**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**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  June 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 August 10, 2010 was 10,187,714.

 

 

 

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**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                                 | 65 |
| Item 4.                             | Controls and  Procedures                                                                    | 65 |
|                                |                                                                                        |   |
| **PART II  OTHER INFORMATION** | 66                                                                                          |
|                                |                                                                                        |   |
| Item 1.                             | Legal Proceedings                                                                           | 66 |
| Item 1A.                            | Risk Factors                                                                                | 66 |
| Item 2.                             | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 66 |
| Item 3.                             | Defaults  Upon Senior Securities                                                            | 66 |
| Item  4.                            | Reserved                                                                                    | 66 |
| Item 5.                             | Other Information                                                                           | 66 |
| Item  6.                            | Exhibits                                                                                    | 67 |
| SIGNATURES                          | 68                                                                                          |

 

----

 

 

 

**PART I**

** **

**FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDBALANCE SHEETS**

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

** **
| ** **                                                                                                                                                                                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2010**          | ** ** | **2009**              | ** ** |
| ** **                                                                                                                                                                                    | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                                                                    | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                                                                                     |       | $                 | 50,573     |                  | $          | 80,368 |   |
| Restricted cash                                                                                                                                                                               |       | 1,641             |       | 1,364                 |       |
| Portfolio Assets:                                                                                                                                                                             |       |              |       |                  |       |
| Loan portfolios, net of allowance for loan losses  of $45,719 and $65,825, respectively                                                                                                       |       | 189,047           |       | 197,946               |       |
| Real estate held for sale                                                                                                                                                                     |       | 23,186            |       | 17,051                |       |
| Real estate held for investment, net                                                                                                                                                          |       | 9,153             |       | 9,387                 |       |
| Total Portfolio Assets                                                                                                                                                                        |       | 221,386           |       | 224,384               |       |
| Loans receivable:                                                                                                                                                                             |       |              |       |                  |       |
| Loans receivable - affiliates, net of allowance  for loan losses of $500 and $67, respectively                                                                                                |       | 21,867            |       | 26,122                |       |
| Loans receivable - SBA held for sale                                                                                                                                                          |       | 7,697             |       | 821                   |       |
| Loans receivable - SBA held for investment, net of  allowance for loan losses of $346 and $490, respectively                                                                                  |       | 15,165            |       | 15,445                |       |
| Loans receivable - other, net of allowance for  loan losses of $1,083 and $-0-, respectively                                                                                                  |       | 14,654            |       | 10,233                |       |
| Total loans receivable, net                                                                                                                                                                   |       | 59,383            |       | 52,621                |       |
| Investment securities available for sale                                                                                                                                                      |       | 1,394             |       | 1,836                 |       |
| Equity investments                                                                                                                                                                            |       | 91,640            |       | 71,491                |       |
| Service fees receivable ($602 and $809 from  affiliates, respectively)                                                                                                                        |       | 656               |       | 850                   |       |
| Servicing assets - SBA loans                                                                                                                                                                  |       | 876               |       | 1,056                 |       |
| Other assets, net                                                                                                                                                                             |       | 38,425            |       | 31,104                |       |
| Total Assets (1)                                                                                                                                                                              |       | $                 | 465,974    |                  | $          | 465,074 |   |
| ** **                                                                                                                                                                                    | ** ** | ** **        | ** ** | ** **            | ** ** |
| **LIABILITIES  AND EQUITY**                                                                                                                                                                   |       |              |       |                  |       |
| Liabilities:                                                                                                                                                                                  |       |              |       |                  |       |
| Notes payable to banks and other                                                                                                                                                              |       | $                 | 305,561    |                  | $          | 305,888 |   |
| Note payable to affiliate                                                                                                                                                                     |       | 7,760             |       | 7,838                 |       |
| Other liabilities                                                                                                                                                                             |       | 30,099            |       | 26,077                |       |
| Total Liabilities                                                                                                                                                                             |       | 343,420           |       | 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: 11,687,714 and 11,483,824,  respectively ; shares outstanding: 10,187,714 and 9,983,824, respectively) |       | 117               |       | 115                   |       |
| Treasury stock, at cost: 1,500,000 shares                                                                                                                                                     |       | (10,923           | )          | (10,923               | )          |
| Paid in capital                                                                                                                                                                               |       | 104,881           |       | 103,326               |       |
| Accumulated deficit                                                                                                                                                                           |       | (10,163           | )          | (18,329               | )          |
| Accumulated other comprehensive income (loss)                                                                                                                                                 |       | (1,274            | )          | 3,460                 |       |
| FirstCity Stockholders’ Equity                                                                                                                                                           |       | 82,638            |       | 77,649                |       |
| Noncontrolling interests                                                                                                                                                                      |       | 39,916            |       | 47,622                |       |
| Total Equity                                                                                                                                                                                  |       | 122,554           |       | 125,271               |       |
| Total Liabilities and Equity                                                                                                                                                                  |       | $                 | 465,974    |                  | $          | 465,074 |   |

 

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| (1) | Our consolidated assets at June 30, 2010 include  the following assets of certain variable interest entities (“VIEs”) that can  only be used to settle the liabilities of those VIEs: Cash and cash  equivalents, $28.0  million; Portfolio Assets, $216.9 million; Loans  receivable, $59.8 million; Equity investments, $61.9 million; Other  assets, $37.1 million; and Total assets, $403.6 million. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

See accompanying notes to consolidated financialstatements.

 

2

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF OPERATIONS (Unaudited)**

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

 
| ** **                                                                                                                                                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                                                                    | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                                                                                    | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Revenues:**                                                                                                                                                                 | ** ** | ** **             | ** ** | ** **           | ** ** | ** ** |   |   |   |
| ***Finance and  Servicing:***                                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| Servicing fees ($1,551 and $2,137 from affiliates  for the three month periods, respectively, and $3,446 and $4,264 from  affiliates for the six month periods, respectively) |       | $                      | 1,743      |                 | $          | 2,403 |   | $ | 3,746 |   | $ | 4,795 |   |
| Income from Portfolio Assets                                                                                                                                                  |       | 14,622                 |       | 14,077               |       | 26,085 |   | 23,120 |   |
| Gain on sale of SBA loans held for sale, net                                                                                                                                  |       | 163                    |       | 610                  |       | 163 |   | 610 |   |
| Gain on sale of investment securities                                                                                                                                         |       | 3,250                  |       | —               |       | 3,250 |   | — |   |
| Interest income from SBA loans                                                                                                                                                |       | 313                    |       | 295                  |       | 581 |   | 641 |   |
| Interest income from loans receivable - affiliates                                                                                                                            |       | 773                    |       | 939                  |       | 1,727 |   | 1,862 |   |
| Interest income from loans receivable - other                                                                                                                                 |       | 229                    |       | 364                  |       | 361 |   | 793 |   |
| Other income                                                                                                                                                                  |       | 1,565                  |       | 1,118                |       | 2,696 |   | 1,998 |   |
|                                                                                                                                                                          |       | 22,658                 |       | 19,806               |       | 38,609 |   | 33,819 |   |
| ***Manufacturing,  Railroad and Coal Mine:***                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| Operating revenues - manufacturing                                                                                                                                            |       | 6,107                  |       | —               |       | 10,466 |   | — |   |
| Operating revenues - railroad                                                                                                                                                 |       | 1,192                  |       | 705                  |       | 2,457 |   | 1,452 |   |
| Operating revenues - coal mine                                                                                                                                                |       | 13,100                 |       | —               |       | 13,100 |   | — |   |
| Other                                                                                                                                                                         |       | 4                      |       | 150                  |       | 4 |   | 1,070 |   |
|                                                                                                                                                                          |       | 20,403                 |       | 855                  |       | 26,027 |   | 2,522 |   |
| Total revenues                                                                                                                                                                |       | 43,061                 |       | 20,661               |       | 64,636 |   | 36,341 |   |
| **Costs and expenses:**                                                                                                                                                       |       |                   |       |                 |       |   |   |   |   |
| ***Finance and  Servicing:***                                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| Interest and fees on notes payable to banks and  other                                                                                                                        |       | 3,334                  |       | 3,125                |       | 6,376 |   | 6,134 |   |
| Interest and fees on note payable to affiliate                                                                                                                                |       | 400                    |       | 444                  |       | 792 |   | 877 |   |
| Salaries and benefits                                                                                                                                                         |       | 6,001                  |       | 5,796                |       | 11,072 |   | 10,607 |   |
| Provision for loan and impairment losses                                                                                                                                      |       | 2,625                  |       | 677                  |       | 4,327 |   | 1,783 |   |
| Asset-level expenses                                                                                                                                                          |       | 2,103                  |       | 1,417                |       | 3,724 |   | 2,654 |   |
| Other                                                                                                                                                                         |       | 3,306                  |       | 1,903                |       | 6,502 |   | 4,949 |   |
|                                                                                                                                                                          |       | 17,769                 |       | 13,362               |       | 32,793 |   | 27,004 |   |
| ***Manufacturing,  Railroad and Coal Mine:***                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| Cost of revenues and operating costs -  manufacturing                                                                                                                         |       | 5,952                  |       | —               |       | 10,788 |   | — |   |
| Cost of revenues and operating costs - railroad                                                                                                                               |       | 627                    |       | 535                  |       | 1,233 |   | 1,026 |   |
| Cost of revenues and operating costs - coal mine                                                                                                                              |       | 13,295                 |       | —               |       | 13,295 |   | — |   |
|                                                                                                                                                                          |       | 19,874                 |       | 535                  |       | 25,316 |   | 1,026 |   |
| Total costs and expenses                                                                                                                                                      |       | 37,643                 |       | 13,897               |       | 58,109 |   | 28,030 |   |
| **Earnings before other revenue and  income taxes**                                                                                                                           |       | 5,418                  |       | 6,764                |       | 6,527 |   | 8,311 |   |
| Equity in earnings of unconsolidated subsidiaries                                                                                                                             |       | 1,816                  |       | 1,198                |       | 4,045 |   | 1,052 |   |
| Gain on business combinations                                                                                                                                                 |       | 4,838                  |       | 1,455                |       | 5,729 |   | 1,455 |   |
| Earnings before income taxes                                                                                                                                                  |       | 12,072                 |       | 9,417                |       | 16,301 |   | 10,818 |   |
| Income tax expense                                                                                                                                                            |       | 1,205                  |       | 440                  |       | 719 |   | 849 |   |
| Net earnings                                                                                                                                                                  |       | 10,867                 |       | 8,977                |       | 15,582 |   | 9,969 |   |
| Less: Net income attributable to noncontrolling  interests                                                                                                                    |       | 2,802                  |       | 1,231                |       | 7,416 |   | 1,579 |   |
| Net earnings attributable to FirstCity                                                                                                                                        |       | $                      | 8,065      |                 | $          | 7,746 |   | $ | 8,166 |   | $ | 8,390 |   |
|                                                                                                                                                                          |       |                   |       |                 |       |   |   |   |   |
| Basic earnings per share                                                                                                                                                      |       | $                      | 0.81       |                 | $          | 0.79 |   | $ | 0.82 |   | $ | 0.85 |   |
| Diluted earnings per share                                                                                                                                                    |       | $                      | 0.80       |                 | $          | 0.76 |   | $ | 0.81 |   | $ | 0.84 |   |

 

See accompanying notes to consolidated financialstatements.

 

3

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME (Unaudited)**

**(Dollars in thousands)**

 
| ** **                                                                                               | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                               | ** ** | **June 30,**    | ** ** |
| ** **                                                                                               | ** ** | **2010**             | ** ** | **2009** | ** ** |
| Net earnings                                                                                             |       | $                    | 15,582     |   | $ | 9,969 |   |
| Other comprehensive income (loss):                                                                       |       |                 |       |   |   |
| Net unrealized gain (loss) on securities available  for sale                                             |       | (972                 | )          | 310 |   |
| Reclassification adjustment for unrealized gain on  security available for sale included in net earnings |       | (1,352               | )          | — |   |
| Foreign currency translation adjustments                                                                 |       | (4,795               | )          | 2,487 |   |
| Total other comprehensive income (loss)                                                                  |       | (7,119               | )          | 2,797 |   |
| Total comprehensive income                                                                               |       | 8,463                |       | 12,766 |   |
| Less comprehensive (income) loss attributable to  noncontrolling interests:                              |       |                 |       |   |   |
| Net income                                                                                               |       | (7,416               | )          | (1,579 | ) |
| Net unrealized loss on securities available for  sale                                                    |       | 250                  |       | — |   |
| Foreign currency translation adjustments                                                                 |       | 2,135                |       | (216 | ) |
| Comprehensive income attributable to FirstCity                                                           |       | $                    | 3,432      |   | $ | 10,971 |   |

 

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                                                   |       | —                      |       | —       |       | —       |       | 8,390 |   | — |   | 1,579 |   | 9,969 |   |
| Change  in net unrealized gain on securities available for sale |       | —                      |       | —       |       | —       |       | — |   | 310 |   | — |   | 310 |   |
| Foreign  currency translation adjustments                       |       | —                      |       | —       |       | —       |       | — |   | 2,271 |   | 216 |   | 2,487 |   |
| Stock-based  compensation expense                               |       | —                      |       | —       |       | 130          |       | — |   | — |   | — |   | 130 |   |
| Purchases  of subsidiary shares in noncontrolling interests     |       | —                      |       | —       |       | 774          |       | — |   | — |   | (3,591 | ) | (2,817 | ) |
| Investments  in majority-owned entities                         |       | —                      |       | —       |       | —       |       | — |   | — |   | 25,410 |   | 25,410 |   |
| Distributions  to noncontrolling interests                      |       | —                      |       | —       |       | —       |       | — |   | — |   | (2,245 | ) | (2,245 | ) |
| **Balances, June 30, 2009**                                |       | $                           | 113        |         | $          | (10,923      | )          | $ | 102,779 |   | $ | (28,683 | ) | $ | (1,145 | ) | $ | 36,978 |   | $ | 99,119 |   |
|                                                            |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |
| **Balances, December 31, 2009**                            |       | $                           | 115        |         | $          | (10,923      | )          | $ | 103,326 |   | $ | (18,329 | ) | $ | 3,460 |   | $ | 47,622 |   | $ | 125,271 |   |
| Net  earnings                                                   |       | —                      |       | —       |       | —       |       | 8,166 |   | — |   | 7,416 |   | 15,582 |   |
| Change  in net unrealized gain on securities available for sale |       | —                      |       | —       |       | —       |       | — |   | (2,074 | ) | (250 | ) | (2,324 | ) |
| Foreign  currency translation adjustments                       |       | —                      |       | —       |       | —       |       | — |   | (2,660 | ) | (2,135 | ) | (4,795 | ) |
| Exercise  of common stock options                               |       | —                      |       | —       |       | 50           |       | — |   | — |   | — |   | 50 |   |
| Issuance  of common stock                                       |       | 2                           |       |         |       | 888          |       |   |   |   |   |   |   | 890 |   |
| Stock-based  compensation expense                               |       | —                      |       | —       |       | 327          |       | — |   | — |   | — |   | 327 |   |
| Purchases  of subsidiary shares in noncontrolling interests     |       | —                      |       | —       |       | —       |       | — |   | — |   | (40 | ) | (40 | ) |
| Other  activity                                                 |       | —                      |       | —       |       | 290          |       | — |   | — |   | (329 | ) | (39 | ) |
| Investments  in majority-owned entities                         |       | —                      |       | —       |       | —       |       | — |   | — |   | 5,129 |   | 5,129 |   |
| Distributions  to noncontrolling interests                      |       | —                      |       | —       |       | —       |       | — |   | — |   | (17,497 | ) | (17,497 | ) |
| **Balances, June 30, 2010**                                |       | $                           | 117        |         | $          | (10,923      | )          | $ | 104,881 |   | $ | (10,163 | ) | $ | (1,274 | ) | $ | 39,916 |   | $ | 122,554 |   |

 

See accompanying notes to consolidated financialstatements.

 

5

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**FIRSTCITY FINANCIAL CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (Unaudited)**

**(Dollars in thousands)**

 
| ** **                                                                                     | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                     | ** ** | **June 30,**    | ** ** |
| ** **                                                                                     | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                                                                                           | ** ** | ** **           | ** ** | **See  Note 1** | ** ** |
| **Cash flows from operating  activities:**                                                     |       |                 |       |   |   |
| Net earnings                                                                                   |       | $                    | 15,582     |   | $ | 9,969 |   |
| Adjustments to reconcile net earnings to net cash  provided by (used in) operating activities: |       |                 |       |   |   |
| Net principal advances on SBA loans held for sale                                              |       | (8,882               | )          | (11,437 | ) |
| Proceeds from sales of SBA loans held for sale,  net                                           |       | 2,317                |       | 13,819 |   |
| Proceeds applied to income from Portfolio Assets                                               |       | 2,126                |       | 10,460 |   |
| Income from Portfolio Assets                                                                   |       | (26,085              | )          | (23,120 | ) |
| Capitalized interest and costs on Portfolio Assets  and loans receivable                       |       | (369                 | )          | (768 | ) |
| Provision for loan and impairment losses                                                       |       | 4,327                |       | 1,783 |   |
| Foreign currency transaction losses (gains), net                                               |       | 1,095                |       | (300 | ) |
| Equity in earnings of unconsolidated subsidiaries                                              |       | (4,045               | )          | (1,052 | ) |
| Gain on sale of SBA loans held for sale, net                                                   |       | (163                 | )          | (610 | ) |
| 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                                                                  |       | 5,788                |       | 1,991 |   |
| Net premium amortization of loans receivable                                                   |       | (164                 | )          | (33 | ) |
| Stock-based compensation expense                                                               |       | 327                  |       | 130 |   |
| Decrease (increase) in restricted cash                                                         |       | (579                 | )          | 102 |   |
| Decrease (increase) in service fees receivable                                                 |       | 194                  |       | (336 | ) |
| Increase in other assets                                                                       |       | (1,587               | )          | (965 | ) |
| Deferred income tax benefit                                                                    |       | (563                 | )          | — |   |
| Increase in other liabilities                                                                  |       | 2,732                |       | 5,379 |   |
| Net cash provided by (used in) operating  activities                                           |       | (16,928              | )          | 2,637 |   |
| **Cash flows from investing  activities:**                                                     |       |                 |       |   |   |
| Purchases of property and equipment, net                                                       |       | (711                 | )          | (1,358 | ) |
| Proceeds from sale of railroad property                                                        |       | —               |       | 1,350 |   |
| Cash paid for business combinations, net of cash  acquired                                     |       | (1,570               | )          | (7,149 | ) |
| Decrease in cash from deconsolidation of  subsidiary                                           |       | (875                 | )          | — |   |
| Net principal advances on loans receivable                                                     |       | (3,151               | )          | (1,611 | ) |
| Net principal payments (advances) on SBA loans  held for investment                            |       | 252                  |       | (2,020 | ) |
| Purchase of investment securities available for  sale                                          |       | (1,360               | )          | — |   |
| Proceeds from sale of investment security                                                      |       | 3,250                |       | — |   |
| Net principal payments on investment securities  available for sale                            |       | 732                  |       | 2,242 |   |
| Purchases of Portfolio Assets                                                                  |       | (25,166              | )          | (134,966 | ) |
| Proceeds applied to principal on Portfolio Assets                                              |       | 68,760               |       | 71,629 |   |
| Contributions to unconsolidated subsidiaries                                                   |       | (30,865              | )          | (1,222 | ) |
| Distributions from unconsolidated subsidiaries                                                 |       | 4,493                |       | 7,034 |   |
| Net cash provided by (used in) investing  activities                                           |       | 13,789               |       | (66,071 | ) |
| **Cash flows from financing  activities:**                                                     |       |                 |       |   |   |
| Borrowings under notes payable to banks and other                                              |       | 41,101               |       | 137,604 |   |
| Principal payments of notes payable to affiliates                                              |       | (79                  | )          | — |   |
| Principal payments of notes payable to banks and  other, net                                   |       | (55,831              | )          | (84,570 | ) |
| Payments of debt issuance costs and loan fees                                                  |       | (2,342               | )          | (647 | ) |
| Proceeds from secured borrowings, net                                                          |       | 2,602                |       | — |   |
| Contributions from noncontrolling interests                                                    |       | 4,581                |       | 22,270 |   |
| Distributions to noncontrolling interests                                                      |       | (17,497              | )          | (2,245 | ) |
| Cash paid for subsidiary shares in noncontrolling  interests                                   |       | (40                  | )          | (2,796 | ) |
| Proceeds from issuance of common stock                                                         |       | 940                  |       | — |   |
| Net cash provided by (used in) financing  activities                                           |       | (26,565              | )          | 69,616 |   |
| **Effect of exchange rate changes  on cash and cash equivalents**                              |       | (91                  | )          | 236 |   |
| **Net increase (decrease) in cash  and cash equivalents**                                      |       | (29,795              | )          | 6,418 |   |
| **Cash and cash equivalents,  beginning of period**                                            |       | 80,368               |       | 19,103 |   |
| **Cash and cash equivalents, end of  period**                                                  |       | $                    | 50,573     |   | $ | 25,521 |   |
| **Supplemental disclosure of cash  flow information:**                                         | ** ** | ** **           | ** ** | ** ** | ** ** |
| Cash paid during the period for:                                                               |       |                 | ** ** | ** ** | ** ** |
| Interest                                                                                       |       | $                    | 4,829      |   | $ | 4,852 |   |
| Income taxes, net of refunds                                                                   |       | 124                  |       | 90 |   |

 

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)**

 

***Correction of an Error in Previously IssuedConsolidated Statements of Cash Flows***

 

The Company determined that it has incorrectly reportedcertain amounts related to Portfolio Asset activities as “Cash flows fromoperating activities” in the consolidated statements of cash flows for allreporting periods prior to September 30, 2009. Upon subsequent review, theCompany determined that applicable Portfolio Asset transactions, primarilypurchases and principal collections, should be reported as “Cash flows frominvesting activities.” In this Form 10-Q, for reasons described below, theCompany is revising its consolidated statement of cash flows for the priorreporting period so that applicable Portfolio Asset transactions are reportedas “Cash flows from investing activities” instead of “Cash flows from operatingactivities.” All financial information contained in this Form 10-Q giveseffect to these revisions. The revisions did not result in a change to theCompany’s previously-reported revenues, expenses, net earnings (loss), cash andcash equivalents, or stockholders’ equity.

