UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

Form 10-Q

 

 

Commission file number 033-19694

 

FirstCity Financial Corporation

(Exact name of registrant as specified in its charter)

 

 

(254) 761-2800

(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 ý     No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). 
Yes o     No ý

 

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

 

The number of shares of common stock, par value $.01 per share, outstanding at November 1, 2005 was 11,307,187.

 

 

TABLE OF CONTENTS

 

PART I
Item 1.  Financial Statements
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
Item 4.  Controls and Procedures
PART II
OTHER INFORMATION
Item 1.  Legal Proceedings
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.  Defaults Upon Senior Securities
Item 4.  Submission of Matters to a Vote of Security Holders
Item 5.  Other Information
Item 6.  Exhibits
SIGNATURES
Exhibit Index
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification of CEO Pursuant to Section 906
Certification of CFO Pursuant to Section 906

 

 

Table of Contents

 

PART I

 

FINANCIAL INFORMATION

 

Item 1.  Financial Statements.

 

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

 

		September 30,			December 31,
		2005			2004
		(Unaudited)
ASSETS
Cash and cash equivalents		$	7,522		$	9,724
Portfolio Assets, net		43,197			37,952
Loans receivable from Acquisition Partnerships held for investment		19,394			21,255
Equity investments		65,652			57,815
Deferred tax asset, net		20,101			20,101
Service fees receivable from affiliates		1,269			1,631
Other assets, net		7,851			8,562
Discontinued mortgage assets		167			1,817
Total Assets		$	165,153		$	158,857
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Notes payable to affiliates		$	671		$	491
Notes payable other		61,538			50,812
Minority interest		1,207			1,292
Liabilities from discontinued consumer operations		311			9,033
Liabilities from discontinued mortgage operations		—			50
Other liabilities		4,160			4,756
Total Liabilities		67,887			66,434
Commitments and contingencies (note 12)
Stockholders’ equity:
Optional preferred stock (par value $.01 per share; 98,000,000 shares authorized; no shares issued or outstanding)		—			—
Common stock (par value $.01 per share; 100,000,000 shares authorized; shares issued and outstanding: 11,299,687 and 11,260,687, respectively)		113			113
Paid in capital		99,809			99,364
Accumulated deficit		(4,006		)	(10,289		)
Accumulated other comprehensive income		1,350			3,235
Total Stockholders’ Equity		97,266			92,423
Total Liabilities and Stockholders’ Equity		$	165,153		$	158,857

 

See accompanying notes to consolidated financial statements.

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2005			2004			2005			2004
Revenues:
Servicing fees from affiliates		$	2,891		$	3,328		$	8,972		$	10,076
Gain on resolution of Portfolio Assets		1,299			601			4,366			838
Interest income from affiliates		420			653			1,293			1,694
Loan interest income		825			215			1,903			339
Other income		269			489			1,079			2,303
Total revenues		5,704			5,286			17,613			15,250
Expenses:
Interest and fees on notes payable to affiliates		9			12			27			57
Interest and fees on notes payable — other		909			2,074			2,619			5,580
Interest on shares subject to mandatory redemption		—			66			—			199
Salaries and benefits		3,571			3,673			11,413			11,227
Provision for loan and impairment losses		322			1			436			23
Occupancy, data processing, communication and other		1,908			2,141			5,574			5,374
Total expenses		6,719			7,967			20,069			22,460
Equity in earnings of investments		1,783			3,656			8,874			10,470
Earnings from continuing operations before income taxes and minority interest		768			975			6,418			3,260
Income tax benefit (expense)		(79		)	11			(321		)	(145		)
Minority interest		3			(34		)	(36		)	(43		)
Earnings from continuing operations		692			952			6,061			3,072
Discontinued operations
Earnings (loss) from discontinued operations		(281		)	2,211			(378		)	8,666
Income taxes		600			(255		)	600			(682		)
Net earnings from discontinued operations		319			1,956			222			7,984
Net earnings		$	1,011		$	2,908		$	6,283		$	11,056
Basic earnings per common share are as follows:
Earnings from continuing operations		$	0.06		$	0.09		$	0.54		$	0.28
Discontinued operations		$	0.03		$	0.17		$	0.02		$	0.71
Net earnings to common stockholders		$	0.09		$	0.26		$	0.56		$	0.99
Weighted average common shares outstanding		11,298			11,236			11,278			11,223
Diluted earnings per common share are as follows:
Earnings from continuing operations		$	0.05		$	0.08		$	0.50		$	0.26
Discontinued operations		$	0.03		$	0.17		$	0.02		$	0.68
Net earnings to common stockholders		$	0.08		$	0.25		$	0.52		$	0.94
Weighted average common shares outstanding		12,008			11,837			12,012			11,816

 

See accompanying notes to consolidated financial statements.

