servicing contract that:
a) represents a transfer of the servicer's financial assets that meets the
requirements for sale accounting, b) represents a transfer of the servicer's
financial assets to a qualifying special-purpose entity in a guaranteed mortgage
securitization in which the transferor retains all of the resulting securities
and classifies them as either available-for-sale securities or trading
securities in accordance with SFAS 115, "Accounting for Certain Investments in
Debt and Equity Securities", or c) represents an acquisition or assumption of an
obligation to service a financial asset that does not relate to financial assets
of the servicer or its consolidated affiliates.
SFAS 156 also requires all separately recognized servicing assets and
liabilities to be initially measured at fair value, if practicable, and allows
an entity to chose from two subsequent measurement methods for each class of
separately recognized servicing assets and liabilities. The two methods are: a)
the amortization method which amortizes servicing assets or liabilities in
proportion to and over the period of estimated net servicing income or net
servicing loss and assesses servicing assets or liabilities for impairment or
increased obligation based on fair value at each reporting date, and b) the fair
value measurement method which measures servicing assets or liabilities at fair
value each reporting date and reports changes in fair value in earnings in the
period in which the changes occur.
A prospective application of SFAS 156 is required as of the beginning
of an entity's first fiscal year that begins after September 15, 2006. We have
not yet determined which subsequent measurement method we will adopt effective
January 1, 2007. As of September 30, 2006, the estimated fair value of our
mortgage servicing rights was $243,666 as compared to a carrying value of
$173,911. These amounts include commercial mortgage servicing rights acquired on
June 20, 2006 that have a fair value and carrying value of $1,943 and $1,927,
respectively, at September 30, 2006.
SFAS No. 157, "Fair Value Measurements." SFAS No.157, which was issued
in September 2006, defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles and expands disclosures
about fair value measurement. This statement applies under other accounting
pronouncements that require or permit fair value measurements and does not
require any new fair value measurements. The statement requires disclosures
about the fair value of assets and liabilities in all periods subsequent to
initial recognition, including tabular disclosure of quantitative data in both
annual and interim periods and a narrative discussion of valuation techniques
used in all annual periods. SFAS No.157 is effective for fiscal years beginning
after November 15, 2007. We are currently assessing the impact that SFAS No.157
will have on our consolidated financial statements.
FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes
- an interpretation of FASB Statement No.109" ("FIN 48"). FIN 48 was issued in
June 2006 and clarifies the accounting for uncertainty in income taxes
recognized in a company's financial statements and prescribes a recognition
threshold and measurement attribute for the financial statement recognition and
measurement of a tax position expected to be taken in a tax return, including
determining whether a tax position, based on its technical merits, is more
likely than not to be sustained upon examination, including any related appeals
or litigation processes. The Interpretation also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure and transition. FIN 48 is effective for fiscal years
beginning after December 15, 2006. We are currently assessing the impact that
FIN 48 will have on our consolidated financial statements.
SEC Staff Accounting Bulletin No. 108, "Considering the Effects of
Prior Year Misstatements when Quantifying Misstatements in Current Year
Financial Statements" ("SAB No. 108") In September 2006, the SEC issued SAB No.
108, which provides guidance on quantifying and evaluating the materiality of
unrecorded misstatements from the prior year when evaluating misstatements in
current year financial statements. SAB No. 108 requires that companies quantify
misstatements using both a balance sheet and an income statement approach and to
evaluate whether either approach results in quantifying an error that is
material. If the effect of the initial adoption of SAB No. 108 is material, then
companies will record the cumulative effect adjustment in opening retained
earnings as of the year of adoption and disclose the nature and amount of each
individual error being corrected. SAB No. 108 is effective for the first fiscal
year ending after November 15, 2006. We believe that the adoption of SAB No. 108
will not have a material impact on our consolidated financial statements.
NOTE 3 BASIC AND DILUTED EARNINGS PER SHARE
We are required to present both basic and diluted earnings per share
("EPS") on the face of our statement of operations. Basic EPS excludes common
stock equivalents and is calculated by dividing net income by the weighted
average number of common shares outstanding during the year. We calculate
diluted EPS by dividing net income, as adjusted to add back interest expense on
the 3.25% Contingent Convertible Senior Unsecured Notes due 2024 ("Convertible
Notes"), by the weighted average number of common shares outstanding including
the potential dilutive common shares related to outstanding stock options,
restricted stock awards and the Convertible Notes.
10
The following is a reconciliation of the calculation of basic EPS to
diluted EPS for the periods ended September 30:
Three months Nine months
--------------------------- ---------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Basic EPS:
----------
Net income .................................................... $ 16,970 $ 7,945 $ 192,589 $ 13,240
============ ============ ============ ============
Weighted average shares of common stock ....................... 62,505,740 62,975,006 62,855,616 62,843,375
============ ============ ============ ============
Basic EPS ..................................................... $ 0.27 $ 0.13 $ 3.06 $ 0.21
============ ============ ============ ============
Diluted EPS:
------------
Net income .................................................... $ 16,970 $ 7,945 $ 192,589 $ 13,240
Interest expense on Convertible Notes, net of income tax (1) .. 708 1,381 2,134 --
------------ ------------ ------------ ------------
Adjusted net income ........................................... $ 17,678 $ 9,326 $ 194,723 $ 13,240
============ ============ ============ ============
Weighted average shares of common stock ....................... 62,505,740 62,975,006 62,855,616 62,843,375
Effect of dilutive elements:
Convertible Notes (1) ....................................... 7,962,205 13,599,019 7,962,205 --
Stock options (2) ........................................... 1,178,747 723,542 937,958 812,251
Common stock awards ......................................... 42,740 99,902 42,836 187,415
------------ ------------ ------------ ------------
Dilutive weighted average shares of common stock .............. 71,689,432 77,397,469 71,798,615 63,843,041
============ ============ ============ ============
Diluted EPS ................................................... $ 0.25 $ 0.12 $ 2.71 $ 0.21
============ ============ ============ ============
(1) The effect of our Convertible Notes on diluted EPS is computed using the
if-converted method. Interest expense and related amortization costs
applicable to the Convertible Notes, net of income tax, are added back to
net income. Conversion of the Convertible Notes into shares of common
stock has not been assumed for purposes of computing diluted EPS for the
nine months ended September 30, 2005 because the effect would be
anti-dilutive. The effect is anti-dilutive whenever interest expense on
the Convertible Notes, net of income tax, per common share obtainable on
conversion exceeds basic EPS.
(2) Excludes an average of 437,132 and 1,551,865 of options that were
anti-dilutive for the third quarter of 2006 and 2005, respectively,
because their exercise price was greater than the average market price of
our stock. Year to date, an average of 1,013,506 and 1,604,358 options
were anti-dilutive for 2006 and 2005, respectively.
At OCN's Annual Meeting on May 4, 2006, the shareholders approved a
proposal to amend OCN's Articles of Incorporation to effect a 1-for-10 reverse
stock split, followed immediately by a 10-for-1 forward stock split (the
"Reverse/Forward Split"). We completed the Reverse/Forward Split on May 12, 2006
(the "Effective Date").
As a result of the Reverse/Forward Split, accounts with less than ten
shares of common stock were converted on the Effective Date into the right to
receive a cash payment for each share held equal in value to the average
official closing price of the common stock on The New York Stock Exchange over
the ten trading days immediately preceding the Effective Date. A total of 1,259
shares have been retired to date at a cost of $11.29 per share. Ultimately, a
total of 2,385 shares held by 1,127 shareholders will be retired. All
shareholder accounts holding ten shares or more were unaffected, and the total
number of shares held by such accounts did not change. The Reverse/Forward Split
had an insignificant effect on EPS.
NOTE 4 DERIVATIVE FINANCIAL INSTRUMENTS
Except for our swap agreement, our derivative contracts are
exchange-traded; therefore, holders of these instruments look to the exchange
for performance under these contracts and not to the holders of the offsetting
futures contracts. Using exchange-traded instruments minimizes our exposure to
risk from nonperformance under these contracts. We are exposed to credit loss in
the event of nonperformance by the counterparty to the swap agreement, and we
control this risk through credit monitoring procedures, including financial
analysis, dollar limits and other monitoring procedures. The notional amount of
our contracts does not represent our exposure to credit loss.
Foreign Currency Exchange Rate Risk Management
Our primary exposure to foreign currency exchange rates relates to the
British Pound versus the U.S. Dollar. We entered into foreign currency futures
contracts to hedge our net investment in a subsidiary in the United Kingdom that
holds subprime residual securities (the "UK residuals"). We have determined that
11
the local currency of our investment in UK residuals is the functional currency.
The foreign currency derivative financial instrument related to our investment
in the UK residuals was designated as a hedge. Accordingly, for this instrument
we include the gains or losses in the net unrealized foreign currency
translation in accumulated other comprehensive income in stockholders' equity.
The following table summarizes our use of British pound currency
futures during 2006:
Notional
Amounts (in
Dollars)
------------
Balance at December 31, 2005 .................................. $ 23,148
Additions .................................................. 69,488
Maturities ................................................. (70,287)
Terminations ............................................... --
------------
Balance at September 30, 2006 ................................. $ 22,349
============
Fair value at September 30, 2006 .............................. $ 68
============
Maturity ...................................................... Dec. 2006
Interest Rate Risk Management
In connection with our Residential Origination Services business, we
acquire certain mortgage loan portfolios with the intention of selling or
securitizing them within a short period of time. We have used a combination of
interest rate swaps and Eurodollar interest rate futures contracts to hedge the
exposure to interest rate risk represented by our loans held for resale. Under
the interest rate swap agreement, we pay a fixed rate and receive a floating
rate. The Eurodollar interest rate futures contracts and interest rate swaps
were not designated as hedges, and we recognize our gains and losses in
earnings and report them as a component of other income (expense), net.
The following table summarizes our use of interest rate risk management
derivative financial instruments during 2006:
Notional Amounts
-----------------------------
Short
Eurodollar
Interest Rate Interest Rate
Futures Swaps
------------ ------------
Balance at December 31, 2005 ................. $ 3,261,000 $ --
Additions ................................. 2,397,000 70,000
Maturities ................................ (639,000) --
Terminations .............................. (4,297,000) --
------------ ------------
Balance at September 30, 2006 ................ $ 722,000 $ 70,000
============ ============
Fair value at September 30, 2006 ............. $ (378) $ (668)
============ ============
Dec. 2006 to
Maturity...................................... Sept. 2011 July 2008
The net realized and unrealized gains (losses) included in earnings for
these instruments were $(2,054) and $845 for the three and nine months ended
September 30, 2006, respectively. We had no investment in such instruments
during the same periods of 2005.
NOTE 5 REGULATORY MATTERS
Effective June 30, 2005, the Bank terminated its status as a federal
savings bank. Prior to returning its original thrift charter to the Office of
Thrift Supervision ("OTS"), the Bank operated as a federal savings bank, and OCN
was a registered savings and loan holding company. Our primary regulatory
authority was the OTS.
Pursuant to the conditions set forth in the OTS Approval, OCN entered
into an agreement (the "Guaranty") in favor of the OTS and any holders of claims
with respect to liabilities assumed by OLS from the Bank (the "Assumed
Liabilities"). Assumed Liabilities include all legal actions against the Bank.
Assumed liabilities do not include the customer deposit and other liabilities
that were assumed by Marathon National Bank of New York ("Marathon") in
connection with the Branch Purchase and Deposit Assumption agreement. The
Guaranty contains affirmative covenants relating to the maintenance of a $5,000
cash collateral account, reporting requirements, transactions with affiliates,
preservation of the existence of our subsidiaries and maintenance of not less
than $35,000 of unencumbered financial assets. Pursuant to the Guaranty, we have
12
also agreed to certain limits on the incurrence of debt, merger or sale
transactions, disposition of assets and payment of dividends. As of September
30, 2006, we were in compliance with all of the covenants specified in the
Guaranty.
The Guaranty will remain in effect until the later of (a) the sixth
anniversary of the date on which the Bank's federal bank charter was cancelled
or (b) the date on which we have paid in full (i) any obligations that arise out
of the Assumed Liabilities with respect to which a claim has been asserted on or
prior to the sixth anniversary of the date on which the Bank's federal bank
charter was cancelled and (ii) all other amounts payable by us under the
Guaranty.
BOK is licensed as a credit institution (Kreditinstitut) under the laws
of the Federal Republic of Germany and is supervised and regulated in Germany by
the German Federal Financial Supervisory Authority (Bundesanstalt fur
Finanzdienstleistungsaufsicht, or BaFin), the German Central Bank (Deutsche
Bundesbank) and, in respect of minimum reserves on deposits, the European
Central Bank. BOK, under its license, may engage not only in a number of
traditional banking activities such as deposit and lending business, but also in
investment banking, underwriting and securities trading transactions, both for
its own account and for customers. BOK is currently not material to our
operations.
NOTE 6 INCOME TAXES
The following table provides details of our income tax expense for the
periods indicated:
Three months Nine months
--------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
---------------------------------------------------------- ------------ ------------ ------------ ------------
Income tax expense on income before taxes ................ $ 9,403 $ 2,282 $ 17,847 $ 3,973
Reversal of valuation allowance on deferred tax assets ... -- -- (145,211) (843)
Provision for recapture of base year bad debt reserves ... -- -- -- 1,967
------------ ------------ ------------ ------------
Total income tax expense (benefit) ................... $ 9,403 $ 2,282 $ (127,364) $ 5,097
============ ============ ============ ============
In the second quarter of 2006, we reversed $145,211 of valuation
allowances on our deferred tax assets in order to increase the net deferred tax
asset to the amount that is more likely than not to be realized in future
periods. The valuation allowance has declined from $163,802 at December 31, 2005
to $13,796 at September 30, 2006. The remaining valuation allowance includes
$5,115 related to capital loss carryforwards.
We maintain a valuation allowance in an amount sufficient to reduce our
deferred tax asset to the amount that is more likely than not to be realized.
The amount of the valuation allowance is based on consideration of all available
evidence, both positive and negative, including our recent earnings history,
current tax position and estimates of future taxable income. The tax character
(ordinary versus capital) and the carry forward and carry back periods of
certain tax attributes (e.g., capital losses and tax credits) are also
considered. We assess the amount of our valuation allowance each quarter.
