**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, DC 20549**

 

**Form 10-Q**

 
| **(Mark  One)**                                             |
|-------------------------------------------------------------|
| ** **                                                  |
| **x**                                                       | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                  | ** ** |
| **For the quarterly period ended  September 30, 2010** |
| ** **                                                  | ** ** |
| **o**                                                       | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**Commission file number 033-19694**

 

**FirstCity Financial Corporation**

(Exact name of registrant as specified in itscharter)

* *

| **Delaware**                             | ** ** | **76-0243729**      |
|------------------------------------------|------------|---------------------|
| (State or other jurisdiction of          |       | (I.R.S. Employer    |
| incorporation or organization)           |       | Identification No.) |
|                                     |       |                |
| **6400 Imperial Drive,**                 |       |                |
| **Waco, TX**                             | ** ** | **76712**           |
| (Address of principal executive offices) |       | (Zip Code)          |

 

**(254) 761-2800**

(Registrant’s telephone number, including areacode)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes x     No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes o  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act. (Check one.)

 

| Large  accelerated filer £                |   | Accelerated  filer £    |
|------------------------------------------------|--------|------------------------------|
|                                           |   |                         |
| Non-accelerated  filer £                  |   | Smaller  reporting company x |
| (Do  not check if a smaller reporting company) |   |                         |

 

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No x

 

The number of shares of common stock, par value $.01 pershare, outstanding at November 10, 2010 was 10,198,214.

 

 

 

----

 

 

**TABLE OF CONTENTS**

 
| **PART I**                    |                                                                                        |
|------------------------------------|---------------------------------------------------------------------------------------------|
|                               |                                                                                        |   |
| Item 1.                            | Financial Statements                                                                        | 2 |
|                               | Consolidated  Balance Sheets                                                                | 2 |
|                               | Consolidated  Statements of Operations                                                      | 3 |
|                               | Consolidated  Statements of Comprehensive Income                                            | 4 |
|                               | Consolidated  Statements of Stockholders’ Equity                                       | 5 |
|                               | Consolidated  Statements of Cash Flows                                                      | 6 |
|                               | Notes to  Consolidated Financial Statements                                                 | 7 |
| Item 2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 42 |
| Item 3.                            | Quantitative  and Qualitative Disclosures About Market Risk                                 | 67 |
| Item 4.                            | Controls and  Procedures                                                                    | 67 |
|                               |                                                                                        |   |
| **PART II OTHER INFORMATION** | 68                                                                                          |
|                               |                                                                                        |   |
| Item 1.                            | Legal Proceedings                                                                           | 68 |
| Item 1A.                           | Risk Factors                                                                                | 68 |
| Item 2.                            | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 68 |
| Item 3.                            | Defaults  Upon Senior Securities                                                            | 68 |
| Item  4.                           | Reserved                                                                                    | 68 |
| Item 5.                            | Other Information                                                                           | 68 |
| Item  6.                           | Exhibits                                                                                    | 69 |
| SIGNATURES                         | 70                                                                                          |

 

----

 

**PART I**

 

**FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

** **

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDBALANCE SHEETS**

**(Dollars in thousands, except share data)**

 
| ** **                                                                                                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| ** **                                                                                                                                                                                    | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                                                    | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                                                                                     |       | $                      | 35,549     |                  | $          | 80,368 |   |
| Restricted cash                                                                                                                                                                               |       | 1,356                  |       | 1,364                 |       |
| Portfolio Assets:                                                                                                                                                                             |       |                   |       |                  |       |
| Loan portfolios, net of allowance for loan losses  of $47,578 and $65,825, respectively                                                                                                       |       | 175,100                |       | 197,946               |       |
| Real estate held for sale                                                                                                                                                                     |       | 29,557                 |       | 17,051                |       |
| Real estate held for investment, net                                                                                                                                                          |       | 7,095                  |       | 9,387                 |       |
| Total Portfolio Assets                                                                                                                                                                        |       | 211,752                |       | 224,384               |       |
| Loans receivable:                                                                                                                                                                             |       |                   |       |                  |       |
| Loans receivable - affiliates, net of allowance  for loan losses of $433 and $67, respectively                                                                                                |       | 18,101                 |       | 26,122                |       |
| Loans receivable - SBA held for sale                                                                                                                                                          |       | 8,336                  |       | 821                   |       |
| Loans receivable - SBA held for investment, net of  allowance for loan losses of $244 and $490, respectively                                                                                  |       | 15,008                 |       | 15,445                |       |
| Loans receivable - other, net of allowance for  loan losses of $1,083 and $-0-, respectively                                                                                                  |       | 14,393                 |       | 10,233                |       |
| Total loans receivable, net                                                                                                                                                                   |       | 55,838                 |       | 52,621                |       |
| Investment securities available for sale                                                                                                                                                      |       | 2,189                  |       | 1,836                 |       |
| Equity investments                                                                                                                                                                            |       | 101,524                |       | 71,491                |       |
| Service fees receivable ($2,265 and $809 from  affiliates, respectively)                                                                                                                      |       | 2,325                  |       | 850                   |       |
| Servicing assets - SBA loans                                                                                                                                                                  |       | 839                    |       | 1,056                 |       |
| Other assets, net                                                                                                                                                                             |       | 33,791                 |       | 31,104                |       |
| Total Assets (1)                                                                                                                                                                              |       | $                      | 445,163    |                  | $          | 465,074 |   |
| ** **                                                                                                                                                                                    | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES  AND EQUITY**                                                                                                                                                                   |       |                   |       |                  |       |
| Liabilities:                                                                                                                                                                                  |       |                   |       |                  |       |
| Notes payable to banks and other                                                                                                                                                              |       | $                      | 285,975    |                  | $          | 305,888 |   |
| Note payable to affiliate                                                                                                                                                                     |       | 7,686                  |       | 7,838                 |       |
| Other liabilities                                                                                                                                                                             |       | 29,839                 |       | 26,077                |       |
| Total Liabilities                                                                                                                                                                             |       | 323,500                |       | 339,803               |       |
| Commitments and contingencies (Note 19)                                                                                                                                                       |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                    |       |                   |       |                  |       |
| Optional preferred stock (par value $.01 per  share; 98,000,000 shares authorized; no shares issued or outstanding)                                                                           |       | —                 |       | —                |       |
| Common stock (par value $.01 per share;  100,000,000 shares authorized; shares issued: 11,698,214 and 11,483,824,  respectively ; shares outstanding: 10,198,214 and 9,983,824, respectively) |       | 117                    |       | 115                   |       |
| Treasury stock, at cost: 1,500,000 shares                                                                                                                                                     |       | (10,923                | )          | (10,923               | )          |
| Paid in capital                                                                                                                                                                               |       | 105,070                |       | 103,326               |       |
| Accumulated deficit                                                                                                                                                                           |       | (7,604                 | )          | (18,329               | )          |
| Accumulated other comprehensive income (loss)                                                                                                                                                 |       | (2,867                 | )          | 3,460                 |       |
| FirstCity Stockholders’ Equity                                                                                                                                                           |       | 83,793                 |       | 77,649                |       |
| Noncontrolling interests                                                                                                                                                                      |       | 37,870                 |       | 47,622                |       |
| Total Equity                                                                                                                                                                                  |       | 121,663                |       | 125,271               |       |
| Total Liabilities and Equity                                                                                                                                                                  |       | $                      | 445,163    |                  | $          | 465,074 |   |

 

----

(1)          Our consolidated assets at September 30, 2010 include the followingassets of certain variable interest entities (“VIEs”) that can only be used tosettle the liabilities of those VIEs: Cash and cash equivalents, $19.7 million;Portfolio Assets, $198.5 million; Loans receivable, $55.8 million; Equityinvestments, $69.4 million; Other assets, $30.9 million; and Total assets,$374.3 million.

 

See accompanying notes to consolidated financialstatements.

 

2

----

 

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF OPERATIONS (Unaudited)**

**(Dollars in thousands, except per share data)**

 

 
| ** **                                                                                                                                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                                                                                     | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Revenues:**                                                                                                                                                                  | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** |   |   |   |
| ***Finance and  Servicing:***                                                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Servicing fees ($2,083 and $2,019 from affiliates  for the three month periods, respectively, and $5,529 and $6,282 from  affiliates for the nine month periods, respectively) |       | $                                | 2,252      |                            | $          | 2,222 |   | $ | 5,998 |   | $ | 7,017 |   |
| Income from Portfolio Assets                                                                                                                                                   |       | 8,195                            |       | 12,134                          |       | 34,280 |   | 35,254 |   |
| Gain on sale of SBA loans held for sale, net                                                                                                                                   |       | 197                              |       | 301                             |       | 360 |   | 911 |   |
| Gain on sale of investment securities                                                                                                                                          |       | —                           |       | —                          |       | 3,250 |   | — |   |
| Interest income from SBA loans                                                                                                                                                 |       | 314                              |       | 299                             |       | 895 |   | 940 |   |
| Interest income from loans receivable - affiliates                                                                                                                             |       | 864                              |       | 1,078                           |       | 2,591 |   | 2,940 |   |
| Interest income from loans receivable - other                                                                                                                                  |       | 233                              |       | 99                              |       | 594 |   | 892 |   |
| Other income                                                                                                                                                                   |       | 1,856                            |       | 1,701                           |       | 4,552 |   | 3,699 |   |
|                                                                                                                                                                           |       | 13,911                           |       | 17,834                          |       | 52,520 |   | 51,653 |   |
| ***Manufacturing,  Railroad and Coal Mine:***                                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Operating revenues - manufacturing                                                                                                                                             |       | —                           |       | —                          |       | 10,466 |   | — |   |
| Operating revenues - railroad                                                                                                                                                  |       | 998                              |       | 776                             |       | 3,455 |   | 2,228 |   |
| Operating revenues - coal mine                                                                                                                                                 |       | 15,329                           |       | —                          |       | 28,429 |   | — |   |
| Other                                                                                                                                                                          |       | —                           |       | 121                             |       | 4 |   | 1,192 |   |
|                                                                                                                                                                           |       | 16,327                           |       | 897                             |       | 42,354 |   | 3,420 |   |
| Total revenues                                                                                                                                                                 |       | 30,238                           |       | 18,731                          |       | 94,874 |   | 55,073 |   |
| **Costs and expenses:**                                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| ***Finance and  Servicing:***                                                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Interest and fees on notes payable to banks and  other                                                                                                                         |       | 4,211                            |       | 3,043                           |       | 10,587 |   | 9,177 |   |
| Interest and fees on note payable to affiliate                                                                                                                                 |       | 393                              |       | 428                             |       | 1,185 |   | 1,305 |   |
| Salaries and benefits                                                                                                                                                          |       | 4,995                            |       | 5,048                           |       | 16,067 |   | 15,654 |   |
| Provision for loan and impairment losses                                                                                                                                       |       | 4,090                            |       | 425                             |       | 8,417 |   | 2,208 |   |
| Asset-level expenses                                                                                                                                                           |       | 2,257                            |       | 1,992                           |       | 5,981 |   | 4,646 |   |
| Other                                                                                                                                                                          |       | 2,158                            |       | 2,868                           |       | 8,660 |   | 7,819 |   |
|                                                                                                                                                                           |       | 18,104                           |       | 13,804                          |       | 50,897 |   | 40,809 |   |
| ***Manufacturing,  Railroad and Coal Mine:***                                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues and operating costs -  manufacturing                                                                                                                          |       | —                           |       | —                          |       | 10,788 |   | — |   |
| Cost of revenues and operating costs - railroad                                                                                                                                |       | 635                              |       | 506                             |       | 1,868 |   | 1,532 |   |
| Cost of revenues and operating costs - coal mine                                                                                                                               |       | 15,662                           |       | —                          |       | 28,957 |   | — |   |
|                                                                                                                                                                           |       | 16,297                           |       | 506                             |       | 41,613 |   | 1,532 |   |
| Total costs and expenses                                                                                                                                                       |       | 34,401                           |       | 14,310                          |       | 92,510 |   | 42,341 |   |
| **Earnings (loss) before other  revenue and income taxes**                                                                                                                     |       | (4,163                           | )          | 4,421                           |       | 2,364 |   | 12,732 |   |
| Equity in earnings of unconsolidated subsidiaries                                                                                                                              |       | 9,962                            |       | 421                             |       | 14,007 |   | 1,473 |   |
| Gain on business combinations                                                                                                                                                  |       | —                           |       | —                          |       | 5,729 |   | 1,455 |   |
| Earnings before income taxes                                                                                                                                                   |       | 5,799                            |       | 4,842                           |       | 22,100 |   | 15,660 |   |
| Income tax expense                                                                                                                                                             |       | 473                              |       | 1,254                           |       | 1,192 |   | 2,103 |   |
| Net earnings                                                                                                                                                                   |       | 5,326                            |       | 3,588                           |       | 20,908 |   | 13,557 |   |
| Less: Net income attributable to noncontrolling  interests                                                                                                                     |       | 2,767                            |       | 1,588                           |       | 10,183 |   | 3,167 |   |
| Net earnings attributable to FirstCity                                                                                                                                         |       | $                                | 2,559      |                            | $          | 2,000 |   | $ | 10,725 |   | $ | 10,390 |   |
|                                                                                                                                                                           |       |                             |       |                            |       |   |   |   |   |
| Basic earnings per share                                                                                                                                                       |       | $                                | 0.25       |                            | $          | 0.20 |   | $ | 1.07 |   | $ | 1.06 |   |
| Diluted earnings per share                                                                                                                                                     |       | $                                | 0.25       |                            | $          | 0.19 |   | $ | 1.06 |   | $ | 1.02 |   |

 

See accompanying notes to consolidated financialstatements.

 

3

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME (Unaudited)**

**(Dollars in thousands)**

 
| ** **                                                                                               | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                               | ** ** | **September 30,**          | ** ** |
| ** **                                                                                               | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| Net earnings                                                                                             |       | $                               | 20,908     |   | $ | 13,557 |   |
| Other comprehensive income (loss):                                                                       |       |                            |       |   |   |
| Net unrealized gain (loss) on securities available  for sale                                             |       | (1,358                          | )          | 1,636 |   |
| Reclassification adjustment for unrealized gain on  security available for sale included in net earnings |       | (1,352                          | )          | — |   |
| Foreign currency translation adjustments                                                                 |       | (5,623                          | )          | 2,313 |   |
| Total other comprehensive income (loss)                                                                  |       | (8,333                          | )          | 3,949 |   |
| Total comprehensive income                                                                               |       | 12,575                          |       | 17,506 |   |
| Less comprehensive (income) loss attributable to  noncontrolling interests:                              |       |                            |       |   |   |
| Net income                                                                                               |       | (10,183                         | )          | (3,167 | ) |
| Net unrealized loss (gain) on securities available  for sale                                             |       | 241                             |       | (326 | ) |
| Foreign currency translation adjustments                                                                 |       | 1,765                           |       | (356 | ) |
| Comprehensive income attributable to FirstCity                                                           |       | $                               | 4,398      |   | $ | 13,657 |   |

 

See accompanying notes to consolidated financialstatements.

 

4

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY (Unaudited)**

**(Dollars in thousands)**

 
| ** **                                                      | ** ** | **FirstCity Stockholders** | ** ** | ** **   | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------|------------|--------------|------------|------------------|------------|
| ** **                                                      | ** ** | ** **                      | ** ** | ** **   | ** ** | ** **       | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | ** **                      | ** ** | ** **   | ** ** | ** **       | ** ** | ** ** | ** ** | **Other** | ** ** | **Non-** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **Common**                      | ** ** | **Treasury** | ** ** | **Paid in** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **controlling** | ** ** | **Total** | ** ** |
| ** **                                                      | ** ** | **Stock**                       | ** ** | **Stock**    | ** ** | **Capital**      | ** ** | **Deficit** | ** ** | **Income (Loss)** | ** ** | **Interests** | ** ** | **Equity** | ** ** |
| ** **                                                      | ** ** | ** **                      | ** ** | ** **   | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balances, December 31, 2008**                            |       | $                               | 113        |         | $          | (10,923          | )          | $ | 101,875 |   | $ | (37,073 | ) | $ | (3,726 | ) | $ | 15,609 |   | $ | 65,875 |   |
| Net  earnings                                                   |       | —                          |       | —       |       | —           |       | 10,390 |   | — |   | 3,167 |   | 13,557 |   |
| Change  in net unrealized gain on securities available for sale |       | —                          |       | —       |       | —           |       | — |   | 1,310 |   | 326 |   | 1,636 |   |
| Foreign  currency translation adjustments                       |       | —                          |       | —       |       | —           |       | — |   | 1,957 |   | 356 |   | 2,313 |   |
| Exercise  of common stock options                               |       | —                          |       | —       |       | 113              |       | — |   | — |   | — |   | 113 |   |
| Stock-based  compensation expense                               |       | —                          |       | —       |       | 438              |       | — |   | — |   | — |   | 438 |   |
| Purchases  of subsidiary shares in noncontrolling interests     |       | —                          |       | —       |       | 641              |       | — |   | — |   | (3,458 | ) | (2,817 | ) |
| Investments  in majority-owned entities                         |       | —                          |       | —       |       | —           |       | — |   | — |   | 46,306 |   | 46,306 |   |
| Distributions  to noncontrolling interests                      |       | —                          |       | —       |       | —           |       | — |   | — |   | (9,961 | ) | (9,961 | ) |
| **Balances, September 30, 2009**                           |       | $                               | 113        |         | $          | (10,923          | )          | $ | 103,067 |   | $ | (26,683 | ) | $ | (459 | ) | $ | 52,345 |   | $ | 117,460 |   |
|                                                            |       |                            |       |         |       |             |       |   |   |   |   |   |   |   |   |
| **Balances, December 31, 2009**                            |       | $                               | 115        |         | $          | (10,923          | )          | $ | 103,326 |   | $ | (18,329 | ) | $ | 3,460 |   | $ | 47,622 |   | $ | 125,271 |   |
| Net  earnings                                                   |       | —                          |       | —       |       | —           |       | 10,725 |   | — |   | 10,183 |   | 20,908 |   |
| Change  in net unrealized gain on securities available for sale |       | —                          |       | —       |       | —           |       | — |   | (2,469 | ) | (241 | ) | (2,710 | ) |
| Foreign  currency translation adjustments                       |       | —                          |       | —       |       | —           |       | — |   | (3,858 | ) | (1,765 | ) | (5,623 | ) |
| Exercise  of common stock options                               |       | —                          |       | —       |       | 70               |       | — |   | — |   | — |   | 70 |   |
| Issuance  of common stock                                       |       | 2                               |       | —       |       | 888              |       | — |   | — |   | — |   | 890 |   |
| Stock-based  compensation expense                               |       | —                          |       | —       |       | 496              |       | — |   | — |   | — |   | 496 |   |
| Purchases  of subsidiary shares in noncontrolling interests     |       | —                          |       | —       |       | —           |       | — |   | — |   | (324 | ) | (324 | ) |
| Other  activity                                                 |       | —                          |       | —       |       | 290              |       | — |   | — |   | (328 | ) | (38 | ) |
| Investments  in majority-owned entities                         |       | —                          |       | —       |       | —           |       | — |   | — |   | 5,495 |   | 5,495 |   |
| Distributions  to noncontrolling interests                      |       | —                          |       | —       |       | —           |       | — |   | — |   | (22,772 | ) | (22,772 | ) |
| **Balances, September 30, 2010**                           |       | $                               | 117        |         | $          | (10,923          | )          | $ | 105,070 |   | $ | (7,604 | ) | $ | (2,867 | ) | $ | 37,870 |   | $ | 121,663 |   |

 

See accompanying notes to consolidated financialstatements.

 

5

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (Unaudited)**

**(Dollars in thousands)**

 
| ** **                                                                                     | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                     | ** ** | **September 30,**          | ** ** |
| ** **                                                                                     | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| ** **                                                                                     | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Cash flows from operating  activities:**                                                     |       |                            |       |   |   |
| Net earnings                                                                                   |       | $                               | 20,908     |   | $ | 13,557 |   |
| Adjustments to reconcile net earnings to net cash  provided by (used in) operating activities: |       |                            |       |   |   |
| Net principal advances on SBA loans held for sale                                              |       | (11,857                         | )          | (13,491 | ) |
| Proceeds from sales of SBA loans held for sale,  net                                           |       | 4,964                           |       | 18,155 |   |
| Proceeds applied to income from Portfolio Assets                                               |       | 2,170                           |       | 15,324 |   |
| Income from Portfolio Assets                                                                   |       | (34,280                         | )          | (35,254 | ) |
| Capitalized interest and costs on Portfolio Assets  and loans receivable                       |       | (564                            | )          | (955 | ) |
| Provision for loan and impairment losses                                                       |       | 8,417                           |       | 2,208 |   |
| Foreign currency transaction losses (gains), net                                               |       | 433                             |       | (441 | ) |
| Equity in earnings of unconsolidated subsidiaries                                              |       | (14,007                         | )          | (1,473 | ) |
| Gain on sale of SBA loans held for sale, net                                                   |       | (360                            | )          | (911 | ) |
| Gain on sale of railroad property                                                              |       | —                          |       | (920 | ) |
| Gain on business combinations                                                                  |       | (5,729                          | )          | (1,455 | ) |
| Gain on sale of investment security                                                            |       | (3,250                          | )          | — |   |
| Depreciation and amortization                                                                  |       | 10,298                          |       | 3,007 |   |
| Net premium amortization of loans receivable                                                   |       | (225                            | )          | (96 | ) |
| Stock-based compensation expense                                                               |       | 496                             |       | 438 |   |
| Decrease in restricted cash                                                                    |       | (294                            | )          | 178 |   |
| Increase in service fees receivable                                                            |       | (1,475                          | )          | (254 | ) |
| Increase in other assets                                                                       |       | (1,818                          | )          | (1,756 | ) |
| Deferred income tax benefit                                                                    |       | (530                            | )          | — |   |
| Increase in other liabilities                                                                  |       | 3,619                           |       | 5,594 |   |
| Net cash provided by (used in) operating  activities                                           |       | (23,084                         | )          | 1,455 |   |
| **Cash flows from investing  activities:**                                                     |       |                            |       |   |   |
| Purchases of property and equipment, net                                                       |       | (1,719                          | )          | (2,071 | ) |
| Proceeds from sale of railroad property                                                        |       | —                          |       | 1,350 |   |
| Proceeds from sale of subsidiaries and equity  investments                                     |       | 125                             |       | — |   |
| Cash paid for business combinations, net of cash  acquired                                     |       | (1,570                          | )          | (7,149 | ) |
| Decrease in cash from deconsolidation of  subsidiary                                           |       | (875                            | )          | — |   |
| Net principal payments (advances) on loans  receivable                                         |       | 1,434                           |       | (1,946 | ) |
| Net principal payments (advances) on SBA loans  held for investment                            |       | 227                             |       | (1,830 | ) |
| Purchase of investment securities available for  sale                                          |       | (2,636                          | )          | — |   |
| Net principal payments on investment securities  available for sale                            |       | 797                             |       | 3,469 |   |
| Proceeds from sale of investment security                                                      |       | 3,250                           |       | — |   |
| Purchases of Portfolio Assets                                                                  |       | (33,861                         | )          | (171,921 | ) |
| Proceeds applied to principal on Portfolio Assets                                              |       | 91,570                          |       | 109,120 |   |
| Contributions to unconsolidated subsidiaries                                                   |       | (32,755                         | )          | (3,890 | ) |
| Distributions from unconsolidated subsidiaries                                                 |       | 8,226                           |       | 9,297 |   |
| Net cash provided by (used in) investing  activities                                           |       | 32,213                          |       | (65,571 | ) |
| **Cash flows from financing  activities:**                                                     |       |                            |       |   |   |
| Borrowings under notes payable to banks and other                                              |       | 46,766                          |       | 160,872 |   |
| Principal payments of notes payable to affiliates                                              |       | (154                            | )          | (600 | ) |
| Principal payments of notes payable to banks and  other                                        |       | (83,858                         | )          | (110,082 | ) |
| Payments of debt issuance costs and loan fees                                                  |       | (3,068                          | )          | (854 | ) |
| Proceeds from secured borrowings, net                                                          |       | 3,591                           |       | — |   |
| Contributions from noncontrolling interests                                                    |       | 4,947                           |       | 40,991 |   |
| Distributions to noncontrolling interests                                                      |       | (22,772                         | )          | (9,961 | ) |
| Cash paid for subsidiary shares in noncontrolling  interests                                   |       | (324                            | )          | (2,796 | ) |
| Proceeds from issuance of common stock                                                         |       | 960                             |       | 113 |   |
| Net cash provided by (used in) financing  activities                                           |       | (53,912                         | )          | 77,683 |   |
| **Effect of exchange rate changes  on cash and cash equivalents**                              |       | (36                             | )          | 322 |   |
| **Net increase (decrease) in cash  and cash equivalents**                                      |       | (44,819                         | )          | 13,889 |   |
| **Cash and cash equivalents,  beginning of period**                                            |       | 80,368                          |       | 19,103 |   |
| **Cash and cash equivalents, end of  period**                                                  |       | $                               | 35,549     |   | $ | 32,992 |   |
| **Supplemental disclosure of cash  flow information:**                                         | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash paid during the period for:                                                               |       |                            | ** ** | ** ** | ** ** |
| Interest                                                                                       |       | $                               | 8,368      |   | $ | 7,279 |   |
| Income taxes, net of refunds                                                                   |       | 276                             |       | 222 |   |

 

See accompanying notes to consolidated financialstatements.

 

6

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

 

**(1)  Basis of Presentation and Summary of Significant AccountingPolicies**

 

***Nature of Operations***

 

FirstCity FinancialCorporation, a Delaware corporation, is a financial services companyheadquartered in Waco, Texas with offices throughout the United States andMexico and a presence in Europe and South America. When we refer to “FirstCity,”“the Company,” “we,” “our” or “us” in this Quarterly Report on Form 10-Q,we mean FirstCity Financial Corporation and subsidiaries (consolidated).

 

TheCompany engages in two major business segments — Portfolio Asset Acquisitionand Resolution and Special Situations Platform. The Portfolio Asset Acquisitionand Resolution business has been the Company’s core business segment since itcommenced operations in 1986. In the Portfolio Asset Acquisition and Resolutionbusiness, the Company acquires portfolios of performing and non-performingloans and other assets (collectively, “Portfolio Assets” or “Portfolios”),generally at a discount to their legal principal balances or appraised values,and services and resolves such Portfolio Assets in an effort to maximize thepresent value of the ultimate cash recoveries. FirstCity acquires the PortfolioAssets for its own account or through investment entities formed with one ormore other co-investors (each such entity, an “Acquisition Partnership”). TheCompany engages in its Special Situations Platform business through its majorityownership in an investment company that was formed in April 2007. Throughits Special Situations Platform, the Company provides investment capital toprivately-held middle-market companies through flexible capital structuringarrangements to generate an attractive risk-adjusted return. These capitalinvestments primarily take the form of senior and junior financingarrangements, but also include direct equity investments, common equitywarrants, distressed debt transactions, and leveraged buyouts. Refer to Note 18for additional information on the Company’s major business segments.

 

***Basis of Presentation***

 

The accompanying unauditedconsolidated financial statements in this Form 10-Q were prepared inaccordance with U.S. generally accepted accounting principles (“GAAP”) forinterim information and with instructions to Form 10-Q and Article 10of Regulation S-X. Accordingly, the consolidated financial statements do notinclude all of the information and footnote disclosures required by GAAP forcomplete consolidated financial statements. In the opinion of management, theaccompanying consolidated financial statements include all adjustments,consisting only of normal recurring adjustments, necessary for a fairpresentation of the Company’s financial position and results of operations. Theinterim results of operations disclosed herein are not necessarily indicativeof the results that may be expected for a full year or any future period.Certain amounts in the consolidated financial statements and disclosures forprior periods were reclassified to conform to the current period presentation.These interim consolidated financial statements should be read in conjunctionwith the Company’s consolidated financial statements and footnotes theretoincluded in our annual report on Form 10-K for the year ended December 31,2009, as amended (“2009 Form 10-K”).

 

Theconsolidated financial statements in this Form 10-Q include the accountsof FirstCity, its wholly-owned and majority-owned subsidiaries, and certainvariable interest entities (“VIEs”). All significant intercompany transactionsand balances have been eliminated in consolidation. We consolidate all VIEswhere we are the primary beneficiary as prescribed by the Financial AccountingStandards Board’s (the “FASB”) accounting guidance on the consolidation ofVIEs. The primary beneficiary of a VIE is the party that has the power todirect the activities that most-significantly impact the economic performanceof the entity and the obligation to absorb losses or the right to receivebenefits that could potentially be significant to the entity. Refer to Note 16for more information.

 

TheCompany does not consolidate equity investments in 20%- to 50%-owned entitiesthat are not VIEs where the Company does not have an effective controllinginterest, or equity investments in 20%- to 50%-owned entities that are VIEswhere the Company is not the primary beneficiary. Rather, such investments areaccounted for under the equity-method of accounting since the Company has theability to exercise significant influence over the investees’ operating andfinancial policies. The Company also accounts for its unconsolidated equityinvestments in less than 20%-owned entities under the equity-method ofaccounting. FirstCity has the ability to exercise significant influence overthe operating and financial policies of these entities, despite itscomparatively smaller ownership percentage, due primarily to its activeparticipation in the policy-making process as well as its involvement in the dailymanagement activities.

 

7

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

***Out-of-Period Adjustments***

 

In the first quarter of 2010, upon the determinationthat deferred tax items related to our foreign jurisdictions had been misstatedby $1.5 million as of December 31, 2009, the Company recorded a $1.0million adjustment to deferred tax benefit and a $0.5 million adjustment toequity in earnings of unconsolidated subsidiaries in order to properly statethe net deferred tax asset. The adjustment was not material to our consolidatedfinancial statements for the quarterly or year-to-date periods ended March 31,2010 or September 30, 2010 or the year ended December 31, 2009.

 

In addition, in the first quarter of 2010, the Companyrecorded certain loan impairments that included $1.2 million in impairmentsthat should have been recorded during the year ended December 31, 2009.The out-of-period adjustments were not material to our consolidated financialstatements for the quarterly or year-to-date periods ended March 31, 2010or September 30, 2010 or the year ended December 31, 2009.

 

***Use of Estimates***

 

Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the consolidated financial statements and the reported amounts of revenuesand expenses during the reporting period. Estimates that are particularlysusceptible to significant change in the near-term relate to the estimation offuture collections on Portfolio Assets used in the calculation of income fromPortfolio Assets; valuation of deferred tax assets and assumptions used in thecalculation of income taxes; valuation of servicing assets, investmentsecurities, loans receivable (including loans receivable held in securitizationtrusts), and real estate; valuation of assets, liabilities, non-controllinginterests and contingencies attributable to business combinations; guaranteeobligations and indemnifications; and legal contingencies. These estimates andassumptions are based on management’s best estimates and judgment. Managementevaluates its estimates and assumptions on an ongoing basis using historicalexperience and other factors, including the current economic environment. Weadjust such estimates and assumptions when facts and circumstances dictate. Thecontinuance of challenging economic conditions and disruptions in thefinancial, capital, real estate and foreign currency markets, have combined toincrease the uncertainty inherent in such estimates and assumptions. As futureevents and their effects cannot be determined with precision, actual resultscould differ significantly from these estimates. Changes in these estimatesresulting from continuing changes in the economic environment will be reflectedin the financial statements in future periods.

 

***Portfolio Assets***

 

The Company invests inPortfolio Assets and services and resolves such Portfolio Assets in an effortto maximize the present value of the ultimate cash recoveries. The PortfolioAssets are generally non-homogeneous assets, including loans of varying qualitiesthat are secured by diverse collateral types and real estate. Some PortfolioAssets are loans for which resolution is tied primarily to the real estatesecuring the loan, while others may be collateralized business loans, theresolution of which may be based on the cash flows of the business or theunderlying collateral.

 

The following is adescription of the classifications and related accounting policies for theCompany’s significant classes of Portfolio Assets:

 

PurchasedCredit-Impaired Loans

 

The Company accounts foracquired loans and loan portfolios with evidence of credit deterioration sinceorigination (“Purchased Credit-Impaired Loans”) at fair value on theacquisition date. The amounts paid for Purchased Credit-Impaired Loans reflectthe Company’s determination that the loans have experienced deterioration incredit quality since origination and that it is probable the Company will beunable to collect all amounts due according to the contractual terms of theunderlying loans. At acquisition, the Company reviews each individual loan to determine whether there is evidence ofdeterioration of credit quality since origination and if it is probable thatthe Company will be unable to collect all amounts due according to the loan’scontractual terms. If both conditions exist, the Company determineswhether each such loan is to be accounted for individually or whether suchloans will be assembled into static pools based on common risk characteristics(primarily loan type and collateral). Static pools of individual loan accountsmay be established and accounted for as a single economic unit for therecognition of income, principal payments and loss provision. Once a staticloan pool is established, individual accounts are generally not added to or removedfrom the pool (unless the Company 

 

8

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

sells, forecloses or writes-off the loan). Atacquisition, the Company determines the excess of the scheduled contractualpayments over all cash flows expected to be collected for the loan or loan poolas an amount that should not be accreted (“nonaccretable difference”). Theexcess of the cash flows from the loan or loan pool expected to be collected atacquisition over the initial investment (“accretable difference”) is recognized as interest income overthe remaining life of the loan or loan pool on a level-yield basis (“accretableyield”). The discount (i.e. the difference between the cost of each loan orloan pool and the related aggregate contractual receivable balance) is notrecorded because the Company does not expect to fully collect each contractualreceivable balance. As a result, these loans and loan pools are recorded atcost (which approximates fair value) at the time of acquisition.

 

The Company accounts forPurchased Credit-Impaired Loans using either the interest method or anon-accrual method (through application of the cost-recovery or cash basismethod of accounting). Application of the interest method is dependent onmanagement’s ability to develop a reasonable expectation as to both the timingand amount of cash flows expected to be collected. In the event the Companycannot develop or establish a reasonable expectation as to both the timing andamount of cash flows expected to be collected, the Company uses thecost-recovery or cash basis method of accounting.

