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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

Form 10-K

Commission file number 033-19694

FirstCity Financial Corporation
(Exact name of registrant as specified in its charter)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:
None

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

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

        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 o No ý

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

        Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check One)

Large accelerated filer o                Accelerated filer ý                Non-accelerated filer o

        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 aggregate market value of the voting and non-voting common equity held by non-affiliates, based upon the closing price of the common stock on the Nasdaq National Market System as of June 30, 2006, was $104,695,227.

        The number of shares of common stock outstanding at July 9, 2007, was 10,789,137.

DOCUMENTS INCORPORATED BY REFERENCE
(To The Extent Indicated Herein)

FIRSTCITY FINANCIAL CORPORATION

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FORWARD LOOKING INFORMATION

        Some of the statements in this report constitute forward-looking statements by words such as "believe," "expect," "anticipate," "optimistic," "intend," "plan," "aim," "will," "may," "should," "could," "would," "likely," "estimate," "predict," "potential," or "continue" or other similar expressions. Under "Item 1A. Risk Factors", we discuss certain factors that affect our business and operations and factors that may cause our actual results to differ materially from these forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly or revise any forward-looking statements.

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PART I

Item 1.    Business.

General

        FirstCity Financial Corporation (the "Company," "FirstCity," "we" or "us"), a Delaware corporation, is a financial services company headquartered in Waco, Texas with offices throughout the United States and Mexico and a presence in Europe and South America. The Company began operating in 1986 as a specialty financial services company focused on acquiring and resolving distressed loans and other assets purchased at a discount relative to the aggregate unpaid principal balance of the loans or the appraised value of the other assets ("Face Value"). To date the Company has acquired, for its own account and through various affiliated partnerships, pools of assets or single assets (collectively referred to as "Portfolio Assets" or "Portfolios") with a Face Value of approximately $9.5 billion. The Company's servicing expertise, which it has developed largely through the resolution of distressed assets, is a cornerstone of its growth strategy. Today the Company is engaged in one reportable business segment—Portfolio Asset acquisition and resolution. See Note 8 of the Company's Consolidated Financial Statements for certain financial information about this segment of the Company. The Company's consumer lending operations have been discontinued as of September 21, 2004. The only asset remaining from discontinued mortgage operations is an investment security resulting from the retention of a residual interest in a securitization transaction. See Note 3 of the Consolidated Financial Statements.

Securities Exchange Act Reports and Additional Information

        FirstCity makes available free of charge on or through its website at www.fcfc.com, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other information releases including all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission ("SEC"). Also, the SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC. The public can obtain any documents that the Company files with the SEC at www.sec.gov.

Business Strategy

        The Company's core business is the acquisition, management, servicing and resolution of Portfolio Assets. Key elements of the Company's overall business strategy include:

•

Increasing the Company's investments in Portfolio Assets acquired from financial institutions and government agencies, both for its own account or through investment entities formed with one or more other co-investors, thereby capitalizing on the expertise of partners whose skills complement those of the Company.



•

Identifying and acquiring, through non-traditional niche sources, distressed assets and other asset classes that meet the Company's investment criteria, which may involve the utilization of special acquisition structures.



•

Acquiring, managing, servicing and resolving Portfolio Assets in certain international markets, either separately or in partnership with others.



•

Capitalizing on the Company's servicing expertise to enter into new markets with servicing agreements that provide for reimbursement of costs of entry and operations plus an incentive servicing fee after certain thresholds are met without requiring substantial equity investments.



•

Maximizing growth in operations, thereby permitting the utilization of the Company's net operating loss carryforwards ("NOLs").

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Background

        The Company began operating in the financial service business in 1986 as a purchaser of distressed assets from the Federal Deposit Insurance Corporation ("FDIC") and the Resolution Trust Corporation ("RTC"). From its original office in Waco, Texas, with a staff of four professionals, the Company's asset acquisition and resolution business grew to become a significant participant in an industry fueled by the problems experienced by banks and thrifts throughout the United States. In the late 1980s, the Company also began acquiring assets from healthy financial institutions interested in eliminating nonperforming assets from their portfolios. The Company began its relationship with Cargill in 1991. Since that time, the Company and Cargill have formed a series of Acquisition Partnerships through which they have jointly acquired over $7.8 billion in Face Value of Portfolio Assets.

        In July 1995, the Company acquired by merger (the "Merger") First City Bancorporation of Texas, Inc. ("FCBOT"), a former bank holding company that had been engaged in a proceeding under Chapter 11 of the United States Bankruptcy Code since November 1992. As a result of the Merger, the Common Stock of the Company became publicly held. In addition, as a result of the Merger, the Company retained FCBOT's rights to approximately $596 million in NOLs, which the Company uses to offset taxable income generated by the Company and its consolidated subsidiaries.

        In July 1997, the Company acquired Harbor Financial Group, Inc. and its subsidiaries (collectively referred to as "Mortgage Corp.") and expanded into related niche financial services markets, such as mortgage conduit banking, conducted through one of its subsidiaries, FC Capital Corp. ("Capital Corp."), and consumer finance, conducted through another of its subsidiaries, FirstCity Consumer Lending Corporation ("Consumer Corp."). In 1999, the Company formally adopted plans to discontinue the operations of Mortgage Corp. and Capital Corp. As a result, the operations of such entities have ceased and the results of historical operations for Mortgage Corp. and Capital Corp. have been reflected as discontinued mortgage operations.

        As a result of the liquidity constraints created by the discontinued operations of Mortgage Corp. and Capital Corp., in the third quarter of 2000, Consumer Corp. completed the sale of a 49% equity interest in its automobile finance operation to IFA Drive GP Holdings LLC ("IFA-GP") and IFA Drive LP Holdings LLC ("IFA-LP"), wholly-owned subsidiaries of BoS(USA), Inc. ("BoS(USA)"), a wholly-owned subsidiary of Bank of Scotland, for a purchase price of $15 million cash and resulted in a gain of $12.1 million ($4 million was deferred and recognized in the December 2002 recapitalization discussed below).

        In December 2002, FirstCity completed a recapitalization in which holders of FirstCity's redeemable preferred stock, par value $.01 per share ("New Preferred Stock"), representing 89.3% of the shares previously outstanding, exchanged 1,092,210 shares of New Preferred Stock for 2,417,388 shares of common stock and $10.5 million. On December 30, 2004, FirstCity redeemed all of the outstanding shares of its New Preferred Stock at a total redemption price of $21.525 per share. The redemption price represented the liquidation preference of the New Preferred Stock plus the final normal quarterly dividend of $.525 per share. FirstCity also recognized the $4 million gain (previously deferred) from the release of its guaranty of Drive's indebtedness to BoS(USA), Inc. ("BoS(USA)"). BoS(USA)'s warrant to purchase 1,975,000 shares of non-voting common stock was cancelled. FirstCity also acquired the minority interest in FirstCity Holdings held by Terry R. DeWitt, G. Stephen Fillip and James C. Holmes, each of whom were Senior Vice Presidents of FirstCity, by issuing 400,000 shares of common stock of the Company and a cash flow note which was settled for $310,000 in 2006 as part of the transaction with American International Group, Inc. ("AIG"), which is discussed below.

        On November 1, 2004, FirstCity and certain of its subsidiaries completed the sale of its remaining 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") for a total purchase price of $108.5 million in cash, which

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resulted in distributions and payments to FirstCity and Consumer Corp. in the aggregate amount of $86.8 million in cash from various sources.

        On December 30, 2004, FirstCity redeemed all of the outstanding shares of its New Preferred Stock at a total redemption price of $21.525 per share. The redemption price represented the liquidation preference of the New Preferred Stock plus the final normal quarterly dividend of $.525 per share.

        During the third quarter of 2006, FirstCity completed a total restructure of its investments in Mexico in a transaction which aligned FirstCity with AIG. The Company received $1.9 million in incentive service fees related to the sale of certain assets in Mexico which occurred as a result of the restructure. The details of the restructure are provided in Note 6 to the Consolidated Financial Statements. In addition, the Company recorded a gain on the sale of equity investments of $2.5 million. This gain consisted of: 1) one domestic equity investment resulting in a gain of $1.3 million and; 2) a partial sale of Mexico equity investments in connection with a restructure with AIG resulting in a gain of $1.2 million.

Portfolio Asset Acquisition and Resolution Business

        In the Portfolio Asset acquisition and resolution business, 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 Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer ("SOP 03-3"). 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. See Note 1 of the consolidated financial statements for discussion of the impact of SOP 03-3, on FirstCity's accounting for Portfolio Assets in 2006.

        Portfolios are either acquired for FirstCity's own account or through investment entities formed with one or more other co-investors (each such entity, an "Acquisition Partnership"). To date, FirstCity and the Acquisition Partnerships have acquired over $9.5 billion in Face Value of assets, with FirstCity's equity investment being $533 million.

Sources of Assets Acquired

        In the early 1990s large quantities of nonperforming assets were available for acquisition from the RTC and the FDIC. Since 1993, sellers of nonperforming assets have included private sellers as well as government agencies such as the Small Business Administration. Private sellers include financial institutions, insurance companies, and other institutional lenders, both in the United States and in various foreign countries. As a result of mergers, acquisitions and corporate downsizing efforts, other business entities frequently seek to dispose of excess real estate or other financial assets not meeting the strategic needs of a seller. Sales of such assets improve the seller's balance sheet, reduce overhead costs, reduce staffing requirements and avoid management and personnel distractions associated with the intensive and time-consuming task of resolving loans and disposing of real estate. Consolidations within a broad range of industries, especially banking, have augmented the trend of financial institutions and other sellers packaging and selling asset portfolios to investors as a means of disposing of nonperforming loans or other surplus or non-strategic assets.

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Portfolio Assets

        FirstCity acquires and manages Portfolio Assets, which are generally purchased at a discount to Face Value by FirstCity or through Acquisition Partnerships. The Portfolio Assets are generally nonhomogeneous assets, including loans of varying qualities that are unsecured or secured by diverse collateral types and real estate. Some of the secured Portfolio Assets are loans for which resolution is tied primarily to the real estate securing the loan, while others may be collateralized business loans, the resolution of which may be based either on real estate, business assets or other collateral cash flow.

        FirstCity seeks to resolve Portfolio Assets through (i) a negotiated settlement with the borrower in which the borrower pays all or a discounted amount of the loan, (ii) conversion of the loan into a performing asset through extensive servicing efforts followed by either a sale of the loan to a third party or retention of the loan by FirstCity or the Acquisition Partnerships or (iii) foreclosure and sale of the collateral securing the loan.

        FirstCity has substantial experience acquiring, managing and resolving a wide variety of asset types and classes. As a result, it does not limit itself as to the types of Portfolios it will evaluate and purchase. FirstCity's willingness to acquire Portfolio Assets is generally determined by factors including the information that is available regarding the assets in a Portfolio, the price at which the Portfolio can be acquired and the expected net cash flows from the resolution of such assets. FirstCity and the Acquisition Partnerships have acquired Portfolio Assets in virtually all 50 states, the Virgin Islands, Dominican Republic, Puerto Rico, Chile, France, Germany, Japan, Mexico, and Argentina. FirstCity believes that its willingness to acquire nonhomogeneous Portfolio Assets without regard to geographic location provides it with an advantage over certain competitors that limit their activities to either a specific asset type or geographic location.

        FirstCity also seeks to capitalize on emerging opportunities in foreign countries in which the market for nonperforming loans of the type generally purchased by FirstCity is less efficient than the market for such assets in the United States. FirstCity has a 20.43% effective interest in MCS et Associes ("MCS"), a French asset servicing company. FirstCity is, in conjunction with MCS and Cargill, actively pursuing opportunities to purchase pools of Portfolio Assets in France and other areas of Western Europe. In addition, FirstCity has offices in Guadalajara and Mexico City, Mexico that facilitate FirstCity's participation in acquisition of Portfolios in Mexico. Since 2004, FirstCity has also participated in Portfolio acquisitions in Germany and South America, primarily in Argentina and Chile.

        The following table presents selected data for the Portfolio Assets acquired by FirstCity:

Portfolio Assets Acquired

(1)

Includes investments made in the form of equity and notes receivable from the Acquisition Partnerships payable to affiliates of the investors.

(2)

Includes investments made in the form of equity and notes receivable from the Acquisition Partnerships payable to affiliates of the Company.

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Portfolio Purchases by Region

Sources of Portfolio Assets

        FirstCity develops its Portfolio Asset opportunities through a variety of sources. Since the activities or contemplated activities of expected sellers are generally publicized in industry publications and through other similar sources, FirstCity monitors such publications and similar sources. FirstCity also maintains relationships with a variety of parties involved as sellers or as brokers or agents for sellers. Many of the brokers and agents concentrate by asset type and have become familiar with FirstCity's acquisition criteria and periodically approach FirstCity with identified opportunities. In addition, business referrals from other investors in Acquisition Partnerships, repeat business from previous sellers, focused marketing by FirstCity and the nationwide presence of FirstCity are important sources of business.

        FirstCity identifies investment opportunities in foreign markets in much the same manner as in the United States. In varying degrees of volume and efficiency, the markets of Europe, Asia, and Latin America all include sellers of nonperforming assets. In some countries, such as Mexico, the government has taken a very active role in the management and orderly disposition of these types of assets. FirstCity's established presence in Mexico and France provides a strong base for the identification, valuation, and acquisition of assets in those countries, as well as in adjacent markets. FirstCity continues to identify partners who have contacts within various foreign markets and or can assist in locating Portfolio Asset opportunities with FirstCity.

