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PHH CORP 10-Q 2007
FORM 10-Q
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
     
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the quarterly period ended June 30, 2007
 
OR
     
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission File No. 1-7797
 
 
 
 
 
     
MARYLAND
(State or other jurisdiction of
incorporation or organization)
  52-0551284
(I.R.S. Employer
Identification Number)
     
3000 LEADENHALL ROAD
MT. LAUREL, NEW JERSEY
(Address of principal executive offices)
  08054
(Zip Code)
 
856-917-1744
(Registrant’s telephone number, including area code)
 
 
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:  Yes þ     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act:  Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o     No þ
 
As of July 16, 2007, 53,680,315 shares of common stock were outstanding.
 


 

 
 
                 
Item
 
Description
  Page
 
    Cautionary Note Regarding Forward-Looking Statements   2
 
PART I
1
  Financial Statements   4
2
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   32
3
  Quantitative and Qualitative Disclosures About Market Risk   62
4
  Controls and Procedures   65
 
PART II
1
  Legal Proceedings   67
1A
  Risk Factors   68
2
  Unregistered Sales of Equity Securities and Use of Proceeds   69
3
  Defaults Upon Senior Securities   69
4
  Submission of Matters to a Vote of Security Holders   70
5
  Other Information   70
6
  Exhibits   70
             
    Signatures   71
    Exhibit Index   72
 EX-4.5: SUPPLEMENTAL INDENTURE
 EX-31.I.1: CERTIFICATION
 EX-31.I.2: CERTIFICATION
 EX-32.1: CERTIFICATION
 EX-32.2: CERTIFICATION


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Except as expressly indicated or unless the context otherwise requires, the “Company,” “PHH,” “we,” “our” or “us” means PHH Corporation, a Maryland corporation, and its subsidiaries.
 
 
This Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 (the “Form 10-Q”) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors and were derived utilizing numerous important assumptions that may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Investors are cautioned not to place undue reliance on these forward-looking statements.
 
Statements preceded by, followed by or that otherwise include the words “believes,” “expects,” “anticipates,” “intends,” “projects,” “estimates,” “plans,” “may increase,” “may fluctuate” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” “may” and “could” are generally forward-looking in nature and are not historical facts. Forward-looking statements in this Form 10-Q include, but are not limited to, the following: (i) our expectations regarding the impact of the adoption of recently issued accounting pronouncements on our financial statements; (ii) our expectation that the amount of unrecognized income tax benefits will change in the next twelve months; (iii) our belief that we would have various periods to cure an event of default if one or more notices of default were to be given by our lenders or trustees under certain of our financing agreements with respect to the delivery of our financial statements; (iv) our belief that any existing legal claims or proceedings other than the several purported class actions filed against us as discussed in this Form 10-Q would not have a material adverse effect on our business, financial position, results of operations or cash flows and our intent to respond appropriately in defending against the several purported class actions filed against us as discussed in this Form 10-Q; (v) our expectations regarding refinance activity, home sale volumes and purchase originations, a near-term downturn, increasing competition and the contraction of margins and volumes in the mortgage industry and our intention to take advantage of this environment by leveraging our existing mortgage origination services platform to enter into new outsourcing relationships; (vi) our expectation that recent developments in the secondary mortgage market will negatively impact Gain on sale of mortgage loans, net in the third quarter of 2007 and may continue to have a negative impact during the fourth quarter of 2007 and perhaps longer; (vii) our expected savings for the remainder of 2007 from cost-reducing initiatives implemented in our Mortgage Production and Mortgage Servicing segments; (viii) our belief that growth in our Fleet Management Services segment will be negatively impacted during the remainder of 2007 by the proposed Merger (as defined in Note 2, “Proposed Merger” in the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q); (ix) our belief that our sources of liquidity are adequate to fund operations for the next 12 months; (x) our expected capital expenditures for 2007 and (xi) our expectation that our disclosure controls and procedures will not be effective as of September 30, 2007 and December 31, 2007.
 
The factors and assumptions discussed below and the risks and uncertainties described in “Item 1A. Risk Factors” in this Form 10-Q and “Item 1A. Risk Factors” included in our Annual Report on Form 10-K for the year ended December 31, 2006 could cause actual results to differ materially from those expressed in such forward-looking statements:
 
  n   the material weaknesses that we identified in our internal control over financial reporting and the ineffectiveness of our disclosure controls and procedures;
 
  n   our ability to implement changes to our internal control over financial reporting in order to remediate identified material weaknesses and other control deficiencies;
 
  n   the outcome of civil litigation pending against us, our Directors, Chief Executive Officer, and former Chief Financial Officer and whether our indemnification obligations for such Directors and executive officers will be covered by our directors and officers insurance;
 
  n   the effects of environmental, economic or political conditions on the international, national or regional economy, the outbreak or escalation of hostilities or terrorist attacks and the impact thereof on our businesses;


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  n   the effects of a decline in the volume or value of United States home sales, due to adverse economic changes or otherwise, on our Mortgage Production and Mortgage Servicing segments;
 
  n   the effects of changes in current interest rates on our Mortgage Production and Mortgage Servicing segments and on our financing costs;
 
  n   the effects of changes in spreads between mortgage rates and swap rates, option volatility and the shape of the yield curve, particularly on the performance of our risk management activities;
 
  n   our ability to develop and implement operational, technological and financial systems to manage growing operations and to achieve enhanced earnings or effect cost savings;
 
  n   the effects of competition in our existing and potential future lines of business, including the impact of competition with greater financial resources and broader product lines;
 
  n   the impact of the proposed Merger on our business and the price of our Common stock, including our ability to satisfy the conditions required to consummate the Merger, the impact of the announcement of the Merger on our business relationships and operating results and the impact of costs, fees and expenses related to the Merger;
 
  n   our ability to quickly reduce overhead and infrastructure costs in response to a reduction in revenue;
 
  n   our ability to implement fully integrated disaster recovery technology solutions in the event of a disaster;
 
  n   our ability to obtain financing on acceptable terms to finance our growth strategy, to operate within the limitations imposed by financing arrangements and to maintain our credit ratings;
 
  n   our ability to maintain a functional corporate structure and to operate as an independent organization;
 
  n   our ability to maintain our relationships with our existing clients;
 
  n   a deterioration in the performance of assets held as collateral for secured borrowings, a downgrade in our credit ratings below investment grade or any failure to comply with certain financial covenants under our financing agreements and
 
  n   changes in laws and regulations, including changes in accounting standards, mortgage- and real estate-related regulations and state, federal and foreign tax laws.
 
Other factors and assumptions not identified above were also involved in the derivation of these forward-looking statements, and the failure of such other assumptions to be realized as well as other factors may also cause actual results to differ materially from those projected. Most of these factors are difficult to predict accurately and are generally beyond our control.
 
The factors and assumptions discussed above may have an impact on the continued accuracy of any forward-looking statements that we make. Except for our ongoing obligations to disclose material information under the federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events unless required by law. For any forward-looking statements contained in any document, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.


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Item 1.   Financial Statements
 
PHH CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In millions, except per share data)
 
                                 
    Three Months
    Six Months
 
    Ended June 30,     Ended June 30,  
    2007     2006     2007     2006  
 
Revenues
                               
Mortgage fees
  $ 37     $ 35     $ 67     $ 65  
Fleet management fees
    42       38       81       78  
                                 
Net fee income
    79       73       148       143  
                                 
Fleet lease income
    397       385       787       753  
                                 
Gain on sale of mortgage loans, net
    70       69       113       126  
                                 
Mortgage interest income
    98       94       189       170  
Mortgage interest expense
    (72 )     (69 )     (143 )     (129 )
                                 
Mortgage net finance income
    26       25       46       41  
                                 
Loan servicing income
    131       124       261       254  
                                 
Change in fair value of mortgage servicing rights
    89       (3 )     17       65  
Net derivative loss related to mortgage servicing rights
    (207 )     (106 )     (212 )     (286 )
                                 
Valuation adjustments related to mortgage servicing rights
    (118 )     (109 )     (195 )     (221 )
                                 
Net loan servicing income
    13       15       66       33  
                                 
Other income
    25       22       46       42  
                                 
Net revenues
    610       589       1,206       1,138  
                                 
Expenses
                               
Salaries and related expenses
    81       89       168       176  
Occupancy and other office expenses
    18       20       36       40  
Depreciation on operating leases
    315       304       626       610  
Fleet interest expense
    55       49       104       92  
Other depreciation and amortization
    8       9       16       18  
Other operating expenses
    92       94       182       177  
                                 
Total expenses
    569       565       1,132       1,113  
                                 
Income before income taxes and minority interest
    41       24       74       25  
Provision for income taxes
    39       22       57       35  
                                 
Income (loss) before minority interest
    2       2       17       (10 )
Minority interest in income of consolidated entities, net of income taxes of $(2), $(1), $(2) and $0
    3       1       3        
                                 
Net (loss) income
  $ (1 )   $ 1     $ 14     $ (10 )
                                 
Basic (loss) earnings per share
  $ (0.02 )   $ 0.01     $ 0.26     $ (0.19 )
                                 
Diluted (loss) earnings per share
  $ (0.02 )   $ 0.01     $ 0.25     $ (0.19 )
                                 
 
See Notes to Condensed Consolidated Financial Statements.


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PHH CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In millions, except share data)
 
             
    June 30,
  December 31,
    2007   2006
 
ASSETS            
Cash and cash equivalents
  $ 136   $ 123
Restricted cash
    599     559
Mortgage loans held for sale, net
    2,921     2,936
Accounts receivable, net
    471     462
Net investment in fleet leases
    4,248     4,147
Mortgage servicing rights
    2,249     1,971
Investment securities
    42     35
Property, plant and equipment, net
    60     64
Goodwill
    86     86
Other assets
    434     377
             
Total assets
  $ 11,246   $ 10,760
             
             
LIABILITIES AND STOCKHOLDERS’ EQUITY            
Accounts payable and accrued expenses
  $ 503   $ 494
Debt
    7,984     7,647
Deferred income taxes
    802     766
Other liabilities
    382     307
             
Total liabilities
    9,671     9,214
             
Commitments and contingencies (Note 11)
       
Minority interest
    35     31
STOCKHOLDERS’ EQUITY
           
Preferred stock, $0.01 par value; 10,000,000 shares authorized; none issued or outstanding at June 30, 2007 or December 31, 2006
       
Common stock, $0.01 par value; 100,000,000 shares authorized; 53,506,822 shares issued and outstanding at June 30, 2007 and December 31, 2006
    1     1
Additional paid-in capital
    965     961
Retained earnings
    553     540
Accumulated other comprehensive income
    21     13
             
Total stockholders’ equity
    1,540     1,515
             
Total liabilities and stockholders’ equity
  $ 11,246   $ 10,760
             
 
See Notes to Condensed Consolidated Financial Statements.


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PHH CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
Six Months Ended June 30, 2007
(Unaudited)
(In millions, except share data)
 
                                         
                      Accumulated
     
            Additional
        Other
  Total
 
    Common Stock   Paid-In
  Retained
    Comprehensive
  Stockholders’
 
    Shares   Amount   Capital   Earnings     Income   Equity  
 
Balance at December 31, 2006
    53,506,822   $ 1   $ 961   $ 540     $ 13   $ 1,515  
Effect of adoption of FIN 48
                (1 )         (1 )
Net income
                14           14  
Other comprehensive income, net of income taxes of $(1)
                      8     8  
Stock compensation expense
            4               4  
                                         
Balance at June 30, 2007
    53,506,822   $ 1   $ 965   $ 553     $ 21   $ 1,540  
                                         
 
See Notes to Condensed Consolidated Financial Statements.


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PHH CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In millions)
 
                 
    Six Months
 
    Ended June 30,  
    2007     2006  
 
Cash flows from operating activities:
               
Net income (loss)
  $ 14     $ (10 )
Adjustments to reconcile Net income (loss) to net cash provided by operating activities:
               
Capitalization of originated mortgage servicing rights
    (227 )     (218 )
Net unrealized loss on mortgage servicing rights and related derivatives
    195       221  
Vehicle depreciation
    626       610  
Other depreciation and amortization
    16       18  
Origination of mortgage loans held for sale
    (16,246 )     (17,211 )
Proceeds on sale of and payments from mortgage loans held for sale
    16,228       16,858  
Other adjustments and changes in other assets and liabilities, net
    30       (24 )
                 
Net cash provided by operating activities
    636       244  
                 
Cash flows from investing activities:
               
Investment in vehicles
    (1,197 )     (1,413 )
Proceeds on sale of investment vehicles
    470       637  
Purchase of mortgage servicing rights
    (34 )     (8 )
Cash paid on derivatives related to mortgage servicing rights
    (52 )     (12 )
Net settlement payments for derivatives related to mortgage servicing rights
    (77 )     (212 )
Purchases of property, plant and equipment
    (11 )     (13 )
Net assets acquired, net of cash acquired and acquisition-related payments
          (2 )
Increase in Restricted cash
    (40 )     (152 )
Other, net
    5       9  
                 
Net cash used in investing activities
    (936 )     (1,166 )
                 
Cash flows from financing activities:
               
Net increase in short-term borrowings
    212        
Proceeds from borrowings
    11,569       11,436  
Principal payments on borrowings
    (11,461 )     (10,512 )
Issuances of Company Common stock
          1  
Other, net
    (7 )     (5 )
                 
Net cash provided by financing activities
    313       920  
                 
Effect of changes in exchange rates on Cash and cash equivalents
          1  
                 
Net increase (decrease) in Cash and cash equivalents
    13       (1 )
Cash and cash equivalents at beginning of period
    123       107  
                 
Cash and cash equivalents at end of period
  $ 136     $ 106  
                 
 
See Notes to Condensed Consolidated Financial Statements.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
1.   Summary of Significant Accounting Policies
 
 
PHH Corporation and subsidiaries (“PHH” or the “Company”) is a leading outsource provider of mortgage and fleet management services operating in the following business segments:
 
  •  Mortgage Production—provides mortgage loan origination services and sells mortgage loans.
 
  •  Mortgage Servicing—provides servicing activities for originated and purchased loans.
 
  •  Fleet Management Services—provides commercial fleet management services.
 
The Condensed Consolidated Financial Statements include the accounts and transactions of PHH and its subsidiaries, as well as entities in which the Company directly or indirectly has a controlling interest and variable interest entities of which the Company is the primary beneficiary. PHH Home Loans, LLC and its subsidiaries (collectively, “PHH Home Loans” or the “Mortgage Venture”) are consolidated within PHH’s Condensed Consolidated Financial Statements, and Realogy Corporation’s ownership interest is presented as Minority interest in the Condensed Consolidated Balance Sheets and Minority interest in income of consolidated entities, net of income taxes in the Condensed Consolidated Statements of Operations.
 
The Condensed Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and disclosures required by GAAP for complete financial statements. In management’s opinion, the unaudited Condensed Consolidated Financial Statements contain all normal, recurring adjustments necessary for a fair presentation of the financial position and results of operations for the interim periods presented. The results of operations reported for interim periods are not necessarily indicative of the results of operations for the entire year or any subsequent interim period. These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 (the “2006 Form 10-K”).
 
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions include, but are not limited to, those related to the valuation of mortgage servicing rights (“MSRs”), financial instruments and Goodwill and the determination of certain income tax assets and liabilities and associated valuation allowances. Actual results could differ from those estimates.
 
During the preparation of the Condensed Consolidated Financial Statements as of and for the three months ended March 31, 2006, the Company identified and corrected errors related to prior periods. The effect of correcting these errors on the Condensed Consolidated Statement of Operations for the six months ended June 30, 2006 was to reduce Net loss by $3 million (net of income taxes of $2 million). The corrections included an adjustment for franchise tax accruals previously recorded during the years ended December 31, 2002 and 2003 and certain other miscellaneous adjustments related to the year ended December 31, 2005. The Company evaluated the impact of the adjustments and determined that they are not material, individually or in the aggregate to any of the periods affected, specifically the six months ended June 30, 2006 or the years ended December 31, 2006, 2005, 2003 or 2002.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

 
Accounting for Hybrid Instruments.  In February 2006, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). SFAS No. 155 permits an entity to elect fair value measurement of any hybrid financial instrument that contains an embedded derivative that otherwise would have required bifurcation, clarifies which interest-only and principal-only strips are not subject to the requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”) and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS No. 155 was effective January 1, 2007. The adoption of SFAS No. 155 did not impact the Company’s Condensed Consolidated Financial Statements.
 