In assessing the amount of the valuation allowance in the second
quarter of 2006, our determination that it was appropriate to reverse $145,211
was primarily based on the following:
o Cumulative earnings in recent periods;
o Positive outlook for future earnings, including positive changes
in the market factors affecting our Residential Servicing business
that suggest continued strong earnings performance;
o The disposal of nearly all of our non-core assets.
In the second quarter of 2005, we recorded a provision of $1,967
($1,124 net of a related reversal of the valuation allowance on the deferred tax
asset) to recognize a deferred tax liability arising from the recapture of bad
debt reserves in connection with our termination of the Bank's status as a
federal savings bank.
Income tax expense on income before income taxes differs from amounts
that would be computed by applying the Federal corporate income tax rate of 35%
primarily because of the effect of foreign taxes, foreign income with an
indefinite deferral from U.S. taxation, losses from consolidated VIEs, state
taxes, low-income housing tax credits and changes in the deferred tax valuation
allowance. Excluding the effect of the reversal of valuation allowances on
deferred tax assets in the second quarter of 2006, our effective tax rate was
27.36% for the first nine months of 2006. Excluding the effect of the provision
for the recapture of bad debt reserves in the second quarter of 2005, our
effective tax rate was 21.67% for the first nine months of 2005. We estimate our
effective tax rate based on projected full-year results, and we revise the
estimate quarterly during the year.
13
NOTE 7 BUSINESS SEGMENT REPORTING
A brief description of our business segments, aligned within our two
areas of focus, is as follows:
Servicing
---------
o Residential Servicing. Through this business we provide loan
servicing including asset management and resolution services to third
party owners of subprime residential mortgage and high loan-to-value
loans for a fee. We acquire the rights to service loans by purchasing
them or by entering into subservicing contracts. This segment also
includes our residential loan servicing system product
(REALServicing).
o Commercial Servicing. This segment includes the results of both our
domestic and international servicing of commercial assets (loans and
real estate), as well as our commercial loan servicing product
(REALSynergy). International servicing is conducted through Global
Servicing Solutions, LLC ("GSS") and its subsidiaries.
o Ocwen Recovery Group. This business primarily conducts collection
activities for third party owners of unsecured receivables and
charged off second mortgages and for a portfolio of unsecured credit
card receivables that we acquired during the period 1998 through
2000.
Loan Processing and Origination Services
----------------------------------------
o Residential Origination Services. This business, which now includes
the results of our former Business Process Outsourcing segment,
provides: various loan origination services, including residential
property valuation services, mortgage due diligence, fulfillment,
title services; loan refinancing for Residential Servicing customers;
and outsourcing services to third parties including mortgage
underwriting, data entry, call center services and mortgage research.
This segment also includes our subprime loan origination activities,
internet-based vendor management system product (REALTrans) and
subprime residual trading securities.
Corporate Items and Other. This segment includes items of revenue and
expense that are not directly related to a business including our equity
investment in Bankruptcy Management Solutions, Inc. ("BMS"), business activities
that are individually insignificant, interest income on short-term investments
of cash and the related costs of financing these investments and certain other
corporate expenses.
We allocate interest income and expense to each business segment for
funds raised or funding of investments made. We also allocate expenses generated
by corporate support services to each business segment.
Financial information for our segments is as follows:
Total Assets
---------------------------
September 30, December 31,
2006 2005
------------ ------------
Residential Servicing ............................ $ 899,799 $ 783,560
Commercial Servicing ............................. 11,766 6,433
Ocwen Recovery Group ............................. 560 1,002
Residential Origination Services ................. 288,843 680,625
------------ ------------
1,200,968 1,471,620
Corporate Items and Other ........................ 711,805 382,553
------------ ------------
$ 1,912,773 $ 1,854,173
============ ============
14
Operating Other Income Pre-Tax
Revenue Expenses (Expense) Income (Loss)
------------ ------------ ------------ ------------
For the three months ended September 30, 2006
------------------------------------------------------------
Residential Servicing .................................. $ 87,455 $ 56,150 $ (7,362) $ 23,943
Commercial Servicing ................................... 2,269 2,629 106 (254)
Ocwen Recovery Group ................................... 1,740 2,163 39 (384)
Residential Origination Services ....................... 20,061 21,349 6,922 5,634
------------ ------------ ------------ ------------
111,525 82,291 (295) 28,939
Corporate Items and Other .............................. (1,376) 2,837 1,647 (2,566)
------------ ------------ ------------ ------------
$ 110,149 $ 85,128 $ 1,352 $ 26,373
============ ============ ============ ============
For the three months ended September 30, 2005
------------------------------------------------------------
Residential Servicing .................................. $ 71,074 $ 57,557 $ (5,821) $ 7,696
Commercial Servicing ................................... 6,262 3,885 (314) 2,063
Ocwen Recovery Group ................................... 2,712 3,484 122 (650)
Residential Origination Services ....................... 17,422 17,838 715 299
------------ ------------ ------------ ------------
97,470 82,764 (5,298) 9,408
Corporate Items and Other .............................. (560) 1,184 2,563 819
------------ ------------ ------------ ------------
$ 96,910 $ 83,948 $ (2,735) $ 10,227
============ ============ ============ ============
For the nine months ended September 30, 2006
------------------------------------------------------------
Residential Servicing .................................. $ 250,305 $ 170,453 $ (19,969) $ 59,883
Commercial Servicing ................................... 8,468 8,263 88 293
Ocwen Recovery Group ................................... 5,797 6,725 314 (614)
Residential Origination Services ....................... 54,507 64,331 19,147 9,323
------------ ------------ ------------ ------------
319,077 249,772 (420) 68,885
Corporate Items and Other............................... (1,342) 7,084 4,766 (3,660)
------------ ------------ ------------ ------------
$ 317,735 $ 256,856 $ 4,346 $ 65,225
============ ============ ============ ============
For the nine months ended September 30, 2005
------------------------------------------------------------
Residential Servicing .................................. $ 207,980 $ 179,598 $ (15,140) $ 13,242
Commercial Servicing ................................... 15,260 12,282 (559) 2,419
Ocwen Recovery Group ................................... 9,799 9,938 238 99
Residential Origination Services ....................... 48,003 47,208 4,425 5,220
------------ ------------ ------------ ------------
281,042 249,026 (11,036) 20,980
Corporate Items and Other .............................. (629) 5,660 3,646 (2,643)
------------ ------------ ------------ ------------
$ 280,413 $ 254,686 $ (7,390) $ 18,337
============ ============ ============ ============
NOTE 8 ACQUISITION
OCN and Charlesbank Equity Fund VI, Limited Partnership and related
funds (collectively, "Charlesbank") recently formed BMS Holdings, Inc. ("BMS
Holdings") for the purpose of effecting the purchase of BMS, a leading provider
of bankruptcy case management software solutions to Chapter 7 Bankruptcy
Trustees. On July 31, 2006, BMS Holdings completed the acquisition of all of the
issued and outstanding shares of BMS from its stockholders and a warrant holder.
The total cost was approximately $444,000, with OCN and Charlesbank each
contributing approximately $46,000 in equity. Approximately $345,000 of the
investment was funded by BMS through the issuance of first and second lien debt.
Our investment in BMS Holdings represents an equity interest of approximately
46%. We account for our investment in BMS Holdings using the equity method of
accounting. Our investment in BMS Holdings is included in other assets and our
equity in its earnings is included in other income (expense), net beginning
August 1, 2006.
The acquisition has been accounted for by BMS Holdings as a purchase,
and, accordingly, BMS Holdings has allocated the purchase price to the
underlying tangible and identifiable intangible assets acquired and liabilities
assumed based upon their estimated fair values at the date of the acquisition.
The allocation of the purchase price may be subject to change based on final
estimates of fair value.
The condensed balance sheet and statement of operations of BMS Holdings
are as follows:
15
BMS HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Balance Sheet (Unaudited)
At September 30, 2006
(Dollars in thousands)
Assets
Total current assets ............................................ $ 14,490
Long-term assets:
Goodwill ..................................................... 219,495
Other intangibles, net ....................................... 300,586
Other long-term assets ....................................... 17,560
------------
Total assets ............................................... $ 552,131
============
Liabilities and Stockholders' Equity
Total current liabilities ....................................... $ 12,733
Deferred tax liability .......................................... 97,505
Long-term debt, less current portion ............................ 342,412
------------
Total liabilities ............................................ 452,650
Total stockholders' equity ................................... 99,481
------------
Total liabilities and stockholders' equity ................. $ 552,131
============
BMS HOLDINGS, INC. AND SUBSIDIARIES
Consolidated Statement of Operations (Unaudited)
For the Period from August 1, 2006 to September 30, 2006
(Dollars in thousands)
Revenues ........................................................ $ 11,196
Cost of sales ................................................... 723
------------
Gross profit ................................................. 10,473
Selling, general and administrative ............................. 3,238
------------
Income from operations ....................................... 7,235
Interest expense, net ........................................... 5,883
------------
Income before income taxes ................................... 1,352
Provision for income taxes ...................................... 541
------------
Net income ................................................... $ 811
============
NOTE 9 COMMITMENTS AND CONTINGENCIES
At September 30, 2006, we had commitments of $79,999 to fund loans
secured by mortgages on single family residential properties. We also have
commitments to sell $15,150 of loans held for resale, generally within 30 days
of funding.
Through our investment in subordinated residual securities, which had a
fair value of $46,904 at September 30, 2006, we support senior classes of
securities. Principal from the underlying mortgage loans generally is allocated
first to the senior classes, with the most senior class having a priority right
to the cash flow from the mortgage loans until its payment requirements are
satisfied. To the extent that there are defaults and unrecoverable losses on the
underlying mortgage loans, resulting in reduced cash flows, the most subordinate
security will be the first to bear this loss. Because subordinate and residual
interests generally have no credit support, to the extent there are realized
losses on the mortgage loans comprising the mortgage collateral for such debt
securities, we may not recover our remaining investment.
Under the terms of the sales agreements entered into in connection with
the sale of certain of our affordable housing properties, we have a commitment
to fund cash deficits that may arise from the operations of those properties.
The remaining term of these commitments ranges from one to six years. The
maximum obligation that could arise under these commitments was $3,734 as of
September 30, 2006. Any operating deficits we fund are supported by a promissory
note to be repaid to us from future cash flows of the property. In addition, we
have provided to the purchasers of certain affordable housing properties
guaranties against the possible recapture of future tax credits. We have never
experienced a recapture of tax credits on any of the affordable housing
properties in which we invested or sold. We have not recognized these guaranties
as a liability because the probability of recapture is considered remote.
Under the terms of the Assignment and Assumption agreement, OLS has
become the successor to the Bank with respect to all legal actions. Therefore,
any references to the Bank in connection with the following legal matters
pertain to OLS as successor.
16
On April 13, 2004, the United States Judicial Panel on Multi-district
Litigation granted our petition to transfer and consolidate a number of lawsuits
against the Bank, OCN and various third parties arising out of the servicing of
plaintiffs' mortgage loans into a single case to proceed in the United States
District Court for the Northern District of Illinois under caption styled: In re
Ocwen Federal Bank FSB Mortgage Servicing Litigation, MDL Docket No. 1604 (the
"MDL Proceeding"). Currently, there are approximately 58 lawsuits consolidated
in the MDL Proceeding involving 74 mortgage loans that we currently or
previously serviced. Additional similar lawsuits have been brought in other
courts, some of which may be transferred to and consolidated in the MDL
Proceeding. The borrowers in many of these lawsuits seek class action
certification. Others have brought individual actions. No class has been
certified in the MDL Proceeding or any related lawsuits. On May 19, 2006,
plaintiffs filed an Amended Consolidated Class Action Complaint containing
various claims under federal statutes, including the Real Estate Settlement
Procedures Act and Fair Debt Collection Practices Act, federal bankruptcy laws,
state deceptive trade practices statutes and common law. The claims are
generally based on allegations of improper loan servicing practices, including
(i) charging borrowers allegedly improper or unnecessary fees such as breach
letter fees, hazard insurance premiums, foreclosure-related fees, late fees,
property inspection fees and bankruptcy-related fees; (ii) untimely posting and
misapplication of borrower payments; and (iii) improperly treating borrowers as
in default on their loans. While the Amended Consolidated Complaint does not set
forth any specific amounts of claimed damages, plaintiffs are not precluded from
requesting leave of court to amend further the Consolidated Complaint or
otherwise seeking damages should the matter proceed to trial. On April 25, 2005,
the court entered an Opinion and Order granting the Bank partial summary
judgment finding that, as a matter of law, the mortgage loan contracts signed by
plaintiffs authorize the imposition of breach letter fees and other legitimate
default or foreclosure related expenses. The court explained that its ruling was
in favor of defendants to the specific and limited extent that plaintiffs'
claims challenge the propriety of the above-mentioned fees. On May 16, 2006,
after having denied defendants' motions to dismiss various portions of the
Consolidated Complaint on federal preemption and procedural grounds, as well as
our motion to dismiss OCN from the case for lack of personal jurisdiction, the
court granted our motion to take an interlocutory appeal on the federal
preemption issue. On July 29, 2006, the United States Court of Appeals for the
Seventh Circuit granted our request to hear our appeal on the federal preemption
issue. The appeal on that issue is presently pending. We believe the allegations
in the MDL Proceeding are without merit and will continue to vigorously defend
against them.
On June 2, 2006, settlements in principle were reached with the law
firms representing plaintiff-borrowers in a number of filed and threatened cases
challenging various loan servicing fees, primarily in the states of Alabama and
Mississippi. None of these cases sought class certification, although 23 of them
had been consolidated in the MDL Proceeding. The settlements in principle are
subject to the completion of definitive settlement and release agreements to be
separately entered into with each of the individual plaintiff-borrowers
involved.