Asset Analysis and Underwriting

        Prior to making an offer to acquire any Portfolio, FirstCity performs an extensive evaluation of the assets that comprise the Portfolio. If, as is often the case, the Portfolio Assets are nonhomogeneous, FirstCity will evaluate all individual assets determined to be significant to the total of the proposed purchase. If the Portfolio Assets are homogenous in nature, a sample of the assets comprising the Portfolio may be selected for evaluation. The evaluation of individual assets generally includes analyzing the credit and collateral file or other due diligence information supplied by the seller. Based upon such seller-provided information, FirstCity will undertake additional evaluations of the asset, that, to the extent permitted by the seller, will include site visits to, and environmental reviews of the property securing the loan or the asset proposed to be purchased. FirstCity will also analyze relevant local economic and market conditions based on information obtained from its prior experience in the market or from other sources, such as local appraisers, real estate principals, realtors and brokers.

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        The evaluation includes an analysis of an asset's projected cash flow and sources of repayment, including the availability of third party guarantees. FirstCity values loans (and other assets included in a portfolio) on the basis of its estimate of the present value of estimated cash flow to be derived in the resolution process. Once the cash flow estimates for a proposed purchase and the financing and partnership structure, if any, are finalized, FirstCity can complete the determination of its proposed purchase price for the targeted Portfolio Assets. Purchases are subject to purchase and sale agreements between the seller and the purchasing affiliate of FirstCity.

        The analysis and underwriting procedure in foreign markets follows the same extensive diligence philosophy as that employed by the Company domestically. Additional risks are evaluated in foreign markets, including economic factors (inflation or deflation), currency strength, short and long-term market stability and political concerns. These risks are evaluated and priced into the cost of the acquisition.

Servicing

        After a Portfolio is acquired, FirstCity assigns the Portfolio Assets to account servicing officers who are independent of the personnel that performed the due diligence evaluation in connection with the purchase of the Portfolio. Portfolio Assets are serviced either at the Company's headquarters or in one of FirstCity's other offices. FirstCity may establish servicing operations in locations in close proximity to significant concentrations of Portfolio Assets. Such offices are reviewed for closing after the assets in the geographic region surrounding the office are substantially resolved. The assigned account servicing officer develops a business plan and budget for each asset based upon an independent review of the cash flow projections developed during the investment evaluation, physical inspections of assets or collateral underlying the related loans, evaluation of local market conditions and discussions with the relevant borrower. Budgets are periodically reviewed and revised as necessary. FirstCity employs loan-tracking software and other operational systems that are generally similar to systems used by commercial banks, but which have been enhanced to track both the collected and the projected cash flows from Portfolio Assets.

        FirstCity services, in all material respects, the Portfolio Assets owned for its own account, the Portfolio Assets owned by the Acquisition Partnerships and, to a very limited extent, certain Portfolio Assets owned by third parties. In connection with the Acquisition Partnerships in the United States, FirstCity generally earns a servicing fee, which is a percentage of gross cash collections generated rather than a management fee based on the Face Value of the asset being serviced. The rate of servicing fee charged is generally a function of the average Face Value of the assets within each pool being serviced (the larger the average Face Value of the assets in a Portfolio, the lower the fee percentage within the prescribed range), the type of assets and the level of servicing required on each asset. For the Mexican Acquisition Partnerships, FirstCity earns a servicing fee based on costs of servicing plus a profit margin. The Company also has certain consulting contracts with its Mexican investment entities pursuant to which the Company is entitled to additional compensation for servicing once a specified return to the investors has been achieved. The Acquisition Partnerships in France are serviced by MCS in which the Company maintains a 20.4% direct and indirect equity interest.

Structure and Financing of Portfolio Asset Purchases

        Portfolio Assets are either acquired for the account of a subsidiary of FirstCity or through the Acquisition Partnerships. Portfolio Assets owned directly by a subsidiary of FirstCity may be funded with loans made by FirstCity to its subsidiaries, equity financing provided by an affiliate of Cargill, the Bank of Scotland or other third parties and secured debt that is recourse only to the Acquisition Partnership.

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        Each Acquisition Partnership is a separate legal entity, (generally a limited partnership, but may instead be a limited liability company, trust, corporation or other type of entity). FirstCity and an investor typically form a corporation to serve as the corporate general partner of each Acquisition Partnership. Generally, for domestic Acquisition Partnerships, FirstCity and another investor each own 50% of the general partner and a 49.5% limited partnership interest in the domestic Acquisition Partnership (the general partner owns the other 1% interest). Cargill or its affiliates are the investor in the vast majority of the Acquisition Partnerships currently in existence. See "Relationship with Cargill." Certain institutional investors have also held limited partnership interests in the Acquisition Partnerships and may hold interests in the related corporate general partners.

        The Acquisition Partnerships are generally financed by debt, secured only by the assets of the individual entity, and are nonrecourse to the Company, its co-investors and the other Acquisition Partnerships. FirstCity believes that this legal structure insulates the Company and the other Acquisition Partnerships from certain potential risks, while permitting FirstCity to share in the economic benefits of each Acquisition Partnership.

        Senior secured acquisition financing by Bank of Scotland and Cargill provides the majority of the funding for the purchase of Portfolios. Senior acquisition financing is obtained at variable interest rates with negotiated spreads to the base rates. The terms of the senior acquisition debt of the Acquisition Partnerships often allow, under certain conditions, distributions to equity partners before the debt is repaid in full.

        Prior to maturity of the senior acquisition debt, the Acquisition Partnerships typically refinance the senior acquisition debt with long-term debt secured by the assets of the partnership. Such long-term debt generally accrues interest at a lower rate than the senior acquisition debt, has collateral terms similar to the senior acquisition debt, and permits distributions of excess cash flow generated by the Acquisition Partnership to the equity partners so long as the partnership is in compliance with applicable financial covenants.

        In foreign markets, FirstCity conducts analysis with respect to the establishment of ownership structures. Prior to investment, FirstCity, in conjunction with its co-investors, performs significant due diligence and planning on the tax, licensing, and other ownership issues of the particular country. As in the United States, each foreign Acquisition Partnership is a separate legal entity, generally formed as the equivalent of a limited liability company or a liquidating trust.

Relationship with Cargill

        Cargill, a diversified financial services company, is a wholly owned subsidiary of Cargill, Incorporated, which is generally regarded as one of the world's largest privately held corporations and has offices worldwide. Cargill and its affiliates have historically provided significant debt and equity financing to the Acquisition Partnerships. In addition, FirstCity, while not dependent on Cargill, believes its relationship with Cargill enhances FirstCity's credibility as a purchaser of Portfolio Assets and facilitates its ability to expand into related businesses and foreign markets.

        Prior to 2006, the Company, FirstCity Servicing Corporation, Cargill and its wholly owned subsidiary CFSC Capital Corp. II ("CFSC"), under the terms of Right of First Refusal Agreement, were parties to a Right of First Refusal Agreement and Due Diligence Reimbursement Agreement effective as of January 1, 1998, as amended (the "Right of First Refusal Agreement") from 1992 through February 1, 2006. Pursuant to the Right of First Refusal Agreement, if the Company received an invitation to bid on or otherwise obtain an opportunity to acquire Portfolio Assets in the United States, Mexico, Central America or South America within certain thresholds, CFSC had the option to participate in the proposed purchase through an Acquisition Partnership.

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        The Right of First Refusal Agreement did not prohibit the Company from holding discussions with entities other than CFSC regarding potential joint purchases of interests in loans, receivables, real estate or other assets, provided that any such purchase was subject to CFSC's right to participate in the Company's share of the investment. The Right of First Refusal Agreement further provided that, subject to certain conditions, CFSC would pay to the Company a monthly amount to cover due diligence expense, plus 50% of the third party due diligence expenses incurred by the Company in connection with proposed asset purchases. The Right of First Refusal Agreement was a restatement and extension of a similar agreement entered into among the Company, certain members of the Company's management and Cargill in 1992.

        The Right of First Refusal Agreement terminated on February 28, 2006.

Relationship with AIG

        On August 8, 2006, Strategic Mexican Investment Partners, L.P. ("SMIP"), an affiliate of the Company, and AIG formed Bidmex Holding, LLP for the purpose of acquiring certain Mexican Portfolios by purchasing the interests of Cargill and SMIP. As result, AIG and the Company acquired 85% and 15%, respectively, of the ownership interest in Bidmex Holding, LLP.

        AIG and the Company have expressed a mutual interest in pursuing other business opportunities in Latin America. The Company is not dependent on AIG for future liquidity or funding.

Relationship with the Bank of Scotland

        FirstCity has had a significant relationship with Bank of Scotland and The Governor and The Company of the Bank of Scotland ("BoS-UK") and their subsidiaries since September 1997. FirstCity and its wholly-owned subsidiaries have entered into loan agreements with Bank of Scotland and its affiliates, BoS (USA) Inc. and BoS-UK from time to time since 1997.

        On November 1, 2006, FirstCity Financial Corporation ("FirstCity") and Bank of Scotland, as agent for the lenders, entered into an Amendment No. 4 to Revolving Credit Agreement, dated as of October 31, 2006 (the "Amendment"). The Amendment amended the existing $96,000,000 revolving credit facility entered into on November 12, 2004, to increase the revolving credit facility to $175,000,000 that matures on November 12, 2010. The Amendment made the following changes to the existing loan facility that is used to finance the senior debt and equity portion of portfolio and asset purchases made by FirstCity and to provide for the issuance of letters of credit and working capital loans: (i) increased the maximum outstanding amount of loans and letters of credit issued under the loan facility that may be outstanding under the loan facility to $175,000,000; (ii) reduced the available interest rates under the loan facility by 0.5% per annum; (iii) increased the maximum value for assets that can be included in the borrowing base from the acquisition of portfolio assets in certain countries as follows (a) Mexico increased to $30,000,000, (b) Brazil increased to $5,000,000, (c) Chile to $10,000,000, and (d) Argentina or Uruguay to $6,000,000; (iv) increased the limit for Loans that can be borrowed in Euros under the loan facility to $50,000,000; (v) increased the maximum amount of letters of credit that can be issued under the loan facility to $40,000,000; (vi) increased the maximum amount of working capital loans that can be outstanding under the loan facility to $35,000,000; (vii) provided for an additional upfront fee paid to Bank of Scotland in the amount of $830,000; (viii) amended the requirement for the ratio of EBITDA to Interest Coverage to be not less than 1.50 to 1.00 for each twelve month period, and added a new covenant that FirstCity must maintain a ratio of Cumulative Current Recovered and Projected Collections to Cumulative Original Projected Collections of not less than 0.90 to 1.00; and (ix) extended the maturity date for the loan facility to November 12, 2010. The obligations of FirstCity under the Revolving Credit Agreement are guaranteed by substantially all of the wholly-owned subsidiaries of FirstCity and are secured by security interests in substantially all of the assets of FirstCity and its wholly-owned subsidiaries.

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        On December 14, 2006, the Company and Bank of Scotland, as agent for the lenders, entered into an Amendment No. 5 to Revolving Credit Agreement, dated as of December 14, 2006 (the "Amendment"). The Amendment amended the existing $96,000,000 revolving credit facility entered into on November 12, 2004, to (i) increase the borrowing base availability from 60% to 70%, and (ii) to increase the margin for LIBOR loans from 2.25% to 2.50% at any time that the loan to value ratio is greater than 1.20 to 2.00.

        On June 29, 2007, the Company and Bank of Scotland, as agent for the lenders, entered into an Amendment No. 9 to Revolving Credit Agreement, dated as of June 29, 2007 and effective as of March 31, 2007 (the "Amendment"). The Amendment amended the existing $96,000,000 revolving credit facility entered into on November 12, 2004, to provide that the ratio of Indebtedness to Tangible Net Worth should be equal to or less than 3.5 to 1.00 for the last day of the fiscal quarter. See "Liquidity and Capital Resources" in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

        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 is 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 an annual 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 $350,000, (viii) provides for facility fees of $100,000, for the period commencing on the Effective Date to but excluding the first anniversary thereof, $75,000, for the period commencing on the first anniversary of the Effective Date to but excluding the second anniversary thereof, and $50,000, 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.

        On June 29, 2007, FH Partners, L.P., and Bank of Scotland entered into an Amendment No. 1 to the Revolving Credit Agreement, dated as of June 29, 2007 (the "Amendment"). The Amendment amended the existing $50 million revolving credit facility entered into on August 26, 2005, to provide that all other financial covenants will mirror the key covenants of the facility that FirstCity has with Bank of Scotland.

        FirstCity has obtained consents from the Bank of Scotland to the delivery of its annual audited financial statements for Fiscal Year 2006, its monthly financial statements for January 2007 through June 2007, the Annual Report on Form 10-K for the year ended December 31, 2006 and the Form 10-Q for the period ending March 31, 2007, by not later than July 31, 2007. The extensions were granted under the terms of both FirstCity's revolving credit facility and the revolving acquisition facility provided to FH Partners L.P., to allow FirstCity and FH Partners, L.P. to continue to utilize those loan facilities in the normal course of business.

