摩根士丹利 (MS) 2005 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Saxon Capital fourth-quarter earnings conference call.

At this time, all participant lines are in a listen-only mode.

Later, there will be an opportunity for your questions, and instructions will be given at this time. (OPERATOR INSTRUCTIONS) As a reminder, this conference call is being recorded.

I would now like to turn the conference over to the Vice President of Investor Relations, Bobbi Roberts.

Please go ahead.

Good morning and welcome to Saxon Capital's 2005 fourth-quarter and year-end earnings conference call.

Joining me this morning is Mike Sawyer, our Chief Executive Officer, and Rob Eastep, our Chief Financial Officer.

We issued a press release this morning which is available along with our summary of financial data on our Web page at www.saxonmortgage.com.

As is customary, I would like to begin with the following information on forward-looking statements.

Statements in this discussion reflecting our future plans and strategies are forward-looking statements that are based on current expectations and assumptions.

These expectations and assumptions are subject to risks and uncertainties which could affect our future plans.

Saxon's actual results and the timing and occurrence of expected events could differ materially from our plans and expectations due to a number of factors.

We refer you to the press release issued this morning as well as our annual report on Form 10-K for the year ended December 31, 2005, for more information about factors that could affect our business and results.

You should also be aware that all information in this discussion is as of March 31, 2006, and we undertake no duty to update any forward-looking statements.

With that, I can turn the call over to Mike Sawyer.

Thank you, Bobbi.

Good morning, everyone, and welcome to our conference call.

I would like to touch on a few trends that we've seen in the industry and then speak to a few of our 2005 highlights, before turning the call over to Rob to discuss the financial results and the restatement of prior years for FAS 133.

In 2005, there have been many challenges and industry changes.

We have seen the Federal Reserve Board continue their trend of rate increases; intense price competition among subprime lenders which is counter to whatever the industry has ever experienced in a rising rate environment; new affordability products that bring additional credit risk like option ARMs and negative amortization products.

And credit and underwriting has been of lesser concern than origination growth and market share.

During the fourth quarter and throughout 2005, we have seen unprecedented prepayment speeds, considering the interest rate environment that we were in.

Prepay speeds for the fourth quarter were 39% and 37.5% for the year, CPR, as compared to 35% for the fourth quarter of 2004 and 36% for the full year of 2004.

One month LIBOR rates increased 53 basis points from the third quarter of 2005 to year-end and 200 basis points from the year-end 2004 to year-end 2005.

As of last week, one month LIBOR has increased 43 basis points since year-end.

We anticipate that the one-month LIBOR trend will continue through the remainder of 2006.

At Saxon, we have stood behind our disciplines of underwriting and credit.

We have maintained our pricing disciplines and priced our loans for the long-term risk and return.

We have continued the investment and credit analysis fraud detection and servicing quality.

Finally, we have focused a great deal of our time and energy on reducing our cost to produce.

Going back to 2004, we began working on refining our origination model to achieve economies of scale and drive down our cost to originate, while maintaining our credit discipline.

During the fourth quarter, we began to see the results of some of the difficult decisions we had to make in late 2004 and throughout 2005.

We experienced a net cost to produce of 245 points for the fourth quarter of 2005, which is the lowest that Saxon has ever achieved.

We're not satisfied, however, and we know that we can improve, and continue to work to do so.

This is a never-ending process, and we will always be looking at how to improve our workflow processes, increase our efficiencies, and reduce our overall costs.

It is important to note that throughout the transition to a more centralized retail origination model, and the combining of retail and wholesale back-end operations, we have been careful to ensure that we retained the credit discipline that is intrinsic to the value that Saxon brings to its shareholders.

As we will speak to later, it will become apparent how this focus on credit drives the performance of our portfolio.

While we significantly restructured our back-office operations and centralized our retail platform, our production for 2005 only slightly decreased compared to 2004.

The fourth quarter of 2005, we saw volume increase by 7% compared to our third quarter in 2005.

In addition, our fourth-quarter '05 volume was only 5% less than our record fourth-quarter 2004 production levels.

Saxon achieve these volume levels, however, with approximately 160 less production channel FTEs at year-end compared to 12/31/04.

This is a reduction of 24% of the total production FTEs over the year.

Again, we're beginning to see the traction take place with the changes we have made throughout 2005.

We are excited about what 2006 will bring due to our continued investment in the growth of our production platform with our new loan origination system, [Net Oxygen], which is scheduled to roll out in a few short weeks.

Since our last conference call in November, we have increased the weighted average coupon on our loans in production by approximately 20 basis points.

This is in addition to the 90 basis point increase in WAC from June 30 to our November call.

These coupon increases are beginning to appear in our production numbers as our fourth quarter's production's weighted average coupon was 7.9% as compared to 7.3% for the third quarter, which is a 60 basis point increase.