On November 3, 2004, the trial judge in litigation brought by Cartel
Asset Management, Inc. ("Cartel") against OCN, the Bank and Ocwen Technology
Xchange, Inc. ("OTX"), a subsidiary that has been dissolved, in federal court in
Denver, Colorado entered final judgment in the amount of $520 against OTX and
nominal damages of two dollars against the Bank. In the November 3, 2004 order,
the judge reduced a prior jury verdict in the amount of $9,320 after trial on
this matter involving allegations of misappropriation of trade secrets and
contract-related claims brought by a former vendor. The litigation does not
relate to our Residential Servicing business. Notwithstanding the nominal damage
award against the Bank, it was assessed a statutory award to Cartel of
attorneys' fees in an additional amount of $170, and the Bank and OTX were
further assessed costs in the amount of $9. Cartel and defendants are pursuing
cross-appeals in the United States Court of Appeals for the Tenth Circuit. We
intend to continue to vigorously defend this matter.
On February 8, 2005, a jury in the Circuit Court for Palm Beach County,
Florida returned verdicts of $1,000 and $1,056 in compensatory damages in favor
of two former employees of the Bank in a lawsuit against OCN and the Bank. The
jury rejected plaintiffs' request for punitive damages. The plaintiffs brought
claims under the Florida Civil Rights Act, the Florida Whistleblower Act and
state tort law, arising out of an alleged invasion of privacy and related
incidents allegedly committed by other former employees of the Bank in 1998 for
which plaintiffs sought to hold the Ocwen defendants vicariously liable. We
believe the verdicts, which were reduced to final judgments on May 20, 2005, as
well as an additional award of $900 in plaintiffs' attorneys' fees, are against
the weight of evidence and contrary to law. We intend to continue to vigorously
defend this matter and have taken an appeal to the Florida Court of Appeals.
On February 9, 2006, the County Court for Galveston County, Texas
entered judgment in the amount of $1,830 against Ocwen and in favor of a
plaintiff-borrower who defaulted on a mortgage loan that we serviced. The
plaintiff claimed that Ocwen's foreclosure on the loan violated the Texas
Deceptive Trade Practices Act and other state statutes and common law. This
judgment reduced a prior jury verdict of $11,500. We believe the judgment,
comprised of $5 in actual damages, approximately $675 in emotional distress,
statutory and other damages and interest, and $1,150 for attorneys' fees, is
against the weight of evidence and contrary to law. We intend to continue to
vigorously defend this matter and have taken an appeal to the Texas Court of
Appeals.
On September 13, 2006, the Bankruptcy Trustee in Chapter 7 proceedings
involving American Business Financial Services, Inc., ("ABFS") brought an action
against a number of defendants, including OLS, in Bankruptcy Court in Delaware.
The action arises out of Debtor-in-Possession financing to ABFS by defendant
Greenwich Capital Financial Products, Inc. and the subsequent purchases by OLS
of mortgage servicing rights and certain residual interests in mortgage-backed
securities previously held by ABFS. The Trustee's allegations variously include
turnover, fraudulent transfers, breach of fiduciary duty, breach of contract,
common law fraud, civil conspiracy and conversion. The Trustee seeks
17
compensatory damages jointly and severally against all defendants in an amount
in excess of $70,000, along with punitive damages in an unspecified amount,
declaratory and equitable relief, and attorney's fees. OLS has brought a
separate action against the Trustee, in his representative capacity, seeking
damages of approximately $2,500 arising out of the ABFS mortgage servicing
rights purchase transaction. By stipulation of counsel dated October 9, 2006,
OLS's deadline by which to answer, move or otherwise respond to the Trustee's
action was extended to November 10, 2006, and OLS's separate action against the
Trustee was dismissed without prejudice with the right to replead such claims as
counter claims in the Trustee's action or otherwise as a separate action should
the Trustee's action be dismissed. We believe that the Trustee's allegations
against OLS are without merit and intend to continue to vigorously defend
against this matter.
OCN is subject to various other pending legal proceedings. In our
opinion, the resolution of these proceedings will not have a material effect on
our financial condition, results of operations or cash flows. We continuously
monitor the status of our litigation, including advice from external legal
counsel, and perform periodic assessments of our litigation for potential loss
accrual and disclosure. We accrue for settlements, judgments on appeal and filed
and/or threatened cases when it is probable that a liability has been incurred
and the amount of loss can be reasonably estimated.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(Dollars in thousand, except share data)
The following discussion of our results of operations, consolidated
financial condition and capital resources and liquidity should be read in
conjunction with our Selected Consolidated Financial Information, Consolidated
Financial Statements and the related notes, all included elsewhere herein.
RISK FACTORS AND CRITICAL ACCOUNTING POLICIES
Risk Factors
We include a discussion of the principal risks and uncertainties that
affect or could affect our business operations under Item 1A on pages 8 through
12 of our Annual Report on Form 10-K for the year ended December 31, 2005. There
have been no material changes to this information during 2006.
Critical Accounting Policies
Our ability to measure and report our operating results and financial
position is heavily influenced by the need to estimate the impact or outcome of
risks in the marketplace or other future events. Our critical accounting
policies are those that relate to the estimation and measurement of these risks.
Because they inherently involve significant judgments and uncertainties, an
understanding of these policies is fundamental to understanding Management's
Discussion and Analysis of Results of Operations and Financial Condition. Our
significant accounting policies are discussed in detail on pages 17 through 19
of Management's Discussion and Analysis of Results of Operations and Financial
Condition and in Note 1 of our Consolidated Financial Statements included in our
Annual Report on Form 10-K for the year ended December 31, 2005. There have been
no material changes to this information during 2006.
Forward Looking Statements
This Quarterly Report contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, including, but not
limited to the following:
o projections as to the availability of financing necessary to expand our
residential servicing business;
o assumptions related to the sources of liquidity and the adequacy of
financial resources;
o estimates regarding valuation allowances; and
o expectations as to the effect of resolution of pending legal proceedings on
our financial condition.
Forward-looking statements are not guarantees of future performance,
and involve a number of assumptions, risks and uncertainties that could cause
actual results to differ materially. Important factors that could cause actual
results to differ materially from those suggested by the forward-looking
statements include, but are not limited to, the following:
o general economic and market conditions,
o prevailing interest rates,
o availability and price of servicing rights for purchase,
o governmental regulations and policies,
o availability of adequate and timely sources of liquidity,
o uncertainty related to dispute resolution and litigation.
18
Further information on the risks specific to our business are detailed
within this report and our other reports and filings with the Securities and
Exchange Commission, including our periodic report on Form 10-K for the year
ended December 31, 2005, Form 10-Q for the quarters ended March 31, 2006 and
June 30, 2006 and our Forms 8-K filed during 2006. The forward-looking
statements speak only as of the date they are made and should not be relied
upon. OCN undertakes no obligation to update or revise the forward-looking
statements.
OVERVIEW
Changes in Financial Condition
September 30, December 31, Increase
2006 2005 (Decrease)
------------ ------------ ------------
Assets ................................. $ 1,912,773 $ 1,854,173 $ 58,600
Liabilities ............................ 1,373,680 1,504,913 (131,233)
Minority interest in subsidiaries ...... 1,905 1,853 52
Stockholder's equity ................... 537,188 347,407 189,781
o The $58,600 increase in total assets is primarily due to a $148,988
increase in net deferred tax assets, a $143,547 increase in cash and
investment grade securities, a $98,128 increase in servicing advances, a
$25,248 increase in mortgage servicing rights and a $51,600 increase in
other assets. The increase in other assets is primarily the result of our
$45,809 investment in BMS. The increase in deferred tax assets, net,
resulted primarily from the reversal of $145,211 of valuation allowances in
the second quarter. The increase in advances is largely due to the growth
in our servicing portfolio during 2006. This increase was partially offset
by a $411,776 reduction in loans held for resale, largely reflecting two
securitization transactions that closed during the first six months of the
year.
o The $131,233 decrease in total liabilities is largely the result of a
$258,813 decline in amounts due under lines of credit and other secured
borrowings, primarily reflecting reduced funding requirements on the lower
balance of loans held for resale. This decline was offset in part by a
$120,840 increase in servicer liabilities. At September 30, 2006 we had
$272,845 of unused borrowing capacity on our existing credit facilities.
o The $189,781 increase in stockholder's equity is primarily due to net
income of $192,589 and the exercise of 478,356 stock options, partially
offset by the repurchase of 1,000,000 shares of common stock.
Results of Operations
Three months Nine months
--------------------------- Favorable ---------------------------- Favorable
For the periods ended September 30, 2006 2005 (Unfavorable) 2006 2005 (Unfavorable)
----------------------------------- ------------ ------------ ------------ ------------ ------------ ------------
Revenue ........................... $ 110,149 $ 96,910 $ 13,239 $ 317,735 $ 280,413 $ 37,322
Operating expenses ................ 85,128 83,948 (1,180) 256,856 254,686 (2,170)
Other income (expense), net ....... 1,352 (2,735) 4,087 4,346 (7,390) 11,736
------------ ------------ ------------ ------------ ------------ ------------
Income before income taxes ........ 26,373 10,227 16,146 65,225 18,337 46,888
Income tax expense (benefit) ...... 9,403 2,282 (7,121) (127,364) 5,097 132,461
------------ ------------ ------------ ------------ ------------ ------------
Net income ........................ $ 16,970 $ 7,945 $ 9,025 $ 192,589 $ 13,240 $ 179,349
============ ============ ============ ============ ============ ============
Earnings per share:
Basic ......................... $ 0.27 $ 0.13 $ 0.14 $ 3.06 $ 0.21 $ 2.85
Diluted ....................... $ 0.25 $ 0.12 $ 0.13 $ 2.71 $ 0.21 $ 2.50
o The improvement in revenue primarily reflects increased revenue from the
Residential Servicing segment due to higher servicing fees on a larger
servicing portfolio and the positive impact of rising short-term interest
rates on revenue from custodial accounts ("float earnings"). The positive
impact of higher short-term interest rates on float earnings has been
partly offset by an increase in interest expense on variable-rate financing
associated with servicing advances and mortgage servicing rights. An
increase in process management fee revenue from the Residential Origination
Services segment was offset by a decline in revenue from the Commercial
Servicing Segment, primarily reflecting the sale of our GSS Japan
operations in December 2005.
o Higher income before income taxes in 2006 primarily reflects the continued
strong performance of the Residential Servicing segment. Pre-tax income of
this segment was $23,943 and $59,883 for the third quarter and first nine
months of 2006, respectively, as compared to $7,696 and $13,242 for the
same periods of 2005. This improvement is due to higher revenues, as
discussed above, and a reduction in total operating expenses, including a
reduction in interest paid to investors related to loan pay-offs. Improved
operating results in our settlement services, property valuation and
business processing operations of the Residential Origination Services
19
segment have been somewhat offset by a decline in pre-tax earnings from the
Commercial Servicing segment that is largely due to the sale of our GSS
Japan operations.
o The net tax benefit for the nine months ended September 30, 2006 includes
the reversal of $145,211 of deferred tax asset valuation allowances during
the second quarter to increase the net deferred tax asset to the amount
that is more likely than not to be realized in future periods.
We provide additional financial information and discuss our segment
results in the following section.
SEGMENTS
We periodically review our business segment reporting structure based
on the evolving alignment of our business activities. In connection with such a
review, we have merged our Business Process Outsourcing segment into our
Residential Origination Services segment effective in the third quarter of 2006.
This change reflects management changes that have taken place in the third
quarter and the realignment of resources to achieve cost reductions and
increased focus in delivering mortgage-loan-related outsourced services to the
mortgage industry. Amounts for all prior periods have been restated to reflect
this reorganization on a comparable basis. The following section provides a
discussion of the changes in financial condition of our business segments during
the nine months ended September 30, 2006 and a discussion of pre-tax results of
operations of our business segments for the three and nine-month periods ended
September 30, 2006 and 2005.