        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 under certain circumstances to additional warrants in connection with the existing warrant for 425,000 shares 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.

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Business Strategy of Portfolio Asset Acquisition and Resolution Business

        Historically, FirstCity has leveraged its expertise in asset resolution and servicing by investing in a wide variety of asset types across a broad geographic scope. FirstCity continues to follow this investment strategy and seeks expansion opportunities into new asset classes and geographic areas when it believes it can achieve attractive risk adjusted returns. The following items are significant elements of FirstCity's business strategy in the portfolio acquisition and resolution business:

•

Traditional markets.    FirstCity believes it will continue to invest in Portfolio Assets acquired from financial institutions and government agencies, both for its own account or through investment entities formed with Cargill or one or more other co-investors.



•

Niche markets.    FirstCity believes it will continue to pursue profitable private market niches in which to invest. The niche investment opportunities that FirstCity has pursued to date include (i) the acquisition of improved or unimproved real estate, including excess retail sites, and (ii) periodic purchases of single financial or real estate assets from banks and other financial institutions with which FirstCity has established relationships, and from a variety of other sellers that are familiar with the Company's reputation for acting quickly and efficiently.



•

Foreign markets.    FirstCity believes that the foreign markets for Portfolio Assets are less developed than the U.S. market, and therefore provide a greater opportunity to achieve attractive risk adjusted returns. FirstCity has purchased Portfolio Assets in France, Germany, Japan (sold in 1999), Mexico, the Virgin Islands, Dominican Republic, Puerto Rico, Chile and Argentina and expects to continue to seek purchase opportunities outside of the United States.



•

SBA Lending.    In November 2006, the Company, through its subsidiary American Business Lending, Inc. ("ABL") acquired a license from the U.S. Small Business Administration (the "SBA") to originate and service SBA 7(a) loans. The Company believes that the ability to originate these types of loans provides the diversity to create an attractive growth opportunity within the domestic market.

Consumer Lending—Discontinued Operations

        On September 21, 2004, FirstCity and certain of its subsidiaries entered into a definitive agreement to sell the remaining 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 the net cash proceeds from these transactions were primarily used to pay off debt.

        Pursuant to Statement of Financial Accounting Standards ("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. The assets and liabilities of such operations have been classified as "Discontinued Consumer Assets Held for Sale" and "Liabilities from Discontinued Consumer Operations."

Government Regulation

        Certain aspects of the Company's Portfolio Asset acquisition and resolution business are subject to regulation under various foreign, federal, state and local statutes and regulations that impose requirements and restrictions affecting, among other things, disclosures to obligors, the terms of secured transactions, collection, repossession and claims handling procedures, multiple qualification and licensing requirements for doing business in various jurisdictions, and other trade practices.

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Competition

        The Portfolio Asset acquisition business is highly competitive. Some of the Company's principal competitors are substantially larger and better capitalized than the Company. Because of these resources, these companies may be better able than the Company to acquire Portfolio Assets, to pursue new business opportunities or to survive periods of industry consolidation. Generally, there are three aspects of the distressed asset business: due diligence, Portfolio management, and servicing. The Company is a major participant in all three areas. In comparison, certain of its competitors (including certain securities and banking firms) have historically competed primarily as portfolio purchasers and have customarily engaged other parties to conduct due diligence on potential Portfolio purchases and to service acquired assets, and certain other competitors (including certain banking and other firms) have historically competed primarily as servicing companies.

        The Company believes that its ability to acquire Portfolios for its own account and through Acquisition Partnerships will be an important component of the Company's overall future growth. Acquisitions of Portfolios are often based on competitive bidding, which involves the danger of bidding too low (which generates no business), or bidding too high (which could result in the purchase of a Portfolio at an economically unattractive price).

Employees

        The Company had 208 employees as of December 31, 2006. No employee is a member of a labor union or party to a collective bargaining agreement. The Company believes that its relations with its employees are good.

Foreign Operations

        We have investments in various Acquisition Partnerships and servicing entities in Europe and Central and South America. Revenues outside of the U.S. are a material part of our business, and they accounted for more than 40% of our consolidated revenues in each year in the three-year period ended December 31, 2006. See Note 8 to the Consolidated Financial Statements for the year ended December 31, 2006.

        In maintaining foreign operations, our business is exposed to risks inherent in such operations, including those of currency fluctuations. Information on currency exchange risk appears in Part II, Item 7A of this Annual Report on Form 10-K, which information is incorporated herein by reference.

        Financial information about geographic areas, including net sales and assets, for the years in the period ended December 31, 2006 appears in Note 8 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K, which information is incorporated herein by reference.

Item 1A.    Risk Factors.

        This section highlights specific risks that could affect our Company and its businesses. You should carefully consider each of the following risks and all of the other information set forth in this Annual Report on Form 10-K. Based on the information currently known to us, we believe that the following information identifies the most significant risk factors affecting our Company. However, the risks and uncertainties our Company faces are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business.

        If any of the following risks and uncertainties develops into actual events or the circumstances described in the risks and uncertainties occur, these events or circumstances could have a material

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adverse effect on our business, financial condition or results of operations. These events could also have a negative effect on the trading price of our securities.

We may not predict the availability of Portfolio Assets.

        Long-term cycles in the general economy affect the business of acquiring and resolving Portfolio Assets. We cannot predict our future annual acquisition volume of Portfolio Assets. Moreover, our future purchase of Portfolio Assets will depend on the availability of Portfolios offered for sale, the availability of capital and our ability to submit successful bids to purchase Portfolio Assets. Due to the highly competitive environment of the business of acquiring Portfolio Assets in the United States, we may be required to acquire Portfolio Assets at higher prices lowering our profit margins on the resolution of such Portfolios. To offset these changes in the domestic arena, we continue to develop our presence in other markets. Under certain circumstances, we may choose not to bid for Portfolio Assets that we believe cannot be acquired at attractive prices. As a result of all the above factors, we may be materially adversely affected by variations on our Portfolio Asset purchases, and the revenue derived from the resolution of such Portfolio Assets.

Our ability to manage risks associated with growth and entry into new businesses and foreign markets may be limited.

        We have entered into new business related to the Portfolio Asset acquisition business and new foreign markets in the Portfolio Asset acquisition business. We have also recently entered into the business of originating and servicing loans as a small business lending company through our ninety-six percent (96%) investment in American Business Lending, Inc. ("ABL") and acquisition by ABL of unguaranteed portions of certain business loans, certain loan servicing rights and obligations including certain fees to be earned on the portion of such loans that are guaranteed by the U.S. Small Business Administration. Additionally, we have entered into a special situations platform that will buy or finance distressed debt and companies, originate junior and senior bridge loans, and execute lower middle market buyouts through our eighty percent (80%) investment in FirstCity Crestone. We are also expanding operations in Latin America and Europe.

        The entry into these new businesses and foreign markets has resulted in increased demands on our personnel and systems. The development and integration of the new businesses and operations in foreign venues requires the investment of additional capital and the continuous involvement of our senior management. We also must manage a variety of businesses and operations in foreign venues with differing markets, customer bases, financial products, systems and managements. An inability to develop, integrate and manage our businesses and operations in foreign venues could have a material adverse effect on our financial condition, results of operations and business prospects. Risks related to the start up of a business or entry into a new foreign market, including the ability to implement the new business plan and strategy to generate sufficient revenues necessary to avoid losses common to start up companies, the availability of opportunities for investment in the markets to be entered, the dependency of new businesses for liquidity and our ability to support and manage continued growth is dependent upon, among other things, our ability to attract and retain senior management for each of our businesses, to hire, train, and manage our workforce and to continue to develop the skills necessary for us to compete successfully in our existing and new businesses and operations in foreign venues . There can be no assurance that we will successfully meet all of these challenges.

It is likely that our actual experience will not be consistent with the assumptions underlying our Portfolio Asset performance and that the differences may be material and adverse.

        We determine the purchase price and carrying value of Portfolio Assets acquired by us by estimating expected future cash flows from such assets. We develop and revise such estimates based on our historical experience and current market conditions, and based on the discount rates that we

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believe are appropriate for the assets comprising the Portfolios. In addition, many obligors on Portfolio Assets have impaired or poor credit history, low income or other adverse credit events. We are subject to various risks associated with these borrowers, including, but not limited to, the risk that the borrowers will not satisfy their debt service obligations and that the realizable value of the assets securing their loans will not be sufficient to repay the borrowers' debt. If our Portfolio Asset performance differs from our assumptions and estimates, we may be materially adversely affected.

Investments in and revenues from our foreign operations are subject to the risks associated with transactions involving foreign currencies.

        We have acquired, and manage and resolve, Portfolio Assets located in Europe and Latin America and are actively pursuing opportunities to purchase additional pools of distressed assets in these locations. Foreign operations are subject to various special risks, including currency translation risks, currency exchange rate fluctuations, exchange controls and different political, social and legal environments within such foreign markets. To the extent future financing in foreign currencies is unavailable at reasonable rates, we will be further exposed to currency translation risks, currency exchange rate fluctuations and exchange controls. In addition, earnings of foreign operations may be subject to foreign income taxes that reduce cash flow available to meet debt service requirements and our other obligations, which may be payable even if we have no earnings on a consolidated basis. Fluctuation in our reported results from operations in foreign countries could materially adversely affect us.

We may be materially adversely affected by fluctuation in interest rates.

        Most of our borrowings are at variable rates of interest. We will be materially impacted by fluctuations in interest rates.

        In addition, a substantial and sustained decline in interest rates may adversely impact the amount of distressed assets available for purchase by us. The value of our interest-earning assets and liabilities may be directly affected by the level of and fluctuations in interest rates, including the valuation of any residual interests in securitizations that would be severely impacted by increased loan prepayments resulting from declining interest rates.

Our liquidity or ability to raise capital may be limited.

        The successful execution of our business strategy depends on our continued access to financing. In addition, we must also have access to liquidity to invest as equity or subordinated debt to meet our capital needs. We rely upon access to the capital markets and the cash flow from our subsidiaries to fund asset growth and to provide sources of liquidity. Our ability to issue and sell common equity (including securities convertible into, or exercisable or exchangeable for, common equity) is limited as a result of the tax laws relating to the preservation of the NOLs available to us as a result of the Merger. There can be no assurance that our funding relationships with commercial banks, investment banks and financial services companies (including the Bank of Scotland) will continue past their respective current maturity dates. If these credit facilities are not extended and we cannot find alternative funding sources on satisfactory terms, or at all, we may be materially adversely affected. See "Liquidity and Capital Resources."

We may be materially adversely affected by the decline in value of collateral securing loans acquired for resolution.

        The value of the collateral securing loans acquired for resolution, as well as real estate or other acquired distressed assets, is subject to various risks, including uninsured damage, change in location or

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decline in value caused by use, age or market conditions. We may be materially adversely affected by any material decline in the value of such collateral.

We may not have access to the estimated net operating loss carryforwards.

        We believe that, as a result of the Merger, approximately $596 million of NOLs were available to us to offset future taxable income as of December 31, 1995. Since December 31, 1995, we have generated an additional $131 million in tax operating losses, utilized $46 million of NOLs, written-off $84 million of NOLs, and had expiring NOLs of $36 million in 2005 and $179 million in 2006. Accordingly, as of December 31, 2006, we believe that we have approximately $382 million of NOLs available to offset future taxable income. Out of the total $382 million of NOLs, we estimate that we will be able to utilize $57 million, which equates to a $20 million deferred tax asset on our books and records. However, because our position in respect of the $596 million NOLs resulting from the Merger is based upon factual determinations and upon legal issues with respect to which there is uncertainty and because no ruling has been obtained from the Internal Revenue Service (the "IRS") regarding the availability of the NOLs to us, there can be no assurance that the IRS will not challenge the availability of such NOLs and, if challenged, that the IRS will not be successful in disallowing this portion of our NOLs, with the result that our $20 million deferred tax asset would be reduced or eliminated.

        Some of the NOLs may be carried forward to offset our future federal taxable income through the year 2021; however, the availability of some of the NOLs began to expire beginning in 2005. Our ability to utilize such NOLs will be severely limited if there is a more than 50% ownership change at our company during a three-year testing period within the meaning of section 382 of the Internal Revenue Code of 1986, as amended (the "Tax Code").

        If we were unable to utilize our NOLs to offset future taxable income, we would lose our ability to generate capital to support our expansion plans on a tax-advantaged basis, to offset our pretax income and our consolidated subsidiaries' pretax income, and to have access to the cash flow that would otherwise be represented by payments of federal tax liabilities.

It is possible that our actual experience will not be consistent with the assumptions regarding recognition of deferred tax asset and that the differences may be material and adverse.

        As noted above, we have NOLs available for federal income tax purposes to offset future federal taxable income, if any, through the year 2021. A valuation allowance is provided to reduce the deferred tax assets to a level, which, more likely than not, will be realized. Realization is determined based on our management's expectation of generating sufficient taxable income in a look forward period over the next four years. The ultimate realization of the resulting net deferred tax asset is dependent upon generating sufficient taxable income prior to expiration of the net operating loss carryforwards. Although realization is not assured, management believes it is more likely than not that all of the recorded deferred tax asset, net of the allowance, will be realized. The amount of the deferred tax asset considered realizable, however, could be adjusted in the future if estimates of future taxable income during the carryforward period change. The change in valuation allowance represents a change in the estimate of the future taxable income during the carryforward period since the prior year-end and utilization of net operating loss carryforwards since the Merger. Our ability to realize the deferred tax asset is periodically reviewed and the valuation allowance is adjusted accordingly. See "Discussion of Critical Accounting Policies—Deferred Tax Asset."