Uncertainty in Income Taxes.  In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken in a tax return. The Company must presume the income tax position will be examined by the relevant tax authority and determine whether it is more likely than not that the income tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. An income tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The Company is required to record a liability for unrecognized income tax benefits for the amount of the benefit included in its previously filed income tax returns and its financial results expected to be included in income tax returns to be filed for periods through the date of its Condensed Consolidated Financial Statements for income tax positions for which it is more likely than not that a tax position will not be sustained upon examination by the respective taxing authority. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 was effective January 1, 2007. The cumulative effect of applying the provisions of FIN 48 represented a change in accounting principle and was recorded as an adjustment to the opening balance of Retained earnings.
 
The Company adopted the provisions of FIN 48 effective January 1, 2007. As a result of the implementation of FIN 48, the Company recorded a $1 million increase in the liability for unrecognized income tax benefits, resulting in a $1 million decrease in Retained earnings as of January 1, 2007.
 
On January 1, 2007, prior to the implementation of FIN 48, the Company’s liability for income tax contingency reserves was $27 million. On January 1, 2007, after recording the effect of the adoption of FIN 48, which was a $1 million increase to such reserves, the Company’s total liability for unrecognized income tax benefits was $28 million. From January 1, 2007 (after recording the effect of the adoption of FIN 48) to June 30, 2007, the Company’s total liability for income tax contingency reserves increased by $18 million as a result of current year activity related to income tax positions taken during prior years. The Company’s total liability for unrecognized income tax benefits was $46 million as of June 30, 2007, all of which would impact the Company’s effective income tax rate if these unrecognized income tax benefits were recognized.
 
It is expected that the amount of unrecognized income tax benefits will change in the next twelve months. This change may be material. However, the Company is unable to project the impact of these unrecognized income tax benefits on its results of operations or financial position for future reporting periods due to the volatility of market and other factors.
 
The Company recognizes interest and penalties accrued related to unrecognized income tax benefits in the Provision for income taxes in the Condensed Consolidated Statements of Operations, which is consistent with the recognition of these items in prior reporting periods. As of January 1, 2007, after the adoption of FIN 48, and as of June 30, 2007, the Company’s estimated liability for the potential payment of interest and penalties was


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

$1 million, which is included in the liability for unrecognized income tax benefits. The amount of interest and penalties included in the Provision for income taxes in the Condensed Consolidated Statements of Operations for both the three and six months ended June 30, 2007 was not significant.
 
The Company became a consolidated income tax filer with the Internal Revenue Service (the “IRS”) and certain state jurisdictions subsequent to a spin-off from Cendant Corporation (now known as Avis Budget Group, Inc., but referred to as “Cendant” within these Notes to Condensed Consolidated Financial Statements) on February 1, 2005 (the “Spin-Off”). All federal and certain state income tax filings prior thereto were part of Cendant’s consolidated income tax filing group and the Company is indemnified subject to the Amended Tax Sharing Agreement (as defined and discussed in Note 11, “Commitments and Contingencies”). All periods subsequent to the Spin-Off are subject to examination by the IRS and state jurisdictions. In addition to filing federal income tax returns, the Company files income tax returns in numerous states and Canada. As of June 30, 2007, the Company’s foreign and state income tax filings are subject to examination for periods ranging from 2001 to 2005, dependent upon jurisdiction.
 
 
Fair Value Measurements.  In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The changes to current practice resulting from the application of SFAS No. 157 relate to the definition of fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 with earlier application permitted, subject to certain conditions. The provisions of SFAS No. 157 should be applied prospectively as of the beginning of the fiscal year in which it is initially applied, except for certain financial instruments which require retrospective application as of the beginning of the fiscal year of initial application (a limited form of retrospective application). The transition adjustment, measured as the difference between the carrying amounts and the fair values of those financial instruments at the date SFAS No. 157 is initially applied, should be recognized as a cumulative-effect adjustment to the opening balance of Retained earnings. The Company is currently evaluating the impact of adopting SFAS No. 157 on its Consolidated Financial Statements.
 
Fair Value Option.  In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits entities to choose, at specified election dates, to measure eligible items at fair value (the “Fair Value Option”). Unrealized gains and losses on items for which the Fair Value Option has been elected are reported in earnings. The Fair Value Option is applied instrument by instrument (with certain exceptions), is irrevocable (unless a new election date occurs) and is applied only to an entire instrument. The effect of the first remeasurement to fair value is reported as a cumulative-effect adjustment to the opening balance of Retained earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 with earlier application permitted, subject to certain conditions. The Company is currently evaluating the impact of adopting SFAS No. 159 on its Consolidated Financial Statements.
 
Offsetting of Amounts Related to Certain Contracts.  In April 2007, the FASB issued FASB Staff Position (“FSP”) FIN 39-1, “Amendment of FASB Interpretation No. 39” (“FSP FIN 39-1”). FSP FIN 39-1 modifies FASB Interpretation No. 39, “Offsetting of Amounts Related to Certain Contracts” by permitting companies to offset fair value amounts recognized for multiple derivative instruments executed with the same counterparty under a master netting arrangement against fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral arising from the same master netting arrangement as the derivative instruments. FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007 with earlier application permitted. Retrospective application is required for all prior period financial statements presented. The Company does not expect the adoption of FSP FIN 39-1 to have an impact on its Consolidated Financial Statements, as its practice of netting cash collateral against net derivative assets and liabilities under the same master netting arrangements is consistent with the provisions of FSP FIN 39-1.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

2.   Proposed Merger
 
On March 15, 2007, the Company entered into a definitive agreement (the “Merger Agreement”) with General Electric Capital Corporation (“GE”) and its wholly owned subsidiary, Jade Merger Sub, Inc. to be acquired (the “Merger”). In conjunction with the Merger, GE entered into an agreement to sell the mortgage operations of the Company to an affiliate of The Blackstone Group (“Blackstone”), a global investment and advisory firm. The Merger is subject to approval by the Company’s stockholders and state licensing and other regulatory approvals, as well as various other closing conditions. Under the terms of the Merger Agreement, at closing, the Company’s stockholders will receive $31.50 per share in cash and shares of the Company’s Common stock will no longer be listed on the New York Stock Exchange (the “NYSE”). The Merger Agreement contains certain restrictions on the Company’s ability to incur new indebtedness and to pay dividends on its Common stock as well as on the payment of intercompany dividends by certain of its subsidiaries without the prior written consent of GE.
 
On March 14, 2007, prior to the execution of the Merger Agreement, the Company entered into an amendment to the Rights Agreement, dated as of January 28, 2005, between the Company and The Bank of New York (the “Rights Agreement”). The amendment revises certain terms of the Rights Agreement to render it inapplicable to the Merger and the other transactions contemplated by the Merger Agreement.
 
In connection with the Merger, on March 14, 2007, the Company and its subsidiaries, PHH Mortgage Corporation (“PHH Mortgage”) and PHH Broker Partner Corporation, entered into a Consent and Amendment (the “Consent”) with TM Acquisition Corp., PHH Home Loans and Realogy Corporation’s subsidiaries, Realogy Real Estate Services Group, LLC, Realogy Real Estate Services Venture Partner, Inc., Century 21 Real Estate LLC, Coldwell Banker Real Estate Corporation, ERA Franchise Systems, Inc. and Sotheby’s International Realty Affiliates, Inc. which provides for the following: (i) consents from the parties under the operating agreement of the Mortgage Venture, a strategic relationship agreement between Realogy Corporation (“Realogy”) and the Company, a management services agreement between the Mortgage Venture and PHH Mortgage, trademark license agreements between certain Realogy subsidiaries and PHH Mortgage and the Mortgage Venture and a marketing agreement between PHH Mortgage and certain Realogy subsidiaries (collectively, the “Realogy Agreements”) to the Merger and the related transactions contemplated thereby; (ii) certain corrective amendments to certain provisions of the Realogy Agreements as a result of Cendant’s spin-off of Realogy into an independent publicly traded company and certain other amendments to change in control, non-compete, fee and other provisions in the Realogy Agreements and (iii) undertakings as to certain other actions and agreements with respect to the foregoing consents and amendments. (On April 10, 2007, Realogy became a wholly owned subsidiary of Domus Holdings Corp., an affiliate of Apollo Management VI, L.P., following the completion of a merger and related transactions.) The amendments to the Realogy Agreements effected pursuant to the Consent will be effective immediately prior to the closing of the sale of the Company’s mortgage operations to Blackstone immediately following the completion of the Merger. The provisions of the Consent will terminate and be void in the event that either the Merger Agreement or the agreement for the sale of the Company’s mortgage operations is terminated.
 
On March 14, 2007, PHH Mortgage also entered into a Waiver and Amendment Agreement (the “Waiver”) with Merrill Lynch Credit Corporation (“Merrill Lynch”), which provides for the following: (i) the waiver of Merrill Lynch’s rights in connection with a change in control of the Company and PHH Mortgage under a servicing rights purchase and sale agreement between PHH Mortgage and Merrill Lynch, a portfolio servicing agreement between PHH Mortgage and Merrill Lynch, an origination assistance agreement between PHH Mortgage and Merrill Lynch (the “OAA”), a loan purchase and sale agreement between PHH Mortgage and Merrill Lynch and an Equity Access and Omega loan subservicing agreement between PHH Mortgage and Merrill Lynch (collectively, the “Merrill Lynch Agreements”) as a result of the Merger, the sale of the Company’s mortgage operations and the related transactions contemplated thereby; (ii) an amendment to the OAA, effective as of the closing of the sale of the Company’s mortgage operations to Blackstone following the completion of the Merger, and (iii) undertakings as to certain other actions, including further negotiation of certain amendments to


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

the Merrill Lynch Agreements and other agreements with respect to the foregoing amendments. The provisions of the Waiver will terminate and be void in the event that the Merger Agreement is terminated.
 
3.  (Loss) Earnings Per Share
 
Basic (loss) earnings per share was computed by dividing net (loss) earnings during the period by the weighted-average number of shares outstanding during the period. Diluted (loss) earnings per share was computed by dividing net (loss) earnings by the weighted-average number of shares outstanding, assuming all potentially dilutive common shares were issued. The weighted-average computation of the dilutive effect of potentially issuable shares of Common stock under the treasury stock method for the three months ended June 30, 2007 excludes approximately 3.7 million outstanding stock-based awards as their inclusion would be anti-dilutive. The weighted-average computation of the dilutive effect of potentially issuable shares of Common stock under the treasury stock method for the six months ended June 30, 2006 excludes approximately 3.9 million outstanding stock-based awards as their inclusion would be anti-dilutive.
 
The following table summarizes the basic and diluted (loss) earnings per share calculations for the periods indicated:
 
                             
    Three Months
  Six Months
 
    Ended June 30,   Ended June 30,  
    2007     2006   2007   2006  
    (In millions, except share and per share data)  
 
Net (loss) income
  $ (1 )   $ 1   $ 14   $ (10 )
                             
Weighted-average common shares outstanding—basic
    53,817,732       53,613,684     53,786,246     53,547,500  
Effect of potentially dilutive securities:
                           
Stock options
          529,358     763,774      
Restricted stock units
          291,431     169,958      
                             
Weighted-average common shares outstanding—diluted
    53,817,732       54,434,473     54,719,978     53,547,500  
                             
Basic (loss) earnings per share
  $ (0.02 )   $ 0.01   $ 0.26   $ (0.19 )
                             
Diluted (loss) earnings per share
  $ (0.02 )   $ 0.01   $ 0.25   $ (0.19 )
                             
 
4.   Mortgage Loans Held for Sale
 
Mortgage loans held for sale, net consisted of:
 
             
    June 30,
  December 31,
    2007   2006
    (In millions)
 
Mortgage loans held for sale (“MLHS”)
  $ 2,750   $ 2,676
Home equity lines of credit
    80     141
Construction loans
    68     101
Net deferred loan origination fees and expenses
    23     18
             
Mortgage loans held for sale, net
  $ 2,921   $ 2,936
             
 
At June 30, 2007, the Company pledged $2.3 billion of Mortgage loans held for sale, net as collateral in asset-backed debt arrangements.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

5.   Mortgage Servicing Rights
 
The activity in the Company’s loan servicing portfolio associated with its capitalized MSRs consisted of:
 
                 
    Six Months
 
    Ended June 30,  
    2007     2006  
    (In millions)  
 
Balance, beginning of period
  $   146,836     $   145,827  
Additions
    17,888       16,070  
Payoffs, sales and curtailments
    (13,075 )     (14,932 )
                 
Balance, end of period
  $ 151,649     $ 146,965  
                 
 
The activity in the Company’s capitalized MSRs consisted of:
 
                 
    Six Months
 
    Ended June 30,  
    2007     2006  
    (In millions)  
 
Mortgage Servicing Rights:
               
Balance, beginning of period
  $ 1,971     $ 2,152  
Effect of adoption of SFAS No. 156 (1)
          (243 )
Additions
    261       226  
Changes in fair value due to:
               
Realization of expected cash flows
    (163 )     (200 )
Changes in market inputs or assumptions used in the valuation model
    180       265  
Sales and deletions
          (8 )
                 
Balance, end of period
    2,249       2,192  
                 
Valuation Allowance:
               
Balance, beginning of period
          (243 )
Effect of adoption of SFAS No. 156 (1)
          243  
                 
Balance, end of period
           
                 
Mortgage servicing rights
  $ 2,249     $ 2,192  
                 
 
 
(1) After the adoption of SFAS No. 156, “Accounting for Servicing of Financial Assets” (“SFAS No. 156”) effective January 1, 2006, MSRs are recorded at fair value.
 
The significant assumptions used in estimating the fair value of MSRs at June 30, 2007 and 2006 were as follows (in annual rates):
 
                 
    June 30,  
    2007     2006  
 
Prepayment speed
    16%       16%  
Discount rate
    11%       10%  
Volatility
    13%       13%  
 
The value of the Company’s MSRs is driven by the net positive cash flows associated with the Company’s servicing activities. These cash flows include contractually specified servicing fees, late fees and other ancillary servicing revenue. The Company recorded contractually specified servicing fees, late fees and other ancillary


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

servicing revenue within Loan servicing income in the Condensed Consolidated Statements of Operations as follows:
 
                                 
    Three Months
    Six Months
 
    Ended June 30,     Ended June 30,  
    2007     2006     2007     2006  
    (In millions)  
 
Net service fee revenue
  $   125     $   120     $   249     $   242  
Late fees
    5       5       11       10  
Other ancillary servicing revenue
    6       4       11       9  
 
As of June 30, 2007, the Company’s MSRs had a weighted-average life of approximately 5.5 years. Approximately 67% of the MSRs associated with the loan servicing portfolio as of June 30, 2007 were restricted from sale without prior approval from the Company’s private-label clients or investors.
 
The following summarizes certain information regarding the initial and ending capitalization rates of the Company’s MSRs:
                 
    Six Months
 
    Ended June 30,  
    2007     2006  
 
Initial capitalization rate of additions to MSRs
    1.46%       1.41%  
 
                 
    June 30,  
    2007     2006  
 
Capitalized servicing rate (based on fair value)
    1.48 %     1.49 %
Capitalized servicing multiple (based on fair value)
    4.6       4.7  
Weighted-average servicing fee (in basis points)
    33       32  
 
The net impact to the Condensed Consolidated Statements of Operations resulting from changes in the fair value of the Company’s MSRs and related derivatives was as follows:
 
                                 
    Three Months
    Six Months
 
    Ended June 30,     Ended June 30,  
    2007     2006     2007     2006  
    (In millions)  
 
Changes in fair value of mortgage servicing rights due to:
                               
Realization of expected cash flows
  $ (88 )   $ (116 )   $ (163 )   $ (200 )
Changes in market inputs or assumptions used in the valuation model
    177       113       180       265  
Net derivative loss related to mortgage servicing rights (See Note 7)
    (207 )     (106 )     (212 )     (286 )
                                 
Valuation adjustments related to mortgage servicing rights
  $   (118 )   $   (109 )   $   (195 )   $   (221 )
                                 
 
6.   Loan Servicing Portfolio
 
The following tables summarize certain information regarding the Company’s mortgage loan servicing portfolio for the periods indicated. Unless otherwise noted, the information presented includes both loans held for sale and loans subserviced for others.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

                 
    Six Months
 
    Ended June 30,  
    2007     2006  
    (In millions)  
 
Balance, beginning of period (1)
  $   160,222     $   154,843  
Additions (2)
    19,951       18,478  
Payoffs and curtailments (2)
    (15,591 )     (16,176 )
Addition of certain subserviced home equity loans as of June 30, 2006 (1)
          2,130  
                 
Balance, end of period (1)
  $ 164,582     $ 159,275  
                 
 
(1) Prior to June 30, 2006, certain home equity loans subserviced for others were excluded from the disclosed portfolio activity. As a result of a systems conversion during the second quarter of 2006, these loans subserviced for others are included in the portfolio balance as of January 1, 2007, June 30, 2007 and June 30, 2006. The amount of home equity loans subserviced for others and excluded from the portfolio balance as of January 1, 2006 was approximately $2.5 billion.
 