The following table presents the assets and liabilities of each of our
business segments at September 30, 2006:
Ocwen Residential Corporate Business
Residential Commercial Recovery Origination Items and Segments
Servicing Servicing Group Services Other Consolidated
------------ ------------ ------------ ------------ ------------ ------------
Assets
Cash ......................................... $ -- $ 5,559 $ -- $ 511 $ 186,162 $ 192,232
Trading securities:
Investment grade ........................... -- -- -- -- 222,611 222,611
Subordinates and residuals ................. -- -- -- 46,188 716 46,904
Loans held for resale ........................ -- -- -- 212,895 -- 212,895
Advances ..................................... 294,271 351 -- 8,704 1,048 304,374
Match funded advances ........................ 390,575 -- -- -- -- 390,575
Mortgage servicing rights .................... 171,984 1,927 -- -- -- 173,911
Receivables .................................. 21,296 3,007 500 12,437 21,025 58,265
Deferred tax asset, net ...................... -- -- -- -- 169,258 169,258
Premises and equipment ....................... 1,355 204 56 1,121 33,611 36,347
Other assets ................................. 20,318 718 4 6,987 77,374 105,401
------------ ------------ ------------ ------------ ------------ ------------
Total assets ............................... $ 899,799 $ 11,766 $ 560 $ 288,843 $ 711,805 $ 1,912,773
============ ============ ============ ============ ============ ============
Liabilities
Match funded liabilities ..................... $ 356,179 $ -- $ -- $ -- $ -- $ 356,179
Servicer liabilities ......................... 419,732 -- -- -- -- 419,732
Lines of credit and other secured borrowings.. 159,743 -- -- 193,449 14,443 367,635
Debt securities .............................. -- -- -- -- 150,329 150,329
Other liabilities ............................ 31,077 3,058 2,483 5,882 37,305 79,805
------------ ------------ ------------ ------------ ------------ ------------
Total liabilities .......................... $ 966,731 $ 3,058 $ 2,483 $ 199,331 $ 202,077 $ 1,373,680
============ ============ ============ ============ ============ ============
20
The following tables present the pre-tax statements of operations for
each of our business segments for the nine months ended September 30, 2006:
Ocwen Residential Corporate Business
Residential Commercial Recovery Origination Items and Segments
Servicing Servicing Group Services Other Consolidated
------------ ------------ ----------- ------------ ------------ ------------
Revenue
Servicing and subservicing fees ..... $ 239,141 $ 4,004 $ 5,797 $ 1,075 $ (1,580) $ 248,437
Process management fees ............. 6,617 4 -- 53,138 (9) 59,750
Other revenues ...................... 4,547 4,460 -- 294 247 9,548
------------ ------------ ----------- ------------ ------------ ------------
Total revenue .................... 250,305 8,468 5,797 54,507 (1,342) 317,735
------------ ------------ ----------- ------------ ------------ ------------
Operating expenses
Compensation and benefits .......... 23,436 4,266 2,655 20,072 18,609 69,038
Amortization of servicing rights ... 80,948 86 -- -- -- 81,034
Servicing and origination .......... 20,132 21 356 18,698 -- 39,207
Technology and communications ...... 15,086 1,411 1,177 7,094 (5,597) 19,171
Professional services .............. 10,373 571 194 4,445 6,800 22,383
Occupancy and equipment ............ 8,174 460 706 2,305 2,939 14,584
Other operating expenses ........... 12,304 1,448 1,637 11,717 (15,667) 11,439
------------ ------------ ----------- ------------ ------------ ------------
Total operating expenses ......... 170,453 8,263 6,725 64,331 7,084 256,856
------------ ------------ ----------- ------------ ------------ ------------
Other income (expense)
Interest income .................... 378 39 -- 30,312 6,148 36,877
Interest expense ................... (20,330) (17) -- (15,563) (2,964) (38,874)
Gain (loss) on trading securities .. -- -- -- 4,136 (653) 3,483
Loss on loans held for resale, net . -- -- -- (1,306) -- (1,306)
Gain on debt repurchases ........... -- -- -- -- 25 25
Other, net ......................... (17) 66 314 1,568 2,210 4,141
------------ ------------ ----------- ------------ ------------ ------------
Other income (expense), net ...... (19,969) 88 314 19,147 4,766 4,346
------------ ------------ ----------- ------------ ------------ ------------
Pre tax income (loss) ................. $ 59,883 $ 293 $ (614) $ 9,323 $ (3,660) $ 65,225
============ ============ =========== ============ ============ ============
Residential Servicing
The following table sets forth information regarding residential loans
and real estate serviced for others:
Loans (1)(2)(3) Real Estate Total (4)
--------------------------- --------------------------- ---------------------------
Amount Count Amount Count Amount Count
------------ ------------ ------------ ------------ ------------ ------------
September 30, 2006:
Performing ......... $ 42,996,242 375,230 $ -- -- $ 42,996,242 375,230
Non-Performing ..... 6,472,920 63,914 1,320,020 14,251 7,792,940 78,165
------------ ------------ ------------ ------------ ------------ ------------
$ 49,469,162 439,144 $ 1,320,020 14,251 $ 50,789,182 453,395
============ ============ ============ ============ ============ ============
December 31, 2005:
Performing ......... $ 36,532,664 297,649 $ -- -- $ 36,532,664 297,649
Non-performing ..... 5,125,116 57,420 1,121,268 13,733 6,246,384 71,153
------------ ------------ ------------ ------------ ------------ ------------
$ 41,657,780 355,069 $ 1,121,268 13,733 $ 42,779,048 368,802
============ ============ ============ ============ ============ ============
September 30, 2005
Performing ......... $ 30,742,262 263,960 $ -- -- $ 30,742,262 263,960
Non-performing ..... 4,640,753 54,123 1,130,684 13,793 5,771,437 67,916
------------ ------------ ------------ ------------ ------------ ------------
$ 35,383,015 318,083 $ 1,130,684 13,793 36,513,699 331,876
============ ============ ============ ============ ============ ============
(1) At September 30, 2006 we serviced 299,278 subprime loans with a total
unpaid principal balance of $39,235,394 as compared to 304,234 subprime
loans with an unpaid principal balance of $37,429,090 at December 31,
2005. At September 30, 2005, we serviced 268,469 subprime loans with a
total unpaid principal balance of $31,199,651. Subprime loans represent
residential loans we service that were made to borrowers who generally
did not qualify under guidelines of Fannie Mae and Freddie Mac
("nonconforming loans").
(2) Non-performing loans have been delinquent for 90 days or more. Performing
loans are current or have been delinquent for less than 90 days.
(3) We serviced under subservicing contracts 145,234 residential loans with
an unpaid principal balance of $13,283,363 as of September 30, 2006. This
compares to 105,873 residential loans with an unpaid principal balance of
$10,983,237 serviced under subservicing contracts at December 31, 2005.
21
(4) The average unpaid principal balance of assets serviced during the three
and nine months ended September 30, 2006 was $49,978,600 and $46,424,617
respectively, as compared to $37,146,943 and $37,189,607 for the same
periods of 2005.
The following table sets forth information regarding the changes in our
portfolio of residential assets serviced for others:
Amount Count
---------------------------- ----------------------------
For the nine months ended September 30, 2006 2005 2006 2005
----------------------------------------------- ------------ ------------ ------------ ------------
Servicing portfolio at beginning of period .... $ 42,779,048 $ 34,524,491 368,802 320,185
Additions ..................................... 28,545,686 25,368,818 235,975 181,036
Less: Runoff (1) .............................. (20,535,552) (23,379,610) (151,382) (169,345)
------------ ------------ ------------ ------------
Servicing portfolio at end of period .......... $ 50,789,182 $ 36,513,699 453,395 331,876
============ ============ ============ ============
(1) Runoff includes principal repayments on loans, servicing transfers and
other asset resolutions.
Additions primarily represent servicing purchased from the owners of
the mortgages, servicing retained in connection with the securitization of our
own loans and servicing obtained by entering into subservicing agreements with
other entities that own the servicing rights.
Comparative selected balance sheet data is as follows:
------------------------------------------------------
September 30, December 31,
2006 2005
------------ ------------
Total assets ....................................... $ 899,799 $ 783,560
Advances ....................................... 294,271 215,207
Match funded advances .......................... 390,575 377,105
Mortgage servicing rights ...................... 171,984 148,663
Receivables .................................... 21,296 23,323
Total liabilities .................................. $ 966,731 $ 745,760
Match funded liabilities ....................... 356,179 339,292
Servicer liabilities ........................... 419,732 298,892
Lines of credit and other secured borrowings ... 159,743 81,218
Advances. During any period in which the borrower is not making
payments, we are required under certain servicing agreements to advance our own
funds to meet contractual principal and interest remittance requirements for
investors, pay property taxes and insurance premiums and process foreclosures.
We also advance funds to maintain, repair and market real estate properties on
behalf of investors. Advances on loans serviced for others consist of the
following:
September 30, December 31,
2006 2005
------------ ------------
Principal and interest ......................... $ 90,558 $ 40,201
Taxes and insurance ............................ 94,915 98,331
Other .......................................... 108,798 76,675
------------ ------------
$ 294,271 $ 215,207
============ ============
We are entitled to recover advances from borrowers for reinstated and
performing loans and from investors for foreclosed loans. We record a charge to
earnings to the extent that advances are uncollectible under provisions of the
servicing contracts, taking into consideration historical loss and delinquency
experience, length of delinquency and the amount of the advance. Advances on
loans serviced for others are net of reserves of $513 and $570 as of September
30, 2006 and December 31, 2005, respectively.
Match Funded Advances. Match funded advances consist of the following:
September 30, December 31,
2006 2005
------------ ------------
Principal and interest ......................... $ 180,284 $ 174,252
Taxes and insurance ............................ 125,965 129,700
Other .......................................... 84,326 73,153
------------ ------------
$ 390,575 $ 377,105
============ ============
22
Match funded advances on loans serviced for others result from our
transfers of residential loan servicing advances to special purpose entities
("SPEs") in exchange for cash. These transfers have been made under the terms of
two advance facility agreements, as amended, under which we have retained
effective control of the advances. The match funded advances are owned by the
SPEs and are not available to satisfy general claims of our creditors.
Mortgage Servicing Rights. The unamortized balance of mortgage
servicing rights is primarily related to subprime residential loans. Mortgage
servicing rights increased by $23,321 during the first nine months of 2006 as
new purchases exceeded amortization.
Balance at December 31, 2005 ................................... $ 148,663
Purchases ...................................................... 100,185
Retained from the securitization of loans ...................... 4,084
Amortization ................................................... (80,948)
------------
Balance at September 30, 2006 .................................. $ 171,984
============
We purchase servicing rights from the owners of the mortgages or retain
them in connection with the securitization of our own loans. At September 30,
2006 we serviced loans under 468 servicing agreements for 30 investors. This
compares to 466 servicing agreements for 22 investors at December 31, 2005.
Receivables. Receivables related to the Residential Servicing business
include $3,567 and $15,674 at September 30, 2006 and December 31, 2005,
respectively, representing fees earned from the servicing of loans and real
estate. The remaining balance consists principally of reimbursable expenses due
from loan servicing investors. The total balance of receivables for this segment
is net of an allowance for doubtful accounts of $5,181 and $6,509 at September
30, 2006 and December 31, 2005, respectively.
Match Funded Liabilities. Match funded liabilities are obligations
secured by the collateral underlying the related match funded assets and are
repaid through the cash proceeds arising from those assets. We account for and
report match funded liabilities as secured borrowings with pledges of
collateral.
Balance Outstanding
Unused ---------------------------
Borrowing September 30, December 31,
Collateral Interest Rate Capacity 2006 2005
---------------------- ----------------------------------- ------------ ------------ ------------
Advances (1) See (1) below $ 13,345 $ 261,655 $ 238,943
Advances (2) 1-Month LIBOR + 175 basis points 30,476 94,524 100,349
------------ ------------ ------------
$ 43,821 $ 356,179 $ 339,292
============ ============ ============
(1) In November 2004, we executed a servicing advance securitization. This
transaction involved the issuance of a term note for $100,000 and a
one-year variable funding note for a maximum of $75,000. On March 31,
2005, we executed an indenture supplement to the November 2004
securitization with a closing date of April 6, 2005. This supplement
included the issuance of a second term note for $75,000. In addition,
the maximum amount of the variable funding note was increased to
$100,000. The original term note bears interest at LIBOR plus 50 basis
points, and the second term note bears interest at LIBOR plus 40 basis
points. The variable funding note bears interest at a commercial paper
rate plus a margin. This rate approximates LIBOR plus 50 basis points.
The original term note under this facility has a stated maturity of
October 2013, and the second term note has a stated maturity of March
2014. The variable funding note has a stated maturity of November 2011.
1-Month LIBOR was 5.32% and 4.39% at September 30, 2006 and December
31, 2005, respectively.
(2) Under the terms of the agreement, we are eligible to finance additional
advances on loans serviced for others up to a maximum balance of
$125,000. This facility will mature in January 2007.
Servicer Liabilities. Servicer liabilities represent amounts that we
have collected, primarily from Residential Servicing borrowers, that will be
deposited in custodial accounts and excluded from our balance sheet, paid
directly to an investment trust or refunded to borrowers. The principal
components of servicer liabilities are as follows:
September 30, December 31,
2006 2005
------------ ------------
Borrower payments due to custodial accounts .......... $ 353,808 $ 225,862
Escrow payments due to custodial accounts ............ 14,292 22,573
Partial payments and other unapplied balances ........ 51,632 50,457
------------ ------------
$ 419,732 $ 298,892
============ ============
23
Lines of Credit and Other Secured Borrowings. During the third quarter
of 2006, we negotiated amendments to the senior secured credit agreement to
extend its maturity to August 2007 and to increase the maximum borrowing from
$140,000 to $285,000. Terms of the credit arrangement are as follows:
Unused Balance Outstanding
Borrowing ----------------------------------------
Borrowing Type Interest Rate Maturity Capacity September 30, 2006 December 31, 2005
----------------------- -------------------------- ----------------- -------------- ------------------ -------------------
Senior secured credit 1-Month LIBOR + 150 or
agreement (1) 225 basis points August 2007 $ 125,257 $ 159,743 $ 81,218
(1) May be secured by mortgage servicing rights, advances on loans serviced
for others, receivables and mortgage loans. Borrowing bears interest at
1-Month LIBOR plus a margin of 150 to 225 basis points depending on the
type of collateral pledged.
Comparative selected operations data is as follows:
---------------------------------------------------
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
---------------------------------------- ------------ ------------ ------------ ------------
Pre-tax income ......................... $ 23,943 $ 7,696 $ 59,883 $ 13,242
Revenue:
Servicing and subservicing fees ..... $ 83,468 $ 68,267 $ 239,141 $ 199,521
Process management fees ............. 2,584 1,782 6,617 5,622
Other ............................... 1,403 1,025 4,547 2,837
------------ ------------ ------------ ------------
Total revenue ..................... $ 87,455 $ 71,074 $ 250,305 $ 207,980
============ ============ ============ ============
Operating expenses:
Compensation and benefits ........... $ 7,989 $ 8,464 $ 23,436 $ 27,491
Amortization of servicing rights .... 27,010 22,975 80,948 73,020
Servicing and origination ........... 7,365 9,032 20,132 27,164
Technology and communications ....... 4,734 5,630 15,086 17,648
Professional services ............... 2,325 2,352 10,373 8,723
Occupancy and equipment ............. 2,773 2,501 8,174 7,351
Other ............................... 3,954 6,603 12,304 18,201
------------ ------------ ------------ ------------
Total operating expenses .......... $ 56,150 $ 57,557 $ 170,453 $ 179,598
============ ============ ============ ============
Other income (expense):
Interest income ..................... $ 116 $ 87 $ 378 $ 229
Interest expense .................... (7,219) (5,895) (20,330) (15,350)
Other ............................... (259) (13) (17) (19)
------------ ------------ ------------ ------------
Total other income (expense) ..... $ (7,362) $ (5,821) $ (19,969) $ (15,140)
============ ============ ============ ============
Servicing and Subservicing Fees. The principal components of servicing
and subservicing fees are provided in the table below:
Three months Nine months
--------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
----------------------------------------------------- ------------ ------------ ------------ ------------
Servicing and subservicing fees ..................... $ 52,017 $ 40,309 $ 152,487 $ 127,960
Revenue from custodial accounts (float earnings) .... 13,533 9,549 35,456 22,614
Late charges ........................................ 9,427 9,083 27,707 26,832
Prepayment and collection related fees .............. 2,438 2,071 7,329 6,513
Other fees .......................................... 6,053 7,255 16,162 15,602
------------ ------------ ------------ ------------
$ 83,468 $ 68,267 $ 239,141 $ 199,521
============ ============ ============ ============
The increase in servicing and subservicing fees in the 2006 periods as
compared to the same periods of 2005 is primarily due to the increase in the
average balance of loans serviced. Total servicing and subservicing fees for the
three and nine months ended September 30, 2006 increased by 29% and 19%,
respectively, as compared to the same periods of 2005. The increase in the
average balance is due to growth in the loan servicing portfolio and reduced
run-off of the existing portfolio due to slower prepayment speeds. The average
balance of assets serviced during the three and nine months ended September 30,
2006 increased by 35% and 25%, respectively, as compared to the 2005 periods.