 

*Interest method of accounting*.  Under the interest method, an effectiveinterest rate, or internal rate of return (“IRR”), is applied to the cost basisof the loan or loan pool. The excess of the contractual cash flows overexpected cash flows cannot be recognized as an adjustment of income or expenseor on the balance sheet. The IRR that is calculated when the loan is purchasedremains constant as the basis for subsequent impairment testing (performed atleast quarterly) and income recognition. Subsequent decreases in projected cashflows do not change the IRR, but are recognized as an impairment of the costbasis of the loan or loan pool (to maintain the then-current IRR), and arereflected in the consolidated statements of operations through provisionscharged to operations, with a corresponding allowance offsetting the loan orloan pool in the consolidated balance sheets. FirstCity establishes allowancesfor loans and loan pools acquired with credit deterioration to reflect onlythose losses incurred after acquisition — that is, the cash flows expected atacquisition that are no longer expected to be collected. Significant increasesin actual or expected future cash flows are used first to reverse any existingallowance for that loan or loan pool, and any remaining increase may berecognized prospectively through an upward adjustment of the IRR over theremaining life of the loan or loan pool. Any increase to the IRR then becomesthe new benchmark for impairment testing and income recognition. Income fromloans and loan pools accounted for under the interest method is accrued basedon the IRR of each loan or loan pool applied to the respective adjusted costbasis. Gross collections in excess of the interest accrual and impairments willreduce the carrying value of the loan or loan pool, while gross collectionsless than the interest accrual will increase the carrying value. The IRR iscalculated based on the timing and amount of anticipated cash flows using theCompany’s proprietary collection models.

 

*Cost-recovery method ofaccounting. *If the amountand timing of future cash collections on a loan are not reasonably estimable,the Company accounts for such asset on the cost-recovery method. Under thecost-recovery method, no income is recognized until the Company has fullycollected the cost of the loan, or until such time as the Company considers thetiming and amount of collections to be reasonably estimable and begins torecognize income based on the interest method as described above. At leastquarterly, the Company performs an evaluation to determine if the remainingamount that is probable of collection is less than the carrying value of theloan or loan pool, and if so, recognizes impairment through provisions chargedto operations. The carrying value of Purchased Credit-Impaired Loans accountedfor under the cost-recovery method approximated $59.1 million (including $8.2million of loans pending management’s post-purchase evaluation) at September 30,2010, and $96.3 million (including $12.7 million of loans pending management’spost-purchase evaluation) at December 31, 2009.

 

*Cash basis method of accounting.*  If only the amount of future cash collectionson a loan is reasonably estimable, the Company accounts for such asset on anindividual loan basis under the cash basis method of accounting. Under the cashbasis method, no income is recognized unless collections are received duringthe period, or until such time as the Company considers the timing ofcollections to be reasonably estimable and begins to recognize income based onthe interest method as described above. Income is recognized for the differencebetween the collections and a pro-rata portion of cost on a loan. Costallocation is based on a proration of actual collections divided by totalprojected collections on the loan. Significant increases in future cash flowsmay be recognized prospectively as income over the remaining life of the loanthrough increased amounts allocated to income when collections are subsequentlyreceived. Subsequent decreases in projected cash flows are recognized asimpairment of the loan’s cost basis to maintain a constant cost allocationbased on initial projections. Management implemented the cash basis method ofaccounting for such eligible loans in 2009 as a result of increased uncertaintyin the timing of future collections (attributable primarily to the borrowers’inability to obtain financing to refinance the loans). The carrying value ofPurchased Credit-Impaired Loans accounted for under the cash basis methodapproximated $106.8 million and $42.1 million at September 30, 2010 and December 31,2009, respectively.

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

UBNLoan Portfolio

 

In September 2008, theCompany, through a wholly-owned subsidiary, acquired an additional ownershipinterest in UBN, SA (“UBN”) in a transaction that was accounted for as a stepacquisition under FASB’s business combination accounting guidance. As a resultof the transaction, UBN became a consolidated subsidiary of the Company. Assuch, FirstCity added UBN’s loan portfolio to its consolidated balance sheet inSeptember 2008. On the date of the acquisition, the amount of loans andallowance for loan losses related to UBN’s loan portfolio approximated $69.1million (including $67.3 million of non-performing loans) and $66.6 million,respectively.

 

The allowance for loanlosses on the UBN loan portfolio represents management’s estimate of creditlosses inherent in the loan portfolio at the balance sheet date. Managementestablishes an allowance for loan losses through a provision charged tooperations when a loan is determined to be impaired. A loan is considered to beimpaired when, based on current information and events, it is probable theCompany will not be able to collect all amounts due according to thecontractual terms of the loan agreement. Loans are charged-off against theallowance when all possible means of collection have been exhausted and theremaining balance due is deemed uncollectible. At least quarterly, managementevaluates the need for an allowance on an individual-loan basis for the UBNloan portfolio by considering information about specific borrower situations,legal collection proceedings, estimated collateral values, general economicconditions, and other factors. This evaluation is inherently subjective as itrequires estimates that are susceptible to significant revisions as moreinformation becomes available.

 

RealEstate

 

Portfolio Assets consistingof real estate include properties that were purchased from a variety of sellersor acquired through loan foreclosure. Rental income, net of expenses, isgenerally recognized when received. The Company accounts for its real estateproperties on an individual-asset basis as opposed to a pool basis. Thefollowing is a description of the classifications and related accountingpolicies for the Company’s various classes of real estate Portfolio Assets:

 

*Classification and Impairment Evaluation*

 

Real estate held for sale primarily includes realestate acquired through loan foreclosure. The Company classifies a property asheld for sale if (1) management commits to a plan to sell the property; (2) theCompany actively markets the property in its current condition for a price thatis reasonable in comparison to its fair value; and (3) managementconsiders the sale of such property within one year of the balance sheet dateto be probable. Real estate held for sale is stated at the lower of cost orfair value less estimated disposition costs. Real estate is not depreciatedwhile it is classified as held for sale. Impairment losses are recorded if aproperty’s fair value less estimated disposition costs is less than itscarrying amount, and charged to operations in the period the impairment isidentified.

 

Real estate held for investment generally includesacquired properties and is carried at cost less depreciation and amortization,as applicable. The Company classifies a property as held for investment if theproperty is still under development and/or management does not expect theproperty to be sold within one year of the balance sheet date. The Companyperiodically reviews its property held for investment for impairment wheneverevents or changes in circumstances indicate the carrying amount of the assetmay not be recoverable. Recoverability of property held for investment ismeasured by comparison of the carrying amount of the asset to future netundiscounted cash flows expected to be generated by the property. If theproperty is considered impaired, the impairment to be recognized is measured bythe amount by which the carrying amount of the property exceeds its fair value.Fair value is determined by discounted cash flows or market comparisons.

 

*Cost Capitalization and Allocation*

 

Real estate properties acquired through, or in lieuof, loan foreclosure are initially recorded at the lower of cost (i.e. theunderlying loan’s carrying value) or estimated fair value less dispositioncosts at the date of foreclosure — establishing a new cost basis. The amount,if any, by which the carrying value of the underlying loan exceeds the property’sfair value less estimated disposition costs at the foreclosure date is chargedas a loss against operations. Expenditures for repairs, maintenance, and otherholding costs are charged to operations as incurred.

 

Real estate properties acquired through a purchasetransaction are initially recorded at the cost of the acquisition. The cost ofacquired property includes the purchase price of the property, legal fees, andcertain other acquisition costs. Subsequent to acquisition, 

 

10

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

the Company capitalizes capital improvements and expenditures relatedto significant betterments and replacements, including costs related to thedevelopment and improvement of the property for its intended use. Expendituresfor repairs, maintenance, and other holding costs are charged to operations as incurred.

 

*Disposition of Real Estate*

 

Gains on disposition ofreal estate are recognized upon the sale of the underlying property if thetransaction qualifies for gain recognition under the full accrual method, asprescribed by the FASB’s accounting guidance on real estate sales transactions.If the transaction does not meet the criteria for the full accrual method ofprofit recognition based on our assessment, we account for the sale based on anappropriate deferral method determined by the nature and extent of the buyer’sinvestment and our continuing involvement.

 

***Loans Receivable***

 

The portions of U.S. SmallBusiness Administration (“SBA”) loans that are guaranteed by the SBA areclassified by management as loans held for sale. These loans are recorded atthe lower of aggregate cost or estimated fair value. The fair value of SBAloans held for sale is based primarily on what secondary markets are currentlyoffering for loans with similar characteristics, or the contractual price forloan sales already consummated but which cannot be recognized as accountingsales until the expiration of a recourse period. Net unrealized losses, if any,are recognized through a valuation allowance through a charge to income. Thecarrying value of SBA loans held for sale is net of premiums as well asdeferred origination fees and costs. Premiums and net origination fees andcosts are deferred and included in the basis of the loans in calculating gainsand losses upon sale. SBA loans are generally secured by the borrowing entities’assets such as accounts receivable, property and equipment, and other businessassets. The Company generally sells the guaranteed portion of each loan to athird-party investor and retains the servicing rights. The non-guaranteedportion of SBA loans is classified as held for investment. As described in Note2, effective January 1, 2010, the Company adopted new accounting guidancethat requires SBA loan transactions subject to the SBA’s premium recourseprovision to be accounted for initially as secured borrowings rather than assetsales. After the premium recourse provisions have elapsed, the transaction willbe recorded as a sale and the resulting net gain on sale will be recognized —which is based on the difference between the proceeds received and theallocated carrying value of the loan sold.

 

Loans receivable consistingof loans made to affiliated entities (including Acquisition Partnerships andother equity-method investees) and non-affiliated entities, and thenon-guaranteed portions of SBA loans, are classified by management as held forinvestment. These loans are reported at their outstanding principal balancesnet of any unearned income, charge-offs, unamortized deferred fees and costs onoriginated loans, and unamortized premiums or discounts on purchased loans.Loan origination fees and costs, as well as purchase premiums and discounts,are amortized as level-yield adjustments over the respective loan terms.Unamortized net fees, costs, premiums or discounts are recognized upon earlyrepayment or sale of the loan. Repayment of the loans is generally dependentupon future cash flows of the borrowers, future cash flows of the underlyingcollateral, and distributions made from affiliated entities. Interest isaccrued when earned in accordance with the contractual terms of the loans.Interest is recognized on an accrual basis at the applicable interest rate onthe principal amount outstanding.

 

The Company evaluates theneed for impairment on loans receivable held for investment on an individual-loanbasis at least quarterly by reviewing the collectibility of the loans in lightof various factors, as applicable, such as estimated future cash receipts ofthe borrower or underlying collateral, historical experience, estimated valueof underlying collateral, prevailing economic conditions, and industryconcentrations. This evaluation is inherently subjective as it requiresestimates that are susceptible to significant revision as more informationbecomes available. We consider a loan to be impaired when, based on currentinformation and events, we determine it is probable that we will not be able tocollect all amounts due according to the loan’s contractual terms (includingscheduled interest payments). When management identifies a loan as impaired, wemeasure the impairment based on discounted future cash flows, except when thesource of repayment is the operation or liquidation of the collateral. In thesecases, we use the current fair value of the collateral, less estimated sellingcosts, instead of discounted cash flows. When a loan is determined to beimpaired, we cease to accrue interest on the note and interest previouslyaccrued but not collected becomes part of our recorded investment in the loanand is collectively reviewed for impairment. When ultimate collectibility ofthe impaired note is in doubt, all collections are applied to reduce theprincipal amount of such notes until the principal has been recovered, andcollections thereafter are recognized as interest income. We return a loan to accrualstatus when we determine that the collectibility of principal and interest isreasonably assured. Impairment losses are charged against an allowance accountthrough provisions charged to operations in the period impairment isidentified. Loans are written-off against the allowance when all possible meansof collection have been exhausted and the potential for recovery is consideredremote.

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

***Revenue Recognition —Special Situations Platform Subsidiaries***

 

The Company’s consolidatedrailroad subsidiary, which interchanges rail cars with connecting carriers andprovides rail freight services for on-line customers, recognizes freightrevenue at the time the shipment is either delivered to or received from theconnecting carrier at the point of interchange. Industrial switching and otherservice revenues are recognized as such services are provided.

 

The Company’s consolidatedcoal mine subsidiary, which engages primarily in the purchase and sale of coaland coal-related products, generates revenue under a short-term coal salescontract with a major utility company (the contract is scheduled to expire on oraround December 2010). Revenue is recognized when coal is delivered to thecustomer at an agreed-upon destination as specified in the related contract (atwhich point title and risk of loss passes to the customer). The Companyconsolidated the coal mine subsidiary effective April 1, 2010 after itobtained control of the entity at such time (refer to Note 3 for additionalinformation).

 

The Company’s manufacturingsubsidiary, which engages principally in the design, production and sale ofwireless transmission equipment and software solutions, recognizes revenuederived from the sale of equipment upon shipment of the product. Revenueassociated with software solutions is recognized ratably over the period of theunderlying agreements. Effective June 30, 2010, the Company beganaccounting for its investment in this manufacturing subsidiary as anequity-method investment (instead of a controlled, consolidated subsidiary) —refer to Note 3 for additional information.

 

**(2)  New Accounting Guidance**

 

*Recently Adopted AccountingGuidance*

 

Consolidation of VariableInterest Entities (“VIEs”)

 

Effective January 1,2010, the Company adopted the FASB’s accounting guidance on the consolidationof VIEs (issued in June 2009). This new guidance eliminates the exemptionfor QSPEs; revises previous guidance by replacing the quantitative-based risksand rewards calculation for determining which enterprise, if any, has acontrolling financial interest in a VIE with a qualitative approach focused onidentifying which enterprise has both the power to direct the activities of theVIE that most-significantly impacts the entity’s economic performance and hasthe obligation to absorb losses or the right to receive benefits that could besignificant to the entity; requires reconsideration of whether an entity is aVIE when any changes in facts and circumstances occur such that the holders ofthe equity investment at risk, as a group, lose the power from voting rights orsimilar rights of those investments to direct the activities of the entity thatmost significantly impact the entity’s economic performance; and requiresongoing assessments of whether an enterprise is the primary beneficiary of aVIE and additional disclosures about an enterprise’s involvement in VIEs. Theadoption of this guidance did not have a material impact on our consolidatedfinancial statements. Refer to Note 16 for additional information about theCompany’s involvement with VIEs.

 

Transfers of FinancialAssets

 

Effective January 1,2010, the Company adopted the FASB’s guidance on accounting for transfers offinancial assets (issued in June 2009). This guidance amends previousguidance which, among other changes, eliminates the concept of a QSPE, changesthe requirements for de-recognizing financial assets, defines the term “participatinginterest” to establish specific conditions for reporting a transfer of aportion of a financial asset as a sale, and requires additional disclosures.The recognition and measurement provisions are effective for transfersoccurring on or after January 1, 2010. The new accounting guidance delaysthe Company’s recognition of the sale of guaranteed portions of SBA loans untilexpiration of the premium recourse provisions, and requires such transactionsto be accounted for initially as a secured borrowing. As such, the Company didnot recognize any gains related to SBA loan sales for the first three months of2010. Once the premium recourse provisions have elapsed, the transaction willbe recorded as a sale with the guaranteed portion of the SBA loan and thesecured borrowing removed from the balance sheet and the resulting gain on salerecorded. Refer to Notes 1 and 5 for additional information.

 

Fair Value MeasurementsDisclosure

 

InJanuary 2010, the FASB issued new accounting guidance that amendedexisting guidance for fair value disclosures. This guidance requires separatedisclosures of significant transfers of items in and out of Levels 1 and 2 inthe fair value hierarchy, and to 

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

describe the reasons for the transfers. Theupdated guidance also clarifies, among other things, that fair valuemeasurement disclosures should be provided for each class of assets andliabilities, and that disclosures of inputs and valuation techniques should beprovided for both recurring and non-recurring Level 2 and Level 3 fair valuemeasurements. We adopted this new guidance for the quarterly period ended March 31,2010. Since this guidance is disclosure-only in nature, our adoption of theguidance did not significantly impact the Company’s consolidated financialstatements. Refer to Note 15 for additional information.

 

Subsequent Events Disclosure

 

InMarch 2010, the FASB issued guidance that amends existing guidance (issuedin May 2009) that established the general standards of accounting anddisclosure for subsequent events. Among other things, the new guidanceeliminates the requirement for SEC filers, as defined in the guidance, todisclose the date through which subsequent events have been evaluated. Thatchange is effective immediately. SEC filers continue to be required to evaluatesubsequent events through the date the financial statements are issued.Although the new guidance eliminates the requirement for SEC filers to disclosethe date through which subsequent events have been evaluated, it does notprohibit SEC filers from disclosing such date. The new guidance also clarifiesthe requirement to disclose the date through which subsequent events have beenevaluated in reissued financial statements to apply only to such statementsthat have been restated to correct an error or to apply U.S. GAAPretrospectively. The adoption of this guidance did not have a material impacton our consolidated financial statements.

 

Loan Modifications and Loan Pool Accounting

 

InApril 2010, the FASB issued guidance that clarifies the accounting forloan modifications when the loan is part of a pool that is accounted for as asingle asset. The new guidance provides that modifications of loans that areaccounted for within a pool do not result in the removal of those loans fromthe pool even if the modification of those loans would otherwise be considereda troubled debt restructuring. An entity will continue to be required toconsider whether the pool of assets in which the loan is included is impairedif expected cash flows for the pool change. This guidance does not affect theaccounting for loans that are not accounted for within pools. Loans accountedfor individually continue to be subject to the troubled debt restructuringaccounting provisions. The new guidance also allows entities to make a one-timeelection to terminate accounting for loans in a pool, which may be made on apool-by-pool basis, upon adoption of this new guidance. We early-adopted theprovisions of this new guidance, as permitted, effective April 1, 2010.The adoption of this guidance did not have a material impact on ourconsolidated financial statements.

 

*Recently Issued Accounting Guidance*

 

Finance Receivables andAllowance for Credit Losses Disclosure

 

In July 2010, the FASBissued updated guidance related to credit risk disclosures for financereceivables and the related allowance for credit losses. The updated guidancerequires entities to disclose information at disaggregated levels, specificallydefined as “portfolio segments” and “classes”. Expanded disclosures include,among other things, roll-forward schedules of the allowance for credit lossesand information regarding the credit quality of receivables (including theiraging) as of the end of a reporting period. The Company will adopt theperiod-end provisions of this new guidance in its consolidated financialstatements for the year ended December 31, 2010, and the activity-relatedprovisions of the guidance in the first quarter 2011. While the provisions ofthis new guidance will require significant expansion of our disclosures on thecredit quality of financing receivables and the allowance for credit losses, wedo not expect the adoption to have an effect on our financial condition andresults of operations.

 

Fair Value MeasurementsDisclosure

 

In January 2010, theFASB issued updated guidance related to fair value measurements anddisclosures, which requires a reporting entity to disclose separately, areconciliation for fair value measurements using significant unobservableinputs (Level 3) information about purchases, sales, issuances and settlements(that is, on a gross basis rather than one net number). The updated guidance iseffective for interim or annual financial reporting periods beginning afterDecember 15, 2010 and for interim periods within the fiscal year. Sincethis guidance is disclosure-only in nature, management does not expect theadoption of this updated guidance to have a material impact on our financialcondition and results of operations.

 

13

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

**(3)  Business Combinations and Deconsolidation of a Subsidiary**

 

*Coal Mine Operation — Business Combination*

 

EffectiveApril 1, 2010, the Company, through its majority-owned Special SituationsPlatform subsidiary, obtained control of an equity-method investee (coal mineoperation) after the investee acquired and redeemed the 55.5% ownershipinterest held by the then-majority shareholder in exchange for a $4.6 millionnote payable. As a result of the equity interest redemption, the Company’sownership interest in the investee increased to 88.8% from 39.5% and the coalmine operation became a consolidated subsidiary of the Company. The transfer ofa controlling interest in the investee to the Company was accounted for as abusiness combination, and accordingly, all of the assets and liabilities of thecoal mine operation were measured at fair value on the date control wasobtained and included in the Company’s consolidated balance sheet, net ofintercompany account balances that were eliminated in consolidation. Thefollowing table reflects the estimated fair value of the coal mine operation’sidentifiable assets and liabilities, and the estimated fair value of thenoncontrolling interest, that were included in the Company’s consolidatedbalance sheet at April 1, 2010 (in thousands):

 
| Cash                                       |   | $      | 1,597  |   |
|--------------------------------------------|--------|--------|--------|--------|
| Coal supply agreement (1)                  |   | 13,092 |   |
| Accounts receivable and other assets (1)   |   | 3,699  |   |
| Total assets                               |   | $      | 18,388 |   |
|                                       |   |   |   |
| Note payable                               |   | $      | 4,615  |   |
| Coal purchase agreement (2)                |   | 2,394  |   |
| Intercompany liability (3)                 |   | 4,086  |   |
| Accounts payable and other liabilities (2) |   | 2,415  |   |
| Total liabilities                          |   | $      | 13,510 |   |
|                                       |   |   |   |
| Noncontrolling interest                    |   | $      | 548    |   |

 

----

(1) Included in “Other assets” on the Company’s consolidated balance sheet.

(2) Included in “Other liabilities” on the Company’s consolidated balance sheet.

(3) Eliminated in consolidation with the Company’s consolidated financialstatements.

 

Inaddition to measuring the subsidiary’s assets and liabilities at fair value atthe date control was obtained on April 1, 2010, the Company’s carryingvalue of its previously-held equity-method investment in the coal minesubsidiary was re-measured to fair value under accounting guidance applicableto business combinations. The fair value of the Company’s total interest in thesubsidiary after the business combination exceeded the carrying value of itspreviously-held equity interest by approximately $4.8 million, which theCompany recognized as “Gain on business combinations” in its consolidatedstatement of operations for the nine-month period ended September 30,2010. The Company’s carrying value of its previously-held equity investment inthe coal mine subsidiary included the effects of the investee’s distribution ofa wholly-owned equipment subsidiary (i.e. spin-off transaction), effective April 1,2010, to the owners in proportion to their then-existing ownership percentages.The spin-off transaction effected by the investee was recorded at carryingvalue and the Company’s proportionate share of equity in the distributed entityapproximated $2.7 million — which it continued to record as an equity-methodinvestment after the spin-off.

 

TheCompany’s application of business combination accounting in connection withobtaining control of the coal mine subsidiary resulted in the Company’srecognition of an asset for an above-market-price coal supply agreement and aliability for an above-market-price coal purchase agreement. The fair values ofthe coal supply and coal purchase agreements were based on discounted cash flowcalculations of the difference between the expected contract revenues and costsbased on the stated contractual terms and the estimated net contract revenuesand costs derived from applying forward-market commodity prices as of April 1,2010. The discount rate used for the calculations was obtained from independentpricing reflecting broker market quotes. The coal supply asset and coalpurchase liability are being amortized over the actual amount of tons shippedunder each contract (which are both scheduled to expire in December 2010).

 

14

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

*Domestic Acquisition Partnerships — Business Combinations*

 

OnMarch 31, 2010, the Company acquired an additional 50% ownership interestin three domestic Acquisition Partnerships for $4.4 million. As a result ofthis transaction, the Company’s ownership interest in each of these entitiesincreased to 100% and the Company obtained control of such entities, resultingin these Acquisition Partnerships becoming consolidated subsidiaries of theCompany. The transaction was accounted for as a business combination, andaccordingly, all of the assets and liabilities of these AcquisitionPartnerships were measured at fair value on the acquisition date and includedin the Company’s consolidated balance sheet. The following table reflects thefair value of the Acquisition Partnerships’ assets and liabilities that wereincluded in the Company’s consolidated balance sheet on the acquisition date(in thousands):

 

**Recognized amounts of identified assets acquired and liabilitiesassumed (at fair value):**

 
| Cash                   |   | $      | 1,427  |   |
|------------------------|--------|--------|--------|--------|
| Portfolio Assets       |   | 21,765 |   |
| Other assets           |   | 82     |   |
| Total assets           |   | $      | 23,274 |   |
|                   |   |   |   |
| Notes payable to banks |   | $      | 13,811 |   |
| Other liabilities      |   | 235    |   |
| Total liabilities      |   | $      | 14,046 |   |

 

Pursuantto accounting provisions applicable to business combinations, the Company’scarrying value of its previously-held equity-method investments in theseAcquisition Partnerships was re-measured to fair value at the acquisition date.The fair value of the Company’s previously-held equity interests exceeded theaggregate carrying values by approximately $0.9 million. As such, the Companyrecognized a $0.9 million gain attributable to the re-measurement of itspreviously-held equity interests on the acquisition date (included in “Gain onbusiness combinations” in the Company’s consolidated statement of operationsfor the nine-month period ended September 30, 2010).

 

*Manufacturing Subsidiary — Deconsolidation*

 

In December 2009, theCompany, through its majority-owned Special Situations Platform subsidiary,acquired a majority controlling interest in a manufacturing subsidiary(involved in the design, production and sale of wireless transmission equipmentand software solutions). The manufacturing subsidiary’s accounts and results ofoperations have been included in the Company’s consolidated financialstatements since the acquisition. However, effective June 30, 2010, theCompany and the noncontrolling owners consented to certain amendments to thesubsidiary’s operating agreement that resulted in the Company ceasing to have acontrolling interest, but retaining a noncontrolling interest and elevatedeconomic interests, in the manufacturing entity. Accordingly, the Companydeconsolidated and removed the carrying values of the manufacturing subsidiary’sassets ($9.9 million) and liabilities ($9.6 million) and the carrying value ofthe noncontrolling interest ($39,000) attributed to the subsidiary from itsconsolidated balance sheet on June 30, 2010. The Company also recorded itsretained noncontrolling interest in the manufacturing entity at estimated fairvalue of approximately $0.3 million at June 30, 2010. No gain or loss wasrecognized by the Company as a result of deconsolidating this subsidiary. On June 30,2010, the Company started to account for its retained investment in themanufacturing entity using the equity-method of accounting. Consequently, theCompany no longer reports the individual revenue and expense line-items of themanufacturing entity’s operations in its consolidated statements of operations(rather, the Company began recording its share of the subsidiary’s net earningsas “Equity in earnings of unconsolidated subsidiaries” beginning July 1,2010).

 

15

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

**(4)  Portfolio Assets**

 

Portfolio Assets are summarized as follows:

 
| ** **                      | ** ** | **September 30, 2010**     | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                      | ** ** | **Outstanding**                      | ** ** | **Allowance for** | ** ** | **Outstanding** | ** ** |
| ** **                      | ** ** | **Balance**                          | ** ** | **Loan Losses** | ** ** | **Balance, net** | ** ** |
| Loan Portfolios:                |       |                                 |       |   |   |   |   |
| Purchased Credit-Impaired Loans |       | $                                    | 167,722    |   | $ | 1,297 |   | $ | 166,425 |   |
| Purchased performing loans      |       | 4,070                                |       | 9 |   | 4,061 |   |
| UBN:                            |       |                                 |       |   |   |   |   |
| Non-performing loans            |       | 48,123                               |       | 46,217 |   | 1,906 |   |
| Performing loans                |       | 1,069                                |       | — |   | 1,069 |   |
| Other                           |       | 1,694                                |       | 55 |   | 1,639 |   |
| Total                           |       | $                                    | 222,678    |   | $ | 47,578 |   | $ | 175,100 |   |

 
| ** **                      | ** ** | **December 31, 2009**      | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                      | ** ** | **Outstanding**                      | ** ** | **Allowance for** | ** ** | **Outstanding** | ** ** |
| ** **                      | ** ** | **Balance**                          | ** ** | **Loan Losses** | ** ** | **Balance, net** | ** ** |
| Loan Portfolios:                |       |                                 |       |   |   |   |   |
| Purchased Credit-Impaired Loans |       | $                                    | 192,920    |   | $ | 6,927 |   | $ | 185,993 |   |
| Purchased performing loans      |       | 3,986                                |       | 25 |   | 3,961 |   |
| UBN:                            |       |                                 |       |   |   |   |   |
| Non-performing loans            |       | 60,929                               |       | 58,624 |   | 2,305 |   |
| Performing loans                |       | 1,555                                |       | — |   | 1,555 |   |
| Other                           |       | 4,381                                |       | 249 |   | 4,132 |   |
| Total                           |       | $                                    | 263,771    |   | $ | 65,825 |   | $ | 197,946 |   |

 
| ** **                               | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)** | ** ** |
| Real Estate Portfolios:                  | ** ** | ** **                           | ** ** | ** **            | ** ** |
| Real estate held for sale                |       | $                                    | 29,557     |                  | $          | 17,051 |   |
| Real estate held for investment, net (1) |       | 7,095                                |       | 9,387                 |       |
| Total                                    |       | $                                    | 36,652     |                  | $          | 26,438 |   |

 

----

(1)          Includes lease-related intangible balances (net) ofapproximately $0.7 million and $0.8 million at September 30, 2010 and December 31,2009, respectively.

 

Income from Portfolio Assets is summarized as follows:

 
| ** **                      | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                      | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Loan Portfolios:                | ** ** | ** **                           | ** ** | ** **                      |       |   |   |   |   |
| Purchased Credit-Impaired Loans |       | $                                    | 6,051      |                            | $          | 10,626 |   | $ | 28,791 |   | $ | 32,879 |   |
| Purchased performing loans      |       | 87                                   |       | 59                              |       | 213 |   | 232 |   |
| UBN                             |       | 130                                  |       | 260                             |       | 766 |   | 535 |   |
| Other                           |       | 1,245                                |       | 91                              |       | 1,633 |   | 520 |   |
| Real Estate Portfolios          |       | 682                                  |       | 1,098                           |       | 2,877 |   | 1,088 |   |
| Income from Portfolio Assets    |       | $                                    | 8,195      |                            | $          | 12,134 |   | $ | 34,280 |   | $ | 35,254 |   |

 

16

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

For the nine-month periodended September 30, 2010, the Company recorded provisions for loan andimpairment losses, net of recoveries, by a charge to income of $6.7 million —which is composed of a $2.7 million provision for loan losses, net ofrecoveries, and a $4.0 million impairment charge on real estate portfolios. Forthe nine-month period ended September 30, 2009, the Company recorded aprovision for loan and impairment losses on Portfolio Assets of $0.8 million —which is composed of a $0.6 million impairment charge on real estate portfoliosand a $0.2 million provision for loan losses, net of recoveries.

 

The changes in the allowancefor loan losses on Portfolio Assets are as follows:

 
| ** **              | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **              | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **              | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance       |       | $                                    | (45,719    | )                               | $          | (69,082 | ) | $ | (65,825 | ) | $ | (76,365 | ) |
| Provisions              |       | (943                                 | )          | (2,958                          | )          | (3,268 | ) | (3,618 | ) |
| Recoveries              |       | 154                                  |       | 3,023                           |       | 614 |   | 3,405 |   |
| Charge-offs             |       | 523                                  |       | 7,372                           |       | 11,932 |   | 15,019 |   |
| Translation adjustments |       | (1,593                               | )          | (643                            | )          | 8,969 |   | (729 | ) |
| Ending Balance          |       | $                                    | (47,578    | )                               | $          | (62,288 | ) | $ | (47,578 | ) | $ | (62,288 | ) |

 

Accretable yield representsthe amount of income the Company can expect to generate over the remaining lifeof its existing Purchased Credit-Impaired Loans based on estimated future cashflows as of September 30, 2010 and December 31, 2009.Reclassifications from nonaccretable difference to accretable yield primarilyresult from the Company’s increase in its estimates of future cash flows.Reclassifications to nonaccretable difference from accretable yield primarilyresults from the Company’s decrease in its estimates of future cash flows.Changes in accretable yield related to the Company’s Purchased Credit-ImpairedLoans for the three- and nine-month periods ended September 30, 2010 and2009 are as follows:

 
| ** **                                           | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                           | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                                    |       | $                                    | 2,449      |                            | $          | 52,936 |   | $ | 12,923 |   | $ | 58,114 |   |
| Additions                                            |       | —                               |       | —                          |       | — |   | 23,077 |   |
| Accretion                                            |       | (37                                  | )          | (3,769                          | )          | (2,163 | ) | (14,229 | ) |
| Reclassification (to) from nonaccretable  difference |       | 4                                    |       | 656                             |       | (2,138 | ) | 2,115 |   |
| Disposals                                            |       | 328                                  |       | (2,353                          | )          | (2,613 | ) | (8,545 | ) |
| Transfer to non-accrual                              |       | —                               |       | (25,127                         | )          | (3,039 | ) | (38,412 | ) |
| Translation adjustments                              |       | 6                                    |       | (90                             | )          | (220 | ) | 133 |   |
| Ending Balance                                       |       | $                                    | 2,750      |                            | $          | 22,253 |   | $ | 2,750 |   | $ | 22,253 |   |

 

Acquisitions of PurchasedCredit-Impaired Loans for the three- and nine-month periods ended September 30,2010 and 2009, respectively, are summarized in the table below:

 
| ** **                                                              | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                              | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                                              | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands)** | ** ** |
| Face value at acquisition                                               |       | $                                    | 11,390     |                            | $          | 53,358 |   | $ | 63,146 |   | $ | 306,188 |   |
| Cash flows expected to be collected at  acquisition, net of adjustments |       | 12,939                               |       | 70,252                          |       | 51,557 |   | 234,680 |   |
| Basis in acquired loans at acquisition                                  |       | 8,267                                |       | 36,932                          |       | 32,632 |   | 171,620 |   |
|                                                                         |            |                                      |            |                                 |            |  |  |  |  |  |  |  |  |

 

17

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

**(5)  Loans Receivable**

 

Thefollowing is a composition of the Company’s loans receivable by loan type andregion:

 
| ** **                                                                   | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                                   | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                                                                   | ** ** | **(Dollars in thousands)** | ** ** |
| Domestic:                                                                    |       |                                 |       |                  |       |
| Commercial and industrial:                                                   |       |                                 |       |                  |       |
| Affiliates, net of allowance for loan losses of  $-0- and $67, respectively  |       | $                                    | 7,094      |                  | $          | 13,177 |   |
| SBA, net of allowance for loan losses of $244 and  $490, respectively        |       | 23,344                               |       | 16,266                |       |
| Other                                                                        |       | 8,054                                |       | 1,402                 |       |
| Real estate:                                                                 |       |                                 |       |                  |       |
| Other, net of allowance for loan losses of $1,083  and $-0-, respectively    |       | 6,339                                |       | 8,831                 |       |
|                                                                         |       |                                 |       |                  |       |
| Foreign - commercial and industrial:                                         |       |                                 |       |                  |       |
| Affiliates, net of allowance for loan losses of  $433 and $-0-, respectively |       | 11,007                               |       | 12,945                |       |
|                                                                         |       |                                 |       |                  |       |
| Total loans, net                                                             |       | $                                    | 55,838     |                  | $          | 52,621 |   |

 

***Loans receivable —affiliates***

 

Loans receivable —affiliates, which are designated by management as held for investment, aresummarized as follows:

 

 
| ** **                    | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance           |       | $                                    | 17,291     |                  | $          | 24,757 |   |
| Allowance for loan losses     |       | (433                                 | )          | (67                   | )          |
| Discounts, net                |       | (170                                 | )          | (237                  | )          |
| Capitalized interest          |       | 1,413                                |       | 1,669                 |       |
| Carrying amount of loans, net |       | $                                    | 18,101     |                  | $          | 26,122 |   |

 

A summary of activity inloans receivable — affiliates follows:

 
| ** **                      | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                      | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance               |       | $                                    | 21,867     |                            | $          | 29,746 |   | $ | 26,122 |   | $ | 27,080 |   |
| Advances                        |       | 23                                   |       | 3,486                           |       | 573 |   | 8,638 |   |
| Payments received               |       | (4,336                               | )          | (2,334                          | )          | (7,226 | ) | (4,944 | ) |
| Capitalized interest            |       | 96                                   |       | 103                             |       | 233 |   | 272 |   |
| Provision for loan impairment   |       | 68                                   |       | —                          |       | (365 | ) | — |   |
| Discount accretion, net         |       | 23                                   |       | 15                              |       | 67 |   | 15 |   |
| Other noncash adjustments (1)   |       | —                               |       | —                          |       | (1,001 | ) | — |   |
| Foreign exchange gains (losses) |       | 360                                  |       | 195                             |       | (302 | ) | 150 |   |
| Ending Balance                  |       | $                                    | 18,101     |                            | $          | 31,211 |   | $ | 18,101 |   | $ | 31,211 |   |

 

18

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

----

(1)          Represents the removal of a $4.1 million loan to aformer equity-method investee (coal mine subsidiary) upon consolidation of theentity effective April 1, 2010, and the addition of a $3.1 million loan toa former consolidated entity (manufacturing subsidiary) upon thedeconsolidation of the entity effective June 30, 2010. Refer to Note 3 foradditional information.