We may incur significant costs relating to removal of hazardous substances or waste from real property in its Portfolio Assets.

        We acquire through our subsidiaries and affiliates real property in our Portfolio Asset acquisition and resolution business. There is a risk that properties acquired by us could contain hazardous

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substances or waste, contaminants or pollutants. We may be required to remove such substances from the affected properties at our expense, and the cost of such removal may substantially exceed the value of the affected properties or the loans secured by such properties. Furthermore, we may not have adequate remedies against the prior owners or other responsible parties to recover our costs, either as a matter of law or regulation, or as a result of such prior owners' financial inability to pay such costs. We may find it difficult or impossible to sell the affected properties either prior to or following any such removal.

We may not be able to successfully compete in the business in which we operate.

        The business in which we operate is highly competitive. Some of our principal competitors are substantially larger and better capitalized than us. Because of their resources, these companies may be better able than us to acquire Portfolio Assets, to pursue new business opportunities or to survive periods of industry consolidation. Access to and the cost of capital are critical to our ability to compete. Many of our competitors have superior access to capital sources and can arrange or obtain lower cost of capital, resulting in a competitive disadvantage to us with respect to such competitors.

        In addition, certain of our competitors may have higher risk tolerances or different risk assessments, which could allow these competitors to establish lower margin requirements and pricing levels than those established by us. In the event a significant number of competitors establish pricing levels below those established by us, our ability to compete would be materially adversely affected.

We may be adversely affected by a general deterioration in economic conditions.

        Periods of economic slowdown or recession, or declining demand for commercial real estate or commercial or consumer loans may adversely affect our business. Periods of economic slowdown or recession, whether general, regional or industry-related, may adversely affect the resolution of Portfolio Assets, lead to a decline in prices or demand for collateral underlying Portfolio Assets, or increase the cost of capital invested by us and the length of time that capital is invested in a particular Portfolio. All or any one of these events could decrease the rate of return and profits to be realized from such Portfolio and materially adversely affect our consolidated financial position, results of operations and business prospects.

We may be adversely affected by the regulated environment in which we operate.

        Some aspects of our business are subject to regulation, examination and licensing under various federal, state and local statutes and regulations that impose requirements and restrictions affecting, among other things, credit activities, maximum interest rates, finance and other charges, disclosures to obligors, the terms of secured transactions, collection, repossession and claims handling procedures, multiple qualification and licensing requirements for doing business in various jurisdictions, and other trade practices. We believe to be currently in compliance in all material respects with applicable regulations, but there can be no assurance that we will be able to maintain such compliance. Failure to comply with, or changes in, these laws or regulations, or the expansion of our business into jurisdictions that have adopted more stringent regulatory requirements than those in which we currently conduct business, could have an adverse effect on our company by, among other things, limiting the income we may generate on existing and additional loans, limiting the states in which we may operate or restricting our ability to realize on the collateral securing its loans. See "Item 1—Business—Government Regulation."

We may be adversely affected by the result of certain legal proceedings.

        Periodically, our company, our subsidiaries, our affiliates and the Acquisition Partnerships are parties to or otherwise involved in legal proceedings arising in the normal course of business.

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We may be adversely affected by a termination of our relationship with Cargill.

        Our relationship with Cargill is material in a number of respects. Cargill, a subsidiary of Cargill, Incorporated, a privately held, multi-national agricultural and financial services company, has provided equity and debt financings for some of the Acquisition Partnerships. Cargill beneficially owns approximately 2.28% of our outstanding Common Stock, and a Cargill designee, Jeffery Leu, is a member of our Board of Directors. We believe that our relationship with Cargill significantly enhances our credibility as a purchaser of Portfolio Assets and facilitates its ability to expand into other businesses and foreign markets.

        Although our management believes that our relationship with Cargill is excellent, there can be no assurance that such relationship will continue in the future. As we have begun to acquire more portfolios on our own or with other partners and have secured alternative sources of financing, our dependence on Cargill has diminished. There can be no assurance that such alternative financing will continue to be available. Any termination of such relationship could have a material adverse effect on our consolidated financial position, results of operations and business prospects.

We may be adversely affected by a termination of employment of certain key personnel.

        We are dependent on the efforts of our senior executive officers, particularly James T. Sartain (President and Chief Executive Officer). We are also dependent on several of the key members of our management who are instrumental in developing and implementing the business strategy for the Company. In addition, our borrowing facilities include key personnel provisions. These provisions generally provide that if certain key personnel are no longer employed and suitable replacements are not found within a defined time limit, certain facilities become due and payable. We may be adversely affected by the inability or unwillingness of one or more of these individuals to continue in his present role. There can be no assurance that any of the foregoing individuals will continue to serve in his current capacity or for what time period such service might continue. We do not maintain key person life insurance for any of its senior executive officers.

Our directors and executive officers may effectively control any vote of stockholders of our company.

        Our directors and executive officers collectively beneficially own 15.83% of the Common Stock. Although there are no agreements or arrangements with respect to voting such Common Stock among such persons, they, if acting together, may effectively be able to control any vote of our stockholders and thereby exert considerable influence over the affairs of our company. James T. Sartain, President and Chief Executive Officer of our company, is the beneficial owner of 5.68% of the Common Stock. There can be no assurance that the interests of management or the other entities and individuals will be aligned with our other stockholders.

Restrictions on transfer of shares may prevent certain holders of our Common Stock from transferring such stock.

        Our Amended and Restated Certificate of Incorporation (the "Certificate of Incorporation") contains provisions restricting the transfer of its securities that are designed to delay, defer or prevent a change of control of our company by deterring unsolicited tender offers or other unilateral takeover proposals and compelling negotiations with our Board of Directors rather than non-negotiated takeover attempts even if such events may be in the best interests of our stockholders. Our Certificate of Incorporation also contains certain provisions restricting the transfer of securities in our company that are designed to prevent ownership changes that might limit or eliminate our ability to use our NOLs resulting from the Merger. Such restrictions may prevent certain holders of Common Stock from transferring such stock even if such holders are permitted to sell such stock without restriction under the Securities Act of 1933, as amended, and may limit our ability to sell Common Stock to certain

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existing holders of Common Stock at an advantageous time or at a time when capital may be required but unavailable from any other source.

We may be adversely affected by period to period variances.

        The revenue of our company and Acquisition Partnerships is based on proceeds realized from the resolution of the Portfolio Assets, which proceeds have historically varied significantly and likely will continue to vary significantly from period to period. Consequently, our period-to-period revenue and results of operations have historically varied, and are likely to continue to vary, correspondingly. Such variances, alone or with other factors, such as conditions in the economy or the financial services industries or other developments affecting us, may result in significant fluctuations in our reported operations and in the trading prices of our securities, particularly the Common Stock.

We may be adversely affected by tax, monetary and fiscal policy changes.

        We originate and acquire financial assets, the value and income potential of which are subject to influence by foreign regulations, various state and federal tax, monetary and fiscal policies in effect from time to time. The nature and direction of such policies are entirely outside our control, and we cannot predict the timing or effect of changes in such policies. Changes in such policies could have a material adverse effect on our consolidated financial position, results of operations and business prospects.

We may be adversely affected by changes in future cash receipts.

        We have in the past been able to establish with reasonable accuracy the estimated future cash receipts over the life of a purchased asset pool. Changes in economic conditions, fluctuations in interest rates, deterioration of collateral values, and other factors described in this section could cause the estimates of future cash flows to be materially different than actual cash receipts.

        The effects of an increase in the estimated future cash receipts would generally increase revenues from Portfolio Assets by increasing gross profit on a non-performing or real estate pool and increasing the effective yield on a performing or SOP 03-3 Portfolio while a decrease in future cash receipts would generally have the effect of reducing revenues by reducing gross profit on a non-performing or real estate pool and decreasing the effective yield on a performing or SOP 03-3 Portfolio. In some cases a reduction in the total future cash receipts by collecting those cash receipts sooner than expected could have a positive impact on our revenues from Portfolio Assets due to reduced interest expense and other carrying costs associated with the Portfolio Assets. Although such trend is a generally positive trend, we may be adversely affected by the higher levels of interest expense and other carrying costs of the Portfolios negating any potentially positive effects.

Item 1B.    Unresolved Staff Comments.

        None.

Item 2.    Properties.

        The Company occupies approximately 61,000 square feet of office space, all of which is leased. The Company leases its current headquarters building under a noncancellable operating lease, which expires December 31, 2011 with an option to renew for an additional five years. All leases of the other offices of the Company and subsidiaries expire prior to 2015. Such office space is suitable and adequate

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for the Company's current needs. The following is a list of the Company's principal physical properties leased as of December 31, 2006.

Item 3.    Legal Proceedings.

FCLT Litigation

        On January 19, 2005, Prudential Financial, Inc. ("Prudential") filed a petition in interpleader seeking to interplead 321,211 shares of Prudential common stock and any associated dividends arising from the demutualization of Prudential in December 2000. The shares of Prudential common stock related to group annuity contracts purchased by First-City National Bank of Houston, as trustee of the First City Bancorporation Employee Retirement Trust (the "Trust") to fund obligations to participants in the First City Bancorporation Employee Retirement Plan (the "'Plan") in connection with termination of the Plan and the Trust in 1987. FirstCity, FCLT Loans Asset Corp. ("FCLT"), an alleged assignee of the FirstCity Liquidating Trust, JP Morgan Chase Bank, National Association ("JP Morgan"), and First-City National Bank of Houston as trustee of the Trust were made defendants in the suit as claimants to the Prudential common stock and dividends. An agreed order dated January 27, 2005, was entered by the court providing that the Prudential common stock be transferred to JP Morgan as record owner and that JP Morgan sell the stock. The January 27, 2005 order also provided that the proceeds from the sale be held by JP Morgan pending resolution, by agreement or court order, of all conflicting claims to the proceeds. JP Morgan advised that the Prudential common stock was sold on January 28, 2005 for total proceeds of approximately $17.5 million. JP Morgan also received funds in the amount of approximately $489,000, which were dividend payments related to the Prudential common stock. The proceeds are being held by JP Morgan pending resolution of the conflicting claims. JP Morgan filed a third party action naming Mr. Blair as a third party defendant with an alleged interest in the demutualization proceeds. On October 1, 2005, the court certified a class represented by Mr. Blair.

        FirstCity, FCLT and Mr. Blair each filed motions for summary judgment asserting ownership of the proceeds of the common stock and the dividends and accrued income. On March 21, 2006, FirstCity received notice that the 152nd District Court, Harris County, Texas granted FirstCity's motion for partial summary judgment. The order granting FirstCity's motion for partial summary judgment rendered judgment in favor of FirstCity as to the ownership of the demutualization proceeds. The court's summary judgment order also denied the claims to ownership of the demutualization proceeds by FCLT and Mr. Blair, individually and as representative of the proposed class of employee beneficiaries. The motions submitted to the court prior to its order dated March 21, 2006 did not address all matters pending in the lawsuit. Mr. Blair, as class representative, filed a motion for new trial to set aside the summary judgment in favor of FirstCity and for reconsideration of granting Mr. Blair's motion for summary judgment. FCLT filed a motion for the court to reconsider its order granting the partial summary judgment for FirstCity. FirstCity moved for summary judgment on all remaining claims and for entry of a final judgment on May 12, 2006. On August 14, 2006, the court entered an order (i) finding that FirstCity is the sole owner of the "demutualization proceeds" being the proceeds from the sale of the 321,211 shares of Prudential Financial, Inc. stock, the dividends on

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such shares and all accrued interest and income arising there from, (2) granting FirstCity's motion for summary judgment against FCLT's claims for breach of contract and tortious interference, (3) providing that JP Morgan continue to hold the demutualization proceeds until the appellate process has been completed, (4) denying the request by FirstCity that FCLT or Mr. Blair be required to post bond or other form of security on appeal, and (5) denying all other claims for relief. FCLT and Mr. Blair filed notices of appeal to the First or Fourteenth Court of Appeals of the State of Texas. The appeal has been assigned to the First Court of Appeals and all parties have filed their briefs with the court. The parties participated in court ordered mediation on February 13, 2007 which was unsuccessful. FirstCity cannot give any assurances as to the time period for the appeal of the final judgment or the timing of receipt or ultimate amount of proceeds to be received, if any.

        In the trial court, FCLT filed a counterclaim against FirstCity claims for damages related to alleged breaches of contract by FirstCity related to failure to assign the proceeds to FCLT and FirstCity's assertion of a claim to the proceeds and a claim for tortious interference by FirstCity as a result of FirstCity's claim for the proceeds. In connection with that claim, FCLT seeks to recover attorney's fees and other damages related to the assertion by FirstCity of an interest in the shares of Prudential common stock. No amount has been asserted by FCLT Loans Asset Corp. and the company does not believe that its actions give rise to a claim by FCLT Loans Asset Corp. The trial court denied these claims of FCLT in its orders resolving claims with respect to the motions for summary judgment filed by each of the parties. The appeal by FCLT seeks to overturn the summary judgment rendered against it with respect to these claims. FirstCity believes that the claims of FCLT are without merit and that it has valid defenses to these claims.