 

Company management considered all of the relevantquantitative and qualitative factors related to the correction of the errorunder Securities and Exchange Commission (“SEC”) guidance on considering theeffects of prior period misstatements when quantifying misstatements in thecurrent period financial statements, and determined that the impact onpreviously-issued financial statements was not material. Therefore, the Companyis revising the prior period consolidated statement of cash flows for the immaterialerror in this Form 10-Q and is not amending previously-filed reports.

 

The following tables reconcile the Company’sconsolidated statement of cash flows from the previously-reported results tothe revised results for the six-month period ended June 30, 2009:

 
| ** **                                                               | ** ** | **Six Months Ended**       | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                               | ** ** | **June 30,**          | ** ** |
| ** **                                                               | ** ** | **2009**                   | ** ** |
| ** **                                                               | ** ** | **(Dollars in thousands)** | ** ** |
| Consolidated Statements of Cash Flows:                                   |       |                       |       |
| Cash flows from operating activities (as reported)                       |       | $                          | (60,700    | ) |
| Impact of revision on purchases of Portfolio  Assets                     |       | 134,966                    |       |
| Impact of revision on proceeds applied to principal  on Portfolio Assets |       | (71,629                    | )          |
| Cash flows from operating activities (as revised)                        |       | $                          | 2,637      |   |
|                                                                     |       |                       |       |
| Cash flows from investing activities (as reported)                       |       | $                          | (2,734     | ) |
| Impact of revision on purchases of Portfolio Assets                      |       | $                          | (134,966   | ) |
| Impact of revision on proceeds applied to principal  on Portfolio Assets |       | 71,629                     |       |
| Cash flows from investing activities (as revised)                        |       | $                          | (66,071    | ) |

 

***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.  Theadjustment was not material to our consolidated financial statements for thequarterly or year-to-date periods ended March 31, 2010 or June 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 June 30, 2010 or the year ended December 31, 2009.

 

8

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

***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.Illiquid credit markets, along with volatile financial, real estate and foreigncurrency markets, have combined to increase the uncertainty inherent in suchestimates and assumptions. As future events and their effects cannot bedetermined with precision, actual results could differ significantly from theseestimates. Changes in these estimates resulting from continuing changes in theeconomic environment will be reflected in the financial statements in futureperiods.

 

***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 varyingqualities that are secured by diverse collateral types and real estate. SomePortfolio Assets are loans for which resolution is tied primarily to the realestate securing the loan, while others may be collateralized business loans,the resolution 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 orremoved from the pool (unless the Company sells, forecloses or writes-off theloan). At acquisition, the Company determines the excess of the scheduledcontractual payments over all cash flows expected to be collected for the loanor loan pool as an amount that should not be accreted (“nonaccretabledifference”). The excess of the cash flows from the loan or loan pool expectedto be collected at acquisition over the initial investment (“accretable difference”) is recognizedas interest income over the remaining life of the loan or loan pool on alevel-yield basis (“accretable yield”). The discount (i.e. the differencebetween the cost of each loan or loan pool and the related aggregatecontractual receivable balance) is not recorded because the Company does notexpect to fully collect each contractual receivable balance. As a result, theseloans and loan pools are recorded at cost (which approximates fair value) atthe 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.

 

9

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

*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 valuation allowance offsetting theloan or loan pool in the consolidated balance sheets. FirstCity establishesvaluation allowances for loans and loan pools acquired with creditdeterioration to reflect only those losses incurred after acquisition — thatis, the cash flows expected at acquisition that are no longer expected to becollected. Significant increases in actual or expected future cash flows areused first to reverse any existing valuation allowance for that loan or loanpool, and any remaining increase may be recognized prospectively through anupward adjustment of the IRR over the remaining life of the loan or loan pool.Any increase to the IRR then becomes the new benchmark for impairment testingand income recognition. Income from loans and loan pools accounted for underthe interest method is accrued based on the IRR of each loan or loan poolapplied to the respective adjusted cost basis. Gross collections in excess ofthe interest accrual and impairments will reduce the carrying value of the loanor loan pool, while gross collections less than the interest accrual willincrease the carrying value. The IRR is calculated based on the timing andamount of anticipated cash flows using the Company’s proprietary collectionmodels.

 

*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 charged tooperations. The carrying value of Purchased Credit-Impaired Loans accounted forunder the cost-recovery method approximated $66.4 million (including $2.5million of loans pending management’s post-purchase evaluation) at June 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 $112.7 million and $42.1 million at June 30, 2010 and December 31,2009, respectively.

 

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 the contractualterms of the loan agreement. Loans are 

 

10

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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 more informationbecomes 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 net undiscountedcash flows expected to be generated by the property. If the property isconsidered impaired, the impairment to be recognized is measured by the amountby which the carrying amount of the property exceeds its fair value. Fair valueis 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, the Companycapitalizes capital improvements and expenditures related to significantbetterments and replacements, including costs related to the development andimprovement of the property for its intended use. Expenditures for 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.

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

***Loans Receivable***

 

The portion 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 90-day premiumrecourse provision to be accounted for initially as secured borrowings ratherthan asset sales. After the premium recourse provision has elapsed, thetransaction will be recorded as a sale and the resulting net gain on sale willbe recognized — which is based on the difference between the proceeds receivedand the allocated 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 portion 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 anindividual-loan basis at least quarterly by reviewing the collectibility of theloans in light of various factors, as applicable, such as estimated future cashreceipts of the borrower or underlying collateral, historical experience,estimated value of underlying collateral, prevailing economic conditions, andindustry concentrations. This evaluation is inherently subjective as itrequires estimates that are susceptible to significant revision as moreinformation becomes available. We consider a loan to be impaired when, based oncurrent information and events, we determine it is probable that we will not beable to collect all amounts due according to the loan’s contractual terms(including scheduled interest payments). When management identifies a loan asimpaired, we measure the impairment based on discounted future cash flows,except when the source of repayment is the operation or liquidation of thecollateral. In these cases, we use the current fair value of the collateral,less estimated selling costs, instead of discounted cash flows. When a loan isdetermined to be impaired, we cease to accrue interest on the note and interestpreviously accrued but not collected becomes part of our recorded investment inthe loan and is collectively reviewed for impairment. When ultimatecollectibility of the impaired note is in doubt, all collections are applied toreduce the principal amount of such notes until the principal has beenrecovered, and collections thereafter are recognized as interest income. Wereturn a loan to accrual status when we determine that the collectibility ofprincipal and interest is reasonably assured. Impairment losses are chargedagainst an allowance account through provisions charged to operations in theperiod impairment is identified. Loans are written-off against the allowancewhen all possible means of collection have been exhausted and the potential forrecovery is considered remote.

 

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

 

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.

 

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 the

 

12

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

connecting carrier at thepoint of interchange. Industrial switching and other service revenues arerecognized 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 onor around 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 it obtainedcontrol of the entity at such time (refer to Note 3 for additionalinformation).

 

**(2)  New Accounting Guidance**

 

Consolidation of VariableInterest Entities (“VIEs”)

 

Effective January 1, 2010,the Company adopted the FASB’s accounting guidance on the consolidation of VIEs(issued in June 2009). This new guidance eliminates the exemption for QSPEs;revises previous guidance by replacing the quantitative-based risks and rewardscalculation for determining which enterprise, if any, has a controllingfinancial interest in a VIE with a qualitative approach focused on identifyingwhich enterprise has both the power to direct the activities of the VIE thatmost-significantly impacts the entity’s economic performance and has theobligation 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 previous guidancewhich, among other changes, eliminates the concept of a QSPE, changes therequirements 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 delays theCompany’s recognition of the sale of guaranteed portions of SBA loans untilexpiration of the 90-day premium recourse provision, and requires suchtransactions to be accounted for initially as a secured borrowing. As such, theCompany did not recognize any gains related to SBA loan sales for the first threemonths of 2010. Once the premium recourse provision has elapsed, thetransaction will be recorded as a sale with the guaranteed portion of the SBAloan and the secured borrowing removed from the balance sheet and the resultinggain on sale recorded. Refer to Notes 1 and 5 for additional information.

 

FairValue

 

InJanuary 2010, the FASB issued new accounting guidance that amended existingguidance 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 the reasons for the transfers; requires disclosureof purchases, sales, issuances and settlements activity on a gross (rather thannet) basis relative in the Level 3 reconciliation of fair value measurementsfor assets and liabilities measured at fair value on a recurring basis; andclarifies, among other things, that fair value measurement disclosures shouldbe provided for each class of assets and liabilities, and that disclosures ofinputs and valuation techniques should be provided for both recurring andnon-recurring Level 2 and Level 3 fair value measurements. We adopted this newguidance for the quarterly period ended March 31, 2010, except for therequirement to provide Level 3 activity of purchases, sales, issuances andsettlements on a gross basis, which will be effective beginning the firstquarter of 2011. Since this guidance is disclosure-only in nature, our adoptionof the guidance did not significantly impact the Company’s consolidated financialstatements. Refer to Note 15 for additional information.

 

SubsequentEvents

 

InMarch 2010, the FASB issued guidance that amends existing guidance (issued inMay 2009) that established the general standards of accounting and disclosurefor subsequent events. Among other things, the new guidance eliminates therequirement for 

 

13

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

SECfilers, as defined in the guidance, to disclose the date through whichsubsequent events have been evaluated. That change is effective immediately.SEC filers continue to be required to evaluate subsequent events through thedate the financial statements are issued. Although the new guidance eliminatesthe requirement for SEC filers to disclose the date through which subsequentevents have been evaluated, it does not prohibit SEC filers from disclosingsuch date. The new guidance also clarifies the requirement to disclose the datethrough which subsequent events have been evaluated in reissued financialstatements to apply only to such statements that have been restated to correctan error or to apply U.S. GAAP retrospectively. The adoption of this guidancedid not have a material impact on our consolidated financial statements.

 

LoanModifications and Loan Pool Accounting

 

InApril 2010, the FASB issued guidance that clarifies the accounting for loanmodifications when the loan is part of a pool that is accounted for as a singleasset. The new guidance provides that modifications of loans that are accountedfor within a pool do not result in the removal of those loans from the pooleven if the modification of those loans would otherwise be considered atroubled debt restructuring. An entity will continue to be required to considerwhether the pool of assets in which the loan is included is impaired ifexpected 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. Theadoption of this guidance did not have a material impact on our consolidatedfinancial statements.

 

**(3)  Business Combinations andDeconsolidation 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’sconsolidated balance sheet as of June 30, 2010.

(2)  Included in “Other liabilities” on theCompany’s consolidated balance sheet as of June 30, 2010.

(3)  Eliminated in consolidation with the Company’sconsolidated financial statements.

 

Inaddition to measuring the subsidiary’s assets and liabilities at fair value atthe date control was obtained on April 1, 2010, the Company’s carrying value ofits previously-held equity-method investment in the coal mine subsidiary wasre-measured to fair value under accounting guidance applicable to businesscombinations. The fair value of the Company’s total interest in the subsidiaryafter 

 

14

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

 

thebusiness combination exceeded the carrying value of its previously-held equityinterest by approximately $4.8 million, which the Company recognized as “Gainon business combinations” in its consolidated statement of operations for thesix-month period ended June 30, 2010. The Company’s carrying value of itspreviously-held equity investment in the coal mine subsidiary included theeffects of the investee’s distribution of a wholly-owned equipment subsidiary(i.e. spin-off transaction), effective April 1, 2010, to the owners inproportion to their then-existing ownership percentages. The spin-offtransaction effected by the investee was recorded at carrying value and theCompany’s proportionate share of equity in the distributed entity approximated$2.7 million — which it continued to record as an equity-method investmentafter 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).

 

*Domestic Acquisition Partnerships — Business Combinations*

 

OnMarch 31, 2010, the Company acquired an additional 50% ownership interest inthree domestic Acquisition Partnerships for $4.4 million. As a result of thistransaction, 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 |   |

 

Pursuant to accountingprovisions applicable to business combinations, the Company’s carrying value ofits previously-held equity-method investments in these Acquisition Partnershipswas re-measured to fair value at the acquisition date. The fair value of theCompany’s previously-held equity interests exceeded the aggregate carryingvalues by approximately $0.9 million. As such, the Company recognized a $0.9million gain attributable to the re-measurement of its previously-held equityinterests on the acquisition date (included in “Gain on business combinations”in the Company’s consolidated statement of operations for the six-month periodended June 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, the Companyand the noncontrolling owners consented to certain amendments to the subsidiary’soperating agreement that resulted in the Company ceasing to have a controllinginterest, but retaining a noncontrolling interest and elevated economicinterests, in the manufacturing entity. Accordingly, the Company deconsolidatedand removed the carrying values of the manufacturing subsidiary’s assets ($9.9million) and liabilities ($9.6 million) and the carrying value of thenoncontrolling interest ($39,000) attributed to the subsidiary from itsconsolidated balance sheet 

 

15

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

on June 30, 2010. TheCompany also recorded its retained noncontrolling interest in the manufacturingentity at estimated fair value of approximately $0.3 million at June 30, 2010.No gain or loss was recognized by the Company as a result of deconsolidatingthis subsidiary. On June 30, 2010, the Company began to account for itsretained investment in the manufacturing entity using the equity-method ofaccounting; consequently, the Company will no longer report the individualrevenue and expense line-items of the manufacturing entity’s operations in itsconsolidated statement of operations (rather, the Company will record its shareof the subsidiary’s net earnings as “Equity in earnings of unconsolidatedsubsidiaries” beginning July 1, 2010).

 

**(4)  Portfolio Assets**

 

Portfolio Assets are summarized as follows:

 
| ** **                      | ** ** | **June 30, 2010**          | ** ** |
|---------------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                      | ** ** | **Outstanding**            | ** ** | **Allowance for** | ** ** | **Outstanding** | ** ** |
| ** **                      | ** ** | **Balance**                | ** ** | **Loan Losses** | ** ** | **Balance, net** | ** ** |
| Loan Portfolios:                |       |                       |       |   |   |   |   |
| Purchased Credit-Impaired Loans |       | $                          | 180,495    |   | $ | 868 |   | $ | 179,627 |   |
| Purchased performing loans      |       | 3,664                      |       | 9 |   | 3,655 |   |
| UBN:                            |       |                       |       |   |   |   |   |
| Non-performing loans            |       | 46,730                     |       | 44,773 |   | 1,957 |   |
| Performing loans                |       | 1,018                      |       | — |   | 1,018 |   |
| Other                           |       | 2,859                      |       | 69 |   | 2,790 |   |
| Total                           |       | $                          | 234,766    |   | $ | 45,719 |   | $ | 189,047 |   |

 
| ** **                      | ** ** | **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 |   |

 
| ** **                               | ** ** | **June 30,**               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|----------------------------|------------|------------------|------------|
| ** **                               | ** ** | **2010**                   | ** ** | **2009**         | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)** | ** ** |
| Real Estate Portfolios:                  | ** ** | ** **                 | ** ** | ** **       | ** ** |
| Real estate held for sale                |       | $                          | 23,186     |             | $          | 17,051 |   |
| Real estate held for investment, net (1) |       | 9,153                      |       | 9,387            |       |
| Total                                    |       | $                          | 32,339     |             | $          | 26,438 |   |

 

----

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

 

16

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** **

**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

Income from Portfolio Assets is summarized as follows:

 
| ** **                      | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|---------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                      | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                      | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Loan Portfolios:                | ** ** | ** **                 | ** ** | ** **           |       |   |   |   |   |
| Purchased Credit-Impaired Loans |       | $                          | 12,716     |                 | $          | 13,530 |   | $ | 22,740 |   | $ | 22,253 |   |
| Purchased performing loans      |       | 66                         |       | 94                   |       | 126 |   | 173 |   |
| UBN                             |       | 92                         |       | 42                   |       | 636 |   | 275 |   |
| Other                           |       | 99                         |       | 241                  |       | 388 |   | 429 |   |
| Real Estate Portfolios          |       | 1,649                      |       | 170                  |       | 2,195 |   | (10 | ) |
| Income from Portfolio Assets    |       | $                          | 14,622     |                 | $          | 14,077 |   | $ | 26,085 |   | $ | 23,120 |   |

 

For the six-month periodended June 30, 2010, the Company recorded provisions for loan andimpairment losses, net of recoveries, by a charge to income of $2.6 million —which is composed of a $1.9 million provision for loan losses, net ofrecoveries, and a $0.7 million impairment charge on real estate portfolios. Forthe six-month period ended June 30, 2009, the Company recorded a provisionfor loan and impairment losses on Portfolio Assets of $0.7 million — which iscomposed of a $0.4 million impairment charge on real estate portfolios and a$0.3 million provision for loan losses, net of recoveries.

 

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

 
| ** **              | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **              | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **              | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **              | ** ** | **(Dollars in thousands)** | ** ** | ** **           | ** ** | ** ** | ** ** |
| Beginning Balance       |       | $                          | (59,853    | )                    | $          | (71,922 | ) | $ | (65,825 | ) | $ | (76,365 | ) |
| Provisions              |       | (1,113                     | )          | 581                  |       | (2,325 | ) | (660 | ) |
| Recoveries              |       | 297                        |       | 70                   |       | 460 |   | 382 |   |
| Charge-offs             |       | 9,726                      |       | 6,220                |       | 11,409 |   | 7,647 |   |
| Translation adjustments |       | 5,224                      |       | (4,031               | )          | 10,562 |   | (86 | ) |
| Ending Balance          |       | $                          | (45,719    | )                    | $          | (69,082 | ) | $ | (45,719 | ) | $ | (69,082 | ) |

 

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 June 30, 2010 and December 31, 2009. Reclassificationsfrom nonaccretable difference to accretable yield primarily result from theCompany’s increase in its estimates of future cash flows. Reclassifications tononaccretable difference from accretable yield primarily results from theCompany’s decrease in its estimates of future cash flows. Changes in accretableyield related to the Company’s Purchased Credit-Impaired Loans for the three-and six-month periods ended June 30, 2010 and 2009 are as follows:

 
| ** **                                     | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                                     | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                              |       | $                          | 10,176     |                 | $          | 56,640 |   | $ | 12,923 |   | $ | 58,114 |   |
| Additions                                      |       | —                     |       | 12,146               |       | — |   | 23,077 |   |
| Accretion                                      |       | (222                       | )          | (5,562               | )          | (2,126 | ) | (10,460 | ) |
| Reclassification from nonaccretable difference |       | (2,493                     | )          | (1,022               | )          | (2,142 | ) | 1,459 |   |
| Disposals                                      |       | (2,082                     | )          | (2,381               | )          | (2,941 | ) | (6,193 | ) |
| Transfer to non-accrual                        |       | (2,885                     | )          | (8,652               | )          | (3,039 | ) | (13,284 | ) |
| Translation adjustments                        |       | (45                        | )          | 1,767                |       | (226 | ) | 223 |   |
| Ending Balance                                 |       | $                          | 2,449      |                 | $          | 52,936 |   | $ | 2,449 |   | $ | 52,936 |   |

 

17

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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

 
| ** **                                                              | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                                              | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                                                              | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands)** | ** ** |
| Face value at acquisition                                               |       | $                          | 17,219     |                 | $          | 112,058 |   | $ | 51,756 |   | $ | 252,830 |   |
| Cash flows expected to be collected at  acquisition, net of adjustments |       | 9,819                      |       | 83,306               |       | 38,618 |   | 164,428 |   |
| Basis in acquired loans at acquisition                                  |       | 6,251                      |       | 64,497               |       | 24,365 |   | 134,688 |   |
|                                                                         |            |                            |            |                      |            |  |  |  |  |  |  |  |  |

 

**(5)  Loans Receivable**

 

The following is acomposition of the Company’s loans receivable by loan type and region:

 
| ** **                                                                   | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                                   | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                                                                   | ** ** | **(Dollars in thousands)** | ** ** |
| Domestic:                                                                    |       |                       |       |                  |       |
| Commercial and industrial:                                                   |       |                       |       |                  |       |
| Affiliates, net of allowance for loan losses of  $67                         |       | $                          | 10,952     |                  | $          | 13,177 |   |
| SBA, net of allowance for loan losses of $346 and  $490, respectively        |       | 22,862                     |       | 16,266                |       |
| Other                                                                        |       | 8,049                      |       | 1,402                 |       |
| Real estate:                                                                 |       |                       |       |                  |       |
| Other, net of allowance for loan losses of $1,083  and $-0-, respectively    |       | 6,605                      |       | 8,831                 |       |
|                                                                         |       |                       |       |                  |       |
| Foreign - commercial and industrial:                                         |       |                       |       |                  |       |
| Affiliates, net of allowance for loan losses of  $433 and $-0-, respectively |       | 10,915                     |       | 12,945                |       |
|                                                                         |       |                       |       |                  |       |
| Total loans, net                                                             |       | $                          | 59,383     |                  | $          | 52,621 |   |

 

***Loans receivable —affiliates***

 

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

 
| ** **                    | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance           |       | $                          | 21,243     |                  | $          | 24,757 |   |
| Allowance for loan losses     |       | (500                       | )          | (67                   | )          |
| Discounts, net                |       | (193                       | )          | (237                  | )          |
| Capitalized interest          |       | 1,317                      |       | 1,669                 |       |
| Carrying amount of loans, net |       | $                          | 21,867     |                  | $          | 26,122 |   |

 

18

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

A summary of activity inloans receivable — affiliates follows:

 
| ** **                      | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|---------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                      | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                      | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance               |       | $                          | 23,816     |                 | $          | 27,827 |   | $ | 26,122 |   | $ | 27,080 |   |
| Advances                        |       | 400                        |       | 2,852                |       | 550 |   | 5,152 |   |
| Payments received               |       | (660                       | )          | (1,333               | )          | (2,890 | ) | (2,610 | ) |
| Capitalized interest            |       | 88                         |       | 88                   |       | 137 |   | 169 |   |
| Provision for loan impairment   |       | (433                       | )          | —               |       | (433 | ) | — |   |
| Discount accretion, net         |       | 22                         |       | —               |       | 44 |   | — |   |
| Other noncash adjustments (1)   |       | (1,001                     | )          | —               |       | (1,001 | ) | — |   |
| Foreign exchange gains (losses) |       | (365                       | )          | 312                  |       | (662 | ) | (45 | ) |
| Ending Balance                  |       | $                          | 21,867     |                 | $          | 29,746 |   | $ | 21,867 |   | $ | 29,746 |   |

 

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(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 six months endedJune 30, 2010. The Company recorded no provisions for impairment for thesix-month period ended June 30, 2009.