 

Loansreceivable — affiliates represent (1) advances to Acquisition Partnershipsand other affiliates to acquire portfolios of performing and non-performingcommercial and consumer loans and other assets; and (2) senior debtfinancing arrangements with equity-method investees to provide capital forbusiness expansion and operations. Loans receivable — affiliates are generallysecured by the underlying collateral that was acquired with the loan proceeds.Advances to affiliates to acquire loan portfolios are secured by the underlyingcollateral of the individual notes within the portfolios (which is generallyreal estate), whereas advances to affiliates for capital investments andworking capital are generally secured by business assets (i.e. accountsreceivable, inventory and equipment). The Company recorded $0.4 million of netprovisions for impairment on loans receivable — affiliates for the nine monthsended September 30, 2010. The Company recorded no provisions forimpairment for the nine-month period ended September 30, 2009.

 

AtSeptember 30, 2010, the Company’s recorded investment in impaired andnon-accrual loans receivable — affiliates totaled $0.9 million. The averagerecorded investment in these impaired and non-accrual loans approximated $0.4million for the nine-month period ended September 30, 2010. At September 30,2010, the Company had $0.4 million of allowances specifically related to theseloans.

 

***Loans receivable — SBA held for sale***

 

Loansreceivable — SBA held for sale are summarized as follows:

 
| ** **                     | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                     | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance            |       | $                                    | 8,227      |                  | $          | 821 |   |
| Capitalized costs, net of fees |       | 109                                  |       | —                |       |
| Carrying amount of loans, net  |       | $                                    | 8,336      |                  | $          | 821 |   |

 

Changes in loans receivable —SBA held for sale are as follows:

 
| ** **                         | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                         | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                  |       | $                                    | 7,697      |                            | $          | 3,492 |   | $ | 821 |   | $ | 4,901 |   |
| Originations and advances of loans |       | 2,992                                |       | 2,115                           |       | 11,881 |   | 13,715 |   |
| Payments received                  |       | (17                                  | )          | (61                             | )          | (24 | ) | (224 | ) |
| Capitalized costs                  |       | 27                                   |       | (43                             | )          | 110 |   | (61 | ) |
| Loans sold, net                    |       | (2,363                               | )          | (3,920                          | )          | (4,452 | ) | (16,748 | ) |
| Ending Balance                     |       | $                                    | 8,336      |                            | $          | 1,583 |   | $ | 8,336 |   | $ | 1,583 |   |

 

Loansreceivable — SBA held for sale represent the portions of SBA loans acquired andoriginated by the Company that are guaranteed by the SBA. These loans aresecured by the borrowing entities’ assets such as accounts, property, equipmentand other business assets. The Company recorded no write-downs of SBA loansheld for sale below their cost for the nine months ended September 30, 2010and 2009.

 

AtSeptember 30, 2010, SBA loans held for sale include $3.2 million inguaranteed portions of SBA loans sold and subject to premium recourseprovisions. In accordance with FASB’s accounting guidance on transfers offinancial assets (issued in June 2009) that became effective in the firstquarter of 2010, an off-setting secured borrowing has been recorded and isincluded in “Other liabilities” in the Company’s consolidated balance sheet.After the premium recourse provisions have elapsed, the Company will recognizethe gain related to the sale, and remove the guaranteed portion of the SBA loan(i.e. the pledged asset) and the secured borrowing from the balance sheet.Refer to Note 2 for additional information.

 

19

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

***Loans receivable — SBA held for investment, net***

 

Loansreceivable — SBA held for investment are summarized as follows:

 
| ** **                    | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance           |       | $                                    | 16,206     |                  | $          | 17,072 |   |
| Allowance for loan losses     |       | (243                                 | )          | (490                  | )          |
| Discounts, net                |       | (1,078                               | )          | (1,245                | )          |
| Capitalized costs             |       | 123                                  |       | 108                   |       |
| Carrying amount of loans, net |       | $                                    | 15,008     |                  | $          | 15,445 |   |

 

Changes in loans receivable —SBA held for investment are as follows:

 
| ** **                           | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                           | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                           | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                    |       | $                                    | 15,165     |                            | $          | 16,203 |   | $ | 15,445 |   | $ | 14,405 |   |
| Originations and advances of loans   |       | 371                                  |       | 288                             |       | 1,421 |   | 3,055 |   |
| Payments received                    |       | (355                                 | )          | (484                            | )          | (1,671 | ) | (1,277 | ) |
| Capitalized costs                    |       | 5                                    |       | 3                               |       | 15 |   | 46 |   |
| Change in allowance for loan losses  |       | 103                                  |       | (329                            | )          | 247 |   | (407 | ) |
| Discount accretion, net              |       | 7                                    |       | 6                               |       | 95 |   | (135 | ) |
| Charge-offs                          |       | (203                                 | )          | (25                             | )          | (459 | ) | (25 | ) |
| Transfers to other real estate owned |       | (85                                  | )          | —                          |       | (85 | ) | — |   |
| Ending Balance                       |       | $                                    | 15,008     |                            | $          | 15,662 |   | $ | 15,008 |   | $ | 15,662 |   |

 

Loansreceivable — SBA held for investment represent the non-guaranteed portions ofSBA loans purchased and originated by the Company. These loans are secured bythe borrowing entities’ assets such as accounts, property, equipment and otherbusiness assets. The Company recorded net impairment provisions to SBA loansheld for investment of $0.2 million and $0.4 million for the nine-month periodsended September 30, 2010 and 2009, respectively.

 

Changesin the allowance for loan losses related to loans receivable — SBA held forinvestment are as follows:

 
| ** **        | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **        | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **        | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **        | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance |       | $                                    | (346       | )                               | $          | (112 | ) | $ | (490 | ) | $ | (34 | ) |
| Provisions        |       | (107                                 | )          | (364                            | )          | (299 | ) | (461 | ) |
| Recoveries        |       | 4                                    |       | 12                              |       | 84 |   | 31 |   |
| Charge-offs       |       | 206                                  |       | 23                              |       | 462 |   | 23 |   |
| Ending Balance    |       | $                                    | (243       | )                               | $          | (441 | ) | $ | (243 | ) | $ | (441 | ) |

 

At September 30, 2010,the Company’s recorded investment in impaired and non-accrual loans receivable —SBA held for investment totaled $0.3 million. The average recorded investmentin these impaired and non-accrual loans approximated $0.4 million for thenine-month period ended September 30, 2010. At September 30, 2010,the Company had $0.2 million of allowances specifically related to these loans.

 

20

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

***Loans receivable — other***

 

Loans receivable — other,which are designated by management as held for investment, are summarized asfollows:

 
| ** **                     | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                     | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance            |       | $                                    | 15,257     |                  | $          | 9,992 |   |
| Allowance for loan losses      |       | (1,083                               | )          | —                |       |
| Discounts, net                 |       | (27                                  | )          | (7                    | )          |
| Capitalized interest and costs |       | 246                                  |       | 248                   |       |
| Carrying amount of loans, net  |       | $                                    | 14,393     |                  | $          | 10,233 |   |

 

Changes in loans receivable —other are as follows:

 
| ** **                          | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                          | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                   |       | $                                    | 14,654     |                            | $          | 11,698 |   | $ | 10,233 |   | $ | 13,533 |   |
| Advances                            |       | 1,953                                |       | 1,737                           |       | 12,505 |   | 5,105 |   |
| Payments received                   |       | (2,225                               | )          | (2,554                          | )          | (7,286 | ) | (6,853 | ) |
| Capitalized interest and costs      |       | —                               |       | —                          |       | (2 | ) | 44 |   |
| Change in allowance for loan losses |       | —                               |       | 1,548                           |       | (1,083 | ) | 581 |   |
| Discount accretion, net             |       | 11                                   |       | 2                               |       | 26 |   | 11 |   |
| Charge-offs                         |       | —                               |       | (1,548                          | )          | — |   | (1,548 | ) |
| Foreign exchange gains              |       | —                               |       | —                          |       | — |   | 10 |   |
| Ending Balance                      |       | $                                    | 14,393     |                            | $          | 10,883 |   | $ | 14,393 |   | $ | 10,883 |   |

 

Loansreceivable — other include loans made to non-affiliated entities and aresecured by the borrowing entities’ assets such as accounts receivable,inventory, property and equipment, real estate and various other assets. TheCompany recorded impairment provisions on loans receivable — other ofapproximately $1.1 million and $1.0 million for the nine-month periods ended September 30,2010 and 2009, respectively.

 

Changesin the allowance for loan losses related to loans receivable — other are asfollows:

 
| ** **        | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **        | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **        | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **        | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance |       | $                                    | (1,083     | )                               | $          | (1,548 | ) | $ | — |   | $ | (581 | ) |
| Provisions        |       | —                               |       | —                          |       | (1,083 | ) | (967 | ) |
| Charge-offs       |       | —                               |       | 1,548                           |       | — |   | 1,548 |   |
| Ending Balance    |       | $                                    | (1,083     | )                               | $          | — |   | $ | (1,083 | ) | $ | — |   |

 

AtSeptember 30, 2010, the Company’s recorded investment in impaired andnon-accrual loans receivable — other totaled $6.3 million. The average recordedinvestment in these impaired and non-accrual loans approximated $7.3 millionfor the nine-month period ended September 30, 2010. At September 30,2010, the Company had $1.1 million of allowances specifically related to theseloans.

 

**(6)  Equity Investments**

 

TheCompany has non-marketable equity investments in Acquisition Partnerships andtheir general partners, and non-marketableequity investments in various servicing and operating entities, that areaccounted for under the equity-method of accounting. The 

 

21

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

 

condensedcombined financial position and results of operations of the AcquisitionPartnerships (which include the domestic and foreign Acquisition Partnershipsand their general partners) and the servicing and operating entities(collectively, the “Equity Investees”), are summarized as follows:

 

**Condensed Combined Balance Sheets**

 

| ** **                                             | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                                             | ** ** | **(Dollars in thousands)** | ** ** |
| **Acquisition Partnerships:**                          |       |                                 |       |                  |       |
| Assets                                                 |       | $                                    | 360,058    |                  | $          | 282,999 |   |
| Liabilities                                            |       | $                                    | 62,835     |                  | $          | 97,135 |   |
| Net equity                                             |       | 297,223                              |       | 185,864               |       |
|                                                   |       | $                                    | 360,058    |                  | $          | 282,999 |   |
| **Servicing and operating entities:**                  |       |                                 |       |                  |       |
| Assets                                                 |       | $                                    | 169,302    |                  | $          | 134,384 |   |
| Liabilities                                            |       | $                                    | 97,942     |                  | $          | 79,375 |   |
| Net equity                                             |       | 71,360                               |       | 55,009                |       |
|                                                   |       | $                                    | 169,302    |                  | $          | 134,384 |   |
| **Total:**                                             | ** ** | ** **                           |       |                  |       |
| Assets                                                 |       | $                                    | 529,360    |                  | $          | 417,383 |   |
| Liabilities                                            |       | $                                    | 160,777    |                  | $          | 176,510 |   |
| Net equity                                             |       | 368,583                              |       | 240,873               |       |
|                                                   |       | $                                    | 529,360    |                  | $          | 417,383 |   |
|                                                   |       |                                 |       |                  |       |
| Equity investment in Acquisition Partnerships          |       | $                                    | 53,477     |                  | $          | 41,029 |   |
| Equity investment in servicing and operating  entities |       | 48,047                               |       | 30,462                |       |
|                                                   |       | $                                    | 101,524    |                  | $          | 71,491 |   |

 

**Condensed Combined Summary of Operations**

 

| ** **                                              | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                              | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands)** | ** ** |
| **Acquisition Partnerships:**                           | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                |       | $                                    | 9,554      |                            | $          | 7,191 |   | $ | 24,964 |   | $ | 28,693 |   |
| Costs and expenses                                      |       | 13,774                               |       | 10,476                          |       | 34,052 |   | 27,884 |   |
| Net earnings (loss)                                     |       | $                                    | (4,220     | )                               | $          | (3,285 | ) | $ | (9,088 | ) | $ | 809 |   |
|                                                    |       |                                 |       |                            |       |   |   |   |   |
| **Servicing and operating entities:**                   |       |                                 |       |                            |       |   |   |   |   |
| Revenues                                                |       | $                                    | 39,254     |                            | $          | 21,889 |   | $ | 84,794 |   | $ | 58,760 |   |
| Costs and expenses                                      |       | 22,504                               |       | 19,117                          |       | 56,478 |   | 56,701 |   |
| Net earnings                                            |       | $                                    | 16,750     |                            | $          | 2,772 |   | $ | 28,316 |   | $ | 2,059 |   |
|                                                    |       |                                 |       |                            |       |   |   |   |   |
| Equity in earnings (loss) of Acquisition  Partnerships  |       | $                                    | (1,806     | )                               | $          | (797 | ) | $ | (2,689 | ) | $ | 445 |   |
| Equity in earnings of servicing and operating  entities |       | 11,768                               |       | 1,218                           |       | 16,696 |   | 1,028 |   |
|                                                    |       | $                                    | 9,962      |                            | $          | 421 |   | $ | 14,007 |   | $ | 1,473 |   |

 

InMarch 2010, the Company acquired a controlling interest in three domesticAcquisition Partnerships in which it previously held a noncontrolling interest.In addition, in April 2010, the Company obtained a controlling interest ina coal mine subsidiary in which it previously held a noncontrolling interest.As a result of these transactions, the Acquisition Partnerships and coal minesubsidiary converted from equity-method investments to consolidatedsubsidiaries of the Company. As such, the assets, liabilities and equity of 

 

22

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

 

theseentities are not included in the applicable balance sheet tables above andbelow at September 30, 2010; and their results of operations since therespective transaction dates are not included in the applicable earnings tablesabove and below for the nine-month period ended September 30, 2010. Furthermore,in connection with the activity related to the coal mine subsidiary, theCompany obtained a direct noncontrolling interest in an equipment subsidiarythat was previously wholly-owned and consolidated by the coal mine subsidiary(obtained through a spin-off transaction effected by the coal mine subsidiaryin April 2010). As such, the assets, liabilities and equity of thisequipment subsidiary are included in the applicable balance sheet tables aboveand below at September 30, 2010; and its results of operations since thetransaction date are included in the applicable earnings tables above and belowfor the nine-month period ended September 30, 2010. Refer to Note 3 foradditional information related to these transactions.

 

OnJune 30, 2010, the Company entered into an arrangement with athen-consolidated manufacturing subsidiary that resulted in the Company ceasingto have a controlling interest, but retaining a noncontrolling interest, in theentity. As a result, the manufacturing subsidiary converted to an equity-methodinvestment from a consolidated subsidiary of the Company. As such, the assets,liabilities and equity of this manufacturing subsidiary are included in theapplicable balance sheet tables above and below at September 30, 2010, andits results of operations since the transaction date are included in theapplicable earnings tables above and below for the nine-month period ended September 30,2010. Refer to Note 3 for additional information related to this transaction.

 

AtSeptember 30, 2010 and December 31, 2009, the AcquisitionPartnerships’ total carrying value of loans accounted for under non-accrualmethods of accounting (i.e. cost-recovery or cash basis method) approximated$271.5 million and $180.0 million, respectively.

 

The combined assets andequity of the Equity Investees, and the Company’s carrying value of its equityinvestments in the Equity Investees, are summarized by geographic region below.

 
| ** **                                                        | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                                                        | ** ** | **(Dollars in thousands)** | ** ** |
| Combined assets of the Equity Investees: | ** ** | ** **                           | ** ** | ** **            | ** ** |
| Domestic:                                                         |       |                                 |       |                  |       |
| Acquisition Partnerships                                          |       | $                                    | 177,582    |                  | $          | 58,190 |   |
| Operating entities                                                |       | 62,265                               |       | 31,481                |       |
| Latin America:                                                    |       |                                 |       |                  |       |
| Acquisition Partnerships                                          |       | 130,305                              |       | 139,214               |       |
| Servicing entities                                                |       | 10,298                               |       | 13,328                |       |
| Europe:                                                           |       |                                 |       |                  |       |
| Acquisition Partnerships                                          |       | 52,171                               |       | 85,595                |       |
| Servicing entities                                                |       | 96,739                               |       | 89,575                |       |
|                                                              |       | $                                    | 529,360    |                  | $          | 417,383 |   |

 

23

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 
| ** **                                                                        | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                                        | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                                                                        | ** ** | **(Dollars in thousands)** | ** ** |
| Combined equity of the Equity Investees:                                          |       |                                 |       |                  |       |
| Domestic:                                                                         |       |                                 |       |                  |       |
| Acquisition Partnerships                                                          |       | $                                    | 172,909    |                  | $          | 36,696 |   |
| Operating entities                                                                |       | 22,435                               |       | 5,574                 |       |
| Latin America:                                                                    |       |                                 |       |                  |       |
| Acquisition Partnerships                                                          |       | 110,989                              |       | 115,768               |       |
| Servicing entities                                                                |       | (1,231                               | )          | 427                   |       |
| Europe:                                                                           |       |                                 |       |                  |       |
| Acquisition Partnerships                                                          |       | 13,325                               |       | 33,400                |       |
| Servicing entities                                                                |       | 50,156                               |       | 49,008                |       |
|                                                                              |       | $                                    | 368,583    |                  | $          | 240,873 |   |
|                                                                              |       |                                 |       |                  |       |
| Company’s carrying value of its equity investments  in the Equity Investees: |       |                                 |       |                  |       |
| Domestic:                                                                         |       |                                 |       |                  |       |
| Acquisition Partnerships                                                          |       | $                                    | 33,032     |                  | $          | 13,575 |   |
| Operating entities                                                                |       | 15,048                               |       | 1,659                 |       |
| Latin America:                                                                    |       |                                 |       |                  |       |
| Acquisition Partnerships                                                          |       | 16,205                               |       | 17,532                |       |
| Servicing entities                                                                |       | 1,806                                |       | 2,677                 |       |
| Europe:                                                                           |       |                                 |       |                  |       |
| Acquisition Partnerships                                                          |       | 4,240                                |       | 9,922                 |       |
| Servicing entities                                                                |       | 31,193                               |       | 26,126                |       |
|                                                                              |       | $                                    | 101,524    |                  | $          | 71,491 |   |

 

Revenues and earnings(losses) of the Equity Investees, and the Company’s share of equity in earnings(losses) of those entities, are summarized by geographic region below. Thetables below include individual entities and combined entities under commonmanagement that are considered to be significant subsidiaries of FirstCity at September 30,2010.

 
| ** **                                 | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                 | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Revenues of the Equity Investees:          |       |                                 |       |                            |       |   |   |   |   |
| Domestic:                                  |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                   |       | $                                    | 4,558      |                            | $          | 1,087 |   | $ | 7,168 |   | $ | 5,693 |   |
| FC Crestone Oak LLC (operating entity) (1) |       | 21,374                               |       | 379                             |       | 25,824 |   | 534 |   |
| Other operating entities                   |       | 6,274                                |       | 9,729                           |       | 19,173 |   | 22,767 |   |
| Latin America:                             |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                   |       | 4,666                                |       | 3,805                           |       | 14,990 |   | 9,242 |   |
| Servicing entity                           |       | 2,345                                |       | 2,427                           |       | 6,855 |   | 7,751 |   |
| Europe:                                    |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                   |       | 330                                  |       | 2,299                           |       | 2,806 |   | 13,758 |   |
| MCS et Associes (servicing entity)         |       | 8,420                                |       | 8,116                           |       | 30,326 |   | 23,826 |   |
| Other servicing entities                   |       | 841                                  |       | 1,238                           |       | 2,616 |   | 3,882 |   |
| ** **                                 |       | $                                    | 48,808     |                            | $          | 29,080 |   | $ | 109,758 |   | $ | 87,453 |   |

 

24

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 
| ** **                                                         | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                                         | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                               |       | **(Dollars in thousands)** |       |
| Net earnings (loss) of the Equity Investees:                       |       |                                 |       |                            |       |   |   |   |   |
| Domestic:                                                          |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                                           |       | $                                    | 1,586      |                            | $          | (277 | ) | $ | 2,129 |   | $ | 1,137 |   |
| FC Crestone Oak LLC (operating entity) (1)                         |       | 17,408                               |       | (3                              | )          | 20,236 |   | (347 | ) |
| Other operating entities                                           |       | (1,089                               | )          | 3,325                           |       | 1,352 |   | 3,687 |   |
| Latin America:                                                     |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                                           |       | (2,324                               | )          | (2,015                          | )          | (4,456 | ) | (3,044 | ) |
| Servicing entity                                                   |       | (226                                 | )          | (439                            | )          | (1,676 | ) | (1,374 | ) |
| Europe:                                                            |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                                           |       | (3,481                               | )          | (993                            | )          | (6,761 | ) | 2,716 |   |
| MCS et Associes (servicing entity)                                 |       | 855                                  |       | (20                             | )          | 8,985 |   | 203 |   |
| Other servicing entities                                           |       | (199                                 | )          | (91                             | )          | (581 | ) | (110 | ) |
|                                                               |       | $                                    | 12,530     |                            | $          | (513 | ) | $ | 19,228 |   | $ | 2,868 |   |
|                                                               |       |                                 |       |                            |       |   |   |   |   |
| Company’s equity in earnings (loss) of the Equity  Investees: |       |                                 |       |                            |       |   |   |   |   |
| Domestic:                                                          |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                                           |       | $                                    | (98        | )                               | $          | (300 | ) | $ | (61 | ) | $ | 216 |   |
| FC Crestone Oak LLC (operating entity) (1)                         |       | 12,440                               |       | 19                              |       | 14,293 |   | (3 | ) |
| Other operating entities                                           |       | (1,032                               | )          | 1,445                           |       | (33 | ) | 1,664 |   |
| Latin America:                                                     |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                                           |       | (550                                 | )          | (207                            | )          | (505 | ) | (460 | ) |
| Servicing entity                                                   |       | (113                                 | )          | (220                            | )          | (838 | ) | (687 | ) |
| Europe:                                                            |       |                                 |       |                            |       |   |   |   |   |
| Acquisition Partnerships                                           |       | (1,157                               | )          | (290                            | )          | (2,123 | ) | 689 |   |
| MCS et Associes (servicing entity)                                 |       | 505                                  |       | (11                             | )          | 3,369 |   | 72 |   |
| Other servicing entities                                           |       | (33                                  | )          | (15                             | )          | (95 | ) | (18 | ) |
|                                                               |       | $                                    | 9,962      |                            | $          | 421 |   | $ | 14,007 |   | $ | 1,473 |   |

 

----

(1)          FC Crestone Oak LLC operatesin the prefabricated building manufacturing industry.

 

At September 30, 2010,the Company had $25.6 million in Euro-denominated debt for the purpose ofhedging a portion of the Company’s net equity investments in Europe. Refer to Note 11 for additional information.

 

**(7)  Servicing Assets — SBA Loans**

 

The Company recognizesservicing assets through the sale of originated SBA loans when the rights toservice those loans are retained. Servicing rights resulting from the sale ofloans are initially recognized at fair value at the date of transfer. TheCompany subsequently measures the carrying value of the servicing assets byusing the amortization method, which amortizes the servicing assets inproportion to and over the period of estimated net servicing income, andevaluates servicing assets for impairment based on fair value at each reportingdate. The Company evaluates the possible impairment of servicing assets basedon the difference between the carrying amount and current fair value of theservicing assets. Impairment is charged to servicing fees in the periodrecognized.

 

25

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

 

Changes in the Company’samortized servicing assets are as follows:

 
| ** **                                  | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                  | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                  | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                           |       | $                                    | 949        |                            | $          | 1,001 |   | $ | 1,115 |   | $ | 785 |   |
| Servicing Assets capitalized                |       | 45                                   |       | 97                              |       | 85 |   | 409 |   |
| Servicing Assets amortized                  |       | (51                                  | )          | (59                             | )          | (257 | ) | (155 | ) |
| Ending Balance                              |       | $                                    | 943        |                            | $          | 1,039 |   | $ | 943 |   | $ | 1,039 |   |
| ** **                                  | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Reserve for impairment of servicing assets: |       |                                 |       |                            |       |   |   |   |   |
| Beginning Balance                           |       | $                                    | (73        | )                               | $          | (27 | ) | $ | (59 | ) | $ | (63 | ) |
| Impairments                                 |       | (31                                  | )          | (27                             | )          | (46 | ) | (43 | ) |
| Recoveries                                  |       | —                               |       | —                          |       | 1 |   | 52 |   |
| Ending Balance                              |       | $                                    | (104       | )                               | $          | (54 | ) | $ | (104 | ) | $ | (54 | ) |
|                                        |       |                                 |       |                            |       |   |   |   |   |
| Ending Balance (net of reserve)             |       | $                                    | 839        |                            | $          | 985 |   | $ | 839 |   | $ | 985 |   |
| ** **                                  | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fair value of amortized servicing assets:   |       |                                 |       |                            |       |   |   |   |   |
| Beginning balance                           |       | $                                    | 971        |                            | $          | 974 |   | $ | 1,162 |   | $ | 722 |   |
| Ending balance                              |       | $                                    | 907        |                            | $          | 985 |   | $ | 907 |   | $ | 985 |   |

 

TheCompany relies primarily on a discounted cash flow model to estimate the fairvalue of its servicing assets. This model calculates estimated fair value ofthe servicing assets using significant assumptions including a discount rate of15.0% and prepayment speeds of 14.0% to 15.0% (depending on certaincharacteristics of the related loans). In the event future prepayments aresignificant or impairments are incurred, and future expected cash flows areinadequate to cover the unamortized servicing assets, additional amortizationor impairment charges would be recognized.

 

**(8)  Notes Payable — Senior Credit Facilities with Bank ofScotland plc and BoS(USA), Inc.**

 

OnJune 25, 2010, FirstCity Commercial Corporation (“FC Commercial”) and FHPartners LLC (“FH Partners”), as borrowers, and FLBG Corporation (“FLBG Corp.”),as guarantor, all of which are wholly-owned subsidiaries of FirstCity, and Bankof Scotland and BoS(USA), Inc. (collectively, “Bank of Scotland”), aslenders, entered into a Reducing Note Facility Agreement (“Reducing NoteFacility”). In addition, on June 25, 2010, FirstCity executed a LimitedGuaranty Agreement guarantying payment of the indebtedness under the ReducingNote Facility to a maximum amount of $75.0 million.

 

TheReducing Note Facility amended and restated the following loan facilitiespreviously provided by Bank of Scotland to FirstCity and FH Partners:(a) Revolving Credit Agreement dated November 12, 2004, as amended,to FirstCity ($225.0 million loan facility); (b) Revolving CreditAgreement dated August 26, 2005, as amended, to FH Partners ($100.0million loan facility); and (c) Subordinated Delayed Draw Credit Agreementdated September 5, 2007, as amended, to FirstCity ($25.0 million loan facility)(collectively, “Prior Credit Agreements”). The Prior Credit Agreements wereguaranteed by substantially all of the wholly-owned subsidiaries of FirstCityand secured by substantially all of the assets of FirstCity and its wholly-ownedsubsidiaries. The outstanding indebtedness and letter of credit obligationsunder the Prior Credit Agreements in the amount of $268.6 million wererefinanced into the Reducing Note Facility, which provides for a scheduledamortization over 3 years ($43.6 million in the first year, $80.0 million inthe second year, $60.0 million in the first nine months of the third year, and$85.0 million due on June 25, 2013, the maturity date).

 

Thematerial terms of the Reducing Note Facility and related agreements are asfollows:

 

·                  Limited guaranty provided by FirstCity forthe repayment of the indebtedness under the Reducing Note Facility to a maximumamount of $75.0 million, plus costs of enforcement and certain contingentindemnities;

 

26

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

·                  No advances will be made under the loanfacility, except for draws on outstanding letters of credit in the amount of$22.35 million which are included in the amount of the loan facility ($11.9million was advanced in October 2010 — see discussion below);

·                  Repayment will be made from the cash flowfrom assets and equity investments which were pledged to secure the PriorCredit Agreements;

·                  FirstCity will receive unencumbered cash of20% of the monthly net cash flows (i.e. cash “leak-through”) up to $25.0million, after (a) payment to Bank of Scotland of interest and fees; and(b) payment of a scheduled overhead allowance to FirstCity ServicingCorporation (“FC Servicing”), a wholly-owned subsidiary of FirstCity, of $38.9million over 3 years ($1.5 million per month for the first year, $1.03 millionper month for the second year, and $0.7 million per month for the third year);

·                  Fluctuating interest rate equal to, at FCCommercial’s option, either (a) the greater of (i) one month *London Interbank Offering Rate*(“LIBOR”)plus 3.5% (subject to LIBOR floor of 1.0%) or (ii) 4.5%, or (b) Bankof Scotland’s prime rate plus 3.0%;

·                  FC Commercial and FH Partners may designate aportion of the debt under the Reducing Note Facility to be borrowed in Euros upto a maximum amount of Euros equivalent to USD $27.5 million; and

·                  FirstCity must maintain a minimum tangiblenet worth (as defined) requirement of $60.0 million.

 

Feespaid to Bank of Scotland in connection with the Reducing Note Facility through September 30,2010 totaled $1.85 million, with $683,000 paid in March 2010 (inconnection with an extension of the Prior Credit Facilities), $675,000 paid in June 2010,and $501,000 paid from July to September 2010. A final loan feepayment of $167,000 was made in October 2010.

 

TheReducing Note Facility is guaranteed by FLBG Corp. and all of its subsidiaries(“Covered Entities”), which represent the entities that were subject to theobligations of the Prior Credit Facilities other than FirstCity and FCServicing. The Reducing Note Facility is secured by substantially all of theassets of the Covered Entities. FC Investment Holdings Corporation (anewly-formed wholly-owned subsidiary of FirstCity) and its current and futuresubsidiaries, or other entities in which such subsidiaries own any equityinterest (“Non-Covered Entities”), are not subject to, do not guarantee and donot provide security interests in their assets to secure the Reducing NoteFacility. FC Servicing only provides a non-recourse security interest incertain equity interests owned by it and in most of the servicing fees frompreviously-existing agreements which secured the Prior Credit Facilities. FCServicing does not provide a security interest in servicing agreements enteredinto with the Non-Covered Entities or in any of its other assets and does notguarantee the Reducing Note Facility.

 

TheReducing Note Facility contains covenants, representations and warranties onthe part of FLBG Corp., FC Commercial and FH Partners that are typical fortransactions of this type. In addition, the Reducing Note Facility containscustomary events of default, including failure to make required payments,failure to comply with certain agreements or covenants, failure to pay, ordefault under, certain other indebtedness, certain events of bankruptcy andinsolvency, and failure to pay certain judgments. In the event that an event ofdefault occurs and is continuing, Bank of Scotland may accelerate theindebtedness under the Reducing Note Facility.

 

AtSeptember 30, 2010, the unpaid principal balance on this loan facility was$227.9 million. In October 2010, a letter of credit under the ReducingNote Facility was funded in the amount of $11.9 million, and the proceeds wereused to pay-off a bank note payable that was owed by an affiliated Mexicanentity of the Company (see Note 19). The entire amount of the funded letter ofcredit was added to the unpaid principal obligation under the terms andconditions of the Reducing Note Facility.

 

**(9)  Stockholders’ Equity**

 

OnJune 29, 2010, the Company issued and sold 150,000 shares of its commonstock to an accredited investor pursuant to a securities purchase agreement ata price of $5.93 per share, resulting in aggregate proceeds of $0.9 million.

 

**(10)  Accumulated Other Comprehensive Income (Loss)**

 

Accumulated other comprehensive income (loss) iscomposed of the following as of September 30, 2010 and December 31,2009:

 

27

----

** **

**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 
| ** **                                                 | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Cumulative foreign currency translation  adjustments       |       | $                                    | (2,903     | )                     | $          | 956 |   |
| Net unrealized gains on securities available for  sale (1) |       | 36                                   |       | 2,504                 |       |
| Total accumulated other comprehensive income  (loss)       |       | $                                    | (2,867     | )                     | $          | 3,460 |   |

 

----

(1)          Includes$0.5 million and $1.4 million at September 30, 2010 and December 31,2009, respectively, attributable to FirstCity’s proportionate share of netunrealized gains recorded by an investee accounted for under the equity-methodof accounting.