So far in 2006, our weighted average coupon on production is approximately 8.4%.

We were encouraged by the pricing increases we saw in the marketplace during the fourth quarter of 2005.

However, we saw some originators decrease their pricing during January and February and again this week.

We continue to see excellent results in our portfolio performance.

We have seen an 8% growth in our owned portfolio since year-end 2004, despite heightened prepayment speeds.

However, our charge-offs have decreased for the same time period.

GAAP charge-offs were 58 basis points for year-end 2005 as compared to 73 basis points for year-end 2004.

While our serious delinquency ratio increased 30 basis points from year-end 2004 to 6.9%, this is in line with the seasoning of our portfolio and our performance expectations.

We have grown our third-party servicing portfolio by 30% since year-end 2004.

While we did see a slight decline in receivables from third-quarter 2005 to fourth quarter 2005, we're off to a strong start in 2006, with over $3 billion in third-party portfolios already purchased and/or committed to.

With that overview of the highlights and accomplishments for 2005, I would like to turn the call over to Rob Eastep, our Chief Financial Officer, to discuss the financial results and the restatement in more detail.

Thanks, Mike.

For the listening audience, all the numbers I reference, they will be at their restated amount.

Subsequent to the issuance of our December 31, 2004, financial statements, we determined that we needed to restate prior financial statements to correct the way we have historically accounted for derivatives.

On December 5, 2005, an SEC official expressed new views regarding the appropriate application of hedge accounting.

We subsequently re-evaluated our application of hedge accounting and determined that we were inappropriately applying hedge accounting to its derivatives.

Prior to this re-evaluation, we believe that our accounting was consistent with GAAP.

Previously, changes in the fair value of cash flow hedges were recorded in other comprehensive income, net of income taxes; and the change in the fair value of previous fair value hedges were recorded as basis adjustments on mortgage loans, which were amortized into earnings through interest income as a yield adjustment of the previously hedged loans.

Our designation of derivative instruments as cash flow hedges for the period October 1, 2002, to September 30, 2005, did not meet the requirements of FAS 133 with regard to documentation [in effect from this testing].

Additionally, our designation of derivative instruments as fair value hedges for the period July 6, 2001, to September 30, 2002, did not meet the requirements of FAS 133 with regard to hedging similar assets.

As a result, in the press release, the consolidated financial statements for the year ended December 31, 2001, through 2004 and for each of the interim reporting periods of 2005 and 2004 have been restated from the amounts previously reported to account for the derivative instruments as undesignated derivatives, with all changes in the fair value of the derivative instruments recognized in the consolidated statements of operations.

The cumulative impact of the elimination of hedge accounting from the third-quarter 2001 through the third quarter of 2005 is a decrease to reported net income by $5.1 million or 2%.

Including the fourth quarter of 2005, which was not restated, the cumulative impact was an increase of net income of $500,000.

The resulting change in accounting treatment has no impact on the timing of operating cash flows or cash flows under any derivative contract.

It does not affect the Company's ability to make required payments on its outstanding debt obligations.

In addition, we reclassified certain amounts previously recorded in interest income to provision for loan loss and servicing income, to conform to our 2005 presentation.

There was no impact on net income for these reclassifications.

Going forward, Saxon will record the hedging activity through its income statement under the derivative gains or losses line item.

Because of the change in derivative accounting, beginning this quarter we have introduced the use of core net interest income for margin similar to others.

We feel this measure is useful to investors, as it includes the effect of cash settlements on derivatives, for example, swaps and options, that represent current period changes in one-month LIBOR, but exclude non-cash fair value changes in derivatives, which represent the future expectations of one-month LIBOR.

A full reconciliation and definition of the core net interest income and margin can be found in Schedule B of our press release.

For the quarter, Saxon reported net income of $17.8 million or $0.35 per share diluted, compared to $31.9 million or $0.63 per share diluted for the third-quarter 2005.

For the year ended 2005, Saxon recorded net income of $110.7 million or $2.08 per share diluted, compared to $106.3 million or $2.91 per share diluted for the prior year.

GAAP net income includes all activities related to our hedging program.

In the fourth quarter, we paid out our regular $0.50 along with a $0.14 special dividend.

In total we paid $2.24 in dividends for 2005.

Also recently we declared a $0.50 per share dividend for the first quarter, which is payable on April 28 to shareholders of record on April 3.

We did see our core net interest income margin before provision decline in the fourth quarter, which is a direct result of the 53 basis point increase in one-month LIBOR during the quarter.

This increase in cost of funds was partially offset by the net cash settlement received during the quarter from our hedging activity.

Our core net interest margin after provision did increase in the quarter, which is due to a lower provision requirement.

As many of you are aware, in the third quarter we provided for $6.8 million in potential losses related to Hurricane Katrina.