(2) Excludes activity related to certain home equity loans subserviced for others described above in the six months ended June 30, 2006.
 
                 
    June 30,  
    2007     2006  
    (In millions)  
 
Owned servicing portfolio
  $   155,343     $   150,644  
Subserviced portfolio
    9,239       8,631  
                 
Total servicing portfolio
  $ 164,582     $ 159,275  
                 
Fixed rate
  $ 106,876     $ 101,614  
Adjustable rate
    57,706       57,661  
                 
Total servicing portfolio
  $ 164,582     $ 159,275  
                 
Conventional loans
  $ 152,803     $ 147,958  
Government loans
    7,842       7,034  
Home equity lines of credit
    3,937       4,283  
                 
Total servicing portfolio
  $ 164,582     $ 159,275  
                 
Weighted-average interest rate
    6.1 %     6.0 %
                 
 
Portfolio Delinquency (1)
                                 
    June 30,  
    2007     2006  
    Number
    Unpaid
    Number
    Unpaid
 
    of Loans     Balance     of Loans     Balance  
 
30 days
    1.96 %     1.68 %     1.70 %     1.43 %
60 days
    0.39 %     0.32 %     0.32 %     0.25 %
90 or more days
    0.31 %     0.25 %     0.30 %     0.22 %
                         
Total delinquency
    2.66 %     2.25 %     2.32 %     1.90 %
                         
Foreclosure/real estate owned/bankruptcies
    0.83 %     0.66 %     0.84 %     0.58 %
                         
 
(1) Represents the loan servicing portfolio delinquencies as a percentage of the total number of loans and the total unpaid balance of the portfolio.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

7.   Derivatives and Risk Management Activities
 
The Company’s principal market exposure is to interest rate risk, specifically long-term United States (“U.S.”) Treasury (“Treasury”) and mortgage interest rates due to their impact on mortgage-related assets and commitments. The Company also has exposure to the London Interbank Offered Rate (“LIBOR”) and commercial paper interest rates due to their impact on variable-rate borrowings, other interest rate sensitive liabilities and net investment in variable-rate lease assets. The Company uses various financial instruments, including swap contracts, forward delivery commitments, futures and options contracts to manage and reduce this risk.
 
The following is a description of the Company’s risk management policies related to interest rate lock commitments (“IRLCs”), MLHS, MSRs and debt:
 
Interest Rate Lock Commitments.  IRLCs represent an agreement to extend credit to a mortgage loan applicant whereby the interest rate on the loan is set prior to funding. The loan commitment binds the Company (subject to the loan approval process) to lend funds to a potential borrower at the specified rate, regardless of whether interest rates have changed between the commitment date and the loan funding date. The Company’s loan commitments generally range between 30 and 90 days; however, the borrower is not obligated to obtain the loan. As such, the Company’s outstanding IRLCs are subject to interest rate risk and related price risk during the period from the IRLC through the loan funding date or expiration date. In addition, the Company is subject to fallout risk, which is the risk that an approved borrower will choose not to close on the loan. The Company uses forward delivery commitments to manage these risks. The Company considers historical commitment-to-closing ratios to estimate the quantity of mortgage loans that will fund within the terms of the IRLCs.
 
IRLCs are defined as derivative instruments under SFAS No. 133, as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” Because IRLCs are considered derivatives, the associated risk management activities do not qualify for hedge accounting under SFAS No. 133. Therefore, the IRLCs and the related derivative instruments are considered freestanding derivatives and are classified as Other assets or Other liabilities in the Condensed Consolidated Balance Sheets with changes in their fair values recorded as a component of Gain on sale of mortgage loans, net in the Condensed Consolidated Statements of Operations.
 
Mortgage Loans Held for Sale.  The Company is subject to interest rate and price risk on its MLHS from the loan funding date until the date the loan is sold into the secondary market. The Company uses mortgage forward delivery commitments to hedge these risks. These forward delivery commitments fix the forward sales price that will be realized in the secondary market and thereby reduce the interest rate and price risk to the Company. Such forward delivery commitments are designated and classified as fair value hedges to the extent they qualify for hedge accounting under SFAS No. 133. Forward delivery commitments that do not qualify for hedge accounting are considered freestanding derivatives. The forward delivery commitments are included in Other assets or Other liabilities in the Condensed Consolidated Balance Sheets. Changes in the fair value of all forward delivery commitments are recorded as a component of Gain on sale of mortgage loans, net in the Condensed Consolidated Statements of Operations. Changes in the fair value of MLHS are recorded as a component of Gain on sale of mortgage loans, net to the extent they qualify for hedge accounting under SFAS No. 133. Changes in the fair value of MLHS are not recorded to the extent the hedge relationship is deemed to be ineffective under SFAS No. 133.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

The following table provides a summary of the changes in the fair values of IRLCs, MLHS and the related derivatives:
 
                                 
    Three Months
    Six Months
 
    Ended June 30,     Ended June 30,  
    2007     2006     2007     2006  
    (In millions)  
 
Change in value of IRLCs
  $   (40 )   $   (32 )   $   (39 )   $   (52 )
Change in value of MLHS
    (11 )     (3 )     (13 )     (5 )
                                 
Total change in value of IRLCs and MLHS
    (51 )     (35 )     (52 )     (57 )
                                 
Mark-to-market of derivatives designated as hedges of MLHS
    3             1       (1 )
Mark-to-market of freestanding derivatives (1)
    80       52       79       96  
                                 
Net gain on derivatives
    83       52       80       95  
                                 
Net gain on hedging activities (2)
  $ 32     $ 17     $ 28     $ 38  
                                 
 
(1) Amount includes $14 million and $5 million of ineffectiveness recognized on hedges of MLHS during the three months ended June 30, 2007 and 2006, respectively, and $12 million and $9 million of ineffectiveness recognized on hedges of MLHS during the six months ended June 30, 2007 and 2006, respectively, due to the application of SFAS No. 133. In accordance with SFAS No. 133, the change in the value of MLHS is only recorded to the extent the related derivatives are considered hedge effective. The ineffective portion of designated derivatives represents the change in the fair value of derivatives for which there were no corresponding changes in the value of the loans that did not qualify for hedge accounting under SFAS No. 133.
 
(2) During the three months ended June 30, 2007 and 2006, the Company recognized $(8) million and $(3) million, respectively, of hedge ineffectiveness on derivatives designated as hedges of MLHS that qualified for hedge accounting under SFAS No. 133. During the six months ended June 30, 2007 and 2006, the Company recognized $(12) million and $(6) million, respectively, of hedge ineffectiveness on derivatives designated as hedges of MLHS that qualified for hedge accounting under SFAS No. 133.
 
Mortgage Servicing Rights.  The Company’s MSRs are subject to substantial interest rate risk as the mortgage notes underlying the MSRs permit the borrowers to prepay the loans. Therefore, the value of the MSRs tends to diminish in periods of declining interest rates (as prepayments increase) and increase in periods of rising interest rates (as prepayments decrease). The Company uses a combination of derivative instruments to offset potential adverse changes in the fair value of its MSRs that could affect reported earnings. The gain or loss on derivatives is intended to react in the opposite direction of the change in the fair value of MSRs. The MSRs derivatives generally increase in value as interest rates decline and decrease in value as interest rates rise. For all periods presented, all of the derivatives associated with the MSRs were freestanding derivatives and were not designated in a hedge relationship pursuant to SFAS No. 133. These derivatives are classified as Other assets or Other liabilities in the Condensed Consolidated Balance Sheets with changes in their fair values recorded in Net derivative loss related to mortgage servicing rights in the Condensed Consolidated Statements of Operations.
 
The Company uses interest rate swap contracts, interest rate futures contracts, interest rate forward contracts, mortgage forward contracts, options on forward contracts, options on futures contracts, options on swap contracts and principal-only swaps in its risk management activities related to its MSRs.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

The net activity in the Company’s derivatives related to MSRs consisted of:
 
                 
    Six Months
 
    Ended June 30,  
    2007     2006  
    (In millions)  
 
Net balance, beginning of period
  $  (1)   $ 44  (2)
Additions
    52       12  
Changes in fair value
      (212 )       (286 )
Net settlement payments
    77       212  
                 
Net balance, end of period
  $ (83 ) (3)   $ (18 ) (4)
                 
 
(1) The net balance represents the gross asset of $56 million (recorded within Other assets in the Condensed Consolidated Balance Sheet) net of the gross liability of $56 million (recorded within Other liabilities in the Condensed Consolidated Balance Sheet).
 
(2) The net balance represents the gross asset of $73 million (recorded within Other assets) net of the gross liability of $29 million (recorded within Other liabilities).
 
(3) The net balance represents the gross asset of $42 million (recorded within Other assets in the Condensed Consolidated Balance Sheet) net of the gross liability of $125 million (recorded within Other liabilities in the Condensed Consolidated Balance Sheet).
 
(4) The net balance represents the gross asset of $32 million (recorded within Other assets) net of the gross liability of $50 million (recorded within Other liabilities).
 
Debt.  The Company uses various hedging strategies and derivative financial instruments to create a desired mix of fixed-and variable-rate assets and liabilities. Derivative instruments used in these hedging strategies include swaps, interest rate caps and instruments with purchased option features. To more closely match the characteristics of the related assets, including the Company’s net investment in variable-rate lease assets, the Company either issues variable-rate debt or fixed-rate debt, which may be swapped to variable LIBOR-based rates. The derivatives used to manage the risk associated with the Company’s fixed-rate debt include instruments that were designated as fair value hedges as well as instruments that were not designated as fair value hedges. The terms of the derivatives that were designated as fair value hedges match those of the underlying hedged debt resulting in no net impact on the Company’s results of operations during the three and six months ended June 30, 2007 and 2006, except to create the accrual of interest expense at variable rates. Net gains and losses recognized during the three and six months ended June 30, 2007 and the three months ended June 30, 2006 related to instruments which did not qualify for hedge accounting treatment pursuant to SFAS No. 133 were not significant and were recorded in Mortgage interest expense in the Condensed Consolidated Statements of Operations. The Company recognized net losses of $1 million during the six months ended June 30, 2006 related to instruments which did not qualify for hedge accounting treatment pursuant to SFAS No. 133, which were recorded in Mortgage interest expense in the Condensed Consolidated Statement of Operations.
 
From time-to-time, the Company uses derivatives that convert variable cash flows to fixed cash flows to manage the risk associated with its variable-rate debt and net investment in variable-rate lease assets. Such derivatives may include freestanding derivatives and derivatives designated as cash flow hedges. The Company recognized net losses of $1 million during each of the three and six months ended June 30, 2007 and 2006 related to instruments that were not designated as cash flow hedges, which were included in Fleet interest expense in the Condensed Consolidated Statements of Operations.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

8.   Vehicle Leasing Activities
 
The components of Net investment in fleet leases were as follows:
 
                 
    June 30,
    December 31,
 
    2007     2006  
    (In millions)  
 
Operating Leases:
               
Vehicles under open-end operating leases
  $ 7,192     $ 6,958  
Vehicles under closed-end operating leases
    253       273  
                 
Vehicles under operating leases
    7,445       7,231  
Less: Accumulated depreciation
    (3,611 )     (3,541 )
                 
Net investment in operating leases
    3,834       3,690  
                 
Direct Financing Leases:
               
Lease payments receivable
    179       182  
Less: Unearned income
    (12 )     (25 )
                 
Net investment in direct financing leases
    167       157  
                 
Off-Lease Vehicles:
               
Vehicles not yet subject to a lease
    242       292  
Vehicles held for sale
    14       20  
Less: Accumulated depreciation
    (9 )     (12 )
                 
Net investment in off-lease vehicles
    247       300  
                 
Net investment in fleet leases
  $ 4,248     $ 4,147  
                 


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

9.   Debt and Borrowing Arrangements
 
The following tables summarize the components of the Company’s indebtedness as of June 30, 2007 and December 31, 2006:
 
                                 
    June 30, 2007  
    Vehicle
    Mortgage
             
    Management
    Warehouse
             
    Asset-Backed
    Asset-Backed
    Unsecured
       
    Debt     Debt     Debt     Total  
    (In millions)  
 
Term notes
  $     $ 400     $ 627     $ 1,027  
Variable funding notes
    3,639       825             4,464  
Subordinated debt
          50             50  
Commercial paper
          694       635       1,329  
Borrowings under credit facilities
          152       921       1,073  
Other
    14       13       14       41  
                                 
    $ 3,653     $ 2,134     $ 2,197     $ 7,984  
                                 
 
                                 
    December 31, 2006  
    Vehicle
    Mortgage
             
    Management
    Warehouse
             
    Asset-Backed
    Asset-Backed
    Unsecured
       
    Debt     Debt     Debt     Total  
    (In millions)  
 
Term notes
  $     $ 400     $ 646     $ 1,046  
Variable funding notes
    3,532       774             4,306  
Subordinated debt
          50             50  
Commercial paper
          688       411       1,099  
Borrowings under credit facilities
          66       1,019       1,085  
Other
    9       26       26       61  
                                 
    $ 3,541     $ 2,004     $ 2,102     $ 7,647  
                                 
 
 
 
Vehicle management asset-backed debt primarily represents variable-rate debt issued by the Company’s wholly owned subsidiary, Chesapeake Funding LLC (“Chesapeake”) to support the acquisition of vehicles used by the Fleet Management Services segment’s leasing operations. As of June 30, 2007 and December 31, 2006, variable funding notes outstanding under this arrangement aggregated $3.6 billion and $3.5 billion, respectively. The debt issued as of June 30, 2007 was collateralized by approximately $4.2 billion of leased vehicles and related assets, primarily included in Net investment in fleet leases in the Condensed Consolidated Balance Sheet and is not available to pay the Company’s general obligations. The titles to all the vehicles collateralizing the debt issued by Chesapeake are held in a bankruptcy remote trust, and the Company acts as a servicer of all such leases. The bankruptcy remote trust also acts as a lessor under both operating and direct financing lease agreements. The agreements governing the Series 2006-1 notes, with capacity of $2.9 billion, and the Series 2006-2 notes, with capacity of $1.0 billion, are scheduled to expire on March 4, 2008 and November 30, 2007, respectively (the “Scheduled Expiry Dates”). These agreements are renewable on or before the Scheduled Expiry Dates, subject to agreement by the parties. If the agreements are not renewed, monthly repayments on the notes are required to be made as certain cash inflows are received relating to the securitized vehicle leases and related assets beginning in the month following the Scheduled Expiry Dates and ending up to 125 months after the Scheduled Expiry Dates. The weighted-average interest rate of vehicle management asset-backed debt arrangements was 5.8% and 5.7% as of June 30, 2007 and December 31, 2006, respectively.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

As of June 30, 2007, the total capacity under vehicle management asset-backed debt arrangements was approximately $3.9 billion, and the Company had $261 million of unused capacity available.
 