 

**(11)  Foreign Currency ExchangeRisk Management**

 

We use Euro-denominated debtas a non-derivative financial instrument to partially off-set the Company’sbusiness exposure to foreign currency exchange risk attributable to our netinvestments in Europe. Our focus is to manage the economic risks associatedwith our European subsidiaries, which are the foreign currency exchange risksthat will ultimately be realized when we exchange one currency for another. Tohelp protect the Company’s net investment in certain of its European subsidiaryoperations from adverse changes in foreign currency exchange rates, wedenominate a portion of our debt in the same functional currency used by theEuropean subsidiaries. At September 30, 2010, the Company carried $25.6million in Euro-denominated debt and designated the debt as a non-derivativehedge of its net investment in certain European subsidiaries. The Companydesignated the hedging relationship such that changes in the net investmentsbeing hedged are expected to be naturally off-set by corresponding changes inthe value of the Euro-denominated debt. We consider our investments in Europeansubsidiaries to be denominated in a relatively stable currency and of along-term nature.

 

The effective portion of thenet foreign investment hedge is reported in accumulated other comprehensiveincome (loss) as part of the cumulative translation adjustment. Any ineffectiveportion of the net foreign investment hedge is recognized in earnings as otherincome (expense) during the period of change. Effectiveness of the hedgingrelationship is measured and designated at the beginning of each month bycomparing the outstanding balance of the Euro-denominated debt to the carryingvalue of the designated net equity investments.

 

At September 30, 2010and December 31, 2009, the carrying value and line item caption of theCompany’s non-derivative instrument was reported on the consolidated balancesheets as follows (in thousands):

 
| **Non-Derivative**            | ** ** | ** **             | ** ** | ** **                       | ** ** | ** **                      | ** ** |
|-------------------------------|------------|------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **Instrument in**        | ** ** | ** **             | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| **Net Investment**       | ** ** | **Balance Sheet** | ** ** | **Carrying Value at:** | ** ** |
| **Hedging Relationship** | ** ** | **Location**           | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|                          |       |                   |       |                             |       |                            |       |
| Euro-denominated debt         |       | Notes payable to banks |       | $                                | 25,578     |                            | $          | 24,824 |   |
|                               |            |                        |            |                                  |            |                                 |            |  |  |

 

28

----

** **

**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

The effect of thenon-derivative instrument qualifying and designated as a hedging instrument innet foreign investment hedges on the consolidated financial statements for thethree- and nine-month month periods ended September 30, 2010 and 2009 wasas follows (in thousands):

 
| ** **                    | ** ** | ** **                               | ** ** | ** **                                 | ** ** | ** **                             | ** ** | **Amount of Gain (Loss)** | ** ** |
|-------------------------------|------------|------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | ** **                               | ** ** | ** **                                 | ** ** | ** **                             | ** ** | **Recognized in Income**       | ** ** |
| ** **                    | ** ** | **Amount of Gain (Loss)** | ** ** | ** **                                 | ** ** | **(Ineffective Portion and** | ** ** |
| ** **                    | ** ** | **Recognized in AOCI**         | ** ** | ** **                                 | ** ** | **Amount Excluded from**     | ** ** |
| **Non-Derivative**            | ** ** | **(Effective Portion)**             | ** ** | **Location of Gain (Loss)** | ** ** | **Effectiveness Testing)**        | ** ** |
| **Instrument in**        | ** ** | **Three Months Ended**         | ** ** | **Reclassified from**                 | ** ** | **Three Months Ended**       | ** ** |
| **Net Investment**       | ** ** | **September 30,**                   | ** ** | **AOCI into Income**             | ** ** | **September 30,**                 | ** ** |
| **Hedging Relationship** | ** ** | **2010**                                 | ** ** | **2009**                                   | ** ** | **(Effective Portion)**           | ** ** | **2010**                                 | ** ** | **2009** | ** ** |
|                          |       |                                     |       |                                       |       |                                   |       |                                     |       |   |   |
| Euro-denominated debt         |       | $                                        | (2,665     | )                                          | $          | (857                                   | )          | Other income (expense)                   |       | $ | — |   | $ | — |   |
|                               |            |                                          |            |                                            |            |                                        |            |                                          |            |  |  |  |  |  |  |

 
| ** **                    | ** ** | ** **                               | ** ** | ** **                                 | ** ** | ** **                             | ** ** | ** **                               | ** ** |
|-------------------------------|------------|------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | ** **                               | ** ** | ** **                                 | ** ** | ** **                             | ** ** | **Amount of Gain (Loss)** | ** ** |
| ** **                    | ** ** | ** **                               | ** ** | ** **                                 | ** ** | ** **                             | ** ** | **Recognized in Income**       | ** ** |
| ** **                    | ** ** | **Amount of Gain (Loss)** | ** ** | ** **                                 | ** ** | **(Ineffective Portion and** | ** ** |
| ** **                    | ** ** | **Recognized in AOCI**         | ** ** | ** **                                 | ** ** | **Amount Excluded from**     | ** ** |
| **Non-Derivative**            | ** ** | **(Effective Portion)**             | ** ** | **Location of Gain (Loss)** | ** ** | **Effectiveness Testing)**        | ** ** |
| **Instrument in**        | ** ** | **Nine Months Ended**          | ** ** | **Reclassified from**                 | ** ** | **Nine Months Ended**        | ** ** |
| **Net Investment**       | ** ** | **September 30,**                   | ** ** | **AOCI into Income**             | ** ** | **September 30,**                 | ** ** |
| **Hedging Relationship** | ** ** | **2010**                                 | ** ** | **2009**                                   | ** ** | **(Effective Portion)**           | ** ** | **2010**                                 | ** ** | **2009** | ** ** |
|                          |       |                                     |       |                                       |       |                                   |       |                                     |       |   |   |
| Euro-denominated debt         |       | $                                        | 726        |                                       | $          | (598                                   | )          | Other income (expense)                   |       | $ | — |   | $ | — |   |
|                               |            |                                          |            |                                            |            |                                        |            |                                          |            |  |  |  |  |  |  |

 

**(12)  Income Taxes**

 

Weare subject to income taxes in both the United States and thenon-U.S. jurisdictions in which we operate. Income tax expense for thethree- and nine-month periods ended September 30, 2010 and 2009 iscomposed of the following components:

 
| ** **                                    | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                    | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                    | ** ** | **(Dollars in thousands)** | ** ** |
| State current income tax expense (benefit)    |       | $                                    | (28        | )                               | $          | (141 | ) | $ | 516 |   | $ | 408 |   |
| Federal current income tax benefit            |       | (171                                 | )          | —                          |       | — |   | — |   |
| Foreign current income tax expense            |       | 378                                  |       | 1,357                           |       | 963 |   | 1,559 |   |
| Foreign deferred income tax expense (benefit) |       | 294                                  |       | 38                              |       | (287 | ) | 136 |   |
| Total                                         |       | $                                    | 473        |                            | $          | 1,254 |   | $ | 1,192 |   | $ | 2,103 |   |

 

The Company recognizes deferredtax assets and liabilities in both the U.S. and foreign jurisdictions based onthe future tax consequences attributable to temporary differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases, and for net operating loss and tax creditcarryforwards. The Company’s deferred tax assets, net of valuation allowances,totaled $0.4 million at September 30, 2010 (included in “Other assets” inour consolidated balance sheet). The net deferred tax asset at September 30,2010 relates to our recognition of foreign tax benefits associated with U.S.GAAP adjustments to a consolidated foreign subsidiary’s local financialstatements, combined with the timing of income tax payments made by the foreignsubsidiary in its local jurisdiction. The recognition of these foreign taxbenefits is not dependent upon future taxable income in the subsidiary’sforeign jurisdiction, but rather upon reversal of the U.S. GAAP adjustments infuture periods.

 

The Company also has asubstantial amount of domestic deferred tax assets attributable primarily tonet operating loss and capital loss carryforwards for U.S. federal income taxpurposes, and differences between the carrying amounts and the tax bases ofAcquisition Partnership investments. At September 30, 2010 and December 31,2009, the Company established a full valuation

 

29

----

 

**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

allowance for its U.S.deferred tax assets due to the lack of sufficient objective evidence regardingthe realization of these assets in the foreseeable future. We will continue toevaluate the deferred tax asset valuation allowance balances in all of ourU.S. and foreign subsidiaries throughout 2010 to determine the appropriatelevel of valuation allowances.

 

**(13)  Stock-Based Compensation**

 

Accounting for stock-basedcompensation requires that the cost resulting from all stock-based payments berecognized in the financial statements based on the grant-date fair value ofthe award. The Company’s stock-based compensation expense consists of stockoptions and restricted stock awards (2010 only). We recognized stock-basedcompensation cost of approximately $0.2 million and $0.5 million for the three-and nine-month periods ended September 30, 2010, respectively, and $0.3million and $0.4 million for the three- and nine-month periods ended September 302009, respectively.

 

*Stock Options*

 

A summary of the Company’sstock options and related activity as of and for the nine months ended September 30,2010 is presented below:

 
| ** **                                     | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **              | ** ** |
|------------------------------------------------|------------|------------|------------|--------------|------------|-----------------|------------|-------------------------|------------|
| ** **                                     | ** ** | ** ** | ** ** | ** **   | ** ** | **Average**     | ** ** | ** **              | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Remaining**   | ** ** | ** **              | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | **Average**  | ** ** | **Contractual** | ** ** | **Aggregate**           | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Term**        | ** ** | **Intrinsic**           | ** ** |
| ** **                                     | ** ** | **Shares** | ** ** | **Price**    | ** ** | **(Years)**     | ** ** | **Value**               | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** **   | ** ** | ** **      | ** ** | **(in thousands)** | ** ** |
| Options outstanding at January 1, 2010    |       | 921,400    |       | $            | 7.10       |            |       |                    |       |   |
| Granted                                        |       | —     |       | —       |       |            |       |                    |       |
| Exercised                                      |       | (35,500    | )          | 2.00         |       |            |       |                    |       |
| Expired                                        |       | (31,000    | )          | 9.09         |       |            |       |                    |       |
| Forfeited                                      |       | —     |       | —       |       |            |       |                    |       |
| Options outstanding at September 30, 2010 |       | 854,900    |       | $            | 7.24       |            | 5.92       |                    | $          | 1,250 |   |
| Options exercisable at September 30, 2010 |       | 602,900    |       | $            | 7.13       |            | 4.83       |                    | $          | 1,025 |   |

 

The total intrinsic value ofstock options exercised during the nine-month period ended September 30,2010 was $0.2 million. As of September 30, 2010, there was approximately$1.2 million of total unrecognized compensation cost related to unvested stockoptions. That cost is expected to be recognized over a weighted average periodof 2.6 years.

 

*Restricted Stock Awards*

 

In February 2010, theCompany granted 28,890 restricted stock awards that vest in one installment onthe first anniversary of the date of grant. The grant-date fair value of eachaward was $5.97 — which was based on the grant-date fair value of our commonstock. Holders of the restricted stock awards have voting rights, and vestingof the grants is based on their continued service. Sales of the restrictedstock are prohibited until the awards vest. At September 30, 2010, theCompany had 28,890 outstanding, unvested restricted stock awards with totalunrecognized compensation cost of $0.1 million to be recognized over a weightedaverage period of 0.2 years.

 

**(14)  Net Earnings per CommonShare**

 

Earnings per share (“EPS”)is presented for both basic EPS and diluted EPS. We compute basic EPS bydividing net earnings available to common stockholders by the weighted-averagenumber of common shares outstanding during the year. Diluted EPS is computed bydividing net earnings available to common stockholders by the weighted-averagenumber of common shares outstanding during the year, plus the dilutive effectof common stock equivalents such as stock options and warrants. We excludethese common stock equivalents from the computation of diluted EPS when theeffect of inclusion would be anti-dilutive.

 

30

----

 

**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

Basic and diluted netearnings per common share were computed as follows:

 
| ** **                                                                        | ** ** | **Three Months Ended**                                                | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                        | ** ** | **September 30,**                                                          | ** ** | **September 30,**          | ** ** |
| ** **                                                                        | ** ** | **2010**                                                                        | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                        | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| ** **                                                                        | ** ** | ** **                                                                      | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net earnings                                                                      |       | $                                                                               | 5,326      |                            | $          | 3,588 |   | 20,908 |   | 13,557 |   |
| Less: net income attributable to the noncontrolling  interest                     |       | 2,767                                                                           |       | 1,588                           |       | 10,183 |   | 3,167 |   |
| Net earnings attributable to FirstCity                                            |       | $                                                                               | 2,559      |                            | $          | 2,000 |   | $ | 10,725 |   | $ | 10,390 |   |
|                                                                              |       |                                                                            |       |                            |       |   |   |   |   |
| Weighted average outstanding shares of common  stock (in thousands)               |       | 10,160                                                                          |       | 9,838                           |       | 10,054 |   | 9,834 |   |
| Dilutive effect of:                                                               |       |                                                                            |       |                            |       |   |   |   |   |
| Warrants                                                                          |       | —                                                                          |       | 276                             |       | — |   | 194 |   |
| Dilutive effect of stock options                                                  |       | 120                                                                             |       | 211                             |       | 108 |   | 132 |   |
| Weighted average outstanding shares of common  stock and common stock equivalents |       | 10,280                                                                          |       | 10,325                          |       | 10,162 |   | 10,160 |   |
|                                                                              |       |                                                                            |       |                            |       |   |   |   |   |
| Net earnings per share:                                                           |       |                                                                            |       |                            |       |   |   |   |   |
| Basic                                                                             |       | $                                                                               | 0.25       |                            | $          | 0.20 |   | $ | 1.07 |   | $ | 1.06 |   |
| Diluted                                                                           |       | $                                                                               | 0.25       |                            | $          | 0.19 |   | $ | 1.06 |   | $ | 1.02 |   |

 

**(15)  Fair Value**

 

Fair Value Measurements

 

Thefair value of an asset or liability is the price that would be received to sellthat asset or paid to transfer that liability in an orderly transactionoccurring in the principal market (or most advantageous market in the absenceof a principal market) for such asset or liability. In estimating fair value,the Company utilizes valuation techniques that are consistent with the marketapproach, the income approach and/or the cost approach. Such valuationtechniques are consistently applied. Inputs to valuation techniques include theassumptions that market participants would use in pricing an asset orliability. The accounting guidance on fair value measurements establishes afair value hierarchy that prioritizes the inputs to valuation techniques tomeasure fair value. The hierarchy gives the highest priority to unadjustedquoted prices in active markets for identical assets or liabilities (Level 1measurements) and the lowest priority to measurements involving significantunobservable inputs (Level 3 measurements). The three levels of the fair valuehierarchy are described below:

 

·                  Level 1 — Valuations are based upon quotedprices (unadjusted) in active exchange markets involving identical assets andliabilities that the Company has the ability to access at the measurement date.

 

·                  Level 2 — Observable inputs other than Level1 prices, such as quoted prices for similar instruments in active markets;quoted prices and valuations for identical or similar instruments in marketsthat are not active; and model-based valuation techniques with significantassumptions and inputs that are observable in the market or can be derivedprincipally from or corroborated by observable market data.

 

·                  Level 3 — Valuations are derived frommodel-based techniques that use inputs and significant assumptions that aresupported by little or no observable market data. These unobservableassumptions reflect estimates of assumptions that market participants would usein pricing the asset or liability. Valuation techniques include the use ofpricing models, discounted cash flow models and similar techniques.

 

Thelevel of fair value hierarchy within which a fair value measurement in itsentirety falls is based on the lowest level input that is most-significant tothe fair value measurement in its entirety.

 

31

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

*Assets Measured at Fair Value on a Recurring Basis*

 

Thetable below presents the Company’s balances of assets measured at fair value ona recurring basis at September 30, 2010 and December 31, 2009. TheCompany did not have any liabilities that were measured at fair value on arecurring basis at September 30, 2010 and December 31, 2009.

 
| ** **                                | ** ** | **At September 30, 2010** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| **(Dollars in thousands)**      | ** ** | **Level 1**                         | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Investment securities available for sale: |       |                                     |       |   |   |   |   |   |   |
| Marketable equity security                |       | $                                        | 268        |   | — |   | — |   | $ | 268 |   |
| Asset-backed security                     |       | —                                   |       | — |   | 1,921 |   | 1,921 |   |
|                                      |       | $                                        | 268        |   | — |   | 1,921 |   | $ | 2,189 |   |
| ** **                                | ** ** | ** **                               | ** ** |
| ** **                                | ** ** | **At December 31, 2009**  | ** ** |
| **(Dollars in thousands)**      | ** ** | **Level 1**                         | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Investment security available for sale:   |       |                                     |       |   |   |   |   |   |   |
| Asset-backed security                     |       | $                                        | —     |   | — |   | 1,836 |   | $ | 1,836 |   |

 

TheCompany measures fair value for its asset-backed securities using discountedcash flow models based on assumptions and inputs that are corroborated bylittle or no observable market data (Level 3 measurement). The Company usesthis measurement technique because pricing information and market-participantassumptions for its asset-backed securities are not readily accessible andfrequently released to the public. At September 30, 2010 and December 31,2009, the carrying value of the Company’s asset-backed securities (at fairvalue) approximated $1.9 million and $1.8 million, respectively. The tablebelow summarizes the changes to these Level 3 assets measured at fair value ona recurring basis for the three- and nine-month periods ended September 30,2010 and 2009, respectively:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(Dollars in thousands)**                  | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| Balance, beginning of period                          |       | $                                | 692        |                            | $          | 2,993 |   | $ | 1,836 |   | $ | 5,251 |   |
| Total net gains (losses) for the period included  in: |       |                             |       |                            |       |   |   |   |   |
| Net income                                            |       | —                           |       | —                          |       | 3,250 |   | — |   |
| Other comprehensive income (loss)                     |       | —                           |       | (10                             | )          | (1,115 | ) | (26 | ) |
| Purchases, sales, issuances and settlements, net      |       | 1,211                            |       | (1,228                          | )          | (2,049 | ) | (3,470 | ) |
| Foreign currency translation adjustments              |       | 18                               |       | —                          |       | (1 | ) | — |   |
| Net transfers into Level 3                            |       | —                           |       | —                          |       | — |   | — |   |
| Balance, end of period                                |       | $                                | 1,921      |                            | $          | 1,755 |   | $ | 1,921 |   | $ | 1,755 |   |

 

Therewere no transfers of assets or liabilities recorded at fair value on arecurring basis into or out of Level 3 fair value measurements during thethree- or nine-month periods ended September 30, 2010 and 2009.

 

*Assets Measured at Fair Value on a Non-Recurring Basis*

 

TheCompany may be required, from time to time, to measure certain financial andnon-financial assets at fair value on a non-recurring basis. These adjustmentsto fair value generally result from write-downs of financial and non-financialassets as a result of impairment or application of lower-of-cost or fair valueaccounting. For assets measured at fair value on a non-recurring basis thatwere still on the Company’s consolidated balance sheet at September 30,2010 and December 31, 2009, the following table provides the fair valuehierarchy and the carrying value of the related individual assets at eachrespective period end:

 

32

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 
| ** **                                          | ** ** | **Carrying Value at September 30, 2010** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| **(Dollars in thousands)**                | ** ** | **Level 1**                                                  | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Portfolio Assets - loans (1)                        |       | $                                                                 | —     |   | $ | — |   | $ | 504 |   | $ | 504 |   |
| Loans receivable - SBA held for investment (1) |       | —                                                            |       | — |   | 563 |   | 563 |   |
| Loans receivable - other (1)                        |       | —                                                            |       | — |   | 1,917 |   | 1,917 |   |
| Real estate held for sale (2)                       |       | —                                                            |       | 13,563 |   | — |   | 13,563 |   |
| Real estate held for investment                     |       | —                                                            |       | 7,095 |   | — |   | 7,095 |   |
|                                                |       |                                                              |       |   |   |   |   |   |   |
| ** **                                          | ** ** | **Carrying Value at December 31, 2009**  | ** ** |
| **(Dollars in thousands)**                | ** ** | **Level 1**                                                  | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Portfolio Assets - loans (1)                        |       | $                                                                 | —     |   | $ | — |   | $ | 12,460 |   | $ | 12,460 |   |
| Loans receivable - SBA held for investment (1)      |       | —                                                            |       | — |   | 829 |   | 829 |   |
| Real estate held for sale (2)                       |       | —                                                            |       | 7,231 |   | — |   | 7,231 |   |

 

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(1)   Represents the carryingvalue of impaired loans that were measured for impairment using the estimatedfair value of the collateral for collateral-dependent loans.

(2)   Represents the carryingvalue of foreclosed real estate properties that were impaired and measured atfair value subsequent to their initial classification as foreclosed assets.

 

Thefollowing table presents the decrease in value of certain assets held at therespective period end that were measured at fair value on a non-recurring basisfor which a fair value adjustment was included in the Company’s results ofoperations during the respective period:

 
| ** **                                     | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------|------------|---------------------------------|------------|
| ** **                                     | ** ** | **September 30,**          | ** ** |
| **(Dollars in thousands)**           | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| Portfolio Assets - loans (1)                   |       | $                               | (519       | ) | $ | (1,007 | ) |
| Loans receivable - SBA held for investment (1) |       | (215                            | )          | (430 | ) |
| Loans receivable - other (1)                   |       | (1,168                          | )          | — |   |
| Real estate held for sale (2)                  |       | (2,079                          | )          | (583 | ) |
| Real estate held for investment                |       | (1,922                          | )          | — |   |
| Total                                          |       | $                               | (5,903     | ) | $ | (2,020 | ) |

 

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(1)   Represents write-downs ofloans based on the estimated fair value of the collateral forcollateral-dependent loans.

(2)   Represents losses onforeclosed real estate properties that were measured at fair value subsequentto their initial classification as foreclosed assets.

 

Thefair values of “Portfolio Assets — loans,” “Loans receivable — SBA held forinvestment” and “Loans receivable — other,” as measured on a non-recurringbasis, are based on collateral valuations using observable and unobservableinputs, adjusted for various considerations such as market conditions, economicand competitive environment, and other assets with similar characteristics(i.e. type, location, etc.) that, in management’s opinion, reflectelements a market participant would consider. The Company classifies its fairvalue measurement techniques for these assets as Level 3 inputs for thefollowing reasons: (1) distressed asset transactions generally occur ininactive markets for which observable market prices are not readily available(i.e. price quotations vary substantially over time and among market-makers,and pricing information is generally not released to the public); and (2) theCompany’s valuation techniques that are most-significant to the fair valuemeasurements are principally derived from assumptions and inputs that arecorroborated by little or no observable market data.

 

Thefair values of “Real estate held for sale” and “Real estate held forinvestment,” as measured on a non-recurring basis, are generally based oncollateral valuations using observable inputs.

 

Weattempt to base our fair values on the price that would be received to sell anasset in an orderly transaction between market participants at the measurementdate. It is our policy to maximize the use of observable inputs, when reasonablyavailable and without undue cost, and minimize the use of unobservable inputswhen developing fair value measurements in accordance with the fair valuehierarchy. Fair value measurements for assets where there exists limited or noobservable market data and, therefore, are based principally on our ownestimates and assumptions, are often calculated based on collateral valuationsadjusted for the economic and

 

33

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

competitiveenvironment, the characteristics of the asset, and other such factors.Additionally, there may be inherent weaknesses in any valuation technique, andchanges in the underlying assumptions used, including discount rates andestimates of future cash flows, that could significantly affect the results ofcurrent or future values.

 

Estimated Fair Values ofFinancial Instruments Not Recorded at Fair Value in their Entirety on a RecurringBasis

 

In addition to the methodsand assumptions we use to measure the fair value of financial instruments asdiscussed in the section above, we used the following methods and assumptionsto estimate the fair value of our financial instruments that are not recordedat fair value in their entirety on a recurring basis in the Company’sconsolidated balance sheets. The fair value estimates were based on pertinentinformation that was available to management as of the respective dates. Thefair value estimates have not been revalued for purposes of these financialstatements since those dates and, therefore, current estimates of fair valuemay differ significantly from the amounts presented. The amounts providedherein are estimates of the exchange price that would be received to sell anasset or paid to transfer a liability in an orderly transaction (i.e. not aforced transaction, such as liquidation or distressed sale). Because activemarkets do not exist for a significant portion of the Company’s financialinstruments, management used present value techniques and other valuationmodels to estimate the fair values of its financial instruments. Thesevaluation methods require considerable judgment, and the resulting estimates offair value can be significantly affected by the assumptions made and methodsused. Accordingly, the estimates provided herein do not necessarily indicateamounts which could be realized in a current exchange. The Company believes theimprecision of an estimate could be significant.

 

***Cash and Cash Equivalents: ***The carryingamount of cash and cash equivalents approximated fair value at September 30,2010 and December 31, 2009.

 

***Loans ReceivableHeld-for-Sale: ***Loansheld-for-sale (primarily SBA loans held-for-sale) are carried on the Company’sconsolidated balance sheet at the lower of cost or fair value. The fair valueof loans held-for-sale is generally based on what secondary markets arecurrently offering for loans with similar characteristics, or prices of theCompany’s SBA loan transactions that were previously consummated and pendingsales accounting treatment. At September 30, 2010 and December 31,2009, the carrying amount of loans held-for-sale approximated $8.3 million and$0.8 million, respectively, and the estimated fair values approximated $9.2million and $0.9 million, respectively.

 

***Loan Portfolio Assets and Loans Receivable: ***Estimated fair values of loan Portfolio Assets andfixed-rate loans receivable are generally determined using a discounted cashflow model, adjusted by an amount for estimated losses, that employs marketdiscount rates and other adjustments that would be expected to be made by amarket participant. The estimated fair value for variable-rate loans thatre-price frequently is based on carrying values adjusted for estimated creditlosses and other adjustments that would be expected to be made by a marketparticipant. The estimated fair value for impaired loans is generally based on collateralvaluations using observable and unobservable inputs, adjusted for variousconsiderations thatwould be expected to be made by a market participant; or discounted cashflow models that employ market discount rates and other adjustments that would be expected tobe made by a market participant. Management’s estimates and assumptionsregarding credit risk, cash flows and discount rates are judgmentallydetermined using available market and specific borrower information. At September 30,2010 and December 31, 2009, the carrying amounts of Portfolio Assets —loans and loans receivable (including accrued interest) approximated $226.6million and $253.0 million, respectively, and the estimated fair valuesapproximated $343.6 million and $371.1 million, respectively.

 

***Servicing Assets: ***The fair valueof servicing assets is based on a combination of a discounted cash flow modelof future net servicing income and analysis of current market data to estimatethe fair value of our servicing assets. The key assumptions used to calculateestimated fair value of the servicing assets include prepayment speeds anddiscount rate. The fair value estimate excludes the value of servicing rightsfor loans sold with premium recourse provisions in which the servicing rightshave not been capitalized. See Note 7 for the carrying amount and estimatedfair values of servicing assets as of September 30, 2010 and December 31,2009.

 

***Notes Payable: ***Management believes theinterest rates and terms on its debt obligations approximate the rates andterms currently offered by other lenders for similar debt instruments ofcomparable terms. As such, management believes that the carrying amount ofnotes payable approximates fair value at September 30, 2010 and December 31,2009.

 

***Note Payable to Affiliate: ***Estimated fair value of the Company’s notepayable to affiliate (including related interest payable) is based on thepresent value of future projected cash flows using a discount rate thatreflects the risks inherent in those cash flows. At September 30, 2010and December 31, 2009, the carrying amount of the note and interest payable to affiliate was$11.3 million and $10.3 million, respectively, and the estimated fair valuesapproximated $7.5 million and $6.5 million, respectively.

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

**(16)****  Variable Interest Entities**

 

In the normal course ofbusiness, the Company enters into various types of on- and off-balance sheettransactions with entities that involve variable interests. Variable interestsare generally defined as contractual, ownership or other economic interests inan entity that change with fluctuations in the entity’s net asset value. Ifcertain characteristics are present in these transactions, the entity issubject to a variable interests consolidation analysis, and consolidation isbased on variable interests, and not solely on ownership of the entity’soutstanding voting stock. In making the determination as to whether an entityis considered to be a variable interest entity (“VIE”), we first perform aqualitative analysis, which requires certain subjective decisions regarding ourassessments, including, but not limited to, the design of the entity, thevariability that the entity was designed to create and pass along to itsinterest holders, the rights of the parties, and the purpose of thearrangement. If we cannot conclude after a qualitative analysis whether anentity is a VIE, we perform a quantitative analysis.

 

If an entity is determinedto be a VIE, we determine if our variable interest causes us to be consideredthe primary beneficiary. We are the primary beneficiary and are required toconsolidate the entity if we have the power to direct the activities of the VIEthat most-significantly impact the entity’s economic performance and we havethe obligation to absorb losses or the right to receive returns that could besignificant to the entity. The assessment of the party that has the power todirect the activities of the VIE may require significant management judgmentwhen more than one party has power, or more than one party is involved in thedesign of the VIE but no party has the power to direct the ongoing activitiesthat could be significant. We are required to continually assess whether we arethe primary beneficiary and, therefore, may consolidate a VIE through theduration of our involvement.

 

The following provides asummary for which the Company has entered into significant transactions withdifferent types of VIEs:

 

Acquisition Partnership VIEs — The Companyis involved with Acquisition Partnerships that were formed with one or moreinvestors to invest in Portfolio Assets. These Acquisition Partnerships aretypically financed through debt and/or equity provided by the investors (includingFirstCity). Certain of these Acquisition Partnerships are VIEs becausegenerally they do not have sufficient equity to finance their activitieswithout additional subordinated financial support, or the investors do not havethe ability to make significant decisions about the Acquisition Partnership’sactivities. The voting interests for all but three of the AcquisitionPartnership VIEs are either wholly-owned or majority-owned by non-affiliatedinvestors, and the Company determined that it was not the primary beneficiaryof these minority-owned Acquisition Partnership VIEs. However, the Company isdeemed to be the primary beneficiary for three Acquisition Partnership VIEs inwhich the Company and respective non-affiliated investors each hold equal ownershipand voting interests. The investors and third-party creditors, includingFirstCity, generally have recourse only to the extent of the assets held by theAcquisition Partnership VIEs. Certain third-party creditors have recourse toboth FirstCity and the non-affiliated investors where we jointly provide aguaranty to the Acquisition Partnership VIE. The Company does not generallyprovide financial support to any Acquisition Partnership VIE beyond that whichis contractually required, but may provide additional liquidity alongside thenon-affiliated investors to fund additional investments.

 

Operating Entity VIEs — The Companyhas significant variable interests with various commercial enterprise entities(attributable primarily to certain equity and debt investments made byFirstCity Denver — our Special Situations Platform business). FirstCityprovided financing in the form of debt and/or equity to help finance theactivities of the Operating Entity VIEs. These Operating Entities are VIEsbecause generally they do not have sufficient equity to finance theiractivities without additional subordinated financial support. The votinginterests for all of the Operating Entity VIEs are either wholly-owned ormajority-owned by non-affiliated investors, and the Company determined that itwas not the primary beneficiary of these minority-owned Operating Entity VIEs.The investors and creditors, including FirstCity, generally have recourse onlyto the extent of the assets held by the Operating Entity VIEs. The Company doesnot generally provide financial support to any Operating Entity VIE beyond thatwhich is contractually required.

 

Special-Purpose InvestmentEntity VIEs — The Company has significant variable interestswith special-purpose investment entities that were created to invest inPortfolio Assets, debt and equity investments, and various other types ofinvestments. Certain of these special-purpose investment entities are VIEsbecause they do not have sufficient equity to finance their activities without additionalsubordinated financial support. The Company owns all of the voting and equityinterests in the Special-Purpose Investment Entity VIEs, and the Company wasdetermined to be the primary beneficiary of these entities. A third-party creditor has recourse toFirstCity up to $75.0 million under a limited guaranty provision related to thedebt of these entities, which is collateralized by their assets, only to theextent that such pledged assets of the Special-Purpose Investment Entity VIEsdo not generate sufficient cash to service and

 

35

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

repaythe debt (see Note 8). The Company does not generally provide financialsupport to the Special-Purpose Investment Entity VIEs beyond that which iscontractually required.

 

The following table displaysthe carrying amount and classification of assets and liabilities of the Company’sconsolidated VIEs, for which the Company does not hold a majority votinginterest, that are included in its consolidated balance sheet as of September 30,2010. We record third-party ownership in these consolidated VIEs in “Noncontrollinginterests” in our consolidated balance sheet.

 
| ** **                             | ** ** | **Acquisition**                  | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| ** **                             | ** ** | **Partnership VIEs**        | ** ** |
| ** **                             | ** ** | **(Dollars in  thousands)** | ** ** |
| Cash                                   |       | $                                | 1,418      |   |
| Portfolio Assets, net                  |       | 39,155                           |       |
| Other assets                           |       | 14                               |       |
| Total assets of consolidated VIEs      |       | $                                | 40,587     |   |
|                                   |       |                             |       |
| Total liabilities of consolidated VIEs |       | $                                | 468        |   |

 

The following table summarizesthe carrying amounts of the assets included in the Company’s consolidatedbalance sheet and the maximum loss exposure as of September 30, 2010related to the Company’s variable interests in unconsolidated VIEs.

 
| ** **                   | ** ** | **Assets on FirstCity’s  Consolidated Balance Sheet** | ** ** | **FirstCity’s  Maximum** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | **Loans**                                                                      | ** ** | **Equity**                    | ** ** | **Exposure** | ** ** |
| **Type of VIE**    | ** ** | **Receivable**                                                                 | ** ** | **Investment**                | ** ** | **to Loss (1)** | ** ** |
| ** **                   | ** ** | **(Dollars in thousands)**                                           | ** ** |
| Acquisition Partnership VIEs |       | $                                                                              | 1,575      |                          | $          | 2,058 |   | $ | 5,462 |   |
| Operating Entity VIEs        |       | 10,072                                                                         |       | (408                          | )          | 9,664 |   |
| Total                        |       | $                                                                              | 11,647     |                          | $          | 1,650 |   | $ | 15,126 |   |

 

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(1)   Includes maximum exposure toloss attributable to FirstCity’s debt guarantees provided for certainAcquisition Partnership VIEs.

 

**(17)  Other Related PartyTransactions**

 

The Company has contractedwith the Acquisition Partnerships and related parties as a third party loanservicer. Servicing fees and due diligence fees (included in other income)derived from such affiliates totaled $2.1 million and $2.0 million for thethree month periods ended September 30, 2010 and 2009, respectively, and$5.5 million and $6.3 million for the nine month periods ended September 30,2010 and 2009, respectively.