During the fourth quarter, we reversed $2.3 million of our Katrina loan loss reserve due to the receipt of property inspections and appraisals on properties in the affected area.

Our provision for loan losses excluding this reversal was $13.8 million as compared to the third-quarter 2005 provision of 12.3, excluding the original Katrina provision.

The increase in provision is in line with the seasonality of our portfolio and our expectations.

During the quarter, our total delinquencies increased $69 million from the third quarter, which is in line with seasonal trends.

Again, those numbers are excluding the Hurricane Katrina delinquencies.

From a charge-off perspective, we were very pleased with the results, as our portfolio continues to perform well within our delinquency expectations.

We continue to see lower losses on our 2003 through 2005 vintage portfolios come through our charge-off numbers as compared to a year ago.

Our GAAP charge-offs were $10.9 million in the fourth quarter of 2005 versus $11 million in the same quarter a year ago.

Our year-ending GAAP charge-offs were $36.9 million for 2005 as compared to $43.6 million for 2004, which is a 15% decrease, with a corresponding 7% increase in the total portfolio.

Our third-party servicing income continued to trend upwards in the fourth quarter with a 12% increase over third quarter and 83% increase over fourth-quarter 2004.

Servicing income increased 151% from 2004 to 2005.

This increase in our servicing income is driven by our increase in third-party portfolio in 2005.

The decision to increase the investment in the servicing business was due to the pricing competitiveness that we saw in late 2004 through 2005 on the origination side of the business.

As Mike mentioned earlier, we do expect to continue to grow the third-party portfolio and are on track to meet our 2006 goals.

Let me now turn our attention to operating expenses.

Total operating expenses decreased 6% from the third quarter to the fourth quarter, while originations increase 7%.

During the fourth quarter, we began to see some of the financial benefits of origination platform changes that we have been working on throughout 2005.

As Mike mentioned earlier, by year end we were operating with 166 less FTEs in our production channels.

In addition, we had 60 less FTEs in our shared services department.

This is a total decline in our workforce of 12%.

Our net cost to produce for the fourth quarter was 245 basis points as compared to 294 basis points in Q3 and 284 basis points in Q4 of 2004.

Year-over-year, our net cost to produce has declined to 286 basis points from 291 basis points.

Total operating expenses increased by 7% year-over-year, with the majority of that occurring in the growth in our servicing channel due to the continued growth in our servicing portfolio.

As Mike mentioned earlier, we did see a 30% growth in our third-party servicing portfolio; and our total servicing portfolio growth was 23% year-over-year.

We have decreased our cost of service to its lowest level ever at 15 basis points for the fourth quarter.

Year-over-year, our cost of service is at 17 basis points for 2005 as compared to 24 basis points in 2004.

What has offset some of the decline in total operating expenses is the decrease in our capitalized expenses or deferred direct loan origination cost or FAS 91 cost.

For 2005, our deferred loan cost declined 21% from our 2004 level.

This reduction in deferred loan cost is primarily the result of a lower cost per loan in retail and wholesale.

The effect of FAS 91 deferrals are not included in our cost to produce numbers.

In summary, we saw continued margin compression having a negative impact on our financial results.

This has been offset somewhat by our decision to deploy capital away from lower yielding originations and into third-party servicing and by our efforts to reduce G&A expenses.

In addition, we are beginning to see the benefits from our changes in the front-end retail lending platform and consolidated back-office production model.

Efficiencies that we have spoken to you about over the last two quarters are now working through to the bottom line.

While our results are not yet where we want them to be, we are confident that we are making the right decisions to deploy our capital where it makes the best long-term impact and to create efficient operations in our production, servicing, and shared services areas.

With that, I would like to turn the call back over to Mike.

Thank you, Rob.

Before we open the call up to a question and answer period from our listeners, I would like to summarize 2005.

It was a difficult and challenging year for us.

Extremely competitive pricing and rising interest rates presented us with a number of challenges.

However, within this extremely competitive environment, we have positioned Saxon for future success by increasing our efficiencies and managing costs while maintaining our pricing and credit disciplines.

In a marketplace that focused on volume growth, Saxon opted to focus on preserving a quality asset base.

Rather than competing by significantly increasing production volumes by cutting pricing, we elected to maintain our disciplines and to preserve our capital for more profitable future opportunities.

Our experienced leadership team has adhered to Saxon's disciplines with solid decision-making and execution.

The decisions made within this difficult environment have prepared us for the future, and we continue to focus on producing only quality assets.

I would now like to turn the call over to our operator so we can take any questions from our listeners.

(OPERATOR INSTRUCTIONS) Scott Valentin from Friedman, Billings, Ramsey.

On the servicing portfolio, it has been a bright spot for Saxon; you guys have been growing it fairly aggressively.

I was curious.

In the fourth quarter, the volume actually dipped.