 
Bishop’s Gate Residential Mortgage Trust (“Bishop’s Gate”) is a consolidated bankruptcy remote special purpose entity that is utilized to warehouse mortgage loans originated by the Company prior to their sale into the secondary market. The activities of Bishop’s Gate are limited to (i) purchasing mortgage loans from the Company’s mortgage subsidiary, (ii) issuing commercial paper, senior term notes, subordinated certificates and/or borrowing under a liquidity agreement to effect such purchases, (iii) entering into interest rate swaps to hedge interest rate risk and certain non-credit-related market risk on the purchased mortgage loans, (iv) selling and securitizing the acquired mortgage loans to third parties and (v) engaging in certain related transactions. As of both June 30, 2007 and December 31, 2006, the Bishop’s Gate term notes (the “Bishop’s Gate Notes”) issued under the Base Indenture dated as of December 11, 1998 between The Bank of New York, as Indenture Trustee and Bishop’s Gate aggregated $400 million. The Bishop’s Gate Notes are variable-rate instruments and are scheduled to mature in November 2008. The weighted-average interest rate on the Bishop’s Gate Notes as of both June 30, 2007 and December 31, 2006 was 5.7%. As of both June 30, 2007 and December 31, 2006, the Bishop’s Gate subordinated certificates (the “Bishop’s Gate Certificates”) aggregated $50 million. The Bishop’s Gate Certificates are primarily fixed-rate instruments and are scheduled to mature in May 2008. The weighted-average interest rate on the Bishop’s Gate Certificates as of both June 30, 2007 and December 31, 2006 was 5.6%. As of June 30, 2007 and December 31, 2006, the Bishop’s Gate commercial paper, issued under the Amended and Restated Liquidity Agreement, dated as of December 11, 1998, as further amended and restated as of December 2, 2003, among Bishop’s Gate, certain banks listed therein and JPMorgan Chase Bank, as Agent (the “Bishop’s Gate Liquidity Agreement”), aggregated $694 million and $688 million, respectively. The Bishop’s Gate commercial paper are fixed-rate instruments and mature within 90 days of issuance. The Bishop’s Gate Liquidity Agreement is scheduled to expire on November 30, 2007. The weighted-average interest rate on the Bishop’s Gate commercial paper as of June 30, 2007 and December 31, 2006 was 5.3% and 5.4%, respectively. As of June 30, 2007, the debt issued by Bishop’s Gate was collateralized by approximately $1.2 billion of underlying mortgage loans and related assets, primarily recorded in Mortgage loans held for sale, net in the Condensed Consolidated Balance Sheet.
 
The Company also maintains a $750 million committed mortgage repurchase facility (the “Mortgage Repurchase Facility”) that is used to finance mortgage loans originated by PHH Mortgage, the Company’s wholly owned subsidiary. The Mortgage Repurchase Facility is funded by a multi-seller conduit, and the Company generally uses it to supplement the capacity of Bishop’s Gate and unsecured borrowings used to fund the Company’s mortgage warehouse needs. As of June 30, 2007, borrowings under the Mortgage Repurchase Facility were $568 million and were collateralized by underlying mortgage loans and related assets of $617 million, primarily included in Mortgage loans held for sale, net in the Condensed Consolidated Balance Sheet. As of December 31, 2006, borrowings under this facility were $505 million. As of both June 30, 2007 and December 31, 2006, borrowings under this variable-rate facility bore interest at 5.4%. The Mortgage Repurchase Facility expires on October 29, 2007 and is renewable on an annual basis, subject to agreement by the parties. The assets collateralizing this facility are not available to pay the Company’s general obligations.
 
The Mortgage Venture maintains a $350 million repurchase facility (the “Mortgage Venture Repurchase Facility”) with Bank of Montreal and Barclays Bank PLC as Bank Principals and Fairway Finance Company, LLC and Sheffield Receivables Corporation as Conduit Principals. As of June 30, 2007, borrowings under the Mortgage Venture Repurchase Facility were $257 million and were collateralized by underlying mortgage loans and related assets of $311 million, primarily included in Mortgage loans held for sale, net in the Condensed Consolidated Balance Sheet. As of December 31, 2006, borrowings under this facility were $269 million. Borrowings under this variable-rate facility bore interest at 5.4% as of both June 30, 2007 and December 31, 2006. The Mortgage Venture also pays an annual liquidity fee of 20 basis points (“bps”) on 102%


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

of the program size. The maturity date for this facility is June 1, 2009, subject to annual renewals of certain underlying conduit liquidity arrangements. The assets collateralizing this facility are not available to pay the Company’s general obligations.
 
The Mortgage Venture also maintains a $200 million secured line of credit agreement with Barclays Bank PLC, Bank of Montreal and JPMorgan Chase Bank, N.A. that is used to finance mortgage loans originated by the Mortgage Venture. As of June 30, 2007, borrowings under this secured line of credit were $137 million and were collateralized by underlying mortgage loans and related assets of $172 million, primarily included in Mortgage loans held for sale, net in the Condensed Consolidated Balance Sheet. As of December 31, 2006, borrowings under this line of credit were $58 million. This variable-rate line of credit bore interest at 6.2% as of both June 30, 2007 and December 31, 2006. The expiration date of this line of credit agreement is October 5, 2007.
 
As of June 30, 2007, the total capacity under mortgage warehouse asset-backed debt arrangements was approximately $2.8 billion, and the Company had approximately $647 million of unused capacity available.
 
 
 
The outstanding carrying value of term notes as of June 30, 2007 and December 31, 2006 consisted of $627 million and $646 million, respectively, of medium-term notes (“MTNs”) publicly issued under the Indenture, dated as of November 6, 2000 (as amended and supplemented, the “MTN Indenture”) by and between PHH and The Bank of New York, as successor trustee for Bank One Trust Company, N.A. As of June 30, 2007, the outstanding MTNs were scheduled to mature between July 2007 and April 2018. The effective rate of interest for the MTNs outstanding as of both June 30, 2007 and December 31, 2006 was 6.8%.
 
 
The Company’s policy is to maintain available capacity under its committed credit facilities (described below) to fully support its outstanding unsecured commercial paper. The Company had unsecured commercial paper obligations of $635 million and $411 million as of June 30, 2007 and December 31, 2006, respectively. This commercial paper is fixed-rate and matures within 90 days of issuance. The weighted-average interest rate on outstanding unsecured commercial paper as of both June 30, 2007 and December 31, 2006 was 5.7%.
 
 
The Company is party to the Amended and Restated Competitive Advance and Revolving Credit Agreement (the “Amended Credit Facility”), dated as of January 6, 2006, among PHH Corporation, a group of lenders and JPMorgan Chase Bank, N.A., as administrative agent. Borrowings under the Amended Credit Facility were $306 million and $404 million as of June 30, 2007 and December 31, 2006, respectively. The termination date of this $1.3 billion agreement is January 6, 2011. Pricing under the Amended Credit Facility is based upon the Company’s senior unsecured long-term debt ratings. If the ratings on the Company’s senior unsecured long-term debt assigned by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings are not equivalent to each other, the second highest credit rating assigned by them determines pricing under the Amended Credit Facility. Borrowings under the Amended Credit Facility bore interest at LIBOR plus a margin of 38 bps as of December 31, 2006. The Amended Credit Facility also requires the Company to pay utilization fees if its usage exceeds 50% of the aggregate commitments under the Amended Credit Facility and per annum facility fees. As of December 31, 2006, the per annum utilization and facility fees were 10 bps and 12 bps, respectively.
 
On January 22, 2007, Standard & Poor’s downgraded its rating on the Company’s senior unsecured long-term debt to BBB-. As a result, the fees and interest rates on borrowings under the Amended Credit Facility increased. After the downgrade, borrowings under the Amended Credit Facility bear interest at LIBOR plus a margin of


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

47.5 bps. In addition, the per annum utilization and facility fees increased to 12.5 bps and 15 bps, respectively. In the event that both of the Company’s second highest and lowest credit ratings are downgraded in the future, the margin over LIBOR and the facility fee under the Amended Credit Facility would become 70 bps and 17.5 bps, respectively, while the utilization fee would remain 12.5 bps.
 
The Company also maintains an unsecured revolving credit agreement (the “Supplemental Credit Facility”) with a group of lenders and JPMorgan Chase Bank, N.A., as administrative agent. Borrowings under the Supplemental Credit Facility were $200 million as of both June 30, 2007 and December 31, 2006. As of December 31, 2006, pricing under the Supplemental Credit Facility was based upon the Company’s senior unsecured long-term debt ratings assigned by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, and borrowings bore interest at LIBOR plus a margin of 38 bps. The Supplemental Credit Facility also required the Company to pay per annum utilization fees if its usage exceeded 50% of the aggregate commitments under the Supplemental Credit Facility and per annum facility fees. As of December 31, 2006, the per annum utilization and facility fees were 10 bps and 12 bps, respectively. The Company was also required to pay an additional facility fee of 10 bps against the outstanding commitments under the facility as of October 6, 2006. After Standard & Poor’s downgraded its rating on the Company’s senior unsecured long-term debt on January 22, 2007, borrowings under the Supplemental Credit Facility bore interest at LIBOR plus a margin of 47.5 bps and the utilization and facility fees were increased to 12.5 bps and 15 bps, respectively.
 
On February 22, 2007, the Supplemental Credit Facility was amended to extend its expiration date to December 15, 2007, reduce the total commitment to $200 million and modify the fees and interest rate paid on outstanding borrowings. After this amendment, pricing under the Supplemental Credit Facility is based upon the Company’s senior unsecured long-term debt ratings assigned by Moody’s Investors Service and Standard & Poor’s. As a result of this amendment, borrowings under the Supplemental Credit Facility bear interest at LIBOR plus a margin of 82.5 bps and the per annum facility fee increased to 17.5 bps. The amendment eliminated the per annum utilization fee under the Supplemental Credit Facility. In the event that either the Moody’s Investors Service or the Standard & Poor’s rating is downgraded in the future, the margin over LIBOR and the per annum facility fee under the Supplemental Credit Facility would become 105 bps and 20 bps, respectively. In the event that both of the Moody’s Investors Service and Standard & Poor’s ratings are downgraded in the future, the margin over LIBOR and the per annum facility fee under the Supplemental Credit Facility would become 127.5 bps and 22.5 bps, respectively.
 
The Company is party to an unsecured credit agreement with a group of lenders and JPMorgan Chase Bank, N.A., as administrative agent, that provided capacity solely for the repayment of the MTNs that occurred during the third quarter of 2006 (the “Tender Support Facility”). Borrowings under the Tender Support Facility were $415 million as of both June 30, 2007 and December 31, 2006. Pricing under the Tender Support Facility is based upon the Company’s senior unsecured long-term debt ratings assigned by Moody’s Investors Service and Standard & Poor’s. As of December 31, 2006, borrowings under this agreement bore interest at LIBOR plus a margin of 75 bps. The Tender Support Facility also required the Company to pay an initial fee of 10 bps of the commitment and a per annum commitment fee of 12 bps as of December 31, 2006. In addition, during 2006, the Company paid a one-time fee of 15 bps against borrowings of $415 million drawn under the Tender Support Facility. After Standard & Poor’s downgraded its rating on the Company’s senior unsecured long-term debt on January 22, 2007, borrowings under the Tender Support Facility bore interest at LIBOR plus a margin of 100 bps and the per annum commitment fee was increased to 17.5 bps. On February 22, 2007, the Tender Support Facility was amended to extend its expiration date to December 15, 2007, reduce the total commitment to $415 million, modify the interest rates to be paid on the Company’s outstanding borrowings based on certain of its senior unsecured long-term debt ratings and eliminate the per annum commitment fee. As of June 30, 2007, borrowings under the Tender Support Facility continued to bear interest at LIBOR plus a margin of 100 bps. In the event that either the Moody’s Investors Service or the Standard & Poor’s rating is downgraded in the future, the margin over LIBOR under the Tender Support Facility would become 125 bps. In the event that both of the Moody’s Investors Service and Standard & Poor’s ratings are downgraded in the future, the margin over LIBOR under the Tender Support Facility would become 150 bps.


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

The Company maintains other unsecured credit facilities in the ordinary course of business as set forth in “Debt Maturities” below.
 
 
The following table provides the contractual maturities of the Company’s indebtedness at June 30, 2007 except for the Company’s vehicle management asset-backed notes, where estimated payments have been used assuming the underlying agreements were not renewed (the indentures related to vehicle management asset-backed notes require principal payments based on cash inflows relating to the securitized vehicle leases and related assets if the indentures are not renewed on or before the Scheduled Expiry Dates):
 
                         
    Asset-Backed     Unsecured     Total  
    (In millions)  
 
Within one year
  $   2,125     $   1,476     $   3,601  
Between one and two years
    1,545             1,545  
Between two and three years
    883       5       888  
Between three and four years
    642       306       948  
Between four and five years
    359             359  
Thereafter
    233       410       643  
                         
    $ 5,787     $ 2,197     $ 7,984  
                         
 
As of June 30, 2007, available funding under the Company’s asset-backed debt arrangements and unsecured committed credit facilities consisted of:
 
                   
        Utilized
  Available
    Capacity (1)   Capacity   Capacity
    (In millions)
 
Asset-Backed Funding Arrangements:
                 
Vehicle management
  $ 3,914   $ 3,653   $ 261
Mortgage warehouse
    2,781     2,134     647
Unsecured Committed Credit Facilities (2)
    1,916     1,557     359
 
(1) Capacity is dependent upon maintaining compliance with, or obtaining waivers of, the terms, conditions and covenants of the respective agreements. With respect to asset-backed funding arrangements, capacity may be further limited by the availability of asset eligibility requirements under the respective agreements.
 
(2) Available capacity reflects a reduction in availability due to an allocation against the facilities of $635 million which fully supports the outstanding unsecured commercial paper issued by the Company as of June 30, 2007. Under the Company’s policy, all of the outstanding unsecured commercial paper is supported by available capacity under its unsecured committed credit facilities with the exception of the Tender Support Facility. The sole purpose of the Tender Support Facility is the funding of the retirement of MTNs. In addition, utilized capacity reflects a $1 million letter of credit issued under the Amended Credit Facility.
 
Beginning on March 16, 2006, access to the Company’s shelf registration statement for public debt issuances was no longer available due to the Company’s non-current filing status with the SEC. Although the Company became current in its filing status with the SEC on June 28, 2007, its shelf registration statement will continue to be unavailable for twelve months after the date on which it became current, assuming it remains current in its filing status.
 
 
Certain of the Company’s debt arrangements require the maintenance of certain financial ratios and contain restrictive covenants, including, but not limited to, restrictions on indebtedness of material subsidiaries, mergers,


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

liens, liquidations and sale and leaseback transactions. The Amended Credit Facility, the Supplemental Credit Facility, the Tender Support Facility, the Mortgage Repurchase Facility and the Mortgage Venture Repurchase Facility require that the Company maintain: (i) on the last day of each fiscal quarter, net worth of $1.0 billion plus 25% of net income, if positive, for each fiscal quarter ended after December 31, 2004 and (ii) at any time, a ratio of indebtedness to tangible net worth no greater than 10:1. The MTN Indenture requires that the Company maintain a debt to tangible equity ratio of not more than 10:1. The MTN Indenture also restricts the Company from paying dividends if, after giving effect to the dividend payment, the debt to equity ratio exceeds 6.5:1. At June 30, 2007, the Company was in compliance with all of its financial covenants related to its debt arrangements.
 
Under many of the Company’s financing, servicing, hedging and related agreements and instruments (collectively, the “Financing Agreements”), the Company is required to provide consolidated and/or subsidiary-level audited annual financial statements, unaudited quarterly financial statements and related documents. The delay in completing the 2005 audited financial statements, the restatement of financial results for periods prior to the quarter ended December 31, 2005 and the delays in completing the unaudited quarterly financial statements for 2006, the 2006 audited annual financial statements and the unaudited quarterly financial statements for the quarter ended March 31, 2007 created the potential for breaches under certain of the Financing Agreements for failure to deliver the financial statements and/or documents by specified deadlines, as well as potential breaches of other covenants.
 
During 2006, the Company obtained waivers under the Amended Credit Facility, the Supplemental Credit Facility, the Tender Support Facility, the Mortgage Repurchase Facility, the financing agreements for Chesapeake and Bishop’s Gate and other agreements which waived certain potential breaches of covenants under those instruments and extended the deadlines (the “Extended Deadlines”) for the delivery of its financial statements and related documents to the various lenders under those instruments. The Extended Deadline for the delivery of the Company’s financial statements for the quarter ended March 31, 2007 was June 29, 2007. The Company’s financial statements for the quarter ended March 31, 2007 were filed with the SEC on June 28, 2007.
 