 

AtJune 30, 2010, the Company’s recorded investment in impaired andnon-accrual loans receivable — affiliates totaled $0.8 million. The averagerecorded investment in these impaired and non-accrual loans approximated $0.1million for the six-month period ended June 30, 2010. At June 30,2010, the Company had $0.4 million of valuation allowances specifically relatedto these loans.

 

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

 

Loansreceivable — SBA held for sale are summarized as follows:

 
| ** **                     | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                     | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance            |       | $                          | 7,616      |                  | $          | 821 |   |
| Capitalized costs, net of fees |       | 81                         |       | —                |       |
| Carrying amount of loans, net  |       | $                          | 7,697      |                  | $          | 821 |   |

 

19

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

Changesin loans receivable — SBA held for sale are as follows:

 
| ** **                         | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                         | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                         | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                  |       | $                          | 4,895      |                 | $          | 9,720 |   | $ | 821 |   | $ | 4,901 |   |
| Originations and advances of loans |       | 4,860                      |       | 6,787                |       | 8,889 |   | 11,600 |   |
| Payments received                  |       | —                     |       | (88                  | )          | (7 | ) | (163 | ) |
| Capitalized costs                  |       | 31                         |       | (99                  | )          | 83 |   | (18 | ) |
| Loans sold, net                    |       | (2,089                     | )          | (12,828              | )          | (2,089 | ) | (12,828 | ) |
| Ending Balance                     |       | $                          | 7,697      |                 | $          | 3,492 |   | $ | 7,697 |   | $ | 3,492 |   |

 

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 six months ended June 30, 2010 and2009.

 

AtJune 30, 2010, SBA loans held for sale include $2.4 million in guaranteedportions of SBA loans sold and subject to a 90-day premium recourse provision.In accordance with FASB’s accounting guidance on transfers of financial assets(issued in June 2009) that became effective in the first quarter of 2010,an off-setting secured borrowing has been recorded and is included in “Otherliabilities” in the Company’s consolidated balance sheet. After the premiumrecourse provision has elapsed, the Company will record the transaction as asale with the guaranteed portion of the SBA loan and the secured borrowingremoved from the balance sheet and the resulting gain on sale recorded. Referto Note 2 for additional information.

 

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

 

Loansreceivable — SBA held for investment are summarized as follows:

 
| ** **                    | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance           |       | $                          | 16,497     |                  | $          | 17,072 |   |
| Allowance for loan losses     |       | (346                       | )          | (490                  | )          |
| Discounts, net                |       | (1,105                     | )          | (1,245                | )          |
| Capitalized costs             |       | 119                        |       | 108                   |       |
| Carrying amount of loans, net |       | $                          | 15,165     |                  | $          | 15,445 |   |

 

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

 
| ** **                          | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                          | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                          | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                   |       | $                          | 15,156     |                 | $          | 15,673 |   | $ | 15,445 |   | $ | 14,405 |   |
| Originations and advances of loans  |       | 572                        |       | 1,163                |       | 1,050 |   | 2,767 |   |
| Payments received                   |       | (499                       | )          | (405                 | )          | (1,316 | ) | (793 | ) |
| Capitalized costs                   |       | 7                          |       | 17                   |       | 10 |   | 43 |   |
| Change in allowance for loan losses |       | (100                       | )          | (63                  | )          | 144 |   | (78 | ) |
| Discount accretion, net             |       | 31                         |       | (182                 | )          | 88 |   | (141 | ) |
| Charge-offs                         |       | (2                         | )          | —               |       | (256 | ) | — |   |
| Ending Balance                      |       | $                          | 15,165     |                 | $          | 16,203 |   | $ | 15,165 |   | $ | 16,203 |   |

 

20

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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 $112,000 and $78,000 for the six-month periods ended June 30,2010 and 2009, respectively.

 

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

 
| ** **        | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-------------------|------------|----------------------------|------------|----------------------|------------|
| ** **        | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **        | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **        | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance |       | $                          | (246       | )                    | $          | (49 | ) | $ | (490 | ) | $ | (34 | ) |
| Provisions        |       | (110                       | )          | (76                  | )          | (192 | ) | (97 | ) |
| Recoveries        |       | 8                          |       | 13                   |       | 80 |   | 19 |   |
| Charge-offs       |       | 2                          |       | —               |       | 256 |   | — |   |
| Ending Balance    |       | $                          | (346       | )                    | $          | (112 | ) | $ | (346 | ) | $ | (112 | ) |

 

At June 30, 2010, theCompany’s recorded investment in impaired and non-accrual loans receivable —SBA held for investment totaled $0.6 million. The average recorded investmentin these impaired and non-accrual loans approximated $0.4 million for thesix-month period ended June 30, 2010. At June 30, 2010, the Companyhad $0.2 million of valuation allowances specifically related to these loans.

 

***Loans receivable — other***

 

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

 
| ** **                     | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                     | ** ** | **(Dollars in thousands)** | ** ** |
| Outstanding balance            |       | $                          | 15,530     |                  | $          | 9,992 |   |
| Allowance for loan losses      |       | (1,083                     | )          | —                |       |
| Discounts, net                 |       | (38                        | )          | (7                    | )          |
| Capitalized interest and costs |       | 245                        |       | 248                   |       |
| Carrying amount of loans, net  |       | $                          | 14,654     |                  | $          | 10,233 |   |

 

Changes in loans receivable —other are as follows:

 
| ** **                          | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                          | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                          | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                   |       | $                          | 12,878     |                 | $          | 13,411 |   | $ | 10,233 |   | $ | 13,533 |   |
| Advances                            |       | 5,374                      |       | 1,381                |       | 10,552 |   | 3,368 |   |
| Payments received                   |       | (3,039                     | )          | (2,170               | )          | (5,061 | ) | (4,299 | ) |
| Capitalized interest and costs      |       | —                     |       | 26                   |       | (2 | ) | 44 |   |
| Change in allowance for loan losses |       | (567                       | )          | (967                 | )          | (1,083 | ) | (967 | ) |
| Discount accretion, net             |       | 8                          |       | 2                    |       | 15 |   | 9 |   |
| Foreign exchange losses             |       | —                     |       | 15                   |       | — |   | 10 |   |
| Ending Balance                      |       | $                          | 14,654     |                 | $          | 11,698 |   | $ | 14,654 |   | $ | 11,698 |   |

 

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. The Companyrecorded impairment provisions on loans receivable — other of approximately$1.1 million and $1.0 million for the six-month periods ended June 30,2010 and 2009, respectively.

 

21

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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

 
| ** **        | ** ** | **Three Months Ended**     | ** **    | **Six Months Ended** | ** ** |
|-------------------|------------|----------------------------|---------------|----------------------|------------|
| ** **        | ** ** | **June 30,**               | ** **    | **June 30,**         | ** ** |
| ** **        | ** ** | **2010**                   | ** **    | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **        | ** ** | **(Dollars in thousands)** | ** **    |
| Beginning Balance |       | $                          |  (516    | )                    | $          |  — |   | $ |  — |   | $ |  — |   |
| Provisions        |       | (567                       | )             | (967                 | )          | (1,083 | ) | (967 | ) |
| Charge-offs       |       | —                     |          | —               |       | — |   | — |   |
| Ending Balance    |       | $                          |   (1,083 | )                    | $          |    (967 | ) | $ |   (1,083 | ) | $ |  (967 | ) |

 

AtJune 30, 2010, the Company’s recorded investment in impaired and non-accrualloans receivable — other totaled $6.6 million. The average recorded investmentin these impaired and non-accrual loans approximated $7.8 million for thesix-month period ended June 30, 2010. At June 30, 2010, the Company had $1.1million of valuation allowances specifically related to these loans.

 

**(6)  Equity Investments**

 

TheCompany has equity investments in Acquisition Partnerships and their generalpartners, and equity investments in variousservicing and operating entities, that are accounted for under theequity-method of accounting. The condensed combined financial position andresults of operations of the Acquisition Partnerships (which include thedomestic and foreign Acquisition Partnerships and their general partners) andthe servicing and operating entities (collectively, the “Equity Investees”),are summarized as follows:

 

**Condensed Combined Balance Sheets**

 
| ** **                                             | ** ** | **June 30,**               | ** **    | **December 31,** | ** ** |
|--------------------------------------------------------|------------|----------------------------|---------------|------------------|------------|
| ** **                                             | ** ** | **2010**                   | ** **    | **2009**         | ** ** |
| ** **                                             | ** ** | **(Dollars in thousands)** | ** **    |
| **Acquisition Partnerships:**                          |       |                       |          |             |       |
| Assets                                                 |       | $                          |  359,993 |             | $          |  282,999 |   |
| Liabilities                                            |       | $                          |  63,331  |             | $          |  97,135 |   |
| Net equity                                             |       | 296,662                    |          | 185,864          |       |
|                                                   |       | $                          | 359,993       |             | $          |   282,999 |   |
| **Servicing and operating entities:**                  |       |                       |          |             |       |
| Assets              |       | $                          | 143,731       |             | $          |   134,384 |   |
| Liabilities                                            |       | $                          | 87,946        |             | $          | 79,375 |   |
| Net equity                                             |       | 55,785                     |          | 55,009           |       |
|                                                   |       | $                          | 143,731       |             | $          |   134,384 |   |
| **Total:**                                             | ** ** | ** **                 |          |             |       |
| Assets                                                 |       | $                          | 503,724       |             | $          |   417,383 |   |
| Liabilities                                            |       | $                          | 151,277       |             | $          | 176,510 |   |
| Net equity                                             |       | 352,447                    |          | 240,873          |       |
|                                                   |       | $                          | 503,724       |             | $          |  417,383 |   |
|                                                   | ** ** | ** **                 | ** **    | ** **       | ** ** |
| Equity investment in Acquisition Partnerships          |       | $                          |  55,050  |             | $          |   41,029 |   |
| Equity investment in servicing and operating  entities |       | 36,590                     |          | 30,462           |       |
|                                                   |       | $                          |  91,640  |             | $          |  71,491 |   |

 

22

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

**Condensed Combined Summary of Operations**

 
| ** **                                                     | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **June 30,**               | ** ** | **June 30,**         | ** ** |
| ** **                                                     | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| **Acquisition Partnerships:**                                  | ** ** | ** **                 | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                       |       | $                          | 8,292      |                 | $          | 11,092 |   | $ | 15,410 |   | $ | 21,502 |   |
| Costs and expenses                                             |       | 10,103                     |       | (2,473               | )          | 20,278 |   | 17,408 |   |
| Net earnings (loss)                                            |       | $                          | (1,811     | )                    | $          | 13,565 |   | $ | (4,868 | ) | $ | 4,094 |   |
|                                                           |       |                       |       |                 |       |   |   |   |   |
| **Servicing and operating entities:**                          |       |                       |       |                 |       |   |   |   |   |
| Revenues                                                       |       | $                          | 19,328     |                 | $          | 16,143 |   | $ | 45,540 |   | $ | 36,871 |   |
| Costs and expenses                                             |       | 16,005                     |       | 18,601               |       | 33,974 |   | 37,584 |   |
| Net earnings (loss)                                            |       | $                          | 3,323      |                 | $          | (2,458 | ) | $ | 11,566 |   | $ | (713 | ) |
|                                                           |       |                       |       |                 |       |   |   |   |   |
| Equity in earnings (loss) of Acquisition  Partnerships         |       | $                          | (275       | )                    | $          | 2,133 |   | $ | (883 | ) | $ | 1,242 |   |
| Equity in earnings (loss) of servicing and  operating entities |       | 2,091                      |       | (935                 | )          | 4,928 |   | (190 | ) |
|                                                           |       | $                          | 1,816      |                 | $          | 1,198 |   | $ | 4,045 |   | $ | 1,052 |   |

 

InMarch 2010, the Company acquired a controlling interest in three domesticAcquisition Partnerships in which it previously held a noncontrolling interestin each such entity. In addition, in April 2010, the Company obtained acontrolling interest in a coal mine subsidiary in which it previously held anoncontrolling interest. As a result of these transactions, the AcquisitionPartnerships and coal mine subsidiary converted from equity-method investmentsto consolidated subsidiaries of the Company. As such, the assets, liabilitiesand equity of these entities are not included in the applicable balance sheettables above and below at June 30, 2010; and their results of operations fromthe respective transaction dates are not included in the applicable earningstables above and below for the six-month period ended June 30, 2010.Furthermore, in connection with the activity related to the coal minesubsidiary, the Company obtained a direct noncontrolling interest in anequipment subsidiary that was previously wholly-owned and consolidated by thecoal mine subsidiary (obtained through a spin-off transaction effected by thecoal mine subsidiary in April 2010). As such, the assets, liabilities andequity of this equipment subsidiary are included in the applicable balancesheet tables above and below at June 30, 2010; and its results of operationsfrom the transaction date are included in the applicable earnings tables aboveand below for the six-month period ended June 30, 2010. Refer to Note 3 foradditional information related to these transactions.

 

OnJune 30, 2010, the Company entered into an arrangement with a then-consolidatedmanufacturing subsidiary that resulted in the Company ceasing to have acontrolling interest, but retaining a noncontrolling interest, in the entity.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 June 30, 2010. Refer to Note3 for additional information related to this transaction.

 

AtJune 30, 2010 and December 31, 2009, the Acquisition Partnerships’ totalcarrying value of loans accounted for under non-accrual methods of accounting(i.e. cost-recovery or cash basis method) approximated $300.0 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.

 

23

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 
| ** **                                                                        | ** ** | **June 30,**               | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------|------------|------------------|------------|
| ** **                                                                        | ** ** | **2010**                   | ** ** | **2009**         | ** ** |
| ** **                                                                        | ** ** | **(Dollars in thousands)** | ** ** |
| Combined assets of the Equity Investees:                                          |       |                       |       |             |       |
| Domestic:                                                                         |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | $                          | 173,113    |             | $          | 58,190 |   |
| Operating entities                                                                |       | 56,475                     |       | 31,481           |       |
| Latin America:                                                                    |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | 132,670                    |       | 139,214          |       |
| Servicing entities                                                                |       | 9,843                      |       | 13,328           |       |
| Europe:                                                                           |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | 54,210                     |       | 85,595           |       |
| Servicing entities                                                                |       | 77,413                     |       | 89,575           |       |
|                                                                              |       | $                          | 503,724    |             | $          | 417,383 |   |
| Combined equity of the Equity Investees:                                          |       |                       |       |             |       |
| Domestic:                                                                         |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | $                          | 169,325    |             | $          | 36,696 |   |
| Operating entities                                                                |       | 12,574                     |       | 5,574            |       |
| Latin America:                                                                    |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | 110,525                    |       | 115,768          |       |
| Servicing entities                                                                |       | (1,026                     | )          | 427              |       |
| Europe:                                                                           |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | 16,812                     |       | 33,400           |       |
| Servicing entities                                                                |       | 44,237                     |       | 49,008           |       |
|                                                                              |       | $                          | 352,447    |             | $          | 240,873 |   |
| Company’s carrying value of its equity investments  in the Equity Investees: |       |                       |       |             |       |
| Domestic:                                                                         |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | $                          | 32,508     |             | $          | 13,575 |   |
| Operating entities                                                                |       | 5,581                      |       | 1,659            |       |
| Latin America:                                                                    |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | 17,144                     |       | 17,532           |       |
| Servicing entities                                                                |       | 1,788                      |       | 2,677            |       |
| Europe:                                                                           |       |                       |       |             |       |
| Acquisition Partnerships                                                          |       | 5,398                      |       | 9,922            |       |
| Servicing entities                                                                |       | 29,221                     |       | 26,126           |       |
|                                                                              |       | $                          | 91,640     |             | $          | 71,491 |   |

 

24

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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 atJune 30, 2010.

 
| ** **                                                         | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                                         | ** ** | **June 30,**               | ** ** | **June 30,**         | ** ** |
| ** **                                                         | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                         | ** ** | **(Dollars in thousands)** | ** ** |
| Revenues of the Equity Investees:                                  |       |                       |       |                 |       |   |   |   |   |
| Domestic:                                                          |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | $                          | 782        |                 | $          | 2,966 |   | $ | 2,610 |   | $ | 4,606 |   |
| Teton Buildings LLC (operating entity)                             |       | 2,388                      |       | (991                 | )          | 4,450 |   | 155 |   |
| Other operating entities                                           |       | 4,898                      |       | 5,183                |       | 12,899 |   | 13,038 |   |
| Latin America:                                                     |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | 6,927                      |       | 2,912                |       | 10,324 |   | 5,437 |   |
| Servicing entity                                                   |       | 2,346                      |       | 3,036                |       | 4,510 |   | 5,324 |   |
| Europe:                                                            |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | 584                        |       | 5,214                |       | 2,476 |   | 11,459 |   |
| MCS et Associes (servicing entity)                                 |       | 8,903                      |       | 7,548                |       | 21,906 |   | 15,710 |   |
| Other servicing entities                                           |       | 792                        |       | 1,367                |       | 1,775 |   | 2,644 |   |
| ** **                                                         |       | $                          | 27,620     |                 | $          | 27,235 |   | $ | 60,950 |   | $ | 58,373 |   |
|                                                               |       |                       |       |                 |       |   |   |   |   |
| Net earnings (loss) of the Equity Investees:                       |       |                       |       |                 |       |   |   |   |   |
| Domestic:                                                          |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | $                          | (222       | )                    | $          | 1,310 |   | $ | 543 |   | $ | 1,414 |   |
| Teton Buildings LLC (operating entity)                             |       | 1,570                      |       | (218                 | )          | 2,828 |   | (344 | ) |
| Other operating entities                                           |       | 947                        |       | (1,743               | )          | 2,441 |   | 362 |   |
| Latin America:                                                     |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | (299                       | )          | 11,344               |       | (2,132 | ) | (1,029 | ) |
| Servicing entity                                                   |       | (185                       | )          | (409                 | )          | (1,450 | ) | (935 | ) |
| Europe:                                                            |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | (1,291                     | )          | 911                  |       | (3,280 | ) | 3,709 |   |
| MCS et Associes (servicing entity)                                 |       | 1,223                      |       | (50                  | )          | 8,130 |   | 223 |   |
| Other servicing entities                                           |       | (231                       | )          | (38                  | )          | (382 | ) | (19 | ) |
|                                                               |       | $                          | 1,512      |                 | $          | 11,107 |   | $ | 6,698 |   | $ | 3,381 |   |
|                                                               |       |                       |       |                 |       |   |   |   |   |
| Company’s equity in earnings (loss) of the Equity  Investees: |       |                       |       |                 |       |   |   |   |   |
| Domestic:                                                          |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | $                          | (95        | )                    | $          | 515 |   | $ | 37 |   | $ | 516 |   |
| Teton Buildings LLC (operating entity)                             |       | 1,256                      |       | (28                  | )          | 1,853 |   | (22 | ) |
| Other operating entities                                           |       | 550                        |       | (614                 | )          | 999 |   | 219 |   |
| Latin America:                                                     |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | 165                        |       | 1,391                |       | 45 |   | (253 | ) |
| Servicing entity                                                   |       | (93                        | )          | (204                 | )          | (725 | ) | (467 | ) |
| Europe:                                                            |       |                       |       |                 |       |   |   |   |   |
| Acquisition Partnerships                                           |       | (346                       | )          | 227                  |       | (966 | ) | 979 |   |
| MCS et Associes (servicing entity)                                 |       | 416                        |       | (83                  | )          | 2,864 |   | 83 |   |
| Other servicing entities                                           |       | (37                        | )          | (6                   | )          | (62 | ) | (3 | ) |
|                                                               |       | $                          | 1,816      |                 | $          | 1,198 |   | $ | 4,045 |   | $ | 1,052 |   |

 

At June 30, 2010, theCompany had $23.2 million in Euro-denominated debt for the purpose of hedging aportion of the Company’s net equity investments in Europe. Refer to Note 11 for additional information.

 

25

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

**(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, and evaluatesservicing assets for impairment based on fair value at each reporting date. TheCompany evaluates the possible impairment of servicing assets based on thedifference between the carrying amount and current fair value of the servicingassets. Impairment is charged to servicing fees in the period recognized.

 

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

 
| ** **                                  | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                  | ** ** | **June 30,**               | ** ** | **June 30,**         | ** ** |
| ** **                                  | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Beginning Balance                           |       | $                          | 960        |                 | $          | 739 |   | $ | 1,115 |   | $ | 785 |   |
| Servicing Assets capitalized                |       | 40                         |       | 312                  |       | 40 |   | 312 |   |
| Servicing Assets amortized                  |       | (51                        | )          | (50                  | )          | (206 | ) | (96 | ) |
| Ending Balance                              |       | $                          | 949        |                 | $          | 1,001 |   | $ | 949 |   | $ | 1,001 |   |
| ** **                                  | ** ** | ** **                 | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Reserve for impairment of servicing assets: |       |                       |       |                 |       |   |   |   |   |
| Beginning Balance                           |       | $                          | (71        | )                    | $          | (44 | ) | $ | (59 | ) | $ | (63 | ) |
| Impairments                                 |       | (3                         | )          | (16                  | )          | (15 | ) | (16 | ) |
| Recoveries                                  |       | 1                          |       | 33                   |       | 1 |   | 52 |   |
| Ending Balance                              |       | $                          | (73        | )                    | $          | (27 | ) | $ | (73 | ) | $ | (27 | ) |
|                                        |       |                       |       |                 |       |   |   |   |   |
| Ending Balance (net of reserve)             |       | $                          | 876        |                 | $          | 974 |   | $ | 876 |   | $ | 974 |   |
| ** **                                  | ** ** | ** **                 | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fair value of amortized servicing assets:   |       |                       |       |                 |       |   |   |   |   |
| Beginning balance                           |       | $                          | 985        |                 | $          | 695 |   | $ | 1,162 |   | $ | 722 |   |
| Ending balance                              |       | $                          | 971        |                 | $          | 974 |   | $ | 971 |   | $ | 974 |   |

 

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 of12.5% 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 — SeniorCredit Facilities with Bank of Scotland 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 loanfacility) (collectively, “Existing Credit Agreements”). The Existing CreditAgreements were guaranteed by substantially all of the wholly-owned subsidiariesof FirstCity and secured by substantially all of the assets of FirstCity andits wholly-owned subsidiaries. The outstanding indebtedness and existing letterof credit obligations under the Existing Credit Agreements in the amount of$268.6 million were refinanced into the Reducing Note Facility, which providesfor a scheduled amortization over 3 years ($43.6 million in the first year,$80.0 million in the second year, $60.0 million in the first nine months of thethird year, and $85.0 million due on June 25, 2013, the maturity date).