Was pricing too competitive in the fourth quarter, or what drove that?

No, it was really -- you know what, I will let Rob take that one.

In 2005, kind of from a capital strategy standpoint, what we had decided to do is we accelerated our purchases, what we had planned for 2005, into the first quarter through the third quarter of 2005.

We have picked back up substantially in the first quarter of 2006, where we have purchased or committed to well over $3 billion in third-party servicing.

Really in the fourth quarter it was a period that we really focused on the human capital aspect of it.

Because as Mike said at the outset on the call, we rapidly have grown the third-party servicing platform.

So really it was the time for us to focus on human capital and make sure we were appropriately staffed to handle the growth that we had for 2006, get our training in place for the growth in 2006.

And really it was to take that quarter to set us up for the growth in 2006.

We were also integrating our second platform that we opened up in Richmond in 2005, and we wanted to make sure that everything was working together in both platforms.

Okay, I guess following up on that thought, how big can the servicing platform get, based on the infrastructure you have now?

Depending on our choice of deploying capital, we have a capacity in-house right now of approximately $50 billion.

However, we could easily expand that without having to add geographic space by relocating some of our people.

Okay.

Then I guess you hit the nail on the head.

From a capital allocation perspective, where is the best return right now?

Is it portfolio-ing loans, or is it servicing?

Where are you seeing the better return on your capital?

Well, we always look at it over the long term, Scott.

Obviously, with reduced margins, portfolio-ing the loans in this environment is not the highest return.

However, we do strive to keep a balance, and long term we feel that ownership of the loan and the customer throughout the life of the asset is the best way to go.

All that being said, right now, given where pricing is in the servicing market, our market-leading low cost to service and, on our high performance, servicing right now gives us a better return after-tax.

Okay.

One follow-up question and I will get back in the queue.

But on the margin, it performed better than we thought for the quarter, holding at 3%.

Where do you -- I imagine there is still pressure on the margin given current production probably not earning the 3%.

Is that an accurate statement?

I would say that pricing is more rational than it was through the last three quarters of last year.

I believe that the market has a way to go to return to what I would consider good profitability.

We tend to, as we always have, be more price selective, because we compete with service and not giving away the price.

But margins are still under pressure, yes.

The good part about it is, while we were not happy with having to restate due to the FAS 133 documentation requirements, our hedging program has been very effective and has helped us to maintain and support our margin in the portfolio.

Okay, thank you.

Rick Shane from Jefferies.

One thing I noticed, the other expenses were up $2 million.

Can you talk a little bit about what drove that in the quarter?

Rob?

Yes, that was expenses related to some REO property that we had, that we have additional net realizable value [declination] in the fourth quarter.

Is that some -- should we continue to expect to see that track higher?

That goes up and down, Rich.

What we do is every quarter, the REO properties in inventory are revalued; and sometimes they are adjusted up, sometimes they are adjusted down.

We had some aged inventory.

We also had some Hurricane Katrina related stuff that affected that number.

Got it.

So that is actually not even a cash number.

It is just a mark-to-market on the REO.

It is the mark-to-market on the REO, correct.

Got it.

Then if you can just help me understand this a little better, when I am looking at the tax reconciliation, the taxable reconciliation, you add back $55.6 million in provision; and the GAAP provision for the year was $42 million.

I am assuming that there is some subtle difference.

I just don't understand why the number is that different.

Rick, I must be prescient, because we just happen to have [John Wilson], who is our Vice President of Tax, here on the call with us today.

I will turn that answer over to John.

Great, thanks Mike.

Yes, the provision had two components in it.

The $42 million that you referenced, that was one component of it.

But there was also a $13 million interest component that was in another line item.

In the 10-K, you'll see a reconciliation of that provision in the footnotes to get you back to the $55 million.

Okay, great.

Thank you.

So basically the $13 million is interest that you expected to earn that you are foregoing?

Is that on loans in addition to where you think you're taking principal loss?

It is fairly -- it is interest that we are advancing to the trust, that theoretically you would say that they are on non-accrual at that point in time.

So we're providing for it.

Okay, thank you.

David West from Davenport & Company.

Just curious, the bankruptcy law changes in the fourth quarter.

Sequentially, I noticed you have some increase in your bankruptcy-related past due and charge-off activity in your press release.

But would you say that had any significant impact?

It didn't look like the increase was overly material.

No, I would say that it was not material.

We were expecting, because of the change in the law, to see some uptick, but primarily in the third quarter, as people tried to beat the change in the law.

But it really hasn't changed.

The uptick is more primarily to the overall seasoning of the portfolio and the slight rise in delinquencies.

However, I do repeat that we are very happy with the performance on the portfolio; and it remains well within our forecasted modeling.

Relating to your earlier comment on the margins still being under pressure, to what extent are you seeing any changes in prepayments?