Third quarter and year to date 2006 prepayment speeds averaged 31% and 30%,
respectively. This compares to an average of 39.6% and 38.4% in the third
24
quarter and year to date periods of 2005. The decline in mortgage prepayment
speeds is largely due to rising mortgage interest rates and a leveling off of
the gains in housing values.
Increases in short-term interest rates have had a positive impact on
float earnings. Although the average balance of funds that we have received from
borrowers but which are held in custodial accounts until remitted to investors
has declined in the 2006 periods, the average yield we earned on these funds
increased. The following table summarizes information regarding float earnings:
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
-------------------------------------------- ------------ ------------ ------------ ------------
Average custodial account balances ......... $ 1,036,500 $ 1,176,400 $ 1,008,600 $ 1,153,100
Float earnings ............................. $ 13,533 $ 9,549 $ 35,456 $ 22,614
Annualized yield ........................... 5.22% 3.25% 4.69% 2.62%
Custodial accounts are excluded from our balance sheet. The decline in
the average balance in the 2006 periods is primarily due to a decline in
mortgage prepayment speeds offset by the increase in the average balance of
loans serviced. The underlying servicing agreements restrict the investment of
float balances to certain types of instruments. We are responsible for any
losses incurred on the investment of these funds.
Compensation and Benefits Expense. The decrease in compensation expense
and benefits in the third quarter and first nine months of 2006 as compared to
the same periods of 2005 has occurred primarily due to a decline in the average
number of employees in the U.S. as a result of cost reduction initiatives put in
place in 2005, including a greater utilization of the lower cost workforce in
India. Although average employment in India increased in the 2006 periods, total
average employment declined, and the ratio of India employment to total
employment increased as compared to the 2005 periods.
Average employment in the Residential Servicing segment is as follows:
Three months Nine months
--------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------- ------------ ------------ ------------ ------------
India ..................................... 1,013 944 968 928
United States ............................. 414 485 425 544
------------ ------------ ------------ ------------
1,427 1,429 1,393 1,472
============ ============ ============ ============
Amortization of Servicing Rights. Amortization expense for the third
quarter 2006 increased by $4,035, or 18%, as compared to the third quarter of
2005. Year to date amortization expense for 2006 increased by $7,928, or 11%, as
compared to 2005. This increase in amortization expense in the 2006 periods is
due to an increase in our investment in mortgage servicing rights, offset by a
reduction in the rate of amortization primarily as a result of slower mortgage
prepayment speeds.
Servicing and Origination Expenses. The principal components of
servicing and origination expenses are as follows:
Three months Nine months
--------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------- ------------ ------------ ------------ ------------
Compensating interest expense ............. $ 3,445 $ 6,256 $ 10,106 $ 18,070
Satisfaction expense ...................... 1,652 1,334 4,605 4,633
Other ..................................... 2,268 1,442 5,421 4,461
------------ ------------ ------------ ------------
$ 7,365 $ 9,032 $ 20,132 $ 27,164
============ ============ ============ ============
The primary reason for the decline in compensating interest expense in
the third quarter and first nine months of 2006 as compared to the same periods
of 2005 is a shift towards a higher percentage of loans serviced under a
mid-month structure versus a calendar month structure. Under a calendar month
structure, compensating interest is paid to the securitization trust for a full
month of interest on all loans that prepay during the month; whereas under a
mid-month structure, we are not obligated to pay the compensating interest on
prepayments that occur during the first half of the month. The decline in
compensating interest expense attributed to slower prepayment speeds experienced
in 2006 has been largely offset by an increase in the average size of the loan
servicing portfolio during that same period.
Professional Services Expenses. Professional services expense for the
first nine months of 2006 includes a provision of $2,950 recorded in the second
quarter to increase litigation accruals related to ongoing cases. This increase
in litigation accruals is primarily related to settlements in principle that
were reached with the law firms representing plaintiff-borrowers in a number of
filed and threatened cases challenging various loan servicing fees, primarily in
the states of Alabama and Mississippi. None of these cases sought class
25
certification, although 23 of them had been consolidated in the MDL Proceeding.
The settlements in principle are subject to the completion of definitive
settlement and release agreements to be separately entered into with each of the
individual plaintiff-borrowers involved.
Other Operating Expenses. Other consists primarily of overhead
allocation charges and bad debt expense. The decrease in other operating
expenses in the 2006 periods is due in large part to a decline in bad debt
expense. Bad debt expense amounted to $(361) and $2,354 in the third quarter of
2006 and 2005, respectively. Year to date, bad debt expense amounted to $(159)
and $5,305 during 2006 and 2005, respectively. The higher bad debt expense in
2005 was primarily the result of providing for aged reimbursable expenses.
Interest Expense. The increase in interest expense in the 2006 periods
reflects an increase in financing costs associated with our servicing advances
and mortgage servicing rights that is largely due to higher interest rates.
1-month LIBOR has increased from 3.86% at September 30, 2005 to 5.32% at
September 30, 2006.
Commercial Servicing
Comparative selected balance sheet data is as follows:
------------------------------------------------------
September 30, December 31,
2006 2005
------------ ------------
Total assets ..................................... $ 11,766 $ 6,433
Cash .......................................... 5,559 3,057
Mortgage servicing rights ..................... 1,927 --
Receivables ................................... 3,007 2,508
Total liabilities ................................ $ 3,058 $ 3,220
Mortgage Servicing Rights. On June 20, 2006, our GSS Canada operations
acquired the master servicing rights to service 75 commercial loans with an
unpaid principal balance of $531,079 (GSS Canada is also the primary servicer on
a substantial portion of these loans). These master serviced loans had an unpaid
principal balance of $520,487 at September 30, 2006.
Comparative selected operations data is as follows:
---------------------------------------------------
Three months Nine months
---------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------- ------------ ------------ ------------ ------------
Pre-tax income ............................ $ (254) $ 2,063 $ 293 $ 2,419
Revenue:
Servicing and subservicing fees ....... $ 925 $ 4,919 $ 4,004 $ 10,713
Other ................................. 1,344 1,343 4,464 4,547
------------ ------------ ------------ ------------
Total revenue ...................... $ 2,269 $ 6,262 $ 8,468 $ 15,260
============ ============ ============ ============
Operating expenses ........................ $ 2,629 $ 3,885 $ 8,263 $ 12,282
The following table sets forth information regarding commercial loans
and real estate serviced for others:
Loans Real Estate Total
--------------------------- --------------------------- ---------------------------
Amount Count Amount Count Amount Count
------------ ------------ ------------ ------------ ------------ ------------
September 30, 2006:
Performing .......... $ 3,350,809 403 $ -- -- $ 3,350,809 403
Non-performing ...... 285,155 367 21,123 5 306,278 372
------------ ------------ ------------ ------------ ------------ ------------
$ 3,635,964 770 $ 21,123 5 $ 3,657,087 775
============ ============ ============ ============ ============ ============
December 31, 2005:
Performing .......... $ 1,389,787 300 $ -- -- $ 1,389,787 300
Non-performing ...... 193,635 274 56,719 69 250,354 343
------------ ------------ ------------ ------------ ------------ ------------
$ 1,583,422 574 $ 56,719 69 $ 1,640,141 643
============ ============ ============ ============ ============ ============
September 30, 2005:
Performing .......... $ 1,701,455 324 $ -- -- $ 1,701,455 324
Non-performing ...... 11,129,948 8,807 81,636 79 11,211,584 8,886
------------ ------------ ------------ ------------ ------------ ------------
$ 12,831,403 9,131 $ 81,636 79 $ 12,913,039 9,210
============ ============ ============ ============ ============ ============
26
At September 30, 2006, our international offices serviced a total of
572 loans with an unpaid principal balance of $3,388,444. This compares to 272
loans with an unpaid principal balance of $1,269,796 serviced at December 31,
2005, and 8,798 loans with an unpaid principal balance of $12,332,121 at
September 30, 2005. The increase in loans serviced by our international offices
in 2006 is primarily attributed to our GSS Germany operations, which commenced
servicing loans in late 2005. Loans serviced by our GSS Canada operations also
increased in 2006 as a result of the acquisition of servicing rights discussed
above. The decline in loans serviced by our international offices as compared to
September 30, 2005 is primarily due to the sale of our GSS Japan subsidiaries in
December 2005.
Servicing Fees. The principal components of servicing and subservicing
fees are as follows:
Three months Nine months
--------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------- ------------ ------------ ------------ ------------
International servicing fees:
GSS Germany ........................... $ 461 $ -- $ 1,301 $ --
GSS Canada ............................ 338 152 787 237
GSS Taiwan ............................ -- 1,875 675 2,453
GSS Japan ............................. -- 860 -- 3,869
------------ ------------ ------------ ------------
$ 799 $ 2,887 $ 2,763 $ 6,559
Domestic servicing fees ................... 126 2,032 1,241 4,154
------------ ------------ ------------ ------------
$ 925 $ 4,919 $ 4,004 $ 10,713
============ ============ ============ ============
The decline in GSS Japan servicing fees in the 2006 periods reflects
the sale of our subsidiaries in December 2005. GSS Taiwan continues to provide
consulting services, but it has ceased its servicing activities effective in
March 2006. GSS Germany began servicing loans in late 2005. The decline in
domestic servicing fees in 2006 reflects a decline in the portfolio of assets
serviced. Asset resolution fees declined from $1,314 and $2,256 for the three
and nine months ended September 30, 2005, respectively, to $4 and $560 for the
same periods of 2006.
Operating Expenses. The decline in operating expenses in the 2006
periods is primarily due to the sale of our GSS Japan operations in December
2005. Operating expenses of the GSS Japan subsidiaries that we sold were $914
and $2,930 for the three and nine months ended September 30, 2005, respectively.
Ocwen Recovery Group
Comparative selected operations data is as follows:
---------------------------------------------------
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------- ------------ ------------ ------------ ------------
Pre-tax income (loss) ..................... $ (384) $ (650) $ (614) $ 99
Revenue:
Servicing fees:
Third-party collections ............. $ 1,542 $ 2,464 $ 5,182 $ 8,839
Proprietary collections ............. 198 248 615 960
------------ ------------ ------------ ------------
Total revenue ..................... $ 1,740 $ 2,712 $ 5,797 $ 9,799
============ ============ ============ ============
Operating expenses ........................ $ 2,163 $ 3,484 $ 6,725 $ 9,938
The decline in revenue in the 2006 periods reflects an ongoing shift in
revenue from a maturing portfolio of higher margin proprietary assets to lower
yielding third-party contracts. The decrease in operating expenses in 2006 is
largely the result of ongoing process improvements, technology enhancements and
a greater utilization of lower cost resources in India.
27
Residential Origination Services
Comparative selected balance sheet data is as follows:
------------------------------------------------------
September 30, December 31,
2006 2005
------------ ------------
Total assets ..................................... $ 288,843 $ 680,625
Subordinate and residual trading securities ... 46,189 27,023
Loans held for resale ......................... 212,895 624,671
Receivables ................................... 12,437 19,680
Total liabilities ................................ $ 199,331 $ 538,417
Lines of credit and other secured borrowings .. 193,449 530,569
Trading Securities. During the first nine months of 2006, trading
securities increased by $19,166 largely due to residual securities with a fair
value of $17,673 at September 30, 2006 that were retained in connection with the
first and second quarter loan securitizations. In addition to providing various
mortgage due diligence and loan origination services, our strategy in this
business includes the targeted acquisition of residual securities. We acquire
residual securities directly from third parties or retain them in connection
with loan securitization transactions.
Subordinate and residual securities do not have a contractual maturity
but are paid down over time as cash distributions are received. The weighted
average remaining life of these securities was 2.76 years at September 30, 2006.
The anticipated effective yield to maturity as of September 30, 2006 based on
the purchase price, actual cash flows received to date and the current estimate
of future cash flows under the pricing assumptions at September 30, 2006 was
25.11%. The original anticipated effective yield to maturity based on the
purchase price and anticipated future cash flows under pricing assumptions at
the time of purchase was 18.62%. Differences in the September 30, 2006
anticipated yield to maturity from that originally anticipated are due to
differences between estimated cash flows and actual cash flows. Each quarter, we
update the assumptions used to estimate future cash flows based on the actual
results to date. The primary assumptions include prepayment speeds, loss rates
and the discount rate. The mortgages that underlie our residential trading
unrated subprime subordinate and residual securities amounted to $882,776 at
September 30, 2006 and are secured by properties located in 50 states, one U.S.
territory and the UK. The largest aggregate value of mortgages in any one state,
territory or foreign country is $137,705 in Florida.
Loans Held for Resale. Loans held for resale represent single-family
residential loans originated or acquired by our Residential Origination Services
segment that we intend to sell or securitize. The $411,776 decline in loans held
for resale during the first nine months of 2006 is primarily due to the first
quarter securitization of loans with a carrying value of $428,168 that we had
acquired during the fourth quarter of 2005. During the second quarter of 2006,
we also completed the securitization of loans with a carrying value of $214,522
that we had acquired primarily during the first quarter of 2006. The aggregate
balances related to our other loan refinancing, origination and sale programs
have also declined during 2006. Loans held for resale are carried at the lower
of cost or market value and were comprised of the following at September 30,
2006:
o Loans with a carrying value of $68,737, net of a market valuation reserve
of $1,371, originated in connection with our subprime origination
operations. The carrying value at September 30, 2006 includes $2,880 of
non-performing loans.
o Loans with a carrying value of $15,150 originated in response to requests
from Residential Servicing customers to refinance their mortgages. Only
loans with sales commitments prior to closing are originated under this
program. Of the loans outstanding at September 30, 2006, nearly all were
sold in October 2006.
o Loans with a carrying value of $129,008, net of a market valuation
reserve of $9,317, acquired as a part of our securitization activities.