Other Litigation

        Periodically, FirstCity, its subsidiaries, its affiliates and the Acquisition Partnerships are parties to or otherwise involved in legal proceedings arising in the normal course of business. While the outcome of the ordinary course legal proceedings, and the related activities, are not certain, based on present assessments, management does not believe that they will have a material adverse effect on the consolidated financial position, results of operations or liquidity of FirstCity, its subsidiaries, its affiliates or the Acquisition Partnerships.

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

        No matters were submitted to a vote of security holders during the quarter ended December 31, 2006.

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PART II

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

        The Company's common stock, $.01 par value per share ("Common Stock") is traded on the Nasdaq Global Select Market under the symbol FCFC. The number of holders of record of Common Stock on July 9, 2007 was approximately 740, as provided by American Stock Transfer, the Company's transfer agent. High and low stock prices for the Common Stock in the two years ended December 31, 2006 and December 31, 2005 are displayed in the following table:

        The Company has never declared or paid a dividend on the Common Stock. The Company currently intends to retain future earnings to finance its growth and development and therefore does not anticipate that it will declare or pay any dividends on the Common Stock in the foreseeable future. Any future determination as to payment of dividends will be made at the discretion of the Board of Directors of the Company and will depend upon the Company's operating results, financial condition, capital requirements, general business conditions and such other factors that the Board of Directors deems relevant. Certain loan facilities to which the Company and its subsidiaries are parties contain restrictions relating to the payment of dividends and other distributions.

        There were no stock repurchases by the Company in the fourth quarter of 2006.

Item 6.    Selected Financial Data.

        The following tables set forth selected consolidated financial information regarding the Company's results of operations and balance sheets. The data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Item 7 and with the related Consolidated Financial Statements and Notes thereto under Item 8 of this Annual Report on Form 10-K, respectively.

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Selected Financial Data

        In December 2002, FirstCity completed a recapitalization in which holders of the New Preferred Stock exchanged 1,092,210 shares of New Preferred Stock, for 2,417,388 shares of common stock and $10.5 million. During 2003, 4,400 shares of New Preferred Stock were redeemed for 8,200 shares of common stock, leaving 126,291 shares outstanding at December 31, 2003. On December 30, 2004, FirstCity redeemed all of the outstanding shares of its New Preferred Stock at a total redemption price of $21.525 per share. The redemption price represented the liquidation preference of the New Preferred Stock plus the final normal quarterly dividend of $.525 per share. In addition, FirstCity issued 400,000 shares of common stock as part of a transaction to acquire the minority interest in FirstCity Holdings, Inc. from Terry R. DeWitt, G. Stephen Fillip and James C. Holmes.

        In December 2004, FirstCity redeemed all of the outstanding shares of its New Preferred Stock at a total redemption price of $21.525 per share. The redemption price represented the liquidation preference of the New Preferred Stock plus the fourth quarter 2004 dividend of $.525 per share. FirstCity completed the sale of its 31% investment in Drive in November 2004. As a result, the consumer lending segment conducted through Drive was no longer considered a principal reportable segment and is treated as a discontinued operation. The results of historical operations have been reflected as discontinued operations in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.

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Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations.

        The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements of the Company (including the Notes thereto) included elsewhere in this Annual Report on Form 10-K.

Overview

        FirstCity is a financial services company engaged in the acquisition and resolution of portfolios of assets or single assets (collectively referred to as "Portfolio Assets"). The Portfolio Asset acquisition and resolution business involves acquiring 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.

        During 2006, the Company recorded earnings to common stockholders on a diluted basis of $9.8 million or $0.83 per common share. The operating contribution from the Portfolio Asset acquisition and resolution segment was $15.1 million compared with $13.8 million for 2005. The Company was able to invest $144.0 million in portfolio acquisitions of $297.0 million during 2006 of which $103.4 million was invested in the United States, $32.9 million in Europe, and $7.7 million in Latin America. In addition to the portfolio acquisitions during 2006, FirstCity invested $9.2 million in partnerships as well as $19.0 million in the form of loans to unrelated entities. As a result, earning assets (equity investments, inventory, loans receivable, and interest receivable) increased to $250.4 million in 2006 compared to $153.4 million in 2005. The 2006 investment level of $144 million represents the highest amount invested in a single year in the history of the Company's Portfolio Asset acquisition and resolution business.

        During the third quarter of 2006, FirstCity completed a total restructure of its investments in Mexico in a transaction which aligned FirstCity with AIG. The Company received $1.9 million in incentive service fees related to the sale of certain assets in Mexico which occurred as a result of the restructure. The details of the restructure are provided in Note 6 to the Consolidated Financial Statements. In addition, the Company recorded a gain on the sale of equity investments of $2.5 million. This gain consisted of: 1) one domestic equity investment resulting in a gain of $1.3 million and 2) a partial sale of Mexico equity investments in connection with a restructure with AIG resulting in a gain of $1.2 million.

        Management remains positive on the outlook of the Company. The acquisitions for 2006 contributed to a $97 million net increase in the primary earning assets base of the Company and FirstCity is currently evaluating 25 different transactions representing over $1.5 billion in face value of assets.

        In November 2006, the Company was able to secure an increase in its revolving line of credit with the Bank of Scotland up to a maximum of $175 million. The original line of credit was $96 million and, in accordance with the terms of the agreement, had been reduced to $90.7 million.

        In November 2006, the Company, through its subsidiary American Business Lending, Inc., acquired a license from the U.S. Small Business Administration (the "SBA") to originate and service SBA 7(a) loans. In addition, a $25 million revolving loan facility was obtained from Wells Fargo Foothill, Inc. ("WFF") to assist in the financing of these loans. In February 2007, this facility was increased to $40 million.

        In the fourth quarter of 2004, FirstCity sold its 31% beneficial ownership interest in Drive. This sale generated a $53.3 million net gain ($54.4 million gain, net of $1.1 million in taxes) which was reflected in the 2004 results of the Company as "earnings from discontinued operations." The $86.8 million proceeds from the sale were primarily used to retire debt. Following the sale, FirstCity and Bank of Scotland restructured the then-existing $50 million revolving credit facility into a

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$96 million revolving acquisition facility, which has subsequently been amended to a $175 million facility that matures in November 2010.

        The Company's financial results are affected by many factors including levels of and fluctuations in interest rates, fluctuations in the underlying values of real estate and other assets, the timing of and ability to liquidate assets, and the availability and prices for loans and assets acquired in all of the Company's businesses. The Company's business and results of operations are also affected by the availability of financing with terms acceptable to the Company and the Company's access to capital markets, including the securitization markets.

        As a result of the significant period to period fluctuations in the revenues and earnings of the Company's Portfolio Asset acquisition and resolution business, period to period comparisons of the Company's results of continuing operations may not be meaningful.

Results of Independent Investigation

        The Audit Committee of the Board of Directors conducted an independent investigation to review whether FirstCity and its subsidiaries received inadequate compensation, or other improprieties occurred, with respect to the sale of a loan portfolio to a third party, and FirstCity's compliance with laws applicable to its foreign operations as a result of allegations against an officer of an affiliate of FirstCity regarding matters that occurred prior to the individual's becoming an officer of that affiliate. The Audit Committee engaged an outside law firm to act as independent counsel and conduct the investigation. Independent counsel worked with external forensic accountants to conduct its review.

        The Independent Investigation found that the loan portfolio sale was initiated by other portfolio investors, who owned a majority investment in the portfolio, and that the portfolio appeared to have been sold for the best price available at the time. The Independent Investigation found no evidence indicating that FirstCity or any officer, manager or full-time employee personally benefited from the transactions relating to the portfolio sale. The Independent Investigation concluded that the sales price received by FirstCity and the other portfolio investors was reasonable based upon the information that was available at the time of the sale.

        The Independent Investigation concluded that it was unable to complete its review of the issues relating to allegations against the officer of an affiliate of FirstCity due to its inability to access certain documentation outside FirstCity's custody and control. FirstCity has reviewed these issues, performed on-site procedures at the affiliate location and has determined that no adjustment to FirstCity's financial statements is required in connection with this issue.

        The Independent Investigation recommended improvements designed to provide additional assurances for accurate financial reporting, particularly with respect to FirstCity's Latin American operations, and to improve FirstCity's internal control structure. The Independent Investigation also recommended changes in FirstCity's approach to foreign business relationships. In addition, the Independent Investigation made a number of recommendations aimed at improving FirstCity's compliance practices and procedures. FirstCity has already begun taking steps to implement the foregoing recommendations.

        FirstCity has not identified any material adjustment to its financial statements that is required in connection with the results of the Independent Investigation. The costs associated with the investigation through July 6, 2007 were approximately $2.0 million, with $1.2 million reflected in the first quarter 2007 results and approximately $800,000 to be reflected in the second quarter 2007 results.

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Results of Operations

2006 Compared to 2005

        Net earnings to common stockholders were $9.8 million in 2006 compared to $8.2 million in 2005. On a per share basis, diluted net earnings to common stockholders were $.83 in 2006 compared to $.69 in 2005. The Company reported earnings from continuing operations of $9.9 million in 2006 compared to $8.1 million in 2005. Losses from discontinued operations were $75,000 in 2006 compared to earnings of $153,000 in 2005. Following is a discussion of the Portfolio Asset acquisition and resolution segment and other corporate overhead as presented in note 8 of the consolidated financial statements.

Portfolio Asset Acquisition and Resolution

        The operating contribution from the Portfolio Asset acquisition and resolution business of $15.1 million in 2006 increased from $13.8 million in 2005. FirstCity purchased $297.0 million of Portfolio Assets during 2006 ($206 million through the Acquisition Partnerships) compared to $146.6 million in acquisitions in 2005. FirstCity's investment in these acquisitions was $144.0 million and $71.4 million in 2006 and 2005, respectively. FirstCity's year-end investment in wholly-owned Portfolio Assets was $108.7 million at December 31, 2006 compared to $49.3 million at December 31, 2005.

        Servicing fee revenues.    Servicing fee revenues increased by 9.8% to $12.9 million in 2006 from $11.8 million in 2005. Service fees from the Latin American partnerships (including incentive service fees) increased by $1.3 million or 16.3% as a result of a $1.9 million incentive service fee resulting from the restructure of the Mexican Investment Platform offset by efforts to reduce operating costs in Mexico. For the Mexican Acquisition Partnerships, FirstCity earns a servicing fee based on costs of servicing plus a profit margin. Service fees from domestic Acquisition Partnerships decreased by $.18 million or 5% due to a lower service fee rate produced based on the mix of collections.

        Income from Portfolio Assets.    Income from Portfolio Assets increased 33.0% to $11.0 million in 2006 compared to $8.3 million in 2005, primarily due to increased resolution of portfolio assets. FirstCity's average investment in wholly-owned domestic portfolio assets was $60.1 million and $40.9 million during 2006 and 2005, respectively.

        Interest income from affiliates.    Interest income from affiliates decreased slightly to $1.5 million in 2006 from $1.8 million in 2005.

        Interest income from loans receivable—other.    Interest income from loans receivable—other was $.6 million in 2006 and relates to loans originated in the latter half of 2006 which included loans to a Canadian real estate company, and two domestic real estate companies.

        Other income.    Other income was $1.6 million in 2006 compared to $1.7 million in 2005, primarily due to a reduction in the estimated carrying value of loans payable to certain members of management by $.3 million. See further discussion related to these loans in note 2 of the consolidated financial statements.

        Expenses.    Operating expenses were $26.4 million in 2006 compared to $21.7 in 2005. The following is a discussion of the major components.

        Interest and fees on notes payable increased to $8.3 million in 2006 compared to $4.0 million in 2005. The average debt for the period increased to $100.3 million in 2006 from $56.4 million in 2005 and the average cost of borrowing increased to 8.3% in 2006 from 7.1% in 2005.

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        Salaries and benefits decreased to $11.4 million in 2006 from $12.1 million in 2005. Total personnel within the Portfolio Asset acquisition and resolution segment were 176 and 184 at December 31, 2006 and 2005, respectively.

        The provision for loan and impairment losses was $271,000 in 2006 and $212,000 in 2005. See note 1(e) of the consolidated financial statements for a detailed discussion on FirstCity's allowance for loan losses.

        Occupancy, data processing, communication and other expenses increased by 23% to $6.5 million in 2006 from $5.3 million in 2005 primarily due to higher servicing and legal and accounting fees.

        Minority interest expense was minimal from year to year.

        Equity in earnings of investments.    Equity in earnings of investments decreased slightly to $11.8 million in 2006 compared to $12.0 million in 2005. Equity earnings in Acquisition Partnerships decreased by 3.9% to $10.9 million in 2006 from $11.4 in 2005. Equity in earnings of servicing entities increased by 28.9% to $.8 million in 2006 from $.6 million in 2005. Following is a discussion of equity earnings in Acquisition Partnerships by geographic region. See note 6 to the consolidated financial statements for a summary of revenues and earnings of the Acquisition Partnerships and equity in earnings of the Acquisition Partnerships.

