PIONEER FINANCIAL SERVICES INC – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

    The discussion set forth below, in the quarterly report of Pioneer Financial Services, Inc. ("PFS"), with its wholly owned subsidiaries (collectively "we," "us," "our" or the "Company"), contains forward-looking statements within the meaning of federal securities law.  Words such as "may," "will," "expect," "anticipate," "believe," "estimate," "continue," "predict," or other similar words, identify forward-looking statements.  Forward-looking statements appear in a number of places in this report and include statements regarding our intent, belief or current expectation about, among other things, trends affecting the markets in which we operate our business, financial condition and growth strategies.  Although we believe that the expectations reflected in these forward-looking statements are based on reasonable assumptions, forward-looking statements are not guarantees of future performance and involve risks and uncertainties.  Actual results may differ materially from those predicted in the forward-looking statements as a result of various factors, including, but not limited to, those risk factors set forth in our annual report on Form 10-K for the period ended September 30, 2011  under Part I- Item 1A-Risk Factors.  If any of these risk factors occur, they could have an adverse effect on our business, financial condition and results of operation.  When considering forward-looking statements you should keep these risk factors in mind, as well as the other cautionary statements set forth in this report.  These forward-looking statements are made as of the date of this filing.  You should not place undue reliance on any forward-looking statement.  We are not obligated to update forward-looking statements and will not update any forward-looking statements in this quarterly report on Form 10-Q to reflect future events or developments.    Overview    We are a wholly owned subsidiary of MidCountry Financial Corp., a Georgia corporation ("MCFC").  We purchase consumer loans, on a worldwide basis, made primarily to active-duty, career retired U.S. military personnel or U.S. Department of Defense employees.  We purchase primarily from two different types of sources.  Our largest source of military loans is the Consumer Banking Division ("MBD") of MidCountry Bank ("MCB"), a federally chartered stock savings bank and wholly owned subsidiary of MCFC, an affiliate who originates military loans through a network of loan production offices and via the Internet. Military families use these loan proceeds to purchase goods and services.  In July 2011, we entered into an Amended and Restated Non-Recourse Loan Sale and Master Services Agreement ("LSMS Agreement") with MBD that outlines the terms of the sale and servicing of these loans.  We also purchase retail installment contracts from retail merchants that sell consumer goods to active-duty or career retired U.S. military personnel or U.S. Department of Defense employees. We plan to hold these military loans and retail installment contracts until repaid.    Our finance receivables, whether originated or purchased, are effectively unsecured and consist of loans originated by MBD or purchased from retail merchants.  All finance receivables have fixed interest rates and typically have a maturity of less than 48 months. During the second quarter of fiscal 2012, the average size of a loan when acquired was approximately $3,342.  A large portion of our customers are unable to obtain financing from traditional sources due to factors such as their age, frequent relocations and lack of credit history. These factors may not allow them to build relationships with traditional sources of financing.   

Improvement of our profitability is dependent upon the growth in amount of finance receivables we are able to acquire from MBD or retail merchants and the maintenance of loan quality.

    We are not associated with, nor are we endorsed by, the U.S. military or U.S. Department of Defense.  However, we do seek to maintain a positive, supportive relationship with the military community.    

Critical Accounting Policies

    In our 2011 Annual Report on Form 10-K, we identified the critical accounting policies which affect our more significant estimates and assumptions used in preparing our consolidated financial statements. We have not changed these policies from those previously disclosed in our Annual Report.                                           18  --------------------------------------------------------------------------------

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Lending and Servicing Operations

   Primary Supplier of Loans    We have retained MBD as our primary supplier of loans.  Under the LSMS Agreement, MBD uses our underwriting criteria (which was developed from our past customer credit repayment experience and is periodically revalidated based on current portfolio performance).  These criteria primarily require the following:   

† All borrowers are primarily active-duty, career retired U.S. military personnel or U.S. Department of Defense employees.

† All potential borrowers must complete standardized credit applications either in person at one of MBD's loan production offices or online via the Internet.

† A thorough review must be conducted on all applicants' military service history.

† Loan repayment terms are generally structured to repay the entire loan prior to the customer's estimated separation from the military.