Under certain of the Financing Agreements, the lenders or trustees have the right to notify the Company if they believe it has breached a covenant under the operative documents and may declare an event of default. If one or more notices of default were to be given with respect to the delivery of the Company’s financial statements, the Company believes it would have various periods in which to cure such events of default. If it does not cure the events of default or obtain necessary waivers within the required time periods or certain extended time periods, the maturity of some of its debt could be accelerated and its ability to incur additional indebtedness could be restricted. In addition, events of default or acceleration under certain of the Company’s Financing Agreements would trigger cross-default provisions under certain of its other Financing Agreements.
 
10.   Income Taxes
 
The Company records its interim income tax provisions by applying a projected full-year effective income tax rate to its quarterly Income before income taxes and minority interest for results that it deems to be reliably estimable in accordance with FASB Interpretation No. 18, “Accounting for Income Taxes in Interim Periods.” Certain results dependent on fair value adjustments of the Company’s Mortgage Production and Mortgage Servicing segments are considered not to be reliably estimable and therefore the Company records discrete year-to-date income tax provisions on those results.
 
During the three months ended June 30, 2007, the Provision for income taxes was $39 million and was significantly impacted by a $17 million increase in liabilities for income tax contingencies and a $6 million increase in valuation allowances for deferred tax assets (primarily state net operating losses generated during the three months ended June 30, 2007) for which the Company believes it is more likely than not that the deferred tax assets will not be realized.


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

During the three months ended June 30, 2006, the Provision for income taxes was $22 million and was significantly impacted by a $9 million increase in liabilities for income tax contingencies. In addition, the Company recorded state income tax expense of $6 million. Due to the Company’s 2006 year-to-date and projected full-year mix of income and loss from its operations by entity and state income tax jurisdiction, there was a significant difference in the 2006 state income tax effective rate in comparison to the 2007 state income tax effective rate.
 
During the six months ended June 30, 2007, the Provision for income taxes was $57 million and was significantly impacted by an $18 million increase in liabilities for income tax contingencies and a $10 million increase in valuation allowances for deferred tax assets (primarily state net operating losses generated during the six months ended June 30, 2007) for which the Company believes it is more likely than not that the deferred tax assets will not be realized.
 
During the six months ended June 30, 2006, the Provision for income taxes was $35 million and was significantly impacted by a $24 million increase in liabilities for income tax contingencies and a $1 million increase in valuation allowances for deferred tax assets (primarily state net operating losses generated during the six months ended June 30, 2006) for which the Company believed it was more likely than not that the deferred tax assets would not be realized. In addition, the Company recorded state income tax expense of $2 million. Due to the Company’s 2006 year-to-date and projected full-year mix of income and loss from its operations by entity and state income tax jurisdiction, there was a significant difference in the 2006 state income tax effective rate in comparison to the 2007 state income tax effective rate.
 
11.   Commitments and Contingencies
 
 
In connection with the Spin-Off, the Company and Cendant entered into a tax sharing agreement dated January 31, 2005, which was amended on December 21, 2005 (the “Amended Tax Sharing Agreement”). The Amended Tax Sharing Agreement governs the allocation of liabilities for taxes between Cendant and the Company, indemnification for certain tax liabilities and responsibility for preparing and filing tax returns and defending tax contests, as well as other tax-related matters. The Amended Tax Sharing Agreement contains certain provisions relating to the treatment of the ultimate settlement of Cendant tax contingencies that relate to audit adjustments due to taxing authorities’ review of income tax returns. The Company’s tax basis in certain assets may be adjusted in the future, and the Company may be required to remit tax benefits ultimately realized by the Company to Cendant in certain circumstances. Certain of the effects of future adjustments relating to years the Company was included in Cendant’s income tax returns that change the tax basis of assets, liabilities and net operating loss and tax credit carryforward amounts may be recorded in equity rather than as an adjustment to the tax provision.
 
Also, pursuant to the Amended Tax Sharing Agreement, the Company and Cendant have agreed to indemnify each other for certain liabilities and obligations. The Company’s indemnification obligations could be significant in certain circumstances. For example, the Company is required to indemnify Cendant for any taxes incurred by it and its affiliates as a result of any action, misrepresentation or omission by the Company or its affiliates that causes the distribution of the Company’s Common stock by Cendant or the internal reorganization transactions relating thereto to fail to qualify as tax-free. In the event that the Spin-Off or the internal reorganization transactions relating thereto do not qualify as tax-free for any reason other than the actions, misrepresentations or omissions of Cendant or the Company or its respective subsidiaries, then the Company would be responsible for 13.7% of any taxes resulting from such a determination. This percentage was based on the relative pro forma net book values of Cendant and the Company as of September 30, 2004, without giving effect to any adjustments to the book values of certain long-lived assets that may be required as a result of the Spin-Off and the related transactions. The Company cannot determine whether it will have to indemnify Cendant or its affiliates for any


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

substantial obligations in the future. The Company also has no assurance that if Cendant or any of its affiliates is required to indemnify the Company for any substantial obligations, they will be able to satisfy those obligations.
 
Cendant disclosed in its Annual Report on Form 10-K for the year ended December 31, 2006 (the “Cendant 2006 Form 10-K”) (filed on March 1, 2007 under Avis Budget Group, Inc.) that it and its subsidiaries are the subject of an IRS audit for the tax years ended December 31, 2003 through 2006. The Company, since it was a subsidiary of Cendant through January 31, 2005, is included in this IRS audit of Cendant. Under certain provisions of the IRS regulations, the Company and its subsidiaries are subject to several liability to the IRS (together with Cendant and certain of its affiliates (the “Cendant Group”) prior to the Spin-Off) for any consolidated federal income tax liability of the Cendant Group arising in a taxable year during any part of which they were members of the Cendant Group. Cendant also disclosed in the Cendant 2006 Form 10-K that it settled the IRS audit for the taxable years 1998 through 2002 that included the Company. As provided in the Amended Tax Sharing Agreement, Cendant is responsible for and required to pay to the IRS all taxes required to be reported on the consolidated federal returns for taxable periods ended on or before January 31, 2005. Pursuant to the Amended Tax Sharing Agreement, Cendant is solely responsible for separate state taxes on a significant number of the Company’s income tax returns for years 2003 and prior. In addition, Cendant is solely responsible for paying tax deficiencies arising from adjustments to the Company’s federal income tax returns and for the Company’s state and local income tax returns filed on a consolidated, combined or unitary basis with Cendant for taxable periods ended on or before the Spin-Off, except for those taxes which might be attributable to the Spin-Off or internal reorganization transactions relating thereto, as more fully discussed above. The Company will be solely responsible for any tax deficiencies arising from adjustments to separate state and local income tax returns for taxable periods ending after 2003 and for adjustments to federal and all state and local income tax returns for periods after the Spin-Off.
 
 
The Company is party to various claims and legal proceedings from time-to-time related to contract disputes and other commercial, employment and tax matters. Except as disclosed below, the Company is not aware of any legal proceedings that it believes could have, individually or in the aggregate, a material adverse effect on its business, financial position, results of operations or cash flows.
 
In March and April 2006, several purported class actions were filed against the Company, its Chief Executive Officer and its former Chief Financial Officer in the U.S. District Court for the District of New Jersey. The plaintiffs seek to represent an alleged class consisting of all persons (other than the Company’s officers and Directors and their affiliates) who purchased the Company’s Common stock during certain time periods beginning March 15, 2005 in one case and May 12, 2005 in the other cases and ending March 1, 2006. The plaintiffs allege, among other matters, that the defendants violated Section 10(b) of the Securities Exchange Act of 1934, as amended and Rule 10b-5 thereunder. Additionally, two derivative actions were filed in the U.S. District Court for the District of New Jersey against the Company, its former Chief Financial Officer and each member of its Board of Directors. Both of these derivative actions have since been voluntarily dismissed by the plaintiffs.
 
Following the announcement of the Merger in March 2007, two purported class actions were filed against the Company and each member of its Board of Directors in the Circuit Court for Baltimore County, Maryland (the “Court”). The first of these actions also named GE and Blackstone as defendants. The plaintiffs seek to represent an alleged class consisting of all persons (other than the Company’s officers and Directors and their affiliates) holding the Company’s Common stock. In support of their request for injunctive and other relief, the plaintiffs allege, among other matters, that the members of the Board of Directors breached their fiduciary duties by failing to maximize stockholder value in approving the Merger Agreement. On or about April 10, 2007, the claims against Blackstone were dismissed without prejudice. On May 11, 2007, the Court consolidated the two cases into one action. On July 27, 2007, the plaintiffs filed a consolidated amended complaint. This pleading did not name GE or Blackstone as defendants. It essentially repeated the allegations previously made against the members of the Company’s Board of Directors and added


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

allegations that the disclosures made in the preliminary proxy statement filed with the SEC on June 18, 2007 omitted certain material facts. On August 7, 2007, the Court dismissed the consolidated amended complaint on the ground that the plaintiffs’ claims could only be asserted derivatively, whereas the plaintiffs were seeking to assert their claims directly. The Court gave the plaintiffs the option of having the dismissal be with prejudice and without leave to amend, in which event they would be able to file a notice of appeal, or without prejudice and with leave to amend, in which event they would be able to serve a demand on the Company’s Board of Directors or file a pleading in which they attempt to demonstrate that demand would have been futile.
 
Due to the inherent uncertainties of litigation, and because these actions are at a preliminary stage, the Company cannot accurately predict the ultimate outcome of these matters at this time. The Company cannot make an estimate of the possible loss or range of loss at this time. The Company intends to respond appropriately in defending against the alleged claims in each of these matters. The ultimate resolution of these matters could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
 
 
The Company sells a majority of its loans on a non-recourse basis. The Company also provides representations and warranties to purchasers and insurers of the loans sold. In the event of a breach of these representations and warranties, the Company may be required to repurchase a mortgage loan or indemnify the purchaser, and any subsequent loss on the mortgage loan may be borne by the Company. If there is no breach of a representation and warranty provision, the Company has no obligation to repurchase the loan or indemnify the investor against loss. The Company’s owned servicing portfolio represents the maximum potential exposure related to representations and warranty provisions.
 
Conforming conventional loans serviced by the Company are securitized through Federal National Mortgage Association (“Fannie Mae”) or Federal Home Loan Mortgage Corporation (“Freddie Mac”) programs. Such servicing is performed on a non-recourse basis, whereby foreclosure losses are generally the responsibility of Fannie Mae or Freddie Mac. The government loans serviced by the Company are generally securitized through Government National Mortgage Association programs. These government loans are either insured against loss by the Federal Housing Administration or partially guaranteed against loss by the Department of Veterans Affairs. Additionally, jumbo mortgage loans are serviced for various investors on a non-recourse basis.
 
While the majority of the mortgage loans serviced by the Company were sold without recourse, the Company has a program in which it provides credit enhancement for a limited period of time to the purchasers of mortgage loans by retaining a portion of the credit risk. The retained credit risk, which represents the unpaid principal balance of the loans, was $2.8 billion as of June 30, 2007. In addition, the outstanding balance of loans sold with recourse by the Company was $553 million as of June 30, 2007.
 
As of June 30, 2007, the Company had a liability of $24 million, recorded in Other liabilities in the Condensed Consolidated Balance Sheet, for probable losses related to the Company’s loan servicing portfolio.
 
 
Through the Company’s wholly owned mortgage reinsurance subsidiary, Atrium Insurance Corporation, the Company has entered into contracts with several primary mortgage insurance companies to provide mortgage reinsurance on certain mortgage loans in the Company’s loan servicing portfolio. Through these contracts, the Company is exposed to losses on mortgage loans pooled by year of origination. Loss rates on these pools are determined based on the unpaid principal balance of the underlying loans. The Company indemnifies the primary mortgage insurers for loss rates that fall between a stated minimum and maximum. In return for absorbing this loss exposure, the Company is contractually entitled to a portion of the insurance premium from the primary mortgage insurers. As of June 30, 2007, the Company provided such mortgage reinsurance for approximately $9.6 billion of mortgage loans in its servicing portfolio. As stated above, the Company’s contracts with the primary mortgage insurers limit its maximum potential exposure to reinsurance losses, which was $694 million as of June 30, 2007.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

The Company is required to hold securities in trust related to this potential obligation, which were included in Restricted cash in the Condensed Consolidated Balance Sheet as of June 30, 2007. As of June 30, 2007, a liability of $20 million was recorded in Other liabilities in the Condensed Consolidated Balance Sheet for estimated losses associated with the Company’s mortgage reinsurance activities.
 
 
As of June 30, 2007, the Company had commitments to fund mortgage loans with agreed-upon rates or rate protection amounting to $5.0 billion. Additionally, as of June 30, 2007, the Company had commitments to fund open home equity lines of credit of $3.1 billion and construction loans of $34 million.
 
 
Commitments to sell loans generally have fixed expiration dates or other termination clauses and may require the payment of a fee. The Company may settle the forward delivery commitments on a net basis; therefore, the commitments outstanding do not necessarily represent future cash obligations. The Company’s $5.0 billion of forward delivery commitments as of June 30, 2007 generally will be settled within 90 days of the individual commitment date.
 
 
In connection with the Spin-Off, the Company entered into a separation agreement with Cendant (the “Separation Agreement”), pursuant to which, the Company has agreed to indemnify Cendant for any losses (other than losses relating to taxes, indemnification for which is provided in the Amended Tax Sharing Agreement) that any party seeks to impose upon Cendant or its affiliates that relate to, arise or result from: (i) any of the Company’s liabilities, including, among other things: (a) all liabilities reflected in the Company’s pro forma balance sheet as of September 30, 2004 or that would be, or should have been, reflected in such balance sheet, (b) all liabilities relating to the Company’s business whether before or after the date of the Spin-Off, (c) all liabilities that relate to, or arise from any performance guaranty of Avis Group Holdings, Inc. in connection with indebtedness issued by Chesapeake Funding LLC (which changed its name to Chesapeake Finance Holdings LLC effective March 7, 2006), (d) any liabilities relating to the Company’s or its affiliates’ employees and (e) all liabilities that are expressly allocated to the Company or its affiliates, or which are not specifically assumed by Cendant or any of its affiliates, pursuant to the Separation Agreement, the Amended Tax Sharing Agreement or a transition services agreement the Company entered into in connection with the Spin-Off (the “Transition Services Agreement”); (ii) any breach by the Company or its affiliates of the Separation Agreement, the Amended Tax Sharing Agreement or the Transition Services Agreement and (iii) any liabilities relating to information in the registration statement on Form 8-A filed with the SEC on January 18, 2005, the information statement filed by the Company as an exhibit to its Current Report on Form 8-K filed on January 19, 2005 (the “January 19, 2005 Form 8-K”) or the investor presentation filed as an exhibit to the January 19, 2005 Form 8-K, other than portions thereof provided by Cendant.
 
There are no specific limitations on the maximum potential amount of future payments to be made under this indemnification, nor is the Company able to develop an estimate of the maximum potential amount of future payments to be made under this indemnification, if any, as the triggering events are not subject to predictability.
 
 
In the ordinary course of business, the Company enters into numerous agreements that contain standard guarantees and indemnities whereby the Company indemnifies another party for breaches of representations and warranties. Such guarantees or indemnifications are granted under various agreements, including those governing leases of real estate, access to credit facilities, use of derivatives and issuances of debt or equity securities. The guarantees or indemnifications issued are for the benefit of the buyers in sale agreements and sellers in purchase agreements, landlords in lease contracts, financial institutions in credit facility arrangements and derivative contracts and underwriters in debt or equity security issuances. While some of these guarantees extend only for the duration of the underlying agreement, many survive the expiration of the term of the agreement or extend into perpetuity (unless subject to a legal statute of limitations). There are no specific limitations on the maximum


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

potential amount of future payments that the Company could be required to make under these guarantees, and the Company is unable to develop an estimate of the maximum potential amount of future payments to be made under these guarantees, if any, as the triggering events are not subject to predictability. With respect to certain of the aforementioned guarantees, such as indemnifications of landlords against third-party claims for the use of real estate property leased by the Company, the Company maintains insurance coverage that mitigates any potential payments to be made.
 