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Domestic—Equity in earnings of domestic Acquisition Partnerships decreased by 19.1% to $6.5 million in 2006 compared to $8.0 in 2005 primarily as a result of declines in earnings from older partnerships as the Portfolios liquidate. These partnerships reflected net earnings of $13.8 million in 2006 compared to $19.4 million in 2005. Income from Portfolio Assets in 2005 was generated primarily from loans acquired prior to 2005, whereas income in 2006 was generated primarily from loans acquired after 2004. Although collections on Portfolio Assets increased to $114 million in 2006 from $101 million in 2005, income from Portfolio Assets acquired after 2004 is less sensitive to collections than from Portfolio Assets acquired prior to 2005. For Portfolios acquired after 2004, income is recognized ratably over the remaining life of the Portfolio based on an expected yield. For nonperforming loans acquired prior to 2005, income is recognized to the extent that collections exceed a pro rata portion of allocated cost from the pool.



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Latin America—Equity in loss of Latin American Acquisition Partnerships remained flat at $.2 million in 2006 compared to $.2 million in 2005. These partnerships reflected a loss of $6.9 million in 2006 compared to $3.7 million in 2005. Although the revenues were higher compared to the previous period, the partnerships recorded foreign exchange losses of $10.5 million in 2006 compared to gains of $17 million in 2005 (of which $.6 million losses and $1.4 million gains are included in equity earnings, respectively). In addition, provisions net of recoveries of allowance for loan losses of $1.4 million were recorded in 2006 compared to $11 million for the same period in 2005. Interest expense of $9.3 million and $10.4 million were recorded in 2006 and 2005 respectively. This interest was owed to the investors in these partnerships, of which FirstCity recorded $.9 million and $1.6 million as interest income in 2006 and 2005, respectively. FirstCity eliminated substantially all of its loans receivable from the Mexican acquisition partnerships as a result of the restructure of the Mexican Investment Platform during the third quarter of 2006.



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Europe—Equity in earnings of European Acquisition Partnerships increased by 29.8% to $4.6 million in 2006 compared to $3.6 million in 2005. This increase was principally due to an increase in investments in European acquisitions. During 2006 and 2005, FirstCity recorded $1.1 million and $.8 million, respectively, in foreign currency transactions gains (included in other expenses) related to investments in Europe. During 2006, FirstCity invested in three new portfolios in Germany. The management of the Company anticipates that the cash flow

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generated by these new portfolios will produce a positive contribution to future equity earnings in Europe.

        Gain on sale of equity investments.    Gain on sale of equity investments of $2.5 million was recorded in 2006. This gain primarily consisted of: 1) one domestic equity investment resulting in a gain of $1.3 million; and 2) a partial sale of twelve Latin American equity investments to AIG resulting in a gain of $1.2 million in accordance with the restructuring of the Mexican Investment Platform.

Other Items Affecting Operations

        The following items affect the Company's overall results of operations and are not directly allocated to the Portfolio Asset acquisition and resolution business discussed above.

        Corporate interest and overhead.    Net corporate overhead expenses (excluding taxes) decreased from $5.6 million in 2005 to $5.2 million in 2006, primarily due to increased management fee income from acquisition partnerships, from $.5 million in 2005 to $.7 million in 2006. Other expenses increased due to recording $.4 million in stock option expense beginning 2006 in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, offset by decreased legal and accounting fees from $1.3 million in 2005 to $1.0 million in 2006.

        Income taxes.    Provision for income taxes was $186,000 in 2006 compared to $250,000 in 2005, and taxes in both years related primarily to state income taxes. Federal income taxes are provided at a 35% rate applied to taxable income or loss and are offset by NOLs that the Company believes are available. The tax benefit of the NOLs is recorded in the period during which the benefit is realized. The Company recorded no deferred tax provision in 2006 and 2005.

        Discontinued Operations.    The Company recorded a provision of $75,000 in 2006 for additional losses from discontinued mortgage operations compared to $356,000 in 2005. At December 31, 2006, the only asset remaining from discontinued mortgage operations was 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 the underlying asset. The assumptions used in the valuation model consider both industry as well as the Company's historical experience. As the security "runs off," assumptions are reviewed in light of historical evidence in revising the prospective results of the model. These revised assumptions could potentially result in either an increase or decrease in the estimated cash receipts. An additional provision is booked based on the output of the valuation model if deemed necessary.

        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. The transaction did not have an impact on the results of operations, but did result in the elimination of $.8 million of residual interest previously classified as discontinued mortgage assets.

        Earnings from discontinued consumer operations were zero in 2006 compared to $509,000 in 2005. On November 1, 2004, FirstCity completed the sale of its remaining 31% interest in Drive and recognized a net gain of $53.3 million. In 2005, an estimated tax provision of $.6 million was reversed due to lower than anticipated state income taxes related to the sale.

2005 Compared to 2004

        Net earnings to common stockholders were $8.2 million in 2005 compared to $63.6 million in 2004. On a per share basis, diluted net earnings to common stockholders were $.69 in 2005 compared to $5.37 in 2004. The Company reported earnings from continuing operations of $8.1 million in 2005

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compared to $5.0 million in 2004. Earnings from discontinued operations were $153,000 in 2005 and $58.6 million in 2004.

Portfolio Asset Acquisition and Resolution

        The operating contribution from the Portfolio Asset Acquisition and Resolution business of $13.8 million in 2005 decreased from $14.4 million in 2004. FirstCity purchased $147 million of Portfolio Assets during 2005 ($115 million through the Acquisition Partnerships) compared to $174 million in acquisitions in 2004. FirstCity's investment in these acquisitions was $71.4 million and $59.8 million in 2005 and 2004, respectively. FirstCity's year-end investment in wholly-owned Portfolio Assets was $49.3 million at December 31, 2005 compared to $38.0 million at December 31, 2004.

        Servicing fee revenues.    Servicing fee revenues decreased by 14% to $11.8 million in 2005 from $13.7 million in 2004. Service fees from the Latin American partnerships (including incentive service fees) decreased by $.7 million or 8% as a result of efforts to reduce operating costs in Mexico. For the Mexican Acquisition Partnerships, FirstCity earns a servicing fee based on costs of servicing plus a profit margin. Service fees from domestic Acquisition Partnerships decreased by $1.3 million or 26% due to lower collections.

        Income from Portfolio Assets.    Income from Portfolio Assets increased to $8.3 million in 2005 compared to $2.5 million in 2004, primarily due to increased resolution of portfolio assets. FirstCity's average investment in wholly-owned domestic portfolio assets was $40.9 million and $17.6 million during 2005 and 2004, respectively.

        Interest income from affiliates.    Interest income from affiliates decreased to $1.8 million in 2005 from $2.3 million in 2004.

        Other income.    Other income was $1.7 million in 2005 compared to $2.1 million in 2004. This decrease was primarily due to a reduction in 2004 of the estimated carrying value of loans payable to certain members of management, which increased other income by $.8 million. See further discussion related to these loans in note 2 of the consolidated financial statements. In 2005, the decrease was offset in part by an increase in reimbursements of due diligence expenses which will vary from period to period.

        Expenses.    Operating expenses were $21.7 million in 2005 compared to $21.0 in 2004.

        Interest and fees on notes payable increased slightly to $4.0 million in 2005 compared to $3.8 million in 2004. The average debt for the period increased to $56.4 million in 2005 from $43.6 million in 2004; however, the average cost of borrowing declined to 7.1% in 2005 from 8.71% in 2004.

        Salaries and benefits decreased slightly to $12.1 million in 2005 from $12.4 million in 2004. Total personnel within the Portfolio Asset acquisition and resolution segment were 184 and 204 at December 31, 2005 and 2004, respectively.

        The provision for loan and impairment losses was $212,000 in 2005 and $30,000 in 2004. See note 1(e) of the consolidated financial statements for a detailed discussion on FirstCity's allowance for loan losses.

        Occupancy, data processing, communication and other expenses increased by 12% to $5.3 million in 2005 from $4.7 million in 2004 primarily due to higher property protection expenses.

        Minority interest expense was minimal from year to year.

        Equity in earnings of investments.    Equity in earnings of investments decreased by 19% to $12.0 million in 2005 compared to $14.9 million in 2004. Equity earnings in Acquisition Partnerships

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decreased by 19% to $11.4 million in 2005 from $14.0 in 2004. Equity in earnings of servicing entities decreased by 32% to $.6 million in 2005 from $.9 million in 2004. Following is a discussion of equity earnings in Acquisition Partnerships by geographic region. See note 6 to the consolidated financial statements for a summary of revenues and earnings of the Acquisition Partnerships and equity in earnings of the Acquisition Partnerships.

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Domestic—Equity in earnings of domestic Acquisition Partnerships decreased by 19% to $8.0 million in 2005 compared to $9.9 in 2004 primarily as a result of a decrease in collections of $101 million in 2005 compared to $121 million in 2004.



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Latin America—Equity in loss of Latin American Acquisition Partnerships decreased to $.2 million in 2005 compared to $1.0 million in 2004. These partnerships recorded foreign exchange gains of $17 million in 2005 compared to $3.0 million in 2004, of which $1.4 million and $.2 million are included in equity earnings, respectively. These gains reduced the impact of a decrease in collections in 2005 to $65 million from $73 million in 2004, and the increase in the provision for impairments on loans to $11 million in 2005 compared to $.7 million in 2004. These partnerships reflected a loss of $3.7 million in 2005 compared to $5.3 million in 2004. Interest expense of $10.4 million and $11.6 million were recorded in 2005 and 2004; respectively. This interest is owed to the investors of these partnerships, of which FirstCity recorded $1.6 million and $2.0 million in 2005 and 2004, respectively, as interest income.



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Europe—Equity in earnings of European Acquisition Partnerships decreased by 30% to $3.6 million in 2005 compared to $5.1 million in 2004. This decrease was principally due to a decrease in collections in 2005 to $57 million compared to $90.4 million in 2004. During 2005 and 2004, FirstCity recorded $.8 million and $.7 million, respectively, in foreign currency transactions gains (included in other expenses) related to investments in Europe. During the fourth quarter of 2005, FirstCity invested in two new portfolios in Germany.

Other Items Affecting Operations

        The following items affect the Company's overall results of operations and are not directly allocated to the Portfolio Asset acquisition and resolution business discussed above.

        Corporate interest and overhead.    Company level interest expense was zero in 2005 compared to $3.4 million in 2004 as a result of the payoff of corporate debt in November 2004 from proceeds received on the sale of the Company's 31% beneficial interest in Drive. Other net corporate overhead expenses (excluding taxes) decreased to $5.6 million in 2005 from $5.9 million in 2004.

        Income taxes.    Provision for income taxes was $250,000 in 2005 and related primarily to state income taxes. Taxes in 2004 were $75,000 and related primarily to federal alternative minimum taxes. Federal income taxes are provided at a 35% rate applied to taxable income or loss and are offset by NOLs that the Company believes are available. The tax benefit of the NOLs is recorded in the period during which the benefit is realized. The Company recorded no deferred tax provision in 2005 and 2004.

        Discontinued Operations.    The Company recorded a provision of $.4 million in 2005 for additional losses from discontinued mortgage operations compared to $3.8 million in 2004. At December 31, 2005, the only asset remaining from discontinued mortgage operations was 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 the underlying asset. The assumptions used in the valuation model consider both industry as well as the Company's historical experience. As the security "runs off," assumptions are reviewed in light of historical evidence in revising the prospective results of the model. These revised assumptions could potentially result in either an increase or decrease in the estimated cash receipts. An additional provision is booked based on the output of the valuation model if deemed necessary.

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        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. The transaction did not have an impact on the results of operations, but did result in the elimination of $.8 million of residual interest previously classified as discontinued mortgage assets.

        Earnings from discontinued consumer operations were $.5 million in 2005 compared to $62.5 million in 2004. On November 1, 2004, FirstCity completed the sale of its remaining 31% interest in Drive and recognized at net gain of $53.3 million. During the third quarter of 2005, an estimated tax provision of $.6 million was reversed due to lower than anticipated state income taxes related to the sale.

Portfolio Asset Acquisition and Resolution

        In 2006 the Company invested $144 million in Portfolios acquired through Acquisition Partnerships and subsidiaries. Acquisitions by the Company over the last five years are summarized as follows:

        Revenues with respect to the Company's Portfolio Asset acquisition and resolution segment consist primarily of (i) servicing fees from Acquisition Partnerships for the servicing activities performed related to the assets held in the Acquisition Partnerships, (ii) interest income on performing Portfolio Assets and loans receivable, and (iii) gains on disposition of assets. The Company also records equity in earnings of affiliated Acquisition Partnerships and servicing entities.

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 $175 million revolving acquisition facility with Bank of Scotland as most recently amended on June 29, 2007, used to finance the senior debt and equity portion of portfolio and asset purchases made by FirstCity and to provide for the issuance of letters of credit and working capital loans. The obligations of FirstCity under this facility are guaranteed by substantially all of the wholly-owned subsidiaries of FirstCity and are secured by security interests in substantially all of the assets of

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FirstCity and its wholly-owned subsidiaries. An additional upfront fee was paid to Bank of Scotland in the amount of $830,000. The primary terms and key covenants of this facility are as follows:

•

The maximum outstanding amount of loans and letters of credit issued under the loan facility that may be outstanding under the loan facility is $175 million;



•

The available interest rates under the loan facility are LIBOR plus 2.00% to 2.50% per annum;



•

The maximum value for assets that can be included in the borrowing base from the acquisition of portfolio assets in certain countries are as follows: Mexico—$30 million, Brazil—$5 million, Chile—$10 million, and Argentina or Uruguay—$6 million;



•

The limit for Loans that can be borrowed in Euros under the loan facility is $50 million;



•

The maximum amount of letters of credit that can be issued under the loan facility is $40 million;



•

The maximum amount of working capital loans that can be outstanding under the loan facility is $35 million;



•

The ratio of EBITDA to Interest Coverage should not be not less than 1.50 to 1.00 for each twelve month period;



•

The ratio of Indebtedness to Tangible Net Worth should be equal to or less than 3.5 to 1.00 for the last day of the fiscal quarter;



•

The ratio of Cumulative Current Recovered and Projected Collections to Cumulative Original Projected Collections should not be less than 0.90 to 1.00; and



•

The maturity date for the loan facility is November 12, 2010.