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

(Dollars in thousands)

(Unaudited)

 

													Accumulated
		Number of											Other			Total
		Common		Common			Paid in			Accumulated			Comprehensive			Stockholders’
		Shares		Stock			Capital			Deficit			Income			Equity
Balances, December 31, 2003		11,193,687		$	112		$	99,168		$	(73,923	)	$	3,612		$	28,969
Exercise of common stock options		67,000		1			196			—			—			197
Comprehensive income:
Net earnings for 2004		—		—			—			63,634			—			63,634
Translation adjustments		—		—			—			—			(377		)	(377		)
Total comprehensive income																63,257
Balances, December 31, 2004		11,260,687		113			99,364			(10,289		)	3,235			92,423
Exercise of common stock options		39,000		—			162			—			—			162
Additional paid-in capital arising from sale of shares by investee		—		—			283			—			—			283
Comprehensive income:
Net earnings for the first nine months of 2005		—		—			—			6,283			—			6,283
Translation adjustments		—		—			—			—			(1,885		)	(1,885		)
Total comprehensive income																4,398
Balances, September 30, 2005		11,299,687		$	113		$	99,809		$	(4,006	)	$	1,350		$	97,266

 

See accompanying notes to consolidated financial statements.

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

		Nine Months Ended
		September 30,
		2005			2004
Cash flows from operating activities:
Net earnings		$	6,283		$	11,056
Adjustments to reconcile net earnings to net cash used in operating activities:
Net earnings from discontinued operations		(222		)	(7,984		)
Purchase of Portfolio Assets and loans receivable, net		(19,306		)	(38,237		)
Proceeds applied to principal on Portfolio Assets and loans receivable		20,189			9,195
Gain on resolution of Portfolio Assets		(4,366		)	(838		)
Capitalized interest and costs on Portfolio Assets and loans receivable		(217		)	(138		)
Provision for loan and impairment losses		436			23
Equity in earnings of investments		(8,874		)	(10,470		)
Depreciation and amortization		661			612
Decrease in service fees receivable from affiliate		362			504
Increase in other assets		(489		)	(81		)
Change in debt imputed value		214			(759		)
Decrease in other liabilities		(1,722		)	(3,232		)
Net cash used in operating activities		(7,051		)	(40,349		)
Cash flows from investing activities:
Property and equipment, net		(108		)	(168		)
Contributions to Acquisition Partnerships and Servicing Entities		(18,373		)	(9,732		)
Distributions from Acquisition Partnerships and Servicing Entities		17,907			22,074
Net cash provided by (used in) investing activities		(574		)	12,174
Cash flows from financing activities:
Borrowings under notes payable — other		68,622			60,767
Payments of notes payable to affiliates		(34		)	(18		)
Payments of notes payable — other		(56,427		)	(29,345		)
Payment of dividends on preferred stock		—			(1,392		)
Proceeds from issuance of common stock		162			121
Net cash provided by financing activities		12,323			30,133
Net cash provided by continuing operations		4,698			1,958
Net cash provided by (used in) discontinued operations		(6,900		)	562
Net increase (decrease) in cash and cash equivalents		(2,202		)	2,520
Cash and cash equivalents, beginning of period		9,724			2,745
Cash and cash equivalents, end of period		$	7,522		$	5,265
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest		$	1,982		$	5,073
Income taxes		317			779

 

See accompanying notes to consolidated financial statements.

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2005

(Dollars in thousands, except per share data)

(Unaudited)

 

(1)  Basis of Presentation

 

FirstCity Financial Corporation (the “Company” or “FirstCity”) is a financial services company with offices throughout the United States and Mexico, with a presence in France and South America. At September 30, 2005, the Company was engaged in one principal reportable segment - portfolio asset acquisition and resolution.  The portfolio asset acquisition and resolution business involves acquiring portfolios of loans, real estate and other assets or single assets (collectively referred to as “Portfolios” or  “Portfolio Assets”) at a discount to face value and servicing and resolving such Portfolios in an effort to maximize the present value of the ultimate cash recoveries.  On September 21, 2004, FirstCity and certain of its subsidiaries entered into a Securities Purchase Agreement relating to the sale of a 31% beneficial ownership interest in Drive Financial Services LP (“Drive”) and its general partner, Drive GP LLC, to IFA Drive GP Holdings LLC (“IFA-GP”), IFA Drive LP Holdings LLC (“IFA-LP”) and Drive Management LP (“MG-LP”).  As a result of the execution of the sale agreement, the consumer lending segment conducted through Drive was no longer considered a principal reportable segment and is treated as a discontinued operation.