 

26

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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

 

·                  FirstCity provides a limited guaranty for therepayment 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;

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

·                  Provides for a fluctuating interest rateequal to, at FC Commercial’s option, either (a) the greater of(i) one month *London Interbank OfferingRate*(“LIBOR”) plus 3.5% (subject to LIBOR floor of 1.0%) or(ii) 4.5%, or (b) Bank of Scotland’s prime rate plus 3.0%;

·                  Allows FC Commercial and FH Partners todesignate a portion of the debt under the Reducing Note Facility to be borrowedin Euros up to a maximum amount of Euros equivalent to USD $27.5 million;

·                  Requires FirstCity to maintain a minimumtangible net worth (as defined) requirement of $60.0 million; and

·                  Provides for an upfront fee to be paid toBank of Scotland in the amount of $2.0 million, payable as follows: $0.7million paid on March 26, 2010 (in connection with an extension of theExisting Credit Facilities), $0.7 million on June 25, 2010, and paymentsof $0.2 million from the cash flow of the pledged assets on the first day ofJuly, August, September and 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 Existing 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 Existing 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.

 

**(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 June 30, 2010 and December 31, 2009:

 

27

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 
| ** **                                                 | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Cumulative foreign currency translation  adjustments       |       | $                          | (1,705     | )                     | $          | 956 |   |
| Net unrealized gains on securities available for  sale (1) |       | 431                        |       | 2,504                 |       |
| Total accumulated other comprehensive income  (loss)       |       | $                          | (1,274     | )                     | $          | 3,460 |   |

 

----

(1)         Includes$0.5 million and $1.4 million at June 30, 2010 and December 31, 2009,respectively, attributable to FirstCity’s proportionate share of net unrealizedgains recorded by an investee accounted for under the equity-method of 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 June 30, 2010, the Company carried $23.2 millionin Euro-denominated debt and designated the debt as a non-derivative hedge ofits net investment in certain European subsidiaries. The Company designated thehedging relationship such that changes in the net investments being hedged areexpected to be naturally off-set by corresponding changes in the value of theEuro-denominated debt. We consider our investments in European subsidiaries tobe denominated in a relatively stable currency and of a long-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 June 30, 2010 and December 31,2009, the carrying value and line item caption of the Company’s non-derivativeinstrument was reported on the consolidated balance sheets as follows (inthousands):

 
| **Non-Derivative**       | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                 | ** ** |
|--------------------------|------------|------------------------|------------|------------------------|------------|----------------------------|------------|
| **Instrument in**        | ** ** | ** **             | ** ** | ** **             | ** ** | ** **                 | ** ** |
| **Net Investment**       | ** ** | **Balance Sheet**      | ** ** | **Carrying Value at:** | ** ** |
| **Hedging Relationship** | ** ** | **Location**           | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|                     |       |                   |       |                   |       |                       |       |
| Euro-denominated debt    |       | Notes payable to banks |       | $                      | 23,235     |                       | $          | 24,824 |   |
|                          |            |                        |            |                        |            |                            |            |  |  |

 

28

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**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 the three-and six-month month periods ended June 30, 2010 and 2009 was as 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**       | ** ** | **June 30,**         | ** ** | **AOCI into Income**        | ** ** | **June 30,**            | ** ** |
| **Hedging Relationship** | ** ** | **2010**                  | ** ** | **2009**                    | ** ** | **(Effective Portion)**      | ** ** | **2010**                  | ** ** | **2009** | ** ** |
|                     |       |                      |       |                        |       |                         |       |                      |       |   |   |
| Euro-denominated debt    |       | $                         | 1,849      |                        | $          | (1,753                       | )          | 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**        | ** ** | **Six Months Ended**      | ** ** | **Reclassified from**       | ** ** | **Six Months Ended**         | ** ** |
| **Net Investment**       | ** ** | **June 30,**         | ** ** | **AOCI into Income**        | ** ** | **June 30,**            | ** ** |
| **Hedging Relationship** | ** ** | **2010**                  | ** ** | **2009**                    | ** ** | **(Effective Portion)**      | ** ** | **2010**                  | ** ** | **2009** | ** ** |
|                     |       |                      |       |                        |       |                         |       |                      |       |   |   |
| Euro-denominated debt    |       | $                         | 3,391      |                        | $          | 259                          |       | 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 six-month periods ended June 30, 2010 and 2009 is composed ofthe following components:

 
| ** **                                    | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                                    | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                    | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                    | ** ** | ** **                 | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| State current income tax expense              |       | $                          | 242        |                 | $          | 353 |   | $ | 544 |   | $ | 549 |   |
| Federal current income tax expense            |       | 171                        |       | —               |       | 171 |   | — |   |
| Foreign current income tax expense            |       | 564                        |       | 4                    |       | 585 |   | 202 |   |
| Foreign deferred income tax expense (benefit) |       | 228                        |       | 83                   |       | (581 | ) | 98 |   |
| Total                                         |       | $                          | 1,205      |                 | $          | 440 |   | $ | 719 |   | $ | 849 |   |

 

The Company recognizesdeferred tax assets and liabilities in both the U.S. and foreign jurisdictionsbased on the future tax consequences attributable to temporary differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax bases, and for net operating loss and taxcredit carryforwards. The Company’s deferred tax assets, net of valuationallowances, totaled $0.4 million at June 30, 2010 (included in “Otherassets” in our consolidated balance sheet) and $-0- at December 31, 2009.The increase in the net deferred tax assets during the six-month period ended June 30,2010 relates to our ability to recognize foreign tax benefits associated withU.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 of 

 

29

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

Acquisition Partnershipinvestments. At June 30, 2010 and December 31, 2009, the Companyestablished a full valuation allowance for its U.S. deferred tax assets due tothe lack of sufficient objective evidence regarding the realization of theseassets in the foreseeable future. We will continue to evaluate the deferred taxasset valuation allowance balances in all of our U.S. and foreignsubsidiaries throughout 2010 to determine the appropriate level of valuationallowances.

 

**(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 $0.3 million for the three-and six-month periods ended June 30, 2010, respectively, and $25,000 and$0.1 million for the three- and six-month periods ended June 30 2009,respectively.

 

*Stock Options*

 

A summary of the Company’sstock options and related activity as of and for the six months ended June 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                                 |       | (25,000    | )          | 2.00         |       |            |       |                    |       |
| Expired                                   |       | (31,000    | )          | 9.09         |       |            |       |                    |       |
| Forfeited                                 |       | —     |       | —       |       |            |       |                    |       |
| Options outstanding at June 30, 2010 |       | 865,400    |       | $            | 7.18       |            | 6.10       |                    | $          | 645 |   |
| Options exercisable at June 30, 2010      |       | 545,900    |       | $            | 7.06       |            | 4.49       |                    | $          | 645 |   |

 

The total intrinsic value ofstock options exercised during the six-month period ended June 30, 2010was $0.1 million. As of June 30, 2010, there was approximately $1.3million of total unrecognized compensation cost related to unvested stockoptions. That cost is expected to be recognized over a weighted average periodof 1.4 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 each awardwas $5.97 — which was based on the grant-date fair value of our common stock.Holders of the restricted stock awards have voting rights, and vesting of thegrants is based on their continued service. Sales of the restricted stock areprohibited until the awards vest. At June 30, 2010, the Company had 28,890outstanding, unvested restricted stock awards with total unrecognizedcompensation cost of $0.1 million to be recognized over a weighted averageperiod of 0.3 years.

 

**(14)  Net Earnings per Common Share**

 

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

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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

 
| ** **                                                                        | ** ** | **Three Months Ended**                            | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|----------------------|------------|
| ** **                                                                        | ** ** | **June 30,**                                 | ** ** | **June 30,**    | ** ** |
| ** **                                                                        | ** ** | **2010**                                          | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                        | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| ** **                                                                        | ** ** | ** **                                        | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net earnings                                                                      |       | $                                                 | 10,867     |                 | $          | 8,977 |   | 15,582 |   | 9,969 |   |
| Less: net income attributable to the  noncontrolling interest                     |       | 2,802                                             |       | 1,231                |       | 7,416 |   | 1,579 |   |
| Net earnings attributable to FirstCity                                            |       | $                                                 | 8,065      |                 | $          | 7,746 |   | $ | 8,166 |   | $ | 8,390 |   |
|                                                                              |       |                                              |       |                 |       |   |   |   |   |
| Weighted average outstanding shares of common stock  (in thousands)               |       | 10,009                                            |       | 9,832                |       | 10,000 |   | 9,832 |   |
| Dilutive effect of:                                                               |       |                                              |       |                 |       |   |   |   |   |
| Warrants                                                                          |       | —                                            |       | 181                  |       | — |   | 99 |   |
| Dilutive effect of stock options                                                  |       | 108                                               |       | 122                  |       | 101 |   | 52 |   |
| Weighted average outstanding shares of common  stock and common stock equivalents |       | 10,117                                            |       | 10,135               |       | 10,101 |   | 9,983 |   |
|                                                                              |       |                                              |       |                 |       |   |   |   |   |
| Net earnings per share:                                                           |       |                                              |       |                 |       |   |   |   |   |
| Basic                                                                             |       | $                                                 | 0.81       |                 | $          | 0.79 |   | $ | 0.82 |   | $ | 0.85 |   |
| Diluted                                                                           |       | $                                                 | 0.80       |                 | $          | 0.76 |   | $ | 0.81 |   | $ | 0.84 |   |

 

**(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. Valuation techniques includethe use of pricing models, discounted cash flow models and similarmethodologies.

 

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 June 30, 2010 and December 31, 2009. The Companydid not have any liabilities that were measured at fair value on a recurringbasis at June 30, 2010 and December 31, 2009.

 
| ** **                                | ** ** | **At June 30, 2010** | ** ** |
|-------------------------------------------|------------|---------------------------|------------|
| **(Dollars  in thousands)**               | ** ** | **Level 1**               | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Investment securities available for sale: |       |                      |       |   |   |   |   |   |   |
| Marketable equity security                |       | $                         | 701        |   | — |   | — |   | $ | 701 |   |
| Asset-backed security                     |       | —                    |       | — |   | 692 |   | 692 |   |
|                                      |       | $                         | 701        |   | — |   | 692 |   | $ | 1,393 |   |

 
| ** **                              | ** ** | **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 and frequentlyreleased to the public. At June 30, 2010 and December 31, 2009, thecarrying value of the Company’s asset-backed securities (at fair value)approximated $0.7 million and $1.8 million, respectively. The table belowsummarizes the changes to these Level 3 assets measured at fair value on arecurring basis for the three- and six-month periods ended June 30, 2010and 2009, respectively:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                            | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| **(Dollars in thousands)**                  | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| Balance, beginning of period                          |       | $                      | 1,530      |                 | $          | 4,279 |   | $ | 1,836 |   | $ | 5,251 |   |
| Total net gains (losses) for the period included  in: |       |                   |       |                 |       |   |   |   |   |
| Net income                                            |       | 3,250                  |       | —               |       | 3,250 |   | — |   |
| Other comprehensive income (loss)                     |       | (1,457                 | )          | (9                   | )          | (1,115 | ) | (16 | ) |
| Purchases, sales, issuances and settlements, net      |       | (2,612                 | )          | (1,277               | )          | (3,260 | ) | (2,242 | ) |
| Foreign currency translation adjustments              |       | (19                    | )          | —               |       | (19 | ) | — |   |
| Net transfers into Level 3                            |       | —                 |       | —               |       | — |   | — |   |
| Balance, end of period                                |       | $                      | 692        |                 | $          | 2,993 |   | $ | 692 |   | $ | 2,993 |   |

 

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 six-month periods ended June 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 June 30, 2010and 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 June 30, 2010** | ** ** |
|------------------------------------------------|------------|------------------------------------------|------------|
| **(Dollars  in thousands)**                    | ** ** | **Level 1**                              | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Portfolio Assets - loans (1)                   |       | $                                        | —     |   | $ | — |   | $ | 353 |   | $ | 353 |   |
| Loans receivable - SBA held for investment (1) |       | —                                   |       | — |   | 838 |   | 838 |   |
| Loans receivable - other (1)                   |       | —                                   |       | — |   | 1,917 |   | 1,917 |   |
| Real estate held for sale (2)                  |       | —                                   |       | 6,606 |   | — |   | 6,606 |   |
|                                                |            |                                          |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                     | ** ** | **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 |   |
|                                                |            |                                              |            |  |  |  |  |  |  |  |  |  |  |

 

----

(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.

 

The following table presents the decrease in value of certain assetsheld at the respective period end that were measured at fair value on anon-recurring basis for which a fair value adjustment was included in theCompany’s results of operations during the respective period:  

 
| ** **                                     | ** ** | **Six Months ended** | ** ** |
|------------------------------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | **June 30,**    | ** ** |
| **(Dollars  in thousands)**                    | ** ** | **2010**             | ** ** | **2009** | ** ** |
| Portfolio Assets - loans (1)                   |       | $                    | (494       | ) | $ | (735 | ) |
| Loans receivable - SBA held for investment (1) |       | (102                 | )          | — |   |
| Loans receivable - other (1)                   |       | (1,168               | )          | — |   |
| Real estate held for sale (2)                  |       | (738                 | )          | (461 | ) |
| Total                                          |       | $                    | (2,502     | ) | $ | (1,196 | ) |

 

----

(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, reflect elements amarket participant would consider. The Company classifies its fair valuemeasurement techniques for these assets as Level 3 inputs for the followingreasons: (1) distressed asset transactions generally occur in inactivemarkets for which observable market prices are not readily available (i.e.price quotations vary substantially over time and among market-makers, andpricing 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 value of “Real estate held for sale,” as measured on a non-recurringbasis, is generally based on collateral 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, whenreasonably available and without undue cost, and minimize the use ofunobservable inputs when developing fair value measurements in accordance withthe fair value hierarchy. Fair value measurements for assets where there existslimited or no observable market data and, therefore, are based principally onour own estimates and assumptions, are often calculated based on collateralvaluations adjusted for the economic and competitive environment, thecharacteristics of the asset, and other such factors. Additionally, there maybe inherent weaknesses in any valuation technique, and changes in theunderlying assumptions used, including discount rates and estimates of futurecash flows, that could significantly affect the results of current or futurevalues.

 

33

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

Estimated Fair Values ofFinancial Instruments Not Recorded at Fair Value in their Entirety on aRecurring Basis

 

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 June 30,2010 and December 31, 2009.

 

***Loans Receivable Held-for-Sale: ***Loans held-for-sale(primarily SBA loans held-for-sale) are carried on the Company’s consolidatedbalance sheet at the lower of cost or fair value. The fair value of loansheld-for-sale is generally based on what secondary markets are currently offeringfor loans with similar characteristics, or prices of the Company’s SBA loantransactions that were previously consummated and pending sales accountingtreatment. At June 30, 2010 and December 31, 2009, the carryingamount of loans held-for-sale approximated $7.7 million and $0.8 million,respectively, and the estimated fair values approximated $8.2 million and $0.9million, 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 June 30,2010 and December 31, 2009, the carrying amounts of Portfolio Assets —loans and loans receivable (including accrued interest) approximated $244.6million and $253.0 million, respectively, and the estimated fair valuesapproximated $360.8 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 90-day premium recourse provisions in which the servicingrights have not been capitalized. See Note 7 for the carrying amount andestimated fair values of servicing assets as of June 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 June 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 June 30, 2010 and December 31,2009, thecarrying amount of the note and interest payable to affiliate was $11.0 millionand $10.3 million, respectively, and the estimated fair values approximated$7.1 million and $6.5 million, respectively.

 

34

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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(including FirstCity). Certain of these Acquisition Partnerships are VIEsbecause generally they do not have sufficient equity to finance theiractivities without additional subordinated financial support, or the investorsdo not have the ability to make significant decisions about the AcquisitionPartnership’s activities. The voting interests for all but three of theAcquisition Partnership 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 equalownership and voting interests. The investors and third-party creditors,including FirstCity, generally have recourse only to the extent of the assetsheld by the Acquisition Partnership VIEs. Certain third-party creditors haverecourse to both FirstCity and the non-affiliated investors where we jointlyprovide a guaranty to the Acquisition Partnership VIE. The Company does notgenerally provide financial support to any Acquisition Partnership VIE beyondthat which is contractually required, but may provide additional liquidityalongside the non-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 withoutadditional subordinated financial support. The Company owns all of the votingand equity interests in the Special-Purpose Investment Entity VIEs, and theCompany was determined to be the primary beneficiary of these entities. Athird-party creditor has recourse to FirstCity up to $75.0 million under alimited guaranty provision related to the debt of these entities, which iscollateralized by their assets, only to the extent that such pledged assets ofthe Special-Purpose Investment Entity VIEs do not generate sufficient cash toservice and repay the debt (see Note 8). The Company does not generally providefinancial support to the Special-Purpose Investment Entity VIEs beyond thatwhich is contractually required.

 

Thefollowing table displays the carrying amount and classification of assets andliabilities of the Company’s consolidated VIEs, for which the Company does nothold a majority voting interest, that are included in its consolidated balancesheet as of June 30, 2010. We record third-party ownership in theseconsolidated VIEs in “Noncontrolling interests” in our consolidated balancesheet.

 

35

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 
| ** **                             | ** ** | **Acquisition**             | ** ** |
|----------------------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **Partnership VIEs**        | ** ** |
| ** **                             | ** ** | **(Dollars in  thousands)** | ** ** |
| Cash                                   |       | $                           | 1,675      |   |
| Portfolio Assets, net                  |       | 44,367                      |       |
| Other assets                           |       | 14                          |       |
| Total assets of consolidated VIEs      |       | $                           | 46,056     |   |
|                                   |       |                        |       |
| Total liabilities of consolidated VIEs |       | $                           | 156        |   |

 

The following tablesummarizes the carrying amounts of the assets included in the Company’sconsolidated balance sheet and the maximum loss exposure as of June 30,2010 related 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 |       | $                                                          | 1,414      |                          | $          | 2,255 |   | $ | 5,498 |   |
| Operating Entity VIEs        |       | 14,004                                                     |       | 1,228                         |       | 15,232 |   |
| Total                        |       | $                                                          | 15,418     |                          | $          | 3,483 |   | $ | 20,730 |   |

 

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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 $1.6 million and $2.1 million for the threemonth periods ended June 30, 2010 and 2009, respectively, and $3.4 millionand $4.3 million for the six month periods ended June 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 June 30, 2010 and 2009, and $0.2 million during each of thesix-month periods ended June 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 June 30, 2010 and December 31, 2009, the notereceivable held by BMX Holding III had a carrying amount of $7.8 million(included in “Loans receivable — affiliates” on the Company’s consolidatedbalance sheet), and accrued interest of $3.3 million and $2.5 million,respectively (included in “Other assets, net” on the Company’s consolidatedbalance sheet). At June 30, 2010 and December 31, 2009, the notepayable to MCS Trust had a carrying amount of $7.8 million (reported as “Notespayable to affiliate” on the Company’s consolidated balance sheet), and accruedinterest of $3.3 million and $2.5 million, respectively (included in “Otherliabilities” on the Company’s consolidated balance sheet). Should the notepayable be forgiven at some future date, the corresponding note receivablewould be forgiven as well.

 

36

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

**(18)  Segment Reporting**

 

At June 30, 2010 and2009, the Company was engaged in two major business segments — Portfolio AssetAcquisition and Resolution business and Special Situations Platform business.

 

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 equity investments,common equity warrants, distressed debt transactions, and leveraged buyouts.FirstCity Denver’s primary investment objective is to generate both currentincome and capital appreciation through debt and equity investments, and togenerally structure the investments to be repaid or exited in 24 to 60 months.