    To the extent MBD originates loans under these standards, MBD is obligated to sell such loans to us and we are obligated to purchase such loans.  Loans purchased from MBD and those originated by us prior to MCFC acquiring us in June 2007 are referred to as "military loans."  See our annual report under "Item 1A.  Risk Factors- MBD may modify underwriting and servicing standards and does not have to lend to the traditional customers who meet our business model and lending guidelines, which may materially adversely affect our business operations, cash flow, results of operations, financial condition and profitability."    Loan Purchasing    General.  We have more than 25 years of experience underwriting, originating, monitoring and servicing consumer loans to the military market and developed a deep understanding of the military and the military lifestyle. Through this extensive knowledge of our customer base, we developed a proprietary credit scoring model that focuses on the unique characteristics of the military market, as well as traditional credit scoring variables that are currently utilized by MBD when originating loans in this market.  We incorporated these proprietary underwriting guidelines and scoring model into our loan origination system to facilitate auto-decisioning and risk-based pricing on our loans.    For the loans we purchase, MBD uses our proprietary underwriting guidelines and scoring model when it originates loans.  Under these guidelines, in evaluating the creditworthiness of potential customers, MBD primarily examines the individual's debt to income ratio, discretionary income, military rank, time served in the military and prior credit experience. Loans are limited to amounts that the customer could reasonably be expected to repay from that discretionary income.  The majority of finance receivables we own are under $10,000, repayable in equal monthly installments and have terms no longer than 48 months.  Loan repayment terms are generally structured to repay the entire loan prior to the customer's estimated separation from the military. However, when we purchase loans from MBD, we cannot predict when or whether a customer may unexpectedly leave the military or when or whether other events could occur that result in not being repaid prior to a customer's departure from the military.    A risk in all consumer lending and retail sales financing transactions is the customer's unwillingness or inability to repay obligations. An unwillingness to repay is usually evidenced by a consumer's historical credit repayment record. An inability to repay occurs after initial credit evaluation and funding and usually results from lower income due to early separation from the military or reduction in rank, major medical expenses, or divorce.  Occasionally, these types of events are so economically severe that the customer files for protection under the bankruptcy laws.  Standard underwriting guidelines are used at the time the customer applies for a loan to help minimize the risk of unwillingness or inability to repay.  These guidelines were developed from past customer credit repayment experience and are periodically revalidated based on current portfolio performance.  MBD uses these guidelines to predict the relative likelihood of credit applicants repaying their obligation to us.  We purchase loans made to consumers who fit our underwriting guidelines.  The amount and interest rate of the military loan or retail installment contract transaction purchased are set by MBD or the retail merchant based upon our underwriting guidelines considering the estimated credit risk assumed.                                           19  --------------------------------------------------------------------------------

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    As a customer service, we consider purchasing a new loan from MBD that includes a refinanced portion if the existing borrower has demonstrated a positive payment history with us and where the transaction creates an economic benefit to the customer after fully underwriting the new loan request to ensure proper debt ratio, credit history and payment performance. We will not purchase refinancings made to cure delinquency or for the sole purpose of creating fee income. Generally, we purchase refinancing of existing loans when a portion of the new loan proceeds is used to repay the balance of the existing loan and the remaining portion is advanced to the customer.  Approximately 25.3% of the amount of military loans we purchased in the second quarter of fiscal 2012 were refinancings of outstanding loans compared to 25.7% during the second quarter of fiscal 2011.    Military Loans Purchased from MBD.  We purchase military loans from MBD if they meet our lending guidelines.  We have given MBD the rights to our lending guidelines and extensive experience with lending to the military marketplace. Pursuant to the LSMS Agreement, we transferred the rights to our underwriting model and lending system to MBD.  However, we retained ownership of this model and the lending system.  Using our model and system, MBD originates these loans directly through its loan production offices and over the Internet.    Retail Installment Contracts.  We purchase retail installment contracts that meet our quality standards and return on investment objectives from approximately 318 active retail merchant locations.  Retail installment contracts are finance receivable notes generated during the purchase of consumer goods by active-duty or career retired U.S. military personnel or U.S. Department of Defense employees.  These customers have demonstrated an apparent need to finance a retail purchase and a willingness to use credit.  We generally acquire these contracts without recourse to the originating merchant.  However, reserve agreements with many retail merchants allow us to withhold funds from the merchant's proceeds to create reserves to be used in the event a customer defaults and the loan is deemed uncollectible.  Retail installment contracts generally have maximum terms of 48 months.    

