UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FirstCity Financial Corporation

Delaware (State or other jurisdiction of incorporation or organization)		76-0243729 (I.R.S. Employer Identification No.)
6400 Imperial Drive, Waco, TX (Address of principal executive offices)		76712 (Zip Code)

(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 þ 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 þ

     The number of shares of common stock, par value $.01 per share, outstanding at August 5, 2005 was 11,297,187.

 

 

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)

		June 30,				December 31,
		2005				2004
		(Unaudited)
ASSETS
Cash and cash equivalents		$	5,337			$	9,724
Portfolio Assets, net			43,862				37,952
Loans receivable from Acquisition Partnerships held for investment			20,400				21,255
Equity investments			53,181				57,815
Deferred tax asset, net			20,101				20,101
Service fees receivable from affiliates			1,232				1,631
Other assets, net			7,196				8,562
Discontinued mortgage assets			409				1,817
Total Assets		$	151,718			$	158,857
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Notes payable to affiliates		$	545			$	491
Notes payable other			49,153				50,812
Minority interest			1,277				1,292
Liabilities from discontinued consumer operations			987				9,033
Liabilities from discontinued mortgage operations			—				50
Other liabilities			3,589				4,756
Total Liabilities			55,551				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: 11,293,437 and 11,260,687, respectively)			113				113
Paid in capital			99,482				99,364
Accumulated deficit			(5,017	)			(10,289	)
Accumulated other comprehensive income			1,589				3,235
Total Stockholders’ Equity			96,167				92,423
Total Liabilities and Stockholders’ Equity		$	151,718			$	158,857

See accompanying notes to consolidated financial statements.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Revenues:
Servicing fees from affiliates		$	2,909			$	3,716			$	6,081			$	6,748
Gain on resolution of Portfolio Assets			1,205				162				3,067				237
Equity in earnings of investments			3,690				2,639				7,091				6,814
Interest income from affiliates			460				617				895				1,061
Loan interest income			589				25				1,056				104
Other income			426				470				810				1,814
Total revenues			9,279				7,629				19,000				16,778
Expenses:
Interest and fees on notes payable to affiliates			10				20				18				45
Interest and fees on notes payable — other			838				1,818				1,710				3,506
Interest on shares subject to mandatory redemption			—				67				—				133
Salaries and benefits			3,684				3,477				7,842				7,554
Provision for loan and impairment losses			29				22				114				22
Occupancy, data processing, communication and other			1,753				1,784				3,666				3,233
Total expenses			6,314				7,188				13,350				14,493
Earnings from continuing operations before income taxes and minority interest			2,965				441				5,650				2,285
Income taxes			(103	)			(72	)			(242	)			(156	)
Earnings from continuing operations before minority interest			2,862				369				5,408				2,129
Minority interest			(42	)			17				(39	)			(9	)
Earnings from continuing operations			2,820				386				5,369				2,120
Discontinued operations
Earnings (loss) from discontinued operations			(97	)			3,312				(97	)			6,455
Income taxes			—				(399	)			—				(427	)
Net earnings (loss) from discontinued operations			(97	)			2,913				(97	)			6,028
Net earnings		$	2,723			$	3,299			$	5,272			$	8,148
Basic earnings per common share are as follows:
Earnings from continuing operations		$	0.25			$	0.03			$	0.48			$	0.19
Discontinued operations		$	(0.01	)		$	0.26			$	(0.01	)		$	0.54
Net earnings to common stockholders		$	0.24			$	0.29			$	0.47			$	0.73
Weighted average common shares outstanding			11,274				11,235				11,268				11,216
Diluted earnings per common share are as follows:
Earnings from continuing operations		$	0.24			$	0.03			$	0.45			$	0.18
Discontinued operations		$	(0.01	)		$	0.25			$	(0.01	)		$	0.51
Net earnings to common stockholders		$	0.23			$	0.28			$	0.44			$	0.69
Weighted average common shares outstanding			12,025				11,820				12,016				11,806

See accompanying notes to consolidated financial statements.