Loans with a carrying value of $118,865 were acquired in connection with
the termination of securitization trusts during the third quarter of 2006
in which we were the servicer and held the residual securities. We are
actively negotiating the securitization or sale of these loans. The
remaining loans were acquired during the second quarter of 2006 and the
third quarter of 2005. The carrying value at September 30, 2006 includes
$35,591 of non-performing loans.
Receivables. The $7,243 decrease in receivables during the first nine
months of 2006 is primarily due to the collection of interest and other amounts
related to loans held for resale, the balance of which has declined
significantly since the end of the year, as discussed above.
28
Lines of Credit and Other Secured Borrowings. Lines of credit and other
secured borrowings, which are secured by residential mortgage loans unless
otherwise noted, are as follows:
Balance Outstanding at
Unused ----------------------------
Borrowing September 30, December 31,
Borrowing Type Interest Rate Maturity Capacity 2006 2005
-------------------------- -------------------------------- -------------- ---------- ------------- -----------
Repurchase agreement (1) 1-Month LIBOR + 75 basis March 2006 $ -- $ -- $ 459,400
points
1-Month LIBOR + 75 - 150
Repurchase agreement (2) basis points August 2007 12,544 122,456 --
Overnight LIBOR + 80 -
Repurchase agreement (3) 110 basis points June 2007 33,039 41,961 --
Repurchase agreement 1-Month LIBOR + 50 basis February 2007 4,517 5,483 --
points
Repurchase agreement (4) 1-month LIBOR +125 basis April 2036 N/A 2,216 --
points
Master loan and security 1-Month LIBOR + 55 or 355
agreement (5) to 1005 basis points June 2007 53,667 21,333 71,169
---------- ----------- -----------
$ 103,767 $ 193,449 $ 530,569
========== =========== ===========
(1) This agreement matured on March 31, 2006 and was not extended. The loans
we acquired in the fourth quarter of 2005 were funded through a
transaction involving the sale of loans under this agreement to
repurchase, which we accounted for as a collateralized financing. The
loans were securitized in the first quarter of 2006, and the outstanding
balance was repaid.
(2) The interest rate on this agreement varies based on the type of asset
sold, which can be current or past mortgage loans or real estate owned.
We entered into this agreement in August 2006.
(3) The interest rate on this agreement varies based on the type of loan
sold. The size of this facility has been reduced to $75,000, and the
maturity date has been extended to June 29, 2007. Overnight LIBOR was
5.38% at September 30, 2006.
(4) This agreement has no stated credit limit. Lending is determined for each
transaction based on the acceptability of the securities presented as
collateral.
(5) We, together with two consolidated VIEs, one of which is now consolidated
as a majority-owned subsidiary, entered into this agreement on October
11, 2005, and borrowings under this agreement are secured by mortgage
loans. We can borrow up to 100% of the principal balance of the mortgage
loans or 98% of the market value of the loans whichever is lower.
Borrowing up to 90% of the unpaid principal balance of the loans or 88.2%
of the market value of the loans bears interest at LIBOR plus 55 basis
points. Borrowing above this level bears interest at LIBOR plus 355 to
1005 basis points, depending on the type of loan. Subsequently, the
remaining VIE was removed from this facility, and the maximum amount of
the facility was reduced to $75,000.
29
Comparative selected operations data is as follows:
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------------------ ------------ ------------ ------------ ------------
Pre-tax income (loss) ................................ $ 5,634 $ 299 $ 9,323 $ 5,220
Revenue:
Process management fees .......................... $ 19,252 17,368 $ 53,138 $ 47,913
Other ............................................ 809 55 1,369 90
------------ ------------ ------------ ------------
Total revenue .................................. $ 20,061 $ 17,423 $ 54,507 $ 48,003
============ ============ ============ ============
Operating expenses:
Compensation and benefits ........................ $ 5,553 $ 4,118 $ 20,072 $ 11,601
Servicing and origination ........................ 5,780 6,544 18,698 17,247
Technology and communications .................... 2,136 2,473 7,094 6,795
Professional services ............................ 1,400 892 4,445 1,298
Occupancy and equipment .......................... 705 498 2,305 1,605
Other ............................................ 5,775 3,313 11,717 8,662
------------ ------------ ------------ ------------
Total operating expenses ....................... $ 21,349 $ 17,838 $ 64,331 $ 47,208
============ ============ ============ ============
Other income (expense):
Interest income:
Subordinate and residual trading securities .... $ 3,491 $ 2,791 $ 9,690 $ 9,546
Loans held for resale .......................... 6,746 105 20,414 113
Other .......................................... -- 39 208 43
------------ ------------ ------------ ------------
Total interest income ......................... 10,237 2,935 30,312 9,702
Interest expense ................................. (3,300) (1,453) (15,563) (2,421)
Gain (loss) on trading securities ................ 2,227 (882) 4,136 (3,590)
Gain (loss) on loans held for resale, net ........ (85) -- (1,306) --
Other, net ....................................... (2,157) 115 1,568 734
------------ ------------ ------------ ------------
Total other income (expense) ................... $ 6,922 $ 715 $ 19,147 $ 4,425
============ ============ ============ ============
Process Management Fees. The principal components of process management
fees are:
Three months Nine months
--------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------- ------------ ------------ ------------ ------------
Property valuation fees ................... $ 7,853 $ 7,385 $ 21,097 $ 21,687
Mortgage due diligence fees ............... 5,094 5,224 15,807 14,527
Loan refinancing fees ..................... 2,173 1,566 6,641 4,123
Other ..................................... 4,132 3,193 9,593 7,576
------------ ------------ ------------ ------------
$ 19,252 $ 17,368 $ 53,138 $ 47,913
============ ============ ============ ============
Other process management fees primarily includes title service and
other fees earned from vendors in the REALTrans network.
Compensation and Benefits Expense. Compensation and benefits expense
for the 2006 periods include a VIE that we began consolidating as of the end of
2005. This entity is a small start-up subprime loan originator that commenced
operations in July 2005. During the second quarter of 2006, our voting interest
in this VIE exceeded 50%, and it is now consolidated as a majority-owned
subsidiary. Compensation and benefits expense related to this entity amounted to
$1,390 and $5,454 for the third quarter and first nine months of 2006,
respectively. In addition, compensation and benefit expenses associated with the
mortgage fulfillment center and due diligence operation we acquired in December
2004 increased by $190 and $3,445 in the three and nine month periods ended
September 30, 2006, respectively, as compared to the same periods of the prior
year. This increase is primarily due to increased staffing as a result of
building capacity in this business.
Servicing and Origination Expenses. Servicing and origination expenses
consist primarily of fees incurred in connection with the residential property
valuation services that we provided. These fees amounted to $4,290 and $4,877
during the third quarter of 2006 and 2005, respectively. Year to date, such fees
amounted to $12,489 and $13,882 during 2006 and 2005, respectively. Servicing
and origination expenses also include expenses related to loan refinancing and
title services.
Professional Services Expenses. The increase in professional services
in the 2006 periods is primarily due to underwriting fees and other direct costs
incurred in connection with the two loan securitization transactions.
30
Other Operating Expenses. Other operating expenses for the three and
nine months ended September 30, 2006 includes $2,142 and $3,823, respectively,
of bad debt provisions and charge offs. This compares to $531 and $639 for the
same periods of 2005.
Interest Income. The increase in interest income on loans held for
resale in the third quarter and first nine months of 2006 as compared to the
same periods of 2005 is largely due to an increase in the average balance of
loans held for resale, primarily as a result of acquisitions during the fourth
quarter of 2005 and in 2006. The consolidation of the subprime originations VIE
as of the end of 2005 also contributed to the increase. Interest income on
subordinate and residual trading securities is primarily comprised of interest
earned on the UK residuals.
Interest Expense. The increase in interest expense in the third quarter
and first nine months of 2006 as compared to the same periods of 2005 reflects
the additional funding requirements as a result of the increase in the average
balance of loans held for resale. The increase is also partially attributed to
the consolidation of the subprime originations VIE as of the end of 2005.
Gain (Loss) on Trading Securities. The following table sets forth the
unrealized and realized gains (losses) on trading securities for the periods
indicated:
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 (1) 2005 (1)(2) 2006 (1) 2005 (1)(2)
------------------------------------------- ------------ ------------ ------------ ------------
Unrealized gains (losses) ................. $ (1,490) $ (2,901) $ 254 $ (5,609)
Realized gains (losses) ................... 3,717 2,019 3,882 2,019
------------ ------------ ------------ ------------
$ 2,227 $ (882) $ 4,136 $ (3,590)
============ ============ ============ ============
(1) Includes unrealized losses of $1,801 and $3,674 for the three and nine
months ended September 30, 2006, respectively, on the UK residuals.
Unrealized losses on these securities for the same periods of 2005 were
$2,837 and $5,108. We also earn interest income on the UK residuals, which
amounted to $2,825 and $7,784 during the three and nine months ended
September 30, 2006, respectively. For the 2005 periods, interest income
earned on the UK residuals was $2,191 and $8,240. The unrealized losses on
the UK residuals in the 2006 periods are offset by unrealized gains of $490
and $3,891 during the third quarter and first nine months, respectively, on
subordinate and residual securities acquired or retained in connection with
securitization transactions.
(2) In both June 2005 and June 2006, we purchased unrated residual securities
related to loans for which we were already the master servicer for the
securitizations. As the master servicer, we had the clean-up call rights to
collapse the related trusts once the balance of the underlying loans
outstanding reached the optional termination amount of 10% of the original
amount of loans in the securitization. In the third quarter of both 2005
and 2006, we exercised our call rights and purchased the remaining loans
from the trusts. As a result, the over collateralization was remitted to
us, and we realized a gain on the residual securities that we had
purchased. We purchased the loans, which were classified as loans held for
resale, with the intention of securitizing or selling them. A portion of
the loans that we acquired were nonperforming, and we recorded a provision
to reduce these nonperforming loans to their market value, yielding a net
gain of $3,717 and $2,019 during the third quarter of 2006 and 2005,
respectively, as detailed in the table below.
For the three and nine months ended September 30, 2006 2005
------------------------------------------------- ------------ ------------
Realized gain on trading securities ............ $ 12,729 $ 8,495
Valuation loss on loans acquired ............... (9,012) (6,476)
------------ ------------
Net gain ................................... $ 3,717 $ 2,019
============ ============
Gain (Loss) on Loans Held for Resale, Net. The components of gain
(loss) on loans held for resale, net, are:
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
--------------------------------------------- ------------ ------------ ------------ ------------
Gain (loss) on sales and securitizations .... $ 582 $ -- $ 1,710 $ --
Valuation losses ............................ (667) -- (3,016) --
------------ ------------ ------------ ------------
$ (85) $ -- $ (1,306) $ --
============ ============ ============ ============
During the second quarter, we recorded a loss of $2,294 on the
securitization of $214,522 of loans, the majority of which we had acquired
during the first quarter of 2006. A gain of $3,105 was recognized in the first
quarter on the securitization of loans with a carrying value of $428,168 that we
had acquired during the fourth quarter of 2005. We determine the gain by
allocating the carrying value of the loans between loans sold and the interests
retained, based on their relative estimated fair values. The gain on sale that
we report represents the difference between the cash proceeds from the sale and
the cost allocated to the loans sold. In connection with these securitizations,
we retained the mortgage servicing rights and the residual securities. Gains on
sales of loans related to our origination activities amounted to $582 and $899
31
for the three and nine months ended September 30, 2006, respectively. Valuation
losses represent charges that we recorded to reduce loans held for resale to
market value.
Other, Net. Other income for the third quarter and first nine months of
2006 includes $(2,054) and $845, respectively, of net realized and unrealized
gains related to Eurodollar interest rate futures contracts.
Corporate Items and Other
Comparative selected balance sheet data is as follows:
------------------------------------------------------
September 30, December 31,
2006 2005
------------ ------------
Total assets ..................................... $ 711,805 $ 382,553
Cash .......................................... 186,162 264,373
Trading securities ............................ 223,327 4,939
Receivables ................................... 21,026 21,891
Deferred tax assets, net ...................... 169,258 20,270
Premises and equipment, net ................... 33,611 37,227
Other assets .................................. 77,373 32,756
Total liabilities ................................ $ 202,077 $ 214,934
Lines of credit and other secured borrowings .. 14,443 14,661
Debt securities ............................... 150,329 154,329
Other liabilities ............................. 37,305 45,944
Trading Securities. The fair value of our trading securities in the
Corporate Items and Other segment is as follows:
September 30, December 31,
2006 2005
------------ ------------
Investment grade securities:
Commercial paper (maturing October 2, 2006) .. $ 146,348 $ --
Money market funds ........................... 75,167 --
Other ........................................ 1,096 1,685
------------ ------------
222,611 1,685
Subordinates ..................................... 716 3,254
------------ ------------
$ 223,327 $ 4,939
============ ============
Receivables. Receivables in this segment consist of the following:
September 30, December 31,
2006 2005
------------ ------------
Amounts due from sales of affordable housing properties .... $ 12,783 $ 13,160
Security deposits .......................................... 3,471 3,678
Other ...................................................... 4,772 5,053
------------ ------------
$ 21,026 $ 21,891
============ ============
Payments to be received in future years (through June 2014) from the
sale of investments in affordable housing properties are net of unaccreted
discounts of $1,187 and $1,530 and reserves for doubtful accounts of $6,531 and
$6,150 at September 30, 2006 and December 31, 2005, respectively. Our final sale
of an affordable housing limited partnership investment occurred during 2005.
Deferred tax assets, net. The $148,988 increase in deferred tax assets,
net, in 2006 is primarily due to the reversal of $145,211 of valuation
allowances during the second quarter. This reversal was recorded as an income
tax benefit. Based on our cumulative earnings in recent periods and a more
stable outlook for future taxable income, we determined that it was appropriate
to reverse this portion of the deferred tax asset valuation allowance in order
to increase the net deferred tax asset to the amount that we are more likely
than not to realize in future periods. Deferred tax assets are net of valuation
allowances totaling $13,796 and $163,802 at September 30, 2006 and December 31,
2005, respectively. See Note 6 to our Interim Consolidated Financial Statements.