Management and Recordkeeping Services

    We have retained MBD to provide management and recordkeeping services in accordance with the LSMS Agreement.  MBD services our finance receivables. For these management and recordkeeping services, we pay MBD a monthly fee in an amount equal to 0.7% (8.4% annually) of the outstanding principal balance of the military loans and retail installment contracts serviced as of the last day of each month. The fee can be adjusted annually on the basis of the annual increase or decrease in the Consumer Price Index.  Also, as part of its compensation for performing these management and record keeping services, MBD retains all ancillary revenue, including late charges and insufficient funds fees, associated with these loans and retail installment contracts.  For these services, we also pay MBD an annual fee of $33.86 for each military loan and retail installment contract owned by us at the end of the prior fiscal year. The annual fee is paid in monthly installments. This fee can be adjusted annually on the basis of the annual increase or decrease in the Consumer Price Index.  In addition, this quarter, we paid MBD $0.6 million in fees connected with MBD's origination of the military loans, as compared with $0.6 million in the same quarter last year.    To facilitate MBD's servicing of the military loans and retail installment contracts, we have granted MBD (i) the non-exclusive rights to use certain intellectual properties, including our trade names and service marks, and (ii) the right to use our Daybreak loan processing system and related hardware and software. We have also granted MBD non-exclusive rights to market additional products and services to our U.S. military borrowers. We retain all other borrower relationships.    Sources of Income    We generate revenues primarily from interest income earned on the military loans purchased from MBD, loans previously originated by us and retail installment contracts purchased from retail merchants. We also earn revenues from debt protection fees and credit reinsurance premiums. For purposes of the following discussion, "revenues" means the sum of our finance income and fees.    If our customers are killed, injured, become ill among other events, including during war, the Company will have payment obligations.  The liability we establish for possible losses related to our debt protection and reinsurance operations and the corresponding charges to our income to maintain this amount are actuarially evaluated annually and we consider this amount adequate.                                           20  --------------------------------------------------------------------------------

   Table of Contents    Finance Receivables    Our finance receivables are comprised of loans purchased from MBD (collectively referred to below as "military loans") and retail installment contracts.  The following table sets forth certain information about the components of our finance receivables as of the end of the periods presented:                                                           March 31,                    September 30,                                                          2012                            2011                                                     (dollars in thousands, except average note balance) Finance receivables: Total finance receivables balance                $             380,957     $                        405,234 Average note balance                             $               2,661     $                          2,699 Total number of notes                                          143,188                              150,155  Military loans: Total military receivables                       $             350,077     $                        370,602 Percent of total finance receivables                             91.89 %                              91.45 % Average note balance                             $               2,846     $                          2,898 Number of notes                                                123,024                              127,878  Retail installment contracts: Total retail installment contract receivables    $              30,880     $                         34,632 Percent of total finance receivables                              8.11 %                               8.55 % Average note balance                             $               1,531     $                          1,555 Number of notes                                                 20,164                               22,277                                            21 

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   Table of Contents    Net Interest Margin    The principal component of our profitability is net interest margin, which is the difference between the interest earned on our finance receivables and the interest paid on borrowed funds.  Some state and federal statutes regulate the interest rates that may be charged to our customers.  In addition, competitive market conditions also impact the interest rates.    Our interest expense is sensitive to general market interest rate fluctuations. These general market fluctuations directly impact our cost of funds.  General inability to increase the interest rates earned on new and existing finance receivables restricts our ability to react to increases in cost of funds. Accordingly, increases in market interest rates generally will narrow interest rate spreads and lower profitability, while decreases in market interest rates generally will widen interest rate spreads and increase profitability.    

The following table presents important data relating to our net interest margin as of the end of the periods presented:

                                         Three Months Ended               Six Months Ended                                           March 31,                       March 31,                                      2012            2011            2012            2011                                     (dollars in thousands)          (dollars in thousands) Total finance receivables balance                          $     380,957    $   382,313    $     380,957    $   382,313  Average total finance receivables (1)                  $     394,549    $   390,665    $     403,483    $   392,715  Average interest bearing liabilities (1)                  $     274,200    $   271,842    $     280,663    $   283,268  Total interest income and fees                             $      27,784    $    27,904    $      57,190    $    56,645  Total interest expense           $       4,882    $     4,789    $       9,867    $     9,535    

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(1)  Averages are computed using month-end proforma balances.                                           22 

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Results of Operations and Financial Condition

    Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011    Total Finance Receivables.  Our aggregate finance receivables decreased 0.34% or $1.3 million, to $381.0 million on March 31, 2012 from $382.3 million on March 31, 2011.  Lower than expected demand for military loans led to a decline in originations for the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011.  Our primary supplier of loans, MBD saw a 2.3% or $1.6 million decrease in military loan originations during the second quarter of fiscal 2012.  Our acquisition of retail installment contracts decreased during the second quarter of fiscal 2012 by $2.0 million or 27.1% compared to the second quarter of fiscal 2011.  See further discussion in the sections entitled "Loan Acquisition" and "Liquidity and Capital Resources."    Interest Income and Fees.  Interest income and fees represented 95.7% of our total revenue for the second quarter of fiscal 2012 compared to 93.7% for the second quarter of fiscal 2011. Interest income and fees decreased to $27.8 million in the second quarter of fiscal 2012 from $27.9 million for the second quarter of fiscal 2011, a decrease of $0.1 million or 0.4%.    Interest Expense.  Interest expense in the second quarter of 2012 increased to $4.9 million compared to $4.8 million or 2.1% for the second quarter of fiscal 2012.  This increase is due to the increase in our junior subordinated investment notes to $64.8 million as of March 31, 2012, compared to $53.6 million as of March 31, 2011, an increase of $11.2 million or 20.9% and slightly offset by a decrease of average other interest bearing liabilities of 3.7%.    Provision for Credit Losses.  The provision for credit losses in the second quarter of fiscal 2012 increased to $9.4 million from $6.1 million in the second quarter of fiscal 2011, an increase of $3.3 million or 54.1%.  Net charge offs increased to $8.9 million in the second quarter of fiscal 2012 from $6.2 million in the second quarter of fiscal 2011, an increase of $2.7 million or 43.5%. 