I know they have remained at pretty high levels.

But with rates now finally kind of moving up a bit, have you seen prepayments slow?

Prepayments have definitely slowed.

Rob, do you want to give an estimate?

Yes, Dave, for what we have seen through February of 2006 is we have seen CPR speeds probably drop about 10% from fourth quarter of 2005 to about a 34 CPR speed; and that is compared to a 39 CPR speed for the fourth quarter.

So about 10% decline.

Okay, great.

Then on the servicing, kind of follow-up; you indicated that you were in pretty good position to expand that here in the current year.

What are you seeing regarding pricing for external servicing?

Pricing is up slightly.

However, it is very close to what we have paid through the second half of last year.

Our returns have held.

They have actually increased, given our lower average cost of servicing.

Great.

Then last, I guess kind of a strategic question.

One or two of your peer companies have decided to abandon the REIT structure I guess in this difficult environment.

Has that been a subject of discussion within the Saxon boardroom?

Well, I really can't comment on that.

What I would say about it is, while the REIT structure continues to be the most tax-efficient way to hold mortgage loans portfolio, it is obviously in an asset environment where the yield on the assets has decreased over the last year almost 200 basis points, it takes extremely efficient and experienced management to properly manage the portfolio and the dividend, and to properly account for the differential between tax and GAAP.

That is a capital balancing requirement that requires accurate modeling, and understanding how the assets that you put on the books are going to perform, and the relationship between the value of the asset and what the interest rate environment is at the time.

So, we are very comfortable with where we are at.

We are liquid as you can see in the earnings release and our K. And we are poised for future growth in both the portfolio and our servicing business.

Thank you very much.

Matthew Howlett from Fox-Pitt, Kelton.

In terms of the cost to originate, it has come down nicely in all through channels.

Any sort of guidance with the new origination system in place, where you see that?

We don't give future guidance.

But I would say that in the fourth quarter, two things would have us looking positive to continue the trend, which has continued over several years, although we accelerated it in '05.

There were still remnants and/or costs involved in the closing of our branches and the reduction in staffing in the fourth quarter that were onetime costs that we won't see going forward.

In addition to which, we're rolling out our new loan origination system.

We have every expectation that we will see efficiencies derived from that.

We have -- we field reengineered our platform so that we can support a larger or greater level of volume with fewer additional FTEs as we continue to grow the business.

So without giving a forecast, what I would say is we remain very positive in our ability to continue to gain efficiency and lower our cost to produce.

Great.

Then just, and I realize without giving guidance in terms of volume, suggestions are 10%, 15% total market down year-over-year.

Are you seeing there is still plenty of demand in terms of cash-outs?

Yes, we're actually very pleased with how volume has gone during the first quarter.

Being a relatively smaller player in a very large market, and the way that we compete for our customer and the customer that we draw, we feel very, very comfortable that we can continue to grow the business even in a flat to slightly declining market.

I would also state that I'm a little more positive on total volumes for the marketplace over the next two years.

There is over $1.5 trillion, and that is with a T, of two-year ARM product and interest-only product that over the next 18 months will be resetting in an interest rate environment that is 2 to 300 basis points higher.

That will cause tremendous demand for refinances and cash-out refinances, which is our bread and butter.

So we think that given the relative consolidation that is happening in our marketplace and continuing to happen, and given our relatively liquid working capital condition, we feel that we are poised to take advantage of positive trends happening in the marketplace.

Great, just a follow-up on that.

I noticed that you have always been -- your purchase share has always been a lot smaller than some of your competitors, and I think that may have to do with sort of the 80/20 product and so forth.

Are you just not pushing that product?

It really gets down to what makes Saxon different in the market.

We don't compete on rate.

Generally, your rate term finance and your purchase customer try to shop for the lowest rate they can get.

That is why, historically, 70-plus% of our business, as high as 78% in some quarters, is cash-out refinancings.

We compete on service and speed and consistency.

If you look at the percentage of our purchase money product that is purchase money, a large majority of it is jumbo, where the customer has fewer places to go, and is less price-sensitive, and more interested in getting a quality loan as fast as he can get it, because he wants the house.

That allows us, because of the higher risk with the jumbo loan and our ability to compete with speed, to attract that customer.

But we have never been a price competitor.

We do not intend to be.

Our focus is to maximize our return on our shareholders equity at all times; and we feel that there is still significant opportunity to compete under that business model.

Great, thanks, Michael.

Bose George from KBW.

You had a question about the book value.

Could you just go over the impact of the restatement on book value?

Because it seemed like the cumulative earnings impact was minimal.

So I was just wondering why that went down.

Yes, I can get you that.

There's two components of the FAS 133 restatement; one was cash flow hedges and the other was fair value hedges.

As we have had in our disclosures before, we have -- and as I have said on the call -- we have the asset deferred hedge loss.