 

The unaudited consolidated financial statements of FirstCity reflect, in the opinion of management, all adjustments, consisting only of normal and recurring adjustments, necessary to present fairly FirstCity’s consolidated financial position at September 30, 2005, its results of operations for the three and nine month periods ended September 30, 2005 and 2004 and cash flows for the nine month periods ended September 30, 2005 and 2004.  Certain disclosures have been condensed or omitted from these financial statements. Accordingly, these financial statements should be read with the consolidated financial statements included in the Company’s 2004 Annual Report on Form 10-K.  Certain amounts in the consolidated financial statements for prior years have been reclassified to conform with current consolidated financial statement presentation.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include (i) the estimation of future collections on purchased portfolio assets used in the calculation of net gain on resolution of portfolio assets, (ii) interest rate environments, (iii) valuation of the deferred tax asset, and (iv) prepayment speeds and collectibility of loans held in inventory, in securitization trusts and held for investment. Actual results could differ materially from those estimates.

 

(2)  Liquidity and Capital Resources

 

The Company requires liquidity to fund its operations, working capital, payment of debt, equity for acquisition of Portfolio Assets, investments in and advances to entities formed with other investors to acquire Portfolios (“Acquisition Partnerships”) and other investments. The potential sources of liquidity are funds generated from operations, equity distributions from the Acquisition Partnerships, interest and principal payments on subordinated intercompany debt, dividends from the Company’s subsidiaries, borrowings from revolving lines of credit and other credit facilities, proceeds from equity market transactions, securitization and other structured finance transactions and other special purpose short-term borrowings.

 

FirstCity has a $96 million revolving acquisition facility with Bank of Scotland that matures in November 2008.  This facility is used to finance the equity portion of distressed asset pool purchases and to provide for the issuance of Letters of Credit and working capital loans.  The $96 million facility (i) allows loans to be made in Euros up to a maximum amount in Euros that is equivalent to 35 million U.S. dollars, (ii) allows loans to be made for acquisition of Portfolio Assets in Latin America of up to $35 million, (iii) provides for an interest rate of London Interbank Offered Rate (LIBOR) plus 2.50% to 2.75%, (iv) provides for an annual commitment fee of 0.20% of the unused balance of the revolving acquisition facility, and (v) provides that the aggregate borrowings under the facility do not exceed 60% of the net present value of FirstCity’s interest in Portfolio Assets and in Acquisition Partnerships pledged to secure the acquisition facility.

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

In August 2005, FH Partners, L.P., an indirect wholly-owned affiliate of FirstCity, and Bank of Scotland, acting through its New York branch, as agent for itself as lender, entered into a Revolving Credit Agreement that provides a $50 million revolving portfolio acquisition facility for FH Partners, L.P. to be secured by all of the assets of FH Partners, L.P.  The loan facility will be used to finance portfolio and asset purchases.  The facility (i) allows loans to be made for the acquisition of portfolio assets in the United States, (ii) provides that each loan may be in an amount of up to 70% of the net present value of the assets being acquired with the proceeds of the loan, (iii) provides that the aggregate outstanding balances of all loans will not exceed 65% of the net present value of the assets securing the loan facility, (iv) provides for an interest rate of LIBOR plus 2.0%, (v) provides for a commitment fee of 0.20% of the unused balance of the revolving acquisition facility, (vi) provides for a utilization fee of 0.75% of the amount of each loan made under the loan facility, (vii) provides for an upfront fee of $350 thousand, (viii) provides for facility fees of $100 thousand, for the period commencing on the Effective Date to but excluding the first anniversary thereof, $75 thousand, for the period commencing on the first anniversary of the Effective Date to but excluding the second anniversary thereof, and $50 thousand, for each subsequent one-year period, and (ix) provides for a maturity date of November 12, 2008.  The obligations of FH Partners, L.P. under the Revolving Credit Agreement are guaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity.

 

At September 30, 2005, the Company had $10.1 million in Euro-denominated debt for the purpose of hedging a portion of the net equity investments in Europe. In general, the type of risk hedged relates to the foreign currency exposure of net investments in Europe caused by movements in Euro exchange rates. The Company entered into the hedging relationship such that changes in the net investments being hedged are expected to be offset by corresponding changes in the values of the Euro-denominated debt. Effectiveness of the hedging relationship is measured and designated at the beginning of each month by comparing the outstanding balance of the Euro-denominated debt to the carrying value of the designated net equity investments. The net foreign currency translation gain (loss) included in accumulated other comprehensive income relating to the Euro-denominated debt was ($.10) million and $1.2 million, respectively, for the three and nine months ended September 30, 2005 and zero for the same periods in 2004.