The

 net charge off ratio increased to 9.1% for the second quarter of fiscal 2012 compared to 6.4% for the second quarter of fiscal 2011. See further discussion in "Credit Loss Experience and Provision for Credit Losses."    Noninterest Income.  Noninterest income consists of revenue from debt protection fees, and credit reinsurance premiums which were $1.2 million in the second quarter of fiscal 2012 compared to $1.9 million in the second quarter of fiscal 2011, a decrease of $0.7 million or 36.8%.  Noninterest income decreased during the second quarter of fiscal 2012 due to a decrease in our military loan originations in the second quarter of fiscal 2012 of 2.3% compared to second quarter of fiscal 2011.    Noninterest Expense.  Noninterest expense in the second quarter of fiscal 2012 was $11.7 million compared to $12.1 million for the second quarter of fiscal 2011.  Management and recordkeeping services fees in the second quarter of fiscal 2012 increased by $0.1 million or 1.4% from the second quarter of fiscal 2011 due to an increase in the average finance receivables of 1.0% upon which this fee is based. This increase is offset by other individually immaterial decreases in noninterest expense.    Provision for Income Taxes.  The Company's effective tax rate is 39.4% in the second quarter of fiscal 2012 compared to 38.8% in the second quarter of fiscal 2011, or an increase of 0.6%.  This increase is primarily due to a change in state apportionment factors driven by a shift in business mix as a result of the mix of product revenue.                                           23 

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   Table of Contents      Six Months Ended March 31, 2012 Compared to Six Months Ended March 31, 2011    Total Finance Receivables.  Our aggregate finance receivables decreased 6.0% or $24.2 million, to $381.0 million on March 31, 2012 from $405.2 million on September 30, 2011.  Lower than expected demand for military loans led to a decline in originations for the first six months of fiscal 2012 compared to the first six months of fiscal 2011.  Our primary supplier of loans, MBD saw a 6.8% or $13.1 million decrease in military loan originations during the first six months of fiscal 2012.  Our acquisition of retail installment contracts decreased during the first six months of fiscal 2012 by $2.5 million or 15.4% compared to the first quarter of fiscal 2011.  See further discussion in the sections entitled "Loan Acquisition" and "Liquidity and Capital Resources."    Interest Income and Fees.  Interest income and fees represented 95.4% of our total revenue for the first six months of fiscal 2012 compared to 94.1% for the first six months of fiscal 2011. Interest income and fees increased to $57.2 million in the first six months of fiscal 2012 from $56.6 million for the first six months of fiscal 2011, an increase of $0.6 million or 1.1%.  This increase was primarily due to an increase in average total finance receivables of 2.7%.    Interest Expense.  Interest expense in the first six months of 2012 increased to $9.9 million compared to $9.5 million or 4.2% for the first six months of fiscal 2011.  This increase is due to the increase in our junior subordinated investment notes to $64.8 million as of March 31, 2012, compared to $53.6 million as of March 31, 2011, an increase of $11.2 million or 20.9% and slightly offset by a decrease of average other interest bearing liabilities of 3.7%.    Provision for Credit Losses.  The provision for credit losses in the first six months of fiscal 2012 increased to $17.0 million from $12.9 million in the first six months of fiscal 2011, an increase of $4.1 million or 31.8%.  Net charge offs increased to $15.6 million in the first six months of fiscal 2012 from $12.4 million in the first six months of fiscal 2011, an increase of $3.2 million or 25.8%.  The net charge off ratio increased to 7.7% for the first six months of fiscal 2012 compared to 6.3% for the first six months of fiscal 2011. See further discussion in "Credit Loss Experience and Provision for Credit Losses."    Noninterest Income.  Noninterest income consists of revenue from debt protection fees, and credit reinsurance premiums which were $2.7 million in the first six months of fiscal 2012 compared to $3.6 million in the first six months of fiscal 2011, a decrease of $0.9 million or 25.0%.  Noninterest income decreased during the first six months of fiscal 2012 due to a decrease in our military loan originations in the first six months of fiscal 2012 of 6.8% compared to the first six months of fiscal 2011.    Noninterest Expense.  Noninterest expense in the first six months of fiscal 2012 was $23.4 million compared to $24.0 million for the first six months of fiscal 2011.  Management and recordkeeping services fees in the first six months of fiscal 2012 increased by $0.4 million or 2.3% from the first six months of fiscal 2011 due to an increase in the average finance receivables of 2.7% upon which this fee is based.  Amortization of intangibles decreased by $0.4 million in the first six months of fiscal 2012 compared to the first six months of fiscal 2011.  Other individually immaterial expenses also decreased in the first six months of fiscal 2012 compared to the first six months of fiscal 2011.    Provision for Income Taxes.  The Company's effective tax rate is 39.2% in the first six months of fiscal 2012 compared to 38.4% in the first six months of fiscal 2011, or an increase of 0.8%.  This increase is primarily due to a change in state apportionment factors driven by a shift in business mix as a result of the mix of product revenue.                                           24 