 

FC Servicing and MCS etAssociates (“MCS”), an equity-method investee of FirstCity in which FCServicing has a direct 11.89% ownership interest, are parties to certainagreements in which FC Servicing provides consultation services and personnelto be employed by MCS to assist in developing and managing due diligence andservicing systems. Under these agreements, MCS provides the supplied personnelwith compensation, tax equalization payments, housing allowances,transportation allowance, and tax preparation services. MCS also paysconsulting fees to FC Servicing and reimburses FC Servicing for travel, hotel,airfare, and meal expenses incurred related to the provision of the services.FirstCity recorded fees from MCS of $0.1 million during each of the three-monthperiods ended September 30, 2010 and 2009, and $0.3 million during each ofthe nine-month periods ended September 30, 2010 and 2009.

 

Through a series ofrelated-party transactions in 2008, FC Acquisitions SRL de CV (“FC Acquisitions”),a majority-owned Mexican subsidiary of FirstCity, acquired a loan portfolio inMexico. The final funding for this transaction resulted in a note payable toMCS Trust SA de CV (“MCS Trust”) by FC Acquisitions, and a note receivable fromMCS Trust held by BMX Holding III LLC (“BMX Holding III”), a majority-ownedsubsidiary of FirstCity. The accounts of MCS Trust are consolidated by BMXHolding II, a FirstCity equity-method investee in which it has an 8.0%ownership interest. At September 30, 2010 and December 31, 2009, thenote

 

36

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

receivable held by BMXHolding III had a carrying amount of $7.7 million and $7.8 million,respectively (included in “Loans receivable — affiliates” on the Company’sconsolidated balance sheet), and accrued interest of $3.7 million and $2.5million, respectively (included in “Other assets, net” on the Company’sconsolidated balance sheet). At September 30, 2010 and December 31,2009, the note payable to MCS Trust had a carrying amount of $7.7 million and$7.8 million, respectively (reported as “Notes payable to affiliate” on theCompany’s consolidated balance sheet), and accrued interest of $3.7 million and$2.5 million, respectively (included in “Other liabilities” on the Company’sconsolidated balance sheet). Should the note payable be forgiven at some futuredate, the corresponding note receivable would be forgiven as well.

 

**(18)  Segment Reporting**

 

At September 30, 2010and 2009, the Company was engaged in two major business segments — PortfolioAsset Acquisition and Resolution business and Special Situations Platformbusiness.

 

In the Portfolio AssetAcquisition and Resolution business, the Company acquires and resolvesPortfolio Assets, which are generally acquired at a discount to their legalprincipal balance or appraised value. Purchases may be in the form of pools ofassets or individual assets. The Portfolio Assets are generally aggregated,including loans of varying qualities that are secured or unsecured by diversecollateral types and real estate. Some Portfolio Assets are loans for whichresolution is linked primarily to the real estate securing the loan, whileothers may be collateralized business loans for which resolution may be basedeither on real estate, business assets or other collateral cash flow. PortfolioAssets are acquired on behalf of the Company or its consolidated subsidiaries,and on behalf of domestic and foreign Acquisition Partnerships in which apartially-owned affiliate of the Company is the general partner and the Companyand other investors are limited partners. The Company services, manages andultimately resolves or otherwise disposes of substantially all Portfolio Assetsacquired by the Company, its Acquisition Partnerships, or other relatedentities. The Company services such assets until they are collected or sold.

 

The Company engages in itsSpecial Situations Platform business through its majority ownership interest inFirstCity Denver — which was formed in April 2007. Through its SpecialSituations Platform business, the Company provides investment capital toprivately-held middle-market companies through flexible capital structuringarrangements. The nature of the capital investments primarily takes the form ofsenior and junior financing arrangements, but also includes direct equityinvestments, common equity warrants, distressed debt transactions, andleveraged buyouts. FirstCity Denver’s primary investment objective is togenerate both current income and capital appreciation through debt and equityinvestments, and to generally structure the investments to be repaid or exitedin 24 to 60 months.

 

Operating segment revenues and profitability, and areconciliation to net earnings for the three and nine months ended September 30,2010 and 2009, are as follows:

 
| ** **                                                | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                                | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Portfolio Asset Acquisition and  Resolution:**          | ** ** | ** **                           |       |                            | ** ** | ** ** |   |   |   |
| Total revenues                                            |       | $                                    | 12,823     |                            | $          | 16,817 |   | $ | 49,358 |   | $ | 49,083 |   |
| Operating contribution, net of direct taxes               |       | $                                    | (3,346     | )                               | $          | 2,028 |   | $ | 2,795 |   | $ | 14,082 |   |
| ** **                                                | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Special Situations Platform:**                          |       |                                 |       |                            |       |   |   |   |   |
| Total revenues                                            |       | $                                    | 17,410     |                            | $          | 1,820 |   | $ | 45,422 |   | $ | 5,733 |   |
| Operating contribution (loss), net of direct taxes        |       | $                                    | 8,013      |                            | $          | 1,615 |   | $ | 13,991 |   | $ | 1,820 |   |
|                                                      |       |                                 |       |                            |       |   |   |   |   |
| Total operating contribution, net of direct taxes         |       | $                                    | 4,667      |                            | $          | 3,643 |   | $ | 16,786 |   | $ | 15,902 |   |
| ** **                                                | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Corporate Overhead:**                                   | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries and benefits and other income and  expenses, net |       | 2,223                                |       | 1,754                           |       | 5,996 |   | 5,533 |   |
| Income tax expense (benefit)                              |       | (115                                 | )          | (111                            | )          | 65 |   | (21 | ) |
| Net earnings attributable to FirstCity                    |       | $                                    | 2,559      |                            | $          | 2,000 |   | $ | 10,725 |   | $ | 10,390 |   |

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

Revenuesand equity in earnings of investments from the Special Situations Platformsegment are all attributable to domestic operations. Revenues and equity in earnings of unconsolidated equity-methodinvestments from the Portfolio Asset Acquisition and Resolution segment areattributable to domestic and foreign operations as follows:

 
| ** **    | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|---------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **    | ** ** | **2010**                             | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **    | ** ** | **(Dollars in thousands)** | ** ** |
| Domestic      |       | $                                    | 7,543      |                            | $          | 12,506 |   | $ | 31,752 |   | $ | 38,024 |   |
| Latin America |       | 2,466                                |       | 2,811                           |       | 7,159 |   | 8,085 |   |
| Europe        |       | 1,368                                |       | 457                             |       | 10,194 |   | 2,770 |   |
| Other         |       | —                               |       | —                          |       | — |   | 16 |   |
| Total         |       | $                                    | 11,377     |                            | $          | 15,774 |   | $ | 49,105 |   | $ | 48,895 |   |

 

Total assets for each of the segments and areconciliation to total assets follows:

 
| ** **                                   | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                                   | ** ** | **(Dollars in thousands)** | ** ** |
| Cash and cash equivalents                    |       | $                                    | 35,549     |                  | $          | 80,368 |   |
| Restricted cash                              |       | 1,356                                |       | 1,364                 |       |
| Portfolio acquisition and resolution assets: |       |                                 |       |                  |       |
| Domestic                                     |       | 246,732                              |       | 225,406               |       |
| Latin America                                |       | 39,077                               |       | 41,248                |       |
| Europe                                       |       | 50,060                               |       | 57,888                |       |
| Special situations platform assets           |       | 50,337                               |       | 41,688                |       |
| Other non-earning assets, net                |       | 22,052                               |       | 17,112                |       |
| Total assets                                 |       | $                                    | 445,163    |                  | $          | 465,074 |   |

 

**(19)  Commitments andContingencies**

 

*Legal Proceedings*

 

There have been no materialdevelopments regarding any matters disclosed under Part I, Item 3 “LegalProceedings” in our 2009 Form 10-K.

 

*Investment Agreement with VärdeInvestment Partners, L.P.*

 

EffectiveApril 1, 2010, FC Diversified Holdings LLC (“FC Diversified”) and FCServicing, wholly-owned subsidiaries of FirstCity, and Värde InvestmentPartners, L.P. (“Värde”), entered into an Investment Agreement that provides,among other things, a “right of first refusal” provision. Pursuant to theInvestment Agreement, FC Diversified and FC Servicing granted Värde a right offirst refusal to participate in distressed asset investment opportunities inwhich the aggregate amount of the proposed investment is to exceed $3.0million. FC Diversified and FC Servicing are required to follow a prescribednotice procedure pursuant to which Värde has the option to participate in aproposed investment, whether in the form of a direct purchase, equityinvestment or loan, by requiring that the purchase, acquisition or loan beeffected through an acquisition entity formed by FC Diversified (or itsaffiliate) and Värde (or its affiliate). An affiliate of FC Diversified willown from 5% to 25% of the acquisition entity at FC Diversified’s determination.The Investment Agreement has a termination date of June 30, 2015, which issubject to consecutive automatic one-year extensions without any action by FCDiversified, FC Servicing and Värde. FC Servicing will be the servicer for allof the acquisition entities formed by FC Diversified and Värde. The parties mayterminate the Investment Agreement prior to June 30, 2015 under certainconditions.

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

*Indemnification Obligation Commitments*

 

On August 8, 2006, anInterest Purchase and Sale Agreement (“IP&S Agreement”) was entered into byand among Bidmex Holding LLC (“Bidmex Holding”), as buyer, and StrategicMexican Investment Partners L.P. (“SMIP”), a wholly-owned subsidiary of FirstCity,and Cargill Financial Services International Inc. (“CFSI”), (collectively, the “Sellers”),as seller, and eleven U.S. limited liability companies (“LLCs”) which investedin Mexican portfolio acquisition entities (“SRLs”) and the AIG entities as additionalparties.  In the IP&S Agreement, the Sellers and the LLCs made variousrepresentations and warranties concerning (i) the existence and ownershipof the LLCs and the related SRLs, (ii) the assets and liabilities of theLLCs, (iii) taxes related to periods prior to August 8, 2006, and (iv) theoperations of the LLCs and SRLs. The Sellers agreed to indemnify Bidmex Holdingand AIG Entities from damages resulting from a breach of any representation orwarranty contained in the IP&S Agreement on a several and not joint basisaccording to their respective ownership percentages in each LLC as to anymatter related to a particular LLC, or on the basis of 80% to CFSI and 20% toSMIP as to any matter that could not be identified to a particular LLC. The indemnityobligation under the IP&S Agreement survives for a period of the statute oflimitations for matters related to taxes, existence and authority,capitalization and good standing of the LLCs and SRLs. The Sellers are notrequired to make any payments as a result of the indemnity provisions of theIP&S Agreement until the aggregate amount payable under that agreement andthe Asset Purchase Agreement (defined below) exceeds $250,000; however, claimsrelated to taxes and fraud are not subject to this $250,000 threshold. TheIP&S Agreement limits the liability of the Sellers for indemnifiable lossesto the Aggregate Purchase Price (defined below) (without duplication of amountsrecovered pursuant to the terms of the Asset Purchase Agreement). At this time,management does not believe that this potential obligation will have a materialadverse impact on the Company’s consolidated results of operations, financialposition or liquidity.

 

Also on August 8, 2006,Bidmex Holding entered into an Agreement for the Onerous Transfer of Loans andLitigious Rights (the “Asset Purchase Agreement”) between and among ResidencialOeste S. de R.L. de C.V., as seller (the “Asset Seller”), an affiliate of CFSIand SMIP, Residencial Oeste 2 S. de R.L. de C.V., as purchaser (the “AssetPurchaser”), and CFSI, SMIP, and Bidmex Acquisition LLC, the parent of theAsset Purchaser, as additional parties. The Asset Purchase Agreement providedfor the sale of the loan portfolio owned by the Asset Seller to the AssetPurchaser for a purchase price of $10.1 million on the closing date, whichpurchase price is part of the Aggregate Purchase Price.  In the AssetPurchase Agreement, the Asset Seller and the Sellers made variousrepresentations and warranties concerning (i) the existence and ownershipof the Seller, (ii) the ownership of the loan portfolio, (iii) taxesrelated to periods arising prior to the closing date, and (iv) theexistence of the loans comprising the loan portfolio and other matters relatedto the loan portfolio. The Asset Seller agreed to indemnify the AssetPurchaser from damages resulting from a breach of any representation orwarranty. The indemnity obligation under the Asset Purchase Agreement survivesfor a period of the statute of limitations for matters related to existence andownership of the Seller, ownership of the loans, and taxes for periods prior toAugust 8, 2006. The Seller is not required to make any payments as aresult of the indemnity provisions of the Asset Purchase Agreement until theaggregate amount payable under that Agreement exceeds $25,000; however, claimsrelated to taxes and fraud are not subject to this $25,000 threshold. TheIP&S Agreement limits the liability of the Sellers for indemnifiable lossesunder the Asset Purchase Agreement to the Aggregate Purchase Price. At thistime, management does not believe that this potential obligation will have amaterial adverse impact on the Company’s consolidated results of operations,financial position or liquidity.

 

*Subordinated Equity Investment*

 

Duringthe period from December 1998 to March 2005, FirstCity Mexico Inc.and SMIP, each wholly-owned subsidiaries of FirstCity, and CFSI and, in someinstances, other investors, acquired 12 residential and commercialnon-performing loan portfolios from financial institutions in Mexico (the “MexicanPortfolios”). Each portfolio was acquired by a Mexican limited liabilitycompany (each a “Mexican SRL”) that was owned by a Delaware limited liabilitycompany formed by each investor group.  On August 8, 2006, SMIP and NationalUnion Fire Insurance Company of Pittsburgh, Pa., American General LifeInsurance Company and American General Life and Accident Insurance Company,affiliates of AIG Global Asset Management Holdings Corp. (collectively the “AIGEntities”) formed Bidmex Holding for the purpose of acquiring the MexicanPortfolios by purchasing the interests of Cargill and SMIP in eleven of theMexican limited liability companies (the “LLCs”) and purchasing the loanportfolio of one of the Mexican limited liability companies (the “PurchasedPortfolio”) for an aggregate purchase price of U.S. $119.3 million as of thatdate (the “Aggregate Purchase Price”). SMIP acquired 15% of the membershipinterests in Bidmex Holding. A 9% interest acquired by SMIP is ofequivalent standing to membership interests held by the AIG affiliatesrepresenting 85% of the membership interests. The remaining 6% membershipinterest acquired by SMIP is subordinate to the other owners of interests inBidmex Holding, who will receive the return of and a return on theircontribution equivalent to an 9% internal rate of return with respect to theirinterests prior to SMIP receiving the return of and a return on its capitalcontribution equivalent to a 9% internal rate of return with respect to its 6% interest.At September 30, 2010, the carrying value of SMIP’s membership interestsin Bidmex Holding that is included in the

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

Company’sconsolidated balance sheet as an equity-method investment approximated $11.0million ($5.2 million for the 9% membership interest and $5.8 million for the6% membership interest).

 

*Guarantees and Letters of Credit*

 

FCCommercial and FH Partners, as borrowers, have a term loan with Bank ofScotland. FirstCity provides a limited guaranty for the repayment of theindebtedness under this loan to a maximum amount of $75.0 million, plus costsof enforcement and certain contingent indemnities. At September 30, 2010,the unpaid principal balance on this loan was $227.9 million. Refer to Note 8for additional information.

 

AmericanBusiness Lending, Inc. (“ABL”), a wholly-owned subsidiary of FirstCity,has a $25.0 million revolving loan facility with Wells Fargo Capital Finance (“WFCF”).The obligations under this facility are secured by substantially all of theassets of ABL, and FirstCity provides WFCF with an unconditional guaranty onABL’s obligations under the loan facility up to a maximum of $5.0 million plusenforcement cost. At September 30, 2010, the unpaid principal balance onthis loan facility was $15.1 million.

 

FCCommercial provides guarantees to various financial institutions related totheir financing arrangements with certain Acquisition Partnerships. Theunderlying financing arrangements of these Acquisitions Partnerships havevarious maturities ranging from October 2011 to July 2013, and aresecured primarily by certain real estate properties held by the AcquisitionPartnerships. At September 30, 2010, the unpaid debt obligations of theseAcquisition Partnerships attributed to FC Commercial’s underlying guarantiesapproximated $1.4 million.

 

Fondode Inversion Privado NPL Fund One (“PIF1”), an equity-method investment ofFirstCity, has a credit facility with Banco Santander Chile, S.A. with anunpaid principal balance of $9.2 million at September 30, 2010. PIF1 usesthe credit facility to finance the purchases of loan portfolios. Pursuant toterms of the credit facility, FirstCity was required to provide a stand-byletter of credit from Bank of Scotland that would satisfy the current loanbalance upon demand. At September 30, 2010, FirstCity had a letter ofcredit in the amount of $9.5 million from Bank of Scotland under the terms ofFirstCity’s loan facility with Bank of Scotland, with Banco Santander Chile,S.A. as the letter of credit beneficiary. In the event that a demand is madeunder the $9.5 million letter of credit, FirstCity would be required toreimburse Bank of Scotland by making payment to Bank of Scotland for allamounts disbursed or to be disbursed by Bank of Scotland under the letter ofcredit.

 

FirstCityMexico SA de CV, a wholly-owned Mexican affiliate of FirstCity, has a loanagreement with Banco Santander, S.A. that allows loans to be made in Mexicanpesos. At September 30, 2010, the Company had 142,240,000 in Mexicanpeso-denominated debt, which was equivalent to $11.4 million U.S. dollars. Theproceeds were used to pay down the acquisition facility with the Bank ofScotland. Pursuant to the terms of the credit facility, FirstCity Mexico SA deCV was required to provide a stand-by letter of credit from Bank of Scotlandthat would satisfy the loan balance upon demand.  At September 30,2010, FirstCity had a letter of credit in the amount of $12.6 million from Bankof Scotland under the terms of FirstCity’s Reducing Note Facility with Bank ofScotland. In October 2010, the letter of credit was funded in the amountof $11.9 million, and the proceeds were used to pay-off FirstCity Mexico SA deCV’s note payable to Banco Santander, S.A. The entire amount of the fundedletter of credit was added to the unpaid principal obligation of FirstCity’sReducing Note Facility with Bank of Scotland (see Note 8).

 

*Environmental Matters*

 

TheCompany generally retains environmental consultants to conduct or updateenvironmental assessments in connection with the Company’s foreclosed andacquired real estate properties. These environmental assessments have notrevealed environmental conditions that the Company believes will have amaterial adverse effect on its business, assets, financial condition, resultsof operations or liquidity, and the Company is not otherwise aware ofenvironmental conditions with respect to properties that the Company believeswould have such a material adverse effect. However, from time to time,environmental conditions at the Company’s properties have required and may inthe future require environmental testing and/or regulatory filings, as well asremedial action. Liabilities for future remediation costs are recorded whenenvironmental assessments and/or remedial efforts are probable and the costscan be reasonably estimated. Other than for assessments, the timing andmagnitude of these accruals generally are based on the completion ofinvestigations or other studies or a commitment to a formal plan of action.

 

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

 

*Limited-Life Subsidiaries*

 

AtSeptember 30, 2010, the estimated settlement value of the Company’snoncontrolling interests in consolidated limited-life subsidiaries approximated$2.0 million. The Company’s carrying value of the noncontrolling interestsrecognized on the consolidated balance sheet related to these limited-lifesubsidiaries approximated $0.5 million at September 30, 2010.

 

*Income Taxes*

 

Weare subject to income taxes in both the United States and thenon-U.S. jurisdictions in which we operate. Certain of our entities areunder examination by the relevant taxing authorities for various tax years. Weregularly assess the potential outcome of current and future examinations ineach of the taxing jurisdictions when determining the adequacy of the provisionfor income taxes. We have only recorded financial statement benefits for taxpositions which we believe reflect the “more-likely-than-not” criteriaincorporated in the FASB’s authoritative guidance on accounting for uncertaintyin income taxes, and we have established income tax reserves in accordance withthis authoritative guidance where necessary. Once a financial statement benefitfor a tax position is recorded or a tax reserve is established, we adjust itonly when there is more information available or when an event occursnecessitating a change. While we believe that the amount of the recordedfinancial statement benefits and tax reserves reflect the more-likely-than-notcriteria, it is possible that the ultimate outcome of current or futureexaminations may result in a reduction to the tax benefits previously recordedon the financial statements or may exceed the current income tax reserves inamounts that could be material.

 

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**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

**Overview**

 

FirstCity is amulti-national specialty financial services company that engages in two majorbusiness segments — Portfolio Asset Acquisition and Resolution and SpecialSituations Platform. The Portfolio Asset Acquisition and Resolution businesshas been the Company’s core business segment since it commenced operations in1986. In the Portfolio Asset Acquisition and Resolution business, the Companyacquires portfolios of performing and non-performing loans and other assets(collectively, “Portfolio Assets” or “Portfolios”), generally at a discount totheir legal principal balances or appraised values, and services and resolves(i.e. liquidates) such Portfolio Assets in an effort to maximize the presentvalue of the ultimate cash recoveries. FirstCity acquires the Portfolio Assetsfor its own account or through investment entities formed with co-investors(each such entity, an “Acquisition Partnership”).

 

Through its SpecialSituations Platform, the Company provides investment capital to privately-heldmiddle-market companies through flexible capital structuring arrangements togenerate an attractive risk-adjusted return. These capital investmentsprimarily take the form of senior and junior financing arrangements, but alsoinclude direct equity investments, common equity warrants, distressed debttransactions, and leveraged buyouts.

 

***Summary Financial Results***

 

FirstCityrecorded net earnings of $2.6 million, or $0.25 per common share diluted, forthe third quarter of 2010 (“Q3 2010”), compared to $2.0 million, or $0.19 percommon share diluted, for the third quarter of 2009 (“Q3 2009”). FirstCityrecorded net earnings of $10.7 million, or $1.06 per common share diluted, forthe nine-month period ended September 30, 2010 (“YTD 2010”), compared to$10.4 million, or $1.02 per common share diluted, for the nine-month periodended September 30, 2009 (“YTD 2009”). Components of FirstCity’s resultsof operations for the three and nine-month periods ended September 30,2010 and 2009, respectively, are detailed below (dollars in thousands, exceptper share data):

 
| ** **                                 | ** ** | **Three Months Ended**                                                | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **September 30,**                                                          | ** ** | **September 30,**          | ** ** |
| ** **                                 | ** ** | **2010**                                                                        | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                 | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Portfolio Asset Acquisition and Resolution |       | $                                                                               | (3,346     | )                               | $          | 2,028 |   | $ | 2,795 |   | $ | 14,082 |   |
| Special Situations Platform                |       | 8,013                                                                           |       | 1,615                           |       | 13,991 |   | 1,820 |   |
| Operating contribution                     |       | 4,667                                                                           |       | 3,643                           |       | 16,786 |   | 15,902 |   |
| Corporate overhead                         |       | (2,108                                                                          | )          | (1,643                          | )          | (6,061 | ) | (5,512 | ) |
| Net earnings attributable to FirstCity     |       | $                                                                               | 2,559      |                            | $          | 2,000 |   | $ | 10,725 |   | $ | 10,390 |   |
| Diluted earnings per common share          |       | $                                                                               | 0.25       |                            | $          | 0.19 |   | $ | 1.06 |   | $ | 1.02 |   |

 

Referto the heading “**Results of Operations**” below for adetailed review of the Company’s operations for the comparative periodspresented in the table above.

 

*Portfolio Asset Acquisition andResolution.* The Company’squarterly earnings related to its Portfolio Asset Acquisition and Resolutionbusiness segment decreased to a $3.3 million loss in Q3 2010 from $2.0 millionof earnings in Q3 2009. The decrease in earnings in Q3 2010 compared to Q3 2009was primarily due to a $1.8 million increase in net impairment provisionsrecorded to consolidated assets and a $3.9 million decrease in Portfolio Assetsincome. The Company’s year-to-date earnings related to this business segmentdecreased to $2.8 million in YTD 2010 from $14.1 million in YTD 2009. Thedecrease in earnings in YTD 2010 compared to YTD 2009 was primarily due to a$4.2 million increase in net impairment provisions recorded to consolidatedassets, a $4.4 million increase in net income attributable to noncontrolling interests,a $1.3 million increase in interest and fees on notes payable, and a $1.3million increase in asset-level expenses, off-set partially by a $3.3 milliongain that was recorded in YTD 2010 on the sale of an investment security. Referto the heading “**Results of Operations**” below for adetailed review of the Company’s operations in this business segment for thecomparative periods presented in the table above.

* *

*SpecialSituations Platform.* TheCompany’s quarterly earnings related to its Special Situations Platformbusiness segment increased to $8.0 million in Q3 2010 from $1.6 million in Q32009. The increase in earnings in Q3 2010 compared to Q3 2009 was primarily dueto a $9.9 million increase in equity in earnings of unconsolidatedsubsidiaries, off-set partially by a $1.9 million increase in net impairmentprovisions recorded to consolidated assets and a $1.3 million increase in netincome attributable to noncontrolling 

 

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interests.The Company’s year-to-date earnings related to this business segment increasedto $14.0 million in YTD 2010 from $1.8 million in YTD 2009. The increase inearnings in YTD 2010 compared to YTD 2009 was primarily due to a $12.6 millionincrease in equity in earnings of unconsolidated subsidiaries and a $4.8million business combination gain that was recorded in YTD 2010, off-setpartially by a $2.1 million increase in net impairment provisions recorded toconsolidated assets and a $2.6 million increase in net income attributable tononcontrolling interests. Refer to the heading “**Results ofOperations**” below for a detailed review of the Company’s operationsin this business segment for the comparative periods presented in the tableabove.

 

***Summary InvestmentActivity***

 

In Q3 2010, FirstCity andits investment partners acquired $15.0 million of domestic Portfolio Assetinvestments with a face value of approximately $27.0 million — of whichFirstCity’s investment acquisition share was $10.5 million. In addition to itsPortfolio Asset acquisitions in Q3 2010, FirstCity invested $5.1 million innon-portfolio investments, consisting of $3.4 million in the form of SBA loanoriginations and advances; $1.6 million of equity investments in foreignpartnerships; and $0.1 million in the form of equity investments under itsSpecial Situations Platform (“FirstCity Denver”).

 

At September 30, 2010,the carrying value of FirstCity’s earning assets (primarily Portfolio Assets,equity investments, loans receivable and entity-level earning assets)approximated $386.2 million — compared to $366.2 million at December 31,2009 and $393.0 million a year ago. The global distribution of FirstCity’searning assets (at carrying value) at September 30, 2010 included $297.0million in the United States; $50.1 million in Europe; and $39.1 million inLatin America.

 

Referto the headings “**Portfolio Asset Acquisitions — PortfolioAsset Acquisition and Resolution Business Segment**” and “**Middle-Market Company Capital Investments — Special Situations PlatformBusiness Segment**” below for additional information related to ourinvestment activities and composition.

 

**Management’sOutlook**

 

Our revenues consistprimarily of (1) income from our Portfolio Assets, loan investments andAcquisition Partnerships; (2) servicing fee income and incentive incomebased on the performance of the portfolio assets that we manage; and (3) incomegenerated by our debt and equity investments (consolidated and unconsolidated)in privately-held middle-market companies. Our ability to maintain and growrevenues depends on our ability to secure investment opportunities, obtainfinancing for transactions, and to consummate investments and deliverattractive risk-adjusted returns. Our ability to execute this strategy dependsupon a number of market conditions — including the strength and liquidity ofU.S. and global economies and financial markets.

 

While we are seeing signs ofimprovement and stabilization in U.S. and global economic conditions andfinancial markets, these conditions and markets remain challenging and theirrecovery has been imbalanced. Despite substantial losses reported in thefinancial services sector over the past two years, and continued volatility anduncertainty in U.S. and global economies and financial markets, managementremains positive on the outlook of the Company and believes that current marketconditions should not hinder FirstCity’s ability to expand its business. Whiledisruptions and uncertainty in the markets may adversely effect our existingpositions, we believe such conditions generally present significant newinvestment opportunities for distressed asset acquisition and middle-markettransactions. At the moment, however, we believe that challenging marketconditions and government-implemented programs and regulations have reducedtransaction flow in the marketplace, and that distressed asset prices have yetto fall to levels commensurate with expectations of market participants. Due tothe difficulty and challenges related to servicing and resolving these underperformingand non-performing assets, we believe that financial institutions and otherentities will actively seek to shed these assets over time as economicconditions and financial markets stabilize and government-imposed restrictionslapse. Sales of such assets improve the sellers’ financial position (i.e. assetquality and capital positions), reduce overhead costs and staffingrequirements, and reduce management and personnel distractions associated withthe intensive and time-consuming task of resolving loans and disposing of realestate.

 

Market commentators andanalysts have expressed the belief that it will take some time for the U.S. andglobal economies and financial markets to fully recover, but it is not clear ifadverse conditions will again intensify. As a result, the continued challengingeconomic conditions could still materially and adversely impact (i) ourability to price and fund new distressed asset and middle-market capitalinvestment opportunities on attractive terms; (ii) the ability of ourborrowers to repay or refinance their debt obligations to us; (iii) thevalue of the underlying real estate properties and other assets securing ourpurchased and originated loan investments; and/or (iv) the financialcondition, operations and liquidity of the underlying servicing and operatingentities in which we have an equity investment. There can be no assurance thatthe value of our Portfolio Assets, loan investments and other investmentassets, or

 

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the performance of ourequity-method investees and consolidated subsidiaries, will not be negativelyimpacted by challenging economic conditions which could have a negative impacton our future results.

 

In addition to various otherdebt and equity investment opportunities, we continue to seek distressed assetinvestment opportunities under our investment agreement with Värde (see Note 19 of the consolidated financialstatements included in Item 1 of this Form 10-Q). The Company’sinvolvement in these investments will come in the form of minority ownership(ranging from 5% to 25% at FirstCity’s determination) of an acquisition entityformed by FirstCity and Värde. FirstCity will also be the servicer forthe acquisition entities formed with Värde. FirstCity’s increased holdings inthe minority-owned, unconsolidated acquisition entities under this investmentagreement represent a shift in the Company’s portfolio asset acquisitionhistory over the past 2-3 years — which came in the form of consolidated portfolioassets. As such, in the context of the Company’s Portfolio Asset Acquisitionand Resolution business segment, management expects to see a gradual shift inthe composition of FirstCity’s income attributed to distressed assetinvestments to “Equity in earnings of unconsolidated subsidiaries”(unconsolidated equity-method investments) from “Income from Portfolio Assets”(consolidated portfolio assets). Management also expects to see a gradualincrease in service fee income over time related to the performance of ourservicing responsibilities related to these unconsolidated acquisitionentities. Refer to the heading “**Results of Operations**”below for additional information related to our Portfolio Asset Acquisition andResolution operations.

 

Our ability to make newinvestments is dependent on (1) the cashleak-through and overhead allowance provisions included in our loan facilitywith Bank of Scotland (see Note 8 of the consolidated financial statementsincluded in Item 1 of this Form 10-Q); (2) residual cash flows from thepledged assets and equity investments after full repayment of the Bank ofScotland debt; (3) our current holdings of unencumbered cash and portfolioassets; and (4) our investment agreement in place with Värde (see Note 19 of the consolidated financialstatements included in Item 1 of this Form 10-Q). While managementbelieves that these cash flow sources will provide FirstCity with funding andliquidity to supports its operations and investment activities, FirstCity continuesto actively seek additional sources of liquidity and alternative fundingsources.

 

**Results of Operations**

 

The following discussion and analysis is based on thesegment reporting information presented in Note 18 to the consolidatedfinancial statements of the Company included in Item 1 of this Form 10-Q,and should be read in conjunction with the consolidated financial statements(including the notes thereto) included elsewhere in this Form 10-Q.

 

Asa result of significant period-to-period fluctuations in our revenues andearnings, period-to-period comparisons of the results of our operations may notbe meaningful. The Company’s financial results are impacted by many factorsincluding, but not limited to, general economic conditions; fluctuations ininterest rates and foreign currency exchange rates; fluctuations in theunderlying values of real estate and other assets; the timing and ability tocollect and liquidate assets; increased competition from other market playersin the industries in which we operate; and the availability, pricing and termsfor Portfolio Assets, middle-market transactions and other investments in allof the Company’s businesses. The Company’s business and results of operationsare also impacted by the availability of liquidity to fund its investmentactivity and operations, and our access to capital markets. Such factors,individually or combined with other factors, may result in significantfluctuations in our reported operations and in the trading price of our commonstock.

 

***Q3 2010 Compared to Q3 2009***

 

FirstCity’snet earnings to common stockholders totaled $2.6 million in Q3 2010 compared tonet earnings of $2.0 million in Q3 2009. On a per share basis, diluted netearnings to common stockholders were $0.25 in Q3 2010 compared to $0.19 in Q32009. The following is a discussion andanalysis of FirstCity’s net earnings based on its reportable business segments.

 

*Portfolio Asset Acquisition and Resolution*

 

Throughour Portfolio Asset Acquisition andResolution (“PAA&R”) business segment, FirstCity and its investmentpartners acquired $15.0 million of Portfolio Assets in Q3 2010 with anapproximate face value of $27.0 million, compared to the Company’s involvementin acquiring $48.7 million of Portfolio Assets in Q3 2009 with an approximateface value of $115.1 million. In Q3 2010, FirstCity’s investment acquisitionshare in the Portfolio Asset acquisitions was $10.5 million — consisting of$8.9 million acquired through consolidated Portfolios and $1.6 million acquiredthrough unconsolidated Portfolios. In Q3 2009, FirstCity’s investmentacquisition share in Portfolio Asset acquisitions was $21.0 million — consistingof $18.6 million acquired through consolidated Portfolios and $2.4 millionacquired through unconsolidated Portfolios. Generally speaking, incomerecognized from our investments in consolidated portfolio assets is reported as“Income from Portfolio Assets” on our consolidated statements of operations,whereas income from our

 

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investmentsin unconsolidated subsidiaries that acquire portfolio assets is reported as “Equityin earnings of unconsolidated subsidiaries.” Furthermore, since we function asthe servicer for the vast majority of our domestic and Latin Americanunconsolidated portfolio assets, we also recognize fee income related to theperformance of our servicing responsibilities. This fee income is reported as “Servicingfees” on our consolidated statements of operations. We also generate servicefee income from our domestic and Latin American consolidated portfolio assetsthat we service; however, this income is eliminated in consolidation and, assuch, is not included on our consolidated statements of operations.

 

InQ3 2010, FirstCity invested an additional $5.0 million in non-portfolioinvestments in the form of SBA loan originations and advances, direct equityinvestments, and other loan investments, compared to $2.4 million of additional non-portfolio investments in the form of****SBA loan originations and advances in Q3 2009. Refer to theheading “**Portfolio Asset Acquisitions — Portfolio AssetAcquisition and Resolution Business Segment**” below for additionalinformation related to our investment activities and composition in ourPAA&R segment.