 

BoS (USA) Inc. (“BoS (USA)”) has a warrant to purchase 425,000 shares of the Company’s voting Common Stock at $2.3125 per share. BoS (USA) is entitled to additional warrants in connection with this existing warrant for 425,000 shares under certain specific situations to retain its ability to acquire approximately 4.86% of the Company’s voting Common Stock.  The warrant will expire on August 31, 2010, if it is not exercised prior to that date.

 

Management believes that the Bank of Scotland loan facilities, the related fees generated from the servicing of assets and equity distributions from existing Acquisition Partnerships and wholly-owned portfolios will allow the Company to meet its obligations as they come due during the next twelve months.

 

(3)         New Accounting Pronouncements

 

In December 2003, the Accounting Standards Executive Committee issued Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (“SOP 03-3”). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. SOP 03-3 limits the yield that may be accreted on a loan portfolio to the excess of undiscounted expected cash flows over the initial investment in the loan portfolio. SOP 03-3 became effective January 1, 2005. FirstCity accounts for all loans acquired after 2004 in accordance with SOP 03-3. For loans acquired prior to January 1, 2005, FirstCity adopted the provisions of SOP 03-3, as they apply to decreases in cash flows expected to be collected, on a prospective basis.

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”). SFAS 123R supersedes APB Opinion No. 25, which requires recognition of an expense when goods or services are provided. SFAS 123R requires the determination of the fair value of the share-based compensation at the grant date and the recognition of the related expense over the period in which the share-based compensation vests. SFAS 123R permits a prospective or two modified versions of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by the original SFAS No. 123. The Company will utilize the prospective method.  In April 2005, the SEC amended the compliance date of SFAS 123R to allow companies to implement SFAS 123R at the beginning of their next fiscal year.  Therefore, on January 1, 2006, the Company will begin recognizing an expense for unvested share-based compensation that has been issued or will be issued after that date. Based on current unvested stock options

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

outstanding, the Company anticipates approximately $1.7 million in unvested compensation cost at January 1, 2006 to be expensed prospectively.

 

In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004, which provides guidance under SFAS No. 109, Accounting for Income Taxes, with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the “Jobs Act”) on enterprises’ income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. The Jobs Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. Management does not expect FSP No. 109-2 to have an impact on the Company as any taxes on repatriated foreign earnings are offset by the Company’s NOLs.

 

On June 29, 2005, the FASB ratified the consensus reached by Emerging Issues Task Force (“EITF”) on Issue No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity when the Limited Partners Have Certain Rights.  The consensus reached by the EITF at the June 2005 meeting was that a sole general partner is presumed to control a limited partnership (or similar entity) and should consolidate the limited partnership unless (1) the limited partners possess substantive kick-out rights or (2) the limited partners possess substantive participating rights. This ratification of EITF Issue No. 04-5 has caused the amendments of Statement of Position 78-9, Accounting for Investments in Real Estate Ventures,  and EITF Issue No. 96-16, Investor’s Accounting for an Investee When the Investor has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights.  EITF 04-5 is effective for all new and modified agreements effective June 29, 2005. For pre-existing agreements that are not modified, the EITF is effective as of the beginning of the first fiscal reporting period beginning after December 15, 2005. The Company has evaluated the impact of the adoption of EITF 04-5 and does not believe the impact will be significant to the Company’s results of operations or financial position.

 

In November 2005, the FASB issued FASB Staff Position FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“FSP 115-1”).  FSP 115-1 addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impaired loss.  FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments.  The provisions of FSP 115-1 are effective for reporting periods beginning after December 15, 2005.  The Company does not anticipate that this statement will have a significant impact on its financial position or results of operations.

 

(4)  Discontinued Operations

 

Discontinued operations are comprised of two components previously reported as the Company’s residential and commercial mortgage banking business (“Mortgage”) and the consumer lending business conducted through the Company’s minority interest investment in Drive (“Consumer”).  Earnings (loss) from discontinued operations are summarized as follows:

 

		Three Months Ended							Nine Months Ended
		September 30,							September 30,
		2005				2004			2005			2004
Mortgage		$		(252	)	$	(950	)	$	(346	)	$	(1,200	)
Consumer		571				2,906			568			9,184
Net earnings from discontinued operations		$	319			$	1,956		$	222		$	7,984

 

Mortgage

 

At September 30, 2005, the only asset remaining from discontinued mortgage operations is an investment security resulting from the retention of a residual interest in a securitization transaction. This security is in “run-off,” and the Company is contractually obligated to service these assets.  The cash flows are collected over a period of time and are valued using prepayment assumptions of 32% for fixed rate loans and 34% for variable rate loans. Overall loss rates are estimated at 14% of collateral.  The Company recorded provisions of $.3 million and $1.2 million in the first nine months of 2005 and 2004, respectively, for losses from discontinued mortgage operations.