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   Table of Contents    Delinquency Experience    Our customers are required to make monthly payments of interest and principal. Our servicer, MBD, under our supervision, analyzes our delinquencies on a recency delinquency basis utilizing our guidelines.  A loan is delinquent under the recency method when a full payment (95% or more of the contracted payment amount) has not been received for 30 days after the last full payment.    The following table sets forth our delinquency experience as of the end of the periods presented for accounts for which payments are 60 days or more past due.                                                 March 31,       September 30,       March 31,                                                2012              2011              2011                                                         (dollars in thousands) Total finance receivables                  $     380,957    $       405,234    $     382,313 Total finance receivables balances 60 days or more past due                             12,526             13,954 

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 Total finance receivables balances 60 days or more past due as a percent of total finance receivables                           3.29 %             3.44 %           2.94 %    

Credit Loss Experience and Provision for Credit Losses

    General.  The allowance for credit losses is maintained at an amount that management considers sufficient to cover estimated losses inherent in the outstanding finance receivable portfolio. We utilize a statistical model based on potential credit risk trends incorporating both historical and prospective factors to estimate losses.  These results and management's judgment are used to estimate future losses and in establishing the current provision and allowance for credit losses. These estimates are influenced by factors outside our control, such as economic conditions, current or future military deployments and completion of military service prior to repayment of loan. There is uncertainty inherent in these estimates, making it reasonably possible that they could change in the near term.  See our annual report "Item 1A. Risk Factors - If a customer leaves the military prior to repaying the military loan, there is an increased risk that loan will not be repaid."    Military Loans.  Our charge-off policy is to charge off military loans at 180 days past due or earlier if management deems it appropriate.  Charge-offs can occur when a customer leaves the military prior to repaying the finance receivable or is subject to longer term and more frequent deployments. Generally, loans purchased or originated by us are structured so that the entire amount is repaid prior to a customer's estimated separation from the military. When purchasing loans, however, we cannot predict when or whether a customer may depart from the military early.  Accordingly, we cannot implement policies or procedures for MBD to follow to ensure that we will be repaid in full prior to a customer leaving the military, nor can we predict when a customer may be subject to deployment at a duration or frequency that causes a default on their loans. As of March 31, 2012 and September 30, 2011, we had approximately $9.4 million, or 2.5% of our total portfolio, and $8.9 million, or 2.2% of our total portfolio, respectively, from customers who had advised us of their separation from the military prior to repaying their loan.  As of March 31, 2011 and September 30, 2010, we had approximately $7.3 million, or 2.0% of our total portfolio, and $5.9 million, or 1.5% of our total portfolio, respectively, from customers who had advised us of their separation from the military prior to repaying their loan.  Another source of loss is when a customer declares bankruptcy.  See our annual report "Item 7.  Management Discussion and Analysis of Financial Condition and Results of Operations - Nonperforming Assets."                                           25  --------------------------------------------------------------------------------

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    The following table presents net charge-offs on military loans and net charge-offs as a percentage of military loans as of the end of the periods presented:                                           Three Months Ended              Six Months Ended                                             March 31,                      March 31,                                        2012            2011           2012            2011                                      (dollars in thousands)         (dollars in thousands) Military loans: Military loans charged-off         $       9,435    $    7,113    $      16,519    $   13,682 Less recoveries                              999         1,118            1,714         1,954 Net charge-offs                    $       8,436    $    5,995    $      14,805    $   11,728 Average military loan receivables (1)                    $     362,302    $  356,456    $     370,111    $  351,763 Percentage of net charge-offs to average military receivables (annualized)                                9.31 %        6.73 %           8.00 %        6.67 %    

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(1) Averages are computed using month-end balances.