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			32,750				—				118				—				—				118
Comprehensive income:
Net earnings for the first six months of 2005			—				—				—				5,272				—				5,272
Translation adjustments			—				—				—				—				(1,646	)			(1,646	)
Total comprehensive income																							3,626
Balances, June 30, 2005			11,293,437			$	113			$	99,482			$	(5,017	)		$	1,589			$	96,167

See accompanying notes to consolidated financial statements.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)

		Six Months Ended
		June 30,
		2005				2004
Cash flows from operating activities:
Net earnings		$	5,272			$	8,148
Adjustments to reconcile net earnings to net cash used in operating activities:
Net (earnings) loss from discontinued operations			97				(6,028	)
Purchase of Portfolio Assets and loans receivable, net			(15,883	)			(13,372	)
Proceeds applied to principal on Portfolio Assets and loans receivable			14,440				3,892
Gain on resolution of Portfolio Assets			(3,067	)			(237	)
Capitalized interest and costs on Portfolio Assets and loans receivable			(155	)			(92	)
Provision for loan and impairment losses			114				22
Equity in earnings of investments			(7,091	)			(6,814	)
Depreciation and amortization			461				409
Decrease in service fees receivable from affiliate			399				357
Decrease (increase) in other assets			405				(2,217	)
Change in debt imputed value			58				(759	)
Increase (decrease) in other liabilities			(2,022	)			457
Net cash used in operating activities			(6,972	)			(16,234	)
Cash flows from investing activities:
Property and equipment, net			(82	)			(124	)
Contributions to Acquisition Partnerships and Servicing Entities			(3,752	)			(8,552	)
Distributions from Acquisition Partnerships and Servicing Entities			13,292				13,248
Net cash provided by investing activities			9,458				4,572
Cash flows from financing activities:
Borrowings under notes payable to affiliates			—				—
Borrowing under notes payable — other			29,532				31,816
Payments of notes payable to affiliates			(4	)			(3	)
Payments of notes payable — other			(29,734	)			(19,565	)
Proceeds from issuance of common stock			118				120
Net cash used in financing activities			(88	)			12,368
Net cash provided by continuing operations			2,398				706
Net cash provided by (used in) discontinued operations			(6,785	)			372
Net increase (decrease) in cash and cash equivalents			(4,387	)			1,078
Cash and cash equivalents, beginning of period			9,724				2,745
Cash and cash equivalents, end of period		$	5,337			$	3,823
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest		$	1,276			$	2,864
Income taxes			213				242
Non-cash financing activities:
Dividends accumulated and not paid on preferred stock			—				133

See accompanying notes to consolidated financial statements.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 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 June 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 June 30, 2005, its results of operations for the three and six month periods ended June 30, 2005 and 2004 and cash flows for the six month periods ended June 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 the estimation of future collections on purchased portfolio assets used in the calculation of net gain on resolution of portfolio assets, interest rate environments, valuation of the deferred tax asset, and 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 Libor plus 2.50% to 2.75%, (iv) provides for a 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.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

     At June 30, 2005, the Company had $11.3 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 included in accumulated other comprehensive income relating to the Euro-denominated debt was $771 and $1,299, respectively, for the three and six months ended June 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 facility, 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 outstanding, the Company anticipates approximately $.8 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

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

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.

(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								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Mortgage		$	(94	)		$	(250	)		$	(94	)		$	(250	)
Consumer			(3	)			3,163				(3	)			6,278
Net earnings (loss) from discontinued operations		$	(97	)		$	2,913			$	(97	)		$	6,028

     Mortgage

     At June 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 security is recorded at the lower of its carrying value or fair value less cost to sell. The cash flows are collected over a period of time and are valued using prepayment assumptions of 32% for fixed rate loans and 33% for variable rate loans. Overall loss rates are estimated at 14% of collateral. The Company recorded provisions of $78 and $250 in the first six months of 2005 and 2004, respectively, for losses from discontinued mortgage operations.

     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 June 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 June 30, 2005 and December 31, 2004. The liabilities of such operations have been classified as “Liabilities from discontinued consumer operations,” respectively on the June 30, 2005 and December 31, 2004 balance sheets and consisted primarily of accrued state taxes at June 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.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

     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								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Equity in earnings		$	—			$	5,118			$	—			$	10,155
Interest and fees on notes payable to affiliate			—				(532	)			—				(1,417	)
Other expenses			(3	)			(1	)			(3	)			(4	)
Income taxes			—				(399	)			—				(427	)
Minority interest			—				(1,023	)			—				(2,029	)
Earnings (loss) from discontinued consumer operations		$	(3	)		$	3,163			$	(3	)		$	6,278

(5) Portfolio Assets

     Portfolio Assets are summarized as follows:

		June 30,				December 31,
		2005				2004
Loan Portfolios
Loans Acquired Prior to 2005
Non-performing Portfolio Assets		$	13,732			$	19,993
Performing Portfolio Assets			12,750				16,039
Loans Acquired After 2004
Loans acquired with credit deterioration			10,668				—
Loans acquired with no credit deterioration			4,887				—
Outstanding balance			42,037				36,032
Allowance for loan losses			(114	)			—
Carrying amount of loans, net of allowance			41,923				36,032
Real Estate Portfolios			1,939				1,920
Portfolio Assets, net		$	43,862			$	37,952

     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.