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

In April 2005, the Company exercised an early purchase option on the 1998-1 securitization.  Loans receivable were recorded at $6.1 million in accordance with EITF 02-9, Accounting for Changes That Result in a Transferor Regaining Control of Financial Assets Sold.  FirstCity evaluated each loan at the acquisition date to determine whether there was evidence of credit deterioration since origination.  At September 30, 2005, the acquired loans are included in Portfolio Assets in the consolidated balance sheet and classified as either “loans acquired with credit deterioration” or “loans acquired without credit deterioration.”  See note 5 for a description of the accounting policy for these loans.

 

Consumer

 

On September 21, 2004, FirstCity and certain of its subsidiaries entered into a definitive agreement to sell a 31% beneficial ownership interest in Drive and its general partner, Drive GP LLC, to IFA-GP, IFA-LP and MG-LP for a total purchase price of $108.5 million in cash, resulting in distributions and payments to FirstCity in the aggregate amount of $86.8 million in cash, from various sources.  The sale was completed on November 1, 2004, and net cash proceeds from these transactions were primarily used to pay off debt.

 

Pursuant to SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the consolidated financial statements have been reclassified for all periods presented to reflect the operations, assets and liabilities of the consumer business segment as discontinued operations.  There were no consumer assets held for sale as of September 30, 2005 and December 31, 2004.  The liabilities of such operations have been classified as “Liabilities from discontinued consumer operations,” respectively on the September 30, 2005 and December 31, 2004 balance sheets and consisted primarily of accrued state taxes at September 30, 2005.   The liability at December 31, 2004 related to accrued state taxes and an $8.0 million participation liability owed to Bank of Scotland, which was paid in the first quarter of 2005.  An estimated tax provision of $.6 million was reversed in third quarter of 2005 due to lower than anticipated state income taxes related to the sale of Drive.

 

The net earnings from discontinued consumer operations are classified on the consolidated statements of operations as “Earnings from discontinued operations.”  Summarized results of discontinued consumer operations are as follows:

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2005			2004			2005			2004
Equity in earnings		$	—		$	4,680		$	—		$	14,835
Interest and fees on notes payable to affiliate		—			(584		)	—			(2,001		)
Other expenses		(29		)	—			(32		)	(4		)
Income taxes		600			(255		)	600			(682		)
Minority interest		—			(935		)	—			(2,964		)
Earnings from discontinued consumer operations		$	571		$	2,906		$	568		$	9,184

 

(5)  Portfolio Assets

 

Portfolio Assets are summarized as follows:

 

		September 30,			December 31,
		2005			2004
Loan Portfolios
Loans Acquired Prior to 2005
Non-performing Portfolio Assets		$	11,950		$	19,993
Performing Portfolio Assets		12,388			16,039
Loans Acquired After 2004
Loans acquired with credit deterioration		9,426			—
Loans acquired with no credit deterioration		4,471			—
Outstanding balance		38,235			36,032
Allowance for loan losses		(419		)	—
Carrying amount of loans, net of allowance		37,816			36,032
Real Estate Portfolios, net of allowance		2,985			1,920
Operating Lease Equipment, net		2,396			—
Portfolio Assets, net		$	43,197		$	37,952

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

Portfolio Assets are pledged to secure notes payable that are non-recourse to FirstCity or any affiliate other than the entity that incurred the debt.  See Note 2 for a description of the Revolving Credit agreement between FH Partners, L.P. and Bank of Scotland, which is guaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity.

 

FirstCity primarily acquires loans in groups or portfolios that have experienced deterioration of credit quality between origination and the Company’s acquisition of the loans.  The amount paid for a loan reflects FirstCity’s determination that it is probable the Company will be unable to collect all amounts due according to the loan’s contractual terms.