    Retail Installment Contracts.  Under many of our arrangements with retail merchants, we may withhold a percentage (usually between five and ten percent) of the principal amount of the retail installment contract purchased.  The amounts withheld from a particular retail merchant are recorded in a specific reserve account.  Any losses incurred on the retail installment contracts purchased from that retail merchant are charged against its reserve account, as specified in the agreement with such retail merchant.  Upon the retail merchant's request, and no more often than annually, we will pay the retail merchant the amount by which its reserve account exceeds 15% of the aggregate outstanding balance on all retail installment contracts purchased from them, less losses we have sustained, or reasonably could sustain, due to debtor defaults, collection expenses, delinquencies and breaches of our agreement with the retail merchant.    Our allowance for credit losses is utilized to the extent that the loss on any individual retail installment contract exceeds the retail merchant's aggregate reserve account at the time of the loss. Currently, we have instances where we have extinguished a portion of our merchant reserves and may sustain additional charge-offs as these merchants' portfolios liquidate.  The financial impact of these potential future losses is deemed to be immaterial to the overall financial condition and results of operations of the Company.    The following table presents net charge-offs on retail installment contracts and net charge-offs as a percentage of retail installment contracts as of the end of the periods presented:                                             Three Months Ended               Six Months Ended                                               March 31,                      March 31,                                           2012           2011           2012            2011                                        (dollars in thousands)          (dollars in thousands) Retail installment contracts: Contracts charged-off                $          615    $     344    $         994    $       850 Less recoveries                                 118          128              208            222 Net charge-offs                      $          497    $     216    $         786    $       628 Average retail installment contract receivables (1)             $       32,247    $  39,634    $      33,372    $    40,952 Percentage of net charge-offs to average retail installment contract receivables (annualized)              6.16 %       2.18 %           4.71 %         3.07 %    

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(1) Averages are computed using month-end balances.

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   Table of Contents    Allowance for Credit Losses.  The following table presents our allowance for credit losses on finance receivables as of the end of the periods presented:                                          Three Months Ended            Six Months Ended                                           March 31,                    March 31,                                        2012           2011         2012           2011                                     (dollars in thousands)       (dollars in thousands) Balance, beginning of period      $       26,296    $ 25,146   $      25,396    $  24,496 Finance receivables charged-off          (10,050 )    (7,457 )       (17,513 )    (14,532 ) Less recoveries                            1,117       1,246           1,922        2,176 Net charge-offs                           (8,933 )    (6,211 )       (15,591 )    (12,356 ) Provision for credit losses                9,433       6,061          16,991       12,856 Balance, end of period            $       26,796    $ 24,996   $      26,796    $  24,996     We maintain an allowance for credit losses, which represents management's best estimate of future losses inherent in the outstanding finance receivable portfolio.  The allowance for credit losses is reduced by actual credit losses and is increased by the provision for credit losses and recoveries of previous credit losses.  The provision for credit losses is charged to earnings to bring the total allowance to a level considered necessary by management.  As the portfolio of finance receivables consists of a large number of relatively small, homogenous accounts, the finance receivables are evaluated for impairment as two separate components: military loans and retail installment contracts. Management considers numerous factors in estimating losses in our credit portfolio, including the following:    †          prior credit losses and recovery experience;  †          current economic conditions;  †          current finance receivable delinquency trends; and  †          demographics of the current finance receivable portfolio.    The following table sets forth changes in the components of our allowance for credit losses on finance receivables as of the end of the periods presented:                                          Three Months Ended               Six Months Ended                                           March 31,                       March 31,                                      2012            2011            2012            2011                                     (dollars in thousands)          (dollars in thousands) Average total finance receivables (1)                  $     394,549    $   390,665    $     403,483    $   392,715 Provision for credit losses              9,433          6,061           16,991         12,856 Net charge-offs                          8,933          6,211           15,591         12,356 Net charge-offs as a percentage of average total finance receivables (annualized)                              9.06 %         6.36 %           7.73 %         6.29 % Allowance for credit losses      $      26,796    $    24,996    $      26,796    $    24,996 Allowance as a percentage of average total finance receivables                               6.79 %         6.40 %           6.64 %         6.36 %    

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(1) Averages are computed using month-end balances.