     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. FirstCity acquired no wholly-owned loan portfolios during the first quarter of 2005, and eight wholly-owned loan portfolios during the second quarter of 2005.

     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:

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

   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 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 accrete 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.

     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

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

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 June 30, 2005 were as follows:

		Three Months Ended				Six Months Ended
		June 30,				June 30,
		2005				2005
Beginning Balance		$	—			$	—
Additions			3,239				3,239
Accretion			(111	)			(111	)
Reclassification from (to) nonaccretable difference			—				—
Disposals			—				—
Ending Balance		$	3,128			$	3,128

     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 and if so, recognizes a loss. 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 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. 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 six months ended June 30, 2005, FirstCity established an allowance for loan losses by a charge to the income statement of $114.

     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				Six Months Ended
		June 30,				June 30,
		2005				2005
Face value at acquisition		$	14,497			$	14,497
Cash flows expected to be collected at acquisition			13,991				13,991
Basis in acquired loans at acquisition			10,751				10,751

   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 June 30, 2005 and December 31, 2004 were $.4 million and zero, respectively.

     Interest accrual ceases when payments are no later than 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 June 30, 2005, the Company had no valuation allowance on these loans.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

   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 no allowance for impairment charges during the six months ended June 30, 2005 and 2004.

  (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:

		June 30,				December 31,
		2005				2004
LatinAmerica		$	18,212			$	19,170
Europe			484				548
Domestic			1,704				1,537
		$	20,400			$	21,255

     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 $78 and $472 during the first six 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 a French servicing company from 10% to 12% and in a French Acquisition Partnership from 33% to 43%. 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:

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

Condensed Combined Balance Sheets

		June 30,				December 31,
		2005				2004
Assets		$	411,448			$	479,776
Liabilities		$	378,329			$	410,469
Net equity			33,119				69,307
		$	411,448			$	479,776
Equity investment in Acquisition Partnerships		$	47,349			$	52,410
Equity investment in servicing entities			5,832				5,405
		$	53,181			$	57,815

Condensed Combined Summary of Operations

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Proceeds from resolution of Portfolio Assets		$	63,048			$	63,297			$	108,700			$	125,632
Gain on resolution of Portfolio Assets			25,650				22,140				45,814				42,709
Interest income on performing Portfolio Assets			2,649				2,266				4,755				5,165
Net earnings		$	11,874			$	811			$	20,906			$	16,855
Equity in earnings of Acquisition Partnerships		$	3,362			$	2,492			$	6,410			$	6,337
Equity in earnings of servicing entities			328				147				681				477
		$	3,690			$	2,639			$	7,091			$	6,814

     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.

		June 30,				December 31,
		2005				2004
Assets:
Domestic:
WAMCO Partnerships		$	145,460			$	172,464
MinnTex Investment Partners LP			523				840
Other			10,586				10,406
Latin America			195,531				207,455
Europe			59,348				88,611
		$	411,448			$	479,776

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

		June 30,				December 31,
		2005				2004
Equity (deficit):
Domestic:
WAMCO Partnerships		$	70,629			$	81,233
MinnTex Investment Partners LP			471				763
Other			6,006				6,012
Latin America			(85,542	)			(85,789	)
Europe			41,555				67,088
		$	33,119			$	69,307
Equity investment in Acquisition Partnerships:
Domestic:
WAMCO Partnerships		$	31,122			$	34,521
MinnTex Investment Partners LP			156				252
Other			2,875				2,916
Latin America			1,579				1,538
Europe			11,617				13,183
		$	47,349			$	52,410

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								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Revenues:
Domestic:
WAMCO Partnerships		$	8,066			$	8,415			$	17,008			$	14,849
MinnTex Investment Partners LP			1,502				2,274				3,107				4,804
Other			32				4				66				48
Latin America			5,815				6,574				11,214				10,812
Europe			13,020				7,411				19,543				17,877
		$	28,435			$	24,678			$	50,938			$	48,390
Net earnings (loss):
Domestic:
WAMCO Partnerships		$	3,422			$	4,450			$	7,627			$	7,019
MinnTex Investment Partners LP			1,343				2,031				2,776				4,284
Other			(126	)			(202	)			(233	)			(384	)
Latin America			2,868				(9,429	)			2,745				(5,729	)
Europe			4,367				3,961				7,991				11,665
		$	11,874			$	811			$	20,906			$	16,855
Equity in earnings (loss) of Acquisition Partnerships:
Domestic:
WAMCO Partnerships		$	1,499			$	1,980			$	3,356			$	3,247
MinnTex Investment Partners LP			443				671				916				1,414
Other			(31	)			(57	)			(48	)			(118	)
Latin America			365				(891	)			191				(779	)
Europe			1,086				789				1,995				2,573
		$	3,362			$	2,492			$	6,410			$	6,337