 

The operating contribution from our PAA&R businesssegment resulted in a $3.3 million operating loss in Q3 2010 compared to a $2.0million operating gain for the same period in 2009. The following is a summaryof the results of operations for the Company’s PAA&R business segment forthe Q3 2010 and Q3 2009:

 
| ** **                                                   | ** ** | **Three Months Ended**     | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                   | ** ** | **September 30,**               | ** ** |
| ** **                                                   | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                                                   | ** ** | **(Dollars in thousands)** | ** ** |
| **Portfolio Asset Acquisition and  Resolution:**             | ** ** | ** **                           |       |   |   |
| Revenues:                                                    |       |                                 |       |   |   |
| Servicing fees                                               |       | $                                    | 2,252      |   | $ | 2,222 |   |
| Income from Portfolio Assets                                 |       | 8,195                                |       | 12,134 |   |
| Gain on sale of SBA loans held for sale, net                 |       | 197                                  |       | 301 |   |
| Interest income from SBA loans                               |       | 314                                  |       | 299 |   |
| Interest income from loans receivable - affiliates           |       | 435                                  |       | 471 |   |
| Other income                                                 |       | 1,430                                |       | 1,390 |   |
| Total revenues                                               |       | 12,823                               |       | 16,817 |   |
| Expenses:                                                    |       |                                 |       |   |   |
| Interest and fees on notes payable                           |       | 4,483                                |       | 3,366 |   |
| Salaries and benefits                                        |       | 3,664                                |       | 3,687 |   |
| Provision for loan and impairment losses, net of  recoveries |       | 2,236                                |       | 425 |   |
| Asset-level expenses                                         |       | 2,083                                |       | 1,858 |   |
| Other                                                        |       | 821                                  |       | 1,653 |   |
| Total expenses                                               |       | 13,287                               |       | 10,989 |   |
| Equity in losses of unconsolidated subsidiaries              |       | (1,446                               | )          | (1,043 | ) |
| Net income attributable to noncontrolling  interests         |       | (1,219                               | )          | (1,326 | ) |
| Operating contribution (loss) before direct taxes            |       | $                                    | (3,129     | ) | $ | 3,459 |   |
| Operating contribution (loss), net of direct taxes           |       | $                                    | (3,346     | ) | $ | 2,028 |   |

 

*Servicing fee revenues. *Servicingfee revenues remained steady at $2.3 million in Q3 2010 compared to $2.2million in Q3 2009. Servicing fees from domestic Acquisition Partnershipstotaled $0.8 million in Q3 2010 compared to $0.5 million in Q3 2009, whileservicing fees from Latin American Acquisition Partnerships totaled $1.4million in Q3 2010 and $1.7 million in Q3 2009. Servicing fees from domesticAcquisition Partnerships are generally based on a percentage of the collectionsreceived from Portfolio Assets held by these unconsolidated partnerships;whereas servicing fees from Latin American Acquisition Partnerships aregenerally based on the cost of servicing plus a profit margin. The increase inservicing fees from domestic Acquisition Partnerships for Q3 2010 in comparisonto Q3 2009 was attributable primarily to an increase in collections fromunconsolidated domestic partnerships to $21.3 million for Q3 2010 compared to$4.7 million for Q3 2009. The decline in servicing fees from the Latin AmericanAcquisition Partnerships was attributable to a decrease in the servicing costsrelated to those unconsolidated partnerships in Q3 2010 compared to Q3 2009(i.e. the lower the servicing costs incurred by these partnerships, the lowerthe service fee income recognized by the Company).

 

*Income from Portfolio Assets*.  Income from Portfolio Assetsdecreased to $8.2 million in Q3 2010 compared to $12.1 million in Q3 2009. Thedecrease in income from Portfolio Assets in Q3 2010 compared to Q3 2009 wasattributed primarily to a shift in the

 

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income-recognition methods used by management forcertain of the Company’s existing and newly-acquired Portfolio Assets tonon-accrual income methods (cost-recovery or cash basis) from theinterest-accrual income method over the past 12-18 months. We applynon-accrual income-recognition methods to Portfolio Assets, as applicable, dueto uncertainties related to estimating the timing and/or amount of collectionsas a result of the current economic environment. As such, income accretion from Portfolio Assets decreased by $3.7million in Q3 2010 compared to Q3 2009. Refer to Note 1 of the consolidatedfinancial statements included in Item 1 of this Form 10-Q for a summary ofour income-recognition accounting policies related to Portfolio Assets, andNote 4 of the consolidated financial statements for a summary of income fromPortfolio Assets.

 

*Gain on sale of SBA loans heldfor sale. *The Company recorded a $0.2 million gain on the sales of SBA loans inQ3 2010 with a $2.5 million net basis in the loans sold, compared to a $0.3 million gain on the sales of SBAloans in Q3 2009 with a $4.0 million net basis in the loans sold. Gains on SBAloan sales reflect the Company’s participation in the SBA guaranteed loanprogram. Under the SBA 7(a) program, the SBA guarantees up to 90 percentof the principal on a qualifying loan. The Company generally sells theguaranteed portions of originated loans into the secondary market and retainsthe unguaranteed portion for investment.

 

*Interest income from SBAloans. *Interestincome from SBA loans remained constant at $0.3 million for both Q3 2010 and Q32009. FirstCity’s average investment level in SBA loans held-for-investmentapproximated $15.1 million for Q3 2010 compared to $16.0 million for Q3 2009.

 

*Interest income from loansreceivable — affiliates. *Interest income from loans receivable — affiliates remained steady at$0.4 million in Q3 2010 compared to $0.5 million for Q3 2009. FirstCity’saverage investment level in loans receivable — affiliates in its PAA&Rsegment approximated $11.0 million for Q3 2010 compared to $14.0 million for Q32009.

 

*Interest income from loansreceivable — other. * The Company did not recognizeinterest income from loans receivable — other in Q3 2010 or Q3 2009 from itsnon-affiliated loan investments because management accounted for such loansunder the non-accrual method of accounting during both periods. FirstCity’saverage investment in loans receivable — other in its PAA&R segment was$4.6 million in Q3 2010, compared to its average investment in such loans of$6.4 million in Q3 2009 (all of which were accounted for under the non-accrualmethod during both periods).

 

*Other income*.  Other income from the Company’sPAA&R segment remained constant at $1.4 million for both Q3 2010 and Q32009.

 

*Expenses. *Operatingcosts and expenses approximated $13.3 million and $11.0 million in Q3 2010 andQ3 2009, respectively. The following is a discussion of the major components ofoperating costs and expenses.

 

Interest expense and fees on notes payable totaled $4.5million and $3.4 million for Q3 2010 and Q3 2009, respectively. FirstCity’saverage outstanding debt in its PAA&R segment was $289.1 million in Q3 2010compared to $292.2 million in Q3 2009. The Company’s average cost of borrowingsincreased to 6.2% in Q3 2010 compared to 4.6% in Q3 2009, primarily due to thehigher interest and fees charged on our Reducing Note Facility with Bank ofScotland (closed in June 2010) compared to the interest rates and feesunder the loan facilities we had in place with Bank of Scotland last year.

 

Salaries and benefits remained constant at $3.7 millionfor both Q3 2010 and Q3 2009. The total number of personnel within thePAA&R segment was 202 and 216 at September 30, 2010 and 2009,respectively.

 

Netprovisions for loan and impairment losses on consolidated Portfolio Assets andloans receivable in our PAA&R segment totaled $2.2 million in Q3 2010compared to $0.4 million in Q3 2009. The $2.2 million of net impairmentprovisions in Q3 2010 were attributed primarily to declines in values of loancollateral and real estate assets in our domestic loans and Portfolios. Theimpairment provisions were identified in connection with management’s quarterlyevaluation of the collectibility of the Company’s Portfolio Assets and loansreceivable. The process for evaluatingand measuring impairment is critical to our financial results, as it requiressubjective and complex judgments due to the need to make estimates about theimpact of matters that are uncertain. This process also requires estimates thatare susceptible to significant revision as more information becomes available.It remains unclear what impact the continuance of challenging economicconditions and disruptions in the financial, capital and real estate markets will ultimately have on our financialresults. These conditions could adversely impact our business if commercialreal estate properties experience a significant and prolonged decline in valueor if borrowers cannot refinance their loans and/or continue to make payments(which in turn could lead to rising loan defaults and foreclosures on loancollateral). Therefore, we cannot provide assurance that, in any particularfuture period, we will not incur additional impairment provisions.

 

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Asset-level expenses, which generally represent costsincurred by FirstCity to manage consolidated Portfolio Assets, supportforeclosed properties and to protect its security interests in loan collateral,increased slightly to $2.1 million in Q3 2010 from $1.9 million in Q3 2009. The increased level of expenses is attributedprimarily to the Company’s increased holdings in foreclosed real estate andother held-for-sale properties, which totaled $29.6 million at September 30,2010 compared to $16.6 million a year ago.

 

Other costs and expenses in the Company’s PAA&Rsegment decreased to $0.8 million in Q3 2010 from $1.7 million in Q3 2009, dueprimarily to $0.7 million of foreign currency exchange gains attributed to ourconsolidated foreign operations in Q3 2010 compared to $0.1 million of foreigncurrency exchange gains recognized in Q3 2009 — a $0.6 million improvement(attributed mainly to our consolidated European operations). The Euro currencystrengthened against the U.S. dollar more in Q3 2010 compared to Q3 2009.

 

*Equity in losses ofunconsolidated subsidiaries. *Equity in losses of unconsolidated subsidiaries (Acquisition Partnershipand servicing entities) from our PAA&R segment increased by $0.4 million inQ3 2010 compared to Q3 2009. Equity in losses of our unconsolidated AcquisitionPartnerships increased to $1.8 million for Q3 2010 from $0.8 million for Q32009, whereas equity in earnings of our unconsolidated servicing entitiesincreased to $0.4 million of earnings in Q3 2010 compared to $0.2 million inlosses in Q3 2009. The following is a discussion of equity in earnings fromFirstCity’s Acquisition Partnerships (by geographic region) and servicingentities. Refer to Note 6 of the consolidated financial statements included inItem 1 of this Form 10-Q for a summary of revenues, earnings and equity inearnings of FirstCity’s equity-method investments by region.

 

·             *Domestic* — Totalrevenues reported by our domestic Acquisition Partnerships increased to $4.6million in Q3 2010 compared to $1.1 million in Q3 2009. In addition, total net earnings reported by our domesticpartnerships improved to $1.6 million in net earnings for Q3 2010 compared to$0.3 million in net losses for Q3 2009. The increase in total revenuesand net earnings in Q3 2010 compared to Q3 2009 was attributable primarily toan increase in collections to $21.3 million in Q3 2010 from $4.7 million in Q32009; off-set partially by a $0.9 million increase in net impairment provisionsin Q3 2010 compared to Q3 2009. The collective activity described abovetranslated to a favorable decline in FirstCity’s share of domestic partnershiplosses to $0.1 million in losses for Q3 2010 compared to $0.3 million in lossesfor Q3 2009. FirstCity’s average investment in domestic AcquisitionPartnerships increased to $32.5 million for Q3 2010 from $12.4 million for Q32009, due primarily to increased investment activity by newly-formed domesticAcquisition Partnerships under FirstCity’s investment agreement with Värde (see Note 19 of the consolidated financialstatements included in Item 1 of this Form 10-Q). In light ofFirstCity’s increased holdings in domestic portfolio investments acquiredthrough equity-method investments in unconsolidated Acquisition Partnershipsinstead of consolidated Portfolio Assets over the past year, the Companyexpects equity in earnings of domestic partnerships to gradually increase overtime in comparison to income from consolidated domestic Portfolio Assets.

 

·         *LatinAmerica* — Total revenues reported by our Latin American AcquisitionPartnerships increased to $4.7 million in Q3 2010 from $3.8 million in Q3 2009.However, total net losses reported by our Latin American partnerships increasedto $2.3 million for Q3 2010 compared to$2.0 million for Q3 2009. Total collections from Latin American partnershipsdecreased to $6.1 million in Q3 2010 compared to $8.7 million in Q3 2009.However, the increase in net losses reported by our Latin American partnershipsin Q3 2010 compared to Q3 2009 was due primarily to $1.7 million of additionaltax expense recorded in Q3 2010 compared to Q3 2009, and $0.6 million ofadditional foreign currency exchange losses recorded in Q3 2010 compared to Q32009; off-set partially by a $0.7 million decrease in net impairment provisionsrecorded by these partnerships in Q3 2010 compared to Q3 2009. Thecollective activity described above translated to an unfavorable increase inFirstCity’s share of Latin American partnership losses to $0.6 million inlosses for Q3 2010 compared to $0.2 million in losses for Q3 2009.  FirstCity’s average investment in LatinAmerican Acquisition Partnerships decreased to $16.7 million for Q3 2010compared to $18.0 million for Q3 2009.

 

·             *Europe*—****Total revenues reported by our European AcquisitionPartnerships decreased to $0.3 million in Q3 2010 from $2.3 million in Q3 2009.In addition, total net losses reported by our European partnerships increasedto $3.5 million for Q3 2010 from $1.0 million in losses for Q3 2009. Thedecrease in total partnership revenues and net earnings reported by ourEuropean partnerships was attributed primarily to a decrease in collections to$2.2 million in Q3 2010 compared to $7.2 million in Q3 2009, and a $1.0 millionincrease in net impairment provisions recorded by these partnerships in Q3 2010compared to Q3 2009. Further contributing to the decline in Europeanpartnership revenues was the decrease in the level of Portfolio Asset holdingsby these Acquisition Partnerships over the past two years (see paragraphbelow). The collective activity described above translated to an unfavorableincrease in FirstCity’s share of European partnership losses to $1.2 million inQ3 2010 from $0.3 million in Q3 2009.

 

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FirstCity’saverage investment in European Acquisition Partnerships decreased to $5.1million for Q3 2010 from $11.9 million for Q3 2009 — which contributed to adecline in European partnership collections and FirstCity’s share of Europeanpartnership revenues as discussed above. Inlight of FirstCity’s step-acquisition transaction and resulting consolidationof sixteen French entities (former unconsolidated European AcquisitionPartnerships) in May 2009, the Company expects income from consolidatedEuropean Portfolio Assets to off-set the decline in our equity in earnings ofEuropean Acquisition Partnerships.

 

·             *ServicingEntities*—****Total revenuesreported by our foreign unconsolidated servicing entities remained relativelysteady at $11.6 million in Q3 2010 compared to $11.8 million in Q3 2009.However, total net earnings reported by these entities improved to $0.4 millionof net earnings in Q3 2010 from $0.6 million of net losses in Q3 2009. Theincrease in net earnings reported by the underlying servicing entities wasattributed primarily to $0.8 million of deferred tax benefits recorded by theseentities in Q3 2010. The collective activity described above translated to anincrease in FirstCity’s share of earnings from its foreign servicing entitiesto $0.4 million in earnings for Q3 2010 from $0.3 million in losses for Q32009.

 

*Net income attributable to noncontrollinginterests. *Net income attributable to noncontrolling interests represents theportions of net earnings that are attributable to our co-investors in ourmajority-owned, consolidated Acquisition Partnerships. The amount of net incomeattributable to noncontrolling interests in these consolidated AcquisitionPartnerships remained constant at $1.2 million for Q3 2010 compared to $1.3million for Q3 2009.

 

***SpecialSituations Platform Business Segment***

 

Theoperating contribution from the Special Situations Platform business segment (“FirstCityDenver”) resulted in an $8.0 million operating gain in Q3 2010 compared to a$1.6 million operating gain in Q3 2009. In Q3 2010, FirstCity Denver provided$0.1 million of investment capital to privately-held middle-market companies inthe form of direct equity investments, compared to $3.5 million of investmentcapital provided to such companies in the form of debt investments in Q3 2009.Since its inception in April 2007, FirstCity Denver has been involved inmiddle-market transactions with total investment values of $84.7 million, andhas provided $56.9 million of investment capital in connection with theseinvestments.

 

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Thefollowing is a summary of the results of operations for the Company’s SpecialSituations Platform business segment for Q32010 and Q3 2009:

 
| ** **                                           | ** ** | **Three Months Ended**     | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **September 30,**               | ** ** |
| ** **                                           | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Special Situations Platform:**                     |       |                                 |       |   |   |
| Revenues:                                            |       |                                 |       |   |   |
| Interest income from loans receivable                |       | $                                    | 662        |   | $ | 706 |   |
| Operating revenue - railroad                         |       | 998                                  |       | 776 |   |
| Operating revenue - coal mine                        |       | 15,329                               |       | — |   |
| Other income                                         |       | 421                                  |       | 338 |   |
| Total revenues                                       |       | 17,410                               |       | 1,820 |   |
| Expenses - Railroad Operations:                      |       |                                 |       |   |   |
| Interest and fees on notes payable                   |       | 36                                   |       | 29 |   |
| Salaries and benefits                                |       | 279                                  |       | 252 |   |
| Other                                                |       | 320                                  |       | 225 |   |
| Total railroad expenses                              |       | 635                                  |       | 506 |   |
| Expenses - Coal Mine Operations:                     |       |                                 |       |   |   |
| Interest and fees on notes payable                   |       | 20                                   |       | — |   |
| Salaries and benefits                                |       | 65                                   |       | — |   |
| Cost of sales                                        |       | 10,006                               |       | — |   |
| Amortization                                         |       | 5,200                                |       | — |   |
| Other                                                |       | 371                                  |       | — |   |
| Total coal mine expenses                             |       | 15,662                               |       | — |   |
| Expenses - Other:                                    |       |                                 |       |   |   |
| Interest and fees on notes payable                   |       | 121                                  |       | 116 |   |
| Salaries and benefits                                |       | (35                                  | )          | 280 |   |
| Provision for loan and impairment losses             |       | 1,854                                |       | — |   |
| Other                                                |       | 648                                  |       | 571 |   |
| Total other expenses                                 |       | 2,588                                |       | 967 |   |
| Total expenses                                       |       | 18,885                               |       | 1,473 |   |
| Equity in earnings of unconsolidated subsidiaries    |       | 11,408                               |       | 1,464 |   |
| Net income attributable to noncontrolling  interests |       | (1,548                               | )          | (262 | ) |
| Operating contribution before taxes                  |       | $                                    | 8,385      |   | $ | 1,549 |   |
| Operating contribution, net of direct taxes          |       | $                                    | 8,013      |   | $ | 1,615 |   |

* *

*Interest income from loansreceivable. * Interest income from loansreceivable remained constant at $0.7 million for both Q3 2010 and Q3 2009.FirstCity Denver’s average investment in loans receivable was $20.0 million forQ3 2010 — including $1.9 million accounted for under the non-accrual method ofaccounting. For Q3 2009, FirstCity Denver’s average investment in loansreceivable was $20.9 million — including $3.0 million accounted for under thenon-accrual method of accounting.

 

*Revenue andexpenses from railroad operations*.  Revenue and expenses from railroad operationsrepresents the results of operations recorded by FirstCity Denver’smajority-owned railroad companies (engaged primarily ininterchanging rail cars with connecting carriers and providing rail freightservices for on-line customers). Revenuefrom railroad operations increased by $0.2 million in Q3 2010 compared to Q3 2009 due to an increase in railcar movement services performed in Q3 2010 compared to Q3 2009. Totalexpenses in Q3 2010 attributable to the railroad operations remained relativelyconstant in comparison to Q3 2009.

 

*Revenue and expenses from coalmine operations*.  Revenue and expenses from coal mineoperations represent the consolidated results of operations recorded byFirstCity Denver’s majority-owned coal mine subsidiary (engagedprimarily in the purchase and sale of coal and coal-related products) whichbecame a consolidated subsidiary on April 1, 2010 — the date FirstCityDenver increased its ownership interest and obtained a controlling interest inthe entity. The coal mine entity generates revenue under a short-term coalsales contract with a major utility company. FirstCity Denver’s application ofbusiness combination accounting in connection with obtaining control of thecoal mine subsidiary resulted in the recognition of an asset for the coalsupply agreement and a liability for the

 

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coalpurchase agreement. The coal supply asset and coal purchase liability are beingamortized over the actual amount of tons shipped under each contract (which areboth scheduled to expire in December 2010). The Company does not expect the coal mine subsidiary’s operations toextend beyond the completion of its existing coal contracts. Refer to Note 3 tothe consolidated financial statements included in Item 1 of this Form 10-Qfor additional information on this transaction.

 

*Other income*.  Other income in Q3 2010 remainedrelatively constant in comparison to Q3 2009.

 

*Expenses —Other. *Otherexpenses increased by $1.6 million in Q3 2010 compared to Q3 2009 primarily dueto a $1.9 million impairment provision recorded in Q3 2010 on a commercial realestate investment. This impairment provision was attributed to adecline in value of the real estate property. The impairment provision wasidentified in connection with management’s regular evaluation of thecollectibility of FirstCity Denver’s investments. The process for evaluating and measuring impairment is critical to ourfinancial results, as it requires subjective and complex judgments due to theneed to make estimates about the impact of matters that are uncertain. Thisprocess also requires estimates that are susceptible to significant revision asmore information becomes available. It remains unclear what impact the continuanceof challenging economic conditions and disruptions in the financial, capitaland real estate markets will ultimatelyhave on our financial results. These conditions could adversely impact ourbusiness if borrowers cannot refinance their loans and/or continue to makepayments, or if the values of our underlying loan collateral and real estateproperties continue to decline. Therefore, we cannot provide assurance that, inany particular future period, we will not incur additional impairmentprovisions.

 

*Equity in earnings ofunconsolidated subsidiaries. *Equity in earnings of unconsolidated subsidiaries significantly increasedto $11.4 million in Q3 2010 from $1.5 million in Q3 2009. The increase in Q32010 was due primarily to $12.4 million of additional equity in earningsrecorded by FirstCity Denver in Q3 2010 compared to Q3 2009 for its share ofnet earnings from an equity-method investment in a prefabricated buildingmanufacturing entity. This entity reported significantly-higher net earnings inQ3 2010 related to a short-term lease agreement with a single customer. Thislease agreement does not extend beyond Q3 2010; however, under terms of arelated agreement, the manufacturing entity is due another $3.9 million fromthe customer (although the entity has not recognized any revenue related tothis receivable due to uncertainty regarding the collectibility of the amount).If the building manufacturing entity collects the entire $3.9 million, the netearnings impact to FirstCity would approximate $1.5 million. The increase inequity in earnings for Q3 2010 was off-set partially by $1.5 million ofadditional equity in losses recorded by FirstCity Denver in Q3 2010 compared toQ3 2009 for its share of net losses from equity-method investments in arestaurant management entity and multiple manufacturing concerns (including anew equity-method investment effective Q3 2010 in a wireless transmissionequipment and software solutions entity that was formerly accounted for as aconsolidated subsidiary until FirstCity Denver ceased having a controllinginterest in the entity effective June 30, 2010 — refer to Note 3 to theconsolidated financial statements included in Item 1 of this Form 10-Q foradditional information). The increased losses reported by these entities in Q32010 were due primarily to lower-than-expected sales volumes during the period.The increase in equity in earnings for Q3 2010 was also off-set partially by a$0.9 million decrease in equity in earnings in Q3 2010 compared to Q3 2009attributable to FirstCity Denver’s share of net earnings from its equity-methodinvestments in the coal mine operation described above. FirstCity Denver didnot account for the coal mine operation under the equity-method of accountingin Q3 2010 since it obtained a controlling interest in the subsidiary effectiveApril 1, 2010 (refer to Note 3 to the consolidated financial statementsincluded in Item 1 of this Form 10-Q for additional information).

 

*Net income attributable tononcontrolling interests. *The amount of net income attributable to noncontrolling interests relatedto FirstCity Denver, an 80%-owned subsidiary of FirstCity, increased to $1.5million for Q3 2010 compared to $0.3 million for Q3 2009. The increase in Q32010 was due primarily to additional net earnings reported by FirstCity Denverin Q3 2010 compared to Q3 2009 (mainly related to an increase in equity inearnings from unconsolidated subsidiaries as discussed above).

 

***First Nine Months of 2010 Compared to FirstNine Months of 2009***

 

FirstCityrecorded net earnings of $10.7 million, or $1.06 per common share diluted, forYTD 2010, compared to $10.4 million, or $1.02 per common share diluted, for YTD2009. The following is a discussion andanalysis of FirstCity’s net earnings based on its reportable business segments.

 

*Portfolio Asset Acquisition and Resolution*

 

Throughour PAA&R business segment, FirstCityand its investment partners acquired $174.7 million of Portfolio Assets in YTD2010 with an approximate face value of $312.5 million, compared to the Company’sinvolvement in acquiring $186.0 million of Portfolio Assets in YTD 2009 with anapproximate face value of $373.6 million. In YTD 2010, FirstCity’s investmentacquisition share in the Portfolio Asset acquisitions was $53.2 million — with$29.4 million acquired through consolidated Portfolios and $23.8 millionacquired through unconsolidated Portfolios. In YTD 2009, FirstCity’s investmentacquisition share in Portfolio Asset

 

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acquisitionswas $134.5 million — with $131.5 million acquired through consolidatedPortfolios and $3.0 million acquired through unconsolidated Portfolios.Generally speaking, income recognized from our investments in consolidatedportfolio assets is reported as “Income from Portfolio Assets” on ourconsolidated statements of operations, whereas income from our investments inunconsolidated subsidiaries that acquire portfolio assets is reported as “Equityin earnings of unconsolidated subsidiaries.” Furthermore, since we function asthe servicer for the vast majority of our domestic and Latin Americanunconsolidated portfolio assets, we also recognize fee income related to theperformance of our servicing responsibilities. This fee income is reported as “Servicingfees” on our consolidated statements of operations. We also generate servicefee income from our domestic and Latin American consolidated portfolio assetsthat we service; however, this income is eliminated in consolidation and, assuch, is not included on our consolidated statements of operations.

 

InYTD 2010, FirstCity invested an additional $28.4 million in non-portfolioinvestments in the form of SBA loan originations and advances, direct equityinvestments, and other loan investments, compared to $28.0 million of additional non-portfolio investments in the form of****SBA loan originations and advances and direct equityinvestments in YTD 2009. Refer to the heading “**PortfolioAsset Acquisitions — Portfolio Asset Acquisition and Resolution BusinessSegment**” below for additional information related to our investmentactivities and composition in our PAA&R segment.

 

The operating contribution from our PAA&R businesssegment resulted in a $2.8 million operating gain in YTD 2010 compared to a$14.1 million operating gain in YTD 2009. The following is a summary of theresults of operations for the Company’s PAA&R business segment for YTD 2010and YTD 2009:

 
| ** **                                                   | ** ** | **Nine Months Ended**      | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                   | ** ** | **September 30,**               | ** ** |
| ** **                                                   | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                                                   | ** ** | **(Dollars in thousands)** | ** ** |
| **Portfolio Asset Acquisition and  Resolution:**             | ** ** | ** **                           |       |   |   |
| Revenues:                                                    |       |                                 |       |   |   |
| Servicing fees                                               |       | $                                    | 5,998      |   | $ | 7,017 |   |
| Income from Portfolio Assets                                 |       | 34,280                               |       | 35,254 |   |
| Gain on sale of SBA loans held for sale, net                 |       | 360                                  |       | 911 |   |
| Gain on sale of investment securities                        |       | 3,250                                |       | — |   |
| Interest income from SBA loans                               |       | 895                                  |       | 940 |   |
| Interest income from loans receivable - affiliates           |       | 1,371                                |       | 1,560 |   |
| Interest income from loans receivable - other                |       | —                               |       | 414 |   |
| Other income                                                 |       | 3,204                                |       | 2,987 |   |
| Total revenues                                               |       | 49,358                               |       | 49,083 |   |
| Expenses:                                                    |       |                                 |       |   |   |
| Interest and fees on notes payable                           |       | 11,420                               |       | 10,128 |   |
| Salaries and benefits                                        |       | 11,764                               |       | 11,208 |   |
| Provision for loan and impairment losses, net of  recoveries |       | 5,394                                |       | 1,241 |   |
| Asset-level expenses                                         |       | 5,519                                |       | 4,208 |   |
| Other                                                        |       | 5,212                                |       | 4,674 |   |
| Total expenses                                               |       | 39,309                               |       | 31,459 |   |
| Equity in losses of unconsolidated subsidiaries              |       | (253                                 | )          | (188 | ) |
| Gain on business combinations                                |       | 891                                  |       | 1,455 |   |
| Net income attributable to noncontrolling  interests         |       | (7,290                               | )          | (2,854 | ) |
| Operating contribution before direct taxes                   |       | $                                    | 3,397      |   | $ | 16,037 |   |
| Operating contribution, net of direct taxes                  |       | $                                    | 2,795      |   | $ | 14,082 |   |

 

*Servicing fee revenues. *Servicingfee revenues decreased to $6.0 million in YTD 2010 from $7.0 million in YTD 2009.Servicing fees from domestic Acquisition Partnerships totaled $1.3 million inYTD 2010 compared to $1.8 million in YTD 2009, while servicing fees from LatinAmerican Acquisition Partnerships totaled $4.7 million in YTD 2010 and $5.2million in YTD 2009. Servicing fees from domestic Acquisition Partnerships aregenerally based on a percentage of the collections received from PortfolioAssets held by these unconsolidated partnerships; whereas servicing fees fromLatin American Acquisition Partnerships are generally based on the cost ofservicing plus a profit margin. The decline in servicing fees from domesticAcquisition Partnerships was due primarily to $0.8 million of performance-basedfees (based on certain domestic partnerships achieving economic thresholds)recognized in YTD 2009 compared to YTD 2010, off-set partially by the impact ofincreased collections from unconsolidated domestic partnerships to

 

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$29.2 million for YTD 2010 from $19.0 million for YTD2009. The decline in servicing fees from the Latin American AcquisitionPartnerships was attributable to a decrease in the servicing costs related tothose unconsolidated partnerships in YTD 2010 compared to YTD 2009 (i.e. thelower the servicing costs incurred by these partnerships, the lower the servicefee income recognized by the Company).

 

*Income from Portfolio Assets*.  Income from Portfolio Assetsdecreased slightly to $34.3 million in YTD 2010 compared to $35.3 million inYTD 2009. The net decrease in income from Portfolio Assets was attributedprimarily to a shift in the income-recognition methods used by management forcertain of the Company’s existing and newly-acquired Portfolio Assets tonon-accrual income methods (cost-recovery or cash basis) from theinterest-accrual income method over the past 12-18 months. We applynon-accrual income-recognition methods to Portfolio Assets, as applicable, dueto uncertainties related to estimating the timing and/or amount of collectionsas a result of the current economic environment. As such, income accretion from Portfolio Assets decreased by $12.1million in YTD 2010 compared to YTD 2009. This income decrease was off-setpartially by $11.1 million of additional Portfolio Asset liquidation income andgains recognized in YTD 2010 compared to YTD 2009. Although collections fromconsolidated Portfolio Assets decreased to $94.0 million in YTD 2010 from $124.6million in YTD 2009, FirstCity was able to recognize significantly-highermargins on certain Portfolio Asset liquidations in YTD 2010 compared to YTD2009. Refer to Note 1 of the consolidated financial statements included in Item1 of this Form 10-Q for a summary of our income-recognition accountingpolicies related to Portfolio Assets, and Note 4 of the consolidated financialstatements for a summary of income from Portfolio Assets.

 

*Gain on sale of SBA loans heldfor sale. *The Company recorded $0.4 million of gains on the sales of SBA loans inYTD 2010 with a $4.6 million net basis in the loans sold, compared to $0.9 million of gains on the sales of SBAloans in YTD 2009 with a $17.2 million net basis in the loans sold. Gains onSBA loan sales reflect the Company’s participation in the SBA guaranteed loanprogram. Under the SBA 7(a) program, the SBA guarantees up to 90 percentof the principal on a qualifying loan. The Company generally sells theguaranteed portions of originated loans into the secondary market and retainsthe unguaranteed portion for investment.

 

*Gain on sale of investmentsecurities. *In YTD 2010, the Company recognized a $3.3 million gain related to thesale of its investment security that represented a beneficial interest insecuritized financial assets. No such sales were recorded in YTD 2009.

 

*Interest income from SBAloans. *Interestincome from SBA loans remained constant at $0.9 million for both YTD 2010 andYTD 2009. FirstCity’s average investment level in SBA loans held-for-investmentapproximated $15.2 million for YTD 2010 compared to $15.6 million for YTD 2009.

 

*Interest income from loansreceivable — affiliates. *Interest income from loans receivable — affiliates decreased slightly to$1.4 million in YTD 2010 compared to $1.6 million YTD 2009. The interest incomedecline is attributed to a decline in FirstCity’s average investment level inloans receivable — affiliates in its PAA&R segment to $11.8 million for YTD2010 compared to $14.0 million for YTD 2009.

 

*Interest income from loansreceivable — other. * Interest income from loansreceivable — other decreased by $0.4 million for YTD 2010 compared to YTD 2009.The Company did not recognize interest income from loans receivable — other inYTD 2010 from its non-affiliated loan investments because management accountedfor such loans under the non-accrual method of accounting during the entireperiod. FirstCity’s average investment in loans receivable — other in itsPAA&R segment was $5.0 million in YTD 2010, compared to its average investmentin such loans of $6.9 million in YTD 2009 (including $2.1 million accounted forunder the non-accrual method).

 

*Other income*.  Other income from the Company’sPAA&R segment remained relatively constant at $3.2 million in YTD 2010compared to $3.0 million in YTD 2009.

 

*Expenses. *Operatingexpenses approximated $39.3 million and $31.5 million in YTD 2010 and YTD 2009,respectively. The following is a discussion of the major components ofoperating expenses.

 

Interest expense and fees on notes payable totaled $11.4million for YTD 2010 and $10.1 million for YTD 2009. FirstCity’s averageoutstanding debt in its PAA&R segment increased to $291.7 million in YTD2010 from $279.5 million in YTD 2009 — primarily to finance its increasedinvestment activity and to provide working capital to support future growth.The Company’s average cost of borrowings increased to 5.2% in YTD 2010 comparedto 4.8% in YTD 2009, primarily due to the higher interest and fees charged onour Reducing Note Facility with Bank of Scotland (closed in June 2010)compared to the interest rates and fees under the loan facilities we had inplace with Bank of Scotland last year.