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   Table of Contents    Loan Acquisition    Asset growth is the most important factor in determining our future revenues. In connection with purchasing the loans, we pay MBD a fee in the amount of $30.00 for each military consumer loan originated by MBD and purchased by us. This fee is adjusted annually on the basis of the annual increase or decrease in MBD's deferred acquisition cost analysis.  Our loan acquisitions decreased for the first six months of fiscal 2012 to $193.3 million from $208.8 million in the first six months of fiscal 2011.    The following table sets forth our overall purchases of military loans and retail installment contracts, including those refinanced, as of the end of the periods presented:                                                 Three Months Ended                Six Months Ended                                                  March 31,                         March 31,                                             2012              2011            2012            2011                                             (dollars in thousands, except average note balance) Total loans acquired/originated: Gross balance                         $         73,313    $     76,948    $     193,264    $  208,808 Number of finance receivable notes              21,935          23,087           56,927        61,827 Average note amount                   $          3,342    $      3,333    $       3,395    $    3,377  Military loans: Gross balance                         $         67,856    $     69,458    $     179,648    $  192,712 Number of finance receivable notes              19,507          19,983           50,723        55,198 Average note amount                   $          3,479    $      3,476    $       3,542    $    3,491  Retail installment contracts: Gross balance                         $          5,457    $      7,490    $      13,616    $   16,096 Number of finance receivable notes               2,428           3,104            6,204         6,629 Average note amount                   $          2,247    $      2,413    $       2,195    $    2,428    

Liquidity and Capital Resources

    A relatively high ratio of borrowings to invested capital is customary in the consumer finance industry.  Our principal use of cash is to purchase military loans and retail installment contracts.  We use borrowings to fund the difference, if any, between the cash used to purchase military loans and retail installment contracts and the cash generated from loan repayments and operations.  This amount is generally cash used in investing activities.  Cash provided from investing activities in the first six months of fiscal 2012 was approximately $4.0 million and cash used in financing activities was $20.9 million, which was funded from $27.4 million in operating activities.  Cash used in investing activities in the first six months of fiscal 2011 was approximately $7.2 million and cash used in financing activities was $16.9 million, which was funded by operating activities of $23.6 million.    Financing activities primarily consist of borrowing and repayments of debt incurred under our Secured Senior Lending Agreement, dated June 12, 2009 (the "SSLA").  With the ongoing uncertainty in the financial markets and the economic conditions generally, some lenders within our credit group, at their discretion, may reduce their willingness to lend at the current levels.  We have borrowings as of March 31, 2012 of $6.1 million from withdrawing banks who previously participated in the Senior Lending Agreement ("SLA") or SSLA.    To further enhance our information technology capabilities, we have engaged a third party to provide assistance with the evaluation of our existing Daybreak lending system, which may ultimately result in the conversion to a new lending system.  The system evaluation commenced in April 2012, with future capital expenditures expected throughout fiscal year 2012 and 2013.                                           28  --------------------------------------------------------------------------------

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    On January 6, 2012, the SEC declared effective our post-effective amendment to our amended registration statement originally filed with the Securities and Exchange Commission in January 2010 (File No. 333-164109) ("2012 Registration Statement").  Pursuant to this 2012 Registration Statement, along with the accompanying prospectus, we registered an offering of our investment notes, with a maximum aggregate offering price of $50 million, on a continuous basis with an expected termination date of January 28, 2013, unless terminated earlier at our discretion.  As of March 31, 2012, we have issued 284 investment notes in conjunction with this offering with an aggregate value of $18.8 million.    

Senior Indebtedness - Bank Debt.

On June 12, 2009, we entered into the SSLA with certain lenders. The SSLA replaced and superseded the SLA, dated as of June 9, 1993, as subsequently amended and restated. The Company filed a Form 8-K on June 18, 2009 providing a brief description of the material terms of the SSLA.