12.   Stock-Related Matters
 
On March 19, 2007, the Company received notice from the NYSE that it would be subject to the procedures specified in Section 802.01E, “SEC Annual Report Timely Filing Criteria,” of the NYSE’s Listed Company Manual as a result of not meeting the deadline for filing its 2006 Form 10-K. Section 802.01E of the NYSE’s Listed Company Manual provides, among other things, that the NYSE will monitor the Company and the filing status of its 2006 Form 10-K. In addition, the Company concluded that it did not satisfy the requirements of Section 203.01 of the NYSE’s Listed Company Manual as a result of the delay in filing its 2006 Form 10-K. The Company filed its 2006 Form 10-K with the SEC on May 24, 2007.
 
13.   Accumulated Other Comprehensive Income
 
The components of comprehensive income (loss) are summarized as follows:
 
                                 
    Three Months
    Six Months
 
    Ended June 30,     Ended June 30,  
    2007     2006     2007     2006  
    (In millions)  
 
Net (loss) income
  $   (1 )   $     1     $   14     $   (10 )
                                 
Other comprehensive income:
                               
Currency translation adjustments
    8       4       9       4  
Unrealized losses on available-for-sale securities, net of income taxes
                (1 )     (1 )
                                 
Total other comprehensive income
    8       4       8       3  
                                 
Total comprehensive income (loss)
  $ 7     $ 5     $ 22     $ (7 )
                                 
 
The after-tax components of Accumulated other comprehensive income were as follows:
 
                                 
          Unrealized
             
          Gains
             
    Currency
    (Losses) on
    Defined
    Accumulated
 
    Translation
    Available-for-
    Benefit
    Other Comprehensive
 
    Adjustment     Sale Securities     Plans     Income  
    (In millions)  
 
Balance at December 31, 2006
  $ 15     $ 2     $ (4 )   $ 13  
Change during 2007
    9       (1 )           8  
                                 
Balance at June 30, 2007
  $ 24     $ 1     $ (4 )   $ 21  
                                 
 
All components of Accumulated other comprehensive income presented above are net of income taxes except for currency translation adjustments, which exclude income taxes related to essentially permanent investments in foreign subsidiaries.
 
14.   Segment Information
 
The Company conducts its operations through three business segments: Mortgage Production, Mortgage Servicing and Fleet Management Services. Certain income and expenses not allocated to the three reportable segments and intersegment eliminations are reported under the heading Other.


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PHH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(Unaudited)

The Company’s management evaluates the operating results of each of its reportable segments based upon Net revenues and segment profit or loss, which is presented as the income or loss before income tax provisions and after Minority interest in income or loss of consolidated entities, net of income taxes. The Mortgage Production segment profit or loss excludes Realogy’s minority interest in the profits and losses of the Mortgage Venture.
 
The Company’s segment results were as follows:
 
                                               
    Net Revenues   Segment (Loss) Profit (1)  
    Three Months
        Three Months
       
    Ended June 30,         Ended June 30,        
    2007     2006     Change   2007     2006     Change  
    (In millions)  
 
Mortgage Production segment
  $ 106     $ 106     $   $ (8 )   $ (18 )   $ 10  
Mortgage Servicing segment
    39       38       1     17       14       3  
                                               
Total Mortgage Services
    145       144       1     9       (4 )     13  
Fleet Management Services segment
    466       446       20     30       27       3  
                                               
Total reportable segments
    611       590       21     39       23       16  
Other (2)
    (1 )     (1 )         (1 )           (1 )
                                               
Total Company
  $ 610     $ 589     $ 21   $ 38     $ 23     $ 15  
                                               
 
                                                 
                      Segment (Loss) Profit (1)  
    Net Revenues     Six Months
       
    Six Months Ended June 30,           Ended June 30,        
    2007     2006     Change     2007     2006     Change  
    (In millions)  
 
Mortgage Production segment
  $ 177     $ 194     $ (17 )   $ (47 )   $ (47 )   $  
Mortgage Servicing segment
    114       71       43       72       21       51  
                                                 
Total Mortgage Services
    291       265       26       25       (26 )     51  
Fleet Management Services segment
    916       874       42       51       51        
                                                 
Total reportable segments
    1,207       1,139       68       76       25       51  
Other (2)
    (1 )     (1 )           (5 )           (5 )
                                                 
Total Company
  $ 1,206     $ 1,138     $ 68     $ 71     $ 25     $ 46  
                                                 
 
(1) The following is a reconciliation of Income before income taxes and minority interest to segment profit:
 
                         
    Three Months
  Six Months
    Ended June 30,   Ended June 30,
    2007   2006   2007   2006
    (In millions)
 
Income before income taxes and minority interest
  $ 41   $ 24   $ 74   $ 25
Minority interest in income of consolidated entities, net of income taxes
    3     1     3    
                         
Segment profit
  $ 38   $ 23   $ 71   $ 25
                         
 
(2) Net revenues reported under the heading Other for the three and six months ended June 30, 2007 and 2006 represent the elimination of $1 million of intersegment revenues recorded by the Mortgage Servicing segment, which are offset in segment profit by the elimination of $1 million of intersegment expense recorded by the Fleet Management Services segment. Segment loss reported under the heading Other for the three and six months ended June 30, 2007 represents expenses related to the proposed Merger.


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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Except as expressly indicated or unless the context otherwise requires, the “Company,” “PHH,” “we,” “our” or “us” means PHH Corporation, a Maryland corporation, and its subsidiaries. This Item 2 should be read in conjunction with the “Cautionary Note Regarding Forward-Looking Statements” and “Item 1A. Risk Factors” included in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2007 (the “Form 10-Q”) and “Item 1. Business,” “Item 1A. Risk Factors,” “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2006 (our“2006 Form 10-K”). Based on the material weaknesses identified in connection with management’s assessment of our internal control over financial reporting, management concluded that our internal control over financial reporting was not effective as of December 31, 2006. (See “Item 9A. Controls and Procedures” in our 2006 Form 10-K for more information.) In addition, based on the evaluation and identification of these material weaknesses, management concluded that our disclosure controls and procedures were not effective as of June 30, 2007. (See “Item 4. Controls and Procedures” included herein for more information.)
 
 
We are a leading outsource provider of mortgage and fleet management services. We conduct our business through three operating segments, a Mortgage Production segment, a Mortgage Servicing segment and a Fleet Management Services segment. Our Mortgage Production segment originates, purchases and sells mortgage loans through PHH Mortgage Corporation and its subsidiaries (collectively, “PHH Mortgage”) which includes PHH Home Loans, LLC and its subsidiaries (collectively, “PHH Home Loans” or the “Mortgage Venture”). PHH Home Loans is a mortgage venture that we maintain with Realogy Corporation (“Realogy”). Our Mortgage Production segment generated 15% of our Net revenues for the six months ended June 30, 2007. Our Mortgage Servicing segment services mortgage loans that either PHH Mortgage or PHH Home Loans originated. Our Mortgage Servicing segment also purchases mortgage servicing rights (“MSRs”) and acts as a subservicer for certain clients that own the underlying MSRs. Our Mortgage Servicing segment generated 9% of our Net revenues for the six months ended June 30, 2007. Our Fleet Management Services segment provides commercial fleet management services to corporate clients and government agencies throughout the United States (“U.S.”) and Canada through PHH Vehicle Management Services Group LLC (“PHH Arval”). Our Fleet Management Services segment generated 76% of our Net revenues for the six months ended June 30, 2007.
 
On March 15, 2007, we entered into a definitive agreement (the “Merger Agreement”) with General Electric Capital Corporation (“GE”) and its wholly owned subsidiary, Jade Merger Sub, Inc. to be acquired (the “Merger”). In conjunction with the Merger, GE entered into an agreement to sell our mortgage operations to an affiliate of The Blackstone Group (“Blackstone”), a global investment and advisory firm. The Merger is subject to approval by our stockholders and state licensing and other regulatory approvals, as well as various other closing conditions. Under the terms of the Merger Agreement, at closing, our stockholders will receive $31.50 per share in cash and shares of our Common stock will no longer be listed on the New York Stock Exchange (the “NYSE”). The Merger Agreement contains certain restrictions on our ability to incur new indebtedness and to pay dividends on our Common stock as well as on the payment of intercompany dividends by certain of our subsidiaries without the prior written consent of GE. See Note 2, “Proposed Merger” in the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q for more information.
 
 
The aggregate demand for mortgage loans in the U.S. is a primary driver of the Mortgage Production and Mortgage Servicing segments’ operating results. The demand for mortgage loans is affected by external factors including prevailing mortgage rates and the strength of the U.S. housing market. The long-term outlook for the mortgage industry remains strong with increasing levels of mortgage debt outstanding and home ownership driving the expected growth. However, in the near term, we expect the industry to continue to experience a downturn evidenced by increasing mortgage loan delinquencies and reduced origination levels. Lower origination volume, ongoing pricing pressures and a flat yield curve negatively impacted the results of operations of our Mortgage Production and Mortgage Servicing segments throughout 2006. As of June 2007, the Federal National Mortgage Association’s Economic and Mortgage Market Developments estimated that industry originations


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during 2006 were $2.8 trillion and forecasted a decline in industry originations during 2007 of approximately 9% from estimated 2006 levels, due to a 12% expected decline in purchase originations and a 5% expected decline in refinance originations.
 
Volatility in interest rates may have a significant impact on our Mortgage Production and Mortgage Servicing segments, including a negative impact on origination volumes and the value of our MSRs and related hedges. Volatility in interest rates may also result in changes in the shape or slope of the yield curve, which is a key factor in our MSR valuation model and the effectiveness of our hedging strategy. Furthermore, recent developments in the industry have resulted in more restrictive credit standards that may negatively impact home affordability and the demand for housing and related origination volumes for the mortgage industry. Many subprime origination companies have entered bankruptcy proceedings, shut down or severely curtailed their lending activities. Industry-wide mortgage loan delinquency rates have increased and may continue to increase over last year’s levels. With more restrictive credit standards, borrowers, particularly subprime borrowers, are less able to purchase a home. We expect that refinance activity over the next several quarters will be bolstered by the volume of adjustable-rate mortgages originated over the last five years nearing their interest-rate-reset dates creating an incentive for borrowers to refinance. However, based on home sale trends during the first six months of 2007, we expect that home sale volumes and purchase originations will decrease or remain flat during the remainder of 2007 and perhaps longer. (See “Item 1A. Risk Factors—Risks Related to our Business—Downward trends in the real estate market could adversely impact our business, profitability or results of operations.” in our 2006 Form 10-K for more information.)
 
The secondary mortgage market has been adversely impacted during the second quarter of 2007 and through the filing date of this Form 10-Q by deteriorating investor demand for mortgage loan products, particularly with regard to subprime, Alt-A and non-conforming products, as investors are tightening credit standards and offering less favorable pricing. The continued deterioration of the secondary mortgage market in such products and the expansion of this impact to more traditional prime loan products could have a negative impact on profit margins for the mortgage industry in the second half of 2007. While we adjust interest rates for new mortgage loan originations to reflect the current secondary market conditions and provide appropriate profit margins, we expect that the recent market developments will negatively impact Gain on sale of mortgage loans, net in the third quarter of 2007 and may continue to have a negative impact during the fourth quarter of 2007 and perhaps longer. In addition, increases in interest rates for new mortgage loan originations required as a result of these secondary mortgage market conditions may reduce the demand for mortgage loan originations, which could further impact profitability in our Mortgage Production segment. (See “Item 1A. Risk Factors—Risks Related to our Business—Recent developments in the subprime mortgage market may negatively affect the mortgage loan origination volumes and profitability of mortgage loan products that we offer in our Mortgage Production segment.” in our 2006 Form 10-K for more information.)
 
As a result of these factors, we expect that the mortgage industry will remain increasingly competitive throughout the remainder of 2007 as excess origination capacity and lower origination volumes put pressure on production margins and ultimately result in further industry consolidation. We intend to take advantage of this environment by leveraging our existing mortgage origination services platform to enter into new outsourcing relationships as more companies determine that it is no longer economically feasible to compete in the industry, however, there can be no assurance that we will be successful in this effort whether as a result of uncertainties regarding the proposed Merger or otherwise. During the year ended December 31, 2006 and the six months ended June 30, 2007, we sought to reduce costs in our Mortgage Production and Mortgage Servicing segments to better align our resources and expenses with anticipated mortgage origination volumes. These cost-reduction initiatives favorably impacted our pre-tax results for the second quarter of 2007 and the six months ended June 30, 2007 by $11 million and $19 million, respectively, and we expect that they will favorably impact our pre-tax results for the remainder of 2007 by approximately $21 million.
 
 
The market size for the U.S. commercial fleet management services market has displayed little or no growth over the last several years as reported by the Automotive Fleet 2007, 2006 and 2005 Fact Books. Growth in our Fleet Management Services segment is driven principally by increased market share in the large fleet (greater than 500 units) and national fleet (75 to 500 units) markets and increased fee-based services, which growth we anticipate will be negatively impacted during the remainder of 2007 by the proposed Merger.


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Results of Operations — Second Quarter 2007 vs. Second Quarter 2006
 
 
Our consolidated results of operations for the second quarters of 2007 and 2006 were comprised of the following:
 
                   
    Three Months
   
    Ended June 30,    
    2007   2006   Change
    (In millions)
 
Net revenues
  $ 610   $ 589   $ 21
Total expenses
    569     565     4
                   
Income before income taxes and minority interest
    41     24     17
Provision for income taxes
    39     22     17
                   
Income before minority interest
  $ 2   $ 2   $
                   
 
During the second quarter of 2007, our Net revenues increased by $21 million (4%) compared to the second quarter of 2006, due to increases of $20 million and $1 million in our Fleet Management Services and Mortgage Servicing segments, respectively. Our Income before income taxes and minority interest increased by $17 million (71%) during the second quarter of 2007 compared to the second quarter of 2006 due to favorable changes of $12 million, $3 million and $3 million in our Mortgage Production, Mortgage Servicing and Fleet Management Services segments, respectively, that were partially offset by a $1 million increase in other expenses not allocated to our reportable segments.
 
We record our interim income tax provisions by applying a projected full-year effective income tax rate to our quarterly pre-tax income or loss for results that we deem to be reliably estimable in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 18, “Accounting for Income Taxes in Interim Periods” (“FIN 18”). Certain results dependent on fair value adjustments of our Mortgage Production and Mortgage Servicing segments are considered not to be reliably estimable and therefore we record discrete year-to-date income tax provisions on those results.
 
During the second quarter of 2007, the Provision for income taxes was $39 million and was significantly impacted by a $17 million increase in liabilities for income tax contingencies and a $6 million increase in valuation allowances for deferred tax assets (primarily state net operating losses generated during the second quarter of 2007) for which we believe it is more likely than not that the deferred tax assets will not be realized.
 
During the second quarter of 2006, the Provision for income taxes was $22 million and was significantly impacted by a $9 million increase in liabilities for income tax contingencies. In addition, we recorded state income tax expense of $6 million. Due to our 2006 year-to-date and projected full-year mix of income and loss from our operations by entity and state income tax jurisdiction, there was a significant difference in the 2006 state income tax effective rate in comparison to the 2007 state income tax effective rate.
 
Segment Results
 
Discussed below are the results of operations for each of our reportable segments. Certain income and expenses not allocated to our reportable segments and intersegment eliminations are reported under the heading Other. Our management evaluates the operating results of each of our reportable segments based upon Net revenues and segment profit or loss, which is presented as the income or loss before income tax provisions and after Minority interest in income or loss of consolidated entities, net of income taxes. The Mortgage Production segment profit or loss excludes Realogy’s minority interest in the profits and losses of the Mortgage Venture.