 

On January 1, 2005, FirstCity adopted the provisions of SOP 03-3.  The adoption of SOP 03-3 did not have a material impact on the Company’s consolidated results of operations.  For loan portfolios acquired prior to January 1, 2005, FirstCity designated these loans as non-performing Portfolio Assets or performing Portfolio Assets.  Such designation was made at the acquisition of the pool and does not change even though the actual performance of the loans may change. FirstCity accounts for all loans acquired after 2004 in accordance with SOP 03-3.  Pursuant to SOP 03-3, the following is a description of each classification and the related accounting policy accorded to each Portfolio type:

 

Loans Acquired Prior to 2005

 

Non-Performing Portfolio Assets

 

Non-performing Portfolio Assets consist primarily of distressed loans and loan related assets, such as foreclosed upon collateral. Prior to January 1, 2005, Portfolio Assets were designated as non-performing if a majority of all of the loans in the Portfolio were significantly under performing in accordance with the contractual terms of the underlying loan agreements at the date of acquisition. Net gain on resolution of non-performing Portfolio Assets is recognized as income to the extent that proceeds collected exceed a pro rata portion of allocated cost from the pool. Cost allocation is based on a proration of actual proceeds divided by total estimated proceeds of the pool. No interest income is recognized separately on non-performing Portfolio Assets. All proceeds, of whatever type, are included in proceeds from resolution of Portfolio Assets in determining the gain on resolution of such assets. Once a non-performing Portfolio Asset becomes impaired, all future proceeds are allocated to reduce the carrying value of the Portfolio.  Accounting for non-performing Portfolios is on a pool basis as opposed to an individual asset-by-asset basis.

 

Performing Portfolio Assets

 

Performing Portfolio Assets consist primarily of Portfolios of consumer and commercial loans acquired at a discount from the aggregate amount of the borrowers’ obligation. Prior to January 1, 2005, performing Portfolio Assets were accounted for using the interest method – acquisition discounts for the Portfolio as a whole are accreted as an adjustment to yield over the estimated life of the Portfolio.  Performing Portfolio Assets are carried at the unpaid principal balance of the underlying loans, net of acquisition discounts and allowance for loan losses. Significant increases in expected future cash flows may be recognized prospectively through an upward adjustment of the internal rate of return (“IRR”) over a portfolio’s remaining life. Any increase to the IRR then becomes the new benchmark for impairment testing. Income on performing Portfolio Assets is accrued monthly based on each loan pool’s effective IRR. Cash flows greater than the interest accrual will reduce the carrying value of the pool. Likewise, cash flows that are less than the accrual will increase the carrying balance. The IRR is estimated and periodically recalculated based on the timing and amount of anticipated cash flows using the Company’s proprietary collection model. Gains are recognized on the performing Portfolio Assets when sufficient funds are received to fully satisfy the obligation on loans included in the pool, either from funds from the borrower or sale of the loan. The gain recognized represents the difference between the proceeds received and the allocated carrying value of the individual loan in the pool.

 

Impairment of Loans Acquired Prior to 2005

 

Management’s best estimate of IRR as of January 1, 2005, is the basis for subsequent impairment testing. If it is probable that all cash flows estimated at acquisition plus any changes to expected cash flows arising from changes in estimates after acquisition would not be collected, the carrying value of a pool would be written down to maintain the then current IRR.  Prior to January 1, 2005, impairment charges would be taken to the income statement with a corresponding write-off of the receivable balance.  Consequently, no allowance for loan loss was recorded prior to January 1, 2005.  For the nine months ended September 30, 2005, FirstCity established an allowance for loan losses by a charge to the income statement of $.4 million.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

A pool can become fully amortized (zero carrying balance on the balance sheet) while still generating cash collections. In this case, all cash collections are recognized as revenue when received. Additionally, the Company uses the cost recovery method when timing and amount of collections on a particular pool of accounts cannot be reasonably predicted. Under the cost recovery method, no revenue is recognized until the Company has fully collected the cost of the portfolio, or until such time that the Company considers the collections to be probable and estimable and begins to recognize income based on the interest method as described above.

 

Loans Acquired After 2004

 

Loans Acquired With Credit Deterioration

 

At acquisition, FirstCity reviews each loan to determine whether there is evidence of deterioration of credit quality since origination and if it is probable that FirstCity will be unable to collect all amounts due according to the loan’s contractual terms. If both conditions exist, FirstCity determines whether each such loan is to be accounted for individually or whether such loans will be assembled into pools of loans based on common risk characteristics (loan type, collateral type, geographical location, performance status and borrower relationship).