 

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

 
| ** **                                                | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **                                                | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Portfolio Asset Acquisition and  Resolution:**          | ** ** | ** **                 |       |                 | ** ** | ** ** |   |   |   |
| Total revenues                                            |       | $                          | 21,813     |                 | $          | 18,969 |   | $ | 36,535 |   | $ | 32,266 |   |
| Operating contribution, net of direct taxes               |       | $                          | 5,048      |                 | $          | 11,138 |   | $ | 6,141 |   | $ | 12,054 |   |
| ** **                                                | ** ** | ** **                 | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Special Situations Platform:**                          |       |                       |       |                 |       |   |   |   |   |
| Total revenues                                            |       | $                          | 21,202     |                 | $          | 1,575 |   | $ | 28,012 |   | $ | 3,913 |   |
| Operating contribution (loss), net of direct taxes        |       | $                          | 5,263      |                 | $          | (1,132 | ) | $ | 5,978 |   | $ | 205 |   |
|                                                      |       |                       |       |                 |       |   |   |   |   |
| Total operating contribution, net of direct taxes         |       | $                          | 10,311     |                 | $          | 10,006 |   | $ | 12,119 |   | $ | 12,259 |   |
| ** **                                                | ** ** | ** **                 | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Corporate Overhead:**                                   | ** ** | ** **                 | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries and benefits and other income and  expenses, net |       | 2,067                      |       | 2,157                |       | 3,773 |   | 3,779 |   |
| Income tax expense                                        |       | 179                        |       | 103                  |       | 180 |   | 90 |   |
| Net earnings attributable to FirstCity                    |       | $                          | 8,065      |                 | $          | 7,746 |   | $ | 8,166 |   | $ | 8,390 |   |

 

37

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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**     | ** ** | **Six Months Ended** | ** ** |
|---------------|------------|----------------------------|------------|----------------------|------------|
| ** **    | ** ** | **June 30,**          | ** ** | **June 30,**    | ** ** |
| ** **    | ** ** | **2010**                   | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **    | ** ** | **(Dollars in thousands)** | ** ** |
| Domestic      |       | $                          | 15,828     |                 | $          | 15,785 |   | $ | 24,209 |   | $ | 25,518 |   |
| Latin America |       | 2,908                      |       | 4,355                |       | 4,693 |   | 5,274 |   |
| Europe        |       | 3,087                      |       | 661                  |       | 8,826 |   | 2,313 |   |
| Other         |       | —                     |       | 8                    |       | — |   | 16 |   |
| Total         |       | $                          | 21,823     |                 | $          | 20,809 |   | $ | 37,728 |   | $ | 33,121 |   |

 

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

 
| ** **                                   | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                                   | ** ** | **(Dollars in thousands)** | ** ** |
| Cash and cash equivalents                    |       | $                          | 50,573     |                  | $          | 80,368 |   |
| Restricted cash                              |       | 1,641                      |       | 1,364                 |       |
| Portfolio acquisition and resolution assets: |       |                       |       |                  |       |
| Domestic                                     |       | 253,784                    |       | 225,406               |       |
| Latin America                                |       | 40,161                     |       | 41,248                |       |
| Europe                                       |       | 47,573                     |       | 57,888                |       |
| Special situations platform assets           |       | 46,162                     |       | 41,688                |       |
| Other non-earning assets, net                |       | 26,080                     |       | 17,112                |       |
| Total assets                                 |       | $                          | 465,974    |                  | $          | 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 ObligationCommitments*

 

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 ofFirstCity, and Cargill Financial Services International Inc. (“CFSI”),(collectively, the “Sellers”), as seller, and eleven U.S. limited liabilitycompanies (“LLCs”) which invested in Mexican portfolio acquisition entities (“SRLs”)and the AIG entities as additional parties.  In the IP&S Agreement,the Sellers and the LLCs made various representations and warranties concerning(i) the existence and ownership of the LLCs and the related SRLs, (ii) theassets and liabilities of the LLCs, (iii) taxes related to periods priorto August 8, 2006, and (iv) the operations of the LLCs and SRLs. TheSellers agreed to indemnify Bidmex Holding and AIG Entities from damagesresulting from a breach of any representation or warranty contained in theIP&S Agreement on a several and not joint basis according to their respectiveownership percentages in each LLC as to any matter related to a particular LLC,or on the basis of 80% to CFSI and 20% to SMIP as to any matter that could notbe identified to a particular LLC. The indemnity obligation under the IP&SAgreement survives for a period of the statute of limitations for mattersrelated to taxes, existence and authority, capitalization and good standing ofthe LLCs and SRLs. The Sellers are not required to make any payments as aresult of the indemnity provisions of the IP&S Agreement until theaggregate amount payable under that agreement and the Asset Purchase Agreement(defined below) exceeds $250,000; however, claims related to taxes and fraudare not subject to this $250,000 threshold. The IP&S Agreement limits theliability of the Sellers for indemnifiable losses to the Aggregate PurchasePrice (defined below) (without duplication of amounts recovered pursuant to theterms of the Asset Purchase Agreement). At this time, management does notbelieve that this potential obligation will have a material adverse impact onthe Company’s consolidated results of operations, financial position orliquidity.

 

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, which purchaseprice is part of the Aggregate Purchase Price.  In the Asset PurchaseAgreement, the Asset Seller and the Sellers made various representations andwarranties concerning (i) the existence and ownership of the Seller, (ii) theownership of the loan portfolio, (iii) taxes related to periods arisingprior to the closing date, and (iv) the existence of the loans comprisingthe loan portfolio and other matters related to the loan portfolio. TheAsset Seller agreed to indemnify the Asset Purchaser from damages resultingfrom a breach of any representation or warranty. The indemnity obligation underthe Asset Purchase Agreement survives for a period of the statute oflimitations for matters related to existence and ownership of the Seller,ownership of the loans, and taxes for periods prior to August 8,2006. The Seller is not required to make any payments as a result of theindemnity provisions of the Asset Purchase Agreement until the aggregate amountpayable under that Agreement exceeds $25,000; however, claims related to taxesand fraud are not subject to this $25,000 threshold. The IP&SAgreement limits the liability of the Sellers for indemnifiable losses underthe Asset Purchase Agreement to the Aggregate Purchase Price. 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.

 

*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 andNational Union 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 Mexican Portfoliosby purchasing the interests of Cargill and SMIP in eleven of the Mexicanlimited liability companies (the “LLCs”) and purchasing the loan portfolio ofone of the Mexican limited liability companies (the “Purchased Portfolio”) foran aggregate purchase price of U.S. $119.3 million as of that date (the “AggregatePurchase Price”). SMIP acquired 15% of the membership interests in BidmexHolding. A 9% interest acquired by SMIP is of equivalent standing tomembership interests held by the AIG affiliates representing 85% of themembership interests. The remaining 6% membership interest acquired bySMIP is subordinate to the other owners of interests in Bidmex Holding, whowill receive the return of and a return on their contribution equivalent to an9% internal rate of return with respect to their interests prior to SMIPreceiving the return of and a return on its capital contribution equivalent toa 9% internal rate of return with respect to its 6% interest. At June 30,2010, the carrying value of SMIP’s membership interests in Bidmex Holding thatis included in the Company’s consolidated balance sheet approximated $11.6million ($5.3 million for the 9% membership interest and $6.3 million for the6% membership interest).

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

*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 June 30, 2010, theunpaid principal balance on this loan was $244.8 million. Refer to Note 8 foradditional 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 June 30, 2010, the unpaid principal balance on thisloan facility was $15.4 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 July 2010 to September 2012, and aresecured primarily by certain real estate properties held by the AcquisitionPartnerships. At June 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 $9.0 million at June 30, 2010. PIF1 uses thecredit facility to finance the purchases of loan portfolios. Pursuant to termsof the credit facility, FirstCity was required to provide a stand-by letter ofcredit from Bank of Scotland that would satisfy the current loan balance upondemand. At June 30, 2010, FirstCity had a letter of credit in the amountof $9.75 million from Bank of Scotland under the terms of FirstCity’s loanfacility with Bank of Scotland, with Banco Santander Chile, S.A. as the letterof credit beneficiary. In the event that a demand is made under the $9.75million letter of credit, FirstCity would be required to reimburse Bank ofScotland by making payment to Bank of Scotland for all amounts disbursed or tobe disbursed by Bank of Scotland under the letter of credit.

 

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 June 30, 2010, the Company had 142,240,000 in Mexicanpeso-denominated debt, which was equivalent to $11.2 million U.S. dollars. Theproceeds were used to pay down the acquisition facility with the Bank ofScotland.  Pursuant to the terms of thecredit facility, FirstCity Mexico SA de CV was required to provide a stand-byletter of credit from Bank of Scotland that would satisfy the loan balance upondemand.  At June 30, 2010, FirstCity had a letter of credit in theamount of $12.6 million from Bank of Scotland under the terms of FirstCity’sloan facility with Bank of Scotland.  In the event that a demand is madeunder the $12.6 million letter of credit, FirstCity is required to reimburseBank of Scotland by making payment to Bank of Scotland for all amountsdisbursed or to be disbursed by Bank of Scotland under the letter of credit.

 

*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.

 

*Limited-Life Subsidiaries*

 

AtJune 30, 2010, the estimated settlement value of the Company’snoncontrolling interests in consolidated limited-life subsidiaries approximated$2.4 million. The Company’s carrying value of the noncontrolling interestsrecognized on the consolidated balance sheet related to these limited-lifesubsidiaries approximated $0.8 million at June 30, 2010.

 

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**FIRSTCITY FINANCIAL CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

*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 a financialservices company that engages in two major business segments — Portfolio AssetAcquisition and Resolution and Special Situations Platform. The Portfolio AssetAcquisition and Resolution business has been the Company’s core businesssegment since it commenced operations in 1986. In the Portfolio AssetAcquisition and Resolution business, the Company acquires portfolios of performingand non-performing loans 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 the presentvalue of the ultimate cash recoveries. Through its Special Situations Platform,the Company provides investment capital to privately-held middle-marketcompanies through flexible capital structuring arrangements to generate anattractive risk-adjusted return. These capital investments primarily take theform of senior and junior financing arrangements, but also include directequity investments, common equity warrants, distressed debt transactions, andleveraged buyouts.

 

FirstCityrecorded net earnings of $8.1 million, or $0.80 per common share diluted, forthe second quarter of 2010 (“Q2 2010”), compared to $7.7 million, or $0.76 percommon share diluted, for the second quarter of 2009 (“Q2 2009”). Components ofFirstCity’s results of operations for the three and six-month periods ended June 30,2010 and 2009, respectively, are detailed below (dollars in thousands, exceptper share data):

 
| ** **                                 | ** ** | **Three Months Ended**                            | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------|------------|----------------------|------------|
| ** **                                 | ** ** | **June 30,**                                 | ** ** | **June 30,**    | ** ** |
| ** **                                 | ** ** | **2010**                                          | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                 | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Portfolio Asset Acquisition and Resolution |       | $                                                 | 5,048      |                 | $          | 11,138 |   | $ | 6,141 |   | $ | 12,054 |   |
| Special Situations Platform                |       | 5,263                                             |       | (1,132               | )          | 5,978 |   | 205 |   |
| Operating contribution                     |       | 10,311                                            |       | 10,006               |       | 12,119 |   | 12,259 |   |
| Corporate overhead                         |       | (2,246                                            | )          | (2,260               | )          | (3,953 | ) | (3,869 | ) |
| Net earnings attributable to FirstCity     |       | $                                                 | 8,065      |                 | $          | 7,746 |   | $ | 8,166 |   | $ | 8,390 |   |
| Diluted earnings per common share          |       | $                                                 | 0.80       |                 | $          | 0.76 |   | $ | 0.81 |   | $ | 0.84 |   |

 

Referto **Results of Operations** below for adetailed review of the Company’s operations for Q2 2010 compared to Q2 2009.

 

In Q2 2010, FirstCity andits investment partners acquired $141.6 million of domestic Portfolio Assetinvestments with a face value of approximately $251.0 million — of whichFirstCity’s investment acquisition share was $28.1 million. In addition to itsPortfolio Asset acquisitions in Q2 2010, FirstCity invested $22.6 million innon-portfolio investments, consisting of $5.4 million in the form of SBA loanoriginations and advances; $8.1 million in the form of debt and equityinvestments ($4.6 million financed through investee entity’s debt) under itsSpecial Situations Platform (“FirstCity Denver”); $6.6 million of equityinvestments in foreign partnerships; and $2.5 million of other debt and equityinvestments.

 

At June 30, 2010, thecarrying value of FirstCity’s earning assets (primarily Portfolio Assets,equity investments, loans receivable and entity-level earning assets)approximated $387.7 million — compared to $366.2 million at December 31,2009 and $383.2 million a year ago. The global distribution of FirstCity’searning assets (at carrying value) at June 30, 2010 included $299.9million in the United States; $47.6 million in Europe; and $40.2 million inLatin America.

 

*Net Impairment Provisions*

 

The Company incurred $3.2million of net impairment provisions in Q2 2010 compared to $2.0 million of netimpairment provisions in Q2 2009. Our net impairment provisions in Q2 2010 werecomposed of $2.6 million of net provisions recorded to our consolidated loansand portfolios, and $0.6 million as our share of net impairment provisionsrecorded to loans and portfolios held in our unconsolidated AcquisitionPartnerships. The global distribution of the $3.2 million net impairmentprovisions recorded by the Company in Q2 2010 included $2.3 million in theUnited States, $0.2 million in Latin America, and $0.7 million in Europe. Theseimpairment provisions were attributed primarily to declines in values of loancollateral and real estate assets in our domestic loans and portfolios, andchanges in future cash flow estimates from our foreign loans and portfolios.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

 

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aresusceptible to significant revision as more information becomes available. Itremains unclear what impact the illiquid markets, real estate value declinesand the overall economic slowdown will ultimately have on our financialresults. These conditions could adversely impact our business if borrowerscannot refinance their loans and/or continue to make payments — which in turncould lead to rising loan defaults and foreclosures on loan collateral.Therefore, we cannot provide assurance that, in any particular future period,we will not incur additional impairment provisions.

 

*Foreign Currency TransactionGains*

 

The combined impact offoreign currency transactions from the Company’s consolidated andunconsolidated foreign operations resulted in a $0.6 million foreign currencyexchange loss in Q2 2010 (compared to a combined impact of $2.2 million inforeign currency transaction gain in Q2 2009). The Company’s combined foreigncurrency exchange loss in Q2 2010 was attributable primarily to our Europeanoperations (due to the weakening of the Euro against the U.S. dollar during Q22010). It remains unclear what impactthat weakened global economic conditions will have on our financial holdings andinvestments from our European and Latin American operations. As such, we cannotprovide assurance that, in any particular future period, we will not incurforeign currency transaction losses.

 

*Management’sOutlook*

 

Despite substantial lossesreported in the financial services sector over the past two years and continuedvolatility in U.S. and global economies and financial markets, managementremains positive on the outlook of the Company. Management believes thatcurrent market conditions should not hinder FirstCity’s ability to expand itsbusiness, and that distressed asset acquisition and middle-market transactionopportunities at attractive prices and returns are available. As discussedabove, FirstCity’s investment level for Q2 2010 totaled $50.7 million.

 

Asreported in our June 30, 2010 news release and in our Current Report on Form 8-Kfiled with the SEC on July 1, 2010, FirstCity and Bank of Scotland reachedagreement and closed on a $268.6 million Reducing Note Facility Agreement (“ReducingNote Facility”) that allows for repayment to Bank of Scotland over time as cashflows from the underlying assets securing the loan facility are realized. TheCompany’s outstanding indebtedness and existing letter of credit obligationsunder its then-existing loan facilities with Bank of Scotland were refinancedinto the Reducing Note Facility. The terms of the Reducing Note Facility, amongother things, allow FirstCity to receive unencumbered cash of 20% of themonthly net cash flows from the pledged assets (i.e. cash “leak-through”) up to$25.0 million after (i) payment to Bank of Scotland of interest and fees and(ii) payment of a scheduled overhead allowance to FirstCity of $38.9 millionover three years. Refer to **Liquidity and CapitalResources** below for additional terms and information related to theReducing Note Facility.

 

Inaddition, as reported in the June 30, 2010 news release and Current Reporton Form 8-K filed with the SEC on July 1, 2010 mentioned above,FirstCity and Värde entered into 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 and performanceof the portfolios acquired).

 

Thecash flows from the assets and equity interests from the Company’s investments madein connection with the Investment Agreement are not subject to the securityinterest requirements of Bank of Scotland’s Reducing Note Facility describedabove. Further details about the structure of the Investment Agreement withVärde and the terms of the Investment and Securities Purchase Agreements areincluded in the above-mentioned press release and Current Report on Form 8-K.

 

We believe that the Investment Agreement in place with Värde, combinedwith (1) the cash leak-through andoverhead allowance provisions included in Bank of Scotland’s Reducing NoteFacility (described above); (2) our estimates of residual cash flows from thepledged assets and equity investments after full repayment of the Bank ofScotland debt; and (3) our current holdings of unencumbered cash andportfolio assets, will provide FirstCity with additional funding andliquidity to support its operations and investment activities.

 

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**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, prices 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 financing with terms acceptable to theCompany, and our access to capital markets. Such factors, individually orcombined with other factors, may result in significant fluctuations in ourreported operations and in the trading price of our common stock.

 

***Q2 2010 Compared to Q2 2009***

 

Netearnings to common stockholders totaled $8.1 million in Q2 2010 compared to netearnings of $7.7 million in Q2 2009. On a per share basis, diluted net earningsto common stockholders were $0.80 in Q2 2010 compared to $0.76 in Q2 2009.

 

*Portfolio Asset Acquisition and Resolution*

 

The operating contribution from the Portfolio AssetAcquisition and Resolution (“PAA&R”) segment resulted in a $5.0 millionoperating gain in Q2 2010 compared to an $11.1 million operating gain for thesame period in 2009. FirstCity and its investment partners acquired$141.6 million of Portfolio Assets in Q2 2010 with an approximate face value of$251.0 million, compared to the Company’s involvement in acquiring $67.1million of Portfolio Assets in Q2 2009 with an approximate face value of $117.8million. In Q2 2010, FirstCity’s investment share in the Portfolio Assetacquisitions was $28.1 million — with $5.9 million acquired throughconsolidated Portfolios and $22.2 million acquired through unconsolidatedPortfolios. In Q2 2009, FirstCity’s investment share in Portfolio Assetacquisitions was $48.6 million — with $48.0 million acquired throughconsolidated Portfolios. In Q2 2010, FirstCity invested an additional $14.5million in non-portfolio investments in the form of SBA loan originations andadvances, direct equity investments, and other loan investments, compared to $7.9 million of additional non-portfolioinvestments in the form of****SBA loanoriginations and advances, and $11.2million in direct equity investments (attributable primarily to European entityacquisitions), in Q2 2009.

 

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The following is a summary of the results of operationsfor the Company’s PAA&R business segment for the three-month periods endedJune 30, 2010 and 2009:

 
| ** **                                                   | ** ** | **Three Months Ended**     |       |
|--------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                   | ** ** | **June 30,**          |       |
| ** **                                                   | ** ** | **2010**                   | ** ** | **2009** |   |
| ** **                                                   | ** ** | **(Dollars in thousands)** |       |
| **Portfolio Asset Acquisition and  Resolution:**             | ** ** | ** **                 |       |   |   |
| Revenues:                                                    |       |                       |       |   |   |
| Servicing fees                                               |       | $                          | 1,743      |   | $ | 2,403 |   |
| Income from Portfolio Assets                                 |       | 14,622                     |       | 14,077 |   |
| Gain on sale of SBA loans held for sale, net                 |       | 163                        |       | 610 |   |
| Gain on sale of investment securities                        |       | 3,250                      |       | — |   |
| Interest income from SBA loans                               |       | 313                        |       | 295 |   |
| Interest income from loans receivable - affiliates           |       | 459                        |       | 553 |   |
| Interest income from loans receivable - other                |       | —                     |       | 207 |   |
| Other income                                                 |       | 1,263                      |       | 824 |   |
| Total revenues                                               |       | 21,813                     |       | 18,969 |   |
| Expenses:                                                    |       |                       |       |   |   |
| Interest and fees on notes payable                           |       | 3,616                      |       | 3,438 |   |
| Salaries and benefits                                        |       | 4,253                      |       | 3,952 |   |
| Provision for loan and impairment losses, net of  recoveries |       | 2,057                      |       | (290 | ) |
| Asset-level expenses                                         |       | 1,941                      |       | 1,244 |   |
| Other                                                        |       | 2,274                      |       | 908 |   |
| Total expenses                                               |       | 14,141                     |       | 9,252 |   |
| Equity in net earnings of unconsolidated  subsidiaries       |       | 10                         |       | 1,840 |   |
| Gain on business combinations                                |       | —                     |       | 1,455 |   |
| Net income attributable to noncontrolling  interests         |       | (1,595                     | )          | (1,611 | ) |
| Operating contribution before direct taxes                   |       | $                          | 6,087      |   | $ | 11,401 |   |
| Operating contribution, net of direct taxes                  |       | $                          | 5,048      |   | $ | 11,138 |   |

 

*Servicing fee revenues. *Servicingfee revenues decreased to $1.7 million in Q2 2010 from $2.4 million in Q2 2009.Servicing fees from domestic Acquisition Partnerships totaled $0.1 million inQ2 2010 compared to $0.5 million in Q2 2009, while servicing fees from LatinAmerican Acquisition Partnerships totaled $1.5 million in Q2 2010 and $1.7million in Q2 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 for Q2 2010 in comparison to Q2 2009 was attributableprimarily to a decline in collections from unconsolidated domestic partnershipsto $2.5 million for Q2 2010 compared to $9.9 million for Q2 2009. The declinein servicing fees from the Latin American Acquisition Partnerships wasattributable to a decrease in the servicing costs related to thoseunconsolidated partnerships in Q2 2010 compared to Q2 2009 (i.e. the lower theservicing costs incurred by these partnerships, the lower the service feeincome recognized by the Company).

 

*Income from Portfolio Assets*.  Income from Portfolio Assetsincreased to $14.6 million in Q2 2010 compared to $14.1 million in Q2 2009. Theincrease in income from Portfolio Assets is attributed primarily to an increasein FirstCity’s average investment in consolidated Portfolio Assets in itsPAA&R segment to $221.0 million for Q2 2010 compared to $205.6 million forQ2 2009. Refer to Note 4 of the consolidated financial statements included inItem 1 of this Form 10-Q for a summary of income from Portfolio Assets.

 

*Gain on sale of SBA loans heldfor sale. *The Company recorded a $0.2 million gain on the sales of SBA loans inQ2 2010 with a $2.1 million net basis in the loans sold, compared to a $0.6 million gain on the sales of SBAloans in Q2 2009 with a $13.2 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.

 

*Gain on sale of investmentsecurities. *In Q2 2010, the Company recognized a $3.3 million gain related to thesale of its investment security that represented a beneficial interest insecuritized financial assets.

 

*Interest income from SBAloans. *Interestincome from SBA loans remained constant at $0.3 million for both Q2 2010 and Q22009.

 

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*Interest income from loansreceivable — affiliates. *Interest income from loans receivable — affiliates decreased to $0.5million in Q2 2010 compared to $0.6 million for Q2 2009. The interest incomedecline is attributed primarily to a decline in FirstCity’s average investmentlevel in loans receivable — affiliates in its PAA&R segment to $11.6million for Q2 2010 compared to $14.2 million for Q2 2009.

 

*Interest income from loansreceivable — other. * Interest income from loansreceivable — other decreased by $0.2 million for Q2 2010 compared to Q2 2009.The decline in interest income in Q2 2010 compared to Q2 2009 is attributableto FirstCity’s increased holdings in Q2 2010 of such loans accounted for underthe non-accrual method of accounting. FirstCity’s average investment in loansreceivable — other in its PAA&R segment was $5.0 million in Q2 2010 (all ofwhich were accounted for under the non-accrual method during the entireperiod), compared to its average investment in such loans of $7.0 million in Q22009 (all of which were income-accruing loans during the entire period).