 

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Salaries and benefits increased modestly to $11.8 millionin YTD 2010 from $11.2 million in YTD 2009, due primarily to increased costsrelated to base salaries, payroll taxes and employee benefits and bonuses inthe PAA&R segment in YTD 2010 compared to YTD 2009. The total number ofpersonnel within the PAA&R segment was 202 and 216 at September 30,2010 and 2009, respectively.

 

Netprovisions for loan and impairment losses on our consolidated Portfolio Assetsand loans receivable in our PAA&R segment totaled $5.4 million in YTD 2010and $1.2 million in YTD 2009. The $5.4 million of net impairment provisions inYTD 2010 were attributed primarily to declines in values of real estateproperties and loan collateral related to our domestic Portfolio Assets andloans. The impairment provisions were identified in connection with management’squarterly evaluation of the collectibility of the Company’s Portfolio Assetsand loans receivable. The process forevaluating and measuring impairment is critical to our financial results, as itrequires subjective and complex judgments due to the need to make estimatesabout the impact of matters that are uncertain. This process also requiresestimates that are susceptible to significant revision as more informationbecomes available. It remains unclear what impact the continuance ofchallenging economic conditions and disruptions in the financial, capital andreal estate markets will ultimatelyhave on our financial results. These conditions could adversely impact ourbusiness if commercial real estate properties experience a significant andprolonged decline in value or if borrowers cannot refinance their loans and/orcontinue to make payments (which in turn could lead to rising loan defaults andforeclosures on loan collateral). Therefore, we cannot provide assurance that,in any particular future period, we will not incur additional impairmentprovisions.

 

Asset-level expenses, which generally represent costsincurred by FirstCity to manage consolidated Portfolio Assets in its PAA&Rbusiness segment, support foreclosed properties and to protect its securityinterests in loan collateral, increased to $5.5 million in YTD 2010from $4.2 million in YTD 2009. Theincreased level of expenses is attributed primarily to the Company’s increasedholdings in foreclosed real estate properties, which totaled $29.6 million at September 30,2010 compared to $16.6 million a year ago, and an increase in the Company’saverage investment level in consolidated Portfolio Assets to $212.0 million forYTD 2010 from $196.3 million for YTD 2009.

 

Other costs and expenses in the Company’s PAA&Rsegment increased to $5.2 million for YTD 2010 from $4.7 million for YTD 2009,primarily due to $0.4 million of foreign currency exchange losses attributed toour consolidated foreign operations in YTD 2010 compared to $0.4 million offoreign currency exchange gains recognized in YTD 2009 — a $0.8 millionfavorable swing (attributed mainly to our consolidated European operations).The Euro currency strengthened against the U.S. dollar more in YTD 2010compared to YTD 2009.

 

*Equity in losses ofunconsolidated subsidiaries. *Equity in losses of unconsolidated subsidiaries (Acquisition Partnershipand servicing entities) from our PAA&R segment increased slightly by $0.1million in YTD 2010 compared to YTD 2009. Equity in losses of ourunconsolidated Acquisition Partnerships totaled $2.7 million in YTD 2010compared to equity in earnings of $0.4 million in YTD 2009, whereas equity inearnings of our unconsolidated servicing entities increased to $2.4 million ofearnings in YTD 2010 compared to $0.6 million of losses in YTD 2009. Thefollowing is a discussion of equity in earnings from FirstCity’s AcquisitionPartnerships (by geographic region) and servicing entities. Refer to Note 6 ofthe consolidated financial statements included in Item 1 of this Form 10-Qfor a summary of revenues, earnings and equity in earnings of FirstCity’sequity-method investments by region.

 

·             *Domestic* — Totalrevenues reported by domestic Acquisition Partnerships increased to $7.2million in YTD 2010 compared to $5.7 million in YTD 2009. In addition, total net earnings reported by domesticpartnerships increased to $2.1 million in YTD 2010 compared to $1.1 million inYTD 2009. The increase in total revenues and net earnings in YTD 2010compared to YTD 2009 was attributable primarily to an increase in collectionsto $29.2 million in YTD 2010 from $19.0 million in YTD 2009; which was off-setpartially by a $0.6 million increase in net impairment provisions recorded bythese partnerships in YTD 2010 compared to YTD 2009, and a $2.5 million declinein interest and accretion income in YTD 2010 compared to YTD 2009 due primarilyto an increase in the level of domestic partnership loan portfolios accountedfor on a non-accrual method of accounting (cost-recovery or cash basis) insteadof the interest method (i.e. accrual method). Under U.S. GAAP, the interestmethod of accounting for income-recognition purposes is not appropriate ifmanagement does not have the ability to develop a reasonable expectation ofboth the timing and amount of future cash flows to be collected. Although totalrevenues and net earnings reported by our domestic Acquisition Partnershipsincreased in YTD 2010 compared to YTD 2009, the collective activity describedabove translated to a decrease in FirstCity’s share of domestic partnership netearnings to a $0.1 million loss for YTD 2010 compared to $0.2 million ofearnings for YTD 2009. This $0.3 million unfavorable swing is attributed to thecomposition of FirstCity’s ownership mix in the domestic AcquisitionPartnerships that reported net earnings and losses in YTD 2010 compared to YTD2009. FirstCity’s average investment in domestic Acquisition Partnershipsincreased to $21.4 million for YTD 2010 from $13.8 million for YTD 2009, dueprimarily to increased investment activity in newly-formed 

 

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domesticAcquisition Partnerships under FirstCity’s investment agreement with Värde (see Note 19 of the consolidated financialstatements included in Item 1 of this Form 10-Q). In light ofFirstCity’s increased holdings in domestic portfolio investments acquiredthrough equity-method investments in unconsolidated Acquisition Partnershipsinstead of consolidated Portfolio Assets over the past year, the Companyexpects equity in earnings of domestic partnerships to gradually increase overtime in comparison to income from consolidated Portfolio Assets.

 

·         *LatinAmerica* — Total revenues reported by Latin American Acquisition Partnershipsincreased to $15.0 million in YTD 2010 from $9.2 million in YTD 2009. However,total net losses reported by our Latin American partnerships increased to $4.5 million in YTD 2010 compared to $3.0 millionYTD 2009. Total collections from our Latin American partnerships increased to$22.2 million in YTD 2010 compared to $20.5 million in YTD 2009, whichcontributed to the favorable increase in total partnership revenues. The increasein revenues reported by our Latin American partnerships in YTD 2010 was off-setby the following (which contributed to the increase in net losses thesepartnerships reported in YTD 2010): (1) $1.2 million of foreign currencyexchange losses recorded by these partnerships in YTD 2010 compared to $2.1million of foreign currency exchange gains recorded in YTD 2009 — a $3.3million unfavorable swing; (2) $3.1 million of additional tax-relatedexpense recorded in YTD 2010 compared to YTD 2009 (primarily related toincreased income from collections in Brazil combined with reversals of certainvalue-added tax receivables in Mexico); and (3) $1.2 million of additionalnet impairment provisions recorded in YTD 2010 compared to YTD 2009. Thecollective activity described above translated to FirstCity’s share of LatinAmerican partnership losses totaling $0.5 million for both YTD 2010 and YTD2009. FirstCity’s average investment in Latin American Acquisition Partnershipsdecreased to $17.1 million for YTD 2010 compared to $17.8 million for YTD 2009.

 

·             *Europe*—****Total revenues reported by European AcquisitionPartnerships decreased to $2.8 million in YTD 2010 from $13.8 million in YTD2009. In addition, total net earnings reported by the European partnershipsdecreased sharply to $6.8 million in losses for YTD 2010 from $2.7 million inearnings for YTD 2009. The decrease in total partnership revenues and netearnings reported by our European partnerships was attributed primarily to adecrease in collections to $12.1 million in YTD 2010 compared to $22.6 millionin YTD 2009, off-set partially by a $1.3 million decrease in service feeexpense reported by these partnerships in YTD 2010 compared to YTD 2009.Further contributing to the decline in European partnership revenues was thedecrease in the level of Portfolio Asset holdings by these AcquisitionPartnerships over the past two years (see paragraph below). The collectiveactivity described above translated to an unfavorable decrease in FirstCity’sshare of European partnership earnings to $2.1 million in losses for YTD 2010from $0.7 million in earnings for YTD 2009.

 

FirstCity’saverage investment in European Acquisition Partnerships decreased to $6.5million for YTD 2010 from $12.6 million for YTD 2009 — which contributed to adecline in European partnership collections and FirstCity’s share of Europeanpartnership revenues as discussed above. Inlight of FirstCity’s step-acquisition transaction and resulting consolidationof sixteen French entities (former unconsolidated European AcquisitionPartnerships) in May 2009, the Company expects income from consolidatedPortfolio Assets to off-set the decline in European partnership revenues.

 

·             *ServicingEntities*—****Total revenuesreported by our foreign unconsolidated servicing entities increased to $39.8million in YTD 2010 from $35.5 million in YTD 2009, and total net earningsreported by these entities improved to $6.7 million in net earnings for YTD2010 from $1.3 million of net losses for YTD 2009. The increase in net earningsreported by the underlying servicing entities was attributed primarily to (1) additionalinvestment income of $4.1 million recorded in YTD 2010 compared to YTD 2009; (2) a$2.5 million decrease in income tax provisions in YTD 2010 compared to YTD 2009as a result of our ability to recognize foreign tax benefits associated withU.S. GAAP adjustments to an unconsolidated European servicing entity’s localfinancial statements, combined with the timing of income tax payments made bythe foreign servicing entity in its local jurisdiction; and (3) a $1.1million decrease in operating costs attributed to a Latin American servicingentity in YTD 2010 compared to YTD 2009. The collective activity describedabove translated to an increase in FirstCity’s share of earnings from itsforeign servicing entities to $2.4 million in earnings for YTD 2010 from $0.6million in losses for YTD 2009.

 

*Gain on business combinations.*  In YTD 2010, the Company recordeda $0.9 million gain attributable to a step-acquisition transaction in which theCompany acquired a controlling financial interest in three domestic AcquisitionPartnerships. The Company owned a noncontrolling equity interest in theseentities prior to the transaction. Under business combination accountingguidance, the Company’s previously-held noncontrolling interests in theseentities were re-measured to fair value on the acquisition date — whichresulted in the Company’s recognition of the $0.9 million gain. Refer to Note 3of the consolidated financial statements included in Item 1 of this Form 10-Qfor additional information on this transaction. In YTD 2009, the Companyrecorded a $1.5 million gain attributable to a step-acquisition transaction inwhich the Company acquired a controlling financial interest in certain FrenchAcquisition Partnerships. The Company owned a noncontrolling equity interest inthese entities prior to the transaction. Under business combination accounting guidance,the Company’s previously-held noncontrolling interests in the French entitieswere re-measured to fair value on the acquisition date (May 2009) — whichresulted in the Company’s recognition of the $1.5 million gain.

 

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*Net income attributable tononcontrolling interests. *Net income attributable to noncontrolling interests represents theportions of net earnings that are attributable to our co-investors in ourmajority-owned, consolidated Acquisition Partnerships. The amount of net incomeattributable to noncontrolling interests in these consolidated AcquisitionPartnerships increased to $7.3 million for YTD 2010 from $2.9 million for YTD2009. This increase is attributed to an increase in net earnings from thesemajority-owned, consolidated Acquisition Partnerships in YTD 2010 compared toYTD 2009 (i.e. an increase in the amount of net earnings reported by thesemajority-owned entities translates to an increase in the amount of net earningsapportioned to the noncontrolling investors).

 

***SpecialSituations Platform Business Segment***

 

Theoperating contribution from the Special Situations Platform business segment (“FirstCityDenver”) increased significantly to $14.0 million in YTD 2010 compared to $1.8million in YTD 2009. In YTD 2010, FirstCity Denver provided $13.0 million ofinvestment capital to privately-held middle-market companies in the form ofdebt and direct equity investments ($4.6 million financed through an investeeentity’s debt), compared to $9.0 million of investment capital provided to suchcompanies in the form of debt and equity in YTD 2009. Since its inception in April 2007,FirstCity Denver has been involved in middle-market transactions with totalinvestment values of $84.7 million, and has provided $56.9 million ofinvestment capital in connection with these investments.

 

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Thefollowing is a summary of the results of operations for the Company’s SpecialSituations Platform business segment forYTD 2010 and YTD 2009:

 
| ** **                                           | ** ** | **Nine Months Ended**      | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **September 30,**               | ** ** |
| ** **                                           | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Special Situations Platform:**                     |       |                                 |       |   |   |
| Revenues:                                            |       |                                 |       |   |   |
| Interest income from loans receivable                |       | $                                    | 1,814      |   | $ | 1,858 |   |
| Operating revenue - railroad                         |       | 3,455                                |       | 2,228 |   |
| Operating revenue - manufacturing                    |       | 10,466                               |       | — |   |
| Operating revenue - coal mine                        |       | 28,429                               |       | — |   |
| Other income                                         |       | 1,258                                |       | 1,647 |   |
| Total revenues                                       |       | 45,422                               |       | 5,733 |   |
| Expenses - Railroad Operations:                      |       |                                 |       |   |   |
| Interest and fees on notes payable                   |       | 111                                  |       | 84 |   |
| Salaries and benefits                                |       | 815                                  |       | 732 |   |
| Other                                                |       | 942                                  |       | 716 |   |
| Total railroad expenses                              |       | 1,868                                |       | 1,532 |   |
| Expenses - Manufacturing Operations:                 |       |                                 |       |   |   |
| Salaries and benefits                                |       | 2,396                                |       | — |   |
| Cost of sales                                        |       | 6,011                                |       | — |   |
| Other                                                |       | 2,381                                |       | — |   |
| Total manufacturing expenses                         |       | 10,788                               |       | — |   |
| Expenses - Coal Mine Operations:                     |       |                                 |       |   |   |
| Interest and fees on notes payable                   |       | 57                                   |       | — |   |
| Salaries and benefits                                |       | 132                                  |       | — |   |
| Cost of sales                                        |       | 19,316                               |       | — |   |
| Amortization                                         |       | 8,662                                |       | — |   |
| Other                                                |       | 790                                  |       | — |   |
| Total coal mine expenses                             |       | 28,957                               |       | — |   |
| Expenses - Other:                                    |       |                                 |       |   |   |
| Interest and fees on notes payable                   |       | 352                                  |       | 347 |   |
| Salaries and benefits                                |       | 706                                  |       | 750 |   |
| Provision for loan and impairment losses             |       | 3,023                                |       | 967 |   |
| Other                                                |       | 1,417                                |       | 1,496 |   |
| Total other expenses                                 |       | 5,498                                |       | 3,560 |   |
| Total expenses                                       |       | 47,111                               |       | 5,092 |   |
| Equity in earnings of unconsolidated subsidiaries    |       | 14,260                               |       | 1,661 |   |
| Gain on business combinations                        |       | 4,838                                |       | — |   |
| Net income attributable to noncontrolling  interests |       | (2,893                               | )          | (313 | ) |
| Operating contribution before taxes                  |       | $                                    | 14,516     |   | $ | 1,989 |   |
| Operating contribution, net of direct taxes          |       | $                                    | 13,991     |   | $ | 1,820 |   |

 

*Interest income from loansreceivable.* Interest income from loans receivable remainedsteady at $1.8 million in YTD 2010 compared to $1.9 million in YTD 2009.FirstCity Denver’s average investment in loans receivable was $19.3 million forYTD 2010 — including $2.4 million accounted for under the cost recovery method.For YTD 2009, FirstCity Denver’s average investment in loans receivable was$20.1 million — including $1.9 million accounted for under the cost recoverymethod

 

*Revenue andexpenses from railroad operations*.  Revenue and expenses from railroad operationsrepresents the results of operations recorded by FirstCity Denver’smajority-owned railroad companies (engaged primarily ininterchanging rail cars with connecting carriers and providing rail freightservices for on-line customers). Revenuefrom railroad operations increased by $1.2 million in YTD 2010 compared to YTD 2009 due to an increase in railcar movement services performed in YTD 2010 compared to 

 

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YTD2009. Total expenses in YTD 2010 attributable to the railroad operationsremained relatively constant in comparison to YTD 2009.

 

*Revenue and expenses frommanufacturing operations*.  Revenue and expenses from manufacturingoperations represents the consolidated results of operations recorded byFirstCity Denver’s manufacturing company (engaged principally in thedesign, production and sale of wireless transmission equipment and softwaresolutions) through June 30, 2010.FirstCity acquired a controlling interest in this company in December 2009;however, on June 30, 2010, FirstCity Denver ceased to have a controllinginterest, but retained a noncontrolling interest and elevated economicinterests, in this manufacturing subsidiary. As such, on June 30, 2010,FirstCity Denver deconsolidated this subsidiary and began to account forits retained investment in the manufacturing entity using the equity-method ofaccounting. Consequently, subsequent to June 30, 2010, FirstCity Denver nolonger reports the individual revenue and expense line-items of themanufacturing entity’s operations in its consolidated statement of operations(rather, FirstCity Denver now records its share of the subsidiary’s netearnings as “Equity in earnings of unconsolidated subsidiaries”). Refer to Note 3 to the consolidated financialstatements included in Item 1 of this Form 10-Q for additional informationon this transaction. The company’s sales in YTD 2010 (through June 30,2010) were composed of $6.7 million related to equipment and $3.8 millionrelated to software solutions. In YTD 2010, 32% of the company’s sales weremade to international customers.

 

*Revenue and expenses from coalmine operations and gain on business combinations*.  Revenue and expenses from coalmine operations represent the consolidated results of operations recorded byFirstCity Denver’s majority-owned coal mine subsidiary (engaged primarilyin the purchase and sale of coal and coal-related products) which became aconsolidated subsidiary on April 1, 2010 — the date FirstCity Denverincreased its ownership interest and obtained a controlling interest in theentity. The coal mine entity generates revenue under a short-term coal salescontract with a major utility company. FirstCity Denver’s application ofbusiness combination accounting in connection with obtaining control of thecoal mine subsidiary resulted in the recognition of an asset for the coalsupply agreement and a liability for a coal purchase agreement. The coal supplyasset and coal purchase liability are being amortized over the actual amount oftons shipped under each contract (which are both scheduled to expire in December 2010).  FirstCity Denver also recognized a $4.8million business combination gain based on the excess of the fair value of itstotal interest in the coal mine subsidiary after the business combination overthe carrying value of its previously-held equity interest. The Company does notexpect the coal mine subsidiary’s operations to extend beyond the completion ofits existing coal contracts. Refer to Note3 to the consolidated financial statements included in Item 1 of this Form 10-Qfor additional information on this transaction.

 

*Other income*.  Other income in YTD 2010decreased modestly by $0.4 million in comparison to YTD 2009, primarily due to$1.2 million of gains recognized by FirstCity Denver’s consolidatedsubsidiaries in YTD 2009 (mainly railroad operations) in connection withproperty and equipment sales compared to $0.2 million of such gains recorded inYTD 2010. The decrease in other income in YTD 2010 was off-set partially by anincrease in ancillary income generated by FirstCity Denver’s consolidatedsubsidiaries in YTD 2010 compared to YTD 2009.

 

*Expenses —Other. *Otherexpenses increased by $1.9 million in YTD 2010 compared to YTD 2009 primarilydue to $2.1 million of additional net impairment provisions recorded on real estateproperties and loan investments in YTD 2010 compared to YTD 2009. The impairmentprovisions were identified in connection with management’s regular evaluationof the collectibility of FirstCity Denver’s investments. The process for evaluating and measuringimpairment is critical to our financial results, as it requires subjective andcomplex judgments due to the need to make estimates about the impact of mattersthat are uncertain. This process also requires estimates that are susceptibleto significant revision as more information becomes available. It remainsunclear what impact the continuance of challenging economic conditionsand disruptions in the financial, capital and real estate markets will ultimately have on our financialresults. These conditions could adversely impact our business if borrowerscannot refinance their loans and/or continue to make payments, or if the valuesof our underlying loan collateral and real estate properties continue todecline. Therefore, we cannot provide assurance that, in any particular futureperiod, we will not incur additional impairment provisions.

 

*Equity in earnings ofunconsolidated subsidiaries. *Equity in earnings of unconsolidated subsidiaries significantly increasedto $14.3 million in YTD 2010 from $1.7 million in YTD 2009. The increase in YTD2010 was due primarily to $14.3 million of additional equity in earningsrecorded by FirstCity Denver in YTD 2010 compared to YTD 2009 for its share ofnet earnings from an equity-method investment in a prefabricated buildingmanufacturing entity. This entity reported significantly-higher net earnings inYTD 2010 related to a short-term lease agreement with a single customer. Thislease agreement does not extend beyond September 30, 2010; however, under termsof a related agreement, the manufacturing entity is due another $3.9 millionfrom the customer (although the entity has not recognized any income related tothis receivable due to uncertainty regarding the collectibility of the amount).If the building manufacturing entity collects the entire $3.9 million, the netearnings impact to FirstCity would approximate $1.5 million. The increase inequity in earnings for YTD 2010 was also due in part to $0.5 million ofadditional equity in earnings recorded by FirstCity Denver in YTD 2010 comparedto YTD 2009 for its share of net earnings from its former equity-methodinvestment in the coal mine operation (FirstCity Denver consolidated thissubsidiary effective April 1, 2010 — refer to discussion above) andnewly-obtained direct equity-method investment in a coal mine equipmentsubsidiary (refer to Note 3 to the consolidated 

 

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financial statements included in Item 1 of this Form 10-Qfor additional information on this transaction). The increase in equity inearnings for YTD 2010 was off-set partially by $2.2 million of additionalequity in losses recorded by FirstCity Denver in YTD 2010 compared to YTD 2009for its share of net losses from equity-method investments in a restaurantmanagement entity and multiple manufacturing concerns (including a newequity-method investment effective Q3 2010 in a wireless transmission equipmentand software solutions entity that was formerly accounted for as a consolidatedsubsidiary until FirstCity Denver ceased having a controlling interest in theentity effective June 30, 2010 — refer to Note 3 to the consolidatedfinancial statements included in Item 1 of this Form 10-Q for additionalinformation). The increased losses reported by these entities in YTD 2010 weredue primarily to lower-than-expected sales volumes during the period.

 

*Net income attributable tononcontrolling interests. *The amount of net income attributable to noncontrolling interests relatedto FirstCity Denver, an 80%-owned subsidiary of FirstCity, increased to $2.9million for YTD 2010 compared to $0.3 million for YTD 2009. The increase in YTD2010 was due primarily to additional net earnings reported by FirstCity Denverin YTD 2010 compared to YTD 2009 (mainly related to an increase in equity inearnings from unconsolidated subsidiaries as discussed above).

 

**Financial Condition**

 

Significant changes in FirstCity’s financial conditionduring the first nine months of 2010 resulted from the following:

 

Consolidated assets of $445.2 million at September 30,2010 were $19.9 million lower than consolidated assets at December 31,2009. The decrease in consolidated assets was attributed primarily to (1) a$44.8 million decrease in cash due primarily to net principal repayments on notespayable, net investment activity, and distributions paid to noncontrollinginterests (refer to the consolidated statement of cash flows in Item 1 of this Form 10-Qfor additional information on cash changes); and (2) a $12.6 million netdecrease in the Company’s consolidated Portfolio Assets in YTD 2010 attributedto net principal collections and net impairment provisions. The decrease intotal assets in YTD 2010 was off-set partially by a $30.0 million increase inequity-method investments due to increased investment activity attributed toexisting and newly-formed Acquisition Partnerships (primarily domestic) in YTD2010, and an increase in the equity in earnings attributed to theunconsolidated subsidiaries in YTD 2010 (primarily FirstCity Denver’s subsidiaries).

 

Consolidated liabilities of $323.5 million as of September 30,2010 were $16.3 million lower than consolidated liabilities at December 31,2009. The decrease in consolidated liabilities was attributed primarily to a$20.1 million net decrease in notes payable in YTD 2010 (attributed to netprincipal repayments), off-set partially by a $3.6 million increase in securedborrowings (included in “Other liabilities”) in YTD 2010 related to the Company’sSBA loan sales activities.

 

FirstCity’s reported amount of noncontrolling interests(included as a component of equity) decreased by $9.8 million since December 31,2009 primarily due to $22.8 million of distributions paid to noncontrollinginterests in YTD 2010, off-set partially by $10.2 million of net earnings and$5.5 million of investments in majority-owned entities attributed tononcontrolling interests. Refer to the consolidated statement of stockholders’equity in Item 1 of this Form 10-Q for additional information on thesechanges.

 

**Portfolio Asset Acquisitions —Portfolio Asset Acquisition and Resolution Business Segment**

 

Revenueswith respect to the Company’s PAA&R business segment consist primarily of (i) incomefrom Portfolio Assets and loans receivable; (ii) gains on the dispositionand settlement of Portfolio Assets and other assets; and (iii) servicingfees from Acquisition Partnerships for the performance of servicing activitiesrelated to the assets held in unconsolidated Acquisition Partnerships. TheCompany also records equity in earnings of unconsolidated AcquisitionPartnerships and servicing entities accounted for under the equity-method ofaccounting. Generally speaking, income recognized from our investments inconsolidated portfolio assets is reported as “Income from Portfolio Assets” onour consolidated statements of operations, whereas income from our investmentsin unconsolidated subsidiaries that acquire portfolio assets is reported as “Equityin earnings of unconsolidated subsidiaries.” Furthermore, since we function asthe servicer for the vast majority of our domestic and Latin Americanunconsolidated portfolio assets, we also recognize fee income related to theperformance of our servicing responsibilities. This fee income is reported as “Servicingfees” on our consolidated statements of operations. We also generate servicefee income from our domestic and Latin American consolidated portfolio assetsthat we service; however, this income is eliminated in consolidation and, assuch, is not included on our consolidated statements of operations.

 

The following table includes information related toPortfolio Assets acquired by the Company in YTD 2010 and YTD 2009.

 

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| ** **                             | ** ** | **Nine Months Ended**      | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|
| ** **                             | ** ** | **September 30, 2010**     | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                             | ** ** | **Wholly-Owned**                     | ** ** | **Majority-Owned** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Consolidated**                     | ** ** | **Consolidated** | ** ** | **Unconsolidated** | ** ** | **Total** | ** ** |
| Face Value                             |       | $                                    | 33,251     |   | $ | 31,487 |   | $ | 247,808 |   | $ | 312,546 |   |
| Total purchase price                   |       | $                                    | 16,575     |   | $ | 17,650 |   | $ | 140,480 |   | $ | 174,705 |   |
| Total equity invested by all investors |       | $                                    | 16,575     |   | $ | 17,429 |   | $ | 141,807 |   | $ | 175,811 |   |
| Total equity invested by FirstCity     |       | $                                    | 16,575     |   | $ | 12,848 |   | $ | 23,817 |   | $ | 53,240 |   |
| Total number of Portfolio Assets       |       | 7                                    |       | 31 |   | 211 |   | 249 |   |

 
| ** **                             | ** ** | **Nine Months Ended**      | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|
| ** **                             | ** ** | **September 30, 2009**     | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                             | ** ** | **Wholly-Owned**                     | ** ** | **Majority-Owned** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Consolidated**                     | ** ** | **Consolidated** | ** ** | **Unconsolidated** | ** ** | **Total** | ** ** |
| Face Value                             |       | $                                    | 174,797    |   | $ | 131,391 |   | $ | 67,440 |   | $ | 373,628 |   |
| Total purchase price                   |       | $                                    | 90,795     |   | $ | 80,683 |   | $ | 14,504 |   | $ | 185,982 |   |
| Total equity invested by all investors |       | $                                    | 90,795     |   | $ | 81,401 |   | $ | 14,851 |   | $ | 187,047 |   |
| Total equity invested by FirstCity     |       | $                                    | 90,795     |   | $ | 40,701 |   | $ | 2,970 |   | $ | 134,466 |   |
| Total number of Portfolio Assets       |       | 181                                  |       | 451 |   | 99 |   | 731 |   |

 

The table below provides asummary of our loan Portfolio Assets as of September 30, 2010 and December 31,2009. Our Purchased Credit-Impaired Loans are categorized based on the commonrisk characteristics that management generally uses for pooling purposes (whenmanagement elects to pool groups of purchased loans).

 
| ** **                      | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| **Loan and Loan Pool Type**     |       |                                 |       |                  |       |
| Purchased Credit-Impaired Loans |       |                                 |       |                  |       |
| Domestic:                       |       |                                 |       |                  |       |
| Commercial real estate          |       | $                                    | 123,964    |                  | $          | 138,485 |   |
| Business assets                 |       | 20,498                               |       | 26,983                |       |
| Other                           |       | 6,606                                |       | 3,906                 |       |
| Latin America                   |       | 9,789                                |       | 10,545                |       |
| Europe                          |       | 6,865                                |       | 13,001                |       |
| UBN loan portfolio:             |       |                                 |       |                  |       |
| Non-performing loans            |       | 48,123                               |       | 60,929                |       |
| Performing loans                |       | 1,069                                |       | 1,555                 |       |
| Other                           |       | 5,764                                |       | 8,367                 |       |
| Outstanding balance             |       | 222,678                              |       | 263,771               |       |
| Allowance for loan losses       |       | (47,578                              | )          | (65,825               | )          |
| Carrying amount, net            |       | $                                    | 175,100    |                  | $          | 197,946 |   |

 

The following table providesa summary of the changes in the allowance for loan losses related to our loanPortfolio Assets:

 
| ** **                                    | ** ** | **Purchased Credit-Impaired Loans** | ** ** | **Other**    | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------|------------|--------------|------------|------------|------------|
| ** **                                    | ** ** | **Domestic**                                  | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Commercial**                                | ** ** | **Business** | ** ** | ** ** | ** ** | **Latin** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(dollars in thousands)**          | ** ** | **Real Estate**                          | ** ** | **Assets**   | ** ** | **Other**  | ** ** | **America** | ** ** | **Europe** | ** ** | **UBN** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Beginning  Balance, January 1, 2010 |       | $                                             | 5,914      |         | $          | 394        |       | $ | 390 |   | $ | 100 |   | $ | 128 |   | $ | 58,624 |   | $ | 275 |   | $ | 65,825 |   |
| Provisions                                    |       | 1,990                                         |       | 407          |       | 141        |       | 120 |   | 484 |   | — |   | 126 |   | 3,268 |   |
| Recoveries                                    |       | (70                                           | )          | (1           | )          | (7         | )          | — |   | — |   | (520 | ) | (16 | ) | (614 | ) |
| Charge  offs                                  |       | (7,392                                        | )          | (587         | )          | (434       | )          | — |   | (243 | ) | (2,955 | ) | (321 | ) | (11,932 | ) |
| Translation  adjustments                      |       | —                                        |       | —       |       | —     |       | (3 | ) | (35 | ) | (8,931 | ) | — |   | (8,969 | ) |
| Ending  Balance, September 30, 2010 |       | $                                             | 442        |         | $          | 213        |       | $ | 90 |   | $ | 217 |   | $ | 334 |   | $ | 46,218 |   | $ | 64 |   | $ | 47,578 |   |

 

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Due to uncertainties relatedprimarily to estimating the timing and/or amount of collections on PurchasedCredit-Impaired Loans as a result of the current economic environment, theCompany’s levels of such loans and loan pools accounted for on a non-accrualincome-recognition method of accounting (cost-recovery or cash basis) increasedto $165.9 million at September 30, 2010 from $138.4 million at December 31,2009. Under U.S. GAAP, the interest method (i.e. accrual method) of accountingis not appropriate if management does not have the ability to develop areasonable expectation of both the timing and amount of future cash flows to becollected. Refer to Note 1 of theconsolidated financial statements included in Item 1 of this Form 10-Q foradditional information and accounting policies related to our PurchasedCredit-Impaired Loans. The following tables provide a summary of theCompany’s loan Portfolio Assets, including Purchased Credit-Impaired Loans, byincome-recognition method as of September 30, 2010 and December 31,2009 (dollars in thousands):

 
| ** **    | ** ** | **September 30, 2010** | ** ** |
|---------------|------------|----------------------------------|------------|
| ** **    | ** ** | **Income-Accruing Loans**   | ** ** | **Non-Accrual Loans** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Purchased**                    | ** ** | ** ** | ** ** | **Purchased Credit-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Credit-**                      | ** ** | ** ** | ** ** | **Impaired Loans** | ** ** | **Other** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Impaired**                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Cost recovery** | ** ** | ** ** | ** ** | **Cost recovery** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Loans**                        | ** ** | **Other** | ** ** | **Cash basis** | ** ** | **basis** | ** ** | **Cash basis** | ** ** | **basis** | ** ** | **Total** | ** ** |
| United States |       | $                                | 495        |   | $ | 4,061 |   | $ | 100,255 |   | $ | 49,573 |   | $ | 1,638 |   | $ | — |   | $ | 156,022 |   |
|          |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| France        |       | —                           |       | 1,069 |   | 3,860 |   | — |   | — |   | 1,906 |   | 6,835 |   |
|          |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany       |       | —                           |       | — |   | 2,671 |   | — |   | — |   | — |   | 2,671 |   |
|          |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Mexico        |       | —                           |       | — |   | — |   | 9,572 |   | — |   | — |   | 9,572 |   |
|          |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total**     |       | $                                | 495        |   | $ | 5,130 |   | $ | 106,786 |   | $ | 59,145 |   | $ | 1,638 |   | $ | 1,906 |   | $ | 175,100 |   |

 
| ** **    | ** ** | **December 31, 2009** | ** ** |
|---------------|------------|---------------------------------|------------|
| ** **    | ** ** | **Income-Accruing Loans**  | ** ** | **Non-Accrual Loans** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Purchased**                   | ** ** | ** ** | ** ** | **Purchased Credit-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Credit-**                     | ** ** | ** ** | ** ** | **Impaired Loans** | ** ** | **Other** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Impaired**                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Cost recovery** | ** ** | ** ** | ** ** | **Cost recovery** | ** ** | ** ** | ** ** |
| ** **    | ** ** | **Loans**                       | ** ** | **Other** | ** ** | **Cash basis** | ** ** | **basis** | ** ** | **Cash basis** | ** ** | **basis** | ** ** | **Total** | ** ** |
| United States |       | $                               | 42,385     |   | $ | 5,323 |   | $ | 42,125 |   | $ | 78,165 |   | $ | 2,770 |   | $ | — |   | $ | 170,768 |   |
|          |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| France        |       | —                          |       | 1,555 |   | — |   | 7,648 |   | — |   | 2,305 |   | 11,508 |   |
|          |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany       |       | 5,225                           |       | — |   | — |   | — |   | — |   | — |   | 5,225 |   |
|          |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Mexico        |       | —                          |       | — |   | — |   | 10,445 |   | — |   | — |   | 10,445 |   |
|          |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total**     |       | $                               | 47,610     |   | $ | 6,878 |   | $ | 42,125 |   | $ | 96,258 |   | $ | 2,770 |   | $ | 2,305 |   | $ | 197,946 |   |

 

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**Middle-MarketCompany Capital Investments — Special Situations Platform Business Segment**

 

Revenues with respect to theCompany’s Special Situations Platform business segment consist primarily of (i) interestand fee income from loan investments; (ii) revenues from majority-ownedoperating entities; and (iii) equity in earnings of minority-ownedinvestments in operating entities accounted for under the equity-method ofaccounting.