 

FirstCity considers expected prepayments, and estimates the amount and timing of undiscounted expected principal, interest, and other cash flows (expected at acquisition) for each loan and each subsequently aggregated pool of loans. FirstCity determines the excess of the loan’s or pool’s scheduled contractual principal and contractual interest payments over all cash flows expected at acquisition as an amount that should not be accreted (nonaccretable difference). The excess of the loan’s cash flows expected to be collected at acquisition over the initial investment in the loan or pool is accreted into interest income over the remaining life of the loan or pool (accretable yield).  Changes in accretable yield at September 30, 2005 were as follows:

 

		Three Months Ended			Nine Months Ended
		September 30,			September 30,
		2005			2005
Beginning Balance		$	2,830		$	—
Additions		326			3,267
Accretion		(250		)	(361		)
Reclassification from (to) nonaccretable difference		—			—
Disposals		(206		)	(206		)
Ending Balance		$	2,700		$	2,700

 

Over the life of the loan or pool, FirstCity continues to estimate cash flows expected to be collected. FirstCity evaluates at the balance sheet date whether the present value of its loans determined using the effective interest rates has decreased below book value and if so, a valuation allowance is established for any impairment identified through provisions charged to operations in the period the impairment is identified. The present value of any subsequent increase in the loan’s or pool’s actual cash flows or cash flows expected to be collected is used first to reverse any existing valuation allowance for that loan or pool. Any remaining increases in the present value of cash flows expected to be collected will be used to recalculate the amount of accretable yield recognized on a prospective basis over the pool’s remaining life.

 

FirstCity establishes valuation allowances for all acquired loans subject to SOP 03-3 to reflect only those losses incurred after acquisition—that is, the present value of cash flows expected at acquisition that are not expected to be collected. Valuation allowances are established only subsequent to acquisition of the loans.  As of September 30, 2005, FirstCity did not establish an allowance for acquired loans subject to SOP 03-3.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

Loans acquired during each period for which it was probable at acquisition that all contractually required payments would not be collected are as follows:

 

		Three Months Ended			Nine Months Ended
		September 30,			September 30,
		2005			2005
Face value at acquisition		$	1,354		$	15,851
Cash flows expected to be collected at acquisition		1,311			15,004
Basis in acquired loans at acquisition		985			11,737

 

Loans Acquired With No Credit Deterioration

 

Loans acquired without evidence of credit deterioration at acquisition for which FirstCity has the positive intent and ability to hold for the foreseeable future are classified as held for investment and reported at their unpaid principal balance net of unamortized purchase discounts or premiums. The net unamortized purchase discounts as of September 30, 2005 and December 31, 2004 were $36 thousand and zero, respectively.

 

Interest accrual ceases when payments become 90 days contractually past due.  An allowance for loan losses is established when a loan becomes impaired.  A loan is impaired when full payment under the loan terms is not expected.  Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Loan losses are charged against the allowance when management believes that the uncollectibility of a loan balance is confirmed.  At September 30, 2005, the Company had established a valuation allowance of $22 thousand on these loans.

 

Real Estate Portfolios

 

Real estate Portfolios consist of real estate acquired from a variety of sellers. Such Portfolios are carried at the lower of cost or fair value less estimated costs to sell. Costs relating to the development and improvement of real estate for its intended use are capitalized, whereas those relating to holding assets are charged to expense. Income or loss is recognized upon the disposal of the real estate. Rental income, net of expenses, on real estate Portfolios is recognized when received. Accounting for the Portfolios is on an individual asset-by-asset basis as opposed to a pool basis. Subsequent to acquisition, the amortized cost of a real estate Portfolio is evaluated for impairment on a quarterly basis. The evaluation of impairment is determined based on the review of the estimated future cash receipts, which represents the net realizable value of the real estate Portfolio. A valuation allowance is established for any impairment identified through provisions charged to operations in the period the impairment is identified. The Company recorded an allowance of $18 thousand for impairment charges during the nine months ended September 30, 2005 and none during the nine months ended September 30, 2004.

 

Operating Lease Equipment

 

Operating lease equipment is carried at cost less accumulated depreciation and is depreciated to estimated residual value using the straight-line method over the estimated useful life or the term of the lease.  Income from this operating lease is reported on a straight-line basis over, and in accordance with, the terms of the lease.

 

(6)  Loans Receivable from Acquisition Partnerships Held for Investment

 

Loans receivable from Acquisition Partnerships held for investment consist primarily of loans from certain partnerships located in Mexico and are summarized as follows:

 

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

The loans receivable from Acquisition Partnerships are secured by the assets/loans acquired by the partnerships with purchase money loans provided by affiliates of the investors to the partnerships to purchase the asset pools held in those entities. These loans are evaluated for impairment by analyzing the expected future cash flows from the underlying assets within each pool to determine that the cash flows were sufficient to repay these notes. The Company applies the asset valuation methodology consistently in all venues and uses the same proprietary asset management system to evaluate impairment on all asset pools. The results of this evaluation indicated that cash flows from the pools will be sufficient to repay the loans and no allowances for impairment were necessary.