We have an asset on the books.

At year-end it was about $24 million.

So through the unwind of the hedge, we took that fair value deferred loss as a realized loss back in '01 and '02.

So that asset is no longer on the books, and the offset to that is book value.

Now the offset to that is that that was an asset that would be amortized in future years that we are no longer going to be amortizing.

So theoretically, that $24 million will come back into book value over the next couple years, as we eliminate the need to amortize that asset.

Okay.

Actually, also, the increase in the accumulated deficit in the fourth quarter, what was driving that number?

The $40-some million?

That was the excess dividends over the retained earnings, because we are dividending out a higher percentage of our income as compared to GAAP income.

It is the differential between the dividends paid and the GAAP earnings.

Okay, great.

Actually, just one quick follow-up on the servicing.

You mentioned that you were -- you mentioned your 2006 goals.

Have you sort of specified your goals in terms of how large you want to get that portfolio?

Internally, we have, yes.

But externally, we want to continue to grow it as prudently and as large as we can.

Bose, one other point on the book value from third quarter to fourth quarter.

Based on the dates that we declared the dividends, you actually had third-quarter and fourth-quarter dividend hit in the fourth quarter.

Because remember, we declared our dividend in December of 2005.

So you actually have two quarters' worth of dividend hit in the fourth quarter.

That will happen every fourth quarter generally going forward.

Okay, thanks a lot.

Chris Brendler from Stifel Nicolaus.

A couple questions.

First, on the retail side, nice improvement in the cost there.

Just sort of where do you stand on the transformation of that platform?

You mentioned all the refi activity that needs to take place going forward.

How well positioned is that group to capture a lot of that volume?

I feel that we're very well positioned.

We have basically completed our restructuring of the business model and the organization of the processes.

What we have left to do will occur over the next 30 to 45 days as we roll out our new generation loan origination system, Net Oxygen.

One that is in place, all the pieces will be there, and it will be a matter of adding staff as we grow the business.

But the core staff that we have right now and the operational staff that we have can certainly support a higher level of business than we are doing over the last quarter.

That was all part of the restructuring that took place over the last year.

But we are very happy with where it stands, and we are very positive about the future, especially on the retail side of the business.

Fair to say it will be a larger part of your originations in '06?

Absolutely.

Okay.

Second, on your volume comments, I think I sort of share those views that the market will be stronger than people generally expect in '06, and maybe even into '07.

But one thing I think that's sort of the caveat to that is you also talk about how pricing needs to continue to increase.

Can pricing continue to increase and still get the volume?

Or are borrowers starting to feel the pain of these higher rates, and that is why we have seen competitors start to lower their rates?

Or is that more just the competition for volume?

It is a two-part question.

First of all, will the increasing rates affect production volume?

Well, the rate term refinance guy who is trying to shop for a lower rate and purchase money will most definitely be hit by rising rates.

Economics 101.

And it even goes through in our business, although our business has always been and continues to be less sensitive than the prime business.

On the other hand, the rise in rates increases the pressure.

Because even though our customers may have to increase their interest rate by 200 basis points, let's say, from two years ago, they will still be able to save a net cash debt outflow by refinancing and accessing some of the equity that has been built up over the last two, three, four years by paying off much higher rate and shorter-term amortization period credit card and auto loan and student loan debt.

So I see a good opening for the type of business that Saxon focuses on.

Now, in terms of margins in the business, why do I see margins continuing to increase?

Well, very simply, there is a one-to-one relationship between the net margin on your business that you originate and the premiums that you can sell those loans for.

Now Saxon doesn't sell loans, but we exist in a marketplace that is driven by the larger competitors that need to sell those loans in order to generate growth capital.

Because, especially given the leverage position of most of our competitors today, they really don't have access to the equity markets or the debt markets; and so they have to generate capital by selling loans at a premium.

Where loan coupons are today, given interest rate costs, that is not happening.

That is why you are seeing continued upward pressure on coupons.

We are and remain profitable at the margin levels today because of the life of loan cost advantages that we have in servicing, lower losses, lower servicing cost, and the premium additional margin that we get on the loans that we originate.

So we remain profitable today while many -- and I reinforce many -- of our competitors have not been profitable over the last six months to a year.

As margins increase, we expect and believe that our profitability will increase.

That is why I remain positive and why we chose last year not to invest our capital in a portfolio of breakeven to money-losing loans.

We felt that we would rather make a 30% return servicing those loans for other people, and so we built-up our servicing portfolio and capabilities.

Okay, great.

One additional question.

My understanding that the secondary markets were particularly off when you did your last securitization in December.

As you look at your next securitization, I would expect you would get better execution.

But I've also heard that there's a lot more tiering going on today.

Just where do you think you stand on that front, and what should we expect when you do your next deal?