    As of March 31, 2012, we had $193.5 million of senior debt outstanding, compared to $214.5 million at September 30, 2011, a decrease of $21.0 million, or 9.8%. The SSLA is an uncommitted facility that provides common terms and conditions pursuant to which individual lenders that are a party to the SSLA may choose to make loans to us in the future.  Any lender may elect not to participate in any future fundings at any time without penalty.  The term of the current SSLA ends on March 31, 2013 and is automatically extended annually unless any lender gives written notice of its objection by March 1 of each calendar year.  As of March 31, 2012, we could request up to $144.6 million in additional funds and remain in compliance with the terms of the SSLA.  No lender, however, has any contractual obligation to lend us these additional funds.  As of March 31, 2012 we were in compliance with all covenants under the SSLA.    There were no advances outstanding under the revolving credit line as of March 31, 2012 and September 30, 2011. When a lender elects not to participate in future fundings, any existing borrowings from that lender under the revolving credit line are payable in 12 equal monthly installments. Interest on borrowings under the revolving credit line is payable monthly and is based on prime or 5.0%, whichever is greater.  Interest on borrowings was 5.0% at March 31, 2012 and 2011.    As of March 31, 2012, the lenders have indicated a willingness to participate in fundings up to an aggregate of $338.1 million during the next 12 months, an increase of $18.9 million from September 30, 2011, of which $193.5 million is currently outstanding.  Included in this amount are borrowings of $6.1 million from withdrawing banks who previously participated in the SLA or SSLA.    In the third quarter of fiscal 2010, we amended the SSLA to allow additional banks to become parties to the SSLA in a modified non-voting role.  We have identified each lender that has voting rights under the SSLA as a "voting bank." and each lender that does not have voting rights under the SSLA as a "non-voting bank."  While all voting and non-voting banks have the same rights to the collateral and are a party to the same terms and conditions of the SSLA, all of the non-voting banks acknowledge and agree that they have no right to vote on any matter nor to prohibit or restrict any action by us, or the voting banks.                                           29 

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Senior Indebtedness Table - Bank Debt.

As of March 31, 2012 and September 30, 2011, the total borrowings and availability under the SSLA consisted of the following amounts for the end of the periods presented:

                                                               Pro forma (1)                         Pro forma (2)                                              March 31,        March 31,        September 30,      September 30,                                                 2012            2012               2011               2011                                                                    (dollars in thousands) Revolving credit line: Total facility                               $   45,000    $        45,000    $        40,000    $        40,000 Balance at end of period                              -             13,247                  -             14,100 Maximum available credit (3)                     45,000             31,753             40,000             25,900  Term notes: (4) Voting banks                                 $  252,500    $       252,500    $       227,500    $       227,500 Withdrawing banks                                 6,121              6,121             14,852             14,852 Non-voting banks                                 34,496             34,496             36,823             36,823 Total facility                               $  293,117    $       293,117    $       279,175    $       279,175 Balance at end of period                        193,472            193,472            214,491            214,491 Maximum available credit (3)                     99,645             99,645             64,684             64,684  Total revolving and term notes: (4) Voting banks                                 $  297,500    $       297,500    $       267,500    $       267,500 Withdrawing banks                                 6,121              6,121             14,852             14,852 Non-voting banks                                 34,496             34,496             36,823             36,823 Total facility                               $  338,117    $       338,117    $       319,175    $       319,175 Balance at end of period                        193,472            206,719            214,491            228,591 Maximum available credit (3)                    144,645            131,398            102,714             90,584 Credit facility available (5)                   103,661             90,414            104,684             90,584 Percent utilization of voting banks               51.38 %            55.83 %            61.60 %            66.14 % Percent utilization of the total facility         57.22 %            61.14 %            67.20 %            71.62 %    

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(1) Total facility pro forma assumes the early allotment payments received March 30, 2012 that were due on April 1, 2012.

(2) Total facility pro forma assumes the early allotment payments received September 30, 2011 that were due on October 1, 2011.

  (3) Maximum available credit assumes proceeds in excess of the amounts shown below under "Credit facility available" are used to increase qualifying finance receivables and all terms of the SSLA are met, including maintaining a senior indebtedness to consolidated net receivable ratio of not more than 80.0%.  

(4) Includes 48-month amortizing term notes.

(5) Credit available is based on the existing asset borrowing base and maintaining a senior indebtedness to consolidated net notes receivable ratio of not more than 80.0%. Does not include withdrawing banks.

    Subordinated Debt - Parent.  In the second quarter of fiscal 2010, we amended our SSLA to convert the parent note from a term facility to a revolving line of credit.  Funding on this line of credit is provided as needed at our discretion and dependent upon the availability of our parent with a maximum principal balance of $25.0 million.  Interest is payable monthly and is based on prime or 5.0%, whichever is greater.  During the second quarter of fiscal 2012, there were no borrowings or repayments on this debt.  As of March 31, 2012 and September 30, 2011, there was no outstanding balance.    Outstanding Investment Notes.  We fund certain capital and financial needs through the sale of investment notes.  These notes have varying fixed interest rates and are subordinate to all senior indebtedness.  We can redeem these notes at any time upon 30 days written notice.  As of March 31, 2012, we had outstanding $64.8 million of these notes (with accrued interest), which includes a $0.3 million purchase adjustment.  The purchase adjustments relate to fair value adjustments recorded as part of the Transaction.  These notes had a weighted average interest rate of 9.23%.  Included in the $64.8 million is approximately $18.8 million of funds from our most recent offering.  See discussion in "Item No.1 Notes to Condensed Consolidated Financial Statements."                                           30 

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