 

Equity method losses which were recorded to reduce the loans and interest receivable from certain Mexican partnerships were $.5 million and $.4 million during the first nine months of 2005 and 2004, respectively, in compliance with EITF 98-13, Accounting by an Equity Method Investor for Investee Losses When the Investor Has Loans to and Investments in Other Securities of the Investee.

 

(7)  Equity Investments

 

The Company has investments in Acquisition Partnerships and their general partners and investments in servicing entities that are accounted for under the equity method. During the first quarter of 2005, FirstCity invested $2.0 million to increase its ownership percentage in MCS et Associes, S.A. (“MCS”), a French servicing company, from 10% to 12% and in PRL Development, SAS, a French Acquisition Partnership, from 33% to 43%. These additional investments provided a combined direct and indirect ownership interest in MCS of 18.3%.

 

In 2005, MCS sold its investment in Common Stock of FirstCity resulting in a gain of $1.5 million.  FirstCity accounted for its proportionate interest in this gain as an increase in the Company’s carrying amount of its investment in MCS of $.3 million and an increase in additional paid-in capital.

 

The condensed combined financial position and results of operations of the Acquisition Partnerships (excluding servicing entities), which include the domestic and foreign Acquisition Partnerships and their general partners, are summarized below:

 

Condensed Combined Balance Sheets

 

		September 30,			December 31,
		2005			2004
Assets		$	410,048		$	479,776
Liabilities		$	363,299		$	410,469
Net equity		46,749			69,307
		$	410,048		$	479,776
Equity investment in Acquisition Partnerships		$	59,830		$	52,410
Equity investment in servicing entities		5,822			5,405
		$	65,652		$	57,815

 

Condensed Combined Summary of Operations

 

		Three Months Ended						Nine Months Ended
		September 30,						September 30,
		2005			2004			2005			2004
Proceeds from resolution of Portfolio Assets		$	35,637		$	72,738		$	136,310		$	198,370
Gain on resolution of Portfolio Assets		14,668			21,842			52,455			64,551
Interest income on Portfolio Assets		2,267			2,365			7,022			7,530
Net earnings (loss)		$	(981	)	$	11,849		$	19,925		$	28,704
Equity in earnings of Acquisition Partnerships		$	1,975		$	3,507		$	8,385		$	9,844
Equity in earnings (loss) of servicing entities		(192		)	149			489			626
		$	1,783		$	3,656		$	8,874		$	10,470

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

The assets and equity of the Acquisition Partnerships and equity investments in the Acquisition Partnerships are summarized by geographic region below. The WAMCO Partnerships represent limited partnerships and limited liability companies in which the Company has a common ownership with Cargill.  MinnTex Investment Partners LP is considered to be a significant subsidiary of FirstCity.

 

 

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (continued)

 

Revenues and earnings (loss) of the Acquisition Partnerships and equity in earnings (loss) of the Acquisition Partnerships are summarized by geographic region below.

 

		Three Months Ended											Nine Months Ended
		September 30,											September 30,
		2005								2004			2005			2004
Revenues:
Domestic:
WAMCO Partnerships		$						4,591		$	7,743		$	21,599		$	22,592
MinnTex Investment Partners LP		991								2,110			4,098			6,914
Other		866								22			932			70
Latin America		6,053								7,473			17,267			18,284
Europe		4,686								8,821			16,202			26,699
		$					17,187			$	26,169		$	60,098		$	74,559
Net earnings (loss):
Domestic:
WAMCO Partnerships		$				2,079				$	3,822		$	9,706		$	10,841
MinnTex Investment Partners LP		900								1,885			3,676			6,169
Other		614								(165		)	381			(549		)
Latin America		(7,522							)	562			(4,777		)	(5,167		)
Europe		2,948								5,745			10,939			17,410
		$			(981				)	$	11,849		$	19,925		$	28,704
Equity in earnings (loss) of Acquisition Partnerships:
Domestic:
WAMCO Partnerships		$		1,162						$	1,852		$	4,518		$	5,099
MinnTex Investment Partners LP		297								622			1,213			2,036
Other		325								(54		)	277			(172		)
Latin America		(441							)	(70		)	(250		)	(849		)
Europe		632								1,157			2,627			3,730
		$	1,975							$	3,507		$	8,385		$	9,844

 

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