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

     Combining statements of operations for the WAMCO Partnerships follow. WAMCO XXVIII, WAMCO XXX, WAMCO 31 and WAMCO 33 are considered to be significant subsidiaries of FirstCity.

Three Months Ended June 30, 2005

		WAMCO				WAMCO				WAMCO				WAMCO				Other
		XXVIII				XXX				31				33				Partnerships				Combined
Proceeds from resolution of Portfolio Assets		$	1,361			$	4,137			$	5,325			$	3,377			$	6,502			$	20,702
Cost of Portfolio Assets resolved			1,057				3,098				3,880				2,724				3,278				14,037
Gain on resolution of Portfolio Assets			304				1,039				1,445				653				3,224				6,665
Interest income on performing Portfolio Assets			14				—				138				590				643				1,385
Interest and fees expense — affiliate			(36	)			—				—				(367	)			(195	)			(598	)
Interest and fees expense — other			—				(59	)			(309	)			(149	)			(26	)			(543	)
Provision for loan and impairment losses			—				(57	)			—				(625	)			(129	)			(811	)
Service fees — affiliate			(65	)			(137	)			(157	)			(127	)			(306	)			(792	)
General, administrative and operating expenses			(50	)			(160	)			(101	)			(124	)			(1,465	)			(1,900	)
Other income, net			2				3				8				—				3				16
Net earnings (loss)		$	169			$	629			$	1,024			$	(149	)		$	1,749			$	3,422

Three Months Ended June 30, 2004

		WAMCO				WAMCO				WAMCO				WAMCO				Other
		XXVIII				XXX					31				33			Partnerships				Combined
Proceeds from resolution of Portfolio Assets		$	4,520			$	2,103			$	3,848			$	2,182			$	12,395			$	25,048
Cost of Portfolio Assets resolved			3,677				1,553				2,962				1,563				8,360				18,115
Gain on resolution of Portfolio Assets			843				550				886				619				4,035				6,933
Interest income on performing Portfolio Assets			93				—				426				53				902				1,474
Interest and fees expense — affiliate			(114	)			—				—				(196	)			(194	)			(504	)
Interest and fees expense — other			(81	)			(111	)			(414	)			—				(47	)			(653	)
Provision for loan and impairment losses			(35	)			—				—				—				(29	)			(64	)
Service fees — affiliate			(171	)			(80	)			(171	)			(75	)			(521	)			(1,018	)
General, administrative and operating expenses			82				(99	)			(81	)			(142	)			(1,486	)			(1,726	)
Other income, net			1				1				2				—				4				8
Net earnings		$	618			$	261			$	648			$	259			$	2,664			$	4,450

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

Six Months Ended June 30, 2005

		WAMCO				WAMCO				WAMCO				WAMCO				Other
		XXVIII				XXX				31				33				Partnerships				Combined
Proceeds from resolution of Portfolio Assets		$	2,165			$	5,143			$	10,915			$	10,427			$	14,582			$	43,232
Cost of Portfolio Assets resolved			1,663				3,843				8,672				8,010				6,687				28,875
Gain on resolution of Portfolio Assets			502				1,300				2,243				2,417				7,895				14,357
Interest income on performing Portfolio Assets			32				—				401				1,038				1,130				2,601
Interest and fees expense — affiliate			(77	)			—				—				(893	)			(350	)			(1,320	)
Interest and fees expense — other			(6	)			(151	)			(630	)			(149	)			(65	)			(1,001	)
Provision for loan and impairment losses			—				(57	)			—				(675	)			(171	)			(903	)
Service fees — affiliate			(110	)			(183	)			(359	)			(377	)			(770	)			(1,799	)
General, administrative and operating expenses			(47	)			(245	)			(192	)			(243	)			(3,631	)			(4,358	)
Other income, net			6				5				14				—				25				50
Net earnings		$	300			$	669			$	1,477			$	1,118			$	4,063			$	7,627