        FH Partners, L.P., an indirect wholly-owned affiliate of FirstCity, has a revolving loan facility with Bank of Scotland, as most recently amended on June 29, 2007, that provides for 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 an annual commitment fee of 0.20% of the average daily 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 $350,000, (viii) provides for facility fees of $100,000, for the period commencing on the effective date and ending the day before the first anniversary thereof, $75,000, for the period commencing on the first anniversary of the effective date and ending the day before the second anniversary thereof, and $50,000, for each subsequent one-year period, (ix) provides that all other financial covenants will mirror the key covenants of the facility that FirstCity has with Bank of Scotland, and (x) provides for a maturity date of November 12, 2008. The obligations of FH Partners, L.P. under the facility are guaranteed by FirstCity and the primary wholly-owned subsidiaries of FirstCity.

        At December 31, 2006, the Company had $48.3 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

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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 ($2.5) million for the year ended December 31, 2006, $1.3 million for 2005, and ($.3) million for 2004.

        On September 22, 2006, FirstCity NPL S.A., a Chilean affiliate of FirstCity Chile Ltda and FirstCity, entered into a revolving line of credit with a maximum loan amount in Chilean pesos equivalent to $10.0 million U.S. Dollars with CORPBANCA Sociedad Anónima Bancaria ("CB") to finance the purchase of delinquent and due accounts. The revolving line of credit was structured by Corpbanca Asesorías Financieras S.A. ("CAF"). Pursuant to the terms of the credit facility, FirstCity NPL S.A. was required to provide a stand-by letter of credit from Bank of Scotland that would satisfy the loan balance upon demand. At December 31, 2006, FirstCity had a letter of credit in the amount of $6.3 million from Bank of Scotland under the terms of FirstCity's revolving acquisition facility with Bank of Scotland. In the event that a demand is made under the $6.3 million letter of credit, FirstCity is required to reimburse Bank of Scotland by making payment to Bank of Scotland for all amounts disbursed or to be disbursed by Bank of Scotland under the letter of credit.

        On November 29, 2006, FirstCity Mexico SA de CV, a Mexican affiliate of FirstCity, entered into a revolving line of credit with a maximum loan amount in Mexican pesos equivalent to $13.4 million U.S. Dollars with Banco Santander, S.A. The proceeds were used to pay down the acquisition facility with the Bank of Scotland. Pursuant to the terms of the credit facility, FirstCity Mexico SA de CV was required to provide a stand-by letter of credit from Bank of Scotland that would satisfy the loan balance upon demand. At December 31, 2006, FirstCity had a letter of credit in the amount of $14.1 million from Bank of Scotland under the terms of FirstCity's revolving acquisition facility with Bank of Scotland. In the event that a demand is made under the $14.1 million letter of credit, FirstCity is required to reimburse Bank of Scotland by making payment to Bank of Scotland for all amounts disbursed or to be disbursed by Bank of Scotland under the letter of credit.

        On December 20, 2006, American Business Lending, Inc. ("ABL"), a subsidiary of FirstCity, and Wells Fargo Foothill, Inc., entered into a Credit Agreement dated effective as of December 15, 2006 that provides for a $25 million revolving loan facility for ABL which is secured by substantially all of the assets of ABL. The revolving loan facility, (i) allows advances in the maximum amount of $25 million to be made under the Credit Agreement for the purpose of paying fees and expenses in connection with the closing of the Credit Agreement and financing loans made by ABL, a portion of which are guaranteed by the U.S. Small Business Administration, (ii) provides that the aggregate outstanding principal amount of the advances made to ABL under the Credit Agreement may not exceed the amount by which (a) the sum of (1) up to one hundred percent (100%) of the net eligible SBA guaranteed loans made by ABL, plus (2) up to eighty percent (80%) of the net eligible non-guaranteed loans made by ABL (or portion thereof), exceeds (b) the sum of (1) any reserves for obligations of ABL related to the bank products, plus (2) the aggregate amount, if any, of loan reserves then established and outstanding, plus (3) the aggregate amount of any other reserves established by WFF, (iii) provides for an interest rate of LIBOR plus 2.625% or, alternatively, the greater of (x) the Wells Fargo prime rate or (y) seven and one-half percent (7.50%) per annum, (iv) provides for a closing fee of $125,000, being one-half of one percent (0.50%) of the Maximum Credit Line available under the Credit Agreement, (v) provides for an unused credit line fee in an amount equal to one-quarter of one percent (0.25%) per annum of the average daily difference during the month in question (or portion thereof) between (i) the Maximum Credit Line and (ii) the aggregate outstanding principal amount of the advances outstanding under the Credit Agreement for such month (or portion thereof), (vi) provides in the event of the termination of the Credit Agreement by ABL for a prepayment fee of three percent (3.0%) of the Maximum Credit Line if paid prior to December 14, 2007, two percent (2.0%) of the Maximum Credit Line if paid during the period beginning December 15, 2007 and ending December 14, 2008, and one percent (1.0%) of the Maximum Credit Line if paid during the period beginning December 15, 2008 and ending December 13, 2009, and

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(vii) provides for a maturity date of December 14, 2009. At December 31, 2006, the balance of this facility was zero. In February 2007 American Business Lending, Inc., an affiliate of FirstCity, and Wells Fargo Foothill, Inc., amended the Credit Agreement to increase the revolving credit facility to a maximum credit line of $40 million that matures on December 13, 2009. In connection with this amendment, FirstCity provided Wells Fargo Foothill, Inc. with an unconditional guaranty of the obligations under the loan facility on behalf of ABL up to a maximum of $5 million. This guaranty will remain in effect for the life of the loan facility.

        The Credit Agreement has covenants that are customary for a facility of this type, including maximum capital expenditure levels and financial covenants related to indebtedness to tangible net worth ratio, earnings before interest, taxes, depreciation and amortization, and tangible net worth for ABL. The Credit Agreement contains representations and warranties by ABL, events of default and other provisions that are customary for a facility of this type. The security agreement executed by ABL to secure the obligations under the Credit Agreement grants a security interest to WFF in all of the assets of ABL except (a) the unguaranteed portions of any SBA-guaranteed loan originated by AMRESCO SBA Holdings, Inc. ("ASBA") and transferred to ABL pursuant to the Asset Purchase Agreement dated as of June 30, 2006, by and among NCS I, LLC and ASBA, as sellers, ABL, as the purchaser, and FirstCity Business Lending Corporation and FirstCity pursuant to which ABL acquired those SBA loans, and any other assets transferred by ASBA to ABL pursuant to that Asset Purchase Agreement, including, the Small Business Lending Corporation license. The security agreement also contains other provisions that are customary for a facility of this type. Pursuant to the terms in the Asset Purchase Agreement, the Sellers retained control over the loan assets transferred.

        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.

        Excluding the term acquisition facilities of the unconsolidated Acquisition Partnerships, as of December 31, 2006, the Company and its subsidiaries had credit facilities providing for borrowings in an aggregate principal amount of $292 million and outstanding borrowings of $188 million.

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

Discussion of Critical Accounting Policies

        In the ordinary course of business, the Company has made a number of estimates and assumptions relating to the reporting of results of operations and financial position in the preparation of its consolidated financial statements in conformity with accounting principles generally accepted in the United States. Actual results could differ significantly from those estimates under different assumptions and conditions. The Company believes that the following discussion addresses the Company's most critical accounting policies, which are those that are most important to the portrayal of the Company's consolidated financial position and results and require management's most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Revenue Recognition: Portfolio Assets

        On January 1, 2005, FirstCity adopted the provisions of SOP 03-3 (as defined under "Effect of New Accounting Standards"). For loan portfolios acquired prior to January 1, 2005, FirstCity

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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 nonperforming loans acquired after 2004 in accordance with SOP 03-3. 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. Accounting for non-performing portfolios is on a pool basis as opposed to an individual asset-by-asset basis. 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.

        All non-performing Portfolio Assets are purchased at discounts from their outstanding legal principal amount, the total of the aggregate of expected future sales prices and the total payments to be received from obligors. Subsequent to acquisition, the adjusted cost of non-performing Portfolio Assets 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 non-performing pool. Once it is determined that there is impairment, 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 in 2006 and 2005 and $16,000 in 2004.

        The actual future proceeds of the pool could vary materially from the estimated proceeds of the pool due to changes in economic conditions, deterioration of collateral values, deterioration in the borrower's financial condition and other conditions described in the risk factors discussed earlier in this document. In the event that the actual future proceeds of the pool exceed the current estimates, the reported future results of the Company could be higher than anticipated and would result in a higher net gain on resolution of non-performing Portfolio Assets. In the event that actual future proceeds of the pool are less than current estimates, the reported future results of the Company could be lower than anticipated and would result in lower net gain on resolution of non-performing Portfolio Assets or possibly require the Company to recognize impairment in the value of the pool.

Performing Portfolio Assets

        Performing Portfolio Assets consist primarily of portfolios of 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.

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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.

        The actual future cash flows of the pool could vary materially from the expected future cash flows of the pool due to changes in economic conditions, changes in collateral values, deterioration in the borrowers financial condition, restructure or renewal of individual loans in the pool, sale of loans within the pool and other conditions described in the risk factors discussed earlier in this document. In the event that the actual future cash flows of the pool exceed the current estimates, the reported future results of the Company could be higher than anticipated and would result in a higher level of interest income due to greater amounts of discount accretion being included in revenue derived from the performing Portfolio Assets as well as higher gains recognized on the sale of individual loans from a pool. In the event that actual future cash flows of the pool are less than current estimates, the reported future results of the Company could be lower than anticipated and would result in a lower level of interest income and reduced gains from the sale of assets from a pool, lower levels of interest income as a result of lower amounts of discount accretion being included in revenue derived from performing Portfolio Assets or possibly require the Company to recognize impairment in the value of the pool due to a decline in the present value of the expected future cash flows.

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. The Company recorded provisions for impairment of loans in the amounts of $62,000 in 2006, $132,000 in 2005 and $13,000 in 2004.

        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 (including loan type, collateral type, geographical location, performance status and borrower relationship).

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        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").

        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. The Company established a valuation allowance of $132,000 in 2006 and none in 2005 on these loans.

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.

        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. The Company established a valuation allowance of $49,000 in 2006 and $31,000 in 2005 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 real estate portfolios is evaluated for impairment on a quarterly basis. The evaluation of impairment is determined based on the review of the estimated future cash receipts, net of costs to sell, which represents the net realizable value of the real estate portfolio. Impairment losses are charged to operations in the period the impairment is identified. The Company recorded impairment losses of $28,000, $49,000, and $1,000 as of December 31, 2006, 2005 and 2004, respectively.

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Deferred Tax Asset

        As a part of the process of preparing its consolidated financial statements, the Company is required to calculate its income taxes in each of the jurisdictions in which it operates. This process involves calculating the Company's current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effects of future changes in tax laws or changes in tax rates are not anticipated. The measurement of deferred tax assets, if any, is reduced by the amount of any tax benefits that, based on available evidence, are not expected to be realized.

        As a result of the Merger, the Company has substantial federal NOLs that can be used to offset the tax liability associated with the Company's pre-tax earnings until the earlier of the expiration or utilization of such NOLs. The Company accounts for the benefit of the NOLs by recording the benefit as an asset and then establishing an allowance to value the net deferred tax asset at a value commensurate with the Company's expectation of being able to utilize the recognized benefit in the foreseeable future. Such estimates are reevaluated on a quarterly basis with the adjustment to the allowance recorded as an adjustment to the income tax expense generated by the quarterly operating results. Significant events that change the Company's view of its currently estimated ability to utilize the tax benefits result in substantial changes to the estimated allowance required to value the deferred tax benefits recognized in the Company's periodic consolidated financial statements. The Company's analysis resulted in no change in 2006, 2005 and 2004.

        The Company has a net deferred tax asset of $20.1 million in the consolidated balance sheet as of December 31, 2006, which is composed of a gross deferred tax asset of $118.9 million net of a valuation allowance of $98.8 million. As discussed in note 3 of the consolidated financial statements, FirstCity sold its remaining 31% interest in Drive in November 2004. The ultimate realization of the resulting net deferred tax asset is dependent upon generating sufficient taxable income from its continuing operations prior to expiration of the net operating loss carryforwards. Although realization is not assured, management believes that the deferred tax asset, net of allowance, has been carried at low levels, and thus, the sale of Drive has no impact on FirstCity's ability to realize all of the deferred tax asset, net of allowance. The amount of the deferred tax asset considered realizable, however, could be adjusted in the future if estimates of future taxable income during the carryforward period change. The ability of the Company to realize the deferred tax asset is periodically reviewed and the valuation allowance is adjusted accordingly. See "Item 1A. Risk Factors."