 

Investments by FirstCityDenver since its inception in April 2007 are summarized below:

** **
| ** **                           | ** ** | **Total**      | ** ** | **FirstCity Denver’s Investment** | ** ** |
|--------------------------------------|------------|----------------|------------|--------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Investment** | ** ** | **Debt**                                         | ** ** | **Equity** | ** ** | **Total** | ** ** |
|                                 |       |           |       |                                             |       |   |   |   |   |
| First nine months of 2010            |       | $              | 13,564     |                                             | $          | 8,650 |   | $ | 4,395 |   | $ | 13,045 |   |
| Total 2009                           |       | 20,058         |       | 12,023                                           |       | 392 |   | 12,415 |   |
| Total 2008                           |       | 28,750         |       | 16,650                                           |       | 3,256 |   | 19,906 |   |
| Total 2007                           |       | 22,314         |       | 5,630                                            |       | 5,900 |   | 11,530 |   |
|                                      |            |                |            |                                                  |            |  |  |  |  |  |  |  |  |

 

**Provision for Income Taxes**

 

The Company has substantial net operating losscarryforwards (“NOLs”) for U.S. federal income tax purposes which can be used to off-set the tax liabilityassociated with the Company’s pre-tax earnings until the earlier of theexpiration or utilization of such NOLs. The Company accounts for the benefit ofthese NOLs, and other income tax items in both the U.S. and the non-U.S.jurisdictions in which we operate,  underthe asset and liability method. Deferred tax assets and liabilities arerecognized based on the future tax consequences attributable to temporarydifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and operating loss and taxcredit carryforwards. Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose temporary differences are expected to be recovered or settled. We reducethe carrying amounts of deferred tax assets by a valuation allowance if, basedon the available evidence, it is more likely than not that such assets will notbe realized. Accordingly, the need to establish valuation allowances fordeferred tax assets is assessed periodically by the Company based on themore-likely-than-not realization threshold criterion. In the assessment,appropriate consideration is given to all positive and negative evidencerelated to the realization of the deferred tax assets. This assessmentconsiders, among other factors, the nature, frequency and severity of currentand cumulative losses, forecasts of future profitability, excess of appreciatedasset value over the tax basis of net assets, the duration of statutorycarryforward periods, the Company’s experience with utilizing availableoperating loss and tax credit carryforwards, and tax planning strategies. Inmaking such assessments, significant weight is given to evidence that can beobjectively verified. At September 30, 2010, the Company carried a fullvaluation allowance for its U.S. deferred tax assets due to the lack ofsufficient objective evidence regarding the realization of these assets in theforeseeable future. We will continue to evaluate the deferred tax assetvaluation allowance balances in all of our U.S. and foreign subsidiariesthroughout 2010 to determine the appropriate level of valuation allowances.

 

**Liquidity and Capital Resources**

 

***Overview***

 

The Company requiresliquidity to fund its operations, Portfolio Asset acquisitions, investments inand advances to Acquisition Partnerships, capital investments in privately-heldmiddle-market companies, other debt and equity investments, repayments of bankborrowings and other debt, and working capital to support our growth.Historically, our primary sources of liquidity have been funds generated fromoperations (primarily loan and real estate collections and service fees),equity distributions from the Acquisition Partnerships and other subsidiaries,interest and principal payments on subordinated intercompany debt, dividendsfrom the Company’s subsidiaries, borrowings from credit facilities withexternal lenders, and other special-purpose short-term borrowings.

 

Our ability to make fundoperations and new investments is dependent on (1) the cash leak-through and overhead allowance provisions included in our loanfacility with Bank of Scotland (as discussed below); (2) residual cash flowsfrom the pledged assets and equity investments after full repayment of the Bankof Scotland debt (as discussed below); (3) our current holdings ofunencumbered cash and portfolio assets; and (4) our investment agreementwith Värde (see discussions belowand Note 1 of the consolidated financialstatements included in Item 1 of this Form 10-Q for additionalinformation). Many factors, including general economic conditions, areessential to our ability to generate cash flows. Fluctuations in ourcollections, investment income, credit availability, and adverse changes inother factors could have a negative impact on our ability to generatesufficient cash flows to support our business. Despite recent credit marketconditions, we have continued to have access to liquidity in both our PAA&Rand 

 

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Special Situations Platformbusiness segments through our unencumbered cash and portfolio assets, creditfacility commitments with external lenders, and/or an investment agreement inplace with Värde. While management believesthat these cash flow sources will provide FirstCity with funding and liquidityto supports its operations and investment activities, FirstCity continues toactively seek additional sources of liquidity and alternative funding sources.

 

*Reducing Note Facility with Bankof Scotland and BoS(USA) (collectively, “Bank of Scotland”)*

 

In June 2010, FirstCityrefinanced its loan facilities with Bank of Scotland and closed on a $268.6million Reducing Note Facility Agreement (“Reducing Note Facility”) that allowsfor repayment to Bank of Scotland over time as cash flows from the underlyingassets securing the loan facility are realized. The Company’s outstandingindebtedness and letter of credit obligations under its then-existing loan facilitieswith Bank of Scotland were refinanced into the Reducing Note Facility. Refer to***Credit Facilities*** below for theprimary terms of this note facility.

 

*Investment Agreement with Värde Investment Partners, L.P. (“Värde”)*

 

FirstCityand Värde are parties to an investment agreement, effective April 1, 2010,whereby Värde may invest up to $750 million, at its discretion, alongsideFirstCity in distressed loan portfolios and similar investment opportunities,subject to the terms and conditions contained in the agreement. The primaryterms of the Investment Agreement are as follows:

 

·                 FirstCity will act as the exclusive servicerfor the investment portfolios;

·                 FirstCity will provide Värde with a “right offirst refusal” with regard to distressed asset investment opportunities inexcess of $3 million sourced by FirstCity;

·                 FirstCity, at its determination, willco-invest between 5%-25% in each investment;

·                 FirstCity will receive a $200,000 monthlyretainer in exchange for its services and commitments;

·                 FirstCity will receive a base servicing fee(based on investment portfolio collections) and will be eligible to receiveadditional incentive-based servicing fees (depending on the performance of theportfolios acquired); and

·                 FirstCity will be eligible to receiveincentive-based management fees (depending on the aggregate amount andperformance of the portfolios acquired).

 

Thecash flows from the assets and equity interests from the Company’s investmentsmade in connection with the investment agreement with Värde, which are held byFC Investment Holdings Corporation and its subsidiaries, are not subject to thesecurity interest requirements of Bank of Scotland’s Reducing Note Facilitydescribed above.

 

***Consolidated Statements ofCash Flows***

 

The following is an analysisof the cash flows related to FirstCity’s consolidated operations for YTD 2010and YTD 2009:

 

Our operating activitiesused cash of $23.1 million and provided cash of $1.5 million for YTD 2010 andYTD 2009, respectively. For YTD 2010, net cash used in operations wasattributable primarily to $11.9 million of net principal advances on SBA loansheld for sale; $34.3 million of non-cash deductions for income accretion andgains on Portfolio Assets; $14.0 million of non-cash deductions for equityearnings from equity-method investments; and $9.0 million of non-cashdeductions attributed to gains recognized on business combination transactionsand the sale of an investment security — off-set partially by $20.9 million ofnet earnings; $5.0 million of proceeds from SBA loan sales; $2.2 million ofproceeds applied to income from Portfolio Assets; and $18.7 million of non-cashadd-backs related to provisions for loan and impairment losses, depreciationand amortization (including $6.8 million of net amortization attributable tothe coal supply and coal purchase contracts on the balance sheet of ourconsolidated coal mine subsidiary). For YTD 2009, net cash provided byoperations was attributable primarily to $13.6 million of net earnings; $18.2million of proceeds from sales of SBA loans held for sale; $15.3 million ofproceeds applied to income from Portfolio Assets; $5.6 million increase inother liabilities; and $5.2 million of non-cash add-backs related todepreciation, amortization, and provisions for loan and impairment losses —off-set partially by $13.5 million of net principal advances on SBA loans heldfor sale; $35.3 million for income accretion and 

 

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gains on Portfolio Assets;$1.5 million of equity earnings from equity-method investments, and $1.5million for a step acquisition gain. The remaining changes in the periods weredue primarily to net changes in other accounts related to our operatingactivities.

 

Our investing activities providedcash of $32.2 million and used cash of $65.6 million for YTD 2010 and YTD 2009,respectively. For YTD 2010, net cash provided by investing activities wasattributable primarily to $57.7 million of principal collections on PortfolioAssets (net of purchases); $8.2 million of distributions from our equity-methodinvestments; $1.7 million of net principal repayments from our loaninvestments; and $3.3 million of proceeds from the sale of an investmentsecurity — off-set partially by $32.8 million of contributions to ourequity-method investments; $1.6 million paid for business combinations (net ofcash acquired); $1.7 million of property and equipment purchases; $2.6 millionof investment security purchases; and a $0.9 million reduction in cashattributed to the deconsolidation of our manufacturing subsidiary. For YTD2009, net cash used in investing activities was attributable primarily toPortfolio Asset purchases of $62.8 million (net of principal collections); $7.1million paid for business combinations; $2.1 million of property and equipmentpurchases; $3.9 million of equity investment contributions; and $3.8 million ofnet advances and originations for loan investments — off-set partially by $9.3million of distributions from equity-method investments; $3.5 million ofprincipal payments on an investment security available for sale; and $1.4million of proceeds from sales of property. The remaining changes in theperiods were due primarily to net changes in other accounts related to ourinvesting activities.

 

Our financing activitiesused cash of $53.9 million and provided cash of $77.7 million for YTD 2010 andYTD 2009, respectively. For YTD 2010, net cash used in financing activities wasattributable primarily to $40.3 million of principal payments on notes payableand loan fee payments (net of borrowings), and $22.8 million of cashdistributions paid to noncontrolling interests — off-set partially by $4.9million of contributions from noncontrolling interests primarily to acquirePortfolio Assets through consolidated subsidiaries; $1.0 million of proceedsfrom the issuance of common stock; and $3.6 million of proceeds from securedborrowings related to SBA loan sale transactions (net of principal repayments).For YTD 2009, net cash provided by financing activities was attributable to$49.3 million of net borrowings to finance our Portfolio Asset acquisitions andother investments and $41.0 million of contributions from noncontrolling interestsprimarily to acquire Portfolio Assets through consolidated subsidiaries —off-set partially $10.0 million of cash distributions to noncontrollinginterests and $2.8 million of cash paid to acquire additional equity innoncontrolling interests.  The remainingchanges in the periods were due primarily to net changes in other accountsrelated to our financing activities.

 

Cashpaid for interest expense approximated $8.4 million and $7.3 million for YTD2010 and YTD 2009. Substantially all of our interest expense was paid on ourcredit facilities and other borrowings. FirstCity’saverage outstanding debt increased to $303.6 million for YTD 2010 from $290.6million for YTD 2009, while the average cost of borrowings increased to 5.2% in2010 compared to 4.9% in 2009. The increase in the Company’s debt levelsince September 30, 2009 is a result of increased net borrowings tofinance the Company’s growth and investment transactions. The increase in the Company’s average cost ofborrowings was due primarily to the higher interest and fees charged on ourReducing Note Facility with Bank of Scotland (closed in June 2010)compared to the interest rates and fees under the loan facilities we had inplace with Bank of Scotland last year.

 

***Statements of Cash Flows —Consolidated Railroad and Coal Mine Operations***

 

The following is an analysisof the cash flows related to FirstCity’s majority-owned railroad and coal minesubsidiaries for YTD 2010 and YTD 2009, as applicable. The cash flow effectsdescribed below are included in the Company’s analysis of its consolidated cashflows for YTD 2010 and YTD 2009, as applicable, as discussed above. The cashflows related to FirstCity’s formerly-consolidated majority-owned manufacturingsubsidiary were not material to the Company’s consolidated cash flows.

 

Railroad Operations CashFlows

 

The following is an analysisof the cash flows related to FirstCity’s majority-owned railroad operation forYTD 2010 and YTD 2009. All significant intercompany balances and transactionshave been eliminated in consolidation.

 

The operating activities ofthe railroad subsidiary provided cash of $2.6 million for YTD 2010,attributable primarily to $1.6 million of net earnings and a $1.0 millionincrease in operating liabilities. The railroad subsidiary’s investingactivities used cash of $1.5 million for YTD 2010 related to property andequipment purchases. The railroad subsidiary’s financing activities used cashof $0.7 million for YTD 2010, attributable to $0.3 million of principalpayments on a bank note payable and $0.4 million of distributions to thenoncontrolling equity owners and FirstCity (eliminated in consolidation).

 

The operating activities ofthe railroad subsidiary provided cash of $1.6 million for YTD 2009 —attributable primarily to $1.7 million of net earnings and a $1.2 millionincrease in other liabilities; off-set partially by $1.2 million of gains onsales of property and equipment. The railroad subsidiary’s investing activitiesused cash of $0.3 million in YTD 2009, which includes $1.6 million of 

 

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proceeds from property andequipment sales; off-set by $1.5 million of property and equipment purchases.The railroad subsidiary’s financing activities used cash of $1.4 million for YTD2009  — attributable primarily toproviding $1.3 million of capital to FirstCity (parent company) throughprincipal repayments on a capital note (eliminated in consolidation).

 

Coal Mine Operations CashFlows

 

The following is an analysisof the cash flows related to FirstCity’s majority-owned coal mine operation forthe six-month period ended September 30, 2010 (FirstCity consolidated thecoal mine subsidiary effective April 1, 2010 after it obtained control ofthe entity at such time — refer to Note 3of the consolidated financial statements included in Item 1 of this Form 10-Qfor additional information). All significant intercompany balances andtransactions have been eliminated in consolidation.

 

The operating activities ofthe coal mine subsidiary provided cash of $6.0 million for the six-month periodended September 30, 2010 — attributable primarily to a $0.8 millionincrease in other liabilities and a $6.8 million non-cash add-back foramortization; off-set partially by $0.7 million of net losses and a $0.9million decrease in other assets. The financing activities of the coal minesubsidiary used $7.4 million of cash for the six-month period ended September 30,2010, attributed primarily to $2.6 million of principal repayments on a notepayable and $4.5 million of payments to the noncontrolling equity owner andFirstCity (parent company) through distributions and principal repayments on acapital note (eliminated in consolidation). The coal mine subsidiary did notrecord any cash flows related to investing activities during the six-monthperiod ended September 30, 2010.

 

***Credit Facilities***

 

OnJune 25, 2010, FirstCity Commercial Corporation (“FC Commercial”) and FHPartners LLC (“FH Partners”), as borrowers, and FLBG Corporation (“FLBG Corp.”),as guarantor, all of which are wholly-owned subsidiaries of FirstCity, and Bankof Scotland and BoS(USA), Inc. (collectively, “Bank of Scotland”), aslenders, entered into a Reducing Note Facility Agreement (“Reducing NoteFacility”). In addition, on June 25, 2010, FirstCity executed a LimitedGuaranty Agreement guarantying payment of the indebtedness under the ReducingNote Facility to a maximum amount of $75.0 million.

 

TheReducing Note Facility amended and restated the following loan facilitiespreviously provided by Bank of Scotland to FirstCity and FH Partners:(a) Revolving Credit Agreement dated November 12, 2004, as amended,to FirstCity ($225.0 million loan facility); (b) Revolving CreditAgreement dated August 26, 2005, as amended, to FH Partners ($100.0million loan facility); and (c) Subordinated Delayed Draw Credit Agreementdated September 5, 2007, as amended, to FirstCity ($25.0 million loanfacility) (collectively, “Prior Credit Agreements”). The Prior CreditAgreements were guaranteed by substantially all of the wholly-ownedsubsidiaries of FirstCity and secured by substantially all of the assets ofFirstCity and its wholly-owned subsidiaries. The outstanding indebtedness and letterof credit obligations under the Prior Credit Agreements in the amount of $268.6million were refinanced into the Reducing Note Facility, which provides for ascheduled amortization over 3 years ($43.6 million in the first year, $80.0million in the second year, $60.0 million in the first nine months of the thirdyear, and $85.0 million due on June 25, 2013, the maturity date).

 

Thematerial terms of the Reducing Note Facility and related agreements are asfollows:

 

·                 Limited guaranty provided by FirstCity forthe repayment of the indebtedness under the Reducing Note Facility to a maximumamount of $75.0 million, plus costs of enforcement and certain contingentindemnities;

·                 No advances will be made under the loanfacility, except for draws on outstanding letters of credit in the amount of$22.35 million which are included in the amount of the loan facility ($11.9million was advanced in October 2010 — see discussion below);

·                 Repayment will be made from the cash flowfrom assets and equity investments which were pledged to secure the PriorCredit Agreements;

·                 FirstCity will receive unencumbered cash of20% of the monthly net cash flows (i.e. cash “leak-through”) up to $25.0million, after (a) payment to Bank of Scotland of interest and fees; and(b) payment of a scheduled overhead allowance to FirstCity ServicingCorporation (“FC Servicing”), a wholly-owned subsidiary of FirstCity, of $38.9million over 3 years ($1.5 million per month for the first year, $1.03 millionper month for the second year, and $0.7 million per month for the third year);

·                 Fluctuating interest rate equal to, at FCCommercial’s option, either (a) the greater of (i) one month *London Interbank Offering Rate*(“LIBOR”)plus 3.5% (subject to LIBOR floor of 1.0%) or (ii) 4.5%, or (b) Bankof Scotland’s prime rate plus 3.0%;

 

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·                 FC Commercial and FH Partners may designate aportion of the debt under the Reducing Note Facility to be borrowed in Euros upto a maximum amount of Euros equivalent to USD $27.5 million; and

·                 FirstCity must maintain a minimum tangiblenet worth (as defined) requirement of $60.0 million.

 

Feespaid to Bank of Scotland in connection with the Reducing Note Facility through September 30,2010 totaled $1.85 million, with $683,000 paid in March 2010 (inconnection with an extension of the Prior Credit Facilities), $675,000 paid in June 2010,and $501,000 paid from July to September 2010. A final loan feepayment of $167,000 was made in October 2010.

 

TheReducing Note Facility is guaranteed by FLBG Corp. and all of its subsidiaries(“Covered Entities”), which represent the entities that were subject to theobligations of the Prior Credit Facilities other than FirstCity and FCServicing. The Reducing Note Facility is secured by substantially all of theassets of the Covered Entities. FC Investment Holdings Corporation (anewly-formed wholly-owned subsidiary of FirstCity) and its current and futuresubsidiaries, or other entities in which such subsidiaries own any equityinterest (“Non-Covered Entities”), are not subject to, do not guarantee and donot provide security interests in their assets to secure the Reducing NoteFacility. FC Servicing only provides a non-recourse security interest incertain equity interests owned by it and in most of the servicing fees frompreviously-existing agreements which secured the Prior Credit Facilities. FCServicing does not provide a security interest in servicing agreements enteredinto with the Non-Covered Entities or in any of its other assets and does notguarantee the Reducing Note Facility.

 

TheReducing Note Facility contains covenants, representations and warranties onthe part of FLBG Corp., FC Commercial and FH Partners that are typical fortransactions of this type. In addition, the Reducing Note Facility containscustomary events of default, including failure to make required payments,failure to comply with certain agreements or covenants, failure to pay, ordefault under, certain other indebtedness, certain events of bankruptcy andinsolvency, and failure to pay certain judgments. In the event that an event ofdefault occurs and is continuing, Bank of Scotland may accelerate theindebtedness under the Reducing Note Facility.

 

AtSeptember 30, 2010, the unpaid principal balance on this loan facility was$227.9 million. In October 2010, a letter of credit under the ReducingNote Facility was funded in the amount of $11.9 million, and the proceeds wereused to pay-off a bank note payable that was owed by an affiliated Mexicanentity of FirstCity (described below). The entire amount of the funded letterof credit was added to the unpaid principal obligation under the terms andconditions of the Reducing Note Facility.

 

FirstCity has $25.6 millionin Euro-denominated debt on the Reducing Note Facility for the purpose ofhedging a portion of the Company’s net equity investments in Europe. Refer to Note 11 to our consolidated financialstatements included in Item 1 of this Form 10-Q for additionalinformation.

 

*Banco Santander, S.A.*

 

FirstCity Mexico SA de CV, awholly-owned Mexican affiliate of FirstCity, has a loan agreement with BancoSantander, S.A. that allows loans to be made in Mexican pesos. At September 30,2010, the Company had 142,240,000 in Mexican peso-denominated debt, which wasequivalent to $11.4 million U.S. dollars. The proceeds were used to pay downthe acquisition facility with the Bank of Scotland. Pursuant to the terms ofthe credit facility, FirstCity Mexico SA de CV was required to provide astand-by letter of credit from Bank of Scotland that would satisfy the loanbalance upon demand.  At September 30, 2010, FirstCity had a letterof credit in the amount of $12.6 million from Bank of Scotland under the termsof FirstCity’s Reducing Note Facility with Bank of Scotland. In October 2010,the letter of credit was funded in the amount of $11.9 million, and the proceedswere used to pay-off FirstCity Mexico SA de CV’s note payable to BancoSantander, S.A. The entire amount of the funded letter of credit was added tothe unpaid principal obligation of FirstCity’s Reducing Note Facility with Bankof Scotland.

 

*Wells Fargo Foothill, LLC*

 

At September 30, 2010,ABL had a $25.0 million revolving loan facility with Wells Fargo CapitalFinance (“WFCF”) for the purpose of financing and acquiring SBA loans. Thiscredit facility matures in January 2012 and is secured by substantiallyall of the assets of ABL. In addition, FirstCity provides WFCF with anunconditional guaranty for all of ABL’s obligations up to a maximum of $5.0million plus enforcement costs. The primary terms and key covenants of thisloan facility are described in our 2009 Form 10-K. At September 30,2010, ABL was in compliance with all covenants or other requirements set forthin the credit agreement or other agreements with WFCF.

 

The following tablesummarizes the material terms of the credit facilities of FirstCity and itsconsolidated subsidiaries and the outstanding borrowings under such facilitiesas of September 30, 2010 and December 31, 2009.

 

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| ** **                                                                                                                      | ** ** | ** **                                                                                                                                                                       | ** ** | ** **                                                                                                                                                                                   | ** ** | **Outstanding**                      | ** ** | **Outstanding**       | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                      | ** ** | ** **                                                                                                                                                                       | ** ** | ** **                                                                                                                                                                                   | ** ** | **Borrowings**                       | ** ** | **Borrowings**        | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                                                                                                                                                       | ** ** | ** **                                                                                                                                                                                   | ** ** | **as of**                       | ** ** | **as of**        | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                                                                                                                                                       | ** ** | ** **                                                                                                                                                                                   | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                      | ** ** | **Interest Rate**                                                                                                                                                           | ** ** | **Other Terms and Conditions**                                                                                                                                                | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| ** **                                                                                                                      | ** ** | ** **                                                                                                                                                                       | ** ** | ** **                                                                                                                                                                                   | ** ** | **(Dollars in thousands)** | ** ** |
| **Notes  payable to banks and other:**                                                                                          |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| ** **                                                                                                                      |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Bank  of Scotland reducing note facility (includes $25.6 million denominated in  Euros at September 30, 2010)              |       | Election of  (a) greater of (i) one-month LIBOR plus 3.5% (subject to LIBOR  floor of 1.0%) or (ii) 4.5%, or (b) Bank of Scotland’s prime rate  of 3.0% |       | Secured by substantially  all assets and equity investments of FirstCity Commercial Corp. and FH  Partners LLC and guaranteed by FirstCity up to $75.0 million, matures  June 2013      |       | $                                    | 227,929    |                  | $          | — |   |
| ** **                                                                                                                      |       |                                                                                                                                                                             |       |                                                                                                                                                                                         | ** ** | ** **                           | ** ** | ** **            | ** ** |
| Bank  of Scotland $225 million revolving loan facility (included $24.8 million  denominated in Euros at December 31, 2009) |       | LIBOR-indexed plus 2.5%                                                                                                                                                          |       | Secured by substantially  all assets of FirstCity and certain subsidiaries and guaranteed by by  substantially all of FirstCity’s consolidated subsidiaries, refinanced  June 2010 |       | —                               |       | 182,324               |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Bank  of Scotland $100 million revolving loan facility                                                                          |       | LIBOR-indexed plus 2.0%                                                                                                                                                          |       | Secured by all assets of  FH Partners LLC and guaranteed by FirstCity and certain of its consolidated  subsidiaries, refinanced June 2010                                               |       | —                               |       | 58,506                |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| BoS(USA)  $25 million subordinated credit agreement                                                                             |       | LIBOR + 5.0%                                                                                                                                                                     |       | Secured by substantially  all assets of FirstCity and certain subsidiaries and guaranteed by  substantially all of FirstCity’s consolidated subsidiaries, refinanced  June 2010    |       | —                               |       | 25,000                |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| WFCF  $25 million revolving loan facility                                                                                       |       | Alternate interest rates  based on Wells Fargo base rate plus margin, LIBOR plus margin, or 7.5%                                                                                 |       | Secured by assets of ABL  and guaranteed by FirstCity up to $5.0 million, matures January 2012                                                                                          |       | 15,117                               |       | 10,694                |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Banco  Santander term loan **[1]**(denominated in Mexican pesos)                                                                |       | 28-day Mexican index  rate (TIIE) plus 2.0%                                                                                                                                      |       | Secured by Bank of  Scotland letter of credit, matures November 2010, commitment amount  142.2 million MXN                                                                              |       | 10,929                               |       | 10,986                |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Bank  of America term loan                                                                                                      |       | Greater of (prime or  federal funds rate plus 0.5%) plus margin, or LIBOR plus margin                                                                                            |       | Secured by assets of  FirstCity’s consolidated railroad subsidiaries, matures March 2011                                                                                           |       | 2,815                                |       | 3,086                 |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Bank  of America $1 million revolving loan facility                                                                             |       | Greater of (prime or  federal funds rate + 0.5%) plus margin, or LIBOR plus margin                                                                                               |       | Secured by assets of  FirstCity’s consolidated railroad subsidiaries, matures March 2011                                                                                           |       | 395                                  |       | 395                   |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Bank  of America term note                                                                                                      |       | LIBOR plus 1.65%                                                                                                                                                                 |       | Secured by all assets of  WAMCO 30, Ltd., matures November 2010                                                                                                                         |       | 11,525                               |       | —                |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Merrill  Lynch Mortgage Trust term loan                                                                                         |       | 6.07% fixed                                                                                                                                                                      |       | Secured by assets of  Oregon Short Line Building, matures April 2016                                                                                                                    |       | 7,371                                |       | 7,452                 |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| B.E.S.V.  term loans denominated in Euros                                                                                       |       | Various rates at 1-month  Eurobor + 3.5% or 3-month Eurobor + 3.0%                                                                                                               |       | Secured by assets of  UBN, various maturities ranging from May 2012 to May 2013                                                                                                    |       | 6,349                                |       | 5,433                 |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| Other  notes and participations payable                                                                                         |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       | 3,545                                |       | 2,012                 |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       | 285,975                              |       | 305,888               |       |
| **Note payable to affiliate:**                                                                                                  |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| MCS  Trust SA de CV term loan                                                                                                   |       | 20.0% fixed                                                                                                                                                                      |       | Secured by assets of FC  Acquisitions, SRL de CV, matures June 2020                                                                                                                     |       | 7,686                                |       | 7,838                 |       |
|                                                                                                                            |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       |                                 |       |                  |       |
| **Total notes payable**                                                                                                         |       |                                                                                                                                                                             |       |                                                                                                                                                                                         |       | $                                    | 293,661    |                  | $          | 313,726 |   |

 

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**[1]****       **In October 2010,a letter of credit under the Company’s Reducing Note Facility with Bank ofScotland was funded in the amount of $11.9 million, and the proceeds were usedto pay-off this term note payable to Banco Santander. The entire amount of thefunded letter of credit was added to the unpaid principal obligation of FirstCity’sReducing Note Facility with Bank of Scotland.

 

**Off-BalanceSheet Arrangements**

 

TheCompany’s off-balance sheet arrangements relate primarily to indemnificationobligations and guaranty agreements (refer to Note 19 of the consolidatedfinancial statements included in Item 1 of this Form 10-Q for informationon our off-balance sheet arrangements). We do not believe that these or anyother off-balance sheet arrangements have or are reasonably likely to have acurrent or future effect on the Company’s financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that is material to investors.However, there can be no assurance that such arrangements will not have anysuch future effects on the Company.

 

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**Cautionary Statement Regarding Forward-Looking Statements**

 

This Quarterly Report on Form 10-Qincludes forward-looking statements as defined in the Private SecuritiesLitigation Reform Act of 1995. In addition, we may make other written and oralcommunications from time to time that contain such statements. All statements,other than statements of historical fact, are forward-looking statements,including statements regarding our expected financial position, futurefinancial performance, overall trends, liquidity and capital needs, and otherstatements of expectations, beliefs, future plans and strategies, anticipatedevents or trends, and similar expressions concerning matters that are not historicalfacts. In this context, words such as “anticipates,” “believes,” “expects,” “estimates,”“plans,” “intends,” “could,” “should,” “will,” “may” and similar words orexpressions are intended to identify forward-looking statements and are nothistorical facts.

 

Theseforward-looking statements involve risks, uncertainties and assumptions that,if they never materialize or prove incorrect, could cause our results to differmaterially from those expressed or implied by such forward-looking statements.For a discussion on the risks, uncertainties and assumptions that affect ourbusiness, operating results and financial condition, you should carefullyreview the “CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS”qualification and Item 7. “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included in our 2009 Form 10-K, andItem 2. “Management’s Discussion and Analysis of Financial Condition andResults of Operations” of this Form 10-Q.

 

We are also subject to otherrisks detailed herein or detailed from time-to-time in our filings with theSEC. The listed risks referenced above are not intended to be exhaustive andthe order in which the risks appear is not intended as an indication of theirrelative weight or importance. We operate in continually changing businessenvironments, and new risk factors emerge from time to time. We cannot predictthese new risk factors, nor can we assess the impact, if any, of these new riskfactors on our business or the extent to which any factor, or combination offactors, may cause actual results to differ materially from those projected inany forward-looking statements.

 

You are cautioned that ourforward-looking statements could be wrong in light of these and other risks,uncertainties and assumptions, which change over time. Actual results,developments and outcomes may differ materially from those expressed in, orimplied by, our forward-looking statements. The forward-looking statementsspeak only as of the date the statement is made, and we have no obligation topublicly update or revise our forward-looking statements to reflect facts,circumstances, assumptions or events that occur after the date theforward-looking statements are made.

 

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk.**

 

As a “smaller reportingcompany” as defined by Item 10 of Regulation S-K, the Company is not requiredto provide information required by this Item.

 

**Item 4.  Controls and Procedures.**

 

*Evaluation of Disclosure Controlsand Procedures*

 

TheCompany’s management evaluated, with the participation of our principalexecutive officer and principal financial officer, or persons performingsimilar functions, the effectiveness of our disclosure controls and procedures,as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as of the end of the period covered by this report. Basedon this evaluation, our principal executive officer and principal financialofficer have concluded that, as of the end of the period covered by thisreport, our disclosure controls and procedures were effective to ensure thatinformation we are required to disclose in the reports that we file or submitunder the Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms relating to FirstCity, including our consolidated subsidiaries, and wasaccumulated and communicated to the Company’s management, including theprincipal executive officer and principal financial officer, or personsperforming similar functions, as appropriate to allow timely decisionsregarding required disclosure.

 

*Changes in Internal Controls*

 

Inconnection with the evaluation required by paragraph (d) of Rule 13a-15under the Exchange Act, there was no change identified in our internal controlover financial reporting that occurred during the last fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**PART II**

 

**OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

Therehave been no material developments regarding any matters disclosed under Part I, Item3 “Legal Proceedings” in our 2009 Form 10-K.

 

**Item 1A.  Risk Factors.**

 

Asa “smaller reporting company” as defined by Item 10 of Regulation S-K, theCompany is not required to provide information required by this Item.

 

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

 

None.

 

**Item 3.  Defaults Upon Senior Securities.**

 

None.

 

**Item 4.  Reserved.**

 

**Item 5.  OtherInformation.**

 

None.

 

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**Item 6.  Exhibits.**

*** ***
| **Exhibit********Number** | ** ** | **Description of Exhibit**                                                                                                                            |
|---------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                | ** ** | ** **                                                                                                                                                      |
| 31.1*                     | —     | Certification of the Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                   |
|                      |       |                                                                                                                                                            |
| 31.2*                     | —     | Certification of the Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                   |
|                      |       |                                                                                                                                                            |
| 32.1*                     | —     | Certification of the Chief  Executive Officer pursuant to 18 U.S.C Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |
|                      |       |                                                                                                                                                            |
| 32.2*                     | —     | Certification of the Chief  Financial Officer pursuant to 18 U.S.C Section 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

----

* Filed herewith.

 

69

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**SIGNATURES**

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.

 
|                          | FIRSTCITY  FINANCIAL CORPORATION |
|-------------------------------|----------------------------------|
| Dated: November 15, 2010 |                             |   |
|                          |                             |   |
|                          |                             |   |
|                          | By:                              | /s/ JAMES T. SARTAIN |
|                          |                             | James T. Sartain |
|                          |                             | *President and Chief Executive* |
|                          |                             | *Officer and Director* |
|                          |                             | *(Duly authorized officer and* |
|                          |                             | *Principal Executive Officer)* |
|                          |                             | * * |
|                          |                             | * * |
|                          | By:                              | /s/ J. BRYAN BAKER |
|                          |                             | J. Bryan Baker |
|                          |                             | *Senior Vice President and* |
|                          |                             | *Chief Financial Officer* |
|                          |                             | *(Duly authorized officer and* |
|                          |                             | *Principal Financial and* |
|                          |                             | *Accounting Officer)* |

 

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