32
Other Assets. Other assets held by this segment are comprised of the
following:
September 30, December 31,
2006 2005
------------ ------------
Investment in BMS Holdings ....................... $ 45,809 $ --
Interest earning collateral deposits ............. 15,445 15,164
Goodwill and intangibles ......................... 5,435 5,435
Deferred debt-related issuance costs ............. 3,996 4,755
Real estate ...................................... 3,265 4,062
Prepaid expenses ................................. 2,907 2,390
Other ............................................ 516 950
------------ ------------
$ 77,373 $ 32,756
============ ============
Interest earning collateral deposits at September 30, 2006 and December
31, 2005 include $9,034 and $8,912, respectively, of deposits that were required
in order to obtain surety bonds for affordable housing properties that we sold
before the end of the fifteen-year tax credit amortization period and on which
we have previously claimed tax credits on our income tax returns. In October
2006, our collateral requirements related to these surety bonds were reduced,
and $4,021 of deposits were returned to us, including interest. Interest earning
collateral deposit balances also include a $5,000 cash collateral account
required under the Guaranty we entered into in connection with debanking.
Lines of Credit and Other Secured Borrowings. Lines of credit and other
secured borrowings in this segment represent a mortgage note collateralized by
our loan servicing call center located in Orlando, Florida. This note has a
fixed interest rate of 5.62% and matures in October 2014.
Debt Securities. Debt securities consist of the following:
September 30, December 31,
2006 2005
------------ ------------
3.25% Contingent Convertible Senior Unsecured Notes due August 1, 2024 .... $ 96,900 $ 100,900
10.875% Capital Securities due August 1, 2027 ............................. 53,429 53,429
------------ ------------
$ 150,329 $ 154,329
============ ============
The Convertible Notes declined by $4,000 during 2006 as a result of
repurchases during the first quarter that generated total gains of $25, net of
the write-off of unamortized issuance costs.
Other Liabilities. Other liabilities in this segment consist primarily
of accruals for incentive compensation awards, audit fees, legal fees and
settlements, interest on debt securities and other operating expenses. Other
liabilities also include funds of third parties held on deposit by BOK.
Comparative selected operations data is as follows:
---------------------------------------------------
Three months Nine months
---------------------------- ----------------------------
For the periods ended September 30, 2006 2005 2006 2005
--------------------------------------------- ------------ ------------ ------------ ------------
Pre-tax income (loss) ....................... $ (2,566) $ 818 $ (3,660) $ (2,642)
Revenue ..................................... $ (1,376) $ (561) $ (1,342) $ (629)
Operating expenses .......................... $ 2,837 $ 1,184 $ 7,084 $ 5,659
Other income (expense), net:
Interest income ......................... $ 2,093 $ 625 $ 6,148 $ 6,662
Interest expense ........................ (1,033) (691) (2,964) (7,578)
Gain (loss) on trading securities ....... (70) 139 (653) 181
Gain on debt repurchases ................ -- 897 25 897
Other, net .............................. 657 1,593 2,210 3,484
------------ ------------ ------------ ------------
Total other income (expense) .......... $ 1,647 $ 2,563 $ 4,766 $ 3,646
============ ============ ============ ============
Operating Expenses. Operating expenses for 2005 reflect the reversal of
$1,920 of reserves in the third quarter. Operating expenses for the quarter
ended September 30, 2006 and 2005 include $1,941 and $1,580, respectively, of
expenses associated with business activities that are individually
insignificant, primarily Affordable Housing, Commercial Assets and BOK. Year to
date, the expenses associated with these business activities were $4,979 and
$4,155 for 2006 and 2005, respectively. Affordable Housing operating expenses
for 2006 include a $1,000 provision, which was recorded in the third quarter,
related to the potential settlement of a contractual dispute.
33
Interest Income. The increase in interest income in the third quarter
of 2006 largely reflects an increase in investment grade securities, primarily
commercial paper. Year to date, interest income was higher in 2005, reflecting
higher balances of cash, investment grade securities and other short-term
investments leading up to debanking on June 30, 2005. This was partially offset
by an increase in interest income on a commercial unrated subordinate security
arising out of a cash distribution in the first quarter of 2006.
Interest Expense. The higher year to date interest expense in 2005
reflects a decline in debt securities as a result of repurchases during the
third and fourth quarters of 2005. Also, interest expense for 2005 included
$2,906 on customer deposits prior to debanking. We retained a greater amount of
interest expense in the Corporate Items and Other segment in the first six
months of 2005, reflecting the high cash and investment balances that we were
holding in preparation for debanking.
Gain (Loss) on Trading Securities. The losses in 2006 primarily reflect
a decline in the fair value of a commercial unrated subordinate security as a
result of a large cash distribution received in the first quarter of 2006. This
distribution also resulted in an increase in interest income as previously
disclosed.
Other, net. The 2006 periods include a gain of $1,261 from the sale of
a land parcel during the second quarter and equity in earnings of BMS Holdings
of $374 for the months of August and September. The 2005 periods include a gain
of $1,750 in the second quarter in connection with the assumption by Marathon of
our customer deposit liabilities as part of debanking, a gain of $1,882 in the
third quarter from the sale of a real estate investment and a loss of $1,272 in
the third quarter from the sale of an affordable housing property. The three and
nine months ended September 30, 2005 also include $948 and $1,900, respectively,
of interest income on federal income tax refund claims that were collected in
September 2005.
MINORITY INTEREST IN SUBSIDIARY
Minority interest of $1,905 and $1,853 at September 30, 2006 and
December 31, 2005, respectively, primarily represents the 30% investment in GSS
held by Merrill Lynch.
STOCKHOLDER'S EQUITY
Stockholders' equity amounted to $537,188 at September 30, 2006 as
compared to $347,407 at December 31, 2005. The $189,781 increase in
stockholders' equity during first nine months of 2006 was primarily due to net
income of $192,589 and the issuance of 555,547 shares of common stock to
employees as a result of the exercise of stock options and the vesting of stock
awards, offset in part by the repurchase of 1,001,259 shares for $11,014.
Information regarding purchases of our common stock during the nine
months ended September 30, 2006 is as follows:
Average Total number of shares Maximum number of shares that
Share Price purchased as part of publicly may yet be purchased under
Period Number of shares paid announced plans the plans
------------------------------------------------------------------------------------------------------------------------------------
May - May 31 1,001,259 $11.00 -- 5,568,900
We purchased 1,000,000 shares on May 9, 2006 from a corporation
controlled by a member of OCN's Board of Directors at a price of $11.00 per
share. As disclosed in Note 3 to the Interim Consolidated Financial Statements,
we also purchased a total of 1,259 fractional shares in connection with the
Reverse/Forward Split. Our ability to repurchase shares of our common stock is
restricted under the terms of the Guaranty that we entered into with the OTS in
connection with debanking.
INCOME TAX EXPENSE (BENEFIT)
The following table provides details of our income tax expense
(benefit) for the periods indicated:
Three months Nine months
-------------------------- ---------------------------
For the periods ended September 30, 2006 2005 2006 2005
------------------------------------------------------------------------- ------------ ------------ ------------ ------------
Income tax expense (benefit) on income before taxes ..................... $ 9,403 $ 2,282 $ 17,847 $ 3,973
Provision for (reversal of) valuation allowance on deferred tax assets .. -- -- (145,211) (843)
Provision for recapture of base year bad debt reserves .................. -- -- -- 1,967
------------ ------------ ------------ ------------
Total income tax expense (benefit) .................................. $ 9,403 $ 2,282 $ (127,364) $ 5,097
============ ============ ============ ============
34
As disclosed in Note 6 to our Interim Consolidated Financial
Statements, we reversed $145,211 of valuation allowances on our deferred tax
assets during the second quarter of 2006 in order to increase the net deferred
tax asset to the amount that is more likely than not to be realized in future
periods. Our determination that it was appropriate to reverse the valuation
allowances in the second quarter of 2006 was primarily based on the following:
o Cumulative earnings in recent periods;
o Positive outlook for future earnings, including positive changes
in the market factors affecting our Residential Servicing business
that suggest continued strong earnings performance;
o The disposal of nearly all of our non-core assets.
In the second quarter of 2005, we recorded a provision of $1,967
($1,124 net of a related reversal of the valuation allowance on the deferred tax
asset) to recognize a deferred tax liability arising from the recapture of bad
debt reserves in connection with our termination of the Bank's status as a
federal savings bank.
Income tax expense on income before income taxes differs from amounts
that would be computed by applying the Federal corporate income tax rate of 35%
primarily because of the effect of foreign taxes, foreign income with an
indefinite deferral from U.S. taxation, losses from consolidated VIEs, state
taxes, low-income housing tax credits and changes in the deferred tax valuation
allowance. Excluding the effect of the reversal of valuation allowances on
deferred tax assets in the second quarter of 2006, our effective tax rate was
27.36% for the first nine months of 2006. Excluding the effect of the one-time
provision for the recapture of bad debt reserves in the second quarter of 2005,
our effective tax rate was 21.67% for the first nine months of 2005. We estimate
our effective tax rate based on projected full-year results, and we revise the
estimate quarterly during the year.
LIQUIDITY, COMMITMENTS AND OFF-BALANCE SHEET RISKS
Liquidity
Our primary sources of funds for liquidity are:
o Lines of credit and other secured borrowings o Servicing fees
o Match funded liabilities o Payments received on trading securities
o Debt securities o Interest payments on and proceeds from
sales of loans
We closely monitor our liquidity position and ongoing funding
requirements. At September 30, 2006, we had $190,856 of unrestricted cash, which
represented 10% of total assets. We also had $222,611 of investment grade
securities at September 30, 2006. Total cash and investment grade securities
comprised 22% of total assets at September 30, 2006. Under certain of our credit
facilities, we are required to maintain minimum liquidity levels. Among the
risks and challenges associated with our funding activities are the following:
o Cash requirements to fund our acquisition of additional servicing rights
and related advances and to fund existing operations and growth in other
core business lines.
o The maturity of existing secured lines of credit and repurchase
agreements at various dates through August 2007, subject to the renewals
of these agreements. We had an aggregate balance of $350,976 outstanding
under these agreements at September 30, 2006. In addition, one of our
match funded agreements expires in January 2007. The balance outstanding
under this agreement was $94,524 at September 30, 2006.
35
Our credit facilities are summarized as follows:
Unused Borrowing Balance Outstanding
Maturity Capacity September 30, 2006
--------------------- ---------------- ------------------
Residential Servicing:
Match funded liability ............ Nov. 2011 - Mar. 2014 $ 13,345 $ 261,655
Match funded liability ............ Jan. 2007 30,476 94,524
Secured line of credit ............ Aug. 2007 125,257 159,743
---------------- -----------------
169,078 515,922
---------------- -----------------
Residential Origination Services:
Repurchase agreement .............. Aug. 2007 12,544 122,456
Repurchase agreement .............. Jun. 2007 33,039 41,961
Repurchase agreement .............. Feb. 2007 4,517 5,483
Repurchase agreement .............. Apr. 2036 -- 2,216
Secured line of credit ............ Jun. 2007 53,667 21,333
---------------- -----------------
103,767 193,449
---------------- -----------------
Corporate Items and Other:
Mortgage .......................... Oct. 2014 -- 14,443
Convertible Notes ................. Aug. 2024 -- 96,900
Capital Securities ................ Aug. 2027 -- 53,429
---------------- -----------------
-- 164,772
---------------- -----------------
$ 272,845 $ 874,143
================ =================
We grow our Residential Servicing business primarily through the
purchase of servicing rights or by entering into subservicing agreements.
Servicing rights entitle us as the owner to earn servicing fees and other types
of ancillary income, but they also impose on us various obligations as the
servicer. Among these are the obligations to advance our own funds to meet
contractual principal and interest payments for certain investors and to pay
taxes, insurance and various other items that are required to preserve the
assets being serviced.
Our ability to expand our Residential Servicing business depends in
part on our ability to obtain additional financing to purchase new servicing
rights and to fund servicing advances. We currently use a variety of sources of
debt to finance these assets, including match funded agreements and secured
credit facilities. Our credit facilities provide funds to us in amounts that are
less than the full value of the related servicing assets that serve as
collateral for the credit facilities. If we cannot replace or renew these
sources as they mature or obtain additional sources of financing, we may be
unable to acquire new servicing rights or make the associated advances.
We believe that our existing sources of liquidity, including internally
generated funds, will be adequate to fund planned activities, although there can
be no assurances in this regard. At September 30, 2006, we had $272,845 of
unused borrowing capacity under existing credit agreements. We continue to
evaluate other sources of liquidity, such as lines of credit from unaffiliated
parties, match funded debt and other secured borrowings. We are examining all of
our asset classes to identify additional funding opportunities including
receivables, the balance of which amounted to $58,265 at September 30, 2006. We
are also examining opportunities to obtain additional funding on loans held for
resale during the holding period and to increase financing on our servicing
rights and advances.
Total cash and investment grade securities, which are primarily
comprised of cash equivalents, increased by $143,547 during the nine months
ended September 30, 2006. Operating activities for this same period provided
$351,246 of cash. Cash used by investing and financing activities primarily
consisted of the purchase of $102,198 of mortgage servicing rights, the
investment of $45,809 in BMS, and the repayment of $285,947 of credit lines and
other secured borrowings. A more detailed discussion of cash flows follows.
Our operating activities provided $351,246 and used $23,550 of cash
flows during the nine months ended September 30, 2006 and 2005, respectively.
The higher net cash flows provided by operating activities in 2006 primarily
reflects a significant decline in loans held for resale during the year as a
result of sales and securitizations. During the first nine months of 2006,
proceeds from sales and securitizations of loans held for resale exceeded
purchases and originations during the period by $474,212. Also, $50,685 of
principal payments were received on loans held for resale during the first nine
months of 2006. During the first nine months of 2005, originations exceeded
sales and securitizations by $79,481. Partially offsetting the increase in cash
flows in 2006 from loans held for resale is an increase in cash used by trading
activities, largely reflecting an increase in investment grade securities.