 

*Other income*.  Other income from the Company’sPAA&R segment increased to $1.3 million in Q2 2010 compared to $0.8 millionfor Q2 2009, primarily due to $0.7 million of additional due diligence incomerecorded in Q2 2010 compared to Q2 2009 as a result of increased investmentactivity in Q2 2010 compared to Q2 2009.

 

*Expenses. *Operatingexpenses approximated $14.1 million and $9.3 million in Q2 2010 and Q2 2009,respectively. The following is a discussion of the major components ofoperating expenses.

 

Interest expense and fees on notes payable totaled $3.6million and $3.4 million for Q2 2010 and Q2 2009, respectively. FirstCity’saverage outstanding debt in its PAA&R segment increased to $298.2 millionin Q2 2010 from $291.4 million in Q2 2009 — primarily to finance its increasedinvestment activity and to provide working capital to support future growth.The Company’s average cost of borrowings increased slightly to 4.9% in Q2 2010compared to 4.7% in Q2 2009.

 

Salaries and benefits totaled $4.3 million and $4.0million in Q2 2010 and Q2 2009, respectively. The total number of personnelwithin the PAA&R segment was 207 and 209 at June 30, 2010 and 2009,respectively.

 

Netprovisions for loan and impairment losses on consolidated Portfolio Assets andloans receivable in our PAA&R segment totaled $2.1 million in Q2 2010. Netrecoveries for loan and impairment losses totaled $0.3 million in Q2 2009. The$2.1 million of net impairment provisions in Q2 2010 were attributed primarilyto declines in values of loan collateral and real estate assets in our domesticloans and Portfolios, which was responsible for $1.6 million of the Company’sconsolidated net provisions recorded in Q2 2010. The impairment provisions wereidentified in connection with management’s quarterly evaluation of the collectibilityof the Company’s Portfolio Assets and loans receivable. 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 illiquidmarkets, real estate value declines and the overall economic slowdown willultimately have on our financial results. Therefore, we cannot provideassurance that, in any particular future period, we will not incur additionalimpairment provisions.

 

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 to $1.9 million in Q2 2010 from $1.2 million in Q2 2009. Theincreased level of expenses is attributed primarily to the Company’s increasedholdings in consolidated Portfolio Assets (the Company’s average investment inconsolidated Portfolio Assets in its PAA&R segment totaled $221.0 millionfor Q2 2010 compared to $205.6 million for Q2 2009).

 

Other costs and expenses in the Company’s PAA&Rsegment increased to $2.3 million for Q2 2010 from $0.9 million for Q2 2009,due to $0.6 million of foreign currency exchange losses attributed to ourconsolidated foreign operations in Q2 2010 compared to $0.9 million of foreigncurrency exchange gains recognized in Q2 2009 — a $1.5 million unfavorableswing (attributed mainly to our consolidated European operations). The Eurocurrency weakened against the U.S. dollar in Q2 2010 compared to Q2 2009.

 

*Equity in earnings of unconsolidatedsubsidiaries. *Equity in earnings of unconsolidated subsidiaries (AcquisitionPartnership and servicing entities) from our PAA&R segment decreased by$1.8 million in Q2 2010 compared to Q2 2009. Equity in earnings of ourunconsolidated Acquisition Partnerships was $0.3 million in losses for Q2 2010compared to $2.1 million in earnings for Q2 2009, whereas equity in earnings ofour unconsolidated servicing entities increased to $0.3 million of earnings inQ2 2010 compared to $0.3 million of losses in Q2 2009. The following is adiscussion of equity in earnings from FirstCity’s Acquisition Partnerships (by

 

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geographic region) and servicing entities. Refer to Note6 of the 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 decreased to $0.8 millionin Q2 2010 compared to $3.0 million in Q2 2009. In addition, total net earnings reported by domesticpartnerships decreased to $0.2 million in net losses for Q2 2010 compared to$1.3 million in net earnings for Q2 2009. The decrease in total revenuesand net earnings in Q2 2010 compared to Q2 2009 was attributable primarily to adecrease in collections to $2.5 million in Q2 2010 from $9.9 million in Q22009; and a $0.9 million decline in interest and accretion income in Q2 2010compared to Q2 2009 due to an increase in the level of domestic partnershiploan portfolios accounted for on a non-accrual method of accounting(cost-recovery or cash basis) instead of the interest method (i.e. accrualmethod). Under U.S. GAAP, the interest method of accounting is not appropriateif management does not have the ability to develop a reasonable expectation ofboth the timing and amount of future cash flows to be collected. The collectiveactivity described above translated to a decrease in FirstCity’s share ofdomestic partnership earnings to $0.1 million in losses for Q2 2010 from $0.5million in earnings for Q2 2009. FirstCity’s average investment in domesticAcquisition Partnerships increased to $19.0 million for Q2 2010 from $13.9million for Q2 2009, due primarily to increased investment activity bynewly-formed domestic Acquisition Partnerships under FirstCity’s investmentagreement with Värde.

 

·         *LatinAmerica* — Total revenues reported by Latin American Acquisition Partnershipsincreased to $6.9 million in Q2 2010 from $2.9 million in Q2 2009. However,total net earnings reported by Latin American partnerships decreasedsignificantly to $0.3 million in losses forQ2 2010 compared to $11.3 million in earnings for Q2 2009. Total collectionsfrom Latin American partnerships increased to $10.0 million in Q2 2010 comparedto $5.8 million in Q2 2009. The significant change in net earnings reported by theLatin American partnerships in Q2 2010 compared to Q2 2009 was due primarily toforeign currency exchange losses of $0.8 million recorded by these partnershipsin Q2 2010 compared to $13.9 million of foreign currency exchange gainsrecorded in Q2 2009 — a $14.7 million unfavorable swing. The significantforeign currency exchange gains recorded by these partnerships in Q2 2009stemmed from the translation impact to their U.S. dollar-denominated debt froman approximate 12% devaluation of the Mexican peso during the period (comparedto an approximate 1.5% appreciation of the Mexican peso during Q2 2010). Thecollective activity described above translated to an unfavorable decline inFirstCity’s share of earnings in Latin American partnerships to $0.2 million inearnings for Q2 2010 compared to $1.4 million in earnings for Q2 2009.  FirstCity’s average investment in LatinAmerican Acquisition Partnerships remained relatively flat at $17.2 million forQ2 2010 compared to $17.5 million for Q2 2009.

 

·             *Europe*—****Total revenues reported by European AcquisitionPartnerships decreased to $0.6 million in Q2 2010 from $5.2 million in Q2 2009.In addition, total net earnings reported by the European partnerships decreasedto $1.3 million in losses in Q2 2010 from $0.9 million in earnings for Q2 2009.The decrease in total partnership revenues and net earnings reported by theEuropean partnerships was attributed primarily to (1) decrease incollections to $2.0 million in Q2 2010 compared to $6.3 million in Q2 2009;off-set partially by a decrease in net impairment provisions to $1.1 million inQ2 2010 from $2.7 million in Q2 2009. In addition, contributing to the declinein European partnership revenues was the decrease in Portfolio Asset holdingsby these Acquisition Partnerships over the past two years (see paragraphbelow). The collective activity described above translated to a decrease inFirstCity’s share of European partnership earnings to $0.3 million in lossesfor Q2 2010 from $0.2 million in earnings for Q2 2009.

 

FirstCity’saverage investment in European Acquisition Partnerships decreased to $6.2million for Q2 2010 from $12.8 million for Q2 2009 — which contributed to adecline in FirstCity’s share of European partnership revenues as discussedabove. In light of FirstCity’sstep-acquisition transaction and resulting consolidation of sixteen Frenchentities (former unconsolidated European Acquisition Partnerships) in May 2009,the Company expects income from consolidated Portfolio Assets to off-set thedecline in European partnerships revenues.

 

·             *ServicingEntities*—****Total revenuesreported by our foreign unconsolidated servicing entities remained relativelysteady at $12.0 million in Q2 2010 compared to $12.0 million in Q2 2009;however, total net earnings reported by these entities improved to $0.8 millionof net earnings in Q2 2010 from $0.5 million of net losses in Q2 2009. Theincrease in net earnings reported by the underlying servicing entities wasattributed primarily to a $1.2 million decline in operating costs and expensesin Q2 2010 compared to Q2 2009. The collective activity described abovetranslated to an increase in FirstCity’s share of earnings from our servicingentities to $0.3 million in earnings for Q2 2010 from $0.3 million in lossesfor Q2 2009.

 

*Gain on business combinations.*  * *In Q2 2009, the Company recorded a$1.5 million gain attributable to a step acquisition transaction in which theCompany acquired a controlling financial interest in certain French AcquisitionPartnerships. The Company

 

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owned a noncontrolling equity interest in these entitiesprior to the transaction. Pursuant to business combination accountingstandards, the Company measured the assets and liabilities of these partnershipsat fair value on the acquisition date, and the Company re-measured to fairvalue the carrying value of its previously-held equity-method investments inthe partnerships. The fair value of the Company’s total interests in thepartnerships after the step acquisition exceeded the carrying value of itspreviously-held equity interests by $1.5 million — which resulted in theCompany’s recognition of the $1.5 million gain.

 

*Net income attributable tononcontrolling interests. *The amount of net income attributable to noncontrolling interestsremained constant at $1.6 million for both Q2 2010 and Q2 2009. The Company’scarrying value of noncontrolling interests on its consolidated balance sheetsattributed to consolidated Acquisition Partnerships, which represents theequity in these consolidated subsidiaries not attributable to FirstCity,increased to $37.1 million at June 30, 2010 from $36.2 million at June 30,2009.

 

***SpecialSituations Platform Business Segment***

 

Theoperating contribution from the Special Situations Platform business segment (“FirstCityDenver”) resulted in a $5.3 million operating gain in Q2 2010 compared to a$1.1 million operating loss in Q2 2009. In Q2 2010, FirstCity Denver provided$8.1 million of investment capital to privately-held middle-market companies inthe form of debt and direct equity investments ($4.6 million financed throughinvestee entity’s debt), compared to $3.2 million of investment capitalprovided to such companies in the form of debt and direct equity investments inQ2 2009. Since its inception in April 2007, FirstCity Denver has beeninvolved in middle-market transactions with total investment values in excessof $84.5 million, and has provided $56.7 million of investment capital inconnection with these investments.

 

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Thefollowing is a summary of the results of operations for the Company’s SpecialSituations Platform business segment for Q22010 and Q2 2009:

 
| ** **                                                    | ** ** | **Three Months Ended**     | ** ** |
|---------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                    | ** ** | **June 30,**          | ** ** |
| ** **                                                    | ** ** | **2010**                   | ** ** | **2009** | ** ** |
| ** **                                                    | ** ** | **(Dollars in thousands)** | ** ** |
| **Special Situations Platform:**                              |       |                       |       |   |   |
| Revenues:                                                     |       |                       |       |   |   |
| Interest income from loans receivable                         |       | $                          | 543        |   | $ | 544 |   |
| Operating revenue - railroad                                  |       | 1,192                      |       | 705 |   |
| Operating revenue - manufacturing                             |       | 6,107                      |       | — |   |
| Operating revenue - coal mine                                 |       | 13,100                     |       | — |   |
| Other income                                                  |       | 260                        |       | 326 |   |
| Total revenues                                                |       | 21,202                     |       | 1,575 |   |
| Expenses - Railroad Operations:                               |       |                       |       |   |   |
| Interest and fees on notes payable                            |       | 37                         |       | 20 |   |
| Salaries and benefits                                         |       | 260                        |       | 236 |   |
| Other                                                         |       | 330                        |       | 279 |   |
| Total railroad expenses                                       |       | 627                        |       | 535 |   |
| Expenses - Manufacturing Operations:                          |       |                       |       |   |   |
| Salaries and benefits                                         |       | 1,189                      |       | — |   |
| Cost of sales                                                 |       | 3,468                      |       | — |   |
| Other                                                         |       | 1,295                      |       | — |   |
| Total manufacturing expenses                                  |       | 5,952                      |       | — |   |
| Expenses - Coal Mine Operations:                              |       |                       |       |   |   |
| Interest and fees on notes payable                            |       | 37                         |       | — |   |
| Salaries and benefits                                         |       | 67                         |       | — |   |
| Cost of sales                                                 |       | 9,310                      |       | — |   |
| Amortization                                                  |       | 3,461                      |       | — |   |
| Other                                                         |       | 420                        |       | — |   |
| Total coal mine expenses                                      |       | 13,295                     |       | — |   |
| Expenses - Other:                                             |       |                       |       |   |   |
| Interest and fees on notes payable                            |       | 118                        |       | 116 |   |
| Salaries and benefits                                         |       | 444                        |       | 278 |   |
| Provision for loan and impairment losses                      |       | 568                        |       | 967 |   |
| Other                                                         |       | 385                        |       | 475 |   |
| Total other expenses                                          |       | 1,515                      |       | 1,836 |   |
| Total expenses                                                |       | 21,389                     |       | 2,371 |   |
| Equity in net earnings (loss) of unconsolidated  subsidiaries |       | 1,806                      |       | (642 | ) |
| Gain on business combinations                                 |       | 4,838                      |       | — |   |
| Net (income) loss attributable to noncontrolling  interests   |       | (1,207                     | )          | 380 |   |
| Operating contribution (loss) before taxes                    |       | $                          | 5,250      |   | $ | (1,058 | ) |
| Operating contribution (loss), net of direct taxes            |       | $                          | 5,263      |   | $ | (1,132 | ) |

 

*Interest income from loansreceivable. * Interest income from loansreceivable in the second quarter of 2010 remained constant in comparison to Q2 2009. FirstCity Denver’s averageinvestment in loans receivable was $19.6 million for Q2 2010 — including $2.3million accounted for under the non-accrual method of accounting. For Q2 2009,FirstCity Denver’s average investment in loans receivable was $20.8 million.

 

*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 $0.5 

 

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millionin Q2 2010 compared to Q2 2009 due toan increase in rail car movement services performed in Q2 2010 compared to Q22009. Total expenses in Q2 2010 attributable to the railroad operationsremained relatively constant in comparison to Q2 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) that it acquired in December 2009.The company’s sales in Q2 2010 were composed of $4.3 million related toequipment and $1.8 million related to software solutions. In Q2 2010, 38% ofthe company’s sales were made to international customers. On June 30, 2010,FirstCity Denver ceased to have a controlling interest, but retained anoncontrolling interest and elevated economic interests, in the manufacturingsubsidiary. As such, on June 30, 2010, FirstCity Denver deconsolidated thebalance sheet accounts of this subsidiary and began to account for itsretained investment in the manufacturing entity using the equity-method ofaccounting. Consequently, FirstCity Denver will no longer report the individualrevenue and expense line-items of the manufacturing entity’s operations in itsconsolidated statement of operations (rather, FirstCity Denver will record itsshare of the subsidiary’s net earnings as “Equity in earnings of unconsolidatedsubsidiaries” beginning July 1, 2010).Refer to Note 3 to the consolidated financial statements included in Item 1 ofthis Form 10-Q for additional information on this transaction.

 

*Revenue and expenses from coalmine operations*.  Revenue and expenses from coal mineoperations represents 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) since April 1,2010 — the date FirstCity Denver increased its ownership interest and obtaineda controlling interest in the entity. The coal mine entity generates revenueunder a short-term coal sales contract with a major utility company. FirstCityDenver’s application of business combination accounting in connection withobtaining control of the coal mine subsidiary resulted in the recognition of anasset for the coal supply agreement and a liability for a coal purchaseagreement. 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). Refer to Note 3 to the consolidated financial statements included inItem 1 of this Form 10-Q for additional information on this transaction.

 

*Other income*.  Other income in Q2 2010 remainedrelatively constant in comparison to Q2 2009.

 

*Expenses —Other. *Otherexpense decreased by $0.3 million in Q2 2010 compared to Q2 2009 primarily dueto a $0.4 million decrease in net impairment provisions recorded in Q2 2010 onmiddle-market company debt investments. The impairment provisionswere identified in connection with management’s regular evaluation of thecollectibility of FirstCity Denver’s loan 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; andestimates that are susceptible to significant revision as more informationbecomes available.

 

*Equity in net earnings ofunconsolidated subsidiaries. *Equity in net earnings of unconsolidated subsidiaries totaled $1.8million in Q2 2010 and $0.6 million in lossesin Q2 2009 — which is composed primarily of FirstCity Denver’s equity earningsin its equity-method investments related to the coal mine operation andmultiple manufacturing concerns. In Q2 2010, FirstCity Denver’s share of netearnings in unconsolidated subsidiaries was composed primarily of $0.8 millionin earnings from its newly-obtained direct equity-method investment in a coal mineequipment subsidiary (refer to Note 3 to the consolidated financial statementsincluded in Item 1 of this Form 10-Q for additional information on thistransaction) and $1.1 million in earnings from manufacturing entities. For Q22009, FirstCity Denver’s equity in earnings attributable to the coal mine’soperations approximated $0.5 million; however, FirstCity Denver’s share of netearnings in the coal mine was off-set by its share ($1.1 million) of a one-timecharge incurred by the coal mine company in Q2 2009 to relinquish its futurereclamation liability. As discussed above, FirstCity Denver stopped accountingfor the coal mine operation under the equity-method of accounting effective April 1,2010 after it obtained a controlling interest in the subsidiary.

 

***First Six Months of 2010 Compared to FirstSix Months of 2009***

 

Netearnings to common stockholders totaled $8.2 million in the first six months of2010 (“YTD 2010”) compared to net earnings of $8.4 million in the first sixmonths of 2009 (“YTD 2009”). On a per share basis, diluted net earnings tocommon stockholders were $0.81 in YTD 2010 compared to $0.84 in YTD 2009.

 

*Portfolio Asset Acquisition and Resolution*

 

The operating contribution from the Portfolio AssetAcquisition and Resolution (“PAA&R”) segment resulted in a $6.1 millionoperating gain in YTD 2010 compared to a $12.1 million operating gain for YTD2009. FirstCity and its investment partners acquired 

 

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$159.7million of Portfolio Assets in YTD 2010 with an approximate Face Value of$285.5 million, compared to its involvement in acquiring $137.3 million ofPortfolio Assets in YTD 2009 with an approximate Face Value of $258.5 million.In YTD 2010, FirstCity’s investment share in Portfolio Asset acquisitions was$42.7 million — with $20.5 million acquired through consolidated Portfolios and$22.2 million through unconsolidated Portfolios. In YTD 2009, FirstCity’sinvestment share in the Portfolio Asset acquisitions was $113.5 million — primarilyacquired through consolidated Portfolios. In YTD 2010, FirstCity invested anadditional $23.5 million in non-portfolio investments in the form of SBA loanoriginations and advances, direct equity investments, and other loaninvestments, compared to $14.4 million ofadditional non-portfolio investments in the form of****SBAloan originations and advances, aswell as $11.2 million in direct equity investments (attributable primarily toEuropean entity acquisitions), in YTD 2009.

 

The following is a summary of the results of operationsfor the Company’s PAA&R business segment for YTD 2010 and YTD 2009:

 
| ** **                                                    | ** ** | **Six Months Ended**       | ** ** |
|---------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                    | ** ** | **June 30,**          | ** ** |
| ** **                                                    | ** ** | **2010**                   | ** ** | **2009** | ** ** |
| ** **                                                    | ** ** | **(Dollars in thousands)** | ** ** |
| **Portfolio Asset Acquisition and  Resolution:**              | ** ** | ** **                 |       |   |   |
| Revenues:                                                     |       |                       |       |   |   |
| Servicing fees                                                |       | $                          | 3,746      |   | $ | 4,795 |   |
| Income from Portfolio Assets                                  |       | 26,085                     |       | 23,120 |   |
| Gain on sale of SBA loans held for sale, net                  |       | 163                        |       | 610 |   |
| Gain on sale of investment securities                         |       | 3,250                      |       | — |   |
| Interest income from SBA loans                                |       | 581                        |       | 641 |   |
| Interest income from loans receivable - affiliates            |       | 936                        |       | 1,089 |   |
| Interest income from loans receivable - other                 |       | —                     |       | 414 |   |
| Other income                                                  |       | 1,774                      |       | 1,597 |   |
| Total revenues                                                |       | 36,535                     |       | 32,266 |   |
| Expenses:                                                     |       |                       |       |   |   |
| Interest and fees on notes payable                            |       | 6,937                      |       | 6,762 |   |
| Salaries and benefits                                         |       | 8,100                      |       | 7,521 |   |
| Provision for loan and impairment losses, net of  recoveries  |       | 3,158                      |       | 816 |   |
| Asset-level expenses                                          |       | 3,436                      |       | 2,350 |   |
| Other                                                         |       | 4,391                      |       | 3,021 |   |
| Total expenses                                                |       | 26,022                     |       | 20,470 |   |
| Equity in net earnings (loss) of unconsolidated  subsidiaries |       | 1,193                      |       | 855 |   |
| Gain on business combinations                                 |       | 891                        |       | 1,455 |   |
| Net income attributable to noncontrolling  interests          |       | (6,071                     | )          | (1,528 | ) |
| Operating contribution before direct taxes                    |       | $                          | 6,526      |   | $ | 12,578 |   |
| Operating contribution, net of direct taxes                   |       | $                          | 6,141      |   | $ | 12,054 |   |

 

*Servicing fee revenues. *Servicingfee revenues decreased to $3.7 million in YTD 2010 from $4.8 million in YTD2009. Servicing fees from domestic Acquisition Partnerships totaled $0.3million in YTD 2010 compared to $1.0 million in YTD 2009, while servicing feesfrom Latin American Acquisition Partnerships totaled $3.2 million in YTD 2010and $3.5 million in YTD 2009. Servicing fees from domestic AcquisitionPartnerships are generally based on a percentage of the collections receivedfrom Portfolio Assets held by these unconsolidated partnerships; whereasservicing fees from Latin American Acquisition Partnerships are generally basedon the cost of servicing plus a profit margin. The decline in servicing feesfrom domestic Acquisition Partnerships for YTD 2010 in comparison to YTD 2009was attributable primarily to a decline in collections from unconsolidateddomestic partnerships to $7.9 million for YTD 2010 compared to $14.4 millionfor YTD 2009. 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 Assetsincreased to $26.1 million in YTD 2010 compared to $23.1 million in YTD 2009.The increase in income from Portfolio Assets is attributed primarily to anincrease in FirstCity’s average investment in consolidated Portfolio Assets inits PAA&R segment increased to $214.7 million for YTD 2010 from $181.2million for YTD 2009. 

