H&R Block's 2002 Annual Report -- Financials

MORTGAGE OPERATIONS
Through Option One Mortgage Corporation and H&R Block Mortgage Corporation, this segment offers a wide range of home mortgage products. This segment is primarily engaged in the origination, servicing and sale of nonconforming and conforming mortgage loans. This segment offers a flexible product line to borrowers who are creditworthy but do not meet traditional underwriting criteria, through a network of mortgage brokers. Conforming mortgage loan products, as well as the same flexible product line available through brokers, are offered through some H&R Block Financial Advisors branch offices and H&R Block Mortgage Corporation retail offices.

A primary source of revenue for this segment is the recognition of gains on sales of mortgage loans. This segment also holds residual interests in securitized mortgage loans in which cash flows are received over the life of the loans. The subsequent securitization of these residual interests in the form of a net interest margin bond (“NIM”) results in the receipt of a substantial portion of the cash from the residual at the closing of the NIM transaction, rather than over the actual life of the loans.

During fiscal 2002, the Company’s residual interests performed better than expected primarily due to lower interest rates, as well as lower loan losses and prepayments to date than originally projected in the valuation models. The lower rates reduced the interest payments to the bondholders, thereby allowing the bondholders and residual interest holders to receive cash related to principal and interest payments, respectively, earlier than expected in the valuation models. As a result of these items and in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” the Company recorded pretax mark-to-market write-up adjustments in the fair value of its residual interest of $151.1 million during fiscal 2002. These write-ups are recorded, net of deferred taxes, in other comprehensive income and are then accreted into income throughout the remaining life of those residual interests. Future changes in interest rates or other assumptions could cause additional adjustments to the fair value of the residual interests and would cause changes to the accretion of these residual interests in future periods.

One of the Company’s core strategic objectives is creating a financial partnership with its tax clients through delivery of advice, coupled with the products and services needed to act on that advice. The Company’s initiative to serve the mortgage needs of its tax clients through its retail mortgage operations resulted in 43.2% of all retail loans, and 7.3% of all loans originated during fiscal year 2002, coming from H&R Block tax clients, compared to 29.4% and 5.0%, respectively, in fiscal year 2001.
Management utilizes operating profit margin to evaluate this segment’s performance. Operating profit margin is defined as pretax earnings before goodwill amortization divided by volume of loans originated.

Fiscal 2002 compared to fiscal 2001
Revenues increased by $319.1 million or 76.7%, to $734.9 million, for the year ended April 30, 2002 compared to the previous year. The increase is primarily due to an increase in production volume, higher interest income, a favorable secondary market environment and a larger servicing portfolio.

Revenues related to the sale of mortgage loans increased by $212.2 million or 86.7% to $457.0 million over the prior year resulting from a significant increase in loan origination volume and better pricing execution on mortgage loan sales. During fiscal year 2002, the Company’s loan origination volume increased 75.5% over last year. The increase in loan production is a result of an increase in the average loan size, an increase in the size of the sales force, an improvement in the closing ratio and to a lesser extent, the declining interest rate environment. The average loan size increased to $128 thousand from $109 thousand in fiscal 2001 and the closing ratio improved to 50.3% from 44.9% in the prior year. The total execution price for fiscal year 2002 was 4.30% compared to 3.71% for last year. The execution price is defined as the total premium received divided by the total balance of loans sold. The better execution price is partially attributable to the declining interest rate environment that has the effect of widening spreads on mortgage loan sales, as well as better structuring of the deals. Somewhat offsetting the increase in the gain on sale were losses of $31.0 million that were recorded in 2002 related to adverse changes in the timing and amount of cash flows on certain residual interests.

Servicing revenues increased $36.9 million to $147.2 million for the year ended April 30, 2002 as compared to the same period last year. The increase reflects a higher average loan servicing portfolio balance. The average servicing portfolio for the twelve-month period increased 25.2% compared to the same period last year.

Interest income for the year ended April 30, 2002 was $127.9 million, an increase of $70.3 million or 122.3% over the prior year. This increase is primarily the result of the declining interest rate environment, which improves the excess retained interest spread earned. The excess retained interest spread for fiscal year 2002 was 5.58% compared to 2.65% for last year. Also contributing to the increase in interest income is higher accretion income on residual interests during fiscal year 2002.

Pretax earnings increased $201.4 million or 146.0%, to $339.4 million for the year ended April 30, 2002. The improved performance is primarily due to the increase in revenues as discussed above. In addition to higher loan volumes, improved closing ratios and focus on operating efficiencies helped drive a decline in the net cost of origination. The increase in compensation and benefits is due to an increase in the number of employees supporting the increase in volumes. The increase in variable servicing and processing expense is due to the increase in the size of the servicing portfolio and a $11.6 million write-down of mortgage servicing rights (“MSRs”) and other servicing related assets recorded in fiscal 2002 to reflect a change in the assumptions underlying the related loan portfolios. The year ended April 30, 2002 also benefited by $13.6 million in reduced goodwill amortization compared to the prior year from the adoption of SFAS 141 and 142.