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Our segment results were as follows:
 
                                               
    Net Revenues   Segment (Loss) Profit (1)  
    Three Months
        Three Months
       
    Ended June 30,         Ended June 30,        
    2007     2006     Change   2007     2006     Change  
    (In millions)  
 
Mortgage Production segment
  $ 106     $ 106     $   $ (8 )   $ (18 )   $ 10  
Mortgage Servicing segment
    39       38       1     17       14       3  
                                               
Total Mortgage Services
    145       144       1     9       (4 )     13  
Fleet Management Services segment
    466       446       20     30       27       3  
                                               
Total reportable segments
    611       590       21     39       23       16  
Other (2)
    (1 )     (1 )         (1 )           (1 )
                                               
Total Company
  $ 610     $ 589     $ 21   $ 38     $ 23     $ 15  
                                               
 
(1) The following is a reconciliation of Income before income taxes and minority interest to segment profit:
 
             
    Three Months
    Ended June 30,
    2007   2006
    (In millions)
 
Income before income taxes and minority interest
  $ 41   $ 24
Minority interest in income of consolidated entities, net of income taxes
    3     1
             
Segment profit
  $ 38   $ 23
             
 
(2) Net revenues reported under the heading Other for the three months ended June 30, 2007 and 2006 represent the elimination of $1 million of intersegment revenues recorded by the Mortgage Servicing segment, which are offset in segment profit by the elimination of $1 million of intersegment expense recorded by the Fleet Management Services segment. Segment loss reported under the heading Other for the three months ended June 30, 2007 represents expenses related to the proposed Merger.
 
Mortgage Production Segment
 
Net revenues remained at the same level in the second quarter of 2007 compared to the second quarter of 2006. As discussed in greater detail below, a $5 million unfavorable change in Mortgage net finance (expense) income was offset by a $2 million increase in Mortgage fees, a $2 million increase in Other income and a $1 million increase in Gain on sale of mortgage loans, net.
 
Segment loss decreased by $10 million (56%) in the second quarter of 2007 compared to the second quarter of 2006 as a $12 million (10%) decrease in Total expenses was partially offset by a $2 million increase in Minority interest in income of consolidated entities, net of income taxes. The $12 million reduction in Total expenses was primarily due to a $6 million decrease in Salaries and related expenses and a $3 million decrease in Occupancy and other office expenses.


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The following tables present a summary of our financial results and key related drivers for the Mortgage Production segment, and are followed by a discussion of each of the key components of Net revenues and Total expenses:
 
                             
    Three Months
           
    Ended June 30,            
    2007   2006   Change     % Change  
    (Dollars in millions, except
       
    average loan amount)        
 
Loans closed to be sold
  $ 8,845   $ 9,435   $ (590 )     (6 )%
Fee-based closings
    2,866     2,334     532       23 %
                             
Total closings
  $ 11,711   $ 11,769   $ (58 )      
                             
Purchase closings
  $ 7,276   $ 8,512   $ (1,236 )     (15 )%
Refinance closings
    4,435     3,257     1,178       36 %
                             
Total closings
  $ 11,711   $ 11,769   $ (58 )      
                             
Fixed rate
  $ 7,598   $ 6,444   $ 1,154       18 %
Adjustable rate
    4,113     5,325     (1,212 )            (23 )%
                             
Total closings
  $ 11,711   $ 11,769   $ (58 )      
                             
Number of loans closed (units)
    54,305     57,907     (3,602 )     (6 )%
                             
Average loan amount
  $   215,651   $   203,240   $   12,411       6 %
                             
Loans sold
  $ 8,774   $ 8,854   $ (80 )     (1 )%
                             
 
                                 
    Three Months
             
    Ended June 30,              
    2007     2006     Change     % Change  
    (In millions)        
 
Mortgage fees
  $ 37     $ 35     $ 2       6 %
                                 
Gain on sale of mortgage loans, net
    70       69       1       1 %
                                 
Mortgage interest income
    51       50       1       2 %
Mortgage interest expense
    (54 )     (48 )     (6 )     (13 )%
                                 
Mortgage net finance (expense) income
    (3 )     2       (5 )           n/m  (1)
                                 
Other income
    2             2       n/m  (1)
                                 
Net revenues
        106           106              
                                 
Salaries and related expenses
    50       56       (6 )     (11 )%
Occupancy and other office expenses
    11       14       (3 )     (21 )%
Other depreciation and amortization
    3       5       (2 )     (40 )%
Other operating expenses
    47       48       (1 )     (2 )%
                                 
Total expenses
    111       123       (12 )     (10 )%
                                 
Loss before income taxes
    (5 )     (17 )     12       71 %
Minority interest in income of consolidated entities, net of income taxes
    3       1       2       200 %
                                 
Segment loss
  $ (8 )   $ (18 )   $ 10       56 %
                                 
(1) n/m — Not meaningful.
 
 
Mortgage fees consist primarily of fees collected on loans originated for others (including brokered loans and loans originated through our financial institutions channel), fees on cancelled loans and appraisal and other income generated by our appraisal services business. Mortgage fees collected on loans originated through our financial institutions channel are recorded in Mortgage fees when the financial institution retains the underlying loan. Loans purchased from financial institutions are included in loans closed to be sold while loans originated by us and retained by financial institutions are included in fee-based closings.


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Fee income on loans closed to be sold is deferred until the loans are sold and recognized in Gain on sale of mortgage loans, net in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases” (“SFAS No. 91”). Fee income on fee-based closings is recorded in Mortgage fees and is recognized at the time of closing.
 
Loans closed to be sold and fee-based closings are the key drivers of Mortgage fees. Fees generated by our appraisal services business are recorded when the services are performed, regardless of whether the loan closes and are associated with both loans closed to be sold and fee-based closings.
 
Although total closings decreased slightly during the second quarter of 2007 compared to the second quarter of 2006, Mortgage fees increased by $2 million (6%) as the effect of a 6% decrease in loans closed to be sold (fee income is deferred until the loans are sold in accordance with SFAS No. 91) was more than offset by a 23% increase in fee-based closings (fees income is recognized at the time of closing). The change in mix between fee-based closings and loans closed to be sold was primarily due to an increase in fee-based closings from our financial institution clients during the second quarter of 2007 compared to the second quarter of 2006. The $58 million decrease in total closings from the second quarter of 2006 to the second quarter of 2007 was attributable to a $1.2 billion (15%) decrease in purchase closings that was almost completely offset by a $1.2 billion (36%) increase in refinance closings. The decline in purchase closings was due to the decline in overall housing purchases in the second quarter of 2007 compared to the second quarter of 2006. Refinancing activity is sensitive to interest rate changes relative to borrowers’ current interest rates, and typically increases when interest rates fall and decreases when interest rates rise. (See “Item 1A. Risk Factors—Risks Related to our Business—Downward trends in the real estate market could adversely impact our business, profitability or results of operations.” in our 2006 Form 10-K.)
 
 
Gain on sale of mortgage loans, net consists of the following:
 
  n   Gain on loans sold, including the changes in the fair value of all loan-related derivatives including our interest rate lock commitments (“IRLCs”), freestanding loan-related derivatives and loan derivatives designated in a hedge relationship. See Note 7, “Derivatives and Risk Management Activities” in the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q. To the extent the derivatives are considered effective hedges under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), changes in the fair value of the mortgage loans would be recorded;
 
  n   The initial value of capitalized servicing, which represents a non-cash increase to our MSRs. Subsequent changes in the fair value of MSRs are recorded in Net loan servicing income in the Mortgage Servicing segment and
 
  n   Recognition of net loan origination fees and expenses previously deferred under SFAS No. 91.
 
The components of Gain on sale of mortgage loans, net were as follows:
 
                                 
    Three Months
             
    Ended June 30,              
    2007     2006     Change     % Change  
    (In millions)        
 
(Loss) gain on loans sold
  $ (13 )   $ 5     $ (18 )         n/m (1)
Initial value of capitalized servicing
    132       126       6       5 %
Recognition of deferred fees and costs, net
    (49 )     (62 )     13       21 %
                                 
Gain on sale of mortgage loans, net
  $ 70     $ 69     $ 1       1 %
                                 
 
(1) n/m — Not meaningful.


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Gain on sale of mortgage loans, net increased by $1 million (1%) from the second quarter of 2006 to the second quarter of 2007 due to a $13 million decrease in the recognition of deferred fees and costs and a $6 million increase in the initial value of capitalized servicing that were partially offset by an $18 million unfavorable change in (loss) gain on loans sold. The $13 million decrease in the recognition of deferred fees and costs was primarily due to lower deferred costs as a result of a lower volume of loans closed to be sold and the impact of cost-reduction initiatives. The $6 million increase in the initial value of capitalized servicing was caused by an increase of 7 basis points (“bps”) in the initial capitalized servicing rate in the second quarter of 2007 compared to the second quarter of 2006 that was partially offset by a decrease in the volume of loans sold. The increase in the initial capitalized servicing rate from the second quarter of 2006 to the second quarter of 2007 is primarily related to the capitalization of a higher blend of fixed-rate loans compared to adjustable-rate loans, as fixed-rate loans have a higher initial servicing value than adjustable-rate loans. The $18 million unfavorable change in (loss) gain on loans sold was the result of a $12 million decline in the market value of certain loans held for sale that are expected to be sold at a discount due to either origination flaws or performance issues, a $3 million unfavorable variance from economic hedge ineffectiveness resulting from our risk management activities related to IRLCs and mortgage loans and a $3 million decline in margins on loans sold. The $3 million unfavorable variance from economic hedge ineffectiveness resulting from our risk management activities related to IRLCs and mortgage loans was due to an increase in losses recognized from $7 million during the second quarter of 2006 to $10 million during the second quarter of 2007. Typically, when industry loan volumes decline due to a rising interest rate environment or other factors, competitive pricing pressures occur as mortgage companies compete for fewer customers, which results in lower margins.
 
 
Mortgage net finance (expense) income allocable to the Mortgage Production segment consists of interest income on mortgage loans held for sale (“MLHS”) and interest expense allocated on debt used to fund MLHS and is driven by the average volume of loans held for sale, the average volume of outstanding borrowings, the note rate on loans held for sale and the cost of funds rate of our outstanding borrowings. Mortgage net finance (expense) income allocable to the Mortgage Production segment changed unfavorably by $5 million in the second quarter of 2007 compared to the second quarter of 2006 due to a $6 million (13%) increase in Mortgage interest expense that was partially offset by a $1 million (2%) increase in Mortgage interest income. The $6 million increase in Mortgage interest expense was attributable to increases of $5 million due to a higher cost of funds from our outstanding borrowings and $1 million due to higher average borrowings. A significant portion of our loan originations are funded with variable-rate short-term debt. The average one-month London Interbank Offered Rate (“LIBOR”), which is used as a benchmark for short-term rates, increased by 23 bps in the second quarter of 2007 compared to the second quarter of 2006. The $1 million increase in Mortgage interest income was primarily due to higher average loans held for sale.
 
 
Salaries and related expenses allocable to the Mortgage Production segment are reflected net of loan origination costs deferred under SFAS No. 91 and consist of commissions paid to employees involved in the loan origination process, as well as compensation, payroll taxes and benefits paid to employees in our mortgage production operations and allocations for overhead. Salaries and related expenses decreased by $6 million (11%) in the second quarter of 2007 compared to the second quarter of 2006. During the second quarter of 2007, employee attrition, a reduction in incentive bonus expense and the realized benefit of cost-reduction initiatives caused a $16 million decline in Salaries and related expenses compared to the second quarter of 2006 that was partially offset by a $10 million decrease in deferred expenses under SFAS No. 91. The decrease in deferred expenses under SFAS No. 91 during the second quarter of 2007 was primarily due to lower volumes of loans closed to be sold and the impact of cost-reduction initiatives.
 
 
Other operating expenses allocable to the Mortgage Production segment are reflected net of loan origination costs deferred under SFAS No. 91 and consist of production-related direct expenses, appraisal expense and allocations for overhead. Other operating expenses decreased by $1 million (2%) during the second quarter of


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2007 compared to the second quarter of 2006. The decrease during the second quarter of 2007 was primarily attributable to the impact of cost-reduction initiatives.
 
 
Net revenues increased by $1 million (3%) in the second quarter of 2007 compared to the second quarter of 2006. As discussed in greater detail below, the increase in Net revenues was due to increases of $7 million in Loan servicing income and $4 million in Mortgage net finance income that were partially offset by a $9 million unfavorable change in Valuation adjustments related to mortgage servicing rights and a $1 million increase in Other expense.
 
Segment profit increased by $3 million (21%) in the second quarter of 2007 compared to the second quarter of 2006 due to a $2 million (8%) decrease in Total expenses and the $1 million increase in Net revenues. The $2 million decrease in Total expenses was primarily due to a decrease of $2 million in Salaries and related expenses.
 
The following tables present a summary of our financial results and a key related driver for the Mortgage Servicing segment, and are followed by a discussion of each of the key components of Net revenues and Total expenses:
 
                           
    Three Months
         
    Ended June 30,          
    2007   2006   Change   % Change  
    (In millions)      
 
Average loan servicing portfolio
  $ 163,136   $ 158,726   $ 4,410     3 %
                           
 
                                 
    Three Months
             
    Ended June 30,              
    2007     2006     Change     % Change  
    (In millions)  
 
Mortgage interest income
  $ 48     $ 45     $ 3       7 %
Mortgage interest expense
    (20 )     (21 )     1       5 %
                                 
Mortgage net finance income
    28       24       4       17 %
                                 
Loan servicing income
    131       124       7       6 %
                                 
Change in fair value of mortgage servicing rights
    89       (3 )     92       n/m(1 )
Net derivative loss related to mortgage servicing rights
    (207 )     (106 )     (101 )     (95 )%
                                 
Valuation adjustments related to mortgage servicing rights
    (118 )     (109 )     (9 )     (8 )%
                                 
Net loan servicing income
    13       15       (2 )     (13 )%
                                 
Other expense
    (2 )     (1 )     (1 )     (100 )%
                                 
Net revenues
    39       38       1       3 %
                                 
Salaries and related expenses
    6       8       (2 )     (25 )%
Occupancy and other office expenses
    3       2       1       50 %
Other depreciation and amortization
    1       1              
Other operating expenses
    12       13       (1 )     (8 )%
                                 
Total expenses
    22       24       (2 )     (8 )%
                                 
Segment profit
  $ 17     $ 14     $ 3       21 %
                                 
 
(1) n/m — Not meaningful.
 
 
Mortgage net finance income allocable to the Mortgage Servicing segment consists of interest income credits from escrow balances, interest income from investment balances (including investments held by our reinsurance


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subsidiary) and interest expense allocated on debt used to fund our MSRs, and is driven by the average volume of outstanding borrowings and the cost of funds rate of our outstanding borrowings. Mortgage net finance income increased by $4 million (17%) in the second quarter of 2007 compared to the second quarter of 2006, primarily due to higher interest income from escrow balances. This increase was primarily due to higher short-term interest rates in the second quarter of 2007 compared to the second quarter of 2006 since the escrow balances earn income based upon one-month LIBOR.
 
 
Loan servicing income includes recurring servicing fees, other ancillary fees and net reinsurance income from our wholly owned reinsurance subsidiary, Atrium Insurance Corporation (“Atrium”). Recurring servicing fees are recognized upon receipt of the coupon payment from the borrower and recorded net of guaranty fees. Net reinsurance income represents premiums earned on reinsurance contracts, net of ceding commission and adjustments to the allowance for reinsurance losses. The primary driver for Loan servicing income is average loan servicing portfolio.
 
The components of Loan servicing income were as follows:
 
                                 
    Three Months
             
    Ended June 30,              
    2007     2006     Change     % Change  
    (In millions)        
 
Net service fee revenue
  $ 125     $ 120     $ 5       4 %
Late fees and other ancillary servicing revenue
    11       9       2       22 %
Curtailment interest paid to investors
    (12 )     (11 )     (1 )     (9 )%
Net reinsurance income
    7       6       1       17 %
                                 
Loan servicing income
  $ 131     $ 124     $ 7       6 %
                                 
 
Loan servicing income increased by $7 million (6%) from the second quarter of 2007 to the second quarter of 2006 primarily due to increases in net service fee revenue and late fees and other ancillary servicing revenue. The increases in net service fee revenue and late fees and other ancillary servicing revenue were primarily related to the 3% increase in the average loan servicing portfolio during the second quarter of 2007 compared to the second quarter of 2006.
 