 

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Refer to Note 4 of the consolidated financial statementsincluded in Item 1 of this Form 10-Q 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 inYTD 2010 with a $2.1 million net basis in the loans sold, compared to a $0.6 million gain on the sales of SBAloans in YTD 2009 with a $13.2 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.

 

*Interest income from SBAloans. *Interestincome from SBA loans remained constant at $0.6 million for both YTD 2010 andYTD 2009.

 

*Interest income from loansreceivable — affiliates. *Interest income from loans receivable — affiliates decreased slightly to$0.9 million in YTD 2010 compared to $1.1 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 $12.1 million for YTD2010 compared to $14.1 million for YTD 2009.

 

*Interest income from loansreceivable — other. * Interest income from loans receivable— other decreased by $0.4 million for YTD 2010 compared to YTD 2009. Thedecline in interest income in YTD 2010 compared to YTD 2009 is attributable toFirstCity’s increased holdings in YTD 2010 of such loans accounted for underthe non-accrual method of accounting. FirstCity’s average investment in loansreceivable — other in its PAA&R segment was $5.3 million in YTD 2010 (allof which were accounted for under the non-accrual method during the entireperiod), compared to its average investment in such loans of $7.2 million inYTD 2009 (all of which were income-accruing loans during the entire period).

 

*Other income*.  Other income from the Company’sPAA&R segment remained relatively constant at $1.8 million in YTD 2010compared to $1.6 million in YTD 2009.

 

*Expenses. *Operatingexpenses approximated $26.0 million and $20.5 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 $6.9million for YTD 2010 and $6.8 million for YTD 2009. FirstCity’s averageoutstanding debt in its PAA&R segment increased to $294.1 million in YTD2010 from $274.3 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 in its PAA&R segment decreasedslightly to 4.7% in YTD 2010 compared to 4.9% in YTD 2009.

 

Salaries and benefits increased to $8.1 million in YTD2010 from $7.5 million in YTD 2009, due primarily to increased costs related tobase salaries, payroll taxes and employee benefits in the PAA&R segment inYTD 2010 compared to YTD 2009. The total number of personnel within thePAA&R segment was 207 and 209 at June 30, 2010 and 2009, respectively.

 

Netprovisions for loan and impairment losses on our consolidated Portfolio Assetsand loans receivable in our PAA&R segment totaled $3.2 million in YTD 2010and $0.8 million in YTD 2009. The $3.2 million of net impairment provisions inYTD 2010 were attributed primarily to declines in values of loan collateral andreal estate assets in our domestic loans and Portfolios, which was responsiblefor $2.6 million of the Company’s consolidated net provisions recorded in YTD2010. 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 illiquid markets, realestate value declines and the overall economic slowdown will ultimately have onour financial results. Therefore, we cannot provide assurance that, in anyparticular future period, we will not incur additional impairment provisions.

 

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 to $3.4 million in YTD 2010 from $2.4 million in YTD 2009. The increased level of expenses is attributedprimarily to the Company’s increased holdings in consolidated Portfolio

 

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Assets (the Company’s average investment in consolidatedPortfolio Assets in its PAA&R segment totaled $214.7 million for YTD 2010compared to $181.2 million for YTD 2009).

 

Other costs and expenses in the Company’s PAA&Rsegment increased to $4.4 million for YTD 2010 from $3.0 million for YTD 2009,due to $1.1 million of foreign currency exchange losses attributed to ourconsolidated foreign operations in YTD 2010 compared to $0.3 million of foreigncurrency exchange gains recognized in YTD 2009 — a $1.4 million unfavorableswing (attributed mainly to our consolidated European operations). The Eurocurrency weakened against the U.S. dollar in YTD 2010.

 

*Equity in earnings ofunconsolidated subsidiaries. *Equity in earnings of unconsolidated subsidiaries (AcquisitionPartnership and servicing entities) from our PAA&R segment increased by$0.3 million in YTD 2010 compared to YTD 2009. Equity in earnings of ourunconsolidated Acquisition Partnerships was $0.9 million in losses for YTD 2010compared to $1.2 million in earnings for YTD 2009, whereas equity in earningsof our unconsolidated servicing entities increased to $2.1 million of earningsin YTD 2010 compared to $0.4 million of losses in YTD 2009. The following is adiscussion of equity in earnings from FirstCity’s Acquisition Partnerships (bygeographic region) and servicing entities. Refer to Note 6 of the consolidatedfinancial statements included in Item 1 of this Form 10-Q for a summary ofrevenues, earnings and equity in earnings of FirstCity’s equity-methodinvestments by region.

 

·             *Domestic* — Totalrevenues reported by domestic Acquisition Partnerships decreased to $2.6million in YTD 2010 compared to $4.6 million in YTD 2009. In addition, total net earnings reported by domesticpartnerships decreased to $0.5 million in YTD 2010 compared to $1.4 million inYTD 2009. The decrease in total revenues and net earnings in YTD 2010compared to YTD 2009 was attributable primarily to a decrease in collections to$7.8 million in YTD 2010 from $14.4 million in YTD 2009; and a $1.9 milliondecline in interest and accretion income in YTD 2010 compared to YTD 2009 dueto 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 is not appropriate if management does not have the abilityto develop a reasonable expectation of both the timing and amount of futurecash flows to be collected. The collective activity described above translatedto a decrease in FirstCity’s share of domestic partnership earnings to $37,000for YTD 2010 from $0.5 million for YTD 2009. FirstCity’s average investment indomestic Acquisition Partnerships increased to $16.6 million for YTD 2010 from$14.4 million for YTD 2009, due primarily to increased investment activity bynewly-formed domestic Acquisition Partnerships under FirstCity’s investmentagreement with Värde.

 

·         *LatinAmerica* — Total revenues reported by Latin American Acquisition Partnershipsincreased to $10.3 million in YTD 2010 from $5.4 million in YTD 2009. However,the Latin American partnerships reported total net losses of $2.1 million in YTD 2010 compared to $1.0 millionYTD 2009. Total collections from Latin American partnerships increased to $16.1million in YTD 2010 compared to $11.9 million in YTD 2009. The increased netlosses reported by the Latin American partnerships in YTD 2010 compared to YTD2009 was due primarily to (1) a $2.7 million decrease in foreign currencyexchange gains recognized by these partnerships in YTD 2010 compared to YTD2009; (2) $1.9 million of additional net impairment provisions recorded inYTD 2010 compared to YTD 2009; and (3) $1.3 million of additional taxexpense recorded in YTD 2010 compared to YTD 2009. The collectiveactivity described above translated to a modest increase in FirstCity’s shareof earnings in Latin American partnerships to $45,000 in earnings for YTD 2010compared to $0.3 million in losses for YTD 2009.  FirstCity’s average investment in Latin American AcquisitionPartnerships remained relatively flat at $17.3 million for YTD 2010 compared to$17.8 million for YTD 2009.

 

·             *Europe*—****Total revenues reported by European AcquisitionPartnerships decreased to $2.5 million in YTD 2010 from $11.5 million in YTD2009. In addition, total net earnings reported by the European partnershipsdecreased sharply to $3.3 million in losses in YTD 2010 from $3.7 million inearnings for YTD 2009. The decrease in total partnership revenues and netearnings reported by the European partnerships was attributed primarily to a decreasein collections to $9.9 million in YTD 2010 compared to $15.4 million in YTD2009; off-set partially by a decrease in net impairment provisions to $2.6million in YTD 2010 from $3.6 million in YTD 2009. In addition, contributing tothe decline in European partnership revenues and net earnings was the decreasein Portfolio Asset holdings by these Acquisition Partnerships over the past twoyears (see paragraph below). The collective activity described above translatedto a decrease in FirstCity’s share of European partnership earnings to $1.0million in losses for YTD 2010 from $1.0 million in earnings for YTD 2009.

 

FirstCity’saverage investment in European Acquisition Partnerships decreased to $7.2million for YTD 2010 from $13.0 million for YTD 2009 — which contributed to adecline in FirstCity’s share of European partnership revenues as discussedabove. In light of FirstCity’sstep-acquisition transaction and resulting consolidation of sixteen Frenchentities (former 

 

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unconsolidated European Acquisition Partnerships) in May 2009,the Company expects income from consolidated Portfolio Assets to off-set thedecline in European partnerships revenues.

 

·             *ServicingEntities*—****Total revenuesreported by our foreign unconsolidated servicing entities increased to $28.2million in YTD 2010 from $23.7 million in YTD 2009, and total net earningsreported by these entities improved to $6.3 million in YTD 2010 from $0.7million of net losses in YTD 2009. The increase in net earnings reported by theunderlying servicing entities was attributed primarily to (1) additionalinvestment income of $4.0 million recorded in YTD 2010 compared to YTD 2009;and (2) a $2.2 million decrease in income tax provisions in YTD 2010compared to YTD 2009 as a result of our ability to recognize foreign taxbenefits associated with U.S. GAAP adjustments to an unconsolidated foreignservicing entity’s local financial statements, combined with the timing offederal income tax payments made by the foreign servicing entity in its localjurisdiction. The collective activity described above translated to an increasein FirstCity’s share of earnings from our servicing entities to $2.1 million inearnings for YTD 2010 from $0.4 million 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. Pursuant to business combination accountingstandards, 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. Pursuant to business combinationaccounting standards, the Company’s previously-held noncontrolling interests inthe French entities were re-measured to fair value on the acquisition date (May 2009)— which resulted in the Company’s recognition of the $1.5 million gain.

 

*Net income attributable tononcontrolling interests. *Noncontrolling interest expense represents the portion of net earnings thatis attributable to our co-investors in our majority-owned, consolidatedAcquisition Partnerships. The amount of net income attributable tononcontrolling interests increased to $6.1 million for YTD 2010 from $1.5million for YTD 2009. This increase is attributed to an increase in netearnings from these majority-owned, consolidated Acquisition Partnerships inYTD 2010 compared to YTD 2009 (i.e. an increase in the amount of net earningsreported by these majority-owned entities translates to an increase in theamount of net earnings apportioned to the noncontrolling investors).

 

***SpecialSituations Platform Business Segment***

 

Theoperating contribution from the Special Situations Platform business segment (“FirstCityDenver”) totaled $6.0 million in YTD 2010 compared to $0.2 million in YTD 2009.In YTD 2010, FirstCity Denver provided $12.9 million of investment capital toprivately-held middle-market companies in the form of debt and direct equityinvestments ($4.6 million financed through investee entity’s debt),compared to $5.6 million of investment capital provided to such companies inthe 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 in excess of $84.5 million, and has provided $56.7 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 forthe YTD 2010 and YTD 2009:

 
| ** **                                             | ** ** | **Six Months Ended**       | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|
| ** **                                             | ** ** | **June 30,**          | ** ** |
| ** **                                             | ** ** | **2010**                   | ** ** | **2009** | ** ** |
| ** **                                             | ** ** | **(Dollars in thousands)** | ** ** |
| **Special Situations Platform:**                       |       |                       |       |   |   |
| Revenues:                                              |       |                       |       |   |   |
| Interest income from loans receivable                  |       | $                          | 1,152      |   | $ | 1,152 |   |
| Operating revenue - railroad                           |       | 2,457                      |       | 1,452 |   |
| Operating revenue - manufacturing                      |       | 10,466                     |       | — |   |
| Operating revenue - coal mine                          |       | 13,100                     |       | — |   |
| Other income                                           |       | 837                        |       | 1,309 |   |
| Total revenues                                         |       | 28,012                     |       | 3,913 |   |
| Expenses - Railroad Operations:                        |       |                       |       |   |   |
| Interest and fees on notes payable                     |       | 74                         |       | 55 |   |
| Salaries and benefits                                  |       | 537                        |       | 479 |   |
| Other                                                  |       | 622                        |       | 492 |   |
| Total railroad expenses                                |       | 1,233                      |       | 1,026 |   |
| 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                     |       | 37                         |       | — |   |
| Salaries and benefits                                  |       | 67                         |       | — |   |
| Cost of sales                                          |       | 9,310                      |       | — |   |
| Amortization                                           |       | 3,461                      |       | — |   |
| Other                                                  |       | 420                        |       | — |   |
| Total coal mine expenses                               |       | 13,295                     |       | — |   |
| Expenses - Other:                                      |       |                       |       |   |   |
| Interest and fees on notes payable                     |       | 231                        |       | 231 |   |
| Salaries and benefits                                  |       | 740                        |       | 471 |   |
| Provision for loan and impairment losses               |       | 1,169                      |       | 967 |   |
| Other                                                  |       | 769                        |       | 924 |   |
| Total other expenses                                   |       | 2,909                      |       | 2,593 |   |
| Total expenses                                         |       | 28,225                     |       | 3,619 |   |
| Equity in net earnings of unconsolidated  subsidiaries |       | 2,852                      |       | 197 |   |
| Gain on business combinations                          |       | 4,838                      |       | — |   |
| Net income attributable to noncontrolling  interests   |       | (1,345                     | )          | (51 | ) |
| Operating contribution before taxes                    |       | $                          | 6,132      |   | $ | 440 |   |
| Operating contribution, net of direct taxes            |       | $                          | 5,978      |   | $ | 205 |   |

 

*Interest income from loansreceivable. * Interest income from loansreceivable in YTD 2010 remainedconstant in comparison to YTD 2009. FirstCity Denver’s average investment inloans receivable was $19.1 million for YTD 2010 — including $2.6 millionaccounted for under the cost recovery method. For YTD 2009, FirstCity Denver’saverage investment in loans receivable was $19.7 million.

 

*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 $1.0 

 

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millionin YTD 2010 compared to YTD 2009 dueto an increase in rail car movement services performed in the first six monthsof 2010. Total expenses in YTD 2010 attributable to the railroadoperations remained 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) that it acquired in December 2009.The company’s sales in YTD 2010 were composed of $6.7 million related toequipment and $3.8 million related to software solutions. In YTD 2010, 32% ofthe company’s sales were made to international customers. On June 30,2010, FirstCity Denver ceased to have a controlling interest, but retained anoncontrolling interest and elevated economic interests, in the manufacturingsubsidiary. As such, on June 30, 2010, FirstCity Denver deconsolidated thebalance sheet accounts of this subsidiary and began to account for itsretained investment in the manufacturing entity using the equity-method ofaccounting. Consequently, FirstCity Denver will no longer report the individualrevenue and expense line-items of the manufacturing entity’s operations in itsconsolidated statement of operations (rather, FirstCity Denver will record itsshare of the subsidiary’s net earnings as “Equity in earnings of unconsolidatedsubsidiaries” beginning July 1, 2010).Refer to Note 3 to the consolidated financial statements included in Item 1 ofthis Form 10-Q for additional information on this transaction.

 

*Revenue and expenses from coalmine operations*.  Revenue and expenses from coal mineoperations represents 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) since April 1,2010 — the date FirstCity Denver increased its ownership interest and obtaineda controlling interest in the entity. The coal mine entity generates revenueunder a short-term coal sales contract with a major utility company. FirstCityDenver’s application of business combination accounting in connection withobtaining control of the coal mine subsidiary resulted in the recognition of anasset for the coal supply agreement and a liability for a coal purchaseagreement. 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). Refer to Note 3 to the consolidated financial statements included inItem 1 of this Form 10-Q for additional information on this transaction.

 

*Other income*.  Other income in YTD 2010decreased by $0.5 million in comparison to YTD 2009 primarily due to $0.9million of gains recognized by FirstCity Denver’s railroad operations in YTD2009 in connection with property and equipment sales (no significant amounts ofgains on the sales of property and equipment were recognized in YTD 2010).

 

*Expenses —Other. *Otherexpense increased by $0.3 million in YTD 2010 compared to YTD 2009 primarilydue to $0.2 million of additional net impairment provisions recorded onmiddle-market company debt 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 loan 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; and estimates that are susceptible to significant revisionas more information becomes available.

 

*Equity in net earnings of in unconsolidatedsubsidiaries. *Equity in net earnings of unconsolidated subsidiaries totaled $2.9million in YTD 2010 and $0.2 million in YTD2009 — which is composed primarily of FirstCity Denver’s equity earnings in itsequity-method investments related to the coal mine operation and multiplemanufacturing concerns. In YTD 2010, FirstCity Denver’s share of net earningsin unconsolidated subsidiaries was composed primarily of $0.9 million inearnings from its former equity-method investment in a coal mine operation(FirstCity Denver consolidated this subsidiary effective April 1, 2010 —refer to discussion above), $0.8 million in earnings from its newly-obtained directequity-method investment coal mine equipment subsidiary (refer to Note 3 to theconsolidated financial statements included in Item 1 of this Form 10-Q foradditional information on this transaction), and $1.2 million in earnings frommanufacturing entities. For YTD 2009, FirstCity Denver’s equity in earningsattributable to the coal mine’s operations approximated $1.3 million; however,FirstCity Denver’s share of net earnings in the coal mine was off-set by itsshare ($1.1 million) of a one-time charge incurred by the coal mine company inYTD 2009 to relinquish its future reclamation liability.

 

**Financial Condition**

 

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

 

Consolidated assets of $466.0 million at June 30,2010 were $0.9 million higher than consolidated assets at December 31,2009. The increase in consolidated assets was attributed primarily to (1) a$20.1 million increase in equity-method investments due to increased investmentactivity in YTD 2010 attributed to existing and newly-formed AcquisitionPartnerships (primarily domestic); (2) a $6.2 million net increase inother assets attributed to the Company’s consolidation of a coal mine operationand deconsolidation of a 

 

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manufacturing subsidiary in YTD 2010 (refer to Note 3 tothe consolidated financial statements included in Item 1 of this Form 10-Qfor additional information on these transactions); and (3) a $6.9 millionnet increase in SBA loans held for sale due to increased loan originations andadvances in YTD 2010; off-set partially by (1) a $29.8 million decrease incash (refer to the consolidated statement of cash flows in Item 1 of this Form 10-Qfor additional information on cash changes); and (2) a $3.0 million netdecrease in the Company’s consolidated Portfolio Assets in YTD 2010.

 

Consolidated liabilities of $343.4 million as of June 30,2010 were $3.6 million higher than consolidated liabilities at December 31,2009. The increase in consolidated liabilities was attributed primarily to a$2.7 million net increase in other liabilities due to the Company’sconsolidation of a coal mine operation and deconsolidation of a manufacturingsubsidiary in YTD 2010 (refer to Note 3 to the consolidated financialstatements included in Item 1 of this Form 10-Q for additional informationon these transactions).

 

FirstCity’s reported amount of noncontrolling interests(included as a component of equity) decreased by $7.7 million since December 31,2009 primarily due to $17.5 million of distributions to noncontrollinginterests in YTD 2010, off-set partially by $7.4 million of net earnings and$5.1 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.

 

Portfolio Asset acquisitions by the Company for YTD 2010and the last five full fiscal years are as follows:

 
| ** **               | ** ** | **Purchase**               | ** ** | **FirstCity**  | ** ** |
|--------------------------|------------|----------------------------|------------|----------------|------------|
| ** **               | ** ** | **Price**                  | ** ** | **Investment** | ** ** |
| ** **               | ** ** | **(Dollars in thousands)** | ** ** |
| First six months of 2010 |       | $                          | 159,680    |           | $          | 42,727 |   |
| Total 2009               |       | 200,590                    |       | 147,654        |       |
| Total 2008               |       | 89,314                     |       | 72,307         |       |
| Total 2007               |       | 214,333                    |       | 126,714        |       |
| Total 2006               |       | 296,990                    |       | 144,048        |       |
| Total 2005               |       | 146,581                    |       | 71,405         |       |
|                          |            |                            |            |                |            |  |  |

 

The table below provides asummary of our loan Portfolio Assets as of June 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).

 

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| ** **                      | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2010**                   | ** ** | **2009**              | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| **Loan and Loan Pool Type**     |       |                       |       |                  |       |
| Purchased Credit-Impaired Loans |       |                       |       |                  |       |
| Domestic:                       |       |                       |       |                  |       |
| Commercial real estate          |       | $                          | 133,563    |                  | $          | 138,485 |   |
| Business assets                 |       | 22,452                     |       | 26,983                |       |
| Other                           |       | 7,038                      |       | 3,906                 |       |
| Latin America                   |       | 10,251                     |       | 10,545                |       |
| Europe                          |       | 7,191                      |       | 13,001                |       |
| UBN loan portfolio:             |       |                       |       |                  |       |
| Non-performing loans            |       | 46,730                     |       | 60,929                |       |
| Performing loans                |       | 1,018                      |       | 1,555                 |       |
| Other                           |       | 6,523                      |       | 8,367                 |       |
| Outstanding balance             |       | 234,766                    |       | 263,771               |       |
| Allowance for loan losses       |       | (45,719                    | )          | (65,825               | )          |
| Carrying amount, net            |       | $                          | 189,047    |                  | $          | 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                               |       | 1,485                                |       | 142          |       | 87         |       | 117 |   | 368 |   | — |   | 126 |   | 2,325 |   |
| Recoveries                               |       | (70                                  | )          | —       |       | (7         | )          | — |   | — |   | (382 | ) | (1 | ) | (460 | ) |
| Charge  offs                             |       | (7,196                               | )          | (260         | )          | (434       | )          | — |   | (243 | ) | (2,955 | ) | (321 | ) | (11,409 | ) |
| Translation  adjustments                 |       | —                               |       | —       |       | —     |       | — |   | (48 | ) | (10,514 | ) | — |   | (10,562 | ) |
| Ending  Balance, June 30, 2010      |       | $                                    | 133        |         | $          | 276        |       | $ | 36 |   | $ | 217 |   | $ | 205 |   | $ | 44,773 |   | $ | 79 |   | $ | 45,719 |   |

 

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-accrualmethod of accounting (cost-recovery or cash basis) increased to $179.1 millionat June 30, 2010 from $138.4 million at December 31, 2009. Under U.S.GAAP, the interest method (i.e. accrual method) of accounting is notappropriate if management does not have the ability to develop a reasonableexpectation of both the timing and amount of future cash flows to be collected.Refer to Note 1 of the consolidatedfinancial statements included in Item 1 of this Form 10-Q for additionalinformation and accounting policies related to our Purchased Credit-ImpairedLoans. The following tables provide a summary of the Company’s PurchasedCredit-Impaired Loans by income-recognition method as of June 30, 2010 andDecember 31, 2009 (dollars in thousands):

 
| ** **     | ** ** | **June 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** | ** ** | **Real  Estate** | ** ** | **Total** | ** ** |
| United  States |       | $                          | 527        |   | $ | 4,760 |   | $ | 105,765 |   | $ | 56,316 |   | $ | 1,685 |   | $ | — |   | $ | 32,339 |   | $ | 201,392 |   |
|           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| France         |       | —                     |       | 1,018 |   | 4,068 |   | 7 |   | — |   | 1,957 |   | — |   | 7,050 |   |
|           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Germany        |       | —                     |       | — |   | 2,911 |   | — |   | — |   | — |   | — |   | 2,911 |   |
|           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Mexico         |       | —                     |       | — |   | — |   | 10,033 |   | — |   | — |   | — |   | 10,033 |   |
|           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total**      |       | $                          | 527        |   | $ | 5,778 |   | $ | 112,744 |   | $ | 66,356 |   | $ | 1,685 |   | $ | 1,957 |   | $ | 32,339 |   | $ | 221,386 |   |

 

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| ** **     | ** ** | **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** | ** ** | **Real  Estate** | ** ** | **Total** | ** ** |
| United  States |       | $                           | 42,385     |   | $ | 5,323 |   | $ | 42,125 |   | $ | 78,165 |   | $ | 2,770 |   | $ | — |   | $ | 26,438 |   | $ | 197,206 |   |
|           |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 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 |   | $ | 26,438 |   | $ | 224,384 |   |

 

**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 unconsolidated investmentsaccounted for under the equity-method of accounting.