Saxon, and you bring up a very good point which is another reason why I expect margins to increase.

We meet regularly with all three rating agencies.

They express concern, as they always do in a rising rate environment, about potential loss and delinquencies in new loan originations.

Saxon has been, and to the best of my knowledge always has been, at least while I have been here, a Tier 1 issuer in the asset-backed market, even though we are a relatively small stand-alone issuer.

That goes back to our 20-plus years of issuing high credit quality, consistently performing securitizations backed by Saxon underwritten loans.

I do not expect that that will change.

We have seen increased credit enhancement levels throughout the marketplace and throughout our securitizations.

As margins continue to increase, those credit enhancement levels will be able to be supported.

For the people in our business who have to sell whole loans to make a profit, that premium is driven by the securitization structure that the loan buyer who eventually securitizes the loans is going to use.

So that will be an added pressure to drive margins higher than they are today.

Okay, great.

Thanks.

Jim Larkins from Wasatch.

I wondered if you could give some color on the ROE of the portfolio today, being at 11% for the fourth quarter.

Your coupons are up nicely, it sounds like.

But given the increase in LIBOR, are you going to be able to start to drive up that 11%?

Or do you think we're going to be treading water for a while there?

This is Rob.

I think, what we have seen so far in 2006 and what we have done from a pricing standpoint, I think right now we are probably I would say level with that 11% ROE from the current originations.

I think a lot it goes by to what Mike was saying as far as what happens from a pricing standpoint.

Obviously, from a pricing standpoint, any time we have the opportunity to take some additional pricing increases we definitely do that.

The other component of the ROE is, with our declining cost to produce, on our current production we are seeing a pretty good pickup in the economics of the loan.

Not just the cost to produce from a strict G&A standpoint, but also on the retail side from additional fees collected.

And also on the wholesale and correspondent side from some pricing changes that we made to reduce our premium cost, especially on the correspondent side.

So overall, I think that we are going to see the economics on our production increase over the next couple quarters.

But again, the biggest driver of it is going to be what happens from a pricing competition standpoint.

Jim, there is one other factor that I would like to add that we sometimes forget.

Prepaid speeds are slowing, and a good 75% or more of our portfolio is two and three-year ARM product originated over the last two to three years.

While our cost of the bonds reacts immediately to the monthly market LIBOR, one-month LIBOR, the loans adjust after two and three-year periods, and on the I/O product on a monthly basis.

But it takes a while for the portfolio to catch up.

So there will be some added margin to the portfolio as these loans continue to hit their reset dates.

While prepay speeds do go up, there is still a significant portion of those loans that remain on the portfolio after their adjustment.

Great.

You alluded to kind of a 30% return on the servicing portfolio.

Is that kind of a good number to think about what you can make there?

Yes, that is a pretax number, Jim.

After-tax, obviously, because that is a taxable REIT sub, it is down around 20%.

But that is still better than -- and that is an unleveraged number because we do not currently lever the servicing portfolio, although we could.

But it is still a better return in this environment, although I am very positive that that is going to shift back to more normalized for all the reasons that I have discussed on the call.

Okay, I haven't had a chance to go through some of the taxable REIT numbers and reconciliation there.

But I wanted to understand, how can I look at the $0.50 dividend versus kind of the $0.30 kind of core earnings?

How does the core earnings reflect kind of the dividend power of the Company?

Or should I not look at it that way?

I will let Rob go to that.

Yes, when you look at the core earnings, again, you're kind of taking a GAAP number, taking in the impact of the hedges.

But I guess it is somewhat of a good reflection of the earnings power.

But you have got to take into consideration the provision for loan losses, because that is in the GAAP number.

We still have much higher level of GAAP provisions or expense than we're actually seeing a tax charge-off.

So I think, then, in addition to that, we still have some of the old REMICs that are coming through that are impacting that.

But the number one impact when you compare core to taxable income is going to be our provision for loan loss right now.

So if you adjust for that, for the difference in provision for loan loss, I think you'll get a pretty good indicator of the earnings power.

Okay.

The income from the TRS from servicing is being held in the Company, and that is not being dividended out.

Is that correct?

That is correct, it is retained.

It goes into retained earnings and it supports the growth of both portfolios.

Okay, then on the servicing business, if losses were to go to what I think might be a more normalized 100 to 150 basis points of loss per year, which I think historically is kind of in the ballpark, how would that affect your cost to service, if you were to see those type of loss levels in the portfolio?

Right.

It actually, for a couple of reasons, it would actually increase, I believe, our income.

Primarily because increased delinquencies and losses means a higher level of late charge collections for us.

We do not have loss exposure on the third-party business.

It would slightly increase our cost of service, because obviously foreclosed and bankrupt loans are more expensive.

But that is a much smaller number when you compare the amount of late charge income that comes in.

Then finally, I think that it will also provide us -- and you hit on a key point.