 
Valuation adjustments related to mortgage servicing rights includes Change in fair value of mortgage servicing rights and Net derivative loss related to mortgage servicing rights. The components of Valuation adjustments related to mortgage servicing rights are discussed separately below.
 
Change in Fair Value of Mortgage Servicing Rights:  The fair value of our MSRs is estimated based upon projections of expected future cash flows from our MSRs considering prepayment estimates, our historical prepayment rates, portfolio characteristics, interest rates based on interest rate yield curves, implied volatility and other economic factors. Generally, the value of our MSRs is expected to increase when interest rates rise and decrease when interest rates decline due to the effect those changes in interest rates have on prepayment estimates. Other factors noted above as well as the overall market demand for MSRs may also affect the MSRs valuation. The MSRs valuation is validated quarterly by comparison to a third-party market valuation of our portfolio.
 
The Change in fair value of mortgage servicing rights is attributable to the realization of expected cash flows and market factors which impact the market inputs and assumptions used in our valuation model. During the second quarter of 2007, the fair value of our MSRs was reduced by $88 million due to the realization of expected cash flows. During the second quarter of 2006, the fair value of our MSRs was reduced by $116 million due to the realization of expected cash flows. The change in fair value due to changes in market inputs or assumptions used in the valuation model was a favorable change of $177 million during the second quarter of 2007. The change in fair value due to changes in market inputs or assumptions used in the valuation model was a favorable change of $113 million during the second quarter of 2006. The favorable changes during the second quarters of 2007 and


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2006 were primarily due to increases in mortgage interest rates leading to lower expected prepayments. The 10-year U.S. Treasury (“Treasury”) rate, which is widely regarded as a benchmark for mortgage rates increased by 38 bps during the second quarter of 2007 compared to an increase of 29 bps during the second quarter of 2006.
 
Net Derivative Loss Related to Mortgage Servicing Rights:  We use a combination of derivatives to protect against potential adverse changes in the value of our MSRs resulting from a decline in interest rates. See Note 7, “Derivatives and Risk Management Activities” in the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q. The amount and composition of derivatives used will depend on the exposure to loss of value on our MSRs, the expected cost of the derivatives and the increased earnings generated by origination of new loans resulting from the decline in interest rates (the natural business hedge). The natural business hedge provides a benefit when increased borrower refinancing activity results in higher production volumes which would partially offset declines in the value of our MSRs thereby reducing the need to use derivatives. The benefit of the natural business hedge depends on the decline in interest rates required to create an incentive for borrowers to refinance their mortgage loans and lower their interest rates. (See “Item 1A. Risk Factors—Risks Related to our Business—Certain hedging strategies that we use to manage interest rate risk associated with our MSRs and other mortgage-related assets and commitments may not be effective in mitigating those risks.” in our 2006 Form 10-K for more information.)
 
During the second quarter of 2007, the value of derivatives related to our MSRs decreased by $207 million. During the second quarter of 2006, the value of derivatives related to our MSRs decreased by $106 million. As described below, our net results from MSRs risk management activities were a loss of $30 million and a gain of $7 million during the second quarters of 2007 and 2006, respectively. Refer to “Item 3. Quantitative and Qualitative Disclosures About Market Risk” for an analysis of the impact of 25 bps, 50 bps and 100 bps changes in interest rates on the valuation of our MSRs and related derivatives at June 30, 2007.
 
The following table outlines Net (loss) gain on MSRs risk management activities:
 
                 
    Three Months
 
    Ended June 30,  
    2007     2006  
    (In millions)  
 
Net derivative loss related to mortgage servicing rights
  $   (207 )   $   (106 )
Change in fair value of mortgage servicing rights due to changes in market inputs or assumptions used in the valuation model
    177       113  
                 
Net (loss) gain on MSRs risk management activities
  $ (30 )   $ 7  
                 
 
 
Other expense allocable to the Mortgage Servicing segment consists primarily of net gains or losses on investment securities and increased by $1 million (100%) in the second quarter of 2007 compared to the second quarter of 2006.
 
 
Salaries and related expenses allocable to the Mortgage Servicing segment consist of compensation, payroll taxes and benefits paid to employees in our mortgage loan servicing operations and allocations for overhead. Salaries and related expenses decreased by $2 million (25%) during the second quarter of 2007 compared to the second quarter of 2006 due to a decrease in incentive bonus expense and the realized benefit of cost-reduction initiatives.
 
 
Net revenues increased by $20 million (4%) in the second quarter of 2007 compared to the second quarter of 2006. As discussed in greater detail below, the increase in Net revenues was due to increases of $12 million in Fleet lease income, $4 million in Fleet management fees and $4 million in Other income.
 
Segment profit increased by $3 million (11%) in the second quarter of 2007 compared to the second quarter of 2006 due to the $20 million increase in Net revenues that was partially offset by a $17 million (4%) increase in


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Total expenses. The $17 million increase in Total expenses was primarily due to an $11 million increase in Depreciation on operating leases and a $6 million increase in Fleet interest expense.
 
The following tables present a summary of our financial results and related drivers for the Fleet Management Services segment, and are followed by a discussion of each of the key components of our Net revenues and Total expenses:
 
                                 
    Average for the
             
    Three Months
             
    Ended June 30,              
    2007     2006     Change     % Change  
    (In thousands of units)        
 
Leased vehicles
    342       334       8       2 %
Maintenance service cards
    334       339       (5 )     (1 )%
Fuel cards
    339       326       13       4 %
Accident management vehicles
    339       327       12       4 %
 
                                 
    Three Months
             
    Ended June 30,              
    2007     2006     Change     % Change  
    (In millions)        
 
Fleet management fees
  $ 42     $ 38     $ 4       11 %
Fleet lease income
    397       385       12       3 %
Other income
    27       23       4       17 %
                                 
Net revenues
    466       446       20       4 %
                                 
Salaries and related expenses
    22       22              
Occupancy and other office expenses
    4       4              
Depreciation on operating leases
    315       304       11       4 %
Fleet interest expense
    56       50       6       12 %
Other depreciation and amortization
    4       3       1       33 %
Other operating expenses
    35       36       (1 )     (3 )%
                                 
Total expenses
    436       419       17       4 %
                                 
Segment profit
  $ 30     $ 27     $ 3       11 %
                                 
 
 
Fleet management fees consist primarily of the revenues of our principal fee-based products: fuel cards, maintenance services, accident management services and monthly management fees for leased vehicles. Fleet management fees increased by $4 million (11%) in the second quarter of 2007 compared to the second quarter of 2006, due to a $2 million increase in revenue from our principal fee-based products and a $2 million increase in revenue from other fee-based products.
 
 
Fleet lease income increased by $12 million (3%) during the second quarter of 2007 compared to the second quarter of 2006, primarily due to higher total lease billings resulting from higher interest rates on variable-interest rate leases and new leases and a 2% increase in leased vehicles.
 
 
Other income consists principally of the revenue generated by our dealerships and other miscellaneous revenues. Other income increased by $4 million (17%) during the second quarter of 2007 compared to the second quarter of 2006, primarily due to increased interest income.


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Depreciation on operating leases is the depreciation expense associated with our leased asset portfolio. Depreciation on operating leases during the second quarter of 2007 increased by $11 million (4%) compared to the second quarter of 2006, primarily due to the 2% increase in leased units.
 
 
Fleet interest expense increased by $6 million (12%) during the second quarter of 2007 compared to the second quarter of 2006, primarily due to rising short-term interest rates and increased borrowings associated with the 2% increase in leased vehicles.
 
Results of Operations — Six Months Ended June 30, 2007 vs. Six Months Ended June 30, 2006
 
 
Our consolidated results of operations for the six months ended June 30, 2007 and 2006 were comprised of the following:
 
                         
    Six Months
       
    Ended June 30,        
    2007     2006     Change  
    (In millions)  
 
Net revenues
  $ 1,206     $ 1,138     $ 68  
Total expenses
    1,132       1,113       19  
                         
Income before income taxes and minority interest
    74       25       49  
Provision for income taxes
    57       35       22  
                         
Income (loss) before minority interest
  $ 17     $ (10 )   $ 27  
                         
 
During the six months ended June 30, 2007, our Net revenues increased by $68 million (6%) compared to the six months ended June 30, 2006, due to increases of $43 million and $42 million in our Mortgage Servicing and Fleet Management Services segments, respectively, that were partially offset by a $17 million decrease in our Mortgage Production segment. Our Income before income taxes and minority interest increased by $49 million (196%) during the six months ended June 30, 2007 compared to the six months ended June 30, 2006 due to favorable changes of $51 million and $3 million in our Mortgage Servicing and Mortgage Production segments, respectively, that were partially offset by a $5 million increase in other expenses not allocated to our reportable segments.
 
During the preparation of the Condensed Consolidated Financial Statements as of and for the three months ended March 31, 2006, we identified and corrected errors related to prior periods. The effect of correcting these errors on the Condensed Consolidated Statement of Operations for the six months ended June 30, 2006 was to reduce Net loss by $3 million (net of income taxes of $2 million). The corrections included an adjustment for franchise tax accruals previously recorded during the years ended December 31, 2002 and 2003 and certain other miscellaneous adjustments related to the year ended December 31, 2005. We evaluated the impact of the adjustments and determined that they are not material, individually or in the aggregate to any of the periods affected, specifically the six months ended June 30, 2006 or the years ended December 31, 2006, 2005, 2003 or 2002.
 
We record our interim income tax provisions by applying a projected full-year effective income tax rate to our quarterly pre-tax income or loss for results that we deem to be reliably estimable in accordance with FIN 18. Certain results dependent on fair value adjustments of our Mortgage Production and Mortgage Servicing segments are considered not to be reliably estimable and therefore we record discrete year-to-date income tax provisions on those results.
 
During the six months ended June 30, 2007, the Provision for income taxes was $57 million and was significantly impacted by an $18 million increase in liabilities for income tax contingencies and a $10 million increase in valuation allowances for deferred tax assets (primarily state net operating losses generated during the


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six months ended June 30, 2007) for which we believe it is more likely than not that the deferred tax assets will not be realized.
 
During the six months ended June 30, 2006, the Provision for income taxes was $35 million and was significantly impacted by a $24 million increase in liabilities for income tax contingencies and a $1 million increase in valuation allowances for deferred tax assets (primarily state net operating losses generated during the six months ended June 30, 2006) for which we believed it was more likely than not that the deferred tax assets would not be realized. In addition, we recorded state income tax expense of $2 million. Due to our 2006 year-to-date and projected full-year mix of income and loss from our operations by entity and state income tax jurisdiction, there was a significant difference in the 2006 state income tax effective rate in comparison to the 2007 state income tax effective rate.
 
Segment Results
 
Discussed below are the results of operations for each of our reportable segments. Certain income and expenses not allocated to our reportable segments and intersegment eliminations are reported under the heading Other. Our management evaluates the operating results of each of our reportable segments based upon Net revenues and segment profit or loss, which is presented as the income or loss before income tax provisions and after Minority interest in income or loss of consolidated entities, net of income taxes. The Mortgage Production segment profit or loss excludes Realogy’s minority interest in the profits and losses of the Mortgage Venture.
 
Our segment results were as follows:
 
                                                 
    Net Revenues     Segment (Loss) Profit (1)  
    Six Months
          Six Months
       
    Ended June 30,           Ended June 30,        
    2007     2006     Change     2007     2006     Change  
    (In millions)  
 
Mortgage Production segment
  $ 177     $ 194     $ (17 )   $ (47 )   $ (47 )   $  
Mortgage Servicing segment
    114       71       43       72       21       51  
                                                 
Total Mortgage Services
    291       265       26       25       (26 )     51  
Fleet Management Services segment
    916       874       42       51       51        
                                                 
Total reportable segments
    1,207       1,139       68       76       25       51  
Other (2)
    (1 )     (1 )           (5 )           (5 )
                                                 
Total Company
  $ 1,206     $ 1,138     $ 68     $ 71     $ 25     $ 46  
                                                 
 
(1) The following is a reconciliation of Income before income taxes and minority interest to segment profit:
 
                 
    Six Months
 
    Ended June 30,  
    2007     2006  
    (In millions)  
 
Income before income taxes and minority interest
  $ 74     $ 25  
Minority interest in income of consolidated entities, net of income taxes
    3        
                 
Segment profit
  $ 71     $ 25  
                 
 
(2) Net revenues reported under the heading Other for the six months ended June 30, 2007 and 2006 represent the elimination of $1 million of intersegment revenues recorded by the Mortgage Servicing segment, which are offset in segment profit by the elimination of $1 million of intersegment expense recorded by the Fleet Management Services segment. Segment loss reported under the heading Other for the six months ended June 30, 2007 represents expenses related to the proposed Merger.
 
 
Net revenues decreased by $17 million (9%) during the six months ended June 30, 2007 compared to the six months ended June 30, 2006. As discussed in greater detail below, the decrease in Net revenues was due to a $13 million decrease in Gain on sale of mortgage loans, net and an $8 million unfavorable change in Mortgage net


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finance (expense) income that were partially offset by a $2 million increase in Mortgage fees and a $2 million increase in Other income.
 
Segment loss remained at the same level during the six months ended June 30, 2007 compared to the six months ended June 30, 2006 as the $17 million decrease in Net revenues and a $3 million unfavorable change in Minority interest in income of consolidated entities, net of income taxes, were offset by a $20 million (8%) decrease in Total expenses. The $20 million reduction in Total expenses was due to decreases of $9 million in Salaries and related expenses, $4 million in Occupancy and other office expenses, $4 million in Other operating expenses and $3 million in Other depreciation and amortization.
 
The following tables present a summary of our financial results and key related drivers for the Mortgage Production segment, and are followed by a discussion of each of the key components of Net revenues and Total expenses:
 
                             
    Six Months
           
    Ended June 30,            
    2007   2006   Change     % Change  
    (Dollars in millions, except
       
    average loan amount)        
 
Loans closed to be sold
  $ 15,849   $ 16,640   $ (791 )     (5 )%
Fee-based closings
    5,212     4,370     842       19 %
                             
Total closings
  $ 21,061   $ 21,010   $ 51        
                             
Purchase closings
  $ 12,936   $ 14,670   $ (1,734 )     (12 )%
Refinance closings
    8,125     6,340     1,785       28 %
                             
Total closings
  $ 21,061   $ 21,010   $ 51        
                             
Fixed rate
  $ 13,541   $ 11,301   $ 2,240       20 %
Adjustable rate
    7,520     9,709     (2,189 )     (23 )%
                             
Total closings
  $ 21,061   $ 21,010   $ 51        
                             
Number of loans closed (units)
    98,328     104,323     (5,995 )     (6 )%
                             
Average loan amount
  $ 214,188   $ 201,394   $ 12,794       6 %
                             
Loans sold
  $ 15,613   $ 16,132   $ (519 )     (3 )%
                             
 
                                 
    Six Months
             
    Ended June 30,              
    2007     2006     Change     % Change  
    (In millions)        
 
Mortgage fees
  $ 67     $ 65     $ 2       3 %
                                 
Gain on sale of mortgage loans, net
    113       126       (13 )     (10 )%
                                 
Mortgage interest income
    99       90       9       10 %
Mortgage interest expense
    (104 )     (87 )     (17 )     (20 )%
                                 
Mortgage net finance (expense) income
    (5 )     3       (8 )            n/m  (1)
                                 
Other income
    2             2       n/m  (1)
                                 
Net revenues
    177       194       (17 )     (9 )%
                                 
Salaries and related expenses
    102       111       (9 )     (8 )%
Occupancy and other office expenses
    22       26       (4 )     (15 )%
Other depreciation and amortization
    8       11       (3 )     (27 )%
Other operating expenses
    89       93       (4 )     (4 )%
                                 
Total expenses
    221       241       (20 )     (8 )%
                                 
Loss before income taxes
    (44 )     (47 )     3       6 %
Minority interest in income of consolidated entities, net of income taxes
    3             3       n/m  (1)
                                 
Segment loss
  $ (47 )   $ (47 )   $        
                                 
 
(1) n/m — Not meaningful.


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Mortgage fees consist primarily of fees collected on loans originated for others (including brokered loans and loans originated through our financial institutions channel), fees on cancelled loans and appraisal and other income generated by our appraisal serv