 

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 six months of 2010   |       | $              | 13,416     |                                   | $          | 8,650 |   | $ | 4,247 |   | $ | 12,897 |   |
| 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 thenon-U.S. jurisdictions in which we operate,  under the asset and liability method. Deferred tax assets andliabilities are recognized based on the future tax consequences attributable totemporary differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and operatingloss and tax credit carryforwards. Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. We reduce the carrying amounts of deferred tax assets by a valuationallowance if, based on the available evidence, it is more likely than not thatsuch assets will not be realized. Accordingly, the need to establish valuationallowances for deferred tax assets is assessed periodically by the Companybased on the more-likely-than-not realization threshold criterion. In theassessment, appropriate consideration is given to all positive and negativeevidence related 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 June 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.

 

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**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 investments, repayments of bank borrowings andother debt, and working capital to support our growth. Historically, ourprimary sources of liquidity have been funds generated from operations(primarily loan collections and service fees), equity distributions from theAcquisition Partnerships and other subsidiaries, interest and principalpayments on subordinated intercompany debt, dividends from the Company’ssubsidiaries, borrowings from credit facilities with external lenders, andother special-purpose short-term borrowings.

 

Cash generated from ouroperations and investments is dependent primarily upon our ability to collecton our consolidated Portfolio Assets (and Portfolio Assets in our AcquisitionPartnerships) and loan investments. Many factors, including general economicconditions, are essential to our ability to generate cash flows. Fluctuationsin our collections, investment income, credit availability, and adverse changesin other 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 PortfolioAsset Acquisition and Resolution and Special Situations Platform businesssegments through our credit facility commitments with our external lenders. Asdiscussed below, the Company refinanced its credit facilities with its primaryexternal lender, and executed an investment agreement with a privately-held,registered investment firm.

 

*Credit Facilities Renewal withBank of Scotland and BoS(USA) (collectively, “Bank of Scotland”)*

 

As reported in our June 30,2010 news release and in our Current Report on Form 8-K filed with the SECon July 1, 2010, FirstCity and Bank of Scotland reached agreement andclosed on a $268.6 million Reducing Note Facility Agreement (“Reducing NoteFacility”) that allows for repayment to Bank of Scotland over time as cashflows from the underlying assets securing the loan facility are realized. TheCompany’s outstanding indebtedness and existing letter of credit obligationsunder its then-existing loan facilities with Bank of Scotland were refinancedinto the Reducing Note Facility. Refer to ***Credit Facilities***below for the primary terms of this note facility.

 

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

 

Asreported in the June 30, 2010 news release and Current Report on Form 8-Kfiled with the SEC on July 1, 2010 mentioned above, FirstCity and Värdeentered into an Investment Agreement, effective April 1, 2010, wherebyVärde may invest up to $750 million, at its discretion, alongside FirstCity indistressed loan portfolios and similar investment opportunities, subject to theterms and conditions contained in the agreement. The primary terms of theInvestment 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 and performanceof the portfolios acquired).

 

Thecash flows from the assets and equity interests from the Company’s investments madein connection with the Investment Agreement, which are held by FC InvestmentHoldings Corporation and its subsidiaries, are not subject to the securityinterest requirements of Bank of Scotland’s Reducing Note Facility describedabove.

 

Webelieve that the Investment Agreement in place with Värde, combined with (1) thecash leak-through and overhead allowanceprovisions included in Bank of Scotland’s Reducing Note Facility (describedabove); (2) our estimates of residual cash flows from the pledged assetsand equity investments after full repayment of the Bank of Scotland debt; and(3) our current holdings of unencumbered cash and portfolio assets, willprovide FirstCity with additional funding and liquidity to support itsoperations and investment activities.

 

***Consolidated Statements ofCash Flows***

 

The following is an analysisof the cash flows related to FirstCity’s consolidated operations for thesix-month periods ended June 30, 2010 and 2009:

 

Our operating activitiesused cash of $16.9 million and provided cash of $2.6 million for the six-monthperiods ended June 30, 2010 and 2009, respectively. For the six-monthperiod ended June 30, 2010, net cash used in operations was attributableprimarily to $8.9 million of net principal advances on SBA loans held for sale;$26.1 million of non-cash deductions for income accretion and gains onPortfolio Assets; $4.0 million of non-cash deductions for equity earnings fromequity-method investments; and $9.0 million of non-cash deductions attributedto gains recognized on business combination transactions and the sale of aninvestment security — off-set partially by $15.6 million of net earnings; $2.3million of proceeds from SBA loan sales; $2.1 million of proceeds applied toincome from Portfolio Assets; and $10.1 million of non-cash add-backs relatedto provisions for loan and impairment losses, depreciation and amortization(including $3.5 million of net amortization attributable to the coal supply andcoal purchase contracts on the balance sheet of our consolidated coal minesubsidiary). Net cash provided by operations for the six-month period endedJune 30, 2009 was attributable primarily to $10.0 million of net earnings;$13.8 million of proceeds from SBA loan sales; $10.5 million of proceedsapplied to income from Portfolio Assets; and $3.8 million of non-cash add-backsrelated to provisions for loan and impairment losses, depreciation andamortization — off-set partially by $11.4 million of net principal advances onSBA loans held for sale; $1.1 million of non-cash deductions for equityearnings from equity-method investments; and $2.4 million non-cash deductionsattributed to gains recognized on a business combination transaction and salesof property and equipment. The remaining changes in the periods were dueprimarily to net changes in other accounts related to our operating activities.

 

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Our investing activitiesprovided cash of $13.8 million and used cash of $66.1 million for the six-monthperiods ended June 30, 2010 and 2009, respectively. For the six-monthperiod ended June 30, 2010, net cash provided by investing activities wasattributable primarily to $43.6 million of principal collections on PortfolioAssets (net of purchases); $4.5 million of distributions from our equity-methodinvestments; and $3.3 million of proceeds from the sale of an investmentsecurity — off-set partially by $30.9 million of contributions to ourequity-method investments; $2.9 million of net advances and originations forloan investments; $1.6 million paid for business combinations (net of cashacquired); and $0.9 million reduction in cash attributed to the deconsolidationof our manufacturing subsidiary. Net cash used in investing activities for thesix-month period ended June 30, 2009 was attributable primarily to $63.3million of Portfolio Assets purchases (net of principal collections); $3.6million of net advances and originations for loan investments; $7.1 millionpaid for a business combination (net of cash acquired); $1.4 million ofproperty and equipment purchases; and $1.2 million of contributions to ourequity-method investments — off-set partially by $7.0 million of distributionsfrom our equity-method investments; $2.2 million of principal payments on aninvestment security; and $1.4 million of proceeds from property and equipmentsales. The remaining changes in the periods were due primarily to net changesin other accounts related to our investing activities.

 

Our financing activitiesused cash of $26.6 million and provided cash of $69.6 million for the six-monthperiods ended June 30, 2010 and 2009, respectively. For the six-monthperiod ended June 30, 2010, net cash used in financing activities wasattributable primarily to $17.2 million of principal payments on notes payableand loan fee payments (net of borrowings), and $17.5 million of distributionsto noncontrolling interests — off-set partially by $4.6 million ofcontributions from noncontrolling interests primarily to acquire PortfolioAssets through consolidated subsidiaries; $1.0 million of proceeds from theissuance of common stock; and $2.6 million of proceeds from secured borrowings relatedto SBA loan sale transactions (net of principal repayments). Net cash providedby financing activities for the six-month period ended June 30, 2009 wasattributable primarily to $52.4 million of net borrowings to finance ourPortfolio Asset acquisitions and other investments (net of principal repaymentsand loan fee payments), and $22.3 million of contributions from noncontrollinginterests primarily to acquire Portfolio Assets through consolidatedsubsidiaries — off-set partially by $2.2 million of distributions tononcontrolling interests and $2.8 million of cash paid to acquire subsidiaryshares in noncontrolling interests. The remaining changes in the periods weredue primarily to net changes in other accounts related to our financingactivities.

 

Cash paid for interestexpense approximated $4.8 million and $4.9 million for the six-month periodsended June 30, 2010 and 2009. Substantially all of our interest expensewas paid on our credit facilities and other borrowings. FirstCity’s average outstanding debt increased to $305.5 million for thefirst six months of 2010 from $285.3 million for the first six months of 2009,while the average cost of borrowings decreased to 4.8% in 2010 compared to 5.0%in 2009. The increase in the Company’s debt level since June 30,2009 is a result of increased net borrowings to finance the Company’s growthand investment transactions.

 

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

 

The following is an analysisof the cash flows related to FirstCity’s majority-owned railroad and coal minesubsidiaries for the six-month periods ended June 30, 2010 and 2009, asapplicable. The cash flow effects described below are included in the Company’sanalysis of its consolidated cash flows for the six-month periods ended June 30,2010 and 2009, as applicable, as discussed above. The cash flows related toFirstCity’s majority-owned manufacturing subsidiary were not material to theCompany’s consolidated cash flows.

 

Railroad Operations Statementsof Cash Flows

 

The following is an analysisof the cash flows related to FirstCity’s majority-owned railroad operation forthe six-month periods ended June 30, 2010 and 2009. All significantintercompany balances and transactions have been eliminated in consolidation.

 

The operating activities ofthe railroad subsidiary provided cash of $1.5 million for the first six monthsof 2010, attributable primarily to $1.2 million of net earnings. The railroadsubsidiary’s investing activities used cash of $0.6 million for 2010,attributable to property and equipment purchases. The railroad subsidiary’sfinancing activities used cash of $0.4 million for 2010, attributable to $0.2million of principal payments on a bank note payable and $0.2 million ofdistributions to the noncontrolling equity owners and FirstCity (eliminated inconsolidation).

 

The operating activities ofthe railroad subsidiary provided cash of $0.9 million for the first six monthsof 2009 — attributable primarily to $1.3 million of net earnings and a $0.7million increase in other liabilities; off-set partially by a $1.1 millionnon-cash deduction related to gains recognized from property and equipmentsales. The railroad subsidiary’s investing activities provided cash of $0.3million for 2009 — attributable to $1.5 million of proceeds from property andequipment sales; off-set by $1.2 million of property and equipment purchases.The railroad subsidiary’s financing activities used cash of $1.3 million for2009, attributable primarily to $1.4 million of payments to the noncontrollingequity owners and FirstCity (parent company) through distributions andprincipal repayments on a capital note (eliminated in consolidation).

 

Coal Mine OperationsStatement of Cash Flows

 

The following is an analysisof the cash flows related to FirstCity’s majority-owned coal mine operation forthe three-month period ended June 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 $2.4 million for the three-monthperiod ended June 30, 2010 — attributable primarily to a$1.0 million increase in other liabilities and a $3.5 million non-cash add-backfor amortization; off-set partially by $0.3 million of net losses and a $1.7million decrease in other assets. The financing activities of the coal minesubsidiary used $2.2 million of cash for the three-month period ended June 30,2010, attributed primarily to $0.5 million of principal repayments no a notepayable and $1.6 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 from investing activities during the three-month periodended June 30, 2010.

 

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***Credit Facilities***

 

FirstCityCommercial Corporation (“FC Commercial”) and FH Partners LLC (“FH Partners”),as borrowers, and FLBG Corporation (“FLBG Corp.”), as guarantor, all of whichare wholly-owned subsidiaries of FirstCity, have a $268.6 term note facility (“ReducingNote Facility”) with Bank of Scotland. The Reducing Note Facility amended andrestated the following loan facilities previously provided by Bank of Scotlandto FirstCity and FH Partners: (a) Revolving Credit Agreement datedNovember 12, 2004, as amended, to FirstCity ($225.0 million loanfacility); (b) Revolving Credit Agreement dated August 26, 2005, asamended, to FH Partners ($100.0 million loan facility); and(c) Subordinated Delayed Draw Credit Agreement dated September 5,2007, as amended, to FirstCity ($25.0 million loan facility) (collectively, “ExistingCredit Agreements”). The Existing Credit Agreements were guaranteed bysubstantially all of the wholly-owned subsidiaries of FirstCity and secured bysubstantially all of the assets of FirstCity and its wholly-owned subsidiaries.The outstanding indebtedness and existing letter of credit obligations underthe Existing Credit Agreements in the amount of $268.6 million were refinancedinto the Reducing Note Facility, which provides for a scheduled amortizationover 3 years ($43.6 million in the first year, $80.0 million in the secondyear, $60.0 million in the first nine months of the third year, and $85.0million due on June 25, 2013, the maturity date).

 

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

 

·                  FirstCity provides a limited guaranty for therepayment 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 loan facility,except for draws on outstanding letters of credit in the amount of $22.35million which are included in the amount of the loan facility;

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

·                  Provides for a fluctuating interest rateequal to, at FC Commercial’s option, either (a) the greater of(i) one month *London Interbank OfferingRate*(“LIBOR”) plus 3.5% (subject to LIBOR floor of 1.0%) or(ii) 4.5%, or (b) Bank of Scotland’s prime rate plus 3.0%;

·                  Allows FC Commercial and FH Partners todesignate a portion of the debt under the Reducing Note Facility to be borrowedin Euros up to a maximum amount of Euros equivalent to USD $27.5 million;

·                  Requires FirstCity to maintain a minimumtangible net worth (as defined) requirement of $60.0 million; and

·                  Provides for an upfront fee to be paid toBank of Scotland in the amount of $2.0 million, payable as follows: $0.7million paid on March 26, 2010 (in connection with an extension of theExisting Credit Facilities), $0.7 million on June 25, 2010, and paymentsof $0.2 million from the cash flow of the pledged assets on the first day ofJuly, August, September and 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 Existing 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 Existing 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, 

 

62

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certainother indebtedness, certain events of bankruptcy and insolvency, and failure topay certain judgments. In the event that an event of default occurs and iscontinuing, Bank of Scotland may accelerate the indebtedness under the ReducingNote Facility. At June 30, 2010, FC Commercial and FH Partners were incompliance with all covenants or other requirements set forth in the ReducingNote Facility or related agreements.

 

FirstCity has $23.2 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, aMexican affiliate of FirstCity, has a term note with Banco Santander, S.A. withan unpaid principal balance of 142,240,000 Mexican pesos at June 30, 2010,which was equivalent to $11.2 million U.S. dollars on that date. The loanproceeds are 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 June 30, 2010,FirstCity had a letter of credit in the amount of $12.6 million from Bank ofScotland under the terms of FirstCity’s revolving acquisition facility withBank of Scotland. In the event that a demand is made under the $12.6million letter of credit, FirstCity would be required to reimburse Bank ofScotland by making payment to Bank of Scotland for all amounts disbursed or tobe disbursed by Bank of Scotland under the letter of credit.

 

*Wells Fargo Foothill, LLC*

 

At June 30, 2010, ABLhad a $25.0 million revolving loan facility with Wells Fargo Capital Finance (“WFCF”)for the purpose of financing and acquiring SBA loans. This credit facilitymatures in January 2012 and is secured by substantially all of the assetsof ABL. In addition, FirstCity provides WFCF with an unconditionalguaranty for all of ABL’s obligations up to a maximum of $5.0 million plusenforcement costs. The primary terms and key covenants of this loan facilityare described in our 2009 Form 10-K. At June 30, 2010, ABL was incompliance with all covenants or other requirements set forth in the creditagreement 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 June 30, 2010 and December 31, 2009.

 

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| ** **                                                                                                                 | ** ** | ** **                                                                                                                                                  | ** ** | ** **                                                                                                                                                                                   | ** ** | **Outstanding**             | ** **    | **Outstanding**       | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|---------------|-----------------------|------------|
| ** **                                                                                                                 | ** ** | ** **                                                                                                                                                  | ** ** | ** **                                                                                                                                                                                   | ** ** | **Borrowings**              | ** **    | **Borrowings**        | ** ** |
| ** **                                                                                                                 | ** ** | ** **                                                                                                                                                  | ** ** | ** **                                                                                                                                                                                   | ** ** | **as  of**                  | ** **    | **as  of**            | ** ** |
| ** **                                                                                                                 | ** ** | ** **                                                                                                                                                  | ** ** | ** **                                                                                                                                                                                   | ** ** | **June 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 $23.2 million denominated in  Euros at June 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 Commerical Corp. and FH  Partners LLC and guaranteed by FirstCity up to $75.0 million, matures  June 2013      | ** ** | $                           | 244,759       | ** **            | $          | — | ** ** |
| ** **                                                                                                                 |       |                                                                                                                                                        |       |                                                                                                                                                                                         | ** ** | ** **                  | ** **    | ** **            | ** ** |
| 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                                                                                          |       | 15,420                      |          | 10,694                |       |
|                                                                                                                       |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       |                        |          |                  |       |
| Banco  Santander term loan 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                                                                              |       | 11,040                      |          | 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                                                                                           |       | 2,904                       |          | 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.                                                                                                                                                |       | 12,171                      |          | —                |       |
|                                                                                                                       |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       |                        |          |                  |       |
| Merrill  Lynch Mortgage Trust term loan                                                                                    |       | 6.07%  fixed                                                                                                                                                |       | Secured by assets of  Oregon Short Line Building, matures April 2016                                                                                                                    |       | 7,398                       |          | 7,452                 |       |
|                                                                                                                       |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       |                        |          |                  |       |
| B.E.S.V.  term loan 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                                                                                                              |       | 5,788                       |          | 5,433                 |       |
|                                                                                                                       |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       |                        |          |                  |       |
| Other  notes and participations payable                                                                                    |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       | 5,686                       |          | 2,012                 |       |
|                                                                                                                       |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       |                        |          |                  |       |
|                                                                                                                       |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       | 305,561                     |          | 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                                                                                                                     |       | 7,760                       |          | 7,838                 |       |
|                                                                                                                       |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       |                        |          |                  |       |
| **Total notes payable**                                                                                                    |       |                                                                                                                                                        |       |                                                                                                                                                                                         |       | $                           |  313,321 |                  | $          |  313,726 |   |

 

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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 nothistorical facts. In this context, words such as “anticipates,” “believes,” “expects,”“estimates,” “plans,” “intends,” “could,” “should,” “will,” “may” and similarwords or expressions are intended to identify forward-looking statements andare not historical 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.

 

65

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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.**

 

OnJune 29, 2010, we issued and sold 150,000 shares of our common stock toVärde Investment Partners L.P. pursuant to the terms of a securities purchaseagreement at a per share price of $5.93, resulting in aggregate proceeds to usof $889,500.

 

Theissuance and sale of common stock described above was made in reliance uponexemptions from registration afforded by Section 4(2) of theSecurities Act of 1933 and Rule 506 of Regulation D as promulgated by theUnited States Securities and Exchange Commission under the Securities Actrelating to sales by an issuer not involving any public offering, to the extentan exemption from such registration was required.

 

Nounderwriters were involved in the issuance and/or sale of the foregoingsecurities. All of the foregoing securities are deemed restricted securitiesfor purposes of the Securities Act. All certificates representing the issuedshares of common stock described above included appropriate legends settingforth that the securities have not been registered and the applicablerestrictions on transfer.

 

**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**                                                                                                                                                                                                                                                                                                      |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                                                  |
| 10.57*              | —     | Reducing Note Facility  Agreement, dated June 25, 2010, among FirstCity Financial Corporation  and FH Partners LLC, as Borrowers, FLBG Corporation, as Guarantor, Bank of  Scotland plc and BoS(USA), Inc., as Lenders, and Bank of Scotland plc,  acting through its New Your Branch, as Agent and Collateral Agent                        |
|                |       |                                                                                                                                                                                                                                                                                                                                                  |
| 10.58*              | —     | Limited Guaranty  Agreement, dated June 25, 2010, by FirstCity Financial Corporation, as  Guarantor, in favor of Bank of Scotland plc, acting through its New York  Branch, as Agent, for the benefit of Bank of Scotland plc and BoS(USA), Inc.,  as Lenders and parties to the Reducing Note Facility Agreement dated June 25,  2010 |
|                |       |                                                                                                                                                                                                                                                                                                                                                  |
| 10.59*              | —     | Form of Investment  Agreement, dated June 29, 2010, by and between FC Diversified Holdings  LLC and FirstCity Servicing Corporation and Värde Investment Partners, L.P. (confidential treatment has been  requested for this exhibit and confidential portions have been filed with the  Securities and Exchange Commission)           |
|                |       |                                                                                                                                                                                                                                                                                                                                                  |
| 10.60*              | —     | Securities Purchase  Agreement, dated June 29, 2010, by and among FirstCity Financial  Corporation and Värde Investment  Partners, L.P.                                                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                  |
| 10.61*              | —     | Form of Restricted Stock  Award Agreement under the FirstCity Financial Corporation 2010 Stock Option  and Award Plan                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                  |
| 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.

 

67

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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: August 16, 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 Officer)* |

 

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