Equity Investments in Acquisition Partnerships

        FirstCity accounts for its investments in Acquisition Partnerships and their general partners using the equity method of accounting. This accounting method generally results in the pass-through of its pro rata share of earnings from the partnerships' activities as if it had a direct investment in the underlying Portfolio Assets held by the partnerships. The revenues and earnings of the partnerships are determined on a basis consistent with the accounting methodology applied to Portfolio Assets as described in the preceding paragraphs. FirstCity has ownership interests in the various partnerships that range from 2% to 50%. The Company also holds investments in servicing entities that are accounted for under the equity method.

        Distributions of cash flow from the Acquisition Partnerships are a function of the terms and covenants of the loan agreements related to the secured borrowings of the Acquisition Partnerships.

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Generally, the terms of the underlying loan agreements permit some distribution of cash flow to the equity partners so long as loan to cost and loan to value relationships are in compliance with the terms and covenants of the applicable loan agreement. Once the secured borrowings of the Acquisition Partnerships are fully paid, all cash flow in excess of operating expenses is available for distribution to the equity partners.

Discontinued Operations

        Discontinued operations are comprised of two components previously reported as the Company's residential and commercial mortgage banking business and the consumer lending business conducted through FirstCity's minority interest investment in Drive. In November 2004, FirstCity completed the sale of its interest in Drive, and as of December 31, 2004, the Company had zero assets remaining from the discontinued consumer operations, but certain income realized from such operations.

        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 this asset. Prior to the fourth quarter of 2004, FirstCity classified these securities as held to maturity and considered the estimated future gross cash receipts for such investment securities in the computation of the value of such investment securities. In the fourth quarter of 2004, FirstCity's management elected to pursue a strategy to liquidate these assets and carry them as held for sale. Consequently, in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the remaining security is recorded at the lower of their carrying value or fair value less cost to sell. The cash flows are collected over a period of time and are valued using a discount rate of 18% and prepayment assumptions of 32% for fixed rate loans and 33% for variable rate loans. Overall loss rates are estimated at 14% of collateral. The assumptions used in the valuation model consider both industry as well as the Company's historical experience and are reviewed quarterly in light of historical evidence in revising the prospective results of the model. These revised assumptions could potentially result in either an increase or decrease in the estimated cash receipts. An additional provision is booked based on the output of the valuation model if deemed necessary. The Company recorded provisions of $75,000 in 2006, $356,000 in 2005 and $3.8 million in 2004 for additional losses from discontinued mortgage operations. In 2004, the provision primarily relates to FirstCity adjusting the carrying value of the residual interests to fair value. The additional provision in 2005 primarily related to a decrease in the estimated future gross cash receipts on residual interests in securitizations as a result of the actual losses exceeding the losses projected by the valuation model.

Estimates of Future Cash Receipts

        The Company uses estimates to determine future cash receipts from Portfolio Assets. These estimates of future cash receipts from acquired Portfolio Asset pools are utilized in four primary ways:

(i)

to calculate the allocation of cost of sales of non-performing Portfolios;



(ii)

to determine the effective yield of performing Portfolios;



(iii)

to determine the reasonableness of settlement offers received in the liquidation of the Portfolio Assets; and



(iv)

to determine whether or not there is impairment in a pool of Portfolio Assets.

Calculation of the estimates of future cash receipts

        The Company uses a proprietary asset management software program to manage the Portfolio Assets it owns and services. Each asset within a pool is analyzed by an account manager who is responsible for analyzing the characteristics of each asset within a pool. The account manager projects

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future cash receipts and expenses related to each asset and the sum of which provides the total estimated future cash receipts related to a particular purchased asset pool. These estimates are routinely monitored by the Company to determine reasonableness of the estimates provided.

Risks associated with these estimates

        The Company has in the past been able to establish with reasonable accuracy the estimated future cash receipts over the life of a purchased asset pool. Changes in economic conditions, fluctuations in interest rates, deterioration of collateral values, and other factors described in the risk factors section could cause the estimates of future cash flows to be materially different than actual cash receipts.

        The effects of an increase in the estimated future cash receipts would generally increase revenues from Portfolio Assets by increasing gross profit on a non-performing or real estate pool and increasing the effective yield on a performing or SOP 03-3 portfolio while a decrease in future cash receipts would generally have the effect of reducing revenues by reducing gross profit on a non-performing or real estate pool and creating impairment on a performing or SOP 03-3 portfolio. In some cases a reduction in the total future cash receipts by collecting those cash receipts sooner than expected could have a positive impact on the Company's revenues from Portfolio Assets due to reduced interest expense and other carrying costs associated with the Portfolio Assets. Likewise an increase in future cash receipts, although generally a positive trend, could have a negative impact on future revenues of the Company if collected over a longer period, resulting in higher levels of interest expense and other carrying costs of the portfolios negating any potentially positive effects.

Consolidation Policy

        In addition to consolidating entities in which FirstCity has a direct or indirect controlling financial interest, FirstCity evaluates the consolidation of entities to which common conditions of consolidation, such as voting interests and board representation, do not apply. FirstCity performs this evaluation pursuant to FASB Interpretation No. 46R, Consolidation of Variable Interest Entities ("FIN 46R"). FIN 46R provides that, in the absence of clear control through voting interests, board representation or similar rights, a company's exposure, or variable interest, to the economic risks and potential rewards associated with its interest in the entity is the best evidence of control.

        In connection with FIN 46R, when evaluating an entity for consolidation, FirstCity first determines whether an entity is within the scope of FIN 46R and if it is deemed to be a variable interest entity ("VIE"). If the entity is considered to be a VIE, FirstCity determines whether it would be considered the entity's primary beneficiary. FirstCity consolidates those VIEs for which it has determined that it is the primary beneficiary. Generally, FirstCity will consolidate an entity not deemed either a VIE upon a determination that its ownership, direct or indirect, exceeds fifty percent of the outstanding voting shares of an entity and/or that it has the ability to control the financial or operating policies through its voting rights, board representation or other similar rights. For entities where FirstCity does not have a controlling interest (financial or operating), the investments in such entities are accounted for using the equity. FirstCity applies the equity method of accounting when it has the ability to exercise significant influence over operating and financial policies of an investee in accordance with APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock.

        Equity earnings in most of the foreign Acquisition Partnerships are recorded on a one-month lag due to the timing of FirstCity's receipt of those financial statements.

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Contractual Obligations and Commercial Commitments

        The following tables present contractual cash obligations and commercial commitments of the Company as of December 31, 2006. See Notes 7, 13 and 15 of the Notes to Consolidated Financial Statements (dollars in thousands).

Effect of New Accounting Standards

        In February 2007, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No.159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115 ("SFAS 159") SFAS 159 permits entities to choose to measure eligible items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) may be applied instrument by instrument, with certain exceptions, (ii) is irrevocable (unless a new election date occurs) and (iii) is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for the Company on January 1, 2008. The Company is currently evaluating the impact SFAS 159 will have on its financial statements.

        In September 2006, Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, was issued. SFAS No. 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to current practice resulting from the application of SFAS 157 relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November, 15, 2007. The Company is currently evaluating the impact SFAS 157 will have on its financial statements.

        In September 2006, the SEC staff issued Staff Accounting Bulletin Topic 1N, Financial Statements—Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements ("SAB 108"). SAB 108 provides guidance on how prior year misstatements should be evaluated when determining the materiality of misstatements in the current year financial statements. SAB 108 requires materiality to be determined by considering the effect of prior year misstatements on both the current year balance sheet and income statement, with consideration of their carryover and reversing effects. SAB 108 also addresses how to correct material misstatements. The provisions of SAB 108 are effective for the year ending December 31, 2006. The cumulative effect of the initial application of SAB 108 must be reported in the carrying amounts of

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assets and liabilities as of the beginning of the year, with the offsetting balance to retained earnings. The Company adopted SAB 108 and adjusted its opening retained earnings for the year ended December 31, 2006 by approximately $327 thousand, all of which relates to the Company's investments in certain Acquisition Partnerships accounted for under the equity method of accounting. Approximately $152 thousand reflects a correction to write off cumulative translation adjustments related to certain foreign investments during the period 2002 through 2005, and approximately $106 thousand reflects a correction in a Partnership's accounting for property taxes in 2005. The remaining $69 thousand reflects the Company's 2005 correction of accounting for equity earnings on a pro-rata basis recorded in an acquired investment subsequent to the acquisition date. The Company reviewed the annual amount of reduced equity earnings incurred in prior periods for these corrections and considered the effects to be immaterial to prior periods both individually and in the aggregate.

        In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. ("FIN") 48, Accounting for Uncertainty in Income Taxes ("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement of Financial Accounting Standards ("SFAS") No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of this adoption on the Company's consolidated financial position or earnings.

        In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140 ("SFAS 156"). SFAS 156 requires an entity to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in specified situations. Such servicing assets or liabilities would be initially measured at fair value, if practicable, and subsequently measured at amortized value or fair value based upon an election of the reporting entity. SFAS 156 also specifies certain financial statement presentations and disclosures in connection with servicing assets and liabilities. SFAS 156 is effective for fiscal years beginning after September 15, 2006. The adoption of SFAS 156 by the Company on January 1, 2007 did not have a significant impact on the Company's consolidated financial position or earnings.

        On January 1, 2006, FirstCity adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment ("SFAS 123(R)"), that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions, as the Company formerly did, using the intrinsic value method as prescribed by Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), and generally requires that such transactions be accounted for using a fair-value-based method and recognized as expenses in the consolidated statement of operations. FirstCity adopted SFAS 123(R) using the modified prospective method which requires the application of the accounting standard as of January 1, 2006. The consolidated financial statements as of and for the year ended December 31, 2006, reflect the impact of adopting SFAS 123(R). In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

        In November 2005, the FASB issued FASB Staff Position SFAS 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

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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 Company adopted the provisions of FSP 115-1 on January 1, 2006, which did not have a significant impact on the Company's consolidated financial statements.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Risk

        Market risk is the risk of loss from adverse changes in market prices and interest rates. The Company's operations are materially impacted by net gains on sales of loans and net interest margins. The level of gains from loan sales the Company achieves is dependent on demand for the products originated. Net interest margins are dependent on the Company's ability to maintain the spread or interest differential between the interest it charges the customer for loans and the interest the Company is charged for the financing of those loans. The following describes each component of interest bearing assets held by the Company and how each could be affected by changes in interest rates.

        The Company invests in Portfolio Assets both directly through consolidated subsidiaries and indirectly through equity investments in Acquisition Partnerships. Portfolio Assets consist of investments in pools of non-homogenous assets that predominantly consist of loan and real estate assets. Earnings from these assets are based on the estimated future cash flows from such assets and recorded when those cash flows occur. The underlying loans within these pools bear both fixed and variable rates. Due to the non-performing nature and history of these loans, changes in prevailing benchmark rates (such as the prime rate or LIBOR) generally have a nominal effect on the ultimate future cash flow to be realized from the Portfolio Assets.

        Loans receivable consist of investment loans made to Acquisition Partnerships and other unrelated entities, and bear interest at predominately fixed rates. The collectibility of these loans is directly related to the underlying Portfolio Assets of those Acquisition Partnerships, which are non-performing in nature. Therefore, changes in benchmark rates would have minimal effect on the collectibility of these loans.

        FirstCity had $188 million in debt outstanding at December 31, 2006. The Company is exposed to interest rate risk primarily through its variable rate debt, which totaled $185 million or 99% of the Company's total debt. A 50 basis point change in interest rates would increase or decrease FirstCity's annual interest expense by approximately $.9 million annually.

Foreign Currency Risk

        The Company currently has loans and equity investments in Europe, Latin America (i.e. Mexico, Argentina, Dominican Republic and Chile) and Canada.

        In Europe and in Mexico, the Company's investments are primarily in the form of equity and represent a significant portion of the Company's total equity investments. As previously discussed, the revolving acquisition facility with Bank of Scotland for $175 million allows loans to be made in Euros up to a maximum amount in Euros that is equivalent to $50 million U.S. dollars. At December 31, 2006, the Company had $48.3 million in Euro-denominated debt for the purpose of hedging a portion of the net equity investments in Europe. In November 2006 the Company acquired a line of credit facility with Banco Santander, S.A. that allows loans to be made in Mexican pesos up to a maximum that is equivalent to $13.4 million U.S. dollars. At December 31, 2006, the Company had $13.4 million in Mexican peso-denominated debt. Management of the Company feels that these loan agreements will help reduce the risk of adverse effects of currency changes on these investments.

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        A sharp change in the foreign currencies related to the investments in Europe, Latin America and Canada relative to the U.S. dollar could materially adversely affect the financial position and results of operations of the Company. A 5% and 10% incremental depreciation of these currencies would result in an estimated decline in the valuation of the Company's foreign investments and are indicated in the following table. These amounts are estimates; consequently, these amounts are not necessarily indicative of the actual effect of such changes with respect to the Company's consolidated financial position or results of operations.

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Item 8.    Financial Statements and Supplementary Data.

FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

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)

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)

See accompanying notes to consolidated financial statements.

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FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)