Six Months Ended June 30, 2004

		WAMCO				WAMCO				WAMCO				WAMCO				Other
		XXVIII				XXX					31				33			Partnerships				Combined
Proceeds from resolution of Portfolio Assets		$	6,572			$	6,453			$	10,108			$	5,063			$	17,265			$	45,461
Cost of Portfolio Assets resolved			5,190				4,923				8,442				3,875				11,260				33,690
Gain on resolution of Portfolio Assets			1,382				1,530				1,666				1,188				6,005				11,771
Interest income on performing Portfolio Assets			153				—				930				53				1,925				3,061
Interest and fees expense – affiliates			(228	)			—				(133	)			(349	)			(408	)			(1,118	)
Interest and fees expense – other			(185	)			(244	)			(752	)			—				(101	)			(1,282	)
Provision for loan losses			(70	)			—				—				—				(581	)			(651	)
Service fees – affiliate			(263	)			(232	)			(399	)			(171	)			(808	)			(1,873	)
General, administrative and operating expenses			44				(208	)			(226	)			(177	)			(2,339	)			(2,906	)
Other income, net			2				3				5				—				7				17
Net earnings		$	835			$	849			$	1,091			$	544			$	3,700			$	7,019

     Statements of operations for MinnTex Investment Partners LP for the three and six month periods ended June 30, 2005 and 2004 follow:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Proceeds from resolution of Portfolio Assets		$	1,525			$	2,368			$	3,164			$	5,052
Cost of Portfolio Assets resolved			26				95				62				250
Gain on resolution of Portfolio Assets			1,499				2,273				3,102				4,802
Service fees — affiliate			(152	)			(237	)			(316	)			(505	)
General, administrative and operating expenses			(7	)			(6	)			(15	)			(15	)
Other income			3				1				5				2
Net earnings		$	1,343			$	2,031			$	2,776			$	4,284

     FirstCity adopted FASB Interpretation No. 46R, Consolidation of Variable Interest Entities (“FIN 46R”) on January 1, 2004. FIN 46R requires consolidation by the majority holder of expected residual gains and losses of the activities of a variable interest entity (“VIE”). FirstCity holds significant variable interests in certain Acquisition Partnerships, which would be characterized as VIEs. However, FirstCity is not deemed to be the primary beneficiary of any of these entities based on the criteria set forth in FIN46R. At June 30, 2005, FirstCity’s maximum exposure to loss as a result of its involvement with the VIEs is $22.3 million.

   (8) Segment Reporting

     The Company is engaged in one reportable segment — Portfolio Asset acquisition and resolution. The Portfolio Asset acquisition and resolution business involves acquiring Portfolio Assets at a discount to face value and servicing and resolving such Portfolios in

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (continued)

an effort to maximize the present value of the ultimate cash recoveries. The following is a summary of results of operations for the Portfolio Asset acquisition and resolution segment and reconciliation to earnings from continuing operations for the three and six months ended June 30, 2005 and 2004.

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Portfolio Asset Acquisition and Resolution:
Revenues:
Servicing fees		$	2,909			$	3,716			$	6,081			$	6,748
Gain on resolution of Portfolio Assets			1,205				162				3,067				237
Equity in earnings of investments			3,690				2,639				7,091				6,814
Interest income			1,082				667				2,015				1,196
Other			273				305				513				1,439
Total			9,159				7,489				18,767				16,434
Expenses:
Interest and fees on notes payable			848				879				1,728				1,658
Salaries and benefits			2,918				2,938				6,187				5,979
Provision for loan and impairment losses			29				22				114				22
Occupancy, data processing, communication and other			1,151				1,226				2,299				2,225
Minority interest			42				(17	)			39				9
Total			4,988				5,048				10,367				9,893
Operating contribution before direct taxes		$	4,171			$	2,441			$	8,400			$	6,541
Operating contribution, net of direct taxes		$	4,128			$	2,443			$	8,243			$	6,489
Corporate Overhead:
Corporate interest expense			—				1,026				—				2,026
Salaries and benefits, occupancy, professional and other income and expenses, net			1,308				1,031				2,874				2,343
Earnings from continuing operations		$	2,820			$	386			$	5,369			$	2,120

     Revenues from the Portfolio Asset acquisition and resolution segment are attributable to domestic and foreign operations as follows:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2005				2004				2005				2004
Domestic		$	4,764			$	4,204			$	10,726			$	8,350
Latin America			2,973				2,265				5,370				4,862
Europe			1,422				1,020				2,671				3,222
Total		$	9,159			$	7,489			$	18,767			$	16,434