One of the reasons for the extra capacity that we have built into the platform is I fully expect to see opportunities over the next two years to pick up distressed portfolios from companies that cannot support them or service them, at a good price; and/or to be chosen as a backup servicer by trusts for companies that are no longer able to service their loans in accordance with their contracts.

So while we do expect that servicing costs will go up, we have actually budgeted for it.

In this year's plan, we have lowered the number of accounts per employee that David has been running at over the last couple of years.

We continue to see a lower marginal cost of servicing as we grow the portfolio.

But we do think that we are pretty much approaching for subprime portfolio a maximization of efficiency levels without harming the performance of the portfolio.

I hope that answered your question.

That's very helpful.

Were there any MSR writedowns?

Actually I think we had a slight writeup; but no, --.

Yes, nothing material.

Nothing material; and that gets back to, again, how we account for our servicing rights.

We chose when we got into the business to book those rights on our balance sheet at the lower of cost or fair market value.

So where you see the servicing rights in the great majority of the deals that we have, except those that have pretty well aged out, that is the unamortized premium cost for those rights.

In fact the portfolio or the servicing receivable continues to be valued by our outside third-party evaluators at a higher market value than what we have recorded on the books.

Jim, just let me just jump in real quick on the impairment.

We did have approximately $2 million of temporary impairment in the fourth quarter.

Okay.

We don't consider that material.

All right, great.

Then I wanted to get your thoughts on a stock buyback.

We have seen the stock trade down at times well below book value.

It's been pretty quiet both from any insiders buying or any news of the Company buying back.

I wondered if you could talk about that in terms of your strategic deployment of capital, as well as seeing any activity from executive management or the Board buying stock.

Right.

A couple of things.

With everything that's been going on over the last year, it's been very difficult for us to get an open trading window.

I do know that all of us believe in the stock.

I still, other than the onetime sale for the taxes when the option converted, I have never sold a share and don't intend to.

But in terms of the buyback -- and our employee stock program, I buy the maximum every year, as do most of the management.

In terms of a buyback, of using the capital that we have and buying back the stock, you bring up -- there is a good question about my less well-capitalized competitors who became REITs are de-REIT-ing.

One of the issues of being a subprime REIT is access to capital and ability to generate that capital to grow your asset base.

Now I do believe that the redeployment of capital over the last year and a half because of margin compression to the servicing business has maintained our total return to our shareholders.

I do not believe that it would be healthy for the business and it would impair our ability to grow if we were to buy back our stock and use up that growth capital in that regard.

We feel that there will be significant profitable opportunities over the next two years to continue to fully invest the capital that we raised a year and a half ago and to expand the earning power of the portfolio to complete the business plan that we came to the market with two years ago.

At which point in time, when we achieve our full investment and targeted portfolio size, we will be comfortable that we can grow the business at 10% to 12% a year without dilution.

That remains our business plan.

A stock buyback at this point in time would imperil that plan and/or cause us to have to change the focus on how we run the business.

It would make us more dependent on whole loan sales to generate capital.

Okay, thank you.

Greg Lapin from Saranac Capital.

All but one of my questions are answered.

On your new breakout of the 12-month bank statement, one, does this is help explain some of the increase in the statement doc loans?

And are cash reserves becoming more of an industry standard starting in the fourth quarter?

Rob?

The 12-month bank statement product that we have out there, part of that could, does impact the stated income.

Some of that also is some pricing changes that we made with the stated income product.

So there's a couple things going on as far as stated income goes.

But your question on cash reserves in the underwriting, yes, I think that is becoming probably a larger component in the subprime space.

I also want to -- you bring out a good point in observing that.

One of the things that makes Saxon different and one of the reasons why we generally get a higher coupon on our originations, is that most of the marketplace will call 12 and 24-month bank statement loans full documentation loans.

They will price them at that level and they will lend to the LTVs at that level.

The credit markets today, and based upon performance in our business at higher FICO levels, those loans perform very close to that.

However, Saxon is always driven by full disclosure, and we want every risk that we have to be as explained as we can explain it.

So, we made some changes to reflect the credit market's perspective on that product.

However, we want to investors and bondholders to know that that is what the product is.

It is not a full documentation loan, because they are different.

We still price them differently, but we have become a little more competitive based upon historical performance and credit enhancement levels that the agencies require.

Okay, thanks for your comments.

Thank you.

That was our last call, ladies and gentlemen.

I would like to thank you again for joining us this morning.

As always, if you have any future questions or would like some follow-up, please feel free to contact Bobbi Roberts in investor relations.

We remain very, very positive on our outlook for 2006, and we look forward to speaking with you again next quarter.

Thank you.

Ladies and gentlemen, that does conclude your conference for today.

Thank you for your participation and for using AT&T executive teleconference.

You may now disconnect.