Although net income for 2006 increased by $179,349, it includes a tax benefit of
$127,364 primarily reflecting the reversal of $145,211 of deferred tax asset
valuation allowances.
Our investing activities used cash flows totaling $149,271 and $39,617
during the nine months ended September 30, 2006 and 2005, respectively. The
increase in cash flows used by investing activities in 2006 is primarily due to
our $45,809 investment in BMS Holdings and a $45,490 increase in purchases of
mortgage servicing rights.
36
Our financing activities used cash flows of $279,354 and $291,051
during the nine months ended September 30, 2006 and 2005, respectively. Cash
flows used by financing activities in the first nine months of 2006 primarily
reflect a net decrease in collateralized borrowing agreements used to finance
loans held for resale. Net repayments of lines of credit and other secured
borrowings amounted to $285,497 during the first nine months of 2006 as compared
to net proceeds from borrowings of $47,655 for the same period of 2005. Cash
flows used by financing activities during the first nine months of 2005 reflect
a $376,591 decline in deposits and escrow deposits as a result of debanking.
Commitments
We believe that we have adequate resources to fund all unfunded
commitments to the extent required and meet all contractual obligations as they
come due. Such contractual obligations include our Convertible Notes, Capital
Trust Securities, lines of credit and other secured borrowings and operating
leases. See Note 9 to the Interim Consolidated Financial Statements for
additional information regarding commitments and contingencies.
Off-Balance Sheet Risks
As of September 30, 2006 we had outstanding commitments to fund
mortgage loans of $79,999 and outstanding commitments to sell $15,150 of our
loans held for resale.
In addition to commitments to extend credit, we are party to various
off-balance sheet financial instruments in the normal course of our business to
manage our interest rate risk and foreign currency exchange rate risk. We have
also committed to fund operating cash deficits of certain affordable housing
properties that we have sold.
We conduct business with a variety of financial institutions and other
companies in the normal course of business, including counterparties to our
off-balance sheet financial instruments. We are subject to potential financial
loss if the counterparty is unable to complete an agreed upon transaction. We
seek to limit counterparty risk through financial analysis, dollar limits and
other monitoring procedures.
RECENT ACCOUNTING DEVELOPMENTS
During the first quarter of 2006, we adopted SFAS No. 123(R),
"Share-Based Payment"; however, it did not have a material effect on our
consolidated financial statements. For additional information regarding recent
accounting pronouncements, see Note 2 to the Interim Consolidated Financial
Statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk includes interest rate risk, foreign currency exchange rate
risk and liquidity risk. We are exposed to interest rate risk to the degree that
our interest-bearing liabilities mature or reprice at different speeds, or
different bases, than our interest-earning assets. We are exposed to foreign
currency exchange rate risk in connection with our investment in non-U.S. dollar
functional currency operations and to the extent our foreign exchange positions
remain unhedged. Market risk also reflects the risk of declines in the valuation
of trading securities, mortgage servicing rights and in the value of the
collateral underlying loans.
We are also exposed to liquidity risk primarily because of the highly
variable daily cash requirements to support the Residential Servicing business
including acquisitions of mortgage servicing rights, the requirement to make
advances pursuant to servicing contracts and the process of remitting borrower
payments to the custodial accounts. In general, we finance our operations
through operating cash flows and various other sources including long-term debt,
secured lines of credit, match funded agreements and repurchase agreements. See
"Liquidity, Commitments and Off-Balance Sheet Risks" for additional discussion
regarding liquidity.
The primary risk associated with mortgage servicing rights is that they
will lose a portion of their value as a result of higher than anticipated
prepayments occasioned by declining interest rates and rising house prices or
because of higher than anticipated delinquency rates occasioned by deteriorating
credit conditions. Interest rates, prepayment speeds and the payment performance
of the underlying loans significantly affect both our initial and ongoing
valuations and the rate of amortization of mortgage servicing rights. As of
September 30, 2006, the carrying value and estimated fair value of our
residential mortgage servicing rights were $171,984 and $243,666, respectively.
Our Residential Servicing business is characterized by non-interest
earning assets financed by interest-bearing liabilities. Among the more
significant non-interest earning assets are servicing advances and mortgage
servicing rights. At September 30, 2006, we had residential servicing advances
of $684,846 consisting of advances on loans serviced for others of $294,271 and
match funded advances on loans serviced for others of $390,575.
37
We are also exposed to interest rate risk because earnings on our
residential servicing float balances are affected by short-term interest rates.
These float balances, which are not included in our financial statements,
amounted to approximately $723,900 at September 30, 2006. We report these
earnings as a component of servicing and subservicing fees.
Partially offsetting this risk is the fact that a large component of
our outstanding debt is variable rate debt. Therefore, declining rates will also
reduce our interest expense for that financing. At September 30, 2006, the
combined balance of our match funded liabilities, debt securities, lines of
credit and other secured borrowings totaled $874,143. Of this amount $709,371,
or 81%, was variable rate debt, for which debt service costs are sensitive to
changes in interest rates, and $164,772 was fixed rate debt.
Our balance sheet at September 30, 2006 included interest-earning
assets totaling $537,805, including $212,895 of loans held for resale and
$222,611 of investment grade securities.
Impact of Changes in Interest Rates on the Net Value of Interest Rate-Sensitive
Financial Instruments
We perform an interest rate sensitivity analysis of our mortgage
servicing rights portfolio every quarter. We currently estimate that the fair
value of the portfolio increases or decreases by approximately 2% for every 50
basis point increase or decrease in interest rates. This sensitivity analysis is
limited in that it was performed at a particular point in time; only
contemplates certain movements in interest rates; does not incorporate changes
in interest rate volatility; is subject to the accuracy of various assumptions
used, including prepayment forecasts and discount rates; and does not
incorporate other factors that would impact our overall financial performance in
such scenarios. We carry mortgage servicing rights at the lower of amortized
cost or fair value by strata. To the extent that fair value were to decline
below amortized cost, we would record an impairment charge to earnings and
establish a valuation allowance. A subsequent increase in fair value could
result in the recovery of some or all of a previously established valuation
allowance. However, an increase in fair value of a particular stratum above its
amortized cost would not be reflected in current earnings. For these reasons,
this interest rate sensitivity estimate should not be viewed as an earnings
forecast.
Our Investment Management Committee is authorized to utilize a wide
variety of off-balance sheet financial techniques to assist it in the management
of interest rate risk and foreign currency exchange rate risk. These techniques
include interest rate exchange contracts or "swap" agreements, interest rate
caps and floors, U.S. Treasury interest rate futures contracts, Eurodollar
futures contracts, foreign currency futures contracts, foreign currency forwards
and European swaptions and put options.
We have entered into foreign currency futures to hedge our net
investment in the foreign subsidiary that owns the UK residuals. The notional
amount of these futures was (pound)11,938 ($22,349) at September 30, 2006. Our
principal exposure to foreign currency exchange rates exists with the British
Pound versus the U.S. dollar. Our operations in India and the foreign operations
of GSS and BOK also expose us to foreign currency exchange rate risk. However,
this risk is insignificant.
We have also entered into Eurodollar interest rate futures and interest
rate swaps to hedge our exposure to interest rate risk represented by our loans
held for resale prior to their sale or securitization. The notional amounts of
the futures and the interest rate swaps were $722,000 and $70,000, respectively,
at September 30, 2006.
ITEM 4. CONTROLS AND PROCEDURES
Our management, with the participation of our chief executive officer
and chief financial officer, evaluated the effectiveness of our disclosure
controls and procedures (as defined in Rules 13a-15(e) under the Securities
Exchange Act) as of September 30, 2006. Based on this evaluation, our chief
executive officer and chief financial officer concluded that, as of September
30, 2006, our disclosure controls and procedures (1) were designed to ensure
that material information relating to OCN, including its consolidated
subsidiaries, is made known to our chief executive officer and chief financial
officer by others within those entities, particularly during the period in which
this report was being prepared and (2) were operating effectively in that they
provide reasonable assurance that information required to be disclosed by OCN in
the reports that it files or submits under the Securities Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms.
No change in our internal control over financial reporting (as defined
in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred
during the fiscal quarter ended September 30, 2006 that has materially affected,
or is reasonably likely to materially affect, our internal control over
financial reporting.
38
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
See "Note 9 Commitments and Contingencies" of the Interim Consolidated
Financial Statements for information regarding legal proceedings.
ITEM 1A. RISK FACTORS
See our discussion of risk factors on page 18 of "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
ITEM 6. EXHIBITS
(3) Exhibits. (Exhibits marked with a " * " denote management contracts or
compensatory plans or agreements)
2.1 Agreement of Merger dated as of July 25, 1999 among Ocwen
Financial Corporation, Ocwen Asset Investment Corp. and
Ocwen Acquisition Company (1)
2.2 Stock Purchase Agreement dated as of May 23, 2006 by and
among Bankruptcy Management Solutions, Inc., Its
Stockholders and Warrant Holder, and BMS Holdings,
Inc. (2)
2.3 Amendment No.1 dated July 31, 2006 to the Stock Purchase
Agreement by and among Bankruptcy Management Solutions,
Inc., Its Stockholders and Warrant Holder, and BMS
Holdings, Inc. The company agrees to furnish
supplementally a copy of any omitted schedule to the
Commission upon request (2)
3.1 Amended and Restated Articles of Incorporation (3)
3.2 Amended and Restated Bylaws (4)
4.0 Form of Certificate of Common Stock (3)
4.1 Certificate of Trust of Ocwen Capital Trust I (5)
4.2 Amended and Restated Declaration of Trust of Ocwen Capital
Trust I (5)
4.3 Form of Capital Security of Ocwen Capital Trust I
(included in Exhibit 4.4) (5)
4.4 Form of Indenture relating to 10.875% Junior Subordinated
Debentures due 2027 of OCN (5)
4.5 Form of 10.875% Junior Subordinated Debentures due 2027 of
OCN (included in Exhibit 4.6) (5)
4.6 Form of Guarantee of OCN relating to the Capital
Securities of Ocwen Capital Trust I (5)
4.7 Registration Rights Agreement dated as of July 28, 2004,
between OCN and Jeffries & Company Inc. (6)
4.8 Indenture dated as of July 28, 2004, between OCN and the
Bank of New York Trust Company, N.A., as trustee (6)
10.1* Ocwen Financial Corporation 1996 Stock Plan for Directors,
as amended (7)
10.2* Ocwen Financial Corporation 1998 Annual Incentive Plan (8)
10.3 Compensation and Indemnification Agreement, dated as of
May 6, 1999, between OAC and the independent committee of
the Board of Directors (9)
10.4 Indemnity agreement, dated August 24, 1999, among OCN and
OAC's directors (10)
10.5* Amended Ocwen Financial Corporation 1991 Non-Qualified
Stock Option Plan, dated October 26, 1999 (10)
10.6 First Amendment to Agreement, dated March 30, 2000 between
HCT Investments, Inc. and OAIC Partnership I, LP (10)
10.7* Ocwen Financial Corporation Deferral Plan for Directors,
dated March 7, 2005 (11)
10.8 Collateral Trust Agreement, dated June 28, 2005, between
OCN and the Bank of New York Trust Company, N.A. (12)
10.9 Guaranty, dated June 28, 2005, from OCN to the Guaranteed
Parties (12)
10.10 Cash Collateral Agreement, dated June 28, 2005, among OCN,
Bank of New York Trust Company, N.A. as collateral Trustee
and Bank of New York Trust Company, N.A. as Account
Bank (12)
10.11 Stock Purchase Agreement, dated May 5, 2006, between
Wishco, Inc. and OCN (13)
31.1 Certification of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith)
31.2 Certification of the Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 (filed
herewith)
32.1 Certification of the Chief Executive Officer pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 (filed herewith)
32.2 Certification of the Chief Financial Officer pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 (filed herewith)
(1) Incorporated by reference from a similarly described exhibit included
with the Registrant's Current Report on Form 8-K filed with the
Commission on July 26, 1999.
(2) Incorporated by reference from the similarly described exhibit included
with the Registrant's Quarterly Report on Form 10-Q for the quarterly
period ended June 30, 2006.
39
(3) Incorporated by reference from the similarly described exhibit filed in
connection with the Registrant's Registration Statement on Form S-1
(File No. 333-5153) as amended, declared effective by the commission on
September 25, 1996.
(4) Incorporated by reference from the similarly described exhibit included
with the Registrant's Annual Report on Form 10-K for the year ended
December 31, 1998.
(5) Incorporated by reference from the similarly described exhibit filed in
connection with our Registration Statement on Form S-1 (File No.
333-28889), as amended, declared effective by the Commission on August
6, 1997.
(6) Incorporated by reference from the similarly described exhibit included
with Registrant's Quarterly Report on Form 10-Q for the quarterly
period ended June 30, 2004.
(7) Incorporated by reference from the similarly described exhibit filed in
connection with the Registrant's Registration Statement on Form S-8
(File No. 333-44999), effective when filed with the Commission on
January 28, 1998.
(8) Incorporated by reference from the similarly described exhibit to our
definitive Proxy Statement with respect to our 1998 Annual Meeting of
Shareholders as filed with the Commission on March 31, 1998.
(9) Incorporated by reference from OAC's Quarterly Report on Form 10-Q for
the quarterly period ended September 30, 1999. (10) Incorporated by
reference from the similarly described exhibit included with the
Registrant's Quarterly Report on
Form 10-Q for the quarterly period ended March 31, 2000.
(11) Incorporated by reference from the similarly described exhibit included
with the Registrant's Annual Report on Form 10-K for the year ended
December 31, 2004.
(12) Incorporated by reference from the similarly described exhibit included
with the Registrant's Quarterly Report on Form 10-Q for the quarterly
period ended June 30, 2005.
(13) Incorporated by reference from the similarly described exhibit included
with the Registrant's Form 8-K filed with the Commission on May 11,
2006
40
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
OCWEN FINANCIAL CORPORATION
Date: November 9, 2006 By: /s/ DAVID J. GUNTER
-----------------------------------------
David J. Gunter, Senior Vice President &
Chief Financial Officer
(On behalf of the Registrant and as its
principal financial officer)
41